Thursday, November 29, 2007

Prescription Drugs and Oregon

On December 7, 2006, the voters of Oregon passed Measure 44 by a 78% majority. The passage of this measure means that all Oregonians without prescription drug coverage can join the Oregon Prescription Drug Program which is a state-run program that buys prescription drugs in bulk and negotiates for lower prices using volume as leverage. I do not question the reasonableness of this measure or program - given the inadequate access to health insurance in the U.S. and Oregon it is incumbent for states to try and find reasonable solutions in the absence of sound federal policy. But it does raise a question that I think is important in how the government provides incentives to pharmaceutical companies and the perverse incentives programs such as the OPDP might provide.

The fact that the OPDP exists is evidence of the extremely high cost of prescription drugs. Why do drugs cost so much? Partly it is a function of the cost of research, development, trials and manufacturing, and partly it is a function of the fact that for most newer drugs the companies have a monopoly on the market. This monopoly power is granted to companies by the U.S. government in the form of patent protection precisely to incent these firms to invest in research on new drugs so that medical care and treatment can be ever improved. But what do profit maximizing drug companies focus on when exploring new drugs? Drugs for which they anticipate huge markets. These markets are where there are a lot of potential users of a drug and who have money or insurance to buy it. This means that the drugs that are important to the companies themselves (e.g. Viagra) may not be the ones that society might deem most valuable in term of, say, how many lives can be saved or extended (e.g. Anti-Malarial drugs).

So the question that seems important to ask is what drugs are the most commonly sought after drugs in the OPDP? I doubt, for example, that Viagra is one of them (though I would probably be surprised). I think the most commonly sought after drugs are those that treat diseases and illnesses that are more common among lower income individuals like, for example, heart disease. Are there others? Maybe ones that treat diseases associated with common income related illnesses like obesity and diabetes, liver disease, etc. I am not a health economist and I don't have the answers to these specific questions but here is the rub. If programs such as the OPDP lower the margin drug companies receive on these types of drugs it provides further incentives to devote even more resources to finding the next Viagra or drug that deals with health complications associated with aging. So, in a nutshell plans such as OPDP may lower the cost of these drugs but may also stunt the progress on finding better more effective drugs.

This is, of course, no reason to stop the OPDP, rather it is a reason to again think about how we may benefit from one comprehensive health care solution for all Americans rather than a patchwork of state and federal programs. Perhaps it is also time for the federal government to be more proactive in sponsoring research into drugs to combat less-profitable illnesses.

Tuesday, November 27, 2007

Beeronomics: Vertical Differentiation

The trusty John Foyston was back in the Oregonian on Sunday (on the front page no less) with what amounts to a very nice overview of the whole hop and barley shortage problem and what it means to Oregon breweries. It got me thinking, what would economics say about brewery strategies and how might strategic decisions already made affect breweries through this period?

One common product strategy that is often employed by macro-breweries is vertical differentiation. This is where you create different products or different varieties of products for consumers of varying income and affluence. Thus Toyota has its Lexus cars, the Apple iPod comes in cheap, stripped-down versions and sleek fully functional versions, and Budweiser makes Michelob. This is not a strategy we had seen from the micro-breweries until Full Sail introduced Session. Session is a light lager in the Bud tradition, and I have been critical of the decision to introduce it because I fear it blurs the line between craft and industrial brewing, which may cause an erosion of the loyal following craft breweries have created for themselves. (This is why, I believe, the Full Sail name and logo are not easy to find on a bottle of Session)

But this decision could end up being an inspired one if it turns out that consumers do not reduce consumption of beer in the face of higher prices, but instead turn to cheaper beers (as I suspect they will). It also could make sense in the chase for scale efficiencies. For these reasons I think the introduction of Session is probably a very shrewd short-run decision. However, I still fear the long-run consequences of this blurring of market boundaries.

Update: Though there are no studies I could find that looked at cross-price elasticity estimates between macro and micro brews, the short-run price elasticity estimates for macro brews is about -0.3. This is, I suspect, a lower bound for the more pricey craft beers, but means that for a 10% increase in price, brewers can expect about a 3.3% drop in demand. This is good news, but not, as I mentioned, what I consider the danger point for craft breweries - we need estimates of cross-price elasticity for that.

Wednesday, November 21, 2007

Happy Thanksgiving

Remember, economics says you should eat until the marginal benefit of one more bite equals the marginal cost of alka-selzer...and then you should eat some more - who cares about economics, its Thanksgiving!

Tuesday, November 20, 2007

Economist's Notebook: Opportunity Cost

Apropos of my post below on corporate taxes, a reader asks me to explain opportunity cost. The concept of opportunity cost is one of the most important basic concepts an economics student must master. Opportunity costs are what you give up when you undertake a specific activity. Suppose you decide to go to a concert on a Friday night. The explicit costs of doing so are the price of the ticket, what you pay for parking, etc. The opportunity cost of doing so is the value to you of the next best activity forgone. When you are making the decision to go to the concert you probably take opportunity costs into account naturally. You may say to yourself, "well, I really like to go bowling on Friday nights, but this is a one-time chance and I really like the it is worth it even when figuring in the expense of the ticket" Giving up bowling is the opportunity cost of the concert. Though we often naturally figure in opportunity cost when we make such decisions, we don't generally understand that we are doing so, and that by doing so we are making sure we make the right decision.

So when a business thinks about making an investment in, say, a new plant, they must think about the opportunity cost of this investment. What is the next best thing they could do with the money? Suppose it is to invest it in bonds. So the decision to invest in a new plant must yield a higher return than this investment in bonds. The decision to locate a new plant in Oregon therefore means that a firm is giving up the opportunity to locate in another state and thus giving up the opportunity to take advantage of the educated workers, health care system and infrastructure of another state.

Do Companies Really Only Care About Low Taxes?

No. In fact one of the more curious trends in recent years is how business leaders are pushing the government on health care, education, research funding, infrastructure, etc. (Here is but one example from a fairly conservative state) Why? Well, because while it may be true that taxes cut into the immediate bottom line, businesses require lots of social and physical infrastructure - especially modern high-tech industry. Think about what makes a successful business: a skilled and healthy workforce, good ideas and innovations and a reliable physical infrastructure. Its no use having incredibly low taxes if you don't have these, because you can't have a profitable, sustainable business. A skilled and healthy workforce comes from well-educated people who have access to good medical care and who are willing to locate near the company. So what should government do? Provide a good education system that will produce these workers and will attract them to stay when their children enter the school system. Provide a health care system that keeps people healthy and allows small businesses the ability to afford insurance for their workers. Provide the civic and cultural amenities that attracts skilled and educated people. Good ideas and innovations requires investment in higher education and research. Reliable physical infrastructure requires investment in roads, power grids and information networks. These are the things that modern, high-productivity, globally competitive companies want and need.

So if you are going to try and craft government policy to try and attract and spawn these kinds of cutting edge companies what would you do? Sure a low tax burden is desirable, but the first-order concerns are about the human capital environment and the physical infrastructure environment a state provides. To put it another way: paying 10% of my profits in taxes or 20% is immaterial when I cannot turn a profit in the first place. A lower marginal tax rate may be attractive now, but good firms are also very skilled at forecasting (or they wouldn't be so good) and can see if a tax base is unsustainable or is not likely to provide the kind of human capital and physical infrastructure in the future.

Economics is all about incentives and advocates of low taxes will talk constantly about the disincentives that high taxes create - and they are right. But sometimes they seem blind to the entire world of other incentives that exist out there. Good policy comes from understanding all incentives and weighing them carefully just like good economics comes from understanding opportunity costs, not just explicit costs. So what are the opportunity costs of a business locating in Oregon? Hint: it's not the taxes.

Monday, November 19, 2007

Here Comes Your Kicker - Thank the Dismal Scientist

The kicker is a strange piece of public policy in a number of ways, but I want to talk about one way in particular: counting on people like me (economists) to determine future economic conditions in the state and thus the amount of the kicker. Can this possibly be a good idea? I don't think so. Economic forecasts are educated guesses that are generally pretty good in the short-run but are pretty unreliable in the long-run. Why? Well in the short-run, risk is low, much is known and economic conditions are slow to change. But trying to predict the state of the Oregon economy two years out is a fool's errand. Consider the US economy and the subprime mess. The US economy is intensely studied, but until recently there were not many economists who thought 'softness' in the housing sector was that big a deal, now suddenly there is a crisis that could lead to recession soon (yet, again, no one is quite sure). Markets in general are not that wise either, had they been so smart, the price of citigroup stock, for example, would have fallen long ago. So the point is, relying on long range economic forecasts is simply silly.

But I have another concern, one that my be a bit far fetched (but I am not so sure how far fetched). In relying on forecasts instead of outcomes we are relying on something that can itself change economic conditions. What we would call an endogenous process. Here is what I mean: suppose the economic forecast is very pessimistic, this means a lower likely tax burden through a kicker return. This should spur investment in the Oregon economy as people act on expectations of the future and thus this should create even better economic performance and even bigger kicker refunds. Now consider an optimistic economic forecast, this will depress investment and may cause poor economic performance of the Oregon economy. Perhaps this counter-cyclical effect of the kicker is desirable, but I don't think it is understood and I don't think it is a first-best policy. If you want to restrain state spending, why not just limit state spending using some index based on economic outcomes? Or, if you want the state to act counter-cyclically, why not save part of the money collected in good years for lean years and then have the government spend these reserves in bad times as a counter-cyclical influence? (OK, I am speaking like a Keynesian here, but in the short-run, guess what? The Keynes model works incredibly well)

If you don't think my endogeneity story is very plausible then you must believe that people and businesses don't form opinions about the relative pessimism of the forecast. That means we are basically introducing uncertainty into the eventual tax burden of Oregon taxpayers. Uncertainty is not a good thing. Most people and many businesses are risk averse, which means that adding uncertainty will depress investment. If the goal of the kicker is to spur investment in Oregon, than this is counter productive.

Friday, November 16, 2007

Income Mobility in the US

Keith Chu of the Bend Bulletin wrote a very nice article on the new US Treasury Department study of income mobility in the US. He called me to chat but I don't think he learned anything from me - he seemed to grasp the whole thing already. Perhaps he'll become an economics reporter, goodness knows we need more good ones (I once spent an exasperating 20 minutes with an editor of the Denver Post trying to explain the CPI and I still don't think he got it). Anyway, I think he does a nice job explaining the evidence, so I'll let him tell it. Here is an excerpt of his article (which is not available to non-subscribers):

U.S. Treasury notes trend of upward economic mobility
Some labor experts say findings represent natural earning cycles
By Keith Chu / The Bulletin

WASHINGTON — Nearly half of the poorest Americans moved into a higher income bracket over the past 10 years, according to a study released this week by the U.S. Treasury Department.

The department and conservative commentators touted the study as proof that the American dream is alive and well. Two labor market experts said the latest numbers say more about how a person’s earnings change over a lifetime than whether they can climb the economic ladder.

The study compared individuals’ earnings on tax returns from 1996 to their earnings in 2005. It showed that 77 percent of people in the lowest 20 percent of earners saw their incomes increase from 1996 to 2005. About half of the people in the top 20 percent of earnings saw their incomes decrease in that time. All incomes in the study were adjusted for inflation.

“It’s basically saying that the rich are not staying rich and the poor are not staying poor,” said Treasury Department spokesman Andrew DeSouza.

“I think it definitely shows that with the strong economic growth that we saw over the past decade and in recent years of this millennium, (economic growth) contributed significantly for people to move between income groups, whether it is up or down.”

That’s true, but misleading, said Patrick Emerson, assistant professor of economics at Oregon State University. Rather, he said, the Treasury study shows that people naturally make different amounts of money at different points in their lives.

A 62-year-old who is in the top quarter of earners in 1996, for example, would likely be retired in 2005.

Meanwhile, a student leaving grad school at age 25 would probably make significantly more 10 years later.

“This is exactly what you would expect to see just from a standard life cycle of earnings,” Emerson said.

The Treasury study found that 55 percent of people in the bottom 20 percent of earnings remained in that category 10 years later. But about 24 percent in the bottom level moved up one rung, while 11 percent reached the middle 20 percent of earners. About 4 percent of people in the lowest 20 percent reached the top 20 percent of earners, with 7 percent of the lowest category reaching the second-highest level.

Another study released this week, by Julia Isaacs, a fellow at the Brookings Institution, a think tank in Washington, D.C., showed that about two-thirds of U.S. residents live in households with higher incomes than their parents.

That’s probably good news, Isaacs said, but the reason for that mobility is an increase in families with two wage-earners, not higher wages.

“We see some signs that things are good, that there’s been a rise in incomes over generations,” Isaacs said. “Men’s incomes, though, have been stagnant.”

Things like the difference in earnings between rich and poor and income across generations are better gauges of people’s chances of improving their lot than the Treasury report, Emerson said. By those measures, the U.S. ranks behind some European countries, especially Scandinavian ones. Some European countries are much more likely to have residents move up and down the income scale, according to a study by the Organisation for Economic Co-operation and Development, an international think tank.

“It turns out the U.S. actually does worse in those sorts of income-mobility comparisons,” Emerson said.

Mark Thoma has the Wall Street Journal Editorial Page's take on the data.

Beeronomics: Polling Results and You

I deliberately made the question, "what is the best Oregon brewery?," vague and open to interpretation. I didn't, for example, ask for "your favorite" brewery, or the "highest quality." I did this because I wanted, in a completely unscientific way, to examine some economic theories about consumer preference. What led me to think about this was the thought experiment: if you were starting up a new brewery, what would you do for your first offering. You have some choices, go for a style that is well known and liked in Oregon (IPA) or try something distinct and unique (like Hair of the Dog). Obviously, as I mentioned before, brewing is not all about business for many Oregon brewers, but you can't live the dream if you are not making a living.

Economists believe that consumers like variety in what they consume (you don't have the same meal for dinner every day of your life). They also believe that consumer's tastes vary depending on the person and that income matters a lot in the types of goods you consume - higher income individuals have preferences for higher quality or luxury goods. So what is a producer to do given these stylized facts? Well the fact that individual consumers love variety may lead you to try and offer them many beers of many styles (Rogue and Deschutes come immediately to mind), but this is expensive. It is hard to brew in smaller batches, have many different products for which you have to find tap handles and shelf space, and have to market many different beers. Other breweries seem to concentrate on a 'flagship' brew and hope that leads consumers to their other offerings (Widmer and Bridgeport come to mind here). The fact that there are also many different types of consumers out there has two competing effects for which there is often no equilibrium. Do you try and stake out as big a section of consumers by offering them a product somewhere in the middle of the spectrum? Doing so almost assuredly mans you will face tough competition (Terminal Gravity's IPA). Or do you go for a niche market that may be smaller but you have all to your own (HotD Fred)?

Once a brewery is established if faces another set of questions: do we try and grow sales of our established beers or create even less distinct beers to appeal to a wider audience to take advantage of economies of scale, or do we grow our variety to appeal to more customers and to keep current customers happy? I think the trend toward macro-style lagers (Full Sail Session) is a strong move toward the former, while Rogue, for example is a clear example of the other strategy. Finally, I think there is a reputation effect that is hard to break. Widmer is a clear example. When Rob and Kurt started Widmer, they were pioneers brewing styles no one had ever heard of before. In those early days of green palettes what became a hit was what are now considered less-distinct beers. So it is hard to break that early reputation a brewery establishes.

So at last, to the poll results: In a strange and suspicious flurry of voting Rogue surged ahead in the space of a few hours. But I am extremely pleased as I am taking a group of OSU students to meet with Jack Joyce, the owner, and I can share with him the exciting news. He will be so pleased. Deschutes, Full Sail and HotD also garnered much support. For big breweries, Widmer and MacTarnahans (which had for most of the poll had zero votes) had few votes, quite obviously because their beers are not generally considered on par with the others. But I think if I were to try and make something out of them I would say that the strategy of trying to produce a variety of quality beers is what begets a reputation as a great brewery. I voted for Deschutes for this reason. With the exception of Quail Springs, which has now been replaced by the excellent Inversion IPA, every single one of their beers is, in my opinion, a absolutely exceptional, flawless beer. I am stunned at how well they have achieved this feat and thus my vote. Rogue is perhaps a more interesting brewery, always trying out new beers and new takes on old styles, but their offerings, while generally exceptional, have a few less than stellar examples. Terminal Gravity, by contrast makes what may be my favorite IPA, but is not known as a great brewery by my voters probably because that is about the full extent of customers experience with them. Since they have decided to compete on such a popular style, I fear for their continuing success (they have already lost their taps in two local joints here in Corvallis). The most surprising outcome, in my opinion, is Bridgeport. I have such fond memories of the old Bridgeport brewery in the Pearl, when I was an undergrad and the Pearl was still industrial, and I was appalled when I returned after the big remodel. Perhaps this is such an iconic part of Bridgeport's identity that I am not the only one that cannot forgive the injustice. But their IPA is perhaps the quintessential NW beer. Blue Heron was perhaps the pioneering bottled NW micro-brew. What gives, no love for the Ponzis?

Thanks for everyone who participated in the poll and now, go buy some great NW beer and rethink your choice.

Wednesday, November 14, 2007

Beeronomics: Widmer and Red Hook Merger

Its all happening too fast! I had planned, after the close of voting for your favorite Oregon brewery (one day left!!), to write about craft brewers and strategy. I was going to talk about more mainstream strategies like Widmer and less mainstream like Rogue. I was going to talk about product variety strategies, like Full Sail bringing Session to market and Ninkasi's Schwag. And I still will. But the merger between Widmer and Red Hook, as reported in today's Oregonian has forced my hand early, so be prepared for a few days of Beeronomics. (Drat, that monumental post on stabilizing Oregon's revenue collection will have to wait another week it seems)

So what does the Widmer/Red Hook merger signify? One thing is that it may perhaps signify a trend in craft brewing toward larger scale to capture efficiencies. I am fortunate to have Vic and Carol Tremblay as colleagues, for they are experts on the economics of the beer industry. One of the things they have studied is what is known as "Minimum Efficient Scale" (MES) in the beer industry. This is how economists refer to the exhaustion of economies of scale - you know, how things become cheaper per unit as you produce more. It turns out that MES in beermaking has rapidly increased in the past 50 years. In 1960, they estimate, MES was 1 million barrels but had reached 23 million barrels by 2001. (And, by the way, we generally do not think that you can get too big as you can always divide operations between different plants so 23 million barrels is a target to meet or surpass). Why?, well increased mechanization, better transportation and bigger capacity for a start. To give one specific example, in 1987 a high speed canning line in a large brewery could fill 2,000 cans per minute! So to operate just one of these lines efficiently, you would need to produce at least 2.18 million barrels of beer. Methinks Caldera is just a wee bit under that target. This has nothing to do with quality, variety, honor...whatever. These are the cold, hard facts: economies of scale exist in beer brewing, they can be quite large and thus the economic incentive is to grow bigger and become more profitable and/or more competitive.

So where does Widmer/Red Hook fit in all of this? According to the always excellent John Foyston of the Oregonian, the combined brewery will produce 650,000 barrels a year. Far form MES, but probably a significant enough improvement in scale efficiency to make this venture worthwhile. This is about what Sierra Nevada produces, but is still quite far behind Boston Brewing - the craft beer king. It is perhaps no coincidence that Widmer, perhaps the most commercially minded brewery (consumer-driven?), is at the forefront of consolidation. (Both Widmer and Red Hook also have Anheuser-Busch as a minority owner)

This is a troubling trend for the craft brewing industry in Oregon, in my opinion, because there are competing economic forces at work. Consumers love variety, but producers love scale. The question will be, do consumers love variety enough to shell out $9 for a six pack of Dead Guy versus $5 for a six of Broken Halo? (Psst...go for the Dead Guy) I fear the answer to that question, for it is one thing to have brew-pubs where you can find quality, interesting craft beer, but it is another thing to find it in supermarkets (especially when you have two young kids and pubs are not so easy to frequent). This and the shortage and expense of hops and barley make me fearful of what may happen to Oregon's wonderful craft breweries over the next few years. There may be more pressure on economizing on ingredients and reducing the variety of offerings in the years to come.

NB: Jack Joyce of Rogue will be hosting the OSU Economics Club at the Brewery in Newport where we'll get to ask him about all of this stuff. OSU students: contact me if you are interested in joining.

Tuesday, November 13, 2007

Income Disparities: What Does This Mean?

Michele Draeger of the Oregonian created this nifty little graphic which she informed me was drawn from Census data for an article about income gaps in today's O. I suspect it was from the Annual Social and Economic Supplement of the Current Population Survey. In case you are wondering what a Household by Ethnic Group is (as I was), it appears that it is based on the ethnicity of the self-reported "householder." Beyond that I cannot say (if you know more, do share) . Anyway, back to the point: in Oregon there is quite significant income disparity among households of different ethnicity. But what are we to make of such numbers? I think there are a number of competing (and perhaps complementary) explanations. I will restrict myself to what I think are the three big ones.

One, it could be a sign of discrimination by ethnicity and race in the labor market. Two, it could be a symptom of inequality by race and ethnicity in access to health care, educational quality, living environment, etc. Anything that may reduce human capital outcomes (human capital is simply anything that makes you a more productive person like education and experience). Third, it could be a self-selection story: perhaps many African American and Latino families have come to Oregon to take up low-paying jobs. So it is not, in other words, a reflection of unequal access to quality education, but that it just so happens that the African Americans and Latinos that have moved to Oregon are low educated ones. Conversely, as migration from Asia is hard, only the most educated ones make it to Oregon. (There is another argument about racial differences in innate ability but research has shown this to be false).

Where does this leave us in terms of policy? Well the policy implications are quite different. In the fist case it means that more needs to be done in the promotion and enforcement of anti-discrimination laws and perhaps even more affirmative action policies should be enacted. In the second case, it is not about the job market (people are paid based on productivity), but the human capital acquisition that happens in childhood and thus attention should be paid the making school quality more uniform, creating programs that improve childhood nutrition, etc. The third case suggests that there is no problem and therefore any policy intervention is a waste of time.

So which of these explanations seems to be the case? Well, economists, including myself, have studied discrimination in many different areas and found that it still exists and is quite strong. In an act of shameless self-promotion I will assert that workplace discrimination is perhaps the toughest to uncover, but that my paper with Mike Conlin of Michigan State uses a very clever technique to provide an answer, and the answer is yes - even in a place you might not expect it. The second explanation has a lot of empirical evidence as well - students from poor school districts fare less well on standardized tests, for example, and poor childhood nutrition has been shows to have adverse affects on ability. The third explanation is a curious one, it has been made on a national immigration level, but I have not heard in made in these cases, probably because the number of households that have moved to Oregon is probably a small percentage of all households - but who knows, maybe it is bigger than I think.

So this is why we should all be thankful that there are economists in the world to help us find answers to these questions so we can better target our resources and create more effective policy.

Monday, November 12, 2007

Economist's Notebook: Why Doesn't OSU Pay Me to Get a Flu Shot?

Consider the external costs of my getting the flu: I could infect a number of students through my in-class interaction with them, I could miss class meaning that many students will miss out on vital learning (and will suffer mental anguish at the prospect of having a two-hour class on international economics cancelled - the horror!) and I may infect other professors and staff at OSU. The multiplier effect of my getting the flu means I would be a super-infector spreading influenza far and wide across the OSU campus. Surely the cost to OSU of all of this is more than the $20 they are charging me for the flu shot - so why oh why don't they give it to me for free.

Students: I did shell out the $20, so you can thank me now. No worries about me cancelling those two-hour international classes at 8am!

(NB: I have been made aware that Alex Tabarrok at Marginal Revolution has a similar post - see the list of 'Economics Blogs'. OK, but I am sure I thought of it first!)

Economist's Notebook: Do Economists Vote?

Steven Levitt (of "Freakonomics" fame) has a little video on the NY Times' web site explaining why economists don't vote. First, the fact that economists don't vote is news to me, I cannot think of a single example of a colleague who doesn't vote as a principle, and most of my colleagues in the departments of which I have been a part have all voted en-masse. Second, Levitt's explanation for this behavior (which I don't observe) is a familiar one in economics: that the marginal impact of one single vote is zero so there is no reason to vote given its non-zero cost. Now, of course, if you have been well-conditioned and believe in your civic duty to vote you may get utility from doing so, which may explain why some people vote, but in general it does not make sense for most people to vote. Economists, wise as they are, understand this and so don't vote. QED

But I find fault with this reasoning. It may be true that my vote is insignificant, but I believe in markets. And voting on a candidate, measure, etc. is a way of allowing the 'market' to decide on an idea or set of ideas. The only way for this outcome to be efficient is for there to be mass participation in this market and I understand that, while I may be mostly insignificant, I play an important role in making the market efficient. And I, like most economists, believe in efficiency. So I think economists believe in as much information and participation as possible in an election and thus understand that we all do have a small but significant role to play.

Oh and by the way, voting on blog polls is an entrely different matter - your vote is crucial to the well being of all humanity, so make haste and vote!

Thursday, November 8, 2007

Economist's Notebook: Winner-Take-All Markets

One interesting graph that the OCPP produced regarding income inequality in Oregon that really caught my eye was this:

It caught my eye because of the title. Winner-Take-All (WTA) markets are one economic explanation for some of the income inequality we see in the current economy, especially at the very top. The OCPP uses the term in a negative way, but there is a very interesting economic theory behind the term.

The WTA market theory cannot explain all of the observed inequality, but it does go a long way to explain the increasing rewards to the very top of the income distribution, and it is very interesting. The story goes like this: in a modern economy where performance is easily recorded, duplicated, shared or otherwise increasingly impactful, the rewards to being the very best are dramatically higher than being second best. The recording industry is a good example. Before recorded music, musicians were travelling live performers. Being the best may have brought a few more people to each show, but overall the ability to leverage being the very best was small. With the advent of recorded music that was easily duplicated and distributed, being the very best suddenly meant potentially millions more records sold. Professional sports are another example, with increasing media coverage and distribution of live performances, the difference between the best performers in the MLB, say, versus the minor leagues has become humongous even though the difference in ability of a MLB player may be ever so slight relative to a AAA player. But this is not just an entertainment story. You can tell the similar stories with software programming, journalism, investment banking and even corporate leadership. These are all markets where the rewards at the top are hugely different then the rewards just below the top. In cases like CEO pay the theory says that while the difference between the best production line worker and the second best is a pretty small difference in corporate earnings, the difference between the best and second best CEO can mean tens of millions of dollars in corporate earnings. In software the theory says that the rewards grow as one product becomes the standard through something known as network externalities (think of the domination of Windows in the PC market). Finally, instances where there is reward by contest like in litigation can mean that the top litigators can reap most of the spoils.

So the key to WTA markets is the fact that though human capital differences may be small, the rewards are not. And, by the way, despite the title, there does not have to be a single winner in these markets, MLB players in general, top recording artists, top CEOs are all groups of people rewarded disproportionally to the difference in their skill relative to those just below them.

In the next post I take this theory to a local example in my favorite subject: Beeronomics

Beeronomics: What is John Harris Worth?

This here is John Harris - Brewmaster at Full Sail. John Harris is a master brewer - I mean master brewer. The trail of exceptional and iconic beers he has created, first at McMenamins, then at Deschutes and now at Full Sail is truly extraordinary. There are now many craft breweries in Oregon, most producing wonderful beer, but there are only a handful of truly exceptional beers being produced in Oregon and perhaps half are John Harris' creations. These are not only exceptional beers but also exceptionally popular.

So the question is, what is John Harris worth? I mean this to be provocative, but think: now that the craft beer market is exceptionally crowded what is the potential difference in sales from having an almost great beer versus an exceptional beer? It is quite likely a few orders of magnitude. So if you were starting a new brewery as a purely business venture (I am aware and grateful that most breweries are started from other motivations) the difference between a good brewmaster and a great one can mean millions in sales. Like the post above, craft brewing in Oregon seems increasingly to be a winner-take-all market, where a few exceptional breweries get the majority of the shelf space, taps, and overall market share. Someone with John Harris' talents should make disproportionately more than most other brewmasters according to the theory. I don't think it has happened yet, but I would not be surprised to start seeing this in the future (especially as the macro brewers start to try and battle in the micro segment).

Wednesday, November 7, 2007

Oregon Election Results

With the passage of Measure 49 it seems to me that Oregon voters have learned a lesson in externalities and public good and have found that individual rights should not always be advanced at the expense of social objectives. That, in fact, in a market based economy the government has a large role to play to balance the needs of society as a whole and the rights of individuals. It is never an easy line to draw and voters spoke loudly when Measure 37 passed that government had exercised too little restraint. But they also spoke loudly yesterday when they decided that Measure 37 constrained government too much. Perhaps we have found balance, only time will tell. I hope, though, that this can serve as a moment in which most Oregonians can learn to appreciate the delicate balancing act that a democratic government must perform in a market-based economy.

Measure 50 is, for me as an amateur spectator of politics, an extremely interesting litmus test. I have made it clear in an earlier post that I disliked the populist twist of Measure 50 - a sort-of Rube Goldberg device to make it appealing by punishing bad behavior to help kids. I applaud both goals however (trying to reduce smoking and providing health care for uninsured kids) as I think both smoiking and uninsured kids impose heavy costs on society that are born by all of us. However I cannot lament the failure of Measure 50, it just smacked too much of politics and populism. I am also afraid of special taxes that have earmarks, as these do not allow government the flexibility to respond to changing conditions. The real answer is wholesale tax reform in Oregon, a great resetting of government fiscal policy and powers to stop the madness of measure-driven politics and return to representative democracy. I am saddened that the governor has backed away from this just because revenues are up...but I'll leave that for another post.

Monday, November 5, 2007

Income Inequality in Oregon

The Oregon Center for Public Policy recently released a report on rising income inequality in Oregon. I am taking their data on face value, but the Oregon data they present broadly mirror the national trend: income inequality has increased dramatically in the last few decades. There is a raging debate among economists over two main related questions: One, is the rising inequality simply a matter of ever increasing returns to education, especially at the higher levels? Two, is this rising inequality then a matter of simple natural economic forces, or is it being driven by policy?

Let me try and describe both very briefly. As the US economy evolves into a more service and IT driven economy, the returns to higher education compared to a high school diploma, say, are becoming more and more divergent. Since jobs in high tech areas tend to be very high productivity and ever increasingly so, while jobs that require a high school diploma tend to not be very productive and that productivity has not increased much in the last 30 years (think waiters, mechanics, sales people, etc). Thus the returns to these jobs are also diverging as they are related to the productivity of the workers themselves. Few economists dispute these basics, but the debate rages over whether this is enough to explain such a high divergence in incomes. The million dollar question is if this is a result of the natural maturation of the economy or a bi-product of long-standing government policies toward free trade, labor unions, education, corporate taxes and regulation, etc. (I will assert that I agree with many economists who point out that income inequality is also severe before taxes as it is after taxes, so current tax policy is not a good or complete explanation

These debates are mostly centered around national policy because most of this is a national, economy-wide, story. But the answers to these questions are critical because the 'natural evolution of the economy' story suggests that it is not a problem in the sense that government should get involved directly, while the policy story suggests that government is already involved directly and should figure out what policies are creating this divergence and try to change them. I believe that regardless of the true causal link, there is one thing that is clear in the modern economy: to an every increasing degree the path to prosperity is through education and the government is failing badly in this arena. In fact I believe that in my lifetime, without serious refocusing on both K-12 and college education, the U.S. will loose its place as the world's leader in new technological innovations, new markets and new industries. What is not as clear is how active the government should be in income redistribution. There is always a trade off between reducing incentives and lowering investment versus the drag on the economy that a large population of impoverished individuals imposes. But there is also a bigger question about whether increasing inequality threatens our democracy over the long run. I fear that we are already seeing signs of both the economic drag and the political polarization I would expect in the face of increasing income inequality. I don't think we can afford to ignore it any more.

(NB: I will present an economic theory that suggests one partial explanation for the huge increase of incomes at the top of the distribution later this week).

Friday, November 2, 2007 Fun!

OK, so there is not a whole lot of justification for this, other than the fact that Blogger has introduced a new toy and I am interested in playing around with it. I thought of a more economics based question, but since my readership is about 5 people, I don't want to scare them away. Maybe in a few months.

Anyway, you'll notice to the right side of the page a poll about the 'best' Oregon brewery. Yes, mostly this is about my passion for Oregon beer, but there is some economic content too (which I'll reveal at the end of the poll).

The breweries listed are what I identified as the major distributing breweries in Oregon (i.e. the ones whose beer you can buy in the grocery store). If I missed any please inform and I will add - these were the ones from the top of my head. "Best" is up to you to define.

Poll is open for two weeks - giving you lots of time for research. Enjoy!

Beeronomics: Hops Prices and Futures Markets

In light of the recent surge in hops prices it seems reasonable to ask: what do big users of inputs that are prone to big price fluctuations (like crops) do to hedge against risk? They trade in futures markets. Futures markets are set up to facilitate transactions based on promising today to buy or sell a quantity of a commodity for a set price tomorrow. If price increase the buyers is better off, if they decrease the seller is better off, but everyone can be made better off by reducing risk. Undoubtedly big brewers like AB and SABMiller lock in prices for hops well in advance of delivery, but I imagine that small brewers like those we have in Oregon buy at least some of thier hops on spot-markets: markets where you pay the current price when you by and take delivery. This leaves these smaller breweries more prone to risk, which is ironic because it is likely that they are also less able to deal with large fluctuations. I imagine this is more true for the less used varieties upon which they rely heavily.

The only recourse, then, for a small brewery is to pass the increased production costs on to their customers in terms of high prices. It is likely that large brewers will not have to do so to the same extent due to these futures contracts. This means that small brewery beers may increase in price quite a bit while macro brews may not. Will this hurt the small brewery sales? Probably. Both though lower sales from the income effect, customers simply cannot afford to buy the same amount of beer with the higher prices, and the substitution effect, customers may shirt consumption to relatively cheaper beers. The first effect is probably pretty predictable, but the second effect raises a big question: how close are micro and macro brews in terms of consumer's tastes? Are they close substitutes, in which case micro breweries may have a lot to worry about, or are they hardly substitutes at all, in which case the micro breweries have a lot less to worry about? Beer enthusiasts hope that beer drinkers have become sophisticated enough to know that a Bud is not a good substitute for a Dead Guy, for example, but the answer remains to be seen.

Finally, one strategy that may be helpful for craft breweries going forward is to create a buyers cooperative in which they all commit to buying a certain amount of the particularly uncommon hops in advance and try to lock in prices for these hops on futures markets. This would help mitigate the risk, which is particularly dangerous for small breweries.

(Picture is from an 1892 New York Times article)

Thursday, November 1, 2007

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.