Recently in Economics--Teaching Category

The YouTube model is totally free--free to watch, free to upload your own video, free of interruptions. But it doesn't make money. Hulu is only free to watch, and you have to pay the good old-fashioned way, by watching ads you may or may not care about. Yet it generates healthy revenue. These two video outlets illustrate the tension between different variations on the free business model. Although consumers may prefer 100 percent free, a little artificial scarcity is the best way to make money.

Sound schizophrenic? That's the nature of the hybrid world we're entering, where scarcity and abundance exist side by side. We're good at scarcity thinking -- it's the 20th-century organizational model. Now we have to get good at abundance thinking, too.

PZ Myers rightly commends these words of Richard Feynman. There's a message in them too for people wanting to understand economics.

Feynman says:

People say to me: "Are you looking for the ultimate laws of physics?" No, I'm not. I'm just looking to find out more about the world, and if it turns out that there is a simple ultimate law that explains everything, so be it. That would be very nice to discover. If it turns out that it's like an onion with millions of layers and we just get tired of looking at the layers, that's the way it is.

If this is true for physics, it must be even more true for economics. In economics, the search for simple ultimate laws is impeded by the fact that people's behaviour is often* context-dependent; sometimes we're rational, sometimes not; often we're selfish, occasionally not; and so on.

For this reason, calls for a "new economics" based upon simple principles, such as this bilge, get things arse about face.

*not always - we can't generalize so glibly

I know that economists have tried to overcome the constraints these assumptions impose in higher level work. But that really does not matter. It is the basics that are taught in year one that people remember of their economics, and that is that life is all about profit and that unlimited growth is good.

[The price of oil] has plummeted nearly 40% in just three months, from about $147 a barrel in July to below $83 on Friday, with no obvious bottom in sight. If that sounds good, you are probably a driver who winces these days at filling your gas tank. But the downward spiral could mean trouble for oil-rich countries and for the environment.

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.

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.

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.

In my intermediate macroeconomics course, the final project is a simulation of an FOMC meeting where members of the class play the roles of Fed officials. They did exceptionally well. The presentations and discussion were excellent.

My class voted 9 to 7 to cut by another quarter point. (The 7 wanting to hold rates steady)

As far as I can remember, my class has never been wrong, and also as far as I can remember, when the class predicts dissent, there usually, if not always, is (though never as much in the real vote).

It's an unscientific indicator, to be sure. But it is very rewarding to see the students take it so seriously and really learn about how the Fed works.

The real meeting, of course, is tomorrow. More on that later.

This all started with my post on how a computer demonstration allowed me to illustrate a certain technical feature of the Solow model that would otherwise require a lot more setup time. The (unstated) implication being that it allowed me to get to the "good stuff" sooner.

That's a little ironic because both John Palmer and Gavin Kennedy clearly want to focus on the other important institutional aspects of growth. Kennedy wants more attention to a careful and correct reading of Adam Smith (I can't disagree with that), and Palmer wants to focus on reducing transaction costs a la Coase. No doubt that others could come up with entirely reasonable things to add to that list, and no doubt many of those additions are things that, given enough time in the semester, would be beneficial to cover in class.

Yet I think that both John and Gavin overstate the objection to the Solow model (and presumably other models) as just a mathematical exercise--math for math's sake. As John puts it, "Yes the models are a great seive for filtering the students and putting them through the hoops." But in his later post he writes:

Second, the basics of economic growth are extremely important: consumption uses scarce resources that cannot then be available for producing capital goods; saving allows investment, which means more will be available for consumption in the future. We all (I hope) teach something like this in our intro courses when we show that saving today shifts the production possibilities frontier outward for the future.

We agree! And there's probably no better way to quickly and coherently communicate this than a simple undergraduate treatment of the Solow model. You have the most simple dynamics possible. You can talk about investment and depreciation. You can talk about stocks and flows. You can talk about capital seeking a high rate of return. You can talk about the tradeoff inherent in the consumption/saving decision. It's all there in a convenient package that can be covered in one class period.

And really, the Solow model as typically presented at the undergraduate level is not much of a math problem. It reduces to a couple lines of algebra. One does not have to do the full-blown differential equations version.

Perhaps this would be a good time to lay out the way that I approach growth in an intermediate macro course. It is based on the presentation in Steve Williamson's text, but I add my own twist.

1. Overview of growth experiences across the world. Evolution of average world GDP since the industrial revolution. Demonstration of gapminder.org website. Parente and Prescott stylized facts.
2. Malthusian pre-industrial revolution scenario. No growth. Mercantilism.
3. Industrial revolution. Economies begin to accumulate physical capital in a serious way. Solow model is introduced. Growth accounting. Solow model can explain how high marginal product of capital attracts investment. Solow model can't explain why countries take off or why sustained growth occurs. Convergence happens among wealthy countries with similar institutions but no worldwide convergence. Finish with Alwyn Young analysis of TFP in Asia before the financial crisis, which leads directly to...
4. Modern growth. Robert Lucas and Paul Romer style models (sketch... little math). "It's not factor accumulation, it's 'A'" a la Easterly and Levine. Endogenous TFP. Discussion (institutional issues are raised).

It's not particularly math heavy, though there are some opportunities for the motivated student to show off a little. If anyone had the impression that I dwell on the Solow model, I'll clear that up now. But it is a very important part of the context of the whole discussion (not to mention the only way I know to introduce growth accounting). Plus, while the Parente and Prescott approach is not exactly the Solow model, it is of that lineage.

There are so many interesting things to talk about when the time of the semester comes around to discuss growth theories. The simple algebra of an undergraduate version of the Solow model is one of the boring parts, but it is, I believe, necessary. Not as a filtering device (it is a rather coarse filter), but as a way of showing the "measure of our ignorance" (as the Solow residual is sometimes renamed) before moving on to (attempt to) lift the veil of that ignorance.

So anyway, I think we should have more and better presentation tools for streamlining the presentation of the Solow model to make the mechanics clearer and to better allow us to communicate how it revolutionized thinking about growth and how it ultimately showed us that there is so much we don't know without getting our students bogged down in the technical details.

That's what started this whole discussion anyway.

See also: Mike Moffatt (whose comments on the Coase theorem I will take up at a later time), Gabriel Mihalache (who agrees with me while maybe overdoing the case for analytical precision--at least if we're mainly talking about undergraduate pedagogy--but that is to be expected of a soon to be first year Ph.D. student [been there, done that]), and YouNotSneaky (who agrees with me for essentially the right reasons).

John Palmer asks this question in response to yesterday's post.

My response was:

Same reason we teach the Ricardian model of comparative advantage.

Even though it oversimplifies reality to nearly the point of absurdity, it contains many useful insights that are vital to understanding more sophisticated models and policy discussions.

It introduces a way of organizing one's thinking about the topic at hand. (Growth accounting, in Solow's case... a very important concept.)

It is a touchstone in the literature for an entire field. One cannot be considered to be educated in that field without an understanding of it.

It can be augmented and extended fairly easily to obtain more interesting and potentially useful results.

Despite all that, we know that it is a bit too simple to be the only tool in our arsenal. Indeed, to use it as the only tool in our arsenal would be dangerous.

Would not each of these statement apply to the Ricardian model as well as the Solow model? (Readers are invited to suggest others.)

John responds:

Recently a colleague asked me if I teach anything about growth in my intro course. I replied that I teach nothing explicit about growth theories, but I do teach the Coase theorem and the importance of property rights and transaction costs in understanding exchange and growth.

In contrast, Ricardian comparative advantage lies at the heart of exchange; some would argue it is the only argument we have in favour of free trade. It is indeed based on heroic assumptions, but in many instances these assumptions do not detract from the usefulness of the concept. And at least comparative advantage depends on such basic concepts as opportunity costs and relative prices.

I wholeheartedly agree with the emphasis on the Coase theorem--which may be one of the most important ideas in economics. And yes, the Ricardian model is where we show off our propensity to make opportunity cost and relative prices the cornerstone of the entire edifice of our theory. The Solow model does not give opportunity cost and relative prices the same central role. Indeed, they play almost no role (unless you count the rental rate being the marginal product of capital, but one could overlook that if one is not careful).

But the successors of the Solow model do give prices that role. And so again I go back to my assertion that Solow's model provides the basic framework for thinking about the problem of growth accounting, for taking a measure of our ignorance, and for laying the foundation for half-a-century of research. Not a bad record.

And let's be honest. Any model that can get our attention and cause us to take stock of the measure of our ignorance about a problem as deadly serious as economic growth and development is very much worth teaching.

Gabriel M. also comments.

Office hours today: A student had a question about the golden rule saving rate in the Solow growth model. No problem. Bring up the Mathematica demonstration on the Solow model. Use the sliders to show how changing the saving rate causes consumption on the balanced growth path to rise or fall. The concept was effectively communicated faster than I could have stood up, found a dry erase marker, and started to sketch out the model on the whiteboard in my office.

If you teach the Solow model, you really should check it out.

A student sends me this piece by Dani Rodrik.

How does globalization reshape wealth and opportunity around the world? Is it mainly a force for good, enabling poor nations to lift themselves up from poverty by taking part in global markets? Or does it create vast opportunities only for a small minority?

To answer these questions, look no farther than soccer. Ever since European clubs loosened restrictions on the number of foreign players, the game has become truly global.

Read the whole thing.

Via Newmark's Door comes this from the Richmond Fed "Why I Want To Be An Economist". Read it. Many of us have had students who would tell similar stories.

Ruminating on this post by Gabriel Mihalache reminded me of this. It's Preston McAfee's introductory econ text. Since I'm teaching MBA microeconomics this summer, I need to make a note to put this on the list of suggested supplements.

Gabriel has noted some other free books and notes out there as well. The variety of what's out there for economics is truly amazing. McAfee's text is fine for a principles course at Cal Tech but probably too advanced for principles courses at most places. However, one could put it on the reading list as an optional supplement for more advanced courses, as I intend to do.

Students occasionally ask what economics book they should read for pleasure. If you're an econ professor, you know what I mean. Greg Mankiw tells us of a recent conversation he had...

Student: Professor Mankiw, if you could recommend just one book, what book would it be?

[Mankiw]: Am I allowed to recommend my favorite textbook?

Student: No. Textbooks are disallowed.

[Mankiw]: In that case, I'll suggest Milton Friedman's Capitalism and Freedom.

Student: That's funny. That's the same answer I got when I asked this question of Professor Summers.

Capitalism and Freedom is a book that I have recommended as well. As I described previously on this blog, that book was and still is a favorite of mine.

By the time I read Capitalism and Freedom, I had already made up my mind to go to grad school and be an academic economist. So it was not a life changing event in that sense. However, by the time I put the book down I knew that I had made the right choice for me. I remember that one of my thoughts after reading it for the first time* was, "Wow, that's how to make an economic argument." Maybe that's why economists across the spectrum from Mankiw to Summers and undoubtedly many more in-between recommend the book to students.

*It is indeed a shame that I will never again read it for the first time and capture that exact feeling again. I am reminded of an episode of "Classic Albums" on VH1Classic in which one of the members of Pink Floyd (probably David Gilmour, but I don't recall for sure) waxed philosophical about what it must have been like for someone to bring home Dark Side of the Moon, turn out the lights, put on the headphones, and listen to it for the first time--and that since he was so involved with brining it into being he never had that experience for himself. I can't help but wonder if Milton Friedman had a similar experience with Capitalism and Freedom.

I mentioned these once before. Now, I'm starting to contribute to the library of demonstrations. My first contribution is a simple Keynesian IS-LM model. I chose this for my first attempt as it was easy to code and could be widely used in classroom presentations. Granted, I don't make the IS-LM the centerpiece of my class, but it does have some value and students should know what it is.

If you teach macroeconomics, you might want to try it out. It requires the Mathematica version 6 player (free download). Here's a link to the demonstration. Here's a link to all the economics demonstrations. And this is what the interface of my IS-LM demonstration looks like...

Please let me know if you find it useful. I hope to do some more of these in the near future.

The college had a bulletin board contest for the various student organizations. The Economic Student Association took 3rd place (the cash prize will help pay for our trip to St. Louis we're planning). The Finance Club took 1st, but I really shouldn't complain since one of the items on their bulletin board was a sign advertising my talk to their club earlier this week.

Also this week, I heard from a former WIU student now studying for her Ph.D. in economics that she has passed both her comprehensive exams...with a "high pass" in macro. Since I taught both her macro classes in our M.A. program, I am delighted to hear that news. She did both her B.A. and M.A. at WIU.

Another former student of mine recently returned from a semester at Oxford. Still another student is in the running for a very prestigious award. Hopefully he'll find out about that soon.

Not to mention that I have some really bright students this semester as well. Could be one of my best groups yet (compared to any place I've been). We've got some really good econ majors, and some good finance majors getting a minor in econ (a very good and increasingly popular combination here).

Flyers like this one have been seen on campus.

It shouldn't be hard to come up with 45 minutes worth of things to talk about.

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.

Yes, I've been quiet the last few days. It has been final exam week, and on Wednesday it almost required a shovel to get down to the desktop. Things are better now, and I hope to be rejuvenated after the weekend. In the morning, I will be at the Commencement ceremony. As I often do, I will be leading the graduate students (MA Econ) across the stage and handing each of them their diploma cover as we smile for the camera (the actual diploma will be in the mail after grades are in).

Then, after the ceremony, we're going to St. Louis to see Wicked (for the 2nd time).

Have a good weekend!

I figure I've logged about 1600 miles of driving in the last 11 days. That cuts into the time available for blogging. Things should improve now for a while at least.

Yesterday, I was in Chicago with my students competing in the 7th District College Fed Challenge. Three time defending national champion Northwestern University won again. Although the University of Chicago certainly gave them a run for their money. We faced U of C in the first round and thus didn't advance. Even so, the value of the program as a learning experience for our students is tremendous.

Fredric Mishkin spoke yesterday about the risk management approach to monetary policy decisions. This was the basis for the lead off question in the final round Q and A session at the Fed Challenge. By the way, all of the final round teams (in addition to our team), were unanimously in favor of holding rates constant at this point in time. The competition is real-time. Therefore having it so soon after the last meeting does sort of predispose one to holding steady. However, there was a lot of discussion and debate by all the teams about what the outlook is going forward.

As for that outlook, Tim Duy is concerned.

...One has to imagine that the Fed must be feeling a little uneasy about pulling the trigger on another 25bp last Wednesday given Friday’s employment report. Still, they likely take comfort in the belief that they drew a line in the sand with the statement, declaring a balanced risk outlook.

But can they stick to that line during a scary four months? Can they look through to that period of “moderate growth” that they keep predicting? I would like to believe they are ready to stick to their guns, but recent history is not on my side.

...

Can the Fed resist that pressure to keep cutting even if they are confident that the medium term risks are really balanced? If the “risk management” faction at the Fed continues to hold power, it seems like more rates cuts are likely, especially if there is any hint of further softening in employment or investment. That is what recent history tells us.

Standing in the way of additional cuts, however, is these new-found inflation concerns that appeared in the last statement. Declining core-inflation has been cited as a justification for Fed easing based upon decreasing estimates of the neutral Fed funds rate. I would only like to suggest that the recent history of core-PCE is not all that comforting. Looking a three-month inflation trends on an annualized basis:

I detect something of an upward trend in the past four months, on the order of 50bp – perhaps it is too early to be lowering estimates of the neutral rate? Personally, I wouldn’t break out the champagne on the inflation story just yet. It appears, however, that Fed Chairman Ben Bernanke and Governor Frederick Mishkin – the power couple in the “risk management” regime – already popped the cork.

The chart is from Duy's post at Economist's View.

This is precisely a point that was made by my students as well as most of the other teams at the Fed Challenge yesterday. This is a concern going forward. There is a very real risk that any further easing could have nasty repercussions for intermediate to long term inflation expectations. And if the Fed is going to be facing a real inflation problem in a year or two, when the economy is still trying to right itself from the subprime debacle, that's not going to be good for growth either.

See also this article by Bloomberg's John Berry.

Tim Schilling has moved from the Chicago Fed to the Powell Center for Economic Literacy. Thus his blog had to move as well. You can now find it at http://www.valuingeconomics.blogspot.com/. In his latest posts, he finds economic ideas in the Meredith Willson musical The Music Man... everything from elasticity and externalities to the roles of government and the entrepreneur. If you teach economics, put Schilling's blog in your feed reader.

I intended to post last night, but lack of sleep got the better of me. Anyway, the reason that I was away from the computer yesterday is that two other economics faculty and I took a group of econ majors, graduate students, and other interested folks up to the Chicago Board of Trade yesterday to watch what happened on the floor when the Fed announcement came out. Astute readers will recall this post from a few weeks ago:

Note to self: WIU economics faculty and students usually make a trip up to Chicago to see the Board of Trade every year. I am one of the faculty who works on scheduling and arranging the trip. I must do what I can to see if we can get up there on an FOMC day this fall.

The blog is great for keeping some of those notes to self in writing so they can be remembered and acted upon.

Let me also say that I am very happy to be part of a department that places such value on these kinds of experiences for students.

Last spring we saw the Board of Trade on a day where there was considerable activity in the grain markets, but the financial markets were absolutely dead. There were just a few people milling around checking the computer screens, reading the newspaper, and so forth.

Contrast that with yesterday. In the gallery there was a map showing what instruments are traded in each pit. It appeared that the most activity was in the bond futures and options, particularly the 10 year, but a bit of activity in the 2 and 5 year as well. There were some people in what the map showed was the fed funds pit, but the activity was not frantic. My guess is that a lot of that activity is electronic. There was some activity in the Dow futures, more on that later.

We got up to the gallery shortly before 1:15 as traders were quietly waiting for the announcement. I was looking at the bond options area when I heard a noticeable rise in volume from the floor. That's when I turned to the big CNBC monitor in the corner and saw that the announcement had come out and that it was 50 basis points. Within seconds, the pace of activity had increased from relative calm to a rather brisk pace. Yet it was controlled rather than frantic. I would guess that every trader on that floor had a game plan for this possibility that they had thought out ahead of time. They were executing that game plan rather than simply reacting. Had the decision been for 25 basis points, the game plan would have been different, but it would have been similarly executed.

Casual observation: There was some media coverage on the floor. I could see the cameras but from my vantage point I could not see the reporters. It looked like CNBC cut to their camera on the floor a couple times while we were there, and when it did the volume level on the floor seemed to rise. (Playing to the camera?)

Prices of various instruments were posting up to the big digital boards on the wall. Green numbers under the 2 year note futures, red numbers for the 10 year futures reflecting the movements taking place on Wall Street as the short term prices rose (yields fell) and the news was mildly negative for the longer term bonds. As someone who takes an interest in this and teaches it, I have to say that it was quite a sight to see those the hand signals in the pit and look up and see the numbers on the board go red and green as the traders digested the information.

Another way that the trading in Chicago mirrored that on Wall Street was in the Dow futures. Again, we could see on the digital price board that the DJIA was heading upward while all of this was going on. It was up about 170 points at the point when I started to notice what was going on with the futures. Every few minutes there was a little outburst of activity in the futures. As the Dow climbed, the futures kept pace. The September contract expires on Friday, and of course other months prices rose in lock step (this is where you can illustrate the law of iterated expectations).

All told, it was a great day for the students to see economics and finance in action. Before the announcement, we even got to go down to the trading floor briefly as a guest of a trader who knew one of our students. Also that morning, before going to the CBOT, we visited a consulting firm. That gave our students a chance to see more about how economics is used in the "real world". Now I'm working on a handout and presentation as a "debriefing" for the students to reinforce what they learned. I think the title of the presentation will be "What happened while you were watching and why?".

We also got to meet up with a student of ours who just finished an internship in Chicago and leaves next week for a study abroad term at Oxford. Did I tell you that our students can compete with the best?

Later, some thoughts on the rate decision itself.

Brad DeLong is teaching American economic history. I'm scheduled to teach it next year, and I feel his pain when he says that his eyes are bigger than his stomach.

The canonical course on American economic history spends:

* one week on the Spanish conquest

* one week on Amerindians

* one week on colonial settlement

* one week on the American Revolution

* one week on Alexander Hamilton

* one week on agriculture in the Old Northwest

* one week on New England manufactures

* one week on slavery

* one week on the Civil War

* one week on the Gilded Age

* one week on Populism

* one week on Progressivism

* one week on immigration

* one week on the Roaring Twenties

* one week on the Great Crash and the Great Depression

* one week on the New Deal

And we have overshot the end of the semester by three weeks.

He goes on to say that he wants to make room for post WWII history by getting to 1865 by the fourth week. Wow. I think you could buy a little time by spending just one day rather than a full week on the pre-colonial period and on Hamilton. Due to my location, I would switch out agriculture in the Old Northwest for agriculture in the Midwest, put it later in the semester (together with the railroads). Make Populism and Progressivism a day each instead of a week each. Similarly for immigration and the 1920s--make them a day instead of a week.

But even at that, you've only crammed that syllabus into the proper length of the semester. You haven't made room for post WWII.

This is going to require some serious contemplation.

Bryan Caplan had some fun at lunch recently...

At a recent GMU lunch, two economists sparred over the optimal quantity of cash to keep in one's wallet. Economist A holds very little cash, on the grounds that you can pay for virtually everything with credit cards. Economist B holds lots of cash, on the grounds that the foregone interest is virtually nothing, and his time is very valuable.

Whose side do you take, and why? Value of time and foregone interest calculations are welcome.

P.S. Please don't repeat the textbook model of money demand. I'm asking for a concrete solution, not a general framework. :-)

Greg Mankiw defends the textbook model:

For example, suppose that the GMU economist spends $10 per day in cash, takes 10 minutes to go get cash out of his ATM, has a value of time equal to $60 an hour, and earns 5 percent annual interest on balances held at his bank. From this information, the Baumol-Tobin model yields a very specific prediction: The prof should take out $1200 from his bank three times a year and hold an average of $600 in his wallet....

Most people hold much less money on average and go to the ATM much more often than the model predicts for their parameter values. This is a puzzle. It is also a great example to work through in an intermediate macro class. You can generate a good classroom discussion about why the model fails to match behavior.

He then gives two examples (neither of which he finds compelling). My answer to Caplan is that personally, I'm with "Economist A". I don't carry a lot of cash, but that's mainly because I use very little of the stuff and have extremely convenient access to an ATM on campus (which charges no fees as I am a customer of the bank that owns the ATM).

Mankiw's puzzle, however, is not really a puzzle to me. The problem for the model is that the value of time tends to be overestimated in examples like this. Perhaps I can bill my time at $60/hour, but that does not mean that I will at all times and in all places behave as if my time is literally worth $1/minute.

Consider the example that circulated a while back about how Bill Gates wouldn't even bother to pick up a $100 bill off the ground because he makes more money in the time that it would take him to bend over and pick it up. (A clever rendition of that story, complete with a chart, can be found here.) But there's something about the example that doesn't wash. Does Bill Gates literally get paid by the second? No. As clever as this example is, it is not literally true that Bill Gates would forgo the fraction of his income that could be attributed to 4 seconds out of his day when he bends over to pick up a $100 bill. The amount he would forgo might even be more, and is probably often less. Using the value of time as an explanation only makes sense if there is truly something given up. Think about it this way, would Bill Gates be more likely to stop and pick up a $100 bill on his way into an office building for a meeting or on his way out? On his way in, his mind is focused and he doesn't want anything interfering with getting to the meeting. On his way out, he may have a bit of "slack time" (unless he's late for the next meeting). The point is that the true opportunity cost of Bill Gates' time is not uniform throughout the day.

Or how about this one... A lot of people don't bother to pick up pennies. Is it because the value of their time is more than the value of the money that is picked up? Perhaps it is sometimes. But it seems more likely (and more in tune with my own experience) that you just don't want to carry a penny around, or maybe because you suffer disutility from bending over. The value of time matters, but it doesn't have to do all the heavy lifting in this example.

The fact of the matter is that most of us have a bit of "slack time" built into our day by accident or design. Suppose that it takes me 50 minutes to eat lunch and that I like to get to class 5 minutes early. If I'm passing by the ATM on my way to get lunch and it's 60 minutes until my class starts, the time that it takes me to get cash comes out of the 5 minute buffer that I have in my schedule. That's time that I would spend checking my e-mail, looking at my notes, or enjoying the view out my window while I get my thoughts in order. It's a low opportunity cost window of time--small enough to just be counted as the time equivalent of loose change. Those fleeting moments don't aggregate very well into billable $60/hour blocks.

Viewed that way, the puzzle disappears. Personally, ideas tend to come to me in low opportunity cost moments of time, so paradoxically, I value those moments highly. Discuss.

Robert Frank brings up a problem he wrote about two years ago and goes on to compare learning economics to learning a foreign language. Here's part of the article. Read the whole thing.

In a recent paper, Paul J. Ferraro and Laura O. Taylor, economists at Georgia State University, suggest a more troubling possibility — that introductory economics instructors may not have mastered some of the basic concepts themselves. When the researchers described an activity and asked a sample of 199 professional economists to identify its opportunity cost, only one in five answered correctly.

The good news is that an approach that has revolutionized the teaching of foreign languages promises similar gains in economics and other disciplines. I took four years of Spanish in high school, only to have difficulty making myself understood when traveling in Spain. In those days, most language courses focused on arcane grammatical details, the functional equivalent of the technical material that often bedevils introductory economics students. Today, the best language programs try to mimic the organic process by which children learn their native language.

My first exposure to the new approach came during my Peace Corps training for teaching math and science in rural Nepal. All the things we learned to say were grammatically correct, but we were never taught any formal grammatical rules. Starting from scratch, we had to be able to teach, in Nepali, just 13 weeks later. Our linguistic skills were fairly basic, but virtually all of us made it.

Of course, it’s not easy taking this approach consistently in an economics textbook. Ben S. Bernanke and I have tried in our own textbook, but given what the marketplace is willing to accept, we have not yet gotten all the way there.

Just as a few simple sentence patterns enable small children to express an amazing variety of thoughts, a few basic principles do much of the lifting in economics. If someone focuses on only these principles and applies them repeatedly in examples drawn from familiar contexts, they can be mastered easily in a single semester.

The form in which ideas are conveyed is important. Perhaps because our species evolved as storytellers, the human brain is innately receptive to information in narrative form. Years ago, I stumbled upon an assignment that plays directly to this strength.

Twice during the semester, I ask students to pose an interesting question based on something they have personally observed or experienced. In no more than 500 words, they must then use basic economic principles to answer it. I call it the “economic naturalist” assignment, in the spirit of field biologists who use Darwinian principles to interpret the traits and behavior of living things.

Here's his column from two years ago and my response. Economic naturalism is harder to do for macro (current conditions excepted), but macro principles could use a fresh approach as well. Something for the "to do" list.

So many good Dilbert comic strips deal with opportunity costs within the firm. Saturday's made me laugh. Non-economists probably laughed at the punch line. I laughed at the set-up.

David Leonhardt explains why records are made to be broken and why one must always adjust for inflation. (NY Times)

The S.& P. 500, which is a much better measure than the Dow, closed yesterday at 1,549, just 1.4 percent higher than the peak it reached in March 2000. Think about what that means. While the price of nearly everything has risen over the least seven years — while the price of bread has increased almost one-third, for instance — stocks have barely budged. They have only marginally outperformed cash sitting in a bureau drawer. So if we are going to talk about a stock market record, we should be doing the same for a whole lot of other things: Loaves of Bread Surge to New Highs

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.

I learned today that one of our alumni is now Deputy Minister of Finance for Economy and Integration in Paraguay. One of my thesis students from this past year is in the Ministry of Finance in Mozambique. He and I are working on a paper together.

Both came here on a Fulbright Fellowship. Over the years, WIU has attracted many Fulbright students from around the world. They add to the intellectual vitality of the department, and it is rewarding to see them do well.

I received a notification in my e-mail today about the Wolfram Demonstrations Project. If you don't have Mathematica 6.0, you will need to download the free player for the demonstrations. (I have version 5, and it doesn't play the files--you need the new interactive interface in version 6 apparently.)

There are some really nice demonstrations available, including many in for economics.

Take some time this weekend to download the player and experiment with some of the demonstrations. Many would be great for use in classes in math, economics, and the sciences. Enjoy!

Each semsester, my intermediate macro class does an FOMC simulation. Today was the day. The have been researching current economic conditions, the speeches by Fed officials, and so forth. At the end, I polled the class on what action the Fed should take. Of my students, 13 voted to hold interest rates steady. 2 voted to raise, and 2 voted to lower the funds rate.

This is, of course, a completely unscientific poll, but they learned a lot from it. It is the first time in all the semesters that I have assigned this project that there were people favoring three different possibilities.

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.

The reading list grows ever longer. David Colander's latest, The Making of an Economist, Redux will move immediately to the top of my list. I shall put it on the calendar as the first book to read after final exams in a couple weeks. That should be a good way to start the summer.

The book is an update of The Making of an Economist by Colander and Arjo Klamer. Since their book appeared, there has been a sizable influx into the profession by economists trained in the manner highlighted by Colander and Klamer. In the opinion of some, it hasn't been all good.

Of course, I am part of the generation that came of age academically post-Colander and Klamer. I even remember some discussions in class and out of class during my undergraduate days about some of the ground they covered. (And yet still I chose to get my Ph.D.!) So I'm excited to see that Colander has returned for a second look.

Arnold Kling is already into it. He quotes from the book:

In the early 1980's, many students went into graduate economics study thinking that it would be like undergraduate school; today almost all students know better. In effect, students have been prescreened to be comfortable with the mathematics in the program. Similarly, graduate schools know better what they want and select students who are comfortable in the approach that will be taught.

By the mid-1990s, this was already true to a large extent, but it is even more so today.

And...

the macro that is taught to the students in the core has lost touch with both policy and empirical evidence. Instead, students are presented with dynamic stochastic optimal control theory and Euler equations.

I like Euler equations. But Colander has a point. As I made my way through the Ph.D. program, I could not afford to be as introspective as Colander is and others have been. Furthermore, I had no other experience to compare it with--I was not in graduate school in the 1980s. By the end of the program, I admit to a certain amount of an "I did it, so you should have to do it too" style of thinking. It's only natural.

But in the last couple years, I have had the experience of teaching macro at the MA level. This isn't the sort of thing you spend a lot of time training for in grad school, but it is a pretty important task. To get the MA degree, you need to take at least one more course in macro beyond the intermediate (undergraduate) level. (At least this is the case at WIU, and I suspect it is so in any other program--some may require two, but I doubt that any require zero.) What do you put into those courses? Answering this question has made me think harder about macro than I ever did in graduate school--and I didn't think that was possible. It has made me a better teacher at the undergraduate level in the process.

I continue to think hard about this as I ponder revising these courses for my third go-round next year. I plan to share these thoughts on the blog and invite yours as well. To be sure, my MA courses are not comparable to the Ph.D. level mathematical gymnastics that Colander scrutinizes. But neither are they simply a restatement of intermediate undergraduate macro. There needs to be a middle ground. Luckily, the middle ground is a vast wide open space.

Let me close with a comment from Kling:

Another reason that macro does not work in grad school is that studying macro is like studying polio--the serious problem of long-term macroeconomic distress has been eradicated. As recently as when I was in graduate school, the problem of stagflation at least provide some motivation to do applied work. Until there is a major outbreak of inflation or prolonged recession, I think that macro ought to be a history of thought course.

Questions of economic growth still provide motivation for macroeconomists to do applied work. But then, if you are going to study economic growth, you should read David Warsh's Knowledge and the Wealth of Nations.

Incidentally, if you think that Colander's book sounds interesting, you will probably also want to read this article by Robert Solow (hoisted from my graduate macro reading list).

UPDATE: My apologies. The link to the Solow article above requires a subscription. This link through a free site ("findarticles.com") should work.

UPDATE 2: Arnold Kling follows my link to Solow and responds.

Yesterday, I was at the Chicago Fed helping to judge the high school Fed Challenge. I was impressed with the overall quality of presentations. Hopefully some of them will go on to compete in the college version of the competition.

The overwhelming (unanimous?) consensus of the teams competing was to keep the target for the fed funds rate unchanged. No surprises there.

In the Illinois competition, it appears that the schools were all from the Chicago area. Here's hoping that some downstate schools will get involved. It would be great to see the program grow. The more students are exposed to economics in the high schools, the better.

As a side note, Tim Schilling (who works tirelessly at organizing these competitions all around the 7th District) tells me that for my judging efforts I will receive an official "Fed Challenge T-shirt". When it arrives, you can expect a photo for the blog.

As another side note, after the competition, I had a couple hours in Chicago before catching the train home. I spent that time (and could have spent hours more) at the Art Institute of Chicago. The featured exhibition right now is Cezanne to Picasso: Ambroise Vollard, Patron of the Avant-Garde. Well worth your time and the price of admission.

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.

Given that this is the first week of a new semester here, I thought this would be appropriate. Michael Mandel doesn't like using the word scarcity in the definition of economics. He offers an alternative:

Proposed definition: Economics is the study of the functioning-–and malfunctioning--of the economy, with the aim of improving living standards

First of all, saying that economics is the study of the functioning of the economy is in the same vein as saying, as Jacob Viner famously quipped, "Economics is what economists do." True, but not terribly helpful. That economics has the aim of improving living standards is, for me at least, a bit problematic as a definition. It opens up a can or worms over what you mean by "living standards". Not that we shouldn't open that can of worms. In fact, I think it would be useful to have precisely that sort of discussion at the introductory level. But that is precisely the point. I'm not sure it works to have a phrase that is open to so much discussion and interpretation as a crucial part of a definition. To define economics that way would require a lot of context. So, to be fair, I will end my criticism here until I see that context.

Back to the original question, it is true that nearly every textbook definition of economics uses the word "scarcity". But it is not universal. For example, The Economic Way of Thinking by Heyne, Boettke, and Prychitko uses this definition:

Economics is a theory of choice and its unintended consequences. (page 11 of the 10th edition)

Prominent among the unintended consequences in their definition is the emergence of spontaneous order. (You learn this if you read the introductory chapter carefully--again, the context provides a clue.) It's not a bad definition.

In a slightly different vein is this little title hoisted from a syllabus from one of my grad school courses back in the day. From memory (I'll hunt around for the actual copy to make sure I got it right), it was something like this:

Macroeconomics: A study of allocative (in?)efficiency

I've always liked that one. Then there is the definition that I have used for quite a number of years in teaching macro and micro principles. To my knowledge it is not in use anywhere else in precisely these words. I first put it on paper as a grad student and have used it ever since, maybe changing a word or two over the years. I was inspired to write this while trying to put the familiar "circular flow" into words.

Economics is the study of choices made by individuals, how markets coordinate those choices, and how governments influence those choices.

See how it reflects the circular flow that is part of nearly every textbook description of economics? Like Heyne, Boettke, and Prychitko, I give individual choice top billing in my definition. I dislike definitions that put it in terms of how "society chooses". Society doesn't choose. People choose. How those decisions are aggregated matters immensely.

Sometimes individual decisions are aggregated in markets. That implies certain outcomes. Other times, individual decisions are aggregated through direct voting or a representative form of government. That often implies different outcomes. Decisions made by firms are really the result of an aggregation process within the firm itself. Institutions matter. The "rules of the game" matter. (Here again, my thinking has been influenced by Heyne, et al.) What some might call society's choice is a particular combination of individual choices coordinated by markets and influenced though the law by government as well as the weight given to market and to government in the process. How much is market and how much is government is determined by many factors. Most of them are outside the scope of your average economics course, but are still worth thinking about.

My definition has three parts. Individual choice is the heart of all economics--even parts of economics that don't fit neatly into areas related to markets or government (e.g. game theory and bargaining). One could, I suppose, put a full stop right here and call it a day. It is beneficial, however, to single out the role of markets and the role of government as two identifiable arenas in which those choices play out. They are not the only such arenas, but they are the ones about which the body of knowledge in economics has the most to say. When I deliver this lecture in class, this is the context that I try to give my definition.

Let those of us who teach economics never forget that individual choices are the building blocks and that the manner in which an economy aggregates those decisions matters.

UPDATE: See the comments for more. PGL comments and expands on it over at Angry Bear. Arnold Kling at EconLog says this in response:

I am two-handed on this issue. On the one hand, just because food, say, has become more abundant does not mean that we can ignore scarcity. At any moment in time, for a given state of know-how, the conventional definition of economics as dealing with the allocation of scarce resources among competing ends applies.

On the other hand, some of the most interesting economic observations concern relative abundance. Look at our standard of living compared to 100 years ago. Look at South Korea compared with North Korea. Robert Lucas famously said that "The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them it is hard to think of anything else."

The Lucas quote has to be one of the most often quoted lines in all of economics. I quoted it in a different context in the comments to this very post.

However, I don't see "relative abundance" as being on a par with the fundamental problem of scarcity. I agree that the observations to which Kling refers are interesting (and I use those very examples every semester), but they are problems that can be addressed in the context of choices and institutions--which are the twin pillars of my definition above. Focusing on the relative abundance of South Korea and the implications of that abundance for the choices people make is an interesting side issue, but it misses the larger point. What is it about South Korea that is different from North Korea that can explain their relative abundance? In my preferred framework, the relative weight given to markets vs. government in aggregating individual choices is a good place to start.

Back to the original question. Scarcity implies choice. That's the bottom line. And it is my opinion that defining economics in terms of choice (rather than the word "scarcity") resonates more with students. It's not that I don't think scarcity matters, it's that I think there is a better way to word it to get the point across. Here's a slide from tomorrow's lecture to my principles class:

I've been using the same slide (updating the page number with new editions of the text) for I don't remember how long.

And the punch line several slides ahead (after talking about market vs. command economy and--time permitting in this lecture--a brief look at property rights and so forth):

This is a lecture/discussion that I really get into with my principles classes. Sometimes I think that it's the most important lecture of all. If you don't get hooked on economics by talking about these issues, I don't know what will get you. I guess it goes back to the Lucas quote again.

UPDATE 2: Link to EconLog corrected.

I'm sitting here thinking about the first day of the semester tomorrow--trying to come up with some choice little bits to throw into the lecture. One of my classes is an advanced macro course for the MA program. I'm thinking of ending the intro to the lecture like this: "In Econ 502 we cover about 2 or 3 weeks worth of my intermediate macro course on the first day as a review... then things start to get interesting. Let's begin..."

UPDATE: I did say this, and the response was muted--a couple of smiles. They knew I was serious.

For those interested in what we cover, the first couple weeks are a review of static and dynamic optimization with macro applications, followed by growth (Solow, Ramsey, Romer, etc.) and concluding with real business cycles (overview of the literature along with critiques). I plan to sprinkle in a good dose of David Warsh's Knowledge and the Wealth of Nations to stimulate critical discussion. These students have (for the most part) already had exposure to IS-LM, an overview of New Keynesian macro, time consistency, and the permanent income hypothesis. This course is well suited to those looking to apply to a Ph.D. program after finishing their MA here.

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.

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).

Stephen Karlson (Cold Spring Shops) discusses the college rankings, the arms race among universities, and the role of the "mid-majors". Here's a highlight of the long version:

The higher education premium is a premium to human capital formation, not an incentive to acquire a signal. "Nationally-competitive" is a statement about success in teaching, learning, and graduating. Why apologize for these things, or for paying a premium price for premium professors, or for charging a premium price for the opportunity to study with such professors and sharpen your brains with premium classmates?

His next post offers the short version. Remember folks, it's about quality. It's about the intellectual enterprise. The mid-majors can play that game too. To wit:

Short form, example 3, theory class. "Can we practice with some Jacobians?" Hal Varian and David Kreps leave the nastier bits out of their texts ...

I will add another example from here at WIU. In my advanced macro class sometime last year came the request, "Can you suggest more classic papers that we can read?"

Furthermore, my current intermediate macro class is asking some of the best questions I've ever fielded in that course (which I have taught quite a few times).

You get out what you put in. Higher education is not dispensed like water from a tap. You must be prepared to go to the well. We will show you the way.

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.

Steven Landsburg figures out why some hotels charge for internet access and others don't.

The goal, then, is to use amenities to equalize your customers' willingness to pay. Take a stripped-down example: You've got two customers, Jack and Jill. Jack will pay $100 for a room without net access; Jill will pay $120. That poses a pricing problem. But suppose you happen to know that Jack will also pay an extra $20 for net access, while Jill thinks computers are instruments of the devil. Now the pricing problem is solved: Make net access free. Both customers will pay exactly $120 for the room-plus-net package, and that's what you charge.

But he still hasn't figured out why popcorn is so expensive at the movies.

In every important respect, the popcorn pricing problem is identical to the Internet pricing problem. If Jack will pay $10 to see the movie and Jill will pay $12, but Jack really loves popcorn, then a greedy profit-maximizing theater owner will offer to shower Jack with free popcorn until he's willing to pay $12 to get in.

But if Jack and Jill are each willing to pay $12 to see the movie, that same greedy profit-maximizing owner will charge them both $12 and bleed Jack dry at the popcorn stand.

Sometimes the numbers should work out one way; sometimes the other. Yet in the real world, popcorn, unlike wireless Internet, is never free.

It's logically possible that by pure coincidence the numbers at every movie theater in the world all work out the same way, while the numbers at hotels work out one way half the time and the other way the other half. But "pure coincidence" theory is even less satisfying than the "differential greed" theory. There must be something I'm missing that makes popcorn essentially different from Internet access. I remain stumped.

UPDATE: Landsburg also mentions movie popcorn in this article.

Robert Frank's article on a life-or-death cost benefit decision and Steven Landsburg's piece in Slate.

Price controls on water in Bolivia (via EclectEcon and Division of Labour).

Students, click on over to the Big Picture and take a look at the power of compound interest.

In the comment section, "M1EK" is correct with his comment about inflation, but that problem is easily overcome by assuming a constant real contribution instead of a constant nominal contribution.

Western Illinois University has the most sensible final exam schedule I've ever seen. Finals are at or near the regular class time and almost always on the same day as the class regularly meets. No complicated schedule matrix that changes from one semester to the next.

Happily, I'm the first one in my department to be all done. By 9:50am on Tuesday it's all over but the grading.

Now, to write some exams. Have a good weekend, everyone!

Term papers must be coming due from sea to shining sea. My site statistics are showing all kinds of interesting search terms that brought people here from (fill in the blank).edu. Sounds like Cold Spring Shops is seeing something similar.

Word of advice: Blogs themselves are not the greatest scholarly sources for term papers. However, they can be useful for your research. Most bloggers provide references (lots and lots o'links) with their posts. So if Google brought you here, I hope that you find a link to a paper, news item, government source or something else that can add that extra touch to your term paper. I can envision cases where citing a blog would be acceptable (even desirable), but you're taking your chances.

For next semester, I would like to make an assignment for my principles course that gets students reading the economics blogs and seeing what they are, what they aren't, and how they can benefit from them. I'll keep you posted.

Also in the category of "'Tis the season", my finals are done on Tuesday. Posting will be somewhat sporadic until then. Fortunately, I'll be done in time to comment on the FOMC meeting.

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.

Personally, I make students equate the book's definition with exactly what Karlson said. I guess that will do until I write my own book.

Students make this mistake all the time. It's got to be one of the most common. It's also one of the more common errors in the media. Phil Miller (Market Power) finds today's example. Phil writes:

I turned on CNN Headline news this morning (Saturday) and watched a item on gas prices. The reporter, who's name I did not catch toed the party line by going after the greedy oilmen. But then he tried to use economic reasoning to make his point. To explain the rocketing gas prices, he said:

"A short supply increases demand...."

This statement is a rather bizarre version of the common error, namely to link changes in demand directly to changes in supply or vice versa (shortcutting the role of price).

How does one make such an egregious mistake? I'll give you one possibility. Supply disruptions in the gasoline production chain (such as those associated with the recent hurricanes) make people think about gas lines from the 1970s. Of course we know that a true shortage happens only when the price is below the market clearing price. In the '70s, this was due to price controls. But old memories die hard. For many the gut-level reaction is to think of gas lines.

The next step in their reasoning is that if gas shortages are on the horizon, then you'd better get in line now. Or, by the same token, if the price is expected to rise, you'd better buy your gas now. Either way, you arrive at the perfectly economically valid argument that an increase in the expected price (or an increase in the probability that the good will be unavailable in the future) causes an increase in demand now. I would be willing to bet that this sort of logic is what drives people to make a statement like that.

But if they are using that logic to explain the higher prices, their efforts are misplaced. The higher prices (as well as the expectation of higher prices in the future) are due to the decrease in supply itself! The fact that prices rise due to the decrease in supply is the reason why there are no true shortages (outside the hurricane's zone of devastation, at least).

So there you have it. Trying to explain higher prices by thinking about what happens in a shortage causes you to miss the real reason fo the higher prices. And I think that also goes to show what a profound impact those gas lines in the '70s had on the way we think about the market for gasoline. We're so mindful of queueing for gas that in the minds of many people the reason for higher prices must be because we are afraid of queues and we're all rushing out to stockpile gas. In reality, that effect, even to the extent that it does happen in a few cases, is small compared to the main reason for the price increase.

Of course, the panicking buyer afraid of shortages does play into the greedy Big Oil mythology a lot better. You don't think that has anything to do with it, do you?

As I said a while back, principles level is all I ask! The direct linkage of changes in supply to changes in demand is a common error, and it's a particularly bad mistake to make because it leaves out the role of price. Our experience with price controls notwithstanding, changes in price are what induces a response in buyers and sellers. Never forget that.

Couldn't pass this one up. From CNN concerning Ben Bernanke's financial disclosures:

Bernanke was paid $162,100 to be a Fed governor in 2004, and took a slight pay cut to become the chairman of the White House's Council of Economic Advisors earlier this year. He received royalties on one textbook from Pearson worth between $50,001 and $100,000 in 2004, and royalties on a another textbook from McGraw Hill worth only between $201 and $1,000. As of 2005 the Fed chairman is paid $180,100.

For those keeping score, his principles text with Robert Frank is the McGraw Hill book and his intermediate text with Andrew Abel is the Pearson book.

Take care not to generalize too much, as it is just a sample size of one author who happens to have two books. We also don't know the full terms of his contract (if he received an advance from the publisher, and if so, how much). Gregory Mankiw is another macroeconomist with both a principles and an intermediate book (and both are strong sellers). Not sure if he had to disclose his finances when he was on the CEA. (Bernanke is currently on the CEA, but it wasn't until now that the media reported on his finances.) David Colander also has written books for principles and intermediate macro.

Does producing a textbook at another level in the same field lower the average cost of production (writing)? (That is, are there economies of scope?) Does it depend on the field? (Probably.) Not having done it yet, I couldn't tell you from experience, but it's an interesting question.

The comparison of Bernanke's and Greenspan's finances in the article is interesting too.

Tyler Cowen (Marginal Revolution) posted a list of practice questions for his graduate macro class. My students have an exam coming up on Tuesday. This course is one of two macro courses we offer at the master's degree level at WIU--the more policy oriented of the two courses. Borrowing from Cowen's idea, here are some things that I hope my students are thinking about:

1. Give a critique of the IS-LM-AD model as traditionally presented.

2. Give a couple of reasons why AD shocks have real effects in New Keynesian models (i.e. different assumptions that generate rigidity). Are they plausible?

3. What is the role for stabilization policy in the New Keynesian models we studied? As a specific example, consider the staggered price setting model. What is the government able to do that private agents cannot do? What are the limitations of policy?

4. What is the significance of the Lucas Critique? Is the simple version of the New Keynesian staggered price setting model subject to the Lucas Critique? Does it have an exploitable Phillips curve?

This list is not all-inclusive. For my students who might read this, you should also take note of some specific suggestions I made in class. Cowen's 4th point is worth noting as well. (But if my students are reading this, it's not on the test.)

UPDATE: Tyler posts his thoughts on IS-LM. He would get an "A+" on my question 1. In class, we focused primarily on reasons 1, 4, and 6 (which refers to 1) on his list as well as some others (someday when I have time I'll go into more detail). I yield the same concession as he does, which is why I still teach it in the more policy oriented of the two courses. It's what a lot of policymakers have in their head, so it's worth understanding. But I'd say it's more important to realize its shortcomings. Hence, my posing it as a study question.

Arnold Kling at EconLog noticed the WSJ Econoblog yesterday. He poses the discussion question:

If your goal were to have first-year economics understand, say, the role of markets in addressing the disruption in gasoline supplies caused by a hurricane, how would you propose to teach this?

See the comments over there for discussion.

Roberts responds to a critic at Cafe Hayek.

Gavin Kennedy checks in with a comment and a link to his site on Adam Smith's Lost Legacy. He blogs on that site as well. I'll be adding that to the blogroll.

On Smith, please notice the link in the Econoblog piece where I talked about Smith. If you missed it, here it is again.

My study of Adam Smith was influenced tremendously by Deirdre McCloskey. I was fortunate enough to be a part of a graduate seminar in which Deirdre and a handful of us grad students read The Theory of Moral Sentiments, beginning to end. It was there that I came to appreciate Smith like never before. The seminar was great. Dinner at Deirdre's house was always a welcome change for a grad student. But most of all, her thoughts on Smith and the virtues outlined in his various works really resonated with me. I carry it with me to this day.

So read the piece by McCloskey. Just to give you a little teaser, here you go...

The businessmen wearing the Adam Smith ties need to do a little reading of The Wealth of Nations and especially The "Theory of Moral Sentiments" on the train from Westport. Smith did not say, ever, that Greed is Good. And the Christians and other opponents of the sin of avarice need to stop conceding the point to the men of Westport. There is no paradox of thrift, not in a properly Christian world. Nor even in the world we have.

Now, go read the whole thing.

The latest Wall Street Journal Econoblog is up. I had the pleasure of discussing economic literacy with Russell Roberts of George Mason University who co-blogs over at Cafe Hayek with his GMU colleague Don Boudreaux. We had a very stimulating discussion on the causes and consequences of the lack of economic understanding in the public and the media. I hope you enjoy reading it and trust that it will spark some further discussion.

Let me also take this opportunity to publicly thank Professor Roberts for such engaging conversation. And let me also welcome any new readers who have found their way here from the Econoblog site. Glad to have you along for the ride.

Well, the economics blogs sure were buzzing about Robert Frank's article in the NY Times last week. I posted on it here. See also Marginal Revolution (with follow ups here and here) and Market Power. David Tufte (volunataryXchange) posts a rather detailed explanation of the solution from Christopher Decker at the University of Nebraska-Omaha. Check it out. I'm not going to copy the whole thing, and one really should read it all. While I agree with much of what Decker says, neither he nor any of the blogs I mentioned look at the second question in the Frank article. On the second question, there simply can be no room for disagreement. It should be noted that with regard to the first question, Tufte writes,

...if I had written and asked the bothersome question on an exam, I'd be embarrassed at my own lack of clear and complete thinking.

Fair enough. As I said,

Badly worded question, you say? Well, it is true that multiple choice economics questions can be written in fairly obtuse language. It's pretty easy to clean up that question though.

Some economists who answered incorrectly complained that if people could apply the cost-benefit principle, it did not really matter if they knew the precise definition of opportunity cost. So the researchers asked another group of economists to answer an alternative version of the question in which the last sentence was revised to read this way: "What is the smallest amount that seeing Clapton would have to be worth to you to make his concert the better choice?" Again, the correct answer is $10, and although this time a larger percentage got it right, a solid majority still chose incorrectly. (emphasis mine)

Double ouch. The wording is much better (easier) there, and still there was trouble.

Let's be honest. There are a lot of things going on here. A lot of us realized right off the bat that the first question was terribly worded. I continue to say that the second question was pretty clear. So I have to wonder if the researchers were trying to establish something there about how well a fundamental real-life decision-making question squares with the way the textbooks present opportunity cost.

The second version of the question is, I think, a quite realistic decision problem. And in it, the concept of opportunity cost (if not the textbook definition) is crystal clear. The real point of that survey, if the blogosphere is any indication, is that trying to force a decision problem into the textbook definition of opportunity cost could lead to misunderstanding. The confusion has been about whether opportunity cost is a gross or a net concept. In most textbooks, it is gross. But a lot of real life decisions are in the form of "how much is it worth to you to _____________?" Or, "what would the benefit of an action have to be for you to do it?" That's the form of the second question.

So when Decker writes

Let us remember that the most important lesson we learn from an analysis of opportunity cost is that failure to consider the foregone benefits will generally lead to a non-ultility or non-profit maximizing decision. As it turns out, whether or not one uses Method 1 or Method 2, the correct decision will still be made. To see this, consider the following. Let's assume that the benefit one realizes from seeing Clapton (which was not given in the Times article) is $5. The decidedly incorrect decision would be to go see Clapton simply because the ticket is free (i.e. PAYOFFc = $5-$0 = $5 is the wrong measure of PAYOFFc). Clearly a measure of the foregone benefit of seeing Dylan needs to be considered.

He's right about the lesson that should be learned here. But if you think of opportunity cost as a concept more generally (as I think we should), the solution reveals the answer to the real problem in the article--how much does the Clapton concert have to be worth to you for it to be the utility maximizing activity? And it does so without making any assumptions about what its value might be. For the decision problem at hand, the value of the Clapton concert does not need to be known ahead of time, nor do any assumptions need to be made about it to arrive at a useful solution. To be fair, Decker does acknowledge this at the end of his piece. I just think it's important enough to say it over again.

This might seem like much ado about nothing, but it really isn't. You see, economists have no problem going between the first and second versions of the problem in the article. We do that sort of mental gymnastics without so much as a second thought. (That may actually be part of the problem!) But I think when you really compare the two side-by-side, you see that the second version is not only worded better, but is more in keeping with how many of us would solve the decision problem. That second problem is the one that I would like my students to be able to solve.

Go read it. (NY Times)

Needless to say, a course can be valuable even if unpleasant. Unfortunately, however, most students seem to emerge from introductory economics courses without having learned even the most important basic principles. According to one recent study, their ability to answer simple economic questions several months after leaving the course is not measurably different from that of people who never took a principles course.

What explains such abysmal performance? One problem is the encyclopedic range typical of introductory courses. As the Nobel laureate George J. Stigler wrote more than 40 years ago, "The brief exposure to each of a vast array of techniques and problems leaves the student no basic economic logic with which to analyze the economic questions he will face as a citizen."

Another problem is that the introductory course is increasingly tailored not for the majority of students for whom it will be their only economics course, but for the negligible fraction who will go on to become professional economists. Such courses focus on the mathematical models that have become the cornerstone of modern economic theory. These models prove daunting for many students and leave them little time and energy to focus on how basic economic principles help explain everyday behavior.

But there is an even more troubling explanation for students' failure to learn fundamental economic concepts. It is that many of their professors may have only a tenuous grasp of these concepts, since they, too, took encyclopedic introductory courses, followed by advanced courses that were even more technical.

Maybe more on this topic later, but now I must teach.

UPDATE: Ok, silly me, I forgot to include the link. I was literally standing up and ready to dash out the door as I wrote that. So, let's talk a little more about this, shall we? Frank also says,

Virtually all economists consider opportunity cost a central concept. Yet a recent study by Paul J. Ferraro and Laura O. Taylor of Georgia State University suggests that most professional economists may not really understand it. At the 2005 annual meetings of the American Economic Association, the researchers asked almost 200 professional economists to answer this 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."

Got an answer yet? Ok, read on.

The opportunity cost of seeing Clapton is the total value of everything you must sacrifice to attend his concert - namely, the value to you of attending the Dylan concert. That value is $10 - the difference between the $50 that seeing his concert would be worth to you and the $40 you would have to pay for a ticket. So the unambiguously correct answer to the question is $10. Yet only 21.6 percent of the professional economists surveyed chose that answer, a smaller percentage than if they had chosen randomly.

Ouch. Badly worded question, you say? Well, it is true that multiple choice economics questions can be written in fairly obtuse language. It's pretty easy to clean up that question though.

Some economists who answered incorrectly complained that if people could apply the cost-benefit principle, it did not really matter if they knew the precise definition of opportunity cost. So the researchers asked another group of economists to answer an alternative version of the question in which the last sentence was revised to read this way: "What is the smallest amount that seeing Clapton would have to be worth to you to make his concert the better choice?" Again, the correct answer is $10, and although this time a larger percentage got it right, a solid majority still chose incorrectly. (emphasis mine)

Double ouch. The wording is much better (easier) there, and still there was trouble.

Yeah, this is a problem. Opportunity cost is arguably the most important concept in the principles curriculum. Without opportunity cost and an idea of marginal cost and benefit, you don't have supply and demand. If you don't have supply and demand...

We have got to do better. A while back I heard the mathematicians talking about the need for a "lean and lively calculus". This was back when calculus texts were starting to crack the 1000 page mark. Principles texts are a similar story. Although, to be fair, there is some variation. The late Paul Heyne's (et al.) The Economic Way of Thinking still is an example of the "less is more" approach. Greg Mankiw's first edition was quite concise, but it has grown to be less distinguishable from the pack on the dimension of brevity. But as a whole, the texts are pretty encyclopedic.

Lest you think I'm going totally reductionist on you and risk throwing the baby out with the bath, I assure you that's not my intent. But I do think we need to do a bit more to inspire an appreciation for the logical reasoning of economics at the principles level. That may not even mean cutting a lot of things out. It might just mean doing more to relate more advanced concepts to opportunity cost at every chance we get.

I've even gone so far as to explain the Euler equation in a dynamic macro model in terms of opportunity cost. I wouldn't do that in a 20 minute conference talk, but I would in my office to a graduate student.

Thoma read Samuelson's lastest Washington Post piece and didn't like what he saw.

Samuelson first:

… Economics textbooks once described the U.S. economy as mainly self-contained. ... Globalization has shattered this model. More industries face foreign competition or depend on foreign markets. ... Savings and investment have also gone global. … All this alters the U.S. economy. One theory of low American interest rates is that foreign money flows have pushed rates down...

Thoma responds:

I hate to be the one to break it to him, but we’ve been adding terms like net exports to our models for a long time. Even principles books now routinely cover this, something that wasn’t true twenty or more years ago. I'd guess that's somewhere around the age of the textbook he references when he writes his columns. If I thought it would help, I'd send him a new one.

Well, this does raise some interesting issues. First of all, Mark is absolutely right about the state of the textbooks twenty or more years ago. That situation is improving slowly, but it is still far from perfect. It takes a lot more than adding a term for net exports. Some such treatments were/are pretty ad hoc.

Of course, many journalists took macroeconomics more than twenty years ago and thus have little or no formal training in the macroeconomic view of globalization. The good ones have learned from experience on-the-job through the last couple decades watching and reporting on globalization as it happened. Alas, many writers are still living in earlier, simpler times.

Anyone who has taken economics in the last twenty years or so should have seen some international economics, but it hasn't all been fully integrated into the curriculum. For example, ten years ago you might have seen something about exchange rates shifting the aggregate demand curve (don't have the book with me at the moment, but I think I'm remembering correctly). Maybe if you were lucky, your professor told a story about recent currency devaluations and their effect on the domestic economy, but that would be more likely at the intermediate level, not principles. That's better than nothing, but I think if Robert Samuelson looked at one of those books, he'd probably want to toss it out as being less than helpful at really understanding modern international economics.

So what about the state of the art? It's certainly better. One thing that is starting to creep in even at the principles level is a discussion of interest rate and inflation differentials across countries. That's reasonably sophisticated, but you can do it at the principles level if you keep it intuitive and tell lots of good stories (B-school types call them "case studies" which is much more dignified). But I haven't found the sweet spot yet.

At higher levels (I've been prepping for my master's level course lately), things are much better. There really is no excuse for not doing open economy macro at that level in the current environment. But how many business writers have advanced degrees in economics? How many of them received those degrees in the last 10 years (when a lot of good research started to work its way in to the curriculum)?

But the fact remains that many of the points raised by Samuelson are beyond what is in the principles of economics textbooks. I mean, how many principles texts cover home bias, yield curves, and foreign central bank portfolios? Sounds like that's what he's looking for, and that's a lot more than Y=C+I+G+NX.

So Thoma and Samuelson both make some points. I'll add one more to the mix. Until principles texts really do incorporate some international finance into the discussion in a serious way, perhaps economics departments should push international economics courses for business students as an essential part of their preparation for the real world. Even a well-taught principles course is probably not enough.

From Yahoo News: Report: More Competition Leads To Better Prices

My first reaction: This is news? But the article does not totally focus on the wonders of competitive markets, but also on the evils (cue scary sound effects here) of those stores that happen to be located in areas where there are fewer stores around them to compete on the basis of price.

If a big-box retailer is the only store for miles, you may be paying higher prices for items.

5 On Your Side Consumer Specialist Angie Lau reported the more stores vie for business, the more they will compete with each other to get it. Consumers end up coming out on top as the winners.

...

One day, she found that Tide liquid detergent was $7.44 in Parma, but $5.67 in Brooklyn. It's about a 25-percent difference.

...

Some shoppers could not believe that there were differences based on the location of the stores.

To quote the inimitable Wallace Shawn in The Princess Bride, "Inconceivable!"

Moe Dunch, who shops at the Wal-Mart in Cleveland Heights, was one of those shoppers.

Angie: "Do you think it's fair that they don't offer the same bargain price for every store?

Dunch: "If they offer the same bargain price for the store... they should offer it for every store."

NewsChannel5 contacted Wal-Mart's corporate headquarters.

A spokesman said, "All of our merchandise starts out with the same basic price. However, our store managers do have the prerogative to lower prices to meet or beat the competition in their neighborhood."

Target also confirmed the practice of competitive pricing. The store also provided a statement.

It read: "Prices can be impacted by prices at nearby retailers. That's why prices may vary from Target store to Target store."

Competitive pricing doesn't make Jessica Kennan, 19, feel good. She's paying her way through college and needs every dime.

Lau said the valuable lesson is the more stores around a big-box retailer, the lower prices will be.

It's a quiet strategy that retailers don't advertise, Lau said.

(Sarcasm on)And thanks to this reporter, the secret is out.(Sarcasm off)

Nevertheless, busy mothers, like [Anissa] Lopinski chooses between saving time over money.

(Sarcasm on)Imagine! Choosing to save time over money! You mean all those opportunity cost examples I use in my principles of micro course really describe human behavior? Wow!(Sarcasm off)

"It's close to home, and I don't want to be traveling all over city looking for the best buy," she said.

Economists call this "search," as in: Her "search costs" are high, so she shops at the store close to home.

Lau said retailers are banking on more consumers like Lopinski.

Write your own conclusion.

Hat tip: Division of Labour

I could have made this an update to an earlier post, but I think the information is sufficient to warrant a separate post.

Remember that I wanted to see the study that the NY Times cites? King at SCSU Scholars has a link to the survey. Again, I quote the New York Times:

The economic literacy of both students and adults has improved since then, but only slightly.

In the report, it is stated that the test was administered to adults differently in 1999 than in 2005, so the results are not directly comparable (page 4 on this link). Ok, so what about students? 14 of the 20 questions were common to both year's exams, so they compared the results of just those questions. Grading on a standard percentage scale (90%=A, etc.) the distribution looked like this in 1999:

A: 5%
B: 6%
C: 14%
D: 11%
F: 63%

And in 2005:

A: 11%
B: 10%
C: 24%
D: 12%
F: 43%

The heading on that page is "Percentage of students scoring an 'A' or 'B' nearly doubled."

"Slightly"????? Did the NY Times writer read the report????

Admittedly there are still too many "F"s, but this is not a "slight" improvement. Read the whole survey. There are pie charts showing the results of each question for adults and students (and bar charts showing improvement on each question common to both years). It's definitely worth 20 minutes of your time, especially if you teach economics.

The survey does not report the results for adults in 1999, so I don't know how the Times writer can say that the results were better for adults (unless there is a copy of those results out there--I will keep looking). If those old results are out there and if the improvement is only slight for adults, I guess that would mean that the Times writer is only guilty of making an invalid comparison.

There is still a lot of room for improvement in questions on macroeconomics and personal finance. Our work is not done.

Ohhh, don't tempt me at this time of year. But seriously, take a look at this: (hat tip: Brad DeLong)

Thousands of exam papers from England will be sent to India later this year as part of the marking process.

Critics in England say the move is the latest example of cost-cutting by outsourcing, and will result in errors in exam marking and delays in results.

...

The Assessment and Qualifications Alliance (AQA) exam board says that under the new system, GCSE exam scripts from England will be scanned into a computer file.

The answers of candidates will then be divided up between questions requiring longer answers and those with just one word answers - usually found in French and maths papers.

The scanned one word answers will be e-mailed to Madras, where Indian workers type them up so that they can be marked by a computer in England.

So let's see... the student writes a one word answer, it gets scanned, e-mailed to India, transcribed and e-mailed back to be marked by a computer in England.

If that saves money, it tells you something about the wage differential between data entry clerks and graders that I would readily believe.

Alas, I don't think this really applies to most of the grading that college professors do. Sounds more like an extension of the multiple choice test. Though I am not familar with the AQA exam in Britain, it sounds a bit like our ACT, SAT, and other alphabet soup tests.

And wasn't there just a big to-do about the essay feature in the new SAT? Tell me who wants to grade that! I guess there were strict requirements on how the graders were to grade the essays. You probably could write a computer program to grade them, but then if that program ever got leaked to the public... just watch the scores go up!

Bottom line: I don't see any huge deal about this. The profession outsourced grading to optical scanning machines a long time ago. That's not much different from having Indians transcribe one word answers.

My students can rest assured that there will be precious few one word answers on their final exams. (Maybe a couple in the principles course--none in the intermediate course.)

Be sure to check out Tyler Cowen's response:

The obvious question is what we really need professors for anyway -- are we simply magnets of personality to keep students interested?

Well, as I have suggested, I don't think that is the obvious question asked by this particular situation. And even so, we professors still program the "grading computer."

As for whether we are magnets of personality... your mileage may vary.

Increase in the price of a substitute ==> Increase in demand

Driving in your own car and taking mass transit are substitutes. The rising price of gas has cause the price of driving yourself to increase. Therefore, the demand for mass transit increases.

It's happening in St. Louis.

I've taken the Metro in St. Louis quite a few times. It is clean, fast, on time (in my experience anyway) and efficient.

Hat tip: Division of Labour, who adds that the Metro should consider increasing fares to offset their own higher fuel costs.

True, it might be a good idea, especially if fuel costs are likely to remain high. (Alas, that might be the case--too soon for me to commit to a prediction on that.)

Economics works. Use it.

On today's show: "From the CIA World Factbook"

Note to student readers: In the event that you have not used the CIA World Factbook to do basic background research for your international business, international studies, political science, economics, and other term papers, please check it out to see what you've been missing.

Not only will your term papers be filled with up-to-date facts, but you might do better if you ever go on Jeopardy!

Via Cafe Hayek comes this NY Times story:

Oil drilling has long been a more common sight on the arid plains of West Texas, but oil prices topping $50 a barrel are now luring wildcatters to urban areas written off until recently as uneconomical by the energy industry. In fact, crude oil rose $1.37 on Wednesday, or nearly 3 percent, to $53.05 a barrel, the highest closing price since Oct. 26. Traders are concerned that producers and refiners are not keeping up with demand.

I remember trips out to western North Dakota where there are some oil wells. Some years they were pumping; some years they weren't. Hence, I've used that as example in classes before. I should point out that there are some oil wells in Illinois, south of Springfield on I-55. I have never seen those pumping, but I'll let you know next week if they have started. The story in the Times takes it up a notch with drilling right in people's backyards. This could, however, be a boon to the neighborhood when the residents get their royalty payments as the article explains.

I also found this interesting:

Still, a rig operating in the middle of a residential area is raising eyebrows even in Houston, a city known for abhorring zoning restrictions of nearly every stripe. Some geologists suggest that the location of the drilling rig has as much to do with the gap between rich and poor in Houston as with geology.

"You try this in River Oaks and they'd have your hide," Theron Sage, an associate professor of geology and environmental science at the University of Houston, said of the exclusive district of Tudor-style mansions where this city's wealthiest residents live. (River Oaks is about a 20-minute drive from Northmore.)

"This is one of the oddities of $50 oil," Ms. Sage said. "This type of thing doesn't happen with $20 oil."

Law of supply an "oddity"? That comment aside, Ms. Sage brings up a good point. It would take even more expensive oil to get the wealthy neighborhoods to start drilling because they would ask to be compensated more for the inconvenience.