Wednesday, January 20, 2010

You Can Save Money On Your Car Insurance!

There are a lot of commercials for car insurance on television. Many of them claim that people who switch to their insurance company save a certain percent, or a certain amount of dollars, compared to their old car insurance. Yet it can't be possible that every car insurance company has cheaper rates. Can the average person who switches saves 15% or more, or $150, or whatever?

Yes. The reason that it's possible is that the people who wouldn't save money by switching don't switch. As a result, the average person who switches saves money. This is similar to a point Steven Landsburg makes in The Armchair Economist. He argues that grocery stores can truthfully claim that shoppers buying there can save money, because they are each touting the sale prices of their cheapest goods--and these goods are different from store to store.

A remaining question is why there might be enough price dispersion to allow such different policy prices for different consumers; I don't know the answer to that. Perhaps different sellers specialize in different kinds of customers, resulting in specific knowledge and human capital that allows them to charge lower prices to those customers. That is, Safe Auto and GEICO probably attract different customers.

Tuesday, January 19, 2010

O'Brien, Leno, and Coase

In 1960 Ronald Coase's paper "The Problem of Social Cost" was published. In it Coase laid out what has come to be known as the Coase Theorem. There are at least two versions of the theorem, and they can be stated many ways. The version I'll discuss here goes something like this: "In the absence of prohibitively high transactions costs, the same efficient allocation of rights will occur regardless of the initial allocation of rights."

"Efficient" means "the difference between benefits and costs is maximized". "Transactions costs" are the costs of transacting--the costs of bargaining to reach agreements. They could be language barriers, regulatory differences, excessive arrogance or mistaken beliefs of the parties to the agreement, or even coordination failure due to a large number of participants on one or both sides of the negotiation. "Rights" could mean any right to anything--the right to graze one's sheep in a particular area, the right to be free from pollution, the right to pollute, or even the right to host a television show at a particular time.

The recent mess over at NBC over late night television is, I think, a simple example. NBC and Conan O'Brien signed an agreement years ago, in which NBC promised that Conan O'Brien would host the Tonight Show. It is not clear whether the contract guaranteed O'Brien the 11:35 time slot, but let us assume for the sake of argument that it did (even if it doesn't, The Tonight Show is closely associated with that time slot, so that O'Brien might be able to argue that it isn't the same show if it airs at a different time).

Eventually O'Brien took over The Tonight Show from Jay Leno, who got a new show at 10:00. Leno's new show performed poorly. O'Brien's Tonight Show also did not perform as well as NBC had hoped (in particular, NBC's affiliates were especially upset).

Now NBC has a problem. They have promised O'Brien The Tonight Show and (perhaps) its time slot. Leno also wants his old show back, as his new show is about to be canceled. What efficient new bargain can they strike?

It is pretty straightforward, and it is the result that the network and O'Brien are rumored to have struck. NBC buys O'Brien's right to The Tonight show, and lets Leno return to the show. Everyone is better off: The viewers and the NBC affiliates get the show they want (bizarrely--I can't imagine preferring Leno to O'Brien). NBC should expect an increase in profits as a result. Leno gets his old show back, and O'Brien gets a large amount of money, and the opportunity to go to a network that will appreciate him. (If you must have some numbers, suppose the network values having Leno back on The Tonight Show at $60 million, and suppose O'Brien values staying on the show at $20 million. There is a range of offers that would make both parties better off.)

Similarly, if NBC had never promised the show to O'Brien, this same outcome would have occurred--Leno would have the show, and O'Brien would not. The parties end up at the same efficient outcome, regardless of the starting allocation of rights.

What about transactions costs? There could be transactions costs that prevent a bargain from occurring. O'Brien might be offended and stubborn, or he might overestimate how much NBC would be willing to pay for the rights to host The Tonight Show. If he asks too much, NBC declines to pay. Similarly, NBC might underestimate how much O'Brien loves the show, and might try to offer too little. Still, both these problems should be addressable with repeated negotiation. The more serious impediments to bargaining don't seem to exist here.

A side note: I am leaving out wealth effects; I think this is reasonable in this case, given the wealth of the parties involved.

Another side note: I suppose this is also an example of efficient breach.

UPDATE: John Lentz points out that it appears transactions costs were low enough for an efficient bargain to be struck.

Thursday, January 14, 2010

The Opportunity Costs of Foregone Economic Growth

Economic growth is great; it brings people out of poverty, so they can have cleaner water, sufficient food, better medicine, and safer cars, as well as less important things, like bigger houses, cool gadgets, and hundreds of channels of television.

The earthquake disaster and its aftermath in Haiti has reminded me of another benefit of growth: it creates resources that can be used to prevent and deal with crises. A wealthier country would have safer, stronger buildings, fewer of which would have collapsed. A wealthier country would have more and better hospitals that could deal with the wounded. A wealthier country would have an airport that could handle the influx of foreign aide without running out of fuel to get the planes back out again. A wealthy country has accumulated physical and human capital that allows it to deal with emergencies, and to better receive help from other countries during emergencies. Haiti's poverty makes disasters more disastrous, makes internal efforts at recovery impotent, and makes foreign aid less effective.

Wealthy countries aren't immune to disasters, of course--thousands died in the U.S. in Hurricane Katrina, and nearly 15,000 died in France in 2003 during a heat wave. These pale compared to the death toll in Haiti, however. Even if an earthquake occurred in, say, San Francisco, I would expect the death toll to be a much smaller fraction of the population than has occurred in Port au Prince.

It's hard to come up with a silver lining for this, but I'll stretch and try. Tyler Cowen suggests that Haiti as we know it is gone. This is a chance to replace its government and other institutions with new institutions that work better, allowing economic growth and a brighter future. It's hard to be optimistic, however. The old government (or what is left of it) surely won't give up power, and it will try to steer any changes in ways that benefit it at the expense of others. Other countries may try to steer the direction of change to their own advantage. Gangs and criminal organizations may try to carve out their own pieces of the country.

Maybe these problems can be overcome, but it's not clear to me what process would lead to better institutions. One possibility is for a country with relatively health institutions to just take over, copying and pasting its legal system and eventually its traditions. Here the problem is how to figure out which country does this. I wouldn't want, say, Venezuela to take over. I'm not even sure I would want the U.S. to try to run things.

Another possibility is for the U.N. or some other international entity to try to redesign their legal and political systems. I can't see this top-down approach working out well. This sort of central planning problem is just too difficult to solve. No, if beneficial change is going to take place, it will have to be from the bottom-up, and gradual. I'm not sure if the political entities involved will allow this.

(Please note that I'm not repeating the stupid claim sometimes made about the success of Japan after World War II. That is, some said that Japan grew so quickly after the war because they were able to replace their old factories and equipment with new ones. This is ridiculous; absent the war and its destruction of capital, they could have had the old factories and the new ones, or they could have torn down the old stuff if necessary. Destruction of capital is not a path to growth. Rather, I am arguing that destroying old and harmful institutions can be beneficial.)