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?

Fed Chairman Ben Bernanke will be chatting up the central bank’s exit strategy later this week when he testifies before the House Financial Services Committee on February 10. To say that there are political and economic risks hovering over the subject is to understate the potential hazards.

There are risks to tightening too early, which some worry would repeat the mistakes of 1936-1937, when reserve requirements were tightened and the economy slipped into recession. At the same time, it'd be foolish to discount the potential for higher inflation in the years ahead in the wake of the extraordinary monetary stimulus over the past year or so. Regardless of the economic reality, the political pressure to keep rates low is intense, given the weak labor market.

Maxine Udall makes a point I've often made, though in a way I wish I had phrased it:

Now add to this the promotion and tenure policies at even second rate economics departments that require and only reward publication in journals that favor morally vacant, mathematically rigorous, theoretically obtuse existence proofs that more often than not bear no relation to reality as we know it. One is then left with an economics literature that few people, including some who have majored in economics as undergrads, can truly understand, either in its content or in its relevance to the important moral and economic issues that confront us today.

Udall, in my view erroneously, believes that a 'reality-based' economics would be more Keynesian:

Keynes, who advocated that government play a role in moderating the effects of peaks and troughs in the business cycle through regulation of investment banking and automatic demand stabilizers (for example, unemployment compensation and jobs creation through public works) became conflated (perhaps intentionally) with "socialism" and "communism."...

Economics, mathematized and divorced from moral philosophy, was effectively neutered after WW II, at the point when its relevance to "serious economic argument" might have been established and developed. The outcome was perfectly aligned with market forces that would continue to shift the national narrative in ways that would finally succeed in convincing people that "government is the problem". It culminated in repeal of Great Depression era regulation, thereby freeing investment bankers for unfettered speculative gains supported by a seemingly unfettered single-payer credit default safety net.

Which is all fine and good, except for the fact that for Keynesian fiscal stimulus to work you need to waive away a number of real world complications. Non-mathematical theories can " bear no relation to reality as we know it" as well.

Udall also states:

World War II provided the massive Keynesian stimulus needed to haul us out of depression and to cement Keynes ideas about the roles that government could and should play both during economic downturns and to prevent them.

This neglects to take into account the evidence that U.S. military and foreign spending did not go up until 2 years of rapid U.S. economic growth.

The Best Paragraph I've Read on the State of Economics originally appeared on About.com Economics on Monday, February 8th, 2010 at 12:10:53.

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Here I offer some thoughts on last week's numbers for employment, auto sales, and commodity prices.

On Friday the Bureau of Labor Statistics reported that 20,000 fewer Americans were working in January compared with December on a seasonally adjusted basis but that the unemployment rate nevertheless fell from 10.0% in December to 9.7% in January. The discrepancy comes from the fact that the BLS gets employment counts in two different ways. The first is by asking establishments how many people they employed last month, and this establishment survey provides the basis for the reported 20,000 decline in nonfarm payrolls. But a second method is to go to individual residential addresses and ask the occupants how many people living there were working last month. According to the BLS household survey, the number of Americans working increased by a seasonally adjusted 541,000 workers in January over December, though updated population controls make that December-to-January comparison for the household survey problematic. Usually what we hear featured in the press are employment numbers coming from the establishment survey and an unemployment rate coming from the household survey. The wildly diverging fundamental numbers for employment itself in the two surveys account for the reported improvement in the unemployment rate coinciding with no progress yet on jobs. Mark Thoma, Phil Izzo, and of course Bill McBride ([1], [2]) survey the takes of various analysts on what to make of the conflicting numbers.

Normally the establishment survey is regarded as the more reliable, though Tim Kane has argued that the household survey sometimes does a better job of recognizing turning points. We might look to some other labor market indicators to try to referee the current dispute. Automatic Data Processing constructs its own estimate based on the 22 million Americans whose payrolls it helps prepare, and their guess was that the economy shed 22,000 private sector jobs in January on a seasonally adjusted basis. Since BLS estimates that 8,000 government jobs were lost in January, ADP's estimate is about 10,000 more pessimistic than the BLS payroll figure. The Institute for Supply Management's survey of nonmanufacturing establishments found more managers reporting declines in employment than reported increases in employment in January. By contrast, their survey of manufacturing establishments found more managers reporting increases in employment than declines. Fair to say that the signals are mixed, but things may not be as bad as the BLS nonfarm payroll numbers suggest.

Earlier in the week we received reports on January auto sales that could also be described as no better than lukewarm. Americans purchased 6% more light vehicles last month than they had in January 2009. That might sound encouraging, unless you've forgotten that January 2009 was the worst month for car sales out of the last 6 years (on a seasonally unadjusted basis). Last week's good news was that January 2010 was only the third worst month out of the last 6 years, beating both January and February 2009. Nonetheless, that's the same basic arithmetic that gives rise to some hope for 2010 reported growth rates-- things were so awful last year that even a very bad month counts as an improvement.

Data source: Wardsauto.com

I also continue to follow with interest what's been happening to commodity prices, with both oil and copper now off 15% from their values of just a few weeks ago. I'm persuaded that speculation in China has been a big part of the story on both the way up and now on the way down. Greg Merrill calls attention to the estimate by the International Copper Study Group that China's apparent usage of copper grew by 43% in the first 10 months of 2009, while copper usage by the rest of the world fell by 18% over the same period. If stockpiling in China has indeed come to an end, that would explain the sharp fall in prices, and could portend more to come.

Source: Kitco

Source: ino.com

Finally, I have to pass along a story that Mike Shedlock highlighted from Bloomberg:

Non-performing loans in China have risen into the "trillions of renminbi" because of poor lending practices, an insolvency lawyer said.

"We work really closely with SASAC, the state-owned enterprise regulator in China, and there are literally trillions and trillions of renminbi of, frankly, defaulting loans already in China that no one is doing anything about," Neil McDonald, a Hong Kong-based business restructuring and insolvency partner with Lovells LLP, said at an Asia-Pacific Loan Market Association conference yesterday. "At some point there's going to be a reckoning for that."

China's government is tightening controls, including banks' reserve ratios, to prevent record lending from fueling inflation. The Shanghai office of the China Banking Regulatory Commission warned yesterday that a 10 percent fall in property values would treble the number of delinquent loans in the city. Liu Mingkang, chairman of the CBRC, said Jan. 4 that loans were channeled into stock and property speculation last year, which China has been taking measures to stop.

My bottom line: the scales tipped last week in the direction of near-term deflationary pressures, despite the strong 2009:Q4 U.S. GDP report and falling unemployment rate.

Augmenting my previous post, here are two additional graphs, motivated respectively by comments by Econbrowser readers Eric Swanson (for Figure 1) and Cedric Regula and tim kemper (for Figure 2).

Figure 1: Federal debt held by the public as a share of GDP (blue) and as a share of potential GDP. NBER defined recessions shaded gray; assumes last recession ended 09Q2. Vertical dashed line at last Q4 of each Administration, solid vertical line at Q1 of beginning of each Adminisration. Sources: Series FYGFDPUN from St. Louis Fed FREDII, with 09Q4 data from CBO, and BEA, 2009Q4 advance release, CBO (January 2010), NBER, and author's calculations.

Figure 2: Federal debt held by the public as a share of GDP (blue) and Total Federal debt as a share of GDP. NBER defined recessions shaded gray; assumes last recession ended 09Q2. Vertical dashed line at last Q4 of each Administration, solid vertical line at Q1 of beginning of each Adminisration. Sources: Series FYGFDPUN, series GFDEBTN from St. Louis Fed FREDII, and BEA, 2009Q4 advance release, NBER, and author's calculations.

Today's employment report was, well, discouraging. Or was it? The range of opinion was unusually wide, or so it seems.

The reported facts, at least, are clear. Quoting from the Labor Department's press release, "The unemployment rate fell from 10.0 to 9.7% in January, and nonfarm payroll employment was essentially unchanged (-20,000), the U.S. Bureau of Labor Statistics reported today. Employment fell in construction and in transportation and warehousing, while temporary help services and retail trade added jobs."

But that's just the beginning. Or is it the end? You decide. Here's a sampling of the commentary on today's numbers that, for one reason or another, caught our attention...

Craig Newmark posts an excerpt from a Andrew Simms column:

Orthodox economics is based on simplifications that so distort the real world as to make it unrecognisable, yet its basic tenets are credulously repeated on an almost daily basis in national newspapers and on television news. A genuinely evidence-based approach to economic policymaking would not produce a system remotely like the one we have, the business-as-usual version that many climate sceptics seem so eager to defend. Given its task, the vast range of subjects covered, the thousands of scientists involved, and the sheer size of its reports, what's stunning about the IPCC's work is that comparing it to any economic analysis used to actually run the world is like comparing the complete Oxford English Dictionary to a guide to slang published by the Sunday Sport.

Newmark's reaction?

That's really a low blow. Mandatory two-point deduction. Your next foul, sir, you will have to forfeit the fight.

My reaction?

Simms has a point.

More specifically - there is a lot of really good applied economics research out there that uses realistic assumptions, real world data and produces useful outcomes. Then there are theory papers which are nothing but mathematics posing as economics. Models with assumptions such as:

• Heterogeneous agents.
• Absurd market demand curves (e.g. Demand is a constant r until the price p_r then it falls to zero.
• Input prices that do not vary with demand.
• No production externalities. Ever.
• Agents with perfect information (they know the cost structure, strategies and inventory levels of their competitors).
• Zero transaction costs.
• Long run marginal cost curves with a single local minimum.

That's just off the top of my head. I should crack open an issue of Econometrica and find hundreds more.

A fan of Milton Friedman's The Methodology of Positive Economics would respond that it does not matter how absurd the assumptions seem. All that matters is how valid and accurate the model's predictions are. But since most economics models (particularly in macroeconomics) are not easily directly testable nor easily falsifiable, I question how much value we should place on a model with absurd assumptions.

Climate Research vs. Economics Research originally appeared on About.com Economics on Tuesday, February 2nd, 2010 at 07:57:14.

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I get quite a few questions on marginal utility, so I thought I'd create a primer for those of you who are completely new to economics. Please see: Marginal Utility in Economics.

Marginal Utility in Economics originally appeared on About.com Economics on Monday, February 1st, 2010 at 18:10:24.

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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?

Stephen Gordon asks a question I continually asked myself as a Ph.D. student at the University of Rochester:

Why does anyone care about the distinction between convergence in probability and almost sure convergence?

I'm teaching two econometrics classes this term (master's and PhD), and I just covered the parts on asymptotic theory. In both lectures, I stumbled badly at explaining the difference between these two forms of convergence: my heart simply isn't in it...

I've never heard of empirical study where the distinction between the two forms of convergence made a difference...

Why do we force our students to learn these things?

As an aside, undergraduates in economics are often surprised how little economics there is in graduate programs outside of fields courses such as Labor Economics and Public Finance.

Although from an empirical perspective it probably doesn't make sense in the slightest to worry about the distinction between the two types of convergence, I am quite certain it makes a difference in theory papers. Unlike most economists, I tend to use 'theory paper' in a pejorative sense, because too many theory papers:

1. Make assumptions that cannot possibly be true and are not reasonable simplifications of the 'real world'.
   
   
2. Are non-falsifiable, do not make predictions, or have so many free parameters they can be used to predict anything.

You need to know this math in order to be able to publish 'theory papers'. The larger question should be, "why does the economics profession put any value on this work?"

Why Is There So Much Esoteric Math in Economics Grad Programs? originally appeared on About.com Economics on Friday, January 29th, 2010 at 07:56:32.

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From Reuters:

Shaving 3 grams off the daily salt intake of Americans could prevent up to 66,000 strokes, 99,000 heart attacks and 92,000 deaths in the United States, while saving $24 billion in health costs per year, researchers reported on Wednesday...

Salt, which contributes to high blood pressure and heart disease, is widely overused in the United States, with 75 to 80 percent coming from processed food. Men typically consume 10.4 grams per day. For women, the average is 7.3 grams. Its use is rising.

A reduction of 1 gram would prevent 11,000 to 23,000 strokes, 18,000 to 35,000 heart attacks and 15,000 to 32,000 deaths from any cause, the researchers reported in New England Journal of Medicine.

My stock answer is to proclaim Sin Tax!, however that would not work here, for a couple of reasons:

1. Assuming the Reuters article means salt and not sodium, I would guess that a sin tax would have to be at least 10 cents a gram to have any noticable impact. That would make the tax on a 1kg box of Sifto table salt that currently sells for $1.69 equal to $100. Not going to happen.
   
   
2. Memories of Gandhi's Salt March

I am not sure what the answer is - but here the answer is almost certainly not a sin tax or Pigovian tax.

A Public Health Problem That Can't Be Solved With a Pigovian Tax or Sin Tax originally appeared on About.com Economics on Thursday, January 28th, 2010 at 15:25:37.

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Price Elasticity of Demand is the most well-known of all the elasticities in economics. Income Elasticity of Demand, however, is equally as important when considering how the demand for a product and service changes over time (due to economic growth or the business cycle). The Toronto Star has an unusual article on income elasticity: Recession means tough times for sex workers. (Note: article may not be safe for work).

Income Elasticity and the Sex Trade originally appeared on About.com Economics on Thursday, January 28th, 2010 at 12:08:20.

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From Mark Thoma:

The problem is that if (net) exports don't lead the way, then consumption or investment must fill the void if the private sector is going to take care of this on its own. But neither of those seems likely to grow fast enough to accomplish this, at least not anytime soon, and there's some question whether they will return to their pre-crisis levels, consumption growth in particular.

Paul Krugman's point -- the quote is from a bit over a year ago -- was that if consumption, investment, and net exports can't support the growth we need to maintain employment, then government must use aggressive measures to bridge the gap until the private sector can make the necessary adjustments.

On the surface, this logic seems to make sense. In economics 101 we learn that the size of the economy is calculated through the following equation:

Y = C + I + G + (X - M), where

C = consumption

I = Investment

G = Government Spending

(X - M) = Net Exports (eXports - iMports)

If C and I cannot grow 'fast enough', then the growth needs to come from government spending (G) or exports (X) (or a drop in imports).

The problem with this logic is it confuses an accounting identity for an economic model. There is an implicit ceteris paribus assumption in the Thoma/Krugman argument suggests that if X rises, it will not cause changes to any of the other variables. It is fairly straight forward to think of two scenarios where a rise in X will be offset by a decrease in another variable:

1. American companies ship products to Canada that otherwise would have been consumed domestically. X up, C down.
   
   
2. American companies ship products to Canada. Canadians demand U.S. dollars to pay for those goods. U.S. dollar rises vis-a-vis the loonie. Canadian goods now relatively cheaper to Americans, who increase their imports of Canadian goods. X up, M up which offsets (partially or fully) the rise in X.
   
   

To be clear - I am not suggesting that increased exports will not increase U.S. economic growth. But you cannot determine that from this analysis. Confusing an accounting identity with an economic model is an elementary mistake - I'm surprised a Nobel Prize winner would fall into that trap.

Can Exports Get the U.S. Out of Their Slump? originally appeared on About.com Economics on Thursday, January 28th, 2010 at 07:58:08.

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Mark Thoma linked to some terrific data from the Dallas Fed which shows just how awful the labor market has been during this recession, relative to past recessions. Greg Mankiw has a terrific graph showing that the labor market is far worse than what the Obama team predicted would happen without any stimulus.

It would be reasonable to conclude that the stimulus has been useless at best and counterproductive at worst which is exactly what I predicted would happen. There are, of course, other explanations. Given that U.S. labor market is in a worse position than the 'no stimulus' prediction, it is difficult to argue that the problem with the stimulus is that it was too small. Of course the usual suspects will continue to argue just that.

Good Thing We Had All That Stimulus originally appeared on About.com Economics on Thursday, January 28th, 2010 at 07:47:24.

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My colleague Mary Hartley with some data I do not believe I had seen before:

On average, "obese people spend $1400 more a year on health care compared to someone of normal weight," says Eric Finkelstein, the foremost authority on the economics of obesity in the United States. And whether you, your employer, or the government picks up the tab, obesity is running up the health care bill.

I know I have been beating this drum for some time, but it would seem to me that increasing taxes on "junk food" and using the revenue to decrease income taxes is as close to a free lunch as you will ever see in economics. The population will get healthier, health care costs will decrease and economic growth will rise due to lower income taxes.

Now, this will not solve all of America's health care issues:

But just so you know, obesity-related health conditions account for only 9.1 percent of the $4.3 trillion dollars spent on health care last year.

I believe that reducing these expenses by 20% is not unreasonable. This would be a savings of 80 billion dollars - not an insignificant sum. But we do not have to stop there as I have argued before. Related policies include:

• Increased 'sin taxes' on alcohol and tobacco.
  
  
• Pigovian taxes on air pollution.
  
  
• With the added revenue from 1 through 3, increase transfers to the poor (through, say, an guaranteed annual income. Poverty is a source of early mortality, so by fighting poverty we also improve health outcomes). Use the rest to finance tax cuts to corporate income and income tax rates.

Economics shows that we have the opportunity to increase health and reduce health care expenses - now all we need is a politician brave enough to suggest it.

Health Costs and Medical Conditions originally appeared on About.com Economics on Thursday, January 28th, 2010 at 07:28:49.

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A continuation of: Brad DeLong Realizes The Stimulus Didn't Work - And Draws Entirely The Wrong Conclusion.

We had extensive fiscal stimulus and the economy is in worse shape than the 'here is what will happen if we do not implement fiscal stimulus' projections.

That does not necessarily mean that fiscal stimulus does not work. However, can there ever be a possible piece of evidence that shows fiscal stimulus does not work? Seems to me that any outcome can be spun as showing the effectiveness (or for that matter the non-effectiveness) of fiscal stimulus. That is, the fiscal stimulus hypothesis is non-falsifiable. The true believers will never stop believing.

Even though fiscal stimulus does not work in theory and there is no evidence it works in practice, trying to disprove the effectiveness of fiscal stimulus feels a little like trying to disprove that God exists. It makes me question how scientific macroeconomics truly is.

Is Fiscal Stimulus Science or Faith? originally appeared on About.com Economics on Thursday, January 21st, 2010 at 12:44:45.

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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:



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.

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?

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?

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.

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.

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?

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?

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?

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?

“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?

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?

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?

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?

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?

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?

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?

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?

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?

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?

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?

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?

GameStop and EB Games have always been the major players in the used video game market when it comes to retail sales. Given their level of success, it was only a matter of time before other major players, such as Amazon.com and Toys "R" Us, entered the market. But how does this affect the long-term profitability of retailers, game publishers, and game developers?

The short-term motivation of retailers such as GameStop buying and selling used games is that they share none of the profit with developers of the game. Game publishers and developers only receive a payment for the sale of brand new games and are thus negatively affected by the growing used video game market, especially during bad economic times when sales are already lower than desired. Although buying used games instead of new titles might only save consumers $5-$10, some GameStop stores also allow you to return used games within 7 days if they don’t work properly or you simply don’t like the game, an option unavailable if you pay for a new game.

Incentives play a crucial role in economic analysis. Properly aligned incentives can promote desired outcomes in the short run and long run. From the perspective of video game developers, the lost revenue from video games trading hands multiple times in the used market is evident. As an increasing number of retailers realize the gains from entering this market, video game developers will experience decreasing gains from the production of new games.

This provides publishers with the incentive to consider other mediums of distribution, in particular digital distribution. The video game market is not the first entertainment industry to delve into a more technical solution. In the music industry, CDs are being replaced by iPods and MP3s thanks to Apple's iTunes. In the movie rental industry, we have gone from renting at our local store to mailing in movies through services such as Netflix or Blockbuster to downloading movies directly to our TV through the internet or cable services.

Therefore, it is not surprising that the video game market is heading in this direction, especially with the growing popularity of the used video game market. Since its inception, the Nintendo Wii has offered games from older consoles for purchase through the Wii Marketplace. Because the Wii offers free Wi-Fi, Nintendo can bypass the middle man of in-person and online retailers. In addition, Microsoft has begun to experiment with this option by offering smaller-scale, arcade-like games for purchase using Microsoft points that can be purchased in the Xbox Live Marketplace. They also offer free demos of newly released games in hopes of attracting additional sales. The drawback with Microsoft is their Xbox Live internet service is not free, so only users with a paid account can access these services.

Discussion Questions:

1. From the consumer perspective, what would your indifference curves look like for these two goods? Do you believe a used game is equally as good as a new game? How would this affect the demand for used video games?

2. What kind of incentives, if any, could a video game developer provide to GameStop to encourage them to sell new games over used ones?

3. How will the growing popularity of releasing and purchasing video games through an individual console change the market structure of video game retailers? How does this compare to the success of the iPod and MP3s in general?

This is, perhaps, the most engaging and accessible explanation of the current "Great Recession" I have come across. In this 59-minute podcast, Ira Glass and his cohorts at Chicago Public Radio and NPR create an ultra-simplified world of just one eager dollhouse buyer, a would-be banker with $10 in his pocket, and a young man with $90 he wants to put into a savings account to explain the financial mess we find ourselves in. This recording explains why TARP is called TARP, what insolvency is all about, what the term toxic assets means, and why America's biggest banks are afraid to "mark it to market" or re-value those toxic assets.

After listening I have a better appreciation for the state of all things financial but I am left wondering, what's the best way out of this morass?

Discussion Questions

1. Can you point to an underlying cause that precipitated this crisis?

2. Does the government nationalize the banks for a time, robbing banks' shareholders of their investments but allowing banks to start over with a clean slate? Does it help the banks get back on their feet by purchasing toxic assets with taxpayer money at artificially high prices? What are the short and long term effects of these different strategies?

3. Do you think the United States has "learned its lesson"? Will people (and businesses and governments) change their behavior? Or are we doomed to repeat this process?

4. Are there safeguards the government can introduce that will keep this from happening in the future?

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...

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...

For more information on the conference:
http://www.iea-tek2008istanbul.org/

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!

"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

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

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

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.)

Economia Exterior, Primavera 2005, Núm.32, http://www.politicaexterior.com/economiaexterior/EconomiaExterior.php

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."

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

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

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

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