How price-based policies work

06/09/2012 § 4 Comments

Price-based policies are all the rage. A core idea is that we need to get prices ‘right’, and then market forces and consumer rationality will get us to maximum satisfaction. But, as Eric Crampton likes to remind us, slopes are often slippery.

Rather than worry about the coefficient of friction, however, I want to lay out how price-based policies actually work and what that means for policy and welfare.

First, we start with how consumers respond to prices. The technical term for this is ‘elasticity’, but let’s just go with the simpler ‘response’. There are three responses when the price of some item goes up:

  • the item itself — when the price goes up, we usually buy less
  • income response — because spending on the item itself has changed, the money we can spend on everything else also changes
  • other items — we will buy more of some things and less of other things.

One of the key things to understand is whether total spending on the item itself goes up or down. Take petrol, for example. When petrol prices go up, we buy less (in litres)  but not a lot less. As a result, spending on petrol goes up. On the other hand, when prices for some things go up (cherries, mangoes, merino-possum jerseys,…) our total spending on them goes down.

That leads to the income response. This is somewhat simplified, but basically we can have more or less money to spend on other things. We change how much we spend on everything else — heating, healthcare, holidays, etc.

Finally, we also need to take into account how the item itself fits into our total consumption. Take petrol again. When petrol goes up, cars and holidays become more expensive, so we buy less of them. Phone calls and internet connections can substitute for driving somewhere, so we buy more of them.

Now, let’s think about a tax on something like alcohol, ignoring for a moment where the tax revenues go. The tax makes the alcohol more expensive. That pushes up total spending on alcohol. We then have less money to spend on everything else, good and bad. Finally, our spending on everything else shifts around, depending on whether those things go with alcohol or substitute for it.

Are we happier? No, we are not, by assumption. The economic model assumes that we spend our money on the things that provide the most satisfaction. Otherwise, we could change our spending patterns and be happier. When prices go up (without compensating somehow), we are poorer and less able to get satisfaction.

Are we healthier? Well, that’s complicated. Let’s assume that our alcohol consumption (or sugar or fat consumption) is in the ‘harmful’ range. Assume, further, that by consuming less of it (although spending more on it) we are doing ourselves less harm. We have to set against that the income response and the spending on other items. We are poorer, so we buy less healthcare and less home heating. Our spending patterns shift, so we might buy less tobacco (if we smoke when we drink) but we also might buy less tomato juice, celery, and horseradish (because we like Bloody Marys). We may end up healthier, but we may not.

Are we ‘better off’ — has our welfare increased? In one sense, no, it hasn’t, by assumption (see, ‘happier’, above). If, however, we assume that people lack information or we assume that they are too myopic (that is, they know what’s good for themselves but don’t place enough weight on the future), then such policies might increase experienced welfare even as they decrease happiness in the present.

Note, however, the chains of ifs and buts, the assumptions on assumptions. If the lack of information or myopia is sufficient, and if the buying patterns shift towards ‘good’ products on balance, and if the net health impacts are positive, then price-based policies can make us better off.

I’ve left out a lot, a discussion of what happens with the tax revenue being the obvious gap. Even in the simplified example, though, the complexity is obvious. To quote the Dread Pirate Roberts, ‘Anyone who says otherwise is selling something.’

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§ 4 Responses to How price-based policies work

  • Revealed preference may be by assumption. But consider how you’d go about establishing a welfare economics without it! What do costs or benefits even mean in a world where revealed preference doesn’t hold?

    Even in the case where we want to allow addiction to drive preferences, if there’s a meta-preference against that consumption (which there has to be to keep any kind of methodological individualism) then if that meta-preference fails to be revealed in action where there are simple ways of satisfying it (taking things like Disulfiram that make you violently ill if you go and drink again), then ….

    • Bill says:

      All good arguments. The revealed preference assumption is very powerful. I think, though, it helps to remember that it is an assumption. We therefore don’t have to waste time arguing about whether it is ‘true’, whether existing consumption patterns are optimal. They are, by assumption, so let’s move on. It also sets up the next step in the discussion: so, if you don’t agree with the assumption, explain the conditions under which it isn’t true. That generally turns into discussions about information and intertemporal inconsistencies, but those have their own problems (your example of Disulfiram, or work on designing commitment mechanisms).

      The other thing that becomes clear is that we need to be precise about whose preferences are driving the analysis: those of the ‘addict’ or those of the ‘expert’?

  • Brent says:

    You seem to be approaching this from the point of view of a person affected by the changes. It will affect different people in different ways, many of them unpredictable. What is important is the overall effect on the population as a whole. That is something very difficult to predict. Unfortunately, case studies invariably have confounding factors, that are difficult to accurately account for.

    Wouldn’t it be nice if we could introduce a change for part of the country, and compare the effect with the rest of the country used as a control.

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