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.

Kudos to Hewlett-Packard

On September 22, computer equipment maker Hewlett-Packard Co fired their president and CEO and replaced him with former EBay CEO Meg Whitman. (See the Reuters article) While we pass no judgement on the hiring of Ms Whitman, we applaud the decision to fire Leo Apotheker. It’s not that we have anything against Mr. Apotheker, but he was responsible for the bad decisions made at HP over the last few years – whether he made the decisions or not. The result of those decisions has been a steady erosion of shareholder wealth. The chart below shows the adjusted closing prices of HP stock on the NYSE since late 2009.

One aspect in the theory of the firm is that there must be an ultimate monitor. Given the choice of working or ‘shirking’ (not being productive on the job), employees will always opt to shirk since it maximizes utility. To ensure that employees don’t shirk, a firm must employ monitors to ensure productivity. An employee that is caught shirking faces a punishment so that there is a cost to shirking and a benefit to working. Workers then become more productive. 

The argument can also be made for the monitors of the workers. What ensures that they do not shirk in their monitoring duties? The solution to this is another level of monitors whose job it is to monitor the monitors. The same kind of penalty must apply to monitors that shirk. Each successively higher level of monitors receives a higher level of compensation which increases the penalty of shirking.

Ultimately, there must be one person that monitors everything. That person is the President/CEO. The President acquires information about the firms operations and opportunities and makes the decision as to what is to be done and how it is to be done. If something goes wrong, it is the fault of the ultimate monitor. If bad information was received by the President, then someone below him did not do their job, and the ultimate monitor must take responsibility.

HP made two decisions lately that suggest the President made choices based on inaccurate information. One was the acquisition of Palm, the second the foray into the tablet market. Both decisions cost shareholders dearly. It was the President’s fault, he had to take the fall.

Anyone interested in the role of monitoring are encouraged to read the paper by Alchian and Demsetz listed below.

One final thought:

While writing this blog, a newsarticle popped up on the computer screen saying that the President of the Swiss banking firm UBS has resigned as a result of the $2.3 billion loss associated with a rogue trader at their London England branch. (See the Globe and Mail article) 

Alchian, Armen A. and Harold Demsetz  Production, Information Costs, and Economic Organization   The American Economic Review, Vol. 62, No. 5 (Dec 1972)  pp 777-795

A Canadian Institution Succumbs to Technological Change … Finally

The Canadian government has recently announced that it has halted the Canadian Wheat Board’s role as the monopoly seller of Canada’s wheat and barley production. See the Globe and Mail article for all the details. 

Farming conditions in the 1930’s were very different than they are today. Small family owned farms were the norm and farming was a labour-intensive industry. Communications technology made transactions costs relatively high and limited access to financial markets made risk management techniques expensive. Transportation technology also made long distance movement of grains expensive and access to the railway was required in every community. 

As a monopsonistic buyer, the CWB was able to act as an insurer of farm incomes. By managing grain inventories from year to year, the CWB was able to control prices, paying below market prices in some years and above market prices in others. As a monopolistic seller of Canadian wheat and barley they could capture the economies of scale in communication that were not available to individual farmers. As the owner of rail cars, they could reduce transportation costs and insure that all farmers could get their product to market. 

Technology has changed however. Farmers in Leader Sask. can check prices on the ICE Futures Exchange (formerly the Winnipeg Commodities Exchange), the Kansas City Board of Trade, the Chicago Mercantile Exchange and the New York Mercantile Exchange (a division of the CME Group). These exchanges also offer futures and options that can be used to hedge the risk of fluctuating prices. Farmers can even purchase financial derivatives based on the weather. 

Changes in materials and engine technologies have caused the price of capital to decrease relative to labour and farming has become more capital intensive. This has lead to the demise of the family farm and the rise of commercial farming. Larger operations are able to capture the economies of scale provided by bigger and faster harvesters. Transportation technologies have also decreased the price of transporting grains by truck to main railway lines. 

All of the CWB’s reasons for existence have been overcome by technological changes. That doesn’t mean that everyone is happy. Small farmers will no longer be able to compete with the agricultural conglomerates. This leaves them with two choices: continue as they are and bear the costs of their operations, or sell their land to a larger producer. 

Technological change is generally a good thing though it does not affect everyone in the same way. The farms around Leader Sask. will continue to produce food, thought the town of Leader may eventually fade away.

Budget deal gets done and everything fal

The US Congress and Senate finally came to a compromise and passed a bill that increased the debt limit and allowed the US government to continue paying its bills. Why then are equity prices and the Canadian dollar all falling?

The increase in the debt came at a cost. The budget must be cut by $ 2 trillion over the next 10 years. (See a CNN article for details of the deal) That restriction will prevent the government from using discretionary fiscal policy as a tool to stimulate the US economy. With interest rates as low as they can go, the US has no room for expansionary monetary policy either. Since the US dollar is the world’s numeraire currency (the currency against which all others are measured), they have no exchange policy. None of this would be a problem except that it appears the US economy is headed for a recession. (See the Globe and Mail article). It would be a recession that the government cannot fight.

The deal also means that transfer payments from the federal government to the states will be reduced, thereby further straining their budgets. Forty-nine of the fifty states are required to have balanced budgets, so the reduction in transfers must be met by an equivalent reduction in state government spending. Those cuts reduce aggregate demand and further weaken the economy.

Any reduction in the US economy will result in a decrease in their imports. Since the US is Canada’s largest trading partner, our exports will fall. Aggregate spending in Canada is curtailed and that will slow the rate of economic growth here. The reduction in our exports also causes a reduction in the demand for the Canadian dollar which is why the loonie has fallen from its recent highs. (See the Bloomberg article)

The problems in the US have caused investors to reduce their holdings of US dollars, preferring instead the relative safety of gold and the Swiss Franc. We have recently seen record highs for both. The rise in the Swiss Franc has been dramatic enough to cause a decline in that country’s economic growth. To combat this, the central bank in Switzerland has recently reduced their interest rate to 0.25% and has initiated their own version of quantitative easing. The foreign exchange markets are now awash in Francs as the central bank forces down the exchange rate. (See Bloomberg article)

We will be watching the continued fallout from the political situation in Washington and try and keep you informed as the impacts are felt around the globe.