Misapplied economics and overwrought estimates

by Timothy Telleen-Lawton6 min read12th Jan 201531 comments

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I believe that a small piece of rationalist community doctrine is incorrect, and I'd like your help correcting it (or me). Arguing the point by intuition has largely failed, so here I make the case by leaning heavily on the authority of conventional economic wisdom.

The question:

How does an industry's total output respond to decreases in a consumer's purchases; does it shrink by a similar amount, a lesser amount, or not at all?

(Short-run) Answers from the rationalist community:

The consensus answer in the few cases I've seen cited in the broader LW community appears to be that production is reduced by an amount that's smaller than the original decrease in consumption.

Animal Charity Evaluators (ACE):

Fewer people in the market for meat leads to a drop in prices, which causes some other people to buy more meat. The drop in prices does also reduce the amount of meat produced and ultimately consumed, but not by as much as was consumed by people who have left the market.

Peter Hurford:

As is commonly known by economists, when you choose to not buy a product, you lower the demand ever so slightly, which lowers the price ever so slightly, which turns out to re-increase the demand ever so slightly. Therefore, forgoing one pound of meat means that less than one pound of meat actually gets prevented from being factory farmed.

Compassion, by the Pound:

The key points to note are that a permanent decision to reduce meat consumption (1) does ultimately reduce the number of animals on the farm and the amount of meat produced (2), but it has less than a 1-to-1 effect on the amount of meat produced. 

These answers are all correct in the short-run (ie, when the “supply curve” doesn’t have time to shift). If there is less demand for a product, the price will fall, and some other consumers will consume more because of the better deal. One intuitive justification for this is that when producers don’t have time to fully react to a change in demand, the total amount of production and consumption is somewhat ‘anchored’ to prior expectations of demand, so any change in demand will have less than a 1:1 effect on production.

For example, a chicken producer who begins to have negative profits due to the drop in price isn't going to immediately yank their chickens from the shelves; they will sell what they've already produced, and maybe even finish raising the chickens they've already invested in (if the remaining marginal cost is less than the expected sale price), even if they plan to shut down soon.

(Long-run) Answers from neoclassical economics:

In the long-run, however, the chicken producer has time to shrink or shut down the money-losing operation, which reduces the number of chickens on the market (shifts the "supply curve" to the left). The price rises again and the consumers that were only eating chicken because of the sale prices return to other food sources.

As a couple of online economics resources put it:

Policonomics:

The long-run market equilibrium is conformed of successive short-run equilibrium points. The supply curve in the long run will be totally elastic as a result of the flexibility derived from the factors of production and the free entry and exit of firms.

 

AmosWEB*:

The increase in demand causes the equilibrium price of zucchinis [to] increase... and the equilibrium quantity [to] rise... The higher price and larger quantity is achieved as each existing firm in the industry responds to the demand shock.

However, the higher price leads to above-normal economic profit for existing firms. And with freedom of entry and exit, economic profit attracts kumquat, cucumber, and carrot producers into this zucchini industry. An increase in the number of firms in the zucchini industry then causes the market supply curve to shift. How far this curve shifts and where it intersects the new demand curve... determines if the zucchini market is an increasing-cost, decreasing-cost, [or] constant-cost industry.

Constant-Cost Industry: An industry with a horizontal long-run industry supply curve that results because expansion of the industry causes no change in production cost or resource prices. A constant-cost industry occurs because the entry of new firms, prompted by an increase in demand, does not affect the long-run average cost curve of individual firms, which means the minimum efficient scale of production does not change.

[I left out the similar explanations of the increasing- and decreasing-cost cases from the quote above.]

In other words, while certain market characteristics (increasing-cost industries) would lead us to expect that production will fall by less than consumption in the long-run, it could also fall by an equal amount, or even more.

Short-run versus long-run

Economists define the long-run as a scope of time in which producers and consumers have time to react to market dynamics. As such, a change in the market (e.g. reduction in demand) can have one effect in the short-run (reduced price), and a different effect in the long-run (reduced, constant, or increased price). In the real world, there will be many changes to the market in the short-run before the long-run has a chance to react to to any one of them; but we should still expect it to react to the net effect of all of them eventually.

Why do economists even bother measuring short-run dynamics (such as short-run elasticity estimates) on industries if they know that a longer view will render them obsolete? Probably because the demand for such research comes from producers who have to react to the short-run. Producers can't just wait for the long-run to come true; they actively realize it by reacting to short-run changes (otherwise the market would be 'stuck' in the short-run equilibrium).

So if we care about long-run effects, but we don't have any data to know whether the industries and increasing-cost, constant-cost, or decreasing-cost, what prior should we use for our estimates? Basic intuition suggests we should assume an industry is constant-cost in the absence of industry-specific evidence. The rationalist-cited pieces I quoted above are welcome to make an argument that animal industries in particular are increasing-cost, but they haven't done that yet, or even acknowledged that the opposite is also possible.

Are there broader lessons to learn?

Have we really been messing up our cost-effectiveness estimates simply by confusing the short-run and long-run in economics data? If so, why haven't we noticed it before?

I'm not sure. But I wouldn't be surprised if one issue is, in the process of trying to create precise cost-effectiveness-style estimates it's tempting to use data simply because it's there.

How can we identify and prevent this bias in other estimates? Perhaps we should treat quantitative estimates as chains that are no stronger than their weakest link. If you're tempted to build a chain with a particularly weak link, consider if there's a way to build a similar chain without it (possibly gaining robustness at the cost of artificial precision or completeness) or whether chain-logic is even appropriate for the purpose.

For example, perhaps it should have raised flags that ACE's estimates for the above effect on broiler chicken production (which they call "cumulative elasticity factor" or CEF) ranged by more than a factor of 10x, adding almost as much uncertainty to the final calculation for broiler chickens as the 5 other factors combined. (To be fair, the CEF estimates of the other animal products were not as lopsided.)

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Basic intuition suggests we should assume an industry is constant-cost in the absence of industry-specific evidence.

Why on earth should we assume that?

The default assumption is that industries are increasing-cost, because low-hanging fruit is picked first. Just like extracting more oil means exploitation of more difficult-to-extract reserves, and bottling more wine means growing it in regions where the grapes need more looking after, producing more meat means cultivating more marginal land.

So in your case, in the long run, the reduced demand for meat leads to less cultivation of marginal land, leading to a slightly lower price, and so the reduction in meat consumption is slightly less than the amount of meat you would have eaten. The rationalist community, and standard economics, give the same answer, and it is only your very strange assumption (which you bury in the middle of your article!) that causes a discrepancy.

The default assumption is that industries are increasing-cost, because low-hanging fruit is picked first.

I agree this effect will push towards an increasing-cost industry, but there are other effects at play that might be even more powerful such that the industry is constant- or decreasing-cost. For an extreme example, consider the market for computer games; I expect this to be a decreasing-cost industry (the more people buy computer games, the cheaper-per-quality they will be in the long-run, even ignoring technology improvements). For a more moderate example consider haircuts. How confident are you that the price of haircuts will increase the more haircuts there are in the long-run? For example, do you expect the real price of haircuts to rise dramatically as the population of a country grows dramatically? I do not.

My claim is that we shouldn't assume that the meat industries are increasing-cost unless/until we have better reason to do so. The rationalist community pieces implicitly assume that all industries are increasing-cost (and don't give reasoning for that example that's relevant in the long-run), whereas the economics articles I cite show that industries can also be constant- or decreasing-cost as well.

The rationalist community, and standard economics, give the same answer, and it is only your very strange assumption (which you bury in the middle of your article!) that causes a discrepancy.

Actually my prior that industries are constant-cost is not a particularly strong one; I'd be happy if the sources I cite simply remove or justify their assumption that animal product industries in particular are increasing-cost. As I've shown from the standard economics citations, they are actually with me in not assuming that industries are increasing-cost (unless you're arguing that AmosWEB and Policonomics do not represent the standard economics view).

How confident are you that the price of haircuts will increase the more haircuts there are in the long-run? For example, do you expect the real price of haircuts to rise dramatically as the population of a country grows dramatically? I do not.

This confuses supply and demand. The most important factor of production in haircuts is human labour. If you double the population of a country, then you double the number of haircuts demanded, but you also double the amount of labour supplied. Similarly, oil prices wouldn't rise if oil demand doubled... but every oil field doubled in size and output rate.

You are right that some industries may be decreasing-cost at certain margins, and computer games sound like a plausible candidate due to the low marginal cost. However, in the extreme, every industry is increasing-cost, simply because of resource scarcity (consider the situation if computer game demand was so high that 90% of the population worked as game developers). This is why the default assumption is increasing-cost.

As I've shown from the standard economics citations, they are actually with me in not assuming that industries are increasing-cost (unless you're arguing that AmosWEB and Policonomics do not represent the standard economics view).

Neither of these publications make any suggestion as to whether most industries are increasing or decreasing cost in those articles, as far as I can tell. The fact that they don't make such a suggestion doesn't mean that we shouldn't have a prior.

The most important factor of production in haircuts is human labour. If you double the population of a country, then you double the number of haircuts demanded, but you also double the amount of labour supplied.

To get around the objection of increasing labor, let's assume instead that everyone in the country decides to permanently get their hair cut twice as often as before. What do you expect the real price of haircuts to be in 10 years? Significantly higher, about the same, or significantly less? My prior is "about the same" until I have more data.

More generally (and naively), if I had to guess whether a given industry is increasing-, constant-, or decreasing-cost, two factors I would consider are: 1) How important to the cost of the product are inputs that are finite? How much of the market for those inputs goes toward making the product (as opposed to other uses that might substitute away from that input if the price increases)? 2) What economies of scale exist in the production of the product? To what extent will greater demand-per-person allow firms to approach the maximally efficient scale?

I have not seen these (or other relevant) factors used to advocate that animal product industries in particular should be assumed to be increasing-cost. (However I do appreciate your attempt to argue that our prior should be that all industries are increasing-cost in the absence of better evidence, which I argue against in a separate comment.)

You're the first person who disagrees with my conclusion but is willing to admit that some industries will be decreasing-cost (wherein we should expect greater than 1:1 effect on production); that is very refreshing!

in the extreme, every industry is increasing-cost, simply because of resource scarcity (consider the situation if computer game demand was so high that 90% of the population worked as game developers).

Yes, I agree in the extremely-large case. What about the extremely-small case? It's very hard to think of a fledgling market for which the average price would be higher if the market produced 100 units instead of 1 unit. So I think that the vast majority of markets will be decreasing-cost when they're arbitrarily small, and increasing-cost when they're arbitrarily large. What about in between? How do we know where on the spectrum an industry is?

I agree we need a prior. If something could be positive, neutral, or negative, and I have no evidence of which it is, my default meta-prior is neutral. Obviously that is an extremely weak prior (ie I'm very open to being convinced it should be something else), but nothing in the pieces I quoted justifies an increasing-cost prior (they just discuss short-run market dynamics). Your "low hanging fruit" argument comes the closest because it's a valid reason that points in one direction, but it is incompletely argued so far (the "in the extreme" argument is unconvincing since the same can be said of an opposing force).

Without looking at data, my prior on meat production being an increasing cost industry is extremely high.

  1. Meat production is a commodity product. Commodity products compete mainly on price, and so we should expect the industry to be fairly normal (i.e. the sort of industry discussed in econ 101 courses) in terms of competition, costs, etc.

  2. Meat has a number of costly inputs, including feed, water, land and labor. If you have several commodity inputs, you can expect that at least one of them would be a potential bottleneck to increasing the scale of the industry at constant cost. For example, we know that water usage is definitely increasing cost, because the next efficient option after depleting our reservoirs is desalination which is stupid expensive on agriculture scales (and this flows into feed prices).

  3. Meat production is an extremely large and mature industry. We should expect that large and mature industries have scaled up to the point where marginal costs are increasing, because they have had the time and intelligence invested in them to pick the low-hanging and high-hanging productivity fruit.

  4. People who eat meat would like to eat more of it, if only it were cheaper. For example, if MacDonalds introduced a third-pounder for the same price as a quarter pounder, most people would buy it. Since this situation exists, it is probably difficult to provide meat at cheaper prices holding other relevant factors stable. One can imagine another industry where people have no particular desire to purchase more of the given product if the price were lower, such as child car seats and so the industry is limited in size before it achieves minimum cost scale.

Of course, in some sense this dodges another question, which is what is your prior probability prior to. If you had never heard of economics, and were just talking about abstract categories which industries either were a member of or were not a member of, then perhaps you could presume a 50% meta-prior. If someone were to take all the industries in the world at a very fine-grained level, and they presented it to you, perhaps then a 50% probability would be warranted as well. To be honest, I'm not sure what the probability would be in that situation, if you were looking at, like beekeeping and video game production and taxi driving as example categories. But from that point to the point of meat production specifically we have many pieces of knowledge that become our prior before we actually get to the collecting real data. My prior of an industry being increasing marginal cost, weighted by the number of times it gets discussed in newspaper articles, or weighted based on the amount of revenue it generates per year, is much higher than 50%.

Edit: I see that this is somewhat repetitive of what you wrote in your other comment. Oh well, it's already written.

Great! This is the only 'complete' argument I've seen that our prior for animal products industries should be that they are increasing-cost rather than constant-cost. I'm not as confident as you seem to be, but that's more of a quibble at this point, and I'm glad we agree on the meta-prior!

The challenge then is to convince Norwood and Lusk that we want to know the long-run impact of consumer choices on animal production, not the short-run! They're clearly estimating short-run elasticities since (a) their supply curves are way too steep, even for an increasing-cost industry, and (b) they explain their elasticities with an explanation that is irrelevant to the long-run:

Because it takes a year between the time a cow is bred and the time her calf is born, and then it also takes a long period before that cow can be transformed into beef or produce milk, it is difficult for beef and dairy producers to alter production according to changes in consumer preferences.

(consider the situation if computer game demand was so high that 90% of the population worked as game developers)

It would still be decreasing cost since the marginal cost of serving an additional customer is the cost of him downloading a copy of the game.

You seem to compare different models of supply in demand, each based on different assumptions, and each expected to work on different time scales, and declare one of them "incorrect". Presumably what you mean by a more "correct" model is that it explains existing data and predicts future events better than the alternatives. If so, one should take your outline, make it into a proper simulation, plug in the available data, tweak the free parameters to match, then check if its predictions match the data not used to calibrate the model. Only after that you will have an argument for correctness. And only then, say, make a recommendation to the EA community re ways to decrease farm animal production.

To be fair, this bias towards theorizing instead of modeling and testing is a common pitfall of this community. I find it pretty disappointing, but maybe it's just me.

What do you recommend if good data is too costly to collect?

I think that if someone has made a claim but failed to use good data or an empirical model, it should not require good data or an empirical model to convince that person that they were wrong. Great if you have it, but I'm not going to ignore an argument just because it fails to use a model.

What do you recommend if good data is too costly to collect?

Collect better data anyway, real and simulated. Otherwise someone will wave a different argument and reject yours. Happens here all the time.

Also, regarding believable arguments, consider reading http://squid314.livejournal.com/350090.html

How does an industry's total output respond to decreases in a consumer's purchases

I think you mean to ask how an industry's output responds to a decrease in demand since Total output = consumer's purchases + wastage. If just one consumer decided to not buy the good at any price this is what would happen. The question you asked lumps together supply and demand effects and I believe this is the cause of your confusion. A decrease in demand means that for every possible price consumers want to buy less.

The answer is that it depends, and the decrease in sales could be tiny or huge depending on elasticities. The fall in demand will (by definition) have no impact on the supply curve since the supply curve takes into account how much firms are willing to sell at every price and so already accounts for the possibility of prices falling. If this question interests you, look at the elasticity chapter of an introductory microeconomics textbook.

If just one consumer decided to not buy the good at any price this is what would happen.

Yes, I'm referring to a decrease in a consumer's purchases at any price (such as someone becoming vegetarian in a chicken market) not just at one price (in which case, if the price lowered a cent, they would re-enter the market); I agree this also counts as a decrease in demand.

The answer is that it depends, and the decrease in sales could be tiny or huge depending on elasticities.

Yes, if you mean 'long-run elasticities' then we agree. In fact the only thing that confuses me about your answer is what you think I should learn from an introductory microeconomics textbook.

The fall in demand will (by definition) have no impact on the supply curve since the supply curve takes into account how much firms are willing to sell at every price and so already accounts for the possibility of prices falling.

I disagree with your claim and it seems like you're confusing short-run and long-run; I don't think you'll find a definition of supply curve such that it cannot react to changes in demand in the long-run. Policonomics explains such a demand-motivated change in supply (D', S', and E2 refer to the chart in the original post):

Once this market equilibrium is reached, one might ask: what happens if there is an increase in demand? First, this will shift market demand to D’, increasing prices because supply (for the moment) is given. This increase in prices allows for profits to be made, at point 1. However, as seen before, these profits will attract new firms, which will force supply to the right (S’), going to an equilibrium such as E2, where our firm will produce the exact same initial quantity (point 2).

Sorry to repeat myself but by definition a change in demand by itself can not effect the supply curve, short or long run. If Policonomics says otherwise then it's wrong. I'm an academic economist, the author of this textbook, and the host of this podcast.

Given your credentials, I can't fathom you disagree that shifts in demand can cause shifts in the short-run supply curve in the long-run. E.g. if lots of people start/stop eating meat, the short-run supply curve will look different 5 years from now due to that change alone.

Given that I believe you agree with that, I deduce that you only mean that changes in demand cannot shift the short-run supply curve in the short-run, nor shift the long-run supply curve in the long-run. With that I do agree by definition.

Funny that the only post by someone acknowledging negative-sloping long-run supply curves AND refraining from advocating a prior that meat industries are increasing-cost (yay; that's all I really want!) ends up sounding like a disagreement anyway due to semantics : ]

if lots of people start/stop eating meat, the short-run supply curve will look different 5 years from now due to that change alone.

NO!

I'm curious, given my credentials with what probability do you think I'm right?

Edit: I'm embarrassed by this, but I retract what I said.

Given our confidence for opposing positions and your credentials my best guess is that there's a miscommunication, in which case my guess on your correctness won't be well defined. Perhaps there's some critical word I'm using colloquially that has an importantly different meaning in economics.

Perhaps there's some critical word I'm using colloquially that has an importantly different meaning in economics.

Yes and it's "supply curve".

Consider one point on a a firm's supply curve which let's say represents price=$1 and quantity=1000. This means that in the hypothetical situation in which this firm could sell as many goods as it wanted at a price of $1, it would want to sell 1000 goods. There is no reason why a few customers not wanting to buy the product would change this. True, a few customers not buying the product would change the demand curve, which would change the market price, which would change where on the supply curve you will end up, but it won't change the supply curve. The supply curve only changes when holding price constant (and assuming the firm can sell as much as it wants at this price) the firm wants to sell a different amount. This might seem like a small point, but to correctly use supply and demand analysis you need to distinguish between moving along a supply curve (because price changes) and moving to a different supply curve.

I think you are ignoring an important point that erratim is making. If demand is decreased that most certainly can cause later changes in the short-run supply curve. What does the short-run supply curve look like for buggy whips in 2015? Is it the same as it was in 1915? The firms that exist couldn't satisfy the 1915 demand for buggy whips in the short term except at outrageous prices. That's because decreasing demand led to most of those firms disappearing, so that all that's left is artisan hobbyists making buggy whips for Charles Dickens re-enactments (I actually don't know anything about buggy whips, but you get the point).

Changes in demand can change the level of investment in an industry, which clearly changes it's short-run supply curve.

Edit: Fixed accidental replacements of "supply" with "demand"

This is really a definition thing. The supply curve for buggy whips is greater now than in 1915 (meaning that if you held price constant firms would be willing to produce more of them now than in 1915) because it costs less to make them, it's just that the demand is so low that the market price is low and therefore few buggy whips get produced.

Does this imply that short-run aggregate supply curves are independent of the level of investment currently existing in an industry? So, if you have a factory that can only produce 100 widgets, your short-run aggregate supply curve continues on as if you had the ability to have more factories?

Does this imply that short-run aggregate supply curves are independent of the level of investment currently existing in an industry?

No.

I'm guessing this is your argument: I buy fewer widgets, so firms invest less in widget factories, which changes the supply curve. But what's happening is you buy fewer widgets, which lowers price, which moves firms to a different point on their supply curve which has them building fewer factories.

This kind of thing is really easy to get confused about, and isn't important unless, as with the original post, you want to use supply and demand curves to trace out how you can move from one equilibrium to another.

Then what is the difference between short run and long run aggregate supply? I'm confused.

For every possible price the short run supply curve says how much you produce in the short run, whereas the long run supply curve says how much you will produce in the long run. In the simple perfect competition model the long run is enough time for firms to change all of its inputs.

I think I know the difference between changes in supply and movement along the supply curve, and your post confuses me. I take the OP's point to be that, in the long run, a change in demand shifts the short-run supply curve. This is exactly the sort of long-run dynamics scenario McAfee talks about (section 4.2.2, e.g. figures on p. 106). Is McAfee wrong or am I really missing something?

It gets confusing when you talk about how a long run change in demand can shift the short run supply curve when from a social welfare viewpoint what we should care about in this situation is the long run supply curve which wouldn't change, but reading McAfee I can see that I should not have been so certain that I was right. Thanks!

The following line of timeless consumer economics occurred to me. Please poke holes in it —

I shouldn't assume that my decision-making process is a lot better than everyone else's. I don't have unusual levels of access to the facts. If I believe a stock will go down, my belief is based on publicly-available facts which other traders have. Therefore, I should not expect to make a windfall on the basis of my belief, because my belief is not unusually accurate.

However, the same general rule applies to consumer choices. I shouldn't assume that my consumer choices are unique to me, either. If I decide to stop buying product X, it's probably for publicly-available reasons that other consumers also possess. So I should not expect that I am the only one quitting X or switching to Y.

(This doesn't mean that nobody is switching in the other direction, of course, although it may mean I possess no positive evidence of that proposition.)

Therefore, in cases where I am personally involved, as opposed to cases where I'm considering an abstract market I'm not involved in, I should expect that my own decisions indicate more than just my own decisions.

Broadly: You are not the marginal consumer.

However, the same general rule applies to consumer choices.

Not quite, because the metric is different.

Everyone buys and sells stocks for a single reason -- to make money. The profit from a trade, expressed in dollars, is the universal target of optimization. However with consumer choices there is no such single and universal target. Alice, Bob, Charlie, and Dick all buy different cereals -- not because they are irrational, but because they have different tastes and preferences.

I should expect that my own decisions indicate more than just my own decisions.

Yes, you should expect that there are more people like you. But that does NOT necessarily imply that the majority of the consumers in this case are like you.

I wrote: "I should not expect that I am the only one quitting X or switching to Y."

I didn't write: "I should expect that everyone else is quitting X or switching to Y."

Your response generalizes back to the stock market, too --- any time the market clears, the number of shares bought equals the number sold. So everyone intends to make money, but any time a nonzero number of people act on their belief "I should buy!" there is also a nonzero number of people acting on "I should sell!". (Not necessarily the same number, of course; nor does the market always clear.) This isn't necessarily because they have different preferences, but because they have different beliefs.

Indeed, for the market to clear, there have to be people with different beliefs or preferences. If literally everyone believes a stock is going to go to $0, nobody will buy it at any price. But if everyone thinks that it will monotonically rise, some people will at various points want to cash out due to their preferences — to buy a house or something.

I wrote: "I should not expect that I am the only one quitting X or switching to Y."

If you want to treat this literally, this is just a "well, duh" sentence. What's the deeper point behind it?