Duflo, a 37-year-old native of France, is the Abdul Latif Jameel Professor of Poverty Alleviation and Development Economics at MIT and a director of MIT’s Abdul Latif Jameel Poverty Action Lab (J-PAL). Her work uses randomized field experiments to identify highly specific programs that can alleviate poverty, ranging from low-cost medical treatments to innovative education programs.

Watch her talk at a recent TED conference, for a convincing story that simple economic theory, backed by controlled field experiments, can yield important changes in our world.

But the latest recession has caused some big changes. High unemployment meant that fewer people were driving to work, and a slump in consumer spending meant that less freight needed to be moved around the country. As gas prices soared in 2005, the number of miles driven – including commercial and personal – began to fall, and continued to drop after 2008 even as gasoline became cheaper.

From The New York Times

This image – click on it for a larger view – shows periods of what we would expect from a demand curve – downward sloping, showing more miles driven when gas prices are lower.  However there are periods where prices change and driving miles don’t, or when prices increase and miles driven increase.  What gives?

The key is found in the title of this post – ceteris paribus – which loosely translated means “all things remaining equal.” In a typical demand curve we look at changes in price and their impact of demand. We assume that everything else about the market is held constant – remain equal. For this chart, which shows annual data from 1956 to the present, ceteris paribus is not in play. There are many things changing, including driver incomes. So some segments of this historical trend look like a standard demand curve, sloping down and to the right. In other cases, what we are really seeing is a shift in demand, driven by factors other than price.

Here’s a quick list of reasons to tax. Each have a bit longer explanation down below.

We tax to…

1. pay for public services that are easier or more efficient to provide as a community than to pay for individually.  (AKA public goods)
2. correct for inequalities in individual wealth or income – to provide some basic level of food, shelter, medial care, etc. (AKA welfare and other social services)
3. correct for externalities.
4. Change behavior – encourage or discourage through incentives

1. Public Services/Public Goods:  There are services that many people want, but individually we could not afford to buy them. While it is possible for groups of individuals to come together privately to pool their funds and provide the service, they often run into the free rider problem. So we give government the ability to build roads, provide police and fire protection, and many other worthwhile goods and services. Often times voters have to approve the tax to pay for these. Here are some other posts on the topic.

2. Income Redistribution / Social Services: In some economies there is an explicit goal for a Robin Hood policy (take from the rich and give to the poor) – purely to even out income or wealth. In the United States and many other countries there is a social ethic or value that says that the poorest members of society should be able to live in at least some minimum level. This ethic or value is controversial, of course. Some voters support strong government efforts to improve the lives of our poorer members – along the lines of European social democracies. Other voters prefer a self-determination, self-reliance model, where citizens have opportunities but are left to their own to survive or advance in the world. And many voters are somewhere in between. In a later post we’ll show how many tax strategies focus on extracting more tax revenue from the wealthy than from the poor.

3. Correcting Externalities: In economics we call the presence of externalities a market failure. When someone outside of a market transaction is either harmed by or benefits from that transaction, we have an externality. If there is an externality then the market will produce either too much or too little of that good, and will not reach a social optimum. The most common example is factory pollution. When the factory produces a good and pollutes while doing that, others outside the factory are affected. See more on externalities here.

4. Incentives to Change Behavior: Some times we enact taxes to discourage behavior. “Sin taxes” are one such example. Tobacco taxes can be used to defray state health care costs. Generally this is a pretty inefficient mechanism since many of the “sins” are addictive and demand for them price inelastic. More often a tax on tobacco or alcohol is just a convenient way to raise revenue, and voters are more likely to support those taxes over more general income or sales taxes. A more modern application of this category is called a Pigovian tax, and the prime example being discussed is a carbon tax. Taxing activities and products that release carbon into the atmosphere should discourage and reduce those activities.  We also give tax credits for behavior we want to encourage.

Here is the rap version, for your entertainment. The player below gives a teaser, with a link to the full version, which is free to listen to.

Demand, Supply – Rhythm, Rhyme, Results

You are a utilitarian social planner. You have a limited number of H1N1 vaccines. How do you allocate them? Do you (A) give them to specific groups, such as high-risk populations, or (B) sell them to the highest bidder and rebate the revenue lump-sum to everyone? If you choose (A), do you allow those individuals allocated the vaccine to sell their dose to someone else? Be sure to specify the economic environment as carefully as possible. And remember: Your goal is to maximize total utility.

Not only is this relevant to our current flu situation, it raises parallel questions in healthcare reform – on government or society’s ability to ration scarce resources.

A Slate article mentions that the annual price of a hot-dog stand license near the Metropolitan Museum of Art in New York City is $362,201. Licenses are very limited and are bought at auction. The price presumably reflects the economic rent associated with the particular site (the price would be a lot lower in the middle of Central Park). Yet at a fixed cost of $1,000 per day, how can a hot-dog vendor make enough money to cover his variable cost, including the value of his own time?

For my new micro economics students, this is an example of cross price elasticity. This concept looks at how the market for one good (in this case pressure cookers) is impacted by a change in the price of another good (in this case electricity). Though I don’t know the numbers in this scenario, let’s assume that electrical rates went up 10 percent. If we then saw a 15 percent increase in sales of pressure cookers, we’d say that this relationship is elastic – that pressure cooker sales are very responsive to a change in price of electricity.

[T]he world’s principal source of man-made greenhouse gases has always been prosperity. The recession makes that relationship easy to see: shuttered factories don’t spew carbon dioxide; the unemployed drive fewer miles and turn down their furnaces, air-conditioners, and swimming-pool heaters; struggling corporations and families cut back on air travel; even affluent people buy less throwaway junk.

Later he points out,

The world’s financial and energy crises are connected, and they are similar because credit and fossil fuels are forms of leverage: oil, coal, and natural gas are multipliers of labor in much the same way that credit is a multiplier of wealth. Human history is the history of our ascent up what the naturalist Loren Eiseley called “the heat ladder”: coal bested firewood as an amplifier of productivity, and oil and natural gas bested coal. Fossil fuels have enabled us to leverage the strength of our bodies, and we are borrowing against the world’s dwindling store of inexpensive energy in the same way that we borrowed against the illusory equity in our homes.

And now to the real nub of his commentary. Owen points out that the high price of gasoline earlier in 2008 resulted in a six percent drop in gasoline consumption. This, in turn, led to desirable activities on our part, including “[...]pushed down consumption and vehicle miles travelled, stimulated investment in renewable energy, increased public transit ridership, and killed the Hummer.” He goes on to argue, though, that development of more fuel efficient cars, like the hybrid, merely reduce the price of driving, and do not foster a fundamental change in travel, commuting, and related habits.

Take a moment to read the whole article – it is in the comments section, so not as long as a typical New Yorker piece. It is a good application of the power of incentives, the market place, and scarce resources.

In his blog in October, Greg Mankiw pointed to a chart from PhDComics.com that is sure to warm the hearts of college instructors: