Friday, March 31, 2006

The Government as Drug Purchaser

New research by Alan Garber, Charles Jones, and Aplia co-founder Paul Romer, suggests that a system of co-payments for health insurance might encourage a more socially desirable use of pharmaceutical drugs. Firms price patented drugs in a monopolistic way (patent protection typically applies for two decades). By behaving like monopolists, pharmaceutical firms tend to sell fewer patented drugs at higher prices--not necessarily the optimal outcome from a social standpoint. Some consumers are willing to pay more than the marginal cost of producing the patented drug, but monopoly pricing rations them out of the system. In short, the marginal cost of producing patented drugs is often far less than the marginal benefit to consumers. Expanding production would generate more benefits than costs, but monopoly pricing prevents the gains.

Garber, Jones, and Romer point out that patients covered by health insurance do not pay the full price for drugs. They share the cost with their insurers through a co-payment. With co-pay, consumers are more likely to purchase a drug than if they had to bear the full price. Monopoly drug pricing causes consumers to buy less. Insurance co-pay causes consumers to buy more. The counteracting forces of co-pay and monopoly pricing could lead to socially optimal drug consumption.

In Australia, the government offers co-payment for selected drugs. Australia enacted the Pharmaceutical Benefits Scheme (PBS) in the 1950s. Drugs covered by PBS are sold to patients at a price equivalent to the marginal cost of producing and distributing the drug. In the figure to the right, consumers backed by PBS will purchase drugs up to a quantity of Q*. Notice that this is the socially optimal level of drug usage. Q* is the quantity where demand intersects marginal cost; where the marginal benefit from consuming the drug exactly equals the marginal cost of producing it.

The drug companies receive a price that is negotiated with the Australian government (Ppbs). Drug companies always have a right to opt out of the scheme. In this case, they would earn monopoly profits as shaded on the figure [(Pm - c) x Qm)]. Because the drug companies can opt out, the government-negotiated price will need to be just sufficient to give the company the monopoly profit it would otherwise earn. This would be a price such as Ppbs. Notice that the drug companies earn a lower margin on each unit--(Ppbs - c) rather than (Pm - c)--but they sell many more units (Q* > Qm).

This is a win-win situation. Drug companies receive the profits they would in an unregulated market, but drug consumption is at its socially optimal level.

1. Suppose the Australian government had consumers share a fraction of the price charged by pharmaceutical companies, Ppbs, rather than their current fixed charge, c. Would they end up consuming more or less than if they paid a price of c?

2. The Australian government is concerned that its total expenditures on drugs have been growing as new treatments become available. Is this a legitimate concern?

3. Should the U.S. government consider playing a similar role as a purchaser of drugs? What impact would that have on the profits going to drug makers?

Joshua Gans is Professor of Economics at the Melbourne Business School, University of Melbourne. He has co-authored the Pacific Rim Edition of Mankiw's Principles of Economics and his own text, Core Economics for Managers (Thomson, 2005). He maintains his own blog at

Tuesday, March 28, 2006

Bringing the French Unemployment Picture Into Focus

News reports consistently cite the high unemployment rate for young people in France. According to the OECD, in 2002 the unemployment rate for French 20- to- 24-year-olds was 15.5%. This is higher than many other industrialized countries--for example, the same figure for Canada was just 7.2%, less than half of the French statistic.

However, while the difference in the unemployment rate between two adjacent years in the same country can tell you a lot about the state of the economy, the difference in unemployment rates between two countries is harder to interpret because so many factors can differ. To make a meaningful comparison of the labor market in two countries, it helps to look at other variables besides the unemployment rate. For example, the same OECD report also shows that the fraction of all 20- to- 24-year-olds who were unemployed was 8.4% in France, compared to 5.7% in Canada--higher to be sure, but by much less.

How can these two measures of joblessness paint such different pictures? Might it be that labor market conditions in France are not as bad as the unemployment rate suggests? Recall that the unemployment rate is the fraction of the labor force that is unemployed, not the fraction of the population. The unemployment rate is higher in France because a smaller fraction of 20- to- 24-year-olds are in the labor force there. The labor force participation rate for this age group is 54% in France and 79% in Canada.

These rates mean that for every 1000 20 -to- 24-year-olds in France, 540 say they want to work and 84 of them are unemployed, which leads to an unemployment rate of 84/540 or about 15%. For every 1000 20- to- 24-year-olds in Canada, 790 are in the labor force and 57 of them are unemployed, which leads to an unemployment rate of 57/790 or about 7%.

Yet other statistics show more clearly that the labor market opportunities for some young people in France are in fact much worse than in Canada. One useful measure is the duration of unemployment. For each 1000 young people in France, take the 84 who are in the labor force and unemployed. Of these, 34 have been unemployed for more than 6 months. Of the corresponding 57 people who are unemployed in Canada, only 5 have been unemployed for this long. (See Table 2, below.) This tells you that on average, spells of unemployment last much longer in France.

So the two major differences between France and Canada are (1) France has a lower labor force participation rate, and (2) long-term unemployment is much more prevalent in France. There are several explanations for these differences. A recent article in the Financial Times suggested that the main reason for the lower labor force participation rate may be that more twenty-somethings in France attend university. In fact, this can account for only a small part of the difference. The fraction of 20- to- 24-year-olds in education is only five percentage points higher in France--44% compared with 39% in Canada. Most of the 25 percentage point difference in labor force participation rates must therefore arise for some other reason.

A more troubling explanation for both differences is that many young people in France stay out of the labor force because they are discouraged--that is, they have been unemployed for so long that they do not feel that they can find a job, so they stop looking. Or they never bother to look. How many students would try to find a summer job knowing that it could take more than a summer’s worth of searching to find one? If many of the people who are out of the labor force would actually like to work but are so discouraged that they don’t even try, the human cost of France’s labor market rigidities may be even higher than its unemployment rate suggests.

1. Students across France have been protesting a new law that would make it easier for French employers to fire young workers. How might the passage of such a law affect the unemployment rate and the labor force participation rate? Why?

2. France has an unusually high minimum wage. Consider two groups: young people who have completed high school and drop outs who haven’t. Which group would you expect to have more unemployment because of the minimum wage? Would you expect this unemployment to be short-term or long-term?

3. Suppose the poor labor market for French youth encourages French students to stay in school longer than they would otherwise choose to, earning postgraduate degrees. What long-term effect would this have on the French economy?

Paul Romer is currently the STANCO 25 Professor of Economics in the Graduate School of Business at Stanford University and the founder of Aplia.


Monday, March 27, 2006

From the Company that Brought You … Everything

Google recently unveiled Google Finance, new competition for other financial information sites like Yahoo!, CNNMoney, Bloomberg, MSN Money, and Smart Money. This is another step in Google's evolution from an Internet search engine to an all-purpose web portal. Recent Google offerings include free e-mail, news, instant messaging, and mapping services. The longer Google keeps users in its site, the more it collects in ad revenue--the main source of Google’s profits. Google Finance, however, in a very un-capitalistic fashion, will initially not carry ads.

Rather than initially developing its own finance content and commentary, Google will offer a combination of interactive and analytical tools and links to outside media outlets for financial commentary. Some industry experts warn that Google’s drift toward portal status (a branding the company dislikes) may overextend the company as it draws attention and resources away from its search engine. Rumors are swirling that Google plans a foray into a sports site, similar to sites at Yahoo! and MSN.

Google Finance brings innovation to the standard quote and chart services their competitors offer. Users get instant price and volume information by passing the cursor over Google's interactive chart, whose timeline can be easily changed and dragged. On a short enough timeline (a few days or less), you can get price and volume information throughout a day’s trading. Markers on the chart annotate announcements regarding the company so users can instantly see how announcements affect price and volume. Users can also view blog posts about the company, look at related companies, and learn about company management.

However, Google's entrance into the finance arena has already prompted MSN and Yahoo! to announce new features. Google Finance will not have it easy--users tend to be very loyal to their financial websites, and both Yahoo! and MSN have unique tools that create competitive barriers for Google. Google admits the finance site is still a work in progress, including its search features. Oddly enough, the first result in a search from the Google home page for “Google Finance” is a Yahoo! Finance page about Google.

1. Access Google Finance and look up Brady Corporation. Zoom out the chart to the 6-month view and briefly discuss any major news events and corresponding stock price reactions that have occurred.

2. What effect is new competition expected to have on a market? Does it seem like that effect is taking hold in the financial website market?

3. What form can barriers to entry take in a market? What barriers will Google face?

Topics: Google, Finance, Stocks

Imagine There Are No Credit Cards, It’s Not Easy Even if You Try …

What would happen to the U.S. economy if everyone paid off their credit card debt? That's the question a reader sent in to’s John Schoen. It's an important topic: according to the Federal Reserve’s 2004 Survey of Consumer Finances, the percent of families carrying a credit card balance increased from 44.4% to 46.2% from 2001 to 2004, a higher increase than the previous 3-year period. For households carrying balances, the median balance rose 10% to $2,200 and the mean rose nearly 16% to $5,100. The problem is particularly severe for young people just graduating from college--a group some call "Generation Debt."

But even if paying off your own credit card would be good for you, would it be good for the economy as a whole if everyone did? Not necessarily. First, where would the money to pay off this debt come from? Creditors will not simply forgive debts. If consumers stopped all discretionary spending and diverted money to pay down debts, the results would be catastrophic to the economy. Nearly 2/3 of the U.S. economy is based on consumer spending, so GDP would dwindle and unemployment would skyrocket. If consumers tapped their stock and/or house equity to pay down debt, stock and real estate markets would be flooded with sellers and prices would plummet.

Even if it were frictionless, a credit card free world would have less spending power and would rock the financial services industry. Lenders make money by lending, and without consumer debt, banks would have a hard time surviving.

So, the moral of the story is that consumer debt plays a vital role in keeping the economy rolling and stimulating GDP, but it is up to individuals to manage their own finances responsibly.

1. What is the difference between good debt and bad debt? Cite some examples.

2. Do you think people carrying credit card balances is more a function of income or behavior? In other words, if someone carrying a high credit card balance receives a large raise, is he/she more likely to use the extra funds to eliminate the balance or will the balance remain despite the extra income?

Topics: Credit cards, Consumer debt, Personal finance

Friday, March 24, 2006

Two Girls for Every Boy

HBO put plural marriage back on the map with its new show Big Love. It’s time for Aplia Econ Blog to jump on the polygamy bandwagon. Though banned in the United States, polygamy--the practice of having more than one spouse--is not so uncommon in other countries, and in the greater animal kingdom, it's par for the course. So what's the big deal about big love?

Two columnists, Robert Frank (an economist at Cornell's Johnson School and author of Luxury Fever) and Tim Harford (a journalist at the Financial Times and author of The Undercover Economist), recently tackled the economics of polygamy. Both drew some interesting conclusions about shacking up with multiple spouses.

Check out Harford's column first. Note that Harford makes some useful distinctions between the types of plural marriage: polygyny means more than one wife and polyandry means more than one husband.

1. Polygyny often occurs in societies where women have few, if any, of the rights enjoyed by men. According to Harford's tongue-in-cheek take on polygyny, why might women in polygynous, rather than monogamous, societies have more bargaining power in the marriage market?

2. According to economist Kerwin Charles, how does the incarceration rate among black men in America affect the quality of men that black women face in the marriage market? What's the effect of the incarceration rate on the bargaining power of black men who are not in prison?

3. What's the parallel problem in China? Assuming the Chinese government doesn't legalize polyandry (two boys for every girl), what's the dark side of the surplus of single men?

Now take a look at Frank's column in The New York Times.

1. Frank agrees with Harford that polygyny can benefit women, as a small percentage of men would take multiple wives under legalized polygyny. For women prefering monogamy, this leaves an ample supply of men to choose from. According to Frank, men suffer most when men are allowed to have more than one wife. Why?

2. In what way is a "positional arms race" in the marriage market costly to society? What does Frank endorse: laws allowing for plural marriage or laws banning it?

Topics: Polygamy, Marriage market, Supply and demand

China's Chopstick Tax

Planning on buying an SUV or golf accessories in China? Probably not, but in the unlikely event that you are: buy soon. The Chinese government hopes to encourage environmental conservation and curb conspicuous consumption with a slew of new tax hikes on April 1st. An article in The New York Times outlines the new proposals, including taxes on disposable wooden chopsticks and luxury watches.

A tax offers government several opportunities. Taxes raise government revenue, discourage certain activities, and give people an incentive to adopt alternatives to the taxed behavior. Consider an emissions tax. By taxing steel mill emissions a government could raise some revenue, discourage pollution-intensive steel production, and simultaneously give steel mills an incentive to adopt cleaner technology.

1. What types of conservation does the Chinese government hope to encourage by taxing wooden chopsticks and vehicles with large engines?

2. As China increases taxes on vehicles with engines over 2 liters, it is decreasing taxes on vehicles with engines of 1 to 1.5 liters. How will the tax affect foreign automakers that primarily sell big engines in China?

3. Chinese automakers produce relatively small vehicles compared to their foreign counterparts. How will the tax affect the demand for small-engine vehicles?

China plans to tax several luxury items, including watches, golf accessories, and yachts. Consumption of luxury goods tends to be highly price sensitive. In econ jargon, the price elasticity of demand for luxury goods is highly elastic--small price changes induce relatively large changes in quantity demanded. By raising the price of a luxury item with a tax, government can expect a relatively large drop in sales of the item.

Take America's disastrous yacht tax of 1990. Uncle Sam's tax effectively increased high-end yacht prices. Wealthy Americans responded to the tax by substituting away from yachts toward other status symbols like jets, sports cars, horses, handbags, and helicopters. Yacht sales dropped and the tax fell far short of government revenue projections. Employment in the yacht industry went the way of free falling yacht sales--not exactly the intended consequence of the tax.

4. Do you think China's luxury taxes will raise lots of government revenue?

5. China faces a bit of an image problem at the moment. The Communist Party resides over free market prosperity in urban centers even as the heavily state-controlled countryside languishes in poverty. The result is a growing income gap between rural and urban Chinese, made visible by images of luxurious urban prosperity and rural destitution. Might the Communist Party be more interested in discouraging conspicuous consumption than raising revenue?

Topics: Tax


Wednesday, March 22, 2006

The Right Incentives?

The State of Florida just announced a new pay-for-performance program that ties teacher salary raises and bonuses to students' standardized test scores (the first such fully state-backed program). Proponents argue that subjecting American schools to competitive forces will encourage good teaching and higher quality schools. Florida governor Jeb Bush says a system that rewards teachers for improving student performance makes more sense than a system where higher pay is tied solely to academic degrees and years of experience.

Teacher unions and other opponents argue that the pay-for-performance program will fail Florida's students because test scores represent only part of teacher and student achievement. Additionally, teachers work with students of different abilities, making it difficult to fairly evaluate teachers who teach primarily lower-ability students. Standardized tests, they argue, do not measure the intangibles that teachers provide and adding a profit motive may skew the teacher-student relationship.

Remember, people respond to incentives. Steven D. Levitt and Stephen J. Dubner’s best-selling book Freakonomics explores how incentives can get knocked out of whack … even in education. Chapter 1 explores several scenarios (including teachers, sumo wrestlers, bagel sellers, and daycare centers) in which otherwise honest people find subtle ways of cheating because of the incentives they face. In one example, Dubner and Levitt investigate Chicago school teachers that face an economic incentive (sanctions for them or their schools) to improve student performance. They find that some teachers (about 5% in the Chicago sample) cheat by changing their students' answers. Understanding the incentives people face helps shed light upon their subsequent behavior.

1. According to the article, what is the salary supplement teachers receive if they fall in the top 10% of their teaching classification? How much does it amount to for a teacher earning the average Florida salary?

2. Might the incentives in Florida's pay-for-performance program foster the type of cheating Leviit and Dubner found in Chicago? Do you think this plan is a good idea?

3. In Chicago, teachers and schools faced a disincentive to poor student performance--they were punished if students did poorly. In Florida, teachers face an incentive to improve student performance--they get a cash bonus when students do well, but they don't get punished for sub-par performance. Will the positive incentive Florida teachers face encourage more honest behavior?

4. Many shareholder rights advocates suggest that tying executive compensation to the company’s performance is wise because it aligns the executives’ incentives with shareholders. How might this incentive structure create undesirable results?

Topics: Incentives, Education, Freakonomics

March Madness Inc.

Once some harmless fun amongst friends, NCAA basketball tournament betting pools have become a big business. CBS, who owns the tournament’s broadcasting rights, is in the midst of an 11-year, $60 billion dollar contract, whose size is likely related to the amount of betting interest in the tournament. But, down at the ground level, March Madness (or Bracketogy, or the Big Dance) has gripped American life, especially at the office. The “play-in” game Tuesday night may have started on-the-court action, but the real games began at 6pm ET on Selection Sunday when the brackets were announced.

According to Challenger, Gray, & Christmas, a Chicago-based consulting firm, about 58 million workers will fill out brackets for office pools, and the total cost of the tournament to employers could be nearly $3.8 billion in lost productivity.’s partnership with to provide free access to TV broadcasts of the first three rounds (56 games) won’t help matters at all. So, what are companies doing to prevent this productivity-sapping behavior?

Not a thing. According to Challenger, office pools help boost morale and many employers are taking an active role in the office pool biz. Office pools get people throughout the company involved, even those who work remotely or travel frequently. Some office pools require small buy-ins (under $10) and are winner take-all, others offer gift certificates to the winners, and still others offer days off and free meals. Employees at the Motley Fool investing site use the tournament brackets to create a fun new economy based upon basketball outcomes. All-in-all, Challenger encourages employers to take advantage of their employees’ excitement over the tournament and use that energy to offset the productivity lost due to following the games.

In the NCAA tournament, you catch a glimpse of the classic tradeoff employers face as they seek to maximize long-run value by balancing lost productivity during the tournament with the bolstering of employees' spirits and camaraderie, which will hopefully translate into long-run profitability.

1. An "efficiency wage" is an above-market wage that employers post in order to encourage workers to be more productive. In what way is employers' indulgence of workers goofing off watching basketball a form of an efficiency wage?

2. Is there an optimal quantity of distraction in any office environment? How can firms go about finding that quantity?

Topics: Efficiency, March Madness, Motley Fool

Tuesday, March 21, 2006

Unexpected Changes in Rates of Change

Opening up today's paper, you'd have thought something remarkable happened: "Inflation at the wholesale level plunged by the largest amount in nearly three years…much larger than Wall Street had been expecting."

But don't go reordering your portfolio quite yet. A few paragraphs down we learn that the core inflation rate, which disregards energy and food, actually rose by three times the amount analysts were forecasting.

A sensible human being could be forgiven for being confused at this point. Are prices going up or down? Or, are they growing, just at a slower rate? What about energy prices? Aren't energy prices amazingly high right now? Just what exactly is going on?

To parse this problem, think about a car's position, speed, and acceleration. Speed is the rate at which the car's position changes; acceleration is the rate at which the car's speed changes. In this analogy, the price level is akin to the position of the car; inflation is the rate at which prices change, so it's like the car's speed; and changes in inflation are like acceleration.

But there are many measures of inflation. The article mentions two: the overall PPI (Producer Price Index), and the "core" producer inflation rate, which is the PPI of all goods except food and energy. In order to get your head around these, think of the PPI as being the average position of two cars. The position of the first car is the wholesale price of all goods excluding food and energy; it drives along at a sensible, steady clip. The position of the second car represents just food and energy prices; it's volatile, speeding up and slowing down all the time, and sometimes going into reverse.

So what happened this last month? Well, the food and energy car went into reverse, while the core inflation car slowed down a bit. Analysts expected food and energy prices to go into reverse but not by so much. They also expected core inflation to slow down more than the amount it actually did.

1. Do you think it's better to think about the PPI (all inclusive) or the core inflation rate (exclusive of food and energy) when considering inflation? Why?

2. The article mentions the fact that this report may affect the Federal Reserve's thinking on interest rates. If you worked at the Federal Reserve, would this report make you more or less likely to raise interest rates?

3. Why are the prices of food and energy so volatile?

Learn more from the Labor Department's PPI News Release and accompanying data.

Topics: Inflation rate, Price index

Monday, March 20, 2006

Union and Student Protests in France

Student protesters and French unions continue to put up a stiff resistance to the government's labor reform proposals. This BBC article discusses the recent call for a day of strikes and protests. Aplia Econblog wrote about French labor reform in January. The post, copied below, discusses the economics behind the controversial reform proposal.

Dominique de Villepin, France's prime minister, wants to loosen job protection rights for young workers. Existing French labor laws make it difficult and expensive for French firms to fire workers. The laws intend to prevent companies from dismissing employees on a whim. But job protection rights have some unintended consequences as well.

To analyze the effects of the laws, imagine yourself as a French business owner. Suppose a young, inexperienced worker applies for a position with your firm. There's a 50 percent chance she will work hard and a 50 percent chance she will slack off. You might be less willing to take a chance on this inexperienced worker if you face high dismissal costs in the event that she's a slacker. In short, French laws designed to protect workers actually create a disincentive for businesses to hire young, inexperienced workers in the first place. Some argue that this accounts for the sky-high youth unemployment rate in France, which currently stands at 23%--and even higher among immigrant populations.

De Villepin's reform would allow companies to hire workers ages 26 and under on a two-year trial basis. If a young worker excels during the two-year trial, she gets a full-time contract and all of the job protection rights that come with it. But if she doesn't, the employer could let her go at no cost. De Villepin argues that these looser firing restrictions would encourage firms to hire more young workers, driving down the youth unemployment rate.

De Villepin is not the first to propose such reforms. Each time officials proposed youth labor reforms in the past, massive labor union and student protests derailed the legislation--de Villepin can expect more of the same.

1. In addition to job protection measures, France offers comparatively generous unemployment insurance payments and high minimum wages. How do these policies affect the market for inexperienced youth labor?

2. Would you classify the unemployment created by government legislation such as the minimum wage or firing restrictions as structural, frictional, or cyclical?

3. French officials defend job protection measures, arguing that job security makes workers happier, and therefore more productive. How might job protection measures affect worker productivity?

4. If you were a student in France, would you join the protests or endorse de Villepin?

Topics: Labor market, Unemployment, Structural reforms

Friday, March 17, 2006

Job Creation and the Unemployment Rate

A rise in the unemployment rate generally signals a weakening labor market and a weakening economy. A rising unemployment rate typically signals a recession. A falling unemployment rate typically signals economic expansion.

The Bureau of Labor Statistics (BLS) reported that the unemployment rate rose from 4.7% to 4.8% during February 2006. The BLS also reported that the economy created 243,000 new jobs during this same period. More new jobs coupled with a higher unemployment rate--what's going on? Most economists view the rise in the unemployment rate as temporary (Washington Post article). In fact, strong job growth might actually cause an increase in the unemployment rate. Understanding why requires us to look at how the BLS defines unemployment.

A person is unemployed if she is jobless AND actively sought work in the past 4 weeks. The labor force is the number of people employed plus the number of people unemployed. The unemployment rate is the number of people unemployed divided by the labor force. A person who is jobless but has NOT sought work in the past 4 weeks (because she gave up after failing to get a job), is jobless but NOT unemployed--they are not part of the labor force.

Suppose on February 1st, there are 100 people in the labor force and 5 people who are initially unemployed which implies a 5% unemployment rate. Mary, John, and William lost their jobs 4 months ago but stopped looking for work after 2 months of failed attempts. Mary, John, and William are jobless but not unemployed. The economy rebounds and 1 new job is created on February 15th. The job creation inspires Mary, John, and William to begin seeking work again on February 31st.

First, of the 5 people initially unemployed, only 4 will be unemployed because one new job was created. Second, 3 additional people who were not considered unemployed initially (Mary, John, and William) enter the labor force and are now unemployed. The new labor force equals 100 + 3 = 103 people and 4 + 3 = 7 people are unemployed which implies a 6.8% unemployment rate. Hence, the unemployment rate increases because people who were not part of the labor force enter the labor force, raising the number of unemployed people along with the size of the labor force.

1. If job creation continues in March, then would the unemployment rate increase or decrease? What if people continue entering the labor force at an unusually high rate?

2. Should jobless people who did not seek jobs in the past 4 weeks be considered unemployed?

3. Is the unemployment rate a good measure of the health of the economy?

Topics: Unemployment, Pitfalls, Job creation, Macroeconomics

The Wheels on the Bus Get Greased

Most people think public transportation is a great idea…for everyone else. For many car owners, the additional inconvenience of public transit is enough to keep them pumping gas and circling the block for a parking spot. But what if bus drivers were determined to pick you up on time, zip you off to your destination as quickly as possible, and compliment you on your sweater?

The thought is not so far fetched in Chile, where an inventive approach to bus driver pay reduces the slog of public transportation. The evidence from Chile's bus system reinforces the first principle of economics: People respond to incentives. In the case of Chilean bus drivers, people sometimes respond a bit too strongly. Read Austan Goolsbee's latest column to find out more.

1. How do most bus companies in Santiago, Chile pay their bus drivers? How does bus driver compensation affect delays? What about the number of people on buses?

2. What's a sapos? Would a bus driver paid by the hour place any value on the services of sapos?

3. What are some pitfalls of Santiago's bus system? What's the relationship between incentive pay for bus drivers and the number of accidents involving buses?

4. As Goolsbee points out, the problem with taking the bus is traffic congestion. Bad traffic gives people an incentive to take the bus, but slow buses give people an incentive to stick it out in the privacy of their own car--a vicious cycle. Goolsbee's column addresses one solution. Can you think of others? What about a gasoline tax?

Aplia's Econblog recently wrote about Gary Becker's musings on road fees as traffic decongestants. How might city road fees for individual cars improve the efficiency of the bus system?

Topics: Incentives, Unintended consequences, Traffic congestion

Wednesday, March 15, 2006

The Rise of the Licensed Workforce

Occupational licenses supposedly protect consumers from shoddy services by ensuring the service providers meet some standard of competence. No doubt licensed doctors make for safer appendectomies. But are your neighbors really safer if your state licenses astrologers? Are you more likely to lose a finger if your manicurist operates without a nail technician's license? Is your car safer with a licensed parking lot attendant?

Occupational licensing appears to be getting out of hand. According to Morris M. Kleiner, a University of Minnesota economist, roughly 5 percent of Americans worked in state licensed industries in the 1950's. The estimate for 2000? 20 percent. Alan Krueger's most recent New York Times column asks who, exactly, benefits from the increase in occupational licensing--consumers or the licensees?

1. According to Kleiner, why did state licensing increase during the past 50 years?

2. What does evidence from Kleiner's research suggest about the quality of dental and teaching services in states with strict licensing requirements compared to the quality of the same services in less stringent states?

3. What happens to the price and availability of a service, such as dentistry, when states adopt highly restrictive licensing standards? In other words, what effect do licensing requirements in a labor market have on the final product market?

4. How is a manicurist licensing regime similar to a manicurists union? How is it different?

5. What measures does Alan Krueger suggest to ensure that occupational licenses provide useful signals to consumers? What does Morris Kleiner suggest as an informative alternative to occupational licensing?

Topics: Barriers to entry, Links between resource and product markets

Electoral College Daze

The Electoral College, the system by which presidents are elected in the United States, is over 200 years old--according to an editorial in yesterday's New York Times, it's time for a change. The Times argues for the end to the Electoral College on two grounds: (1) that it runs counter to the democratic principle of "one person, one vote," and (2) that it distorts the incentives of both politicians and voters. The first argument is normative-- it deals with how the voting system should work. The second is positive--it deals with how the electoral college affects elections and policy. Economists devote a great deal of research to the second point.

Economists assume that people respond to incentives, and incentives explain much of the behavior we see in competitive marketplaces. It may seem odd that economists should try to model politics. But the political marketplace is similar to any other: sellers (politicians) are competing for support from buyers (voters). Just like sellers everywhere, they research consumer preferences (polls, focus groups) and they advertise their product in an effort to woo as many buyers as possible.

How does the Electoral College play into this? The central problem of a presidential campaign is how to use three major scarce resources--time, money, and political position. Candidates increase their chances of winning by allocating their resources in the most effective way possible. Under the Electoral College system all of a state's electoral votes go to the candidate who wins the most votes in the state. If a state is reliably in one political corner or another, candidates get little marginal benefit from using resources to campaign in that state. For example, neither presidential campaign spent very much time or money in Texas (the home state of George W. Bush) during 2004.

The editorial also points out that the Electoral College system dampens voter turnout, because voters in non-competitive states feel (correctly) that their vote has a minimal chance of affecting the outcome.

1. Think of the television show "Survivor," in which contestants vote each other out of the game. How do the voting rules in that game affect people's decisions about whom to vote for?

2. Presidential candidates actually have to be elected twice: once in the primary by members of their own party, and once in the general election by the whole country. How do they allocate their scarce resources of time, money, and policy positions differently for those two elections? How have changes in the rules by which parties select their candidates affected the kind of candidates who succeed in the primary phase? Would a change in the rules for the general election affect the kind of candidates each party nominated?

3. The Times editorial proposes replacing the Electoral College with straight majority-rule voting. Is that the most efficient way to elect a president? Is it the fairest?

Topics: Political economy, Voting rules

For interested students, there have been many research papers published in the last few years, many of which are quite readable. Economists Nicola Persico and Alessandro Lizzeri showed in a 2001 paper in the American Economic Review how an Electoral College system results in the underprovision of public goods, because politicians don't find it electorally useful to propose public works projects in noncompetitive states. On the other hand, Andrew Gelman, Jonathan Katz, and Francis Tuerlinckx found that voter turnout may actually be higher under the Electoral College because individuals have a higher chance of affecting their own state's outcome than the outcome of the country at large--and under the Electoral College, a shift in an entire state's vote can be decisive.

Also, for a neat interactive map of how the Electoral College works, click here, then click on "electoral votes."

Thursday, March 09, 2006

Steal This Signal

A recent New York Times article discussed how seemingly benign wireless free-riding can turn into a full blown "tragedy of the commons."

Suppose you live in an apartment complex with lots of neighbors. You purchase a wireless router that allows you to surf the web on your laptop from anywhere in your apartment. Unfortunately, your neighbors can use your connection too. They start to realize this, and soon the whole building is free-riding off your connection. Your internet connection slows to a crawl.

In the usual tragedy of the commons story, too many sheep on common grazing land render the land unusable. Like the common grazing land, the wireless service provided by your router is a common resource, a term economists use for a good that is "nonexcludable" (you can't prevent others from using it) but "rival" (one person's use of it diminishes other people's ability to use it.)

Often, the same good (in this case, wireless access to the internet) can be categorized in different ways. If you secure your network with a password, then the service becomes excludable. You could, in principle, sell the right to use your internet connection to your neighbors. In this case the service is a natural monopoly, kind of like cable TV. If only a couple of your neighbors turn out to be free loaders the speed of the service won't be affected, and your wireless service will resemble a public good--neither excludable nor rival.

1. According to the Times article, what happened to Christine and Randy Brodeur before they wised up and secured their wireless network?

2. How many of the wireless networks did the 2004 survey log in Los Angeles? Of the networks they logged, what fraction was actually secured?

3. At what point does an unsecured wireless network become rival in consumption? At what point does your failure to secure your wireless network become a tragedy of the commons--overuse of a common resource?

4. Would requiring wireless network users to secure their networks with a password prevent the common resource problem the Brodeurs experienced?

Interested in the issue of wireless piggybacking? The author of this New York Times op-ed thinks it's a bit sensational to equate wireless free-loading with most cases, anyhow.

Topics: Natural monopoly, Public goods, Common resources, Tragedy of the commons

Wednesday, March 08, 2006

Deal or No Deal

The television show "Deal or No Deal" has gained enormous popularity in recent weeks, winning the avid attention of millions of viewers--and economists.

The game show has simple rules: a single contestant must decide, in up to nine rounds, whether to accept a "bank offer" of a specific amount of cash, or to accept the result of a well-defined lottery. This simple structure makes an economic analysis of contestants' decision-making process unusually feasible.

This National Public Radio segment describes how University of Chicago behavioral economist Richard Thaler, together with a team of researchers from the Netherlands, has analyzed results from 53 episodes of the show. (You can download the academic paper here. The math gets a little heady, but the bulk of the paper is quite readable.)

Behavioral economists like Thaler are interested in how psychology plays into people's economic decision-making processes. The kinds of behavior observed in contestants on a game show, or students in an economics lab, often provide insight into phenomena that affect financial markets and other more "traditional" economic arenas. For example, Thaler and his co-authors find an interesting result in the data: that the more unlucky a contestant is early on, the more he or she is likely to engage in risky behavior in later rounds to achieve a psychological "break-even point." Thaler describes in the NPR piece how this behavior is also observable among mutual fund managers, saying that those "who are trailing their benchmarks in the fourth quarter take on more risk than those who are ahead of their benchmarks."

1) People are often willing to pay for car insurance, even though the expected loss they would incur in a year is less than the amount they have to pay in premiums. Given a choice between taking $10,000 for sure and a 50% chance of $20,000, what do you think these people would do? Do you think that would change if they were on a game show?

2) Suppose you're playing a game like poker or blackjack. You start out with $100 and lose $80 of it. Would you walk away from the table? What if you had gained $80? How might your own behavior in such an environment shed some light on financial markets?

3) One class of behavioral economic models is called "bounded rationality." Rather than assume people are rational, it assumes that they are irrational in some specific way. For example, consider two identical contestants facing a choice between $10,000 for sure and a 50% chance at $20,000. For one of them, this is the first offer they are given. For the other, this offer comes just after losing a chance to win $1 million. Despite the fact that the two face identical problems now, according to Thaler, the one who lost the chance at $1 million may be more willing to take the gamble because their recent loss puts $10,000 in a different perspective. What other kinds of economic phenomena do you think this kind of analysis would help to illuminate?

P.S. For students interested in doing a bit more (ahem) research into the game, you can play an online version of it here.

Topics: Risk and uncertainty, Behavioral economics, Bounded rationality

Friday, March 03, 2006

And You Thought Applying to College Was Hard

Imagine going to Yale for your undergrad, Harvard for your master's, and then having to write the most competitive application essay of your life--for your 18-month-old.

For years, the child population of New York City was in decline, and the number of preschools similarly declined. Recently, however, the number of children has risen by over 25% in the past five years, causing a massive shortage in the preschool market. This article in the New York Times details some of the effects of the shortage, which illustrate many of the same effects that we learn about in our principles of economics course:

  • The price of preschool has risen to over $10,000 per year for a three-year-old.
  • Consulting firms have arisen to help parents place their children in preschools.
  • Parents are asked to write essays, interview for positions, and pay steep application fees.

Can you interpret the article using an economic model? Here are some steps to get you started:

1. Draw the supply and demand for preschool slots in 2000. Then draw the same curves for 2005. Did one or both curves shift? What is the effect on price and quantity?

2. What happens to preschools' profits during a baby boomlet? What effect does this have on the number of preschools that are operating? Show the long-run effect of these higher prices in your supply and demand curves above.

3. We learn in principles of economics that competitive markets allocate goods and services to those with the highest willingness to pay. Is that the case when there is a shortage? What mechanisms mentioned in the article do preschools use to ensure that they offer their slots to the parents who are willing to pay the most?

4. Suppose New York City decided that poor parents were unable to afford daycare, so they put a price cap on preschool at $5,000 per year. What would the effect on the market be?

Topics: Supply and Demand, Equilibrium, Shortage