A Penny Saved Is...

Which scenario would you prefer: (a) losing $30, or (b) losing $30, then losing $90, then regaining the original lost $30? While in most circumstances the first option is the unquestionably preferable, I recently found myself in a situation favoring the latter.

As a member of the Marin Sun Farms “meat club CSA” (community supported agriculture), I order a custom package of meats from a local farm that is delivered (frozen) once a month to a pick-up location near my home. While this arrangement offers me an excellent supply of local meat at a discounted price, the difficulty is remembering the monthly pick-up time. As disclaimed on the Marin Sun Farms website, “Packages not picked up promptly will be forfeited.”

This past Sunday I was sifting through emails when I discovered buried amongst online coupon offerings, eStatements, and a “Hello!” from mom, a reminder email sent the previous Thursday: “Pick up your CSA box today!” My heart sank as I pictured my box of grass-fed beef, lamb, and chicken slowly defrosting, decomposing, and ultimately being discarded. It had been a small shipment, only $30 worth, but nonetheless, I cringed at the waste.

Monday morning I awoke to another minor financial misfortune: a $90 parking ticket proclaiming my violation of section VC22500E – DRIVEWAY BLOCKING. D’oh! I knew when I parked that the rear of my car extended a few inches beyond the curb and into the neighboring driveway, but after half an hour searching for a spot I decided to take my chances (always thinking in economic terms, I figured that the expected cost of a ticket—equal to the true cost times the probability of actually receiving a ticket—was outweighed by the benefit from no longer looking for parking).

Chagrined by my back-to-back oversights, I called the number of the CSA pick-up location, just in case. To my surprise and relief, the woman in charge had managed to store my meat—not their usual policy—and I picked it up later that day.

By Monday night I had experienced the aforementioned $30 (perceived) loss, $90 loss, and $30 (perceived) gain, yet I felt better than I had felt on Sunday night when then I perceived only the $30 loss of meat. This may have had something to do with the order of events (after internalizing the loss of the ticket in the morning, the gain of $30 remained more salient at the end of the day), but I think it had more to do with how I perceived the true value of each loss. To a meat-loving economist, a discarded order constitutes a clear waste of resources—$30 of value—gone. The $90 parking ticket, on the other hand, represents a transfer of resources from me to the city of San Francisco, which ostensibly will put the money to use in the creation or maintenance of the public services I enjoy.

In introductory economics, we make a similar distinction between the deadweight loss and government revenue generated by taxes. Deadweight loss reflects the decrease in benefits to society (producers and consumers) resulting from fewer total transactions taking place. Economists view this loss to consumers and producers as different from the revenues a tax generates. Although both come at the direct expense of consumers and producers, the latter provides governments with the means to furnish public goods and services which indirectly benefit consumers, while the former—like rotten meat—is just no good.


Discussion Questions:

1. Why else might the $90 parking ticket be less painful than losing the meat shipment? Think about the “value” I got from time saved by parking illegally.

2. How does risk aversion factor into the decision of whether it’s worth taking the chance of doing something illegal? Consider a person who frequently speeds and occasionally gets speeding tickets. Ignoring the potential effects on others, might this too be a rational decision?

3. Consider other instances in which financial losses of the same dollar value might be felt in different ways (e.g. forgetting to take a $20 bill out of your pocket before washing it versus accidentally leaving an extra $20 as a tip on a restaurant bill?)

Low Carbs, High Fat…High Prices?

"One box will cost you $740, but if you don’t like it, you could try your luck with the Russian smuggler down the street." There are plenty of goods that might be sold based on discussions like that, but would you ever expect to hear that said about butter? Residents in Norway are currently facing a market like that, according to recent reports.

A recent diet craze emphasizing high fat and low carbs has caused a change in Norwegian consumer preferences. Fads and trends will change the equilibrium price and quantity observed in a market by shifting the demand curve. In this case, the popular new diet increased the demand for butter (shifting the demand curve to the right), while leaving the supply curve unchanged. The standard supply and demand model says a rightward shift of the demand curve leads to an increase in the equilibrium price and quantity consumed. Both of those were observed in real life, as well.

Nonetheless, changes in tastes rarely result in price fluctuations of this magnitude, so how do economists explain why the cost of butter went so high? We see increases (and decreases) in demand every day, but prices rarely swing so wildly. A closer look at the details sheds some light on the source: the government is preventing the free market from doing its work. As the Swedish Dairy Association (Svensk Mjölk) noted, Norway has “very restrictive trading policies, borderline protectionist.” That means that the Norwegian government’s policies make it very difficult (or even impossible) for foreign goods to enter the domestic market.

Though the government does this in an effort to protect Norwegian producers, protective policies like those block markets from working efficiently. When a “shock” to supply or demand occurs (in this case, an increase in demand), protectionist policies prevent foreign producers from entering the market to capture new profits. Because the trend hit quickly, and the production time for agricultural goods isn’t exactly short (you can’t just go out and rent an extra 200 cows overnight), the Norwegian market for butter appears to be relatively inelastic in the short run (that is, even a small percentage change in the quantity supplied is associated with a large percentage change in price). If this trend in preferences continues, prices will remain high until producers have time to react by expanding their farms to accommodate more livestock, hire more workers, and install more processing equipment.

Does that mean that Norwegian consumers are going to continue facing these brutal prices for the coming months? Only time will tell, but if prices persist, it would be a testament to a population stubborn enough (or wealthy enough) to stick to the latest trendy diet, and a government dedicated to hard-line international policies, even at the cost of its own citizens’ welfare.

DISCUSSION QUESTIONS:

1) A change in preferences isn’t the only way that the demand for a good can change. What are some other factors that could cause the demand for butter to increase?

2) Rather than demand returning to where it was (the end of interest in the fad diet), the equilibrium price of butter could also decrease if supply shifts. Which direction would the supply curve need to shift for that to happen? What would happen to the equilibrium quantity? What are some ways that the supply could shift in that direction?

3) Suppose the Norwegian government feels pressure to help lower butter prices. Propose a policy that would help lower prices in the market. Is there a policy that the government could use to generate revenue for itself while lowering the price of butter?

Oz Economics: Will your silver shoes carry you over the desert?

For centuries, gold and silver served as money, but not anymore. Silver went out of circulation in the late 19th century. Gold was effectively banned from circulation in the United States by the Gold Reserve Act of 1934. The last attempt to revive silver in the US as a form of money was made by the Populist Party. In particular, W. J. Bryan, a three-time presidential candidate on the cusp of the 19th and 20th centuries, argued that adherence to the gold standard tightened the money supply and consequently limited access to credit. He claimed that this hurt the entire economy, especially the Midwestern farmers suffering from the deep and prolonged recession of 1890s.

The Populists’ solution was bimetallism – the use of gold and “free silver” – to increase the money supply, which in turn would help the farmers. Their efforts failed, but the debates of those days are immortalized in L. Frank Baum’s The Wonderful Wizard of Oz. According to Henry Littlefield’s famous interpretation of Baum’s fantasy, Dorothy’s silver shoes symbolize the silver money that had to be added to the gold – the yellow brick road – in order for Dorothy’s quest to succeed.*

Money is a special asset. It exists in multiple forms and serves different functions. For example, commodity money such as silver or gold has an intrinsic value, whereas fiat money or paper money has value only as a result of government decree or law. To be used as money, any asset (commodity or fiat) must fulfill the following requirements: It must serve as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. In the modern world, it’s much easier to use paper money than silver or gold coins or bars. However, silver and gold outperform paper money when it comes to the store of value function, because inflation can potentially turn paper money into useless pieces of paper.

Gold is widely used for inflation hedging, which means that when fiat money loses value due to inflation, gold retains its value. The importance of gold as a store of value is underscored by historical price data that shows spikes in the periods of greatest macroeconomic uncertainty. Although not used as a universal medium of exchange, gold still remains an important asset. Its price among pivotal financial market indicators is on a par with Dow Jones and other major stock price indices and Treasury bills.

What about silver? In the past hundred years, it has never come close to gold in importance. The use of silver for investment was negligible until 2008. It was mostly used for industrial applications and for jewelry. Recently, the role of silver has been changing as it becomes an increasingly attractive investment. In 2010, its use as an investment commodity increased to 17 percent of total production. This resulted in an increase in the demand for silver, and consequently, a higher price.

Since then, silver has been appreciating steadily relative to gold. In September 2010, the price of silver was about $20 per ounce, whereas the price of gold was approximately $1,250 per ounce. This yields the gold-silver price ratio of 62.5, which is close to the average for the past two decades. One year later, in September 2011, an ounce of silver was traded for $30 and an ounce of gold for $1,800. Thus the gold-silver price ratio fell to 45. This suggests that silver has begun to function as a store of value and is creeping up on gold. Moreover, current technology significantly increases the liquidity of both gold and silver as assets. Not only is it possible to open an online storage account without leaving your desk, but it is also possible to trade silver and gold shares online without knowing where the metals are physically located.

The quest for a safer investment didn’t just increase the demand for gold, it also dragged silver back into the spotlight. It restored, even if temporarily, silver’s position as a store of value. Even if modern investors don't believe that a pair of silver shoes alone will carry them over the desert of economic instability, they are certainly interested in giving them a try.

* Dorothy’s ruby slippers in the MGM classic movie make no sense economically. Ruby replaced silver for the film because the red ‘popped’ more in the new Technicolor technology.


DISCUSSION QUESTIONS

1. How would expanding the money supply have helped poor farmers at the turn of the 20th century?

2. Would you be willing to accept a gold or silver bar as a means of payment today? Do you think your favorite store at the mall would? Based on your answers, would you say precious metals serve as an effective type of money in our modern society?

3. If two similar investments (like gold and silver) show very different rates of return over the same time period, do you think the investment market is in equilibrium?

Not-so-sunken costs?

I recently had to decide between going to a concert for which I’d already bought a ticket and attending a dinner party with friends. Initially I was compelled to “get my money’s worth” by going to the concert (it was too late to sell the ticket to someone else), in spite of the fact that I would have preferred to go to the dinner (if I hadn’t bought the ticket). According to the economic theory of sunk costs, however, choosing to go to the concert under these circumstances would have been irrational.

Once a good or service has been paid for, the future costs and benefits of actually making use of the purchase should be compared to the future costs and benefits of alternative options—the cost of the purchase, paid in the past, is “sunk” and should not factor into the decision. Suppose that neither the dinner nor the concert would cost me any additional money, but I predicted the enjoyment I would get from the dinner would exceed the potential enjoyment from the concert. Because the expected future benefit minus the (nonexistent) future cost of the dinner exceeded that of the concert, I chose to go to the dinner.

Choosing to ignore sunk costs, however, is not always easy, in part because it can be difficult to distinguish situations in which the cost is truly sunk from those in which it shouldn’t be written off entirely.

Suppose instead I had been asked to bring a bottle of wine to the dinner. In that case, the fact that I had already bought the ticket meant that I was choosing between a concert that would cost no additional money, and a dinner that would cost me the price of a bottle of wine (say $15). Though I would have had a definite preference for going to the dinner and paying $15 for wine over going to the concert and paying $20 for a ticket, it could have been the case that I preferred going to the concert (at no additional cost) to going to dinner (and spending additional money). Although the $20 I’d spent on the ticket was gone either way, it had made one of the options free without affecting the cost of the other option. This would be particularly meaningful if I had a monthly budget for semi-luxuries like concerts and wine, and having spent $20 on the concert, I couldn’t justify spending $15 on a bottle of wine.

The moral of the story is that while you should never consider the “sunk cost” in itself when making decisions, it is relevant to consider how the sunken payment may have altered your current set of options.

Discussion questions:

1. Think about how this kind of analysis would be important to a company that has already invested considerable capital in a project, but later finds a different project that would have been better to invest in. When deciding whether to abandon the first project to invest in the second, how should the money already invested in the first project affect or not affect the decision?

2. Can you think of examples of sunk costs in your life that you might be tempted to not ignore because it can be difficult psychologically to not use things you’ve purchased?

NFL Concessions Meet Economic Tradeoffs

While at the Patriots-Steelers NFL game earlier this season, I made a classic economics observation: tradeoffs are everywhere. It was partway into the second quarter, and dinner time was approaching. Because our seats were up in the highest section possible, this meant short lines at the concession stands, but the quality of food available was poor. The economist in me couldn’t help but see the natural connection to consumer theory, specifically indifference curves.


Indifference curves express how much utility, or happiness, comes from various combinations of goods. Any two points along the same indifference curve must represent two combinations of goods that make you equally happy. Additionally, points on different indifference curves represent different levels of happiness. In terms of the shape of indifference curves, economists make standard assumptions, such as more is better and averages are preferred to extremes. However, consider what the indifference curve mappings would look like if the goods being represented are quality of food and queue length (that is, the length of time you expect to wait in line .)


In this case, a long queue length is undesirable (economists call this a “bad”).That means that if you’re going to tolerate a longer line, the food quality must improve for you to be equally well off; this translates graphically into the increasing shape of the curve above. Also, for any given queue length, a higher quality of food makes you better off, so the level of happiness represented by IC2 must be higher than that of IC1. Finally, because averages are still better than extremes, the bowedness of the curves must be in the northwest direction. This is illustrated on the following graph:


A and C are two possible consumption bundles, while B represents the average of this bundle. Because B is preferred to A and C and you know that consumers are happier with better food and shorter lines (the southeast direction), the curve must be bowed in this way.


As you can see from the graph above, the choice as to whether or not it makes sense to travel throughout the stadium for better food is a simple consumer choice problem. My optimal decision rests on the relative happiness I get from higher food quality versus not waiting in line. What did I choose? A simple burger with french fries in exchange for a short line, so I could watch Brady and the Patriots blow it!


Discussion Questions:

1. What if instead of modeling “queue length” on the vertical axis, you want to show the indifference curves between “food quality” and the “amount of the game you watch from your seat.” How would the shape of the indifference curves change? Which direction represents a higher level of happiness from one curve to another?

2. Suppose that the value of watching the game diminishes because your team is crushing the opposition. How would this change the shape of your indifference curves between queue length and food quality?

3. What if averages are no longer better than extremes? How would that alter the shape of the indifference curves shown above?

Education Regulation

Across the country, students are returning to higher education institutions for the start of another semester, except it seems that the federal government may not want some of those students in classes. This summer, the Department of Education announced new rules that will limit federal loans and grants available to for-profit colleges in order to change the way these institutions do business. These rules base funding on how educational programs meet performance goals, and they have already had an effect; new student enrollments have fallen by nearly 50% at the University of Phoenix, the largest for-profit college.

While both the analysis of the performance policy and larger questions on the economic value of subsidizing education are relevant for economic debate, perhaps it is worth taking a step back and considering something much simpler: holding the initial funding constant, there was a market where buyers (potential students) were happy to trade with sellers (for-profit colleges), but the government chose to intervene and prevent trades that the market otherwise would have facilitated. Most of the time, economists endorse laissez-faire policies, literally “hands off.” This is because government intervention often distorts the market equilibrium and leads to lost surplus, thus lowering welfare for society as a whole. However, sometimes economic theory endorses government intervention, because some policies can correct for market failures and actually raise social welfare.

What are some examples of government intervention that can be economically beneficial?

1. Tragedy of the commons - When public resources are freely available to everyone, they can become overused and permanently damaged. When a government requires fishing licenses to fish in public streams, the intervention limits usage and preserves the environment by preventing over-fishing.

2. Externalities - In some cases, while the private costs and benefits apply to individuals, the consumption of goods can have far-reaching effects on society as a whole. By imposing fines for pollution, the government can make private firms internalize the cost to society of damage done by production.

3. Asymmetric Information - When sellers know more about their product than consumers can reasonably find out, they could exploit that information to rip consumers off. Governments can step in to level the playing field. Consider when a county’s boards of weights and measures routinely calibrate supermarket scales.

4. Incomplete Information - Economists typically assume complete information when analyzing markets. Welfare loss can occur if consumers do not know exactly what is for sale, or if a good fits their needs.

Returning to the case of new rules on for-profit education, perhaps the government has justified its intervention by suggesting that some students don’t know what they are getting themselves into, and are buying a product they don’t need or can’t use. In some cases, the federal government, along with four individual states, is taking things one step further. In August, they filed a lawsuit against another for-profit education company (Education Management Corporation), charging them with fraud. Based on information from whistleblowers, the government is charging:

"The company had a ‘boiler-room style sales culture’ in which recruiters were instructed to use high-pressure sales techniques and inflated claims about career placement to increase student enrollment, regardless of applicants’ qualifications. Recruiters were encouraged to enroll even applicants who were unable to write coherently, who appeared to be under the influence of drugs, or who sought to enroll in an online program but had no computer."

While the fraud case is early in the legal process, the metaphorical jury is still out on the government’s new policies. Regardless of the legal outcome, it’s important to consider the costs and benefits to the parties involved when the government considers intervention.

DISCUSSION QUESTIONS:

1) Will the government regulations related to for-profit education cause a pareto optimal change? Who is better off under these regulations? Is anyone made worse off by these new laws?

2) What should the government consider when debating laissez-faire policies versus intervention?

3) Do you think the government regulation of for-profit colleges is appropriate? Is this a positive or normative question?

4 ) How would the market react if students had to pay for their education entirely out of their own pocket, rather than receiving some government aid? Would you expect the same level of regulation to be introduced?

Crossing the Bridge: Do the Wealthy Live Longer?

A recent study on longevity provides intriguing data on life expectancy (LE) in the United States. Despite the U.S. having the highest health expenditure per capita, life expectancy in the US trails that in most other developed countries.

Life expectancy is a measure of a nation's or community's health that summarizes current mortality statistics by answering the following question: Assuming all current conditions remain unchanged, how long could children born this year be expected to live on average? In 2007, the US ranked 37th in the world in terms of LE at birth, with 75.6 years for men and 80.8 years for women. Across US counties, however, LE ranged from 65.9 to 81.1 years for men and 73.5 to 86.0 years for women. To assess the extent of these disparities, the authors used a benchmark based on ten countries with highest LE in the world. Then they ranked each US county based on how many years it is behind or ahead of the benchmark. For example, if county A has LE of 75 years and it took the benchmark countries years ten years to go from LE of 75 years to the current average of 80 years, then county A is ten years behind the benchmark.

The analysis determined that very few of the US counties are ahead of the benchmark, and most are behind. Some counties are decades behind, ranking close to less developed countries such as Peru and El Salvador. What is perhaps most surprising is that large disparities exist even between neighboring US counties. Take for example two California counties, both in the San Francisco Bay Area: Santa Clara, home to Stanford University, and Alameda, home to UC Berkeley. In 2007, based on LE for men, Santa Clara county was almost a decade ahead of the international benchmark and Alameda county was at least five years behind. An allegory comes to mind: By crossing the Bay Bridge, we jump 15 years back in time! For women, the time travel would be shorter, a decade.

The authors of the cited study are health researchers primarily interested in demographic factors and life style choices that create medically preventable deaths caused by obesity, smoking, and alcohol. Economists have a different interest in these statistics: the link between wealth and health. In 1975, demographer Samuel Preston first reported a positive relationship between GDP per capita and LE. The graphical representation of this relationship is now called the Preston curve. Two properties of the Preston curve are of special interest to policy makers: (1) Life expectancy at birth rises quickly at low levels of per capita income but flattens at high levels of income; (2) The Preston curve shifts upward over time, which is largely explained by improvements in health care technology. The shape of the Preston curve resembles that of a production function, suggesting that health, measured by LE at birth, is a product of a healthcare system where the only input of interest is per capita income.

Some factors that produce health from wealth operate on individual level. Higher income leads to better nutrition, which in turns creates better health outcomes, especially in children. Some operate on the community level (sanitation and other public health measures), and some on the national level (health care system coverage and production of medical knowledge). However, the causality in the Preston curve is unclear, and an alternative explanation is possible: The Preston curve may reflect an impact of health on income. That is, healthier people are able to work more and thus earn more, which enables them to take a better care of their children. Healthier children spend more time studying and thus become more productive workers, etc. This may explain the steeper slope of the Preston curve for the less developed countries where mortality is likely to affect productive members of labor force, while in developed countries, mortality largely affects retirees.

Regardless of the interpretation, the Preston curve remains an empirical observation that holds across countries and suggests that the link between health and income is more important for developing countries than for developed ones. In the case of the United States, does it matter at all? Quite a bit, it turns out. This graph shows a strong relationship between average personal income and LE across California counties. Specifically, average income per capita in Santa Clara county is 16% higher than in Alameda county, $36.5K versus $31.5K. In 2007, LE in Santa Clara county was 80.6 for men and for 83.9 women while in Alameda county it was 77.7 for men and 82.3 for women. So, the Preston curve is relevant even at the county level. Holding all else constant, baby boys and girls born in a relatively wealthier county are expected to live longer.

Discussion questions:

1) Why are researchers from different disciplines interested in life expectancy statistics?

2) What factors might be responsible for the US ranking 37th in the world?

3) What factors could be responsible for the differences in LE in two neighboring US counties with similar demographics and health care systems?

Raising the Roof... on the National Debt

For the past month, House Republicans and the White House have been in a bitter standoff over the national debt ceiling, the legal limit to borrowing that the U.S. government imposes on itself. The law establishing the ceiling has been in effect since 1917, but the ceiling has been raised many times over the past century. The current limit is set at $14.3 trillion. Government spending would have exceeded this limit on May 16th, but the U.S. Treasury has enacted emergency measures that will keep the government and its lenders funded until early August. Failing to increase the debt ceiling could lead to the U.S. being unable to fund military salaries, pay for programs like Medicare, or make interest payments to creditors. But increasing the debt ceiling won’t be easy either.

In the worst-case-scenario, an agreement to raise the debt ceiling would not be reached, and the U.S. government would risk defaulting on interest payments to lenders. The United States government has consistently served as a safe haven for lenders looking to store funds; historically it has never missed a payment. As a result of this reliability, the U.S. economy has been able to enjoy relatively low interest rates. If the U.S. were to consider defaulting on its loans, investing in the U.S. government would become riskier. To attract borrowers and accommodate for the increased risk of not being paid back, real interest rates would have to rise.

John Maynard Keynes wrote in The General Theory of Employment, Interest and Money that aggregate demand (composed of consumption, investment, and government expenditures) is the main determinant of an economy’s level of output. Investment spending, such as the purchase of a new home, is typically financed through borrowing. As real interest rates rise, borrowing becomes more expensive. Because investment is a component of aggregate demand, an abrupt decline in investment would theoretically shift the aggregate demand curve inward as in the graph below. With the US economy struggling to overcome the recession caused by the 2008-2009 financial crisis, a reduction in output and the corresponding fall in employment would certainly be viewed as an unfavorable outcome.

As part of the ongoing debt ceiling discussion, President Obama recently unveiled a plan to reduce deficits over the next twelve years that includes nearly $2 trillion in spending cuts and an increase in the debt ceiling. The government spends nearly $700 billion annually on national defense alone, and it also employs millions of people. As mentioned, government expenditure is a major component of aggregate demand. Economists would expect a reduction in government expenditures to shift aggregate demand inward in a similar manner as decreases to investment.

It is important to also consider the concept of “crowding out.” Whenever there is an increase in government spending, the resulting increase in incomes leads to increased spending and thus a higher demand for money. This increased demand for money causes increased interest rates. The opposite is also true. As government spending is reduced, so too are incomes, money demand, and interest rates. This reduction in interest rates makes borrowing cheaper, and thus stimulates greater private investment. Increased investment would therefore lessen the impact of a shock to aggregate demand from government spending cuts. Those in favor of spending cuts point to the increase in investment to suggest that the cuts won’t significantly decrease aggregate demand. Those opposed to the cuts note that interest rates are already very low so doubt that the cuts would spur much private investment.

It is relatively unlikely that US elected officials would be stubborn enough to permit a seemingly preventable crisis. Remember, the debt ceiling is a constraint that the government arbitrarily places on itself. No matter how the government chooses to proceed, the short-run economy is likely to see some negative consequences. Economists like to talk about optimal decision making, and recognize that sometimes even a “bad” option can be optimal if no other choice will lead to a better outcome. When it comes to the debt ceiling, let’s hope that our elected officials think like economists.

Discussion Questions:

1.) A number of nations around the world hold the U.S. dollar as their reserve currency. Others have periodically pegged their exchange rate to the U.S. dollar (China, for example). What would the implications of a U.S. credit default mean for foreign economies?

2.) Suppose that the debt ceiling remains unchanged. How might the US government prevent defaulting on its loans? How does this compare to the current plan suggested by President Obama?

3.) If you were President of the United States, how would you deal with the current level of debt? Would you increase taxes? If you were to cut programs, which ones would you cut? How might your view change if you were up for reelection?

Correcting Faulty Defaults to Improve Society?

California recently cut $170 million from the amount the state must pay toward 2012’s retirement benefits, according to an article in the Mercury News. With the uncertainty regarding the future of pension plans and social security, private retirement savings are more important than ever. Despite this need, many people have difficulty making consumption sacrifices today to provide for their future selves.

Recent changes to many private firms’ retirement savings programs seem to reflect this need for personal savings. In the past, employees had to actively opt-in to company savings plans by changing their monthly contribution amount from the default of $0 to some positive amount. Traditional economic models of savings assume that people are perfectly rational and will choose the level of saving that maximizes their utility over the entire course of their lives, therefore people’s decisions of how much to save should not be affected by something as small as the effort required to “opt-in” to a plan. Companies have found, however, that merely changing the default option from “no savings” to “X% of paycheck automatically saved” causes a significant increase in employee savings. One firm found that after switching from standard to automatic enrollment in retirement savings plans, the participation rate for new hires was 35 percentage points higher after three months on the job (as compared to those hired before the automatic enrollment). The participation rate remained 25 points higher after two years.

Why would something as seemingly trivial as changing the default setting have such a large impact on the decision of how much to save? The field of behavioral economics acknowledges that people do not always act according to the model of perfect rationality, which requires weighing all costs and benefits (present and future) and accounting for all available information. Deciding how much to save for retirement is an important life decision, yet the “easy” choice of accepting the default option often prevails against the rational action of giving it more serious consideration. Traditional economic models do not explain the widespread tendency to stick with defaults regardless of their suitability, but behavioral economists can replicate this behavior in controlled research environments.

Applying this understanding of behavioral economics to the savings plan structure is an example of “libertarian paternalism,” a school of thought that strives to maintain freedoms (libertarian) while still guiding people towards the choice that society deems best (paternal). The new default setting does not interfere with employees’ rights to do what they please because employees can easily “opt-out” by making a short phone call and signing a form. At the same time, it benefits society by encouraging more people to save, since those who do not sufficiently save for their future needs pose a problem not only to their older selves (who may have to work past their desired retirement age), but also for the government (and thus taxpayers) who may then have to help provide for them as well.

Discussion Questions:

1) Do you think that a company changing the default behavior for a retirement program infringes on employee's rights?

2) How do you make decisions about long-term financial planning? Do you research and model your finances, base your decisions on suggestions (from an employer, family, or friends), or ignore it entirely?

3) Are you surprised that changing a default value has an effect on what people select?

4) Imagine you are a freshman in college choosing a meal plan. You don’t know what the other food options on campus will be like, nor what your schedule will be. What advantages does a “default” option provide in this situation?

Revisiting the Reach of the BP Oil Spill

A year ago, cleanup efforts to recover from the Gulf oil spill were just beginning, but the effects of the spill were already finding their way into markets. While the debates and projections attempt to forecast how far the oil will spread, economists understand that the effects of the spill will reach further than the oil itself ever could. While many initial discussions focused on the local impact of the disaster, applications of the basic supply and demand model shed light on how a regional disaster can spread to national and global markets.

Soon after the disaster, the Associated Press reported that the price of shrimp started to climb in response to the spill. To begin to understand why, consider the direct effect of the spill on the supply of shrimp caught in the Gulf. The graph to the left reflects the market for Gulf-coast shrimp. As shown on the graph the oil spill reduces the supply of locally caught shrimp in the gulf as fishermen have been prevented from conducting much of their normal business. In response to the reduced supply, the equilibrium price rises, while the amount of shrimp sold falls.

Assume that shrimp caught in the Gulf and shrimp caught elsewhere are separate goods, though the markets for each are clearly related. Aside from the environmental problems associated with catching shrimp in the gulf, there may be variations in quality or style between shrimp caught in different locations. That said, shrimp are still shrimp, so even if consumers have a slight preference for one type or another, shrimp from other locations can be considered substitutes. When two goods are substitutes, an increase in the price of one of the goods causes an increase in demand for the other, all else held constant. When the market price for Gulf-caught shrimp rises (along with concerns that shrimp caught in the gulf may be contaminated) many buyers will look to purchase shrimp from other regions, like North Carolina, South Carolina, Georgia, and Texas. The second graph to the left illustrates how an increase in the price of a one good (Gulf shrimp) causes an increase in the demand for a substitute good (non-Gulf shrimp). The result here matches the reports by the AP: An increase in the equilibrium price and quantity of non-Gulf shrimp due to the effects of the oil spill.

Interestingly, the effects of the oil spill will also be felt by companies that have nothing to do with catching anything from the sea. For example, consider the market for tartar sauce. Many people like putting tartar sauce on their shrimp when they eat it, but have no desire to eat tartar sauce on its own. Economists would call tartar sauce a compliment to shrimp. When two goods are compliments, an increase in the price of one of the goods causes a decrease in demand for the other, all else held constant. On the final graph below, you can see the effect that higher equilibrium prices of shrimp have on the tartar sauce market. When the market price goes up, consumers will purchase less shrimp, and if less shrimp is consumed, consumers have less of a need for tartar sauce. This decreases the demand for tartar sauce, resulting in a decrease in the equilibrium price and quantity of tartar sauce.

There is still too much uncertainty about how much damage has been caused and the extent of the long-term effect on the environment for economists to reliably give exact figures on how these markets will change. However, the basic supply and demand confirms that the effects of this spill can be seen far beyond the Gulf region.

Discussion Questions:

1) How will the elasticity of supply and the elasticity of demand for non-Gulf shrimp affect the magnitude of the change in equilibrium price and quantity? How do economists describe the magnitude of a change in demand for one good in response to a change in the price of another?

2) What other markets do you expect to be affected by a change in the price of shrimp? What will happen to the equilibrium price and quantity in each of these markets? Are these goods compliments or substitutes?

3) Suppose that instead of an oil spill earlier this year, weather patterns had changed to make the shrimp season in the Gulf abnormally productive. If it were easier to catch shrimp in the gulf, what would you expect to happen to demand for shrimp caught in other regions? What about the demand for complementary goods like tartar sauce?

4) If you wanted to work on a shrimp fishing boat, all else held constant, which labor market do you think would be more favorable to join, one in the Gulf coast or one in South Carolina? Why?

5) Suppose the fishing industry is monopolistically competitive. Do you expect firms to enter or exit the market in the Gulf right now? In the long-run, assuming that fishing conditions return to their pre-spill levels, what can you say about the firms that will be in the market? Is it possible that any existing firms will be better off now than they were before the spill? If so, how?