bargaining power

Voluntary trade is often beneficial for both traders. If you buy an apple at the farmer's market, hopefully both you and the farmer are better off after trading at whatever price you pay. This paper* asks how the benefits from trade get split among the traders. Who got the better deal, you or the farmer?

One thing that affects this is bargaining power. In this paper, bargaining power is determined by the number of other trading opportunities a particular trader has. If there is one farmer with one apple at a stall and two hungry buyers, it is natural to think the farmer has more bargaining power.

This paper formalizes the intuition that more trading opportunities often increase a trader's bargaining power, and thereby increase her share of the benefits from trade.

* Manea AER 2011 Bargaining in Stationary Networks

tax evasion

Public finance economists devote significant attention to behavioral responses to tax policy. A citizen might respond to an increase in the income tax by choosing to work fewer hours, choosing to work more hours, or choosing a new occupation. She might respond to an increase in the tax on cigarettes by buying fewer cigarettes, or by buying and storing ten cartons before the tax takes effect. All of these responses, and many more, are legal. They are grouped under the heading of tax avoidance. Tax avoidance is by definition legal, and in some cases it is even desirable. If Congress introduced a tax deduction for people who install solar panels, one would hope a few extra people would alter their behavior by installing solar panels.

When a behavioral response is illegal, it is called tax evasion. Today's article is a classic in the public finance literature, and it focuses on a particular type of evasion: misreporting income.

The basic idea is that people choose how much income to report to the tax authority based on their income, the tax rate, the probability of being caught misreporting, and the penalty if they are caught. The paper concludes that people will misreport less when the probability of being caught is high and the penalty is severe, and that increasing the probability of being caught is more or less interchangeable with increasing the severity of the penalty.

There is not an obvious relationship between true income and the extent of misreporting. This is related to the idea that misreporting is like taking a gamble. You "lose" if you evade and get caught and "win" if you evade without getting caught. Are rich people more likely to gamble? Not necessarily. They might be more willing to part with money, but the lure of a successful gamble is also weaker. So the paper does not draw strong conclusions about the relationship between income and the extent of evasion.

What if the probability of detection depends on the extent of misreporting? The paper derives some technical conditions for optimal behavior, but concludes only by echoing the idea that people misreport less when they are more likely to be caught.

What if, when an audit takes place, it discovers not only current cheating but also past cheating? The paper notes that this can be interpreted as a relatively more severe penalty for misreporting, which it has already been noted reduces misreporting. Again there are a few technical results.

This paper comes with caveats. Most employers report income to the IRS, so misreporting is for many employees not a realistic option because it would be so easy to catch them. Some people feel a moral obligation to report truthfully, so they are not tempted by the gamble. For these and other reasons, the paper is not a complete analysis of tax evasion, but it sets up a clean framework.

Allingham Sandmo JPE 1972 Income tax evasion: a theoretical analysis

collateral constraints

In the past this blog focused on my experience in Israel and on Israeli politics. Yonah has wittily and prolifically taken up that thread, so I leave it to him.

I turn now to economics. I'm a fan of the econ blog Marginal Revolution, but that cannot be my model if I hope to finish my PhD on time. Instead I'll use the blog as a commitment device.

Macro and public finance are my fields. As I read articles, I'll distill them into a brief nontechnical summary. I won't do this for all the articles I read, but blogging on a schedule will hopefully force me to keep up a brisk pace and be a good exercise in translating jargon into English. My plan is three summaries per week, posted Monday Wednesday and Friday at noon. Hat tip to Yonah for the schedule structure.

The first paper* is about borrowing limits. Think of a farmer who must borrow money to buy seed and machinery. The bank lending money to the farmer worries that the farmer will not have enough money to repay the loan if there is a bad crop. The bank requires the farmer to pledge farmland as collateral, which the bank will own if the farmer cannot repay. The limit on the farmer's borrowing is the value of the land he has available to pledge as collateral.

The paper considers the case where if one farmer has a bad crop, they all have a bad crop. Think of a bank lending to farmers in one region that is sometimes hit by a flood or drought. Then the bank will own all of the farmland pledged by all of the farmers, because none were able to repay. Things get complicated because the price of the farmland depends on whether there is a good crop or bad crop. In particular, following a bad crop, the price of farmland is low because the bank would like to sell lots of the land it now owns. Knowing that the value of the collateral will drop if it is ever collected, the bank is unwilling to lend very much to the farmers.

Krishnamurthy observes that the farmers could mitigate this problem by buying insurance. If there is no flood, they give some of the bumper crop to the bank. If there is a flood, the bank not only allows them to keep the farmland but also gives them enough money for new equipment and seed.

That seems reasonable enough. But remember that when one crop goes bad they all go bad. That means that when there is a flood, the bank will have to shell out insurance payments to everybody at the same time. How do the farmers know the bank will be able to pay? The same way the bank guaranteed the farmers could pay: by demanding collateral. And now the tables have turned, because the bank might not have enough cash on hand to provide a sufficient amount of insurance to all the farmers in the event of a flood.

Why don't firms fully insure against risk? Krishnamurthy shows that one possible answer to this question is that insurers don't have enough collateral. Krishnamurthy notes that if insurance markets are failing for this reason, then it could be a justification for the government to be more active in providing insurance.

*Krishnamurthy JET 2003 Collateral constraints and the amplification mechanism