Finally Something Positive from the Cubs!

The Chicago Cubs hold the record for
the longest championship drought in the four major US sports, not giving their fans a World Series victory since 1908. But for as much heartache and disappointment the team has given its fans over the years, it also offers the local community something uniquely positive; what economists call a positive externality.

The Cubs have played their home games in Wrigley Field since 1916, two years after the iconic ballpark was built. The stadium sits right across the street from apartment buildings that rise above the outfield bleachers. Residents high enough up in the buildings or people on the roof can see into the ballpark and watch the game as it’s being played. That unique view of the ballpark action led some entrepreneurial building owners to put bleachers on their roofs and sell tickets.

Economically, the good the Cubs produce (the entertainment provided from watching baseball games) is non-excludable because the private firm (the Cubs) cannot prevent some people from consuming the good without paying. When people other than the consumers that purchase any good, gain something from the good’s production, economists call that a positive externality.

Firms that produce goods that give positive externalities do not receive the full economic reward associated with producing the good because they are not paid by everyone who uses it. Those firms can increase profits if they can find a way to make their good excludable and thus, deny the “free” use of their good.

As of the start of this season, it appears the Cubs might be trying to do just that. As a part of a planned stadium renovation, the Cubs have proposed building a large scoreboard that will block the views from neighboring rooftops. Aside from increased advertising that the new scoreboard would bring, it should also help to make their good scarcer and increase demand for tickets, driving prices up.

Where does the story go from here? The team hopes to begin construction this fall, but owners of neighboring buildings have threatened legal action, saying a new scoreboard will “drive them out of business” though it’s possible that an agreement which benefits all the firms involved can be reached (either privately or with the help of local government) before the issue goes to court.

Discussion Questions

Suppose that the Cubs could determine the number of home games they play based solely on attendance, rather than by a schedule set by Major League Baseball.

1. In this scenario, if the team does not get paid when people watch the game from rooftop seats, will the number of games played be socially optimal? What if the team does collect money from rooftop viewers? Explain why.

2. When the outcome is not optimal, will there be too many games played or too few?

3. Propose a policy that the local government could implement to fix the inefficiency and get the team to produce the socially optimal number of games.

4. Economists say a good is rivalrous if one person’s consumption of the good prevents another person from enjoying it. For example, you and I cannot eat the same hamburger. Would you consider the good the Cubs produce to be rivalrous? Does the way a fan sees the game influence your answer?

The Opportunity Costs of Relationships

Since it is generally easy to compare the price-tag cost of one good or service against another, people tend to consider only the monetary cost of a decision. However, what’s also important to consider is the whole value of what you are giving up when you make a decision. In economics, this is known as the opportunity cost. A simple textbook example describes a market that offers two goods for sale: apples and oranges. If an apple can be bought for $1 and an orange for $0.50, the monetary cost of buying an apple is $1, but the opportunity cost is equal to how much you value the two oranges that you give up if you choose to buy an apple. While this observation may not seem particularly important in this context, it can be applied far beyond the realm of monetary dealings.

Romantic relationships are obviously not regular commodities like apples and oranges in that you don’t just head to your local date market and buy a girlfriend or boyfriend. Despite this violation of the competitive hypothesis, relationships have opportunity costs too. That is, the opportunity cost of a relationship is comprised of all the things one foregoes to be in that relationship. While it is not difficult to see the many wonderful things you gain from having a romantic partner, it is easy to overlook the things you give up in exchange.

Here’s a list of some of the things that most people forgo to some degree to be in a relationship:

(1) Spending time with friends and family
(2) Going out and meeting new people
(3) Developing or engaging in hobbies
(4) Working
(5) Exercising

Some people may find that being in a relationship allows them to do more of some of these things (maybe you work out together or spend lots of time with mutual friends), but usually the time you spend with your significant other tends to edge out at least some of the things you like to do on your own.

In economics we represent such trade-offs using graphs like the one below. The red line is known as the budget constraint, and while it typically represents a monetary budget, in this case it represents a sort of time budget for an individual in a relationship with eight hours of leisure time per day (assuming eight hours of sleep and eight hours of work). The eight hours of leisure can be divided anywhere between spending all 8 hours with your significant other or all 8 hours doing other things. Regardless of what allocation a person chooses on the red line, any movement along the line represents a tradeoff of one activity for another.

Despite the perception of economics as dismal science, the point is not that the cost of relationships outweighs the benefits, but rather that there is an opportunity cost to everything. So if you’re single and accustomed to thinking about all the things you’re missing out on, take comfort in the things that you aren't giving up.



Discussion Questions:

1. Consider the graph depicting the time-budget constraint. If a person quits their job and suddenly has more time, how does this affect the person’s position on the line or the position of the line itself?

2. If person A and person B primarily give up time spent with friends when they are in relationships, and person B really likes being with friends, which person’s relationship comes at a higher opportunity cost? If you were to draw each of their indifference curves on the budget constraint graph, how would the two compare?

3. How would being in a relationship affect your overall consumption? If you are in a relationship, are there some goods or services that you would consume more or less of in a given week? Which of these goods would you say are “complementary goods” with relationships? Which are “substitutes?”

4. Sometimes when economists model consumption choices for goods that are consumed over longer periods of time, they introduce switching costs. What sorts of things associated with a break-up may be considered a switching cost? If you assume that breakups are costly, how might this change a person’s decision to allocate their time?

Pigouvian Tax the Rich?

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

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

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

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

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

Discussion Questions:

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

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

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

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

Econolympics

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

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

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

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

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

Discussion Questions:

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

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

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

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?

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?

California's Foil Balloon Problem

A helium-modified voice is good for a laugh, but the joke is risky. Inhale too much helium from the balloon and you'll pass out. It turns out that helium balloons can black out more than just the overzealous prankster. As recent news stories point out, foil helium balloons can get caught up in power lines and cause outages. California utilities reported hundreds of balloon-related outages last year: 211 for northern California's PG&E and 478 for southern California's Edison. California Senate Bill 1499 proposes to deal with the problem by banning foil balloons and fining violators. Though foil balloons can be a problem, a bit of economic analysis suggests that the heavy-handed ban may not be the best remedy.

By increasing the odds of costly power outages, helium balloon consumption imposes external costs on society. The vast majority of electricity consumers outside of the helium balloon market may nonetheless end up incurring some costs when errant balloons make their way into nearby power lines. Since helium balloon consumption imposes external costs, the social benefit of helium balloon consumption is considerably less than the private benefit. When the social value of a good is lower than the private value, there will be an inefficiently high level of consumption in the private market.

So rather than banning the balloons altogether, the California legislature may want to consider a corrective tax. Taxing the consumption of helium balloons would force buyers to internalize the heretofore external costs that the balloons impose on everyone else. The tax would reduce both foil balloons purchased and balloon-related power outages while giving buyers and sellers an incentive to shift toward less disruptive party favors.

To analyze the issue more closely, we need to define some costs and benefits in the market for foil balloons. Because helium balloon consumption generates external costs, the marginal social benefit from a helium balloon will be less than the marginal private benefit:

Marginal Social Benefit (MSB) = Marginal Private Benefit (MPB) – External Cost

In the foil balloon market, the supply curve represents the marginal private cost (MPC) of selling balloons and the demand curve represents the marginal private benefit (MPB) of consuming balloons. The marginal social benefit (MSB) curve lies below the demand curve, since the social value of foil balloons incorporates the external costs. The socially optimal output level occurs where the marginal private cost of producing the balloons is equal to the marginal social benefit of consuming them—well below the market outcome at the intersection of our standard supply and demand curves. At points above the socially optimal output level, the marginal social benefit of the balloons will be less than the marginal cost of producing them. As a result, at least some of the current balloon consumption is inefficient.

Discussion Questions

1. According to our diagram of the hypothetical helium balloon market, what is the size of the tax necessary to achieve the socially optimal output level? Can you think of other markets where corrective taxes have been used or might be used to curb the external costs of consumption or production?

2. Is a ban more costly than a corrective tax in this case? Not all helium balloon buyers are careless with their purchase. Is the tax fair?

3. While a corrective tax has the potential to move a market closer to its social optimum, the use of government revenue from such taxes may be socially inefficient and wasteful. The correction of a market failure may simply beget government failure. Can you think of ways to prevent the government from wasting corrective tax revenues?

4. How would you go about estimating the external costs of helium balloon consumption?

5. What can you say about the price elasticity of the demand for and supply of helium balloons? Many party supply stores claim that any disruption to helium balloon sales will threaten jobs. What do you make of this?

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

No Free Lunches? What About Taco Tuesday?

In the second game of the World Series, Jacoby Ellsbury's second-base steal triggered Taco Bell's "Steal a base, steal a taco" promotion. Between 2:00 PM and 5:00 PM on Tuesday, October 30, Taco Bell made good on a promise of free tacos to anyone in America.

Discussion Questions

1. As with most free stuff, the taco promotion involved some hidden costs for the would-be freeloaders. What are some of the costs associated with taking Taco Bell up on its offer? Did the promotion involve external costs (costs borne by people who were not part of the taco transaction)?

2. An ABC News article pointed out that there has been at least one stolen base in every World Series since 1990. Taco Bell must have expected to make good on the promotion. Why would a profit-maximizing business offer this type of promotion?

3. A free taco isn't exactly "lunch" when you can only get it between 2:00 PM and 5:00 PM. Why were people willing to stand (or drive) in line at odd dining hours in order to get a taco that would normally run you less than a buck?

4. Sunk costs are costs that have been incurred and cannot be recouped, such as the time it took you to get to Taco Bell before realizing there was a long line. Were people sticking out a 20-minute wait for a $1 taco because they failed to ignore sunk costs?

5. In his new book, Tyler Cowen offers the following explanation of signaling: "We signal every time we incur a cost to send a message about ourselves to the outside world." Often, the higher the cost incurred, the stronger the signal. Think of the costs people incur to signal to prospective employers that they have an MBA from Wharton, or to signal to acquaintances that they attended Game 2 of the World Series. Were people signaling their devotion to the Red Sox or, more improbably, to Taco Bell? If the tacos were truly free, would anyone be able to make a strong statement about their baseball fanaticism? Might signaling help to explain the long lines in the final days before the release of products like Apple's iPhone and Microsoft's Xbox?

Too Darn Hot

It’s 85 degrees and sunny on this October day in the Bay Area, and this morning’s review of the New York Times brings a trio of stories related to heat: the tragedy of the fires raging in Southern California; a long article in the Magazine section on decreasing supplies of fresh water due to global warming; and a really interesting article on the effect of lower water levels in the Great Lakes on shipping. There are lots of good economic applications in all three of these articles.

It’s clear that there are winners and losers from warming. For example, the people who lose their homes in Southern California—and their insurance companies—are clearly losers. But others win—think of the windfall that’s about to benefit construction companies in Southern California, which were suffering recently because of the downturn in the housing market. Don’t the fires create rebuilding jobs for them? And don’t they, in turn, spend that money, benefiting others? Could we view the fires as a stimulus to the economy? Maybe there’s insufficient drought in the world after all!

If this argument rings false, that’s because it is. To see why, read one of the most brilliant three-paragraph synopses of economic theory ever written: the first application in Economics in One Lesson by Henry Hazlitt. (Clicking to the next page, “The Blessings of Destruction,” is also worthwhile. Oh, heck, just read the whole book—it will take you an hour.)

Discussion Questions

1. Suppose we assume that global warming is caused by humans, and that it is an example of the tragedy of the commons: everyone suffers because of global warming, but nobody has an individual incentive to stop the behavior that causes it. As Economics in One Lesson demonstrates, Hazlitt was skeptical of government interference in markets beyond the enforcement of property rights. Can you think of any appropriate responses to global warming that involve little to no government interference?

2. Suppose we assume instead that global warming is not caused by humans, but that humans can do things—for example, produce less carbon dioxide—to reduce its effects. How does that change your response to question 1? Does it, in fact, change your response? Why?

3. The article on the Great Lakes says that “for every inch of water that the lakes lose, the ships that ferry bulk materials across them must lighten their loads by 270 tons—or 540,000 pounds—or risk running aground, according to the Lake Carriers’ Association, a trade group for United States-flag cargo companies.” What effect is this likely to have on the structure of the shipping market in the short run and the long run?

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?

The Income Gap and Education

The gap between the incomes of the richest and poorest Americans has been widening since the 1970s. According to a recent New York Times column by Tyler Cowen, the widening gap reflects the difference in earnings growth between high-skilled and low-skilled workers—the earnings of high-school graduates grew more slowly than those of college graduates. A recent paper by Harvard economists Claudia Goldin and Lawrence Katz suggests that immigration accounts for only a small part of the relatively slow earnings growth among high-school graduates.

According to Goldin and Katz, developments in the market for high-skilled labor better explain the growing income gap than developments (such as illegal immigration) in the market for low-skilled labor. Technological improvement typically leads to rising demand for the high-skilled workers capable of using the new technology. Over the past few decades, technological change has increased demand for highly skilled workers, but the supply of such workers has remained stagnant. Strong demand growth coupled with weak supply growth has led to unusually high wage gains for high-skilled workers (as illustrated in the graph above). Read Cowen's column to learn more.

Discussion Questions

1. According to Cowen, how does the educational attainment of the current generation compare to that of their parents?

2. Why has the supply of high-skilled labor increased so slowly? What policies does Katz recommend to remove the bottlenecks that keep Americans from obtaining more education?

3. Will a more educated population guarantee a decrease the income gap between the richest and poorest Americans? What is the rather unpredictable role of technological change in determining the size of the income gap?

Economist Joel Waldfogel's latest Slate piece focuses on an alternative approach to promoting educational attainment among low-income groups. Recent research by Nobel-winning economist James Heckman and University of Michigan economist Dimitriy Masterov suggests that government spending on preschool education offers bigger returns than spending on other parts of the education spectrum (like GED programs or efforts to reduce high-school class sizes). Compared to disadvantaged kids without preschool exposure, disadvantaged kids who received preschool education tended to perform better later in life—higher grades, more likely to graduate, more likely to be employed, less likely to commit crime, and less likely to be on public assistance. Read Waldfogel's column to find out more.

4. Could diverting education spending to intensive preschool programs reduce the income gap between rich and poor Americans? How do differences in cognitive development at kindergarten age feed into differences in earnings potential later in life?

5. Positive externalities occur when we do things that are good for us, but also inadvertently good for others. Preschool provides private benefits directly to families and kids, but it also provides social benefits to the rest of us—social benefits that the parents of young children do not account for when deciding whether to pay for preschool education. What are the social benefits of preschool? Why might government intervention lead to a more efficient preschool outcome?

Here's another Aplia perspective on the disparate wages of low-skilled and high-skilled workers.

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?

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.

John, Paul, George, Ringo, Steve, and Ronald

For the past two decades, there has been a legal fight over whether consumers have had a difficult time comparing Apples to Apples. More specifically, Britain's Apple Corps Ltd.—the company started by the Beatles and currently owned by Paul McCartney, Ringo Starr, John Lennon's widow Yoko Ono, and the estate of George Harrison—was at odds with America's Apple Inc., maker of Macintosh computers and iPods, over who had the rights to the Apple name.

It may seem odd to trademark a fruit's name, although no odder, perhaps, than trademarking Sun, Amazon, Staples, or any other noun. But especially in the information age, the value of a brand name can be crucially important. Suppose I wrote a program, called it "Windows Vista," and sold it online for $30. If it looked just the same as Microsoft's Windows Vista, customers might very well be confused as to which one was the genuine article. This confusion would harm Microsoft. Similarly, argued Apple Corps, the existence of Apple Inc. using the Apple name and logo had an adverse impact on Apple Corps' business.

According to Nobel Prize–winning economist Ronald Coase, the appropriate solution in the case of externalities like this is to have a strong system of property rights. As long as the two parties can bargain with one another, an efficient solution will be reached. Today, an efficient solution was reached—although it was hardly cost-free. According to the terms of the deal announced today, Apple Inc. will own the entire Apple trademark, and will "license certain trademarks back to Apple for continued use," according to Reuters.

In many ways, this is a textbook application of the Coase Theorem. The usual example used to illustrate the Coase Theorem is that of a factory and a fishery that operate along the same river. The factory pollutes the river, which has an adverse effect on the fishery. If the two firms act separately, the factory doesn't take the costs of its pollution into account when figuring out the optimal amount to produce. If the fishery buys the factory, or vice versa, then the combined company is hurting itself when it pollutes, and so is more likely to cut back pollution to the efficient amount: that is, the amount where the marginal benefit of additional pollution to the factory is equal to the marginal cost to the fishery. Similarly, now that Apple Inc. owns the rights to both trademarks, it will presumably be careful not to diminish the Beatles' Apple image—if, indeed, being associated directly with iPods would be considered a negative in today's world.

Discussion Questions

1. Apple's Steve Jobs released a statement saying, "We love the Beatles, and it has been painful being at odds with them over these trademarks." If this dispute was essentially friendly, why did it take 20 years, and huge sums in legal fees, to resolve?

2. Many analysts are now predicting a deal that would make Beatles music—which has so far not been available on any online music service—available via Apple's iTunes. According to the Reuters article, "A source familiar with the situation told Reuters at the time that it was 'safe to assume that something sooner rather than later will happen.'" What effect, if any, do you think the prospect of selling Beatles music on iTunes had on resolving the dispute between the two Apples?

3. The two Apples had reached an agreement in 1991 stating that Apple Inc. could use the Apple logo as long as it didn't enter the music business. When Apple Inc. launched iTunes, Apple Corps sued, saying that Apple Inc. had violated that agreement. Apple Inc. countered that iTunes was just a "data transmission service." Do you think iTunes constitutes a move into the music business? Why or why not?

Cheap Gas Hurts

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

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

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

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

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

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

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

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

Will Saving the Environment Make Us Fat?

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

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

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

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

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

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

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

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

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

Tax Carbon, Not Income

Charles Wheelan--Yahoo! Finance columnist, author of Naked Economics: Undressing the Dismal Science, and public policy lecturer at Chicago's Harris School--has a knack for user-friendly explanations of economic ideas.

The Naked Economist has a modest policy proposal for Presidential hopefuls, Democrat or Republican: Tax carbon, not income. Wheelan proposes a revenue neutral tax policy: Increase taxes on carbon-based energy, like gas and coal, reduce income and payroll taxes, and engineer the changes in such a way that government tax revenues remain the same. Americans might balk at paying even higher prices at the pump, but under Wheelan's proposal they'd write smaller checks to the IRS. Wheelan makes the case for revenue neutral energy tax reform in his latest Yahoo! Finance column.

1. How would the carbon tax change our behavior--the cars and appliances we buy, our driving habits, the way and extent to which we heat or cool our homes? According to Wheelan, what are some environmental and geo-political benefits of the carbon tax? How do payroll and income tax cuts affect our incentive to work?

2. Negative externalities occur when we do stuff that's bad for other people without compensating them for the inconvenience. To what extent would a carbon tax reduce negative externalities associated with fossil fuel consumption?

3. A tax is regressive when the share of your income devoted to the tax declines as your income rises. Since lower-income households tend to spend a greater share of their income on energy than higher-income households, the carbon tax would be regressive. How could policymakers reduce the regressive impact of the carbon tax when cutting income and payroll tax rates?

4. How would our long-term response to carbon taxes present problems for the revenue neutrality of Wheelan's proposal? (In econ jargon: how does the price elasticity of demand for carbon- based energy change as time passes?)

Dollars for Trawlers

Trawlers are boats that drag large nets along the bottom of the ocean in an effort to catch ground-fish like cod, haddock, and flounder. As a recent National Public Radio (NPR) story reports, trawler captains along California's central coast made a killing in the early 1980s. Predictably, other trawlers arrived on the scene to get in on the exceptional profits. Dragging a big, weighted net along the ocean floor is not without its environmental impacts. A permit system prevented over-fishing, but the environmental consequences for the seafloor escalated even as a combination of restricted fishing, competition from new trawlers, and rising fuel costs weakened the earnings of central coast trawler captains.

Enter the Nature Conservancy.

The Nature Conservancy offered to buy fishing permits and trawler boats. After purchasing permits the Conservancy can retire permits entirely or lease them back to the fisherman with a legal constraint on the fisherman's vessel that prohibits trawling. Either way, the trawler buy-out program reduces trawling--those captains who lease permits from the Conservancy are free to fish for permitted species so long as they swear off trawling. The program illustrates an important point. Frequently, the most efficient use of a resource--in this case the seafloor--is its conservation.

1. Fishermen who lease permits from the Conservancy can catch as many fish as the permits allow, provided they use non-trawling techniques. As the NPR story mentions, the federal government is also stepping up efforts to protect swaths of seafloor from trawling.

How will the reduction of trawling along the coast affect the price that California fishermen receive for their catch of ground-fish (the types of fish most commonly caught by trawler nets)? How does the trawler buy-out program affect the trawler captains who choose not to sell their boats or permits to the Conservancy? Do you think the combination of federal regulations and private trawler buy-outs will lead to newer, less environmentally intrusive methods for harvesting ground-fish?

2. The Conservancy's trawler buy-out program is a market-based solution to a negative environmental externality (neither the trawler captains nor the fish consumers incur the environmental costs of seafloor disruption). The government's role is limited to enforcing the contracts between the Conservancy and the fishermen.

How does the Conservancy's approach to conservation differ from that of other environmental groups?

3. Other examples of market-based efforts to curb environmental degradation include greenhouse gas credit buy-outs (see a related Marketplace story here). In what ways are systems of exchangeable permits and credits more efficient vehicles for conservation than government regulations that cap harvests or emissions on a firm-by-firm basis?

Go here for more information on the Nature Conservancy's trawler buy-out program.