Econ 101: Productivity

While I was doing my little morning commute a short little piece on NPR about the latest productivity numbers popped up.  In sum the US Q4 productivity number showed productivity up but by a very small amount.  In other words, productivity growth slowed.  Then there was a quote from economist Richard DeKaser of the Parthenon Group:

While strong productivity growth is usually good for the economy, there are times when slower productivity gains can also be helpful by contributing to jobs and income gains.

Which got me to thinking that, one, it is not clear to many people why productivity growth is a good thing in general if we care about jobs and two, how does productivity growth and employment relate in the short and long run.

First why it is good. The best way to conceptualize this is to use my favorite pedagogical tool, the "Robinson Crusoe" economy. Think of yourself stuck on a deserted tropical island. When first you land there you are terrible at catching fish, collecting coconuts, etc. Let's say you spend your entire day trying to do both and end up with one fish and two coconuts. Over time, however, you get better and better at it so that after a month you could spend your whole day doing both and end up with 20 fish and 50 coconuts. You have become much more productive and now you can consume more than you could before and you don't have to work all day to provide for your basic needs - you can consume more leisure.

This is a simplistic world (a model economy) but it generalizes quite well.  What do high income, high productivity economies look like as compared to low income, low productivity economies?  They have higher consumption (and not just of fancy electronics and stuff, but of quality health care, parks and clean air, education and so forth) and consume more leisure.  For the econ students out there, productivity increases move the production possibility frontier out.

Wealth also creates new investment, new demand and can lead to higher growth all of which is good for employment - new investment, demand and growth translates to new jobs.

So why does DeKaser suggest that slower productivity growth could be a good thing in the short run?  Well let's go back to the Crusoe economy and see that one natural aspect of increased productivity is the ability to spend more time relaxing on the beach and not fishing or climbing coconut trees.  But most Americans can just decide that they would like to work 36 hours this week instead of 40 and take 10% less pay, or take an extra week or two of vacation, etc.  In other words there are rigidities in the labor market that can mean that productivity gains accrue mostly to the currently employed.  When productivity growth is slower than the increase in demand there is only one solution, more workers.

Yes, this means less overall increase in prosperity, but a more widespread enjoyment of the current prosperity.  So while we like to see good productivity growth in general because it is the backbone of economic growth which is the driver of employment in the long run.  In a period of recovery where there is high unemployment but increasing demand, a little slow down in productivity growth might not be such a bad thing if what we are concerned about most is unemployment (which, I suggest, is the main concern right now).

Econ 101: Dynamic Comparative Advantage

This past weekend, the Oregonian reported on something that has been fueling the rumor mill in Corvallis for a few months: HP is most likely scaling down its Corvallis operations.  A few weeks ago they also reported on the shuttering of the Hynix plant in Eugene.  What gives in the Willamette valley?

Well, as a friend who works for HP in Corvallis explained to me, HPs printer business is not growing and in modern business you have to grow revenues.  So without growth in sales, you need to cut costs and a big cost savings is to employ engineers in Asia rather than in the US.

When I teach comparative advantage, the relative productivity advantage that leads to gains from trade, I try to stress that though in the classical Ricardian example there exist static differences in productivity, such productivity differences evolve through time.  Countries like India and China for a long time had a major comparative advantage relative to the US in light manufacturing and other labor intensive activities that came from an abundance of unskilled labor and a relative paucity of skilled labor.  But over the last ten to twenty years, this has begun to change quite dramatically.  India and China have begun to produce more and more skilled engineers, to use but one example.  Thus the relative productivity advantage that the US used to enjoy in engineering is disappearing fast.

Why has the US lost this advantage?  One need only look at the sorry state of the US higher education system to figure this out.  Federal funding for basic research is almost non-existant, states support for public higher education is drying up and the K-12 system is sending (and not sending) kids to college without proper preparation.  From my vantage point it is not hard to feel pretty pessimistic about the future.  Our best hope is to try and hold on to all of the incredibly talented foreigners that come to get advanced degrees (for the time being at least) in the US.  But with stricter immigration policies and ever improving opportunities at home, many foreign students are choosing to return, leaving the US talent-poor and loosing more and more industry.  

So back to Oregon.  What can a state do to combat these job losses?  Produce skilled individuals who have the ability to be high productivity participants in the 21st century.  This takes time and resources for the entire educational system.  Failure to do so will leave us in the unfortunate position of having a comparative advantage in low value-added activities.   

Econ 101: Myth-Busting Self-Service Gas

MYTH 1: Eliminating Gas Station Attendants Will Just Lead to More Profits for the Owners and No Lower Prices for Consumers.

In the comments section of the previous post on the self-service gas poll, Kari Chisholm, an enormously intelligent guy for whom I have lots of respect, gets one terribly wrong. He argues that if gas station attendants were to disappear, gas station owners would just pocket the excess profits. I am sorry Kari but this is just bad economics - and wrong.

Excess profits, or 'rents' in the economics parlance, come from market conditions. Usually rents come from some sort of market concentration (monopoly or oligopoly) that can either be 'natural' (high fixed costs prohibit potential competitors from entering), or 'created' (regulation, patents, strategic entry deterrence, etc.). Now it may be true that gas stations do capture some rents because of special regulations covering the storage of potentially toxic fuel, among other things, but I doubt it is much. You see, it doesn't take very may gas stations to make a competitive market. The reason for this is that gas is, for the most part, a completely generic product and price information is posted very visibly, so consumers are extremely price sensitive and thus to attract them you have to compete fiercely on price. [For you economics students, this is a pretty good example of Bertrand price competition, in which only a few firms will drive the price to marginal cost] Most studies have found the market for retail gas to highly competitive.

Regardless of how competitive they are, however, the real key to why Kari's suggestion is in the fact that the market conditions do not change if you eliminate attendants, so any rents that exist after the elimination of attendants would be there before as well. The only thing that will change is the marginal cost of providing gas to consumers, and this cost savings will be passed on to consumers by force of competition. [And, by the way, when John Corzine proposed the change for New Jersey, the only other state that forbids self-service, it was the gas station industry group itself that was most instrumental in killing it - which should tell you that they did not expect to make higher profits with the switch]

MYTH 2: National Average Gas Prices are a Good Counter-Factual.

No. Local gas prices are determined by, among other things, state taxes, state regulations and especially, distance to pipelines and refineries. Just saying that Oregon's gas prices are consistent with other states prices where self-service gas is allowed tells us nothing. (But, by the way, Oregon is 4th highest in the continental US for regular gas prices according to the latest data from AAA) The true counter-factual is what would happen to prices at your local gas station if the labor costs were reduced - it doesn't take an economist to figure it out. But seeing as I am an economist, here is the basic econ 101 graph of supply and demand in retail gas with two supply curves, one that includes the extra cost of attendants and the other that does not. Note that when you include attendant cost, price goes up.



MYTH 3: Full-Service is a Good Way to Boost Employment and Reduce Driving, both Noble Goals.

If you buy my argument about gas prices, you may say, but wait, don't we want higher gas prices to discourage people to drive and and thus limit the carbon that is released into the atmosphere? To which I would answer, if that is true then you can increase the tax on gas and achieve the same thing, but the difference is government captures the revenue and can then spend it on things like: lower state college tuition for the types of people that would work as a gas station attendant, investments in public transportation, etc.

Also, full-service gas, as mentioned in previous posts has ambiguous effects on overall employment. There will likely be fewer gas stations with full service and high gas prices affect other industries by raising their costs which will also raise supply curves and lower output and employment. It is quite likely that this will actually lower overall state employment, not raise it, which is why we don't mandate employment in general.

But, by the way, none of this really matters, you can keep everything they way it currently is and still give me the right to pump my own gas (while the attendant watches). Surely you can't argue against that? What I would propose, however, is that each gas station must be able to provide the service upon request, but otherwise people would be allowed to pump their own.

Econ 101: Price Discrimination Redux

It occurs to me that one reason current Timbers season ticket holders snapped up the $99 tickets is this: many of them are probably Timbers Army folks who surmised - rightly - that there will be plenty of TA section tickets available when the general public gets to buy tickets and who also surmised - possibly correctly, we'll see - that if they bought $99 season tickets, they could resell them for a lot more than face value.

In other words, the $99 tickets were an arbitrage opportunity: buy them now and buy the regular TA section tickets later (it is general admission so it doesn't matter when you purchase them).  Then sell the $99 tickets later for more money.

Methinks the TA folks knew a good opportunity when they saw it...

RCTID!

Econ 101: Price Discrimination

The Oregon State Beavers have finally learned a little something about price discrimination.  The Oregonian reports that they have increased seat sales by lowering prices - wow, who would have guessed? But you don't always want to sell every unit of a product that you can, especially when you have market power.  This is the lesson of the monopolist.

Consider the example of a downtown parking lot, you might wonder why, if a lot regularly has empty spaces, the lot owners don't just lower the price?  The reason is of course that to fill the lot they may have to lower the price so much that their total revenue actually goes down.  This is because they have to charge the same price to all of their customers.

The way around this is price discrimination which in this case means charging different customers different prices based on their willingness to pay.  Parking lots do a little of this, charging reduced all-day rates to customers that park before a certain time - the idea is that parkers who come in later in the day face a more competitive parking environment and are less price sensitive.

The general rule is that the more you can price discriminate the more you are willing to sell because selling more no longer means that you have to charge lower price to everyone. It is also generally true that the more you are able to price discriminate the more revenue you will be able to make.

In the case of a football stadium, price discrimination is easy: you can still charge a high price for the best seats while reducing the price of the more marginal seats, just as OSU has done.  Before you pass judgement on OSU for being so dense no to have figured this out before you have to realize that there is a constraint: you don't want to make it so attractive that folks that would normally pay for expensive seats find the good deal too tempting and would opt for the cheaper ones.  

An example of this that I have recently encountered is the current Timbers season ticket sales.  They started selling them first to 'priority groups' starting with current season ticket holders.  Now these would likely consist of some of the highest willingness-to-pay folks, but the Timbers also made a bunch of $99 season tickets available from the outset - and these were apparently so tempting even with their less desirable location that they were snapped up right away by the 'wrong' folks.

This decision confuses me - I would have thought that they would not have reduced the price of seats to such a low price until after season ticket sales had been opened up to non 'priority' folks.  But I guess the $99 price was a marketing gimmick to get people to consider season tickets from the start.

The difficulty in trying to get the 'right' people (the low willingness-to-pay people) to buy the low price tickets is a general difficulty in price discrimination.  When you can't tell the willingness-to-pay of customers it becomes tricky to design a pricing scheme that gets people to self-select into the right categories.  Clearly if the goal of the $99 Timbers tickets was to get marginal fans to become season ticket holders, it failed.  So whether the Beavers were smart in reducing the price of these tickets depends on whether people that would not normally have attended a game buy them or whether customers swap high priced tickets for these.  Apparently, as overall sales have increased, it looks like mostly the former.

Beeronomics & Econ 101: Economies of Scale - Redux

After my post this morning, Beervana blogger Jeff Alworth sends along this new picture and writes: "Each one of those tanks at Widmer is 1500 barrels (46,500 gallons)--the annual production of a big brewpub.  There are six in that room and one of the brewers joked, "the biggest six-pack in Portland.""


Here is another aspect of economies of scale: the cube-square law.  According to Galileo (via Wikipedia) this law states: "When an object undergoes a proportional increase in size, its new volume is proportional to the cube of the multiplier and its new surface area is proportional to the square of the multiplier."  So if you double the size of a tank in a brewery, the cost of the materials to make it (stainless steel) increases fourfold but the volume increases eightfold.  So if you have the production to support it, you get double the bang for your buck in tankage - thus the average cost per ounce of beer decreases (all else equal - like just as easy to clean and maintain as smaller tanks).  Now you know.


And for my students - after these two posts, I have now made attending my class today almost entirely redundant, but as it already happened you cannot act on this knowledge - so my ego is safe for another day.  

Beeronomics & Econ 101: Economies of Scale

Over at the Beervana Blog, Jeff Alworth notes (and photos) a new set of tanks being delivered to Coalition Brewery near his house.  To the economist in me this picture says one thing: economies of scale.

Economies of scale simply refer to any productive activity whose average costs decrease with output.  In many cases this is due to large fixed costs - those costs that do not depend on the quantity of the output.  Take this brewhouse for example: the cost of these tanks will be the same if they brew no beer or if they brew to capacity.  Alex at Upright, for example, has a beautiful brewhouse but is only brewing at about 60% capacity - if memory serves.  So if Upright brews more, the average cost of the beer they brew will go down - the fixed cost will be spread across more beer.  Since breweries require a lot of large scale equipment, it is an industry prone to economies of scale. There are other sources of economies of scale that are relevant to the beer industry as well: bottling, distributing and marketing to name three.

The implications of economies of scale have been discussed here at length, but the main one is a tendency for such an industry to be prone to concentration.  It is no accident that the big macrobrewers have become bigger and bigger through acquisitions and mergers.  [I have noted in a previous post how the fact that craft brew is an artisanal product and an experience good creates a countervailing force for small scale brewers to exploit]

The good news for Portland and Oregon craft brewers is that, like these internal economies of scale (that depend on the firm's activity alone), external economies of scale exist.  For example, with a lot of local craft brewers there is more demand for ingredients.  This high demand allows farmers and other input providers to achieve their own economies of scale, promotes competition and allows for efficiency in distribution of inputs.  So it is likely that inputs costs are low in Portland and Oregon not just because of proximity to the growers but because of all the brewing that goes on in Oregon.  [There is also a demand side effect, but that is a topic for another day]

So this external economies of scale is a pretty groovy story: the more local craft brewers brew, the lower are the costs for their fellow brewers.  Once again we see that competitors can also help each other out - even unintentionally.  For an industry that is remarkable for its sense of community and fellowship, this shows that they are not just deluded hippies - they are also savvy businesspeople.

Econ 101: Recessions and Luxury Goods

Photo Credit: Doug Beghtel/The Oregonian

Saks Fifth Avenue is closing its two Pioneer Place locations.  Recessions are tough on purveyors of luxury goods - which economists define as goods on which you spend proportionally more on as incomes rise.  But this works both ways, you spend much less on them as incomes fall - they are often the first things to go out of the budget when belt-tightening is done.  And so Walmart thrives and Saks suffers as Oregonians average incomes plunge.  In fact, Saks is apparently close to inking a deal to open a "Saks off Fifth" discount store in Bridgeport Village.

But don't feel too badly for Saks, when the economy finally returns to robust growth, guess which sector of the retail trade will thrive?  

Econ 101: Perfect Competition, Part 3

Oops...took longer than I had planned to get back to this, sorry.

In my previous two posts on perfect competition I covered the basics of the assumptions (market structure), the supply and demand side (market conduct) and the notion of equilibrium.

Today I am going to talk about why markets are so great.



If we look at the above illustration of market equilibrium for some good there is one aspect that immediately stands out: all the consumers that had a reservation price for the good that was above or equal to the market equilibrium price were able to purchase the good. Similarly, all of the suppliers who were able to supply the good for a cost below or at the market equilibrium price were able to sell their goods. The is one aspect of the efficiency of markets - all of the buyers and sellers who should transact, do. So there is no benefit to either party that is left 'on the table' by the market - all of the possible benefits are enjoyed by the participants in the market.

And notice the next aspect: every single one of these transactions was entered into willingly because they left both buyers and sellers better off. Let's return to the example of the yard sale. Many people have around their houses stuff that they no longer want and can supply it to a market (in this case the market that they created in their front yard) at very low cost. The potential customers are the ones who have some value for the stuff. That people are able to sell stuff from their front yard is a good thing because these buyers and sellers can come together for mutually beneficial exchanges. Society benefits then from having free markets so that such exchanges can happen and everyone can benefit.

There is another aspect of the efficiency of free markets that I will just mention in passing. Since free markets are, by definition, ones that anyone can enter, this causes competitive pressure on the part of firms. Notice that if someone invents a technology or process that can save just a tiny bit of cost, they could reap huge benefits by being able to undercut other firms' prices. This then creates relentless pressure to be efficient on the part of firms and ensures that no firm is wasteful in the sense that they are needlessly costly in their production of any good.

So there you have it - the wonder of free markets. Contrasting this with markets in which there is not free entry shows that less than optimal amounts of the good will be sold and that the firms may not be efficient - both of which lead to lower benefit to society.

MARKET FAILURES

To complete the analysis, let's go back to the implicit assumptions that we started with (the implications of the explicit assumptions I think are more or less self-evident).

In order for these results to hold we have to have full and complete information: most importantly, all consumers must know all about the product (so they can value it properly) and all of the prices that it is being offered at (so they can always go for the lowest). [NB: we can alter the model easily to deal with real world realities like transportation costs, to wit, you would usually go to the store down the block than across town just to save a penny]

There also can be no external costs and benefits. The easy way to see this is with external costs. The supply curve is based on private costs and we get efficiency from the fact that all suppliers with costs below the price supply. But what if, in the production of the good, the supplier gives off toxic smoke that is damaging to local residents' health? Well then the true social cost of the good is higher than the private good and there will be exchange of good that should NOT be exchanged: people who value them for more than the private costs but less than the total costs will buy and consume them when they should not (from a social welfare perspective). These exchanges start diminishing the total surplus from the market and efficiency is lost.

This is precisely the rationale for a carbon tax, by the way. By making the cost of carbon emissions part of the private cost of production, market efficiency is restored.

One last note, these have to be private goods, only those that purchase the good can consume it, so these markets do not work well for things like city parks, streets etc.

So that is the essence of perfect competition and free markets and why economists often extoll the virtues of them. Any good economist will, in the same breath, acknowledge the assumptions and the potential for market failure as well, however. That said, most of us start with the idea that a market solution is the best in most cases and only if it is clear that market failures are significant and that a regulatory solution is available that can correct the failure at a reasonable cost (not more than the cost of the failure itself) should markets be constrained. We do this not out of some fetish for profits, competition and greed, but because we understand that everyone benefits from free markets.

Think of our yard sale example. What if the government outlawed them entirely or put onerous restrictions on them? Lots of people would loose out on the opportunity to engage in mutually beneficial exchange. The poor college student who needs a cheap couch no matter how tattered and the family who have finally replaced their old couch with a new one both benefit from finding each other and transferring the couch. This is what markets are all about.

And, by the way, this is why markets and market-based economies arise naturally and this is also why acting in your own self interest is good for all. The poor college student does not care about the family who bought a new couch and the new family is not acting out of a sense of concern for the college student, but they are helping each other nonetheless.

Econ 101: Perfect Competition, Part 2

Picking up from where I left off last time in Part 1 of this Econ 101 post, let's turn to the supply side.

Firms in perfectly competitive markets are, by assumption, price takers. Since they produce identical products, trying to get consumers to pay more for a particular company's output will not work. And since each individual company is so small relative to the overall size of the market, their own supply decision will not affect prices at all. In addition, the market will easily gobble up all the product they can produce and sell at the market price.

So what do firms do? They produce output as long as the marginal cost is not greater then the market price. Marginal cost is the cost of producing one more unit of output. If this is lower than price, they will earn a positive return on the sale of that unit. So they keep producing until marginal cost (which eventually must rise) reaches the price. So, given a price in the market, we need only trace it to the firm's marginal cost curve to see how much each firm will produce, which means that the firm's marginal cost curve is also its supply curve. [Astute students of econ will also note that there is a shut down condition to meet - if price is so low that you can only make economic losses - but let's assume that away for the time being]

Note that this is the same as saying that firms produce until marginal revenue (benefit) = marginal cost, which is the profit maximizing rule for all firms. In this case as price is fixed, it is exactly the extra revenue a firm earns from the sale of each additional unit of output, so in perfect competition, price = marginal revenue. In fact just about all economic activity is governed by the marginal benefit = marginal cost calculation, so no matter how you dress it up with math it almost always comes down to an expression of this rule.

Anyway, here is what the firm's supply curve looks like and its optimal output decision depending on the price:

If we add up all such firm's supply curves in the market we will get a market supply curve that looks similar: upward sloping.

So now we have the basics of both sides of the market. Buyers who derive satisfaction from the consumption of the good, and sellers who can potentially make it at a cost that is lower than the monetary value of that satisfaction.

This is a good point to stop and think about this aspect of the story for a moment because it will help later when we talk about the great things markets do. A useful example is a yard sale. You may have a bunch of stuff in your basement or garage that is no longer of much use or value to you. You can provide them for sale at a very low cost - you just set them out and put up a few signs to advertise. There are others out there who may value your items a great deal. Perhaps you have children that are growing and you have baby clothes, furniture and equipment to offload, and there are new parents who really need what you have. Because these new parents value the stuff more than you do, a mutually beneficial exchange is possible. So what do you do, you create a market, allow the high valuers to come and purchase the goods at a price somewhere between their value and your own. [Of course they would like to get a low price and you a high, but any price in between your valuations leaves you both better off than before the transaction] Everyone is better off.

EQUILIBRIUM

Once we put the market supply and the market demand curves together on the price-quantity graph, equilibrium is easy to describe. People will continue to purchase more of the good as long as there are sellers who can provide it for less than their reservation prices (and vice-versa, sellers will continue to make more and sell as long as they can find people who value it for more than the marginal cost of production). Putting this on a graph looks like this:

Where the P* and the Q* are the market equilibrium price and quantity. Why? Well if price were any higher there would be too little quantity demanded for what the firms were willing to supply, leading to excess supply. Firms would start cutting price to find willing buyers and price would go down. If price were any lower there would be too much demand and too little supply, or excess demand, and buyers who couldn't find any of the good would start to offer more.

Next time, in Part 3, I'll go over the performance of the market, describing why markets are so great, as well as discuss a few of the possible market failures (assumptions that fail to hold) and what the implications are for the 'great' outcomes of the market.

Econ 101: Perfect Competition, Part 1

A while back (okay, a long while back) I got a request for a basic description of the concept of 'perfect competition' in economics. I am finally following through. This concept is especially important because it is from this that comes the fundamental welfare theorems in economics - meaning that this is where all the "free markets are good" stuff comes from. In the near future I'll do a post or two on monopoly markets and go over the standard "why monopolies are bad" stuff.

I usually spend about four weeks on this material in class so even though this is an abbreviated description, I will do it in parts.

Remember that the point of any model in economics is to present a simplified version of reality that contains essential elements and strips away a lot of the complicating detail. We do this because it provides useful insight into the real world even though it may not mirror it exactly. The 'art' of economic analysis is to understand which models are relevant to each real world situation and what information is useful to extract from those models. A frequent reference point is to Newtonian physics which helps make sense of the physical world that surrounds us even if not perfectly accurate due to the simplifying assumptions.

Which brings us to the process of building an economic model which always begins with a set of assumptions. So here are the assumptions behind the model of perfect competition.

ASSUMPTIONS (MARKET STRUCTURE)

We start by assuming that there are many firms and that entry by new firms and exit by existing firms is 'free,' or that there exist no barriers to such entry and exit. We assume all firms are 'small' in the sense that any output they put on or take off of the market has no influence over the market equilibrium price. We also assume that they all produce identical products. Finally there are some implicit assumptions: that information is full and symmetric and that there are no externalities - that all of the relevant costs and benefits of this economic activity are born by the participants in the market (a counter example is if the production of the product produces harmful emissions that are born by residents of the area of production but not paid for by the firm).

You might already be wondering if this description fits anything at all in the real world. The short answer is no, it doesn't. Some markets come close and a typical classroom example is one of small family farms all producing the same kind of wheat and taking their harvest to the local grain elevator where the market price is posted and they take it or leave it. But even here there are real, if minimal, supply effects, externalities and potential quality differences. Another example is retail gasoline and gas stations as studies have shown that even a little competition keeps prices low.

So what we have is an abstraction of the real world that doesn't quite describe precisely any real world market. So why study it? Because lots of markets come close and by understanding the extremes (monopoly is the other) we begin to understand both the power and limitations of free markets.

MARKET CONDUCT

Obviously there are two sides to every market: demand and supply. Demand comes from all of the people out there who have some desire for the product in question (and as an aside, when talking about a market we always define it for one product). People have different levels of desire for the product (and for multiple units of the same product), have different incomes, wealth, etc., meaning that they all have different levels of "willingness to pay" or "reservation prices." Willingness to pay is simply the most you would be willing to spend on a given unit of a product which is the same as the dollar amount of satisfaction you would get from consuming the product. By assumption if you can find a product being offered at a price that is lower than your willingness to pay, you should buy it and consume it and you will be better off. This is also why it is called reservation price, you would not be willing to purchase it for anything above that price.

For example if you are hungry and a slice of pizza is worth $3 to you and you find a place with $2 slices then, by purchasing it and consuming it, you are a dollar better off than you would have been if there were no pizza available. You traded $2 for $3 worth of satisfaction.

When you add up all of the people who have some demand for a product and their reservation prices, you get a market demand curve. It is downward sloping on a price - quantity graph because at high prices there may be only a few people willing to purchase but as price gets lower you add more and more people to the mix (and more people willing to buy more than one).

Next time: the supply side, equilibrium and efficiency.

Econ 101: Price Discrimination and Arbitrage

On Craigslist just now, I found a 1995 Ford F150 truck advertised for $1000. I could buy this truck and immediately turn it in for a $4500 Cask for Clunkers rebate on a car that got at least 25 MPG. Or I could turn around and sell it to someone walking onto a new car lot who is ready to buy a car. In fact I am not sure why new car dealers are running around snapping up cars like this to offer to prospective customers so that they may take advantage of the Cash for Clunkers program (or perhaps they are). This example illustrates the difficulty of price discrimination.

Price discrimination is, among a few other things, charging different people different prices usually based on their willingness to pay (demand) for it. A classic example is the movie theater with its adult and child prices. Adults are generally willing (able) to pay more for a movie than children are. In the Cash for Clunkers program the government wants to essentially charge a lower price to people with cars that are not very fuel efficient. The challenge to such pricing schemes is that you have to be able to prevent arbitrage - the buying and selling of the same good for different prices. Otherwise you would have kids camped outside of theaters buying up tickets and reselling them to adults. Or people like me buying up old cars and reselling them to people without poor fuel efficiency cars so that they may enjoy the Cash for Clunkers rebate. In this case the program is temporary and the cost of searching for, re-titling the car and turning it in is probably enough to prevent this from happening too much - maybe. But the theater example is easy, which is why there are ticket takers at the door that check that adults are not entering with kids tickets.

Since businesses go for price discrimination it is probably pretty obvious that it is a profit maximizing strategy. In fact, in general, the more businesses are able to price discriminate the more profit they make. Interestingly, however, it is also generally true that more price discrimination leads to more sales which is good for market efficiency. Is it good for consumers? Well when it is done on the basis of group membership it usually depends on which group you are in. For example, when airlines charge more for business travelers and less for vacationers, the business travelers are paying more than they would in the absence of price discrimination, but leisure travelers pay less.

Another example of price discrimination that was brought to my attention is the reciprocal agreements that museums and zoos have. For example, a family membership in the Science Factory in Eugene costs $55, while a family membership in OMSI is almost twice that. This is a type of price discrimination as well - although the products aren't identical it is likely that the demand for science museums are different in the two cities. There is no restriction to becoming a member of the Science Factory as a Portlander and since the two museums have a reciprocity agreement, you could get into OMSI as much as you wanted on the Science Factory card. I almost didn't blog about this as I worried I would spark a surge of defecting OMSI patrons, until I scoured the OMSI website and found the link to the Association of Science - Technology centers which states this about the reciprocity agreement:

Please note—local restrictions apply

1. Based on your science center's/museum's location: Science centers and museums located within 90 miles of each other are excluded from the program unless that exclusion is lifted by mutual agreement. 90 miles is measured "as the crow flies" and not by driving distance. Science centers/museums may create their own local reciprocal program. ASTC does not require or participate in these agreements, or dictate their terms.

2. Based on your residence: To receive Travel Passport Program benefits, you must live more than 90 miles away from the center/museum you wish to visit. Admissions staff reserve the right to request proof of residence for benefits to apply.

So either they were smart at the outset or quickly learned about arbitrage the hard way (I hope OMSI staff are checking). The zoo association has only weak language about not offering to member of zoos that are too close but does not have the residency requirement. So here is a hint for you folks living in Seattle: the Oregon Zoo charges $69 for a family membership, while the Woodland Park Zoo charges $110. Why would you buy a membership up there when you can save $41 a year as an Oregon Zoo member? Oregon is much hipper anyway and this can give you the vicarious thrill of belonging, in some small way, to the state.

Econ 101: Opportunity Cost

One of the most important concepts in economics is opportunity cost.  Economists know that the true cost of any economic activity includes the value of the next best opportunity that you give up.

Thus, I know that on a day that is relentlessly sunny, warm and breezy the cost of blogging is too high...

Econ 101: Compensating Wage Differential

Right in the heart of Portland, I took this picture on a lovely Sunday walk. Can you guess where it is?
The fact that you might have trouble identifying it is testament to the fact that the city is blessed with an abundance of natural forested parklands.

Of course Oregon in general is a beautiful place, and as someone who relishes the gray damp wonder that is the Oregon winter, I get a lot of utility from living here. Because of my strong preference for living in Oregon, I accepted a job that payed considerably less than competing offers I had - in the most dramatic case about 50% less than what a big midwestern state university was offering.

Economists call this a compensating wage differential: the extra money you have to pay to get people to accept unpleasant jobs or the lower salaries you have to offer to people for particularly pleasant jobs. You may have to pay more then for a person who pumps septic tanks all day than someone who delivers flowers. It is a simple idea, you have to compensate people for the difference in the disutility of doing different jobs.

Politicians love to say that it is okay that salaries in Oregon's state universities are much lower than other places because of this: Oregon is such a wonderful place to live that talented academics will come anyway. There is some truth to this statement, but Oregon isn't the only place to live and the population of people like me who are willing to accept much less to be here is pretty small. For instance I was offered quite a bit more to go to a university in a lovely seaside California town - I don't suspect many would have made the decision I did. So, yes, economic theory suggests that Oregon can get away with slightly lower salaries, but there is a limit.

As I talk to some OSU students who are graduating and who have more than one job prospect, I emphasize that they should look past raw salary differentials and think hard about how much they will enjoy the work they will do in each job and ask themselves, how much is the extra pleasure of working at a particular place worth in terms of salary?  What I am telling them, in other words, is figure out your personal compensating wage differential. 

Good luck grads!

Econ 101: The Coase Theorem and the White Stag Sign

Ronald Coase won the Nobel prize in 1991 for his work in understanding the role of property rights in efficient market outcomes. Stealing a page from Bob Frank at Cornell, it is easiest to understand the Coase Theorem by simple example. Suppose two people share an apartment, Jacob and Chuck. The only problem is that Jacob likes to smoke and Chuck is disturbed by smoke. It is worth $150 to Jacob to be able to smoke in his apartment and it is worth $200 to Chuck to live in a place without cigarette smoke.

There are two ways to get the efficient outcome, which is to not have any smoking (because collectively they are $50 better off with this outcome than the other). We could give Chuck the right to live without smoke, or we could give Jacob the right to smoke. Say what? The first is obvious but what about the second?

Think about what would happen in the second case: Chuck would offer Jacob some amount of money between $150 and $200 (let's say $175) to not smoke inside and Jacob would accept. No smoke would happen and this outcome would be efficient. Why? Well, Chuck is $25 better off paying $175 and not having smoke and Jacob is $25 better off not smoking but collecting $175. So they recover the $50 in surplus. The second case is worse for Chuck and better for Jacob relative to the first, but both are efficient.

This is the essence of Coase. As long as negotiations are costless and property right are well defined, an efficient outcome occurs no matter which party has the property rights.

What does this have to do with the White Stag sign? Well suppose that the sign with UofO on it benefits the UofO a sum of $100. But such a sign would negatively impact Portland residents collectively a sum of $200. The efficient outcome is for the sign not to read UofO. If UofO did not have the right to change the sign, problem solved. If the UofO had the right to put whatever it wanted there, residents could offer a sum of more than $100 not to. The problem is it is hard to negotiate such a transaction - it is not costless. Residents would have to come together and propose a deal with UofO and this takes time, effort and resources - all real costs. In the end then, this would not happen and an inefficient outcome would occur.

This is precisely why we have rules and regulations governing such large public displays. In the case of situations where it is hard to negotiate laws are written to impose the burden on the lowest cost participant.

As Frank says: "It is often impractical to negotiate solutions to the problems created by externalities. Hospital patients, for example, are unable to negotiate with passing motorists about not blowing their horns. In such cases, the law tries to impose the burden of adjustment on the party that can accomplish it at lowest cost. Not blowing his horn is a cost to the motorist, but a benefit to the patient. Because peace and quiet is especially valuable for hospital patients, the law prohibits horn blowing in the vicinity of hospitals. "

This is also why I supported Commissioner Leonard's exercise of authority on behalf of Portlanders. Essentially what he did was to assert the appropriate property rights and this led to negotiation on behalf of Portland residents and what is a reasonably efficient outcome.

Econ 101: Nash Equilibrium in a Non-Cooperative Single-Shot Game

Via Greg Mankiw, a wonderful illustration of almost the precise game I used to describe the no stop sign intersection. The outcome is ... predictable.



What would you have done? Are you sure?

Econ 101: Financial Intermediaries

Something in Ethan Lindsey's story on OPB about real estate fraud in Bend caught my attention. Bend attorney Martin Hansen was explaining a crooked deal and made this statement about the deal between the allegedly fraudulent firm and its depositors: “It did not authorize any removal for any purpose whatsoever under any terms in any circumstance. Period. It would just be tantamount to your bank removing money from your savings account to investment in real estate. They don’t have the authority, without your consent.”

Um, just how does he think banking works? In fact, this is precisely what you are doing when you deposit your money in the bank, which is why they pay you interest for the right to use your money. They are required to give you your money on demand, that is true, but they aren't paying you for the pleasure of looking at your stack of cash. They don't need your specific consent to use your money, such consent is part of the contract from the outset.

Which brings up a bigger issue, why are we so interested in getting the banking sector working efficiently again? This is because the banking sector plays such an important role in our economy. All of us with savings have idle money that could be put to productive uses but it is hard for an individual to know about these. Some of us invest directly in startups, stocks, etc. But many of us simply don't have the time knowledge or level of savings to do so. Banks, by consolidating the savings of many individual depositors and making these funds available to loan direct this idle capital to productive uses. This investment is vital for the growth of the economy and benefits us all in general and individually: both depositors and borrowers gain from this transaction that would not have happened without the financial intermediation of the banking system.  

No matter what scale we are talking about, the role of the banking system is essentially the same - taking idle capital from one set of economic actors (whether your neighbor or the Chinese) and directing it to its most productive use (from a new coffee shop to an international conglomerate to a sovereign nation).  Without this essential link between savers and investors, investment general crashes and, well, you can see the result.  

This is why, without a well-functioning credit market the economy is unlikely to turn around and why, like many other economists, I believe the key to the recovery lies in getting the credit markets sorted, and soon.  Everything else is secondary.

Econ 101: External Economies of Scale

Most people understand internal economies of scale, the reduction in average cost of production that comes from producing in mass quantities. Utilizing machines, specializing tasks, economizing with big shipments all make sense. But economists know that economies of scale can be external as well. These come from the fact that a large industry can create economies of scale in upstream and downstream industries, can promote development of new process innovations and can lead to more efficient distribution networks.

I thought of this when I was listening to a commentator on the radio suggesting that the US automobile industry needs to be much smaller. It is quite possible that he is right, but if the automobile industry shrinks it is likely that producing cars will become more expensive, further hurting the industry that remains. Why? External economies of scale. Producers of components and inputs in general will have fewer customers and thus lower demand meaning that they might not be able to produce at an efficient scale, and the same is potentially true for the suppliers of raw materials.

A local example might be the brewing industry in Oregon. I have no idea how true this is, but one example is the fact that there are now (to my knowledge) two competing mobile bottling firms in the region, up from one a year ago, which is likely to reduce costs for the small brewer. More local breweries might also spur the planting of more hops allowing local cultivators to realize economies of scale and thus reduce input prices.

How does this all relate to the current economic catastrophe? Well at a time when demand is waning, firms might not be able to operate as efficiently as possible due to scaling back of operations and as they fail, supporting firms might also become less efficient. On the other hand, labor costs should be coming down pretty quickly as the demand for jobs skyrockets, so the effect on prices is unclear.

Have a good weekend everyone...

Econ 101: How Does it all End?

With new and expensive government programs being announced almost daily, I sense a little fatigue already about how much the government is doing. The housing plan in particular seems to be raising questions about moral hazard and how much the public should insure private risk. On OPBs "Think Out Loud" this morning I heard the opinion that hosing prices should be left to fall without intervention and this would help lower income people afford a home.

The problem with this argument is that if the housing market continues to fall and households net wealth continues to drop and banks continue to hoard capital, demand, which is already plunging, will continue to fall, businesses will fail and these lower income people are not going to have jobs to make them able to buy the houses.

But it does lead to a good question (that I was asked the last time I was on Think Out Loud and did a poor job of answering): if the government did nothing in terms of fiscal stimulus, housing market interventions, etc., how would the downward spiral end?

Well the classic Keynesian story is one of depreciation: over time households and firms who have resisted investment due to belt tightening find that their stuff is starting to wear out. For business this is their productive capital - the machines they use to make stuff to sell, and for households these are consumer durables - cars, washers and dryers, refrigerators and the like. Thus after some time people are forced to start to make these investments again and this starts to turn the tide. Add to this the fact that while households can economize, there is generally a minimal level of consumption that they need, so decreases in demand by households can only fall so far. But this can take a long, long time...

It should be noted (and Krugman has a nice piece on this) that the more typical (post-Keynesian) business cycle theory tells a story of recovery that is based on falling prices which makes the money supply too large and forces down interest rates and spurs on more investment and output. However, we are in a situation currently where the interest rate is a low as it can go and it is not spurring on this new investment. Essentially the aggregate demand curve is near vertical so this mechanism is no longer working.

Econ 101: Paradox of Thrift

You may have heard this term used recently (Paul Krugman, among others, has been talking about it), it is an old term coined by Keynes which describes a type of self-fulfilling prophecy. In a recession, we all do what is individually rational: we pull back on discretionary spending and build up savings as a buffer against the vagaries of a turbulent economy. However, taken together, all of this thrift on the part of citizens creates a drop in aggregate demand that prolongs and deepens the economic downturn. So we become thrifty to guard against bad economic times, but by doing so we actually ensure bad economic times.

But wait, you careful economists will say, becoming thrifty increases savings which should lower interest rates, increase investment and will actually help lead us out of the economic downturn. Plus, decreased demand will cause prices to fall and people will be enticed to spend again. These are both valid criticisms of the paradox of thrift though neither necessarily invalidate it - it depends on how much the aggregate demand fall is countered by the increased investment. But it is certainly true that in this particular economic crisis, low prices have not enticed consumers back in to the market very much (look at the deals you can get on cars versus car sales), and banks are still largely sitting on the money they are getting from savers and the federal government as they continue to try and shore up their balance sheets and worry about the effect the economy is having on borrowers solvency.

Another rationale for federal fiscal stimulus...