Aplia Econ Blog: News for Economics Students

Income and Substitution Effects Explain Changes in Burrito Consumption

2009-07-08T10:16:00.000-07:00

I took many economics courses, and yet it wasn’t until I experienced a change in my own personal finances that I really understood the nature of the income and substitution effects. The technical definitions are as follows: the income effect explains spending responses to effective changes in income level; the substitution effect explains spending responses to changes in the relative price of one good to another.

Only when my parents stopped paying for my groceries did the technical definitions sink in. Back when groceries were “free,” I often faced the following decision: Do I make lunch at home at no personal monetary cost, or do I go out and spend $6 on a burrito? The answer depended on a number of factors, such as (1) how badly I wanted a burrito (my current preference for burritos vs. homemade food); (2) how much money I recently made and spent (my budget constraint); and (3) what I could do if I wasn't preparing food (the opportunity cost of making lunch).

Having to pay for my own groceries altered this decision-making process in two ways. First, the former trade-off between a $6 burrito and the homemade lunch with ingredients paid for by my parents became the choice between a $6 burrito and a homemade lunch that costs me $3 in groceries. Although the price of eating out remained the same, it became relatively less expensive. The explicit cost of getting a burrito is now only $3 more than that of making a sandwich ($6 burrito, $3 sandwich); before it was $6 more ($6 burrito, $0 sandwich). I might now be more likely to choose the burrito than before. In doing so, I would be substituting the burrito for the homemade lunch due to the reduction in the relative price of a burrito. Whether or not I actually choose to do this, however, would depend on the strength of the income effect.

Now that I allocate a substantial portion of my monthly income to buying groceries, I have less money for all other purchases. Among those purchases are burritos, so by adding another item to my budget, the income available for burritos effectively declined. If burritos are normal goods, this negative income effect may lead to a decrease in my burrito consumption.

Which effect dominates? In my case, probably the income effect, but in general—it depends. Given that my budget didn’t encompass a lot of luxury purchases to begin with, dining out was a big part of the non-essential purchases I cut back on to make room in my budget for groceries. I adapted my schedule so that I could go home for lunch more often, and I started buying groceries conducive to paper-bag lunches.

Discussion Questions

1. Suppose your parents decide to stop paying for your textbooks (assuming they paid for them in the first place). What is the expected effect on your food consumption as a whole? Is this an example of the income effect, the substitution effect, or both?

2. In addition to the income and substitution effects changing my spending behavior, paying for my own groceries made me internalize the cost of groceries. How might this affect my overall consumption of food? In terms of economic efficiency, is internalization a good or a bad thing?

3. What are some factors that might affect the opportunity cost of homemade lunches? How would changes in the opportunity cost affect the strength of the income effect vs. the substitution effect?

4. Consider what would happen if you didn’t plan ahead and face the choice between spending half an hour to walk home and prepare lunch or spend $6 to buy lunch. Which effect is likely to dominate if your hourly wage is $7.25? $13? How does this relate to the concept of opportunity cost?

Internet by the Byte

2009-05-26T09:33:00.000-07:00

With significant contributions and analysis from Kasie R. Jean.

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

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

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

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

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

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

Discussion Questions

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

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

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

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

Why Do Monthly Job Loss Estimates Exclude the Farming Sector?

2009-05-08T16:19:00.000-07:00

In April, nonfarm payroll employment declined by more than 500,000 jobs for the sixth month in a row. While the pace of nonfarm job losses slowed, the Bureau of Labor Statistics (BLS) report on the employment situation continues to paint a fairly grim picture. Employment in the farming sector was actually a bit higher in January 2009 (the most recent month for which data is available) than it was in January 2008. Why doesn't the BLS cover farms and ranches in its payroll survey? Might the omission of the farming sector from the BLS payroll survey cause the jobs report to be too gloomy?

According to the BLS, farms simply fall outside the scope of the payroll survey. When the BLS began studying payrolls and employment in 1915, it focused exclusively on the manufacturing sector. The need for more accurate employment estimates during the Great Depression led the BLS to develop more comprehensive estimates of wages and employment in nonfarm industries during the '30s. Historically, at least, one can imagine the relative difficulty of gathering timely employment information in the rural farming sector.

The lack of agriculture in the payroll survey, however, is almost certainly inconsequential. The absence of farms in the Bureau's payroll survey matters less to today's employment picture than it did during the early and mid 20th century. In 1930, 21.5 percent of the workforce worked in farming, and agricultural output represented nearly 8 percent of U.S. economic output. At the turn of the 21st century, less than 2 percent of the labor force worked in agriculture, a sector that now represents less than 1 percent of national economic output.

The small share of the population employed in agriculture makes it unlikely that the Bureau's payroll survey--with a sample covering about one-third of total nonfarm payroll employment--will distort the overall jobs picture by failing to account for farm sector employment. Even an agricultural boom in the midst of the current recession would do little to reverse the dismal national employment trends.

Although the BLS excludes agriculture from its payroll survey, it does capture farm employment indirectly through a survey of 60,000 households. The most widely reported unemployment rate comes from this household survey, which includes respondents from all economic sectors: manufacturing, services, agriculture, or the ranks of the self-employed.

The household survey categorizes a person as employed if they worked for pay at some point during the past week, whether she worked in a factory, on a ranch, in an office, or for herself. A person who does not have a job, but actively searched for one at some point in the preceding four weeks, is considered unemployed. Anyone who does not have a job and has not been looking in the past month is classified as "not in the labor force."

The unemployment rate is simply the ratio of unemployed workers to the labor force (the sum of employed and unemployed workers). As the ranks of the unemployed continued to swell during April, the unemployment rate rose from 8.5 percent to 8.9 percent, reflecting an increase in joblessness among all workers, including farm hands and the self-employed.

Discussion Questions

1. There are a number of jobless people who would like to work but have given up on their job search because they believe it to be futile. The BLS classifies these discouraged workers as 'not in the labor force' rather than unemployed because they did not search for a job in the preceding four weeks. Consulting this table, how does the number of discouraged workers in April 2009 compare to the number in April 2008? If the BLS were to count discouraged workers as unemployed (and, by extension, part of the labor force), what would happen to the unemployment rate?

2. How has the recession affected the ranks of discouraged workers? For more information, consult this recent BLS report.

3. The BLS tracks the number of people who work part time for economic reasons, also known as involuntary part-time workers. By counting anyone who worked for pay during the preceding week as employed, the household survey classifies a number of involuntary part-time workers as employed. In what way does the official unemployment rate miss the underemployment associated with involuntary part-time work? This table contains information on involuntary part-time workers. How has the recession impacted the number of people employed part-time for economic reasons? What happened to the number of involuntary part-time workers between March 2009 and April 2009?

4. Even as Americans eat a larger variety and quantity of foods than ever before, the share of economic output attributable to agriculture declines. How can you explain this development?

The Price Is Wrong, Bob!

2009-04-15T15:41:00.000-07:00

With significant contributions and analysis from Ben Resnick

The Price Is Right, one of America’s favorite game shows, can be used to illustrate numerous economic concepts, including optimal bidding strategies, risk preference, and search theory. Twice an episode, one of the most purely mathematical portions of the show occurs, when contestants take their turn to spin "the big wheel." In addition to being a crucial prelude to the Showcase Showdown, it is a convenient hands-on application of using probability theory to derive an optimal decision-making rule. The wheel contains 20 equally sized panels corresponding to values between $0.05 and $1.00. Three contestants reach the wheel during each half of the show. The winning contestant is the one whose total score comes closest to a dollar without going over; as a prize, they earn one of the two spots in the show’s final round, the Showcase Showdown. One at a time, each contestant spins the wheel to get an initial value. The player then has the option to keep his current value or spin one more time. If he spins again, his final score is the sum of his two spins. Any contestant that goes over $1.00 automatically loses. In the event that two or three contestants are tied with the same final value, they each spin the wheel once, highest score winning.

Consider three contestants: Mr. 1 will spin first, Ms. 2 will spin second, and Mrs. 3 will spin last. Assuming that all of the contestants aim to maximize their chances of winning a spot in the Showcase Showdown, we set out to derive the optimal strategy for Mr. 1. In order to determine his optimal strategy, we will make three simplifying assumptions. First, each result from spinning the wheel is an independently determined random outcome, where each panel is equally likely to be spun. Next, in the event of ties, each tied player has an equal chance of winning (either 50% for a two-person tie or 33% for a three-person tie). Finally, the show pays a $1,000 bonus prize (and a chance to earn even more money on a “bonus spin”) to any contestant scoring exactly $1.00 on one spin or a combination of two spins. However, we will not consider these cash prizes as an extra incentive to spin again since they have no bearing on which contestant goes to the Showcase Showdown. We focus only on the decision-making rule that gives Mr. 1 the best chance to make the final round.

The only decision a player makes during the game is whether to spin again or stop after the first. Clearly this decision will depend on the value of the first spin—the higher the first spin, the more reasonable it is to stop. To explain fully how a player maximizes his chance of reaching the Showcase Showdown, we solved for a cutoff value: the lowest initial spin value where Mr. 1 has a higher probability of winning by staying rather than spinning again. In order to find the optimal stopping value for Mr. 1, we first calculated the probability that Mr. 1 wins the game (either outright or through the tie-breaker) if he stays with any initial spin. This gives 20 different probabilities of winning the game if Mr. 1 stays, one for each possible spin value. For example, if Mr. 1 stops with $0.55, he stands a 7.4% chance of winning whereas if he stops with $1.00, he has an 86.2% of going to the Showcase Showdown. Next, we calculated the odds that Mr. 1 wins if he spins again. To do this, we looked at his likelihood of winning for each possible score after his second spin is added to his first. Mr. 1’s optimal cutoff in this game is $0.70, where stopping with a spin of $0.70 gives a 19.8% chance of winning, but spinning again gives only a 15.8% chance of winning. At any initial spin less than $0.70, Mr. 1 has a better chance of winning by spinning again. For example, after a first spin of $0.65, Mr. 1 has a 14.6% chance of winning if he stops and a 16.8% chance of winning by spinning again. By a similar method, we find that in the case where Mr. 1 goes over $1.00, the stopping rule that maximizes Ms. 2’s chances of winning is to stop with any initial spin of $0.55 or more.

Discussion Questions

1. How would you expect the stopping values to change if a fourth player were added to this game? What would the effect on the stopping values be if we factor in the bonus prize for a total score of exactly $1.00?

2. Given that the stopping values decrease as fewer players remain in the game, do you expect a player with a certain spot in the order to have an advantage? If so, which one?

3. Deal or No Deal is an example of another game show where a contestant’s optimal strategy could be described by a stopping rule. Can you think of other games where this type of strategy can be applied?

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

2009-04-14T18:38:00.001-07:00

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

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

Discussion Questions

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

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

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

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

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

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

2009-04-10T12:04:00.000-07:00

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

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

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

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

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

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

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

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

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

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

$86.25 + $60 + $32.50 = $178.75

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

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

Discussion Questions

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

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

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

On Income Caps and the Market System

2009-04-03T16:03:00.000-07:00

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

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

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

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

Discussion Questions

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

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

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

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

Gainfully Unemployed

2009-04-03T00:27:00.001-07:00

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

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

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

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

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

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

Discussion Questions

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

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

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

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

Digital Distribution Meets the Video Game Market

2009-03-23T11:46:00.001-07:00

GameStop and EB Games have always been the major players in the used video game market when it comes to retail sales. Given their level of success, it was only a matter of time before other major players, such as Amazon.com and Toys "R" Us, entered the market. But how does this affect the long-term profitability of retailers, game publishers, and game developers?

The short-term motivation of retailers such as GameStop buying and selling used games is that they share none of the profit with developers of the game. Game publishers and developers only receive a payment for the sale of brand new games and are thus negatively affected by the growing used video game market, especially during bad economic times when sales are already lower than desired. Although buying used games instead of new titles might only save consumers $5-$10, some GameStop stores also allow you to return used games within 7 days if they don’t work properly or you simply don’t like the game, an option unavailable if you pay for a new game.

Incentives play a crucial role in economic analysis. Properly aligned incentives can promote desired outcomes in the short run and long run. From the perspective of video game developers, the lost revenue from video games trading hands multiple times in the used market is evident. As an increasing number of retailers realize the gains from entering this market, video game developers will experience decreasing gains from the production of new games.

This provides publishers with the incentive to consider other mediums of distribution, in particular digital distribution. The video game market is not the first entertainment industry to delve into a more technical solution. In the music industry, CDs are being replaced by iPods and MP3s thanks to Apple's iTunes. In the movie rental industry, we have gone from renting at our local store to mailing in movies through services such as Netflix or Blockbuster to downloading movies directly to our TV through the internet or cable services.

Therefore, it is not surprising that the video game market is heading in this direction, especially with the growing popularity of the used video game market. Since its inception, the Nintendo Wii has offered games from older consoles for purchase through the Wii Marketplace. Because the Wii offers free Wi-Fi, Nintendo can bypass the middle man of in-person and online retailers. In addition, Microsoft has begun to experiment with this option by offering smaller-scale, arcade-like games for purchase using Microsoft points that can be purchased in the Xbox Live Marketplace. They also offer free demos of newly released games in hopes of attracting additional sales. The drawback with Microsoft is their Xbox Live internet service is not free, so only users with a paid account can access these services.

Discussion Questions:

1. From the consumer perspective, what would your indifference curves look like for these two goods? Do you believe a used game is equally as good as a new game? How would this affect the demand for used video games?

2. What kind of incentives, if any, could a video game developer provide to GameStop to encourage them to sell new games over used ones?

3. How will the growing popularity of releasing and purchasing video games through an individual console change the market structure of video game retailers? How does this compare to the success of the iPod and MP3s in general?

Bovine Intervention

2009-03-23T11:29:00.000-07:00

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

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

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

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

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

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

Discussion Questions

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

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

The Financial Crisis for Dummies

2009-03-13T10:11:00.001-07:00

This is, perhaps, the most engaging and accessible explanation of the current "Great Recession" I have come across. In this 59-minute podcast, Ira Glass and his cohorts at Chicago Public Radio and NPR create an ultra-simplified world of just one eager dollhouse buyer, a would-be banker with $10 in his pocket, and a young man with $90 he wants to put into a savings account to explain the financial mess we find ourselves in. This recording explains why TARP is called TARP, what insolvency is all about, what the term toxic assets means, and why America's biggest banks are afraid to "mark it to market" or re-value those toxic assets.

After listening I have a better appreciation for the state of all things financial but I am left wondering, what's the best way out of this morass?

Discussion Questions

1. Can you point to an underlying cause that precipitated this crisis?

2. Does the government nationalize the banks for a time, robbing banks' shareholders of their investments but allowing banks to start over with a clean slate? Does it help the banks get back on their feet by purchasing toxic assets with taxpayer money at artificially high prices? What are the short and long term effects of these different strategies?

3. Do you think the United States has "learned its lesson"? Will people (and businesses and governments) change their behavior? Or are we doomed to repeat this process?

4. Are there safeguards the government can introduce that will keep this from happening in the future?

Maccaeconomics

2009-03-05T17:55:00.000-08:00

In an earlier post, I commented that I loved Radiohead. And I do, but I LOVE the Beatles. I hope you can appreciate the difference. Think about someone you know who is really obsessed with a band. Now multiply that by 20. That's how much I love the Beatles.

So when I heard about Paul McCartney's intent to play a 4,000-seat venue in Las Vegas this April, one of the smallest public shows since he was backed by Pete Best at the Cavern Club, tears nearly welled up in my eyes. I enlisted the help of friends and family to get tickets online at the moment they became available. Much to my everlasting despair, we were unsuccessful, and I remain ticketless.

Claire, a friend here at Aplia who shares my obsession*, was also trying for tickets that afternoon. She, however, was successful.

There's a book that I recently read that gives good insight on my dilemma: Dan Ariely's Predictably Irrational. In this excellent book, Ariely details his research on what economists call "the endowment effect." The endowment effect states that the value someone places on a good increases when it comes under his ownership. The person would require more to give up a good than he would be willing to pay to receive it. This is in opposition to standard economic theory which would state that these two values should be equal when the good has a functioning market.

Ariely's experiment (PDF) found that students who had won a random lottery for Duke basketball tickets valued their tickets 14 times higher than students who lost the lottery. I found this interesting, and I wanted to see if the endowment effect would hold true for Claire and me, two equally obsessed McCartney fans who were on the opposite side of luck that Saturday afternoon.

How much would I pay for a ticket? Well, I guess it's less than $700, since that is the price on the secondhand market right now, and I haven't made a purchase. Now, how much would Claire require to relinquish her seat to me? See our instant messenger chat below where I asked for the sale:

Knapington: how much would i have to pay you to give up your ticket to Paul, assuming you couldn't re-buy another ticket with the funds?
Claire E: i really don't know if i'd take money--i really want to see paul
Knapington: so if i wrote down $1,000 and handed it to you, you'd say no?
Claire E: I'd say no
Knapington: what if I wrote $5,000
Claire E: nope. it would have to be at least $15,000 - because then i couldn't justify walking away
Knapington: so literally if I wrote a check for $10,000 and offered it to you right now, you'd say no thanks?

So perhaps she was exaggerating a bit—I eventually talked her down to $10,000, but that was as low as she'd hypothetically go. How could two people who at one point equally valued these tickets (each of us said before the sale that we would pay no more than $700 per ticket) hold such different values for the tickets after the fact?

Discussion Questions

1. 2008 was a remarkably bad year for most stocks. If you could sell all of your portfolio of stocks today, would you buy the same stocks again? If not, what keeps you holding on to those that you already own?

2. Think about the recent downturn in the housing market. Many homeowners looking (or needing) to get out of a mortgage they have difficulty affording end up pricing their home at the value they place on the home. Unfortunately, this price is often higher than any reasonable house-hunter would be willing to pay, particularly in current market conditions. How will this affect the homeowner? How will this behavior affect the housing market in general?

3. Can you think of other examples where the endowment effect might keep markets from adjusting as quickly as they otherwise would?

4. Suppose that Ryan is willing to pay $650 for the McCartney ticket while Claire values her ticket at $10,000. How do these figures relate to Dan Ariely's experiment? What if Ryan were willing to pay only $400 for the McCartney ticket?

* After working at Aplia together for some time, we stumbled upon our common obsession, and in our discovery, also realized that we had met each other at a Paul McCartney concert three years prior, and had a 20 minute conversation. Weird.

High Finance: Michael Phelps vs. Kellogg's

2009-02-09T17:59:00.000-08:00

Kellogg's recently dropped its sponsorship of Michael Phelps after a photo of the Olympic swimmer smoking marijuana was printed in a British tabloid. In a recent "Saturday Night Live" sketch, Seth Meyers pointed out that it doesn't necessarily make sense for Kellogg's to have done this:

Discussion Questions

1. What is the economic term for the relationship between marijuana and Kellogg's products that Mr. Meyers is suggesting?

2. Which of the economic theories you've discussed in class best explains why Kellogg's would spend millions of dollars to be associated with Michael Phelps in the first place? Would that same theory be consistent with why it would drop the sponsorship when Phelps's marijuana use came to light? According to that theory, under what circumstances would Kellogg's benefit from dropping Phelps? Under what circumstances might the decision backfire?

3. Analyze Michael Phelps's decision to smoke marijuana from an economic perspective. Clearly, the costs of being caught smoking marijuana are extremely high for him. Can economic theory explain why Michael Phelps chose to make such a bad decision? If not, what could help?

Scrooge's Economic View of Christmas

2009-01-15T04:59:00.001-08:00

We all know how easy it is to get caught up in the Christmas spirit and gift-giving frenzy. A lot of time and energy is spent thinking of the "perfect gift" for friends and family. While I'm sure many are successful in this endeavor, there are undoubtedly a large number of gifts given that people would rather trade in for cash—even if that cash amount is less than the retail price of the good.

Thanks to eBay's anonymous online service, consumers can now do just that! According to a recent study from eBay, more people than ever will sell unwanted items this year. The ongoing recession is partly to blame: many people can probably use the cash from selling gifts to lower their credit card debt, pay their mortgage, or simply cover the bills. But people's general preference for cash to gifts can be explained using the economic fundamentals of utility.

Now that the holiday season has come and gone, many of us find ourselves thinking, "What will I do with another FM transmitter for my iPod?" Oftentimes, both the gift giver and gift receiver could be made better off (that is, receive a higher level of utility or happiness) if a cash exchange had taken place instead. To understand the economic rationale behind this, we turn to the basic consumer theory model of budget constraints and indifference curves.

Recall that an indifference curve maps out all the possible consumption bundles of goods that yield the same level of utility to a given consumer. Indifference curves tell us nothing about what we can afford, but rather how happy a particular bundle will make us. On the other hand, budget constraints show the consumption bundles that we can buy given our income and the prices of goods. Similarly, budget constraints say nothing about what we would like to buy, but rather what we can afford. A consumer's optimal bundle of goods is located where the budget constraint is tangent to the highest possible indifference curve.

But what happens to your budget constraint when you receive a gift? Consider the following simplistic example. You consume only two categories of goods: books and food. You have $80 each week to spend on these two goods. The price of a book is $10, and the price of each unit of food is also $10. Suppose that without receiving a Christmas gift, you would consume 2 books and 6 units of food. This is represented by the graph below:

But now suppose that your grandmother gives you 5 books for Christmas. This means that you can now afford 8 units of food and 5 books without spending any money on books, and you could afford 13 books if you don't spend any money on food. Assume that you cannot return or immediately sell the 5 books your grandmother has given you. If you have a high preference toward food over books, you may find that there is no indifference curve tangent to your new budget constraint in the region where you can now consume-between (4 books, 8 units of food) and (13 books, 0 units of food):

In this case, the optimal consumption bundle does not satisfy the tangency condition because there is no tangency in this restricted region of the budget constraint; we call this a corner solution. In other words, if instead your grandmother gave you the cash she spent on the books (5 books x $10 per book = $50), your budget constraint would also include the grey, dashed region below, and you would be made better off since you can now consume 3 books and 10 units of food.

Discussion Questions

1. How much money could your relative have given you, instead of the present, that would leave you at least as well-off as if you had received the present (that is, with the same level of utility)? Draw this on a standard budget constraint-indifference curve diagram.

2. What elements of real life does standard consumer theory ignore?

3. What gifts, if any, could your grandmother have given you instead of 5 books that would be just as good as if she had given you the cash she spent on them?

Recession-proof

2009-01-05T15:05:00.000-08:00

Doomsayers are coming out of the woodwork en masse as 2008 ended during a dismal economic downturn. With consumer confidence at an all-time low, the financial industry shell-shocked as grand, monolithic companies crumbled all around, and nearly 2 million jobs lost in the past year, the end looks nigh indeed.

But before you don your sandwich boards and raise high your signs, things may not be as bad everywhere as they seem.

The economy rises and falls in what's called a business cycle. Some years are relatively prosperous with rapid economic growth and expansion while other years see the economy contract or stagnate. These fluctuations last over periods of years and their timing is largely unpredictable.

Some firms stick with the general trend of the market, their business conditions weakening when the market weakens, strengthening when the market recovers. These are procyclical firms. Others, countercyclical firms, do the reverse; their business conditions weaken when the times are good, and strengthen when times are bad. There are still other industries that don't depend on how the economy is doing at all.

So, while the bankruptcies and bailouts get the boldest headlines these days, here's a brief list of industries that are doing just fine.

The funeral services industry depends more on long-term trends such as aging populations and baby booms rather than on the twitching of the stock ticker. And of course, it also helps that their services are always in demand.

The entertainment industry is another good example. Revenue from concerts and movies have stayed strong during this economic downturn. Faced with gloom and doom, many find the few hours of escapism well worth the price of admission.

Discount stores, most notably Wal-Mart, are attracting cash-strapped customers looking to get the most out of their money.

As jobs get scarcer, going back to school makes a lot of sense for those looking to weather the fierce competition in the job market and to improve their skills and credentials. According to the Labor Department, the education industry has added 9,800 jobs in November.

Discussion Questions

1) What are other examples of procyclical industries? Countercyclical industries?

2) During the economic boom of the '90s, how did countercyclical industries do? Did more people drop out of school and enter the labor force? Did Wal-Mart suffer a decrease in sales?

3) Do you think prices, in general, drop during a recession? Why or why not?

4) How much do you think countercyclical firms contribute to an economy's eventual recovery?

The Federal Reserve’s New Target Range

2008-12-19T13:46:00.000-08:00

On December 16, 2008, one of the most significant monetary policy decisions in US history was handed down by the Federal Reserve's Open Market Committee (FOMC). In an effort to combat accelerating deflation in the Consumer Price Index (CPI) and massive job losses, the FOMC announced a reduction of its federal funds rate target from 1% to an unprecedented range of 0% to 0.25%. While critics of the move might point to relatively stable core inflation rates (which exclude food and energy), the FOMC was clearly more concerned about the state of the job market and the accelerating deflation reflected in the headline CPI. In fact, for two consecutive months, the US experienced record CPI deflation with rates of -1% in October and -1.7% in November of 2008. Along with OPEC's attempts to curtail oil production, this move by the FOMC is likely to help stabilize the price level.

The Fed announcement is historic for the low level of rates in its targeting and for the unique setting of a target range. This gives the Fed modest room for flexibility above the nominal floor of a zero federal funds rate. Whether it will be enough to spur the feeble economy is doubtful. Fortunately, the FOMC also announced that the federal funds rate is likely to remain within the target range for an extended period. The central bank is also prepared to purchase agency debt and mortgage-backed securities. Furthermore, through the Fed's expanded toolkit, it will begin direct loans to households and small businesses starting in 2009.

Fed chairman Ben Bernanke recognizes that the US economy is ripe for implementing the tenets of his Bernanke Doctrine, outlined in his 2002 speech titled "Deflation: Making Sure 'It' Doesn't Happen Here." In that speech, well before he was appointed to chair the Fed, he stated, "the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending—namely, recession, rising unemployment, and financial stress." Bernanke now has the chance to run the Fed during the precise scenario that he described six years ago.

In fact, the FOMC's press release of December 16, 2008 announces policy that effectively implements most of the seven steps of the Bernanke Doctrine. The FOMC's bold move may stave off a severe recession, but it does not come without potential costs. The combination of aggressive monetary policy, and recent and proposed fiscal stimulus could eventually reduce confidence in the US Treasury's ability to service its debts.

For the time being, Chairman Bernanke appears to be doing what is necessary to support another of his statements from six years ago:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve System. I would like to say to Milton and Anna [Friedman]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

Discussion Questions

1. What could be the negative ramifications of implementing such a bold expansionary monetary policy at this time? How likely do you think it is that such negative ramifications occur?

2. Do you believe that historically low interest rates will be sufficient to save businesses struggling to avoid bankruptcy, such as those in the auto industry?

3. The current state of the US economy bears remarkable similarity to that of the beginning of the Great Depression. Do you think that Chairman Bernanke and his doctrine will keep the US out of a deflationary spiral? Will the doctrine, along with fiscal policy from recently elected officials, be enough to keep America out of a depression?

4. The US national debt held by the public is currently about $6.4 trillion or 45% of the nominal GDP in 2008. Is there any reason to worry over the ability of the US Treasury to meet national debt obligations? Why or why not?

5. Now that gasoline prices have returned to low levels, some economists may believe that it is an appropriate time to raise the federal gasoline tax. Do you agree with this position? Why or why not?

Should the Government Bail Out the Auto Industry?

2008-12-12T16:09:00.001-08:00

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

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

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

Discussion Questions

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

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

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

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

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

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

Debit or Credit?

2008-11-26T13:15:00.000-08:00

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

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

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

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

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

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

FV = PV x (1 + r),

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

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

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

Discussion Questions

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

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

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

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

Should We Be Worried About Deflation?

2008-11-21T15:36:00.000-08:00

We're used to low and stable inflation in the United States—a slow, but steady increase in the prices of goods and services over time. The inflation rate measures the pace at which prices rise over time. The table below shows the CPI (consumer price index)—which measures the average price of a representative basket of consumer goods and services—from July to October in 2007 and 2008, as well as the annual inflation rate. In recent months, the U.S. economy experienced disinflation—the annual inflation rate, while positive, declined from a peak of 5.6% in July to 3.7% in October. The CPI continues to rise year-on-year, but it's doing so at a slower and slower pace.

Notice that the CPI declined significantly in October 2008 (from 218.8 in Sep '08 to 216.6 in Oct '08). In fact, the 1% decrease in consumer prices during October 2008 was the largest one month decline in 61 years. The sharp month-on-month decline in prices raised some fear of deflation. Deflation occurs when the prices of goods and services fall over time. Persistent deflation leads to negative annual inflation rates.

A sharp reduction in total spending by businesses and consumers typically precedes an overall drop in prices. For deflation to persist, business and consumer expectations must adjust. If people expect prices to continue falling, they will postpone purchases. Why buy today what can be obtained more cheaply tomorrow? The postponed spending reduces the current demand for goods and services. With weaker demand, prices fall even further and firms begin to cut back on production and lay off workers. Should we be concerned about this type of deflationary spiral?

Exploring the difference between headline and core inflation can help us answer this question. Headline inflation, reported in the table above, measures changes in all consumer prices. Core inflation measures changes in the CPI excluding food and energy prices. Since food and energy prices tend to be volatile compared to other prices, removing them from the CPI can allow economists to obtain a less distorted view of the inflation trend. The core inflation picture for October 2008 is far less alarming—the CPI less food and energy prices barely registered a change.

Falling energy prices were the primary cause of headline deflation in the month of October. A decrease in the relative price of energy is not necessarily a bad thing. A good's relative price is measured in physical units. Suppose that, in May 2008, the price of gas was $4 per gallon and the price of a movie ticket was $8. To express the relative price of gas in May 2008, we'd say that one gallon of gas cost one-half of a movie ticket. If, in October 2008, gas is down to $2 per gallon but movie tickets still cost $8, we'd say that the relative price of gas is one-quarter of a movie ticket. In other words, gas has become relatively cheaper since energy prices are falling as other prices remain largely the same.

Nobody's complaining about relatively inexpensive gas. Declining energy prices will likely feed through to the prices of other goods and services in the coming months. We may even see a negative year-on-year inflation rate. But a damaging deflationary spiral still seems like a remote possibility. Only when consumers and businesses begin to build expectations of falling prices into their decisions will deflation become a real threat.

Discussion Questions

1. Deflation presents big problems for debtors. Recall that the real interest rate a borrow pays on a loan is equal to the nominal interest rate minus the inflation rate. If you take out a fixed rate loan with a nominal rate of 8% and expected inflation of 2%, you'd expect to pay a real rate of 6%. What happens to your real rate if falling prices push the actual inflation rate to -1%?

2. What would deflation do to the purchasing power of a debtor's principal balance? For instance, how would persistent deflation affect people's ability to repay home loans? How would it affect the already beleaguered housing market?

3. If the Fed fears persistent deflation, what policies should it pursue to ensure that deflationary expectations do not develop? What are the risks associated with anti-deflationary monetary policy? How could government fiscal policy assist the Fed in preventing deflation?

America's Looming Liquidity Trap

2008-11-14T15:01:00.000-08:00

In October 2008, the US unemployment rate hit 6.5%, a 14-and-a-half year high, as announced by the Labor Department. This lofty rate is likely to increase in the coming months in the wake of the ongoing financial crisis and adjustments in the real estate market. It also comes despite two 50 basis point cuts in the target federal funds rate made by the Federal Reserve during that month. These interest rate reductions brought the target fed funds rate down to 1%, a very low target rate by historical standards and close to the nominal rate floor of 0%. The Federal Reserve therefore finds itself in the thorny situation of having only 100 basis points left to work with for possible target rate cuts. (Note that a basis point represents 1/100th of a percentage point, so 1% is 100 basis points.)

The fed funds rate cannot go below 0% because a transaction at a negative nominal rate implies a negative nominal cost of borrowing funds. Furthermore, that implies a positive nominal payoff to the borrower and a positive nominal loss to the lender. Under typical, positive rates of inflation, the real costs and payoffs are amplified. This is shown in the following Fisher equation where i is the nominal interest rate, r is the real interest rate, and is the inflation rate:

This floor for the nominal fed funds rate brings up the very real possibility that the US will soon be mired in a liquidity trap—a situation in which "the monetary authority is unable to stimulate the economy with traditional monetary policy tools." One explanation for this weakness of monetary policy comes from the analysis on the real interest rate given above. In difficult economic times, why would financial institutions take on the risk of lending out money to a borrower who may default on the loan when the real return on even a fully repaid loan is negative!

An excellent source on how our nation might remedy its liquidity trap is given by the 2008 Nobel Laureate in Economic Sciences, Paul Krugman. His 1999 article "Thinking About the Liquidity Trap" offered policy solutions for springing the Japanese economy from the type of liquidity trap that now threatens the United States. Krugman's figure 1 from that paper shows a nice IS-LM example of the ineffectiveness of monetary policy. Wikipedia provides a good introduction to the IS-LM model. Below I present a modified version of Krugman's figure 1, in the context of current US interest rates, to represent traditional monetary expansion with a looming liquidity trap.

An economy may also happen to face declining consumption expenditures, as the US currently does, due to concerns about a rising unemployment rate, which can result in lower exogenous consumption and a falling marginal propensity to consume. In that case, the resulting leftward movements of the IS curve make monetary policy even less effective. Krugman's solution to the scenario is to have the monetary authorities credibly commit to sustained higher future inflation. The expectation that such higher inflation will eat away at the purchasing power of cash holdings should convince consumers to ramp up their spending and move the IS curve rightward.

President-elect Obama and the new Congress will undoubtedly undertake expansionary fiscal policy to attempt to move the IS curve rightward. However, our already massive national debt and the likelihood of waste involved in government spending, support Krugman's solution. Our newly elected officials and the Federal Reserve Board are facing unenviable policy choices.

Discussion Questions

1. Suppose that you were in control of US fiscal and monetary policy. What policies, if any, would you implement to improve US economic conditions?

2. Do you believe that America will soon face a liquidity trap? Why or why not?

3. The International Monetary Fund forecasts that the world's rich economies will collectively experience economic contraction for the first time since World War II. When was the last time America faced a liquidity trap? What circumstances led to that liquidity trap environment?

Precious News

2008-11-07T14:50:00.000-08:00

News of Barack Obama's historic election on November 4 dramatically increased demand for newspapers on November 5. Tall, bold headlines announcing the nation's new president transformed copies of the daily paper into collector's items. Though many publishers printed thousands of extra copies in anticipation of higher demand for their post-election issue, at newsstand prices, supply simply couldn't keep up with the surge in demand. On Wednesday morning, many looking to own a piece of history found only empty news boxes and long lines in front of newsstands.

Not surprisingly, copies of major newspapers' November 5, 2008 issue began selling for as much as $200 on eBay and Craigslist.

This is a classic example of how a market responds to an increase in demand. The market equilibrium on a normal day for newspapers is at point A with price P1 and quantity Q1. As the demand curve for newspapers shifts rightward from D1 to D2 (people want more newspapers at any given price level), both equilibrium quantity and equilibrium price of newspapers increase as a result—from P1 to P2, and Q1 to Q2. On November 5, the quantity of newspapers supplied increased in part because publishers anticipated higher demand and in part because they scrambled to reprint when demand was even higher than expected. In the end, more newspapers appeared in the market, and at higher prices. The new market equilibrium for newspapers on November 5 is now at point B.

Though the consequences of the sudden shock in demand for November 5 newspapers are pretty much as expected, the reasons behind this shock are not so clear.

Though newspapers received renewed attention after the election, newspaper circulation has fallen steadily across the country for years. The ease of instant access to up-to-date information and the accessibility of free content have turned many readers to the Internet for news. The spike in demand for newspapers after the election raises interesting questions about the value of the daily newspaper in a digital world.

Discussion Questions

1. With the prominence of the Internet, why do you think people still wanted physical copies of newspapers with news they probably already knew? What factors do you think drove up the value of newspapers after the election? What do paper newspapers have that websites do not?

2. Some newspapers also raised the price of their November 5 issue. The Washington Post, for example, increased the price of their special post-election edition from $0.50 to $1.50. Considering the huge mark-ups for copies of November 5's newspaper on the Internet, why didn't newspapers raise their own prices even more, to, say, $20 per copy?

3. Does scarcity exist on the Internet? If so, how does it compare to scarcity offline? If not, how does that affect the value of virtual goods as compared to physical goods?

Recent Land Reform in China

2008-10-31T15:03:00.000-07:00

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

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

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

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

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

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

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

Discussion Questions

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

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

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

2008 Nobel Prize in Economic Sciences

2008-10-30T18:31:00.000-07:00

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

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

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

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

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

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

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

Discussion Questions

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

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

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

Selling Palin Short

2008-10-23T18:23:00.001-07:00

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

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

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

Poll	Date	Size	Obama	McCain
West Chester U.	10/5	504	52.3	42
Strategic Vision	10/6	1,200	54	40
Rasmussen	10/6	700	54	41
SurveyUSA	10/6	653	55	40
Marist	10/7	757	53	41
Zogby Interactive	10/11	737	51.6	40.2
SurveyUSA	10/12	516	55	40
Susquehanna	10/18	700	48	40
Morning Call	10/19	594	52	41

These polls all varied in their methodology—whom they polled, how they did it (robocall or a human being making a phone call), and how they weighted the results.

RealClearPolitics.com chooses to average the polls it judges are the best reflection of public opinion. Recently, it listed only the last three polls and averaged them together to predict Obama with 51.7% and McCain with 40.3%. (Note that these don't add up to 100% because of undecided voters.)

FiveThirtyEight.com takes a much more sophisticated approach. It adjusts for trends within Pennsylvania, across the nation, and among demographic groups. Instead of just choosing a few polls, it weights them according to methodology and how out-of-date they are. Then it reports three numbers: the raw weighted average of polls, the trend-adjusted average, and the results of a regression analysis that takes into account demographic and other factors. It also makes a prediction of Election Day based on the likely last-minute decisions of undecided voters. Finally, with all of that analysis in mind, the site makes a prediction as to the likelihood that each candidate will win Pennsylvania on Election Day:

	Obama	McCain
Polling Average	50.8	41.8
Trend-Adjusted	52.3	41.0
538 Regression	52.1	40.7
Projection	54.1	44.4
Win %	98%	2%

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

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

Discussion Questions

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

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

2008-10-14T13:02:00.000-07:00

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

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

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

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

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

Discussion Questions

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

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

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

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