Price indices: constant utility or constant quantity?

Josh Hendrickson argues that an ideal price index should include asset prices. I am not going to address that issue, as I’m not sure what an ideal price index is. But it’s a good post—worth reading if you are interested in price indices.

Instead, I’d like to focus on a less controversial claim in the Hendrickson post:

From that description, one can easily understand why I called that “ideal.” How would one go about finding changes in the cost of a constant-utility basket of goods when utility isn’t really observable?

A practical solution to estimating a price index might be as follows. Consider two-period, two-good example. We observe the price of eggs and the price of milk each period. We also observe the quantity of eggs purchased and the quantity of milk purchased each period. If we want to track changes in prices over time, we could calculate expenditures for period 1 and period 2 using the quantities of eggs and milk purchased in the first period. Alternatively, we could calculate expenditures for period 1 and 2 using the quantities of eggs and milk purchased in the second period. In each case, the first period’s expenditure could be normalized to 100 and the second period price level could be calculated by multiplying 100 by the ratio of expenditures in period 2 to expenditures in period 1. Or, if we want to get really fancy, we could take the geometric average of the ratio of expenditures using both methods and multiply that by 100 to get the price level in the second period.

The purpose of doing any of these three options is that, since you are holding quantities constant across periods, your measures of expenditures are only capturing changes in prices. Effectively, what you are doing is constructing a weighted average of prices in which the weights are fixed quantities of the goods.

This is all pretty standard, similar to what you might find in an economics textbook. But this discussion implicitly assumes an equivalence between fixed quantities and fixed utilities. I will argue that this assumption is not justified, and then use my analysis to explain problems with the Michigan survey of inflation expectations.

To make things as simple as possible, imagine an economy with only one good and no quality changes over time. According to our textbooks, it should be easy to measure the rate of inflation in that sort of economy. But even in that case the inflation rate will differ depending on whether you assume constant utility or constant quantity.

Imagine an economy where the aggregate quantity of the only good increases at 5% per year, while the price of that good rises by 10%/year. You can think of that economy as having a 15% nominal growth rate. (I’ll ignore compounding for simplicity; technically it’s 15.5%). How much extra income would a person need each year in order to maintain a constant utility? I’m not sure, but I’m pretty confident the answer is not 10%, and it’s also not 15%.

1. A person that got a 15% raise would be able to buy 5% more real goods. So presumably their utility would be higher than before.

2. A person that got a 10% raise would be able to buy the same amount of goods, while that person’s acquaintances would be 5% ahead in real terms. So presumably that person would feel worse off in terms of utility.

This suggests that a measure of inflation that holds utility constant would be somewhere between 10% and 15%. You can think of utility as being a function of both absolute quantity of consumption and consumption relative to other people. Furthermore, it would vary by individual. A loner with no friends might be satisfied with a 10% raise, while a person that acutely feels any sort of “unfairness” in life might need almost 15% more income to maintain a constant utility. In other words, there’s a different ideal price index for each person.

Let’s assume that instead of holding utility constant, we hold quantity constant. Then it becomes easy to calculate inflation—which would be exactly 10% in this case. Unfortunately, our textbooks seem to conflate “constant quantity” and “constant utility” in a way that ignores the social aspect of consumption.

My thought experiment involves an economy where quantity grows over time. But the same problem occurs with quality improvements. Here again, a “hedonic” adjustment that attempts to account for quality changes will typically come up with a lower estimate of inflation than an index that holds utility constant. Thus the BLS says that the price of TVs has fallen by more than 99% since 1959 (due to quality improvements), but average people don’t think that way. They want to know how much more it costs to buy the sort of TV their neighbors have, not how much more it costs to buy the sort of TV their grandparents had.

Notice that the Michigan survey of 12-month inflation expectations generally hovers close to 3% from 2000 to 2020, even as measured inflation averaged a bit under 2%. Economists might be inclined to write off the public’s estimate as being “biased”, or “uninformed”. The public doesn’t understand about substitution bias, or quality changes.

Or perhaps the public is taking seriously the “constant utility” definition of inflation. Perhaps they are saying they need about 3% more income to maintain their utility at a constant level. Notice that the public’s estimate of inflation is slightly below the average rise in per capita nominal incomes, and slightly above the inflation estimate you’d get using the economists’ preferred “constant quantity” approach. That’s the same qualitative result we derived in my thought experiment above. Coincidence?

Treasure for pleasure

[Readers trying to avoid sugar for health reasons may want to skip this post.]

My basement recently flooded, and I was forced to knock out some drywall to prevent mold. At one point, I discovered a secret compartment that was completely walled in. It contained several boxes.

Here I should digress and mention that I’ve always been fascinated by the idea of finding treasure. When I was young, I collected old coins. Thus the specific form of treasure I imagined was a box of gold or silver coins that some old rich guy had hidden away, due to the fact that he lost trust in banks after losing his money in the Depression. (I once knew a guy like that.)

As an adult, the few cases where I found treasure involved finding valuable posters and prints in an obscure midwestern antique shop, not hoards of gold coins. It’s thrilling!

For me, the utility derived from treasure vastly exceeds its monetary value. I’d get more pleasure out of finding a box of coins worth $10,000 than I would from seeing my 401k go up by $100,000.

In any case, you cannot imagine how excited I was to see those boxes in that walled-in space. Why would someone hide something there if it were not valuable? I ripped open the first box and discovered . . . 6 rolls of holiday wrapping paper. There was a second box (dimly visible on the right), which was even larger. It contained 10 rolls of wrapping paper. Based on the style, the rolls are from the late 1960s. That means they were brought to this house by the owner who built it in 1979—and then sealed in. Why?

By coincidence, I’ve been reading the short stories by Nathaniel Hawthorne, which are full of parables, allegory and symbolism. What sort of message would Hawthorne find in my anecdote? What sort of message is the universe sending me? A greedy old miser seeks buried gold coins, and discovers that life’s greatest treasure is actually . . .

. . . giving?

Bah humbug.

Break with Trump?

I saw the following headline in the National Review:

What It Took for Republicans to Break with Trump

The article discussed the overwhelming vote to force a TikTok sale, which Trump “opposes”. This is supposedly in contrast to their kowtowing to Trump in voting against a border control bill, which Trump also “opposes”.

Why do I keep using scare quotes for “opposes”? Because with Trump nothing is as it seems. Obviously, Trump supports forcing China to sell TikTok, indeed he tried to do so back in 2020 when he was president. (The courts preventing the forced sale.) And Trump obviously supports the sort of stricter border controls contained in the bill that failed to clear Congress–he enacted similar policies. So what’s going on here?

In the case of the border control bill, Trump “opposed” it because he wants border chaos in the period leading up to the November election. In his “opposition” to forcing the TikTok sale, he wishes to curry favor with younger TikTok users, who would not like to lose their favorite app. Ideally, Biden would succeed in forcing the sale (something Trump secretly wants) and Trump would get votes for loudly defending free speech rights of younger voters.

So it’s a bit disingenuous to suggest the GOP is courageously “breaking with Trump” over TikTok; they are doing precisely what he wants them to do. When Trump makes a public statement, there is only one criterion that determines it’s content—will it win him votes.

This Matt Yglesias tweet caught my eye:

The truth is, almost every single top Republican official privately opposes Trump. We only see these views surface in cases where people are free to speak their minds, as with former GOP presidential candidates, former Trump officials, former vice presidents, Congressmen who are retiring, etc. We also see it in people before they become involved in politics, as with JD Vance. Or in private email conversations, as with Tucker Carlson. The GOP elite virtually all hold Trump in total contempt. (I say virtually all, as there are a few nutcases like Marjorie (Jewish space laser) Greene and Peter (federal prison inmate) Navarro that are true believers.)

DeSantis has “endorsed” Trump. Does anyone seriously think DeSantis will go into the voting both and pull the lever for Trump? Would you, if Trump had accused you of “grooming” teenage girls? People need to use their common sense. Trump has almost no support in the GOP elite. The endorsements are merely a facade, lapped up by people who believe we should take political statements as if they reflect the actual beliefs of the politicians.

PS. People talk a lot about the “deep state”. This is silly. Almost every single person who has the career accomplishments required for a high level DC job privately hates Trump. So why would you expect anything different? It’s not a deep state—there’s no conspiracy. It’s merely that almost all highly qualified people see Trump for what he is.

The decline of economics

In recent years, I’ve been bemoaning a new “dark age of macroeconomics”. I know less about current trends in micro, and thus was interested in these comments by Steven Levitt (from an interview by Jon Hartley):

Steve: “Yeah, yeah, sort of everywhere. Every macro department feels a lot like heavily influenced by Chicago. And I think for better or worse that has been a success story for the Chicago way of thinking. I think just really the opposite for Chicago micro; we have not had very many students who’ve gone out and been influential, maybe Ed Glaeser being a clear counter-example to that. And I think in the marketplace for ideas, I gotta say that the Chicago price theory really has lost. And it hasn’t caught people’s imagination. And I remember I was on a call with Milton Friedman as long after he left. He left Chicago in 1978, but this must have been 20-something years later where he was upset that Chicago price theory was not doing well, that it wasn’t being appreciated. And I remember Casey Mulligan saying, “Hey, Milton, I thought you believed in markets. Let’s just face it, price theory is losing in the market for ideas.” And Milton Friedman got so upset about that. He believed in markets until it applied to Chicago price theory where he thought that it was the right way, so markets shouldn’t have any bearing on it. But I think that’s just the truth. That the people who you think of as being the logical heirs to Chicago price theory, the two that come to mind really are Ed Glaeser and Jesse Shapiro, they’re not at Chicago. And with Kevin [Murphy] retiring, there isn’t, when Kevin Murphy retiring, there just isn’t anybody around now really, other than Casey Mulligan, who could really keep the torch going. And the movement in terms of textbooks and what people are taught is just so away from what I think of Chicago price theory, which is not as mathematical, it’s more about how you take the simple tools the very old tools you know tools that go back to people like Marshall and how you use them. It’s really the skill that I see in Chicago price theory (one that I don’t have) is how do you look at a problem and understand it to the lens of the right tool. And it’s not complicated. It’s usually very simple. Once you can see it, it’s usually not much more than intermediate micro is what gets applied. And it’s more artistic. And I really feel like our field has moved towards technicality. Harder proofs. More mathematical. And I don’t see any going back. I think it is essentially lost to posterity at this point.”

I find this very depressing. To me, Chicago price theory is not just a branch of economics, it is economics. It’s the core of what we know about applying economic theory to the real world. When I’m told that Chicago price theory is going out of style, it tells me that economics as a field is going out of style.

And it is. Does anyone doubt that economists have far less influence in the Biden administration than in previous administrations? Or that they would have little influence in a future Trump administration (likely to be dominated by protectionists like Peter Navarro and Robert Lighthizer)?

PS. I’m not convinced by the “market test”. Political and economic fads go in and out of style. What’s popular at one point in time tells us little or nothing about what will be trendy a few decades into the future. Monetarism lost the market test in the mid-20th century, then won the market test, and then by the end of the century we ended up with a synthesis of monetarist and Keynesian ideas.

Wage inflation in Japan

There is evidence that nominal wages in Japan are finally starting to rise:

Toyota Motor Corp. met its labor union’s demands for increases in salary and bonuses in full for the fourth straight year, in another sign that a sustainable wage-price cycle may be taking hold in Japan’s economy as the central bank considers the timing of a long-awaited interest rate hike.

The yen rose and government bond futures fell — signs traders were adding to bets on an imminent move by the Bank of Japan . . .

Economists expect the results of negotiations between companies and unions to point to stronger wage growth than last year. That should clear the path for the BOJ to end the world’s last negative interest rate regime by April, according to a majority of economists in a Bloomberg survey.

While the media focuses on price inflation in places like Japan (too low) and the US (too high) the real issue has always been wage inflation. Is Japan’s wage inflation sustainable? I don’t know. If I were the BOJ, I’d be in no rush to tighten policy. (Recall the mistakes of 2001 and 2006.)

The same picture works if you replace wage inflation with NGDP growth.