Dark Siders are Part of the 1%

The NY Times posted an article that just helps us with are argument that economics is the subject to study, and we couldn't help ourselves. We just have to rub it in.

The article lists the most common undergraduate degrees held by the top 1% of income earners. Economics placed second. Only pre-med ranked higher.

Resistance is futile.

Credible Threats, Free Riders and Monopsony

It’s rare that we find an article with such a diverse array of topics, but the Financial Post recently published a Bloomberg article that discusses the ongoing problems in the Persian Gulf. 

The background to this story is Iran’s continued research into nuclear energy and their production of weapons grade material. In response, the international community has imposed economic sanctions against Iran. These sanctions include restrictions on international payments for Iranian oil exports.  Despite the sanctions, Iran continues with its nuclear program and now the US and Europe are planning an oil embargo against Iran. Iran has responded by threatening to close access to the Strait of Hormuz through which all tankers leaving the Persian Gulf must pass. 

The first economic issue we have comes from game theory. Is Iran’s threat to close the Straits credible? Whether or not they possess the military capability, the economic damage to Iran itself would be devastating. The government, reportedly, derives 80% of their revenue from oil exports and all that oil must pass through the Strait of Hormuz. The cost of closing the Strait is greater than the benefit and, for this reason, it is unlikely that Iran will follow through on its threat. 

Even if they did attempt to restrict shipping, the US has vowed to use their impressive naval power to ensure that oil from the Gulf States continues to flow. Any long term disruption in oil exports could cause oil prices to rise towards $200 per barrel and lead to another global recession. While the US is incurring all of the costs in patrolling the Gulf, China is enjoying the benefits. This second economic issue is known as the ‘free rider’ problem. It occurs when a good or service is produced and the use of it cannot be restricted to only those that pay. Fireworks and sidewalks are other examples of goods that are ‘non-excludable’. 

The US and Europe are contemplating a complete embargo against Iranian oil. Meanwhile China is sitting back and anxiously waiting for the embargo to happen. 

A monopoly occurs when there is only one seller of a good and most readers are aware that a single seller will increase prices. There is another market condition in which there is only one buyer; a monopsony. If Europe, the US and Japan all refuse to purchase Iranian oil, China would be left as the lone purchaser. A monopolist has significant influence over the price and causes it to rise. A monopsonist can also influence price but causes it to fall. If the embargo goes ahead, China will be able to buy oil cheaper than the rest of the world. 

In this article we see the concepts of credible threats, the free rider problem and monopsony. A rational person would recommend that the Iranian government back down, and a rational government would listen. We will continue to watch this story as it unfolds.

Trolling for Souls

Every semester, I walk into a classroom full of students that are taking my economics course because they “have to”. Economics is required in all of our business programs and business is the most popular division in the university. My job is not simply to get these students through my course, but to seek out the best and brightest, and turn them to the “dark side” – to encourage them to switch their majors and study economics instead of accounting. I call it “trolling for souls”. Every semester I manage to turn a couple.

Economics requires a different way of thinking. It follows the scientific method of reasoning where models are devised, built, tested and revised, much the same way as in physics. The discipline is very logical and quantitative and thus requires a fair amount of understanding of math. It is not a subject that has rules that can be memorized. Economics must be understood. All of the great economists I have met continuously see economics at work in the world around them. That is, after all, the primary purpose of this blog.

The point of this blog is to bring to your attention a survey published on CNN Money that discusses the average pay of university graduates by discipline. Not surprisingly, engineers rank at the top. Business students came second, and within the business degrees, economics ranked first. Yes, you read that correctly: economists make more than accountants, business management and finance majors. This is not an abnormal result. PayScale reports similar results.

The opportunity cost of obtaining an economics degree is comparable to an accounting degree yet the return is higher. Anyone who understands the marginal benefit, marginal cost principle knows the implication of that statement. Those that don’t become accountants.

Doctors should stick to medicine.

A recent article in the Vancouver Sun makes us believe that Dr. Rajendra Kale went to the Hugo Chavez School of Economics (see our previous blog). Dr. Kale has proposed the abolition of parking fees at B.C. hospitals and care facilities. Like President Chavez’s implementation of rent controls, the reduction of parking fees will only result in a shortage of spaces. Where patients are now worried about having to feed the meter, at a zero price they will have to worry about finding a parking spot in the first place.

Any time that prices are set below the market equilibrium, a shortage will exist. When a shortage exists, potential buyers incur “search costs” – which is the value of the time they have to spend searching for something. Significant search costs only exist when there is a shortage. For example, we use Vancouver General’s parking rate of $7.50 per hour and a person that earns a wage of $15 per hour. If parking is “free” and it takes a half hour to find a parking space because there is a shortage, that person has spent $7.50 worth of their time looking for a “free” spot. Economists have a saying: “There’s no such thing as a free lunch”. It means that in every decision, something has to be given up.

For people with wage rates higher than $15 per hour, the opportunity cost of searching for a parking spot will exceed the $7.50 per hour that the hospital is currently charging. It is a nice idea to have volunteers do valet parking, but how much will it cost to do the criminal record checks? I doubt that I would just hand over my keys to someone that offers to park my car for me. We could always pay people to work as valets at hospitals, but the minimum wage is $10 (or soon will be) and no doubt the union will require a wage much higher than that. Perhaps that wage, and the $14 million lost parking revenue will come out of the doctors’ pay, though we doubt it.

There is no indication whether doctors are willing to give up their reserved parking stalls to provide patients with more access to free stalls. We doubt they will, and will argue that their time is too valuable to be looking for parking. Yet this is exactly the argument we are making above. Paying $7.50 to park is less than the time cost that would be incurred in searching.

We could argue this point forever, but since the Doctors are busy playing economist, we have to go prep to do some open heart surgery …. the instructions are on the web somewhere … aren’t they?

Chavezian Economics

It’s always nice when Hugo Chavez, President of Venezuela, or his allies introduce new economic policies. Not so nice for the citizens of Venezuela, but nice for us because they are easy to critique. This time around, it is the imposition of rent controls as reported by the Washington Post.

The new law would expand previous rent freezes to include direct pricing regulations by the government. In addition, any tenant that has been living in a home for 20 years would have the right to buy that home. According to President Chavez, this new program is for “the benefit of the majority”. (The whole issue of social welfare is a topic for an entirely different blog.)

Pick up any introductory microeconomics textbook, however, and you will get a different analysis of the effect of rent controls – a form of price ceilings. Ceilings are designed by politicians to prevent prices from rising and, for them to be effective, they must be below the market clearing price. At prices above the clearing price there will be a surplus and when there is a surplus, prices fall.

When prices are set below market clearing, the number of buyers exceeds the number of sellers. Adam Smith (1776) recognized that prices rise in his circumstance to clear the market. The number of units that people are willing and able to buy is equal to the number of units that others are willing and able to sell when price is allowed to adjust.

The problem with rent controls is that they do exactly the opposite of what they are intended to do. If landlords cannot earn a reasonable rate of return on their investments due to price controls, they will stop building new rental units. Landlords that are currently renting accommodations will find that their revenues are falling and will not be willing or able to properly maintain their rental units. The quantity and quality of rental units will fall.

At the same time, the cost of renting falls below the cost of ownership and more people choose to rent. Others, who were sharing accommodation, now seek units for themselves. This increase in people seeking units, coupled with landlords reducing the availability of units creates a shortage of affordable housing. This is exactly the opposite result that the government was trying to achieve.

The story gets a little worse however. Because there is a shortage of affordable housing it takes longer to actually find a suitable place. The time spent searching for living accommodation imposes an opportunity cost on renters and is a non-productive use of resources. Search costs reduce the total output of the economy.

President Chavez, and other politicians must realize that in the battle between the Invisible Hand and government policy, the Invisible Hand usually wins.

The Economics of Organ Donation

One of Greg Mankiw’s Ten Principles is that people respond to incentives. It always amazes us that policy makers overlook this simply concept. 

Getting people to sign organ donation card or even to donate blood has always been problematic and it may be a result of a lack of incentive. A recent study published by Knowledge@Wharton – the business school at the University of Pennsylvania – offers a solution to the dearth of organ donors. 

According to the study, there are currently 110,000 Americans on the wait list for organs yet only 40% of eligible Americans sign organ donor cards. In two of the three most populous states, New York and Texas, opt-in rates are just 7% and 10%. 

We understand that there is a thriving black market in organs. In that market, money serves as the incentive. Most people are born with two functioning kidneys though the body can function with only one. Thus, unlike most organs, donating a kidney won’t kill you. For some people, the cost of donating a kidney is less than the benefit (price) being offered in the black market. We don’t advocate an open market for organs, but not for ethical reasons. Our objection is based on economic reasons. The market is plagued by asymmetric information leading to both adverse selection and moral hazard problems. We are, however, in favour of compensation for blood donors. (No, two cookies and a glass of orange juice doesn’t cut it) 

The Wharton article explains an experiment done by Judd Kesler from Wharton and Alvin Rosh from Harvard. The experiment looked at the decision to donate organs. Instead of describing the choice in terms of organs however, the researchers used generic commodities. This removes any ethical bias from the experiment. A full description can be found in the Wharton article. 

The result of the experiment shouldn’t be a surprise to anyone. When given an incentive to voluntarily donate a commodity, the number of participants willing to agree to be donors increased significantly. The incentive was fairly simple. When it came time to decide who was to receive an organ, patients that were registered organ donors went to the top of the list. Patients who were willing to give up their organs upon death had a greater probability of receiving organs should they require them. 

Public policy makers need to recognize the powerful effects that incentives play in the allocation of scarce resources.

Babies are Normal Goods

When income rises, the demand for most goods increases, and when income falls, consumers buy less. Economists call these ‘normal’ goods. There are some goods, however, where purchases change in the opposite direction of income. Classic examples of ‘inferior’ goods are macaroni and cheese, used cars and public transit.

A recent study by the Pew Research Centre and reported in the Globe and Mail looked at the effect of income, GDP, unemployment rates and claims for jobless benefits on fertility rates in women aged 15-44. Using births per 1000 women as their dependent variable, the researchers found a significant positive correlation with income and GDP. After GDP fell during the recession of 2007-2008, fertility rates fell from 2008-2009. The suggestion is that the decline in income made women decide not to conceive and that reduced the number of births 9 months later.

The study was conducted in the U.S. and the results were more pronounced for Hispanics and blacks who suffered greater unemployment than did whites. The researchers also found that the effect was more prevalent in states that were hit hardest by the recession, and occurred later in states that went into recession later.

Evidence from previous recessions tends to indicate the fertility rates recover after the recession is over. What we are witnessing is an intertemporal substitution effect. Women are still having children, but they are postponing pregnancy when incomes fall. Not surprisingly, the effect of income changes decreased with age. There was no appreciable effect on women age 40-44 where the intertemporal choice is constrained by menopause.

The evidence suggests that births rise and fall with income and we must therefore conclude that babies are normal goods.