Pigouvian Tax the Rich?

A millionaire in Switzerland was recently fined a world-record $290,000 for driving his Ferrari Testarossa 87 miles per hour in a 50 miles per hour zone. The amount was so high because fines for speeding in Switzerland are based on a driver's wealth (and, in this case, because the driver falsely claimed diplomatic immunity). The story got me thinking about the economics of speeding tickets.

To an economist, speeding tickets can potentially act as a Pigouvian tax: a tax that makes an individual's cost of engaging in an activity equal to the cost imposed on society. For a driver, the cost of speeding includes things like fuel, the increased likelihood of damaging one's car, and injuring oneself in an accident. For society as a whole, though, the cost of speeding also includes the increased likelihood of an accident that damages other people's property or injures other people. As a result, speeding (and driving in general) imposes costs on society above and beyond those incurred by the driver. Moreover, the other people affected by speeding aren't compensated for the risk by the benefits of speeding, which are enjoyed strictly by the driver. Economists refer to the costs from an activity that are imposed on other people without any compensation as negative externalities. By making an individual's costs equal to society's costs, a Pigouvian tax gives individuals incentives to act as if they were considering everyone's costs. By doing so, a Pigouvian tax internalizes the externality and decreases the activity to the level that maximizes net benefits to society.

It can be difficult to set the Pigouvian tax exactly equal to the external costs of driving because these depend on so many hard-to-estimate variables (such as the likelihood of accidents at different speeds and the monetary damage caused by injuries or death). It's easy to determine, however, that externalities don't depend on the wealth of the driver. For example, the potential consequences for others of a poor person driving a rented Ferrari at 87 miles per hour are the same as from a rich person driving his own Ferrari at the same speed. Thus, for speeding tickets to serve as a Pigouvian tax, the fine for driving the same speed in the same car in the same conditions should be the same for everyone, regardless of wealth.

One consequence of not basing them on wealth, however, is that wealthier people will likely speed more. In most cases, the richer you are, the more you are willing to spend to save time, and thus the more willing you are to speed and risk getting a ticket. Moreover, if the "pure desire for speed" (in the words of the Swiss court that sentenced the driver) is a normal good, wealthier people will consume more of it. From an efficiency perspective, this result is completely appropriate. As long as individuals act as if they were considering all the costs of an activity, their decision to engage in it means that there are net benefits to them and thus to society.

However, because speeding puts others' lives at risk, the idea that it is appropriate for wealthier people to speed more runs counter to many people's idea of fairness. Switzerland's law suggests that its citizens are willing to forego the efficient level of speeding in order to obtain an arguably more equitable result—everyone has similar incentives to speed, and endanger others, regardless of wealth. So, if you ever find yourself about to drive in Switzerland, be sure to check your bank account first: the less you have, the better.

Discussion Questions:

1. What if, considering its external costs, $290,000 was actually the appropriate fine for speeding, but that only extremely wealthy drivers paid that much, with most drivers paying considerably less. Who would speed at the appropriate rate, while who would speed more than was appropriate?

2. Consider what factors make speeding more or less dangerous for other people. On what variables could you base fines for speeding so that drivers internalized the external costs?

3. Are there variables used to determine fines for speeding where you live that have little or no relation to the external costs of speeding?

4. In addition to acting as a deterrent for speeding, fines for speeding can also serve as a source of government revenue. How does this consideration impact the efficiency and equity of basing the fines on wealth?

Larry Murphy: Hall of Famer, Champion, Economist?

Over his NHL career, Hall of Fame defenseman Larry Murphy was praised for his reliable defense, gifted offense, and his immense hockey skill. But until now, I doubt he has been lauded for his economic insight. Perhaps even Murphy is unaware that his recent comments about head injuries in the NHL perfectly illustrate a real-world example of moral hazard. Speaking to an NHL.com reporter, Murphy explained current players rely on referees rather than their own decisions to keep them safe on the ice. "You always had to be aware of where you are in relation to the boards and you had to stay close to the boards and protect yourself that way," Murphy said. "Now the play is to turn your back to a guy and it's like, hands off.” While it may appear that Murphy was simply talking about how his sport has changed, his logic rests on the same clear principles economists use when analyzing many situations with the concept of moral hazard.

First, let’s start with a bit of back-story for those not familiar with hockey. The rules of the game allow for a great deal of contact, called checking, during play on the ice. Legally, only the player who controls the puck can be checked, and contact is allowed anywhere on the ice, even near the boards. As modern medical understandings of head injuries and long-term brain damage have advanced, the hockey community, and specifically the NHL, has made efforts to further protect its players. In the past three seasons, a large emphasis in rule enforcement has been made to prevent hits from behind that would send a player head-first into the boards without warning. There is no debate in my eyes that the intent of this policy should be supported in every way. The economics in all this stems from the fact that players have begun to play the game differently due to a change in incentives.

Murphy outlined how current players now take a more aggressive position on the ice because they no longer have to protect themselves; rather, the players know that the referees will protect them by calling penalties. From an economic standpoint, defensemen now face different incentives than they did before the rule change occurred. The risks associated with being hit from behind can be viewed as the cost associated with turning around on the ice. Since the new rules make those dangerous hits less likely, they essentially lower the cost defensemen face when deciding if they should put themselves in a vulnerable position. Economists refer to a moral hazard as any time a change in the larger economic system designed to protect an individual causes that person to alter his behavior to be more risky.

Perhaps the most vivid illustration of moral hazard comes from a quip by an economist who realized that as safety features in automobiles have advanced, so have the number of accidents. He stated that technological advances that have reduced the number of fatal car accidents in the country (e.g. airbags, seatbelts, etc.) would be just as successful as removing all safety features from a car and installing a giant metal spike in the center of the steering wheel that would be sure to impale the driver even in a minor crash. While the comment is tongue in cheek, its underlying point is very valid. Consider if this alternate proposal were true. I imagine that drivers would be much more attentive when driving and make many more efforts to drive safely, such as reducing their speed and avoiding distractions like cell phones. Whether talking about new rules on the ice or safety changes on the road, the theme is the same: as technology changes the rules of the game to make people safer, they will respond by worrying less about risks and engage in more dangerous behavior.

Discussion Questions:

1. Suppose the NHL is unhappy with the change in the style of play that has occurred since hits from behind have been more carefully officiated. What sort of rules or incentives could they introduce to continue to keep protecting players, but return play to the way it was before?

2. Consider the following scenario: A baseball pitcher is traded in the middle of the season. His previous team was the worst defensive team in the league. However, now he has been traded to the team with the best defensive players. In his first start for his new team, his coaches are baffled when he starts throwing many more aggressive and risky pitches that could be hit into play. How would you explain the change in the pitcher’s behavior to his coaches? What would you suggest they do if they want him to continue to pitch the way he did for his previous team?

3. Suppose the U.S. government passes new legislation that provides free healthcare to everyone in the country. As an economist, apply the principle of moral hazard to predict what will happen to the number of doctor visits that patients choose to make in a year.

Econolympics

As a recurring Winter Olympics viewer, I am counting down the days until the games begin on February 12. As an economist, however, I am intrigued by the number of tools an introductory economics course provides students with to analyze the effects of the Olympic games on the local economy of Vancouver. Three topics in particular come to mind that most students will encounter in a basic economics course: consumer spending, negative externalities, and cost-benefit analysis.

A recent article reports that the winter games are expected to boost travel-related spending by $800 million in Vancouver thanks to the incoming surge of general spectators, friends and families of competing Olympians, and athletes themselves to the metro area. But where does this spending go? Hotels, restaurants, and transportation are the likely candidates to benefit from such a surge, so the leisure and tourism industry should receive the largest boost. Although this positive shock to the industry is temporary, Olympics-related spending in 2010 is expected to account for 0.8% of Vancouver’s economic growth, trailing only housing investment and government spending.

However, accompanying this boost in tourism are some negative externalities on locals. While you may not always need a reservation to your favorite restaurant on a normal weeknight, the increase in the number of visitors to the metro area is likely to cause long lines for restaurant-goers. Even getting to your favorite watering hole might be no small feat, as traffic congestion and parking dilemmas are likely to pick up due to the additional vehicles on the road at any given time. Finally, increased pollution and trash creation are also likely to impose a negative externality on residents during the winter games.

Setting up shop for the winter games comes at a high price. Holding the Olympics requires that the host city build the necessary facilities, hire additional security, and provide extra health care in the case of injury to athletes or spectators. This is likely to weigh on the spending budget for Vancouver’s economy. Therefore, standard cost-benefit analysis would require you to determine whether the benefits gained from having the Olympics in a particular city outweigh the costs.

In short, there is a plethora of economic topics you could use as a conversation starter regarding the Olympics. So pick your favorite concept, and analyze away!

Discussion Questions:

1. How would you value having the Olympics in your hometown? Would the benefits you receive from this outweigh the negative externalities imposed on you by the winter games?

2. How do you think the Olympics will affect things like hotel and menu prices during the winter games? Do you expect such a short surge in demand to affect other local pricing? Why or why not?

3. State how the following introductory economic concepts could be used to analyze the effect of the Olympics on Vancouver: the multiplier effect, the Tragedy of the Commons, and demand shocks.

Economics Goes Viral

Nothing gets me more excited than getting people with no formal background in economics to see how econ fits in their everyday life. In light of that, imagine my surprise when my good friend Eva Funderburgh, a professional sculptor, wanted to share some economics with me! Apparently she’s not the only one spreading the video above, because, as of this writing, the viral video above created by TV producer/director John Papola and economist Russ Roberts has already received over half a million views on YouTube! Papola and Roberts’ video does a wonderful job creating a new way to take a traditional economic discussion and make it more approachable and entertaining to a much wider audience. In my mind, every economics student should watch the video, and hopefully share it with others as well. For those with a little more time, NPR has put together a very entertaining look at how the project came to be.

The economic thoughts and ideas represented in the video are spot-on, and the lyrics are a fair presentation of the differing schools of thought. While the deeper issues behind the video are much larger than anyone could take on in a single blog post, I do see a place that might deserve a small footnote. I do not mean to take anything away from all the great work that went into this video, but I feel that Keynes’ introduction might deserve a bit of further discussion:

“John Maynard Keynes, wrote the book on modern macro”

Depending on how you define “modern,” an economist who died more than sixty years ago may no longer fit the bill. I think it is totally appropriate to say that Keynes wrote the book on 20th century macroeconomics, but the research frontier of the field is moving beyond his ideals. Starting in the 1970s, some members of the field have explored more complicated models based on critiques of Keynes’ work by Nobel Prize winners Robert Lucas and Milton Friedman, among others. These researchers worry that some of Keynesian economics’ critical assumptions oversimplify the world and make the model invalid. While Keynesian theory is still widely taught today and used by many people advising current policy decisions, some macroeconomists now advocate for models that are built on individual decision making, rather than only analysis based on total expenditure.

These “micro-founded” macro models seek to explain trends in data that defy Keynesian theory. One difference between these schools of thought centers on if household consumption decisions can change in response to fiscal and monetary policies. For example, Keynesian theory assumes that policy does not affect the fraction of net income spent and saved and that the amount of economy-wide consumption will simply change by the product of the tax’s size and the proportion of a household’s after-tax income spent on consumption (often referred to as the marginal propensity to consume, or MPC).

On the other hand, extensions of the micro-founded model proposed independently by Frank Ramsey, Dave Cass, and Tjalling Koopmans suggest that if the government were to lower taxes and give households more money, consumers may choose to change their entire consumption-spending decision based on having larger net income, thus resulting in a new MPC. Whether or not the assumptions made by Keynes are valid (or small enough to be overlooked) is a matter of personal opinion, but as the research horizon of economics extends more than half a century after his writing, it appears that there is still work to be done before macroeconomics can perfectly explain an entire real-world economy.

Discussion Questions:

1. Why should we “fear” booms and busts? Why might booms and busts be good? Is there an “optimal” level of economic fluctuation?

2. Who do the bartenders “Ben” and “Tim” represent in the video? Why are they pouring liquor? What does the liquor represent?

3. The chorus of the rap has Keynes saying “I want to control markets” and Hayek saying “I want to set [markets] free.” Is either of those positions right or wrong in all circumstances? Under what circumstances is more government intervention in markets warranted, and under what circumstances should the government stay out as much as possible?

4. What are the critiques that Keynes offers of Hayek? What are the criticisms that Hayek proposes about Keynes? Does one side seem to have a much stronger argument than the other, or do they both suggest that the theory’s view of the world is still incomplete?

5. Do you think the financial crisis of the past few years was caused by people who thought more like Keynes or more like Hayek? Why?

Economics of Flu Vaccines

In the last few months, the H1N1 influenza virus, or “swine flu,” has been dominating the news, and many people are worried about access to flu vaccines or “flu shots.” (That is, unless you work for Goldman Sachs, who got first dibs. But don’t they always?)

Unlike other viral diseases, flu viruses constantly mutate, or change into new “strains.” A vaccine that works to protect against a specific strain one year will probably not work to prevent against a new strain the next year. Because of this, hundreds of hours of lab work are devoted each year to identifying specific flu strains, developing a vaccine against them, and then producing that vaccine in large enough quantities to distribute to the population.

This year, the efforts of flu vaccination labs have been split, with only some of the labs producing vaccines against the “regular” flu, and the rest working on vaccines against the specific H1N1 swine flu strain. Because of this, the supplies of both of these types of vaccines are greatly reduced this year in comparison to previous years.

Given the scarcity of both traditional and swine flu vaccines, how should the existing vaccine be distributed? If the goal is to maximize societal health, the flu vaccine should first be given to those whose health would benefit from it the most, who are people at risk of complications and death from the flu, including young children, the elderly, and the immuno-compromised. On the other hand, if the goal is to minimize the cost of the flu to an economy, the most productive and important members of society should get the first vaccine.

To a certain extent, extreme examples on both ends are small in number and easy to take care of. For example, health care employees are at greater risk of contracting any disease and, consequently, of infecting those whose health is vulnerable. So it’s clear they should be the first in line to get the vaccine. But what about people who don’t have such critical jobs (and keep in mind that you probably qualify as one of these people)? This topic relates not only to the health of the economy, but your personal health as well.

Discussion Questions:

1. Do you think that the goal of those who control flu vaccine policy should be to get the best health outcome, to minimize the cost to GDP, or some combination of the two? What public health policies would achieve your preferred policy goal?

2. Assume that society does want to maximize productivity in dollar terms rather than health outcomes. Now, take into consideration the fact that those who do get sick might require expensive medical treatment, the cost of which will be partially borne by society. How does this alter the analysis of who should receive the vaccines?

3. Economists often are fond of markets as allocation mechanisms because the forces of supply and demand determine a price that allocates goods to those who are willing to pay for them the most. How would a market for flu vaccine work? Why is it different from a market for non-life-affecting goods and services, like books or cars?

4. Firms (especially ones with high-productivity employees) value their employees’ health. It is estimated that that the total yearly economic cost of the flu in the U.S. is over $80 billion. Many companies have started to recognize this and have made attempts to protect their own economic interest by paying for or providing flu vaccines to their employees. As a result, employees who otherwise may not have been vaccinated (since the unsubsidized cost exceeds the expected health benefit) are more likely to accept the free vaccine. Is this efficient? Is it equitable?

5. Vaccines have a limited shelf-life – that is, they can only be used for a particular period of time if they are to be effective. For this reason, the timing of development, production, and distribution of flu vaccines in the United States is largely based on the pattern of the flu season in previous years. Go to Google Flu Trends to see a graph comparing the incidence of flu activity in the United States this year with previous years. How does the current flu season differ from previous years? If you were in charge of setting production policy for 2010, what might you change in order to produce the correct amount of vaccine for each strain of flu at the appropriate time?

Fed Chairman Bernanke Chosen as Time Magazine's Person of the Year

In a December 16, 2009 article, Michael Grunwald details the reasoning behind Time Magazine’s choice of Federal Reserve Chairman Ben Bernanke for Person of the Year. The article delves into Bernanke’s background such as his working class roots and the consensus that he is “a leading scholar of the Great Depression.” It also details the unique nature of the crises of 2007-2008 to which the Fed responded in creative and beneficial ways.

Chairman Bernanke is currently awaiting a Senate vote to be confirmed for another term as Fed chairman. The vote is being held up by a Senator from the far left and another from the far right. The Time article is largely critical of those who oppose Bernanke, portraying them as nitpicky demanders of perfection who fail to realize that the Federal Reserve’s actions over the past two years most likely “prevented an economic catastrophe.” It is apparent that the Fed, like most people caught up in benefiting from the bubbles of those years, took too long to recognize the danger signs. Yet, the desire to criticize and rein in the Fed’s power now that the crises are largely history is short-sighted and will be harmful to long-run inflation rates. Most economics textbooks cover the extensive research that shows that greater central bank independence goes along with more stable and lower inflation rates.

As Bernanke is quoted in the article, "We came very, very close to a depression ..." That is because in the fall of 2008, the collapse of the financial sector and asset prices looked remarkably similar to the events that marked the start of the Great Depression. However, thanks largely to the bold actions of Bernanke’s Fed, the US experienced a severe recession rather than a depression. That distinction is significant and reason enough for the awarding of Time Magazine’s honor. Grunwald’s article gives evidence that Bernanke’s knowledge and research into the Depression made him the perfect man to hold one of the most powerful positions for influencing the world economy. As written by Grunwald, “He didn't just reshape U.S. monetary policy; he led an effort to save the world economy.”

Admittedly, the severe recession has caused significant hardship to billions of people. However, based on economists’ consensus definition of recession, the US economy has been in recovery and thus out of recession for several months now. Indeed, the figure to the right shows a picture of an economy that will most likely experience positive net job creation in coming months. Such positive net job creation has not occurred since the recession began in December 2007. This scenario looks much rosier than could have been hoped for back in the fall of 2008. This is an important reason why Bernanke is expected to be confirmed for another term:



Finally, Bernanke’s critics need to understand that macroeconomics is not a true science. Despite the mathematical rigor required to publish articles in the field, macroeconomists cannot perform true experiments with a nation’s economy. Therefore, there is no comparison “control group” of a US economy run by someone who chose not to bailout AIG or who refused to dramatically expand the Federal Reserve’s balance sheet with risky assets. We will never know with any respectable precision what might have happened if it had not been for Bernanke’s bold leadership.

Perhaps someday a scientific genius will invent a time machine so that Bernanke’s critics can go back to the early 1930s to experience a collapsed economy. Most economists agree that the experience of those years is the best counterexample to show what we would have experienced without bold action by the Fed and our elected officials. Let the critics be reminded that the demand for perfection is all too often the enemy of good governance.

Discussion Questions

1. What is your reaction to Time Magazine’s choice of Federal Reserve Chairman Ben Bernanke for Person of the Year? Why?

2. Suppose that you were able to cast a vote in the Senate on Bernanke’s reappointment. How would you vote? Why?

3. Imagine you were currently chairperson of the Fed. What, if anything, would you be doing differently?

4. Do you approve or disapprove of the movement to rein in the power of the Federal Reserve? Explain.

Who Says There's No Such Thing as a Free Lunch

One of the most popular sayings associated with the “dismal science” of economics is “There’s no such thing as a free lunch.” The major idea behind this phrase is that even if you aren’t given a bill to pay, there is always an implicit cost associated with any action.

The economic concept supporting this statement is that of opportunity cost, which is defined as the best foregone alternative. Simply stated, it’s what you give up in order to do something else. Consider the following example: you have $10 that you can either spend on a movie or a pizza. The opportunity cost of going to the movie is therefore the pizza that you give up by attending the movie, and vice versa.

But what about when a good is free to consume? What is the opportunity cost in this situation? Usually in cases like this, the opportunity cost is associated with the value of your time or some other implicit cost. For example, if you work hourly, the time it takes to wait in line for a “free” offer is time that you could’ve spent working and earning money; “free” in this case simply means that there is no explicit monetary cost, but it says nothing about the implicit costs of waiting for the item. Another common example is when you receive a “free” weekend getaway, but the cost is that you have to sit through a 2-hour sales pitch with a timeshare organization.

I was thus astonished when I received something truly for free a few weeks ago at Auntie Annie’s pretzel shop. I was at the mall with my friend when the two of us realized we were getting pretty hungry. Wanting to avoid eating a fast-food meal at the food court, we decided to each grab a pretzel at Auntie Annie’s to hold us off for awhile. As we were waiting in line, one of the workers started giving out samples. My friend suggested that we try them since the line was pretty long and we were quite hungry. As I walked over to receive the samples and my friend stayed in line, the worker also instantly handed me a coupon: BUY ONE PRETZEL, GET ANOTHER ONE FREE. Having already committed to wait in line to purchase two pretzels before I got the coupon—it was my friend’s birthday so the two pretzels were on me—I actually received a free pretzel! After consulting with some other economists, none of us could find an implicit cost that I incurred in order to receive the free pretzel (though you could argue that my time to write this blog post is an after-the-fact cost associated with the pretzel purchase). In short, who says there’s no such thing as a free lunch?

Discussion questions:

1. Can you think of a time in your life where you actually received something for free? That is, there were no explicit monetary costs or implicit opportunity costs.

2. If I was just passing by Auntie Annie’s and received the coupon, why would the second pretzel not be free? What opportunity costs would be associated with using this coupon in that case?

3. Suppose you have a “Buy 10 pretzels, Get One Free” card for Auntie Annie’s. Does it distort your behavior in any way? Is the 11th pretzel actually free?

Leggo My Eggo! Really!

It’s hard to miss the barren shelves in grocery stores due to a pending Eggo Waffle shortage. The recent run on the popular breakfast food is one of the few times when a very clear-cut piece of microeconomics hits home enough to capture the attention of people without an economics background. What fascinates me the most about this story is how people with no interest in economics still have the shortage on the tips of their tongues. I believe there are two different microeconomics concepts at play here: one covered in nearly every introductory economics class and the other a deeper assumption that deserves more discussion than it normally gets.

First, the shortage in stores essentially comes from Kellogg’s self-imposed price ceiling. It seems that Kellogg has decided to continue selling Eggo Waffles at the same manufacturer’s suggested retail price (MSRP) rather than raising it to reflect a decrease in supply since two of their four production plants are out of commission. By leaving the price where it is, there is a shortage in the market because more people would like to buy at the MSRP than Kellogg wants to serve. This decision seems odd to economists because it introduces inefficiency. The price ceiling creates a shortage in the market which leads to the inefficiency. On the corresponding graph, you can see the minimum amount of deadweight loss (DWL) in the market for Eggo waffles given this shortage; the DWL could be larger if those consumers with a lower willingness to pay are the ones who end up buying the existing waffles. One possible reason for the price ceiling is that Kellogg does not want to appear like it is trying to profit off of its own misfortune (the Atlanta plant closed due to heavy rain) and planning (the Tennessee plant closed for repairs).

Operating under typical economic assumptions, unless Kellogg or individual stores decide to raise the price, the shortage in grocery stores should continue. This means that some consumers who would be willing to pay more than the MSRP will be unable to get waffles. Which customers end up with the waffles will only be a matter of timing and luck, and it is very likely that some people who are unable to purchase waffles will value them more than others who buy a box they find on the shelves. One common explanation economists offer about how this situation will be resolved is the emergence of a secondary market or black market. USA Today interviewed Joey Resciniti, a shopper who bought one of the last boxes, who said, “I told my husband that maybe I need to put them on eBay." In secondary markets, people who are lucky enough to buy the boxes at the MSRP are able to turn around and sell them to an unlucky person who is willing to pay above the sticker price but was unable to buy any waffles in the store, exactly what Ms. Resciniti suggested.

The second economic concept at play here is the competitive hypothesis. The classic supply and demand analysis used above rests on some core assumptions of economics, such as rationality of agents, complete information, and the competitive hypothesis. When any of these assumptions are broken, we need a different model to understand what will happen in the world. The competitive hypothesis can be summed up by the assumption that a consumer believes that if they decide to buy a product they can afford, they are able to get it. For example, if I worried that the gas station near my house would run out of coffee before I get there in the morning, I might behave much differently. The same can be said of Eggo Waffle consumers. In the USA Today article, Ms. Resciniti also said, "We have eight of them, and if we ration those—maybe have half an Eggo in one sitting—then it'll last longer.” If consumers believe they will have a hard time finding an item they want to buy, they may instead chose to change what they want to buy. If for example, Ms. Resciniti does start to ration her waffles, then she may need to buy more oatmeal or fresh fruit for breakfast on other days. If consumers start rationing because the competitive hypothesis does not hold, a more complicated model is needed to correctly determine equilibrium behavior.

Discussion Questions:

1. What should the shortage of Eggo Waffles do to the demand for other brands of waffles? What about the demand for maple syrup?

2. Think of some secondary markets you are familiar with, like eBay, ticket scalpers, or craigslist. How are prices determined in these markets? If a secondary market for Eggo Waffles forms, what can you say about the equilibrium price?

3. If a black market for Eggo Waffles did emerge, who would be worse off at the equilibrium? Would anyone be better off?

4. Think of some other real-world examples where the competitive hypothesis is violated. What would need to be added to the basic supply and demand model to accurately predict what people do when they aren’t sure if the store will have the goods they want in stock?

The 2009 Nobel Prize in Economic Sciences

A few weeks ago, the committee that awards the Nobel Prize in Economic Sciences announced the winners of the 2009 award. The prize winners were Elinor Ostrom of Indiana University and Oliver Williamson of the University of California, Berkeley. The committee awarded this year’s prize to these economists for their work in economic governance. For Ostrom, the committee cited her research on the methods that actors use to avoid over utilization of common property resources. Williamson’s research provided theory on the conditions under which firms are better suited for economic organization than markets.

Ostrom found numerous examples in which actors had successfully avoided the “tragedy of the commons.” Standard theory had found that common property resources are too often exploited to the point of inefficiency and depletion. Ostrom examined numerous case studies in which actors avoided resource depletion through various governance structures. Much of her insight involved applying theories of repeated games in which actors may punish others who over extract common property resources.

Williamson provided theory to explain firm organization and conditions under which economic activity is better suited to take place within a firm than in a competitive market. An important basis for his theory involved the timing of work and bargaining. For instance, agreements made prior to work being performed can break down once the work is completed due to a change in the bargaining position of the actors. When the work is highly firm-specific then the actor who completed the work may find himself in a weak market position with only a single prospective buyer. In contrast, by arranging activity within a firm, the ex-ante and ex-post market issues are avoided. Similarly, the firm provides a clear hierarchy of authority which can help to clearly dictate the work that must be done. However, Williamson’s research also highlights an important disadvantage of firms: authority is prone to abuse.

The research of both Nobel Prize winners provided a richer framework for analyzing economic activity through its insight into governance. To learn about their research in greater detail, see the scientific background paper provided by the Nobel committee.

Discussion questions:

1. Describe some ways in which common property resources may be governed for the long term benefit of stakeholders. What are some of the difficulties involved in such governance?

2. What are some of the other advantages or disadvantages of firms, when compared to markets, which are not described above?

3. What other economic governance issues do you observe? Are these issues dealt with in a way that improves or worsens economic efficiency?

Virtually Bankrupt

The space-themed video game EVE Online is described as a massively multiplayer online game (or MMO). In other words, the game is played over the internet in a virtual world where all (or nearly all) characters are controlled by users who are able to interact with each other. EVE Online separates itself from many other MMO games by offering an incredibly robust and fascinating economy, complete with its own currency of InterStellar Kredits (ISK), in-game supported contracts (that cover loans, trade agreements, and hiring other players to complete tasks for a fee), user-created and managed banks, and trade between players (in both money and goods). And if the game wasn’t realistic enough, the in-game universe even mirrored the troubles on Wall St. when the economy was hit by a bank scandal!

In July 2009, a manager of EBank, the largest in-game bank, embezzled 200 billion ISK then turned around and sold the in-game currency outside of the game for a real-world $5,000. Once news of the scandal became public, many depositors became concerned about the bank’s stability and decided to withdraw their money. These fears created a bank run that left EBank short 380 billion ISK. The chairman of the bank attributed this shortfall to both the embezzlement and further mismanagement that stemmed from ignoring safeguards and controls. Only a month later, the bank faced a total deficit of 1.2 trillion ISK and announced that it was freezing withdrawals on current funds and suspending all interest payments until it reached an equity status of 90%. As of this post, depositors are still awaiting the next announcement of EBank’s policies.

Many parts of the EVE online environment closely mimic economic events in the real world, but I do not think a bank run like this could be observed in America today because of the modern level of regulation. That said, the circumstances that led to the game’s financial crisis do mimic real-world occurrences from the early twentieth century. EBank’s problems stem, at least in part, from the fact that it was left to self-regulate and that its actions were largely unmonitored. Historically, similar conditions led to the banking crises of the 1930’s. These wide-spread bank failures led to increased legislation and controls on banking which established three main systems that prevent bank runs today: deposit insurance, capital requirements, and reserve requirements. If members of the game’s community wish to restore a reliable banking system, it seems likely policies that mimic one or more of these systems would be implemented.

However, if banking or using fiat money (currency with no underlying value) is viewed as unreliable, let me propose some other responses the game’s community could have. First, and most simply, a barter economy could develop as the main source of trade. In this scenario, any player seeking a good would need to find another player willing to give that good away in exchange for other goods. Obviously this sort of economy comes with drawbacks, as trade partners take time to find and each trade would need to be negotiated. This barter economy could expand to a commodity money trade system: where all goods are expressed in terms of multiple or fractional values of a single good with intrinsic value. (One of the best known examples of an economy like this occurs in prisons. Inmates are not allowed to hold money, but a system of trade develops around a single good, often cigarettes or energy bars.) Since this underlying good has a use, unlike fiat money, a bank often has no role since players can put money not spent to other uses.

The final system I’ll suggest is trade based on credit. For a system of trade that is built entirely on credit to support long-term trade, all traders in the market must know each other’s reputations prior to trading with any partner (even if they have never met). In the modern world, having a record of every person’s reputation instantly is simply not possible, so we do not observe this kind of trade. However, by definition, all trades occur in a game played over the Internet, so it seems perfectly practical for all players to always have access to websites at the same time. To support a credit trade system, a webpage could track the trading desires of each player (uniquely identified by their in-game name) as well as their reputation. Any player who does not fulfill his or her end of a deal could then be monitored and either punished or simply barred from future trade. All honest players would then be left to agree to turn over a good they don’t need to a player, and in exchange receive what they desire from someone else on credit. One further potential layer to make this more practical would be for all trades to go through a neutral third party (the same way people exchange valuable goods in escrow in the real world). This third party could charge a small fee to make a secure transaction and to maintain the outside website. The third party would also remove the potential for traders to attempt to blackmail each other by falsely reporting dishonest trades in order to sabotage reputations.

Discussion Questions:

1. How did rational expectations contribute to the bank run? Think about whether or not a bank run would have happened if each individual believed that everyone else had faith in the bank.

2. Who was hurt the most by the bank run: debtors, creditors, or people with no ties to the bank?

3. Based on the sale of embezzled money, find the U.S. Dollar-ISK exchange rate. How would the game’s economy change if purchasing in-game fiat with U.S. dollars was allowed?

4. Suppose one player proposes using an entire ship as the unit for commodity money, and another player suggests using one ton of steel as the unit. Assume that half a ship is useless, but that half a ton of steel is half as useful as a full ton. Which of these is a better proposal for commodity money? Is it important that money is divisible?