Recently in Economics--Micro and Markets Category

Q    This new idea for the health insurance rate commission, I guess my confusion is, is this a commission that would sort of be -- serve as a guide to the other states, to the 50 states that do the actual regulating?  Or is this supposed to be a regulatory agency with --

MR. GIBBS:  No, no, no.  This is a -- the Secretary in conjunction with states will develop a review process for unreasonable premium increases.

Q    So the states are still going to be the regulators?  The federal government is --

MR. GIBBS:  Well, obviously they're still going to have --

Q    -- acting as a guidance counselor of sorts?

MR. GIBBS:  They're going to still have a big role in this.  Obviously there are state insurance commissioners that have some ability to change these.  Not everybody does.  But these can -- these will be looked at and evaluated in conjunction with the states, and then steps and measures can be taken.  Because again, Chuck, I think that -- I mean, we've even seen it now with Anthem, that proposed the 39 percent increase, that they've even put that increase on hold.  I think they understand that this was not a --

Q    No, I understand, but is this supposed to be a new federal regulatory agency?

MR. GIBBS:  It's not a new federal agency.  There's no new bureaucracy.  This will be done out of the Secretary's office in Health and Human Services.

Q    Out of HHS?

MR. GIBBS:  And we'll get -- I'll get Reid to walk you through some more --

Q    Okay, because that -- it's just a little confusing if this is a new agency.

MR. GIBBS:  Yes, ma'am.

WASHINGTON -- President Obama will propose on Monday giving the federal government new power to block excessive rate increases by health insurance companies, as he rolls out comprehensive legislation to revamp the nation's health care system, White House officials said Sunday.

...

By focusing on the effort to tighten regulation of insurance costs, a new element not included in either the House or Senate bills, Mr. Obama is seizing on outrage over recent premium increases of up to 39 percent announced by Anthem Blue Cross of California and moving to portray the Democrats' health overhaul as a way to protect Americans from profiteering insurers.

Anthem, California's largest for-profit insurer, has announced premium increases for nearly 700,000 customers, citing the soaring costs of medical care and the effects of a weak economy in which many younger and healthier people are dropping insurance. But the increases, far outpacing the rate of medical inflation, led to outrage among officials in Sacramento and Washington.

The president's bill would grant the federal health and human services secretary new authority to review, and to block, premium increases by private insurers, potentially superseding state insurance regulators. The bill would create a new Health Insurance Rate Authority, made up of health industry experts that would issue an annual report setting the parameters for reasonable rate increases based on conditions in the market.

The legislation would call on the secretary of health and human services to work with state regulators to develop an annual review of rate increases, and if increases are deemed "unjustified" the secretary or the state could block the increase, order the insurer to change it, or even issue a rebate to beneficiaries.

The new rate board would be composed of seven members, including consumer representatives, an insurance industry representative, a physician and other experts like health economists and actuaries, the White House said. The board's annual report would offer guidance to the public and states on whether rate increases should be approved.

Seven (politically appointed) people in charge of deciding how much you'll pay for health insurance.  Of course, they will be infinitely wise, incorruptible, and above political influence, right?  Yeah, right.

[Senator Dianne] Feinstein said that only 25 states allowed their insurance commissioners to regulate rates and that California was not one of them. "For the life of me, I am not sure why not," she said. "The time has come for the secretary of health and human services to step into this."

I'm not a huge fan of government regulation, but in our country we have come to a basic agreement that insurance should be regulated by the states.  This is an imperfect system.  Some states will do it well; others will not.  But the same is true of roads and schools, which have also been left in their care.  So half of the states have figured out how to take care of this themselves, and we need the federal government to be the nanny for the ones that don't have the courage to do it.

Now the fact that Anthem is raising their rates 39 percent suggests to me that Anthem may have caught onto the fact that California's regulatory environment is lax.  If there was a stronger insurance regulator, perhaps they would be a bit less aggressive.  Perhaps.  I'm trying to give the benefit of the doubt here.  Ms. Feinstein, I agree with you that for the life of me, I'm not sure why California hasn't done it since it looks like it might be a problem.  But with all due respect, that's California's problem.

On a related note,

Leaders of the National Governors Association meeting in Washington on Sunday expressed frustration that they had been largely shut out of negotiations over the future of the health care system, even though they would be responsible for carrying out many of the changes envisioned by federal officials. They said they wanted more of a voice in shaping those changes.

Indeed.  Nervous about turning your state's regulatory power over to seven federal appointees?  Come on... what could go wrong?

Mankiw calls this an example of price controls.  He's right, to a point.  Our system of health insurance, such as it is, really stinks.  The fact that it really is 50 different statewide markets with different regulations is bad enough.  Tying health care to employment is another problem.  There are plenty of things that could be done to improve the system.

This isn't one of them.

Selling insurance isn't like selling apples.  There are a lot of variables to consider.  Suppose companies are forced to accept lower rate increases.  There are dozens of ways that they could respond to reduce coverage.  How is that seven member committee going to keep up with that for all the insurance companies in the U.S.?  Are they going to tell them what they have to cover?  What the deductibles can be?  Hardly realistic, is it?  I mean, that sounds like that seven member panel would be more ambitious than whatever bureaucratic apparatus would run Obama's health plan.

Actually, they would probably just publish guidelines as to what is acceptable, but how detailed could those guidelines be?  If a company wanted to go outside those guidelines would they have to appeal?

The mind reels.

There is no way that this would end well.

To be continued...

Interest in the Cash for Clunkers program is slowing, and, if the current trend continues, vehicle sales could be back to pre-Cash for Clunkers levels by August 20, Edmunds.com calculates.

Edmunds.com's analysis of purchase intent on the car-shopping Web site shows sales activity tied to the government's Car Allowance Rebate System (CARS) remains well above the period leading up to its July 27 public launch.

However, activity is 15 percent below the peak of the Cash for Clunkers frenzy, which occurred the last week of July and specifically on July 29. Barring any intervention such as a major incentive program or a significant uptick in the economy, sales will be back to pre-clunker levels by next week. 

...

The funding for the original program was low relative to the size of the auto market, creating a Gold Rush mentality where consumers hurried to take advantage before funding ran out. In fact, it largely sopped up the pool of buyers who owned clunkers and had the ability to buy or finance a new vehicle. In addition, automakers are running extremely low on inventories of vehicles eligible and popular for clunker trades. 

With additional funding now approved, the sense of urgency to participate in the program is gone and the pool of eligible clunker owners who can buy a new vehicle has shrunk. Interest in the program is fading as fast as the first billion was used up. Quite possibly, some of the extra $2 billion will go untapped.

Despite this decline in clunker activity, however, Edmunds.com expects auto sales to be improved through the summer as the economy slowly improves and value-oriented consumers look for deals before the new 2010 models start arriving, said Jessica Caldwell, director of Industry and Pricing Analysis. "The real risk is this fall. Will the economy have picked up enough momentum to keep sales at these levels?"

"If we can sustain this momentum in the industry, it will translate into having a very good ability - for the first time in a long time - to increase production," said Michael DiGiovanni, GM's executive director of global market analysis. "And that will help stem the rising tide of unemployment, and will feed on itself to revive the economy. Recoveries are usually fed by the auto sector."
 
But displaying appropriate caution, neither DiGiovanni nor any other auto company executives pledged immediately to boost production in the wake of CARS mania. LaNeve said that GM is "looking for ways to add production" during the third and fourth quarters, but he didn't make specific promises.

There are many clever moments in the thoroughly satisfying new "Star Trek" movie, but the one that has economists chattering is more than just smart: It strikes right to the core of what the Star Trek future is all about.

The scene comes early, when a pre-pubescent Spock is undergoing the formidable educational process inflicted on all Vulcan children. We see and hear him say the words "nonrival" and "nonexcludable" (and we can imagine his computer tutor nodding encouragingly).

And then we move on, without explanation. To my children, and, I imagine, to most Trekkies, the moment was just one more jargonistic outburst in a franchise that has always delighted in excessive indulgence in meaningless techno-gibberish. But the economists in the audience all started high-fiving each other: Whoa, who could have expected a shout-out to economist Paul Romer's breakthrough paper, "Endogenous Technological Change," in a "Star Trek" movie? Awesome!

For more on the continuing story of Amtrak's growing popularity in the wake of higher gas prices, we turn to today's Wall St. Journal, which says...

WASHINGTON -- The number of people riding Amtrak surged 13.9% in July from a year earlier, as high gas prices caused more commuters to rely on intercity rail.

...

In July, Amtrak said, only one of its services saw fewer riders compared with the previous year. Elsewhere, there were major gains, such as a 33% jump on the Capitol Corridor between San Francisco and Sacramento, Calif.

Even on Amtrak's already heavily traveled Northeast Corridor line from Washington to Boston, passenger counts are up by nearly 8% over last year. Overall, Amtrak is on pace to serve a record 28 million passengers in its current fiscal year, up from the previous high of 25.8 million last year.

Amtrak's newfound popularity has made an impression in Congress, where lawmakers view the rail service as an environmentally friendly, energy-efficient approach to reducing gridlock and expanding transportation options.

The trains serving Macomb (the Illinois Zephyr and the Carl Sandburg) continue to sell out. The advice around here is to get your tickets well in advance.

Of course I have tried to accomplish some things on my summer break as well. In addition to doing a little research, I sat down and knocked out another Mathematica demonstration. You can download it from the Wolfram demonstrations website.

This one was actually pretty easy to do. It's a neat way of looking at how the coefficients of the cubic total cost function affect the average and marginal cost curves. If you use it in class, let me know!

Gas prices are up. So is Amtrak ridership. (Macomb Journal)

If there is any good news about $4 per gallon gasoline, it is that ridership on Amtrak is booming.

...

Ridership on the Illinois Zephyr and Carl Sandburg routes was up 41.4 percent in fiscal 2007, compared to fiscal 2006. Ridership on Illinois state-subsidized routes increased another 180,823 passengers during the first two-thirds of fiscal year 2008, to a total of 670,605.

When I ride the Illinois Zephyr or the Carl Sandburg, it is typically packed. Last time I rode, there were just a handful of empty seats.

I enjoy riding the rails. It's faster than driving, and without the hassle of driving. We don't drive to Chicago anymore if we can avoid it. Take the train!

UPDATE: Stephen Karlson has much more.

And now for something completely different...

One type of post that gets people talking is when I discuss the teaching of economics. So a few posts back, I pointed out that the NY Times confused "demand" and "quantity demanded". The Times wrote:

An open letter signed recently by more than 100 economists said the proposed tax holiday would do little to reduce gas prices. In part, that is because a fall in prices would lead to more demand, which would cause prices to return to their earlier level. The result would be that overseas oil-producing governments would get money now flowing to the United States government in gas taxes.

And I said:

The whole sentence about demand is the sort of circular statement that we caution our students not to make but that newspapers print all the time. Not only is it a terrible misstatement of demand vs quantity demanded, it's not even consistent with the claim (advanced by Krugman among many) that supply is fixed.

John Whitehead pointed out something similar in another story. After taking a little heat in the comments, he links back to me approvingly.

Why the heat? Well, I have to admit that when an economics professor starts to pontificate on demand vs quantity demanded, it tends to border on the pedantic. I know it does. I can't stand it, but I do it anyway. Why? Because the misunderstanding often leads to circular reasoning as it did here. You argue that prices fall, which causes demand to rise, which causes prices to rise and you're back to where you started.

Every principles of economics textbook seems to have a homework question devoted to identifying and critiquing that sort of circular reasoning--often from a real-life example like this.

So we've got a a real problem with the terminology here. It's made worse by the fact that the principles textbook terminology has absolutely zero chance of catching on in the wider world. Face it, journalists are not going to use demand and quantity demanded correctly in an Econ 101 sense. Not going to happen. But we need to figure out how to educate them to avoid making hideous errors even if they don't use Econ 101 terms.

I have addressed this before.... Digging into the archives for Polley's greatest hits of November 2005:

Stephen Karlson (Cold Spring Shops) links to Phil Miller's (Market Power) post and mine on a common media mistake. Karlson adds this,

...the source of the confusion in many observers' minds might be in the terminology of introductory economics (and nowhere else in economics) itself.

Much of the discipline refers to the act of drawing a new demand or supply curve as a "change in demand (or supply)," sometimes calling that an "increase" or "decrease" in demand or supply. A new choice along the same demand or supply curve goes by the cumbersome locution "change in quantity demanded (or supplied.)" Bleah. I recommend the use of the term "shift" to describe the drawing of a new curve, and I'm continually reinforcing "left shift" and "right shift" as "increase" and "decrease" have the potential for mischief on the supply curve. A new choice along the same curve is a "movement along."

I agree. Bleah. He is absolutely right that this terminology is only an issue at the introductory level. Why, you ask? Long story. At more advanced levels, the mathematics forces you to keep track of what is going on without resorting to these labels. That's part of it. We (those of us who teach this) also just tend to obsess over making sure students shift the right curve. These labels, properly used, do force you to be clear about what you're doing. But I agree with Karlson that there has got to be a better way.

Unfortunately, "shift" is not likely to catch on with journalists either. That only makes sense if you're thinking of the curve, and most of their readers aren't thinking that way. So I'm still puzzling over this one. Your suggestions, and any discussion on the topic, are very welcome.

Anyway, back to the article at hand, it is true that the writer confuses demand and quantity demanded. But the greater sin is that the passage was not even consistent with the main critique of the tax holiday. And I don't think that these errors are unrelated. Sloppiness begets sloppiness. Once you introduce that circular logic, the next step is more likely to go off-track. If anything, that's why professors need to continue to instill some professional discipline in the use of language to describe supply and demand.

We just need to come up with something that resonates better with journalists.

A summary of all of my recent comments on the proposed gas tax holiday is as follows:

1. The benefit to the consumer would probably not be literally zero. (This is the part everyone has been seizing on as the most charitable thing being said about the proposal. Ok, so be it. If you call that charitable, you go ahead and run with it. See where it gets you.)

My reason for saying it would not be literally zero is that there is evidence that inventories are higher than usual and that capacity utilization is lower than a couple years ago. The system is probably capable of squeezing out a few more barrels, but not terribly many.

I would also add that the open letter signed by over 100 economists says, "...research shows that waiving the gas tax would generate major profits for oil companies rather than significantly lowering prices for consumers." I have already said that I agree with that letter, and I think they were correct (but subtle) in saying that it would not significantly lower prices, leaving open the very sensible possibility that there might be a very small benefit. I fully agree with their wording.

2. While not literally zero, the consumer benefit is likely to be very small. I'd say a third or less of the total (half of what these authors found concerning the Illinois tax holiday in 2000). And I would probably bet the "under" if it came to that.

3. Good public policy should be well outside of the neighborhood of "pointless". (That is, the effects should be economically as well as statistically significant.) This proposal fails, even under my most charitable assumptions.

4. A tax holiday at the federal level will have less impact than the state tax holiday Illinois had in 2000. Then, gasoline could be diverted to Illinois from other states. That's harder to do at the national scale.

5. The average consumer will absolutely NOT notice the difference. Differences in price between locations and over time in the last couple weeks have far exceeded my most charitable estimate of the gain. Econometric studies would be done after the fact. There would be t-statistics, p-values, arguments over assumptions, and in the end some very small, but probably positive, estimates.

In short, I stand by my statement that consumers would likely see a couple (maybe even a few) pennies worth of benefit. But most importantly, the point I was trying to make was that this: This proposal does not have to be literally pointless for it to be a really bad idea. I think that is a worthwhile point to make.

But again, the relevant question is how much the price would have to fall to get consumers to buy up whatever increase in production would optimally be obtained if the tax were temporarily gone. That is, I think, the clearest statement of the question--and the answer is not much.

UPDATE: I have sent a message adding my name to the open letter.

I posted this as a comment at Angry Bear.

The real question is this: How much would gas prices need to fall in order to induce consumers to buy up whatever additional production would be optimally squeezed out of the refineries if the gas tax temporarily went away?

When you think about it that way for a little bit, it becomes easier to see that the answer is probably greater than zero, but not much.

The most recent data point on refinery capacity from the EIA was 85% in February. Unless things have ramped up immensely in a way that hasn't been seen for years (which due to the higher than average inventories, I doubt is the case), then I am a little bit skeptical of claims that the supplies, even in the short run, are "fixed". (Get this data and more from the EIA.)

From the summer of 2006 to the summer of 2007, inputs of crude oil into the refineries went down, operable capacity went up, and idle capacity went up.

If capacity utilization were on the level it was in 2000, I'd be more inclined to see the supplies as fixed. Any extra capacity would suggest that the consumers would get some benefit from the tax holiday. But again, let me be very clear... the amount that the consumer would benefit would be a small fraction of the tax reduction--5 or 6 cents out of the 18.4 would be as high as I would be comfortable in guessing. Maybe more like 3 or 4 cents. That's just not enough to justify temporarily tinkering with the tax code to win political points. It's bad public policy. If you want to provide relief to working families, fine. There are a dozen better ways.

While looking for something else, I came across this from the Congressional Budget Office...

Various media reports are incorrectly attributing to CBO a figure (that the average driver would save about $30 this summer) associated with a gas tax holiday. CBO has not published such a figure and the citations to CBO are inaccurate.

This misattribution raises a larger point. CBO is a nonpartisan organization, and we are not in the business of scoring or evaluating campaign proposals. In some cases, CBO may have previously estimated or evaluated a proposal similar to one subsequently proposed in a campaign and those estimates generally are available on our website.

The bottom line: If you read something suggesting that we have issued numbers or an analysis about a campaign proposal, you should be skeptical — and also let us know.

Jabberwonk posts the open letter signed by a number of economists opposing the gas tax holiday. Here's the key paragraph.

There are several reasons for this opposition. First, research shows that waiving the gas tax would generate major profits for oil companies rather than significantly lowering prices for consumers. Second, it would encourage people to keep buying costly imported oil and do nothing to encourage conservation. Third, a tax holiday would provide very little relief to families feeling squeezed. Fourth, the gas tax suspension would threaten to increase the already record deficit in the coming year and reduce the amount of money going into the highway trust fund that maintains our infrastructure.

Read closely all of the reasons behind why so many economists oppose the gas tax holiday.

Now look at how the NY Times summarizes it.

An open letter signed recently by more than 100 economists said the proposed tax holiday would do little to reduce gas prices. In part, that is because a fall in prices would lead to more demand, which would cause prices to return to their earlier level. The result would be that overseas oil-producing governments would get money now flowing to the United States government in gas taxes.

The whole sentence about demand is the sort of circular statement that we caution our students not to make but that newspapers print all the time. Not only is it a terrible misstatement of demand vs quantity demanded, it's not even consistent with the claim (advanced by Krugman among many) that supply is fixed.

The Times' statement that oil producing countries would get some of the gain is only true insofar as gasoline production (and therefore oil consumption) would actually increase. As I have pointed out, that effect is likely to be small though positive. I wouldn't call it my main objection to the tax holiday. The open letter is careful to say that "it would encourage people to keep buying costly imported oil and do nothing to encourage conservation," in effect implying that it spending on oil could stay the same as the "fixed supply" adherents would suggest.

Students writing term papers often rephrase the words in an article that they cite, and occasionally the rephrasing ends up changing the economic meaning of the passage (sometimes with comic results). I see this all the time. If I had a nickel for every time I said to myself while grading, "That's not what that article really meant, was it?" I'd have a pretty big collection of nickels. Likewise when I read the Times article, I immediately said, "That can't be what was written in that open letter, can it? No economist would say it that way." Indeed, they did not.

I suppose the Times could say that the paragraph in question was not a summary of the letter but their own analysis. But that would be just as bad, wouldn't it?

Bottom line: Members of the media sometimes have trouble quoting economists correctly because we don't always fill in all the blanks. The media (and students writing term papers) want to fill in those blanks, and sometimes they get it quite wrong. Understanding that people want to fill in those blanks (and understanding the ways that they are tempted to do so) goes a long way toward making you a better communicator of economic ideas.

We've been tough on the "McCain-Clinton gas tax holiday". We economists, that is. Seems there's not one of us who thinks it's a good idea. It's just plain bad public policy. The actual effect will be small. A family that goes through two tanks of gas a week might see a difference of maybe a couple dollars a week under the best case scenario (full explanation here). If you want to give working families some relief there are certainly better ways to do so. A check for $50 for every family with less than $50,000 income would be better targeted, subject to less uncertainty, and would have a larger effect. Just about any economist would tell you this.

Ah, but what do they know.

“Well I’ll tell you what, I’m not going to put my lot in with economists,” -- Hillary Clinton

And...

“When the federal government, through the Fed and the Treasury gave $30 billion in a bailout to Bear Stearns I didn’t hear anybody jump up and say, ‘That’s not going according to the market, that’s rewarding irresponsible behavior.’ We’ve got to get out of this mindset, where somehow, elite opinion is always on the side of doing things that really disadvantage the vast majority of Americans.”

The market reference is strange. You see, I think many economists did have reservations about what happened with Bear Stearns, although many of us ultimately feel that it was necessary to prevent even further catastrophe--one which might have had a pretty sizable impact on "the vast majority of Americans." Rather than take that chance, the Fed decided to put its own credibility up as collateral--no small decision, that.

So suddenly Senator Clinton has all this concern for markets? Is she implying that her gas tax holiday should be supported by economists because it removes the tax that is somehow distorting the free market?

No, more likely it was just a convenient sound bite. But I do see one very troubling problem in this exchange and it's going to have me thinking for a while. These quotes by Senator Clinton show that economists have not done a very good job of explaining what we really know objectively and scientifically to be true. Though my previous post (as well as posts on other blogs) pointed out some caveats, the basic thrust of tax incidence theory is not in question. The questions deal with specific issues such as whether summer production quantities have been set and how costly it would be to change them. That's an objective scientific question. Once we know the answer to it, we know whether the market price of gas would go down by roughly half of the tax cut (as econometric research suggests) or not at all (if quantities are already set).

The level of economic literacy in this country is so low that few people know that this is a point of near 100% agreement among economists. But correct though it may be, it is a counterintuitive result. People expect that the tax cut would drop the price one-for-one. People will believe a politician who tells them that this tax cut will help them. In fact, other policies would help them more, but because this one is believable and strikes an emotional chord, they'll remember it at the ballot box.

To add insult to injury, the same politician can discredit the economists on this point of near 100% agreement and mountains of objective evidence by pointing to a more controversial and unsettled issue where our pronouncements seem to favor the "elites" for reasons that are hard to explain in a hundred words or less, hard to draw on a blackboard, and are based on more recent scholarship.

It's sort of like saying that the meteorologist who sees clouds, hears thunder, and predicts rain should not be believed because he's on the wrong side of the global warming issue for your tastes. That would be ridiculous and should be called out as such. The level of economic understanding necessary for good citizenship is a level that would enable a person to see that connection.

True economic literacy does require some understanding of the concept of elasticity.

Let us begin with this short little post from Brad DeLong which sums it up nicely.

In my inbox right now, from a highly-respected public finance economist:

In the long and sad annals of truly bad ideas, it is unusual for one to receive bipartisan support at such high levels right in the middle of a campaign as this one has...

He is referring, of course, to what has come to be known as the McCain-Clinton gas tax holiday. Reuters has the summary.

"Score one for Obama," wrote Greg Mankiw, a former chairman of President George W. Bush's Council of Economic Advisers. "In light of the side effects associated with driving ... gasoline taxes should be higher than they are, not lower."

Republican McCain and Democrat Clinton, who is battling Obama for their party's nomination, both want to suspend the 18.4-cents-per-gallon federal gas tax during the peak summer driving months to ease the pain of soaring gas prices. The tax is used to fund the Highway Trust Fund that builds and maintains roads and bridges.

Economists said that since refineries cannot increase their supply of gasoline in the space of a few summer months, lower prices will just boost demand and the benefits will flow to oil companies, not consumers.

"You are just going to push up the price of gas by almost the size of the tax cut," said Eric Toder, a senior fellow at the Urban-Brookings Tax Policy Center in Washington.

Paul Krugman adds,

Why doesn’t cutting the gas tax this summer make sense? It’s Econ 101 tax incidence theory: if the supply of a good is more or less unresponsive to the price, the price to consumers will always rise until the quantity demanded falls to match the quantity supplied. Cut taxes, and all that happens is that the pretax price rises by the same amount. The McCain gas tax plan is a giveaway to oil companies, disguised as a gift to consumers.

Is the supply of gasoline really fixed? For this coming summer, it is. Refineries normally run flat out in the summer, the season of peak driving. Any elasticity in the supply comes earlier in the year, when refiners decide how much to put in inventories. The McCain/Clinton gas tax proposal comes too late for that. So it’s Econ 101: the tax cut really goes to the oil companies.

The Clinton twist is that she proposes paying for the revenue loss with an excess profits tax on oil companies. In one pocket, out the other. So it’s pointless, not evil. But it is pointless, and disappointing.

Is it?

Maybe not totally pointless, but definitely in the neighborhood. This is Econ 101--tax incidence theory. This is bread and butter for economists. But our pronouncements are only as good as what we really know about the relevant supply and demand elasticities. To make things even more interesting, the question of incidence (i.e. whose price will rise or fall) is not just a matter of absolute elasticities, but of the relative elasticities of demand and supply. Supply may be relatively fixed in the summer, but if short run demand is also inelastic, it is not a foregone conclusion that the suppliers will get all the benefit.

We take as one of our stylized facts that gasoline demand is fairly inelastic in the very short run. A 10% change in gas prices this month will probably not cause me to change my driving habits much. A permanent 10% increase will cause me to change my habits more over time. The federal excise tax of 18.4 cents is roughly 5% of the going price. In fact, I think we can expect that the fluctuations in price over the summer due to refinery maintenance, hurricanes, pipeline problems, etc. could be as large or larger in magnitude. I wouldn't expect it to change driving habits much at all. In other words, the demand is inelastic. Not perfectly inelastic, but quite inelastic.

Krugman suggests that the supply is practically fixed. If he's right in the extreme case (i.e. perfectly inelastic supply) then the game's over. The oil companies get all the benefit. But that's probably not the case either. A commenter at Angry Bear posts a link to the ever useful Energy Information Administration, or EIA. They point out in a recent newsletter that gasoline inventories are currently at the high end of the normal range. Given that production of the summer formulations has probably not fully ramped up yet, they probably have a little more wiggle room than Krugman is assuming. I'm not saying that they have a lot. But if demand is also quite inelastic, they wouldn't need an awful lot of wiggle room for the tax incidence to be split more equally.

The most recent piece of academic research on this that I could find is in Economics Letters (2004) by Hayley Chouinarda and Jeffrey M. Perloff (non-gated version here). They find that the incidence of the federal tax is split roughly equally between suppliers and consumers. The state taxes fall more on the consumers, and the burden on consumers is smaller in large states.

That last fact might have been useful for Obama to have known back in 2000 when he supported a statewide gas tax holiday in Illinois. As a resident of Illinois then as now, I can tell you that I didn't notice much of a difference. All I remember is seeing the signs on the pumps that told us that the legislature had suspended the sales tax on gas and that this should be reflected in the price.

I remember how I chuckled about it each time I filled up.

You did notice a few cents difference in the immediate run (i.e. shorter than the short run... first few days), but as time went on, elasticities and tax incidence theory did their thing. It was hard to see the difference with the naked eye. So was there any academic research on it?

Funny you should ask... in fact there was. (Hat tip to Daily Kos). Joseph J. Doyle, Jr. and Krislert Samphantharak of MIT and UCSD, respectively, found that the elimination of the 5% tax was associated with about a 3% drop in the retail price, or 6 cents on the (now) quaint sounding average price of $2 per gallon. But again, with the normal market fluctuations going on in the background, this was hard to see without your econometric glasses on.

But that's actually a reasonable conclusion. Given that Chouinarda and Perloff find that the consumer incidence of state taxes was quite high (close to 100%) but definitely smaller in the larger states (like Illinois), I would not be surprised to see that the breakdown was maybe somewhere between 50 and 75% for a state like ours. Doyle Jr. and Samphantharak put it at 60%. So like I said, it's reasonable.

But if Chouinarda and Perloff are correct in that the burden of the federal tax is more evenly split, then you'd notice it even less than we did in Illinois in 2000. If Krugman is even somewhat correct that it is too late in the game for quantity adjustments to be made, then the consumer's benefit shrinks further. Just guessing at a number, say maybe the consumer gets 5 or 6 cents out of the 18.4. With gas at $3.50 and perhaps more than 5 cents of variation across local markets and over time... you're going to need to have super-powered econometrics glasses to see the effect.

My conclusion: Maybe you would benefit 5 or 6 cents per gallon, give or take a couple pennies. Maybe a couple dollars a week. Better than nothing, I suppose, but only a tiny fraction of the "fiscal stimulus" check that I received this week. But then there's the issue of how to replace the lost revenue (revenue that is used to maintain the crumbling roads and to create jobs in a seasonal industry that is going to need to take up some of the slack from the slowdown in construction and manufacturing). Clinton proposes a tax on oil company profits. That's the part that Krugman calls not evil, but pointless. In one pocket and out the other. Maybe not totally pointless, but definitely in the neighborhood.

UPDATE: The Wall Street Journal's Real Time Economics blog says that my comments (specifically the last sentence above) are "probably the strongest show of support available". That may be. Though I meant it to be a bit of "damning through faint praise." My criteria for good public policy is that it be well out of the neighborhood of "pointless." Still, I'll bet others would agree that the consumer might benefit a few cents, but I think it is safe to say that we stand firm in agreement that this is a bad, bad idea.

From MSNBC:

NEW YORK - Drivers have long known that slowing down on the highway means getting more miles to the gallon. Now airlines are trying it, too — adding a few minutes to flights to save millions on fuel.

Southwest Airlines started flying slower about two months ago, and projects it will save $42 million in fuel this year by extending each flight by one to three minutes.

On one Northwest Airlines flight from Paris to Minneapolis earlier this week alone, flying slower saved 162 gallons of fuel, saving the airline $535. It added eight minutes to the flight, extending it to eight hours, 58 minutes.

Kind of reminds me of when American Airlines took an olive out of every salad and saved loads of money. Of course, that was not a response to the price of olives, it was just a general cost cutting measure. But the idea is similar. By decreasing their speed (i.e. decreasing the thrust from the engines) they save a few dollars on each flight. Multiply it by many flights a day over many days and before long it does potentially save a respectable amount of money.

As the price goes up, there does come a point where the airlines decide to try to reduce the quantity of fuel purchased. The demand for fuel by airlines is "derived demand" meaning that it also depends on the market (i.e. the price) of the output. But derived demand curves slope downward too, ceteris paribus.

I received a link to this article via a listserv on teaching economics. It's a sobering look at the effects of bread subsidies in Egypt. Here's a sample:

“The most corrupt sector in the country is the provisions sector,” said a government inspector who asked not to be identified for fear of punishment. His job is to go to bakeries to ensure they are actually using the cheap government flour to produce cheap bread that is sold at the proper price.

The inspector explained why the system was so open to abuse. The government sells bakeries 25-pound bags of flour for 8 Egyptian pounds, the equivalent of about $1.50. The bakeries are then supposed to sell the flatbread at the subsidized rate, which gives them a profit of about $10 from each sack. Or the baker can simply sell the flour on the black market for $15 a bag.

Read the whole thing.

Today's howler is from CNN/Money:

Gasoline is one of those items that some economists consider "inelastic," that is, people will buy it no matter what the cost. But the recent drop in demand puts that into question, and suggest people will cut out unnecessary trips if they are too expensive.

As I try to tell my students, a good or service is not elastic or inelastic--the demand for or the supply of it is. Second, inelastic demand doesn't mean that people will buy it no matter what the cost--budget constraints ensure that eventually the curve slopes back to the left as you go up higher in price. Third, if you want to get really pedantic, it's not a drop in demand, but a drop in the quantity demanded as this is a change induced by higher prices (caused by increased input costs which reduced the supply). Fourth, one should consider short-run vs. long run demand for gasoline since it takes a while for habits to change.

When I read that I had flashbacks to grading exams.

No wait, I did not grade any exams this term that packed this many errors into two sentences. My students are better than that.

I was in the St. Louis area this weekend as several inches of snow fell. A story on the local news (sorry, couldn't find a link) interviewed a young man who was going up and down the streets in a neighborhood shoveling sidewalks and driveways for cash. As I recall, the going rate he charged was $10. It looked like a middle class neighborhood. The people could certainly afford the $10. The young man probably made couple hundred dollars for his day's work. Not an insignificant sum. It really was a significant snowfall for St. Louis, maybe 6-8 inches in some places. (Contain your laughter, King!) So there were a lot of people who don't like to shovel that much snow and were willing to pay to have it done. While it's not a disaster on the scale of a flood or a hurricane, there still is a sense of disruption. A lot of man-hours need to be expended in a short time in order to restore a sense of normalcy.

It was just a man with a shovel--not a professional snow removal firm. I'm not even sure if it was his neighborhood. For all I know, he might have come from across town. (I don't recall if the news story went into that much detail.) Good capitalism? I think so. Self-interested? Absolutely. Is it ethical to engage in this sort of "profiteering" (if we wish to call it that)? Comments are open.

Now, right after the news crew interviewed that young man, they showed a group of citizens going around a neighborhood digging people out for nothing. They were doing it purely out of kindness. I believe that that particular neighborhood had more elderly residents who were the beneficiaries of the volunteers' labor.

So what are we to make of their selfless act? Could they have profited but chose not to? Probably. Are they bad capitalists? Good neighbors? Both?

Does the fact that this is a trade in services rather than goods have any bearing on how we perceive the actions of these individuals? Though the entrepreneur may be charging a little more than what the market for snow shovelers might bear in other times, is it ok since he is providing a labor service? (After all, it's not like he loaded up a pickup truck with shovels and sold them for $20 a piece, right?)

But then, hurricane regions often have guys in trucks swooping in offering their labor services for an exaggerated fee as well. Sometimes they get excoriated for price gouging. What's the difference?

Would it be wrong or unethical to go around charging $10 for shoveling in a neighborhood of poor elderly residents?

This is precisely what I meant in Saturday's post when I said that our attitudes (as well as the law) affect our supply response. So I can be perfectly comfortable saying that I applaud the entrepreneur as well as the volunteers. There are social customs, sometimes at a very local level, that may dictate when it is ok to raise prices in a case like this. Someone charging high fees to the poor and elderly might be met with disapproval from the neighbors (and maybe politely told to take a hike). Yet, people of means are perfectly willing to pay to avoid this unpleasant task that nature has thrust upon them. Few people would have a problem with that.

Honestly, I cannot imagine trying to think through this sort of economic problem without considering these kinds of issues. As Milton Friedman put it this when he wrote his oft-cited article, "The Social Responsibility of Business is to Increase its Profits"

That responsi­bility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while con­forming to the basic rules of the society, both those embodied in law and those embodied in ethical custom. (emphasis mine)

and...

That is why, in my book Capitalism and Freedom, I have called it a "fundamentally subversive doctrine" in a free society, and have said that in such a society, "there is one and only one social responsibility of business–to use it resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud."

We've had a rather spirited discussion of price gouging on this and other blogs. My position is, as it always has been, that the profit motive induces people to bring goods and services to the areas where they are needed most, and that prices should rise to compensate people for the opportunity cost they incur. How much the price will rise, the exact locations where it will rise, and the length of time it will remain elevated will necessarily depend on the particulars of the situation. Modern supply chains are likely to make the price increases smaller, more localized, and shorter. But it still will happen, often in ways that are hard to predict until that particular disaster occurs. But it will happen.

However, that does not give anyone license for deception or for violating the basic social norms. The question is how best to make sure that the goods and services go where they are most valued while discouraging people from violating those social norms. I do not think that vague and selectively enforced price gouging laws are the answer to that question. Information is the greatest weapon against price gougers. Information helps the process of price discovery happen more efficiently. There are private and public means of providing information that are not always used to their fullest extent. That would be a start.

If you look at anyone who looks to recover their opportunity cost as a criminal, then it will discourage the sort of people you want from coming into the affected area--unless they are large enough to be able to eat the cost. But then what of the people in areas out of Wal-Mart's reach? Will their only choice be the suppliers who are willing to risk the condemnation of society--those with less to lose and less of a conscience when it comes to those social norms?

Those are questions worth thinking about.

Apropos of recent discussions here, at Cafe Hayek, and at Angry Bear, I offer this example of how higher prices really do induce people to move goods from one area to another. Supply curves really do slope upward. Transportation costs are important. Read this from the Columbia Missourian from last February. Here's a sample:

A two-year drought and this year’s harsh winter weather are contributing to a national hay shortage that’s hurting many Missouri farmers. Back-to-back years of low hay production are forcing them to decide between selling their livestock or paying two to three times more than last year for hay.

...

The hay shortage has spread across the Midwest and southern Plains states such as Texas and Oklahoma. Tony Hancock, market news reporter for the Missouri Department of Agriculture, said farmers are hard-pressed to find any hay in Missouri. Most are looking to Northern states such as Iowa and Wisconsin that have seen more rainfall.

...

Going north for hay forces farmers to dig deeper into their wallets, especially those in the southern regions. Jeff O’Laughlin, owner of Missouri Hay and Straw in Ashland, said high fuel prices have forced the price of small square bales up $2 to $3. He’s charging $5 to $9 for a small square bale now.

...

The Missouri Department of Agriculture is trying to help the situation by running the “hay hot line,” which connects hay producers with those in need of the product.

If our recent discussions have intrigued you, then you definitely should read the whole article. There are so many things about this article that make is wonderful for an economics course. It is a good illustration of the application of the supply and demand model in the way that it is often applied in discussions of price gouging. And yet, the word "gouging" is not in the article at all, nor is there any sense of moral indignation. It's very matter of fact. There was a drought in Missouri. Hay became scarce. The price rose. Supplies came in from several states away. End of story.

And while I raise this point to defend the economist's usual way of approaching the issue (upward sloping supply curves and all), I am not at all trying to deny spencer's point about how Wal-Mart et al. operate in disaster regions. There are similarities in terms of the overall issue. But there are important differences that are too obvious to even warrant mentioning to the informed readers of this blog, but that I would probably take 5 minutes in a class to discuss (ideally through a Socratic dialogue).

But perhaps the most important difference does warrant a mention, and that is that the time over which this plays out is longer. There is perhaps less of a sense of urgency and catastrophe. Thus there is more time for a reasoned response by both parties in the transaction.

There is an important similarity as well. That is that there is always an additional cost to moving the goods, and that's going to show up on someone's bottom line. Wal-Mart may find that it's costs are small because of its distribution network--small enough that they can absorb it. Great. But that's not always going to be the case. Even for Wal-Mart, if their stores are damaged, the cost of the "last mile" increases substantially.

Finally, there's the government's part in the situation. Rather than punishing price gougers, in the Missouri hay shortage, the government established a hot line for the dissemination of information. Thereby improving the process of price discovery. In a disaster situation, the process of price discovery, so important for markets to work, is severely hampered. The presence of large retailers in competition with each other leads to lower prices because they are able to aggregate a lot of that information. If you have only a few of what spencer so beautifully refers to as "guys in pick-up trucks", the burden of aggregating that information falls on the consumer and that is costly. Having more guys in pick-up trucks (and box trucks, flat beds, and independent semi-truck drivers) would help. Perhaps Wal-Mart can do better, but Wal-Mart is not all powerful. There will be some places they will not reach. There will be some places too costly for them to go the last mile, at least temporarily. Why not encourage local independent sellers to move good into the area, and why doesn't the government assist with the process of price discovery like they do in Missouri. Then, while prices might rise, it would be a smaller and more temporary rise that would be more likely to do some good.

I say this with all due respect to Wal-Mart et al. and spencer's excellent defense of them because any newsreel of disaster footage will tell you that for all the big box retailers do for those areas, they do not completely solve the problem. If they did, you wouldn't have people trying to invent machines that can extract drinking water from the air. Why waste time on that if Wal-Mart can do it all at no additional cost? Because they can't. They can't do it all, and if they tried, their costs would at some point go up. Supply curves do slope up, at least when you're talking about transportation costs in the very short run in a disaster area.

Spencer always comes back to one point. Why should we celebrate the guys in pick-up trucks? Why should we hold them up as examples of how market capitalism works? Well, I'm not sure we should--at least not in the way that he is implying that free market economists do. I think what we should celebrate is the process of price discovery and whatever mechanism helps speed that process along--whether it comes in a pick-up truck, a flatbed, or a blue and white semi-truck from Bentonville. Because in different times and in different situations, each may have more or less role to play. And if government can do something to speed that process along during a time of crisis, then that is an appropriate role for government to play as well.

This post is already getting lengthy and there is, I'm sure, a lot more could be said. But rest assured, spencer, that in a 75 minute class period, there is a lot of time to discuss those other issues that don't always make it into the textbooks. It's not about celebrating the guys in trucks. It's thinking about how our attitudes and how the law affects supply responses and whether that does more harm than good. It's about how there may be good reasons for price gouging laws, but our present ones are too vague to work well. It's about whether there are things the government can do besides passing price gouging laws that might make things work better. That's what it's about--the guys in trucks are bit players in my story.

Spencer at Angry Bear points us to a Division of Labour post. This is from The Oregonian.

In cases of extreme weather and natural disasters, some of the nation's largest retailers now behave like municipalities -- sometimes better.

[R]etailers have created specialized divisions -- or hired outside firms -- to gird for emergencies. The goal: to speed recovery for customers, employees and ultimately sales.

No one is clear how many retailers operate internal emergency units, but the practice is now standard among the biggest players, including Target Corp. and Lowe's Cos. Inc.

This past week, Wal-Mart donated a 40-foot tanker of potable water to Vernonia, [Oregon,] while up north Home Depot opened its still-waterlogged Chehalis store for the town's Chamber of Commerce to pick up face masks and cleaning supplies free of charge.

Such coordination became clear during Hurricane Katrina in 2005, when local governments praised initial responses from retailers as more expedient than those of the Federal Emergency Management Agency.

Spencer adds a jab at libertarians.

Because they [libertarians] seem to be believe the only way to get supplies to natural disaster victims is some guy in the back of a pick-up truck gouging them with high prices.

Well, I don't know if I'm the right guy to defend libertarians. I sympathize with them often, but don't really fully consider myself one. But anyway, I'll bite. After all, spencer has raised the issue here before. I suppose we could dig into the archives and see what I wrote then...

So no, I don't have evidence that guys in pick-up trucks would do a better job. That's the wrong question. I do have a very strong reason to believe that large companies could do a much better job if they knew they wouldn't be excoriated by politicians and the media for making a modest amount of money from it. While I praise them for their generosity, I think you'd get more than five truckloads [of bottled water] from Culligan if they could charge a modest amount for their trouble. The fact that there are still guys in pick-up trucks means the established, reputable companies are not doing enough.

In the present story as well as back then, most of the supplies from the big box stores were donated. A cynical person might say that the big boxes are making that donation hoping that when things get back to normal people will remember their generosity and buy their rebuilding supplies from them. Think of it as a tax deductible advertising expense.

Even so, I don't have any problem with them doing this. I think it's great. Look, there are many reasons that a big box company might have for making these donations. But the bottom line is that they can get supplies into these areas at a low cost, so they aren't losing much. Furthermore, they can afford to take a bit of a hit in the short term in the name of goodwill, community relations, advertising, or what have you.

Let me put it even more bluntly. I hope that Wal-Mart puts all the small time mom-and-pop price gougers in pickup trucks out of business. The world would be a better place.

Maybe it is starting to happen. I think you see fewer stories these days about "guys in pickup trucks" these days. (Though they did at one time exist, and I think they still do. My above-mentioned post has some links in the comments where I point to media discussions of them, though they are getting a bit dated.) But even so, I think the big boxes are still going to fall short of the optimal outcome, meaning the "price gougers" will still exist in the hardest-to-get-to areas.

Here's where the rubber meets the road. There are two reasons that prices can go up. It's either a supply issue or a demand issue. (It can, of course, be both.) In the immediate aftermath of a disaster, the supply of certain items decreases and demand for those items increases. But if a number of large (competing) firms with nearly constant marginal costs and with vast distribution networks can move the supply from one area to another at a low cost, then prices will not rise very much... even if demand increases.

However, I'm not at all convinced that the big boxes are going to donate enough to satisfy all of the demand. Why would they? At some point they would be donating to people who would be willing and able to pay the retail price that prevailed before the storm. Are they able to donate close to the "right" amount that would get the goods to the people who need them most and then sell at the previous price to those willing to buy? Admittedly, I do not know the answer to that question. Though I suspect the answer is no. Do we suffer some loss of efficiency because the big boxes are careful not to give even the appearance of profiteering? Admittedly, I do not know the answer to that question. Though I suspect the answer is yes.

So in the end, what the big box stores are doing is definitely a good thing. The fact that they are doing something (and doing it well and at low cost) is beneficial. They seem to do better than government at times. In fact, maybe the government should pay Wal-Mart and Home Depot to step it up a notch! One way or another, price incentives still are important. Donations won't completely solve the problem.

Ask anyone reading these stories if they think that the big box stores could do more. You'll probably get a lot of "yes" answers. So then the next logical question is, "why don't they?"

UPDATE: More in the comments. And King has more at SCSU Scholars.

How could you forget? Well, it seems that at least one unhappy customer won't let it go. (Wired News)

Dongmei Li of Queens, N.Y., claimed the company violated price discrimination laws when it slashed the price of the 8-gigabyte iPhone by a third, from $599 to $399, within two months of the gadget's June debut.

...

According to Li's lawsuit, filed on Sept. 24 in the U.S. District Court, Eastern District of New York, the price reduction injured early purchasers like herself because they cannot resell the product for the same profit as those who bought the cell phone following the price cut.

Cannot resell the product for the same profit? She was an iPhone speculator?

I could have told you that speculating on iPhones would probably not be wise. Just sit back and enjoy your consumer surplus.

In the newest Journal of Economic Perspectives (Summer 2007) is an article titled "Repugnance as a Constraint on Markets" by Alvin Roth. It's part of a symposium of three articles on organ transplants. I've skimmed it now and will read it more carefully later. Roth makes the claim that as economists we should continue to educate the public about efficiency and tradeoffs, but also be aware of the sources of repugnance that has led legislatures to outlaw drugs, prostitution, ticket scalping, and the sale of human organs, among other things.

It would be a great reading for an undergraduate seminar.

Tyler Cowen has been pushed too far. Why? Listening to people complain about Apple cutting the price of the iPhone.

One customer, Kevin Tofel, was quoted in the NY Times as saying:

“I just felt so used as a consumer,” he said. “They hyped up the iPhone for six months and built up our expectations, and then they grabbed our extra $200 and ran.”

This was too much for Tyler.

It is you people, you who resent Coase (1972), you people who induce wage and price stickiness and widen the Okun gap. You people, who don't know what it means to sit back and enjoy your consumer surplus. You beasts! (emphasis in original)

Ok, so who among us did not expect that this would happen? In fact, when the iPhone came out, one blogger wrote:

There is one certainty however. In a few months, there will be a better model that will be released at about the same price and this one will be sold at a discount. For tech products like this, there is most certainly a dynamic form of price discrimination partly due to the nature of quality improvement and innovation over time and partly due to calculated profit maximizing behavior. The effect is to segment the market into the patient and the impatient.

Man, that sounds familiar.

The only thing I didn't get right about it was how fast it would happen. Two months is sooner than I would have expected, but not terribly so.

So let this be a lesson to you. Big hype around a high tech innovation just cries out for this sort of dynamic price discrimination. The market will be segmented into the patient and the impatient. If you are impatient, you will pay more than those who are patient. There is a price for being the first on the block with a new toy. You gave away some of your consumer surplus, but you've probably got some left. So enjoy being first as long as it lasts. The patient masses will soon join you in enjoying what Tyler calls those "icons of modernity". Should I feel sorry for someone who buys a $2000 computer and complains that a few months later a better one sells for $1800?

"You people...who widen the Okun gap." That's just beautiful.

UPDATE: Wired has a story that should soothe Tyler

"If they told me at the outset the iPhone would be $200 cheaper the next day, I would have thought about it for a second - and still bought it," said Andrew Brin, a 47-year-old addiction therapist in Los Angeles. "It was $600 and that was the price I was willing to pay for it."

Via IN-FORUM (Fargo, ND)

"It gets rid of the stigma that surrounds our business a little bit," [ticket broker Michael] Nowakowski said of the law change. "I just think for years people in Minnesota have been taught that buying or selling tickets at over face value is very similar to buying and selling drugs."

Prosecutions of ticket scalpers have been on the decline for the last few years.

Records kept by the state courts system show only a small number of cases resulted from the scalping law. In Hennepin and Ramsey counties, where the pro sports venues are located, there have been 104 cases carrying a scalping charge since 2002. The most was 35 in 2003; this year saw only two.

First it was copper pipe. Now this... (MSNBC-Associated Press)

With metal prices rising, beer makers say they expect to lose hundreds of thousands of kegs and millions of dollars this year as those stainless steel holders of brew are stolen and sold for scrap.

The beer industry is coupling with the scrap metal recycling industry to let metal buyers know they can’t accept kegs unless they’re sold by the breweries that own them. They’re also pushing for legislation that would require scrap metal recyclers to ask for identification and proof of ownership from would-be sellers.

Some distributors are raising the deposits that they require from customers. How high can they raise the deposits? Certainly a bar owner can put up a few extra dollars per keg, which might encourage them to keep the kegs locked up when not in use. It's the occasional customer buying a keg for a weekend get-together who may be more sensitive to the deposit amount.

What do you think?

Read the whole thing.

Max sounds his "barbaric yawp" over at the TPM Cafe.

Let's look at a few of his positions.

1. Supply and demand, 1. This celebrated and most basic economic model while in principle multidimensional in practice obscures anything interesting that affects market conditions. It bespeaks militant, ideologically-based reductionism. A good illustration is the minimum wage debate. In the usual S&D model, a MW can only reduce employment. Nothing else is logically possible.

We've been over this before. I am reminded of the old quote by Thomas Carlyle that I first heard when I was taking principles of economics, "Teach a parrot the terms 'supply and demand' and you've got an economist." Max's concern that the supply and demand model is taken to a reductionist extreme is nothing new. Unfortunately.

In principle it is multidimensional, but general equilibrium theory is hard to put into the format of a sound bite or an op-ed. The blog medium maybe does a little better at conveying the message because it allows for a more extended and thoughtful discussion.

My main caution about the supply and demand model in its simplest form is that it assumes homogeneous goods (or factors of production--to use the minimum wage example) and perfect competition. When the basic model is used in cases where those conditions are not satisfied, there is potential for mischief.

2. S&D, 2. The outcome in an S&D model in principle has no inherently attractive qualities, in and of itself, since it depends on the distribution of ability to pay. If Oliver Twist has no money to buy a crust of bread, his zero allotment is "efficient." The lack of any normative foundation is typically glossed over.

Or as I like to say, "No normative judgments, please; we're economists." Deirdre McCloskey as chided the profession with variations of that phrase as well, so that's where I picked that up. Max is right up to a point. The supply and demand model is value free in and of itself, but it can shed light on the effects of imposing alternative policies, and policies are generally based on some set of values or norms. It is true that economists often shy away from doing the latter. There are good reasons for being circumspect about recommending one policy over another, and indeed there is some value in specializing in the positive analysis. But we live in a political world, and our models can deal with that if we let them. There is no reason to suppress the normative discussion. The normative questions are the interesting ones--if we give up on those, our students will lose interest.

3. GDP. Add up all the Qs in the S&D models over the year ("final goods and services") and you get GDP. Solemn assurances that GDP is not synonymous with economic welfare fall easily by the wayside. More GDP (and less leisure time, less environmental quality, a less sustainable economic future) is always better. If terrorists knock down the Empire State Building, GDP could go up. More! Better! Comrade Stalin would approve.

See the broken windows fallacy.

7. Capital fundamentalism. As with reductionism of the S&D model, growth modeling zeroes in on private capital accumulation, even though a) other factors are demonstrably important and beg for attention; and b) private capital accumulation may be a consequence of other factors, rather than a cause and appropriate object for policy. Out of an obsession with this premise, the International Monetary Fund has screwed up a lot of countries too weak to ignore its advice.

Other factors are always important. If a model is simple enough to use, it necessarily leaves out many other factors. Those two fundamental facts are at the heart of more than just this criticism. In some research that a student of mine conducted we found that the relationships between growth, capital and other factors can be notoriously hard to identify. Yet, I think it is important to try. And yes, my confidence interval around theoretical growth models has increased once I started reading more of the empirical papers. Does that make me heterodox? Nah, probably not. But I know enough to know that some fundamental questions haven't been answered yet, and thus a little modesty is in order.

9. The unnatural rate of unemployment. Economists used to say it was 6.0, maybe 5.5. Lower would give rise to ruinous inflation. The huge social benefits of another couple of percentage points less unemployment were -- are -- implicitly discounted. Current rate is 4.5. 'Nuff said.

I think I know what he's getting at here. While I also am no fan of the natural rate concept of the old days, I come at it from a different angle. Max's statement here suggests that the social benefits to having a 4.5% unemployment rate were feasible back when economists thought the natural rate was 6%--and without the inflation we all feared back then. I'm not sure about that. The productivity gains of the 1990s did allow for lower unemployment and lower inflation.

When inflation and unemployment came down together in the 1990s, the Friedman-Phelps version of the natural rate gave way to the NAIRU (non-accelerating inflation rate of unemployment). It was not without its skeptics. Estimating the NAIRU is like finding your way around the room in the dark when someone keeps moving the furniture. It is easier to identify what it was in the past based on your experience, but there is no guarantee that it hasn't changed. Again, in what seems to be a common theme here, that would lead me to exercise caution in using the NAIRU to guide policy. Yet, the practical advantages in doing so carry a lot of weight, and so you use your past experience and hope that the furniture hasn't moved too much. And that means that occasionally you'll stub your toe.

But what mechanism would allow the policymaker to systematically do better?

10. "Power? You want the political science dept." Power looms over economic transactions, except in economic theory. Workers do not hire capitalists. Consumers do not choose merchants. Shareholders do not choose managers. Voters do not choose elected officials.

I have wrestled with this problem in my own models. It becomes difficult to produce clear predictions when you allow variations in power (e.g. bargaining power) to enter the model. It is similar to allowing preference shifts. Suddenly you can explain everything--and therefore you can explain nothing. Yet acknowledging the role of power (of various kinds) makes for a compelling narrative sometimes. It's something of a shame that it often needs to be excised from published research. It gives the impression that we don't care about it. That would, at least in my case, be a wrong impression. Yet at the same time, I believe it is appropriate to keep those power considerations separate from the rest of it, lest we end up with a model where anything goes.

I guess that makes me orthodox. Ultimately, I line up on the neoclassical free-market team more often than not, but I never stop asking many of the questions that Max does. And so I temper my free-market analysis with thoughts like: perfect competition is hard to find, rent-seeking in politics influences outcomes, real time estimates of the NAIRU should have a decent confidence interval, not all $1 transactions have the same social value, and power does matter even if it is hard to measure or even describe.

In some circumstances, those considerations are more important than others. But much of the time, they don't radically alter the main story that incentives matter--a story that the orthodoxy mostly gets right.

UPDATE: Max links back. Robert Waldmann also responds. Other blogs covering the topic include Greg Mankiw, Angry Bear and Cafe Hayek.

Everyone knows by now that when a thunderstorm passes through Chicago, it can cause airport delays across the country. Air traffic is all about the flow. Disrupt the flow at one major hub and everyone feels it.

From IN-FORUM (Fargo, ND):

KANSAS CITY, Mo. - Consumers are beginning to pay more at the pump because flooding at a southeast Kansas refinery has reduced fuel supplies and sent wholesale prices soaring, industry experts said.

...

Jon Callen, president of the Kansas Independent Oil and Gas Association, predicted the states most affected by the Coffeyville flooding would be Kansas, Missouri, Arkansas, Oklahoma, Nebraska, Iowa, Minnesota, north Texas and parts of the Dakotas.

"Effectively, the market was balanced before Coffeyville had to shut down. There's now a big hole in the entire market centered in Coffeyville, so the gasoline that Coffeyville was providing the region now is going to want to be made up from other refineries that already have been balanced and had people wanting to buy their gasoline," Callen said.

If paying for something is as easy as swiping a card or passing under an electronic sensor, will you become desensitized and less likely to notice price or tax increases?

Maybe.

PGL at Angry Bear points us to this TPMCafe piece by Jared Bernstein. They both reference the Barry Schwartz piece I discussed here in my last post.

Bernstein uses the Schwartz article as a springboard for detailing the shortcomings of the economics profession, including forecasting (thus the title of this post). Two of his critiques stand out:

2. Economists are reductionists.... the world doesn’t work like the textbooks say it should.

...

3. And one reason for that is, as the NYT oped argues, we misunderstand incentives. To be specific, we exaggerate them.

I have frequently argued (e.g. in this recent post about Iranian gasoline) that the textbook model is not perfect but still useful. In my discussion of the Schwartz op-ed, I conclude that monetary incentives can have nonstandard effects in certain circumstances. We don't completely understand those circumstances and therefore more work is needed. I'm not ashamed to admit that perhaps a little more humility is also needed when considering the possibility of these non-standard effects. But it still remains that the incentive story that drives most economic models is mostly right. The question of whether we exaggerate the magnitude of these effects in our rhetoric (even when we are correct about their existence) is another matter, and I'd be more comfortable if Bernstein didn't lump them together.

I should note also that I have responded to PGL's post in the comments over there. This whole issue of responding to incentives and the usefulness of textbook economics is a worthwhile topic and generates some of the more interesting conversations on the blog. I hope to flesh out some more ideas on this over time.

That's the question that popped into my head when I read this op-ed by Barry Schwartz in the NY Times. You may recall that Schwartz is the author of The Paradox of Choice: Why More Is Less. When this was briefly a hot topic a couple of years ago, I was not impressed with his argument that that we have too much choice. My opinion hasn't changed. But let's hear what he has to say about incentives. The op-ed contains many claims and hypotheses, each of which deserves a rebuttal, so here goes. He writes:

NEW YORK CITY has decided to offer cash rewards to some students based on their attendance records and exam performance. Diligent, high-achieving seventh graders will be able to earn up to $500 in a year. The plan is the brainchild of Roland G. Fryer, an economist who has been appointed as “chief equality officer” of the city’s Department of Education.

The assumption that underlies the project is simple: people respond to incentives. If you want people to do something, you have to make it worth their while. This assumption drives virtually all of economic theory.

Let's pause there because I'm already a little nervous. I feel like I'm walking into a set-up. Honestly, I'm not a big fan of paying students for good grades. I suppose I share the same philosophical objection to it that many people would have. I question whether this is where you would get the most "bang for the buck" in education. It's going to take a lot of convincing to get me to think that this is a good idea. But I'm starting to smell a rat. Follow the logic. An economist proposes paying kids for good performance because people respond to incentives. The social outcome of the plan is debatable, therefore the assumption that "drives virtually all of economic theory" might need some rethinking.

Like I said, it feels like a set-up, but let's see where it leads.

Sure, there are already many rewards in learning: gaining understanding (of yourself and others), having mysterious or unfamiliar aspects of the world opened up to you, demonstrating mastery, satisfying curiosity, inhabiting imaginary worlds created by others, and so on. Learning is also the route to more prosaic rewards, like getting into good colleges and getting good jobs. But these rewards are not doing the job. If they were, children would be doing better in school.

Hard to find anything wrong with that paragraph.

The logic of the plan reveals a second assumption that economists make: the more motives the better. Give people two reasons to do something, the thinking goes, and they will be more likely to do it, and they’ll do it better, than if they have only one. Providing some cash won’t disturb the other rewards of learning, rewards that are intrinsic to the process itself. They will only provide a little boost. Mr. Fryer’s reward scheme is intended to add incentives to the ones that already exist.

Ok, you can't see it, but I'm cringing a bit here. I'm not aware of "the more motives the better" as being an assumption that as economists we frequently call upon. Indeed, the canonical economic models reduce everything to one motive (i.e. the maximization of utility or profit). One can, of course, argue that is problematic as well, but let's leave that for another day.

However, when you drill down a bit, you can see a potential objection. A typical model might work something like this. One can derive utility from intrinsic rewards from some activity. One can also derive utility from things you can buy with money (though in the standard model, not from the money itself). If you receive intrinsic and monetary rewards from doing the activity, the standard model would posit no interaction between the intrinsic benefit and the act of receiving a monetary reward and thus more of either (or both) is preferred to less.

Most of the time, this isn't much of a problem. I like what I do for a living. I get intrinsic benefit from it. I also like the fact that someone pays me to do it so that I can buy other things I like. At the margin I would desire to do more of it if (a) my intrinsic benefit went up for some reason or (b) someone paid me more at the margin.

But what if your intrinsic benefit was affected by the very act of being paid for it? Admittedly, our models tend to ignore the possibility. In our defense, I would posit that the vast majority of applications do not exhibit this phenomenon. However, I'm not ready to dismiss it out of hand. Let's get back to the op-ed.

Unfortunately, these assumptions that economists make about human motivation, though intuitive and straightforward, are false. In particular, the idea that adding motives always helps is false. There are circumstances in which adding an incentive competes with other motives and diminishes their impact. Psychologists have known this for more than 30 years.

Well, by that criteria, all our assumptions (and those of all the social sciences) are false. He says that "the idea that adding motives always helps is false." I'll give him that. "There are circumstances in which adding an incentive..." Ok, fine. But do these assumptions lead to misleading answers in a broad set of applications? Schwartz seems to want us to believe that it does. Obviously I disagree. But neither he nor I have said anything conclusive about the problem at hand--paying students for performance in school.

In one experiment, nursery school children were given the opportunity to draw with special markers. After playing, some of the children were given “good player” awards and others were not. Some time later, the markers were reintroduced to the classroom. The researchers kept track of which children used the markers, and they collected the pictures that had been drawn. The youngsters given awards were less likely to draw at all, and drew worse pictures, than those who were not given the awards.

Why did this happen? Children draw because drawing is fun and because it leads to a result: a picture. The rewards of drawing are intrinsic to the activity itself. The “good player” award gives children another reason to draw: to earn a reward. And it matters — children want recognition. But the recognition undermines the fun, so that later, in the absence of a chance to earn an award, the children aren’t interested in drawing.

Similar results have been obtained with adults. When you pay them for doing things they like, they come to like these activities less and will no longer participate in them without a financial incentive. The intrinsic satisfaction of the activities gets “crowded out” by the extrinsic payoff.

It was at this point in reading the article that I came up with the title for this post. But the real question is even more subtle. Would Tiger Woods play more golf than he does now if he was only doing it for fun and there was no financial reward? Probably not. So Tiger Woods appears to be responding in a standard economic way to the incentives, but the children in the study are not. What gives?

An especially striking example of this was reported in a study of Swiss citizens about a decade ago. Switzerland was holding a referendum about where to put nuclear waste dumps. Researchers went door-to-door in two Swiss cantons and asked people if they would accept a dump in their communities. Though people thought such dumps might be dangerous and might decrease property values, 50 percent of those who were asked said they would accept one. People felt responsibility as Swiss citizens. The dumps had to go somewhere, after all.

But when people were asked if they would accept a nuclear waste dump if they were paid a substantial sum each year (equal to about six weeks’ pay for the average worker), a remarkable thing happened. Now, with two reasons to say yes, only about 25 percent of respondents agreed. The offer of cash undermined the motive to be a good citizen.

It is as if, when asked the question, people asked themselves whether they should respond based on considerations of self-interest or considerations of public responsibility. Half of the people in the uncompensated condition of the study thought they should focus on their responsibilities. But the offer of money, in effect, told people that they should consider only their self-interest. And as it turned out, through the lens of self-interest, even six weeks’ pay wasn’t enough.

That is an interesting result, though I would have the standard set of questions about how it was conducted. Taking it at face value, it's as if the people felt differently just because they were offered money for something that they felt like they had some social duty to do.

Hmmm.... Do you think that people would donate more to charity if it was not tax-deductible? I kind of doubt it. People could always choose not to take the deduction, but most still take it. Presumably, the Swiss people in the survey could reject the money, so the implication is that they feel differently just because they were offered the money. Is it conceivable that just because the government offers us a benefit for giving to charity makes me want to do it less? That is a really tough sell.

On the other hand, prostitution might be an example of an activity in which the act of being offered money changes someone's attitude toward the act. So here's where I come down on this: there probably are some situations where adding a monetary incentive changes things dramatically in a nonstandard way. But they will tend tend to be rather rare situations in which there are strong social mores, attitudes, or pressure to conform to some normative behavior. Is this one of those situations? It deserves further analysis.

Obviously, the intrinsic rewards of learning aren’t working in New York’s schools, at least not for a lot of children. It may be that the current state of achievement is low enough that desperate measures are called for, and it’s worth trying anything. And we don’t know whether in this case, motives will complement or compete.

At least he's honest. He hasn't proved anything, nor have I. The real problem is much deeper.

But it is plausible that when students get paid to go to class and show up for tests, they will be even less interested in the work than they would be if no incentives were present. If that happens, the incentive system will make the learning problem worse in the long run, even if it improves achievement in the short run — unless we’re prepared to follow these children through life, giving them a pat on the head, or an M&M or a check every time they learn something new.

Perhaps worse, the plan will distract us from investigating a more pertinent set of questions: why don’t children get intrinsic satisfaction from learning in school, and how can this failing of education be fixed? Virtually all kindergartners are eager to learn. But by fourth grade, many students need to be bribed. What makes our schools so dystopian that they produce this powerful transformation, almost overnight?

At the conclusion of the article, another thought occurs to me, and it's quite obvious once you think about it. At another level, don't grades themselves represent a system of rewards that distract from the intrinsic benefits of learning? What college professor hasn't dealt with students more concerned with grades than with the real learning? In my Utopian ideal, grades wouldn't be necessary either. But in the real world I believe they are. So the real question here is why the current set of incentives is now less effective at promoting learning than it once was? And my one point of agreement with Schwartz is that the payment proposal could very well distract people from answering that question.

But I think that the basic premise that people respond to incentives could turn out to be very important for the analysis of this issue, even if the idea of paying students for performance turned out to be questionable public policy.

On Wednesday, I posted a story on how Iranians are upset about gasoline rationing. A key point which figures into what follows is this quote from the article:

The new rules limit drivers of private cars to 100 liters, or 26 gallons, every month at the subsidized price per liter of 1,000 rials, or 10 cents. Taxicab drivers are limited to 800 liters a month. (Emphasis mine)

So we are to take away from this article that gasoline is offered for sale to Iranian citizens at the price of 10 cents per liter and that this price is the result of a government subsidy. (NOTE: 10 cents per liter would be 38 cents per gallon. However, another article cites it as 42 cents. It depends on how you round your exchange rate and your gallon to liter conversion. I will use 40 cents from this point on.)

One of my frequent commenters, spencer, raises an objection that essentially boils down to this. Is that 40 cents per gallon price really a subsidy if, as a major oil producer, they are able to produce the gasoline for just pennies per gallon? Don't OPEC countries have lower gasoline prices anyway? Is that a subsidy, or just price discrimination (supplying the domestic market at cost before putting the rest of the supply on the world market as an oligopolist)?

First of all, spencer points out that the domestic refining and distribution network in Iran is nationalized. I should have pointed that out, and I am grateful that he reminded us of that fact. So, the question is would they be within their power to produce their domestic supply of gasoline cheaper because they can extract the oil at a cost that is much below the $70/barrel the oil fetches on the world market? Absolutely.

How much cheaper? For that, I refer to this MSNBC analysis piece by Robert Windrem from January with the provocative headline: Are Saudis waging an oil-price war on Iran? The entire article is worth a read, but here's the part that matters for us:

The trader notes that Iran, OPEC’s second largest producer, is “in trouble” both in the short and long term. Iran’s oil reserves, he notes, are declining more rapidly than Saudi Arabia’s and are more difficult to extract. While a barrel of oil costs the Saudis $2-3 to get out of the ground and to market, that same barrel costs Iran as much as $15-18.

“Iran does have some oil that costs them $8-10 but most of it is in that upper range,” he said.

Moreover, Iran has a large domestic market for oil, particularly fuel oil, which Saudi Arabia, with its smaller population and milder climate, does not.

Perhaps more important, because Iran has limited refining capability, it must import more than 40 percent its gasoline, making it the second largest importer of gasoline in the world after the United States, according to the Department of Energy’s Energy Information Agency.

And since Iran sells gasoline at a rate comparable to the rest of the Gulf states — around 33 cents a gallon — it must subsidize the price on a massive scale. In fact, say traders, Iran is paying about $1.50 per gallon to subsidize domestic gasoline consumption — the world market price of gasoline minus the tiny price per gallon — a practice that is costing Iran billions of dollars annually and eating up most of the state-run oil company’s discretionary funds.

Yes. You see, as I said in a follow up comment to spencer on the previous post, Iran imports around half of its gasoline. The world wholesale price for gasoline is in the neighborhood of $2/gallon. Being as charitable as I could to spencer's argument, I allow for the fact that they may be able to negotiate a better deal than the U.S. can. Even so, the half of the gasoline supply that comes from overseas surely must cost them more than 40 cents per gallon. Maybe they're not losing their shirt, but I don't see them breaking even. Today's research on the subject suggests I might not have had to be so charitable. They might be losing their shirt, if Windrem's sources are correct.

So I think we can safely lay to rest the claim that this really isn't a subsidy. If the oil coming out of the ground costs $15/barrel, then the cost of producing a gallon of gasoline probably exceeds 40 cents per gallon. (It is commonly stated that a barrel of oil yields 19.5 gallons of gasoline among other products. If the other products fetch a high enough price, you might break even overall, but I'm not sure this is the case.)

The fact is that Iran is facing a lack of refinery capacity. Welcome to the club. The question is how will they deal with this. If this was more of a competitive market situation, the answer would be that prices would rise, refinery profits would increase, capacity would be added and price would head back down towards marginal cost.

Yeah, that's textbook theory. It doesn't work literally here in the U.S. because there are a lot of frictions caused by imperfect competition, regulation, externalities, etc. It certainly won't happen in a state controlled monopoly situation as Iran has. But are they immune to the forces of the market. Absolutely not.

So spencer writes, "First, refining is a public sector industry so the economics are secondary."

I'd prefer "non-market".

He continues, "Second, Iran has budgeted a doubling of refining capacity."

So they are responding then? In fact, that seems like a no-brainer. Of course, if domestic demand is building, oil extraction costs are going up, and you're losing your shirt paying for imports because your nationalized firm can't satisfy your domestic consumers, then yeah, I'd say it's time to think about expanding that line in the budget.

But this is not going to be easy for them. If you are a company that builds refineries, is Iran a place where you want to be building them right now? If you are the government of Iran, where is the money going to come from? This is what I meant when, in the first post, I said:

...I would suppose that more comprehensive solutions will be politically difficult.

So in the end, I have to take issue with spencer's final comment,

But what it comes down to is standard economic theory has little to do with the issue and refinery profitability is not really an issue.

That's true only if you think that standard economic theory begins and ends with the perfectly competitive model. In that model, profitability is the main issue. The market fixes imbalances by sending signals to expand or contract and to enter or exit.

However, governments can and do contravene the operation of the market. They do this for good or for evil, but regardless of the reason behind it, the effect is to obscure the signals. Nevertheless, the forces are still there, and they ignore them at their peril. In setting a fixed market price for gasoline, Iran has committed the resources of the state to supply its citizens with the gasoline they demand at that price, even if that means the state's resources will be drained away from other uses. This they can do because profitability is not the main issue. Political economy is. However, there are still no free lunches, even for nationalized firms. Now, both market and non-market forces outside of Iran have combined to increase the drain on its treasury caused by its commitment of resources.

They must now make a choice. They could allow it to continue and supply at a price that is below cost. (A private firm that did so would soon find itself bankrupt.) They could make a long term investment in capital to lower the marginal cost of supplying the product to bring it in line with the price. (Just as a private firm might invest in the ability to perform a task "in-house" rather than pay a high market price.) But as I pointed out, this may be easier said than done.

Of course, they could just raise the price--doing by committee what the markets usually do. If they get it right, bravo. If they get it wrong, well...

Or they could renege on their commitment to their citizens and reveal that the gasoline is too expensive to obtain and supply to them at the established price, so they will not be able to have as much as they want at that price. This has been known to make people violently angry.

I know that spencer and probably some of my other readers think that I've never seen a problem that the market can't fix. That's simply not true. I tend to favor market solutions, but readily admit that government intervention is sometimes necessary. I'm not even suggesting that a move to a free market is desirable or even possible for Iran without a lot of other considerations.

No, my message here is simpler. You can obscure the signals of the price system with the stroke of a pen. But escaping the forces of the market is more difficult by orders of magnitude. The rigidity of Iran's price controls have allowed this problem to "slow-cook" for a long time in a way that doesn't happen in a free market. They must now deal with the consequences of their choices.

In his Economic Scene column, Hal Varian links to this study by researchers at UC-Irvine that does a breakdown of the value added throughout the supply chain for the iPod.

I think I'll assign the article in my principles course this fall.

Iran, awash with crude oil, is finding itself short on refinery capacity. The results aren't pretty.

TEHRAN: Angry drivers set fire to some gasoline stations here after the government announced that fuel would be rationed beginning Wednesday.

The government first planned to start the rationing a year ago, but put the decision off repeatedly out of fear that it would lead to unrest. The plan was announced only a few hours before it took effect. State television reported Wednesday that "several gas stations and public places had been attacked by vandals."

...

The new rules limit drivers of private cars to 100 liters, or 26 gallons, every month at the subsidized price per liter of 1,000 rials, or 10 cents. Taxicab drivers are limited to 800 liters a month.

And then there's this...

The government is still considering whether to allow drivers to buy additional fuel at higher prices.

At 10 cents per liter, I can understand why they have issues with low refinery capacity. Even if the crude oil was free, the cost of running the refinery would make it a rather dicey proposition. Since the government subsidizes gasoline to keep the prices low, one would have to expect that only government subsidies will rectify the refinery capacity issue. Meanwhile the economy continues to grow and demand increases. Something has to give.

Allowing additional purchases at a higher price might be warranted as a stop-gap measure. I would suppose that more comprehensive solutions will be politically difficult.

So you want to be first on your block with an iPhone? It'll cost you.

NEW YORK (Reuters) - Apple Inc. said on Tuesday its hotly anticipated iPhone could cost as much as $3,000 with a required two-year service contract, and a handful of eager buyers started lining up to spend their money.

They don't go on sale until Friday. And to be clear, that is $3000 over the life of the two year contract, as the article later explains...

Apple and AT&T on Tuesday outlined three iPhone rate plans that will be available, from $60 per month for the most basic to just under $100 per month for more talk time. AT&T said iPhone customers could also choose other AT&T service plans listed on its Web site.

While that is consistent with other AT&T wireless plans, it adds $1,400 to $2,400 to the cost of what many say is already a steeply priced $500-to-$600 gadget.

Of course, many people already pay $60 for their wireless plan, so using the economist's favorite concept of opportunity cost, it's the $500-$600 for the iPhone itself that is of interest. Still, that is several times what I paid for our family's two phones combined. (Our monthly rate is comparable to theirs, but again, that's for two phones.)

The story wouldn't be complete without this...

Not only Apple and AT&T are hoping to profit on the iPhone phenomenon. Advertisements on the New York and San Francisco online message boards at Craigslist.org solicited payment for waiting on line to buy an iPhone.

One listing from a self-professed "professional waiter" offered to stand on line for a fee of $100 per eight hours wait. The person will throw in delivery for an extra $50.

One wonders just how high Apple could have pushed up the price for this initial release. There is one certainty however. In a few months, there will be a better model that will be released at about the same price and this one will be sold at a discount. For tech products like this, there is most certainly a dynamic form of price discrimination partly due to the nature of quality improvement and innovation over time and partly due to calculated profit maximizing behavior. The effect is to segment the market into the patient and the impatient.

UPDATE: Felix Salmon thinks they are cheap. Yes, I think they could have gone higher. But on the other hand, as they come out with better models, they may be intending to stick with the $500-$600 price for the top shelf model for some time which will capture a moderate amount of consumer's surplus at each stage of product evolution rather than try to squeeze out too much in the first round. Just a thought.

Oh, and via Wired, we read that the iPhone will be sold in a box just like the iPod and you'll set it all up through iTunes.

Customers will choose their AT&T voice and data plans through iTunes, while iTunes is transferring songs and video files to the iPhone (and iSync or Outlook is copying contacts and calendars). The phone will be activated remotely over the cell network.

"It will go much, much faster than the normal process of buying a cell phone," Allen said. "Apple has a reputation for streamlining the customer experience. I'm sure there's not going to be any box opening in the store. That's such an important part of the process of getting an Apple product."

Because Apple won't be opening boxes in the stores, Allen said buying an iPhone on Friday -- when big crowds are expected -- might be faster at Apple stores than at AT&T stores.

Roll the tape.... On May 10, I wrote:

Of course, the Balkanization of the U.S. gasoline market into geographic regions with different fuel requirements contributes to the market power of the remaining refineries in different geographic regions. If the U.S. gasoline market was really one large market with 142 refineries, would it be profitable for a firm (probably an existing one) to build a new refinery? Talk about a "good question"... that's the one they should have asked.

I was referring to this article from WCCO (Minneapolis).

Anyway, Don at Cafe Hayek today spotlights this paper by Andy Morriss that is apropos to the question. Here is the abstract:

Rising gasoline prices have brought energy issues back to the forefront of public policy debates. Gasoline markets today are the result of almost a hundred years of conflicting regulatory policies, which have left them dangerously fragmented. In this article, I analyze that regulatory history, highlighting the unintended consequences of regulation that have pushed the United States into a series of loosely connected regional markets rather than a broad, deep national market. This fragmentation leaves the American economy is vulnerable to natural disasters, terrorist attacks, and foreign dictators in ways that it need not be. It also produces higher prices for consumers and reduced innovation by refiners.

I intend to read this paper with great interest.

UPDATE: I have now read the paper. Frequent commenter "spencer" takes me to task and I respond in the comments.

The NY Times reports on one of the traveler's perennial annoyances--overbooking. From the article, here's a statistic that, if true, is quite remarkable.

US Airways had revenue of $11.56 billion last year and would have lost out on $1 billion or more of that had it not overbooked, the company said.

The article does not mention the sort of situation that I recently came upon. For one reason or another, my flight got moved to another gate. I believe it was because the aircraft on which we were scheduled to depart had not yet arrived. This meant that we would be departing on an aircraft that was originally intended for another destination.

The problem was that the aircraft was already fueled for that destination which was quite a bit further away.

Since this was a commuter airplane (Saab 340 for those who would recognize that), weight and balance is more of a factor. The extra fuel put us over the desired weight. We all boarded the plane, but after they weighed it, they asked for a couple of volunteers to leave and fly the next day. Enough folks took the bait, and they weighed us again. We were still overweight so they asked for more volunteers.

At that point, it occurred to them that they should just wait until the bags of the bumped passengers were removed as well and weigh us again. This they did, and no others needed to be bumped.

Unfortunately, cases like that do not fit neatly into their computer model.

In a global marketplace, U.S. energy policy has effects on the Mexican agricultural markets. With higher demand for corn due to increased ethanol production, Mexican farmers are choosing to plant corn rather than agave.

MEXICO CITY - Mexican farmers are setting ablaze fields of blue agave, the cactus-like plant used to make the fiery spirit tequila, and resowing the land with corn as soaring U.S. ethanol demand pushes up prices.

The switch to corn will contribute to an expected scarcity of agave in coming years, with officials predicting that farmers will plant between 25 percent and 35 percent less agave this year to turn the land over to corn.

"Those growers are going after what pays best now," said Ismael Vicente Ramirez, head of agriculture at Mexico's Tequila Regulatory Council.

More at MSNBC.

Daniel Gross looks at the bottom lines of some steakhouses and ponders what it means for the broader economy.

Via Slate.

When the Post Office introduced the "forever stamp", the first question on many people's minds was whether this would be a good investment. Should they buy a bundle and save them up for the next time rates go up? Of course, the economist in me figured that if such a strategy would benefit postal customers, it would be unlikely that the Post Office would offer the new stamp. Indeed, the reverse should be true. The fact that the post office is offering the forever stamp suggests that it's a good deal for the Post Office, not for you.

So should you invest in the "forever stamp"?

No. Not as payment for mail services. Slate explains why.

Not being a stamp collector, I can't say whether it would be a good investment from a philatelist's point of view. But my guess is that there will be a lot of them out there, so the scarcity value should not be great. I suppose, however, that I would want a first day cover if I was a serious collector. I'll probably buy a couple to put away for a while and drag them out in twenty years to show to my classes and to my kids. I might even order a first day postmark for the novelty and historical value of it, but that's about it.

UPDATE: ErikR makes a comment that allows me to elaborate on something that the Slate article misses.

This post is really just part III in a discussion of free markets on this blog. If you haven't yet, you might want to read the first two parts, with the comments to the second one. (Part I) (Part II)

Discussion with cactus (of Angry Bear) and others in the comments to my second post has been vigorous. To summarize, cactus's first question was why you don't see on-line markets or communities that operate without any rules (other than U.S. law). That is, why do discussion boards need monitors. Why does EBay have so many policies? And so forth.

That question is fairly easy to deal with because community rules, whether they are written down or simply part of the ethical custom of a group of people are not really regulations or laws. These are private entities with their own goals, objectives, expectations, etc. As such, they can set the house rules for people who want to participate. The fact that different entities exist with different policies (such as the contrast between EBay and Craigslist) means that in fact a vibrant market exists for these different systems. Some people choose one; some choose the other. Far from being a puzzle, this is what one would expect in a relatively free market for on-line communities. When you choose which community to use to sell your old futon, you are choosing what set of rules will govern your activity.

Later, cactus asks why these on-line communities (or indeed any marketplace, stock exchange, or the like) operate in the U.S. when they could go off-shore to avoid the burdensome regulations and laws of the U.S. government?

This is an obvious challenge to the "free market" position. If operating off-shore is a viable option, why isn't it more common? There must be some benefits to operating under U.S. law. If so, this looks like a victory for cactus's side--maybe we need those laws after all.

Not so fast. There are firms that locate off-shore away from U.S. laws. One of the best known categories of these firms would be gambling sites. So the question really is: why do gambling sites go off-shore while others remain subject to U.S. law?

One determining factor may be the amount of interaction you expect to have with the U.S. legal and financial systems. If you want to go public on a U.S. stock exchange, you will need to file papers with the SEC. You might as well just stay on-shore. If you want the protection of the U.S. court system in the event of a dispute with customers or vendors, you might as well stay in the U.S.. Gambling sites probably aren't looking to go public on the NYSE, and for the type of business they do, perhaps the advantages conferred by the U.S. court system are minimal. By the same token, there are compelling tax and regulatory reasons for them to leave. So kiss them good-bye.

Consider this related question: why do so many firms incorporate in Delaware? It started with certain favorable laws. But today an equally compelling reason is the network externalities that come from being part of that system. There are many corporations incorporated in Delaware. That means there are a lot of corporate lawyers. It also means that the state court system has a lot of case law related to corporations. In a sense, the state of Delaware specialized in the types of legal services that make things hospitable for corporations. Because of the history of corporations in Delaware, this equilibrium could probably sustain itself even if the laws of the state became marginally less favorable. There are so many other good reasons to be there.

The same is undoubtedly true for the U.S. as a whole. The usual set of complaints aside, the American legal system has a fairly sizable set of benefits, by virtue of its history of case law, the availability of quality legal advice, and the advantages of coordinating with other agents in that system. In other words, it's not that the various regulations affecting business do not have a cost--they do; and if a firm could get around those costly regulations, they would. But doing so also means turning their back on a valuable network of ancillary benefits. The more important those benefits to the firm, the more likely the firm accepts the cost of staying under the authority of U.S. law.

This could still be true even if it is technically possible for the firm to have access to U.S. capital markets or U.S. courts even while located off-shore. To maintain that access, the firm will have to subject itself to certain laws and regulations. The only reason to locate off-shore is to escape regulation of your activities that don't involve U.S. capital markets or courts. As cactus put it in a comment at Angry Bear discussing what activities are subject to U.S. regulation:

Ford's tapping of the American bond fund market, yes. Ford's activities in Brazil, no.

I would venture that a firm like EBay would have more interactions with American entities than with entities in an off-shore location where they might alternatively locate. So why bother? The comparison to Ford in Brazil is not very apt. Ford goes to Brazil to sell cars to Brazilians. That's a whole other question from where this started.

Gambling sites interact mainly by taking your money in exchange for offering you the privilege of playing games of chance and strategy. They don't need a network of lawyers and bankers to give them access to American legal and financial institutions. For them, the regulatory burden is much worse than the benefit those institutions confer.

Let me finish with a response to a comment from cactus:

...I did suggest that EBay could write its own rules - rules better designed to facilitate things for itself and its users. I also suggested they could write those rules and operate under them at what is to them a very low cost, and thus avoid all the superfluous US laws completely.

The fact that it doesn't is a sign that these useless laws and regulations (i.e., those that exist in the US body of law, but that if EBay were to list its needs from scratch, it would not include) clearly have attached to them some value.

They do write their own rules. Potential customers choose among communities with different rules. This was covered earlier in this post. This is entirely compatible with the free market position.

But could they go off-shore and write their own rules, operate under them, and do better? Not necessarily, for reasons detailed above. They can write their own rules for their community (i.e. policies that tell buyers and sellers how to interact in the community), but they cannot compel other entities outside that community to live under those rules. To the extent that they interact with agents in the U.S. legal and financial system, they have to abide by U.S. rules for those interactions anyway. Furthermore, there may be important network effects that could add to the incentive to remain in the U.S. system.

I find it quite plausible that for all but the simplest transactions (such as taking your money to play an on-line game of chance), the protection and standardization of the Uniform Commercial Code is a pretty good reason to stay in the U.S. legal system. As an aside to illustrate the value of coordination, keep in mind that laws relating to business are mostly state laws, but most states (with the exception of Louisiana because of their heritage of French civil law as opposed to English common law) have standardized (with some exceptions) a set of fairly simple laws mostly relating to sales and methods of payment. As a pragmatic free marketer, I see little reason to try to reinvent that wheel. The benefits from coordination on that set of laws are quite compelling.

And so in conclusion, it is not a fair question to ask why a given firm chooses not to locate in a low regulation or zero regulation environment when its competitors and the entities with which it interacts are located in an established but more regulated financial and legal system. The advantages are not the regulations themselves, but the institutions that have evolved to deal with them (case law, legal advice, etc.). Things would look very different if you started with a tabula rasa. However, given the current environment, relatively few firms would voluntarily step outside the established system if they would have to interact with agents remaining in the established system.

A pragmatic free marketer can come up with several reasons why a given firm would choose to remain in a regulatory environment. Thus it can be consistent to believe that a national economy could benefit from less (but perhaps not zero) regulation even though the firms chose to locate there rather than in lower regulation countries. Other costs and benefits besides simply the direct costs and benefits of the regulations must be considered.

The NY Times editorial staff has a slow day...

The State of Washington is looking out for students and their families by passing a law requiring textbook companies to disclose prices and other relevant information when they market books to college professors in the state. Lawmakers hope that professors who learn the costs upfront will opt for reasonably priced textbooks that cash-strapped students can afford.

This law, along with similar measures pending in several other states, is a response to intense lobbying by student groups, who have complained for years about the bankrupting cost of college textbooks. A 2005 study by the Government Accountability Office found that book costs had nearly tripled over some two decades, thanks in part to pricey but marginally useful CD-ROMs and instructional supplements, as well as the constant issuing of lucrative but little changed new editions — publishing’s version of planned obsolescence.

Of course, no student wants to spend more than absolutely necessary on books. We complained about it when I was a student. It is part of the order of things. But it is true that prices of textbooks have gone up faster than the rate of inflation. I paid roughly $50 for a calculus text (new) in 1990. I think my intermediate macro text in 1992 was around $50 (also new). I pile of used books for a history or philosophy course could generally be had for under $50. My campus job paid minimum wage ($3.95 in 1990 as a freshman in Minnesota). Ignoring taxes, a calculus book took me roughly 12.5 hours to work off. Call it 14 hours once taxes are added in.

Today, comparable books are in the $100-$150 range. Currently at the Illinois minimum wage of $6.50, a $150 book will take about 23 hours to pay off. When students arrive on the campus of WIU in the fall, the minimum wage will be $7.50 and they will need to work 3 fewer hours to pay for that book. More than I had to do, but in the cost/benefit calculus of a college education, still small potatoes.

This is especially true when you consider that you generally do get something back when you sell the book at the end of the semester. I think most students get back approximately 1/2 of the used book price. Hence the number of hours of labor needed to pay for a used calculus book after netting out the resale value is almost certainly in the single digits. Over the course of a 15 week semester, it's less than an hour per week. Yes, it adds up, but not exactly "bankrupting".

But a lot of people think that we need a law. Would it help if publishers were required include the student prices in the marketing materials they send to us professors? I doubt it. Most of us know the average cost of textbooks in our field anyway. Is a marginal $5 or $10 difference in the student price going to cause us to choose one book or another? Probably not. More importantly, is a marginal difference in student price something that should cause us to choose one book over another? If I choose a textbook based on the fact that the style of presentation is similar to my own presentation style for that material (such compatibility has benefits for the student), should I feel guilty for making them pay an extra $10? What is the purpose of the law if not to make professors feel guilty? Is this where the attention needs to be focused?

Now would be a good time to hoist a paragraph from the archives. Almost a year ago, the NY Times ran an editorial on the same topic. I speculated on how the availability of free or low cost alternative texts might affect the market. I stand behind my prediction.

I predict that textbook prices will continue to outpace inflation. There are alternatives to the traditional textbooks. Preston McAfee and Roger McCain are two notable examples of freely available on-line texts in economic principles. The change is slow in coming, but it is happening. But there is another side to this development. There will, I think, always be a substantial market for traditional texts. As some professors leave the market for freely available texts, that leaves a more inelastic demand curve facing the publishers. The effect on the revenues of the publishers will necessarily depend on how many customers leave the market and how much they are able to recoup with price increases. But if, as I suspect, those professors most likely to use the free texts are those who are most price sensitive (on their students' behalf), we should see textbook prices continue to rise.

(Click here for Part I)

These two posts by cactus at Angry Bear, together with the comments following them, illustrate precisely how phrase and the concept of "free markets" can be misused and twisted.

Let us be clear about what he is suggesting. As I see it, his story is something like this. (A) Right-wingers, libertarians, and free marketers want as little regulation as possible. (B) The Internet makes it easy to set up a truly free market with no regulations beyond what government imposes. In fact, by locating off-shore, it could even circumvent the government's regulations. (C) Such truly free markets are hard to find. Even a market oriented site like EBay is far from free, imposing a variety of its own rules. (B) and (C) imply that the free market utopia of (A) must not work in practice or someone would be doing it. Thus, the free marketers must be wrong. True freedom is an impossible dream.

To his credit, cactus does not go as far overboard as some people I've heard over the years in identifying anyone who wants less regulation, less government interference, or more freedom with a "greed is good" mentality (remember Gordon Gecko?) that in the extreme borders on anarchy. But as I read his words, it dredges up memories of those arguments; he is treading close to that territory.

This is an extremely easy argument to counter. Anarchy is not freedom. The ideal of a perfectly competitive market is not achieved by removing all vestiges of government regulation, the rule of law, or social custom. Indeed, most markets are imperfect and require a modest amount of regulation Likewise, the role of law and custom cannot be ignored.

It is blatantly unfair and misleading to suggest that economists or others who frequently appeal to the benefits of free markets, competition, and the profit motive will never be satisfied until all regulations are removed. To suggest that conservatives put up (start an off-shore competitor of EBay where anything goes) or shut up is to make the very same suggestion.

Milton Friedman himself argued that businesses need to "stay within the rules of the game" and engage in "open and free competition without deception or fraud." He also wrote that businesses must conform to the "basic rules of the society, both those embodied in law and those embodied in ethical custom."

Certainly Friedman also argued that the rules of the game should be less restricting than they typically are in practice. Yet property rights must be protected within the rules of the game. There must be an avenue for holding accountable those who would seek to profit through dishonest practices.

And what about ethical and social customs? These end up being reflected in the kinds of regulations, rules, and policies that we impose on ourselves. Pause and consider for a moment the importance of reputation. In the canonical model of perfect competition (supply and demand) reputation does not enter into the discussion. It is assumed that there is perfect information, goods are homogeneous, etc. In real world markets, quality varies across firms and sometimes the person on the other side of the transaction has something to hide. All of a sudden, reputation, and indeed, TRUST is of vital importance. Why should it be surprising that institutions would develop with the expressed purpose of fostering trust (seals of approval, rating systems, Better Business Bureaus, etc.)? In financial markets we have a variety of regulations aimed at fostering trust. EBay allows buyers and seller to give feedback on each other that determines their reputation. Are these antithetical to true free market capitalism? Absolutely not.

Indeed, the oft derided "free market" economists often suggest that these self-imposed, evolutionary, reputation based constraints may yield better outcomes than government interference that is top-down, rigid, and often has unintended consequences as profit seeking agents look for ways around the regulation. That's a far cry from wanting an environment where anything goes.

Easily justifiable reasons for government intervention in specific markets would include the imposition of taxes to correct externalities and providing information and verification to market participants that would be too costly for private agents to obtain themselves (e.g. examining banks to certify to the public that they are solvent).

So where are the free markets? Where you have homogeneous goods, no externalities, no information asymmetry, basic rule of law and property rights, there you might find something that approaches the ideal. EBay is not a good candidate. A small town "farmer's market" is a better one. Such things exist, but on the scale of value added to the economy at large, such things are rather insignificant. Most of the value is created in markets that are not as free. Many of those markets could stand to be freer, but few should be totally unfettered. Most certainly, these markets embody many social and ethical customs without which they would self-destruct in a blaze of "greed is good" glory.

Is cactus suggesting that a "true believer" must eschew those customs for the ideal of "free" markets? How short-sighted that would be.

I'm not a fan of the phrase "free markets". It's not the markets that are or are not free. It's the people. True freedom, whether in a market setting or in other aspects of daily life, does not imply the absence of external and internal checks on our behavior. Free individuals acting in a prudent manner subject to the rule of law and social norms are the key to the market system. When on occasion, for reasons well-known to economists, markets fail them, they can turn to the government.

When the government fails them, to whom do they turn?

Let me begin this post in a manner that you probably wouldn't expect. I am not a fan of the phrase "free market".

Out of curiosity, I did a search of my own blog to see how many times I have used the phrase. (I didn't search all variants--you'll get the picture from just this simple search.) I have used the phrase three times in my own writing and once in a quote--not counting the times it will appear in this post. Two of those were in posts about yuan revaluation and whether the Chinese currency market should be freer. Since the blog is almost three years old, that's a rate of about once a year. Like I said, I'm not crazy about the phrase.

The reason I don't like the phrase "free market" is its meaning has been twisted in the vernacular to the point of it being either a derogatory term or a throwaway phrase from people who aren't careful about what they mean.

But I love the word "market". Markets come in a wide array of forms and serve a variety of functions in the modern world. Some are more regulated; some less regulated. Sometimes those regulations are for good reason; sometimes not. You might say that some markets are freer than others, but I would prefer to employ richer, more descriptive language.

In my opinion, one of the most egregious abuses of the term "free market" is to use it to set up a straw man. Unfortunately, that is what "cactus" at Angry Bear has done in a pair of recent posts. (The first post)

Most of us believe in the same things... we believe that there should be markets, for instance. However, we disagree about the degree of government regulation of those markets. A strict libertarian might feel that there should be zero regulation, but I imagine there aren't that many of those. As a general rule, therefore, I would imagine those on the left will generally want more government regulation of markets than those on the right. The idea, for those on the left, is to reduce externalities, deal with asymmetric information, etc. For those on the right, the market itself will deal with that.

The last two sentences puzzle me. Any economist that I know recognizes externalities, asymmetric information, and a host of other problems as causes of market failure. To suggest that any economist, right-wing or otherwise, would claim that the market itself will fix a market failure is nonsensical. These are the reasons that the broad majority of economists would give as reasons for government intervention, though we may differ on what constitutes these problems or whether a given case is serious enough to risk putting an imperfect government in charge of fixing it. Those are subtle and deep questions that cactus is painting with a very broad brush.

Is it possible that he was referring to the non-economist right-wing? Maybe. But he is going after people on the right who stand up for less regulation and so forth. Most people who speak out publicly on such things have some training in basic (supply and demand) economics. Admittedly, the quality of the economic reasoning coming from those quarters is of very high variance, but that's a story for another day. Also, his use of the pronoun "us" is clearly referring to him and his readers--many of whom are economists, and most have more than a passing interest.

He concludes the first post,

Which raises the question... where are the places on the net for the true believers? The ones which recognize that the government already has sooooooo many laws and rules that adding any more is superfluous. Where are those marketplaces (of goods and ideas) online where we can see the ideal of the right and the libertarians of no rules and regulations (over and above what the government already imposes)?

A discussion in the comments (49 at this count) ensues in which the phrase "free market" is used repeatedly to describe this "anything goes" sort of environment as if that is the capitalist ideal. All of this inspires him to refine his thoughts in his second post on the subject. Getting right to the bottom line...

Put another way... it is relatively simple and inexpensive to set up whatever is the ideal conservative and/or libertarian marketplace, be it in goods, services, shares of stock, or whatever. Complete with buyer beware, no pesky government interference (either regulation or protection), and the like. And given the large number of believers, presumably there would be no lack of buyers and sellers to flock to those relatively regulation-less markets.

So where are these markets?

The straw man is now fully in view. Have you spotted it yet?

This post is already fairly lengthy, and there is no way to give a short response to this. So I invite you to join me in Part II for my response.

Bill Conerly points out that focusing on the average can be misleading. While averages can give you a nice snapshot of the situation, basing management decisions on averages (such as average profit per worker) or other faulty metrics can lead to companies doing, as Conerly puts it, "pretty stupid things." I totally agree.

Case in point (from the Peoria Journal-Star)

By a unanimous vote this week, the [Deer Creek, IL] Village Board decided to ask AmerenCILCO to remove 18 street lights and poles. It is part of an effort to combat rising electric costs.

"When your bill almost triples in a month, you have to figure out what you can do," Village Clerk Lori Lewis said.

Deer Creek is a small town a couple hours from here. This reduces the number of streetlights in the town from 51 to 33. People respond to incentives.

Roll the tape.... from Tuesday:

...I would be wary of a government managed plan for universal broadband access. My fear would be that they would adopt a 20th century solution to a 21st century problem.

Broadband technology (particularly the new wireless broadband) is still evolving. Once you make it a government program, you introduce a lot of rigidity. Better to keep some flexibility until we see which technology is superior. We can, I believe, afford to do that in this case because wireless is a low fixed cost operation compared to high fixed cost utilities such as the electrical grid, the copper wire laid down by Ma Bell, and even cable TV. There will be competition just as there is for wireless phone service--speaking of an industry that went from high class luxury to practically universal access in about a decade.

Friday's Wall Street Journal editorial has this to say:

Much of this [telecommunications sector] growth has been fueled by increased broadband deployment, which makes high-speed Internet services possible. The latest government data show that broadband connections increased by 26% in the first six months of 2006 and by 52% for the full year ending in June 2006.

Also noteworthy, notes telecom analyst Scott Cleland of the Precursor Group, is that of the 11 million broadband additions in the first half of last year, 15% were cable modems, 23% were digital-subscriber lines (DSL) and 58% were of the wireless variety. Between June 2005 and June 2006, wireless broadband subscriptions grew to 11 million from 380,000.

This gives the lie to claims that some sort of cable/DSL duopoly has hampered competition among broadband providers and limited consumer options. That's the charge of those who want "network neutrality" rules that would allow the government to dictate what companies like Verizon and AT&T can charge users of their networks. But the reality is that the telecom industry has taken advantage of this deregulatory environment to provide consumers with more choices at lower prices. Verizon's capital investments since 2000 exceed $100 billion, and such competitors as Cingular, T-Mobile and Sprint are following suit. So are the cable companies.

Memo to Congress: Don't mess this up.

So I just finish telling my class about Zimbabwe last week and now there's this: (Miami Herald)

CARACAS - Meat cuts vanished from Venezuelan supermarkets this week, leaving only unsavory bits like chicken feet, while costly artificial sweeteners have increasingly replaced sugar, and many staples sell far above government-fixed prices.

President Hugo Chávez's administration blames the food supply problems on speculators, but industry officials say government price controls that strangle profits are responsible.

Such shortages have sporadically appeared with items from milk to coffee since early 2003, when Chávez began regulating prices for 400 basic products as a way to counter inflation and protect the poor.

Yet inflation has soared to an accumulated 78 percent in the last four years in an economy awash in petrodollars, and food prices have increased particularly swiftly, creating a widening discrepancy between official prices and the true cost of getting goods to market in Venezuela.

''Shortages have increased significantly as well as violations of price controls,'' Central Bank director Domingo Maza Zavala told Unión Radio on Thursday. ``The difference between real market prices and controlled prices is very high.''

So here we have price controls leading to shortages and black markets. Who does the government blame? Speculators--that is, people who manage to get the goods cheaply and hold out for higher prices. Talk about predictable.

Hat tip to Phil Miller, who says,

It's an excellent example of someone trying to fight the invisible hand and the invisible hand fighting back.

Indeed.

Michael Mandel responds with a comment on his blog that reveals the point he really wants to make.

But I'm just wondering whether "constrained optimization" or scarcity is really the most useful or interesting angle to approach economics with. Right now I have access to far more information, at a zero marginal money price, than I can ever consume (trust me...we in the MSM are living with the flip side of this right now). I could in theory set this up as a constrained optimization problem--time spent online versus time spent working. But solving the constrained optimization problem never would have shown me that blogging, say, or wikipedia, would be useful ways of organizing the flood of information.

Now we're getting somewhere. The textbooks of economics have not caught up with this. He is talking about the economics of information. This is in part a story of increasing returns (along the lines of David Warsh's Knowledge and the Wealth of Nations). This is about division of labor being limited by the extent of the market. And the internet suddenly make the market bigger--hence, blogging and Wikipedia, and so forth. The result is an incredible expansion of information "goods" and a seemingly limitless supply of said information. Some of it worth paying for (in money and time), some of it not (and some of it worth paying for, but offered free of charge...only costing you the time it takes to read it). Hence the market for news/blog aggregators. Hence the value of having someone or something sift and organize the wealth of information. Scarcity is ultimately still there, but not in its 19th century diminishing returns industrial form.

That's the stuff. Let's shift the discussion in that direction. I need to be somewhere in 10 minutes. More later.

UPDATE: Ok. It was not obvious from Mandel's proposed definition that this was what he had in mind. But given his position in the MSM, I can see where he is coming from. However, while the cost of transmitting knowledge has decreased dramatically, this does not eliminate the problem of scarcity--even from markets where such knowledge is traded. The basic tools of economics do not need to be thrown out. Issues of market power become more important. Pricing decisions and intellectual property rights are pushed to the fore.

Here's an example. Suppose you run a web site with free and premium content. The decision about what to make free and what to put behind the subscription wall and what price to charge is one that requires solid economic logic. It's still a profit maximization problem--as surely as for a manufacturer of widgets. But the cost structure is different. Network effects must be addressed. The key determining factor in your decision is going to be what kind of value you provide for the customer. Through your pricing strategy, you try to capture some of that value. (Elasticity of demand matters!) The firm in the knowledge economy wants to know how to provide value, how much of its product to license publicly vs. keep proprietary, and how to effectively segment the market and practice price discrimination. New uses for old tools.

So we are talking about pricing decisions in the presence of very low marginal costs of production--not exactly an area which hinges explicitly on scarcity. However, scarcity is lurking not far away. Think about the way in which a content provider has to think about marketing itself. Mr. Mandel's time is scarce. An information producer has to figure out the best way to get itself in front of his eyeballs--otherwise it's a tree falling in the forest with no one around to hear it. Positioning itself on scarce advertising real estate, exploiting network economies ("such-and-such links to it on his blog..."), and setting its pricing strategy all come together to determine whether the venture is a success. Scarcity and choice are clearly part of what is going on.

But it's not the Malthusian, diminishing returns sort of scarcity that most people associate with the word (and with economics in general). So, in that sense, I understand why he would want to downplay it. Indeed, as I said in the previous post, I do not include the word "scarcity" in my one sentence definition even though I thoroughly address it in my classes.

And since the story can be told quite well by applying the old tools in new ways, I don't see any reason to radically change the definition of economics. However, I do hope that textbooks can catch up and tell the story of innovation and pricing with high fixed costs and low marginal costs. (There are some specialized texts that are starting to, but it hasn't filtered down all the way.) That would be an improvement.

Political Calculations has a tool to calculate the annualized percentage change in the S&P 500 with or without dividend reinvestment and, if you like, adjusted for inflation. Very nice.

Hat tip: Newmark's Door

This month's fedgazette from the Minneapolis Fed features poverty as its theme. There are a number of interesting articles that are worth your attention. In this post, I call your attention to one in particular on income mobility--the ability of individuals and households to move through the income distribution over time.

Income mobility is one of those things that we like to talk about and make claims about. We like to hear stories of "rags to riches", but how often does it really happen? It turns out that we understand relatively little about mobility from a statistical standpoint. Ronald Wirtz writes in the fedgazette article,

Bhashkar Mazumder, an economist at the Federal Reserve Bank of Chicago, has authored several mobility studies in recent years. He said, also via e-mail, that prevailing mobility research throws water on the common notion that U.S. income is highly mobile and more mobile than other countries. More recent studies, like his own, have used much richer longitudinal data that track income over longer periods of time, giving a more accurate reading of lifetime incomes in the United States. Research over the past decade and a half shows that “mobility is relatively low in the U.S. and lower than we thought,” said Mazumder.

...

Nathan Grawe has also done research on income mobility as an economics professor at Carleton College in Minnesota. In his estimation, the four best studies done to date on intergenerational mobility have both positive and negative findings, and most results were not statistically significant; in other words, the findings aren't particularly trustworthy. “All told,” Grawe said via e-mail, “I'd say we have no evidence of change.”

Part of the problem is that studies done before about 1990—which generally concluded that the United States had high mobility—are widely discredited today as faulty, mostly because they relied on very small windows of income data, often just a few years or less. In 1992, Solon published one of the first papers suggesting that U.S. mobility was not as high as everyone thought.

Mazumder's research comes to the same conclusion. But his most recent effort with Daniel Aaronson (also of the Chicago Fed) might have something of a silver lining. They found that current mobility might simply be returning to its historical trend line after experiencing an uptick in the 1970s. In other words, mobility might be worse compared to the 1970s, but it might well be in line with the country's historical average.

Obviously, a lack of longitudinal data going way back will remain a problem. Maybe in fifty years we'll be able to put the current period in historical perspective. Too long for some. You know what Keynes said about the long run. While the evidence here is conflicting and the conclusions not quite conclusive, the situation is better than that concerning the question of how much mobility is optimal.

The notion of perfect mobility—an equal chance for any outcome, regardless of where you start—has a hint of social and economic chaos, by virtue of the fact that it implies a lack of predictability in outcomes regardless of the very things that families and societies tend to value: effort, ability, education and other human capital investment, and parenting.

Economists believe incentives motivate behavior. Grawe, from Carleton College, noted that mobility research was often written “in ways which suggest more mobility is better.” But a society with no obvious determinants for income “would clearly have all sorts of incentive problems.”

For example, parents' attempts to offer certain advantages to their kids—reading to them, sending them to better schools, saving for college, transmitting certain values—might be for naught in a world where these things have no lasting economic effect. In a 2002 working paper on the notion of perfect mobility, sociologist Adam Swift of the University of Oxford wrote, “Even those that regard current mobility patterns as evidence of morally unacceptable unfairness should acknowledge that some mechanisms by which parents transmit advantage—or disadvantage—to their children are unobjectionable and would exist even in an altogether just society.”

In other words, there is no clear guidance at all on how much mobility is optimal or even what we mean by optimal mobility. One cannot escape the fact that mobility requires an appeal to long run incentives, but people do not always behave in accordance with those long run incentives. Hence, a divergence between opportunity and outcomes is assured. This is the world in which we live. And this is why the solution to the problem of income inequality is more difficult than many people realize.

Robert Frank considers the relation between economic growth and happiness in today's NY Times

Does money buy happiness? The rapidly expanding literature on what determines “subjective well-being” appears to suggest a negative answer to this timeless question. Studies consistently find, for example, that when the incomes of everyone in a community grow over time, conventional measures of well-being show little change.

Many critics of economic growth interpret this finding to imply that continued economic growth should no longer be a policy goal in developed countries. They argue that if money buys happiness, it is relative, not absolute, income that matters. As incomes grow, people quickly adapt to their new circumstances, showing no enduring gains in measured happiness. Growth makes the poor happier in low-income countries, critics concede, but not in developed countries, where those at the bottom continue to experience relative deprivation.

All true. But these statements do not imply that economic growth no longer matters in wealthy countries. The reason, in a nutshell, is that happiness and welfare, though related, are very different things. Growth enables us to expand medical research and other activities that clearly enhance human welfare but have little effect on measured happiness levels.

Interpersonal utility comparisons are tricky, to say the least. Later in the article...

Since life is a continuing competitive struggle, this is as it should be. Accident victims who can recover their psychological footing quickly will function more effectively in their new circumstances than those who dwell unhappily on their misfortune. Windfall recipients who quickly recover their hunger for more will compete more effectively than those who linger in complacent euphoria.

...

These observations highlight the weakness of subjective well-being as a metric of welfare. The fact that people adapt quickly to new circumstances, good or bad, is just a design feature of the brain’s motivational system. The fact that a paraplegic may continue to be happy does not imply that his condition has not reduced his welfare. Indeed, many well-adjusted paraplegics report that they would undergo surgery entailing substantial risk of death if doing so promised to restore their mobility. Similarly, the fact that people may adapt quickly to higher incomes says nothing about whether economic growth makes them better off.

Critics of economic growth cite its threat to the planet’s survival. Yet it is not growth per se that threatens, but rather certain kinds of growth. Driving more S.U.V.’s causes harm, but taking more piano lessons does not. Any country with a government not beholden to corporate interests could easily curb environmentally harmful activities through taxation and regulation, redirecting spending toward things that really matter. Across developed countries, higher growth rates are actually associated with cleaner environments, not dirtier ones. The United States is the world’s largest emitter of greenhouse gases not because of its wealth but in spite of it.

Frank is angling for membership in Greg Mankiw's Pigou Club.

But growth’s most compelling promise is continuing progress against premature death, perhaps the most devastating of life’s tragedies. American families with five children in 1800 often saw two or three of them die before the age of 10. That this no longer happens has been a landmark achievement.

Intelligently managed growth will hasten our quest to defeat diseases that continue to strike people down in the prime of life. The mere fact that rising incomes do not bolster self-assessed happiness levels is no reason to abandon this quest.

It certainly is true that progress against premature death is one of the most important results of modern economic growth. But I have to ask if that was a result of intelligently managed growth or just plain growth. Intelligently managed growth sounds a bit too much like social engineering for my tastes. Of course there are limits to what an author can do in one short op-ed column. However, I wish Frank was a little more forthcoming about what he means by "intelligently managed." I wouldn't exactly say that the present growth picture qualifies as intelligently managed. What is the scope of the policies that would make our future growth intelligently managed.

I enjoy Frank's writing, and I certainly am in his camp in praising modern economic growth for what it has done for human welfare even if it doesn't show up in happiness studies. But the end of this column is a little hard for me to swallow. Who will manage the growth? What social welfare function will they maximize? Pigouvian taxes to correct well-defined, measurable externalities are one thing. Intelligently managed growth that taxes some activities and subsidizes others without reference to a specific market failure is quite another.

We'll come back to the price gouging discussion another time. But that episode does remind me that there are so many interesting questions involving basic economics that can generate a lot of interesting discussion.

One difficulty in writing for a general audience (including blogging) is that basic economic ideas tend to oversimplify reality. It's unavoidable really. But we should always remember that the basic textbook theories are useful as a starting point--a model, and not a literal description of reality. For example, a significantly higher minimum wage is sure to reduce employment in a ceteris paribus world. However, it will be nearly impossible to identify the winners and losers from a very small change in the minimum wage so it may not be worth getting too worked up about in a world where ceteris is not paribus. (Russ Nelson, however, would not be moved by this argument. On principle, I agree. But from a pragmatic policy perspective...)

Actually, any discussion in which we talk about "the wage" or "the labor market" is already oversimplified. But we do this anyway. The reason we do is that it can be difficult to go into the details in the length of an op-ed or blog post. We simply cannot possibly discuss a multitude of elasticities and other details. We use economic shorthand. The reader fills in the gaps, sometimes by making assumptions that were not intended. In blogging, at least the comments provide for discussion. Remember, just because the writer didn't say it doesn't mean it can't happen or that the writer didn't think about it or is dismissive of it. It just means that the writer wanted to emphasize something else. Occasionally it matters, but a lot of times it doesn't. Some of the best comment threads are where a commenter and I have agreed about most everything but disagreed about some finer point. Perhaps this post will generate some discussion about the assumptions we make, good or bad.

In the Financial Times, Tim Harford answers his "Dear Economist" mail.

How would an economist respond to the phrase “money is the root of all evil”?

Harford answers,

Economists always seem to talk in dollars and cents, yet few economic models contain any reference to the stuff.

The reason why economists will use strange phrases such as “the value of a kiss is $49” is not that they think money is particularly important, but simply that it is a convenient way to measure things. If a toffee apple is worth $7 then a kiss is as good as seven toffee apples; however if the toffee apples cost $6 and the kiss costs $50 then the toffee apples are a better buy.

I am, of course, reminded of this post from last year. In that post, I quote this article by Robert Frank, who poses a question:

"You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $50."

I still get a bunch of hits from search terms "clapton dylan opportunity cost frank" and variations on that theme.

Harford is doing what Frank did in quantifying the concept of utility in terms of dollars so that comparisons can be made. Economists think like this all the time. Non-economists, not so much. The idea in both is "willingness to pay," which is one of the basic building blocks of economic thinking. It is not surprising to see the idea surface in Harford's column. It will undoubtedly come up again.

What do you think about this? Is this a simple abstract idea that has little application? How does reality complicate the story?

What about the concept of opportunity cost itself? How would you improve our textbook presentation of the idea?

UPDATE: No takers yet? Restating the question: Should opportunity cost be thought cost net of benefits or only what is literally given up with no regard to benefits? Does it matter?

Yes, I know that the original Dylan/Clapton question has been criticized for being poorly worded. Largely that is because it does not explicitly clue in the reader that it is asking for the net cost. One possible reason for confusion is that the textbook definition of opportunity cost is too trivial. Most textbook problems on opportuntity cost don't require any complex thought concerning net cost (e.g. the opportunity cost of 1 apple is 2 oranges or the opportunity cost of sleeping in is going to class). Even the old stand-by example that the opportunity cost of going to college is tuition paid plus foregone wages is stripped of all kinds of interesting details (like the life-changing benefits of socialization in a college atmosphere, etc.) because they are hard to quantify. But when opportunity cost is lurking (unstated) in the background of more complicated quantitative problems it helps to have thought about Harford's example or the Dylan/Clapton question. It is in bridging that gap that most principles texts are lacking.

Thoughts?

UPDATE 2: Gavin Kennedy reminds me that Harford's "Dear Economist" letter misquoted I Timothy 6:10 "The love of money is the root of all evil." I apologize for missing that. As such, Harford gives a terrible theological answer. I did not mean to suggest that his answer was appropriate to the question. I merely wanted to work his answer into this other discussion.

Comments are open to both aspects of the post. If there is sufficient interest, I'll split them off to a separate post.

In response to my last post, Spencer comments:

After disasters major corporations like Wal Mart, Home Depot, etc.., usually do a very good job of resuppling the damaged area with the suplies they need without a significant increase in prices.

Do you have any evidence that a bunch of "price gougers" in pick-up trucks would ever generate a significant increase in the supply of basics like gasoline, electricity, food, medicine and water. Or, is this just another example of assuming a can-opener.

The question got me thinking about those "price gougers in pick-up trucks". Because that is often how they are portrayed in the media. They swoop in with a load of water or chainsaws, charge a bundle, and they're gone. They tend to be from out of town, and the local politicians see it as their duty to keep such opportunists out.

Of course the very reason that price gougers often fit this profile is the fact that the state has made the act illegal. There is a risk to doing what they are doing. That alone contributes to the higher prices that they charge. It also means that it may attract people who are have less to lose, people who are willing to take a risk. The risk is not that the entrepreneurial venture might fail, but that the law might come after them. Established, reputable firms do not want to run afoul of the attorney general, and so you don't see them doing the price gouging. Reputable firms use the opportunity to create goodwill.

Case in point: Culligan donated five semi-truck loads of bottled water after Hurricane Katrina (see the list for a number of other corporate donations). Nice sentiment, and I'm sure the people who received it were grateful. But we wouldn't be having this conversation if a donation of five semi-truck loads was enough to satisfy the demand for water after the hurricane. I did not hear stories of Culligan increasing their sales of water in the area. A brief Google search doesn't turn up much either. But I do find multiple sites mentioning the five donated truckloads.

Consider Spencer's mention of Wal-Mart and Home Depot. Again, a lot of what they provide was donated. And while that is a wonderful thing, there is something a bit odd about the overall picture. What the large companies do in providing donations is good, but falls short of meeting the total demand for these items. Again, the fact that we are having this conversation suggests that in a perfect world these companies would do even more. Are they instead doing just enough to generate some goodwill, some TV ad copy, and a feeling among the residents that they care more than the price gougers in pick-up trucks?

It is also important to note the relevant time frame. The typical pattern as I have observed it reported in the media is that the price gouging tends to be worst in the immediate aftermath. As basic utilities are restored and transportation becomes easier, then the regular retail function of Wal-Mart, Home Depot, et al. can resume. And then price gouging (be it by big boxes or guys in trucks) becomes less of an issue.

Another possibility to consider is that the national chain stores could take a loss on bottled water for a short time in a localized area in the interest of goodwill with the community. That adds an insurance dimension to the problem. Remember that the increase in price after the disaster is associated with the cost of arbitrage across locations. That cost is likely to be smaller for a retailer with a national distribution network, and they might just eat all or part of that cost.

But as long as these disasters continue to lead prosecutors to start a "witch hunt" for anything even resembling a profit motive, reputable companies will not do enough to satisfy the demand. Sure, the token five truckloads of water will come, but that is, pardon the pun, a drop in the bucket. All you will see are guys in pick-ups, who make good targets for politicians wanting to score points with the voters.

There is that which is seen, and that which is unseen. What is unseen here is that Wal-Mart, et al. could possibly satisfy more of the excess demand if they weren't afraid of being punished for trying.

The fact that we treat bottled water in a disaster area in a manner that encourages reputable, national firms to make token donations rather than engage in the unseemly profiteering that might actually help more people should give us pause. The fact that this attitude in government also makes the actions of the less scrupulous profiteers more harmful by forcing them to take additional risks and fly under the radar should also give us pause.

So no, I don't have evidence that guys in pick-up trucks would do a better job. That's the wrong question. I do have a very strong reason to believe that large companies could do a much better job if they knew they wouldn't be excoriated by politicians and the media for making a modest amount of money from it. While I praise them for their generosity, I think you'd get more than five truckloads from Culligan if they could charge a modest amount for their trouble. The fact that there are still guys in pick-up trucks means the established, reputable companies are not doing enough.

The guys in pick-up trucks are a second-best solution to the problem. The first-best solution is for established, reputable firms to enter those areas and drive the high cost risk takers out of business. But that will only happen if the government eases ceases vilifying the notion of profit, even a modest amount, in these situations.

I do have evidence that the government does an absolutely lousy job of providing these goods and services. I don't think that the private sector would do this.

From Wilson Mixon at Division of Labour,

According to a report on NPR, "in a major disaster the government can spend $10-15 per gallon of water." (Link leads to a summary and an audio; LexisNexis has the transcript.)

Couldn't much of this water could be delivered at a fraction of this cost if price gougers were given free rein? Of course, the NPR report is hawking a gee-whiz technical fix, administered by FEMA, not a sensible market response.

It's worth it to listen to the audio. This is a really interesting idea. Basically, they've come up with a way to take water out of the air using a desiccant. An example of this would be those little packets of "silica gel" you find in various product packaging. The technological innovation described in the audio uses the same principle to generate around 1200 gallons of water per day for around 20 cents per gallon. (These numbers are mentioned in the audio.) The 20 cents per gallon is apparently the marginal cost for the fuel to run the machine. The machine itself costs $300,000. That is a lot of overhead. By my calculations, if the machine lasts 10 years and you run it 25 full days per year it will add about a dollar per gallon to the average cost of the water produced.

Even so, it is likely that the average cost from such a machine, if it is as successful as the report makes it sound, would be less than the $10-15 that the government sometimes pays to bring water to a disaster area. So it might be an improvement from the status quo. But what about Mixon's suggestion that letting "price gougers" take care of the problem by bringing water from outside the area and selling it at a higher price? Let us not forget that part of the reason that the prices the "gougers" charge are so high is that the government does a pretty effective job of discouraging them. If the government got out of the way, there would be more "gougers" and the price would be lower. The price differential should approach the transport cost. In such an environment, it may be the case that machines like the one in the NPR report would be considered too costly to implement. It would be interesting to do the detailed cost/benefit analysis on that one.

The fact that the government has taken such a stance to prevent "price gouging" actually helps to justify the purchase of the machine by the government and explains the incentive for private firms to look for this type of solution. All of this just goes to show that private individuals will try to capture the rents associated with various market interventions. One type of activity is praised and the other is vilified. Yet it is not immediately clear which activity yields greater benefits to society.

The NPR report also mentions that the military is interested in this technology. Now that actually makes sense. This could be a revolutionary way to provide water on the battlefield. Wouldn't it make sense to have National Guard units purchase these machines for deployment either in battle or in times of national disaster? Putting the machines in the hands of the National Guard would seem to have a much better cost/benefit calculus than putting them in the hands of FEMA. If allowing markets to work freely is asking too much, can we at least ask that the machines go where they will be used most efficiently?

From Wired: The real story behind the iPod.

Exercise for those who teach principles of economics (especially micro): Come up with as many principles level lessons as you can from this. Here's one:

Apple's team knew it could solve most of the problems plagued by the Nomad. Its FireWire connector could quickly transfer songs from the computer to player -- an entire CD in a few seconds; a huge library of MP3s in minutes. And thanks to the rapidly growing cell phone industry, new batteries and displays were constantly coming to market.

Complementary goods in production Lower input cost per unit of quality--Better and cheaper cell phone batteries and displays lowered the cost and increased the quality of Apple's innovation. (UPDATE: Lower input costs would be a more direct answer, but here is what I was thinking. Smaller batteries and displays were complementary with the smaller sized hard drive and other features of the iPod. What good is the small hard drive if everything else is bulky? What good is it to be mobile if the battery doesn't last? The iPod's value came from the combination of innovations. Only when the size and power requirements on all of these complementary inputs are met does the iPod become viable. Substituting a bulkier battery greatly diminishes the value. That is the sense in which I meant them complementary. Not in the literal production process, but innovative, value-creating process.)

You could probably spend a couple weeks in class on the intellectual property rights issues if you were so inclined. You are invited to post iPod teaching suggestions in the comments.

UPDATE: I also like to use the iPod as an example of invention (small hard drive, battery, etc.), innovation (assembling the various inventions into a music player), and diffusion (network externalities with iTunes, marketing, and adoption by the masses).

Via Truck and Barter comes this from the UK:

Wholesale gas prices for immediate delivery turned negative on Tuesday as supplies surged in from the new Langeled pipeline from Norway.

Britain's gas storage capacity is 96% full so firms need to offload supplies.

It is rare, but prices can be negative.

Enjoy the free lunch from the Wall Street Journal. Richard Epstein and Michael Reich debate the minimum wage, particularly as it relates to Mayor Daley's decision to veto a minimum wage that would have applied to big-box stores in Chicago.

I found the following exchange to be the highlight.

Reich:

I agree that higher minimum wages might lead to somewhat higher prices. But this might be a good tradeoff. To find out, again we must draw from careful empirical studies, not general statements, to quantify the effect. My San Francisco study found that a 26% increase in the minimum wage increased restaurant prices by about 2.5%, or 25 cents for an average $10 menu item. We now know, using Wal-Mart's own data, that if Wal-Mart's hourly pay and benefits scale increased to match those in its industry as a whole, and the costs were fully passed on to consumers, its prices would increase by only a penny on the dollar. Moreover, profit margins have been increasing in large retail companies, so there is room for pay increases that do not translate entirely into price increases. See "Wrestling with Wal-Mart: Tradeoffs between Profits, Wages and Prices."

On the issue of turnover costs, no one is arguing that low-wage firms would individually choose to increase their pay and lower turnover, as the savings would not be sufficient. If all firms are required to do so, however, employment can actually increase. In the field of labor economics, this is a standard argument used to understand minimum wage effects. You will find it in every major undergraduate textbook, including those by free-market-oriented economists such as George Borjas and David MacPherson. You will also find an emphasis on turnover issues in understanding labor markets in the 2006 Economic Report of the President.

Epstein:

On the Wal-Mart profit figures, the numbers that I have seen differ. The average profit per employee is around $2,000 per year. That hardly speaks of massive exploitation of workers. Rather it is consistent with the lower prices that it offers to consumers, often from the least advantaged areas, where prices are estimated at around 8% to 13% below what they would otherwise be. Finally, I am totally puzzled why any labor text would argue that high-wage-low-turnover strategies are only efficient if everyone in town adopts them. The brief explanation that Michael offers here is just not credible.

Why won't the savings be sufficient to induce the change? Indeed any change in position, however small, that improves output should be welcomed, period. There is no prisoner's dilemma game here. A firm that gets higher output from adopting superior strategies should be thrilled if its competitors lag behind. So absent the statute, there should be a really strong incentive to make changes in employment strategies that other firms cannot duplicate. Nor is there any reason in theory to expect non-covered firms to raise wages unless demand for labor increases as the cost increases. It is every bit as likely that non-protected workers will be more numerous and could easily receive lower wages, if they stay in the community at all.

Read it all.

At EconLog, Bryan Caplan writes:

Whenever I'm stuck in a line, I grumble about the need for peak load pricing. Raise the price during popular times, cut the price during off-times, and watch the world's blood pressure fall.

I have the same urge to grumble. Read the whole thing for his idea for a better way to price admission to the movies. Seems reasonable to me.

The Thai government encouraged everyone to wear a yellow shirt to show loyalty to the king. The results were predictable. CNN reports:

Suppliers say they're running out of shirts, and buyers complain they are being gouged by sellers.

The Commerce Ministry threatened Monday to take legal action against factories and retailers who unfairly raise prices or stockpile the shirts to manipulate the market.

Someone didn't think that plan all the way through.

Thus reports the New York Times:

Last year, the number of new college textbooks sold by American publishers dropped for the second year in a row. But the revenue brought in by such books rose for at least the fifth consecutive year, sustained by continuing price increases.

Increase in price and a resulting increase in revenue = inelastic demand.

The article goes on to state that publishers are raising their prices to compensate for the lost revenues due to the increasing popularity of used books as well as the higher costs of "paper, binding and utilities". No mention of marketing costs.

There is no doubt that textbook prices are rising more quickly than inflation. When I was in college in the early '90s, an intermediate macro text sold for around $50 (I still have the price tag on it). Today, a similar text sells for over $130. The CPI meanwhile has increased from around 125 to about 200.

In some sense you get more from college textbooks today. Most have a website, CD, or both. I've always felt that the CDs were designed to get you to buy the new book (with CD included) or shell out extra money for the CD separately. A website has the same issue. A password is typically included with a new book, but used book purchasers can buy a password separately. In my early days of teaching (as a TA in grad school) when CD supplements were relatively new, I was terribly unimpressed. I think they are better now, but my initial experience has kept me from being overly enthusiastic. I will grant that some types of learners can benefit from the types of review exercises on textbook CD supplements. But aside from these extras, the overall quality hasn't changed much. There are good books and better books, just as there have always been.

I predict that textbook prices will continue to outpace inflation. There are alternatives to the traditional textbooks. Preston McAfee and Roger McCain are two notable examples of freely available on-line texts in economic principles. The change is slow in coming, but it is happening. But there is another side to this development. There will, I think, always be a substantial market for traditional texts. As some professors leave the market for freely available texts, that leaves a more inelastic demand curve facing the publishers. The effect on the revenues of the publishers will necessarily depend on how many customers leave the market and how much they are able to recoup with price increases. But if, as I suspect, those professors most likely to use the free texts are those who are most price sensitive (on their students' behalf), we should see textbook prices continue to rise.

Yes, even in the early '90s when textbooks were a relative bargain, we still complained--probably just as much as students today. There are market realities at work here, and as with gasoline, one can only grin and bear it. However, I would offer a little perspective for students. When you sell back your used books, you generally get back a percentage of the used book sale price. Think of it as a semester-long lease with a security deposit. The average used book only costs you a couple dollars per week if you think of it that way. If you're already paying $20,000 per year for tuition, you'll hardly notice it. (Aside: Concern about textbook prices seems more of an issue at state universities where tuition is lower and books are more costly relative to tuition.)

This group would take my leasing analogy and formalize it with an actual rental program. This might make some sense in the age of the internet. Before Amazon.com, I would not want to force students to rent rather than buy. But since students can easily buy books on the internet if they are majoring in the subject and want to keep the book beyond the end of the semester, this may be a sensible way to reduce costs as well as inefficiencies.

Edward Castronova writes in Wired,

What if everything in life were free? You'd think we'd be happier. But game designers know better: We'd be bored.

...That's why today's newer massive synthetic worlds make life hard. It's why we have to scheme, fight, and occasionally beg for food, shelter, transportation, and great big flaming swords. Games show us that scarcity can be fun.

Read the whole thing, and if you want more, check out his interview on Radioeconomics.com.

I'm listening to C-Span2 right now. Sen. Byron Dorgan (D-ND) is telling of how FEMA botched ice delivery after Hurricane Katrina. He is showing a photo of trucks lined up at an Air Force Base in, I believe, Alabama. The truck drivers were told to pick up ice in New York and bring it to Alabama by way of Missouri. Once there, they waited 12 days at that Air Force Base. Then, inexplicably, they were told to deliver their ice to Massachusetts. Cost: $15,000. (Note: It was not clear if he meant that this was per truck or for the whole lot. I have to believe that the opportunity cost of a truck sitting still for 12 days could easily exceed $15,000 as well--especially in a disaster area--so chalk this up as an example of people not being clear about the full cost of something.)

A local sheriff who tried to commandeer the trucks to get the ice to the victims of Katrina is now being prosecuted for his efforts.

I'm sure this will appear in the Congressional Record in case you want to read Dorgan's precise telling of the tale. It sounds unbelievable, but a lot of unbelievable things happened after Katrina. I'm prepared to take Dorgan at face value on this one.

The old Soviet central planners would be proud. Here's a crazy idea: Let the price of ice rise to induce people to transport it and sell it in the affected area. Concerned that the poor wouldn't be able to buy the ice (price gouging)? Let the government buy the ice at the going price and distribute it at the shelters. I honestly think it would be less costly than what happened here.

And they would get ice.

...and if you're right you don't win money--you get a ticket to the game itself?

Read about it. (NY Times)

Joe Kocott and Ian McKinley are both die-hard Pittsburgh Steelers fans. In the past week, Mr. McKinley urgently searched eBay, Craigslist, StubHub and other sources for a ticket to Super Bowl XL, eventually buying one for $2,500, while Mr. Kocott secured tickets for himself, his wife and seven children, and nine others in early January by paying an average of $350 for 18 futures contracts that promised him tickets if the Steelers made it to the championship game.

Futures markets have existed for decades for commodities like pork bellies and oil, whose prices fluctuate over time. The advantage of a futures market is that it allows the buyer and seller to lock in a price, and in that way reduce uncertainty.

There is great uncertainty surrounding sporting events like the Super Bowl, including whether a fan's team will make it to the game and the price of tickets on the secondary market. Stephen K. Happel and Marianne M. Jennings of Arizona State University proposed a futures market for tickets to major events to reduce risk in 2002. Their idea is finally coming to fruition.

As the article by Alan Krueger explains, one of the difficulties of a market like this is that you need to be able to trust the marketmaker to be able to deliver on the tickets. Krueger suggests that sports leagues make some tickets available through these markets.

You would think that someone would have thought of this before. (When I read the article, I admit I had the immediate "why didn't I think of that" response.) I'll bet a few people thought of it and quickly dismissed the idea because of the problems associated with gaining the trust. Trust is a costly thing to establish. But if people don't have any way of knowing that the marketmaker can come through on his end of the bargain, they are going to be very reluctant to put down hundreds of dollars on such a deal.

It's a good lesson for economics students (or anyone) to see the importance of trust and enforceability of contracts.

From the Wall Street Journal:

Though Ford's plan, dubbed the "Way Forward," is still being formulated and is subject to change, the nation's second-largest auto maker is likely to shutter assembly plants in St. Louis, Atlanta and St. Paul, Minn., according to two people familiar with its product plans. Also slated for closure are an engine-parts plant in Windsor, Ontario, and a truck-assembly plant in Cuautitlan, Mexico, said these people.

...

"Gone are the days when we are going to sell 400,000 Explorers [a year] without incentives," said Ford sales analyst George Pipas, commenting on November's results. "It's sayonara."

Sayonara, indeed. And konnichiwa, Toyota and Honda.

UPDATE: James Hamilton has more.

If you teach microeconomics and need a good current event oriented discussion of ag markets, check this out. (NY Times)

This article is mostly about the recent comments on inflation by Fed officials. As such it is worth mentioning on that basis alone. There is, however, not much new to talk about that we haven't discussed already as far as inflation is concerned.

There is a quote at the end that hearkens back to a discussion from a while back on the topic of disasters and GDP.

While [Kansas City Fed president Thomas] Hoenig expressed caution about risks to the economy, especially from potential inflation, he was generally upbeat about prospects for growth.

"While the U.S. economy is going to face some pretty significant challenges, and does face some pretty significant challenges, my overall assessment is that the national economy ... will in fact be able to withstand it and I think have solid growth as we move through this transition into next year, 2006, and beyond," Hoenig said.

He said the hurricanes might subtract 0.5 to 1 percentage point off U.S. economic growth in the second half of this year, according to private and Fed forecasts, though he personally thought it would be closer to 0.5 percentage point.

But the negative impact will be transitory while rebuilding the Gulf Coast regions that were hardest hit will recapture much of the growth next year.

The last paragraph is Reuters wording, not Hoenig's precisely. But it makes the point that I made at the time. If growth falls and then you "recapture much of the growth", is that really a good thing? And if the resource pressures cause the Fed to tighten more than they had anticipated, doesn't that compound matters? Interest rates rise further, perhaps much further if we add another $200 million to the deficit. Is there any reasonable scenario in which real GDP in 2007 ends up higher than it would have been without the hurricanes?

Then why is it that the immediate post-hurricane sound bites are about what a boon this will be to the economy instead of saying that the rebuilding will recapture much of the growth that is lost in the aftermath of the hurricane?

Another story from IN-FORUM: (reg. req'd)

Dean Hornbacher doesn’t want to deny anyone their cup of morning coffee.

But the president of Hornbacher’s is up against a shortfall of two major brands because of far-reaching devastation of Hurricane Katrina, which struck the Gulf Coast on Aug. 29.

White signs hang from the coffee shelves at the south Moorhead Hornbacher’s offering an apology that Folgers and Millstone, two top-selling brands, may be temporarily unavailable.

Cash Wise in Moorhead posted similar signs, warning customers that both brands are in short supply. In response, the store raised the price of a 34.5-ounce can of regular Folgers 90 cents, from $5.98 to $6.88. Hornbacher’s hasn’t significantly raised prices.

You were warned.

Later in the article, it says that Cash Wise did run out of Folgers at one point. Apparently the 90 cent price increase wasn't enough for the market to clear.

In other news of the "that's what we teach" variety, Division of Labour brings us this little tidbit from ABC News:

Delta Air Lines Inc., buffeted by high fuel costs in the wake of Katrina and Rita, said it is reducing its domestic flight schedule.

The Atlanta-based carrier isn't experiencing a shortage of jet fuel, but is conserving energy, it said.

They're right about it not being a shortage. A shortage is what happens when the price doesn't rise enough (see above). Instead, file this one under cost minimization (or its dual, profit maximization). If spinning it as "conserving energy" makes you feel better and sound more friendly, go for it. Maybe someone will believe the spin. The media will dutifully report it without using such crass terms as profit maximization. "Conserving energy" sounds so much better than "cutting costs on jet fuel", and on some level has a similar meaning. To me, however, "conserving energy" has a different connotation than simply buying less of something because the price has gone up. Your mileage may vary.

I wonder if they'll be in the mood to conserve energy when the price of jet fuel comes back down or if they will allow their supply curve to shift out again.

From Reuters:

CHICAGO (Reuters) - The Port of New Orleans resumed commercial operations Wednesday, with the first vessel loaded with general merchandise heading out since it was closed by Hurricane Katrina more than two weeks ago.

"The ship is leaving as we speak," Paul Zimmermann, the port's director of operations, told Reuters by telephone.

He said the vessel, Lykes Flyer, was heading to Brazil, Argentina and Mexico with an assortment of products after unloading a cargo of coffee from Brazil.

Last night on the news, I heard the coffee prices are heading up due to supply disruptions with the Port of New Orleans being closed. As it happened, today (not even one hour ago) I was using one of my favorite supply and demand examples in class. I use some variation of it every semester, but this time it seemed particularly relevant.

If the price of coffee increases, what happens to supply and/or demand in the market for tea? If coffee and tea are substitutes, an increase in the price of coffee will cause people to switch over to tea, thus pushing up the demand for tea and raising its price.

Of course, in class I discuss how this reasoning depends on the assertion that coffee and tea are substitutes. For some people they may not be. But if there exist some people who choose their beverage on the basis of price, then the effect will be as described.

Every principles book seems to have different examples. Coffee and tea is not in all of them, but it does make an appearance in some. This might be a chance to see if it really is true. I intend to check on the price of tea (most tea probably comes from the Far East through the Port of Long Beach and will be relatively unaffected by Katrina). Comments are open for your observations on the price of coffee and tea and your thoughts on the substitutability between them.

Took a drive over to Iowa City today. We filled up in Iowa for $3 and $2.96 per gallon. The going rate in Illinois is higher by about the difference in the taxes. My understanding is that gas is subject to a sales tax in Illinois but not in Iowa. The specific tax on a gallon of gas is about the same in the two states, but the sales tax in Illinois provides the difference.

But (this is the interesting part), I noticed more than one station with bags over the pumps on certain grades. I asked an attendant about this and she said that there are some supply problems. As I understood what she was saying, they weren't getting a delivery when they run out of just one grade of gas. Apparently they will get a delivery when they are running low on all grades. At least that's how I understood it. Comments are open for anyone with more info.

To be honest with you, I'm a little surprised that stations in this situation aren't raising their prices more. Maybe they're afraid of being accused of gouging. In any case, it sounds like distributors are quasi-rationing the supply if I understood the attendant correctly. If the different grades are more-or-less substitutable, the deliveries will go to areas that use a higher total amount of gas. If you think different grades are substitutes, you'll be ok. But if you don't treat different grades as substitutes, then it will seem like a form of non-price rationing.

I'll keep an eye out for this and let you know if it happens on this side of the river. I ask my readers to do the same. Now, on the subject of gouging, Cold Spring Shops had the quote of the day Saturday:

La Profesora Abstraida links to an executive order from Georgia Governor Sonny "Son of Canute" Perdue cautioning retailers against price gouging. It looks like a reasonable request.

For example, a retailer may increase the price of their products as is necessary to replenish their existing daily stock at current market rates, maintaining the same markup percentage he or she applied prior to the enactment of the price gouging statute.

The devil is in that "markup percentage." There are conditions on the elasticities of supply, demand and resource supplies sufficient to ensure that the equilibrium retail price maintains a constant ratio to the wholesale price of a single input. Those sufficient conditions are unlikely to hold in the presence of at the moment inelastic supplies of gasoline, particularly summer grades in ozone-impact areas, and relatively inelastic demands for gasoline. (Each of you may thank me for doing my part to not bid the prices higher. The weather has been quite conducive to bike commuting to work.)

You may thank me as well. I recently traded a 15 mile commute for a 1 mile commute which I sometimes walk. The part about the elasticities and the sufficient conditions for which the wholesale to retail price ratio remains constant is technical economic language for "sometimes asking people to follow old advice is a bad idea when things change". A more detailed explanation is in any good intermediate micro or managerial economics course, but Stephen said it exactly right.

Russell Roberts (Cafe Hayek) has the quote of the day:

Listening to the President beg people not to drive while threatening 'gougers' sets back economic education in America 20 years. Or maybe it's 200. Having the Wall Street Journal (sr) write on Page 1, top story in "What's News" that "Katrina pushed the U.S. closer to a 1970s-style energy crisis" tells you how far we have to go. Or maybe the Journal is presciently anticipating price controls. The implicit price controls of Attorneys General threatening 'gougers' (defined as people who sell something at a price above what they paid for it) is already causing rationing, shortages and lines in some markets.

I started to discuss this in class today, and will continue with it next week. But here's a thought to chew on over the weekend.

As economists, we teach that the appropriate response in a case like this is to let the price rise. Because of the supply bottleneck with refineries off-line, there will be less gas in the short term. No way around that fact. If the price rises, people will modify their habits and the market can be in equilibrium, even if it's an equilibrium we don't happen to like.

Nonetheless, there one aspect of situations like this and that which happened on 9/11 that disturb me. There are cases of stations that spike their price way above the market price. From CNN:

Stations in the Atlanta region were charging as much as $5 a gallon, and one station in Stockbridge, Ga. was charging customers $5.87 a gallon. That led Georgia Governor Sonny Perdue to sign an order putting the state's price-gouging statute into play Thursday.

Let's be serious. $5.87 seems to be above the market equilibrium, even in these times. But I wouldn't prosecute them. Not at all. I'd just tell people not to go there! Find another station! If you're running on empty, just buy a gallon and drive on.

It has, on occasion, been suggested to me that the reason a station might set their price that high would be to promote panic, to get people thinking that it was going even higher. It's not a hypothesis that I dismiss out of hand. But even if it's true, it can be counteracted by some cool-headed thinking on the part of consumers. I'm a little shocked that consumers have been panicking about this. I understood it better on 9/11. Then, we didn't know if the next day would bring a new and different attack. This is a hurricane. It's gone--no longer a threat. There is no reason--none--for the market to respond to this in anything but an orderly fashion. We may not like paying a higher price, but there is no reason for panic, and no reason to pay close to $6/gallon. None.

If consumers were educated better about the supply and demand forces at work in this and other markets, the market might even work a little better because any suppliers who try to "gouge" (though I don't like the word) would find it utterly pointless. Ignore them; don't patronize them, and they will realize that they cannot mess with the market that way.

Any potential "gouging" going on is more a function of economic illiteracy than anything else. And it's bad because it stimulates bad behavior by policymakers. Extreme cases garner a lot of attention and turns the tide in favor of price controls, which would be a big mistake. The appropriate thing to do is to let prices rise and let consumers search for the best deal. Let the market deal with "gougers". The market is a hard master.

And by all means, if you are in college and haven't taken a basic economics course, run, don't walk, to the registrar and sign up now.

The ZIP code is 56572. The blog is 56572. It's the town where I grew up. And gas costs $3.10. (Click to go to the picture).

On one of the news networks (can't remember which one, sorry) an official was being interviewed about the looting in New Orleans. He responded that they would be going after the looters and price gougers to the fullest extent of the law.

As I heard the question, it was not about price gouging but about looting. The interview subject (presumably someone in state government--wish I caught the name) was the one to put them in the same sentence.

Discuss.

UPDATE: I may not have caught the name of the official who made such a statement the other night. But a certain higher ranking official is making headlines. (CNN)

I think there ought to be zero tolerance of people breaking the law during an emergency such as this, whether it be looting, or price-gouging at the gasoline pump or taking advantage of charitable giving, or insurance fraud," Bush said in an interview on ABC's "Good Morning America.

With apologies to Sesame Street... One of these things is not like the others!

In a previous post today, I panned some analysts for indicating that Katrina might end up spurring GDP growth and that the impact of lost wages would be balanced by increased spending on construction. Mark Thoma writes in with a comment. We are in total agreement that GDP counts "bads" as well as goods. But I'd go further in saying that it is dubious that a disaster like this even raises GDP at all. The BEA takes no stand on whether such an event has a positive effect on GDP.

GDP is a measure of the Nation’s current production of goods and services; as such, it is not directly affected by the loss of property (structures and equipment) produced in previous periods. GDP may be affected indirectly by the actions that consumers, businesses, and governments take in response to disruptions in production or to the loss of property, but these responses are not amenable to precise quantification; moreover, the responses may be spread out over a long period of time. For example:

Rebuilding activity, which may occur over many months following a disaster, will typically be reflected in the regular source data used to estimate residential and nonresidential investment. There is no way to disentangle the disaster-related rebuilding from other construction activity.

Tourism and other types of consumer spending may be canceled or postponed in the face of a disaster; whether canceled or merely postponed, the effects will be embedded in the source data that are used to estimate personal consumption expenditures. Again, there is no way to disentangle disaster-related spending from other consumer spending.

The BEA does, however, calculate is how much economic damage is done by disasters. Here is the BEA's calculation for the storms of the 2004 hurricane season. They estimate about a 4 billion dollar hit to personal income from the time of the storms through the 2nd quarter of this year. While that is pocket change in a 12 trillion dollar economy, it's sizeable to those in the affected region.

In simplest terms, I guess you could say that a natural disaster and the rebuilding that follows converts a stock to a flow. Capital is destroyed and new investment is required to replace it. The replacement temporarily generates income and jobs, but it is not clear that there is a gain. I just can't see that an involuntary conversion of stocks to flows is a good thing. If it was, we would do it voluntarily.

Mark also says:

But from the Fed's perspective, in an inflation targetng environment, the important factor is what happens to pressure on prices. ... But looking forward it does seem to me as though this has the potential to increase the demand for inputs in key sectors such as housing putting upward pressure on prices. It is true that we only have what we started with, but to get back there requires the use of additional resources.

So the question is what kind of impact Katrina will have on prices. Certainly there could be some impact on building materials and the like. But remember, we're talking about a fraction of a percent of GDP even if Katrina shatters all records.

And so I have to take issue with part of Tim Duy's commentary on the FOMC minutes today as he relates it to Katrina:

The impact [of Katrina], in my mind, is a classic supply side shock; we can’t really argue that this latest surge in energy prices is driven by strong demand, placing the Fed in the famous conundrum – fight weak output, or fight inflation? But wait, maybe output, nationally, will not be a problem after all. The Gulf States will need extensive rebuilding as Katrina was likely the costliest storm in US history. Consider the billions and billions of dollars of construction materials that will be streaming into the region over the next few years.

At least part of that money would have been spent on something else. It is not all a net gain to GDP. The amount of gain is questionable, and the (unseen) loss is great. Furthermore, it's an almost imperceptable effect on the scale of the national economy (aside from the oil impact). But Duy concludes that the Fed will be primed for more rate hikes, in part because of Katrina, and (if I read him right) the positive demand shock which will result.

Right conclusion; but too much emphasis on the demand shock from Katrina. I think there was evidence in the minutes that the Fed will continue with the rate hikes even if the inflation pressure is coming from the supply shocks (i.e. oil). We can debate the wisdom of this, but I think it may be a moot point. I just don't see the evidence that the aggregate economic impact of whatever demand shock of Katrina's aftermath is enough to factor into the Fed's equation at all. They certainly aren't going to quicken the pace of rate hikes to cool the increased demand due to Katrina.

In related news, the 10 year bond shot up 20 ticks today. An overreaction perhaps (we'll see if it gives any back tomorrow), but it's not exactly a sign that the bond market thinks Katrina will light the inflation fuse.

The Economist says it's possible. (h/t: The Eclectic Econoclast)

Chief among the worries is the oil industry. The Gulf of Mexico provides about a tenth of all the crude oil consumed in America; and almost half of the petrol produced in the country comes from refineries in the states along the gulf's shores. Oil companies are busy assessing how much damage was done to drilling rigs, refineries and port facilities; but even if the infrastructure is largely intact, shipping delays threaten to idle refinery production. This is bad news considering that refineries have been running flat out in recent months to keep up with high demand. The White House says it is considering opening up the strategic petroleum reserve to supply refiners caught short by the hurricane.

The oil situation is really the only aspect of this story that has recessionary undertones. Even at the high end of the damage estimates (admittedly it's early to think about estimating the amount of damage) we're talking maybe a quarter of a percent of GDP. And that's only if the total comes in smashing the record sent by Hurricane Andrew in 1992. There will be lost jobs at hotels and casinos that have been destroyed. There will be disruptions in a myriad of ways large and small. It will result in a slowing of GDP growth in that area, probably for the rest of the year. But viewed in the national statistics, the direct effect will be a small ripple. The big story is Katrina's effect on refining capacity.

I've been hearing reports on various news networks that a little less than 10% (one said 8%... I have no hard evidence on the accuracy of this number) of the nation's refining capacity has been impacted. In an environment where we're already running the refineries full-tilt to keep up with demand, that is a significant hit. Wholesale gas prices are already being affected, and this is only the first 48 hours after the hurricane. Of course it will take a few days before we really know where we stand.

As I mentioned earlier, this is a bigger story than the effect on the crude oil market itself, and no less important to the national picture of our economy. All of a sudden, we're dealing with a bottleneck in the production of gasoline, natural gas, heating oil, and other petroleum products with no clear indication yet of how long this shock could last.

I've been reluctant to join in the chorus of voices predicting recession, and I sincerely hope that this event will not lead me to revise my probabilities too terribly much. Like everyone else, I'm just waiting to see what the news coming out of the refineries is going to be. Calculated Risk has had a couple of posts on this topic, including this one and a pointer to this article from Marketwatch.com. We're in a wait-and-see mode, which is frustrating, but I'm going to resist the urge to speculate any further at this early stage about how long lasting the disruption might be.

$70 oil is tough on the economy, and so is $3 gasoline. Even if oil prices recede a bit because Katrina's impact on the global market is small, the higher gas prices (and heating oil, natural gas, etc) will be a major concern. This is definitely something to watch.

The situation in New Orleans and throughout LA, MS, and AL is indeed grim. As of last report, the water is still rising in New Orleans due to the breaks in the levee. It was disconcerting last night to see so few pictures from New Orleans. That can only mean that it is still nearly impossible to get in there. The pictures starting to trickle out today are not pretty.

But in the face of this disaster, the media does what it always does and adds insult to injury with bad reporting on basic economics. It's like clockwork. See here for a tsunami example. I seriously considered writing a post before Katrina hit, just to get my thoughts out there in front. I decided the only purpose that would serve would be to be a "see, I told you so." I don't think it would have caused stories like this to have been written any differently.

"There will be a lot of rebuilding that is going to need to occur. These things do spur GDP growth," said Ken Mayland, president of ClearView Economics in Pepper Pike, Ohio.

Hat tip: Cafe Hayek.

Oh, and the article goes on...

Diane Swonk, chief economist at Mesirow Financial in Chicago, said wages lost by workers and revenues missed at shops and other businesses would be generally short-lived and replaced by stepped-up demand for construction and other workers and higher sales at home-supplies outlets.

This kind of thing really bugs me. Part of me wants to weep at how misguided such thinking is on the part of these people who really should know better. Part of me wants to be mad at the media for accepting such statements uncritically and perpetuating the myth.

This is the "Broken Windows" fallacy. It's the idea that destruction (as in breaking a window) is somehow positive because it provides economic activity for the person replacing the window. Of course, the person whose window was broken and has it fixed will spend money that he could have spent on something else (and would have spent on something else). And what does he have to show for it? A window... just like he had before.

Russell Roberts of Cafe Hayek tries to give the benefit of the doubt.

Maybe the last two economists quoted were quoted out of context. Or maybe they meant something more nuanced, holding things constant that they didn't explicitly mention.

But I've heard too many interviews like this in context to give them the benefit of the doubt.

This is not to say that some people will not benefit. Bastiat's original story of the broken window makes it clear that the glazier does indeed benefit. Carpenters, restoration companies, and many other types of service providers will see more business. That is true, but it is far from clear that the work that they will be doing adds any net new social value. Mostly, they will be replacing what was lost and that will prevent them from creating anything truly new. If supplies are tight, they will raise their prices (if they are allowed to) which is an efficient response, even if it is hard for the citizens of the affected areas to stomach.

We have a clear need for better reporting and writing about economic issues. I am going to coin a phrase that I hope will catch on. I used it here first. Principles level is all I ask!

The Eclectic Econoclast finds another example.

The television journalists I have been watching do not understand.

Oil is traded in a world market. Katrina had little effect there, as can be seen here which lists oil futures prices. There was a minimal impact on oil futures for January '06.

Gasoline is traded regionally in the U.S., and gasoline futures for January '06 rose by nearly 20%.

The major energy effect of Katrina will be on U.S. (and probably Canadian) gasoline prices because of the impact on refining capacity, not because of the minor impact of world pumping capacity or reserves.

The Eclectic Econoclast then points us to the always excellent James Hamilton, who lays it all out in one of the best post-Katrina blog posts of all.

Finally, to wrap up the blog-roundup on Katrina (at least for now), I note that Phil Miller did make a post ahead of time warning of the kind of foolishness that might follow. I don't have any confirmed reports that the government is cracking down on "price gouging" yet, but I'm sure it will come. Such things are as clockwork. I suspect that some politicians know better but it's just so easy to cater to what people want to hear. No one wants to be for higher gas prices; everyone want to be against them. The willing media just makes their job easier.

Principles level is all I ask!

(Note to my principles students: If you master the content of a good course in principles of economics, just look at how much better you will understand what is going on compared to so many people out there! Just understanding things at the principles level is good enough for many policy discussions. Indeed, there are many instances [often chronicled by econo-bloggers] where the world would be better served if the discussion were elevated to that level.)

UPDATE: I go into more detail in response to a comment below.

Larry Kudlow writes the following at the NRO

On the oil-price shock, I say at least two cheers for higher prices. Why? Because I believe in markets. When the price of energy goes up, demand falls off and supply increases. This is the case today and it represents nothing short of a tectonic shift.

PGL is not pleased.

OK, Kudlow does seem to understand that the supply curve has not shifted inward but what does “demand falls off” mean? Larry – try this: an outward shift of the demand schedule, which has led to the dramatic increase in the price of oil. Kudlow also suggests a higher elastic supply schedule for energy:

The part to which PGL refers is this:

As Dan Yergin, president of Cambridge Energy Research Associates, recently wrote in the Washington Post, rising energy prices today will cause energy supplies to explode tomorrow.

Allow me to make a helpful clarification.

Kudlow's statement, "When the price of energy goes up, demand falls off and supply increases." is the kind of thing I see a lot of as a person who teaches principles of economics. It is a horrible way to say it. Usually, the person saying something like this knows what they are trying to say, but they are easily misunderstood. And in my principles class, I'd tell him to re-write it.

He's obviously talking about long run supply and demand, both of which are more elastic than short run supply and demand. But not every reader will catch that, so at best it sounds awkward. At worst, it sound contradictory since a few sentences later Kudlow says,

The spread of global capitalism to places like China, India, and Eastern Europe is the main cause of the spike in energy prices. It’s a market signal that the new and prospering world economy needs more power. Consequently, this is not a recessionary supply crunch like we had in the 1970s. It’s a growth-oriented demand increase.

Are you dizzy yet? "Demand falls off," and "It's a growth-oriented demand increase." Which is it? Well, it's both... but with a short run vs. long run distinction.

Examples of this sort of imprecise language in public discource are too numerous to mention... and it knows no party lines.

Now, the question of how elastic long run supply might be is another question entirely, one which PGL properly raises. But it would be a lot easier to have that discussion (and Kudlow's readers would be better served) if the good economic terminology (principles level is all I ask) were used.

Mark Thoma piles on about the monetary policy aspect of Kudlow's column.

Hal Varian's Economics Scene column in the NY Times discusses the rise of the micro-multinational.

But offshore work means something quite different to the micro-multinationals. These companies simply would not exist without access to foreign labor. If they succeed, they will certainly hire more American workers as they grow.

The internationalization of small and medium-size enterprises has got to be a big plus for the American economy. It allows the small players to have access to labor markets that only the big boys could afford a few years ago.

It's already happening, and it's becoming more important, even (or should I say especially) in smaller cities where high tech job growth is bound to be on a micro scale.

James Hamilton (Econbrowser) explains the difference between "light sweet" and "heavy sour" crude oil, and in so doing reveals some interesting economic implications with a simple explanation.

Via Marginal Revolution, comes this article from Virginia Postrel. She spends much of the article smacking down the views of Barry Schwartz. If that name is familiar, it might be because that's the same Barry Schwartz who debates Russ Roberts in the NPR interview I linked to here. But Schwartz isn't the only one who thinks we have too much choice.

A sampling from the article:

It’s all too much, declares the latest line of social criticism. Americans are facing a crisis of choice. We’re increasingly unhappy, riddled with anxiety and regret, because we have so much freedom to decide what to do with our money and our lives. Some choice may be good, but we’ve gone over the limit. The result is The Loss of Happiness in Market Democracies, the title of Yale political scientist Robert Lane’s 2000 book on the subject.

To these critics, providing too many choices is the latest way liberal societies in general, and markets in particular, make people miserable. “Choices proliferate beyond our pleasure in choosing and our capacity to handle the choices,” writes Lane. Like cheap food and sedentary labor, the argument goes, abundant choice is not something human beings are biologically evolved to cope with. We’d be better off with fewer decisions to make.

“As the number of choices keeps growing, negative aspects of having a multitude of options begin to appear,” writes Swarthmore psychologist Barry Schwartz in The Paradox of Choice, published in January 2004. “As the number of choices grows further, the negatives escalate until we become overloaded. At this point, choice no longer liberates, but debilitates. It might even be said to tyrannize.”

Schwartz’s book has become a touchstone, not just for social critics but for self-help gurus and marketing professionals looking for the Next Big Thing. Its argument also offers a scientific-seeming alternative to public policies that expand choice, notably in health care and retirement accounts.

And...

“Consumers tend to return to the products they usually buy, not even noticing 75% of the items competing for their attention and their dollars,” writes Schwartz. “Who but a professor doing research would even stop to consider that there are almost 300 different cookie options to choose among?”

And who but a polemicist pursuing an argument would completely ignore what these habits tell us about the world? In a familiar environment, people aren’t overwhelmed by choice. With experience, we learn to negotiate the alternatives. Schwartz may have trouble in The Gap, but a teenager who owns nine pairs of jeans doesn’t. As Schwartz himself notes, “A small-town resident who visits Manhattan is overwhelmed by all that is going on. A New Yorker, thoroughly adapted to the city’s hyperstimulation, is oblivious to it.”

Schwartz treats this habituation as entirely negative, since it’s why we lose our appreciation of once-new pleasures. “When it first became possible to get a wide variety of fruits and vegetables at all times of year, I thought I’d found heaven,” he writes. “Now I take this year-round bounty for granted and get annoyed if the nectarines from Israel or Peru that I can buy in February aren’t sweet and juicy.”

Habituation is indeed a fact of human psychology. That’s one reason we like novelty, including different cuts of jeans. But grumpy social critics like Schwartz never consider the obvious thought experiment: Would you like to go back to the world with fewer options? Granted, dealing with lots of choices causes frustration and regret. But would you really be happier, once you’d become accustomed to them, if those abundant choices disappeared?

Postrel also writes about "satisficing" and taking search costs into account--a concept familiar to any economist.

Best of all...

Schwartz writes that “the proliferation of choice in our lives robs us of the opportunity to decide for ourselves just how important any given decision is.” To the contrary, only the proliferation of choice gives us the opportunity to make the decisions we individually deem most important.

Postrel has it right. Schwartz's comment makes no sense.

So let me take this one step further. What do these "grumpy social critics" think we should do about all this choice? I can't imagine that they would favor regulation on the permissible varieties of orange juice, toothpaste, or whatever. In fact, according to Postrel's article, Schwartz offers personal advice on "satisficing." Nothing wrong with that, if that's as far as it goes. Isn't it a great world that the publishers of books see fit to publish a variety of books so that someone who happens to be seeking Schwartz's advice can find it among the many books in print? After all, someone might find it useful.

Or am I supposed to feel guilty because I have all these choices and actually like it? Should I long for the days of "one-size-fits-all"? Sorry. I don't. I like my orange juice pulp-free, thank you.

Do consumers have too much choice? Stacy Schiff seems to think so. (NY Times)

In taking cluster analysis and its classifications to the logical extreme, are we not building a superfinicky society? Five minutes in any Starbucks line will answer that one. We used to be one nation, undivided, under three networks, three car companies and two brands of toothpaste for all. Today we are the mass niche nation. This is a country in which 40 percent of the eligible population doesn't vote, but can be expected to maneuver its way through a sprawl of options every time it heads out for tooth twine. Increasingly the brick-and-mortar world resembles the virtual one: an infinite landscape of microscopic subcategories, in which one loses oneself, twice.

A friend in Seattle - I'll call him Mitch, because that is his name - reports a full-scale identity crisis in the toothpaste aisle. There he stood, two coupons in hand. Was he ready to become a rejuvenating-effects, tartar-protection kind of guy, or was he wed to the fight against tobacco stains? And to think it all used to boil down to squeezing from the bottom.

The transformative power is dizzying. The pressure is on; the paralysis sets in. It's like a torture session with a demonic optometrist. If A is better than B, and 2 is better than 3, is A better than 2? How to choose among tartar-control and whitening and breath-enhancing? And moreover - this is America - why should we have to? I want it all. Darwinistically speaking, shouldn't "whitening" have automatically ceded to "extra whitening" anyway?

I happen to think consumer choice is good. In fact, I can't get enough. Russ Roberts (Cafe Hayek) agrees in this NPR interview from back in March.

UPDATE: Until today I had not noticed that Don Boudreaux (also of Cafe Hayek) wrote this in response to a letter writer responding to Schiff. Radley Balko agrees as well. Deb Frisch does not agree, but Don doesn't sweat it.