Introduction to the Mind of an Economist

When I think about public policy as an economist, my first instinct is (of course) that a market-based solution is usually the first-best alternative. Unfortunately, this is where many poorly-trained economists (or worse, well-trained economists who should know better) stop. I next think about the potential for market failures: un-realized goals or inefficiencies due to aspects of the market that don't match the textbook version. Market failures always exist - the job of a good economist is to identify them and figure out, one, how important they are, and two if the additional inefficiencies that will arise from government intervention are outweighed by the potential gains from such an intervention.

It is from such a lens that I am often either bemused or delighted by public policy in Oregon (and sometimes both). One of the most visible policies that I find bemusing is the ban on self-service gas in the state. First let us dispense with a number of obvious canards about self-service gas: it is not 'dangerous,' it does not lead to increased environmental damage from sloppy customers pouring gas all over the place, it does not reduce automobile insurance in Oregon, it is not less-efficient. So why do we have this policy? Let me try offer some reasonable arguments for and against. For: the elderly and disabled self-service gas can difficult; it creates jobs for a segment of the population that often has trouble finding employment. Against: it is slow and inefficient; it raises the price of gas; employees (who are often teenagers) are exposed to potentially harmful vapors. Are there any others I have not thought about?

Each of these arguments has an element of truth, so how important are they? Well, I think that they are all fairly unimportant save for the first argument about the elderly and disabled - I'll come back to that in a minute. I have seen a figure of about 7,600 persons who are employed as gas pumpers in Oregon. My guess is that this includes a large-portion who are part-time and for whom the income from their job is not what they live on (i.e. teenagers living at home) , so I think that the real impact on the well-being of Oregonians is minimal - these are simply lousy jobs. Besides if this is good public policy, why don't we mandate employment for many other business (no self-service car washes!, no self-service Laundromats!, etc.)? We don't do this because it dissuades investment in new business. As for the arguments on the other side, I believe it is slower and that gas prices are slightly higher. I don't think either is that important. Perhaps this helps achieve another policy goal of reducing slightly the miles driven, but there are much cleaner ways to do that (to wit, a gas tax). I do not know if there is credible evidence to suggest that teenagers are being harmed by fumes, until there is I shall assume the libertarian stance. So in the end, I think this policy fails the pointless test. I cannot see any good reason for government involvement and, therefore as an economist that believes in limiting government intervention in areas in which it is unnecessary, I think this policy stinks.

Now let me return to the one cogent point I put off. I do think that the elderly and disabled argument has merit, because if you have been to our neighbor states recently, I defy you to find anything other than self-service gas. So I can imagine a case for mandating at least the option of having gas pumped for you. However, again, since this does not seem to be an issue in the other 48 states the do not prohibit self-service gas, I would not be in favor of this amended policy solution until I were convinced that it was necessary.

Other policies I hope to comment on soon: bottle bill, payday loans, sales tax.

Payday Loans Redux

A new staff report by the Federal Reserve Bank of New York seems to confirm my fears about the regulation of payday lenders. As an economist, I believe that things like payday loan businesses arise due to some missing market, and to simply shut down that market does not address the original lacuna that caused it to arise. As payday borrowers are mostly lower income individuals, eliminating payday loans could end up making them worse off. Payday loans, as much as they seem usurious to us, seemed to be providing essential liquidity to a population that has a limited access to credit. Preliminary results are that credit troubles have worsened in areas where payday lenders were prohibited.

Economist's Notebook: Markets and Policy

I have already talked a lot about markets using specific policies and events to highlight aspects that I think are relevant. But I thought, thanks to a suggestion, that it might be worth talking briefly about the good and the bad of markets and the way that I, in general, assess a particular market and think about the potential for policy to do some good.

Here are the basics. As a mechanism for distributing scarce resources, complete free markets are exceptional. By exceptional I mean precisely that they extract every available amount of surplus possible and are, therefore, efficient. For example, if there are a number of people out there with tickets to a Kenny G concert and a number of people who wish to see Kenny G, allowing these individuals to interact in a free market will mean that the exchange of these tickets will ensure that the people who want to see Kenny G the most will get the tickets, and that every seller that wishes to sell for a given price (and for whom there exists a buyers willing to by at or above that price) will be able to sell. In other words, all mutually beneficial transactions will occur. To see this another way, a complete free market will prevent instances where there is a buyer of a Kenny G willing to pay up to, say, $100 for a ticket and a seller willing to accept anything above, say, $50 but a transaction between these two does not occur. This is what is meant by efficient: that last transaction should occur, if it did not occur, $50 worth of surplus (the difference between the $100 and the $50) would not have been created. This is the “miracle,” if you will, of the invisible hand: everyone in this market acts in their own self interest, but socially that create maximum surplus and the most efficient distribution of the tickets (only the people who values them the most will end up with them) and it is the price system that makes this all happen. Markets really are remarkable and this result is what fuels almost all free-market based arguments (individual liberty as a political philosophy is another).

NB: It is worth pausing for a moment to give the important disclaimer that efficiency has nothing to do with equity. Equity may be an important social goal, but does not mean we have to sacrifice efficiency. Extra-market redistributions can accomplish the equity goal, but without efficiency, there is less to redistribute to everyone.

Another note: careful reader may object by saying that the people who value the Kenny G tickets the most are almost surely the richest – and that allocating tickets to them is unfair. But consider this thought experiment. What if seeing Kenny G was worth only $25 to me (yes, perhaps because I have such low income). If I were given a chance to buy a ticket for $25, what would I do? I could go to Kenny G and basically come out even, or I could turn around and find the person who would pay $75 for it and sell it. Then I would come out $50 ahead. Remember everything is scarce and we are all trying to do the best we can with what we have. Creating the most surplus is best for everyone. So preventing this last transaction is what is unfair in this point of view.

So I have shown the basics of why complete free markets are so great, have so much traction in political consciousnesses and are often the lesson undergraduates take away from the little exposure they get to economics. This is partly due to how incredible we economists think they are and how important we think it is for people to understand and appreciate them. But the whole thing, it turns out, rests on a set of assumptions that really never hold in the real world. The four biggies are externalities, public goods, information asymmetries and perfect competition. I have talked about these and will continue to do so in my posts, because understanding these (and their implications for markets) is key, in my view, to evaluating policy. Briefly externalities are the costs and benefits of an economic activity that do not accrue to the person engaged in the activity. They can be positive (maintaining a nice garden in front of my house) or negative (the particulate pollution from my wood-burning fireplace). Either way the free market result is inefficient: I do too little than is socially optimal if the externality is positive and too much if the externality is negative. Public goods are goods in which there are aspects of non-excludability (can’t prevent non-payers from consuming) and non-diminishability (use by one person does not leave less for the next). The classic example of both is radio transmissions. It turns out that for these types of goods (roads, parks, fire protection, etc.) the free market will not allocate a socially efficient amount. Asymmetric information is where, for example, sellers know more about the quality of a good than do buyers. Efficient free markets rely on complete information – everyone (buyers and sellers) knows everything (prices, quality, availability) about everything (all products and their complements and substitutes). Finally, too much market power can be inefficient, so there often has to be perfect competition on the part of buyers and sellers for markets to operate efficiently. (We also know that inefficiencies can arise on the supply side from trying to prevent competition, offering too much variety and engaging in investments that are too risky, to give a few examples).

Almost every market you can imagine has some sort of market failure of the types mentioned above. The key to assessing interventions in free markets is in understanding the nature of the market failure, estimating the impact of the failure (is it important?, if so how important is it?), and then thinking of ways the government can correct the failure. Are the remedies going to be effective? Are they going to create new problems? Are they expensive relative to the cost of the inefficiency? These are all questions I ask every time I start to think about a policy and you will see them and references to the market failures ever time I post about policy.

As an economist I appreciate that free markets are great. But I also understand that most free markets are subject to some sort of failure. Sometimes this is small and interventions are bad, sometimes this is big and interventions are necessary. But I am a typical economist in that I view free markets as the first best when we can make them happen. I am also typical in that I understand that market interventions are often necessary, but that I tend to prefer as small an intervention as possible. Where most of the debate happens among economists is in this last bit – assessing the impact of the failure and the worthiness of the intervention. What I cannot tolerate are self-styled 'economists' who think that free markets are the answer to everything and who show no knowledge or appreciation of market failures - and we see these types far to often in public policy debates (hence this blog).

It is really not that hard to be a good economist, but it appears to be far too easy to be a bad one.

Information, Markets and the Subprime Mess

Though not specific to Oregon, the mortgage market mess is certainly quite relevant given that it affects Oregonians just a s much as anyone else. What strikes me most about the sub-prime mortgage crisis is how it paints, in stark relief, just how important information is for efficient market outcomes. This is a general theme, not specific to mortgage markets.

In a nutshell, the story of the sub-prime mortgage mess goes like this: Lenders, eager to generate new mortgages that they were finding willing buyers for, kept dipping deeper and deeper into the barrel of qualified borrowers. After a while they were scraping the bottom and lending to very risky buyers, compensating the risk by offering very expensive loans. But the expense of the loans was usually delayed by a small period (one, two, three years) - enough time, in other words to off-load the paper and a lot more to follow before the expense kicked in and ignited a wave of defaults. Here is where the information problem kicked in. The wholesalers who were buying the paper and bundling it with a lot of other paper and selling bulk mortgages to investment banks didn't really know what they were buying. Only the people who wrote the loans really know who it was they were lending to. Credit rating agencies were relied upon to provide evaluations of the loans, but they were not effective in assessing the increasing risk of these sub-prime loans.

Then it happened, the expensive parts of the loans kicked in, the default rates started skyrocketing and all of a sudden investment banks, taking huge losses, were not so interested in buying up new paper, especially sub-prime paper but even mortgages from borrowers of moderate risk. This meant that the amount of money available to lend to home buyers dried up precipitously. All because of a lack of information.

Information is essential for efficient markets - it is their life-blood. One of the key assumptions in the familiar Adam Smith 'invisible hand' story is complete information - essentially that everyone who participates in a market knows everything about everything. In this case when there is so little information, speculation ensues and all of a sudden a credit market that looked so efficient, collapses. What is striking to me is that when serious market failures happen (like the lack of credible information in mortgage markets) regulation is an appropriate thing to discuss. What type and how much is debatable, but hoping the market will correct itself in the face of such a lacuna of information is not good governance.

Update: an excellent article in the Wall Street Journal today on Bernanke and the Fed and their response to the sub-prime mess.

Payday Loans

Here is a topic which is a good example of the occasional enormous chasm that divides economists from non-economists and makes 'normal' people think that we just don't 'get it.' The argument for the regulation of the payday loan industry in Oregon (which, among other things, limits the amount of interest that can be charged at 36%) seems overwhelming: these businesses are praying on the poor and vulnerable and indenturing them into debt servitude, furthering their misery and contributing to their poverty. Yet, I don't buy it and I worry that the poor and vulnerable will be made worse off with such regulation, not better.

Let's begin the analysis with the root problem: access to credit for the poor and/or those with poor or no credit histories. This is a considerable hardship because credit provides flexibility when dealing with limited and often transitory income. Access to credit can also be a key to escaping poverty by allowing investments in productive assets (like education) that can increase future incomes. This is what I would call the disease.

Here is a symptom: Because credit at (for lack of a better term) mainstream financial institutions is inaccessible, a host of businesses have cropped up to provide credit to this population. They have been criticised for having exorbitantly high interest rates and short repayment periods. The subtext to this critique is that they are abnormally profiting from other's misfortune. Given as evidence of the scale of the problem are the vast numbers of payday loan shops. But these critiques strike me as completely misguided. The fact that there are many payday loan shops suggests to me that the industry is highly competitive, and therefore that the interest rates they charge are reflective mostly of the costs of doing business in small-scale loans and high delinquency rates. So the proposed cure will cause firms to exit the industry - worsening the disease by further limiting access to credit to the poor. For those that remain and are limited to 36% interest, they will impose more stringent requirements to limit their credit to only the least risky of their clients - again limiting access to credit for the poor.

So I find this a totally misguided policy. I think that payday loans are a problem, but that the problem is with access to credit for this population. What government could do that would be more appropriate perhaps is to mandate that banks, credit unions and thrifts extend credit to this population. To do so these institutions would end up charging more for credit for all and thus this would be a type of transfer from the relatively well to do to the relatively less fortunate. But it would be aimed at the disease and not the symptom.

Finally, one argument that really bothers me (and I am perhaps typical of economists) is that these payday lenders are predatory because borrowers are naive and don't understand what they are getting into when they borrow money. I find this incredibly patronizing - basically "the poor are dumb." While it is true that education and socio-economic status are highly correlated, intelligence is not. And even if people (in general) are not too savvy about understanding the implications of these loans, they tend to be very small and short and one experience is likely enough for borrowers to learn (unlike, say, sub-prime mortgages). It would be one thing if these lenders were accused of fraud (like, say, some sub-prime lenders) and I would be in favor of any sanction against such practices, but the argument is not fraud, but the failure to comprehend. But you don't have to just take my word for it, the issue of whether payday loans are really predatory has been studied very carefully by economists at the fed who find that, in fact, the population of payday loan customers looks very similar to customers of mainstream financial institutions in their delinquency rates and that the payday loan industry appears to be quite competitive.

So, in my view, here is a policy that just gets it wrong - it attacks a symptom, not a disease and is likely to hurt the very people it intends to help.

Textbooks

In the last legislative session, the Oregon House passed a bill aimed at reducing the burden of expensive textbooks on college students. Being a professor myself and dealing with the issue of textbooks I was very interested in this bill as I am acutely aware of the burden that high priced texts creates for students. But is this legislation sensible, will it serve to reduce the burden on students and is it a good example of government intrusion in a market to correct a market failure? Sadly, no. I am convinced it is unlikely to make things better and I fear that it may make actually make things worse. Oh why didn't they talk to an economist before doing this??

Here is the background: textbooks are enormously expensive. They are so expensive because they are expensive to produce and sales are relatively low. Publishers routinely push new editions very quickly with the express aim of circumventing the used textbook market. Professors who write textbooks are not well compensated save for the few who write introductory textbooks for popular subjects that become very well adopted. Though it appears to be a monopoly to a student (and is once a professor selects a particular textbook) it is actually a very competitive industry. The retail end has become competitive as well - no longer are students stuck with the campus bookstore, there are many internet textbook sellers, for example. In fact, I have a voice mail message this morning from a rep trying to get me to switch to 'their' international economics text that is 'just updated and covers the new US trade policy!" So it is not the publishers that are making abnormal returns on texts. So while new editions are produced probably too frequently, essentially textbooks are expensive to buy because they are expensive to make.

The legislation (in the words of the Ashland Daily Tidings):

The bill requires publishers of college textbooks to provide professors and private and public colleges and universities with information regarding their products, including the prices and the frequency of updated editions.

The bill would also make publishers offer higher education institutions the option of ordering each component of bundled textbook packages separately, and disclose the price for textbooks purchased without bundled items such as workbooks and CD-roms.

So how will this legislation potentially help? Well, there is one aspect I am fairly neutral about. When publishers send me info about texts or examination copies of texts, the list price is never given. I select the text I like but then always go and check the prices (it is easy these days, just a few key strokes) to make sure the one I chose is not abnormally expensive. I can imagine may professors never bother to check, but the thing is that in my experience, publishers price very similarly. I have never changed my decision on a text because I found the price too high. This suggests that price competition does exist. But it is probably not as fierce as it would be if prices were provided to professors - and providing professors with list price info is basically costless to publishers. So I have no problem with this, though I am not sure that it is necessary, and I am very doubtful that there will be much gained from it. But if it is costless and may lead to some improvement, why not? (NB: I think if there were a federal requirement that textbook publishers were required to print the list price on the covers, there would be some improvement) Here's why not: if there already is price competition and this makes it a bit worse, publishers will respond by not trying to make new textbooks for categories already well populated - so while price competition may go up, quantity competition may go down. There may end up being only three competing intermediate microeconomics texts to choose from instead of about eight now. The end result may not be lower prices. (By the way, I am not sure how information on frequency of updates really matters if the price in for is provided)

The second part of the legislation is a bigger problem. I understand the motivation. While I rarely have been forced to order a bundle, it happens occasionally. By requiring textbook publishers to offer non-bundled texts and components, it stops this practice. Case in point: this semester the text for my class includes access to the publisher on-line interactive study tools. They are nice, but many students will not want this access. They have no choice if they go to the bookstore. They publisher is doing this to force the purchase of a new text, but I have found numerous used texts available on the internet, so if a student does not wish access there is a easy option. What is the problem with this legislation? Well publishers who bundle can offer the bundle at a cheaper price than the a la carte prices. So students who do want the bundle, or need the bundle will end up paying more not less. So it is again not clear to me that the net effect of this legislation will be students paying less for textbooks.

Now let's turn to the meta-analysis: where is the market failure and is the remedy justified? This is perhaps the reason I have the most problem with this legislation - I can't identify the market failure! There may be one in terms of the professor insisting on a particular text in class, but I see no easy way around that. The market has evolved so that used texts and discounted new texts are easily obtained, publishing academic texts in the US is very competitive and professors are, in my experience, acutely aware of the burden of high text prices. This legislation seems to be aimed at lazy professors who blithely order texts without paying attention to price or bundles. But I find this caricature to be inaccurate. So it is a legislation that I don't think will do much harm or be much of a burden on publishers, but I think is unnecessary and smacks of populism on the part of a state government that is currying favor with college students that they have been screwing for the last 15 years bu underfunding state higher ed.

Finally an economist's note. One of the reasons new texts are so pricey is the fact that there are used texts around. In fact, without used texts there could be economies of scale in the new text industry that would lead to much lower prices. I try and not require anything out of a text that could not be found in a used older-edition text (not always possible). But I realize that is a small way, I am contributing to the high price of new texts. A conundrum, for sure, but publishers are not evil student's blood sucking corporations - they are typical businesses competing in a difficult market.

Oregon and the Bottle Bill

Recently, the Oregon Bottle Bill was expanded to include more types of bottles, including plastic water bottles like those in the picture. The original bottle bill was the first of its kind in the nation and has been credited with greatly reducing litter and with giving the recycling movement a huge boost. All of this is nice, but it also imposes a cost on consumers and retailers and may lead to lower sales for beverage manufacturers. So, is it good public policy?

How I think about this problem is first by focusing on the market failure: externalities. Litter despoiling our landscape, excessive amounts of garbage filling our landfills and excessive use of raw materials (aluminium for cans, say) are all real and not unimportant costs that we all pay when bottles and cans are not recycled - economists call these social costs. However, the costs paid by any one individual disposer of a beverage container is very small, especially compared to the social costs. Thus, this activity has a negative externality associated with it: the private costs are smaller then the social costs. In these cases (where negative externalities exist) the individual incentive to refrain from excessive use and disposal of containers is too small relative to what is optimal for society. This is a classic case for government intervention - similar to the case for government regulation of pollutants from industrial activity. So I buy that there is a strong case to be made for regulation, but at what price? Is this problem worth the cost of the solution?

Here we have to veer off into the realm of conjecture, but it seems clear to me that a $0.05 refundable deposit is a very small cost (the true cost is the time value of the money - i.e. not being able to earn interest on your nickel - and the expense and effort of redeeming the containers) for consumers. For retailers, with the emergence of automated container collection points, it appears that the cost to them has been reduced quite a bit as well. But it is not insignificant: the up-front cost of the machines, the space needed to house them and the expense and effort of handling the used containers are all real. However, I do not notice a large difference in the price of beverages between stores in Oregon and Washington, for example, so I conclude that it is probably not a terribly significant expense.

Finally, there is the question of the recycling itself. Critics argue that recycling uses more resources than it saves. I cannot judge the veracity of this statement, but I will say that with non-renewable resources and toxic pollutants, I think that it is an argument that is not terribly convincing. Even if true however, the motive for the bottle bill is not only energy resource conservation but litter control as well.

So, in the end, my opinion is that the market failure is real and serious, the remedy relatively cheap and painless and thus a very good example of sound policy. One of the things I like most about the policy is that I can choose to pay the extra five cents and dispose of the bottles in my own recycling rather than have to redeem them. Few economists would argue with my description of the market failure, but many may quibble with my analysis of the costs and benefits of the remedy. This is true of most economic policy issues, economists tend to agree on the fundamentals, but disagree on the costs and benefits.