Thursday, June 28, 2007

A Peculiar Market Failure?

I found Jared Diamond's book Collapse to be very disappointing compared to his previous book, Guns, Germs, and Steel. Nevertheless there was one intriguing problem he presented, which seems to me to be a kind of curious market failure, with no obvious solution short of direct government regulation.

Suppose a mining operation begins near your town. The mining company operates in a seemingly environmentally-friendly manner, keeping erosion under control, preventing leakage of tailings, and perhaps even covering up the site after mining is complete. This seems acceptable to nearby residents.

Near the end of the mine's life, the mining company goes bankrupt. Perhaps they set aside enough money in advance to cover up the site, so there is no big eyesore remaining. Perhaps not. In any case, the company goes out of business and disappears. Ten years later a problem appears. Perhaps leakage from the mining site pollutes groundwater, or kills the plants above the site, or dangerous fumes being to escape. Or maybe they just don't have the money to clean up the site after bankruptcy.

What can be done to prevent this? There's no one to sue to recover damages or of whom to demand cleanup. The company is gone. The former owners and operators are not liable for the corporation's actions. If the company truly existed forever there would be no problem; one could sue the company and recover damages, reducing the incentive for other companies to engage in such behavior. So long as a company can make profits and then shut down like this, however, they can escape future damage claims. One cannot file suit for damages that one does not know will exist in ten years, so action prior to the damage isn't possible. If neighbors could inspect the mine regularly themselves, that might also eliminate the problem, but the neighbors would have to hire an expert to look at the problem (which costs money, introducing free-rider problems). They would also have to gain permission from the mining company, which is unlikely to agree.

One potential solution is to end corporate personhood, i.e. eliminate the limited liability enjoyed by owners of corporation, i.e., if a company of which you owned 5% 20 years ago did something bad 20 years ago, you owe 5% of the current damages. The main problem with this is that it will significantly discourage investment in companies. One reason modern stock markets work so well, and are able to finance so many large operations, is that investors know that their liability is limited. Perhaps this tradeoff would be worthwhile. It has the advantage of being a non-regulatory solution--it lets the market continue to work; it simply changes the liability rules under which a market operates.

Another solution, of course, is to simply have the government inspect and carefully regulate every aspect of all mining operations. The problem here is that governments suffer from similar problems to that of the corporation. The people doing the inspection now might not be in those jobs in ten years when problems arise; they're not likely to exercise as much diligence as we would like. That's in addition to the usual problems with government action, such as lack of cost control and regulatory capture (the tendency of regulated businesses to get chummy with the regulators, resulting in decisions that help incumbent firms, rather than unbiased regulation).

Wednesday, June 27, 2007

Econ 101 Introduction

I finished reading a fantastic and important book called The Myth of the Rational Voter by Bryan Caplan. This book has important implications for Public Choice economics, but more interestingly (I hope) for the general reader of this blog, it has implications for how I teach my economics class.

Traditionally I started out by defining economics, talking about trade-offs, and then diving into the Production Possibilities Frontier and other models. Now I think I'm going to start out differently. Here's my very rough sketch of my introductory lecture so far (quoted section is in blue):

-Introduce self, check names, review syllabus

-Begin with questions; do not state category headings:

Before we start, I have some questions for you.

(Anti-market bias)

1) Raise your hand if you believe we should have farm subsidies to ensure that farmers produce enough food for us to eat.

2) Among those of you who raised your hands, keep your hand up if you believe we should have clothing subsidies to ensure that clothing companies produce enough clothes, computer subsidies to ensure that computer manufacturers produce enough computers, and automotive subsidies to ensure that automobile manufacturers produce enough cars.

3) Hands down. Raise your hands if you would be in favor of doing something that would help one million homeless people find homes, food, and medical care.

4) Among those of you who raised your hands, keep your hands up if you would be still be in favor of doing something that would help one million homeless people if it earned a business $100 in profit for each homeless person helped. $1000? $10,000?

(Anti-foreign bias)

1) Raise your hand if you are concerned about the destruction of American jobs and businesses by imported goods from China.

2) Among those of you who raised your hands, keep your hand up if you are concerned about the destruction of Tennessee jobs and businesses by imported goods from Kentucky.

3) Hands down. Raise your hand if you are concerned about immigrants from other countries taking American jobs or putting downward pressure on American wages.

4) Among those of you who raised your hands, keep your hand up if you are concerned about people from Michigan taking Tennesseans' jobs or putting downward pressure on Tennesseans' wages.

5) Hands down. How many of you agree with the following: "Foreign aid makes up roughly forty percent, or less, of the budget."

6) Keep your hand up if you agree that "Foreign aid makes up roughly 30 percent, or less, of the budget". What about 20 percent? 10 percent? 2 percent?

(Make-Work Bias)

1) Raise your hand if you believe that hurricanes, while devastating to the lives of the people they afflict, at least have the side benefit of creating a lot of employment for people who work in rebuilding and cleanup.

2) Keep your hand up if you plan to repeatedly tear down your own house so that you can have the benefit of doing the work of rebuilding it.

3) Hands down. It is currently illegal for car manufacturers to sell cars directly to consumers. Rather, you must, by law, go through an independent dealership. Raise your hand if you agree with the following: "This is a good law because it protects the employment of dealership employees, many of whom would be out of work if manufacturers could sell directly."

4) Keep your hands up if you believe that we could create even more jobs by adding a "dealership dealership", requiring buyers to contact an independent dealer in dealerships, who then puts you in touch with a dealership, who then sells you a car. How about a "dealership dealership dealership"?

(Pessimistic Bias)

1) Raise your hand if you believe that, compared to the average American in 1900, an average American today is roughly 50% wealthier, in terms of material goods.

2) Keep your hand up if you believe that an average American today is twice as wealthy. Three times as wealthy? Five times as wealthy? Ten? Twenty? Thirty?

3) Hands down. Raise your hand if you believe that, with the way the world is headed, the U.S. economy will, probably stop growing within fifty years.

This class is about correcting biases. The answers that economists give to the above questions are usually very different from the answers non-economist provide. One possible explanation is that economists are wrong, but I doubt that answer would occur to you if I were giving counterintuitive results from, say, physics, or chemistry. People tend to trust experts because experts tend to be correct. Another possible explanation is that economists are biased because they're all conservatives, but in fact, the average economist is a moderate Democrat. One could also argue that economists' beliefs are biased because economists are wealthy, and they're really just arguing for policies that are in their class interests. Yet if one looks at the economic beliefs of wealthy people, they are not the same as those of economists.

The best answer is that economists know something that you don't. Noneconomists tend to suffer from biases in their economic thinking. This could occur because of bad education, or cultural norms. These errors are so pervasive across time and geography that I tend to believe they are the result of evolution, hard-wired into us by tends of thousands of years of pre-historic subsistence, when exchange and trade as we know it today did not exist

Whatever the reason, these biases persist, and the goal of this class is to erase them, replacing them with economics. In Bryan Caplan's book The Myth of the Rational Voter, Caplan identifies four economic biases. There are other economic biases (for example, the tendency to think of the number of jobs as fixed), but Caplan's list is very good, and enough for this introduction. The four biases are:

Anti-Market Bias: Non-economists tend not to believe that markets work well. They are suspicious of profit motive, and tend to see exchange as zero-sum--that is, whatever one side gains, the other must lose. Economists believe this view is almost completely wrong.

Anti-Foreign Bias: Non-economists tend to be suspicious of trade with foreigners, and of immigrants from other countries. It is unclear exactly why this is so; non-economists are not usually concerned about similar movements by their fellow citizens. Economists tend to believe that an arbitrary and imaginary line is not important (at least when it comes to trade).

Make-Work Bias: Non-Economists tend to see conserving labor as a bad thing, rather than a good thing. That is, the destruction of jobs is abhorrent, and the creation of jobs is always and everywhere desirable. Economists, by contrast, believe that some job destruction is not only necessary, it is healthy. Furthermore, economists do not believe that creating more jobs (or preserving existing jobs) is always a good thing.

Pessimistic Bias: Non-economists tend to underestimate the effects of economic growth in the past, and underestimate the future growth of the economy. Economists complain quite a bit about policies that reduce growth (and policies which are generally harmful), but that is because economists appreciate the huge effect growth has had upon our standard of living. Economists also believe that economic growth will, for the most part, continue into the foreseeable future.

As to why these biases are wrong, and why you should think like an economist, we will get to that over the course of the semester. Some of these subjects will be covered in Econ 102, rather than this course. For example, Economic Growth is usually a topic covered in a Macroeconomics class, rather than a Microeconomics class. By the end of this course you should be able to articulate the simple arguments in favor of markets and trade, even if you do not agree with them.

How would you answer the questions? What biases do you have? For what it's worth, I can think of one more reason why people might not believe economists: Macroeconomic forecasts are not very good. people might infer from this that economics in general is not very useful, but that would be a mistake. There is much more to economics than economic forecasting, and while economists disagree over some subjects (such as macroeconomic theory), there is a great deal about which they agree.

Monday, June 18, 2007

Using Incentives in Unusual Ways

This past week I had an opportunity to make use of the power of incentives in an unusual way. The neighborhood kids, who are very cute and friendly, come through the house to play with our dog. Sometimes they hang out in the living room and watch TV or sit at the counter while I work in the kitchen.

Last Wednesday evening I realized my cell phone was missing. I had used it the previous evening to make a call, and hadn't touched it since then. It was not where I recalled leaving it. The only people in the house since that call were me, my wife, and a neighborhood kid (who was about twelve years old) who passed through to play with Charlie. Lest you get the wrong impression, we don't just leave the door open. The kids come to the door, knock, and I take them to the backyard.

The twelve-year old girl was my prime suspect. The other possibility was that I had moved the phone and forgotten it, but I ruled that out after my wife got home Thursday evening. I tried calling my phone from her phone but got no answer. I called Verizon to report my phone lost or stolen and asked them to disable it.

The next day was hot and dry, so the neighborhood kids opened a fire hydrant (as they often do) and played in the jet of water. I took the dog outside for a walk, and took note of which kids were outside playing. This seemed like a perfect opportunity to make use of the power of incentives! I called over one of the little kids, a third grader, who is extremely cute and sweet. I told her that I had lost my cell phone, and whoever got it back to me would get $20. She was very excited, and she ran over to tell her friends.

Word apparently got around quickly, as another kid I had never seen before came over to verify the offer and get a description of the phone. I printed out a picture. Within thirty minutes of the original offer they had figured out the culprit (it was indeed my prime suspect, the girl who had come through the house), but they could not convince her to give up the phone. I did not want to get directly involved in order to minimize conflict with neighbors. I decided to simply wait to see what would develop.

After about an hour another neighborhood kid (one of the kids who gave us our dog, actually, and a regular visitor to our house) stopped asking if he could walk our dog. I said he could, and he said he could take me to the house of the girl who had stolen my phone. We walked up the street, and the girl's mother was leaning out of the door. She asked me to come in.

Once inside, the mother ranted at her daughter for quite a while, saying that the daugher had "brought devil work into her house". Apparently the mother had played in the water from the fire hydrant with the kids, and $60 had fallen out of her pocket and been lost. She thought this was a cosmic injustice, as she felt she was a good mother, but a neighbor told her that it was due to "devil work" that had been brought into her house. She dismissed the idea, but then thought about the cell phone her daughter had given her...

Apparently her daughter had come home the night before with a cell phone and charger (I hadn't even realized the charger was missing), saying that another neighborhood kid had found it. The kid in question had not been in our house in over a week. The mother took the phone with the intent to put a new SIM chip in it, giving it a new number and making it her own phone. She would give her daughter her old phone. She got suspicious, however, when I tried to call the number last night from my wife's phone, and decided not to get the chip replaced.

I verified that it was my phone by looking at the pictures on it. The daughter had erased most of the pictures, but there were still two pictures of our deceased cat and one picture of my wife's grandmother. The daughter had also erased all our contacts. Amazingly, the daughter had been unable to place any calls from the phone because she didn't realize that it had an Atlanta area code. She needed to dial 615 first to make calls here in Nashville.

The daughter still denied stealing the phone, even though it was clear at this point that there was no other way the phone could have escaped the house. At this point I decided to pretend I was a deceitful police officer. I told her, truthfully, that there is a webcam in our living room, and that it updates every few seconds. I also told her that the pictures are stored for later viewing. That part was a lie, but she didn't know that. She had probably seen the webcam in the past, as she was fascinated with MP3 players, cell phones, and other small electronics. I told her that she could continue to deny she stole the phone, but that it would probably go easier for her to admit it now, rather than having me go back home and pull up a picture of her caught in the act of stealing the phone.

Faced with the possibility of evidence, she finally confessed, and her mother gave her a sermon. The daughter was ordered to apologize to me, which she did. The mother repeatedly mentioned the $60 that she had lost, obviously fishing to get the $20 that I had promised for the return of the phone. I felt that the $20 belonged to the kid that had brought me over to the house, but in order to avoid tension with a neighbor I paid the woman $20, took my phone and charger, and left. I promised the other child that I would still give him $20, which I did the next day (I had to go by the bank).

It was pretty stupid of me to allow someone to steal my cell phone and charger from my house, and I ended up paying $40 to get them back, but I think it could have ended much worse. It would have cost more than $40 to replace the cell phone, and I could have angered my neighbors by being more aggressive, or elevated tensions even higher by bringing in the police. I was also pleased that I managed to get other people to do some of the work for me. In hindsight, if I had been really clever I would never have disabled the phone. Instead I would have simply walked around the neighborhood calling my phone from my wife's phone, waiting to hear a ring. Then again, as far as I knew, the phone had been sold and was nowhere near my house. I think $40 was a fair price to pay for both the return of my phone and a good story to tell.