Sunday, August 29, 2010

Positional/Context/Prestige Externalities

In an open letter to his students at Berkeley, that I encourage everyone to read, Michael O'Hare wrote last week:
The budget deficit that’s paralyzing Sacramento is about $500 per person; add another $500 to get back to a public sector we don’t have to be ashamed of, and our average income is almost forty times that.
Here's something extremely important - and neglected:

Many middle class people (and poor) will say, hey, an extra $1,000/year will bankrupt me, or will be very hard. I'm barely paying my mortgage, and day care, and student loans,...now.

First off, the tax increase should be highly progressive, so the wealthy pay, say, $4,000, and the very wealthy and super wealthy $10,000, or much more. The solidly middle class might pay $500 (about $40/month), others less, or a lot less.

But what they, and too many economists, really don't realize is this:

It's not that you just pay $500 and that's it; $500 is gone and nothing changes in return. Your student loans would have been lower with this kind of – progressive – tax raise used for smart investment, and your children will require less money from you to go to college. You may get universal pre-school, saving a great deal in pre-school/day care cost, free, or inexpensive, high quality public recreation, and so on.

But here's a huge thing that is tragically neglected in economics, and public discourse in general, positional/context/prestige externalities. If you have $500 less to spend on your house, so do your peers, so housing prices, and your mortgage payment, drop accordingly – maybe the house has more carpet instead of stone or wood floors, but if your neighbors' houses have the same decrease, then there's no feeling like your house is cheap and unprestigious, or low quality, and the intrinsic utility difference is tiny and perhaps negative (I think intrinsically carpet is more comfortable, versatile, and better. I think it provides higher utility when there's not a positional/context/prestige externality).

If you have $500 less to spend on your car, then so do your peers, so you feel you should spend  less on your car, and your car cost drops accordingly – maybe it has a few less horse power, less "silky-smoothness" to its transmission, or less giant wheels, but if your neighbors' cars have the same decrease then there's no feeling like your car is cheap and unprestigious, or low quality (think of how high quality and prestigious the solidly middle class thought their cars were in the 1960s with not even power windows, inexpensive hubcaps, and plastic and fabric, not wood and leather), and the intrinsic difference is tiny, and in some cases, for some, it's negative (I find leather in a family car less comfortable, and it's hot in the summer and cold in the winter. I find this super rigid expensive suspension so you can take a sharp turn at 50 miles per hour with little lean – but you never will do anything like that – less comfortable for the driving most people actually do in a family car, even though it's more costly, thus making it more rare, and gets the car magazines to say the car is prestigious.)

The upshot of this is that people will find if everyone, not just them, has $500 less, then their finances don't really get much tighter – or any tighter – after a period of adjustment. This is why families of a generation or two ago with incomes the same or a lot lower felt a lot more financially comfortable and prosperous, and had much less financial distress. Their homes had carpet and linoleum, not wood and granite, but they felt just as beautiful and prestigious because that's what their neighbors had too – and they had a lot more free time to enjoy those homes – and their families.

What's left, after all of this, is that now you have a massive increase in the quality of your state – in education, infrastructure, parks and recreation, quality of life, as well as higher growth due to greater university investment in science, a more educated populace, and more productive infrastructure – and your finances, your family budget, is the same, or more secure, because your expenses dropped along with the tax increase because of a commensurate drop in the costs of positional/context/prestige externalities.

So much of what we spend on today is what Cornell economist Robert Frank calls conspicuous consumption, things of relatively low intrinsic utility and relatively high positional/context/prestige externality utility. This is as opposed to inconspicuous consumption, such as scientific and medical research to, say, cure cancer, back pain, headaches, or my favorite, so we can eat as much as we want without gaining weight, spending more time with our families, having a cleaner environment without monumental risk of global warming, and a safer one, so children can play freely outside the way they used to, and having better social insurance for the hard working, so they and their families aren't nonetheless financially ruined by a job loss.

One of the most tragic flaws of economics today is the neglect of positional/context/prestige externalities.