Tuesday, October 31, 2006

Prop 87, Rent-Seeking, and Confiscatory Taxes

A number of commentators responded to Paul Romer's post last week on California's Prop 87. Their comments raised a host of interesting issues. It's worth understanding two of them in depth: rent-seeking behavior and confiscatory taxes. Both of these are standard arguments against government taxing and spending activity.

1. Rent Seeking

On the topic of subsidies for alternative energy research, Arnold Kling wrote that "once you open up the can of worms of these taxes and subsidies, a lot of rent-seeking crawls out." In the comments to Kling's post, Charles Kruse was less politic:

When Economics Professor Romer says to his students: "Appropriate government subsidies could encourage a socially optimal level of R&D," this is both mealy-mouthed and misleading. Sure, it "could" happen. But consider how the decisions on subsidies will actually get made and the history of previous schemes--not just ethanol but the Lloyd Cutler/Jimmy Carter Synfuels Corporation and other scams. Even the worst ideas to transfer money to the political class can be dressed up with this sort of language.

Kling and Kruse are speaking of rent-seeking behavior--a problem that arises when government, rather than the market, allocates resources. Rent-seekers attempt to obtain artificial payoffs by spending money to curry the favor of elected politicians. What kinds of rent-seeking behavior might occur around Prop 87? Well, when California's government has an extra $4.1 billion burning a hole in its pocket, a lot of people will have an interest in trying to influence how that money gets spent. Firms may devote resources to getting government contracts rather than doing actual energy research. Talented young people, when choosing what career to go into, may go to work for lobbying firms rather than for firms that actually produce things. In short, society will waste resources on the allocation process that would be better used elsewhere.

Consider an example. Suppose you run a company that makes a new kind of solar energy panel. You've already raised $10 million in venture capital to conduct research. Now Prop 87 passes, and the state is looking around for someone to develop a new kind of solar chip. Getting this grant would be worth $50 million to your company. Say you could spend $2 million of your venture capital on campaign donations to elected officials, or perhaps to charities favored by those who are in charge of allocating the Prop 87 funds. If you do this, you figure, you'll increase your chances of landing a government contract by 10%--an expected payoff of $5 million. This may, from your perspective, be a good prospect. Of course, other companies will have the same incentives. Suppose they all start giving money to politicians and charities. In the end, everyone faces the same probability of getting the contract as before--but many valuable person-hours are wasted in lobbying to influence who does the work.

2. Confiscatory Taxes

If the problem of rent-seeking behavior arises because Prop 87 gives California money to spend, the problem of confiscatory taxes arises from levying the tax in the first place. For example, on Harvard economist Greg Mankiw's blog, commenter Harsh Pencil, a contributor to the John Adams blog, writes:

Paul Romer's analysis is basically correct. In effect, there is very little
difference between this proposed tax and simply confiscating a fraction of the oil under the ground in California. (In fact, if the supply curve is vertical, there is no difference.) In many ways, such taxes are the perfect tax: no distortions.

But there is a larger issue. There is always a motive for government to confiscate sunk assets to fund things which would otherwise require distorting taxes. Just because these discovered reserves are sunk assets now, doesn't mean they always were. Do we really want to encourage citizens to worry about after-the-fact confiscations?

As Pencil says, the confiscatory tax argument might seem at first blush to fly in the face of the normal tax incidence literature, which suggests that the deadweight loss of a tax is lessened if the supply or demand curves are inelastic. However, recall that the long-run supply of oil is much more elastic than the short-run supply. Therefore, even though California can expect not to affect the amount of oil extracted from its wells over the short term through Prop 87, in the long run, the existence of Prop 87 makes drilling new oil wells in California a less profitable prospect.

Even worse, as Pencil points out, if entrepreneurs in all industries believe that California will impose an after-the-fact tax on any risky venture that goes well, the expected return from taking risks is significantly diminished. This goes well beyond the question of oil. Suppose, for example, that you could invest $1 billion in researching a vaccine for HIV/AIDS. If you succeeded, you could produce the vaccine at a cost of $1 per person. Suppose you thought that if you did succeed, the state of California would pass a law stating that it was immoral for you to charge a price above your marginal cost, and levy a tax on your profits. The fear of such a confiscatory tax could be a huge disincentive to research, and might result in the drug not being developed at all.

Discussion Questions

1. The arguments of rent-seeking and confiscatory taxation can be made against much, if not all, government taxing and spending activity. Are these arguments especially true in the case of Prop 87? Why or why not?

2. The problems highlighted here are legitimate costs associated with Prop 87. However, there are also benefits. How can you compare these costs and benefits to find out whether, on the whole, Prop 87 represents a worthwhile policy?

3. Suppose Prop 87 passes, and you are put in charge of distributing the funds to research institutions. What guidelines could you put in place to reduce rent-seeking behavior?

4. Think about the argument that confiscatory taxes decrease risk-taking activity. This argument relies on the notion of a reputation effect: in particular, that the people of California might develop a reputation for passing confiscatory taxes, which would then have an adverse effect on future entrepreneurs. Is this a credible argument? Do California voters--an ever-changing population--have the ability to commit to not passing confiscatory taxes in the future? By contrast, why would the act of passing Prop 87 make it seem more likely that similar measures would pass in the future? (Remember, the voters of California were the same ones who passed Prop 13, perhaps the most famous government-limiting initiative in U.S. history.) Would it be worse or better if the California legislature passed a confiscatory tax?

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Wednesday, October 25, 2006

Slicker than Oil: The Debate Over California’s Proposition 87

Proposition 87, a hotly contested measure on the ballot in California, nicely illustrates the key lessons about tax incidence--who actually pays a tax. The political debate about this Proposition shows that these lessons, which are typically covered in an introductory microeconomics course, are not well understood by the voting public. Is education powerful or what? Armed with knowledge of just a few economic principles, you will be able to analyze important policy issues better than most.

To raise funds for research on and development of alternative fuels, Proposition 87 taxes oil produced in California. (Read a summary of the provisions of this act on the Secretary of State's web site.) Opponents of the tax claim that this tax will increase the price of gasoline at the pump. The following figure shows why this claim is wrong. The market for oil is global, and the price of oil is set by global supply and global demand. California produces less than 1% of all the oil produced in the world, so changes of a few percent in its output would be far too small to have a noticeable effect on global supply and demand. Taken together, all the producers in California are in the same position as a single firm in a competitive industry. They face a residual demand curve for their oil that is horizontal, or perfectly elastic, at a price equal to the world price of oil plus the cost of transporting it to California. Call this price P*.
To understand why the demand curve faced by local producers is horizontal, consider the decisions made by the typical manager of a gasoline refinery. She already has barrels of imported oil delivered to her at the price P* and could order many more at that same price. If the price of oil delivered from a local producer was more than P*, she wouldn't buy any. If it was less, she'd buy as much as she could and cut back on purchases of oil brought into the state from Alaska and the rest of the world. Local producers, understanding this, would be foolish to charge a price less than P*. They'd be leaving money on the table. Even if they did, this wouldn't reduce the price that the refinery manager would charge for gasoline. She'd happily buy all the cheap local oil she could, but still charge the same price for gasoline that other refiners, who continue to import foreign oil, are charging--the price determined by P* and the cost of refining.

What happens if the state of California imposes a tax of T% on the oil produced by the local producers? The figure shows that the price of oil purchased by the refineries is still equal to P*. Local producers receive (1 - T) times P* per barrel of oil. Because they face a horizontal demand curve, they bear the full cost of the tax. They can't pass the tax increase on to consumers.

As the figure shows, local production of oil will fall by a small amount after the tax is imposed, which means that imports of oil will go up. The amount of this reduction depends on the elasticity of the supply curve. As usual, the supply response grows larger over time. Initially, there should be very little supply response, but over time, wells will be retired from service sooner and fewer new wells will be drilled.

What might the size of this impact be? One estimate cited by opponents of Proposition 87 is that local production will fall by an average of about 3.4% or about 22,000 barrels per day over the first 10 years of the life of the tax. Oil produced in California meets only 37% of consumption there. The balance is supplied by oil imported to California from Alaska and the rest of the world. This means that imports of oil into the state would increase by about 1.8%. A gradual increase in imports of this magnitude would be too small to have any perceptible effect on the world price of oil or the transportation costs of oil to California.

The local producers do understand the economics of tax incidence. Chris Hall, an oil producer based in Torrance, CA, was quoted in the San Diego Union-Tribune as saying of the tax that “I can't pass it on…I'm a price taker and not a price maker. I don't determine the market.” Understandably, these producers have raised a lot of funds to support a campaign to oppose the imposition of this new tax. The tax would raise up to $4 billion before it expires, so for oil producers as a group, it makes sense to spend millions of dollars to defeat the tax. What is interesting about the campaign ads that they support is their repeated claim that the tax will raise the price of gasoline. No doubt, their campaign consultants have found that raising this irrelevant issue is the most effective way to get people to vote against this proposition.

Reasonable people can differ about whether Proposition 87 is a good idea. See the web page, by one well-known economist who studies energy, Severin Borenstein, for an even-handed discussion of its plusses and minuses. Or read this critique by Greg Mankiw. Ironically, he is opposed to the proposed tax because it will not increase gasoline prices and therefore will not encourage conservation. This kind of discussion clarifies the issues and helps people understand the underlying economic principles.

The other kind of political discussion, the kind that goes on between battling pundits or in the back and forth of campaign ads, sways some voters because they don't have the benefit of an introductory course in economics. They don't understand something that you do: a tax on a small subset of firms in a competitive industry will not affect the price paid by consumers.

1. Greg Mankiw correctly points out that the tax in Prop 87 is not a Pigovian tax--that is, a tax on oil for the purpose of reducing oil consumption to socially optimal levels. However, the revenues from Prop 87 are intended to subsidize the research and development of alternative energy. Because the marginal private benefit of R&D is less than the marginal social benefit, the market does not allocate enough resources to R&D on alternative fuels. Appropriate government subsidies could encourage a socially optimal level of R&D. Does this mean Prop 87 is in fact a Pigovian subsidy? Should Mankiw and the other members of his Pigou Club support such a policy? (Thomas Friedman and Al Gore, both of whom Mankiw counts among the membership of the Pigou club, already do. Other members of the Pigou club are encouraged to comment…)

2. Would a Pigovian tax on gasoline consumption be a better way to fund research on and development of alternative fuels? Why or why not?

3. How useful is it to enact public policy through ballot measures? On the one hand, polls show that the public isn’t well informed as to the economic consequences of Prop 87 and other ballot measures. On the other hand, the policies developed by legislators are also imperfect. Some people argue that elected officials face few political incentives to tackle long-term problems like global warming. Is Prop 87 an example of “direct democracy” achieving something the legislative process could not? Or is it an example of why setting public policy is best left up to the legislature?

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Thursday, October 19, 2006

A College Degree to Teach the ABC's?

In a recent article, Slate columnist Emily Bazelon examines the issue of whether or not schools should require preschool teachers to hold college degrees. Some argue that preschool teachers do not obtain the necessary job skills by taking college courses. In fact, the characteristics often deemed most important to the job, such as a warm and nurturing personality, are innate qualities that cannot be taught in a classroom. People who have the natural ability and desire to teach young children but aren’t academically inclined shouldn’t be discouraged by a college degree requirement.

On the other hand, Bazelon notes that children would surely benefit from the general knowledge and cultural sensitivity that a college education imparts. This argument is especially pertinent to low-income children, whose parents are often unable to provide an adequate amount of intellectual stimulation at home.

Although these facts suggest it may be optimal to have all preschool teachers be college educated, the traditionally low salaries paid to preschool teachers make it difficult for schools to attract a highly educated pool of candidates. Some states, such as New Jersey, are responding to this dilemma by offering a financial incentive—schools will pay their teachers to go to college and increase their salaries upon graduation.

Two theories help explain why schools reward teachers who obtain a degree. According to the signaling theory of education, teachers are able to communicate to schools that they are intelligent, hard-working people by demonstrating these qualities in an academic setting. In this model, it isn't the case that college makes people better teachers—rather, better teachers are the ones who choose to go to college. According to the human-capital theory of education, the act of going to college makes people better preschool teachers.

1. Which theory do you think applies more in the case of preschool teachers? If you think it's the signaling theory, then does New Jersey's policy make sense?

2. Would a college degree requirement for preschool teachers entice more parents to enroll their children in preschool? How will this affect college enrollment rates in the future?

3. Recent education legislation enacted under No Child Left Behind increases the accountability of elementary school teachers. What effect does this have on the market for preschool teachers? Should preschool teachers also be required to meet certain state standards? What effect would such a requirement have on the labor market for preschool teachers and elementary school teachers?

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Tuesday, October 17, 2006

Nobel Prize in Economics

The Royal Swedish Academy of Sciences awarded the 2006 Nobel Prize in Economics to Edmund S. Phelps. His work on the expectations-augmented Phillips Curve revolutionized the way economists and policymakers view the relationship between inflation and unemployment.

Most economists in the 1960s believed that there was a permanent trade-off between inflation and unemployment, and they referred to this relationship as the Phillips Curve. The Phillips Curve made policymakers' jobs very easy. If unemployment was too high, then Congress could increase spending and the Federal Reserve could print more money. Higher spending and a larger money supply would raise the inflation rate and bring down the unemployment rate. Hence, the purpose of fiscal and monetary policy was to pick the optimal rate for inflation and unemployment.

Phelps's work suggested that the perceived trade-off between unemployment and inflation was only temporary. It also suggested that there would always be some unemployment--the natural rate of unemployment--due to frictions in the labor market. In the long run, Phelps argued, the trade-off between unemployment and inflation disappears--the unemployment rate returns to its natural rate, regardless of the inflation rate. Hence, the modern purpose of fiscal and monetary policy is to pick the optimal path for inflation and unemployment.

The following is a mathematical interpretation of the expectations-augmented Phillips Curve.

Actual Inflation Rate = Expected Inflation Rate + Constant x (Actual Unemployment Rate – Natural Rate of Unemployment)

The actual inflation rate is dependent on two factors: the expected inflation rate and the unemployment gap (the difference between the actual unemployment rate and the natural rate of unemployment).

During the 1960s, economists observed a nice, smooth downward-sloping relationship between the inflation rate and the unemployment rate because expected inflation was constant. However, soon after the 1960s, expected inflation began to converge with the actual inflation rate (the short-run Phillips Curve shifted to the right). We no longer observe a smooth downward-sloping relationship when the expected inflation rate changes.

Phelps argued that in the long run, expected inflation equals actual inflation. Now, let’s look back at the equation. If actual inflation equals expected inflation, then the unemployment rate must equal the natural rate of unemployment.

Therefore, in the long run, Congress and the Fed cannot affect unemployment through spending or printing more money.

1. Some economists have argued that the natural rate of unemployment increased in the 1970s, which led to misguided monetary policy. Use the short-run and long-run Phillips curves to show how a Fed that believes that there is a permanent trade-off between inflation and unemployment would inadvertently increase inflation without affecting the long-run unemployment rate.

2. Why is it important that the Fed targets an inflation rate rather than an unemployment rate?

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A Second Nobel for Economics

The Norwegian Nobel Committee awarded the 2006 Nobel Peace Prize to the Grameen Bank, a for-profit business, and its founder, Bangladeshi economist Muhammad Yunus. The Committee's citation lauded Grameen Bank's innovative efforts to reduce poverty through micro-lending schemes that provide some of the world's poorest citizens with access to credit. So, what's microcredit and how do Yunus and Grameen use it to reduce poverty?

Citizens of developed countries like the United States take credit access for granted. With a stable source of income or a bit of collateral, like a house or a car, an American can take out a loan to start a business, remodel the bathroom, or buy an engagement ring.

Access to credit in less developed countries is far scarcer.

Poor peoples' incomes are inherently less stable and often too low to qualify for lending. The ill-defined property rights in many developing nations make it difficult for poor residents to prove that they own the housing or land that they occupy. Lacking income and legitimate titles to what little collateral they actually have, the credit prospects for most of the world's poor seem bleak. As a result, traditional credit schemes ignore low-income entrepreneurs whose business ideas can help their communities escape poverty.

Yunus had the vision to develop a lending model that could reach low-income entrepreneurs in Bangladesh. He realized that collateral requirements provided borrowers with a strong incentive to pay back their loans rather than defaulting and losing their property. To ensure that poor borrowers faced an equally strong incentive to repay their loans, Yunus replaced collateral with the borrowing circle.

The borrowing circle consists of 5 people--the initial borrower, and four friends who agree to help with loan payments if the going gets rough. (The friends may take out loans as well.) Should the borrower default, all four friends lose access to credit until the loan is repaid in full. Replacing collateral with social pressures worked remarkably well, helping people expand or launch small business ventures. Read this New York Times article to find out more about Yunus and the Grameen Bank.

1. Grameen Bank is a for-profit business, but is it profitable? According to the article, what's the U.S. dollar value of Grameen’s loans since 1983?

2. According to the article, how many borrowers has the Bank served? What percentage of Grameen’s loans is paid back? How do Grameen’s payback rates compare to those of traditional banks in Bangladesh?

3. Why might social pressures provide a greater incentive to repay loans than the threat of losing collateral? What's the downside of defaulting in the Grameen scheme versus a traditional, collateral based scheme?

4. How might credit access change the social standing of Bangladeshi women?

5. How does Yunus feel about relying on charity to battle poverty?

Coincidentally, the Aplia Econ Blog recently asked whether microcredit will reduce poverty.

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Wednesday, October 11, 2006

The Peculiar Economics of Ratings

Recently, Michelin released a new Red Guide for San Francisco. For those who are not foodies, Red Guides are Michelin’s ratings for restaurants and hotels. Their hotel ratings tend to be ignored, while the restaurant ratings are the subject of a great deal of interest and speculation, particularly in France, where the addition (or worse yet, removal) of a “star” can make or break a restaurant. The Michelin guide also raises some interesting economic questions. The peculiar economics of ratings systems has two sides—the consumer side and the supplier side.

Consumers use published ratings as an information-gathering mechanism, a way of economizing on the costly actions associated with determining the quality of a product that they wish to purchase and consume. This is especially true for goods characterized as experience goods--that is, goods for which the consumer cannot easily ascertain the product’s quality prior to purchase. It's also true for durable goods like cars, or for goods that can only be purchased once, like a college education.

The more expensive a good is, the more incentive a buyer has to invest in information gathering. A meal at the local diner may not warrant the time, money, and effort needed to determine the restaurant’s rating. For a trip out of town or a visit to an upscale restaurant, such an investment may be useful, especially because it can help to reduce the risk of a disappointing experience.

Consumers want clear, objective information from a ratings guide. Advertising cannot convey the same kind of information, since it is (appropriately) perceived to be self-serving. Yet, how much faith can we place in the (presumed) objective information from ratings services, like Michelin or the Zagat’s? Is there a potential problem with these ratings guides that can affect the quality of the information they produce?

Sellers clearly can benefit from a favorable rating in these guides--for many restaurants, it can mean a significant boost to their revenues and provide an avenue to other revenue sources (a great rating could pave the way for the chef to write a cookbook, or these days, have their own TV show). Such a system may create perverse incentives for restaurateurs. A restaurant could alter its menu offerings, change the décor, or upgrade the wine and beverages list to improve their rating, but these changes may change the qualities that originally contributed to the restaurant’s popularity among consumers. Further, this can contribute to a restaurant version of an “arms race” to be the top-rated restaurant in a given city. This may be trivial, but the same logic applies to all sellers who compete for ratings rather than consumers. It is not as trivial, for example, in the case of colleges and universities who expend resources to boost their US News rank, or in the case of schools and teachers who “teach to the test” as opposed to teaching valuable academic skills.

1. What determines how much consumers are willing to spend on a restaurant guide for a city? Would this differ between local residents and visitors?

2. How do consumer ratings differ from advertising? When could advertising provide more useful information than a ratings guide?

3. Some people decry products that are supposedly shaped to win the favor of critics; a great example of this is that many people argue that winemakers produce wines to appeal to the tastes of the powerful wine critic Robert Parker. What’s the flaw in this logic?

4. Whose ratings are more valuable—those of expert reviewers like Michelin or the accumulation of opinions from regular diners?

5. When the Michelin ratings were published, many in San Francisco objected to the rankings. Some commentators argued that the taste of the Michelin writers was different than the taste of Californians. Since not everyone's preferences are the same, does it make sense for there to be one "accepted" ranking system? Would your answer be different if the good in question were surgeons rather than restaurants? Why?

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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Thursday, October 05, 2006

Cheap Gas Hurts

Economists rarely advocate higher taxes on a good or service because higher taxes often increase the price that consumers pay and lower the price that producers receive--a "lose-lose" situation for both consumers and producers. However, Pigovian taxes, which are used to correct situations in which the free market produces an inefficient result, might actually increase social welfare. Greg Mankiw, an economist at Harvard and founder of the Pigou Club, argues that such taxes are currently needed on gasoline, due to the negative externalities that accompany gasoline consumption.

A negative externality is a cost imposed on a third-party by the consumers and the producers of a good or service. Take for example, gasoline. Oil companies produce and distribute large amounts of gasoline to satisfy America's desire to drive. How does a person who uses gasoline hurt other people? First, burning gasoline emits toxic chemicals such as carbon monoxide and carcinogens that damage public health. Second, cheap gas contributes to excessive driving which wears down our country's highways and causes traffic congestion. Third, as Al Gore argues, burning gasoline produces carbon dioxide, which contributes to global warming. Fourth, as Thomas L. Friedman has argued, high oil revenues actually support regimes like Iran and Venezuela, decreasing freedom in those countries as well as our own national security.

If the consumption of gasoline imposes a negative externality, then economists say that the marginal social cost (MSC) of gasoline exceeds the marginal private cost (MPC). The invisible hand fails to bring the market to an optimal outcome because the free market equates demand and private supply, and does not take external costs into account. Ideally, the market would equate demand and social supply, but rational consumers would not take into account external costs because they feel someone else should reduce their consumption of gasoline (free-rider problem). The free market leads to an almost shocking result: the price of gasoline (P1) is below the socially-optimal price (P2), and the quantity of gasoline consumed (Q1) exceeds the socially-optimal quantity (Q2).

In other words, in a free market, Americans consume too much gas! The government may remedy the situation by increasing the per-unit tax on gasoline. Higher gas taxes would increase marginal private cost and reduce the gap between social supply and private supply.

1. In a free market, the price of gas is P1 and the quantity of gas consumed is Q1. In this case, what is consumer surplus plus producer surplus minus total external costs?

2. Suppose the government imposes a per-unit tax on gasoline that forces the market to price and produce the socially-optimal quantity (Q2). What is consumer surplus plus producer surplus plus government revenue minus total external costs?

3. An action should be taken if and only if the benefits outweigh the costs. What are the costs of the gas tax in this example? What are the benefits? Which one outweighs the other?

4. The above example assumes the government has perfect information about the size of the externality caused by gasoline. But in reality, measuring the costs and benefits (especially when it comes to things like climate change or the effects on national security) can be difficult. Does this problem of imperfect information mean we should not impose Pigovian taxes? If you think we still should impose Pigovian taxes, what does the problem of imperfect information imply about the optimal level of taxation?

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Wednesday, October 04, 2006

Will Saving the Environment Make Us Fat?

Diesel engines can run on biodiesel, a fuel produced from renewable resources like vegetable oils, animal fats, or the grease found in restaurant fry vats. A small but growing number of people are adjusting their cars to run on both bio and regular diesel. Biodiesel is environmentally friendly. It runs much cleaner than ordinary diesel and is made from renewable resources. The only clue that a car is running on biodiesel is a vague French-fry smell that wafts from your tailpipe.

The French-fry smell is no accident, since you’re basically burning the leftover grease from fast food kitchens. Restaurants that used to pay removal services to get rid of their grease increasingly give it away to those interested in converting it to biodiesel. Who knows, if biodiesel catches on, the fry vat residue from fast food restaurants may be auctioned off to the highest bidder. In fact, new businesses are springing up around opportunities to make use of these “second use” materials.

Cleaner burning fuel, a renewable source of energy, and the re-use of grease that would otherwise have to be disposed of, sounds like a win-win for all concerned, right?

Well, maybe. In a bit of economic irony, one aspect of this win-win situation may have unintended negative consequences, or negative externalities. The restaurants that used to pay to get rid of used fry grease can now give it away to would-be biodiesel makers for free. In short, the rising popularity of biodiesel lowers the costs of fast food production. The restaurants, no longer incurring grease disposal costs, may lower prices in order to increase the quantity of greasy goodness demanded by fast food consumers. If fast food fry vats offer the most grease for biodiesel, the fast food restaurants pass on the grease disposal savings to consumers.

Cheaper fast food would encourage more consumption of what is widely understood to be the most fattening and least nutritious type of food available. That is, biodiesel may reduce the costs from one type of negative externality--the damage associated with burning fossil fuels--while increasing the costs from another--the public health costs associated with obesity. .

As an energy source, biodiesel offers several advantages over fossil fuels, but it’s interesting to note that almost any situation can present unforeseen negative externalities.

1. One reason we eat (and eat, and eat) fattening fast food is that it's cheap. Biodiesel could make cheap fast food even cheaper. Can you think of an incentive-based policy that would neutralize biodiesel's effect on fast food prices and consumption?

2. During the 1990s, the U.S. government's public health campaign against tobacco significantly altered consumer information and preferences about tobacco products. How might a similar public health campaign affect the fast food industry?

3. Fast food doesn't deserve all the blame for America's obesity problem. Less physical jobs and a lack of exercise help explain our collective waste line expansion as well. Can you think of incentive-based policies that would both discourage fossil fuel usage and encourage more physical activity? (Think about policies that influence the way we commute to school and work.)


Monday, October 02, 2006

Neuroeconomics: The Role of the Brain in Economic Decision-Making…or Why We Sometimes Make Stupid Decisions

I recently purchased tickets for a Jack Johnson concert. I’m a big fan of Jack Johnson and I was excited to get a chance to hear him live. On the night of the concert I hopped on the local train and arrived at the venue with plenty of time to spare. When the attendant asked for my tickets, I reached into my pocket and realized with horror that the tickets were gone. I searched everywhere, but to no avail. When the attendant asked me if I’d like to buy another two tickets I was offended. Why would I purchase another set of tickets? I had already paid for the initial set. I left the concert and rode the train home despondent at not seeing my favorite artist.

Economists would call this an irrational decision. Since I had already lost the tickets and could afford to pay for a replacement pair, I should have ignored the sunk costs of the old tickets and seen the concert anyway. But because I was upset about the loss of the tickets, I was unwilling to pay for the concert.

A recent article in The New Yorker by John Cassidy examines the emerging field of neuroeconomics, which examines what happens in your brain when you are faced with different types of economic decisions.

Neuroeconomists believe that different parts of the brain are responsible for different types of decision-making. When presented with enough information, the higher functioning areas of the brain take over and allow you to make rational decisions. However, when presented with too little information, lower brain functions take over leading to emotional or impulsive decisions rather than rational ones.

What does this have to do with economics? Economists have long argued that we can make economic trends or predictions because people ultimately act in rational ways when it comes to economic decisions. However, we may act irrationally in cases where we do not have enough information or in cases where there is a strong emotional component to our decision.

One example Cassidy sites is immediate gratification versus long-term gain. We all know that giving up those little impulse buys and socking that money away instead will ultimately yield a sizeable nest egg in years to come. But that is not what most people actually do. In fact, Cassidy’s article states that “half of all families end their working lives with almost no financial assets.” This would seem to fly in the face of rational economic behavior.

In fact, when researchers used Magnetic Resonance Imaging (MRI) machines to scan the brains of people making economic decisions, it became clear that the prefrontal cortex, which is responsible for higher brain functions like rational decision-making processes, was more active during some types of decisions; conversely, lower portions of the brain were active in other, more emotional types of decisions.

1. Marketing is another field that is very interested in the brain’s decision-making ability. What causes us to make impulsive or emotional decisions? Why do we decide to buy that expensive new gadget when the less expensive one would clearly do the job?

2. Behavioral economists have argued over the past few decades that psychological factors should be incorporated into economic models. Do you think neuroeconomic analysis is a complementary approach to understanding human behavior, or at odds with the behavioral approach?

3. Economists have long struggled with the notion of a "utility function." Does measuring utility neurologically make sense? Do you think that with neurological analysis we can actually find out what people's utility functions are? Why or why not?