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.

Bags Don't Fly Free

As a frequent Southwest passenger, paying for checked baggage is not quite commonplace for me yet, since Southwest is a firm proponent of bags flying free. As any traveler is well aware, many airlines now charge an additional fee for checking baggage, averaging roughly $20 per bag. However, I was initially surprised when I recently checked in online for my US Airways flight, and was offered the option to declare the number of bags I’d be checking and thus pay a reduced price of $5 less per bag.

Although at first glance you might be tempted to think this is a classic example of price discrimination, further examination will reveal other possible explanations for this pricing disparity. If price discrimination were the sole justification for the two different prices, this would mean that US Airways is trying to extract additional consumer surplus (and thus increase profit) by segmenting the market into those who check in online and those who don’t. Based on the pricing differences, this would mean that US Airways believes that those passengers who check in online have a lower willingness to pay than those who check in at the airport.

However, there is reason to believe that many passengers who check in online might actually have higher willingness-to-pays than other passengers, as they are likely to be business travelers who are either in an office with wifi or have internet connections on their phones. Since business travelers tend to have a more inelastic demand for travel services (mostly since they do not directly incur the expense), an argument could be made that this market segmentation isn’t the most profitable.

An alternative, and more plausible, explanation for the two different prices is that US Airways is creating an incentive for passengers to declare the number of bags they’ll be checking and pay for them ahead of time. Incentives are at the core of economic analysis, so this result isn’t incredibly surprising. By charging a lower price to those passengers who “check bags” ahead of time, US Airways is inducing passengers to plan ahead. Some possible justifications for why they would want to do this are as follows:

1. Paying for bags ahead of time reduces the wait time for passengers seeking to check in at the airport. This makes customers happy and more willing to fly US Airways, and perhaps lessens the need for extra employees working the check-in booths.
   
   
2. If passengers declare the number of bags they are checking ahead of time, US Airways can more accurately predict the number of bags that will be on the flight and perhaps the need for overhead space in the cabin.

Discussion Questions:

1. If US Airways’s goal is to increase profits through price discrimination, is the market segmentation they are using appropriate? Can you think of any other existing ways that airlines segregate their markets?

2. How does this information friction about the price of checked bags affect efficiency in this market?

3. Can you think of other markets where different pricing mechanisms exist in order to incentivize a particular action, such as cities charging for trash removal but providing free recycling services?

Internet by the Byte

With significant contributions and analysis from Kasie R. Jean.

Many existing industries follow a pay-per-use pricing structure. Cell phone companies typically charge by the minute and taxi cabs charge by the mile—why should Internet usage be any different?

Time Warner took the pay-per-use approach recently when it announced a pilot pricing model for its broadband Internet service. The new tiered billing system resembles that of most cell phone plans: households choose one of five levels ranging from 5GB ($29.99) per month to 40GB ($54.90) per month (or a yet to be priced 100GB per month) with a $1 fee for each GB over the chosen plan.

For flat-rate customers, Internet bandwidth is like a common resource—everyone can use the Internet as much as they want, but when one person uses a lot of bandwidth, that slows down the service for everyone else. This is a practical example of what economists call “the tragedy of the commons.” The argument claims that heavy Internet usage imposes a negative externality on all users who share a provider. In order to control its product quality, Time Warner tried a tiered pricing plan in hopes that it would discourage large bandwidth users from bogging down the service’s speed. By adding a cost, Time Warner caused consumers to internalize the externality imposed by heavy Internet usage under the flat-rate scheme.

So, what's the downside? There isn't one, unless you happen to be a consumer whose usage puts you in a tier that's priced above the current flat rate. More and more people find themselves in this group as the Internet’s functionality expands. Nowadays it is not uncommon for consumers to work from home, stream episodes of TV shows that they missed, download music, or play video games through their PC console on systems such as the Xbox or Wii. Streaming and downloading are a surprisingly quick way to run through your monthly GB quota in a matter of days.

Suppose that you used to pay a flat rate of $39.99/month with Time Warner. Under the new pricing system, this same monthly fee would entitle you to only 10 GBs/month. A few movie downloads and streamed TV shows later, and you will already have run through your monthly usage allotment and will be stuck paying overage charges for routine Internet tasks.

It's not surprising that the trial runs of the tiered pricing system caused a major uproar among Time Warner users. Under the proposed new pricing, any users consuming more than 10GB’s per month will be paying more for essentially the same service (though access might be faster if the new policy is a successful deterrent to over-use of bandwidth). If Time Warner decides to go through with the pricing switch nationwide, only the very low bandwidth users will actually benefit from it, which will potentially cause a mass exodus from Time Warner to other services.

Discussion Questions

1. Under the newly proposed pricing model, is the overage fee always something consumers should choose to avoid? If you knew you would consume exactly 8GB of bandwidth next month, what is the least cost way to purchase it? Construct a graph that shows the least cost way to consume at any monthly usage.

2. Switching costs play a significant role in the market and pricing structure of an industry. How do switching costs affect Time Warner’s ability to change its pricing scheme with current users?

3. How do consumer preferences and alternative Internet services affect the decision to choose one service or another? Which consumers would prefer a tiered pricing system over a flat rate system?

4. Suppose the new pricing goes into effect. Since video streaming is bandwidth intensive, how might a website (like YouTube) or a service (like Xbox Live) be able to keep its current users?

ARRGGHH... The Stakes Be High, Says I!

When you pay ransom to a hostage-taking pirate, traditional economic theory suggests that you increase the returns to piracy, encouraging more of it. If you kill a hostage-taking pirate, you increase the cost of piracy, which should discourage would-be pirates from taking to the seas.

The response by the Somali pirates to the U.S. Navy's recent killing of three pirates has been just the opposite though. These gangs say they are now devoted to revenge-taking over more ships and taking more hostages than ever. The cost of doing business has risen, and yet they want to do more of this business than ever. Why do you think this is?

Discussion Questions

1. In order to quickly obtain large ransoms, pirates must signal a credible threat to cargo ship owners. How might this credibility issue play into the pirates' response to the actions of the U.S. government?

2. The pirates killed by U.S. Navy snipers were holding an American captain of an American boat with an American crew. Might governments respond differently in situations involving multi-national crews?

3. The pirates who were killed were likely just henchmen with little power in the criminal organization. Did the "cost of doing business" really rise very much for the pirates running the organization?

4. In what ways does the government provision of naval security in international waters resemble a public good? Might the current allocation of security (both private and public) in international waters be inefficiently low?

5. From the standpoint of ransom maximization for a small individual gang of pirates, what is the optimal amount of piracy? What is the ransom maximizing strategy if the piracy off the Somali coast is coordinated by a cartel of gang lords?

On Income Caps and the Market System

Yesterday morning on a local radio station, a few callers discussed a silly idea. The question posed to listeners was this: "Should there be a law against anyone earning over $1 million per year?" One caller talked about the celebrity Kim Kardashian, and how it is not right that she earns so much money. That is absurd. The market is rewarding Kim because of her looks, her connections, and because in recent years her public persona has been well-managed. If companies want to pay her ridiculous amounts of money for her various "talents" because people enjoy being entertained by her, then so be it. It might not be fair, but neither is life. On the bright side, we have a progressive income tax system that will tax such extravagant incomes at higher rates than the rates faced by ordinary Americans. A much better idea would be to raise marginal income tax rates on the highest tax brackets to help limit our budget deficits and get a fair amount of tax revenue from those whom our market system has allowed to earn enormous amounts of income in our nation.

Yet, how could economists ridicule a ban on excessive income when they support President Obama's limits on executive pay for firms that seek government assistance? The reason is that such firms were mismanaged, and as a result, they got pummeled by the market, forcing them to sheepishly seek government bailout funds. In this situation, executive salary caps are a brilliant proposal. If the firms do not like the caps, they could try getting bailed out by the market, but they will find that the market will most likely not come to their rescue. The market system will allow the firms to go bankrupt because of their poor performance. That is what the market system does to firms that perform poorly. Obama's limit is set at "only" $500,000 per year and lasts until the bailout funds are fully repaid by the firm.



The argument against the salary caps proposed by Obama is that these firms will lose good executives because they can be paid more elsewhere. But is this necessarily a problem? There are undoubtedly many capable people with better understanding of risk management and liquidity who would be happy to work for these firms for $500,000 per year. If the firms find that they cannot retain the best executives, then they will find themselves with a greater incentive to refund the taxpayer money that much sooner. If the executives who are running these firms want to earn more than $500,000 per year, they will have to get their firms back in shape and earn enough profit to repay the bailout money. An argument can be made that shareholders can oust poorly performing executives and limit executive pay by changing a corporation's board of directors. This argument is a diversion, as can be seen in an article named Shareholder Power from the Christian Science Monitor.

Let the Kim Kardashians of the financial sector go seek out new firms to mismanage!

Discussion Questions

1. Do you agree with this author's viewpoint about bans on enormous salaries? How about his viewpoint on Obama's executive pay cap plan? Is there inconsistency in his views? Is there inconsistency in yours?

2. How do you feel about America's progressive income tax system? If you were in control of the federal government, what would you do to change it, if anything?

3. What do you think about the concept that government should stay out of the free enterprise system? Do you believe that government involvement has made the global financial crisis worse, or has it helped moderate its severity?

4. Suppose that the U.S. did enact a law against anyone earning over $1 million per year. What would the corporate CEOs, celebrities, athletes, and other top earners do in response? Would they leave the country? What other complications might arise from such a law?

Gainfully Unemployed

A 35-year-old Wisconsin man was recently fired from his job at Qdoba after he trashed the place, throwing pots, pans, desserts, and boxes of hot sauce on the floor. His motive? He claimed he was trying to get fired so he could collect unemployment insurance. Apparently, nobody told him that Wisconsin only pays unemployment benefits for certain types of separations. Not surprisingly, getting fired for intentional wrongdoing isn't covered.

Nearly everyone has had a job they despised. At some point the earnings from the job no longer outweigh the costs of sticking with it. The typical reaction is to simply quit and begin look for a better job. True, the newly unemployed worker will no longer collect any wages. But the added leisure time and the prospect of better work are presumably more than enough compensation for the lost earnings.

During the current economic downturn, fears about prolonged unemployment may make another option more viable: getting fired or laid off. While those who quit are not eligible for government unemployment insurance benefits, those who get fired or laid off might be.

Although the Wisconsin man was unaware that trashing his place of employment would disqualify him for unemployment benefits, other workers may devise less obvious ways of getting themselves removed from their unpleasant job. If they land themselves in the ranks of the unemployed without compromising their unemployment insurance eligibility, they'll be out of an unwanted job and into a welcome series of government checks.

In normal times, the Wisconsin man may have simply quit, but it's not hard to believe that concerns over prolonged unemployment, combined with a dicey understanding of unemployment insurance eligibility, made this decision unacceptable.

It turns out that unemployment benefits influence worker decisions about whether to take a job as well. Search theory economists showed that the last time the British government reduced the number of weeks fired employees could collect unemployment insurance, the average duration of unemployment shrunk by the number of weeks that unemployment benefits were no longer paid.

Discussion Questions

1) Part of the federal economic stimulus package gives state governments the option of using funds to extend the amount of time that an unemployed person can collect benefits. What trade-off do governments face when they choose to extend the duration of unemployment benefit eligibility during tough economic times?

2) At the root of this entire disturbance was the worker's goal to qualify for unemployment. If he had been better informed about the rules regarding dismissal for cause, how would this change his decision?

3) How might a worker hoping to shake lose of a lousy job and collect unemployment insurance benefits game the system?

4) Ignoring cases where those fired are not elligible, would you expect to observe behavior where people seek to get fired to collect unemployment more among high-skill or low-skill workers? Which group typically faces more competition in the job market and has a harder time finding a new job? How are these two ideas related?

Bovine Intervention

A couple of weeks ago, economist Greg Mankiw pointed to an interesting story about so-called cow tax proposals in Europe. The taxes would apply to farmers and ranchers, based on the number of animals they raise—the more cattle in your herd, the larger the tax bill. Thus far, lawmakers in Ireland and Denmark have struck such measures down. The defeated Irish proposal put the tax at €13 for each dairy cow and the Danes were considering a tax as high as €80 per cow.

Why tax livestock? In a word, flatulence. (In two, enteric fermentation.) Cows belch and otherwise discharge their way to about 14% of the world's methane emissions. Like carbon dioxide, methane is a greenhouse gas. Although methane accounts for a relatively small share of all greenhouse gas emissions, it is alarmingly effective at preventing heat from escaping the planet. Compared to carbon dioxide, a little bit of methane goes a long way toward raising the potential for climate change. Reducing methane emissions would help Denmark and Ireland meet their EU climate policy commitments.

Raising livestock generates a negative externality: the costs of methane emissions are born by the general public rather than those directly involved in the production and consumption of meat and dairy. The emissions cause the marginal social cost of producing a pound of beef to exceed the marginal private cost.

The proposed taxes are an attempt to force farmers and ranchers to internalize the heretofore external costs of the methane emissions, bringing the private costs of raising livestock closer inline with the social costs. The tax would raise the costs of producing meat and dairy, reduce the supply of such products, and, consequently, lower methane emissions.

While a tax based on the number of cattle in a herd would undoubtedly reduce farming-related green house gas emissions, it would do so in rather blunt fashion. To see why, consider two ranchers. The first uses specialized cattle feed to reduce the methane emissions of his herd. The second sticks to traditional methods with the typically methane-intensive results. The cow tax, however, is levied equally on each head of cattle, failing to account for the methane reduction efforts of the first rancher.

While the cow tax provides an incentive to cut back on cattle, it doesn't encourage ranchers to adopt any of the promising technologies devised to reduce methane discharge from individual cows. Ideally, climate change policies should focus on the amount of methane emitted rather than the number of cows.

Discussion Questions

1. Can you think of policies to incentivize the adoption of methane-reducing technologies in farming and ranching?

2. Governments in Europe and the United States heavily subsidize the farming and ranching sectors of their economies. How would the removal of such subsidies impact methane emissions in Europe and the U.S.? What about methane emissions from less developed countries?

Debit or Credit?

As an economist and beloved shopper, I shudder in disbelief at how many credit-card owners still purchase items with their debit card. Assuming that you have a debit card and a credit card that is not maxed out, I present the following economic argument for why you should choose to use your credit card over your debit card.

The classic rebuttal I get to this argument is, "People are not responsible; they simply charge things without keeping track until their bill comes in." But how sound an argument is this? When you use your debit card, you still need to maintain a positive balance in your checking account so you don't overdraw and incur any fees. It only takes a little more effort to keep track of credit card purchases if you get into a routine of noting expenditures. For example, you could do the following: Upon making a purchase, set aside the purchased amount into a separate interest-bearing checking or savings account (which is easy and quick to do thanks to online banking), or track purchases in a spreadsheet or program (also easy to do with programs such as Microsoft Excel or Microsoft Money).

Another common response I hear is, "Some people keep a high balance on their credit card." When you use a debit card, the money is automatically withdrawn from your account. So the existing balance on your credit card is irrelevant when deciding whether to purchase the next item with either debit or credit since using your debit card would imply you have the cash on hand to buy it.

Even under the assumption that there is some cost to tracking expenses, there are still three significant reasons why you should use your credit card over your debit card.

1. The time cost of money
2. Typically credit cards offer better rewards programs
3. Build credit

Everyone knows that a dollar today is not worth the same as a dollar tomorrow. If you can forgo spending a dollar until a later time, then that dollar can earn interest until you actually spend it. In economics and finance, we analyze problems such as this using the concepts of present value (PV) and future value (FV). That is, the future value (FV) of a dollar today (PV) is

FV = PV x (1 + r),

where r is the interest rate over the time period in question. Since your debit card requires you to pay for the good today while the credit card allows you to pay for the good in the future at the same nominal price, economically you are better off letting the payment value collect interest until the balance is due and then paying off the balance.

Although debit cards are beginning to offer more competitive rewards programs, credit card companies typically still offer more diverse and appealing options such as cash back, miles, and points programs.

Last, the use of debit cards does not contribute to your credit rating. The responsible use of a credit card is a significant way that you as a consumer can build credit and improve your credit rating.

Discussion Questions

1. Why are some consumers unable to qualify for a credit card? Is their inability to qualify a good signal of their financial well-being?

2. How do rewards programs affect the bottom line of a credit card company? How can they afford to offer such incentives?

3. What kind of rewards would induce you to pay for something immediately rather than in the future by using your debit card over your credit card?

4. One argument for the use of debit cards is the option to receive cash back with your purchase if your bank's ATM is not near by. How does this affect your choice to use you a debit or credit card?

Deterring Suicide Bombers

So far this year, Israel has suffered two attacks at the hands of Palestinian men who resided in East Jerusalem. In the wake of the attacks, Israeli Prime Minister Ehud Olmert renewed a legislative proposal aimed at deterring would-be terrorists by punishing the families of the attackers. Punishment would include home destruction and cancelled access to Israeli social insurance programs. Eric Westervelt's NPR story offers more on the proposed law.

For the moment, let's leave aside the major issue of whether it is moral to punish people for murders committed by a dead relative. The objective of the law is clear: to provide a disincentive to suicide attacks by punishing the perpetrator's surviving family members. Should the law pass, suicide bombers would forgo not only their own lives but also, potentially, the welfare of their families. By raising the opportunity cost of a suicide attack, the supporters of the law hope to reduce the number of attacks. Recent research on the economic roots of terrorism can help us think about whether the policy will achieve its intended consequences.

In a 2003 research paper, Alan Krueger and Jitka Maleckova found that participation in terrorism is unrelated, and possibly even positively related, to a person's income and education. As Daniel Lerner pointed out in a study of Middle East extremism in the 1950s, would-be terrorists are not so much have-nots as they are want-mores. In a more recent article in The American, Krueger cites Claude Berrebi's research on the characteristics of Palestinian terrorists from the West Bank and Gaza Strip:

"[Berrebi] compared suicide bombers to the whole male population aged 16 to 50 and found that the suicide bombers were less than half as likely to come from families that were below the poverty line. In addition, almost 60 percent of the suicide bombers had more than a high school education, compared with less than 15 percent of the general population."

Apparently, better-educated terrorists are more likely to be committed to their organization's goals and also more likely to have the financial means to participate actively. After all, a person needs some level of income security to have pursuits beyond basic subsistence.

Krueger and Maleckova also cite some anecdotal evidence suggesting that terrorist groups attempt to recruit somewhat educated suicide bombers. Nasra Hassan, a UN relief worker, interviewed 250 Palestinians militants and their associates between 1996 and 1999:

"A planner for Islamic Jihad explained to Ms. Hassan that his group scrutinizes the motives of a potential bomber to be sure that the individual is committed to carrying out the task. Apparently, the groups generally reject for suicide bombing missions 'those who are under eighteen, who are the sole wage earners in their families, or who are married and have family responsibilities.'"

The evidence presented by Krueger and Maleckova casts doubt on the effectiveness of the Israeli Prime Minister's proposal. The threat to families isn't much of a threat to a terrorist with minimal or zero family responsibilities. The law may not present much of a threat to terrorists with families either. If the suicide bombers tend to be a bit more educated and financially stable than their peers, they will probably develop a contingency plan that softens the punitive blow to their families. Similarly, terror groups may alter their tactics in response to the law, perhaps offering some sort of compensation to the families of suicide bombers as a recruitment incentive.

Discussion Questions

1. Economic analysis allows us to answer "what if?" questions, such as "What would happen to the number of suicide attacks if the Israeli government punished the families of suicide bombers?" Economics is not so great for dealing with "what should?" questions; but as citizens, we still have to tackle them. What should the Israeli legislature do about Olmert's calls to punish the families of suicide bombers?

2. In Krueger's article from The American, he suggests using "demand-side" policies to reduce the number of terrorist attacks. In the "market" for terrorists, the demanders are terrorist groups hoping to employ the services of suicide bombers. According to Krueger, what types of policies might suppress the demand for terrorists? Can you think of ways for Israel and its allies, like the United States, to go about attacking the financial resources of terror groups?

3. Krueger points out that we're unlikely to find many would-be terrorists among the illiterate and destitute. What does he say about the notion that "the elite become terrorists because they are outraged by the economic conditions of their countrymen?"

Oil Prices and Expectations

Harvard economist Martin Feldstein's latest opinion piece in the Wall Street Journal argues that we can implement policies today that will impact the current price of oil. Current oil production responds to expectations about the future, Feldstein explains. Any significant change in expectations about the future price of oil will have an immediate impact on the current supply of oil. Broadly speaking, the expected price of oil changes for one of two reasons:

1. Changes in expectations about the growth of oil demand; and
2. Changes in expectations about the growth of oil supply.


How might changes in expected oil demand lead to higher current prices? As Feldstein points out, "when oil producers concluded that the demand for oil in China and some other countries will grow more rapidly in future years than they had previously expected, they inferred that the future price of oil would be higher than they had previously believed." If oil producers expect higher future prices for oil, they will curb production today (leave some oil in the ground) in hopes of extracting it at higher prices in the future. On the graph, the current supply of oil shifts to the left, to S1, causing the current price of oil to rise to P1 and the current quantity of oil to decline.

How might changes in expected oil supply lead to higher current prices? Again, from the editorial: "[C]redible reports about the future decline of oil production in Russia and in Mexico implied a higher future global price of oil." If producers expect oil supply growth to weaken in the future, the expected future price of oil rises, and oil producers leave some oil in the ground today in order to extract it at higher future prices. Once again, we'd expect the supply curve for oil to shift to the left, causing the price of oil to rise (to P1) and the quantity of oil to decline.

An increase in expected oil supply or a decrease in expected oil demand would lead to lower current oil prices. If oil producers think that future cars will be much more fuel-efficient than previously believed, they'd expect relatively weak growth in oil demand, and correspondingly lower future prices. In this case, producers respond by pumping more oil today in an effort to avoid lower future prices. Similarly, as Feldstein points out, "increasing the expected future supply of oil would also reduce today's price."

Discussion Questions

1. Although Feldstein points out that a significant increase in expectations about the future supply of oil would put downward pressure on today's price of oil, he does not explicitly endorse a policy of drilling in currently protected areas of the United States. The crucial question is whether or not future drilling in currently protected areas would have a large enough impact on worldwide oil supply to trigger production changes today. What do you think?

2. There's much discussion in the news about how to develop alternative sources of energy that would reduce the future demand for oil. What are some policies that would reduce the future demand for oil and oil-derived products, like gasoline? Would government commitment to these types of policies be credible enough to lower expectations of future oil prices?

3. Not all economists agree with Feldstein about the ability of current energy policies to impact current oil prices. Many (though not necessarily most) believe that there is very little the government can do to achieve lower oil prices in the next few months or years. Why might this be the case?

Ireland's Plastic Bag Tax

In an important scene from the 1999 movie American Beauty, two characters—Jane and Ricky—watch footage of a plastic bag dancing in the wind. That there's beauty all over the place, even in garbage, seems to overwhelm Ricky: "Sometimes there's so much beauty in the world, I feel like I can't take it, like my heart's going to cave in."

Unlike Ricky, Dubliners have to live without the heartbreaking splendor of airborne garbage. Plastic bags nearly disappeared from Ireland's cities after the government began taxing them in 2002. The tax, 33 cents per bag, was enough motivation for most shoppers to replace plastic bags with reusable cloth bags. Ireland's experience illustrates a basic principle of taxation: if you want less of something--like the not-so-biodegradable, sewer-clogging plastic bag--tax it. Read Elisabeth Rosenthal's New York Times article to learn more about Ireland's bag tax.

Discussion Questions

1. There's nothing like a green tax to bring out our inner-environmentalists. As Rosenthal points out, after the tax passed, plastic bag use became socially unacceptable in Ireland. In what way does the tax lower the barrier to adopting a disapproving attitude toward plastic bag use?

2. Ohio issues yellow and red license plates to drivers convicted of drunk driving (apparently, Ohio officials didn't give much thought to tourists from the great state of New Mexico). Can you think of other situations or even laws that are governed largely by the threat of disapproval from others?

3. How is the Irish government's campaign against plastic bags similar to government campaigns against tobacco? In what ways do cigarette and plastic bag taxes increase efficiency for society as a whole?

4. Taxing bad behavior can be good, but implementation and enforcement are issues. It'd be relatively easy to cut down on paper waste from ATM receipts because the fee can be collected electronically at the site of the transaction. Why does a plastic bag tax that works remarkably well in the digitized supermarkets of Ireland run into implementation problems among the vendors and mom and pop shops in China?

Labels: Taxes, Incentives, Market Failure, Externalities, Environment

The 2007 Nobel Prize: Mechanism What?

The 2007 Nobel Prize in Economics went to Leonid Hurwicz, Roger Myerson, and Eric Maskin for “having laid the foundations of mechanism design theory.”

Mechanism design isn’t covered in the typical introductory economics class. The narrative of your first econ class usually goes something like this: “The ‘invisible hand’ of the free market is the most efficient way of answering the fundamental economic questions: what to produce, how to produce it, and who consumes it. Sometimes the market doesn’t work—for example, in the case of externalities or public goods.”

In short, a single mechanism—the “market”—is usually the topic of discussion for intro courses. But there are lots of other mechanisms for answering these fundamental questions. And unlike the market, which is a decentralized mechanism (meaning it is not run by a central authority), there are plenty of man-made institutions that are centralized mechanisms. One example of such a mechanism is an auction, which allocates goods according to bids. Another is a political election, which allocates political power according to the preferences of the electorate. Both auctions and elections have rules, and these rules determine the optimal behavior of bidders and politicians.

One of the biggest challenges of designing an economic mechanism is that people have private information about their own preferences. One of the most famous examples of a mechanism design problem is the provision of public goods. Suppose a small town is considering the establishment of a public park in the town square. Should it ask the citizens how much each of them would value the park, and ask them to contribute that amount? Clearly, each of the citizens would have an incentive to “free ride” on their neighbors by understating their own value of the public good—so as a mechanism, just asking for voluntary contributions leaves a lot to be desired.

We will be creating a news analysis assignment about mechanism design for professors who use Aplia in their classrooms. In the meantime, here are some discussion questions to get the ball rolling.

Discussion Questions

1. “Market failure” often occurs when dealing with things other than purely private goods—for example, public goods, common resources, or goods with externalities. One solution to market failure can be broadly categorized as “market solutions.” An example of such a market solution is the levying of a Pigovian tax, which keeps the basic mechanism of the market but alters the incentives of participants. Another solution to market failure would be to replace the market with another institution entirely. For example, the right to use a specific frequency of the wireless spectrum is allocated by the Federal Communications Commission using an auction mechanism. Can you think of other examples of market failure that we address by using centralized mechanisms? What are the advantages and disadvantages to centralized mechanisms as opposed to market solutions?

2. The term “asymmetric information” refers to cases in which parties hold private (or hidden) information about their preferences or costs. One of the core challenges of mechanism design is to encourage people to reveal their private information in a truthful and credible way. For example, it is easy to show that the optimal strategy for a bidder in a Vickrey auction like eBay is to bid one’s true value. Think of a situation in which asymmetric information causes problems. What kind of mechanism could you design to elicit truthful information from the participants in that situation?

3. A recent Washington Post article has provoked a fair amount of discussion about the effectiveness of torture in acquiring information from prisoners. The most heavily quoted passage of the article reads:

“We got more information out of a German general with a game of chess or Ping-Pong than they do today, with their torture,” said Henry Kolm, 90, an MIT physicist who had been assigned to play chess in Germany with Hitler’s deputy, Rudolf Hess.

What do you think the economic study of mechanism design would have to say about torture? Is it an effective method for eliciting private information? How would an economist interrogate a suspected terrorist?

Time Off for Procreation

William Saletan of Slate and economist Joshua Gans of the Melbourne Business School recently commented on the latest ill-advised birth encouragement policy, this time from Russia. The governor of the Ulyanovsk region in Russia declared September 12 a day off for making babies. The regional government is offering prizes in the form of cash, cars, and appliances to couples that give birth nine months after the Day of Conception. This is on top of President Putin's national proposals to entice would-be mothers with cash, extended maternity leave, and day-care subsidies. The Aplia Econ Blog has already posted here and here about Gans' extensive look at similar birth incentive programs in Australia.

Discussion Questions

1. What, according to Saletan, are the primary reasons for rapid population decline in Russia? Given the causes of depopulation, do you think birth incentive programs stand a reasonable chance of reversing the trend? What long-term policies would you recommend to deal with Russia's declining population?

2. While the effect of birth incentives on long-term population growth is highly debatable, economists Joshua Gans and Andrew Leigh have demonstrated that birth incentives have a significant impact on parental decisions about timing births and inducing labor. What do you expect maternity wards in Ulyanovsk to look like on June 12, 2008? What are the health costs associated with Ulyanovsk's birth incentive policy?

Principals and Agents

The theme of accountability is present in two important debates in Washington this week. On the international front, there are serious questions of how to deal with the lack of political progress in Iraq as Ambassador Crocker and General Petraeus testify before Congress. Likewise, in domestic policy, there's the equally serious question of how to deal with failing schools, as reauthorization of the No Child Left Behind Act (NCLB) of 2001 is debated in the Senate.

While these two issues are worlds apart in scope, the basic problem is the same. In economics, it's known as the principal-agent problem. Rather than looking at how individuals respond to the incentives of market prices, principal-agent theory looks at how "principals" (governments, employers, parents) can set up a system of incentives to encourage specific behavior from "agents" (citizens, workers, children).

Suppose you ran the U.S. government. You'd like to achieve academic success for students at home and real political progress for the Iraqi government. However, you cannot do these things alone: you can only provide incentives for students and teachers on the one hand, and for Iraqi leaders on the other.

So you set "benchmarks." For example, let's focus on the school scenario. The basic strategy of NCLB is that if a certain percentage of students at a school don't pass a standardized test, most of the teachers will be fired and replaced with new ones. This is meant to give teachers an additional incentive to make sure that all their pupils are learning.

The really difficult part comes when benchmarks are not met: when a school fails to meet the standards laid out by NCLB, or when the Iraqi government fails to reach the benchmarks set by the American government. What do you do then? Do you really follow through on your threat? What if you really believe that the teachers were working hard, or that the Iraqis just needed a little more time?

Discussion Questions

1. Think of a situation from your own life in which you wanted someone to do something and were in a position to provide them with incentives to do it. What incentives did you use? Did they work? Did the person do what you wanted?

2. Recent research by Derek Neal and Diane Whitmore Schanzenbach of the University of Chicago suggests that No Child Left Behind has an unintended consequence: "...the design of NCLB almost guarantees that the most academically disadvantaged children will not benefit from its implementation and may actually be harmed." Read the summary of their research. Do their results imply that NCLB should be rescinded? How might it be changed to provide better incentives?

3. Consider the problem of addiction. The main object of rehab and groups like Alcoholics Anonymous is to provide a system of incentives to break someone of addiction. But suppose someone returns to their addiction. What should be done then? Is there a strategic value to lenience when someone doesn't meet a benchmark?

Paul Romer on Economic Growth

Aplia founder Paul Romer was recently interviewed by Russell Roberts of George Mason University (you can find the podcast here). Some of the discussion revolved around Romer's entry on economic growth in the Concise Encyclopedia of Economics.

As Romer points out in both the interview and the encyclopedia entry, small differences in the growth rate of income per capita lead to extraordinary differences in living standards over time. A simple formula allows us to consider the growth of average income over time, where n is the number of years and the growth rate is stated in decimal form:

(Initial per Capita Income Level) x (1 + Growth Rate)ⁿ

In the interview, Romer contrasts growth rates of 2.1% and 2.6% per year. For example, if U.S. income per capita is initially $30,000 and grows at a long-term rate of 2.1% per year, then after a period of 100 years, income per person will be approximately $30,000 x (1.021)¹⁰⁰ = $240,000. How much higher would income per capita be after 100 years at a growth rate of 2.3% per year? What about 2.6%?

To achieve slightly faster income growth, an economy must be able to generate more new ideas and find applications for those ideas that result in more valuable products and services. As Romer points out, human history teaches us that economic growth springs from better ideas, not just from more output. Better ideas generate greater value per unit of input.

Discussion Questions

1. Consider the benefits of a simple idea Romer mentions in his encyclopedia article: the one-size-fits-all lid for coffee cups. How do you think this idea generated more value per unit of input for the coffee-cup manufacturer? What about the coffee shop?

2. According to Romer, "The knowledge needed to provide citizens of the poorest countries with a vastly improved standard of living already exists in the advanced countries." What types of policies serve as barriers to the flow of ideas into poor countries? What types of policies might allow poor countries to take advantage of existing ideas and, as a result, contribute more new ideas of their own?

3. Faster growth and higher living standards depend in part on the strength of the incentives we face to generate and apply new ideas. When people can benefit from an idea without paying for it, the incentive to develop new ideas will be weaker. On the other hand, once an idea is discovered, not allowing it to be shared can be inefficient or even immoral. How do intellectual property rights, such as patents and copyrights, strengthen the incentive to discover new ideas? How might intellectual property rights hinder economic growth? Congress is currently considering reforms to patent laws in the United States. (A recent PC World article highlights the difficulty of designing patent laws that give inventors an incentive to develop new ideas while at the same time encouraging the rapid diffusion of new ideas at minimal cost.)

4. What, according to Romer's piece, are meta-ideas? What meta-ideas have we used in the past to strengthen the incentives to develop new ideas?

Paying It Forward—The Economics of Altruism

I was deep in conversation with my 14-year-old son regarding the relative costs and benefits of wearing a helmet while skateboarding. Guess which side I was on? We were driving from the Bay Area to Davis, California, for Memorial Day weekend. Deep into the task of convincing my son that the various monetary, emotional, and intellectual costs of brain surgery far outweighed the relatively minuscule cost of looking slightly uncool when wearing a helmet, I stopped to pay the toll at the Carcinas Bridge. I reached out to hand the toll taker my $4, but to my astonishment, he waved me off, saying, “The car in front of you paid.” Have you ever had that sinking feeling in your stomach when you’ve done something wrong? I was feeling exactly the opposite! I felt like I had just won some mini-lottery. It changed my whole perspective on the day. I even ignored my son's wisecracks about my having ruined his social life by imposing the helmet “law” on him.

Now, I could have attributed this event to some random act of kindness: certainly commendable, but anomalous nonetheless—except that this was the third time it had happened to me in the last 12 months. In economic terms, this doesn’t seem to add up. Why would so many people pay the toll for complete strangers with no hope of a return on their investment? How did it start? What was the incentive? Who was philanthropist zero? And what of the positive repercussions this created for the rest of the community? What other acts of kindness did this generate?

If economics is about people acting in their own self-interest, does this make sense? Maybe it makes complete sense. Perhaps people are motivated by the personal gratification they derive from their own generosity rather than the desire to make others feel good. In fact, anonymous acts of kindness allow us to imagine that we've done some amount of good that might be far in excess of reality. In that sense, $4 is a small price to pay for a momentary feeling of supreme virtue.

Thus, to some degree, acts of kindness are reciprocal—we aren't giving something for nothing. When we pick up someone else's toll or leave extra money in the parking meter, we magnanimously give up a small amount, but we potentially receive a powerful feeling of satisfaction in return. None of this is to say that the effects of this type of behavior are undeniably positive, simply that the motives involved may have more to do with self-interest than with pure altruism.

Economist Steven Landsburg offered his take on the economics of altruism a few years back in an interesting article in Reason magazine. Check it out here.

Discussion Questions

1. What happens in Vernon Smith's envelope experiment when participants are told that their actions are anonymous? What happens in the experiment when participants are told that researchers will track individual decisions?

2. In the James Cox version of Smith's envelope experiment, donated sums are automatically tripled. How does the behavior of participants change under this scenario? Why, according to Landsburg, is this evidence of something dark and disturbing about human nature?

3. What could the Cox experiment teach charitable organizations about techniques for raising money?

Can Economics Take the Guilt out of Conspicuous Consumption?

Looking at the world through economic lenses can often take the emotional charge out of otherwise controversial decisions. Take the environmental consequences of gasoline consumption. Instead of feeling guilty about driving a big SUV or thinking ill of those who do, why not take the approach suggested by this Time magazine article on carbon budgeting?

What if everyone in the country received the same number of pollution credits regardless of whether they owned a car? The question of who gets to pollute is reduced to a matter of who is willing to incur the cost. And people who do not own cars or who seldom drive benefit from their ability to sell their credits to those who need or want them. The next time someone passed you in a Hummer, you'd know she paid a greener soul for the right to do it.

Discussion Questions

1. How would the pollution-credit scheme change the tradeoff between driving and alternative modes of transportation?

2. Harvard economist Greg Mankiw advocates a gasoline tax for a variety of reasons, including environmental considerations. How is a pollution-credit scheme different from enacting a stiffer tax on gas? How would government enforce pollution-credit usage? Which system would require fewer administrative costs?

3. Critics note that stiffer gasoline taxes would be regressive. That is, a relatively rich person with a gas-guzzling SUV would still devote a smaller share of his or her income to gas taxes than a poor person with a fuel-efficient compact. Would a pollution-credit system face similar concerns?

Who Wants to Be a Harvard Grad?

It's getting tougher and tougher to get into Harvard. The admissions rate—that is, the fraction of applicants who are accepted—has been declining for decades. And you don't need an 800 on your math SATs to figure out why: the number of spots at Harvard has remained roughly the same, while the number of applicants has soared. But why has the number of applicants soared? And should it be soaring?

As with all economic questions, the answer comes down to costs and benefits. The social and economic benefits of attending Harvard are large. To spend four years among the "best of the best" (by some measures, anyway) is an exhilarating experience. And in what Robert Frank calls our "winner-take-all society," going to an elite school may be a necessary first step if you want to compete for the kind of positions (Supreme Court justice, CEO, Nobel Prize winner) that only a microscopic proportion of the human population ever obtain. But these benefits are roughly the same as they have always been: indeed, students can now choose from many more excellent colleges than they could in the past.

In the meantime, what has happened to the cost of getting into Harvard? Harvard alum Michael Winerip recently wrote an essay in the New York Times on how the young people applying to his alma mater now are, on paper at least, much more accomplished than he was at their age. But many of their accomplishments—from a string of 5's on AP tests to touring Europe with youth orchestras—are the result not of increased inner drive among college-bound students, but rather of a nascent industry designed to help students get into college. Winerip writes that, as an alumni interviewer, he interviewed a girl who worked at NASA doing research on weightlessness in mice; his project in high school, by contrast, was a shoebox with soil and bean sprouts. And while some of the students he has interviewed take 10 AP courses and get top scores on all of them, he took a single AP course and scored a 3. However, he writes,

Of course, evolution is not the same as progress. These kids have an AP history textbook that has been specially created to match the content of the AP test, as well as review books and tutors for those tests. We had no AP textbook; many of our readings came from primary documents, and there was no Princeton Review then. I was never tutored in anything and walked into the SATs without having seen a sample SAT question.

As for my bean sprouts project, as bad it was, I did it alone. I interview kids who describe how their schools provide a statistician to analyze their science project data.

Reading Winerip's essay, it may seem as though the costs of getting into Harvard have skyrocketed—but in fact, if one thinks about this like an economist, it quickly becomes clear that the opposite is true. The price of preparing any one element of one's résumé has in fact decreased: for example, one can now buy a textbook that is keyed to the AP test, whereas before, students didn't have access to those resources.

However, total expenditure on college preparatory activities has increased dramatically. This is because, as the law of demand would predict, the lowered cost of achieving specific goals leads to more people attaining those goals—and therefore drives up the number of people applying to Harvard. Furthermore, as more people do the things that used to get you into Harvard, students have to do more and more to set themselves apart from the rest of the crowd.

Discussion Questions

1. Winerip laments the fact that many of these driven students are missing out on the fun of childhood. Is it efficient (in the economic sense of the word) for so much effort to be devoted to getting into college? What are the costs and benefits of this kind of competition?

2. Use a supply-and-demand model to illustrate what has happened in the market for college preparatory activities (tutoring, mentoring, test prep). Note that the probability of getting into Harvard is both dependent on the outcome of that market and a determinant of demand in that market. How is an equilibrium reached that takes both of those factors into consideration?

3. What effect does increased competition for elite schools have on other schools? Is it easier or harder to get into a good state school because of all the competition to get into Harvard? What about the effect on tuition, both at elite schools and other schools?

Taxing Traffic

In a bold speech delivered on Earth Day, New York City Mayor Michael Bloomberg proposed broad changes to improve the environment in the city. A centerpiece of this proposal, sure to be controversial, is an attempt to deal with traffic problems by imposing congestion charges on drivers who enter Manhattan. By charging motorists, the mayor aims to reduce pollution and relieve driving difficulties in the city. The plan would result in payments of up to $8 per day for drivers ($21 for trucks) who enter the busiest sections of the city—what the report calls the “Manhattan Central Business District.” The revenues generated by the fees would be used to fund transportation programs throughout the city, including road improvements, expansion of public transit, promotion of cycling, and increased enforcement of traffic laws.

While Bloomberg’s proposal is innovative, New York is not the first city to consider such fees. Congestion charges have been in place since 2003 in London; and Stockholm, Singapore, and Toronto (among others) employ similar types of fees. The results in London have been fairly dramatic: the number of automobiles in the city decreased by more than 30%, traffic delays declined by 20%–30%, and average road speeds increased by nearly 20%. Opponents of the London plan—and there were many—argued that it would “strangle retailers,” but the feared drop in sales has not materialized.

City traffic imposes dual externalities on residents and commuters—there is the pollution produced by the vehicles in the area, but there is also the effect of traffic itself on drivers. Each driver represents only a small proportion of the actual traffic, but when all of the drivers are added in, the impact can be dramatic, slowing commute times substantially. Congestion charges represent a direct application of what is referred to as a corrective tax—forcing drivers to internalize the external costs that they impose on other drivers. For example, if the average commuter’s opportunity cost is $16 per hour, and the presence of an additional motorist increases the driving time of all other drivers by a total of 30 minutes each day, then the proposed charge of $8 per day could be interpreted as an appropriate tax.

Discussion Questions

1. How would drivers who pay the fees benefit from this program?

2. Beyond the expected benefits of reduced pollution and traffic congestion resulting from the congestion charges, are there other effects that could result from the imposition of these fees?

3. How would the benefits and costs of such a program be distributed?

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 master's and Ph.D. programs.

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?

Will Microcredit Reduce Poverty?

Most people in developed countries can easily use their assets to secure credit. 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 relatively poor developing 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 both income and legitimate titles to what little collateral they actually have, the credit prospects for most of the world's poor seem bleak.

Enter microcreditors. As Tyler Cowen describes in his latest Economics Scene column for The New York Times, microcreditors are non-profit, for-profit, or government organizations that lend small sums to people in poor communities. The microloan recipients open businesses, improve their homes, or pay medical bills--using the loans to invest or consume as they see fit. Read Cowen's commentary to find out more about the benefits and controversies surrounding microcredit in India.

1. According to Cowen, microlenders like Spandana offer poor Indians better rates than traditional money lenders. How do the lending practices of microcredit organizations differ from the practices of traditional money lenders? How does Spandana use community pressure to maintain high repayment rates among its loan recipients? What other incentives encourage borrowers to repay the microloans?

2. Why do some state officials in India oppose the practices of microcreditors like Spandana? According to Cowen, what would legal caps on interest rates do to the solvency of microcreditors? How might legal caps on interest rates change the borrowing habits of India's poor?

3. Cowen visited Hyderabad--a metropolis of over 6 million residents. He suggests that microlending works fairly well for poor people in this urban setting. How might the feasibility of microcredit change in a rural setting? Rural residents in developing countries earn income from farming--a relatively risky vocation because of price volatility and unpredictable weather. Would repayment rates among rural residents likely be higher or lower than those among urban residents? How would traveling to rural settings affect the way microcreditors monitor repayment?

Tiger Conservation

The EDS Corporation's cat herding commercial is good for a laugh, but Barun Mitra--director of the Liberty Institute--is entirely serious about tiger ranching in China and India. According to Mitra, tiger pelts sell for as much as $20,000 on the black market and growing demand for traditional Chinese medicines makes other parts of the tiger lucrative as well. The currently illegal trade in tigers and tiger parts presents an increasingly valuable opportunity for poachers. Poaching, in turn, plays a significant role in keeping the tiger close to extinction. Mitra believes a legal market for tiger parts will save the tiger from extinction. Read his op-ed column in The New York Times to see why.

1. What is the current approach to tiger conservation in India and China?

2. Mitra points out that farmers and ranchers have a strong incentive to ensure that marketable species of livestock (sheep, cattle, chickens, and the like) do not go extinct. Does his argument for conservation through market mechanisms apply to other wild endangered species? Do tigers need to be ranched like cattle in order to give humans an incentive to conserve them?

3. Consider an alternative to outright tiger ranching. Mitra cites a program in Zimbabwe where villagers had property rights on local wildlife. How did the villagers use their property rights to earn money? What conservation incentives did they face? Would similar programs in China and India reduce the threat of tiger extinction? How would villagers with property rights on tigers feel about poachers?

4. Is poaching the only thing keeping tigers close to extinction? What about habitat encroachment? Could a legal market in tiger parts or licensed tiger hunting help to preserve tiger habitat?

The Organ Shortage

Newspaper ads on every college campus beckon cash-strapped students to sell their plasma, sperm, or eggs to the appropriate medical intermediaries. It's Adam Smith's invisible hand at work: People need plasma for blood transfusions; students with excess plasma need cash. Plasma banks facilitate the transaction and everyone's better off.

The enterprising student will wonder whether he can collect on other spare parts--say, a kidney. He cannot. The sale of human organs, whether it benefits a living kidney donor or the family members of a recently deceased heart donor, is illegal in the United States. Why, asks the latest Freakonomics column, is selling a kidney illegal in a country where thousands of people die each year waiting for kidney transplants? Read the column to see what Stephen Dubner and Steven Levitt have to say about the organ shortage.


1. Suppose the graph above represents a market for transplantable kidneys from live donors. Under current law, the price of a kidney is restricted to zero. At a zero price, 15,000 people (most likely friends and family of the recipients) supply a kidney to eligible patients each year. What's the shortage of kidneys at a zero price?

2. Beyond the 15,000 charitable donors our hypothetical supply curve takes a more familiar, upward-sloping shape. Each point on the supply curve represents the seller's cost of providing a transplantable kidney. According to Dubner and Levitt, what are some of the costs that influence the supply decisions of living kidney donors? (Think about forgone wages, medical risks, and the fact that supplying a kidney is a one-time event.)

3. In our hypothetical market for kidneys shown in the graph, what price clears the transplantable kidney market? (See an actual economic estimate of kidney prices in this paper by Gary Becker and Julio Jorge Elias.) Notice that closing the kidney shortage with a free market adds to the cost of a transplant (already upwards of $200,000). Might the additional cost of procuring a kidney price some patients out of the market altogether? That is, would an increase in the price of a transplant reduce the quantity of transplants demanded? Do you think the quantity of transplants demanded is sensitive or insensitive to price (is the price elasticity of demand for transplants perfectly inelastic)?

4. If you're like most normal people, the prospect of a market for kidneys raises all kinds of moral and ethical questions. According to the column, Alvin Roth helped devise a program that uses incentives to elicit organ donations from strangers, but stops short of a free market for organs. How does the New England Program for Kidney Exchange align the incentives of non-related donors and recipients without monetary incentives?

5. Kidneys from living donors are preferable from a medical perspective, but usable organs from the recently deceased are important as well. Of course, doctors can't just go around harvesting organs every time someone dies. Americans, usually at the Department of Motor Vehicles, have to sign-up if they wish to donate usable organs upon death. What would happen to the organ shortage in the United States if all Americans were donors by default?

Check out the Freakonomics website for more about creative solutions to the organ shortage.

Baby Bonus Blunder?

Australians live longer and have fewer children than they used to. In fact, most of the 30 countries in the Organization for Economic Co-operation and Development (OECD) show the classic signs of ageing: rising life expectancy and falling fertility rates. Life expectancy at birth measures the number of years an average person in a population can expect to live. The fertility rate for a population is the average number of childbirths per woman of child-bearing age. Longer life expectancy and lower fertility rates mean that retirees make up a larger share of OECD populations. The graphs below shows the OECD's estimates and projections for life expectancy and the fertility rate.


In OECD countries, retirees receive public benefits, like Social Security or Medicare in the United States, that are financed with taxes from active workers. As a population ages, the ratio of retirees to workers rises--the pool of beneficiaries expands as the tax base shrinks. The pressure on public finances in OECD countries will continue to rise unless the countries adopt policies that raise tax revenues or cut benefits. A host of possible solutions exists, not all of them politically palatable: increasing taxes on workers, cutting retiree benefits, increasing the retirement age, or opening borders to more immigrant workers.

In 2004, the Australian government tackled declining fertility rates head on with a cash-for-babies policy. In May of 2004, the government announced Australian parents would receive A$3,000 (US$2,200) for newborns delivered on or after July 1, 2004. Time will tell whether Australia's baby bonus is large enough to noticeably increase fertility rates, but economists Joshua Gans and Andrew Leigh found that the baby bonus announcement had a big impact in the short term (download their research paper here). How do you think Australian parents with late June due dates responded to the government's announcement? Read Gans and Leigh's opinion piece in The Australian to find out.

1. On which day during the past 30 years were the most Australian babies born? Why?

2. According to Gans and Leigh, roughly 1,000 births were moved as a result of the 2004 baby bonus announcement. Of those, how many births were moved by more than three weeks? How is it possible to postpone births? How did the baby bonus announcement affect Australian maternity wards?

3. Despite the evidence of delayed births resulting from the 2004 announcement, the Australian government recently announced that the baby bonus will rise to A$4,000 on July 1, 2006. How, according to Gans and Leigh, should maternity wards and expectant mothers cope with the transition to the higher bonus? What can the government do to avoid similar disruptions in the future?

4. The rapidly expanding career opportunities for women in OECD countries present would-be moms with tougher trade-offs. Take a career detour to raise-up kids or continue pursuing the corner office? We know that the baby bonus announcement has a big reshuffling effect on birth dates in the short term, but its long-term effects on the kids-career tradeoff and fertility rates are less certain. Do you think Australia's baby bonus will offset a significant portion of the opportunity costs of childbirth faced by working women?

5. Can you think of other policies that would reduce the ratio of benefit-receiving retirees to tax-paying workers? Should the retirement age rise with life expectancy? How would more open immigration policies affect the ratio of retirees to workers? How would more immigration affect racial inequality if immigrants are of a different race than native-born workers?

Topics: Incentives, Trade-offs, Ageing populations

Labor Negotiations: The Non-Medical Incentives of Childbirth

6-6-06 passed recently with nary an episode of satanic import. Nonetheless, some mothers-to-be, late in the third trimester, did not like the idea of delivering on the Day of the Beast--lest their newborn be mistaken for the spawn of Satan. According to a new research paper by Joshua Gans and Andrew Leigh, physicians were probably open to helping parents avoid the inauspicious date. It's not that physicians feared the delivery of the anti-Christ. Rather, June 6, 2006 fell on a Tuesday--so inducing labor in an expectant mother a day earlier or later wouldn't cut into the doctor's weekend tee-time.

Parents often hope to induce or postpone labor for all sorts of non-medical reasons, ranging from tax purposes (parents in many countries stand to capture a sizable tax credit should their babies pop out before January 1) to cultural reasons (choosing the year of the dog over the year of the pig, or Sagittarius over Capricorn). One particularly inauspicious day to be born on is February 29, since that date occurs only once every four years.

On the other hand, physicians have their own preferences over birth dates. In particular, there is a well-documented "weekend effect" in the timing of births. It's safe to assume that neither babies nor women's bodies know the day of the week; yet according to Gans and Leigh, "nearly 29% fewer births occurred on weekends than an even distribution [over days of the week] would predict." Several recent papers have suggested that the reason for this is that it is more expensive to perform medical procedures on weekends, and also that physicians would prefer not to work on weekends.

Think of what happens, then, when an inauspicious day--like, for example, February 29--occurs on a Monday. In such cases, doctors and patients face potentially conflicting incentives. Expectant parents want to induce labor to avoid leap-year babies and physicians want to avoid working on the weekend. Who wins out?

Read the abstract, introduction, and conclusion of the research paper to find out how the conflict of incentives typically sorts itself out. Follow this link and scroll toward the bottom of the page (under the "SSRN Electronic Paper Collection" heading) to download a pdf of the paper.

1. According to Gans and Leigh, how often do physicians accommodate expectant parents who want to induce weekend labor for non-medical reasons?

2. What do the paper's results suggest about the balance of bargaining power between patients and doctors (or other labor resources at hospitals, such as nurses)? Is the medical services consumer always sovereign?

3. Do expectant parents incur more expenses if they give birth on a weekend, or less? What about doctors and hospitals? How might a pricing scheme that allows hospitals to charge different prices for weekend and weekday births improve the welfare of doctors and patients?

4. Think about the statistical methods Gans and Leigh use to make their point. One might think that for tax reasons, January 1 would be a good date to examine for this effect. Why is February 29 a better date study than January 1 for the purposes of this? (Hint: If you were trying to examine the point Gans and Leigh are looking at, you would need to make sure that only the patients cared about the "inauspicious" day, and that only the doctors cared about the weekend…)

Thanks to Chris Makler for valuable additions to this post.

Banking on Gas Prices

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

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

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

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

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

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

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

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

Topics: Finance, Gas prices, Forward contracts, Incentives