Economy from behind an armchair

Of all the subjects or things in the world I think nothing confuses people like economics. We all get the jist of it. We know what money is and what we can use it for and how this complicated flux of transactions flows parallel to everything that happens in the world, small or large. But the minute you try to stop and think about, how it all works, it you feels like you’ll get a brain hemorrhage and I have to question whether I’m really sentiment because I don’t feel like any principle I design actually seems to work at all.

Maybe this is not universal but for me I think this experience stems from the sense that an understanding of economics should be possible to from simply sitting in an armchair smoking a proverbial cigar while theorizing reasonable scenarios. I mean its just a man made thing, completely theoretical, and we’re all a part of it every day so a small list of guiding principles and axioms and we should get this whole thing straightened out right? But no it just doesn’t work that way and of course that’s because economics is actually an empirical science (or at least discipline) which cannot be derived philosophy. Its much too complex. Still, its annoying because as a layman my primary tools are reflection and ‘deduction’ and when those tools consistently yields absurd conclusions one is left without much to go on.

Now what I really was discussing today, pertaining to economics was why house prices are increasing so much more rapidly in Stockholm and Sweden than you might expect. There are a number of theories of course, most quite easily summarized to a layman (and therefore probably horribly incorrect) such as it having to do with residence shortages (demand), low interest rates, good economy and optimism, plain stupidity, a combination of those — or none of those. There are many consequences of these trends but the one I was discussing over this evenings tea session was how taxation affects peoples desires to sell their properties. The prototypical example being an old couple which bought their apartment decades ago for what is today next to nothing but who now can’t be motivated to move out since they have to pay huge amounts of taxes on the nominal profit that is inevitably made from selling the apartment even if they move to one of equivalent market value. It’s profit in the eyes of the state but it does obviously have a lock-in effect. Our discussion was essentially centered on the soundness and fairness of such taxation as opposed to focusing much on the nature of price increases; with me taking the side that such profits are real and must be taxed like all other profits and with my conversational partner arguing points such that it would improve mobility if such profits could be off-set or delayed according to some scheme.

This was just standard political  debate but it did inspire me to think of a particular thought experiment which does yield one of those seemingly absurd conclusions. The concept was simply how a loss averse individual selling an object of ‘constant value’ should behave in a system with both inflation and a profit tax which does not correct for inflation (i.e every real system).

Assume the commodity was bought for 1 unit of currency and its intrinsic value, be there such a thing, does not change over a period of time over which there has been some inflation and in which the equivalent value of the commodity is now (seemingly increased to) i (for example 1.20). If the commodity is sold simply for its ‘true value’ i then the seller will not recover the true value since the nominal profit 1 - i will be taxed with some rate r (for example 0.2). If the seller is loss averse then he should sell it for more than its ‘true value’ with a selling price of v. The principle should be that what remains after taxation should be what one was ‘entitled to’, the increase in nominal value which was only due to inflation. This relation is provided by the equation

(1 - p)(1 - r) = 1 - i

Which is solved for

p = \frac{i - t}{1 - t} \geq i

What is funny is that under a hypothesis of a constant ‘true value’ the loss averse seller in this system is forced to over-price his commodity not to make a loss but since it is a true value no buyer will accept it for it will be perceived as their loss if they do. Of course there are resolutions to this apparent stationary state if we abandon any one axiom such as loss aversion or the notion of a true price, or simply allow for them to meet in the middle with the taxing party redistributing the taxed money in a fair way. But truly the funniest correction is to let buyers be less loss averse than sellers (which is sometimes reasonable) in which case naive recursion will artificially drive up the price upon every reselling.

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