Wednesday, March 31, 2010

Some Wisdom on Gas Prices

Yesterday, I came across this great old article by Tim Harford on gas prices. As it is a wonderful piece of everyday economics, I thought I would share some key excerpts with you (with some comments about why I think it is such a great piece):
Few costs infuriate the modern consumer more than the price at the pump. Type “fuel price riots” into Google for a list of fatal incidents from Yemen to Indonesia. US pundits have been raging against “price gouging” in the wake of Hurricane Katrina’s damage to the energy infrastructure, while in Britain a fuel protest never seems far away. There are plenty of reasons why oil prices should be high at the moment: record world economic growth, disappointing exploration results, disruptions in Venezuela, Nigeria and Iraq, and a Gulf of Mexico full of storm-damaged drilling rigs. But motorists may wonder why the price of petrol leaps up so quickly when the crude oil it comes from was sold when the price was much lower.

It can take weeks or months for oil to get from the fields beneath the Gulf of Mexico into an SUV’s petrol tank. So while crude oil prices have risen, and with them the wholesale price of refined gasoline, the underground tanks at petrol stations have been full of cheaper petrol bought earlier. Yet the price at the pump has risen quickly. It’s infuriating to be paying tomorrow’s high prices today. Surely this is price-gouging?
FYI to instructors, this is a great homework/exam question for students. It is a common misconception that the only fundamental costs are labor, capital and materials. This is an example where opportunity cost (the value of the second best alternative) jumps to the forefront. In my book, Harford's answer earns an A:
Imagine a world where wholesale gasoline prices are increasing but prices at the pump don’t rise immediately. You and I would want to fill up immediately with cheaper petrol. But service stations would have little interest in selling us this cheap petrol, because pump prices are going to rise in a couple of days. The owners of independent stations might regard this as the perfect time to close for the weekend and check out the sights in Blackpool. Why sell cheaply, if their petrol inventory is about to climb 10 per cent in value?

In a world of eager buyers and reluctant sellers, it is no wonder that price increases do not, in fact, wait for the arrival of the expensive petrol in the storage tanks.
To put this into intro micro language, prices rise when the storm hits because waiting is the second best alternative. As soon as the storm destroys some supplies of crude oil, the value of waiting increases for the owners of the pump. To induce the gas stations to part with their valuable stock of gasoline, gasoline consumers will have to pay more.

Then, Harford in his wonderful style raises the true puzzle of gas prices:
The thoughtful motorist might be satisfied with this explanation, until they ponder the conundrum a few weeks later: crude prices and wholesale petrol prices start to fall, but pump prices do not. Petrol prices seem to follow “rocket and feather” behaviour: up quickly and down slowly. This is puzzling. The reverse argument should apply: retailers want to get the expensive petrol sold before the cheap petrol arrives, while motorists, anticipating the fall, should hold off on buying. (There are limits to this, of course: you can only hold off until the gauge starts showing empty.)

So if prices stay high, isn’t this yet more evidence of price gouging?
You will have to read the rest to get Harford's answer, but as an exercise to yourself, see if you can come up with a good answer before you click through [here]. Tim Harford is a fabulous thinker, so it is a nice way to gauge your thinking to see how your ideas compete with his. Who knows? Maybe you will come up with a better explanation. If so, I would love to hear it.

Sunday, March 28, 2010

Learning Economics on a Budget: Part V

It has been a while since I have provided an update on my YouTube project. If you have been following my blog, you know I have been posting videos on microeconomics to YouTube. I am doing this in an effort to make learning economics more accessible (and to sell my own book, which is only $10 for the e-book version).

Over the past few months, I have produced two units: welfare analysis, and single-price monopoly. I have also posted five other useful videos. This post summarizes these new additions. [If you are a feed subscriber, I think you'll have to click through to my blog to see the embedded videos]

Welfare Analysis (Chapter 5 of my book)

To start of my unit on welfare analysis, I introduced the concept of surplus. Specifically, this video demonstrates how to find consumer surplus and producer surplus on the graph.

Once you have an idea of surplus, you can think about policies that maximize the total amount of surplus. Maximizing total surplus is something I call The Efficiency Criterion. I show how to use this criterion in the second video in this unit.

The next application of the efficiency criterion after taxes and subsidies is the efficiency consequence of international trade. I demonstrate this in the third video in this series.

In some sense, there is a fourth video in this unit, but it requires knowledge of the next topic (monopoly). Don't worry. It's coming.

Single-price Monopoly (first part of Chapter 6 of my book)

The second unit I produced is on the economics of monopolies, which are firms that are the only supplier to an industry. The first video explains the basics of monopoly pricing. Specifically, I show why a monopoly faces a different problem than a competitive firm.

In the second video, I use simple calculus to show a fact I use in the first video about the form that marginal revenue takes when demand is linear. [Note: This one ended up being in HD format because I just uploaded the raw video without any edits.]

In the third video, I use calculus more intensively to explain why a monopoly prices on the elastic portion of the demand curve. At the end of the video, I give an intuitive justification for this (that's not really optimal for non-calculus folks, so I'll probably record another video with just that intuitive justification).

In my fourth (and most recent) video, I demonstrate the welfare analysis of monopoly pricing. This video actually fits within both units because it is on both using the efficiency criterion and showing the consequences of monopoly.

What other videos have I posted?

Over the past month or so, I have posted some other useful videos to YouTube. In case you are interested in out-of-sequence economics, here they are:

I completed the discussion of competitive firms' supply decisions by linking the short run to the long run.

In the next video, I demonstrate how to aggregate individual supply curves to obtain a market supply curve, and how to aggregate individual demand curves to obtain a market demand curve. The answer is "adding horizontally," and here's an example:

To help some students I know in real life, I posted this video on extensive form games, and how to solve them. FYI: After I finish my next unit on market failure, my plan is to do a unit on game theory. This video wouldn't be the first in a unit on game theory, but I think it is generally accessible, anyway.

In the last couple of videos, I prove and show some important key implications of The Envelope Theorem (a really important theorem in mathematical economics). Fair warning: This is math heavy.

Here's the second Envelope Theorem video. Lots of math here, too:

If you made it this far, you probably should join my 280+ YouTube subscribers. If you do, you'll get updates every couple of weeks about my most recent videos. If you like what is here, you may also like the other videos I have posted, and I plan to post plenty of new videos in the coming months.

My goal is to produce a useful resource for students of economics. The channel is still a work in progress, but from the comments, I think people are finding it useful. Maybe you will too.

Saturday, March 27, 2010

Poll: Why do you listen to economists?

Greg Mankiw has some interesting comments on his blog today about the role of economics in the public sphere:
In today's NY Times, David Brooks has an interesting column on the field of economics.

While the column is well worth reading, I think it is more wrong than right. Journalists are fond of writing articles about how recent events require a fundamental rethinking of economic theory. It is their job, after all, to identify new things on the horizon. But when they try to predict trends in academic theorizing from current events, they are usually incorrect. In particular, I think what we teach in economics courses is more robust than a reader of David's column would think.
Quoting directly from the column, I found this segment about Russ Roberts' beliefs interesting:
In The Wall Street Journal, Russ Roberts of George Mason University wondered why economics is even considered a science. Real sciences make progress. But in economics, old thinkers cycle in and out of fashion. In real sciences, evidence solves problems. Roberts asked his colleagues if they could think of any econometric study so well done that it had definitively settled a dispute. Nobody could think of one.

“The bottom line is that we should expect less of economists,” Roberts wrote.

According to the column, Roberts is an economist (see Cafe Hayek and EconTalk) who thinks that less should be expected of economists. Maybe people expect too much on some dimensions (forecasting and stock prices), but I would suggest that people should expect different things of economists. From reading Roberts' blog and listening to his podcasts, I think this is what he really meant.

In graduate school, they don't equip us each with a crystal ball, but they do equip us with some valuable tools for analysis. Don't expect us to forecast well, but do expect us to anticipate unintended consequences. By virtue of our training, economists are good at raising relevant concerns about policy proposals.

But, forecasting is hard for everyone, not just economists. With our tools (still not crystal balls), it might still be the case that economists have a comparative advantage here. To the extent that we need forecasting, the economist seems right for the job. Viewed in this light, maybe the problem is that people do not listen to the caveats and assumptions underlying the forecasts.

So, that brings me to my poll question of the week.

What is the most important social role for an economist?

(a) The rational thinker in the room. Economists raise issues of efficiency, scarcity and tradeoffs.
(b) The forecaster. Economists use sophisticated models to predict what the future holds.
(c) The strategy-maker/consultant. Economists don't fulfill a social role per se, but an economist knows strategy, both political and business.
(d) No important role.

The poll -- like all polls -- is open for a week. Please vote early and often (on the sidebar -->). Tell your friends, economists, parents, forecasters, siblings, consultants, and all of the important people in your life to vote. I'm interested in seeing what you have to say.

Wednesday, March 24, 2010

The constituency of efficiency

One of my favorite parts of introductory economics resonated with the events of the past week: efficiency has no constituency.* I bring this catchphrase up because of the interesting reading from Greg Mankiw's blog:
Arthur Okun said the big tradeoff in economics is between equality and efficiency. The health reform bill offers more equality (expanded insurance, more redistribution) and less efficiency (higher marginal tax rates). Whether you think this is a good or bad choice to make, it should not be hard to see the other point of view.

I like to think of the big tradeoff as being between community and liberty. From this perspective, the health reform bill offers more community (all Americans get health insurance, regulated by a centralized authority) and less liberty (insurance mandates, higher taxes). Once again, regardless of whether you are more communitarian or libertarian, a reasonable person should be able to understand the opposite vantagepoint.
On either side, the most fervent politics of health care has been motivated by moral convictions. The left pronounces that they are "helping the less fortunate" and "cracking down on insurance company abuses," while the right says that they are "fighting a government takeover of health care" and "saving grandma from the death panels."

The political opposition to health care reform had nothing to do with preserving economic efficiency; Political support had nothing to do with restoring efficiency either. This was a morally-motivated piece of legislation. To be fair, there are important efficiency considerations to this bill (on both sides), but that's not why it generated so much political debate.

The pivotal issue in passing the bill was whether it would fund abortions with taxpayer money. The most fervent argument against the bill was whether it would "pull the plug on grandma" by rationing care. Even the "this bill will raise your taxes" plea appealed to the voter's self-interest. It wasn't "this bill will raise your taxes, which will give you a disincentive to work, which will reduce the long-run growth rate of GDP... which will make your grandchildren much worse off." On the other side, the moral plea was "how can you deny care to the underprivileged?" In my reading of the debate, these moral pleas were the salient issues. Efficiency was an afterthought.

My takeaway is that politics is the domain for moral issues. That's because economic efficiency just doesn't appeal to people the same way as morality does. In politics, people vote on how policies affect them materially or how the policies make them feel. The pivotal voter doesn't usually vote based on how regulations will affect average (or total) well being.

In the end, those of us who care about efficiency talk about a big tradeoff between equality and efficiency. That's how we justify living in a world of efficiency-depleting policies while still caring about efficiency. But, what stuns me the most is just how absent the discussion of efficiency is from the public sphere. Different strands of morality have many constituents, but efficiency does not.

*I attribute this quote to Richard Stroup who was one of my professors at Montana State University. He may have heard it elsewhere, or he may have made it up, but it is just one of those catchphrases that applies well to the discussion of economics and politics. To be fair, it is probably not true. Economists and students of economics are constituents who care about efficiency, but we are a small, vocal minority. A big reason why we harp on efficiency in introductory microeconomics courses is to expand the constituency who cares about efficiency.

Saturday, March 20, 2010

Poll: What is the role of the bribe?

I recently read a chapter in a book on bribery, by John Noonan. In this chapter, Noonan compared the history of the bribe to the history of slavery and the history of charging interest in banking. In his words:
Is bribery more like slavery or more like usury? Is the idea likely to remain vigorous and even expand its dominance, so that more reciprocities will be challenged and rooted out as contrary to the satisfaction of human needs? Or is bribery likely to shrink, to be applied only in cases of spectacular official greed as usury is invoked where rates of interest become bloated? The future of the bribe depends on whether bribery remains a matter of moral focus and judgment. Reasons, now to be examined, exist for seeing the matter in two conflicting ways.
Noonan proceeds to outline the case for bribery as a "non-moral concept" and contrast it with the case for bribery as a moral concept. Here are the key ideas.

Bribery as a non-moral concept:

1. Everybody does it.
2. It is necessary to do it.
3. Reciprocities are formally indistinguishable (bribes look like gifts and tips, which are not morally dubious).
4. Bribery is immorally enforced.
5. The material effect of bribery is trivial/undemonstrated

Bribery as a moral concept:

1. Bribery is universally shameful (every country has laws against bribery)
2. Bribery is a sellout to the rich
3. Bribery is a betrayal of trust

Noonan -- in review of these arguments -- concludes that bribery will continue to be condemned, and argues that it should be. That brings me to my poll question of the week.

In your opinion, what is the role of the bribe?

(a) Economic necessity, no morality needed.
(b) Morally dubious. Never justified economically.
(c) Wrong both morally and economically.
(d) Right both morally and economically.

As with all polls, this poll is open for a week. Please vote early and often (on the sidebar --->). Do whatever you deem necessary to get your friends to vote. Gifts, tips, and bribes are strongly encouraged to get other people to vote -- unless you are morally opposed. I look forward to seeing what you have to say.

Tuesday, March 16, 2010

Two armies, one island; one fights, one retreats....or does it?

Here's a classic problem in the theory of extensive form games.

Two armies are in conflict over an island that has magical properties. One army is headed by a man named V (he must not be named), and another is headed by a man named D. Both armies want the island, but Army D is in currently possession of it.

The island is situated between the land of D and the land of V, as in the following diagram.
As the diagram illustrates, a bridge connects each army's homeland with the island. Here's how the game proceeds. First, Army V decides whether to attack Army D. Second, Army D decides whether to fight back or retreat.

So, what should happen? It all depends on the payoffs to the armies. Assume that a battle over the island is the worst possible outcome for both armies, but the island is really great, so it might be worth risking a fight. That is, we can think of three distinct outcomes:

(1) Army D gets the island with no fight,
(2) Army V gets the island with no fight, and
(3) The armies fight

Army D prefers (1) over (2), and (2) over (3). Army V prefers (2) over (1), and (1) over (3). One way to represent this is through the following game tree.**

In this game tree, I depict that Army V chooses whether to fight. After seeing this decision, Army D decides on whether to retreat. We solve games like this by starting at the end and working backward. One way to think about this is that Army V's general puts himself in Army D's shoes. V asks, "What would D do if I attacked?"

Neither army likes a fight, so if D were attacked, he would order his army to retreat. Army V knows this, so V assumes this will happen. Based on this assumption, V knows that it is best to attack. And, the outcome of the game is that V attacks, D retreats, and Army V captures the island.

It is no good to be Army D in that version of the story.

Fortunately for D, there's an extension of this story. Put yourself in Army D's shoes. You're on the island, and you know that an attack is imminent from V. How can you prevent V from attacking? After all, if you prevent an attack, you get to keep the island, which is the best scenario for you.

Army V hates fighting just as much as Army D does. So, you might think that sending a note to Army V that says "If you attack, I will attack you back. You don't want that. Do you?" would do the trick. Unfortunately, such a note is no good. It is not a credible commitment. Economists call such signals cheap talk because although their goal is to induce the other army to act differently, the other army knows your best response once he attacks.

With this in mind, let's try a different tactic. Suppose that Army D's general burns his own bridge, effectively taking away the option to retreat (the army has no boats, and the soldiers cannot swim). In this case, D will have no choice but to fight back if Army V attacks. V knows this, and hence, Army V will not attack.

This is better for D, so the general will burn his own bridge. The map will look like this.

There's some irony in the story. Army D wins the island by burning the bridge, but D's soldiers can never go home, and their island is connected to the wrong homeland.

Viewed in this way, the solution seems silly, but this strategy of "burning bridges" is useful beyond just armies, islands, and bridges. Burning the bridge represents making a credible commitment to an action that would be costly if you were not serious about keeping the island. Making credible commitments explains how come men buy engagement rings, why couples who want children get married, how someone can more effectively get up in the morning, and even how someone could commit to a diet.

** If you want to learn more about how to solve extensive form games, I recently posted a video to my YouTube channel that explains how. Here's the embedded video:

Saturday, March 13, 2010

Poll: What is your favorite comic?

My wife started a blog. She writes on much more interesting topics than economics: Home decorating, photography, crafts, and other fun/useful life tips. Today, her post is about why she loves FoxTrot comics.

In her post, she linked to this excellent FoxTrot cartoon about a good business plan. I'll have to admit that my first thought upon reading the comic was that Paige didn't understand opportunity cost....

I love comics that have to do with economics (and even those that don't). So, for today's post/poll I searched the internet for economics comics. Without further ado, this week's poll question is:

Which of these comics is your favorite?

(a) Foxtrot (above)

(b) Frank and Earnest

Frank & Ernest

(c) XKCD: Iterated Prisoner's Dilemma:

(d) XKCD: Daylight Savings (not really about economics, but appropriate timing)

So, which comic of the four do you like the best? The poll is open for a week. Vote early and often, and on the sidebar. Tell your friends to vote. And, don't forget to set your clocks ahead!

Wednesday, March 10, 2010

Some research I have read on the female-male wage gap

One of the striking empirical facts about the wages of women is that women have consistently made less than men. Even in Biblical times, the rate of pay for women was around 60 percent of men's wages.

One might be tempted to brand this difference in compensation as unfair, as there is no apparent difference between the ability of women and men to perform tasks in a modern economy. Clearly, American politics and women's rights should have made some progress. So, how much progress was made between Biblical times and 1980s in the United States? It turns out: not much. According to a paper in the 1988 Journal of Economic Perspectives by Smith and Ward:
Further, virtually all U.S. government sources indicated that women's wages had been fixed at roughly 60 percent of those of men throughout the post-World War II period.
By many accounts this difference in the compensation of women relative to men has diminished since the 1980s, and it did so in a predictable way (Smith and Ward's paper is an exercise in forecasting what would happen to this gap; they correctly foresaw a converging of wages). By the 1980s, women had already begun acquiring much more useful labor market skills: better training in high-paying occupations, longer tenures and better work experience.

These investments in the labor market have big payoffs, and it was foreseeable that women's labor market prospects would improve from the 1980s. Indeed, they have by most standard measures. Broadly speaking, women no longer make 60 percent of what men make, but 75 to 85 percent, depending on how that gap is measured (within occupation, within education group, within age group, etc.)

In fact, a big debate in labor economics is not whether the compensation-gap has closed significantly since the 1980s, but questions about what this means.

One side of the debate -- espoused in a Quarterly Journal of Economics paper by Casey Mulligan and Yona Rubinstein -- argues that women have had precisely the same opportunities to succeed in the labor market over this time of perceived improvement. Mulligan and Rubeinstein attribute the perceived growth in women's wages relative to men as a difference in the composition of the types of women who enter the labor force.

Here's their argument in three pieces.

First, Mulligan and Rubinstein observe that there are two types of women who do not work. (A) Women whose labor market skill set is poor, but they have better opportunities to work as the head of the household. (B) Women whose labor market skill is excellent, but are married to someone who has even better labor market skill. [There are other types, but this stark contrast is useful to see their point]

Second, M&R note that since the 1980s, the variance in the earnings distribution has skyrocketed for men and women. Low skill workers make a little more than they did in the 1980s, but high skill workers make significantly more. This has increased dramatically the returns to having excellent labor market skill.

Third, M&R observe that more women from group (B) work now than before. The composition of the types of women in the labor force has transformed dramatically toward the higher skilled women who didn't find it optimal to work before. Now, they do and this change has altered the female-male wage gap.

This is an interesting and important paper. Mulligan and Rubinstein tell a story that allows for the possibility that the market changed, but the women didn't. Their paper is interesting because it points out a channel through which women's opportunities relative to men didn't change, but their choices did.

On the other hand, it is not clear that this is the only direction of causation. It is plausible that women changed their human capital investment or family structure choices in response to this dramatic market change. It would be surprising if they didn't. That said, it's useful to have a clear and compelling theory for how the world works, and caveats aside, this paper is both clear and compelling.

*As I mentioned earlier in the post, this is a multiple-sided debate. I have some reading to do to understand the points made by the other side, but once I do, I'll probably include an update in a future blog post.

Saturday, March 6, 2010

Poll: Which number would you call?

This image has been circulating around the economics blog-o-sphere.

One look at it, and you know that it is an image an economist would love [for evidence, there are posts about this image here, and here, and here, and it was supposed to be here, but that's where I lose the e-trail]. One of my friends messaged me with a link to this picture about a week ago, and ever since then, I have seen the picture crop up on blog after blog.

From what I can tell, most people have assumed that the $51 bid will win this auction, but I'm not so sure. It's pretty clear that the $50 bid is the actual owner. With that knowledge, how many people would call the higher bidder? I don't know the answer, so that makes it a good poll question for this week.

Which bidder would you call if you found the iPod Touch?

(a) The original owner ($50)
(b) The overbidder ($51)
(c) Neither. I've been looking for an iPod Touch!

As always, the poll is open for a week. Please vote early and often, and on the sidebar. Tell your friends and economist buddies to vote. I look forward to seeing what you have to say.

Wednesday, March 3, 2010

Performance-Enhancing Drugs and Competition

Today, one of my classes had an intense discussion on the issue of whether athletes should be allowed to use performance enhancing drugs (PEDs). A good friend of mine observed that no one forces athletes to use PEDs and fans love to see enhanced performance. So, my friend conjectured, why is there such a big fuss about the use of PEDs? He even proposed having a superhuman league along with a regular human league to appease others in the room. I think it is a touchy subject, but my friend hits on some good points.

Being an economist, I love watching sports because it is an entertaining forum for competitive behavior. Sporting events are an arena in which I can appreciate suitably ingenious strategies. For example, I am a huge fan of American football, but primarily because American football is a haven for interesting strategy. I'm not fond on seeing muscular guys get concussions, but I am fond on seeing a good game with some good strategy.

Given my inclination for watching sports, a natural question to ask is "What effect do PEDs have on the strategic nature of the game?"

In a calculating sense, PEDs have become part of the strategy. In this respect, it is just like training or batting practice or -- even -- drawing up the plays. Recognizing this aspect of PEDs is central to identifying what people identify as wrong with them. If a PED was not a substance that is injected into the athlete, but a specialized training regimen, people would not have a problem with it. That said, if eating raw spinach out of a can allowed someone to hit home runs like Mark McGuire did on his chase for 61, people would not have a problem with that activity either.

Apart from being something that athletes put in their bodies, there's something else going on with PEDs. The illegitimate status of PEDs comes from a confluence of two factors. First, taking a PED is an unnatural attempt to circumvent our typical human limitations. Second, with most PEDs, there are probably some adverse side effects. Coupled with the intense competition of sport, PED use by some players may induce competitors to take the drugs, and then everyone gets to suffer the side effects.

You may recoil and tell me that athletes willingly entered into this contract before joining the sport. That's true, but I would like to draw the analogy between these side effects of PEDs and the motivation for having rules that govern the safety of play in a sport. It is a penalty to grab someone by the facemask in football. It is also a penalty to "spear" (tackle by leading with your helmet down).

These rules make a sport civil, but they also protect the players from the dangers of intense competition in their sport. Rules protect athletes from each other (in the case of a facemask) and from themselves (in the case of spearing, a primary concern is neck injuries on the part of the tackler). At a basic level, rules banning PEDs perform the same function as rules governing the safety of play. As fans, we love to see intense competition, but the savages of competition give us pause.

My point is that there are two sides to the debate on the use of performance enhancing drugs. As an interesting counterpoint, I conjecture that PED use is commonplace in our society. To have a productive morning or evening, most people I know have harnessed the benefit of a favorite PED of mine. What is this performance enhancing drug? Coffee.