Education Regulation

Across the country, students are returning to higher education institutions for the start of another semester, except it seems that the federal government may not want some of those students in classes. This summer, the Department of Education announced new rules that will limit federal loans and grants available to for-profit colleges in order to change the way these institutions do business. These rules base funding on how educational programs meet performance goals, and they have already had an effect; new student enrollments have fallen by nearly 50% at the University of Phoenix, the largest for-profit college.

While both the analysis of the performance policy and larger questions on the economic value of subsidizing education are relevant for economic debate, perhaps it is worth taking a step back and considering something much simpler: holding the initial funding constant, there was a market where buyers (potential students) were happy to trade with sellers (for-profit colleges), but the government chose to intervene and prevent trades that the market otherwise would have facilitated. Most of the time, economists endorse laissez-faire policies, literally “hands off.” This is because government intervention often distorts the market equilibrium and leads to lost surplus, thus lowering welfare for society as a whole. However, sometimes economic theory endorses government intervention, because some policies can correct for market failures and actually raise social welfare.

What are some examples of government intervention that can be economically beneficial?

1. Tragedy of the commons - When public resources are freely available to everyone, they can become overused and permanently damaged. When a government requires fishing licenses to fish in public streams, the intervention limits usage and preserves the environment by preventing over-fishing.

2. Externalities - In some cases, while the private costs and benefits apply to individuals, the consumption of goods can have far-reaching effects on society as a whole. By imposing fines for pollution, the government can make private firms internalize the cost to society of damage done by production.

3. Asymmetric Information - When sellers know more about their product than consumers can reasonably find out, they could exploit that information to rip consumers off. Governments can step in to level the playing field. Consider when a county’s boards of weights and measures routinely calibrate supermarket scales.

4. Incomplete Information - Economists typically assume complete information when analyzing markets. Welfare loss can occur if consumers do not know exactly what is for sale, or if a good fits their needs.

Returning to the case of new rules on for-profit education, perhaps the government has justified its intervention by suggesting that some students don’t know what they are getting themselves into, and are buying a product they don’t need or can’t use. In some cases, the federal government, along with four individual states, is taking things one step further. In August, they filed a lawsuit against another for-profit education company (Education Management Corporation), charging them with fraud. Based on information from whistleblowers, the government is charging:

"The company had a ‘boiler-room style sales culture’ in which recruiters were instructed to use high-pressure sales techniques and inflated claims about career placement to increase student enrollment, regardless of applicants’ qualifications. Recruiters were encouraged to enroll even applicants who were unable to write coherently, who appeared to be under the influence of drugs, or who sought to enroll in an online program but had no computer."

While the fraud case is early in the legal process, the metaphorical jury is still out on the government’s new policies. Regardless of the legal outcome, it’s important to consider the costs and benefits to the parties involved when the government considers intervention.

DISCUSSION QUESTIONS:

1) Will the government regulations related to for-profit education cause a pareto optimal change? Who is better off under these regulations? Is anyone made worse off by these new laws?

2) What should the government consider when debating laissez-faire policies versus intervention?

3) Do you think the government regulation of for-profit colleges is appropriate? Is this a positive or normative question?

4 ) How would the market react if students had to pay for their education entirely out of their own pocket, rather than receiving some government aid? Would you expect the same level of regulation to be introduced?

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.

Moody's Negative Outlook on U.S. Local Government Debt

A few days ago, Moody's Investors Service announced that its outlook for the entire U.S. local government tax-backed and related ratings sector is negative. This is newsworthy not only for municipal bond investors but also for anyone following the U.S. recession. It marks the first time that Moody's issued an outlook on this entire sector, although it has issued ratings on the sector since 1914.

Moody's Investors Service is one of the leading issuers of credit ratings. Investors use these ratings to gauge the risks of investing in debt assets. So, one might conclude that the analysts at Moody's are remarkably pessimistic about the impact that recessionary economic conditions will have on the ability of local governments in the U.S. to meet their debt obligations. This means that the risk of defaults on these debts has risen.

However, Moody's hedged its announcement by mentioning that credit pressures will vary significantly across locales due to differences in economic conditions, property assessment methods, and authority to raise revenue. The varying economic conditions can largely be explained by localities' exposure to industries hit particularly hard by the recession. These include real estate development, auto manufacturing, financial services, tourism, gaming, and general manufacturing. Differences in property tax systems will play a major role. Moody's report shows evidence that about 72% of local government tax revenue comes from property taxes. The bursting of the housing market bubble will bring declines in property tax revenue for most local governments because of falling home values.

Several of these governments might have the authority to increase property, sales, or income tax rates to raise revenue. Whether the elected officials running these localities are willing to do this is an open question. Moody's points out that taxpayers are worried about their own financial conditions and are highly resistant to increases in local taxes. Raising taxes in this environment will be unusually difficult for locally elected officials.

Cutting spending during the economic crisis will not be an attractive option either. In part, this is because many of these governments may face service mandates that prevent them from reducing service-related expenditures. An example of a service mandate is that a state government may mandate that local governments provide health services for the poor. Moody's analysts also reported that the demand for improved government services will make it that much more difficult for these governments to sustain healthy finances. Local officials may find that it is more palatable to default on their bonds rather than raise taxes or cut spending.

The credit crunch is also having a direct impact on local government finance. Moody's report states that access to credit will be more expensive for these governments than it had been in recent years. Moody's negative outlook announcement surely caused investors to demand greater yields on the municipal bonds trading in the credit markets. The company also warned that some localities are in such dire straits that they may be completely shut out of the credit markets.

Yet, the situation ought to be tenable for numerous governments. For instance, some well-managed localities increased their reserves during the boom years and were prudent with the funds generated during the real estate bubble. A simple example from portfolio theory can help show why investors may still be willing to buy the bonds of a cross-section of municipalities.

Suppose that a bond investor purchases three one-year bonds with different expected returns and probabilities of default. For simplicity, we'll assume that the investor is risk-neutral and the bonds pay nothing in the event of default. Bond A has a 25% probability of default this year but pays a coupon of 15% if it avoids default. Bond B has a 50% probability of default this year but pays a coupon of 20% if it avoids default. Bond C has a 75% probability of default this year but pays a coupon of 30% if it avoids default. Let's also assume that all the bonds have a face value of $100 each.

What is the investor's expected payoff from investing in this portfolio? It is


(0.75 × $115) + (0.5 × $120) + (0.25 × $130) =

$86.25 + $60 + $32.50 = $178.75


So, on average, an investor would be willing to pay less than 60% of face value on these bonds to make a positive expected return.

This example was purposefully simple, but from it you can see the advantage of diversification and the problem of gauging risk. If the probabilities of default end up being higher than estimated, the investor might lose money but will only lose all his money in the rare case that all bond issuers default. Yet, if the probabilities of default are lower than estimated, the investor might earn a high rate of return.

Discussion Questions

1. How does the bond portfolio example relate to the impact that mortgage-backed securities had on financial institutions? What must have happened to their default rates for them to become known as "toxic assets"?

2. If you had a large sum of money that you had to use for investment purposes, would you put together a portfolio of U.S. local government debt? If yes, why? If not, explain what your preferred investment would be.

3. Besides an economic recovery, what changes, if any, do you think are needed for local governments to avoid defaults in the future? How feasible are your proposed changes?

Should the Government Bail Out the Auto Industry?

America's Big Three—General Motors, Chrysler, and Ford—are in big trouble. Sales from the not-so-fuel-efficient fleet of American-made vehicles had already suffered considerably because of high gas prices even before the financial crisis began to get serious in September of 2008. Faced with undesirable terms in private credit markets, the Big Three are now turning to the government for financial assistance. The House passed a bill to rescue the Big Three car companies with $15 billion in emergency loans on Wednesday, December 10, but the Senate abandoned the plan the day after. Should the government bail out the auto industry?

Those in favor of the bill argued that the rescue plan can prevent the loss of 500,000 jobs in the auto industry. Job losses in the auto sector would most likely have spillover effects in other sectors. As auto workers lose their jobs, they would consume fewer goods and services, negatively affecting industries in retail, health care, and financial services. With unemployment already rising, supporters of the bailout argued that keeping auto workers in their jobs is much easier than creating new jobs for them.

Opponents of the bill compared the bailout to the inefficiencies generated by government subsidies and tariffs. Many companies face financial problems—why should the government save the Big Three and not the others? Poor performance is typically a good signal that a company should change how and what it produces. A partial government takeover of American auto companies will not ensure that the firms will start producing vehicles that people want to buy. A bailout, according to critics, will simply prolong the inevitable: the consolidation of the American auto industry, the large number of layoffs that come with it, and the migration of workers from autos to more profitable industries.

Discussion Questions

1. What is the role of labor unions in contributing to the financial problems facing the Big Three? In particular, how well do the wages reflect the productivity of the workers in the Big Three? Click here to read more.

2. Do you think the problems faced by the Big Three stem primarily from the recent financial crisis or from longer-term decisions about what types of vehicles to produce and how to produce them?

3. Some suggest that another reason leading to the failure of the Big Three is that American consumers prefer cars made by foreign companies, such as Toyota and Honda, to cars made by American-owned companies. How does the market of foreign-made cars affect the demand for American cars?

4. Foreign-owned automakers, like Toyota and Honda, operate production facilities in the United States and employ American workers. How would these firms be affected by a bailout of the American-owned Big Three? How will foreign auto firms with operations in and outside of the United States be affected if one or more members of the Big Three were allowed to fail?

5. How do the loans compare with tariffs in foreign trade? What advantages and disadvantages do they share in common?

6. What would happen to the broader economy if the plants closed and workers became laid off? What might these workers do to find new employment? Which sectors would employ them?

The Millionaires’ Amendment and the Law of Unintended Consequences

Even more than the law of supply, the law of demand, or the law of diminishing marginal utility, economists love the law of unintended consequences. A brief editorial in the New York Times provides a nice illustration of that law.

One of the McCain-Feingold campaign finance reform laws was an exception to campaign finance limits for the case in which a rich candidate contributes a large amount to his or her own campaign. The idea is simple: campaign finance laws generally govern how candidates for office can raise money from others, but don’t restrict how much money they themselves can spend on their own candidacy. Therefore, if one candidate is of modest means while another is rich, campaign finance laws that make it harder for the poorer candidate to raise money implicitly help the richer candidate.

To solve this problem, McCain-Feingold lifted campaign contribution limits for candidates facing a challenger who spent more than $350,000 of his or her own money on the campaign. This provision of the law is now being challenged as unconstitutional by Jack Davis, a millionaire who ran unsuccessfully for Congress in 2006. Davis claims that the effect of the law is to deter rich people from public service.

The Times editorial makes the following rebuttal:

There is also no sign that the amendment is discouraging the wealthy from running or spending. The very rich are represented in Congress in large numbers. Contrary to Mr. Davis’s claims of “chilling,” the number of candidates who spent more than $1 million of their own money actually increased after the amendment took effect. It is now common for party recruiters to seek out “self-financing”—or wealthy—candidates.

Consider the structure of the two arguments here. Davis argues a theoretical point: that allowing opponents of rich candidates to raise more money will have a “chilling” effect on millionaires running for office. The Times seeks to refute that point with empirical evidence: that the number of wealthy candidates has increased since the amendment was passed.

Now, a fun part of thinking like an economist is being able to parse arguments like this. Here are some questions that get you started.

1. Is Davis’s argument internally consistent? That is, holding all else constant, would you expect this amendment to have a “chilling” effect on millionaire candidates?

2. The amendment cited in the article was part of broader legislation limiting campaign fundraising. What effect would this have on the incentives political party recruiters face when choosing to seek out “self-financing” candidates?

3. Does the Times make the most convincing possible case against Davis? How might you argue the point differently? What is the strongest argument you could use to refute the Times’ point?

4. Think about the goals of John McCain and Russ Feingold, the authors of the campaign finance legislation. How do you think they feel about the fact that one effect of their legislation has been an increase in the recruiting of wealthy candidates? Based on that increase, do you think they would want more or fewer provisions like the Millionaires’ Amendment?