Category Economic Policy

The Effects of Advertising

Danny Vinik Leave a comment

I’m at Logan airport, ready to head back to Duke for my senior year. I’ve been mostly MIA the past two weeks, taking a break after my internship at the Washington Monthly to reboot myself and prepare not just for the upcoming semester, but for all the political chaos surely upcoming as well.

But while I’m at it, I’ll toss in some policy as well: at some airports, I use my Verizon 3G wireless card to access the internet. Not at Logan. It offers free wifi in return for watching a short 15 second advertisement. That sounds like a great deal to me. I didn’t even watch the ad. I was getting my headphones out as it played and when I looked up again, I was connected.

Now, I’m not sure the financials behind the deal but I presume the advertising companies are paying for most of the internet and in return, Logan requires users to watch their ads. I haven’t done any research on how advertisements effect me – I like to thing I ignore them and make rational choices – but those companies have. They have loads of research on the value of advertising and would not have made the deal with Logan unless those ads work. And if they work, then they are distorting users choices. Now, this could be good or bad.

Economic theory stipulates that a rational consumer will always make the optimal, efficient purchase. They have complete knowledge of the product, the competitors’ products and prices. But most of us aren’t rational consumers in that sense. We don’t necessarily research every purchase thoroughly. We don’t check competitors’ prices for most purchases. We just don’t have the time. So maybe the advertiser is helping us out. Maybe it really does have the superior product and its ad is just saving us the research.

But the opposite can also be true: maybe the advertiser is selling the inferior product and “deceives” the consumer into purchasing it (deceives them by distorting the relevant information). Clearly, there is an economic loss here.

But is it offset by the economic benefits of ads from advertisers’ with superior products? If so, then consumers win here. Because if the net costs and benefits are zero, then all that is left is the ad revenue that often goes towards consumers (such as internet in the airport).

And beyond that, companies’ eagerness to spend money on ads does not tell us anything about the net effects of them. In an extreme example, perhaps consumers always purchase an inferior product so companies with the superior product are desperate to advertise their products everywhere. In this situation, those ads help consumers. And, those companies see great net benefit in advertising. So who are the losers here? Well, those companies’ with the inferior products. This is a situation where the more advertising, the better. The fact that the companies’ see a net benefit to advertising is meaningless

What matters is the distortion of those ads: does it lead consumers to make more efficient, economical purchases or not? What about when you include the economic benefits of the ad revenue?

These are important questions as advertisements become more and more prevalent in our day to day lives. For instance, New York City recently announced that it will sell advertisements on metro cards. At first blush, this seems like a great idea. It offers more revenue for the Metro Transit Authority to improve the train. But maybe the ads distort consumers’ choices in a negative manner. If that’s the case, then it isn’t necessarily a great idea. It depends on the benefits those consumers’ receive from the improved metro.

All of this is to say that we don’t fully know. I’m going to go through more research during the next couple of weeks and see what I can find, but it’s important to keep in mind that ads aren’t just annoying (another negative effect that I didn’t mention), they are also an important economic factor in our society.

Yglesias’s Faulty Economics

Danny Vinik Leave a comment

Matt Yglesias just penned a post in defense of Mitt Romney’s tax plan but I think he mixes up the economics quite a bit. He writes:

The good thing about taxes is they raise revenue, which can be used to do useful things. The bad thing about taxes is they may be a drag on economic growth. But here there are two considerations. One is the “incentive effect” of taxes—higher taxes mean less incentive to do economically valuable things. The other is the “income effect”—less money in your pocket means more incentive to do economically valuable things. The genius of Romney’s plan is that by eliminating deductions it leaves middle class families with less money in their pockets (so a pro-growth income effect) while also lowering the tax rate they pay on a marginal dollar of additional earnings (so a pro-growth incentive effect). Basically it’s a huge win. You get a bunch of revenue in a way that bolsters the country’s growth prospects.

Let’st start at the beginning. The first part about taxes raising revenue and hurting growth is correct. But then it gets murky. Yglesias writes “higher taxes mean less incentive to do economically valuable things” and just a line later says, “less money in your pocket means more incentive to do economically valuable things.” But higher taxes means less money in your pocket. They are different ways of saying the same thing. Yet, Yglesias comes to different conclusions for their effects on economic growth.

I understand his train of thought here. A lower marginal tax rate allows people to keep a larger amount of their income. However, fewer deductions allows them to keep a smaller amount of their income. And if the middle class pays more taxes overall (as Romney’s plan does), that means they are keeping a lower share of their income overall and paying a higher effective tax rate. However, this says nothing about whether people will work more or less (which is what I assume Yglesias means by “do economically valuable things”).

Here, there are two different effects: the “income effect” and “substitution effect.” The income effect says that because  the middle class has less after-tax income, people will work more to make-up for their lost earnings. The substitution effect, on the other hand, says that because the middle class will keep a smaller percent of each dollar they earn (remember, overall they are paying more in taxes), they will work less. The question is, which effect dominates the other? If the income effect is a larger, people will work more (or do more economically valuable things). If the opposite is true though, people will work less (or do less economically valuable things).

But we don’t necessarily know which one  would dominate; it depends on a number of different things. So it is wrong to say that it bolsters the country’s growth prospects.

Nevertheless, I agree with the rest of Yglesias’s post that using the extra revenue to pay for a lower effective tax rate on high-income earners is a bad idea. In fact, Romney’s tax plan has a number of major flaws, not to mention that it is mathematically impossible. And given that it doesn’t necessarily improve the country’s growth prospects (which are also more complicated than just the middle-class), it’s tough to defend any aspect of Romney’s plan.

Glen Hubbard: Deliberately Misleading Readers

Danny Vinik 2 Comments

Romney economic advisor Glen Hubbard penned an op-ed today in the Wall Street Journal that is rather infuriating. Let’s look at Hubbard’s first assertion on policy uncertainty:

In response to the recession, the Obama administration chose to emphasize costly, short-term fixes—ineffective stimulus programs, myriad housing programs that went nowhere, and a rush to invest in “green” companies.

As a consequence, uncertainty over policy—particularly over tax and regulatory policy—slowed the recovery and limited job creation. One recent study by Scott Baker and Nicholas Bloom of Stanford University and Steven Davis of the University of Chicago found that this uncertainty reduced GDP by 1.4% in 2011 alone, and that returning to pre-crisis levels of uncertainty would add about 2.3 million jobs in just 18 months.

To the study we go! Here’s the graph of economic policy uncertainty:

Uncertainty rose a bit during the stimulus debate, though that also coincided with the crisis as a whole and TARP occurred right as Lehman Brothers collapsed. It’s certainly not fair to say that those policies did not cause any uncertainty – any policy change is going to make things more uncertain. But look what is responsible for “this uncertainty [that] reduced GDP by 1.4% in 2011 alone.” It’s the debt ceiling dispute! And who was responsible for it? The Republicans! They held the economy hostage for months. That 1.4 percent reduction is exactly what Obama tried to avoid by repeatedly calling for a clean increase of the debt ceiling. Yet, Hubbard is trying to lay the blame on the President! (And by the way, can we stop with this “ineffective stimulus” idea already? It wasn’t.) Continue reading “Glen Hubbard: Deliberately Misleading Readers” →