Friday, 19 December 2014

The russian economic crisis and comparative advantage

As the Russian economy heads towards tough times Putin seems to be pulling up the drawbridge. If Russia is going to prosper then, so the logic goes, it needs to rely less on foreigners and more on itself. This is a familiar nationalist argument that long pre-dates Putin. But it is one that economists have long tried to counter with the logic of comparative advantage.
        Simply put comparative advantage says that a country should produce what it is relatively good at. To give an example suppose that both a barrel of oil and a tablet computer sell for $100 on international markets. If it costs Russia $40 to produce a barrel of oil and $100 to produce a tablet then Russia should produce oil because this is where it has a comparative advantage. Crucially this logic holds even if Russians only want tablets. For instance, with $400 of cash they can produce 10 barrels of oil and trade these on the market for 10 tablets. Or, they can produce 4 tablets themselves. Clearly 10 tablets is better than 4. And pulling up the drawbridge is a bad idea.
        Analysts have also been quick, however, to criticise Russia for becoming too reliant on oil. And this does seem to make for an inconsistent argument. Comparative advantage says that a country should specialize, but then we criticize Russia for becoming over specialized! So, is there a flaw in the logic of comparative advantage?
        Comparative advantage says what a country should produce, not how well it will do producing it. The recent dramatic fall in the price of oil is clearly bad news for any country that specialized in oil. But the logic of comparative advantage still holds firm. To illustrate, let us return to the example above and say the oil price is $60 per barrel. With $400 Russia still produces 10 barrels of oil, which sells for $600 and buys 6 tablets. The purchasing power of Russians has dropped from 10 to 6 tablets but this is still better than the 4 tablets they can make on their own. There is no flaw in the logic of comparative advantage.
         So, where does the call for diversification come from? As far as I know there is no strong economic argument for diversification. The popular argument essentially seems to be specializing is 'too risky' because a country becomes vulnerable to shock. Many, for instance, worry that the UK is over-reliant on the financial services sector. But, risk is something that could be insured against, as evidenced by Norway's wealth fund. 
         I'm not convinced, therefore, that Russia's 'over-reliance' on oil deserves the criticism it gets. Specialising in oil is fine if that is where Russia has comparative advantage. For comparative advantage to really benefit Russians, though, the Russian economy needs a big scale market liberalization and associated reduction in corruption. There is not much sign of that happening any time soon! 

Wednesday, 10 December 2014

Reform of stamp duty should raise revenue

Stamp duty is a tax on house purchases. And it will surely go down in history as one of the most badly designed taxes ever. Why? Because, until last week, the tax operated in bands that applied to the full purchase price. For example, if a house sold for £249,999.99 then it was taxed at a rate of 1% meaning a tax of £2,500. If the price increased by two pence to £250,000.01 then it was taxed at a rate of 3% meaning a tax of £7,500. So, a two pence rise in purchase price meant a £5,000 increase in tax!
         Clearly such a tax is highly distortionary. No one was going to buy a house for £251,000. House prices, therefore, inevitably clustered at the bands of £125,000, £250,000 and £500,000. There was also the clear incentive to circumvent the tax. For instance, to buy a house for £249,999 but then agree to pay £10,000 for the living room curtains.
         In the Chancellor's Autumn Statement stamp duty was finally reformed. The current slab system was replaced with a system of incremental taxation. Paying two pounds more will now cost at most two pence in extra tax. Common sense can breathe a sigh of relief. I found it particularly interesting, though, the way that the Chancellor spun this good news.
         The headline claim was that 98% of home buyers would pay less under the new system than the old. And if you look at some raw numbers like those in the table below it is easy to see why this claim seems justified. Across the board there are seemingly significant gains for home buyers.

       Why may these gains be illusory? House prices are unlikely to stay the same. Houses that were selling for just under £125,000, £250,000 and £500,000 will clearly go up in price. This, in itself, is enough to mean that some will pay more. For instance, someone who would have bought a house for £125,000 but now has to pay £130,000 sees a £100 rise in tax. Similarly, someone who would have a bought a house for £250,000 but now has to pay £260,000 sees a £200 rise in tax.
        These are modest rises but given that a large proportion of transactions take place around the £125,000 and £250,000 mark they are not innocuous. And things may be worse. Because pushing up some prices is inevitably going to push up others. The gains, particularly in the £125,000 to £250,000 bracket, may not, therefore, be as large as the table suggests. The Chancellor may well have pulled off the political magic trick of a popular tax rise.  

Wednesday, 3 December 2014

Phillip Hughes and safety at work

The death of Australian cricketer Phillip Hughes shocked everyone. It serves as a powerful reminder that safety at work, whether it be the sport's field or a gold mine, is not something that should be left to the discretion of individual workers. This point has been most powerful made in recent years by Robert Frank whose argument rests on the notion of positional externalities.
             To illustrate the point consider the game below where two cricketers have to independently decide whether to wear a helmet. The best joint outcome is for them to both wear a helmet (and get a payoff of 10 each). There is, however, an advantage - this is the positional externality - from not wearing a helmet when the other cricketer does (and get 12 to his 0). The advantage comes from increased performance or, in economic speak, from increased productivity and the consequent higher wage. This incentivizes neither player to wear a helmet. Which is a bad outcome for everyone.
 
     
            Instead of 'wear helmet' we could write 'use a safety rope when tree cutting', 'wear a respirator in the gold mine', 'work in a dangerous factory', 'drive the lorry when tired' etc. The crucial point is we end up with a race to the bottom, a race to minimal safety. That gold miners choose to work without a respirator is not evidence that this is what they want. It merely shows that in a competitive world where 'someone else will do the job' incentives drive miners to accept low safety. Individual workers are not able to stop such a race to minimal safety, only rules and regulations can do so.
           Phillip Hughes was wearing a helmet. The simple story above still, though, applies. We could surely produce helmets that would virtually eliminate the risk of death. It is just that without regulation no cricketer would ever choose to wear such a helmet. There will always be an incentive to wear a lighter, more agile, and less safe helmet. Over time, cricket has increased regulations, requiring the use of helmets for under 18s and restricting use of bouncers, but it still takes a relatively hands off approach to safety. Could it do more?
          This is a difficult question. Whenever there is tragedy there is a call for action and this brings with it the possibility of overreacting because of things like hindsight bias. It would, for example, be a false legacy if rules and regulations are put in place that primarily result in less children playing cricket. It is a case of weighing up costs and benefits. I do not think, however, this is as difficult as some suggest. The insight we get from positional externalities is of a general bias towards less than optimal safety. The insight we get from hindsight bias is of a bias towards ad-hoc regulation that does nothing to improve safety. The important thing, therefore, is to keep in mind what the rules and regulations are supposed to achieve. And that requires an understanding of positional externalities.