Sunday, June 13, 2010

What If Analysis - 4

At the writing of this piece, the economy is quite sluggish with unemployment hovering around 10%. Any tax on a consumer product, especially one as important to ordinary existence as gasoline, has a perceived effect on buyers that is the same as a price increase. Buyers feel poorer as a result and consequently are apt to spend less on other goods. Weakening consumer demand is not a good thing now, given the poor performance of the economy overall. That’s a macroeconomic reason. There are microeconomic reasons as well. The tax will create some deadweight loss (gains from trade that are no longer realized as a consequence of the tax) the same sort of loss that would occur where there a monopolistic seller instead of a competitive market. The arguments against the policy are from its immediate consequences. The benefits from the policy are likely to accrue in the future, if innovation with alternative energy sources is successful. Thus, we can envision these benefits as resulting from the decline in the future prices of such alternative energy sources. This way of conceiving the costs and benefits from the policy provides for a potential way to compute which is larger and thereby determine whether the policy is bad or good.

While the above may seem a textbook-type analysis, note that real policy makers in the Obama Administration use these tools to assess government regulations, particularly environmental regulations. This profile of Cass Sunstein, Director of the Office of Information and Regulatory Affairs, gives some insight into how he and other economists (Sunstein was a professor at the University of Chicago, now at Harvard Law School, and has co-authored the popular book Nudge) think about these issues. It turns out that a key consideration is determining the appropriate interest rate to use in performing the cost-benefit analysis. A low interest rate, meaning the future is highly valued, is apt to favor the additional regulation. A high interest rate implies that the present costs will predominate and thus that the additional regulation under consideration will appear unattractive. Perhaps unsurprisingly, there is some disagreement as to which interest rate is appropriate to use.

Let’s bring this essay to a close by tying the ideas here to the notions we came up with in our analytic exercise – reservation price and opportunity cost. In order to compute those we needed to know all values and costs in each scenario, not just with the chosen alternative. These concepts crystallize how economists think about “what if” analysis. They are exceedingly important for that reason.

This essay is meant, however, to convey that these ideas can be misapplied by ignoring issues regarding lack of information, or issues that result because some information is softer than other information which might then be mistakenly ignored, or that sometimes we don’t properly internalize all opportunities and therefore make too myopic a choice. Thus, applying these concepts well in doing a “what if” analysis requires substantial subtlety as well as some humility in that the answer is almost surely tentative and therefore subject to refinement. Those caveats notwithstanding, “what if” analysis is the heart of rational decision making and it is a critical tool to avoid making mistakes in decision that could well have been anticipated in advance.

Do you perform “what if” analysis in any of the big choices you make?