Carbon Taxes

As an economist, one of the biggest frustrations of discussions over climate policy is that we know pretty well what to do - tax carbon (or set up a system of tradable permits, which has similar effects), and that doing so will not be harmful to the economy.  People and firms respond to incentives, and a carbon tax will motivate people to find the lowest-cost ways to reduce emissions.  People are clever and the cost of reducing emissions will likely be much less than many envisioned.

Eduardo Porter's column about British Columbia's carbon tax is yet another illustration of this; he writes:

In 2008, the British Columbia Liberal Party, which confoundingly leans right, introduced a tax on the carbon emissions of businesses and families, cars and trucks, factories and homes across the province. The party stuck to the tax even as the left-leaning New Democratic Party challenged it in provincial elections the next year under the slogan Axe the Tax. The conservatives won soundly at the polls.

Their experience shows that cutting carbon emissions enough to make a difference in preventing global warming remains a difficult challenge. But the most important takeaway for American skeptics is that the policy basically worked as advertised.

British Columbia’s economy did not collapse. In fact, the provincial economy grew faster than its neighbors’ even as its greenhouse gas emissions declined.

“It performed better on all fronts than I think any of us expected,” said Mary Polak, the province’s environment minister. “To the extent that the people who modeled it predicted this, I’m not sure that those of us on the policy end of it really believed it.”

Minimum Wages and Economics

Tim Harford writes on the minimum wage:

The UK minimum wage took effect 16 years ago this week, on April 1 1999. As with the Equal Pay Act, economically literate commentators feared trouble, and for much the same reason: the minimum wage would destroy jobs and harm those it was intended to help. We would face the tragic situation of employers who would only wish to hire at a low wage, workers who would rather have poorly paid work than no work at all, and the government outlawing the whole affair.

And yet, the minimum wage does not seem to have destroyed many jobs — or at least, not in a way that can be discerned by slicing up the aggregate data. (One exception: there is some evidence that in care homes, where large numbers of people are paid the minimum wage, employment has been dented.)

The general trend seems a puzzling suspension of the law of supply and demand. One explanation of the puzzle is that higher wages may attract more committed workers, with higher morale, better attendance and lower turnover. On this view, the minimum wage pushed employers into doing something they might have been wise to do anyway. To the extent that it imposed net costs on employers, they were small enough to make little difference to their appetite for hiring.

An alternative response is that the data are noisy and don’t tell us much, so we should stick to basic economic reasoning. But do we give the data a fair hearing?

At its best, economics is a fruitful dialogue between theory and empirical (data) work.  All economic models are, by nature, simplifications.  One of the judgments we have to make is whether some of the simplifcations we've made are inappropriate.  Testing our models against the data helps us do that.

The first tool an economist will reach for in trying to analyze a market is supply and demand; in that context, a minimum wage is a price floor, which creates an excess supply of labor (i.e., unemployment):

(the equilibrium wage and quantity of labor are labelled with superscript e's, and the m's mark the minimum wage and corresponding amount of labor).

We like supply and demand because it is simple and works well in many context; but the labor market is one case where its simplicity can lead us astray.  As Paul Krugman recently put it:

[B]ecause workers are people, wages are not, in fact, like the price of butter, and how much workers are paid depends as much on social forces and political power as it does on simple supply and demand.

Indeed, some empirical research has demonstrated that minimum wages do not have the effects implied by the supply and demand framework.  This NYT Magazine piece by Annie Lowrey summarized David Card and Alan Krueger's classic paper on the subject and some of the subsequent dispute.

Efficiency Wages

The New York Times has a story about several restaurants that have decided to pay above-market wages.  One of them is Shake Shack, which is starting employees at $9.50/hr:

“The No. 1 reason we pay our team well above the minimum wage is because we believe that if we take care of the team, they will take care of our customers,” said Randy Garutti, the chief executive of Shake Shack.

That, and other anecdotes in the article, are consistent with the "efficiency wage" theory, where firms can induce more effort by paying a higher real wage.  This might arise if firms have a less than perfect ability to monitor individual employees' productivity - paying an above-market wage creates a stronger incentive not to "shirk". 

For more, see this brief 1984 survey by Janet Yellen, who did some of her early academic work in this area.

Pigou!

In the Journal, John Cassidy profiles A.C. Pigou, the Cambridge (UK) economist who pioneered the concept of externalities.

Textbook Case of Market Failure

An interesting feature from the Times on the proliferation of free, on-line textbooks:

SQUINT hard, and textbook publishers can look a lot like drug makers. They both make money from doing obvious good — healing, educating — and they both have customers who may be willing to sacrifice their last pennies to buy what these companies are selling.

It is that fact that can suddenly turn the good guys into bad guys, especially when the prices they charge are compared with generic drugs or ordinary books. A final similarity, in the words of R. Preston McAfee, an economics professor at Cal Tech, is that both textbook publishers and drug makers benefit from the problem of “moral hazards” — that is, the doctor who prescribes medication and the professor who requires a textbook don’t have to bear the cost and thus usually don’t think twice about it.

“The person who pays for the book, the parent or the student, doesn’t choose it,” he said. “There is this sort of creep. It’s always O.K. to add $5.”

In protest of what he says are textbooks’ intolerably high prices — and the dumbing down of their content to appeal to the widest possible market — Professor McAfee has put his introductory economics textbook online free. He says he most likely could have earned a $100,000 advance on the book had he gone the traditional publishing route, and it would have had a list price approaching $200.

“This market is not working very well — except for the shareholders in the textbook publishers,” he said. “We have lots of knowledge, but we are not getting it out.”

He's right. I have moved away from using a textbook for macro principles and I sometimes fantasize about ditching them altogether.

It is not clear what Prof. McAfee himself is maximizing; his behavior seems to be maximizing social rather than personal welfare... He is acting suspiciously like the "social planner" we periodically encounter in economic theory. And not for the first time - see this earlier post on his attempt to fix the academic publishing process.

Competition in the Antitrust Business

The Times reports:

The Justice Department laid out a broad policy on antitrust enforcement on Monday that drew an unusually sharp rebuke from three federal trade commissioners, who said it would protect monopolies from prosecution.

A 215-page report from the Justice Department, coming after nearly a year of public hearings, was originally meant to lay out a governmentwide approach to combating anticompetitive business practices. Instead, it exposed a rift between the Justice Department and the Federal Trade Commission over whether the government was protecting consumers or big businesses.

In a quick response to the Justice Department report, three of the four commissioners on the F.T.C. issued a statement saying that the policy was “a blueprint for radically weakened enforcement” against anticompetitive practices. They said the Justice Department guidelines allowed monopolies to act “with impunity” and “would make it nearly impossible to prosecute a case.”

This is far outside my bailiwick, but it sure sounds like a good thing that the Justice Dept. does not have a monopoly on antitrust. Hm... I wonder would Cournot or Bertrand be more appropriate to model this duopoly? (And that's all the I.O. I know..)

Inefficient Labor Market Outcomes (NY Yankee Edition)

One point made by Keynes is that the classical assumption that labor supply is based on the marginal disutility of working ignores the fact that people care about their relative wages. For example, SI's John Heyman reports:

Saw a headline the other today in an NY paper: "Pavano Solid.'' And I can't think of any bigger waste of space. To learn what Pavano's about, read John Feinstein's interesting book Living on the Black, about Mike Mussina and Tom Glavine. In one story, when Mussina was offered slightly less than $10 million a year in a new contract by the Yankees, he told Cashman, "I can't be paid less than Pavano,'' or words to that effect, and Cashman understood completely. Mussina was then paid $11.5 million a year, or slightly more than the sedentary Pavano.

Keynes (General Theory, ch. 2):

Though the struggle over money-wages between individuals and groups is often believed to determine the general level of real-wages, it is, in fact, concerned with a different object. Since there is imperfect mobility of labour, and wages do not tend to an exact equality of net advantage in different occupations, any individual or group of individuals, who consent to a reduction of money-wages relatively to others, will suffer a relative reduction in real wages, which is a sufficient justification for them to resist it....

In other words, the struggle about money-wages primarily affects the distribution of the aggregate real wage between different labour-groups, and not its average amount per unit of employment, which depends, as we shall see, on a different set of forces. The effect of combination on the part of a group of workers is to protect their relative real wage. The general level of real wages depends on the other forces of the economic system.

Of course, the marginal product of Mussina's labor is way, way higher than Pavano's (a fixed nominal contract the Yankees surely regret).

The EU is Watching Out for You

Paul Krugman sees deregulatory ideology run amok as the culprit in food safety crises that have tomatoes being pulled off the shelves and Koreans protesting importation of US beef. He writes:

[H]ard-core opponents of regulation were once part of the political fringe, but with the rise of modern movement conservatism they moved into the corridors of power. They never had enough votes to abolish the F.D.A. or eliminate meat inspections, but they could and did set about making the agencies charged with ensuring food safety ineffective.

They did this in part by simply denying these agencies enough resources to do the job. For example, the work of the F.D.A. has become vastly more complex over time thanks to the combination of scientific advances and globalization. Yet the agency has a substantially smaller work force now than it did in 1994, the year Republicans took over Congress.

Perhaps even more important, however, was the systematic appointment of foxes to guard henhouses.

Thus, when mad cow disease was detected in the U.S. in 2003, the Department of Agriculture was headed by Ann M. Veneman, a former food-industry lobbyist. And the department’s response to the crisis — which amounted to consistently downplaying the threat and rejecting calls for more extensive testing — seemed driven by the industry’s agenda.

The primary market failure at work here is one of imperfect information - it is prohibitively costly for consumers to obtain detailed information about how every available food ingredient was produced (and, really, would you want to?) in order to make a judgment about the associated risks. In such cases, basic microeconomics tells us that the free market outcome is not optimal and government intervention - possibly through regulation (which is only effective if credibly enforced) - can be welfare-improving. That is, the "free market" view does not represent sound economics.

The same logic applies to the chemicals in everyday products. In the absence of effective government intervention, consumers may be taking greater than optimal levels of risk (i.e. we are taking chances we wouldn't if we had complete knowledge of what's in all that stuff we buy). The uncertainty could also have the effect of deterring consumers from buying products that are indeed perfectly safe (this is why credible regulation is good for producers).

While Washington may be asleep at the switch, the Brussels isn't, and one pleasant side-effect of globalization is that tougher EU regulation may benefit US consumers, or so suggests this fascinating Washington Post story:

Europe this month rolled out new restrictions on makers of chemicals linked to cancer and other health problems, changes that are forcing U.S. industries to find new ways to produce a wide range of everyday products.

The new laws in the European Union require companies to demonstrate that a chemical is safe before it enters commerce -- the opposite of policies in the United States, where regulators must prove that a chemical is harmful before it can be restricted or removed from the market...

Adamantly opposed by the U.S. chemical industry and the Bush administration, the E.U. laws will be phased in over the next decade. It is difficult to know exactly how the changes will affect products sold in the United States. But American manufacturers are already searching for safer alternatives to chemicals used to make thousands of consumer goods, from bike helmets to shower curtains.

The European Union's tough stance on chemical regulation is the latest area in which the Europeans are reshaping business practices with demands that American companies either comply or lose access to a market of 27 countries and nearly 500 million people.

From its crackdown on antitrust practices in the computer industry to its rigorous protection of consumer privacy, the European Union has adopted a regulatory philosophy that emphasizes the consumer. Its approach to managing chemical risks, which started with a trickle of individual bans and has swelled into a wave, is part of a European focus on caution when it comes to health and the environment.

Regulation in the US is weaker than you might think:

The EPA has banned only five chemicals since 1976. The hurdles are so high for the agency that it has been unable to ban asbestos, which is widely acknowledged as a likely carcinogen and is barred in more than 30 countries. Instead, the EPA relies on industry to voluntarily cease production of suspect chemicals.

"If you ask people whether they think the drain cleaner they use in their homes has been tested for safety, they think, 'Of course, the government would have never allowed a product on the market without knowing it's safe,' " said Richard Denison, senior scientist at the Environmental Defense Fund. "When you tell them that's not the case, they can't believe it."

Eep. Because the EU is a large market, it may make sense for producers to conform to their stronger regulations and therefore the same products sold here will live up to European standards. The bad news is that logic only applies insofar as the products are the same, which will depend on the marginal costs associated with producing up to EU standards (the fixed costs of developing products that can be sold there will likely worth bearing for multinationals) relative to the economies of scale gained from producing the same product for both markets.

There would be more incentive for producers to conform to European regulations if US consumers start to look for the CE mark which is used to label products that meet European standards.

Now, if only we could find a way to get the EU involved with our domestic food supply... (that is, Americans would feel much more confident eating Brussels sprouts if they are Brussels-certified).

Speaking (Bob) Frankly

Economists' proofs that markets lead to "efficient" outcomes hold only under a specific set of assumptions, including perfect competition, perfect information, and the absence of externalities. These assumptions, of course, never completely hold - the world we live in is one of "market failure." The benefits of markets are often hard to see and appreciate; understanding them is an important contribution of economics, but it is also important to understand market failures. One of the most acute observers of market failure is Cornell's Bob Frank, who Steven Pearlstein writes about in his Washington Post column:

Think of skyrocketing tuitions among elite colleges and universities that spend lavishly on winning sports teams, rock-climbing walls and scholarships for those who don't even need them, all to attract top students.

Or the runaway compensation for chief executives who would be willing to take the job for half of what they are being paid.

Or the ridiculous prices paid for "it" handbags, fancy watches or houses in the Hamptons.

How do we explain why cities are still tripping over themselves to offer subsidies for baseball stadiums and convention centers in the face of overwhelming evidence that these diminish economic efficiency and welfare rather than enhance them?

And how is it rational that first-year associates at top law firms are paid more than federal judges?

One thread that runs through all these "market failures" is that they involve a kind of competition in which "winning" is more a relative concept than an absolute one -- that the goal is not so much to maximize profits, income or welfare, as economic models assume, but to beat the competitors. In the process, perfectly rational investors, businesses or consumers wind up doing things that are irrational, leaving them no better off than before.

The intellectual roots of this economic theory of relativity go back to Adam Smith, Alfred Marshall and Thorstein Veblen. It got a big boost from game theorists, among them University of Maryland's Thomas C. Schelling, who won a Nobel Prize for his work on unproductive arms races, both economic and military. More recently, the hot new area of behavioral economics has focused considerable light on the seemingly irrational side of homo economus.

Perhaps nobody has done more to expand our understanding of relative competition than Robert H. Frank of Cornell University. Frank's particular focus has been on the importance of status in consumer choices. His point is that the desire for ever-bigger homes, ever-fancier gas grilles, ever-more powerful SUVs is based not on some absolute notion of what is good or sufficient, but rather on the relative basis of what everyone else has.

It is this compulsion to keep up with the Joneses, Frank argues, which leads us to over-spend on status goods that, in the end, make us no happier. Meanwhile, we wind up under-investing in leisure time or "public goods," such as better schools and parks, that would give us more satisfaction.

The latest example of Frank at work is his piece in today's New York Times. He looks at the puzzle of why people contribute to political campaigns, which seems to go against our assumption that people behave in a narrowly self-interested manner:

The problem, as described by Mancur Olson in his classic book, “The Logic of Collective Action,” is that even those who share a presidential candidate’s policy goals will reap no significant material advantage by donating their time or money. After all, with cash donations legally capped at $2,300, even donors who give the maximum have no realistic hope of influencing an election’s outcome. Nor can any individual volunteer — even one whose efforts resulted in hundreds of additional votes for his candidate — realistically hope to tip an election.

Although the logic of the free-rider problem may seem compelling, people’s behavior strikingly contradicts many of its predictions. Last month alone, for example, the presidential campaign of Senator Barack Obama raised over $32 million from more than 250,000 individual donors and sent huge numbers of volunteers into the field. (Disclosure: I’m an Obama contributor myself.) Other campaigns have benefited in similar, if less spectacular, ways from their supporters’ willingness to set narrow self-interest to one side.

Frank goes on to describe a theory from Albert O. Hirschman that posits alternating periods dominated by collective action and by selfishness. So, while Obama was criticized for saying positive things about Ronald Reagan, his "movement" may be a sign that the Reagan era is over...

One crucial thing sometimes students (and professors) misunderstand about the free rider problem - and the assumptions we make about behavior in general - is that economics does not exist to tell people how to act. Economists are social scientists, and our task is to explain human behavior. In Frank's example, what is problematic is not the behavior of the donors, but the fact that economic theory has a hard time explaining it.

Energy Deregulation's Hidden Virtue?

The electricity market was once highly regulated (e.g. prices set by government commissions) on the grounds that utilities are natural monopolies. In recent years, a number of states have de-regulated their energy markets.

The result? Higher prices. The NY Times reports:

Retail electricity prices have risen much more in states that adopted competitive pricing than in those that have retained traditional rates set by the government, new studies based on years of price reports show.

Of course, if there are negative externalities associated with electricity consumption - i.e. global warming-causing carbon emissions - higher prices are a good thing! The de-regulation acts like a stealth carbon tax (except no revenue for the government). Ahh... now I realize that all the politicians, "free market" types and energy lobbyists who pushed deregulation were engaged in a conspiracy to help the environment (no wonder Cheney kept those meetings secret!).

The Economist's Free Exchange blog makes a similar point here.

Intermediate Micro (Donkey Edition)

Late in Tuesday's Democratic presidential debate, Brian Williams gave some of the candidates a chance show off their intermediate microeconomics knowledge (or lack thereof).

We learn that Chris Dodd understands externalities (and what to do about them). From the transcript:

MR. WILLIAMS: ...Are you truly prepared to lead on a national scale the kind of sacrifice it would require where it intersects with the environment?

SEN. DODD: Well, I think you've got to -- I find it somewhat startling here that Ronald Reagan's former secretary of State and George Bush's first economic -- chief economic adviser are, frankly, more courageous and bold on energy policy than my fellow competitors here for this job, the presidency.

I've called for a corporate carbon tax. All of us share the same goals here of achieving energy independence, reducing our dependency on fossil fuels and the carbons they emit. But you're not going to achieve that unless you deal with price, quite frankly, here...

The advisor he refers to is Greg Mankiw, who advocates "Pigouvian" taxes.

The next question went to John Edwards, who must have missed the class on moral hazard (perhaps he had a bad hair day):

MR. WILLIAMS: Senator Edwards, should there be a bottomless well of federal dollars for people who knowingly live in areas of this country that are disaster prone to rebuild their homes if lost in a disaster?

MR. EDWARDS: Well, I think that when families are devastated -- and we've lived with this in North Carolina because we've been regularly hit by hurricanes, and I've spent an awful lot of time in New Orleans. When families are hit by natural disasters, I think it is for the national community to be there for them. I think that's our joint responsibility as a national community to be there for them.

I would have been very keen to learn Mike Gravel's views on resale price maintenance, but, alas, he was not invited. Its not the same without him.

German Efficiency?

According to this fascinating NY Times story, in Germany, it is illegal to sell new books at a discount. This regulation helps keep small, independent bookstores and publishers in business:

In the United States chain stores have largely run neighborhood bookshops out of business. Here in Germany, there are big and small bookstores seemingly on every block. The German Book Association counts 4,208 bookstores among its members. It estimates that there are 14,000 German publishers. Last year 94,716 new titles were published in German. In the United States, with a population nearly four times bigger, there were 172,000 titles published in 2005.

At first glance, this is economically inefficient - high-cost retailers are not driven out of business, economies of scale are not realized, and Germans pay too much for their books. Three reasons come to mind about why the German regulations might make economic sense (i.e. improve overall welfare):

1. People like having bookstores in their neighborhood, and enjoy spending time there (even if they don't buy anything), and like variety, so the small bookstores have a positive externality for consumers.
   
2. A positive externality for national culture (which seems to be the argument of most of the people quoted in the story).
   
3. The utility of the producers themselves. Our customary models of profit maximizing firms ignore the obvious fact that many people - and I suspect this is particularly true of many small business proprietors - are motivated more by a sense of pride and accomplishment in their own work, than by wages.

The Germans are concerned by a recent decision by the Swiss competition commission to allow discounting. The director of the commission said:

It was a cartel. The German and Swiss booksellers said it was for a good purpose — they made a cultural argument, but we are an economic commission. They said the system fosters a broader, deeper market for books, that discounting will hurt the small booksellers who support the small publishers, and then you will have fewer books and more focus on best sellers...

I’m not quite sure they’re completely wrong. Nobody knows for sure yet. But nobody can read one million titles, so the question is, is it better that more people read fewer books or that fewer people read a lot of different books?

That's a good - and difficult to answer - question. However, being an "economic commission" is not a reason to disregard a cultural argument - good economic policy should be about improving the well-being of people ("welfare" or "utility"), much of which derives from difficult to quantify, non-pecuniary sources.

A Big Problem We Ignore

The insanely high rates of incarceration in the United States may be our most unheralded social (and economic) problem - perhaps because there is very little political gain (and much political risk) in taking it on. Nonetheless, last week, Senator Jim Webb of Virginia held a Joint Economic Committee hearing on the subject. According to the committee:

The United States has experienced a sharp increase in its prison population in the past thirty years. From the 1920s to the mid-1970s, the incarceration rate in the United States remained steady at approximately 110 prisoners per 100,000 people. Today, the incarceration rate is 737 inmates per 100,000 residents, comprising 2.1 million persons in federal, state, and local prisons. The United States has 5 percent of the world’s population but now has 25 percent of its prisoners.

Senator Webb also posted some facts about the prison system in the United States. Among them:

The U.S. prison system has enormous economic costs associated with prison construction and operation, productivity losses, and wage effects. In 2006, states spent an estimated $2 billion on prison construction, three times the amount they were spending fifteen years earlier. The combined expenditures of local governments, state governments, and the federal government for law enforcement and corrections total over $200 billion annually. In addition to these costs, the incarceration rate has significant costs associated with the productivity of both prisoners and ex-offenders. The economic output of prisoners is mostly lost to society while they are imprisoned. Negative productivity effects continue after release. This wage penalty grows with time, as previous imprisonment can reduce the wage growth of young men by some 30 percent...
The prison system has a disproportionate impact on minority communities. African Americans, who are 12.4 percent of the population, are more than half of all prison inmates, compared to one-third twenty years ago. Although African-Americans constitute 14 percent of regular drug users, they are 37 percent of those arrested for drug offenses, and 56 percent of persons in state prisons for drug crimes...
Prisons are housing many of the nation’s mentally ill. The number of mentally ill in prison is nearly five times the number in inpatient mental hospitals. Large numbers of mentally ill inmates, as well as inmates with HIV, tuberculosis, and hepatitis also raise serious questions regarding the costs and distribution of health care resources.

As far as I can tell, the hearing didn't get any attention from the press (I learned about it from Ezra Klein's blog), but the Times has an article on the racial disparities in our legal system. The census recently reported that the number of Americans living in college dorms has surpassed the number in prison, but what does it say that this is considered news?

Marginal Utility of What?!

In 1930, Keynes predicted that economic growth would lead to a tremendous increase in leisure time. I recently had my principles students read a NY Times column by Bob Frank where he examined the failure of this prediction. Frank says "decisions to spend are also driven by perceptions of quality, the desire for which knows no bounds. But quality is an inherently relative concept." So, although productivity growth and capital accumulation mean that we could have had rising standards of living and more leisure, we find ourselves working to produce (and be able to afford) goods of ever-higher perceived quality. That came to mind when I read this in the Cincinnati Enquirer:

P&G Launches Smart Toothbrush

Oral-B, the toothbrush brand from the Procter & Gamble Co., announced on Friday it is launching Oral-B Triumph with SmartGuide, a wireless display that allows users to time their brushing....

The company says SmartGuide combines the brushhead, handle and visual display so users receive prompts from microchips. These prompts tell users when they are brushing too hard, when to move to the next quadrant of the mouth and when brushing has lasted two minutes. It also indicates when it is time to replace the brushhead.

One of the weaknesses of mainstream economic theory is the way that we think of preferences. In particular, we typically assume that preferences for particular goods or attributes are an intrinsic, or primitive, aspect of the individual. However, the example above reminds us of something that John Kenneth Galbraith pointed out: businesses are constantly working to create preferences for goods we never imagined we might want. (Here's Brad De Long's review of Richard Parker's fine biography of Galbraith, who passed away last year).

People are from Earth, Economists are from Vulcan

In today's NY Times Economic Scene column, Austan Goolsbee looks at the departure from economically rational behavior known as "loss aversion," which may interfere with home sales as prices slump. He writes:

Economists and other humans don’t always see eye to eye. “Economists tend to think people are crazy because they won’t sell their houses for less than they paid for them — and people think economists are crazy for thinking things exactly like that,” said Professor Christopher Mayer, director of the Paul Milstein Center for Real Estate at Columbia Business School and an authority on real estate economics....

Classical economics can’t explain this behavior. That’s because people who refuse to sell their houses for less than they paid for them are violating a cardinal rule of the market: stuff is worth what it’s worth. It doesn’t matter what you paid for it. But when Professor Mayer and his co-author, David Genesove, a professor of economics at the Hebrew University in Jerusalem, studied the Boston condominium market in the 1990s — scene of one of the biggest real estate busts in recent American memory — the actual patterns of human behavior did not seem to follow the standard rules at all...

As any thinking student of economics realizes, our traditional assumptions about human behavior are not realistic. The goal of economic models is not "realism," however. Even the most elaborate economic model is a vast simplification of an infinitely complex reality. A model which accurately predicts how people will behave is a useful one - Milton Friedman's famous example* is that one could use physics to analyze the shots of a professional billiard player. Even though the player is using instinct and senses, the rules of physics can be used to make accurate predictions of the player's shots. Similarly, utility maximization may make good predictions of human behavior, even though people aren't solving constrained optimization problems in the grocery store.

Goolsbee's column points us to a case where our lack of realism may get us into trouble. The good news - for economic methodology but not home sellers - is that the economics profession recognizes the problem, and some people are working on it. Meyer and Genesove's paper was published in the Quarterly Journal of Economics, one of the most prestigious journals in the field, and Goolsbee himself is a faculty member at Chicago, hardly a backwater of heterodoxy.

*Friedman's example is in a 1953 article titled "The Methodology of Positive Economics," which is a must-read for students of economics.

Easy as MSB = MSC

There are some things that seem so obvious after intermediate microeconomics, but unfortunately much of the citizenry hasn't had that pleasure... One example is the use of Pigouvian taxes on externalities to equate marginal social costs and benefits. In the NY Times, Greg Mankiw makes the case for a carbon tax:

IN the debate over global climate change, there is a yawning gap that needs to be bridged. The gap is not between environmentalists and industrialists, or between Democrats and Republicans. It is between policy wonks and political consultants.

Among policy wonks like me, there is a broad consensus. The scientists tell us that world temperatures are rising because humans are emitting carbon into the atmosphere. Basic economics tells us that when you tax something, you normally get less of it. So if we want to reduce global emissions of carbon, we need a global carbon tax. Q.E.D.

Mankiw explains why a carbon tax is preferable to fuel economy regulations and cap-and-trade. Politically, its a tough sell. Mankiw offers an idea to make it go down easier:

Yet this natural aversion to carbon taxes can be overcome if the revenue from the tax is used to reduce other taxes. By itself, a carbon tax would raise the tax burden on anyone who drives a car or uses electricity produced with fossil fuels, which means just about everybody. Some might fear this would be particularly hard on the poor and middle class.

But Gilbert Metcalf, a professor of economics at Tufts, has shown how revenue from a carbon tax could be used to reduce payroll taxes in a way that would leave the distribution of total tax burden approximately unchanged. He proposes a tax of $15 per metric ton of carbon dioxide, together with a rebate of the federal payroll tax on the first $3,660 of earnings for each worker.

Eminently sensible, but I'm not holding my breath. Mankiw is advising Mitt Romney's campaign - if he can get Romney to come out for a payroll for carbon tax swap, I will be very impressed, with both of them.

We Are All Uninsured

There are now 47 million Americans without health insurance - nearly one-sixth of the population. But as Boston University Economist Laurence Kotlikoff points out, the exposure to risk is much, much broader. In an op-ed titled "We Are All Uninsured Now," he writes:

...the rest of us with health coverage are also uninsured. We too face terrible, albeit more remote, healthcare risks -- the risk that our employer will drop our plan, that Medicare will go bust, that our plan won't cover our needs, that premiums will eat us alive, that our doctor will stop taking our insurance, that long-term care will wipe us out, and that our uninsured friends and family members will need major financial help.

If the point of insurance is to reduce individual risk by pooling it, the American "system" is failing all of us miserably. Kotlikoff offers a voucher scheme as a solution - I'm not sure its better than single-payer national insurance, but it would be an improvement on what we have now (its hard to imagine we could do worse!). (Hat tip to Economist's View).

For Those About to Optimize

We Salute You.

Some people believe Mozart makes you smarter, but does AC/DC make you more rational? This study by Robert Oxoby of the University of Calgary exposed subjects to the music of AC/DC during an economic experiment called the "ultimatum game." The outcomes were found to be less efficient when the subjects listened to AC/DC under original frontman Bon Scott than under Brian Johnson, who replaced Scott in 1980. From the conclusion:

Our analysis has direct implications for policy and organizational design: when policymakers or employers are engaging in negotiations (or setting up environments in which other parties will negotiate) and are interested in playing the music of AC/DC, they should choose from the band's Brian Johnson era discography.

Yes, its a joke. But as the Chronicle of Higher Education reports, many people, including Steven "Freakonomics" Levitt, did not recognize it as such. Hmmmm...

The Rent-Seekers in My Mailbox

Hardly a day goes by without some junk mail from the student-loan industry - why are they so eager to get me to "consolidate" my loans? Because they are subsidized by the government: in the New Yorker, James Surowiecki looks at the political economy of this strange public-private hybrid. He writes:

...it’s four times as expensive for the government to subsidize and guarantee private loans as for it to issue those loans itself. In other words, the current system is not just corrupt. It’s also inefficient. So why are we stuck with it?

In part, it’s ideology, and the dominance of what you might call the privatization mystique—the idea that anything the government can do, the private sector can do better. Often, this makes sense: the free market is more likely to come up with efficient ways of creating and distributing products and services than the government is. But the student-loan market isn’t a free market in any meaningful sense of the term, because the government effectively determines prices, insures against losses, and subsidizes volume. In this environment, most of the competition among private companies is really just squabbling over how to split up the spoils. Economists call this behavior—when a company seeks to manipulate economic conditions rather than actually create value—“rent-seeking.” It’s common in areas where the fetish for privatization has taken hold, such as the outsourcing of homeland security to private contractors and the boom in private Medicare insurers. (The private insurers are less efficient than Medicare and receive billions in subsidies from the government.)...

More than just ideology, though, has kept student-loan companies in their lucrative niche. Economic power has also had something to do with it. Since the mid-nineteen-nineties, the federal government has offered direct student loans, making it unnecessary for students to go through private lenders. The loans are significantly cheaper for the government, but, from the start of this program, private lenders have done all they could to limit its reach. They’ve worked to keep the Education Department from offering discounts and rebates to borrowers. They’ve lobbied against interest-rate cuts on student loans. And they’ve offered colleges millions of dollars to drop out of the direct-loan program...

There are services that most of us believe should be available either universally or at least more broadly than unfettered markets would provide - education and health care being the prime examples. It is an open question (in my mind, at least) whether the public or private sector can deliver them better. In the student loans and medicare cases, it seems like the government does better, but we don't really know how the private sector would do without subsidies. To find the answer, we need to let public and private compete on a level playing field - if the private sector cannot compete without subsidies, let it wither away (and if the private sector can outperform the government, without subsidies, hooray for them).

One reason for my exasperation in the post below with the "first best" economists is that "free markets" are often used as a cover for rent seeking behavior, especially these days. To be fair, any economic ideas are subject to abuse in Washington (and other capitals), so it is important to distinguish between the idea, and the actions taken in the name of the idea. I would imagine there are some similarities in the feelings of true free marketers now about the Bush administration (and late Republican congress) and those of true Marxists about the Soviet Union.

Incidentally, the Democratic congress is making progress on the student loan issue.

Information, Competition and Congress

There's a public choice lesson in here, though as an international macroeconomist, I'm not really qualified to figure out exactly what it is... Today's NY Times reports that "Pet Projects Are Flourishing in Congress:"

If the idea was to shame lawmakers into restraint, it did not work.

Eight months after Democrats vowed to shine light on the dark art of “earmarking” money for pet projects, many lawmakers say the new visibility has only intensified the competition for projects by letting each member see exactly how many everyone else is receiving.

So far this year, House lawmakers have put together spending bills that include almost 6,500 earmarks for almost $11 billion in local projects, half of which the Bush administration opposed.

The earmark frenzy hit fever pitch in recent days, even as the Senate passed new rules that allow more public scrutiny of them.

Far from causing embarrassment, the new transparency has raised the value of earmarks as a measure of members’ clout. Indeed, lawmakers have often competed to have their names attached to individual earmarks and rushed to put out press releases claiming credit for the money they bring home.

Perhaps its not surprising that more information leads to heightened competition - this is true in many markets; think of how much harder the internet makes it to charge a high retail markup or sell a shoddy product when it is easy for consumers to see competitors' prices and get quality reviews. And it is a reminder that members of congress have a strong incentive to maximize their probability of getting re-elected by keeping their constituents happy, and this does not always coincide with the national interest. One might say their rational earmark-seeking behavior has negative externalities - if only the founding fathers knew about Pigouvian taxes!

Before we get carried away with hand-wringing and indignation, its worth keeping in mind two things: (i) some of the projects probably are worthwhile, even if this is a silly way to allocate resources, and (ii) $11 billion is nothing to sneeze at, but its 0.4% of total federal outlays of $2,655 billion (FY 2006), so even if crusaders against "waste, fraud and abuse" were able to eliminate all the earmarks, it would hardly make a dent (and would not go far towards undoing the damage to our fiscal situation from President Bush's tax cuts).

Incidentally, though the local Congressman, John Boehner, is notoriously chummy with lobbyists and special interests he eschews earmarks. I'm sure he'd say its a matter of principle, though maybe he's just afraid of the competition! Too bad, since I really think Oxford would be a nicer place if they built a bypass for US-27.