Hedonic price indexes - not only in America

If you recall a previous blog which linked to a crash course in global economics, you would remember a part about hedonic price adjustments when measuring the Consumer Price Index (CPI). Unfortunately, these methods are being adopted in Australia. For personal computers a hedonic price index was introduced into the Producer Price Indexes in 2003 and into the Consumer Price Index and the National Accounts in 2005.

That means that although prices for computer may be steady, they are falling in ‘real terms’ according to the ABS, thus we are all experiencing cheaper computing. The following graph shows that computers declined in price by 30% from July 2007-08. The same models only dropped in price 15%. So the question is: do we include the extra 15% decline in our price index?

I would suggest that the methods used by the ABS misinterpret the term hedonic. Hedonic psychology is concerned with the attributes of good or service from which we derive pleasure. By breaking down a single product into hedonic attributes we can determine the willingness to pay for component parts.

Hedonic analysis has been happening in property valuation since it first began. To compare heterogeneous goods we break them down into characteristics such as location, views, noise, number of bedrooms, and so on. We can then estimate how much a person may be willing to pay for an identical apartment in a different area, or with different views.

In terms of the computer price index, they have taken factors such as CPU speed, RAM, memory, as the characteristics from which we derive value. But clearly this is not the case. Many people have no idea of these specifics. They just care what it can do – save music, photos, word processing, internet etc. If I write this blog on an old computer, and I getting less satisfaction than writing it on a new computer? Unlikely.

A good that seems to me to be more suitable for hedonic pricing is housing. While house prices have dramatically increased, so have their quality. The renovation boom of the past decade has turned many suburbs into backyardless air-conditioned wonderlands. We can use hedonic methods to easily determine the potential price or rent of a house of apartment based on its features (this is how real estate agents do it in their heads). Now unlike computers, these features closely relate to the benefits we actually derive from the home. An extra bedroom of a given size has a number of possible uses from which we derive benefits. Adjusting for an extra room is prefereable, adjusting for the type of materials on the wall is probably not as good. Just because a more modern material is used (read faster processor, or bigger hardrive) doesn’t mean I can actually use the room (computer) for more purposes than I previously could.

Since housing is a large part of household expenditure (20%+) this type of adjustment might provide interesting results.

Anyway, it’s a slippery slope of political misdirection from here with hedonics. Let’s hope that PCs are just a pet project for now (they are not - one of the desired outcomes of the review of the desktop computer price index is the development of techniques to be applied to hedonic price indexes for other consumer durables), until their methods align a little better with the theory. This may involved surveys of consumers see which attributes provide them with benefits.

Why are the poor, poor?

Economists have tried to determine the reason some countries are wealthy while, relatively speaking, others are poor. They have eliminated a number of reasons that at first seem very logical.

1. Endowment of natural resources.
2. Quality of government and rule of law

However one major flaw is that studies comparing the endowment of natural resources compare current day reserves of resources currently in demand. If they had instead compared endowment of natural resources of use during the rise of agriculture some thousands of years ago, the answer may have been quite different.

I would propose that the reason some countries are poor, despite their current resource endowment, is that they were too slow to take advantage of those resources.

Consider the colonial powers of Europe during the 1600 and 1700s, namely the Dutch, German, English, the Spanish earlier on, the Italians a thousand year earlier, and the Greeks before that. The wealth of these nations grew from their own natural resources AND the quality of their government and rule of law. If there are rival tribes within a State, so many resources are devoted to war, that the accumulation of capital in the form of buildings, ship and machines is impossible.

Given time, any part of Africa could have achieved this type of emergence of civilization and wealth by developing cooperative States. In fact any less developed, or less wealthy, society could have followed this path. But there is a key reason why this did not occur.

The already wealthy European nations began trading, mostly through coercive force, with these less developed countries. Now trade itself is fine if we all start from equal positions and enter into it voluntarily, but history has shown that such ‘perfect markets’ are rare. Often one side has a clear advantage. And so it was with European traders.

If you have zoned out from reading, now is the time to pay attention. The reason trade between the already wealthy nation and the poor nation was not going to improve the situation of each player equally is because the wealthy nations brought with them capital. That is, they had tools, ships, weapons, and all manner of goods (and the knowledge of how to build them) that could be brought to the party, whereas the poor nation merely had labour and natural resources.

Since investment in capital generates a return, the wealthy country could maintain returns on the poor country’s endowment of natural resources. If they were wise (and most were very savvy) they would reinvest in the land itself. Thus the wealthy country would continue to preserve its wealth through the ownership of land and capital of other countries.

In absolute terms, the poor country would probably become ‘less poor’, but in relative terms, the gap in wealth between the rich and poor countries would in fact grow, not diminish. This is capitalism.

However, that is not to say that such a situation is inevitable. With an improved knowledge of the nature of capitalism, the Asian Tigers have been able to adopt the same strategies as the British colonial capitalists once did. By smartly investing in capital, both domestic and abroad, they have broken this historical trend.

Even as I type, China is making moves to acquire Australia’s mineral reserves. They are seeking to begin owning the capital, the physical means of production, by acquiring large shares of mining companies. Thus, they will generate a profit stream back to China from the use of Australia’s natural endowment of resources.

The same thing happens on a domestic level. Those who inherit wealth have a distinct advantage as they preserve their wealth in capital which can generate future returns, thus reinforcing the cycle. But that is not to say that those who start life relatively poor can never prosper. If they follow the simple rule of saving their earnings on labour and investing in capital, they too can prosper.

If economists could take a history lesson and broaden their perspectives a little they would see the simple explanation for the observed divergence in wealth. Given a stable political environment, rules could be attached to foreign aid that might require a proportion of domestic reinvestment in capital works. Poor nations, desperate for foreign capital, might want to rethink the advantages of allowing foreign investment in their natural resources, and instead promote the extraction and use by government owned companies that can keep profits within the country for further reinvestment.

What happened to whistling?

I see in so many black and white films young working class men strolling (perhaps even skipping) to and from work while whistling a merry tune. Why is it that in my hours spent cruising the streets of Brisbane I hear no whistling? Come to think of it, I may the only whistler remaining in Brisbane.

What happened?

Here are my suggestions:
1. People have headphones on playing music for them
2. People don’t know what good music is anymore
3. People have less skill (I remember learning to whistle when I was 7 – it took a while to get proficient)
4. People are afraid of bringing attention to themselves (although they are happy to wear whatever ridiculous fashion is trendy at the time)
5. People are to busy thinking of other things to think about a song
6. People aren’t very good at remembering portions of a song long enough for it to be interesting
7. People have lost imagination and really shy away from trying such a crazy thing as whistling their own melody

I propose – bring back whistling. And my reason is this. When I watch the crazy chimney sweep (thinking of Mary Poppins here) whistling his way to work, it makes me quite cheerful about life. There is a positive externality from whistling.

Maybe it is good government policy to slip some whistling in their next propaganda campaign. If you taught it at school it would lose its appeal. People have to think that they thought of it themselves.

Voting revisited

In keeping with the theme of my last post I will examine elections in more detail.

There are two issues that I want to raise;
1. strategic voting, and
2. the need for electoral districts

Strategic voting is where a person chooses not to vote according to their preferences because the probability of achieving them is very low. They may instead choose to vote for a second choice candidate in the hope of getting a higher probability second choice outcome.

For example, in the recent Queensland election I may have wanted to ditch the current Labor government for the Greens. Knowing that the Greens were unlikely to win a seat, I may vote instead for the LNP who were my second preference, but would have a much higher chance of winning.

The question remains, how many people vote for the major two parties but would really prefer a minor party or independent?

This brings me to my second point. Why do we need electoral districts? Given that each level of government should be concerned about issues covered by its laws irrespective of their location, why do we a need a local person to represent people at a State level? Shouldn’t the concerns of people anywhere in the State be equally as important? Why then the need to differentiate communities by their elected representative?

My solution is simple. Remove electoral districts. Have a parliament made up of representatives from each party in proportion to their vote. If 30% of votes go to a party, they get 30% of the seats to allocate to their best people. People would then have a clear incentive to vote for their preferred party/candidate. In this scenario independents could be elected by anyone in the State – it might be a large ballot paper.

The only problem that remains is getting anything done. If the parliament is made up of ten minority parties with 10% of the seats each, there is a strong incentive to do nothing and blame everyone else for delaying your proposals.

Of course, there is no perfect system. You get better incentives for people to vote for their preferences, you get less done and even more political finger-pointing.

Rewarding bad behaviour

One of the main functions of government is the redistribution of wealth. However, governments also have the luxury of promoting social goals through the incentives offered to both the contributors, and the beneficiaries of this redistribution.

However, the unfortunate problem is that much government intervention rewards 'bad' behaviour.

Let me explain.

A progressive tax system conveys the principle of vertical equity; that those with a greater ability to pay should pay more. However, if you look at this from a slightly different perspective, you are simply punishing the good behaviour of highly productive people. The reverse of this is rewarding people for not working through unemployment benefits.

Don't get me wrong, I believe that these two problems are minor in comparison to the benefits such a welfare structure brings to society. But what about other more controversial ways to use taxes and subsidies?

In the water industry there have been plenty of subsidies lately in both and urban and rural context. In the city, households are given free water tanks and free toilet and shower fittings to promote more efficient use of water. In the country, there is a rural water use efficiency program that essentially subsidises farmers to invest in more efficient irrigation methods.

If you think critically about this you see the perverse incentives. Those households who are already efficient, who already have efficient fittings, get nothing. Those wasteful households who have done nothing to conserve water now get a whole bunch of free stuff. The same applies in the country. Those irrigators who already use more efficient techniques get nothing while those who have caused the water problems by using outdated irrigation methods get subsidised sprinklers.

Rewarding bad behaviour has been happening with the subsidisation of energy efficient lightbulbs, solar hot water, and other 'energy saving' gadgets. Those people who have already spent their own hard earned cash on such things get nothing, while the slackers get some them all for free.

It is equally as bad with the advent of proposed trading schemes for both water and emissions. Those companies and individuals who already use the most water or energy efficient technology have little scope to adapt. Those who use outdated and inefficient technology now get incentives for them to invest in new technology. They also get rewarded with more permits due to their higher historical emissions or water use.

The question that remains is how to overcome these incentives. Well I for one have a view that the water and energy efficiency subsidies are ineffective anyway, so the easiest thing to do is scrap them. For the cap and trade systems, which I believe are currently the best way to deal with finite renewable resources (and for sustainable levels of emissions/pollution), it is a more difficult question. You could, for example, gift permits at the beginning of the scheme inversely related to previous use. The more they have used, the fewer permits they get. But determining an actual measure for this over a vast array of businesses of different scales and different industries seems close to impossible.

I am open for suggestions on how to overcome these issue, and for any other examples of well intentioned policies rewarding bad behaviour.

Another reason for small government

As a new public servant I have discovered what I would call the ‘baseline’ person. They don’t seek to challenge the status quo, they all seem to desire the ‘normal’ life – a house, two cars a pool out on the city fringe. If you tell them you did anything out of the ordinary is immediately received with absolute shock. Mountain biking – shock. “Isn’t that dangerous?” You have longish curly hair – shock. You eat rice that comes wrapped in a leaf – shock. (insert anything that hasn’t recently been on Today Tonight here) – shock.

I am going somewhere with this. Public servants seem to be, either by selection or through indoctrination, reluctant to challenge anything. Also, given the ‘worker’ mentality and fairly widespread unionism, I would suggest that most would be Labor voters.

This leads me to two interesting conclusions.
1. The reluctance to challenge things make them highly likely to vote for the sitting political party, and
2. if that political party is Labor, then the this likelihood is greatly increased.

Therefore, there is a self-fulfilling process happening. Labor governments by their nature prefer more government intervention, thus need a larger government. The more people they employ, the more voters they get indoctrinated, thereby reinforcing their position.

When a challenging party that believes in small government comes along, there is a massive pool of workers who, now indoctrinated, also feel like there job is threatened if the government is going to downsize.

Maybe this goes some way to explaining the Labor dominance in the States. Maybe it helps to explain the failure to get widespread support to dispose of States altogether. There are 1.3million State employees in the country, but only 400,000 employees in the federal and local governments combined.

Then again, maybe I have just seen a representative sample of a much broader population. Given that I have spent the past 10 years on the fringes, rather than in ‘mainstream’ society, this might just be my first real introduction to the silent majority, the baseline person.

Tuscany v Tassie

For those who don’t know, I am planning a trip to Europe in June. The attraction of Europe for me, a simple Aussie, is the history of human society that is embedded in the environment there. The rivers, still often beautiful, have been subjected to thousands of years of human tinkering. No one would even know the original path of some developed rivers. Even the countryside is not ‘natural’, but the product of thousands of years of agriculture in various forms. The cities obviously are the product of man, but still capture humanities path through history to the present. This humanised environment is beautiful and enticing to me.

Then I consider the wild areas of Tasmania and New Zealand. My Dad is a fan of this environment, hiking the tracks in the fresh mountain air, with none of the bustle of city living. But even in this environment, humanisation (for want of a better term) is occurring. Huts are built. Tracks are formed on the side of steep ravines, and fallen trees are transformed in to nifty seating for a weary wanderer.

When I go camping, it is partly to get closer to nature, but in doing so I change it. I instinctively humanise the landscape as I go - remove fallen branches to make some nice open space, forge a track through to the beach, and make a fire place. I want to go out to nature, but then subconsciously change it as soon as I get there. The result then, for me at least, must be better than the landscape in its original form.

At this moment I believe there must be an instinctive desire to humanise our environment, whether we value natural environments or not. But how does this impact our lives in contemporary urban society?

One important thing that springs to mind is that this humanising desire explains why people apparently ‘over value’ design. I live on the darkside with a Mac laptop. Yes, in my opinion it is more functional, but I must admit, in the beginning, the design really appealed. When the initial decision was made, I simply paid for looks. It was humanised.

More specifically, does this kind of desire explain the premium people are willing to pay to own their own home? Yes, home ownership is more secure, but does security explain the massive premium people are willing to pay? Or does the ability to customise, to humanise, to personalise our space contribute to this willingness to pay? I don’t know; it is just a suggestion.

To put the whole thing in reverse, would there be outrage at the suggestion that you couldn’t personalise your office space at work? Would a premium be paid for home ownership if regulations forbade different colour paint, renovations or extensions, and no changes to the garden?

Then again, maybe I’ve picked up on something that is explained by deeper causes and possibly has an evolutionary explanation.

It takes a global financial crisis (GFC) to...

1. Make government function efficiently. In our department budgets have been slashed, people are not being hired, travel expenses are coming down, but the same work is being done. What a way to improve the productivity of government.
2. Send very large but inefficient companies bust. They had so much power to keep doing what they were doing, holding back innovation, adopting new business practices last, but now they're broke, and the efficient guys remain. There will be plenty of slack to be taken up by young innovative companies. Also, rumour has it that Pacific Brands has wanted to cut back their workforce for a while now, but needed the GFC as an excuse.
3. Teach generation Y about the budget constraint. When I was teaching economics to first years they had trouble comprehending that individuals have limited budgets and must choose between various consumption options. A common response was that I just spend what I need, when I need. Maybe now their family funded credit cards are being reined in, and students will start get better results in first year economics.
4. Shelve poor infrastructure investments – I’m thinking of the Northern bypass tunnel here. No one has the money to build this kind of rubbish.
5. Make us all expert economists. The amount of rubbish in the media lately, and the number of unqualified and irrelevant experts is astounding.
6. Actually make people worried enough to pay off their credit card. Hundreds of dollars in interest payments and fees weren’t enough incentive – thanks GFC.
7. Reduce global emissions
8. Prevent new mining operations on environmentally sensitive sites.
9. Decrease politicians pay (US only)
10. Decrease outrageous CEO pay (US only)
11. Give us the cooking practice we used to pay for – for free in our own homes every night!

Can you think of anything else?

Updates

Well, it appears I was ahead of the crowd on at least some of the issues I've been discussing in this blog.

For starters, a previous blog that was critical of the research paper proposing to fix the floor in the emissions trading scheme pre-empted the current debate, which threatens to postpone any emissions reductions measures. You can read about the political debacle it created here.

Another point getting more publicity is the proposal that governments make no new policies in response to the GFC (that's Global Financial Crisis for those out of the loop). My stimulating paradox blog came to the same conclusion as Dan Denning. But hey, who trusts what they read on the internet.

A final update regards the announced (finally) Queensland elections. Given the GFC, the basic lack of innovation over the past decade, the threat to the Great Barrier Reef from climate change, the massive social disruptions likely to be caused from mining operations closing down, I am surprised there is even an opposition wishing to get elected! My bet is that whoever has the catchiest slogan will win - yes, it is a fickle business. But really,there may be plenty of fodder for bloggers in the next month.

Sorry for the cop-out blog, but there will be some detailed analysis next time.

Homogenous Humanity

I want to take a bit of a break from the financial crisis to talk about humanity, and more specifically, racial identity. The growing number of interracial and relationships I have witnessed, including my own, has led me along a line of enquiry that has some interesting implications.

To summarise, the question bugging me is whether the increased interracial breeding, especially in Australia, and probably much more so around the world, will cause distinct racial identities fade away? More importantly, will we end up with a ‘standardised’ race of humans? Or, will other environmental factors contribute to changing the nature of humans? Could we develop new races?

Overall, what will this impact have on our society?

The issue has bugged me since I learnt that there are in fact different races. At primary school I was completely ignorant of race. I had friends back then who I only now realise are Aboriginal, Indian, and Chinese. Further confusion was raised when I discovered that there are many policies that specifically determine outcomes based on race – with various Aboriginal assistance programs. There is an obvious justification for singling out the Aboriginal people for assistance given Australia’s history, but what about the half Aboriginal guy? Should he get half the assistance? Should half of him assist the other half of him? Why does he identify as Aboriginal and not Irish anyway? What about the quarter Aboriginal Chinese Indian African guy? Or is he something else altogether?

This brings me to the important social implications of such racial change. With which groups will the mixed race generations identify. Am I Indian or Chinese? And what if India was at war with China (heaven forbid); with which powerhouse will I side? My point is that the destruction of racial identity might have a beneficial effect of decreasing animosity amongst nations. In Australia especially it would be difficult to conjure domestic support for wars with nations whose racial heritage runs through the blood of many of our citizens.

Will religiousness fade away as racial ties fade? What religion would the son of a Buddhist and a Catholic be?

Would we try and preserve ‘pure’ races? Will some become extinct through breeding alone?

Maybe I should have at least proposed some hypothetical answers to these questions before I started writing. Please, I am interested to know your thoughts. Having a half Anglo-Saxon (what am I anyway?), half Chinese son myself I expect that many more questions will be raised. Will this generation of interracial children have trouble fitting in at school, being neither in the Chinese nor Aussie crowd? Who knows.