March 10, 2010

Consumer credit, credit availability and The Credit CARD Act

Total consumer credit outstanding expanded by $5 billion in January after contracting 15 of the previous 17 months. Consumer credit outstanding includes revolving and nonrevolving credit. Revolving credit is mostly credit card debt, and nonrevolving credit includes loans for items such as vacations, autos, and boats. Even with the slight increase in January, total consumer credit (after adjusting for inflation) has contracted nearly 6 percent since the recession began in December 2007. This number might seem like a huge contraction but compared with three of the past four recessions, it actually looks rather typical. Consumer credit contracted 9 percent in the 1973–75 recession, 11 percent in the 1980 and 1981–82 recessions (treated as one recession here), and 8 percent in the 1990–91 recession.

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However, once the current recession is separated into revolving and nonrevolving credit, the relationship to past recessions changes. Typically in a recession, nonrevolving credit shrinks considerably while revolving credit shrinks little if at all. The trend so far in this recession has been the exact opposite; nonrevolving credit essentially has remained unchanged while revolving credit has shrunk 11 percent.

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Is the decline in consumer credit the result of supply- or demand-side forces? Perhaps the answer is both.

According to the Federal Reserve's Senior Loan Officer Survey, demand for all types of consumer loans (revolving and nonrevolving combined) has fallen since the first quarter of 2009. A decrease in demand for consumer loans is plausible because consumers tend to delay big purchases such as cars and vacations when uncertainty about future income increases. Because future income is affected by job prospects, consumer credit demand lags the recession much like employment does.

The chart below shows banks reporting an increase in willingness to make consumer loans. In fact, the fourth quarter of 2009 marked the first time in nearly three years that more banks reported increased willingness to supply consumer installment loans than have reported decreased willingness.

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Even if banks are more willing to make consumer loans, their lending standards have gotten tougher. Increased credit standards have moderated in recent months, but on average banks are still reporting tightening rather than easing based on the January Senior Loan Officer Survey. This tightening is particularly evident for consumers seeking revolving credit. In fact in the fourth quarter of 2009 banks on average reported increased tightening for credit limits of revolving credit compared with the previous three months. This development came as little surprise since a special question on the Senior Loan Officer Survey in October revealed that banks would tighten a wide range of their credit card policies following the enactment of the Credit CARD Act.

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Looking ahead, it will be interesting to see to what extent the tightening of standards for revolving credit impacts overall lending and to see if the Credit CARD Act ends up impacting revolving credit availability in the long run.

By Ellyn Terry, senior economic research analyst at the Atlanta Fed

A BROADER ARRAY OF RISKS & OPPORTUNITIES IN GLOBAL EQUITIES

The global equity market has cast a long influence on regional stock markets in recent years. Whether it was a bull market on steroids or the opposite effect, the gravitational pull of a broad-minded definition of the world’s equity market has been a major force in moving narrower slices of stocks. Is the long shadow of equity beta now in the process of transition? It’s a little easier to answer “yes” if we consider year-to-date total returns for the primary equity regions around the world.

Modeling problems in credit markets

On Friday I joined fellow blogger Mark Thoma (and a good many other economists) at a very interesting conference on financial markets held at the Federal Reserve Bank of San Francisco. Here I share some ideas I expressed at the conference about the directions I feel this research ought to go.

The theme of the conference, and indeed the topic of a great number of academic papers now being written, is to try to describe what happens when capital markets have trouble efficiently bringing borrowers and lenders together. The motivation for this interest is the correct observation that interbank and other key lending froze up in the fall of 2008, with devastating consequences for the world economy. The objection that I have to many of these papers is that they focus too much on the effects of these disruptions and not enough on the causes. Many models take the view that credit markets were functioning more or less normally up until the fall of 2008, with the object of study taken to be understanding the consequences of how financial disruptions in 2008:Q4 were propagated to the rest of the economy.


One hundred times the level of home mortgage debt (taken from Flow of Funds, Table B100, row 33) divided by nominal GDP (taken from Bureau of Economic Analysis, Table 1.1.5).
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Taken literally, this view would imply that the huge run-up in debt over the last decade was largely benign, and that the core problem is that banks stopped lending in 2008. If that's your perspective, then it's very good news that the rapid growth of debt didn't end just because banks stopped lending.


Federal debt taken from Flow of Funds, Table L106, row 18. Central bank liabilities taken from Flow of Funds, Table L108, row 26.
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My view is that the gross deterioration of underwriting standards suggests that it was the run-up in mortgage debt between 2001 and 2007, and not the failure of mortgage debt to expand further in 2008, that indicates a pathology in credit markets.

Here's another variable that I think played an important role in what we've observed. Robert Shiller's data imply that real home prices in the United States were remarkably stable for over a century. They began an unprecedented climb in the last decade, only to reverse course in equally dramatic fashion in 2006. One of the papers from the conference on which I was asked to comment took the perspective that credit markets were functioning essentially normally in 2008:Q3, with the goal of the research being to quantify the consequences of the disruptions that occurred in 2008:Q4. But surely those disruptions had a great deal to do with the decline in house prices that had been underway for several years at that point, and just as surely that decline in house prices had a great deal to do with the run-up in house prices that preceded the bust.


Shiller's real home price index, 1890-2009. Source: Irrational Exuberance, Princeton, 2005, by Robert Shiller.
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I presume that everyone would agree that the dislocations of 2008:Q4 did not arise in a vacuum. But some might nevertheless defend modeling those disruptions as exogenous events, if the primary purpose is to try to understand how those events affected the rest of the economy. However, I worry that this is more than just a detail of what one chooses to model, but has the danger of becoming a prevailing paradigm of some in policy circles, who may interpret the core problem as the financial events in the fall of 2008, rather than viewing the core problem as the conditions that precipitated those financial events.

Understanding those precipitating conditions strikes me as a higher priority for this kind of research. Is our goal to know how policy should respond to these disruptions, or how to prevent them in the first place? In terms of the narrow objective of evaluating Federal Reserve policy over this period, should we ignore the potential contribution of the low interest rates and lax regulatory regime that accompanied the preceding real-estate price run-up? It is all well and good for the fire-fighters to ask us aren't we glad they have such a high-powered hose with which to douse the raging conflagration. I suppose that a reasonable response might be yes, but where were you four years ago, and who started this fire anyway?

My suggestion for the many researchers interested in adding to our understanding of credit market imperfections would be to focus not so much on 2008 as on 2004-2006. Any economists or policy-makers who believe that the goal of policy is to restore the economy to the conditions of 2005 may be missing the core lesson here.

March 09, 2010

A FED HEAD'S SOBERING ANALYSIS OF THE LABOR MARKET

We've heard this before but we need to hear it again. Today the message comes from Charles Evans, president of the Chicago Federal Reserve Bank. "A number of labor market issues… lead me to think this accommodation will likely be appropriate for some time," he said in prepared remarks delivered at a speech in Washington. In other words, the central bank will keep interest rates low for the foreseeable future. The lack of job growth is the main catalyst. How long will the easy money last? "I think six months is a good time period to say I think we'll have accommodative policy like we have today."

Aspirin

Russ Roberts writes:

Menzie Chinn invokes the CBO "estimates" to argue against those who say the stimulus didn't work. Did the stimulus help turn the economy around and create jobs? I'm skeptical on logical grounds but I confess that I do not have strong empirical evidence on my side.

But those who defend the stimulus have no empirical support either...

...The CBO "estimates" are not an analysis of what the stimulus actually did but rather what some predicted it would do. They have done NO independent non-partisan analysis of what actually happened.

Yesterday, I had a headache. I took a couple tablets of aspirin. (Actually, it was ibuprofen, but the point remains.) My headache subsequently disappeared. I have no direct empirical evidence that the headache disappeared as a consequence of the aspirin, but I have a plethora of studies that suggest that aspirin (or ibuprofen in this case) can relieve headaches.

As the foregoing example suggests, it does seem to me there is empirical evidence. It's just not the direct sort Professor Roberts desires. Admittedly, there is a dispute over the size of the multipliers -- that's why the CBO used ranges. For surveys of many studies of multipliers, see this Econbrowser compilation, especially this entry and this entry.

Raising Revenue Through a VAT

I am a supporter of the VAT, so I was interested in reading Veronique de Rugy's anti-VAT piece The Wrong Policy at the Wrong Time. I was surprised to find that there were two sentences I was in complete agreement with:
Which suggests a final thought: Focusing on revenue mechanisms such as a VAT in deficit-reduction discussions misses the point that spending and revenue tend to be very loosely correlated. Governments spend when don't have revenue and they spend when they do have revenue.
That sounds an awful lot like my anti-'Starve the Beast' argument from Will Higher Taxes on Gasoline Lead to Higher Government Spending?

Raising Revenue Through a VAT originally appeared on About.com Economics on Tuesday, March 9th, 2010 at 16:32:32.

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Pigouvian Tax the Rich?

A millionaire in Switzerland was recently fined a world-record $290,000 for driving his Ferrari Testarossa 87 miles per hour in a 50 miles per hour zone. The amount was so high because fines for speeding in Switzerland are based on a driver's wealth (and, in this case, because the driver falsely claimed diplomatic immunity). The story got me thinking about the economics of speeding tickets.

To an economist, speeding tickets can potentially act as a Pigouvian tax: a tax that makes an individual's cost of engaging in an activity equal to the cost imposed on society. For a driver, the cost of speeding includes things like fuel, the increased likelihood of damaging one's car, and injuring oneself in an accident. For society as a whole, though, the cost of speeding also includes the increased likelihood of an accident that damages other people's property or injures other people. As a result, speeding (and driving in general) imposes costs on society above and beyond those incurred by the driver. Moreover, the other people affected by speeding aren't compensated for the risk by the benefits of speeding, which are enjoyed strictly by the driver. Economists refer to the costs from an activity that are imposed on other people without any compensation as negative externalities. By making an individual's costs equal to society's costs, a Pigouvian tax gives individuals incentives to act as if they were considering everyone's costs. By doing so, a Pigouvian tax internalizes the externality and decreases the activity to the level that maximizes net benefits to society.

It can be difficult to set the Pigouvian tax exactly equal to the external costs of driving because these depend on so many hard-to-estimate variables (such as the likelihood of accidents at different speeds and the monetary damage caused by injuries or death). It's easy to determine, however, that externalities don't depend on the wealth of the driver. For example, the potential consequences for others of a poor person driving a rented Ferrari at 87 miles per hour are the same as from a rich person driving his own Ferrari at the same speed. Thus, for speeding tickets to serve as a Pigouvian tax, the fine for driving the same speed in the same car in the same conditions should be the same for everyone, regardless of wealth.

One consequence of not basing them on wealth, however, is that wealthier people will likely speed more. In most cases, the richer you are, the more you are willing to spend to save time, and thus the more willing you are to speed and risk getting a ticket. Moreover, if the "pure desire for speed" (in the words of the Swiss court that sentenced the driver) is a normal good, wealthier people will consume more of it. From an efficiency perspective, this result is completely appropriate. As long as individuals act as if they were considering all the costs of an activity, their decision to engage in it means that there are net benefits to them and thus to society.

However, because speeding puts others' lives at risk, the idea that it is appropriate for wealthier people to speed more runs counter to many people's idea of fairness. Switzerland's law suggests that its citizens are willing to forego the efficient level of speeding in order to obtain an arguably more equitable result—everyone has similar incentives to speed, and endanger others, regardless of wealth. So, if you ever find yourself about to drive in Switzerland, be sure to check your bank account first: the less you have, the better.

Discussion Questions:

1. What if, considering its external costs, $290,000 was actually the appropriate fine for speeding, but that only extremely wealthy drivers paid that much, with most drivers paying considerably less. Who would speed at the appropriate rate, while who would speed more than was appropriate?

2. Consider what factors make speeding more or less dangerous for other people. On what variables could you base fines for speeding so that drivers internalized the external costs?

3. Are there variables used to determine fines for speeding where you live that have little or no relation to the external costs of speeding?

4. In addition to acting as a deterrent for speeding, fines for speeding can also serve as a source of government revenue. How does this consideration impact the efficiency and equity of basing the fines on wealth?

March 05, 2010

In the beginning, there was a lender of last resort

Steven Pearlstein, business columnist for the Washington Post, asks and answers the question "should the Fed stay out of the bank supervision business?"

"As the Senate begins to focus on how to fix financial regulation, one of the remaining unresolved issues is what role the Federal Reserve should have in supervising banks.

"The correct answer? None at all."

One of the centerpieces of the Pearlstein argument is this:

"The reality is that the Fed's primary focus is and will always be on monetary policy. Bank supervision will continue, as it has been, as a secondary activity that not only receives less attention from the top but will be sacrificed at those rare but crucial moments when the two missions might conflict. Indeed, by arguing that the Fed needs the insights gleaned from bank supervision to be more effective in making monetary policy, the Fed essentially acknowledges this hierarchy in its priorities. Bank supervision is important enough that it ought to be somebody else's top priority."

If you might allow me a moment of personal indulgence, there was a time when I had some sympathy with the sentiment that the "Fed's primary focus is and always will be on monetary policy." I, of course, knew the story of the creation of the Fed, motivated by the need to provide an elastic currency to avoid disruptive fluctuations in prices and a lender of last resort to stop liquidity stress from becoming a full-blown financial crisis. But that was a story from the past. The modern world began in 1935 with the statutory creation of the Federal Open Market Committee, which would eventually evolve, with its central bank brethren in the rest of the world, into the institution described by Pearlstein as being primarily focused on monetary policy.

I felt that way until Sept. 11, 2001. On an average day in the week ending Sept. 5 of that year, the Federal Reserve extended $21 million in discount loans to banks, a reasonably representative volume. On Sept. 12, discount loans amounted to over $45 billion. As a result, the U.S. financial system did not collapse.

The horrible circumstances of 9/11 have been thankfully unique, but there is a case to be made for the proposition that the most important role of the central bank in the recent financial crisis was not in the realm of traditional monetary policy but in the exercise of variations on the lender-of-last-resort function. In fact, in times of acute financial stress, this role must always be so. Witness this remark by Alan Greenspan on Oct. 20, 1987:

"… in a crisis environment, I suspect we shouldn't really focus on longer-term policy questions until we get beyond this immediate period of chaos."

Which brings us to the question of the Fed's role in bank supervision. More precisely, it brings us to comments from Atlanta Fed President Dennis Lockhart, who delivered remarks on Wednesday to the New York Association for Business Economics:

"… the Fed must play a central role in a defense structure designed to prevent or manage future crises. My key argument is the indivisibility of monetary authority, the lender-of-last-resort role, and a substantial direct role in bank supervision. Only the Fed can act as lender of last resort because only the monetary authority can print money in an emergency. To make sound decisions, the lender of last resort needs intimate hard and qualitative knowledge of individual financial institutions, their connectedness to counterparties, and the capacity of management.

"There is sentiment in Washington that would separate these tightly linked functions that are so critical in responding to a financial crisis. Removing the central bank from a supervision role designed to provide totally current, firsthand knowledge and information will weaken defenses against recurrence of financial instability. Flawed defenses could be calamitous in a future we cannot see."

If this advice goes unheeded, I fear we might discover its wisdom in the worst possible circumstances.

By Dave Altig, senior vice president and research director at the Atlanta Fed

March 04, 2010

Larry Murphy: Hall of Famer, Champion, Economist?

Over his NHL career, Hall of Fame defenseman Larry Murphy was praised for his reliable defense, gifted offense, and his immense hockey skill. But until now, I doubt he has been lauded for his economic insight. Perhaps even Murphy is unaware that his recent comments about head injuries in the NHL perfectly illustrate a real-world example of moral hazard. Speaking to an NHL.com reporter, Murphy explained current players rely on referees rather than their own decisions to keep them safe on the ice. "You always had to be aware of where you are in relation to the boards and you had to stay close to the boards and protect yourself that way," Murphy said. "Now the play is to turn your back to a guy and it's like, hands off.” While it may appear that Murphy was simply talking about how his sport has changed, his logic rests on the same clear principles economists use when analyzing many situations with the concept of moral hazard.

First, let’s start with a bit of back-story for those not familiar with hockey. The rules of the game allow for a great deal of contact, called checking, during play on the ice. Legally, only the player who controls the puck can be checked, and contact is allowed anywhere on the ice, even near the boards. As modern medical understandings of head injuries and long-term brain damage have advanced, the hockey community, and specifically the NHL, has made efforts to further protect its players. In the past three seasons, a large emphasis in rule enforcement has been made to prevent hits from behind that would send a player head-first into the boards without warning. There is no debate in my eyes that the intent of this policy should be supported in every way. The economics in all this stems from the fact that players have begun to play the game differently due to a change in incentives.

Murphy outlined how current players now take a more aggressive position on the ice because they no longer have to protect themselves; rather, the players know that the referees will protect them by calling penalties. From an economic standpoint, defensemen now face different incentives than they did before the rule change occurred. The risks associated with being hit from behind can be viewed as the cost associated with turning around on the ice. Since the new rules make those dangerous hits less likely, they essentially lower the cost defensemen face when deciding if they should put themselves in a vulnerable position. Economists refer to a moral hazard as any time a change in the larger economic system designed to protect an individual causes that person to alter his behavior to be more risky.

Perhaps the most vivid illustration of moral hazard comes from a quip by an economist who realized that as safety features in automobiles have advanced, so have the number of accidents. He stated that technological advances that have reduced the number of fatal car accidents in the country (e.g. airbags, seatbelts, etc.) would be just as successful as removing all safety features from a car and installing a giant metal spike in the center of the steering wheel that would be sure to impale the driver even in a minor crash. While the comment is tongue in cheek, its underlying point is very valid. Consider if this alternate proposal were true. I imagine that drivers would be much more attentive when driving and make many more efforts to drive safely, such as reducing their speed and avoiding distractions like cell phones. Whether talking about new rules on the ice or safety changes on the road, the theme is the same: as technology changes the rules of the game to make people safer, they will respond by worrying less about risks and engage in more dangerous behavior.

Discussion Questions:

1. Suppose the NHL is unhappy with the change in the style of play that has occurred since hits from behind have been more carefully officiated. What sort of rules or incentives could they introduce to continue to keep protecting players, but return play to the way it was before?

2. Consider the following scenario: A baseball pitcher is traded in the middle of the season. His previous team was the worst defensive team in the league. However, now he has been traded to the team with the best defensive players. In his first start for his new team, his coaches are baffled when he starts throwing many more aggressive and risky pitches that could be hit into play. How would you explain the change in the pitcher’s behavior to his coaches? What would you suggest they do if they want him to continue to pitch the way he did for his previous team?

3. Suppose the U.S. government passes new legislation that provides free healthcare to everyone in the country. As an economist, apply the principle of moral hazard to predict what will happen to the number of doctor visits that patients choose to make in a year.

February 26, 2010

Exit strategy, tactics, and decision makers

Vincent Reinhart, resident scholar at the American Enterprise Institute and former senior official of the Federal Reserve Board of Governors, heard the Chairman speak and seems to have come away not wholly satisfied.

"… Bernanke will talk about reverse repurchase agreements and interest on excess reserves as congressional committee members nod in agreement. Mastery over tactics, the bet runs, will restore faith in an otherwise undefined future. It is a difficult trick, this confidence game. The Fed will provide enough detail about its tactical exit from its unusual policy accommodation to allay concerns, but not so many specifics as to lead market participants to believe it intends to head for the exit soon.

"Lost in this thicket of expertise will be important public policy questions basic enough to be assigned as homework in a high-school journalism class.

"When will the Fed begin to raise the short-term market interest rate?"

Interestingly, Reinhart himself has his own answer to that question:

"The Fed has the dual responsibility of fostering employment and price stability. As of now, the Fed continues to forecast substantial and lingering unemployment that puts downward pressure on inflation. Until policy makers can produce a forecast that gives a reason to tighten, they will not tighten. That outlook is not likely to change until late this year."

That judgment is certainly not a matter of inside information or any special insight, as there are plenty of statements like this one from Dennis Lockhart, our boss here at the Atlanta Fed:

"I continue to support an interest rate policy described in recent FOMC statements as low for an 'extended period.' What does 'extended period' mean? I don't want to put a date on it. To me, it means the policy rate will be kept low until recovery has shown momentum that is based on private business and consumer demand, job growth is established or at least imminent, and the downside risks appear to be safely navigable. This unwinding is in the context of well-behaved inflation, of course."

In fact, Chairman Bernanke said very much the same thing Wednesday in the first installment of his semiannual testimony before Congress:

" 'The federal funds rate is likely to remain exceptionally low for an extended period,' Bernanke said, repeating language that has been in every Fed statement on monetary policy for the past 14 months…

" 'As the impetus provided by the inventory cycle is temporary and as the fiscal support for economic growth will likely diminish later this year, a sustained recovery will depend on continued growth in private-sector final demand for goods and services,' Bernanke said. 'The job market remains quite weak.' "

Though much of the discussion lately has been about the tools of implementing policy decisions, that is only natural. The objectives of the central bank—including a broad understanding of what sort of economic conditions will drive a change in policy direction—seem to be well understood. What is new is the instruments that may be brought to bear in light of the very large size of the Fed's balance sheet, a legacy of what I view as successful efforts to manage the fallout of the financial crisis.

Reinhart does make note of an interesting governance question that presents itself if the so-called "exit strategy" involves the payment of interest on reserves that banks deposit with the central bank:

"How will the Fed raise the short-term market interest rate? The old-fashioned way of tightening monetary policy is to shrink the amount of reserves outstanding by selling assets. …[T]he Fed will raise the rate it pays on excess reserves (or deposits of banks at the Fed). Banks will pull up interest rates in the money market as the alternative use of reserves—parking them at the Fed—becomes more remunerative.

"Who at the Fed will raise the short-term market interest rate? Congress explicitly gave the authority to raise the interest rate on excess reserves to the Board of Governors (or the seven appointed officials who work in Washington), not the Federal Open Market Committee (FOMC, or the board governors and a subset of reserve bank presidents who normally vote on reserve conditions). Thus, the balance of power within the Fed will shift toward the governors when the instrument of policy becomes the interest rate on reserves. (Bernanke elided this issue in his recent testimony when he left the impression that the FOMC will still set policy in conjunction with the board. In fact, the Federal Reserve Act prohibits the board from delegating monetary policy to others.)"

The institutional fact is certainly correct—the authority to set the interest rate paid on reserves is granted to the Board of Governors, not the FOMC. But, in my view, this is of more theoretical than practical interest. The minutes of the January meeting of the FOMC made clear that, though no definitive decision has yet been made, it may well be the case that the payment of interest on reserves is employed as a transitional tool employed along the road to an environment in which the federal funds rate again reigns supreme:

"With respect to longer-run approaches to implementing monetary policy, most policymakers saw benefits in continuing to use the federal funds rate as the operating target for implementing monetary policy, so long as other money market rates remained closely linked to the federal funds rate. Many thought that an approach in which the primary credit rate was set above the Committee's target for the federal funds rate and the IOER [interest on excess reserves] rate was set below that target—a corridor system—would be beneficial. Participants recognized, however, that the supply of reserve balances would need to be reduced considerably to lift the funds rate above the IOER rate. Several saw advantages to using the IOER rate, rather than a target for a market rate, to indicate the stance of policy. Participants noted that their judgments were tentative, that they would continue to discuss the ultimate operating regime, and that they might well gain useful information about longer-run approaches during the eventual withdrawal of policy accommodation." 

It is also worth noting that if you  pick up any old money and banking textbook, you will likely see listed a trio of tools that the central bank has to affect the money supply: open market operations, reserve requirements, and the discount rate. The latter two have always been the sole or primary province of the Board of Governors. In practice, however, they have been employed as adjuncts to the decisions of the FOMC. As of now, there really is no indication that this is likely to change.

By David Altig, senior vice president and research director at the Atlanta Fed

How Much Does Public Policy Contribute to Long-Term Unemployment?

Arnold Kling quotes from a terrific piece by Eric S. Raymond:
We've spent the last seventy years increasing the hidden overhead and downside risks associated with hiring a worker -- which meant the minimum revenue-per-employee threshold below which hiring doesn't make sense has crept up and up and up, gradually. This effect was partly masked by credit and asset bubbles, but those have now popped. Increasingly it's not just the classic hard-core unemployables (alcoholics, criminal deviants, crazies) that can't pull enough weight to justify a paycheck; it's the marginal ones, the mediocre, and the mildly dysfunctional.
As a small business owner with a number of employees, I agree wholeheartedly with this. The expense of hiring and retaining a worker goes beyond wages and include training costs, employer-side payroll taxes, health insurance and many other items. Some of those (though not all) are direct functions of government regulation (payroll taxes and the minimum wage for low-wage jobs).

If a country really wants to reduce unemployment, the best solution would be to find ways of reducing the costs of employing workers. Eliminating employer-side payroll taxes would be a good start; the revenue can be made up through increased use of value added sales taxes. Swapping the minimum wage for a negative income tax would also increase employment and promote economic efficiency. The Second Welfare Theorem illustrates that altering the market price of a good (such as a price floor on labor) will necessarily lead to inefficiency. We can better achieve the outcome society wants through a straight wealth transfer, such as a negative income tax.

How Much Does Public Policy Contribute to Long-Term Unemployment? originally appeared on About.com Economics on Friday, February 26th, 2010 at 07:32:31.

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February 25, 2010

Oil and Ingenuity

Five years later, We Will Never Run Out of Oil is still one of my most read articles and the source of the majority of the angry e-mails I get. I wonder how many Prof. Boudreaux will receive for For oil, tap ingenuity. I particularly enjoyed this part:
Human creativity and effort also are at work finding not only substitutes for oil, but also new supplies of oil. Each success on this front increases the supply of oil. The reason is that oil deposits that remain unknown are economically nonexistent.

The same is true of oil deposits that are known to exist but are currently too costly to tap. Oil in the Earth's crust that is out of reach with existing technology is no more of a resource today than is oil on Pluto. But if and when human creativity discovers cost-effective techniques for extracting that oil, it then -- and only then -- becomes a resource. In effect, more of the resource "oil" is created.

Of course, as a matter of physics, there is indeed only a finite amount of oil in the Earth. But we have no idea how much. And our ignorance of this physical fact is economically relevant.
For a longer version of this argument, see: We Will Never Run Out of Oil.

Oil and Ingenuity originally appeared on About.com Economics on Thursday, February 25th, 2010 at 09:18:47.

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February 24, 2010

How to Think About Keynesian Economics?

The international trade / public policy course I teach at Ivey is quite Keynesian. Next time I teach the course I will give my students Arnold Kling's How I Think About Keynesian Economics - it is absolutely brilliant. I particularly find this part useful:

Imagine that all of us were chefs, each with a different specialty. In good times, I patronize others' restaurants and other people patronize mine. That is economic activity. In a recession, for some reason we stop going out to eat. I don't enjoy eating my own cooking every meal, but I don't think I can afford to go out. Since I am not patronizing your restaurant, you think you have to cut back on eating out, also. Economic activity declines.

Thinking about the economy in these terms, the idea of using government deficits to boost economic activity makes perfect sense to me.

This reminds me a little of Paul Krugman's baby-sitting scrip story - people stopped using the babysitting scrip, which meant others were not getting additional scrip, which cut back on their use of babysitting scrip and the amount of babysitting declined.

As such I do not think Don Boudreaux's money has to be taken from somewhere else story (that implies fiscal stimulus cannot work) is necessarily correct - that money may be horded (like the babysitting scrip). In theory, fiscal stimulus could work if the money goes from being horded to being spent. Of course, that does not mean that fiscal stimulus is the best option - increasing the supply of money (or scrip) seems far more effective,

In general, I do think fiscal stimulus is highly ineffective, but my criticisms are more practical in nature.

How to Think About Keynesian Economics? originally appeared on About.com Economics on Wednesday, February 24th, 2010 at 17:42:34.

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February 23, 2010

Looking behind the core inflation numbers

Last Friday's consumer price index (CPI) report showed headline inflation in January remaining stable from the previous month at a 2 percent annual rate, a bit above most private forecasts, boosted by higher fuel costs. But the show was stolen by the core measure. Excluding food and energy, consumer inflation saw the largest monthly drop in more than 27 years and its third largest decline in 47 years.

Several factors were behind the decline in the core index (such as falling airline fares, a dip in new car prices, and ongoing declines in prices for household furnishings and operations), but a sizeable drop in shelter prices, which account for more than 40 percent of the core CPI index, was a significant factor in January's dip. A concern that decelerating shelter prices could skew the core inflation measure was noted in the minutes of January's FOMC meeting:

“Though headline inflation had been variable, largely reflecting swings in energy prices, core measures of inflation were subdued and were expected to remain so. One participant noted that core inflation had been held down in recent quarters by unusually slow increases in the price index for shelter, and that the recent behavior of core inflation might be a misleading signal of the underlying inflation trend.”

Chart 1 illustrates the recent decline the in shelter component of the CPI and how, excluding shelter, core inflation has been growing at a more robust pace than is indicated in the overall number.

Chart 1
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However, once we've opened the door for pruning sectors that have displayed unusual price behavior in recent months, we can find a slew of outlying components to pare. Take, for example, vehicle prices. With the impact of the ailing state of U.S. automakers, the federal government's “Cash for Clunkers” program, and the major recalls from Toyota, auto prices have been particularly volatile lately. Used car and truck prices have grown at annual rates between 20 percent and 44 percent in each of the past six months, skewing, some could argue, the core measure upward.

Chart 2 shows core CPI after subtracting both shelter and used vehicle prices, a picture that shows a lower inflation rate—more in line with the numbers in the overall core CPI.

Chart 2
022310b
enlarge

My point here is not to advocate lopping shelter and vehicles, along with the already excluded food and energy prices from inflation—which, by the way, would leave us with less than 45 percent of the overall CPI index. In fact, my argument is the opposite. There are always some components of the index that seem anomalous—on either side of the distribution. Discriminately cropping entire sectors from the CPI may not be the best method for teasing out true underlying price pressures.

Chart 3
022310c
enlarge

The Cleveland Fed uses a more methodical approach to exclude the CPI components that show the most extreme price changes each month. Their calculations show a more subdued underlying inflation environment, with median and trimmed mean CPI hovering around 1 percent for the past several months (chart 3). I'm not endorsing this method as a perfect estimation of “true” underlying inflation, but it does provide an example of indiscriminately trimming the outliers to see what's beneath.

By Laurel Graefe, senior economic research analyst at the Atlanta Fed

February 21, 2010

A Good But Fatally Flawed Argument For Higher Inflation

Paul Krugman makes an excellent argument based on behavior economics on the benefits of higher inflation:
I would add, however, that there's another case for a higher inflation rate -- an argument made most forcefully by Akerlof, Dickens, and Perry (pdf). It goes like this: even in the long run, it's really, really hard to cut nominal wages. Yet when you have very low inflation, getting relative wages right would require that a significant number of workers take wage cuts.
Agreed with all of this. Absolutely correct. But Krugman errs when he concludes:
So having a somewhat higher inflation rate would lead to lower unemployment, not just temporarily, but on a sustained basis.
That is possible, but not certain. What it could also lead to is higher use of labor contracts with cost of living allowances - that is, labor contracts that are indexed for inflation. Using inflation to cut real wages only works if wages are paid in nominal terms. But if the labor market expects inflation to be high for a significant period of time, then we should expect to see wages paid in real terms, at which point the added inflation gets you nothing.

Of course, one possibility is to ban the use of COLA clauses in labor contracts. I would be surprised if any economist, let along Prof. Krugman, would advocate that step.

A Good But Fatally Flawed Argument For Higher Inflation originally appeared on About.com Economics on Sunday, February 21st, 2010 at 12:38:32.

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February 19, 2010

Do We Need To Rethink Canadian Monetary Policy?

A terrific post at Worthwhile Canadian Initiative - Rethinking Canadian macroeconomic policy. A good read even if you're not Canadian. Most interesting is the suggestion is for the Bank of Canada to raise the target inflation rate from 2% to 4%. I am skeptical of our ability to measure long run inflation, but in the period of a year or so we can certainly do so.

I do not believe a higher inflation rate would cause too many economic problems so long as the Bank of Canada could keep it stable between a 3 and 5% bound. I can't imagine the menu costs problem is a great deal more of a problem at 4% rather than 2%. There would be some distributional effects - the Bank of Canada would earn more in seignorage, people on fixed incomes would lose, the Canadian dollar would depreciate (assuming our trading partners did not follow the same policy), so exporters would win but imports would become more expensive.

I agree with Stephen Gordon when he states:
My point of departure is 'If it ain't broke, don't fix it'. And it's not at all clear to me that the 2% target has failed as a policy... We could probably safely trade low and stable inflation against higher and stable inflation as an insurance policy against hitting the lower bound, but it's not clear that this choice is available to us... Did we hit the lower bound, or did we just graze it? The Bank never did see fit to actually implement a policy of quantitative easing, even though it (quite rightly) laid out the groundwork to do so.
One frustrating thing through this whole recession or crisis or whatever you want to call it is how many have equated monetary policy with setting interest rates. However, that is far from the Bank of Canada's or the Federal Reserve's only policy option, despite claims to the contrary by well known economists. As someone who teaches macroeconomics, I must take my share of the blame. For a generation we taught that monetary policy was simply altering the Federal Funds Rate. Occasionally we talked about altering the reserve ratio. I guess it is not surprising that so many believe the zero bound problem is such an important one - we never taught students that there are alternatives!

Do We Need To Rethink Canadian Monetary Policy? originally appeared on About.com Economics on Friday, February 19th, 2010 at 08:17:01.

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February 18, 2010

Cafe Hayek on Peak Oil

Some terrific links here: We're Not Running Out Of - Or Even Low On - Sources of 'Nonrenewable' Energy.

I am not a geologist, so I am not going to provide any commentary on physical reserves. What I can comment on is the bad economics behind the peak oil theory (see: We Will Never Run Out of Oil). Peak oil theorists are a lot like basketball's Washington Generals - they haven't got anything right since 1971.

Just because I haven't posted this in awhile: SUPERKIDS:

From the dim recesses of the 1970s comes SUPERKIDS, a free educational comic published by the Office Of Energy Conservation of the Department Of Energy, Mines, and Resources of Canada and charmingly illustrated by Don Inman!

The comic is a fun read. I, for one, am glad we didn't run out of gasoline in 1986!

Cafe Hayek on Peak Oil originally appeared on About.com Economics on Thursday, February 18th, 2010 at 09:12:04.

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Of Course There's a Case for a VAT!

Tyler Cowen asks: Is there a case for a VAT?

I'm shocked he has to ask this - of course there is! The U.S. federal government has very few options to dig themselves out of their fiscal hole. Their fiscal options are:
  1. Significant cuts in spending, which sounds good in theory, but what to cut?

  2. Hold spending at the level of inflation and let government revenues grow as the economy grows. Easier than cutting spending - but it will take at least a decade for the economy to grow large enough to raise government revenues enough to eliminate the deficit.

  3. Raise taxes.
If you choose option 3, then a value-added tax makes the most sense, for the reasons described in The Efficiency of Value Added Taxes (VATs) over Income Taxes.

Frederic Sautet worries that "VAT rates generally go up quickly but rarely go down", which sounds funny to this Canadian, as our 7% GST, introduced 2 decades ago, replaced a 13% MSFT and has been reduced twice and is now at 5%.

Of Course There's a Case for a VAT! originally appeared on About.com Economics on Thursday, February 18th, 2010 at 08:19:48.

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Did The Stimulus Work?

King at SCSUScholars on the evidence (or non-evidence) that the stimulus package "worked":

Most of what we write about the effects of stimulus are just that, "an attempt to gain knowledge." A bureaucrat writes down some numbers. Reporters and bloggers find flaws. Econometric models estimate the effects, but those models were used to propose the policy put in place. It's not likely those models would go back and say the proposed plan didn't work: Econometric models aren't built to do that: If the model has as a premise that future government spending will create jobs, it isn't going to tell you that past government spending did not. Meanwhile, those in political opposition will look to find contradictions when none really exist. (GDP growth can lead employment growth.) And people get angrier and cynical.

There is nothing wrong with saying we don't know. It might have worked; it might not have. What we know is there are between three and four million fewer jobs than a year ago, and the deficit is larger. We want to know more. We are trying to know more. And if the volume of studies since 2000 of the Great Depression are any indication, we'll still want to know more a century from now.

Terrific stuff. I agree whole-heartedly with King - little evidence can be gained directly from the statistics. There is no shame in saying that we cannot be certain. Because the direct evidence is necessarily so spotty, theory is important. An analysis of the theory behind fiscal stimulus shows that, as the theory is constructed, it cannot work in the real world for anything but very severe recessions.

Did The Stimulus Work? originally appeared on About.com Economics on Thursday, February 18th, 2010 at 02:36:30.

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February 17, 2010

World War II as a Fiscal Stimulus - Part II

In the form of a blog comment in response to World War II As a Fiscal Stimulus?, reader Trevor leaves some terrific data:
You Are Missing Facts.

Government Spending By Year/National GDP By Year

1925: 3.6 Billion / ? (no data)
1931: 4.1 Billion / 76.5 Billion
1932: 4.3 Billion / 58.7 Billion
1933: 5.1 Billion / 56.4 Billion
1934: 5.9 Billion / 66 Billion
1935: 7.5 Billion / 73.3 Billion
1936: 9.2 Billion / 83.8 Billion
1937: 8.8 Billion / 91.9 Billion
1938: 8.4 Billion / 86.1 Billion
1939: 9.2 Billion / 92.2 Billion
1940: 10.1 Billion / 101.4 Billion
1941: 14.2 Billion / 126.7 Billion
1942: 35.5 Billion / 161.9 Billion
1943: 83 Billion / 198.6 Billion
1944: 100 Billion / 219.8 Billion
http://www.usgovernmentspending.com/
and
http://www.bea.gov/national/
1. Government Spending was increasing rapidly before the war. It went from $5.1 Billion in 1933 when FDR was elected to $9.2 in 1939 (your year of growth). That is an 80% increase.
2. Growth from 1938-1939 was 7.1%
Growth from 1939-1940 was 10%

Yes, BUT

Growth from 1937-1939 was less than 0.5%.

(You ignored the dip that took place just before 39′ & 40′)

Effectively there was no change in spending between 37′-40′ but also there was very little change in growth between 37-40 as well. And much of the growth itself was probably fueled on a lag from the massive jumps in spending between 1934-1936. You know that-you are a trained economist-you just chose to ignore it.

3. When government spending during the war started to kick in the economy grew incredibly rapidly. From 1941-1944 the GDP effectively doubled as government spending shot up rapidly. You can't deny that spending=growth in this instance and WW2 spending had an incredible stimulating effect on the economy.

4. After the war, and the government spending, there were no significant economic problems for 30 years. In other words, massive government spending didn't lead to problems later.
This is terrific data, though I am not sure how Trevor draws the conclusion that World War II acted as a fiscal stimulus to get the U.S.A. out of the depression. A straight-forward reading of the data looks as follows:

  1. Government spending ramped up from 1934 to 1936.

  2. There was a short lived but severe recession (depression from 1936 to 1938.

  3. There were two rapid years of economic growth in 1939 and 1940.

  4. U.S. government spending started to ramp up in 1941 and exploded in 1942.
Can anyone explain to me how on earth this shows that World War II spending ended the depression? I just don't see it. In fact, a strict reading of the data could imply that the rise in government spending from 1934-1936 caused the 1936-1938 recession! It didn't, of course, but the fact there's more evidence for that hypothesis than the World War II ended the depression hypothesis is telling.

World War II as a Fiscal Stimulus - Part II originally appeared on About.com Economics on Wednesday, February 17th, 2010 at 07:48:27.

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February 16, 2010

Econolympics

As a recurring Winter Olympics viewer, I am counting down the days until the games begin on February 12. As an economist, however, I am intrigued by the number of tools an introductory economics course provides students with to analyze the effects of the Olympic games on the local economy of Vancouver. Three topics in particular come to mind that most students will encounter in a basic economics course: consumer spending, negative externalities, and cost-benefit analysis.

A recent article reports that the winter games are expected to boost travel-related spending by $800 million in Vancouver thanks to the incoming surge of general spectators, friends and families of competing Olympians, and athletes themselves to the metro area. But where does this spending go? Hotels, restaurants, and transportation are the likely candidates to benefit from such a surge, so the leisure and tourism industry should receive the largest boost. Although this positive shock to the industry is temporary, Olympics-related spending in 2010 is expected to account for 0.8% of Vancouver’s economic growth, trailing only housing investment and government spending.

However, accompanying this boost in tourism are some negative externalities on locals. While you may not always need a reservation to your favorite restaurant on a normal weeknight, the increase in the number of visitors to the metro area is likely to cause long lines for restaurant-goers. Even getting to your favorite watering hole might be no small feat, as traffic congestion and parking dilemmas are likely to pick up due to the additional vehicles on the road at any given time. Finally, increased pollution and trash creation are also likely to impose a negative externality on residents during the winter games.

Setting up shop for the winter games comes at a high price. Holding the Olympics requires that the host city build the necessary facilities, hire additional security, and provide extra health care in the case of injury to athletes or spectators. This is likely to weigh on the spending budget for Vancouver’s economy. Therefore, standard cost-benefit analysis would require you to determine whether the benefits gained from having the Olympics in a particular city outweigh the costs.

In short, there is a plethora of economic topics you could use as a conversation starter regarding the Olympics. So pick your favorite concept, and analyze away!

Discussion Questions:

1. How would you value having the Olympics in your hometown? Would the benefits you receive from this outweigh the negative externalities imposed on you by the winter games?

2. How do you think the Olympics will affect things like hotel and menu prices during the winter games? Do you expect such a short surge in demand to affect other local pricing? Why or why not?

3. State how the following introductory economic concepts could be used to analyze the effect of the Olympics on Vancouver: the multiplier effect, the Tragedy of the Commons, and demand shocks.

February 11, 2010

Economics Goes Viral

Nothing gets me more excited than getting people with no formal background in economics to see how econ fits in their everyday life. In light of that, imagine my surprise when my good friend Eva Funderburgh, a professional sculptor, wanted to share some economics with me! Apparently she’s not the only one spreading the video above, because, as of this writing, the viral video above created by TV producer/director John Papola and economist Russ Roberts has already received over half a million views on YouTube! Papola and Roberts’ video does a wonderful job creating a new way to take a traditional economic discussion and make it more approachable and entertaining to a much wider audience. In my mind, every economics student should watch the video, and hopefully share it with others as well. For those with a little more time, NPR has put together a very entertaining look at how the project came to be.

The economic thoughts and ideas represented in the video are spot-on, and the lyrics are a fair presentation of the differing schools of thought. While the deeper issues behind the video are much larger than anyone could take on in a single blog post, I do see a place that might deserve a small footnote. I do not mean to take anything away from all the great work that went into this video, but I feel that Keynes’ introduction might deserve a bit of further discussion:

“John Maynard Keynes, wrote the book on modern macro”

Depending on how you define “modern,” an economist who died more than sixty years ago may no longer fit the bill. I think it is totally appropriate to say that Keynes wrote the book on 20th century macroeconomics, but the research frontier of the field is moving beyond his ideals. Starting in the 1970s, some members of the field have explored more complicated models based on critiques of Keynes’ work by Nobel Prize winners Robert Lucas and Milton Friedman, among others. These researchers worry that some of Keynesian economics’ critical assumptions oversimplify the world and make the model invalid. While Keynesian theory is still widely taught today and used by many people advising current policy decisions, some macroeconomists now advocate for models that are built on individual decision making, rather than only analysis based on total expenditure.

These “micro-founded” macro models seek to explain trends in data that defy Keynesian theory. One difference between these schools of thought centers on if household consumption decisions can change in response to fiscal and monetary policies. For example, Keynesian theory assumes that policy does not affect the fraction of net income spent and saved and that the amount of economy-wide consumption will simply change by the product of the tax’s size and the proportion of a household’s after-tax income spent on consumption (often referred to as the marginal propensity to consume, or MPC).

On the other hand, extensions of the micro-founded model proposed independently by Frank Ramsey, Dave Cass, and Tjalling Koopmans suggest that if the government were to lower taxes and give households more money, consumers may choose to change their entire consumption-spending decision based on having larger net income, thus resulting in a new MPC. Whether or not the assumptions made by Keynes are valid (or small enough to be overlooked) is a matter of personal opinion, but as the research horizon of economics extends more than half a century after his writing, it appears that there is still work to be done before macroeconomics can perfectly explain an entire real-world economy.

Discussion Questions:

1. Why should we “fear” booms and busts? Why might booms and busts be good? Is there an “optimal” level of economic fluctuation?

2. Who do the bartenders “Ben” and “Tim” represent in the video? Why are they pouring liquor? What does the liquor represent?

3. The chorus of the rap has Keynes saying “I want to control markets” and Hayek saying “I want to set [markets] free.” Is either of those positions right or wrong in all circumstances? Under what circumstances is more government intervention in markets warranted, and under what circumstances should the government stay out as much as possible?

4. What are the critiques that Keynes offers of Hayek? What are the criticisms that Hayek proposes about Keynes? Does one side seem to have a much stronger argument than the other, or do they both suggest that the theory’s view of the world is still incomplete?

5. Do you think the financial crisis of the past few years was caused by people who thought more like Keynes or more like Hayek? Why?

Economics of Flu Vaccines

In the last few months, the H1N1 influenza virus, or “swine flu,” has been dominating the news, and many people are worried about access to flu vaccines or “flu shots.” (That is, unless you work for Goldman Sachs, who got first dibs. But don’t they always?)

Unlike other viral diseases, flu viruses constantly mutate, or change into new “strains.” A vaccine that works to protect against a specific strain one year will probably not work to prevent against a new strain the next year. Because of this, hundreds of hours of lab work are devoted each year to identifying specific flu strains, developing a vaccine against them, and then producing that vaccine in large enough quantities to distribute to the population.

This year, the efforts of flu vaccination labs have been split, with only some of the labs producing vaccines against the “regular” flu, and the rest working on vaccines against the specific H1N1 swine flu strain. Because of this, the supplies of both of these types of vaccines are greatly reduced this year in comparison to previous years.

Given the scarcity of both traditional and swine flu vaccines, how should the existing vaccine be distributed? If the goal is to maximize societal health, the flu vaccine should first be given to those whose health would benefit from it the most, who are people at risk of complications and death from the flu, including young children, the elderly, and the immuno-compromised. On the other hand, if the goal is to minimize the cost of the flu to an economy, the most productive and important members of society should get the first vaccine.

To a certain extent, extreme examples on both ends are small in number and easy to take care of. For example, health care employees are at greater risk of contracting any disease and, consequently, of infecting those whose health is vulnerable. So it’s clear they should be the first in line to get the vaccine. But what about people who don’t have such critical jobs (and keep in mind that you probably qualify as one of these people)? This topic relates not only to the health of the economy, but your personal health as well.

Discussion Questions:

1. Do you think that the goal of those who control flu vaccine policy should be to get the best health outcome, to minimize the cost to GDP, or some combination of the two? What public health policies would achieve your preferred policy goal?

2. Assume that society does want to maximize productivity in dollar terms rather than health outcomes. Now, take into consideration the fact that those who do get sick might require expensive medical treatment, the cost of which will be partially borne by society. How does this alter the analysis of who should receive the vaccines?

3. Economists often are fond of markets as allocation mechanisms because the forces of supply and demand determine a price that allocates goods to those who are willing to pay for them the most. How would a market for flu vaccine work? Why is it different from a market for non-life-affecting goods and services, like books or cars?

4. Firms (especially ones with high-productivity employees) value their employees’ health. It is estimated that that the total yearly economic cost of the flu in the U.S. is over $80 billion. Many companies have started to recognize this and have made attempts to protect their own economic interest by paying for or providing flu vaccines to their employees. As a result, employees who otherwise may not have been vaccinated (since the unsubsidized cost exceeds the expected health benefit) are more likely to accept the free vaccine. Is this efficient? Is it equitable?

5. Vaccines have a limited shelf-life – that is, they can only be used for a particular period of time if they are to be effective. For this reason, the timing of development, production, and distribution of flu vaccines in the United States is largely based on the pattern of the flu season in previous years. Go to Google Flu Trends to see a graph comparing the incidence of flu activity in the United States this year with previous years. How does the current flu season differ from previous years? If you were in charge of setting production policy for 2010, what might you change in order to produce the correct amount of vaccine for each strain of flu at the appropriate time?

January 12, 2010

Fed Chairman Bernanke Chosen as Time Magazine's Person of the Year

In a December 16, 2009 article, Michael Grunwald details the reasoning behind Time Magazine’s choice of Federal Reserve Chairman Ben Bernanke for Person of the Year. The article delves into Bernanke’s background such as his working class roots and the consensus that he is “a leading scholar of the Great Depression.” It also details the unique nature of the crises of 2007-2008 to which the Fed responded in creative and beneficial ways.

Chairman Bernanke is currently awaiting a Senate vote to be confirmed for another term as Fed chairman. The vote is being held up by a Senator from the far left and another from the far right. The Time article is largely critical of those who oppose Bernanke, portraying them as nitpicky demanders of perfection who fail to realize that the Federal Reserve’s actions over the past two years most likely “prevented an economic catastrophe.” It is apparent that the Fed, like most people caught up in benefiting from the bubbles of those years, took too long to recognize the danger signs. Yet, the desire to criticize and rein in the Fed’s power now that the crises are largely history is short-sighted and will be harmful to long-run inflation rates. Most economics textbooks cover the extensive research that shows that greater central bank independence goes along with more stable and lower inflation rates.

As Bernanke is quoted in the article, "We came very, very close to a depression ..." That is because in the fall of 2008, the collapse of the financial sector and asset prices looked remarkably similar to the events that marked the start of the Great Depression. However, thanks largely to the bold actions of Bernanke’s Fed, the US experienced a severe recession rather than a depression. That distinction is significant and reason enough for the awarding of Time Magazine’s honor. Grunwald’s article gives evidence that Bernanke’s knowledge and research into the Depression made him the perfect man to hold one of the most powerful positions for influencing the world economy. As written by Grunwald, “He didn't just reshape U.S. monetary policy; he led an effort to save the world economy.”

Admittedly, the severe recession has caused significant hardship to billions of people. However, based on economists’ consensus definition of recession, the US economy has been in recovery and thus out of recession for several months now. Indeed, the figure to the right shows a picture of an economy that will most likely experience positive net job creation in coming months. Such positive net job creation has not occurred since the recession began in December 2007. This scenario looks much rosier than could have been hoped for back in the fall of 2008. This is an important reason why Bernanke is expected to be confirmed for another term:

Price for Will Ben Bernanke win Senate confirmation for a second term as Fed Chairman? at intrade.com


Finally, Bernanke’s critics need to understand that macroeconomics is not a true science. Despite the mathematical rigor required to publish articles in the field, macroeconomists cannot perform true experiments with a nation’s economy. Therefore, there is no comparison “control group” of a US economy run by someone who chose not to bailout AIG or who refused to dramatically expand the Federal Reserve’s balance sheet with risky assets. We will never know with any respectable precision what might have happened if it had not been for Bernanke’s bold leadership.

Perhaps someday a scientific genius will invent a time machine so that Bernanke’s critics can go back to the early 1930s to experience a collapsed economy. Most economists agree that the experience of those years is the best counterexample to show what we would have experienced without bold action by the Fed and our elected officials. Let the critics be reminded that the demand for perfection is all too often the enemy of good governance.

Discussion Questions

1. What is your reaction to Time Magazine’s choice of Federal Reserve Chairman Ben Bernanke for Person of the Year? Why?

2. Suppose that you were able to cast a vote in the Senate on Bernanke’s reappointment. How would you vote? Why?

3. Imagine you were currently chairperson of the Fed. What, if anything, would you be doing differently?

4. Do you approve or disapprove of the movement to rein in the power of the Federal Reserve? Explain.

December 21, 2009

Who Says There's No Such Thing as a Free Lunch

One of the most popular sayings associated with the “dismal science” of economics is “There’s no such thing as a free lunch.” The major idea behind this phrase is that even if you aren’t given a bill to pay, there is always an implicit cost associated with any action.

The economic concept supporting this statement is that of opportunity cost, which is defined as the best foregone alternative. Simply stated, it’s what you give up in order to do something else. Consider the following example: you have $10 that you can either spend on a movie or a pizza. The opportunity cost of going to the movie is therefore the pizza that you give up by attending the movie, and vice versa.

But what about when a good is free to consume? What is the opportunity cost in this situation? Usually in cases like this, the opportunity cost is associated with the value of your time or some other implicit cost. For example, if you work hourly, the time it takes to wait in line for a “free” offer is time that you could’ve spent working and earning money; “free” in this case simply means that there is no explicit monetary cost, but it says nothing about the implicit costs of waiting for the item. Another common example is when you receive a “free” weekend getaway, but the cost is that you have to sit through a 2-hour sales pitch with a timeshare organization.

I was thus astonished when I received something truly for free a few weeks ago at Auntie Annie’s pretzel shop. I was at the mall with my friend when the two of us realized we were getting pretty hungry. Wanting to avoid eating a fast-food meal at the food court, we decided to each grab a pretzel at Auntie Annie’s to hold us off for awhile. As we were waiting in line, one of the workers started giving out samples. My friend suggested that we try them since the line was pretty long and we were quite hungry. As I walked over to receive the samples and my friend stayed in line, the worker also instantly handed me a coupon: BUY ONE PRETZEL, GET ANOTHER ONE FREE. Having already committed to wait in line to purchase two pretzels before I got the coupon—it was my friend’s birthday so the two pretzels were on me—I actually received a free pretzel! After consulting with some other economists, none of us could find an implicit cost that I incurred in order to receive the free pretzel (though you could argue that my time to write this blog post is an after-the-fact cost associated with the pretzel purchase). In short, who says there’s no such thing as a free lunch?

Discussion questions:

1. Can you think of a time in your life where you actually received something for free? That is, there were no explicit monetary costs or implicit opportunity costs.

2. If I was just passing by Auntie Annie’s and received the coupon, why would the second pretzel not be free? What opportunity costs would be associated with using this coupon in that case?

3. Suppose you have a “Buy 10 pretzels, Get One Free” card for Auntie Annie’s. Does it distort your behavior in any way? Is the 11th pretzel actually free?

December 08, 2009

Leggo My Eggo! Really!

It’s hard to miss the barren shelves in grocery stores due to a pending Eggo Waffle shortage. The recent run on the popular breakfast food is one of the few times when a very clear-cut piece of microeconomics hits home enough to capture the attention of people without an economics background. What fascinates me the most about this story is how people with no interest in economics still have the shortage on the tips of their tongues. I believe there are two different microeconomics concepts at play here: one covered in nearly every introductory economics class and the other a deeper assumption that deserves more discussion than it normally gets.

First, the shortage in stores essentially comes from Kellogg’s self-imposed price ceiling. It seems that Kellogg has decided to continue selling Eggo Waffles at the same manufacturer’s suggested retail price (MSRP) rather than raising it to reflect a decrease in supply since two of their four production plants are out of commission. By leaving the price where it is, there is a shortage in the market because more people would like to buy at the MSRP than Kellogg wants to serve. This decision seems odd to economists because it introduces inefficiency. The price ceiling creates a shortage in the market which leads to the inefficiency. On the corresponding graph, you can see the minimum amount of deadweight loss (DWL) in the market for Eggo waffles given this shortage; the DWL could be larger if those consumers with a lower willingness to pay are the ones who end up buying the existing waffles. One possible reason for the price ceiling is that Kellogg does not want to appear like it is trying to profit off of its own misfortune (the Atlanta plant closed due to heavy rain) and planning (the Tennessee plant closed for repairs).

Operating under typical economic assumptions, unless Kellogg or individual stores decide to raise the price, the shortage in grocery stores should continue. This means that some consumers who would be willing to pay more than the MSRP will be unable to get waffles. Which customers end up with the waffles will only be a matter of timing and luck, and it is very likely that some people who are unable to purchase waffles will value them more than others who buy a box they find on the shelves. One common explanation economists offer about how this situation will be resolved is the emergence of a secondary market or black market. USA Today interviewed Joey Resciniti, a shopper who bought one of the last boxes, who said, “I told my husband that maybe I need to put them on eBay." In secondary markets, people who are lucky enough to buy the boxes at the MSRP are able to turn around and sell them to an unlucky person who is willing to pay above the sticker price but was unable to buy any waffles in the store, exactly what Ms. Resciniti suggested.

The second economic concept at play here is the competitive hypothesis. The classic supply and demand analysis used above rests on some core assumptions of economics, such as rationality of agents, complete information, and the competitive hypothesis. When any of these assumptions are broken, we need a different model to understand what will happen in the world. The competitive hypothesis can be summed up by the assumption that a consumer believes that if they decide to buy a product they can afford, they are able to get it. For example, if I worried that the gas station near my house would run out of coffee before I get there in the morning, I might behave much differently. The same can be said of Eggo Waffle consumers. In the USA Today article, Ms. Resciniti also said, "We have eight of them, and if we ration those—maybe have half an Eggo in one sitting—then it'll last longer.” If consumers believe they will have a hard time finding an item they want to buy, they may instead chose to change what they want to buy. If for example, Ms. Resciniti does start to ration her waffles, then she may need to buy more oatmeal or fresh fruit for breakfast on other days. If consumers start rationing because the competitive hypothesis does not hold, a more complicated model is needed to correctly determine equilibrium behavior.

Discussion Questions:

1. What should the shortage of Eggo Waffles do to the demand for other brands of waffles? What about the demand for maple syrup?

2. Think of some secondary markets you are familiar with, like eBay, ticket scalpers, or craigslist. How are prices determined in these markets? If a secondary market for Eggo Waffles forms, what can you say about the equilibrium price?

3. If a black market for Eggo Waffles did emerge, who would be worse off at the equilibrium? Would anyone be better off?

4. Think of some other real-world examples where the competitive hypothesis is violated. What would need to be added to the basic supply and demand model to accurately predict what people do when they aren’t sure if the store will have the goods they want in stock?

November 30, 2009

The President's Forthcoming "Jobs Summit"--Posner

On December 3 the President will convene a "jobs summit" to consider what if anything to do about the dismal employment picture. And dismal it is. The figure of 10.2 percent unemployment in October understates the problem because people who have given up on seeking a job, or who are involuntarily working part-time rather than full-time, are not counted as unemployed. They are, however, included with the unemployed in the statistics of underemployment, and the underemployment rate has reached 17.5 percent. These rates may continue to rise. And more than in previous downturns, employers have been cutting wages and benefits, which from a worker's standpoint is a form of quasi- or partial unemployment.

At the end of the summer there was some hope for a rapid economic recovery, but that has faded. Recovery from a recession or depression precipitated by a collapse of the banking industry secondary to a housing collapse tends to be slow. Weakened banks are hesitant to lend, and because housing is a big part of household wealth a collapse of housing prices tends to inhibit spending, or alter spending patterns, and especially to inhibit borrowing: debt is a fixed cost, so when household wealth declines people find themselves overindebted. With the supply of and demand for credit weak, economic activity slows. The banks' reluctance to lend, which expresses itself in stricter credit standards, is especially hard on small business, which depends on bank loans for credit; small businesses unlike big cannot finance themselves by issuing bonds or commercial paper or using retained earnings in lieu of credit. And small businesses in the aggregate are big employers. The Administration's ambitious health-care reform is inhibiting hiring by small business by creating uncertainty about the health-insurance costs that employers will bear. Mounting concern with our rapidly growing national debt is a further damper on investment and hence employment.

There is even concern that we may be in a trap in which rising unemployment feeds on itself. Credit defaults are highly correlated with the unemployment rate, so as unemployment rises, defaults rise, and defaults impair bank capital, causing a further tightening of credit, which by hurting small business pushes unemployment up.

All this is speculation and for all I know the unemployment rate will start falling soon and rapidly. But most forecasters think not, and so it is understandable that the Administration would like to do more than it is doing to curb unemployment. But what is there to do? In part because of mistakes in the design, implementation, and explanation of the $787 billion stimulus program enacted last February, and in part because of concern with the rapidly growing federal deficit, the stimulus has become extremely (I think undeservedly) unpopular, and Congress will not enact another stimulus program as urged by left-wing economists.

What then can be done? One possibility, which has been tried in Europe recently, apparently with some success, is to pay employers, through tax credits or otherwise, to hire workers. This is fiscal stimulus--Keynesian deficit financing--by another name. It is like the government's paying a construction company to build a highway, which will require the company to enlarge its workforce. All that might seem to distinguish the job subsidy is that the link between funding and jobs is more direct, which increases its political appeal.

A common objection is that it will encourage fraud--employers will fire workers and then rehire them, to obtain the subsidy. Or, less transparently, it will fire workers and hire replacements, again in order to obtain the subsidy. But a bigger objection, which is also an objection to the original stimulus program, is that it's not targeted on industries or areas of above-average unemployment. Even in an area of low unemployment. an employer will have an incentive to hire workers in order to obtain the subsidy, but he may do this by hiring workers who already have a job, and the net effect on unemployment will therefore depend on what the hired worker's former employer does--maybe just pay him to stay.

There are other ways of stimulating employment, at lower cost and probably with greater impact. One would be to reduce the federal minimum wage, which over a three-year period beginning in 2007 will have risen from $5.15 to $7.25 an hour--a 40 percent increase. As time passes, unemployment becomes less a matter of layoffs and more a matter of failing to provide jobs for new entrants to the workforce, and a reduction in minimum wage would make these new entrants--inexperienced workers with modest wage expectations--far more employable.

Another way to reduce unemployment would be to amend the stimulus law to redirect the remaining unspent funds to areas and industries of high unemployment. Another would be to reduce payroll taxes, including the unemployment-insurance tax and the employer's share of the social security tax; for payroll taxes are part of the cost of labor. The effect on the employer would be similar to that of a wage cut, and would increase the demand for labor. Since social security and unemployment benefits (as opposed to taxes) would be unaffected, the reduction in the taxes would not reduce the employees' full wages and so induce a demand for higher wages. So the employer's net labor cost would fall and his demand for labor rise. The problem is that the government's deficit would increase, but that would also be true of a subsidy for hiring, though it would not be true of a reduction in the minimum wage.

November 29, 2009

How to Increase Employment- Becker

During this "Great Recession", unemployment has risen from under 5% at the beginning of the recession in December of 2007 to more than double that rate to reach its highest level so far in October of 10.2%. This is the second highest unemployment rate in the postwar period, surpassed only by the 10.8% rate in December of 1982. In light of such rather dismal employment figures, it is not surprising that the President will have a "jobs summit" in a few days to consider how to improve the employment market.

Posner correctly indicates that the unemployment rate understates the employment problem since some men and women have left the labor force after giving up finding work, or they are working part time when they would like to work full time. The so-called "underemployment" rate is estimated to be 17.5%, much higher than the unemployment rate. Note, however, that the underemployment rate is far harder to estimate accurately than is the unemployment rate, which itself is difficult to measure.

I have responded to Posner's emphasis on the underemployment rate in previous posts that apples have to be compared with apples. If the underemployment rate, not the unemployment rate, is used to measure the severity of this recession, than the underemployment rate also has to be used for past recessions. Not surprisingly, underemployment was also considerably higher in these recessions than was unemployment. The underemployment rate for December of 1982 is estimated at about 17.1%, also much above the high unemployment rate at that time. Yet while the unemployment rate has not yet reached the rate obtained in 1982, for the first time the estimated underemployment rate has slightly surpassed the rate for that earlier recession.

In addition, while this recession ended during the third quarter (I believe), unemployment usually lags any pickup in the overall economy, so that the unemployment rate is likely to continue to rise further. However, there are signs of a pickup beginning in the labor market: hours worked of those working have been rising, and wage rates rose by about 2% during the past year. The rise in wages-which is uncommon during recessions- also casts doubt on claims of extensive wage cutting during this recession. Yet it is an unusual combination: workers who still have a job are doing better than in other serious recessions, but the underemployment rate has grown to its highest level since the Great Depression.

Keynes and many earlier economists emphasized that unemployment rises during recessions because nominal wage rates tend to be inflexible in the downward direction. The natural way that markets usually eliminate insufficient demand for a good or service, such as labor, is for the price of this good or service to fall. A fall in price stimulates demand and reduces supply until they are brought back to rough equality. Downward inflexible wages prevents that from happening quickly when there is insufficient demand for workers.

The usual suggested remedies are either to stimulate demand for labor, or to reduce the real cost of workers to employers. The stimulus package has tried to stimulate demand. While I believe this package has failed to stimulate demand to any significant degree (see the discussion my earlier posts on January 11, 18, and November 1, 2009), and that the claimed employment effects of the stimulus are vastly overstated, I concentrate my discussion, as Posner does, on reducing the real cost of labor to employers.

If rigid nominal wages were the culprit, inflation would reduce the real value of labor costs, and hence stimulate demand by companies for workers. But deflation rather than inflation is the greater worry now, so this approach does not seem feasible at this time. The alternative is to cut the cost of labor to employers. A frequent suggestion by economists and others is to give employers subsidies for each unemployed person that they hire, but I believe this approach has many problems of implementation. Clearly, companies would have an incentive to fire some employees and replace them with subsidized unemployed workers.

Moreover, if the unemployed hired under the subsidy program received higher pay because companies compete for the subsidy, some workers might remain unemployed rather than accepting jobs now because they expect to do better when the subsidy program is introduced. Others might even quit to become unemployed, so that they can then become employed at better wages through this program. Many other adjustments would make such a subsidy program both extremely difficult to enforce in a net job-creating way, and highly intrusive into the employment decisions of companies as the government tries to close various loopholes that are bound to be discovered.

It is wiser to cut labor costs in other ways. I fully endorse Posner's suggestions to cut the minimum wage, but I do not see that happening with the present Congress. My favorite approach it to try to stimulate the economy by cutting income taxes, especially corporate income taxes and other taxes on capital, both physical and human capital. Such tax cuts will stimulate investments in the economy, and in this way increase the demand for workers.

Of course, tax cuts at this moment would add to the deficit and increase the size of the government debt at a time when the debt has already grown rapidly. Tax cuts may also take time before they raise investments and jobs. On the other hand, tax cuts that add significantly to the growth rate of GDP will have only modest, and possibly even negative, effects on the ratio of the debt to GDP while they increase investments and the demand for workers. This seems to me to be an attractive way to approach solutions to the unemployment problem at the jobs summit this Thursday.

November 13, 2009

Towards Gasoline Market Efficiency


For the past year or so, I’ve been using the same website to save money on gasoline. The parent site of the one I use is Gas Buddy. Commuting to work I spend about $130 per month on gas, or roughly $1,550 per year. There are several reasons for this. Gasoline is one of my biggest work-related expenses, California gas prices are consistently among the highest in the nation, and I’m also an economist. I feel impelled to fill up at the station offering gasoline at the cheapest price, without going significantly out of my way to get there, of course.

Economic theory would typically classify a local gasoline market as a competitive market, yet, I often see differences of 20-25¢ per gallon for the same gasoline grade among nearby stations. Why does the standard model of competition not seem to apply here? Because most consumers probably accept the notion that gasoline of the same grade is nearly identical regardless of the station, competition should drive prices to the same competitive market clearing price. However, gasoline retailers often try to differentiate their product through methods such as affiliated credit cards, which give the holders a discount when they purchase gas with the card from a retailer that is part of the corporate chain. Another strategy they use is to offer a discount on a car wash to consumers who have purchased gas at their station. Nevertheless, it doesn’t seem like such differentiation would be important enough to keep the market from a perfectly competitive equilibrium.

What else might explain these facts? One possibility is that some gas stations employ a strategy of luring customers into their stores with gasoline sold below cost, to sell them high margin convenience goods. Another possibility is that some stations enjoy location advantages that allow them to command higher prices, such as the first station located off of a high traffic freeway exit. Nevertheless, the explanation that I prefer is that gasoline consumers do not have all of the information regarding prices of gasoline in surrounding areas. Websites like Gas Buddy help alleviate this informational deficiency in a nearly costless way thanks to its gas price maps and price lists. As more people use the site, the local gasoline markets covered should theoretically approach a perfectly competitive equilibrium.

Where does the website get its price information? People who are interested in either winning gas cards or making the gas market more efficient have accounts on the site and post gas prices there. Although there are obvious benefits to the information provided by Gas Buddy, there may also be drawbacks to the site. Besides the obvious damage to the profits of gas station companies, there are likely to be people who misuse the information. For example, imagine the user who drives several miles out of his way to fill-up on gas that is only 5 cents cheaper per gallon than the nearest station. This person may save $.75 or so, but environmental costs of the extra driving distance, the cost of the additional gasoline used and vehicle wear, and the value of the person’s extra driving time are likely to sum to significantly more than $.75. So, while getting the cheapest gas is great, remember that there are more to costs than just retail prices.

Author’s note 10/19/09: During her review of this post, Kasie Jean mentioned the possibility that consumers may have gasoline brand loyalties. The author found this unlikely but later received advice from a trusted mechanic regarding the benefits of Chevron with Techron gasoline. The author owns no securities issued by the Chevron corporation.


Discussion Questions


1. Now that you are aware of a gasoline price website, would you use one to locate the cheapest nearby gas prices? Why or why not?

2. Think about the characteristics of perfectly competitive markets. Do you believe that gasoline markets are perfectly competitive? If not, what are some aspects, besides those described above, that keep them from perfect competition?

3. In 2007, a study concluded that the optimal tax on gasoline was $2.10 per gallon. What is your opinion of this conclusion? Do you think that gas price websites would be viewed more if gasoline taxes were significantly higher?

4. In what other ways has the internet made markets more efficient or perhaps less efficient?

The 2009 Nobel Prize in Economic Sciences

A few weeks ago, the committee that awards the Nobel Prize in Economic Sciences announced the winners of the 2009 award. The prize winners were Elinor Ostrom of Indiana University and Oliver Williamson of the University of California, Berkeley. The committee awarded this year’s prize to these economists for their work in economic governance. For Ostrom, the committee cited her research on the methods that actors use to avoid over utilization of common property resources. Williamson’s research provided theory on the conditions under which firms are better suited for economic organization than markets.

Ostrom found numerous examples in which actors had successfully avoided the “tragedy of the commons.” Standard theory had found that common property resources are too often exploited to the point of inefficiency and depletion. Ostrom examined numerous case studies in which actors avoided resource depletion through various governance structures. Much of her insight involved applying theories of repeated games in which actors may punish others who over extract common property resources.

Williamson provided theory to explain firm organization and conditions under which economic activity is better suited to take place within a firm than in a competitive market. An important basis for his theory involved the timing of work and bargaining. For instance, agreements made prior to work being performed can break down once the work is completed due to a change in the bargaining position of the actors. When the work is highly firm-specific then the actor who completed the work may find himself in a weak market position with only a single prospective buyer. In contrast, by arranging activity within a firm, the ex-ante and ex-post market issues are avoided. Similarly, the firm provides a clear hierarchy of authority which can help to clearly dictate the work that must be done. However, Williamson’s research also highlights an important disadvantage of firms: authority is prone to abuse.

The research of both Nobel Prize winners provided a richer framework for analyzing economic activity through its insight into governance. To learn about their research in greater detail, see the scientific background paper provided by the Nobel committee.

Discussion questions:

1. Describe some ways in which common property resources may be governed for the long term benefit of stakeholders. What are some of the difficulties involved in such governance?

2. What are some of the other advantages or disadvantages of firms, when compared to markets, which are not described above?

3. What other economic governance issues do you observe? Are these issues dealt with in a way that improves or worsens economic efficiency?

November 06, 2009

Virtually Bankrupt

The space-themed video game EVE Online is described as a massively multiplayer online game (or MMO). In other words, the game is played over the internet in a virtual world where all (or nearly all) characters are controlled by users who are able to interact with each other. EVE Online separates itself from many other MMO games by offering an incredibly robust and fascinating economy, complete with its own currency of InterStellar Kredits (ISK), in-game supported contracts (that cover loans, trade agreements, and hiring other players to complete tasks for a fee), user-created and managed banks, and trade between players (in both money and goods). And if the game wasn’t realistic enough, the in-game universe even mirrored the troubles on Wall St. when the economy was hit by a bank scandal!

In July 2009, a manager of EBank, the largest in-game bank, embezzled 200 billion ISK then turned around and sold the in-game currency outside of the game for a real-world $5,000. Once news of the scandal became public, many depositors became concerned about the bank’s stability and decided to withdraw their money. These fears created a bank run that left EBank short 380 billion ISK. The chairman of the bank attributed this shortfall to both the embezzlement and further mismanagement that stemmed from ignoring safeguards and controls. Only a month later, the bank faced a total deficit of 1.2 trillion ISK and announced that it was freezing withdrawals on current funds and suspending all interest payments until it reached an equity status of 90%. As of this post, depositors are still awaiting the next announcement of EBank’s policies.

Many parts of the EVE online environment closely mimic economic events in the real world, but I do not think a bank run like this could be observed in America today because of the modern level of regulation. That said, the circumstances that led to the game’s financial crisis do mimic real-world occurrences from the early twentieth century. EBank’s problems stem, at least in part, from the fact that it was left to self-regulate and that its actions were largely unmonitored. Historically, similar conditions led to the banking crises of the 1930’s. These wide-spread bank failures led to increased legislation and controls on banking which established three main systems that prevent bank runs today: deposit insurance, capital requirements, and reserve requirements. If members of the game’s community wish to restore a reliable banking system, it seems likely policies that mimic one or more of these systems would be implemented.

However, if banking or using fiat money (currency with no underlying value) is viewed as unreliable, let me propose some other responses the game’s community could have. First, and most simply, a barter economy could develop as the main source of trade. In this scenario, any player seeking a good would need to find another player willing to give that good away in exchange for other goods. Obviously this sort of economy comes with drawbacks, as trade partners take time to find and each trade would need to be negotiated. This barter economy could expand to a commodity money trade system: where all goods are expressed in terms of multiple or fractional values of a single good with intrinsic value. (One of the best known examples of an economy like this occurs in prisons. Inmates are not allowed to hold money, but a system of trade develops around a single good, often cigarettes or energy bars.) Since this underlying good has a use, unlike fiat money, a bank often has no role since players can put money not spent to other uses.

The final system I’ll suggest is trade based on credit. For a system of trade that is built entirely on credit to support long-term trade, all traders in the market must know each other’s reputations prior to trading with any partner (even if they have never met). In the modern world, having a record of every person’s reputation instantly is simply not possible, so we do not observe this kind of trade. However, by definition, all trades occur in a game played over the Internet, so it seems perfectly practical for all players to always have access to websites at the same time. To support a credit trade system, a webpage could track the trading desires of each player (uniquely identified by their in-game name) as well as their reputation. Any player who does not fulfill his or her end of a deal could then be monitored and either punished or simply barred from future trade. All honest players would then be left to agree to turn over a good they don’t need to a player, and in exchange receive what they desire from someone else on credit. One further potential layer to make this more practical would be for all trades to go through a neutral third party (the same way people exchange valuable goods in escrow in the real world). This third party could charge a small fee to make a secure transaction and to maintain the outside website. The third party would also remove the potential for traders to attempt to blackmail each other by falsely reporting dishonest trades in order to sabotage reputations.

Discussion Questions:

1. How did rational expectations contribute to the bank run? Think about whether or not a bank run would have happened if each individual believed that everyone else had faith in the bank.

2. Who was hurt the most by the bank run: debtors, creditors, or people with no ties to the bank?

3. Based on the sale of embezzled money, find the U.S. Dollar-ISK exchange rate. How would the game’s economy change if purchasing in-game fiat with U.S. dollars was allowed?

4. Suppose one player proposes using an entire ship as the unit for commodity money, and another player suggests using one ton of steel as the unit. Assume that half a ship is useless, but that half a ton of steel is half as useful as a full ton. Which of these is a better proposal for commodity money? Is it important that money is divisible?

October 15, 2009

Bags Don't Fly Free

As a frequent Southwest passenger, paying for checked baggage is not quite commonplace for me yet, since Southwest is a firm proponent of bags flying free. As any traveler is well aware, many airlines now charge an additional fee for checking baggage, averaging roughly $20 per bag. However, I was initially surprised when I recently checked in online for my US Airways flight, and was offered the option to declare the number of bags I’d be checking and thus pay a reduced price of $5 less per bag.

Although at first glance you might be tempted to think this is a classic example of price discrimination, further examination will reveal other possible explanations for this pricing disparity. If price discrimination were the sole justification for the two different prices, this would mean that US Airways is trying to extract additional consumer surplus (and thus increase profit) by segmenting the market into those who check in online and those who don’t. Based on the pricing differences, this would mean that US Airways believes that those passengers who check in online have a lower willingness to pay than those who check in at the airport.

However, there is reason to believe that many passengers who check in online might actually have higher willingness-to-pays than other passengers, as they are likely to be business travelers who are either in an office with wifi or have internet connections on their phones. Since business travelers tend to have a more inelastic demand for travel services (mostly since they do not directly incur the expense), an argument could be made that this market segmentation isn’t the most profitable.

An alternative, and more plausible, explanation for the two different prices is that US Airways is creating an incentive for passengers to declare the number of bags they’ll be checking and pay for them ahead of time. Incentives are at the core of economic analysis, so this result isn’t incredibly surprising. By charging a lower price to those passengers who “check bags” ahead of time, US Airways is inducing passengers to plan ahead. Some possible justifications for why they would want to do this are as follows:

  1. Paying for bags ahead of time reduces the wait time for passengers seeking to check in at the airport. This makes customers happy and more willing to fly US Airways, and perhaps lessens the need for extra employees working the check-in booths.

  2. If passengers declare the number of bags they are checking ahead of time, US Airways can more accurately predict the number of bags that will be on the flight and perhaps the need for overhead space in the cabin.

Discussion Questions:

1. If US Airways’s goal is to increase profits through price discrimination, is the market segmentation they are using appropriate? Can you think of any other existing ways that airlines segregate their markets?

2. How does this information friction about the price of checked bags affect efficiency in this market?

3. Can you think of other markets where different pricing mechanisms exist in order to incentivize a particular action, such as cities charging for trash removal but providing free recycling services?

September 28, 2009

Rethinking Rationing


“There need to be some guarantees that the government is not going to take away the health care decision-making from a patient and their doctor. I think we need to start with the guarantee that there won’t be any government rationing or discrimination of any kind.”

-- Representative Eric Cantor (R-Va.)



As demonstrated by the quote above, the word “rationing” doesn’t sit well with proponents of free markets. While the goal of rationing health care is to control costs by restricting insurance coverage for expensive procedures that yield relatively low benefits, doing so would also limit patients’ freedom to choose treatment options that might otherwise be available under their private insurance plans. As you learned from the basic supply and demand model, restricting the supply of a good can preclude the occurrence of transactions that could benefit both the producer and the consumer. However, the fact that the market for medical treatment is already substantially distorted by the insurance system complicates the standard supply and demand analysis.

When receiving medical treatment under most insurance plans, patients pay a copayment that accounts for only a small portion of the true cost of the treatment. Their insurance company pays the remainder, using the money it receives from monthly payments from all of its insured patients. This monthly payment is known as the insurance premium. While the monthly premium varies with different plans and individual circumstances, the amount charged is largely a function of the total number and cost of insurance claims by insured patients – as the number and cost of treatments covered by insurance companies rises, so too do the premiums paid by the insured.

While the copayment on an expensive procedure may seem like a fair price to the recipient of the treatment, those indirectly paying for the remainder of the cost in the form of high premiums may not consider it such a bargain. In economic terms, the marginal private benefit of treatment is lower than the marginal social cost paid by all the insured.

The benefit to insurance is, of course, the fact that it disperses large risks over a large number of individuals. This increases the utility of risk averse individuals who prefer paying the monthly premium as opposed to the possibility of needing serious medical care and facing enormous costs.

An additional complication to normal cost-benefit analysis is the difficulty of putting a dollar value on life and health. While it is hard to quantify the benefit of a procedure, it is simple to consider the opportunity cost of a procedure: every dollar that is spent on one patient is a dollar that can’t be spent on another. Britain’s National Health care System uses the QALY (Quality-Adjusted Life Year) as a measure of the benefit a medical treatment will provide in terms of the number and quality of years it will add to a patient’s life. Comparing the ratios of QALYs per dollar cost across treatment options, cost-utility analysis helps economists determine the allocation of health care resources that provides the most benefit to society, also known as allocative efficiency.

Markets without distortions are allocatively efficient by nature. In efficient markets, the standard conclusions about rationing can be applied. In the market for health care, however, risk aversion leads people to demand insurance which distorts costs, benefits, and allocative efficiency. While it is beyond the scope of economic analysis to determine whether the ideas behind rationing can be transformed into successful health care policy in the U.S., it can help to illuminate the myriad of economic issues involved.

Discussion Questions

1. President Obama has talked about lowering copayments and bringing down total costs for health care coverage. Based solely on the simple graph presented above, is this a reasonable claim? How could the use of rationing help make this claim more attractive?

2. From a standard economic standpoint, insurance causes “overconsumption” of health care because the marginal benefit of treatment to the patient is often lower than the marginal cost to society. However, the benefit of care is perhaps underestimated, since it does not take into account the positive externalities of treatments like vaccines. How do positive externalities help justify this “overconsumption” in the health care market?

3. Moral hazard refers to a situation in which a person who is protected against risk might behave differently from the way he or she would behave if fully exposed to the risk. Relate this concept to the effect of insurance on health care costs. How might having health insurance affect an individual’s decision to take care of their health? How could moral hazard in the health care market potentially be discouraged?

September 08, 2009

I Read the News Today, Oh Boy.

07.07.07 marked the Live Earth festivals to combat Climate Change. 08.08.08 saw the opening of the Olympic Games in Beijing. 09.09.09? This date, my friends, belongs to Beatles fans. The number 9 has long been associated with the Beatles, specifically John Lennon. For this reason, this date was chosen to release the newly re-mastered Beatles catalogue and the video game "The Beatles: Rock Band."

Since my primary interest is getting my hands on the re-mastered box set, I figured I’d just pre-order it on Amazon so it would arrive straight away. However, I was quickly thwarted by this message indicating that Amazon was out of stock. After further investigation, I found their explanation for this lack of inventory:

“Collectible box sets take time to manufacture, and initial quantities must be determined well in advance of the product release date. In this case, demand has far outstripped initial supply…While we predicted that the box sets would be highly popular items, we had to work with the inventory allocated to us by the manufacturer.”

No problem, I’ll just call my local Best Buy; they should have plenty in stock since it’s a large store in a big city, right? Wrong. The manufacturer allotted Best Buy just eight copies! At least they could have kept with the theme and given them nine!

While it’s possible that the manufacturer just underestimated the demand and is doing all they can to make more and get it into stores, I’m skeptical that they could really be so off the mark. The Beatles have sold nearly a billion records worldwide, their albums hold four spots in Rolling Stone’s all-time top ten, and come on… they’re THE BEATLES.

A more plausible explanation is that this may be a deliberate shortage, designed to make headlines about its popularity and stir up new eventual sales as more of the product is slowly released into stores and onto websites. Tim Harford discusses other possibilities in this Slate post, in reference to the Xbox 360 shortage of 2005.

Discussion Questions

1. Can you think of other examples of supply shortages which successfully generated press?

2. The Beatles catalogue is not available digitally largely due to their dispute with Apple Computer over use of the name “Apple” in the music business; this is because the Beatles had a corporation called Apple Corp (pun intended). How might the fact that the music is not available digitally impact their CD box set sales?

3. How might the shortage of Beatles box sets affect the resale market for this item on websites like eBay, Craigslist, etc? Does this “scalping” of sets achieve allocative efficiency?

4. How does patience (normally referred to in economic models as the parameter β) affect the profitability of this approach to releasing a collectible set?

5. Despite the shortage for the Beatles box set, the price for the good seems relatively consistent across retailers. Why might the manufacturer want to keep prices constant over time? How could this be profit maximizing?

September 03, 2009

Trash Talk

I recently moved from Philadelphia, where trash and recycling pick-up are included in property taxes, to a smaller town where my taxes cover recycling but not trash pick-up. The waste management companies where I currently live offer several pricing options for garbage collection:

1. Pay-by-weight at the dump: The catch is that there’s a minimum $15 fee, so you need to generate lots of garbage to make this worthwhile.

2. Pay-by-the-can pick up: You pay a nominal charge, usually about $3-$3.50, per 33-gallon trash can. Under this option, your fee fluctuates directly with the amount of garbage you produce.

3. Flat rate: You pay a flat monthly fee of say $10, and this includes only 1 trash can pick-up per week. If you have more than one can, you pay an additional fee, but if you don’t have any trash, you will not receive any credit for future collections. This service makes sense if you reliably generate 1 can per week.

I decided to go with option two: pay-by-the-can pick up. Each Tuesday morning, I put out my 33-gallon trash can (if it’s full), and the lowest cost trash company I could find ($3.00 per can) comes to collect. The window in my home office overlooks the road, so I typically hear any cars and trucks that drive by. To my surprise, I heard five different waste management trucks drive by my house in one day! My immediate reaction was: How can this be efficient? Surely there are economies of scale to trash pick up?

Consider the following simple example. Suppose there are four houses located along Country Road. The road is a one way street, so the only way to drive by any of the houses is to drive east along Country Road, passing by all four houses with any trip. If a trash collection company is hired to pick up trash for House 1, what are the additional costs associated with picking up trash at any of the other three houses?


One could argue that the additional costs are negligible. In other words, the cost of picking up trash at the first house is high because you have to have a trash collection truck, a worker to drive it, a worker or two to collect the trash, fuel, etc. But once you’re out on Country Road, the marginal cost of collecting trash from the surrounding houses is just the wear and tear on the truck’s brakes, a slight wage expense to your workers, and the cost of taking care of the additional waste (such as bringing it to the local dump).

It’s probably true that the average cost curve for a trash collection company is not strictly downward sloping since once a certain number of houses are served, the company would need to obtain additional trucks and workers. I would still argue that there are economies of scale for trash collection companies once they enter a particular neighborhood. It seems silly to me that in a given week I see at least ten different trash collection trucks drive by my street.

Wouldn’t it be more profitable for all companies if they each monopolized a small region? The additional cost of collecting trash from a neighboring house must be smaller than the additional cost of servicing a house in an entirely different neighborhood. Even without changing prices, revenue would probably remain constant while costs would decline, leading to higher profits for each firm.

Discussion Questions

1. What kind of market structure does trash collection represent? If the city decided to step in and control trash collection for my town, what pricing options might it choose?

2. Do consumers benefit at all from having several waste management companies to choose from with different pricing schemes?

3. If the city allowed waste management companies to “monopolize” particular neighborhoods, how might this affect the market? What are the effects of competition on prices, welfare, and pick-up quality (such as timeliness, effectiveness, etc)?

4. Given the number of trash collection companies in my neighborhood, what does this say about the profitability of this industry? If the town does not have strict anti-trust laws, would it be profitable for one firm to buy out all the others? What problems might arise if only one firm controlled trash collection for my entire town?

August 21, 2009

The Demand for Natural Light

I once participated in a blind taste test involving eight light beers. Faced with eight un-marked cups, I was certain I’d prefer the priciest, and presumably classiest, light beer in the field. Alas, I chose Natural Light. For me, the cheap and down-market “Natty Light” is the choicest light beer on offer. But people who have (or think they have) a more refined palate gladly pay for a more expensive option like Heineken or Bud Light.

With the economic downturn, however, cash-strapped beer drinkers appear to be switching to cheaper beers like Busch, Natural Light, and Keystone. As average incomes declined in the United States, sales of these cheaper options have increased substantially. Meanwhile, sales of ‘premium’ brands like Budweiser and Heineken were reportedly down 18% and 14% respectively from a year ago in July 2008.

Discussion Questions

1. If, other things being equal, a reduction in average income leads to an increase in the demand for Natural Light, what type of good is “Natty Light”? If, during the same period, the demand for Bud Light declines, what type of good is Bud Light?

2. What additional information would be useful if you were trying to use changes in average income and beer sales to determine whether a particular brand of beer was a normal or inferior good?

3. What strategy might a large beer company adopt to protect itself from an economic downturn?

4. Information Resources, Inc. reports that sales of Bud Light were down about 7% from a year ago in July 2008. Let’s assume that the price of Bud Light is fixed, so that the percentage decrease in sales is the same as the percentage decrease in the quantity of Bud Light demanded. Assume that personal income per capita in the United States declined by about 3.4% over the same period. Keeping in mind that factors other than income probably affected Bud Light sales over this period, use these numbers to come up with a rough estimate of the income elasticity for Bud Light. Is the income elasticity of demand for Bud Light elastic or inelastic? Would you characterize Bud Light as a luxury or a necessity?

August 13, 2009

I'd Like to Bid $1, Bob!

In a previous post, we used The Price Is Right as a starting point for a discussion of probability theory and decision-making analysis. But the opportunities to learn from the show hardly stop there. Another practical game theory application can be observed six times a show – when contestants “bid” in an effort to win a prize and to get on stage from “contestants’ row.”

Each time the game is played, four contestants are shown a prize without being told its price. Each contestant takes their turn announcing a single bid, or guess, as to the value of the prize (rounded to the nearest dollar). All bids are known to all the other players as soon as they are made, and no player may bid the same value as another. After all four bids have been made, the player whose bid is closest to the actual retail price of the prize without going over wins both the prize and the opportunity to come on stage and play a “pricing game” in order to win more valuable prizes. If all four contestants guess a price higher than the price of the prize, all bids are erased and the game is played again. In the case that one of the four players actually guesses the exact value of the prize, they receive an additional cash bonus. For the remaining purposes of this analysis though, we will ignore the cash bonus and simply focus the analysis on a strategy to maximize the chances of winning the prize and going on stage. The game is most easily modeled from the perspective of the fourth player, so we will base our analysis on his perspective.

Suppose the first three players bid b1, b2, and b3; assume these are listed in increasing order because only the value of each of the first three bids matters to the fourth player, not which bid was made by which player. The fourth player will then try to pick a value, b4, that is priced closer to the true price of the prize (call it P) than b1, b2, and b3, without going over. Assuming none of the other three players has bid the exact price, P will fall in one of the following four intervals: (1,b1-1), (b1+1,b2-1), (b2+1,b3-1), (b3+1, ∞).

The optimal strategy for the fourth player is to pick what range they think contains P, then bid the lowest value in that range. It is important to note that any bid higher than this but within the same range does not help him, but it does increase the chance that he goes “over” and loses automatically. Suppose, for example, that the fourth player believes that P= $1,000 and b3=$900 (with b1 and b2 defined to be less than $900). The fourth player should bid exactly $901. With a belief that the price is around $1,000, any bid lower than $900 gives the player who guessed b3 the best chance to win, and any bid higher than $901 gives the same player more chances to win if it turns out the fourth player’s belief about the price is an overestimate. In order to act optimally, the fourth player should always bid either: $1, b1+1, b2+1, or, b3+1. Any other bid makes the fourth player strictly worse off; taking away values for P that make the fourth player win, without providing other values that make him win.

Discussion Questions

1. Given the fourth player’s optimal strategy, how should the third player pick their bid? Keep in mind, when making his choice, the third player knows b1 and b2, as well as the fourth player’s strategy. What method can you use to solve for each player’s optimal strategy in this game?

2. What would you expect to happen if all players wrote down their bids simultaneously and did not know the other players’ guesses when making their own selection?

3. Suppose the cash bonus for bidding the exact value of the prize were very large, so large that players would be willing to risk losing the game for a chance to collect the bonus. How would this change the optimal bidding strategy? How would each player’s risk aversion factor into his decision?

4. Many times on the show, we do not observe this optimal bidding strategy by the fourth player. One possible explanation is that players do not want to appear cutthroat and greedy by bidding a single dollar more than an opponent (thus giving the opponent only one way to win: if his bid is exactly the true price). How would the optimal strategy change if you add reputation costs?

July 08, 2009

Income and Substitution Effects Explain Changes in Burrito Consumption

I took many economics courses, and yet it wasn’t until I experienced a change in my own personal finances that I really understood the nature of the income and substitution effects. The technical definitions are as follows: the income effect explains spending responses to effective changes in income level; the substitution effect explains spending responses to changes in the relative price of one good to another.

Only when my parents stopped paying for my groceries did the technical definitions sink in. Back when groceries were “free,” I often faced the following decision: Do I make lunch at home at no personal monetary cost, or do I go out and spend $6 on a burrito? The answer depended on a number of factors, such as (1) how badly I wanted a burrito (my current preference for burritos vs. homemade food); (2) how much money I recently made and spent (my budget constraint); and (3) what I could do if I wasn't preparing food (the opportunity cost of making lunch).

Having to pay for my own groceries altered this decision-making process in two ways. First, the former trade-off between a $6 burrito and the homemade lunch with ingredients paid for by my parents became the choice between a $6 burrito and a homemade lunch that costs me $3 in groceries. Although the price of eating out remained the same, it became relatively less expensive. The explicit cost of getting a burrito is now only $3 more than that of making a sandwich ($6 burrito, $3 sandwich); before it was $6 more ($6 burrito, $0 sandwich). I might now be more likely to choose the burrito than before. In doing so, I would be substituting the burrito for the homemade lunch due to the reduction in the relative price of a burrito. Whether or not I actually choose to do this, however, would depend on the strength of the income effect.

Now that I allocate a substantial portion of my monthly income to buying groceries, I have less money for all other purchases. Among those purchases are burritos, so by adding another item to my budget, the income available for burritos effectively declined. If burritos are normal goods, this negative income effect may lead to a decrease in my burrito consumption.

Which effect dominates? In my case, probably the income effect, but in general—it depends. Given that my budget didn’t encompass a lot of luxury purchases to begin with, dining out was a big part of the non-essential purchases I cut back on to make room in my budget for groceries. I adapted my schedule so that I could go home for lunch more often, and I started buying groceries conducive to paper-bag lunches.

Discussion Questions

1. Suppose your parents decide to stop paying for your textbooks (assuming they paid for them in the first place). What is the expected effect on your food consumption as a whole? Is this an example of the income effect, the substitution effect, or both?

2. In addition to the income and substitution effects changing my spending behavior, paying for my own groceries made me internalize the cost of groceries. How might this affect my overall consumption of food? In terms of economic efficiency, is internalization a good or a bad thing?

3. What are some factors that might affect the opportunity cost of homemade lunches? How would changes in the opportunity cost affect the strength of the income effect vs. the substitution effect?

4. Consider what would happen if you didn’t plan ahead and face the choice between spending half an hour to walk home and prepare lunch or spend $6 to buy lunch. Which effect is likely to dominate if your hourly wage is $7.25? $13? How does this relate to the concept of opportunity cost?

May 26, 2009

Internet by the Byte

With significant contributions and analysis from Kasie R. Jean.

Many existing industries follow a pay-per-use pricing structure. Cell phone companies typically charge by the minute and taxi cabs charge by the mile—why should Internet usage be any different?

Time Warner took the pay-per-use approach recently when it announced a pilot pricing model for its broadband Internet service. The new tiered billing system resembles that of most cell phone plans: households choose one of five levels ranging from 5GB ($29.99) per month to 40GB ($54.90) per month (or a yet to be priced 100GB per month) with a $1 fee for each GB over the chosen plan.

For flat-rate customers, Internet bandwidth is like a common resource—everyone can use the Internet as much as they want, but when one person uses a lot of bandwidth, that slows down the service for everyone else. This is a practical example of what economists call “the tragedy of the commons.” The argument claims that heavy Internet usage imposes a negative externality on all users who share a provider. In order to control its product quality, Time Warner tried a tiered pricing plan in hopes that it would discourage large bandwidth users from bogging down the service’s speed. By adding a cost, Time Warner caused consumers to internalize the externality imposed by heavy Internet usage under the flat-rate scheme.

So, what's the downside? There isn't one, unless you happen to be a consumer whose usage puts you in a tier that's priced above the current flat rate. More and more people find themselves in this group as the Internet’s functionality expands. Nowadays it is not uncommon for consumers to work from home, stream episodes of TV shows that they missed, download music, or play video games through their PC console on systems such as the Xbox or Wii. Streaming and downloading are a surprisingly quick way to run through your monthly GB quota in a matter of days.

Suppose that you used to pay a flat rate of $39.99/month with Time Warner. Under the new pricing system, this same monthly fee would entitle you to only 10 GBs/month. A few movie downloads and streamed TV shows later, and you will already have run through your monthly usage allotment and will be stuck paying overage charges for routine Internet tasks.

It's not surprising that the trial runs of the tiered pricing system caused a major uproar among Time Warner users. Under the proposed new pricing, any users consuming more than 10GB’s per month will be paying more for essentially the same service (though access might be faster if the new policy is a successful deterrent to over-use of bandwidth). If Time Warner decides to go through with the pricing switch nationwide, only the very low bandwidth users will actually benefit from it, which will potentially cause a mass exodus from Time Warner to other services.

Discussion Questions

1. Under the newly proposed pricing model, is the overage fee always something consumers should choose to avoid? If you knew you would consume exactly 8GB of bandwidth next month, what is the least cost way to purchase it? Construct a graph that shows the least cost way to consume at any monthly usage.

2. Switching costs play a significant role in the market and pricing structure of an industry. How do switching costs affect Time Warner’s ability to change its pricing scheme with current users?

3. How do consumer preferences and alternative Internet services affect the decision to choose one service or another? Which consumers would prefer a tiered pricing system over a flat rate system?

4. Suppose the new pricing goes into effect. Since video streaming is bandwidth intensive, how might a website (like YouTube) or a service (like Xbox Live) be able to keep its current users?

May 11, 2009

Why Do Monthly Job Loss Estimates Exclude the Farming Sector?

In April, nonfarm payroll employment declined by more than 500,000 jobs for the sixth month in a row. While the pace of nonfarm job losses slowed, the Bureau of Labor Statistics (BLS) report on the employment situation continues to paint a fairly grim picture. Employment in the farming sector was actually a bit higher in January 2009 (the most recent month for which data is available) than it was in January 2008. Why doesn't the BLS cover farms and ranches in its payroll survey? Might the omission of the farming sector from the BLS payroll survey cause the jobs report to be too gloomy?

According to the BLS, farms simply fall outside the scope of the payroll survey. When the BLS began studying payrolls and employment in 1915, it focused exclusively on the manufacturing sector. The need for more accurate employment estimates during the Great Depression led the BLS to develop more comprehensive estimates of wages and employment in nonfarm industries during the '30s. Historically, at least, one can imagine the relative difficulty of gathering timely employment information in the rural farming sector.

The lack of agriculture in the payroll survey, however, is almost certainly inconsequential. The absence of farms in the Bureau's payroll survey matters less to today's employment picture than it did during the early and mid 20th century. In 1930, 21.5 percent of the workforce worked in farming, and agricultural output represented nearly 8 percent of U.S. economic output. At the turn of the 21st century, less than 2 percent of the labor force worked in agriculture, a sector that now represents less than 1 percent of national economic output.

The small share of the population employed in agriculture makes it unlikely that the Bureau's payroll survey--with a sample covering about one-third of total nonfarm payroll employment--will distort the overall jobs picture by failing to account for farm sector employment. Even an agricultural boom in the midst of the current recession would do little to reverse the dismal national employment trends.

Although the BLS excludes agriculture from its payroll survey, it does capture farm employment indirectly through a survey of 60,000 households. The most widely reported unemployment rate comes from this household survey, which includes respondents from all economic sectors: manufacturing, services, agriculture, or the ranks of the self-employed.

The household survey categorizes a person as employed if they worked for pay at some point during the past week, whether she worked in a factory, on a ranch, in an office, or for herself. A person who does not have a job, but actively searched for one at some point in the preceding four weeks, is considered unemployed. Anyone who does not have a job and has not been looking in the past month is classified as "not in the labor force."

The unemployment rate is simply the ratio of unemployed workers to the labor force (the sum of employed and unemployed workers). As the ranks of the unemployed continued to swell during April, the unemployment rate rose from 8.5 percent to 8.9 percent, reflecting an increase in joblessness among all workers, including farm hands and the self-employed.

Discussion Questions

1. There are a number of jobless people who would like to work but have given up on their job search because they believe it to be futile. The BLS classifies these discouraged workers as 'not in the labor force' rather than unemployed because they did not search for a job in the preceding four weeks. Consulting this table, how does the number of discouraged workers in April 2009 compare to the number in April 2008? If the BLS were to count discouraged workers as unemployed (and, by extension, part of the labor force), what would happen to the unemployment rate?

2. How has the recession affected the ranks of discouraged workers? For more information, consult this recent BLS report.

3. The BLS tracks the number of people who work part time for economic reasons, also known as involuntary part-time workers. By counting anyone who worked for pay during the preceding week as employed, the household survey classifies a number of involuntary part-time workers as employed. In what way does the official unemployment rate miss the underemployment associated with involuntary part-time work? This table contains information on involuntary part-time workers. How has the recession impacted the number of people employed part-time for economic reasons? What happened to the number of involuntary part-time workers between March 2009 and April 2009?

4. Even as Americans eat a larger variety and quantity of foods than ever before, the share of economic output attributable to agriculture declines. How can you explain this development?

April 24, 2009

The Price Is Wrong, Bob!

With significant contributions and analysis from Ben Resnick

The Price Is Right, one of America’s favorite game shows, can be used to illustrate numerous economic concepts, including optimal bidding strategies, risk preference, and search theory. Twice an episode, one of the most purely mathematical portions of the show occurs, when contestants take their turn to spin "the big wheel." In addition to being a crucial prelude to the Showcase Showdown, it is a convenient hands-on application of using probability theory to derive an optimal decision-making rule. The wheel contains 20 equally sized panels corresponding to values between $0.05 and $1.00. Three contestants reach the wheel during each half of the show. The winning contestant is the one whose total score comes closest to a dollar without going over; as a prize, they earn one of the two spots in the show’s final round, the Showcase Showdown. One at a time, each contestant spins the wheel to get an initial value. The player then has the option to keep his current value or spin one more time. If he spins again, his final score is the sum of his two spins. Any contestant that goes over $1.00 automatically loses. In the event that two or three contestants are tied with the same final value, they each spin the wheel once, highest score winning.

Consider three contestants: Mr. 1 will spin first, Ms. 2 will spin second, and Mrs. 3 will spin last. Assuming that all of the contestants aim to maximize their chances of winning a spot in the Showcase Showdown, we set out to derive the optimal strategy for Mr. 1. In order to determine his optimal strategy, we will make three simplifying assumptions. First, each result from spinning the wheel is an independently determined random outcome, where each panel is equally likely to be spun. Next, in the event of ties, each tied player has an equal chance of winning (either 50% for a two-person tie or 33% for a three-person tie). Finally, the show pays a $1,000 bonus prize (and a chance to earn even more money on a “bonus spin”) to any contestant scoring exactly $1.00 on one spin or a combination of two spins. However, we will not consider these cash prizes as an extra incentive to spin again since they have no bearing on which contestant goes to the Showcase Showdown. We focus only on the decision-making rule that gives Mr. 1 the best chance to make the final round.

The only decision a player makes during the game is whether to spin again or stop after the first. Clearly this decision will depend on the value of the first spin—the higher the first spin, the more reasonable it is to stop. To explain fully how a player maximizes his chance of reaching the Showcase Showdown, we solved for a cutoff value: the lowest initial spin value where Mr. 1 has a higher probability of winning by staying rather than spinning again. In order to find the optimal stopping value for Mr. 1, we first calculated the probability that Mr. 1 wins the game (either outright or through the tie-breaker) if he stays with any initial spin. This gives 20 different probabilities of winning the game if Mr. 1 stays, one for each possible spin value. For example, if Mr. 1 stops with $0.55, he stands a 7.4% chance of winning whereas if he stops with $1.00, he has an 86.2% of going to the Showcase Showdown. Next, we calculated the odds that Mr. 1 wins if he spins again. To do this, we looked at his likelihood of winning for each possible score after his second spin is added to his first. Mr. 1’s optimal cutoff in this game is $0.70, where stopping with a spin of $0.70 gives a 19.8% chance of winning, but spinning again gives only a 15.8% chance of winning. At any initial spin less than $0.70, Mr. 1 has a better chance of winning by spinning again. For example, after a first spin of $0.65, Mr. 1 has a 14.6% chance of winning if he stops and a 16.8% chance of winning by spinning again. By a similar method, we find that in the case where Mr. 1 goes over $1.00, the stopping rule that maximizes Ms. 2’s chances of winning is to stop with any initial spin of $0.55 or more.

Discussion Questions

1. How would you expect the stopping values to change if a fourth player were added to this game? What would the effect on the stopping values be if we factor in the bonus prize for a total score of exactly $1.00?

2. Given that the stopping values decrease as fewer players remain in the game, do you expect a player with a certain spot in the order to have an advantage? If so, which one?

3. Deal or No Deal is an example of another game show where a contestant’s optimal strategy could be described by a stopping rule. Can you think of other games where this type of strategy can be applied?

ARRGGHH... The Stakes Be High, Says I!

When you pay ransom to a hostage-taking pirate, traditional economic theory suggests that you increase the returns to piracy, encouraging more of it. If you kill a hostage-taking pirate, you increase the cost of piracy, which should discourage would-be pirates from taking to the seas.

The response by the Somali pirates to the U.S. Navy's recent killing of three pirates has been just the opposite though. These gangs say they are now devoted to revenge-taking over more ships and taking more hostages than ever. The cost of doing business has risen, and yet they want to do more of this business than ever. Why do you think this is?

Discussion Questions

1. In order to quickly obtain large ransoms, pirates must signal a credible threat to cargo ship owners. How might this credibility issue play into the pirates' response to the actions of the U.S. government?

2. The pirates killed by U.S. Navy snipers were holding an American captain of an American boat with an American crew. Might governments respond differently in situations involving multi-national crews?

3. The pirates who were killed were likely just henchmen with little power in the criminal organization. Did the "cost of doing business" really rise very much for the pirates running the organization?

4. In what ways does the government provision of naval security in international waters resemble a public good? Might the current allocation of security (both private and public) in international waters be inefficiently low?

5. From the standpoint of ransom maximization for a small individual gang of pirates, what is the optimal amount of piracy? What is the ransom maximizing strategy if the piracy off the Somali coast is coordinated by a cartel of gang lords?

April 15, 2009

Moody's Negative Outlook on U.S. Local Government Debt

A few days ago, Moody's Investors Service announced that its outlook for the entire U.S. local government tax-backed and related ratings sector is negative. This is newsworthy not only for municipal bond investors but also for anyone following the U.S. recession. It marks the first time that Moody's issued an outlook on this entire sector, although it has issued ratings on the sector since 1914.

Moody's Investors Service is one of the leading issuers of credit ratings. Investors use these ratings to gauge the risks of investing in debt assets. So, one might conclude that the analysts at Moody's are remarkably pessimistic about the impact that recessionary economic conditions will have on the ability of local governments in the U.S. to meet their debt obligations. This means that the risk of defaults on these debts has risen.

However, Moody's hedged its announcement by mentioning that credit pressures will vary significantly across locales due to differences in economic conditions, property assessment methods, and authority to raise revenue. The varying economic conditions can largely be explained by localities' exposure to industries hit particularly hard by the recession. These include real estate development, auto manufacturing, financial services, tourism, gaming, and general manufacturing. Differences in property tax systems will play a major role. Moody's report shows evidence that about 72% of local government tax revenue comes from property taxes. The bursting of the housing market bubble will bring declines in property tax revenue for most local governments because of falling home values.

Several of these governments might have the authority to increase property, sales, or income tax rates to raise revenue. Whether the elected officials running these localities are willing to do this is an open question. Moody's points out that taxpayers are worried about their own financial conditions and are highly resistant to increases in local taxes. Raising taxes in this environment will be unusually difficult for locally elected officials.

Cutting spending during the economic crisis will not be an attractive option either. In part, this is because many of these governments may face service mandates that prevent them from reducing service-related expenditures. An example of a service mandate is that a state government may mandate that local governments provide health services for the poor. Moody's analysts also reported that the demand for improved government services will make it that much more difficult for these governments to sustain healthy finances. Local officials may find that it is more palatable to default on their bonds rather than raise taxes or cut spending.

The credit crunch is also having a direct impact on local government finance. Moody's report states that access to credit will be more expensive for these governments than it had been in recent years. Moody's negative outlook announcement surely caused investors to demand greater yields on the municipal bonds trading in the credit markets. The company also warned that some localities are in such dire straits that they may be completely shut out of the credit markets.

Yet, the situation ought to be tenable for numerous governments. For instance, some well-managed localities increased their reserves during the boom years and were prudent with the funds generated during the real estate bubble. A simple example from portfolio theory can help show why investors may still be willing to buy the bonds of a cross-section of municipalities.

Suppose that a bond investor purchases three one-year bonds with different expected returns and probabilities of default. For simplicity, we'll assume that the investor is risk-neutral and the bonds pay nothing in the event of default. Bond A has a 25% probability of default this year but pays a coupon of 15% if it avoids default. Bond B has a 50% probability of default this year but pays a coupon of 20% if it avoids default. Bond C has a 75% probability of default this year but pays a coupon of 30% if it avoids default. Let's also assume that all the bonds have a face value of $100 each.

What is the investor's expected payoff from investing in this portfolio? It is


(0.75 × $115) + (0.5 × $120) + (0.25 × $130) =

$86.25 + $60 + $32.50 = $178.75


So, on average, an investor would be willing to pay less than 60% of face value on these bonds to make a positive expected return.

This example was purposefully simple, but from it you can see the advantage of diversification and the problem of gauging risk. If the probabilities of default end up being higher than estimated, the investor might lose money but will only lose all his money in the rare case that all bond issuers default. Yet, if the probabilities of default are lower than estimated, the investor might earn a high rate of return.

Discussion Questions

1. How does the bond portfolio example relate to the impact that mortgage-backed securities had on financial institutions? What must have happened to their default rates for them to become known as "toxic assets"?

2. If you had a large sum of money that you had to use for investment purposes, would you put together a portfolio of U.S. local government debt? If yes, why? If not, explain what your preferred investment would be.

3. Besides an economic recovery, what changes, if any, do you think are needed for local governments to avoid defaults in the future? How feasible are your proposed changes?

April 03, 2009

Gainfully Unemployed

A 35-year-old Wisconsin man was recently fired from his job at Qdoba after he trashed the place, throwing pots, pans, desserts, and boxes of hot sauce on the floor. His motive? He claimed he was trying to get fired so he could collect unemployment insurance. Apparently, nobody told him that Wisconsin only pays unemployment benefits for certain types of separations. Not surprisingly, getting fired for intentional wrongdoing isn't covered.

Nearly everyone has had a job they despised. At some point the earnings from the job no longer outweigh the costs of sticking with it. The typical reaction is to simply quit and begin look for a better job. True, the newly unemployed worker will no longer collect any wages. But the added leisure time and the prospect of better work are presumably more than enough compensation for the lost earnings.

During the current economic downturn, fears about prolonged unemployment may make another option more viable: getting fired or laid off. While those who quit are not eligible for government unemployment insurance benefits, those who get fired or laid off might be.

Although the Wisconsin man was unaware that trashing his place of employment would disqualify him for unemployment benefits, other workers may devise less obvious ways of getting themselves removed from their unpleasant job. If they land themselves in the ranks of the unemployed without compromising their unemployment insurance eligibility, they'll be out of an unwanted job and into a welcome series of government checks.

In normal times, the Wisconsin man may have simply quit, but it's not hard to believe that concerns over prolonged unemployment, combined with a dicey understanding of unemployment insurance eligibility, made this decision unacceptable.

It turns out that unemployment benefits influence worker decisions about whether to take a job as well. Search theory economists showed that the last time the British government reduced the number of weeks fired employees could collect unemployment insurance, the average duration of unemployment shrunk by the number of weeks that unemployment benefits were no longer paid.

Discussion Questions

1) Part of the federal economic stimulus package gives state governments the option of using funds to extend the amount of time that an unemployed person can collect benefits. What trade-off do governments face when they choose to extend the duration of unemployment benefit eligibility during tough economic times?

2) At the root of this entire disturbance was the worker's goal to qualify for unemployment. If he had been better informed about the rules regarding dismissal for cause, how would this change his decision?

3) How might a worker hoping to shake lose of a lousy job and collect unemployment insurance benefits game the system?

4) Ignoring cases where those fired are not elligible, would you expect to observe behavior where people seek to get fired to collect unemployment more among high-skill or low-skill workers? Which group typically faces more competition in the job market and has a harder time finding a new job? How are these two ideas related?

On Income Caps and the Market System

Yesterday morning on a local radio station, a few callers discussed a silly idea. The question posed to listeners was this: "Should there be a law against anyone earning over $1 million per year?" One caller talked about the celebrity Kim Kardashian, and how it is not right that she earns so much money. That is absurd. The market is rewarding Kim because of her looks, her connections, and because in recent years her public persona has been well-managed. If companies want to pay her ridiculous amounts of money for her various "talents" because people enjoy being entertained by her, then so be it. It might not be fair, but neither is life. On the bright side, we have a progressive income tax system that will tax such extravagant incomes at higher rates than the rates faced by ordinary Americans. A much better idea would be to raise marginal income tax rates on the highest tax brackets to help limit our budget deficits and get a fair amount of tax revenue from those whom our market system has allowed to earn enormous amounts of income in our nation.

Yet, how could economists ridicule a ban on excessive income when they support President Obama's limits on executive pay for firms that seek government assistance? The reason is that such firms were mismanaged, and as a result, they got pummeled by the market, forcing them to sheepishly seek government bailout funds. In this situation, executive salary caps are a brilliant proposal. If the firms do not like the caps, they could try getting bailed out by the market, but they will find that the market will most likely not come to their rescue. The market system will allow the firms to go bankrupt because of their poor performance. That is what the market system does to firms that perform poorly. Obama's limit is set at "only" $500,000 per year and lasts until the bailout funds are fully repaid by the firm.



The argument against the salary caps proposed by Obama is that these firms will lose good executives because they can be paid more elsewhere. But is this necessarily a problem? There are undoubtedly many capable people with better understanding of risk management and liquidity who would be happy to work for these firms for $500,000 per year. If the firms find that they cannot retain the best executives, then they will find themselves with a greater incentive to refund the taxpayer money that much sooner. If the executives who are running these firms want to earn more than $500,000 per year, they will have to get their firms back in shape and earn enough profit to repay the bailout money. An argument can be made that shareholders can oust poorly performing executives and limit executive pay by changing a corporation's board of directors. This argument is a diversion, as can be seen in an article named Shareholder Power from the Christian Science Monitor.

Let the Kim Kardashians of the financial sector go seek out new firms to mismanage!

Discussion Questions

1. Do you agree with this author's viewpoint about bans on enormous salaries? How about his viewpoint on Obama's executive pay cap plan? Is there inconsistency in his views? Is there inconsistency in yours?

2. How do you feel about America's progressive income tax system? If you were in control of the federal government, what would you do to change it, if anything?

3. What do you think about the concept that government should stay out of the free enterprise system? Do you believe that government involvement has made the global financial crisis worse, or has it helped moderate its severity?

4. Suppose that the U.S. did enact a law against anyone earning over $1 million per year. What would the corporate CEOs, celebrities, athletes, and other top earners do in response? Would they leave the country? What other complications might arise from such a law?

January 28, 2009

IMF: "Risks to financial stability have intensified"

For those hoping that credit conditions might gradually be returning to normal, today's IMF Global Financial Stability Report market update contained a stark warning: Risks to financial stability have intensified since October 2008. Macroeconomic risks have risen as global growth has fallen precipitously alongside a sharp slowdown of global trade. Credit risks have also risen as a deterioration of economic and financial conditions have resulted in rising loan losses. At the same time, the flight from risky assets and illiquid...

January 27, 2009

CBO: largest growth shortfall since the Great Depression

The Congressional Budget Office's new director, Douglas W. Elmendorf, testified on the state of the US economy before the House Budget Committee today. It makes sober reading. An accompanying blog post summarises his three key points: The economy is currently weathering a recession that started more than a year ago, and absent a change in fiscal policy, CBO projects that the shortfall in the nation’s output relative to potential levels will be the largest– in duration and depth– since the...

July 22, 2008

Nas (2008): "Tracing the Economic Transformation of Turkey from the 1920s to EU Accession"

Nas, Tevfik F. (2008):
Leiden & Boston: Brill/Martinus Nijhoff Publishers.
Table of contents
1. Introduction
2. An Overview of the Turkish Economy: 1920–80
3. Stabilization and Restructuring during the 1980s
4. The Financial Crisis of 1994 and the April 5 Austerity Plan
5. Turkish Inflation
6. The Crisis of 2001 and the Program for the Transition to a Strong Economy
7. Economic and Policy Environment before the 2002 General Election
8. Macroeconomic Policies and Outcomes during the Post-2002 Election Period
9. Turkey and the EU
10. Starting the Accession Talks
11. Prospects for Full Membership: A Commentary

February 12, 2008

EconPapers: "Research on Turkish Economy"


More than 1615 documents matching "Turkish economy" or "Turkey" among working papers, articles, books, book chapters and software indexed in EconPapers Archive : please click here!

July 13, 2007

Macroeconomic Performances of Turkish Governments

"A Comparison of Macroeconomic Performances of Governments in Turkey, 1987-2007"
by Aykut Kibritçioğlu

Abstract:

In this paper, a macroeconomic performance index (MEP10) which consists of selected ten indicators is proposed to evaluate the relative performance of Turkish governments by using monthly data for the period of December 1987 – April 2007. According to the multi-staged evaluation process applied in the study, the governments are grouped in three classes:
(1) Relatively successful governments: 46. government (December 1987 – November 1989), 48. government (June 1991 – November 1991), 54. government (June 1996 – June 1997), and 59. government (March 2002 – April 2007),
(2) Relatively unsuccessful governments: 47. government (November 1989 – June 1991), 49. government (November 1991 – June 1993), 55. government (June 1997 – January 1999) and 53. government (March 1996 – June 1996), and
(3) Most unsuccessful governments: 50.-52. governments (June 1993 – March 1996) and 56.-57. governments (January 1999 – November 2002).The monthly performance index is also used to test some hypotheses regarding the relationship between the length of the governments’ term of office and their macroeconomic performances.


JEL Classification: E65 (Studies of Particular Policy Episodes), O53 (Economywide Country Studies: Asia including Middle East) ve C43

Key Words: Okun’s misery index, macroeconomic performance, macroeconomic stability, governments, political stability, general elections, economic crises, Turkish economy

Language: Turkish

Download: MPRA or Paper

March 15, 2006

Book: "Turkey: Economic Reform & Accession to the European Union"

amazon.com
Turkey: Economic Reform & Accession to the European Union
co-edited by Sübidey Togan & Bernard M. Hoekman
Publisher: World Bank Publications (May 15, 2005)
World Bank Trade and Development Series, Paperback: 400 pages, ISBN: 0821359320

March 06, 2006

World Bank: "Turkey: Country Economic Memorandum, 2006"

The World Bank launched "Turkey: Country Economic Memorandum - Promoting Sustained Growth and Convergence with the European Union". The study aims to contribute to the ongoing process of elaborating a strategic vision on Turkey's policy priorities during EU accession.
To download the full text of the report and/or get more information on it, you may visit:
http://www.worldbank.org.tr/cem2006

October 25, 2005

Prof. Uğur Korum has passed away... - Prof. Uğur Korum'un vefatı...

Professor Uğur Korum, one of the leading and most influential Turkish economists, has passed away on the 22nd of November 2004.
(Sevgili Hocamız, değerli iktisatçı, Ankara Üniversitesi SBF İktisat Bölümü'nün eski öğretim üyelerinden Prof Dr. Uğur Korum'u 22 Kasım 2004 günü kaybettik.)

October 09, 2005

October 06, 2005

"EU foreign ministers agree on membership talks with Turkey"









Economist: The European Union and Turkey have finally agreed on a negotiating framework that will allow formal talks on Turkish membership of the EU to begin.

EU's Press Relies

Worldbank: "Turkey has today crossed the bridge to Europe. This date will go down as one of the most important days in Turkey's history. The opening of accession negotiations with the EU represents an historic moment for Turkey and the EU. The negotiations will be long and cover many difficult subjects, however the end result will bring great benefits to Turkey, the EU and the wider world. The World Bank applauds the decision of the EU Council of Ministers to approve the Framework Agreement and looks forward to supporting Turkey and the EU during the accession process."

August 30, 2005

Forthcoming Book: The Turkish Economy

The Real Economy, Corporate Governance and Reform
Edited by: Sumru G. Altuğ and Alpay Filiztekin
London, UK: Routledge
For more information, please click here!

July 21, 2005

Nowak-Lehmann Danzinger et al.: "The Impact of a Customs Union between Turkey and the EU on Turkey's Exports to the EU: A Reassessment of the Paradox"

by Nowak-Lehmann Danzinger, Felicitas, Dierk Herzer, Inmaculada Martinez-Zarzoso, and Sebastian Vollmer (www.diw.de)
Series: DIW's Working Papers Series, No. 483, April 2005, 31 pages
For more information: please click here; PDF: download

wiiw: "Turkey: Macroeconomic Vulnerability, Competitiveness and the Labour Market"

by Josef Pöschl, Hermine Vidovic, Julia Wörz and Vasily Astrov (www.wiiw.at)
Series: wiiw's Current Analyses and Country Profiles, No. 21, April 2005
116 pages including 42 Tables and 26 Figures
For more information: please click here
Pdf: download

June 21, 2005

Report: "Turkish Agriculture in the 21. Century with Special Reference to Developments within the WTO and EU"

Çakmak, E. and H. Akder (2005): "Çakmak & Akder: "DTÖ ve AB'deki Gelişmeler Işığında 21. Yüzyılda Türkiye Tarımı". İstanbul: TÜSİAD.
Download: http://www.tusiad.org/turkish/rapor/tarim2/tarim.pdf