Aplia Econ Blog: News for Economics Students

The Economics and Egonomics of New Year's Resolutions

2014-01-14T19:05:00.001-08:00

If you are like many Americans, you made a New Year's resolution, and, if you are like most of those people, you will have given up on it before the year is half over. Traditional economic analysis would attribute this result to a difference between what was expected and what actually happened. Either the benefit of maintaining the resolution wasn’t as great as expected, or the cost of maintaining it was more than expected.

While considering benefits and costs is always a good place to start when trying to explain why something happens, this explanation feels incomplete. If it were solely a matter of benefits and costs, we would be far less hard on ourselves when we broke our resolution. Moreover, the difficulty of following through on our intentions probably wouldn’t have been considered an interesting problem by a Nobel laureate. Thomas Schelling, who won the Nobel Prize in Economics in 2005 for his contributions to game theory, postulated in “Egonomics, or the Art of Self Management" that we behave as if we have two selves: The one who wants to achieve a goal, despite its costs, and the one who wants to give up on the goal when faced with those costs. As examples, he wrote that there is "the one who wants clean lungs and a long life and another who adores tobacco" and there is the “one who wants a lean body and another who wants dessert. The two are in a continual contest for control.”

Schelling suggested a classic way to overcome the problem of having two selves: Taking away decision-making ability from the “wayward” self by having the “goal-setting” self pre-commit to certain actions:

Locking away a high-calorie treat so that it is not immediately accessible;
Setting the alarm clock across the room so that we have to get out of bed to turn it off
Pre-ordering a healthy lunch right after breakfast, when an unhealthy choice is least tempting

Since the time that Schelling wrote about these tricks, behavioral economics has provided more insight about why they are useful, and technology has made it easier to implement them. There is an alarm clock that rolls away from you until it is turned off, and there are low-cost safes with time-based locks on them, so that you can lock away a treat until later.

The internet has also made it easier to access tools that boost our resolve. To increase accountability and muster support from his friends, New York Times reporter Brian Stelter tweeted everything he ate in 2010 and ended up losing 90 pounds. For those who need higher stakes to follow through, economists at Yale founded stickk.com, where you can specify that money be donated to a charity you don't like whenever you don't meet your goals. (Why not a charity that you do like? Because then your failure of resolve wouldn't be as costly, making it less unpleasant to give in.) The proliferation of location-aware smartphones has enabled apps like GymPact, which pays you for checking in at the gym when you said you would, where the funds come from those who committed to working out but ending up skipping.

Of course, the internet and smartphones have also made the resolution to maintain focus more difficult. We are always only one website or app away from distraction. Fortunately, there are browser extensions, such as StayFocusd for Chrome and LeechBlock for Firefox, that you can use to limit your access to the internet.

Despite all the forces that make it difficult to keep a resolution, there is still a benefit to making one. Research suggests that those who make a formal resolution are 10 times more likely to succeed in changing than those who do not make a resolution. If your goal-setting self makes a resolution this year, I hope you find this blog post helpful when your “wayward” self wants to break it.

Resources:
Not surprisingly, psychologists also have a lot to say about keeping resolutions, especially with the growing insight that willpower is like a muscle: in the short term, it gets tired with use, but in the long term, use makes it stronger. This article provides advice based on recent psychological research.

Economists disagree and the Nobel Prize in Economics

2013-11-25T09:34:00.003-08:00

Economists are famous, perhaps infamous, for disagreeing with each other. Indeed, economists have
different views on policies, different scientific judgments, and different values. Even economists who share the Nobel Prize in Economics sometimes disagree with each other. This year the prize was given to Eugene Fama, Lars Peter Hansen, and Robert Shiller for highly influential but contradictory theoretical and empirical analysis of asset prices. The huge importance of their research stems from our every day choices between saving in the form of cash, investing in stocks, and real estate. Our decisions depend on our evaluation of the risks and returns associated with these forms of saving. Modern economy also depends on the understanding of asset prices as they provide information for key economic decisions regarding physical investments and consumption. Mispricing of assets leads to financial crises and can damage the overall economy.

The differences in the laureates’ research are well known in the finance community. They also have quite different policy implications. Answering the surprised public, Robert Shiller wrote “We disagree on a number of important points, but there is nothing wrong with our sharing the prize. In fact, I am happy to share it with my co-recipients, even if we sometimes seem to come from different planets.”(http://www.nytimes.com/2013/10/27/business/sharing-nobel-honors-and-agreeing-to-disagree.html?_r=1&).

In the center of the disagreement is the question of whether asset prices are predictable. Clearly, you can make a lot of money if you can predict with a high degree of certainty that one asset will increase more in value than another one. In the 1960s, Fama advanced the efficient-markets theory, which states that prices reflect all publically available knowledge, which implies that average investor can’t beat the market. It also implies that prices follow a random walk, go up or down, which makes deviations from expected returns unpredictable and arbitrage impossible. Fama’s empirical studies supported very limited short-run predictability in stock markets. Even if an asset’s actual price goes above or below its expected price, such deviations are so small that trading costs would exceed any gains from arbitrage. Many concluded that if prices are virtually impossible to predict in the short run, they are even less predictable over longer time horizons. A practical take away from the efficient market theory is that trading by using complex algorithms is no better than by just flipping a coin. You can accidentally have a long series of luck but publicly available information will not ensure you could systematically beat the market. However, in the 1980s, Shiller’s studies of stock-price volatility and longer-term predictability challenged this conclusion. He showed that stock prices exhibit excess volatility – that is, prices significantly deviate from the expected levels in response to events affecting asset prices, such as dividend news – in the short run, and over a few years the overall market is quite predictable. On average, the market tends to move downward following periods when prices are high and upward when prices are low.

Moreover, Shiller suggested some behavioral explanations for asset prices’ excess volatility, which inspired a new field called behavioral finance. For example, he suggested that there are two types of investors: experienced rational investors and so-called “ordinary investors.” Unlike rational investors, the ordinary ones fail to recognize and utilize arbitrage opportunities. Instead of responding to expected returns, they are highly susceptible to the opinions of others about stock prices, similar to fads or fashions. As a result, their trades exacerbate deviations of stock prices and generate excess volatility, which generates arbitrage opportunities for others.

One of the most difficult issues in modeling financial markets is uncertainty. The theory acknowledges that investment decisions involve risk but they also assumes that investors are aware of how markets work and have access to the true data, which allows them to process information efficiently. In real life, we have to deal with very limited information, as there are too many variables that we can neither observe nor measure directly. Hansen has made a lot of progress developing and testing a variety of asset pricing models which allow studying complicated systems with limited information. (http://business.time.com/2013/10/23/nobel-prize-winner-lars-peter-hansen-on-how-economics-has-helped-you/#ixzz2kZ4KXLni )

Why did the Nobel Committee decide to award a joint prize? Fama, Hansen, and Shiller explored price predictability from different angles and produced important empirical findings with important practical implications. For example, Fama’s research inspired the creation of index funds – mutual funds tracking the performance of a particular index, a convenient way to participate in the stock market and diversify a portfolio – in the early 1970s, which has grown to account for over 40% of the worldwide flows into mutual funds. In turn, Shiller’s research is behind the S&P Case-Shiller index that is now the standard real estate price index in the United States. So, it looks like we are from the same planet, after all.

Discussion Questions

1. Why do some people gamble regularly while others would never even consider making a bet?

2. Why are behavioral economics, for which Vernon Smith and Daniel Kahneman received a Nobel Prize in 2002, and now behavioral finance gaining more popularity in the academic and business community?

3. If you had $500 to invest, how much would you invest in an index fund and how much would you put in an individual stock that you thought was going to perform well?

Quantitative Easing Steady, But Bond and Gold Prices Spike

2013-10-01T15:24:00.000-07:00

The Federal Reserve's decision on September 18th to continue purchasing $85 billion in longer-term bonds each month took financial markets by surprise. Collective wisdom expected that the Fed would begin tapering its purchases of U.S. Treasury bonds and mortgage-backed securities—a policy first begun in the aftermath of the financial crisis and known as quantitative easing—and thus, slowing its expansion of the money supply. Instead the Federal Open Market Committee, which determines monetary policy for the Fed, decided that unemployment was still high enough and inflation still low enough to justify a continued expansion of the money supply at the current rate.

It remains to be seen whether the policy will have its intended effect on the economy, but its impact on financial markets can be seen in price spikes at the time of the announcement.

Because market participants expected the Federal Reserve to demand fewer US Treasuries in the future, the price for bonds in the future was expected to be lower than now. In turn, the expectation of lower prices in the future had decreased demand for bonds now, putting downward pressure on current bond prices. If the Fed had acted as the market anticipated, the Fed’s announcement would have had only a minimal impact on prices. When the Fed instead indicated that it would maintain its demand for bonds, buyers and sellers of bonds realized that the future price of bonds would be higher than they expected, and since the future price was going to be higher, owning bonds now suddenly became more attractive. As a result, the current demand for bonds increased, pushing the price of bonds up. This price change can be seen in the graph of an indicator of average bond prices, which shot up just after 2pm Eastern time, when the Federal Reserve made its September 18^th announcement.

(Click image to enlarge.)

Because the effective interest rates paid by bonds decrease when bond prices increase (check your textbook or watch this video from the Khan academy for an explanation of the inverse relationship between bond prices and interest rates), the yield on longer-term US Treasury bonds declined on Sept 18, as can be seen in the screenshot below.

(Click image to enlarge.)

Also notice how low the short-term interest rate is: one-hundredth of 1% for 1-month U.S. Treasury bills. This extremely low rate is another sign of the Federal Reserve's desire to stimulate the economy. In fact, if it could set short-term interest rates lower, it probably would. Instead, since nominal interest rates cannot go below 0% (if they did, you would be paying banks to keep your money with them), the Federal Reserve purchases longer-term bonds in an attempt to give the economy extra stimulus beyond extremely low short-term interest rates.

If the Fed is unable to reverse it later, this extra monetary stimulus will lead to higher inflation. Since gold is traditionally a hedge against inflation (that is, an asset that maintains its real value when prices increase), fears of higher inflation tend to increase the price of gold. As a result, the spike in bond prices due to the Fed’s announcement was accompanied by a spike in gold prices. (Note: the difference in timing on the horizontal axes of the graphs is due to differences in time zone and how often data on prices is collected.)

In an upcoming post, I'll look at how the Fed's decision to extend quantitative easing changed foreign exchange rates, which was actually how I was alerted that the Fed had made a surprise announcement in the first place.

Discussion questions:

How do you think the Fed's decision to extend quantitative easing affected the foreign exchange market? Did the US dollar appreciate or depreciate?
What other markets might have seen dramatic changes due to the Fed's decision?
Ben Bernanke, the Chairman of the Federal Reserve, has stated that he wants monetary policy to be more transparent. What does the financial market's reaction to the Federal Reserve's announcement suggest about the transparency of monetary policy?

Finally Something Positive from the Cubs!

2013-09-03T15:26:00.001-07:00

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?

Paper or Plastic?

2013-06-24T13:46:00.000-07:00

Recently several California towns and counties introduced new rules concerning single-use grocery bags in an attempt to reduce the harmful effects of paper and plastic refuse on the environment. Plastic bags are banned completely while stores are required to charge 10 cents for each recyclable paper bag the customer wants to use. Proponents of the new policy argue it will reduce harm to marine life, damage to utility systems, reduce litter and waste, and conserve natural resources. The opponents, however, maintain that single-use bags are not only convenient for shoppers but actually serve multiple purposes after the initial usage, ranging from waste basket and cat litter containers liners to bike seat covers. The opponents also argue that the ban on plastic bags will boost consumption of a variety of plastic products to substitute for plastic grocery bags, which is not only costlier at the individual level but also might inflict more harm on the environment. The research on both sides of the argument is still inconclusive and lacks hard evidence. However, economic theory might yield some insights and help us see the much needed middle ground.

What we know with certainty is that at the individual level, people benefit from using single-use grocery bags. We also know that prior to the ordinance’s passage, the bags were given indiscriminately and for free. But the bags are also arguably bad for the environment and require recycling, and thus are costly to society. In economic terms, this means the bags create a negative externality – a cost that is not born by the consumers who enjoy the benefits of this product, but by society at large. This cost likely exceeds the benefit from using them.

The graph shows marginal social cost of and demand (or marginal private benefit) for single-use bags in the economy. Suppose that the quantity demanded is 100 billion shopping bags every year when they are given away for free (i.e. when price equals zero). According to some research, this might not be far from the truth for the United States. Suppose that at this quantity, the marginal social cost is 20c per bag, which exceeds the marginal benefit and is therefore not optimal. The law of demand dictates that charging for the bags will reduce consumption. Suppose that a fee of 10c per bag reduces consumption to 50 billion bags, equating the social costs and private benefits of single-use bags.

The 10c fee per paper bag is nothing but a Pigovian tax (named after the English economist Arthur Pigou) as it counteracts the negative externality. If the amount of the tax is set equal to the cost brought about by the negative externality, it will produce an efficient outcome: Only those who value the convenience of having grocery bags ready at the checkout enough to pay for the harm the bags cause will purchase them.

So where does the 10c fee come from? And why ban plastic bags completely instead of charging a fee for them as well? For one thing, the negative externality created by a paper bag is relatively easy to calculate. Since paper decomposes quickly without producing lasting damage to the environment, its harm equals the cost of recycling. So, there is a good reason to believe that the 10c tax is efficient enough. Unfortunately, plastic is another matter. The negative externality from plastic bags exceeds the cost of recycling as it also includes the damage to the environment done by discarded plastic bags, which is difficult to estimate accurately. In the absence of reliable cost information, it is hard to calculate an optimal Pigovian tax. Therefore, it seems reasonable to ban free plastic at the stores and let the market decide the price for substitute products.

Discussion Questions

1. Are single-use grocery bags normal goods?

2. What if the actual negative externality from a paper bag is less than 10c?

3. Could the single-use bags ordinance affect retail grocery sales?

Got Lobster?

2013-05-22T14:30:00.003-07:00

It’s a good thing I don’t have to watch my cholesterol, because after moving to the Maine seacoast last July, I simply cannot get enough lobster. Though I haven’t had to worry about the health cost of consuming lobster, I have been paying attention to changes in the dollar cost over the course of the season. Monitoring prices doesn’t get any easier for this lobster-loving Mainer because every day on the way to my son’s school, I drive by a sign advertising the current price.

The start of the lobster season coincides with an increase in the demand for lobster as summer vacationers head to the Maine beaches. In York, Maine, alone, the population triples during peak season then drops back down again once the school year begins. An increase in demand means upward pressure on price, while an increase in supply means downward pressure on price.

As lobster season came to a close in the summer of 2012, however, word on the street was that there was a surplus of lobsters. With quantity supplied larger than quantity demanded, downward pressure dropped lobster prices to an astonishingly low $2.99/pound for chix (lobsters weighing between 1 and 1.24 pounds), making lobster in southern Maine cheaper than a good steak at the time.

As lobster season ended and the bitter winter set in, the per-pound price of lobster started to tick upward. This is consistent with the basic model of supply and demand—once lobster season was over, supply decreased which put upward pressure on prices and demand decreased which put downward pressure on prices . Over the last year, it appears that supply changes have been more drastic than demand ones, thus the same good that had cost roughly $3 per pound in the summer cost nearly $10 per pound by March 2013 simply because of changes in supply and demand.

Between summer and winter, supply changes outweighed demand effects in the market for Maine lobsters (as evident in the large increase in price), so I am hopeful that lobster prices will drop in the coming months as supply increases so that I can enjoy my favorite butter conduit once more!

Discussion Questions

1. Using a supply and demand diagram, illustrate the shifts in demand and supply after the lobster season ends. Be sure to pay attention to the magnitudes of your shifts so that the equilibrium price rises as described in the article.

2. If lobster fishermen have a bad catch this summer, what would you expect to happen to the price of lobster in Maine in July?

3. How do fluctuations in the market price for lobster affect other markets for food products such as steak and chicken?

Time is Money

2013-05-01T10:55:00.000-07:00

The other day I took my car to the mechanic for what I thought would be a quick maintenance appointment. However, I was sadly mistaken when my bill came in at a whopping $800. Because my knowledge of cars is pretty much limited to things that can be done from the driver’s seat, whatever fluid replacement, alignment adjustment, or component repair the mechanic recommends, I usually pay for with resignation. After reviewing my itemized bill, I wondered whether it really should have cost $30 in labor to replace my windshield wipers, whether my something-or-other-belt really needed to be replaced, or whether I could have perhaps gotten a cheaper set of new tires at Costco. It’s possible (if not quite likely), that a more informed consumer could have saved hundreds of dollars on the same transaction. And yet, it’s unlikely that I’ll do anything differently the next time I go in for repairs.

In many aspects of life, there are ways to save money by becoming more informed about what we’re buying or by learning how to do something ourselves rather than paying for the good or service. For example, a friend of mine learned how to fix guitars because, as a musician, this will save him from having to pay for a lifetime of professional repairs. Personally, I like to cook, and thus I save money by preparing my lunch at home rather than buying it at work. However, my musician friend doesn’t like to cook and therefore spends more money on pre-made lunches than I do, and uses the time he saves by not cooking to engage in activities more valuable to him.

This illustrates one of the fundamental principles of economics: we gain from specialization in the face of scarcity because everything has an opportunity cost. In this case, the opportunity cost of becoming more informed about cars is the time I spend learning about cars rather than doing other activities I enjoy. Given the limitations of time and money, no one can become an expert in everything. To be truly self-sufficient would require a return to our hunter-gather roots when we spent the majority of the day finding food, and even then you might want to assign someone to gather the berries, someone else to prepare the meal, another to build shelter, etc.

A common misperception is that economics is aimed solely at maximizing profit. However, a classic application of economics is the study of how people choose to spend their money and time given the limitations they face in order to maximize utility, or a person’s level of happiness. Because there are not enough hours in the day to find the cheapest way to do everything ourselves, we decide to spend our time either doing things we enjoy (that is, that directly give us higher “utility”) or getting paid to do things we are particularly good at (that is, tasks in which we have a comparative advantage). With the money we earn from working, we can then pay others to get the rest of what we want or need.

Discussion Questions

1. What are some of the things you choose to “specialize in” that others pay for? What are some of the things you pay for that perhaps you could do yourself? Are there other reasons for specializing in something besides being good at it or enjoying it?

2. The exact opportunity cost of an activity can be hard to determine, since it is not easy to put a “value” on your time. How is the opportunity cost of time different for someone who earns a fixed salary versus someone who can always choose the number of hours he or she works?

How Much Does It Cost To Make Cookies?

2013-03-29T13:30:00.000-07:00

“Buyers know what goods cost.” Some version of that assumption comes up in the very first weeks of just about every introductory econ course. It becomes one of the few assumptions that we make to build the model of consumer demand. But every once in a while, life gets in the way and asks “Is that something you really can assume?”

I had to test that assumption recently. I just moved and after unpacking, I was in the mood to make dessert for myself. Of course, I hadn't brought many kitchen supplies with me, so that quickly posed a problem. To make cookies, I needed to buy some wooden spoons, measuring cups, and a cooling rack. None of those are hard items to find, and I happened to live just minutes away from a shopping center that had a regional grocery store, a Wal-Mart, a Target, and a regional department store. I knew that all four stores should have what I want, so the question of where to go really came down to where it would cost the least. And that’s when I realized that one of the most basic assumptions of microeconomics didn't hold true. I didn't know which store would be the cheapest, or even what the prices of the goods should be!

I had some free time on a Saturday and a strong enough curiosity that I wanted to sample prices from each store. Here’s what I found:

STORE	WOODEN SPOON (Dollars per spoon)	COOLING RACK (Dollars per rack)	MEASURING CUPS (Dollars per cup)
GROCERY STORE	$1.50	$4.50	$1.22
WAL-MART	$2.97	$2.99	$1.32
TARGET	$2.03	$3.67	$4.97
DEPARTMENT STORE	$12.00	$7.00	$7.50

I was also shocked by the spread in prices. While I did expect to see some markup at higher-end stores, the range was wider than I expected. I was also surprised that there wasn't one store that had the cheapest prices, across-the-board, for all the goods.

When economists create models, the goal is to make a few assumptions about the world to describe the “typical” human response and show how that response leads to a “general” outcome. My behavior in this case is not what economists would call “typical.” (My friends might even call it weird!) But even for the typical consumer, are the assumptions of the supply and demand model always appropriate?

In a lot of cases, the classic supply and demand model does gives accurate results, but sometimes the assumption that consumers know the distribution of prices isn't appropriate. In those cases, it’s important to understand how behavior will change if an assumption is violated. The classic model does not involve consumers looking for prices, they just know them. As economists, we often say we are assuming “complete information.” When consumers don’t have complete information the market price typically doesn't match the equilibrium price the model predicts. Most of the time the market will be inefficient (contrary to what the model suggests) and both producer and consumer surplus will be lost.

Throughout economics, every conclusion that we draw from a model depends on the assumptions that are used to build that model. Whenever I learn about a new model, I always list the assumptions made and focus on how the results change if the assumption would be removed. Understanding the relationship between assumptions and results is the critical step to applying what we learn from theory and using it to understand what happens in the real world.

DISCUSSION QUESTIONS:

1. When I was getting my information I found that stores rarely carry the exact same goods. (Even if they are the same brand, the packaging might be different. It’s why I calculated my information in per unit prices.) Since I was able to find the goods in multiple locations, but they were not identical, which market structure is the most appropriate to describe kitchen supplies: Monopoly, Oligopoly, Monopolistic Competition, or Perfect competition? Why?

2. While my shopping behavior was a bit different than most people for kitchen supplies, people do “search” when they buy certain goods. Name some items where the supply and demand model isn't as appropriate as a consumer search model would be. Why is it more appropriate to think about consumers searching for these goods?

3. An important part of search theory talks about the cost of searching. Suppose I didn't live near a shopping center and the stores were all 20 minute drives apart. How do you think that distance (and the opportunity cost associated with traveling between them) would change my behavior when I search? How would it change the pricing behavior of the stores?

Assumption Corruption

2013-03-06T09:52:00.001-08:00

A famous economics joke says it best: A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, "Let’s smash the can open with a rock." The chemist says, "Let’s build a fire and heat the can first." The economist says, "Let’s assume that we have a can-opener..."

Though the above example is meant to be extreme, all economic models are based on underlying assumptions. They may pertain to variety of things such as the market structure, pricing mechanism, location, time lags, frictions, mathematical properties, etc., and they are used to simplify economic relationships. An important assumption that drives many popular economic models is that of perfect information. In particular, models rely on the assumption that the prices of all goods and services are known.

As I was recently perusing the latest status updates of my Facebook friends, I noticed the following post: “How much do you pay a 14-year-old high school freshman as a mother’s helper a few days a week?”

As an economist, one might be inclined to quickly answer “whatever the market price is for that service!” However, it is clear from this post that that information is not actually known to the buyer.

While the internet has clearly helped to alleviate this information gap, it can still take time to gather all the relevant information necessary to make an informed decision. Sometimes, the cost of obtaining this information becomes so high that consumers decide not to research at all. For example, if you want to buy a hair dryer, a quick internet search may result in the same model offered at different stores for different prices, so you still wouldn’t know the relevant price for your needs without more digging.

Even though the famous supply and demand model does not completely reflect the real world (since it assumes, among other things, that prices are known), this is not meant to imply that economic models are worthless. It would be impossible to model every detail of the “real world”; rather, it's important to make sure the assumptions are appropriate for what you are trying to analyze. For example, if you’re trying to model the effects of an increase in fuel price on consumers’ demand for SUVs, assuming perfect information for prices does not invalidate the results that it will decrease the demand for this good; it merely simplifies the model into something tractable. But in general, you’ll want to ask yourself the following questions when you examine an economic model: Are the assumptions of this model reasonable? Would changing the assumptions affect the result in a drastic way?

In short, be careful not to become a victim of assumption corruption, but don’t let fear of assumptions keep you away from using models at all either!

Discussion Questions

1. Another popular assumption is that agents act rationally and are utility-maximizers. How can this assumption still be valid in the presence of people volunteering their time or donating money?

2. Consider some other assumptions for the supply and demand model, such as price-taking behavior or the competitive hypothesis. How would relaxing those assumptions change the results of the model, if at all?

3. Why do we study economic models that don’t perfectly match our experience in the real world?

4. What are some other markets where the assumption of perfect information does not hold true in the real world?

Crime, Society, and Me

2013-02-07T10:26:00.001-08:00

A few months ago, my car was burglarized; the side window was broken and my iPod taken. I had to pay $230 for the window repair and although the 2-year old iPod Touch may only have been worth $100, having it stolen was nonetheless very upsetting. On top of that, my husband had to spend $30 and two hours at a carwash cleaning up glass shards. At the end of the day, this crime incident cost my family about $360, not including the loss of time and music stored on the iPod.

Surprisingly, economic theory provides some comfort. According to the economic theory of crime and law enforcement advanced by economist Garry Becker in his famous 1968 article “Crime and Punishment: An Economic Approach” (www.jstor.org/stable/1830482), the societal cost of this crime is lower than the cost to me personally. Becker modeled societal losses from crime as the difference between damages brought about by criminal activities and gains to offenders, which can be summarized as follows:

Social Losses = Damages brought about by criminal activities - Gains to offenders

The complete theory accounts for the cost society bears to maintain the legal system and law enforcement, and also makes a number of important assumptions (for instance, that gains from crime are subject to diminishing returns). However, more importantly, the theory acknowledges that the person who stole my iPod is a member of society too, so although I lost a total of $360, not all of that value was truly lost. When formulated this way, the economic theory of crime enables law enforcement to calculate the “optimal” sanction. That is, when determining the level of resources to devote to crime prevention and punishment, society must weigh the benefit of reduced crime against the costs of law enforcement, incarceration, etc. If this equation ignores the gains to offenders, then the calculated level of punishment will be too high. Assuming the burglar can get $100 for my iPod and ignoring the value of the time spent on cleaning and the sentimental value of the lost music, the loss to society equals only $260. The optimal level of punishment for such a loss should therefore be lower than that associated with a true $360 loss.

Moreover, had the burglar been more skillful and stolen the iPod without breaking the car window, my loss would be exactly equal to the burglar’s gain. Certainly, I still would be upset, but in a larger scheme, this event would not create a noticeable effect on societal welfare. Well, the IRS would be unhappy about the situation too, although for a different reason. I can deduct my losses from the next year's taxes whereas, it is highly unlikely the burglar will ever report the gain as a taxable income.

Discussion questions:

1. If my burglar’s income is lower than my income and assuming diminishing returns to income, could this crime incident be viewed as a welfare improving redistribution of wealth?

2. Why wouldn’t societies be better off by increasing expenditures on law enforcement to such a level that there would be absolutely no crime?

3. Would societies be better off by adopting maximum punishment for all types of crime, violent and non-violent property crimes alike?

Who Pays for Online Discounts?

2012-05-10T13:04:00.000-07:00

The other day I woke up, looked in the mirror, and decided it was time for a haircut. Rather than picking up the phone and calling the salon where I’ve gone in the past, I checked my email, typed “haircut” into the search bar, and was rewarded with a half a dozen email offers from San Francisco salons selling haircut vouchers at 25%, 50% or even 75% off the regular price. All but one offer had since expired, but I was nonetheless amazed that businesses were offering such steep discounts with such regularity.

Traditional coupons seem to have withstood the test of time as a profitable marketing scheme, but the success of any discounting strategy depends on how coupons are used by both new and existing customers. A primary reason firms offer coupons is to attract new customers, in hopes that after experiencing the quality of the product or service, those who were initially only willing to pay the coupon price will later return and pay the full price. Regardless of whether coupons are offered online or delivered in the mail, however, some will invariably be used by existing customers who would have otherwise paid the full price. Thus, although coupons may generate additional revenues from new customers, they also may reduce revenues from existing ones. While I have been drawn to many new hair salons by their coupon offerings, the widespread availability of these offers has made me far less likely to become a repeat customer. Even if I particularly like a cut at one salon, I’m generally willing to take my chances on the next deal to save 50%.

Fortunately for firms, some customers willingly pay the full price to avoid the hassle coupons entail. This enables firms to separate consumers into two groups based on their willingness to pay, a technique known as price discrimination. If a salon can use coupons to gain customers who are willing to pay less (but instead willing to expend the effort required to use a coupon), and still charge a higher price to customers who are willing to pay more (but won’t bother with coupons), then it can increase the volume of its sales without having to lower the price on all sales. Thus, while it may seem that firms should want their coupons to be as easy to use and widely accessible as possible, the lower the “cost” of acquiring and using coupons, the less ability the firm has to continue charging the full price to some customers.

Admittedly, there are other factors to this new online market for coupons that may counteract the difficulties presented above; some people buy coupons but never cash in on the services, some of the “discounts” may actually reflect artificially inflated original prices, and not everyone is willing to take a chance on a new salon for each new haircut. In the long run, the market will likely determine whether or not this particular variation of discounting survives, but until then, I’ll continue to take advantage of half-off haircuts.

Discussion Questions

1. How might the analysis above be different for different types of goods and services? Is there a difference between offering deals on things people buy impulsively versus things that people buy regularly?

2. How does the fact that people actually have to purchase many of these deals in advance of using them (as opposed to simply clipping a coupon that you may or may not end up using) affect the market? How might this benefit or hurt the firms offering deals?

3. How strong is the psychological component of coupons? That is, how might consumers respond differently to a regularly priced car wash for $30 versus a coupon offering a $60 car wash at 50% off? What does economics have to say about these different price schemes and how they should affect the market outcome?

4. Suppose there are only two hair salons, how could you use game theory to model their payoffs when they each must decide to offer a coupon or not?

Hunting for a Cheaper Easter Egg

2012-04-13T12:53:00.003-07:00

Easter egg decorating was more expensive than usual in Europe this year. According to the Wall Street Journal, the annual spike in egg prices—due to their use in Easter food and decorating—was much higher than usual. Compared to the same time last year, prices were up by more than 75% across the European Union and had more than doubled in Poland, Bulgaria, and the Czech Republic.

What’s different about this year? The beginning of 2012 marked the deadline for implementation of a European Union regulation, first issued in 1999, mandating larger cage sizes for hens. Because egg producers have to buy new cages and then use more space to house the same number of hens and produce the same numbers of eggs, the average cost of producing eggs has increased (assuming that having a larger cage doesn’t increase the number of eggs each hen lays). Consequently, some producers have exited the industry, and the remaining producers require higher prices to produce the same number of eggs.

The graph models the consequences of these demand and supply shifts in the egg market, with D1 indicating the normal, non-Easter demand and S1 indicating the supply without a regulation on cages sizes. “D Easter” reflects the increased demand due to Easter, and “S Reg” reflects the shift in supply due to the regulation on cage size.
Note:
P1: price of eggs outside of Easter season without a regulation on cage sizes
P2: price of eggs during Easter season without a regulation (i.e. what prices would have been during previous Easters)
P3: price of eggs this Easter season—that is, with a regulation on cage sizes
P4: price of eggs outside of Easter season with a regulation on cage sizes

The increased demand for eggs at Easter shifts the demand curve to the right, increasing the price of eggs from P1 to P2. The regulation shifts the supply curve up and to the left, causing a further increase in price (about 75% in this model) to P3. As Easter demand recedes and the demand curve shifts back to normal, the supply curve remains shifted, keeping prices, at P4, above what they were in previous years and, according to this model, above even what they were in previous Easters. The exact price and quantity changes will depend on the size of the demand and supply shifts and the elasticities of the demand and supply curves.

While the hens and those concerned with their welfare indubitably appreciate the improvement of their cages, which now have perches and more bedding, better conditions for chickens means higher egg prices for humans. As always, there’s no free lunch, even (perhaps especially) when it includes eggs.

Discussion questions:

1. How much extra would you pay for an egg produced by hens who got to live in better cages?

2. Assuming that all parts of Europe experience equal shifts in supply (which may or may not be true), what do the larger increases in price in Poland, Bulgaria, and the Czech Republic suggest about elasticity of demand for eggs in those countries relative to Europe as a whole? What other explanations are there for the higher price increase in those countries?

3. California Proposition 2, passed in 2008, requires egg producers in California to provide more room for hens starting in 2015. However, the proposition does not require that California retailers only sell eggs produced in California. What do you think will happen to egg prices in California, egg production in California, and egg production in neighboring states?

Kicking through the Ceiling

2012-03-20T05:41:00.008-07:00

In the sports world, it has become cliché for people to say that every second counts. However, we expect that phrase to apply on the field, not to the teams trying to get there. Recently, a friend of mine wanted to register his team for a local kickball league. The registration was online only, starting at noon. He had a problem with his credit card that slowed him down, and by 12:02, all the spots in the league were taken and his team was shut out.

Rather than seeing his misfortune as a sign of kickball’s growing popularity, or the quick typing skills of other kickball managers, the first thing that came to my mind was that the market for league entries must be distorted. The league uses public fields that also need to accommodate other sports and high schools, so time on the fields is limited. Since the kickball league will only have a fixed number of hours on the fields, and since the season needs to accommodate a set number of games, it’s fair to think about the supply of league space as fixed, or perfectly inelastic. Most importantly, even at very high market prices, there is no way to add additional teams to the league.

If limited space were the only constraint on the market, then we could find the equilibrium for the market at the intersection of supply and demand, and thus know the equilibrium price where there are exactly as many teams willing to pay as there are spaces in the league. However, since the league filled up so fast, and teams (like my friend’s) that are willing to pay more than the $500 entry fee are unable to join, it appears that there is an artificial price ceiling in this market. Since the league is publicly run, it is likely that someone decided on a “fair” price to charge, so that entries in the league would be open to people of varying incomes. Unfortunately, price ceilings create shortages, that is, they force some people who desperately want the good to go without it. When goods do not sell for the unrestricted equilibrium price, people who value the entries the most do not necessarily receive them. Thus, the shortage caused by a binding price ceiling will end up lowering society’s total welfare.

Can economic theory suggest a solution that would still offer entries at the “fair” price, but also make sure the entries go to the teams that value them the most? Suppose that the league entries were still given out the same way, but once initially purchased by a team manager, an entry could be resold to a team that did not sign up fast enough, if both parties agree. Teams that got entries and value them at least as much as the equilibrium price will hold on to their entries, but teams that were too slow to purchase them initially will be able to buy them from teams who value them less than the equilibrium price. In terms of the final price and quantity of entries, making the league entries tradable will achieve the same result as removing the price ceiling altogether: the market price for the tradable entries will rise to the unrestricted equilibrium price, and the teams that value them the most will end up in the league. However, setting a lower price initially allows some teams the opportunity to buy that otherwise wouldn’t be able to get them. Society’s total welfare is maximized by either making the entries tradable or removing the price ceiling, the only difference is who earns the surplus. As you can see, there are different ways to maximize society’s welfare. Some can be more complicated than others, but they can accommodate different concerns about fairness.

DISCUSSION QUESTIONS:

1) Currently, the market mechanism used to allocate kickball league entries is first-come-first-served. What behaviors does this sort of mechanism encourage?

2) If league entries are tradable and originally given on a first-come-first-served basis, who would attempt to get the initial entries? Is there a chance people who do not want to have a kickball team might apply for a slot? Under a tradable permit system, does the way the entries are initially allocated affect who receives the most welfare?

3) The Coase Theorem is a public economics result that applies to markets where governments want to reduce pollution. It says that the most efficient way to reduce pollution to any desired level is to give firms in an industry permits to pollute the desired amount, and then allow the firms to trade the permits. Consider the similarities between a fixed number of kickball league entries and a fixed amount of pollution by an industry. What results would you expect to see in the market for pollution permits? What effect would creating that market have on society’s welfare?

Tricky Tax Timing

2012-03-06T15:02:00.009-08:00

After my husband signed a contract in October 2011 to work for a Maine hospital, they asked him if he preferred to get his signing bonus immediately or some time in 2012. The seemingly obvious answer was to get the money as soon as possible. As an economist’s spouse, my husband knows that a dollar today is worth more than a dollar tomorrow. However, after completing our 2011 taxes, we discovered that the answer to this question is not as simple as it seems.

While any economist will tell you that the present value of a dollar today is worth more than receiving that dollar in the future, the reverse of this is also true—spending a dollar tomorrow is cheaper in present value than spending a dollar today. To see this, consider the formula for computing future and present values:

Future Value = Present Value x (1 + Interest Rate)^{Number of Periods}
Present Value = Future Value / (1 + Interest Rate)^{Number of Periods}

If we take the money in 2011, we have to pay taxes on it by April 15, 2012; on the other hand, if we take the money in 2012, the tax payment would be delayed by a year, but we’d also get the bonus later.

Further complicating this was our state of residence. In 2011 we were residents of Pennsylvania, so accepting the signing bonus in 2011 meant that we had to pay taxes in Maine as nonresidents (which came out to about 5.5% of the bonus and required that I file taxes in that state when I normally don’t have to). We also had to pay taxes in Pennsylvania as residents (roughly 3%, but you can deduct the Maine payment so you aren’t fully double taxed), and in local taxes to Williamsport, PA (at another 2%). However, if we had waited to accept the payment in the middle of 2012, we would only pay taxes on this income in Maine as residents next April (roughly 8-10% depending on our joint income next year) and not need to file in Maine in 2011.

We were making less money in 2011 than we will in 2012, so we are in a lower federal tax bracket for our April 2012 filing. Our dilemma is whether or not that break plus the value of getting the money today is enough to compensate us for the additional tax liabilities of receiving the money in 2011. Our inability to foresee that taking the money in 2011 would result in a complicated tax situation might have lead us to make a suboptimal decision. Thus, before quickly jumping on the present value bandwagon and taking the money immediately, it’s important to make sure you have complete information about all future consequences of present-day choices.

Discussion Questions:

1. Another factor that led us to take the money immediately is that we plan to use it to pay down some of my husband’s high-interest rate medical school loans. Does this make our decision more or less rational if the interest rate on his loans is above what we could earn in an interest-bearing account? What if the rate on his loan is below what we could earn in interest?

2. Suppose that we received the signing bonus from a hospital in New Hampshire instead, where there is no state income tax for residents or nonresidents. How does this affect our optimal decision?

3. Suppose we were adopting several kids and I was planning to quit my job to become a full-time, stay-at-home mom, putting us in a lower tax bracket in 2012. How might this affect our decision?

Land or Dishes? Dishes, please!

2012-02-22T16:13:00.006-08:00

On a recent visit to the Los Altos History Museum with my daughters, I found myself hoping that one day they will appreciate my favorite exhibit: a replica of the wheel-of-fortune used by the Los Altos Land Company in the 1930s. During the Great Depression, the company had a difficult time selling plots in the sparsely-populated apricot orchards that later became Los Altos. That land is now part of the Silicon Valley and among the 100 wealthiest communities in the country, but nobody could have predicted that success back then. To offload the property, the struggling company conducted a promotional contest that took place in San Francisco movie theaters. Participants could spin the wheel to win free stuff, including a choice between a set of dishes and a plot of land in Los Altos. A plot of land was about the price of a set of dishes back in the day and according to the exhibit, most people chose the dishes.

What determined this choice? Economic utility theory tells us that the choice between land and dishes is determined by the marginal rate of substitution between them. However, without more information about the consumer, we cannot deduce the winner’s utility function from owning one more set of dishes or one more plot of land by simply knowing that the prices are equal.
Asset pricing theory—an economic theory that attempts to understand the prices of uncertain payments—can give us more insight into the matter. Land and dishes are assets with different properties. Although both could be viewed as durable goods, the set of dishes qualifies as a consumer good, whereas land is largely treated as investment. This allows us to view this scenario as the choice between consumption and investment (or saving); a decision between the two is determined by the relative prices of the two goods, the utility of the consumption good, future returns on investment, and the rate of future discounting (or the degree of impatience). Even without assumptions about the impatience and preferences for fancy dishes, the seemingly naïve choice of the dishes was fully rational given that investment in farm land did not promise great returns at the time.

Now suppose that the lottery winners knew that in 40 years the area’s booming economy would lead to skyrocketing land prices. As a rational economist, if I was a winner at such an event, would I choose dishes or land? My first reaction is: “Of course in this case, I would pick the land!” On the second thought, however, I realize that there is a very good chance that I still would choose the dishes. In troubled times like the Great Depression, both the perception of risk and the demand for liquidity increased, making the dishes a clear winner. Because a set of dishes could be considered a durable good, it could serve as an asset functioning as a store of value. Also, it is easier and less costly to sell or exchange dishes than a plot of land, thus making dishes a more liquid asset than land. Thus simply knowing in 1931 that the Los Altos land would appreciate in a few decades does not imply that it could be immediately converted into cash when needed. In tough economic times, survival today is often more important than planning for the future. Therefore, I would likely choose in favor of current consumption despite the high expected return on investment.

Discussion questions:

1. What piece of information about the dishes and the plot of land is critical in my decision-making?

2. Suppose that land is as liquid as the dishes. How would this affect the choice between the land and the dishes?

3. Would the same economic reasoning apply if it were a dinner instead of the dinnerware?

4. What would be your choice today if you were presented with a similar set of alternatives? Justify why this choice is the same as or different from most people’s choice for dishes in the 1930s.

Househunters Meets Econ

2012-02-07T08:42:00.000-08:00

A famous quip suggests that if you could teach a parrot to say "supply and demand," he could replace 90% of the world's economists. However, what economics is really about is analyzing the decisions people make in the face of scarcity and uncertainty. While the supply-and-demand model does have a wide variety of applications, it also comes with a laundry list of assumptions that give the model its power and tractability. One of these assumptions is complete information about the prices and quality of various goods. But one thing is for sure—in the housing market, there is certainly imperfect information about current and future market conditions.

For example, last week I found myself in an interesting predicament while house hunting. I was faced with two options: I could make an offer on a house currently on the market (going forward we’ll call this House A), with the belief that it was priced-to-sell and thus would likely be unavailable in the coming weeks. Or I could wait a month for more houses to come on the market, thus foregoing House A and incurring additional costs, like the effort to find new houses on the market and travel time to look at houses. This situation is exactly the type of scenario studied by search theory economists.

Search theory is a branch of economics that models markets with search frictions. In this case, “frictions” are the unknowns about what kinds of houses will come on the market in the coming months. You are faced with the choice of either accepting the good you’ve found today (House A) or throwing that choice away and paying a cost to find another choice tomorrow (House B). With some standard assumptions regarding utility and the distribution of houses on the market, the optimal way to shop is to use a reservation strategy; this means that you continue to shop until you find a house that makes you equally or more happy than that of the “reservation house”. This is the house that makes you exactly indifferent between continuing to search and buying it.

Thus, you can imagine my excitement surrounding house hunting. Not only is it fun to peruse the web and schedule showings, but house hunting is a great example of where supply and demand falls short, making room for more appropriate economic models like search theory. In most cases, consumers don’t know with certainty where goods can be found, how much they cost, and if they’re available; rather, they must spend time and money searching for these goods. When people ask me what kind of economics I like to study, my typical response is “the economics of shopping.” Search theory is simply the economic tool I use to describe it.

Discussion Questions:

1. How would you expect the time you have to search for houses to factor into the characteristics of your reservation house? In other words, do you think your level of pickiness will change if you had 3 months left to search versus 12 months?

2. Suppose that you didn’t have to worry about losing a housing option if you decide to search another day. Search theorists called this having “recall” over previous draws. How do you think this affects your “reservation house” if you’re searching over an infinite time period. How about a finite time period such as 12 months?

3. How has the internet alleviated search frictions in the housing market?

4. What other markets might be better explained using search theory as opposed to the standard theory of supply and demand? Why?

Getting Incentives Right

2012-01-25T14:56:00.000-08:00

In September 2010, a natural gas pipeline owned by Pacific Gas & Electric company (PG&E) ruptured in a subdivision of San Bruno, California, starting a fire that killed eight people, destroyed 53 homes, and damaged 120 more. Because San Bruno is only a few miles from the Aplia offices, I took particular notice when I saw the following headline in the San Francisco Chronicle: “PG&E incentive system blamed for leak oversights.”

According to the Chronicle article, PG&E had delegated leak survey crews to find leaks on its pipelines but had been paying bonuses to “supervisors whose leak survey crews found fewer leaks and kept repair costs down.” Two years before the fire, PG&E ended the policy of bonuses and, worried about the consequences of the bonus system, began to redo leak surveys. The subsequent surveys revealed “many more” leaks than had originally been reported.

This result doesn’t come as a surprise if we think about a supply curve for undiscovered leaks -- leaks that exist but are not discovered by the survey crew. While it may at first take some mental gymnastics to think about undiscovered leaks being “supplied,” when you contemplate how the bonus system would effect the effort and diligence of leak survey crews, you can easily imagine the usual upward sloping supply curve like the one on the graph:

As with any upward sloping supply curve, the more that is paid for undiscovered leaks, the more “undiscovered” leaks will be supplied. Equivalently, fewer “discovered” leaks will be supplied.

(Note: The analysis doesn’t rely on the definition of the quantity supplied used here. A similar analysis based on the supply of discovered leaks, which may be easier to think about, leads to the same upward sloping supply curve. The difference is that the bonus system makes the payment for discovering a leak negative, and to account for this, the supply curve has to start at a price below zero (that is, even at a price of zero, there would be leaks discovered, so the price at which no leaks would be discovered would be below zero.)

This analysis doesn’t mean that incentive-based pay is a bad idea. It would make sense to pay to anyone responsible for preventing leaks a bonus based on fewer discovered leaks (assuming that the people in charge of discovering are different from the people in charge of preventing). What this analysis does mean, though, is that you have to match the incentives to the result you want. The price of mismatching incentives is, in some cases, very high.

Discussion questions:

1. Think of an incentive system that would have resulted in fewer leaks going undiscovered. What would be some of the drawbacks of this incentive system, particularly in terms of cost?

2. In the United States, students take standardized tests at various points in their academic career, and in some states, their teachers face dismissal if their students perform poorly on the exams. In those states there have also been reports of teachers fixing their students answers on the tests, and complaints that teachers focus on “teaching to the test,” to the exclusion of skills that cannot be tested. How are the incentives faced by teachers like the incentives faced by PG&E’s leak survey crews? How are they different?

3. What other situations do you know of where an incentive system produces undesirable results? Would the results improve more by changing the incentives or by removing the incentive system altogether?

A Penny Saved Is...

2012-01-13T13:09:00.001-08:00

Which scenario would you prefer: (a) losing $30, or (b) losing $30, then losing $90, then regaining the original lost $30? While in most circumstances the first option is the unquestionably preferable, I recently found myself in a situation favoring the latter.

As a member of the Marin Sun Farms “meat club CSA” (community supported agriculture), I order a custom package of meats from a local farm that is delivered (frozen) once a month to a pick-up location near my home. While this arrangement offers me an excellent supply of local meat at a discounted price, the difficulty is remembering the monthly pick-up time. As disclaimed on the Marin Sun Farms website, “Packages not picked up promptly will be forfeited.”

This past Sunday I was sifting through emails when I discovered buried amongst online coupon offerings, eStatements, and a “Hello!” from mom, a reminder email sent the previous Thursday: “Pick up your CSA box today!” My heart sank as I pictured my box of grass-fed beef, lamb, and chicken slowly defrosting, decomposing, and ultimately being discarded. It had been a small shipment, only $30 worth, but nonetheless, I cringed at the waste.

Monday morning I awoke to another minor financial misfortune: a $90 parking ticket proclaiming my violation of section VC22500E – DRIVEWAY BLOCKING. D’oh! I knew when I parked that the rear of my car extended a few inches beyond the curb and into the neighboring driveway, but after half an hour searching for a spot I decided to take my chances (always thinking in economic terms, I figured that the expected cost of a ticket—equal to the true cost times the probability of actually receiving a ticket—was outweighed by the benefit from no longer looking for parking).

Chagrined by my back-to-back oversights, I called the number of the CSA pick-up location, just in case. To my surprise and relief, the woman in charge had managed to store my meat—not their usual policy—and I picked it up later that day.

By Monday night I had experienced the aforementioned $30 (perceived) loss, $90 loss, and $30 (perceived) gain, yet I felt better than I had felt on Sunday night when then I perceived only the $30 loss of meat. This may have had something to do with the order of events (after internalizing the loss of the ticket in the morning, the gain of $30 remained more salient at the end of the day), but I think it had more to do with how I perceived the true value of each loss. To a meat-loving economist, a discarded order constitutes a clear waste of resources—$30 of value—gone. The $90 parking ticket, on the other hand, represents a transfer of resources from me to the city of San Francisco, which ostensibly will put the money to use in the creation or maintenance of the public services I enjoy.

In introductory economics, we make a similar distinction between the deadweight loss and government revenue generated by taxes. Deadweight loss reflects the decrease in benefits to society (producers and consumers) resulting from fewer total transactions taking place. Economists view this loss to consumers and producers as different from the revenues a tax generates. Although both come at the direct expense of consumers and producers, the latter provides governments with the means to furnish public goods and services which indirectly benefit consumers, while the former—like rotten meat—is just no good.

Discussion Questions:

1. Why else might the $90 parking ticket be less painful than losing the meat shipment? Think about the “value” I got from time saved by parking illegally.

2. How does risk aversion factor into the decision of whether it’s worth taking the chance of doing something illegal? Consider a person who frequently speeds and occasionally gets speeding tickets. Ignoring the potential effects on others, might this too be a rational decision?

3. Consider other instances in which financial losses of the same dollar value might be felt in different ways (e.g. forgetting to take a $20 bill out of your pocket before washing it versus accidentally leaving an extra $20 as a tip on a restaurant bill?)

Low Carbs, High Fat…High Prices?

2011-12-14T04:54:00.000-08:00

"One box will cost you $740, but if you don’t like it, you could try your luck with the Russian smuggler down the street." There are plenty of goods that might be sold based on discussions like that, but would you ever expect to hear that said about butter? Residents in Norway are currently facing a market like that, according to recent reports.

A recent diet craze emphasizing high fat and low carbs has caused a change in Norwegian consumer preferences. Fads and trends will change the equilibrium price and quantity observed in a market by shifting the demand curve. In this case, the popular new diet increased the demand for butter (shifting the demand curve to the right), while leaving the supply curve unchanged. The standard supply and demand model says a rightward shift of the demand curve leads to an increase in the equilibrium price and quantity consumed. Both of those were observed in real life, as well.

Nonetheless, changes in tastes rarely result in price fluctuations of this magnitude, so how do economists explain why the cost of butter went so high? We see increases (and decreases) in demand every day, but prices rarely swing so wildly. A closer look at the details sheds some light on the source: the government is preventing the free market from doing its work. As the Swedish Dairy Association (Svensk Mjölk) noted, Norway has “very restrictive trading policies, borderline protectionist.” That means that the Norwegian government’s policies make it very difficult (or even impossible) for foreign goods to enter the domestic market.

Though the government does this in an effort to protect Norwegian producers, protective policies like those block markets from working efficiently. When a “shock” to supply or demand occurs (in this case, an increase in demand), protectionist policies prevent foreign producers from entering the market to capture new profits. Because the trend hit quickly, and the production time for agricultural goods isn’t exactly short (you can’t just go out and rent an extra 200 cows overnight), the Norwegian market for butter appears to be relatively inelastic in the short run (that is, even a small percentage change in the quantity supplied is associated with a large percentage change in price). If this trend in preferences continues, prices will remain high until producers have time to react by expanding their farms to accommodate more livestock, hire more workers, and install more processing equipment.

Does that mean that Norwegian consumers are going to continue facing these brutal prices for the coming months? Only time will tell, but if prices persist, it would be a testament to a population stubborn enough (or wealthy enough) to stick to the latest trendy diet, and a government dedicated to hard-line international policies, even at the cost of its own citizens’ welfare.

DISCUSSION QUESTIONS:

1) A change in preferences isn’t the only way that the demand for a good can change. What are some other factors that could cause the demand for butter to increase?

2) Rather than demand returning to where it was (the end of interest in the fad diet), the equilibrium price of butter could also decrease if supply shifts. Which direction would the supply curve need to shift for that to happen? What would happen to the equilibrium quantity? What are some ways that the supply could shift in that direction?

3) Suppose the Norwegian government feels pressure to help lower butter prices. Propose a policy that would help lower prices in the market. Is there a policy that the government could use to generate revenue for itself while lowering the price of butter?

Oz Economics: Will your silver shoes carry you over the desert?

2011-11-29T10:31:00.001-08:00

For centuries, gold and silver served as money, but not anymore. Silver went out of circulation in the late 19th century. Gold was effectively banned from circulation in the United States by the Gold Reserve Act of 1934. The last attempt to revive silver in the US as a form of money was made by the Populist Party. In particular, W. J. Bryan, a three-time presidential candidate on the cusp of the 19th and 20th centuries, argued that adherence to the gold standard tightened the money supply and consequently limited access to credit. He claimed that this hurt the entire economy, especially the Midwestern farmers suffering from the deep and prolonged recession of 1890s.

The Populists’ solution was bimetallism – the use of gold and “free silver” – to increase the money supply, which in turn would help the farmers. Their efforts failed, but the debates of those days are immortalized in L. Frank Baum’s The Wonderful Wizard of Oz. According to Henry Littlefield’s famous interpretation of Baum’s fantasy, Dorothy’s silver shoes symbolize the silver money that had to be added to the gold – the yellow brick road – in order for Dorothy’s quest to succeed.*

Money is a special asset. It exists in multiple forms and serves different functions. For example, commodity money such as silver or gold has an intrinsic value, whereas fiat money or paper money has value only as a result of government decree or law. To be used as money, any asset (commodity or fiat) must fulfill the following requirements: It must serve as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. In the modern world, it’s much easier to use paper money than silver or gold coins or bars. However, silver and gold outperform paper money when it comes to the store of value function, because inflation can potentially turn paper money into useless pieces of paper.

Gold is widely used for inflation hedging, which means that when fiat money loses value due to inflation, gold retains its value. The importance of gold as a store of value is underscored by historical price data that shows spikes in the periods of greatest macroeconomic uncertainty. Although not used as a universal medium of exchange, gold still remains an important asset. Its price among pivotal financial market indicators is on a par with Dow Jones and other major stock price indices and Treasury bills.

What about silver? In the past hundred years, it has never come close to gold in importance. The use of silver for investment was negligible until 2008. It was mostly used for industrial applications and for jewelry. Recently, the role of silver has been changing as it becomes an increasingly attractive investment. In 2010, its use as an investment commodity increased to 17 percent of total production. This resulted in an increase in the demand for silver, and consequently, a higher price.

Since then, silver has been appreciating steadily relative to gold. In September 2010, the price of silver was about $20 per ounce, whereas the price of gold was approximately $1,250 per ounce. This yields the gold-silver price ratio of 62.5, which is close to the average for the past two decades. One year later, in September 2011, an ounce of silver was traded for $30 and an ounce of gold for $1,800. Thus the gold-silver price ratio fell to 45. This suggests that silver has begun to function as a store of value and is creeping up on gold. Moreover, current technology significantly increases the liquidity of both gold and silver as assets. Not only is it possible to open an online storage account without leaving your desk, but it is also possible to trade silver and gold shares online without knowing where the metals are physically located.

The quest for a safer investment didn’t just increase the demand for gold, it also dragged silver back into the spotlight. It restored, even if temporarily, silver’s position as a store of value. Even if modern investors don't believe that a pair of silver shoes alone will carry them over the desert of economic instability, they are certainly interested in giving them a try.

* Dorothy’s ruby slippers in the MGM classic movie make no sense economically. Ruby replaced silver for the film because the red ‘popped’ more in the new Technicolor technology.

DISCUSSION QUESTIONS

1. How would expanding the money supply have helped poor farmers at the turn of the 20th century?

2. Would you be willing to accept a gold or silver bar as a means of payment today? Do you think your favorite store at the mall would? Based on your answers, would you say precious metals serve as an effective type of money in our modern society?

3. If two similar investments (like gold and silver) show very different rates of return over the same time period, do you think the investment market is in equilibrium?

Not-so-sunken costs?

2011-11-18T12:59:00.000-08:00

I recently had to decide between going to a concert for which I’d already bought a ticket and attending a dinner party with friends. Initially I was compelled to “get my money’s worth” by going to the concert (it was too late to sell the ticket to someone else), in spite of the fact that I would have preferred to go to the dinner (if I hadn’t bought the ticket). According to the economic theory of sunk costs, however, choosing to go to the concert under these circumstances would have been irrational.

Once a good or service has been paid for, the future costs and benefits of actually making use of the purchase should be compared to the future costs and benefits of alternative options—the cost of the purchase, paid in the past, is “sunk” and should not factor into the decision. Suppose that neither the dinner nor the concert would cost me any additional money, but I predicted the enjoyment I would get from the dinner would exceed the potential enjoyment from the concert. Because the expected future benefit minus the (nonexistent) future cost of the dinner exceeded that of the concert, I chose to go to the dinner.

Choosing to ignore sunk costs, however, is not always easy, in part because it can be difficult to distinguish situations in which the cost is truly sunk from those in which it shouldn’t be written off entirely.

Suppose instead I had been asked to bring a bottle of wine to the dinner. In that case, the fact that I had already bought the ticket meant that I was choosing between a concert that would cost no additional money, and a dinner that would cost me the price of a bottle of wine (say $15). Though I would have had a definite preference for going to the dinner and paying $15 for wine over going to the concert and paying $20 for a ticket, it could have been the case that I preferred going to the concert (at no additional cost) to going to dinner (and spending additional money). Although the $20 I’d spent on the ticket was gone either way, it had made one of the options free without affecting the cost of the other option. This would be particularly meaningful if I had a monthly budget for semi-luxuries like concerts and wine, and having spent $20 on the concert, I couldn’t justify spending $15 on a bottle of wine.

The moral of the story is that while you should never consider the “sunk cost” in itself when making decisions, it is relevant to consider how the sunken payment may have altered your current set of options.

Discussion questions:

1. Think about how this kind of analysis would be important to a company that has already invested considerable capital in a project, but later finds a different project that would have been better to invest in. When deciding whether to abandon the first project to invest in the second, how should the money already invested in the first project affect or not affect the decision?

2. Can you think of examples of sunk costs in your life that you might be tempted to not ignore because it can be difficult psychologically to not use things you’ve purchased?

NFL Concessions Meet Economic Tradeoffs

2011-11-03T15:28:00.000-07:00

While at the Patriots-Steelers NFL game earlier this season, I made a classic economics observation: tradeoffs are everywhere. It was partway into the second quarter, and dinner time was approaching. Because our seats were up in the highest section possible, this meant short lines at the concession stands, but the quality of food available was poor. The economist in me couldn’t help but see the natural connection to consumer theory, specifically indifference curves.

Indifference curves express how much utility, or happiness, comes from various combinations of goods. Any two points along the same indifference curve must represent two combinations of goods that make you equally happy. Additionally, points on different indifference curves represent different levels of happiness. In terms of the shape of indifference curves, economists make standard assumptions, such as more is better and averages are preferred to extremes. However, consider what the indifference curve mappings would look like if the goods being represented are quality of food and queue length (that is, the length of time you expect to wait in line .)

In this case, a long queue length is undesirable (economists call this a “bad”).That means that if you’re going to tolerate a longer line, the food quality must improve for you to be equally well off; this translates graphically into the increasing shape of the curve above. Also, for any given queue length, a higher quality of food makes you better off, so the level of happiness represented by IC2 must be higher than that of IC1. Finally, because averages are still better than extremes, the bowedness of the curves must be in the northwest direction. This is illustrated on the following graph:

A and C are two possible consumption bundles, while B represents the average of this bundle. Because B is preferred to A and C and you know that consumers are happier with better food and shorter lines (the southeast direction), the curve must be bowed in this way.

As you can see from the graph above, the choice as to whether or not it makes sense to travel throughout the stadium for better food is a simple consumer choice problem. My optimal decision rests on the relative happiness I get from higher food quality versus not waiting in line. What did I choose? A simple burger with french fries in exchange for a short line, so I could watch Brady and the Patriots blow it!

Discussion Questions:

1. What if instead of modeling “queue length” on the vertical axis, you want to show the indifference curves between “food quality” and the “amount of the game you watch from your seat.” How would the shape of the indifference curves change? Which direction represents a higher level of happiness from one curve to another?

2. Suppose that the value of watching the game diminishes because your team is crushing the opposition. How would this change the shape of your indifference curves between queue length and food quality?

3. What if averages are no longer better than extremes? How would that alter the shape of the indifference curves shown above?

Education Regulation

2011-08-18T17:39:00.000-07:00

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?

Crossing the Bridge: Do the Wealthy Live Longer?

2011-07-08T13:17:00.001-07:00

A recent study on longevity provides intriguing data on life expectancy (LE) in the United States. Despite the U.S. having the highest health expenditure per capita, life expectancy in the US trails that in most other developed countries.

Life expectancy is a measure of a nation's or community's health that summarizes current mortality statistics by answering the following question: Assuming all current conditions remain unchanged, how long could children born this year be expected to live on average? In 2007, the US ranked 37th in the world in terms of LE at birth, with 75.6 years for men and 80.8 years for women. Across US counties, however, LE ranged from 65.9 to 81.1 years for men and 73.5 to 86.0 years for women. To assess the extent of these disparities, the authors used a benchmark based on ten countries with highest LE in the world. Then they ranked each US county based on how many years it is behind or ahead of the benchmark. For example, if county A has LE of 75 years and it took the benchmark countries years ten years to go from LE of 75 years to the current average of 80 years, then county A is ten years behind the benchmark.

The analysis determined that very few of the US counties are ahead of the benchmark, and most are behind. Some counties are decades behind, ranking close to less developed countries such as Peru and El Salvador. What is perhaps most surprising is that large disparities exist even between neighboring US counties. Take for example two California counties, both in the San Francisco Bay Area: Santa Clara, home to Stanford University, and Alameda, home to UC Berkeley. In 2007, based on LE for men, Santa Clara county was almost a decade ahead of the international benchmark and Alameda county was at least five years behind. An allegory comes to mind: By crossing the Bay Bridge, we jump 15 years back in time! For women, the time travel would be shorter, a decade.

The authors of the cited study are health researchers primarily interested in demographic factors and life style choices that create medically preventable deaths caused by obesity, smoking, and alcohol. Economists have a different interest in these statistics: the link between wealth and health. In 1975, demographer Samuel Preston first reported a positive relationship between GDP per capita and LE. The graphical representation of this relationship is now called the Preston curve. Two properties of the Preston curve are of special interest to policy makers: (1) Life expectancy at birth rises quickly at low levels of per capita income but flattens at high levels of income; (2) The Preston curve shifts upward over time, which is largely explained by improvements in health care technology. The shape of the Preston curve resembles that of a production function, suggesting that health, measured by LE at birth, is a product of a healthcare system where the only input of interest is per capita income.

Some factors that produce health from wealth operate on individual level. Higher income leads to better nutrition, which in turns creates better health outcomes, especially in children. Some operate on the community level (sanitation and other public health measures), and some on the national level (health care system coverage and production of medical knowledge). However, the causality in the Preston curve is unclear, and an alternative explanation is possible: The Preston curve may reflect an impact of health on income. That is, healthier people are able to work more and thus earn more, which enables them to take a better care of their children. Healthier children spend more time studying and thus become more productive workers, etc. This may explain the steeper slope of the Preston curve for the less developed countries where mortality is likely to affect productive members of labor force, while in developed countries, mortality largely affects retirees.

Regardless of the interpretation, the Preston curve remains an empirical observation that holds across countries and suggests that the link between health and income is more important for developing countries than for developed ones. In the case of the United States, does it matter at all? Quite a bit, it turns out. This graph shows a strong relationship between average personal income and LE across California counties. Specifically, average income per capita in Santa Clara county is 16% higher than in Alameda county, $36.5K versus $31.5K. In 2007, LE in Santa Clara county was 80.6 for men and for 83.9 women while in Alameda county it was 77.7 for men and 82.3 for women. So, the Preston curve is relevant even at the county level. Holding all else constant, baby boys and girls born in a relatively wealthier county are expected to live longer.

Discussion questions:

1) Why are researchers from different disciplines interested in life expectancy statistics?

2) What factors might be responsible for the US ranking 37th in the world?

3) What factors could be responsible for the differences in LE in two neighboring US counties with similar demographics and health care systems?

Correcting Faulty Defaults to Improve Society?

2011-06-07T13:21:00.001-07:00

California recently cut $170 million from the amount the state must pay toward 2012’s retirement benefits, according to an article in the Mercury News. With the uncertainty regarding the future of pension plans and social security, private retirement savings are more important than ever. Despite this need, many people have difficulty making consumption sacrifices today to provide for their future selves.

Recent changes to many private firms’ retirement savings programs seem to reflect this need for personal savings. In the past, employees had to actively opt-in to company savings plans by changing their monthly contribution amount from the default of $0 to some positive amount. Traditional economic models of savings assume that people are perfectly rational and will choose the level of saving that maximizes their utility over the entire course of their lives, therefore people’s decisions of how much to save should not be affected by something as small as the effort required to “opt-in” to a plan. Companies have found, however, that merely changing the default option from “no savings” to “X% of paycheck automatically saved” causes a significant increase in employee savings. One firm found that after switching from standard to automatic enrollment in retirement savings plans, the participation rate for new hires was 35 percentage points higher after three months on the job (as compared to those hired before the automatic enrollment). The participation rate remained 25 points higher after two years.

Why would something as seemingly trivial as changing the default setting have such a large impact on the decision of how much to save? The field of behavioral economics acknowledges that people do not always act according to the model of perfect rationality, which requires weighing all costs and benefits (present and future) and accounting for all available information. Deciding how much to save for retirement is an important life decision, yet the “easy” choice of accepting the default option often prevails against the rational action of giving it more serious consideration. Traditional economic models do not explain the widespread tendency to stick with defaults regardless of their suitability, but behavioral economists can replicate this behavior in controlled research environments.

Applying this understanding of behavioral economics to the savings plan structure is an example of “libertarian paternalism,” a school of thought that strives to maintain freedoms (libertarian) while still guiding people towards the choice that society deems best (paternal). The new default setting does not interfere with employees’ rights to do what they please because employees can easily “opt-out” by making a short phone call and signing a form. At the same time, it benefits society by encouraging more people to save, since those who do not sufficiently save for their future needs pose a problem not only to their older selves (who may have to work past their desired retirement age), but also for the government (and thus taxpayers) who may then have to help provide for them as well.

Discussion Questions:

1) Do you think that a company changing the default behavior for a retirement program infringes on employee's rights?

2) How do you make decisions about long-term financial planning? Do you research and model your finances, base your decisions on suggestions (from an employer, family, or friends), or ignore it entirely?

3) Are you surprised that changing a default value has an effect on what people select?

4) Imagine you are a freshman in college choosing a meal plan. You don’t know what the other food options on campus will be like, nor what your schedule will be. What advantages does a “default” option provide in this situation?