Friday, October 31, 2008

Recent Land Reform in China

The Chinese Communist Party (CCP) collectivized—or assigned ownership to a collective rather than to individuals—all land in 1950s. In a second round of land reforms 30 years ago, the CCP assigned small plots of land to each rural family. Families could use the land as they saw fit and sell the resulting crops but the state maintained ownership of the land itself. Selling the property was therefore out of the question.

Last week, the CCP announced a third round of land reforms, allowing farmers to "subcontract, lease, exchange or swap" their land-use rights. Although farmers cannot sell their land, they can lease their land to other farmers for up to 70 years in exchange for cash. For China, the reform represents another step away from communism and another step toward a market-based economy.

Proponents of the policy hope for four positive effects. First, exchange of land among farmers should lead to a more efficient allocation of resources. Previously, people who wanted to leave the farm for work in the cities left their plots of land in the care of elderly parents. Under the new policy, those people can subcontract their land-use rights to farmers who place a higher value on the rights to use the land.

Second, the reform should allow farmers to enjoy economies of scale—the cost reductions that result from higher levels of output. Before the reform, each rural family had a small plot of land, limiting the use of machinery and technology in farming. As a result, agriculture in China remains labor-intensive. The exchange of land-use rights will allow the development of more commercial-scale, larger farms, where farmers can take advantage of more advanced agricultural technology. As farming yields rise, so will China's total contribution to the world food supply.

Higher yields may contribute to the third potential benefit: higher incomes for families in the Chinese countryside. The incomes of some farmers will rise along with the output per acre. Those who would rather leave the countryside can now cash in their land-use rights and pursue better paying opportunities in the cities. The rising incomes should lower the income gap between rural and urban households, easing a social tension.

Finally, the new policy should provide more property protection to farmers. Before, without the rights to lease state-owned land, land grabs by local authorities left many rural families with little to nil in the way of compensation.

Of course, there is no guarantee that the policy will work as intended. Opponents of the measure worry about the effects of the reforms. They argue that the policy will force some farmers to lease property and join the ranks of cheap labor in the cities, increasing the income gap even more as land-use rights become concentrated in the hands of well-off farmers.

Discussion Questions

1. Do you believe that the new policy would provide adequate property protection for small farmers? Could land grabs still occur? Why or why not? Can you think of other economic or political challenges the reforms will create?

2. What new pressures will the cities face if many farmers lease their land and move to urban areas?

3. The ongoing financial crisis in developed countries overshadows the ongoing food crisis in developing countries. The food crisis refers to rising prices for basic food like rice and wheat. If China's land reforms work as intended, how might they affect the global food crisis?

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Thursday, October 30, 2008

2008 Nobel Prize in Economic Sciences

The Royal Swedish Academy of Sciences recently awarded the 2008 Nobel Prize in Economic Sciences (PDF) to Paul Krugman of Princeton University. Krugman showed how economies of scale can help to explain patterns of trade and the location of productive activity. His research into international trade developed a new trade theory that explained trade patterns that previous theories could not. The model that he developed for international trade also became useful for analyzing economic geography.

Before the publication of Krugman's seminal articles, international trade theory was dominated by the concepts of comparative advantage and factor-proportions. The former was due to the insights of David Ricardo, who emphasized opportunity costs as the basis for the gains from international specialization and exchange. Eli Heckscher and Bertil Ohlin further developed the theory by examining cross-country differences in factors of production as the basis for trade patterns. These traditional theories are good at explaining observed trade patterns between a developed nation and a low-income nation.

However, these traditional trade theories are not able to explain the vast majority of trade flows among developed nations. These trade flows, called intra-industry trade, involve trade within the same industries. Such trade does not conform to the traditional theories because opportunity costs and factor proportions are often similar in the nations that exchange products from the same industry. For example, automakers in the U.S. export cars to Japan, and Japanese automakers export cars to the United States. This can't be explained by the Ricardian concept of comparative advantage.

Krugman was awarded this year's Nobel Prize in economics in part because his models of international trade can explain such intra-industry trade as resulting from monopolistic competition, economies of scale, and consumer preference for product diversity. Krugman's model can be illustrated in a graph like the one above, which examines the relationship between the number of firms, the average cost of production, and product price in monopolistically competitive industry. Specifically, the CC curves represent the relationship between firms' average cost of production and the number of firms in an industry, and the PP curve represents the relationship between product price and the number of firms in an industry.

Recall that in a monopolistically competitive industry, firms produce products (like cars) that may differ in quality and style. As more firms enter a given market, each produces less, and average costs increase; therefore, the CC curves are upward sloping. At the same time, more firms mean more competition, which drives prices down; therefore the PP curve is downward sloping.

Where does trade come in? Well, suppose there are automobile producers in the U.S. and Japan. If there is no trade between the two countries, only a certain number of car types will be supported by the sizes of these two markets. But if the two countries can trade, then firms in both countries can sell to consumers in both countries, because some American consumers will prefer Japanese cars and vice versa. This increase in the size of the market means that the automakers are able to produce more cars at lower average cost by taking advantage of economies of scale. In Krugman's model, this causes the CC curve to shift from CC1 to CC2. Consequently, the market equilibrium moves from A to B, which results in a lower equilibrium product price, P, and a greater number of firms, n, producing for the industry. Consumers also benefit from a wider range of available product varieties .

Another important aspect of Krugman's work that was cited by the Nobel committee is the extension of his model to explain the location of economic activity, work that is credited with developing the field of economic geography. It helps to explain the core-periphery pattern of urbanization and migration seen in much of the world. Krugman also made noteworthy contributions to research on strategic trade policy and currency crises. Several pages summarizing his research are presented in the Nobel Prize committee's scientific background paper (PDF).

Discussion Questions

1. Paul Krugman is, for an academic economist, relatively well-known by the public due to his numerous television appearances, books, and articles in the popular press. Some academic economists have been critical of contributions that are easily accessible to the public. Do you believe that such less-scholarly work by Krugman detracts from or adds to the respect he has gained for the contributions which have earned him the Nobel Prize?

2. In what industries besides automobiles do we observe trade patterns which conform to Krugman's theory?

3. What are some of the drawbacks to globalization? Do you think that globalization has had a negative effect on your life, a positive effect on your life, or has had little impact on you? Explain.

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Thursday, October 23, 2008

Selling Palin Short

"I don't worry about the polls. Polls are just a fancy way of systematically predicting what's going to happen."

Thus spoke Tina Fey-as-Sarah Palin on Saturday Night Live. It made for a good line—but are polls really that systematic? Just how well do polls do at predicting the outcome of an election? How can you take the results of multiple polls and paint a convincing picture out of them? Finally, what other mechanisms are there for predicting the outcomes of elections?

There are a number of sites devoted to analyzing the myriad of polls that come out every day as the election nears. Two good sites that take very different approaches are and To compare and contrast their analyses, let's take a look at Pennsylvania, which many analysts deem a pivotal state in this election. Here's a list of Pennsylvania polls taken during October:






West Chester U.





Strategic Vision




















Zogby Interactive















Morning Call





These polls all varied in their methodology—whom they polled, how they did it (robocall or a human being making a phone call), and how they weighted the results. chooses to average the polls it judges are the best reflection of public opinion. Recently, it listed only the last three polls and averaged them together to predict Obama with 51.7% and McCain with 40.3%. (Note that these don't add up to 100% because of undecided voters.) takes a much more sophisticated approach. It adjusts for trends within Pennsylvania, across the nation, and among demographic groups. Instead of just choosing a few polls, it weights them according to methodology and how out-of-date they are. Then it reports three numbers: the raw weighted average of polls, the trend-adjusted average, and the results of a regression analysis that takes into account demographic and other factors. It also makes a prediction of Election Day based on the likely last-minute decisions of undecided voters. Finally, with all of that analysis in mind, the site makes a prediction as to the likelihood that each candidate will win Pennsylvania on Election Day:



Polling Average






538 Regression






Win %



So far we've looked only at sites which analyze polls. But there's another kind of site devoted to predicting the elections: prediction markets. The thinking behind prediction markets is that, just as prices aggregate private information about buyers' values and sellers' costs in a market for goods and services, a market for future events can aggregate private information about the likelihood of those events happening. Two well-known political futures markets are and the Iowa Electronic Markets.

Take a look at the page on Pennsylvania. There you can see the probability the market places on Obama winning the state—as I write this, it's about 85%. It's not quite a bet, it's more like a stock price. This is how it works: there's an option that pays $10 if Obama wins Pennsylvania, and $0 if he doesn't. The price of that option is currently about $8.50. In other words, people are willing to pay $8.50 for a piece of paper that pays $10 if Obama wins the state; therefore, we can interpret this to mean that the "market thinks" there's an 85% chance Obama will win Pennsylvania's 21 electoral votes.

Discussion Questions

1. Suppose you wanted to predict the probability that Obama will win Pennsylvania. How would you go about doing it?
2. We saw above that assigns a 98% probability to Obama winning Pennsylvania, while the Intrade price assigns an 85% probability. Why the difference? Under what conditions would a prediction market be a better predictor of an outcome than a poll? Under what conditions would the reverse be true?
3. Not all prediction markets have the same price for each contract, despite the fact that arbitrage opportunities abound. Why might this be the case? (For those interested, Nate Silver at has an interesting analysis of this phenomenon here.)
4. There are some nonzero prices on intrade for very unlikely events. For example, you might notice that there's an intrade bet on whether Sarah Palin would drop out as the Republican nominee for Vice President, and another market on whether Al Gore will be on the ticket on November 4. Why do these contracts exist? Why do you think they have positive prices?


Tuesday, October 14, 2008

Do You "Appreciate" Wendy's Super Value Menu?

Despite your possible love for the Double Stack burger found on Wendy's $.99 Super Value Menu, the claim made in a recent Wendy's commercial that the burger "appreciates" in value after being purchased is seriously flawed on many levels according to standard economic theory.

Of the many economic fallacies in the commercial, the immediate one that comes to mind is the mix-up between the notions of appreciation and consumer surplus. Recall from your introductory economics courses that consumer surplus is the difference between what a consumer is willing to pay for a good and what he or she actually pays for it. Obviously, you would never buy something if its valuation to you as a consumer was less than the price you must pay. Therefore, according to standard economic theory, consumer surplus must always be at least zero—though it is typically positive for an individual consumer since it is unlikely that you actually pay the true valuation for any good you purchase.

That said, it is not surprising that the "Student" in the commercial won't accept exactly what he paid for the burger since that is not his true valuation of the good. For example, it's possible that his demand curve is of the following shape:

This demand curve implies that Student will pay up to $3 for one Double Stack burger, but then nothing beyond that. This also represents his value for the first Double Stack burger. In this case, Student would receive roughly $2 (= $3 – $1) in consumer surplus by purchasing the Double Stack burger for nearly $1. Obviously, there are an infinite number of possibilities for Student's demand curve, but the one thing we know for certain is that his value of the Double Stack burger is AT LEAST the cost of the burger—but there is nothing preventing his valuation from being higher.

Thus, the idea that Student would not accept a dollar in exchange for his burger has absolutely nothing to do with the proposed "appreciation" of the burger—in other words, Student's valuation of the Double Stack burger has not changed. Rather, this scenario is more reasonably explained by the gains in trade that the buyer receives from purchasing the good at a given price below his private valuation.

Discussion Questions

1. In economics, the notion of a shoe-leather cost—the cost to consumers of actually going to wherever the good is being sold—often plays a role in consumer and producer theory. How would your willingness to accept a dollar for a Double Stack burger change depending on whether you are currently at Wendy's or at home a few miles from the nearest Wendy's?

2. How would this discussion change if Wendy's was able to practice perfect (or first degree) price discrimination?

3. Wendy's often claims that their burger is underpriced and is therefore a value buy. If this were truly the case, why do we not see secondary markets for this good? Is Wendy's really charging the right price?

4. The endowment effect is the idea that people value a good or service more once their property right to it has been established. Is this example of such an effect? Why or why not?

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Friday, October 10, 2008

The Federal Reserve's Expanding Toolkit

On October 8 and 9, major central banks in Europe, the Americas, and Asia took the exceptional step of reducing interest rates in concert to stave off a global economic slowdown during the ongoing financial crisis.

The financial crisis is rooted in the faltering U.S. housing market. Many banks and financial institutions hold assets (such as mortgage-backed securities) that are tied to home loans. As house prices fall and more Americans have trouble paying their mortgages, these assets lose value, and financial institutions find their holdings are worth far less than expected. Such losses hamper the ability of financial institutions to borrow and lend. At the moment, financial institutions are very reluctant to lend to one another for fear of further exposing themselves to mortgage-related losses.

To combat this crisis of confidence, the Fed is dramatically expanding its role as the lender of last resort in the U.S. financial system. In addition to the coordinated rate cut, the Fed's new policy measures include direct loans to insurers and businesses, as well as an unusual level of cooperation with the U.S. Treasury Department. National Public Radio's Laura Conway catalogues the Fed's expanding monetary policy toolkit here.

Discussion Questions

1. Historically, the Fed's status as lender of last resort extended only to commercial banks. How has the scope of the Fed's lending changed as a result of the crisis?

2. Why don't central banks coordinate monetary policy more often?

3. If effective, how will the Treasury's $700 billion rescue package help the Fed's efforts to restore confidence among banks and financial institutions?

4. What constraints do central banks face in responding to the financial crisis?

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Thursday, October 09, 2008

Paul Romer on the Financial Crisis

Aplia's founder, Paul Romer, recently wrote about the financial crisis on the Growth Blog. In his essay, Romer encourages a more open dialogue between the academics who build economic models and the policymakers who respond to unforeseen economic crises in real time. Read the post to find out more.

Discussion Questions
1. Think about the basic models you learned in introductory economics, like supply and demand. How do these models inform your understanding of the financial crisis? What aspects of the crisis do they leave unexplained?

2. How would you rate the performance of the Treasury and the Fed in handling the ongoing crisis? What would you do differently? How can we prevent similar crises from developing in the future?

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