# Seamus Hogan

## Still seeing red: Blame the rules not the ref - The Dismal Science

Sep 17, 2013

I really, really hate 15 on 14 rugby. Three years ago, I wrote a venting post when in the space of five All Black tests we had seen 3 yellow cards and 1 red. On Saturday night in the test match between the All Blacks and South Africa, we saw that quant...

## In defence of simplistic models - The Dismal Science

Sep 02, 2013

This post on methodology is related to recent discussions about the role of maths in economics (Matt has a good summary with the relevant links here), but is actually response to a comment by Chris B over at SciBlogs to my initialpost on Labour’s proposed ban on non-resident ownership of houses. (Yes, this post is long overdue. Events have conspired to keep me away from blogging for a couple of weeks.)

Chris says:
You know, the more I think on it, the more dissatisfied I am with this thought exercise. If only because Seamus has seen fit to call it a “very simple model of the New Zealand housing market”. It realy isn’t . It’s simply a fictional market with certain highly abstract asserted properties. No more realistic or useful than the various maths exercises from my own university level economics classes.
Fair enough. I should have said a simple model to help think about the New Zealand housing market. The point of this post is to ask whether simplistic models can be useful. Note that such models are unrealistic by design. If I were writing an academic paper, I would have used a much more complicated model, and if writing a problem set for an undergraduate class, something only a bit more complicated. But this was a blog post, so the model was designed to be easily solveable in your head. (I hope that the maths exercises from Chris’ university-level economics classes were more involved than this one; if not he was severely short-changed by his university.)

In general, a simplistic model is designed to make one or two points by stripping away every piece of reality except a specific thing that you want to highlight. Some of the assumptions one makes in doing this are simply removing irrelevant reality in order to focus attention on the key aspect of the question at hand. Others are more like dogs that don’t bark in the night; seeing what happens when you assume away some aspect of reality highlights how important that aspect is. Chris lists a whole bunch of assumptions in my model. I won’t go into these in detail, but I would argue that they all fit into one of these two categories. Some, like the assumptions about homogeneous preferences and housing quality are just assuming away irrelevant reality. Others, like the assumption of inelastic supply are non-barking-dog assumptions. As I noted in my original post, when you relax this assumption, you make the case against bans on foreign ownership stronger.

The realism or lack thereof of a model is therefore not a criterion for judging a model’s success. A simplistic model can be criticised for one of three reasons:

a) the intuitive point that is laid bare when all other reality is stripped away is so obvious that the point doesn’t need to be made;
b) the model doesn’t actually illustrate the point being made; or
c) the point is actually wrong, and the model fails because it stripped away some highly relevant aspect of reality.

The third is not necessarily a criticism. If a model’s intuition can be changed by adding in some relevant piece of reality, the process of starting with a simple model and then relaxing the assumptions lays bare what the crucial step is for generating a particular conclusion and informs where one needs to look for empirical evidence supporting it.

Now, in my post, I was looking to make two points: The first was that the price of houses depends on the current and future expected stock of houses and the current and future expected demand for housing (i.e. the willingness of people to pay to live in houses); changing the rules on who is allowed to be non-occupier owners of houses should not change the price of housing absent a mechanism for the policy to affect demand for occupancy or the stock. The second point was that if speculation is pushing up the price of houses, it is only because house prices are expected to increase in the future; attempts to restrict speculation without dealing with the underlying drivers only delay the issue.

Now I don’t think you can say that my model fails on the ground of being too obvious, as so much public commentary on housing policy simply routinely ignores these two points. Whether the model is successful in illustrating the point is very much in the eye of the beholder. For the third criticism, I certainly can imagine relaxing assumptions to generate different conclusions and inform a debate about what is the more likely state of the world. Chris, however, would prefer to eschew the simplistic model altogether. In his words:
Plainly the exercise does not remotely resemble the New Zealand Housing market. Why, then, should we have any particular faith in our ability to extrapolate from the though exercise to what will happen in the real-world economy.
In what sense does the model not resemble the New Zealand housing market? The model has both renters and owner occupiers. It has owners of rental properties who earn investment income from the ownership. It has a future expected increase in the demand for housing, and in that world has landlords earning a below-market rate of return. All describe exactly, say, the Auckland housing market. Yes, the real-world economy has other things as well, but it is important to understand the simple models before adding complications. What is the alternative?  Chris’ conclusion is as follows:
Perhaps a better approach to arguing against the policy on economic grounds would be to identify other places where it has been implemented and talk about the impacts which have resulted. Potentially tricky to isolate the impacts of the policy from other confounding factors, but if it can be done, there’s the advantage of being able to present some empirical evidence against it.
Alternatively, perhaps we might drop the thought exercise entirely as extraneous and talk specifically about how we expect foreign buyers will react to future restrictions on their activities, consequences for investment decisions and the like.
Not so fast. How do social scientists isolate impacts from confounding factors? They use theory. That is, they have a model or competing models in mind that would be consistent with some observed correlations but not with others. And how can you learn anything about how foreign buyers will react to restrictions on their activities and what impact that reaction will have for the housing market, if you don’t have a view about how their behaviour relates to conditions in the housing market, how other people will respond to that reaction, etc.?

In other words, careful empirical and behavioural analysis rests on models, and complicated models rest on simplistic ones. Non-careful analysis, in contrast, rests on unstated models, models that are potentially self-contradictory or rest on assumptions that have assumed away relevant reality but have never been made explicit.

## The Tiwai Point Subsidy - The Dismal Science

Aug 09, 2013

Matt and Paul have both covered the subsidy to Rio Tinto that facilitated a new contract between RT and Meridian Power. There is not a lot to say about the actual policy; Matt's "Urg" pretty much sums it up. But a few points about the politics of this ...

## Affordable Housing: Five Basic Principles - The Dismal Science

Aug 04, 2013

What is it about housing policy that leads to people forgetting basic economic principles? Following on from the extraordinary Labour Party policy that Matt and I jumped on at the start of the week, we had this blog post from Susan Guthrie, and this p...

## Labour’s Housing Policy - The Dismal Science

Jul 30, 2013

I am baffled by the Labour Party proposal to ban foreign speculators from owning houses in New Zealand. O.K. that is not strictly true; as Matt over at TVHE notes, the policy is easy to understand as a cynical appeal to xenophobic New Zealand First voters. But David Shearer is a better person than that, and so I would prefer to remain baffled and try to think through the logic of the proposal.

Consider a very simple model of the New Zealand housing market in which there is a fixed supply of identical houses that will not change over time, and an unchanging demand. Let there be no on-going maintenance or other costs to owning a house, just the one-off capital costs. Finally, let there be a risk-free interest rate of 5%, let demanders be risk-neutral and indifferent between renting and owning for a given cost, and let rental income to a landlord be exempt from tax so that there is no tax advantage to owner-occupied housing. In this world, there would be an unchanging equilibrium rental price for housing over time, and an unchanging price of houses that would be equal to this rental price times 20.

Now change the model a bit. Imagine that demand in one year’s time will double and then stay constant from then on, but that will not be known in the one year before the change. In this world, the equilibrium rental price and the equilibrium house price will both double in one year’s time and current owners of houses (both owner occupiers and landlords) will receive a one-off capital gain at that time.

Now make one more change. Imagine that the future increase in demand becomes known now, but for some reason only known only to people who are not citizens or permanent residents of New Zealand or Australia. In this version of the model, the rental rate would continue to remain constant for a year before doubling, but foreigners would bid up the price of houses now to the point where the capital gain between now and in one-year’s time was sufficient to exactly offset the fact that current rentals are insufficient to cover the capital cost of the house.

Now compare this model to the one where the demand increase was a surprise to everyone. Renters pay exactly the same amount of rent in each period, owner occupiers receive exactly the same capital gain, but can realise it's present value straight away. Foreign speculators receive only the market rate of return on their investments, just like any other inflow of capital that allows New Zealand to fund investment in excess of its saving. The only distributional effect would be a shift in the capital gain from those who would have bought houses during the year before the demand increase to those who would have sold, but there seems no particular reason for policy to favour one of these groups over the other.

In this world, it is hard to see what possible benefit there would be to a policy of banning overseas speculators from owning houses, which is what Labour are proposing. Of course, the assumptions in these three models are extremely unrealistic. So what changes to the model or what welfare function can make sense of this policy? We could relax all the assumptions about indifference between renting and owning, risk neutrality, homogeneity of the housing stock, no tax advantage to owner-occupancy, and no other changes over time, but it wouldn’t change the basic intuition. We could assume that supply is not perfectly elastic, but that would imply that the earlier rise in price from speculation would generate an earlier supply response and hence more housing affordability. And we could assume that, maybe, New Zealanders and Australians know at least as much about the New Zealand housing market as non-Australasians and so can bid up the price of housing without overseas help, in which case banning foreign speculators would have no effect at all.

It is easier to make sense of other parts of Labour’s housing policy. Building 100,000 houses would obviously reduce prices if it added to rather than displaced construction that would otherwise occur, although the policy is silent on how it would find the land on which to build the houses given council zoning restrictions. Similarly, a capital gains tax that excluded the family home, while doing nothing to change supply and demand, would be a way to reduce prices to owner occupiers while increasing prices to renters. Such a policy proposal wouldn’t make much sense from a party representing lower-income households (who are more likely to be renters), but it is perfectly consistent with a party that proposed exempting fresh fruit and vegetables from the GST.

But Labour’s Press release focuses mostly on speculation. The point needs emphasising: speculation that pushes up prices is only profitable if those prices were going to increase anyway for non-speculative reasons. Preventing speculation (if it were possible to do so) only delays the eventual price rise. Doing something about the future price increases by addressing supply constraints would not only be a long-term solution, it would remove the incentive for speculation at the same time. In other words, any politicians whose housing policy consists mainly of an attack on speculation is essentially conceding that they have no long-term solutions at all.

## More Glaeser - The Dismal Science

Jun 28, 2013

Eric posted yesterday on Ed Glaeser's upcoming Condliffe Lecture at the University of Canterbury. Some of you have if the talk will be videoed, given that you are not based on Christchurch. Absent any technical hitches, the talk will be posted on ...

## Can tax and subsidy incidence really be negative? - The Dismal Science

May 16, 2013

Imagine a country where shoes cannot be imported and furthermore the elasticity of supply of shoes is very low. Imagine that the government in this country subsidises shoes. The person on the street who doesn't understand tax incidence might think that...

## What If Lecture on You Tube - The Dismal Science

May 09, 2013

My What If lecture on using Economics to analyse ODI cricket is now up on YouTube. In it I give an "Economics in 4 lessons" overview, and then used the same graphs to talk about cricket. Watching the playback, I wish I had sped through the intro to Eco...

## Increasing consumer surplus through price increases - The Dismal Science

May 07, 2013

As I noted last year, the University of Canterbury administration has this year increased the price of an annual parking permit threefold from (roughly) \$100 to \$300. This raises the price from what was a subsidised rate to something they calculate as being approximately marginal cost. Needless to say, this is something that the Economics department had been advising for a long time, given our propensity to value efficiency even at the expense of our own direct wellbeing. After a few months of experience with the new policy, it has become clear, though, that it is not only efficiency enhancing, but it has also increased consumer surplus even without consideration of what use the university makes of the increased revenue.

How can that be? It is an application of how the deadweight loss triangle in a standard S&D diagram understates the cost of a price floor or ceiling. Previously a parking permit at Canterbury did not confer a right to park; it conferred the right to hunt for a park. Many of us wasted a lot of time searching for a park before giving up and parking on the street several blocks away. The problem was particularly acute on wet days. Some of those who successfully found parks had a low willingness to pay, others who missed out valued the parks much more highly. How do we know this? Well this year, as a result of a trivial price change from next-to-nothing to three times next-to-nothing, the carparks are never full.* Even on the wettest days, one can come in late and always be guaranteed a park. Those cluttering up the parks last year but not this clearly didn’t value the parks highly; this year, it is only those put a high value on parking who get the parks. And how high can that value be. Well we don’t know for sure, but I am sure this story could be replicated here.

So there we have it. The price went up, and so did consumer surplus. Could the same happen in reverse. Well imagine if you were to impose average cost pricing in the retail electricity market despite it being an industry with sharply increasing marginal cost. Everyone would get a lower price for power, but with no guarantee that the lights would come on on demand. Consumer surplus might well go down. And that is without even considering the lost government revenue from publicly owned power companies….

* I find it difficult to comprehend the size of the demand response; think of the Slutzky equation: there is a huge shortage of on-street parking around the university, so there are no close substitutes for on-campus parking; \$300/annum is hardly a large fraction of anyone’s expenditure, student or lecturer. Can the income elasticity really be that high?

## The morality of corporate takings - The Dismal Science

May 07, 2013

In the comments on my post containing the open-letter to the Labour Party’s two Davids a couple of weeks ago, John Small and I got into a discussion about the morality of a government policy that would wipe value from a private company (in this case, suggested changes to the electricity market that would reduce the profits of privately owned electricity companies). John wasn’t sure why I raised the issue of morality; this is worth post on its own.

It is inevitable that changes in government policy will result in both winners and losers, just as changes in the non-governmental actions will. One of the starting points I argue in my Honours class in welfare economics is that, in terms of practical policy (as distinct from the conceptual benchmark of a mythical social planner) the world is, always has been, and always will be Pareto efficient, and so a rule that policy changes cannot impose costs on anyone is tantamount to a rule that policy changes can never occur. But I think we can suggest some guidelines for when government-imposed costs are justified. The key issues are whether the policy is imposing costs on individuals or corporate bodies, whether the policy is a direct appropriation of property or one the imposed costs are indirect, and whether the policy is designed to improve efficiency or serve some social objective. Let’s take each in turn.

• Is the cost imposed directly on individuals or on corporations? Takings from individuals require a higher threshold of benefit than takings from corporations. I don’t here mean to that corporations are somehow separate from the individuals who own them, or that their owners have lesser rights than other citizens; this is simply recognising the fact that company owners have the opportunity to diversify risk in their shareholdings, and hence to diversify the implications of government policy changes. A policy that forced lower electricity prices might wipe value from electricity companies, but add value to electricity buying companies as well as final consumers. If such a policy were efficiency increasing, there is no reason for it to impose significant costs on any diversified shareholder.
• Is the policy one that appropriates resources directly or one that changes the value of current assets? A direct takings, such as when the government uses compulsory purchase to acquire land for a highway, is a more serious use of government power than one that imposes costs indirectly through revaluations of assets, simply because a direct takings has the potential to impose far greater costs to an individual if their personal valuation of the asset is greatly in excess of its market value.
Based on these two criteria, I have no problem on morality grounds with, say, the government’s forcing Telecom to give other companies access to its copper wire network, with the anti-trust actions against Microsoft, or with changes to patent law that would stop Apple from suing Samsung. In each case, the question for me would be simply whether such policies would promote long-run efficiency or not. (In the case of these three examples, I suspect the answer would be No, No, and Yes, but that is an empirical question.)  The issue becomes more when the policy is put in place to achieve social objectives.
• Is the policy one that is designed to improve efficiency or to bring about social redistribution? In my view, the hurdle has to set very high before one can justify a direct or indirect takings to fund redistribution. This is not to say that social redistribution is not warranted, but rather the moral case for redistribution should be grounded in a transparent and honest policy that seeks to share the burden broadly rather than hiding the costs. Financing redistribution through indirect takings smacks too much of offering the other kid’s bat for my taste.
This is the key question in the case of Labour’s proposed electricity reforms. If their proposal were based on a view that market power was keeping price above marginal cost so that reducing price would be efficiency enhancing, then the issue would be the technical one of whether there is market power and whether eliminating that market power through a single payer would cause more problems than it would solve. But the proposed policy is explicitly to set price below marginal cost in order to equate price to average cost. John argued from a utilitarian perspective that the redistributive benefit would likely exceed the efficiency cost. We can debate about how large the efficiency cost would be, and whether, if you had revenue available for redistribution, subsidising electricity prices would be the best way of using it. But if we want to have more redistribution, either with an electricity subsidy or with direct transfers, then we should finance that directly with broad-based tax increases. Let’s not get into the game of arguing for a policy to transfer resources from corporate owners to electricity consumers on the basis of “they must have known that regulation is very very common in this industry” and hence that the costs are ethically inconsequential.