Friday, May 26, 2006

Saving Early

Countless surveys and reports show that a majority of Americans, regardless of age, are woefully financially illiterate. The U.S. personal savings rate has been steadily declining over the past decade, even turning negative in 2005. According to many pundits, the problem is that youngsters are not learning financial responsibility and the importance of saving for the future. These bad habits follow them as they get older.

To fight this trend, some schools are promoting financial literacy at a young age and even starting savings banks. At Sunrise Valley Elementary School in Fairfax, Va, students operate the Sunrise Valley Savings Bank, a school branch of a local bank. There is no minimum balance and student deposits earn 5% annual interest.

Elsewhere, educators and financial institutions have sprung into action, teaching kids about basic money management skills. Indirectly, students will be learning about the power of the time value of money. The TVM is a central topic in finance and revolves around the concept that a certain amount of money received today is worth more than the same amount received sometime in the future. A variety of factors including inflation and the choice to consume or save play a role in this.

The basic TVM equation solved for future value: FV = PV (1 + r)n, where PV is the present value of the amount, r is the interest rate, and n is how long the amount is invested. The story mentions how a ten-year-old student, Nate, is depositing a $5 bill. If Nate continues to earn 5% on his savings until he retires at age 65, that $5 deposit will be worth $73.18, doubling nearly four times. If Nate continues his practice of saving $2 a week until he retires, he would have $30,414 when he retires. This is a slightly more complicated calculation, because there is a periodic payment being made, but trust me it’s right!

1. Near the end of the article, 11-year-old student William says he wants to buy a new skateboard. What is his opportunity cost of saving for a new skateboard?

2. The Sunrise Valley Savings Bank pays its members 5% interest, but it is reasonable to assume students will get higher returns for their money in the future. How much will Nate’s $5 deposit be worth in 55 years if he earns 6% interest? 8%? 10%?

3. To see the importantce of teaching youths to save early, access this savings calculator. If a 10-year-old student saved $1 every day and deposited $365 at the end of each year from now until retirement (at age 65), how much would he/she have at retirement in 55 years? (Hint: Starting amount = $0; Years = 55; $365 additional contributions made annually; and a 10% rate of return compounded annually)

4. Use trial-and-error with the savings calculator to see what annual contributions another student would have to make if he/she didn’t start saving until the age of 55 (ten years from retirement) and wanted the same ending amount. (Hint: Change Years to 10 and try different values for additional contributions until you have about the same ending amount.)

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Thursday, May 25, 2006

Your First Job Matters More Than You Think

If you've just graduated (or are about to) and you have not received a job offer, then you are most likely in good company with many other graduates your age. If so, then frequent trips to your university's career center, searches on, and job interviews will be a large part of your summer.

Austan Goolsbee, an economist at the University of Chicago, asks college graduates to choose their first full-time jobs wisely. Professor Goolsbee summarizes several recent economic papers on the short-run and long-run consequences of graduating in a recession. It is not surprising that graduates in a recession receive lower-paying jobs than graduates in an economic expansion, because there are fewer jobs and even fewer high-paying jobs in a recession than in an economic expansion. However, what is surprising is that recession-graduates perpetually earn less than expansion-graduates over the next ten years!

According to Goolsbee:
The recent evidence shows quite clearly that in today's economy starting at the bottom is a recipe for being underpaid for a long time to come. Graduates' first jobs have an inordinate impact on their career path and their "future income stream," as economists refer to a person's earnings over a lifetime.
In other words, where you start off your career will greatly impact where you end up. Economists call this "path dependence."

1. In a recession, few high-paying jobs are available to college graduates. If you graduate in a recession and settle for a job that pays $30,000 per year, then what stops you from switching to a high-paying job when those jobs become available during an economic expansion?

2. Suppose Chris graduated from Berkeley with a 3.5 GPA in 2001, during a recession. Unable to find a high-paying job, he worked as a waiter for a few years while the economy turned around. When the economy recovered, he applied for a job with a major consulting company. Why might that consulting company hire a new Berkeley grad with a 3.5 GPA rather than Chris?

3. Suppose you have two job offers when you graduate: one as a research assistant for a professor, and another as a lab technician for a pharmaceutical company. The two jobs pay the same amount. What would you expect your career path and future earnings to be if you took the research assistant job? The lab technician job? Which of the two jobs would be harder to get in a recession?

Topics: Labor markets, Unemployment, Costs of business cycles

Thursday, May 18, 2006

Venezuela's Non-Paradox of Value

While U.S. drivers cope with $3.00 a gallon gas prices, people in Venezuela are paying only $2.30. No, not $2.30 a gallon--$2.30 to fill a 19-gallon gas tank.

At 12 cents a gallon, Venezuela has the cheapest gas in the world thanks to government subsidies and President Hugo Chavez's vow to keep gas prices low. In fact, gas in Venezuela is cheaper than mineral water, a seeming violation of the Paradox of Value. The paradox describes the contradiction existing when many goods needed to sustain life have little economic value, while luxury items unnecessary for survival have very high economic values.

The classic illustration of this paradox is the disparity between the value of diamonds and water. Compared to diamonds, water is nearly worthless, yet you cannot survive without it. Meanwhile, diamonds have only aesthetic value and represent conspicuous consumption. In other words, water has high “use” value and low economic value, while diamonds have low use value and high economic value.

1. How does the paradox of value pertaining to water and petroleum hold elsewhere in the world, but not in Venezuela?

2. How does the scarcity question factor into the paradox of value?

3. Where else can the paradox of value be seen? (Hint: Think about the labor market.)

4. If Venezuela were to lift subsidies and let gas prices rise to a market-determined level, what economic and social effects could this have in Venezuela?

Topics: Paradox of value, Scarcity, Marginal utility, Subsidies

Wednesday, May 17, 2006

Sony Turns Up the Volume

When is a bad idea a good idea? Consider "loss leaders," where stores sell products below cost to lure consumers in to buy the sale item and then get them to purchase other stuff on which there is a higher profit margin. How about free cell phones when you sign a service contract?

Sony's announcement of its new Playstation 3 provides another example. Last Tuesday, Sony announced the release date and pricing for PS3. At $499 for the basic model, the PS3 runs about $100 more than the price of Microsoft's Xbox 360. Even so, rumor has it that Sony will take a big hit on the PS3. An article from Cnet reports production costs for the PS3 at $700 to $900 per unit. (See Cnet's breakdown of costs.)

So how can losing $200-$400 on every unit make sense for Sony? It all depends on the popularity of the PS3. Product development is risky and sometimes produces costly failures. These numbers do not represent long-run average costs, and the $700 probably includes some development costs. The Cnet article notes that unit costs drop rapidly after product introduction. Since product configuration does not change after introduction, as output ramps up, Sony can expect rapidly falling component costs. Sony should be able to negotiate volume discounts for the parts and, as with most electronics products, the cost of these parts should fall over time. So, there are large startup costs but marginal cost falls as production increases. This is a common phenomenon. Cnet's sources indicate that component costs should fall to $320 after three years, which would provide a handsome margin on each PS3--nearly $200 per unit--assuming flat pricing on the PS3.

But how else could they make money?
  • Game console producers make a lot of money from the games for these systems--either through their own production or through licensing. So if Sony can break even on the PS3 console, it can still make a killing from game sales if the PS3 wins the battle of the new game systems. These can be considered tie-in sales.

  • Sony has bundled a Blu-ray DVD player into the PS3. Blu-ray is one of two competing formats for high-definition DVDs (the other is HD DVD). Sony is betting a lot of money that Blu-ray will be the dominant format for the next generation of high-definition disks. A successful PS3 would tie lots of consumers to the Blu-ray DVD format, and improve the chances of the success of this standard, which would spill over to sales of other equipment. One could call this a type of network externality.
So, selling for an initial loss may not be a losing proposition after all.

1. Could Sony be successful--win the game system battle with Microsoft--and lose the war? How?

2. When discussing loss leaders, the presumption is a product sold below cost. Which costs are we talking about: average cost, marginal cost, or some other cost?

3. Presumably our discussion implies that Sony expects to work its way down its long-run average cost (LRAC) curve. What factors affect its ability to do this? Why would Sony's production costs fall as the scale of its PS3 production increases in the long run?

4. The information indicates that production costs would fall by at least 50% over a three-year period. Is this a short enough time period for Sony to benefit from these reductions? What would the expected product life be for a game system like the PS3? What happens to the price of these systems over the product life cycle?

Harold Elder is a Professor of Economics at the University of Alabama. His research and teaching focuses on applied microeconomics, including law and economics, public sector economics, and a range of public policy topics. He regularly teaches Principles of Microeconomics in the College of Commerce and Business Administration and is the advisor for his university's Masters and Ph.D. programs.

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Monday, May 15, 2006

Canadian Dutch Disease?

Strong demand for Canadian commodities begets strong demand for the loonie--the nickname for Canada's loon emblazoned dollar. For foreigners to buy up Canadian oil and timber they must first convert their home currency into loonies. As demand for Canadian dollars rises, the loonie appreciates against foreign currencies. That is, the price of the loonie rises--from, say, US$0.60 per C$1 to US$0.90 per C$1.00. Notice that the loonie's rise is not-so-great news for Americans who want to buy Canadian goods and services. Before the appreciation, a loonie costs only 60 cents; after the appreciation, a loonie costs 90 cents. Canadian manufacturing and services sectors, dependent on exports to the United States, may catch the Dutch disease if the loonie continues its lunar trajectory.

Dutch disease infects countries with large natural resource sectors. Strong international demand for commodities (such as oil and timber) increases the exchange rate and effectively reduces the demand for manufacturing and services exports. A stronger loonie makes Canadian exports less attractive to foreigners, particularly Americans. The strong loonie reduces manufacturing and service exports with negative short-term consequences for the Canadians who find themselves out of work as the sectors contract. According to a recent New York Times article, the prospect of parity with America's greenback (an exchange rate of US$1.00 per C$1.00) has Canadian manufacturers and policymakers on edge. The questions below examine additional factors behind the loonie's rise as well as Canada's policy options.

1. A strong loonie reduces manufacturing exports and consequently reduces manufacturing jobs. What percentage of Canadian output do Canadian manufacturers export? Of that, how much goes to the United States?

2. According to Benjamin Tal, a Toronto-based economist, how many manufacturing jobs will the rising loonie wipe out in 2006? Which Canadian industries are simultaneously creating jobs? Is Canada experiencing a net loss or gain in job creation?

3. According to Tal, the rapid appreciation of the loonie "…is much too difficult to swallow for a manufacturing sector that has relied on this subsidy for decades." In what way is a weak loonie a "subsidy" for Canadian manufacturing exporters?

4. Why does Mr. Tal feel that the Canadian dollar will not reach parity with the U.S. dollar?

5. Canada's central bank--the Bank of Canada--can influence the exchange rate through monetary policy. By increasing interest rates, the central bank makes it more attractive for foreigners to buy Canadian bonds, increasing the demand for loonies in the foreign exchange market. Higher interest rates also encourage Canadians to substitute away from foreign bonds towards domestic bonds, decreasing the supply of loonies in the foreign exchange market. By raising interest rates, the Bank of Canada makes the loonie stronger.

Suppose the Bank of Canada reduces interest rates. Would the loonie appreciate (increase in value) or depreciate (decrease in value)?

6. The article mentions the current strength of the Canadian economy (low unemployment, relatively high GDP growth). During economic expansions central banks focus their efforts on sustaining growth without igniting inflation. Recent interest rate hikes by the Bank of Canada suggest monetary policymakers are at least somewhat concerned by the possibility of inflation.

Suppose the Bank of Canada decides to weaken the loonie in an effort to reduce the losses to the Canadian manufacturers. Will the Bank still have control over its domestic goal of low inflation?

Want to read more on this topic? Stephen Gordon, an economist at l'Université Laval in Quebec City, Canada, does not see Dutch disease in Canada. In an April 13 blog post, he points to rising output in the Canadian manufacturing sector--even as the Canadian dollar appreciates and manufacturing employment falls. In his view, rising manufacturing output and strong employment growth elsewhere in the Canadian economy explain the Bank of Canada's reluctance to reign in the loonie thus far.

Topics: Exchange rates, Monetary policy, Open-economy macroeconomics

Wednesday, May 10, 2006

Are the Bush Tax Cuts Progressive? You Make the Call.

It all started with an op-ed in the Wall Street Journal by Edward Lazear and Katherine Baicker, which stated, in part, that "the president's tax cuts have made the tax code more progressive."

Lazear is a Stanford economics professor who took over as the chairman of President Bush's Council of Economic Advisers after the president nominated the previous chairman, Ben Bernanke, to head up the Federal Reserve. Before Bernanke, the post was held by N. Gregory Mankiw of Harvard University. Soon after the op-ed hit the pages, Mankiw explained on his blog why it's difficult to say whether a tax cut makes the tax code more or less progressive:

There are two people. A rich guy earns $200,000. A poor guy earns $20,000. At first, the rich guy pays $50,000 in taxes, and the poor guy pays $1,000. Then a new President takes office and cuts the rich guy’s taxes to $48,000 and the poor guy’s taxes to $800.

Who is getting the better deal?

  • You could say the rich guy gets the better deal: The rich guy gets an extra $2000 in take-home pay, while the poor guy gets only $200. After the tax cut, the difference in take-home pay between the two guys is larger.
  • You could say the deal is evenly balanced: Everyone gets to keep an extra 1 percent of his income.
  • You could say the poor guy gets the better deal: The poor guy gets a 20 percent tax cut, while the rich guy gets only a 4 percent tax cut. After the tax cut, the rich guy pays a larger share of the total tax burden.

It is impossible to say on purely economic grounds which of these
perspectives is better. All of these statements are mathematically correct, even
if they leave the reader with a very different impression.

Not so fast, replied Berkeley economist Brad DeLong on his blog:

Let me try an analogy. I, full professor Brad DeLong, am having lunch with lecturer Dariush Zahedi today. After lunch, I presume Dariush will say we should split the bill--$10 each. Suppose I say: "That isn't fair. Berkeley pays you less (a lot less: what we do to our lecturers is shameful) than it pays me. I should lay out more cash for this lunch. How about this: I put down $5 cash, you put down $0, and we put the balance on your credit card. That would be fairer, wouldn't it?"

Dariush would then be an unhappy camper. He would think--correctly--that I was mocking him.

[The U.S. is] running a deficit of $300-$400 billion a year…That bill will come due: somebody has to pay it. To pretend that it won't--to pretend that you can talk about the progressivity of the burden of paying for the federal government without talking about the long-run incidence of the national debt--well, that would be the equivalent of me telling Dariush that only cash matters: that when we talk about who paid for lunch, we should count only cash put down now, and we shouldn't count the fact that his credit card bill will show an extra $15 due next month.

Is one of these economists right, and the other one wrong? It's not that easy, and understanding why is important. As with any economic question, the answers depend on the model you choose to analyze the situation at hand. Mankiw's model is static: a given tax cut within a given time frame may be viewed as progressive, neutral, or regressive. DeLong's model is dynamic: the overall progressivity of a tax cut depends not only on its effect on income today, but on its effect on future incomes as well. Both economists take their respective models to their appropriate conclusions.

The debate is not, therefore, over whether Mankiw and DeLong make incorrect statements, given the models they choose for their analysis--they're both far too smart to do that. Instead, the debate is over who has chosen more appropriate assumptions. In other words, which story--the one about the two guys who receive tax cuts, or the story about the two professors at lunch--is more useful in analyzing the progressivity of the Bush tax cuts?

Having said all that, it's also important to understand how each economist is "stacking the deck" in the choices of numbers he makes in his model. To illustrate this, think about the following two questions.

1. In Mankiw's example, tax revenues are reduced by a total of $2,200. Mankiw chooses to show the case in which that split is $2,000 from the rich guy and $200 from the poor guy. How would his analysis change if that split were different--say, $2,100 from the rich guy and $100 from the poor guy, or $1,100 from each? Would it become less ambiguous as to whether the tax cut were progressive or regressive? (In other words, while it may be difficult to say whether the Bush tax cuts are progressive or regressive in absolute terms, is it possible to say that other policy options would have been more progressive or regressive?)

2. DeLong argues that Mankiw ignores the long-run incidence of the national debt. The "incidence of the debt" simply tells us who pays the credit card balance. In DeLong's example, the poor lecturer gets stuck with the whole credit card bill. That's like assuming that future taxes are more likely to be borne by the poor than the rich. How would DeLong's argument be altered if the rich paid more of the future taxes? For example, suppose we started out with a "progressive" split: DeLong pays $12 and Dariush pays $8. DeLong suggests that instead, Dariush should pay $6 now and put $1 on his credit card, and DeLong will pay $8 now and put $5 on his credit card. This yields a more regressive split of cash (DeLong pays 1/3 less cash and Dariush pays 1/4 less cash), but a very progressive allocation of debt.


The two articles cited above have ignited a small firestorm on the internet. Here are just a few of the greatest hits.

Brandon Berg responded to Mankiw, arguing that his first two postulated methods of measuring progressivity of a tax cut are flawed because "they both allow us to eliminate the poor guy's tax burden altogether while making the system less 'progressive.'"

Jane Galt responded to DeLong, aruging that when the tax bill comes due, she finds it much more likely, in a political sense, that taxes will be raised on the rich to pay for it. (DeLong responded to her, briefly, suggesting that her argument implies that Bush is a "redistributionist mole"-- a scenario he doesn't feel is very likely.) PGL of Angry Bear pointed out that Galt's point was analyzed in a paper entitled "The Ultimate Burden of the Tax Cuts" by William Gale, Peter Orszag, and Isaac Shapiro, who argued that while it is true that future burdens are more likely to be borne by the rich than the poor,
...the [Bush] tax cuts scale back (or even eliminate) many of the most progressive elements of the federal tax system, including the estate tax, the taxation of capital gains and dividends, the top income tax rates, and the phase-outs of certain exemptions and deductions for households with high incomes. It is unlikely that any method of financing those changes, other than repeal, will be as progressive as the tax provisions that have been scaled back.
Mankiw then addressed Galt and DeLong with a long post entitled "The Progressivity of Budget Deficits," concluding that "saying whether and why deficits are undesirable requires judgments that are more philosophical than economic."

Jason Furman wrote a letter to the Wall Street Journal saying that regardless of the niceties of these arguments, the numbers in the case of the Bush tax cut are clearly regressive:
According to the Tax Policy Center, the tax cuts passed since 2001 have raised the after-tax income of the top 1% of Americans by 5%, while raising the after-tax income of the bottom 60% of Americans by just 2%. In other words, the tax cuts have contributed to widening, not narrowing, the difference in take-home earnings.
Mankiw responded to Furman with a detailed mathematical analysis.

I'm sure that this debate will continue...

Topics: Public finance, Taxes, Equity, Model selection

Tuesday, May 09, 2006

Banking on Gas Prices

Consumers across the nation continue to struggle with skyrocketing oil and gas prices, but some have found an answer with the First Fuel Bank. Drivers can buy gas at an agreed upon price, even though they will not consume those gallons immediately. In effect, they have deposited gallons in the fuel bank, which can be “withdrawn” as they see fit.

This arrangement sounds like an open-ended forward contract on gas. A forward contract is a two-party agreement to exchange an asset at an agreed upon price at a specific date in the future. However, in this case there is no specified date and an option component allows the consumer to “exercise” this forward incrementally as they wish.

Suppose Brooke, a customer, buys 300 gallons at $3.00 a gallon today. Brooke now has the option to buy gas at $3.00 a gallon at any point in the future. If the current market price dips below $3.00, Brooke will simply buy gas at the current, or “spot,” price and leave her gas bank balance alone. Having this choice makes it sound like holding an option, but Brooke has already paid for the gas and exchange will occur at some future date. This fact makes it more of a forward than an option.

1. The article says there are no additional service fees for the transaction (a $1 lifetime membership fee aside). What incentive do retailers have for selling future gas at today’s prices?

2. If gas prices six months from now hit $3.50, how much does Brooke profit by filling her 15 gallon gas tank and using her “gas account”?

3. Suppose gas prices fall below $3.00 for a couple of years and then rise back to $3.20 in three years. When Brooke taps into her “gas account” to fill up her tank, how much does she profit? Are there additional costs at play here?

4. Retailers are committing themselves to supply gas at potentially very low prices in the future. Is there a default risk on their part?

5. If the current price exceeds your locked-in price, do you always want to use your account, or are there cases where you would go ahead and pay the current price?

Topics: Finance, Gas prices, Forward contracts, Incentives

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Monday, May 08, 2006

The Economics of Information (Or the Lack Thereof)

The supply and demand model is great for describing markets where lots of buyers and sellers have good information about the standardized product they're haggling over. Of course, people don't always have good information. Take the market for health insurance. There are lots of buyers and plenty of health insurance providers, but buyers have quite a bit of inside information about how healthy they are--much more than the insurance companies trying to assess the health risks of prospective clients. In highfalutin econspeak, information in insurance markets is located asymmetrically. Translation: buyers know more than sellers. Does the supply and demand model do a good job of describing markets where some participants lack good information?

In 2001, George Akerlof, Michael Spence, and Joseph Stiglitz won the Nobel Prize in economics* for their work examining that very question. Their answer: not so much--markets fail to work as well as supply and demand would predict if buyers or sellers lack good information. To paraphrase Joseph Stiglitz: Adam Smith's invisible hand isn't just invisible in markets with poor information--it's not there at all.

In a recent column, Tim Harford writes about the lessons from Akerlof's seminal 1970 paper, The Market for Lemons. The paper explores a market rife with information problems about quality and reliability--the market for used cars. Read Harford's column to see how a bit of bad information can cause a big market failure.

1. How can low prices in the market for used cars reinforce the worst fears of prospective buyers?

2. If potential sellers of high-quality used cars can't successfully convey information about their cars to buyers, what types of cars are most likely to show up in the used market?

3. How have economists attempted to test Akerlof's idea in the market for used pick-up trucks?

4. Some web services allow you to buy title histories for used cars--that is, good information is available but costly to acquire. How does information technology change information problems in the used car market?

5. As part of their contribution to the economics of information, both Michael Spence and Joseph Stiglitz explored the way firms and individuals deal with information problems in labor markets. How might an information-poor job market come to resemble the market for lemons Akerlof describes? Think about the job application process. How would you signal to employers that you won't be a lemon of a worker? How can employers screen potential employees to reduce their chances of hiring a lemon? For example, could a firm attract a richer pool of job candidates by advertising above average wages? How might above average wages change the work habits of a firms employees?

*The Nobel Prize in economics is the highest honor in the field, but it's actually called the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. Alfred Nobel didn't establish the economics prize in his will--Sweden's central bank created the award in his honor.

Topics: Market for lemons, Asymmetric information, Signaling, Screening

Friday, May 05, 2006

The Business of Doing Good

A recent BBC news article examined a growing movement in the business world to help solve some social ills. The article notes that charities responded to the perils of industrialization during the 19th century, but today social entrepreneurship is being hailed as their possible successor.

Social entrepreneurship means using business approaches to examine societal problems, and it is starting to garner media attention and consideration from business schools. The most prominent academic social entrepreneurship program is Oxford's Skoll Centre for Social Entrepreneurship, named for Jeff Skoll--former eBay president and founder/chairman of the Skoll Foundation. The director of the Skoll Centre notes that social entrepreneurship differs from charity, because it is a more active way of addressing social problems, seeking resolution, and moving on to the next problem.

The Skoll Foundation website identifies social entrepreneurs as those who “share a commitment to pioneering innovations that reshape society and benefit humanity.” The foundation invests in social entrepreneurs who tackle a wide range of issues including: world health, the environment, and human rights.

1. In most economic and financial theory, firms and individuals are motivated by profits. What motivates firms and individuals who are social entrepreneurs? Can non-profit organizations be efficient?

2. Adam Smith contended that society is best off if each individual acts in his own best interest, because resources will be allocated efficiently. How is Adam Smith’s contention consistent or in conflict with social entrepreneurship?

3. The Skoll Foundation bestows grants to non-profit organizations that it feels have the greatest potential to benefit society. What implications does this have toward competition? Is this a good model?

Topics: Social entrepreneurship, Competition, Invisible hand, Incentives

Wednesday, May 03, 2006

Driving Green

Suppose you're in the market for a new car. With the average gasoline price hovering around $3.00 per gallon, buying a hybrid vehicle might seem like the best way to go. Sure, the price of a Toyota Prius or Honda Civic Hybrid might cost more than their gas-guzzling counterparts, but the gas savings and tax credits offset the "green premium." Right?

Think again. Reuters reports that, despite sharply increasing gasoline prices, many hybrid vehicles are staying on car lots a lot longer than expected. And Kiplinger shows that, even in the course of five years, buying a hybrid vehicle might actually be more expensive than buying the gas-guzzling equivalent.

Suppose you want to buy a hybrid and you're going to give it to your son or daughter after five years. You should purchase a hybrid vehicle if and only if the benefits outweigh the costs. The benefits of a hybrid over a non-hybrid include an end-of-year $2,000 tax credit and gas savings accrued over the five years. The hybrid’s costs include an extra $5,000 up-front at the dealership.

We will assume gas sells for about $3.00 per gallon for the next five years, and that you will drive about 12,000 miles per year. If your traditional, non-hybrid car gets 25 miles per gallon and the hybrid will get 20 more miles per gallon, is it worth it to purchase a hybrid?

The cash flows from purchasing the hybrid vehicle rather than the gas-guzzling equivalent are shown below:

At first glance, the hybrid saves you $200 over five years, but that is deceptive because it does not account for the time value of money. If you could earn a 10% annual return investing in a high performing stock index fund, the tax credit and gas savings are worth less than what they appear. In order to calculate the hybrid’s net benefit, we must consider the time value of money, which says $1 today is worth more than $1 tomorrow, because $1 today can be immediately invested to earn a return.

The following shows the present values of the cash flows from purchasing a hybrid vehicle rather than a non-hybrid.

Net Benefit = -$756

Under these assumptions, you are better off buying a traditional car than you are buying a hybrid.

1. What if you drove 16,000 miles per year; is it worth it to buy the hybrid vehicle?

2. Driving a traditional gas-powered car imposes a negative externality (pollution) on the community. How do externalities affect your decision making?

3. Currently, there are only a few hybrid vehicles available in the market. If automakers such as Honda, Toyota, Ford, General Motors, Volkswagen, and Daimler-Chrysler realize that there are unexploited profits to be made in the hybrid vehicle market, how would this affect the premium you pay for a hybrid? If the "green premium" decreases, how would this affect the net benefit of buying a hybrid?


Topics: Finance, Externalities, Time value of money, Invisible hand, Cost benefit analysis

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Tuesday, May 02, 2006

Maximizing the Bagel Dollar

Economics textbooks tend to use simple businesses to illustrate economic theory. For instance, Greg Mankiw’s Principles of Economics uses a bagel shop to illustrate how production costs change as bagel sales increase or decrease. And when it comes to maximizing profits, the standard texts tell us that businesses should price at or above marginal cost.

In a new paper, Freakonomics author Steve Levitt follows up on his study of an innovative bagel business. The business worked on an "honor system." Its owner, Paul F., would leave bagels in a basket at workplaces everyday and ask those who took bagels to leave a payment. It turns out that many workplaces were quite honest and the business has thrived for over 20 years.

In the new paper, Levitt takes the wealth of data from the bagel business and uses it to see whether Paul maximizes profits. Paul's business is ideal: he sells only bagels and donuts, his costs are well known, he understands the demand curve he faces (Paul can see how many bagels and donuts are left unsold each day), and Paul himself was once an economist. If there ever was a business that would be profit maximizing, it's Paul's.

When demand jumps around from day to day, maximizing profits involves doing two things.
  • Get Quantities Right: The first thing a firm must do is make sure that, for the price they are charging, the quantity of bagels matches that demand at that price. It is easy to see that mistakes could lead to stock-outs (shortages) or left-overs (surpluses) [the RED arrows in the figure] Both are costly in terms of lost sales or over-production.
  • Get Prices Right: The second thing a profit maximizing firm needs to do is get the prices right. The price should be set so that quantity demanded at that price equates marginal revenue with marginal cost. Pricing too low or too high [the PURPLE arrows in the figure] leads lost profits for the firm.
Levitt shows that Paul gets quantities right (for both bagels and donuts, there are very few stock-outs or left-overs), but he often gets prices wrong. Paul systematically prices donuts and bagels too low. Indeed, his prices are so low, they fall on the inelastic section of Paul's demand curve--Paul could actually increase total revenue by increasing his prices. Hence, his prices are at a point like P in the figure. At point P, marginal revenue is negative (below the x-axis); so increasing price and reducing sales will raise revenue.

Levitt argues that this might be an issue for many businesses like Paul’s. What Paul gets to see from day-to-day is how well he is doing getting quantities right; since his price doesn’t change, however, he doesn’t see how well he is doing getting prices right. So if he is wrong, he never knows it.

1. Economists believe that firms do not systematically forgo profits because they will experiment with price and quantity changes. Why do you think a bagel business might be reluctant to experiment with price changes?

2. Levitt considers whether pricing is a longer-run decision for the firm and so it may be that Ben was pricing with regard to long-run price elasticity of demand rather than short-run price elasticity of demand. It turns out that even on a longer-run basis, demand was inelastic at Paul’s pricing. Why is it important to distinguish between long and short-run price elasticity when evaluating whether a firm is maximizing profits?

3. Can you think of other examples of businesses that might be systematically pricing too low or too high?

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

Monday, May 01, 2006


Ever wonder what in the world the Fed is saying? In its most recent press release, the committee that sets monetary policy for the Federal Reserve Board said that “some further policy firming” may be needed. But for most of 2005, the releases said that “policy accommodation can be removed.” According to Greg Ip, a sharp journalist at the Wall Street Journal, this “sounds like they are removing the sofa beds from the Fed’s executive lounge.” What does the Fed mean when it says these things? And what’s behind the recent change?

In his column On Language, William Safire offers up this quote from Ip and goes on to explain the special language that the Open Market Committee of the Federal Reserve Board uses to describe its actions. He also gives the explanation that Ip, whom he calls the master code breaker of financial jargon, offers for why they speak in code.

1. Safire identifies several key words and phrases that the Fed uses frequently--words he calls “Fedspeak.” These include productivity gains and possible increase in resource utilization. Can you explain how these economic concepts relate to inflation, which the Fed is tasked with managing? What would productivity gains imply about expected inflation, and why? How would an increase in resource utilization impact inflation?

2. Another key term Safire identifies as “Fedspeak” is accommodative. When applied to policy, Safire says that this code word is supposed to mean “low interest rates that boost the economy.” Some economists refer to a neutral interest rate; that is, a rate which makes actual output in an economy grow at the same rate as the economy's capacity or potential output. The Fed never uses the term neutral interest rate, but if they did, how might they explain the reason for the switch from saying that "policy accommodation can be removed" to "further policy firming may be required?"

3. Safire calls the Federal Reserve a “House of Hints” because it uses these somewhat obscure “code phrases.” Why isn’t the Fed more straightforward? Ip suggests that the Fed relies on “Fedspeak” to retain flexibility in its future policy prescriptions. Can you think of any other reasons why the Fed would speak so cryptically? Imagine that you are the Fed Chairman--an official who is confirmed by Congress and oversees a body (the Fed), whose powers are determined by Congress. Further, imagine that it is an election year, and some politicians running for office are looking for a chance to get some media attention. What type of language would you use if you were considering implementing tighter (i.e., higher interest rate) monetary policy?

Topics: Monetary policy, the Fed, Interest rate

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