I have said that economies are normally "supply-constrained", but that right now many economies are "demand-constrained". Other economists make a similar distinction. Whether an economy is supply- or demand-constrained makes a very big difference to the sorts of policies that work. A policy which increases supply won't work in an economy that is demand-constrained. A policy which increases demand won't work in an economy that is supply-constrained.
What does this distinction mean? And how can we tell whether an economy is demand-constrained or supply-constrained? What precisely is so abnormal about economies in the current financial crisis? Why might expansionary fiscal policy be a good idea now, but normally a bad idea? How can we know this?
It's not as easy as it sounds. The distinction means something very different in macro than in micro. There's a short-run vs. long-run distinction. And when we move away from perfect competition, an economy may be supply-constrained, but look as if it's demand-constrained.
Demand is the quantity people want to buy; supply is the quantity people want to sell. Then there is the actual quantity traded (bought and sold). You (normally) can't force someone to buy something they don't want to; and you can't force someone to sell something they don't want to; but if both buyer and seller want to, the goods are traded. This means that quantity traded is the minimum of: {quantity demanded, and quantity supplied}. Whichever is less, demand or supply, determines the actual quantity of goods traded. (This is called "the short-side rule".)
In microeconomics, the demand curve for apples slopes down, and the supply curve for apples slopes up. In competitive equilibrium, at the price where the two curves cross, quantity traded=quantity demanded=quantity supplied.
If the price of apples is above the competitive equilibrium, there is excess supply, and the quantity of apples is demand-constrained. If the price of apples is below the competitive equilibrium, there is excess demand, and the quantity of apples is supply-constrained. If the price adjusts to competitive equilibrium, the market for apples is both demand-constrained and supply-constrained.
If the market for apples is both demand-constrained and supply-constrained, it sounds as though you need both demand-side and supply-side policies to get an increase in the quantity of apples traded. But of course that isn't true. An increase in demand (shift the curve right) will cause an increase in price, and a movement along the supply curve, increasing quantity supplied. An increase in supply (shift the curve right) will cause a decrease in price, and a movement along the demand curve, increasing quantity demanded.
So if you want to increase the quantity of apples traded, and the price adjusts to competitive equilibrium, either a demand-side or a supply-side policy would work.
If either would work in micro, why wouldn't either work in macro?
The big difference is that the macro Long Run Aggregate Supply curve is assumed to be vertical.
An increase in demand for apples, relative to other goods, will cause an increase in the price of apples, relative to other goods, and an increase in the resources used to produce apples, which are diverted away from producing other goods. The supply curve for apples is not vertical.
Macroeconomists typically assume a vertical LRAS curve, because they believe the economy as a whole behaves very differently from each of its parts. An increase in aggregate demand (for all goods) will cause an increase in price of all goods, but will not increase the amount of resources used to produce all goods, at least not in the long run.
So, with a vertical LRAS curve, a macroeconomy is supply-constrained in the long run. Demand-side policies will not work; they only increase the price level, not real output. It would be exactly the same in microeconomics if we assumed the supply curve for apples was vertical. Only supply-side policies will increase output.
So, what's different about today's economy? Why are so many economists, who make the standard assumption about a vertical LRAS curve, advocating demand-side policies?
It's not because they have suddenly changed their minds about the vertical LRAS curve.
It's not because they have suddenly become much more impatient and decided to care more about the short run than the long-run consequences of policies.
Partly it's because most economists see a role for counter-cyclical demand-side policies, which increase aggregate demand in a recession, and reduce it in a boom, to try to keep output closer to the LRAS curve. We advocate increasing aggregate demand now, and will advocate decreasing aggregate demand in any future boom. Normally we would rely on monetary policy and automatic fiscal stabilisers to do this, but we might consider discretionary fiscal policy now if we believe that central banks have run out of ammunition. All of this assumes, of course, that the Short-Run Aggregate Supply curve is not vertical. And that's what we assume, and the usual explanation is that nominal prices and/or wages take time to adjust to the long-run equilibrium.
All the above is standard macroeconomics.
But that can't be the whole story of what's different now. Since the economy is almost never exactly on the LRAS curve, about half the time we will have lower output than LRAS, and will want to increase aggregate demand. Is this month really no different from 49% of all the other months? What's all the fuss about?
Part of the fuss is about central banks running out of ammunition. We are confident about the effect of orthodox monetary policy (lowering and raising interest rates) on aggregate demand in normal times. We are less confident about the efficacy of orthodox monetary policy when financial markets are in crisis. And when central banks have already cut interest rates as far as they can, we are less confident in the efficacy of unorthodox monetary policy and fiscal policy.
Fiscal policy is like getting grandfather's musket down out of the attic, where we locked it away to stop the kids (politicians, or perhaps ourselves) playing with it. It's an ugly, unreliable, inaccurate, slow, dangerous, weapon to use, and nobody can remember how the damned thing works. And unorthodox monetary policy is a new weapon that looks good, but hasn't been tested.
But most of the fuss is due to a fear of failing to get back to the LRAS curve, at least in a reasonable time.
In a normal recession (and by "normal recession" I only mean "output below LRAS", not some arbitrary "technical" definition, like 2 quarters of declining output), where inflation is forecast to fall below its average or target level, the central bank cuts its interest rate just enough to bring expected future inflation back to target in about 2 years. Having cut the interest rate, the bank is equally afraid that it has cut too much as that it has cut too little. If it cuts too little, output will be less than LRAS. If it cuts too much, output will be more than LRAS.
So in a normal recession, where we are confident that demand-side policies will be implemented and will work, the economy is still supply-constrained. The Canadian economy is normally supply-constrained because the Bank of Canada makes sure it is supply-constrained. Even in a recession, a increase in demand for some goods will cause 100% crowding out of demand for other goods, because the Bank of Canada will make sure it does. The Bank will cut interest rates by less than it would otherwise have done, to ensure output does not exceed LRAS, and future inflation does not exceed the target. Resources are still scarce; goods have opportunity costs; even in recession, once we recognise the endogeneity of monetary policy.
What's different this time is the fear that the demand-side policies will not be powerful enough.
If you believe the economy is demand-constrained, rather than supply-constrained, what you are saying is that you believe that current monetary and fiscal policies, plus any automatic self-equilibrating forces, will not be sufficient to get the economy back to the LRAS curve.
How could you know? If the economy were perfectly competitive, it would be easy to know. If there is excess supply of goods and resources ("involuntary unemployment"), it is demand-constrained. If there is excess demand of goods and resources ("labour shortage"), it is supply-constrained.
But the economy is not perfectly competitive. Macroeconomists have needed to replace the assumption of perfect competition with imperfect competition. A perfectly competitive firm in equilibrium will not want to sell more output at the given equilibrium price. A monopolistically competitive firm in equilibrium will want to sell more output at the given equilibrium price, because price exceeds marginal cost. Similarly, in a labour market with monopolists unions, workers will want to sell more labour at the given equilibrium wage.
Excess supply is a normal feature of an imperfectly competitive economy in long-run macroeconomic equilibrium. Each individual firm and worker may be demand-constrained, but the economy in aggregate is supply-constrained in the long run. Faced with an increase in aggregate demand, with prices and/or wages fixed in the short run, there will be a temporary increase in output and employment. But in the long run, each individual firm and union will want to raise its price or wage relative to other prices and wages. They can't, of course, but the attempt by each to do this will results in ever-accelerating inflation as long as aggregate demand exceeds LRAS.
You can't tell if output is less than LRAS just by looking for excess supply in individual markets. You can only tell in hindsight, by looking to see if inflation accelerated past the target. Looking forward, you can only use judgment.
So if you say the economy is demand-constrained, what you are saying is that your judgment on future inflation is better than the Bank of Canada's judgment. You might be right of course. Or you are saying that the Bank of Canada has run out of ammunition, and is unable to do what it sees as necessary to stop inflation falling below target. And that your judgment is better than the government's judgment when it chose fiscal policy. Again you might be right of course. Or you are saying that the government is unable (perhaps because of fear of deficits on future debt) to do what it sees as necessary to stop inflation falling below target.
Of course, if we didn't have a monetary or fiscal stimulus, then the Canadian economy almost certainly would be demand-constrained. That's why we have the expansionary monetary and fiscal policies. But now we have them, and if the judgment of monetary and fiscal authorities is correct, and at least one of them is free to choose a more expansionary policy if it were judged to be needed, the economy is once again supply-constrained.
Worthwhile Canadian Initiative 
Demand constraint is not a “problem” that needs to be fixed. It is the very logical conclusion to a period of unrestrained consumption and bloated credit.
Recessions are ugly. They are also unavoidable, and in fact quite necessary. We’ve avoided one for 15 years, but only by running excessively easy monetary policy which created a binge of credit and leverage. The so-called Paradox of Thrift is a bullet we’re going to have to bite for the next few years.
Raging Ranter
what you are saying is that the real economy has to suffer for the sins of the financial economy. This makes as much sense to me as saying that the children have to suffer for the sins of the father.
http://www.slate.com/id/9593
This a non-issue…may be interesting for academics with strong peference for one or another side of the policy issue.
The political economy of a nation is based principally on its framework of budget policy. The supply/demand side always adjust to budget policy as implemented by govs.
That’s it…the rest is a lot of garbage!
“Fiscal policy is like getting grandfather’s musket down out of the attic, where we locked it away to stop the kids (politicians, or perhaps ourselves) playing with it. It’s an ugly, unreliable, inaccurate, slow, dangerous, weapon to use, and nobody can remember how the damned thing works.”
This, I think, can be very misleading. First, a bazooka may be a more accurate analogy than a musket. A bazooka is less accurate than a rifle, but it can be more powerful. But second, it misses enormous potential advantages of fiscal policy. If, due to well established in economics, and ubiquitous, free market problems, the proportion of money spent in the economy on consumption is grossly too high, and the proportion spent on high return investment is grossly too low, then monetary policy will generally not change those grossly inefficient proportions, it will just increase demand in those same far too consumption heavy proportions.
With fiscal policy you can increase demand relatively far more through investment than consumption, especially the kinds of very high return investments the free market will grossly underprovide due to well established market problems like externalities, asymmetric information, etc., etc. these include basic scientific and medical research, education, alternative energy, and infrastructure.
Fiscal policy has enormous advantages and your quote can mislead people into thinking it doesn’t.
Otherwise, very good explanation. I do, though, think it’s better to think of the LRAS not as vertical, but as sloped upward and eventually becoming ever higher sloped until it becomes vertical.
By the way, what’s the principle reason why the proportion of money spent in the economy on consumption is grossly too high, and the proportion spent on high return investment is grossly too low? The pink elephant of economics, positional/context/prestige externalities.
Richard:
I was going to use “blunderbuss” (sp?) instead of “musket”, but wasn’t sure if everyone would know what it was. “Bazooka” is good, but Grandfather would not have one locked away in the attic (I hope).
Is fiscal policy more powerful than monetary? I can’t think of a common set of units with which to compare them. Fiscal multipliers are $/$; monetary multipliers are $/%. Not really commensurate.
Now, suppose consumption is permanently too high, and savings and investment too low. Yes, monetary policy cannot fix that. And fiscal policy, in which the government taxes to invest, could fix that.
But that is not what I am talking about: counter-cyclical fiscal policy designed to increase AD temporarily in recessions and reduce AD temporarily in booms. That sounds like long run fiscal policy designed to change the composition of demand, not to help stabilise short-run fluctuations in total demand.
Also, positional goods do NOT cause insufficient saving (they cause insufficient leisure, unless leisure itself is a positional good). Positional effects raise the marginal utility of consumption today, but they equally raise the marginal utility of consumption tomorrow, so they have no direct effect on the trade-off between present and future consumption, so should not affect the consumption/savings decision. Greg Mankiw (I think) had a post on this a few months back.
Reason:
“This makes as much sense to me as saying that the children have to suffer for the sins of the father.”
While I can understand why this concept may be anathema to you, that doesn’t mean that isn’t how the world works. But I think you’re mistaken with this “real economy” and “financial economy” … mental constructs with little real distinction. We’ve lived the high life with cheap money; but it wasn’t sustainable, nor really even desirable. And now, as we all have to live within our real income, those that made their livelihood off of our excessive appetites are left without buyers. And our governments are stepping in to try and artificially keep their obese over-production facilities on life support at our children’s expense (deficit spending)… when the real solution is to let the consumer supply side starve for a while.
The effect is indirect with positional/context/prestige externalities. These externalities make it so that consumption could be cut systematically tremendously, by the trillions per year in the U.S., with very little loss in utility for any individual, as long as every individual kept their same relative position in the conspicuous aspects of their consumption, for example they spent $30,000 on their car instead of $60,000, but everyone else cut their car spending so that a $30,000 car was just as relatively expensive and rare, or $200,000 instead of $400,000, $500,000 instead of $1 million, etc.
While this trillions of cuts in such consumption would lower utility very little, using the savings to then invest in high return projects like in basic scientific and medical research, education, alternative energy, etc. would greatly increase growth and total societal utility greatly, especially with advances in medical science and use of the proceeds to increase non- or little conspicuous consumption, and quality of consumption.
The positional/context/prestige externalities make it possible to have so enormously a beneficial switch towards investment. And they also make it so that people think tax increases, especially focused on the wealthy, will hurt them far more than they actually will, and thus they create more opposition to policies to raise taxes and use the money for high social return investments of the kind that the free market will grossly inefficiently underprovide due to well established in economics market problems.
Have you read Cornell Economist Robert H. Frank’s book on positional/context/prestige externalities, “Luxury Fever”. This should be a must read for all serious economists.
With regard to which is, or can be, more powerful, fiscal or monetary policy, it depends on how you define more powerful. But one way in which fiscal may be more powerful is it’s highest levels. World War II fiscal policy ripped the U.S. and Germany out of an extreme depression to beyond (standard) full employment in a few years. Could any monetary policy do that, or would severe inflation and chaos set in before unemployment could drop that fast?
Richard: I haven’t read Robert Frank’s book. It’s not a new concept though. It was floating around many decades ago.
Suppose it’s true. It doesn’t affect the percentage of income saved or invested. But it does mean we could (in principle) increase taxation, and spend the proceeds on non-positional goods (either consumption or investment) and make everyone better off.
But the savings/investment effects are a red herring.
WW2 was a very big fiscal policy. Could monetary policy do that? If big enough. But you cannot compare the relative size of fiscal and monetary policy, since they are measured in different units.
Monetary policy works by increasing AD. So does fiscal policy. Whether an increase in AD will cause an increase in real output or an increase in inflation depends on the shape of the AS curve. The answer is the same whether the increase in AD was caused by fiscal or monetary policy.
Nick, the way you’re hedging on the positional/context/prestige externalities makes me think you may not realize their vast importance, and the vast potential they allow for policies that monumentally increase societal utility and growth, so I do think it would probably be very worthwhile to read “Luxury Fever” and Frank’s 2005 AER article, “Positional Externalities Cause Large and Preventable Welfare Losses,”. These externalities are given ridiculously little consideration in economics relative to their gargantuan effect on utility and welfare.
I should also add that I don’t think savings/investment is a red herring. Consider the current intertemporal choices and compare them to the optimal ones, Pareto optimal or optimizing total societal utils; either way the mix is extremely different from the current one. Why? There’s a long list of reasons, asymmetric information, frictions, etc., etc., but an enormous reason for the difference between the current mix and the optimal one is positional/context/prestige externalities.
What happens if you fully correct for these externalities? Non, or little, positional consumption and investment go up dramatically, but given the nature of non or little positional goods, it appears likely to me that the current optimal mix is investment heavy, with a dramatic increase in expenditure on basic scientific and medical research to cure things like cancer, arthritis, weight gain, depression, etc., etc.
Perhaps Mankiw did cite some paper where only leisure went up, but Mankiw has a shameful record of constantly intentionally misleading for the right. Why would only one non or little positional good go up when correcting for positional externalities and no other goes up at all. There must have been some grossly unrealistic simple assumptions to this model, or Mankiw is describing it in a deliberately misleading way, which is par for the course for him.
In any case, I think then the odds are good that if the government did optimally fully correct for positional/context/prestige externalities we would end up with a substantially higher percentage of investment spending than we have currently. Thus, I say positional/context/prestige externalities are a big reason for our investment level not being higher.
No Richard: Greg Mankiw did not cite some papers. He laid out the proof in his blog. (I think it was Greg Mankiw, by the way, but my memory may be wrong). And you really should not make those sort of accusations, please. It’s part of the very bad decline in civility, that I associate with recent US politics, and certain bloggers I won’t name. “If someone disagrees with me, he must be lying, and a paid shill”. That sort of argument is the first step towards totalitarianism.
In any case, forget what Greg Mankiw (or whoever it was) did or did not say about positional goods and savings. Listen to what I say. I don’t need Greg Mankiw or anyone to make the argument. (And I had roughly figured it out for myself anyway, before reading Mankiw, or whoever it was).
Positional effects increase the (private) marginal utility of consumption today. That makes people want to consume more today. But unless positional effects suddenly disappear tomorrow, they also increase the (private) marginal utility of consumption tomorrow, which makes people want to consume more tomorrow. Today’s savings increases tomorrow’s consumption. So positional effects increase the marginal utility of both consumption today and savings (or consumption tomorrow). So there is no first-order effect on savings. The two effects roughly balance.
Write down an Euler equation and you will see two positional effects (today’s and tomorrow’s) working in opposite directions on savings. Depending on the precise utility function, either one could be slightly stronger than the other, but as a crude approximation they cancel out.
Put it this way: we want to keep up with the Jones’ today; but we also want to keep up with the Jones’ tomorrow. The first discourages savings; the second encourages savings.
I’m not hedging on the effects of positional goods on savings; I’m denying it. (They will have an effect on the consumption/leisure trade-off, but only if leisure is not a positional good.) And they do distort the socially efficient choice between positional and non-positional consumption goods.
And something must be very wrong with Frank’s book if he can write a whole book about the effect of positional goods on consumption and savings without addressing this issue, which some no-name macroeconomist like me can figure out. I would be annoyed if I took the time to read it, then found out he never even addressed this issue, and one of the main themes of the book was based on a mistake.
Reason, this wasn’t just a “financial economy” problem. The real economy for the past few years has been fueled by debt. Consumers, egged on by lenders offering low interest rates and easy credit, went in way over their heads. Sure, that spending helped drive the real economy. But it couldn’t continue forever. And yes, the kids will suffer.
There’s a major misconception out there that basically says, “If only we’d have regulated banks and derivatives and reined in the financial robber barons, this recession could have been avoided.” Well, had we done that successfully, we’d still have enormous consumer debt, and we’d still have hit the wall once the credit bubbles popped. Anyone who thinks the stock market and/or housing market could have kept going up like they have, creating a permanent “wealth effect”, isn’t living in the real world. Sooner or later, people have to start saving money again. When they do that, it’s called a recession.
It would be much preferable to have tighter monetary policy on an ongoing basis, allowing for slower, but more stable growth. There would still be recessions – in fact there would be more frequent recessions – but we wouldn’t see the blowouts like we’re seeing right now. You can pass all the regulations you want, but easy money will always corrupt the system, and always result in credit bubbles. Regulate derivatives, banking, and house-flipping, that easy money will find some other bubble to inflate. Google “Dutch Tulip Bulb Craze” if you don’t believe me. I’m not saying we don’t need financial regulatory reform – we do. But we need a rethink of monetary policy during times of economic growth even more.
(?????)
Since when is debt part of the real economy? It isn’t even IN most growth models.
ruralcounsel (sic)
I can’t even begin to parse your comment. The economy is a man-made thing. It isn’t driven by some natural laws like physics. It makes no sense to say “that’s the way it works”. If that is the way it works then we should change it. I’m only concerned with how it should work.
Have you forgotten that one man’s expense is another man’s income? Not working today doesn’t create value it destroys it. That is why the duality of the financial economy and the real economy is important to keep track of. The financial economy keeps score. Confusing the two is like confusing a goal (which someone has to work to score) with its reflection on the scoreboard (created at the flick of a switch).
Absolutely agreed, the excesses of debt created an unbalanced economy. But it is important to see that in order to create a balanced, certain parts of the economy have to grow – and to see what can be done to encourage those parts of the economy to grow (yesterday if possible).
My own take is that the INTERNATIONAL financial system is disfunctional. The problem that was allowed to fester was the neo-mercantilist policies of chronic surplus countries (mostly east asia and the middle east) who deliberately manipulated exchange rates to stop their currencies from appreciating. This stopped the normal process by which income trickles down to workers in countries with rapidly rising productivity and surpressed their imports, creating serious imbalances – particularly in the US. The response of the US was to periodically slash short term interest rates to extremely low levels and pump up credit to stop their economy from collapsing because of the steady drain of money leaving through the balance of payments. The problem is we can’t go back, that unless the balance of payments problem is corrected their can’t be sustainable recovery in the US.
If we can’t reform the international financial system, the US should stop issuing debt and just print money until loses its reserve currency status.
I found this post informative, and you answered the question I was going to ask in the last paragraph:
“Of course, if we didn’t have a monetary or fiscal stimulus, then the Canadian economy almost certainly would be demand-constrained. That’s why we have the expansionary monetary and fiscal policies.”
So my new question is this — why is supply-constrained better if the demand is created artificially through debt? Isn’t that just a time bomb? Wouldn’t it better to just leave everyone alone and stop trying to manage the economy?
pointbite
So you are volunteering to do without an income for a while for the good of the economy? (And of course then you would stop paying taxes making the debt worse.) But you are right of course there just aren’t enough people willing to starve for the sake of their country.
reason,
You are assuming money can and should only be created through debt. That’s our current system, it’s not the only possible system. Money CAN circulate permanently if we wanted it too.
Reason, I don’t like seeing (or being) unemployed any more than you do. But there are certain relationships that are pretty much unalterable. And one of them is that easy money in a growing economy creates credit bubbles. Every single time. Niall Ferguson has a great interview in the G & M today in which he states that every asset price bubble in history can be traced back to excess money supply. He’s researched this going back hundreds of years.
As for your assertion that the economy isn’t natural, but rather a creation of man, that’s simply not true. The economy wasn’t “created”. It’s something that happened, through trial and error (mostly error), as civilization formed and humans began trading with each other and acquiring stuff. Once we figured out that carrying out this activity would work better under a certain set of rules, we started regulating, and signing trade agreements, and that sort of thing. In other words, the economy is just a by-product of human nature and human advancement. Economic activity is what happens when we pursue our interests, good, bad or otherwise. I think it is a very grave misconception to believe that the economy is some sort of man-made machine that can be made to do what we want it to do, simply by pulling a few policy levers. Of course policy matters, but it isn’t the precise instrument we’ve deluded ourselves into thinking it is.
Raging Ranter
But is the money supply endogenous or exogenous? Don’t ignore that the US is a democracy and that neo-mercantilism had essentially robbed the US of exchange rate adjustment as a lever of monetary policy. The only way for the US to adjust its negative foreign balance was to either allow the money supply to expand or choose higher unemployment.
As for your second comment, is human nature human or nature? Do the rules make a difference or not? Who makes the rules and why?
I don’t think we really disagree, but your idea that somehow because we have evolved to a certain set of rules, doesn’t mean better rules aren’t possible (particularly in extreme circumstances).
pointbite – I don’t understand your comment at all. I assume you are a gold bug. But we tried that and we know what happens. Some people end up hoarding it, and other economies get in debt deflation spirals that can only end when they reach rock bottom.
But actually, I agree with you, I want more base money and less debt money. I just want it directly issued and spread around (taking care not to issue so much that you create inflation). Debt supply should be limited and interest rates should be higher.
Reason, I don’t necessarily favour the current set of rules. In fact, I very much would like to see regulatory reform in a number of areas, and financial markets in particular (i.e. bringing derivatives under the commodities-futures umbrella and approving only those that trade on transparent markets like the big futures bourses). But the biggest thing I see is a lack of monetary discipline by central bankers everywhere, who focus on the CPI and ignore asset bubbles and credit bubbles until they pop with devastating effects. That hurts all of us. And I don’t see a way of controlling credit bubbles without a tighter, more vigilant monetary regime. And a tighter monetary regime probably means more frequent recessions.
Nick, I think that your argument is good; it’s part of the story, and a factor, but it’s not the whole story. It’s not all factors, and the factors it misses are important. A key thing is it assumes that the rates of return, and amount of possible investment, and possible current consumption, are the same for positional goods and non-positional goods.
Consider this highly stylized example model, just for proof of concept, to show that what you’re concluding does not always hold:
There are two goods in the world (I don’t think two good models, or simple models in general, are always bad; they can be very valuable; they just have to be interpreted properly, which is not necessarily literally).
The two goods are:
1) Luxury cars, or luxury car spending (not necessarily more cars; it could be more spent on a car).
and
2) Cancer research and treatment.
99% of the population does not have cancer, so they cannot consume good 2 currently. They can only invest in it for the future, to improve its future effectiveness, that is, they can pay for research to improve treatment in the future.
Even the other 1% who does have cancer, and can consume treatment now, has a highly binding limit on what they can spend on good 2 currently. Once you have taken the best treatment science currently has to offer, buying any more adds no utility. If you take twice that amount of drugs, it adds no utility, no effectiveness; it actually reduces utility.
In contrast, luxury cars, or luxury car spending, we will assume can be consumed currently by everyone, and without limit for increased, although diminishing, marginal utility.
This is all stylized, but the assumptions on the two goods are basically in sync with reality.
I think, without loss of generality, we can make this a two period model.
Now, we start without government intervention, and we assume that luxury car spending provides two forms of utility, (A) purely positional, and (B) non-positional, or intrinsic. The utility function for car consumption of c might be something like:
U(c) = c^A + c^B
Where A and B are greater than 0 and less than 1, and A is much smaller than B. Let’s assume we calibrate it so that for a $50,000 car, the marginal utility of an extra dollar spent would be 90% positional and just 10% intrinsic. People can invest in car production to consume more car, or more cars, in period 2, and that investment yields a return of ic%, say 5%.
For cancer research and treatment, we assume that it provides only intrinsic utility and no positional utility, so the utility function for spending of $k is:
U(k) = k^D, where D is greater than 0 and less than 1.
People can invest in cancer research for higher utility, more effective treatment in the future for themselves and their family, and the return on that, in units of treatment effectiveness, is ik%. We will assume that ik% is 30%, far higher than ic%.
Now, the next step in this model is to see, with some budget constraint, for a representative agent (person), what combination of consumption, and what combination of saving, maximizes utility.
After that, we next consider the shock of government action, through taxes or some other method, whereby the selection of goods over the two periods, subject to the budget constraint, is chosen to maximize only total intrinsic utility. So the c^B term is zero’ed out.
If you do this, the goods mix would shift far more towards good 2) cancer treatment and research and far less towards good 1) luxury cars, because the utility function of good 1 decreases greatly, while the utility function of good 2 stays the same.
But it’s impossible for society to satisfy its greatly increased preference for good 2 with very much increased current consummation since only 1% of the people can consume it currently, and even that 1% we will assume is already almost all consuming the maximum amount possible. Virtually the only way to increase consumption of good 2) is through investing in it.
So, investment in the future production good 2 will go up greatly. Unless investment in the future production of good 1 goes down on a one-for-one basis, investment (saving) will rise. Why won’t investment in good 1 go down one-for-one? Because considering the low return assumed on investment in car production, this would mean far more consumption of cars in period 2 than in period 1, which is sub-optimal given the decreasing marginal utility of car consumption in a period.
Of course, to make this argument really persuasive, I’d want to actually construct this model rigorously and fully and optimize it before the government addresses the positional externalities and after, and show that after the savings rate was higher. I think this would make a nice paper, with different expansions and versions of the model, production and utility functions, and experiments with a range of parameter values, perhaps with some calibration to the real world. It could make for a nice pub., but I don’t have time to work on it much currently – If you would like to co-author on it sometime, though, let me know. I did a quick literature search and saw nothing like it. It’s sad how little research there is on something as large and important as positional externalities.
As Cornell Economist Frank wrote in 1999, “A cautious reading of the evidence suggests that we could spend roughly one-third less on consumption–roughly $2 trillion per year–and suffer no significant reduction in satisfaction [due to positional/context/prestige externalities]”. Collendar, et. al. write today, posted in Economist’s View:
I can think of no better example of this than the almost complete ignoring and assuming away of positional/context/prestige externalities in economics.
I think a good way to put this is, what you’re saying is true if the average rate of return in the economy stays constant. But when the preferences, and the mix of desired goods shifts towards less positional, via a shock of the government taxing positional/context/prestige externalities, then the average rate of return will not necessarily stay the same.
It appears likely to me that with the shift in preferences away from more positional goods and towards less positional goods, on net many more high-return, and extremely high-return projects will materialize. The average risk adjusted rate of return in society will be much higher, the payoff from waiting to consume will increase, even if people’s patience level stays the same, and as a result saving and investing will increase greatly, where society is optimizing (and for society to optimize, say, total utility, government will have to do a great deal of this investing due to the fact that a relatively large proportion of less-positional goods are substantially public, with free rider problems, etc.)
Richard: I think I am following you now, and can maybe find the source of our disagreement. Going to think about it some more, re-read your comments more carefully, before replying properly.
BTW, here are a couple of simple ways to write down a utility function for a positional good:
1. U = U(my consumption – average person’s consumption)
2. U = U(my consumption/average person’s consumption)
In both examples, I get more utility by increasing my consumption, holding everyone else’s consumption constant, but if everyone increases consumption by the same amount (or same percentage) my utility stays the same.
Ranting Rager
I guess I almost completely agree with you, except I don’t necessarily agree that a tighter money regime means more frequent recessions. The big problem is INTERNATIONAL financial flows, if the exchange rate balanced the current account, then we wouldn’t need so much debt because the leakages from the circular flow would largely stop.
Richard: sorry for the delay in this, but I have been occupied on quantitative easing, and getting my head clear.
I think my head is finally clear on this (or as clear as I can get it).
2 good models are very useful for this problem.
In this context, I think it is useful to distinguish goods along 3 dimensions:
1. Positional vs non-positional
2. Private vs Government (who buys them)
3. Consumption vs investment (or non-durable vs durable)
In your example, the first good is positional, private, and consumption. (OK, it’s a swanky car, which strictly is a consumer durable, and so like an investment, but I don’t think that was intended in your analysis, and you would be just as happy if I replaced the swanky car with meals in a swanky restaurant, where everyone can look in the window and see how important you must be to be eating there).
And your second good is non-positional, government, and investment.
Given that set-up in your example, I agree with your conclusion. There is too much positional, private, and consumption, and too little non-positional, government, and investment.
But I think that result follows because you have assumed that the positional good is a consumption good, and the non-positional good is an investment good.
Here’s another example.
The positional good is a private investment good (big swanky house). The non-positional good is a consumption good (and let’s suppose it’s private as well). Let’s say it’s holidays (can’t think of a better example). We get too much spending on swanky houses, and too little spending on holidays, compared to what is socially optimal. But we also get too much investment (in housing) and too little consumption.
So it all depends on which sort of example is most common. Do positional goods tend to be investment or consumption (relative to non-positional goods). What’s the correlation, across goods, between degree of positionality and degree of investmentness?
The example I had originally in mind was quite different, where it was one good over two periods, and a consumption/savings choice. The quastion was: did the degree of positionality affect the household’s consumption/savings choice. A very different way of modelling the question.
So, you agree that it depends; so I have at least convinced you that it is possible that positional externalities can result in a decrease in saving and investment. It depends on what the positional and non(less)-positional goods are and what people’s preferences are.
You write:
The example I had originally in mind was quite different, where it was one good over two periods, and a consumption/savings choice. The quastion was: did the degree of positionality affect the household’s consumption/savings choice. A very different way of modelling the question.
This is a good example of the fact that proper interpretation of the model, what it tells us about reality, is crucial, and the proper interpretation is often not literal, that is, it’s often not that reality works exactly like the model (as so many in the real business cycles, efficient markets, fresh water crowd like to pretend). The simple one good model gave a good starting point insight, but when you ask about what happens if we move closer to reality and allow multiple goods, you then get very different results, very different possibilities. (I’m not saying you were interpreting the model literally, rather than just asking why the literal interpretation of the model is wrong)
How you define, “investment” and “investment good” is important. If you define it as having any dollar or util value that lasts longer than an instant, this is not a very useful definition, as everything good then becomes an investment good.
You could define it as having a positive dollar return, but then you are not counting the utility return, the return in utils, rather than a marketable return in dollars.
And then there is the social return in utils. If everyone spends twice as much on their cars, then everyone individually gets a lot more positional utils than they would if, as an individual, they hadn’t, and got negative utility from falling behind, but society as a whole get’s no more positional utils (except perhaps for a relatively little amount from comparing themselves to people of the past), so zero (or very little) payoff comes from that investment.
As economists concerned with the economy and total welfare as a whole, I think it’s crucial to look at the social return, what maximizes total societal expected utils, or at least what maximizes total societal utils and is still Pareto efficient (or not far from it).
And here it’s crucial to point out that what matters is not how much we invest, but what is the probability distribution of future returns (in total societal utils) we get. That’s what really counts; that’s really the metric we should consider when defining more or less investment. After all, what’s really a bigger investment? A 50 year investment of $100,000 that yields 30%/year, or a 50 year investment of $1 million that yields 1%/year. The first investment has a payoff of $30,000/year, the second only $10,000/year (If you consider re-investment at those same returns, the first investment will be worth far more in 50 years. With such steep exponential growth, consistent investment at 30% goes crazy after 50 years.)
So a big reason why I think positional/context/prestige externalities hurt investment greatly is not just because they lower the total amount of dollars invested. It’s moreso because it takes tremendous amounts of investment out of areas that have super high returns in total societal utils, like basic scientific and medical research, education, and societal and planetary health and safety.
Richard: yes, you have convinced me that it depends. It’s possible. But will think some more about how plausible it is as a benchmark.