Friday, September 29, 2006

Quiz 3 (due in class Oct 10th)

EC208 - Intro to Microeconomics: Quiz 3 - Market and Government Failure

Professor Matthew Festa

Due in Class Oct 10th, 2006

1) Explain the two differences between a private and public good. Provide one example of a public good that the market will under provide (1 point).

2) Draw a supply and demand curve for fishing. Fishing requires the use of motor boats. Neither the fisher nor the consumer of the fish he catches care about the pollution this causes to the water. This pollution, in turn, damages the property values of homes. What type of externality is this? Should the optimal output and price be higher or lower? Show what shift in any curve should occur to bring about this possibility. Finally, provide two ways the government can bring about this optimal output and price . (3 points).

3) Draw a supply and demand durve for English teachers. Most parents recognize the value of learning to read and write but do not much care if their kids learn anything about great books. However, great books are known to open people's minds up to new and interesting ideas that improve their understand and critical thinking. What type of externality is this? Should the optimal output and price be higher or lower? Show what shift in any curve should occur to bring about this possibility. Finally, provide two ways the government can bring about this optimal output and price . (3 points).

4) Explain the difference between moral hazard and adverse selection with one example for each. Use your notes and/or textbook if you have problems coming up with examples. (2 points).

5) Explain the concept of rational ignorance (1 point).

NYC bans fatty foods

This post is covers both market failure and government failure. Andrew Samwick, an economist at Darthmouth, discusses how NYC is banning Trans fatty foods (like French Fries). He discusses the tradeable permit to pollute system we discussed in class in a joking way here

Of course, this is probably closer to an example of government failure that it is market failure. Do we really think that taxpayer money is best spent....banning French Fries? What about all the jobs that will be lost in the restaurants whose food now tastes like manna?

The Potato Cartel?

Greg mankiw shows how Potato farmers are restricting supply of their crop by......destroying it

Also note his update. They don't understand basic supply and demand! The correct explanation is that by destroying the crop they are shifting the supply curve to the left. This in turn lowers output and creates a shortage. The price level is increased and the Quantity demand decreases as a result until the new equilibrium is reached!

Do you see the importance of these words now?

Thursday, September 28, 2006

Class Handout for Government Failure

Lecture V(Based on Text provided free on Internet.)

Government Failure

I) Rational Ignorance
a. Overall negative costs to society but individually the costs are dispersed in society while the benefits are concentrated
b. Example $1,000,000 cost to society with $800,000 benefits to 5 farmers
c. Rational ignorance on government programs
d. Rational ignorance on voting

II) Median Voter Theory
a. Median voter theory resembles bell curve
b. Politicians running towards the middle
c. Shifts in the Median vote
d. What if the best program lies to the right or left of the curve?

III) Bureaucracy
a. The Iron Triangle (Government, Bureaucracy and voters).
b. Capture Theory
c. Lack of accountability in government
d. Rent Seeking - asking the government for economic profit above and beyond what the market will yield (restricting competition)
e. Logrolling – a liberal and conservative senator both vote for the same bill. Why? Because they trade votes.
f. Earmarks – The Alaskan Bridge to Nowhere

IV) Government as Public Goods
a. Some Public choice theorists suggest that Government itself is a public good.
b. Limitations to Public Choice Theory.

Wednesday, September 27, 2006

Readings for Government Failure (Public Choice Economics)

Since the textbook does not provide a good discussion of Government Failure, the following free links will be used as the textbook for Government failure, often called Public Choice Economics. This link talks about how it may be rationale for you to remain ignorant, which of course is sub-optimal for the perspective of the overall society. Is an overview of Public Choice theory, which takes as its basis rational ignorance. The main claim, government is an underprovided public good. (Theory and Claims are the most important sections to look over for the purposes of this class). The median voter theory discusses how some politicians will "run to the middle" in order to maximize the possibility of being elected. But what if the optimal policy lies somewhere else besides the middle?

Update: This article does an excellent job of explaining public choice economics.

Monday, September 25, 2006

Class Handout for Market Failure

Lecture V(Based on Chapter 17 in the textbook).

Government and Market Failure

I) Public Goods
a. Contrasted with Private Goods
i. Non Rivalry
ii. Non excludability
b. Problems this causes for private markets
c. Examples of defense and vaccines
d. Counter-example of Broadcast Television
e. Marginal Benefit vs Marginal Cost Rule

II) Spillover effects
a. Externalities
b. Spillover costs (environmental pollution)
c. Spillover benefits (education, basic scientific research).

III) Ways to correct Spillover effects
a. Taxes and Subsidies
b. Coase Theorem
c. Direct Control
d. Market Based Approach
i. “Tragedy of the Commons”
ii. Creating a market for externality rights (i.e. property rights to pollute).

IV) Information Failures (i.e. asymmetrical information).
a. Supply and Demand, and the Perfect Competition model we will discuss later, assume perfect information about the product among buyers and sellers.
b. If not, and one party has more relevant information than the other, then resources may not be allocated efficiently.
c. Health care example.
d. Moral Hazard Problem.
e. Adverse Selection.

Next Class: The flip side of this problem, government failure. There is no good chapter in the textbook on this so I will be providing all relevant textbook material you will need free online.

How can you tell if your house will lose value?

Kevin Hassett has a good piece on the housing market here. He is attempting to offer guidance as to whether there is "arbitrage" opportunities to move out of your home and buy it back after the housing market goes "poof."

He makes the following two criticisms of such a move.

1) Transaction costs are high. You have to higher a broker, put your home on the market and basically hope someone is dopey enough to buy it at its 3 year high. Then you have to buy it back--probably from the same person--when the market bottoms out. Hmmmm.

2) Then we have to consider whether prices are going to decline in the first place. He gives some useful guide posts, all of which are based on supply and demand.

a) Look for an increase in supply (an increase in supply lowers price and increases output). If a bunch of McMansions popped up in your town recently, be wary.

b) Take a look at inventories. If a lot of homes are on the market but are not selling (i.e. those real estate stickers on the lawn), that suggests there is a supply and demand imbalance. That is, the quantity supplied is in excess of the quantity demand. In order to correct, prices have the fall and the quantity supplied has to decline.

A caveat: The housing market is peculiar in that it is not liquid. People don't flip their homes left and right, despite the recent demand for investment homes in recent years. Therefore, in anticipation of a price decline, home owners may just decide to sit this one out for a few years and wait to move into a bigger McMansion. Whether this move will be enough to prevent prices declining is something we are, unfortunately, going to have to wait for in upcoming data. The increase in home purchases purely for investment purchases means that some people may have purchased a home they are not living in. They do not face the same contraint in selling the home(since they live somewhere else), but they will be concerned whether they make a profit (hence getting rid of it now in order to make sure them come on top). The main question is: how many are in each camp?

Good post on living standards

In light of the ongoing debate on whether we are better off now than we were in 1973 I refer you to this post . (Note: the title of the blog is a topic we will be discussing shortly).

If you honestly believe that we are worse off now than we were back in 1973, ask yourself this question: If your salary after inflation was going to be $40,000 a year, would you rather have that salary in 1973 or 2006?

Market forces and health care

The WSJ has a well balanced article on Health Savings accounts and how consumers are responding to higher health care costs. Read it here

Saturday, September 23, 2006

Technology, employment and elasticity

Brad Delong has an excellent post reviewing a new book purporting to refute Adam Smith's "fallacies". The whole review is worth a read.

However, there is one part that touches on the topic of price elasticities we discussed last class.

"If the elasticity of demand is low, rapid technological progress in one industry might be associated with a reduction in the demand for labor in those industries. But it would not be if the elasticity of demand is high. For Foley to say that this technological unemployment in low demand-elasticity industries is "one immediate negative effect" of the division of labor without also saying that technological employment in high demand-elasticity industries is "an additional immediate positive effect" of the division of labor--that's Foley putting his thumb on the scales in a foolish way."

Friday, September 22, 2006

Income security accounts

The Economist has an interesting article on Temporary income accounts here (subscription required). The idea is this. Two complications with the modern day economy is that 1) income is more volatile than it was in the past (although job security does not seem to be). 2) some workers today are not unemployment for short durations but for long durations. Therefore, it makes sense to replace temporary unemployment insurance with "income security." Here is the plan.

"The idea is to give every worker an account, unsnappily called a “temporary earnings replacement account” or TERA. While in work, people could set aside money in these accounts. Those who lose their jobs could take cash out. The level and duration of withdrawals would be set by the government and would be the same as under today's unemployment system.

A worker who exhausted his account before he found a new job could borrow from it. Repayments would automatically be deducted from future earnings. At retirement, any outstanding TERA debt would be forgiven, while anyone who had a positive balance could withdraw it."

Something to consider.

Elasticity and Tax Cuts

Back during the early 1980's, an argument was advanced that cutting taxes will increase the amount of workers, increase work effort and have no impact on the budget deficit (since the increase in labor raises tax revenue even though tax rates have actually declined. In theory this is certainly possible. For instance, if I tax you 0% obviously the governmnet will take in no revenuw. However, if I tax 100% of your income the government is likely to collect close to zero revenue as well because you have no incentive to work. Since you don't work, there is no revenue to collect. Some argued, therefore, that decreasing tax rates would boost work effort enough to pay for the entire tax cut.

This obviously did not work out as the deficits in the 1980's and early 1990's attest to. But it does highlight the issue of elasticity. The reality was that the labor supply elasticity was low (increasing income only increased work and effors by less than one). Some on the other side have argued that this suggests taxes could actually be increased so that the benefits exceed the costs (since the elasticity is less than 1 this is certainly possible).

However, merely looking at labor elasticity by itself really does not tell you whether raising taxes (and in the current environment that would mean tilt the tax code much more heavily towards the rich) is a good idea. Martin Feldstein---Harvard Professor, former CEA under Reagan and the head of NBER---explains why.

And in particular if you look at the household response to marginal tax rates, the typical professional economist's view and also that of most tax policy officials is that people don't seem to respond very much. If you look at the relationship between labor force participation and tax rates, or working hours and tax rates, there's not much there. There is for married women, who have more discretion, but for single women, or men between 25 ...

I've argued that that's really looking in the wrong place. The measure of labor supply that matters is not just hours. The relevant labor supply includes human capital formation, choice of occupation, willingness to take risk, entrepreneurship and so on. All of these affect income and tax revenue.

....Therefore, we should look at the data on how taxable income relates to marginal tax rates. I looked at the experience before and after the 1986 tax cut, because that was a very big, bold one. The Treasury provided data that allowed one to track individual taxpayers over time. So you could look at an individual a few years before the 1986 Tax Reform Act and at that same individual a few years later. And that comparison suggested quite a large response: Taxable income responded with an elasticity of about 1, meaning that a 10 percent increase in the after-tax share that an individual got to keep, say, going from 60 percent to 66 percent, would increase their taxable income by 10 percent. So those are big numbers.

Quiz 2

EC208 Intro to Microeconomics – Quiz 2

Professor Matt Festa
Due in class: Wednesday Feb 21th.

1) Draw the supply and demand for nursing care. Over the past few years the average age of the population increased from 40 to 45 years (meaning there are now more older people in the population. Show any shifts in the supply and/or demand curve for nursing care. What will be the effect on price and quantiy of this change in the population composition? (2 points).

2) Draw the supply and demand curve for Ford. Ford develops a new technology that allows for cars to be manufactured quicker and cheaper. In addition, the news reports have been praising the new Fusion car for its fuel efficiency and hot style. Show any shifts in supply and/or demand. What will be the effect on price and quantity of this new information? (3 points).

3) What is the definition of “Price elasticity of demand?” In your own words what does this measure? If I tell you that the price of oil increased 1% and quantity demanded decreased 0.25% what is the price elasticity of demand for oil? Is oil elastic or inelastic? (3 points).

4) Cross Price elasticity of demand – The price of high speed internet connection went up 2% and the quantity demanded of computers declined 4%. Based on your calcution is this a substitute, complementary or independent good (2 points).

Wednesday, September 20, 2006

Class Handout for Elasticities

Lecture V(Based on Chapter 7 in the textbook).

I) Price Elasticity of Demand
a. Formula:
(%change in quantity demand of Product X)/(%change in price of product x)
b. Why use percentage changes rather than just raw units?
c. Elastic demand (graph to show how demand curve looks
d. Inelastic demand (graph to show how demand curve looks
e. Unit elasticity
f. Extreme cases of perfect elasticity and inelasticity .
g. Midpoint Formula:
(Change in quantity)/(sum of quantities/2) / (chance in price)/(sum of prices/2)

II) Total Revenue test
a. Effect on revenue of on lowering price level for
i. Elastic demand
ii. Inelastic demand

III) What determines Price elasticity
a. Substitutability
b. Proportion of income
c. Luxuries vs Necessities
d. Time

IV) Price elasticity of Supply
a. Formula: same as above except with supply instead of demand
b. Short run vs long run
c. Importance of Time in shape of supply curve.

V) Cross elasticity of Demand.
a. What if you want to measure how much extra hamburgers you buy when the price of hot dogs goes up?
b. (% change in q demanded of X)/(%change in price of product Y).
c. Substitute goods X >0
d. Complementary goods X<0
e. Independent goods X at or near 0.

VI) Income elasticity of Demand.
a. How much extra or less hamburgers will you buy if your income changes
b. % change in q demanded/% change in income).
c. Normal goods.
d. Inferior goods

The federal reserve statement

The Fed held their monetary policy meeting today and decided to leave rates unchanged, as expected. However, I couldn't help notice the difference in the first sentence on growth this statement versus last statement.

Last Time:

"Economic growth has moderated from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices"

This time:

The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market.

This almost sounds like a the sentence was literally chopped up. But notice the subtle differences.

1) The housing market is no longer "gradually" cooling. Now its just cooling
2) they didn't mention the lagged effects of past monetary policy, which are surely still at work.
3) They didn't mention energy prices (that one is easy since they have come down in recent months.

Anyway this is interesting if you are a fan of macroeconomics.

Minimum Wage continued

No sooner did I post on the minimum wage did Tyler Cowen write against a letter arguing for an increasing in the minimum wage.

Tyler takes issue with the argument that the minimum wage is an effective tool to fight poverty. He is right on that score.

Minimum wage debate

As we discussed last night, standard economic theory says that setting a price floor (minimum wage) above the equilibrium wage will cause an increase in quantity supplied (people looking for jobs) and a decrease in the quantity demanded (amount of jobs available. However, the impact of this is hotly debated. To summarize the debate let me provide the following links.

Pro increasing minimum wage:

Against the minimum wage:

My opinion: I agree with Professor Mankiw here. The study cited in support of the minimum wage was done comparing food industry employment between New Jersey (which increased the minimum wage) and Pennsylvania (which did not). They actually found the employment went up in New Jersey. As an explanation they offered a complicated model arguing that normal supply and demand was not operating at such a low wage.

Subsequent research has amended this study somewhat and I believe that the consensus is that no adverse unemployment was wage increases the higher you establish the wage.

However, it is hard to use this study in support of any major hikes in the minimum wage, especially when the program is poorly targeted towards helping the working poor. The alternative program, the EITC, is more effective at doing that. The extent that the minimum wage should be hiked can really only be supported if the credit induces an increase in supply and forces the wage down in response. But the evidence for this so far is small and as you will learn or have learned wages tend to be "sticky" downwards.

Anyway that is my two cents.

Tuesday, September 19, 2006

Supply and Demand in Housing (Part II)

Today saw the release of new housing starts and permits (permits are the written permission to construct a new home). You can read the article that summarizes the data here. But this paragraph in particular is helpful:

"Housing starts have been beating a hasty retreat since January as home builders have quickly responded to slowing sales and ballooning inventories of unsold new homes,"

Translation: Slowing demand (sales) has caused an increase in inventories (supply and demand are not in equilibrium). This in turn has caused suppliers to cut back dramatically on the construction of new homes and purchases of permits to build new homes (quantity supply is declining). The question you may have is what about price. Well, the housing market is peculiar in that the overall price level for homes has never fallen. The reasoning behind this is that the housing market is "illiquid" in that it does not adjust fast. But while the sticker price you see at the real estate agency may not fall, inflation ends up eating away the REAL price of a home and thus the price either falls or stops going up in real terms.

Monday, September 18, 2006

Shortages and movie tickets

The Financial Times runs a weekly column called "Dear Economist" by Tim Harford. This letter is on the movie theatre problem: that is, why don't movie theatres raise their ticket prices when they get a blockbuster movie to prevent a shortage or lower their prices when the movie is a bomb.

Dear Economist,

When I go to a restaurant a dish that costs more to make - perhaps lobster or the product of an expensive chefÂ’s imagination - costs more to purchase. The same is true when I go to a clothes store.
However, when I go to see a movie at my local cinema, no matter what the film, no matter how much it cost to make, it costs the same to see.
As I only go to big-budget flicks that have been praised to the rafters, I feel I am being subsidizedd by the poor folks who are watching cheap run-of-the-mill pictures. Why donÂ’t movie theatres have adjustable pricing?
Arthur Spirling, Rochester, NY
Dear Mr Spirling,
You are confused. You are not consuming a film but a film screening, and film screenings cost the same to produce no matter what is in the projector. The price of producing the film in the first place is irrelevant.
Nevertheless, there is a puzzle here. While wshouldn'tdnÂ’t expect big-budget films to command higher ticket prices, these prices should surely vary in an attempt to get every seat in the house full. ItÂ’s not obvious that popular movies should be more expensive: the most popular books tend to enjoy the greatest discounts. But completely uniform pricing is odd.
One explanation is that people might buy a cheap ticket and then sneak into a more expensive screening; but uniform pricing predates the multiplexes. A second explanation, advanced by economist Barak Orbach, is that distributors don’t like to be associated with “discount movies” and so they tell cinemas what price to charge. Since this is illegal in the US, their instructions have to be simple, hence uniform pricing. I prefer the simplest explanation: cheap tickets with minimum confusion is a great way to sell popcorn.

I would also add that theatres do not take in a majority of the ticket revenues. My recollection is that if they sell a ticket for $10 they get on average $4.50 and during the first week that number drops to $3.00. The distribution company gets most of it. Therefore, it is rational for the theatre to "price target"--sell out and then try and get the inelastic consumers to buy popcorn, soda and candy, revenue the theatre keeps for itself.

Falling Oil Prices

Take a look at this article on falling gasoline prices and see if you can draw shifts in your standard supply and demand graph to match his result.

Sunday, September 17, 2006

Ben Stein and scarcity

Here is an interesting column by Ben Stein (of "Win Ben Stein's money" and "Ferris Bueller's day off" fame...He is also an economist). He is discussing the problem of scarcity and how this concept can be taken to extreme--and tragic--consequences.

Class: Thomas Malthus was a noted economist in the 19th century. One of this main ideas was the idea of a Malthusian trap. That is, because food only grows at a linear rate but population grows at an exponential rate (you can only grow so much wheat before you run out of land but people keep..umm..reproducing) there will eventually be mass starvation among people. Let me state that this theory has NOT been born out by history. This is due in part because of technological advances in food production but also because the population stopped having less babies.

Friday, September 15, 2006

Supply and Demand in housing

This WSJ article discusses the housing market and has some interesting tidbits on supply and demand. Read the article here

Supply and Demand is explained rather well below in this paragraph:

What we saw was bleak news for sellers in our region, but good news for buyers like Melissa and Joe: block after block of open-house signs. In fact, we were hard-pressed to find a street that didn't have at least one home for sale -- and many had more than one. What's more, most of the 20 or so homes we visited were vacant -- a sign that homeowners have moved on and are motivated to sell, or that speculators are looking to unload properties before prices go any lower. (Asked why one home was vacant, one agent said frankly: "This was a 'flip' that flopped.")

Quiz 1 (Supply and Demand Part I)

Intro to Microeconomics – Quiz 1 – Supply and Demand. (10 points)

Professor Festa
This Quiz is due in class by Wed Feb 14th. Please put work on a separate piece of paper. Use graphs where necessary.

1) Please draw a supply and demand graph with price and quantity on the correct axis. Provide me with the common sense reason plus one additional economic argument as to why the demand curve slopes down and the supply curve slopes up with respect to price? (2 points)

2) Where will the equilibrium price be on the graph? Explain and show why that is the equilibrium point and not another point on the graph. (2 points).

3) Name 2 characteristics that will shift the demand curve. Then give an example for each and explain which way the demand curve will shift (draw the graph). (2 points).

4) Name 2 characteristics that will shift the supply curve. Then give an example for each and explain which way the supply curve will shift (draw the graph). (2 points).

5) Draw the market for Joe's Taco's and Burrito's. Now consider the following. A chief competitor of Joe's, Taco Bell, has recently run into trouble because their food was determined to contain Ecoli. State any shifts in supply or demand and show on your graph. What will happen to equilibrium Price and Quantity? (2 points).

Thursday, September 14, 2006

Article on Statistics

This article discusses how journalists tend to misuse economic statistics because they do not understand what they are doing. My experience bears this theory out.

Class handout for Lecture 2 (Supply and Demand)

Lectures III and IV (Based on Chapter 3 in the textbook).

Note: I will post a practice problem on the website. There will be a take home quiz posted next Tuesday.

I) The Law of Demand –
a) Why does the demand curve slope downward?
1) Common sense
2) Diminishing Marginal Utility.
3) Income and substitution effect
b) Change in the quantity demanded vs change in demand (very important)
c) Changes in Demand
1) Tastes
2) Number of Buyers
3) Income (caveat: normal vs inferior goods)
4) Price of related goods (substitutes vs complements)

II) Law of Supply
a) Why does the supply curve slope upwards.
1) Common sense
2) Increasing costs per additional unit (marginal cost)
b) Change in the quantity supplied vs a change in supply
c) Changes in Supply
1) Resource Prices
2) Technology
3) Taxes and subsidies
4) Number of sellers
5) Price of other goods

III) Market Equilibrium
a) The automatic tendency for a market to tend towards equilibrium
b) Shortages vs Surpluses as an incentive to move towards equilibrium
c) What determines “Price” Marshall and scissors

IV) Applying supply and demand to the real world
a) Shifting curves
b) Why do sports players get paid so much money?
c) Why did oil prices rise so much during the summer?
d) Why did the fall so fast in thefall?

V) Price Controls
a) Price floor (minimum wage)
b) Price ceiling (oil prices)
c) How this distorts the market

Wednesday, September 13, 2006

Good article on the "dismal science"

This is an excellent article explaining how and why economists think the way they do

This paragraph is related to what I discussed in last nights class

"Economics is dismal because it grapples with the problem of scarcity, which arises because, though our wants are infinite, the resources available to satisfy those wants are finite.
From this comes the first way in which economists make themselves unpopular: by banging on about "opportunity cost". This is the notion that anything you decide to do has a cost, which is the thing you can no longer do. A dollar can be spent only once, so if you spend it on A it's no longer available to be spent on B or C or D."

Monday, September 11, 2006

Class handout for Lecture I

Outline for Chapter 1 (3-5), Chapter 2 (22-23,27-28)

I) Economics – The social science concerned with the efficient use of scarce resources to achieve the maximum satisfaction of wants

II) Scarcity – there is only a limited amount of “goods” in this world. But there are 6 billion people, all of whom want to do different things with these goods. How do we go about allocating these resources?

Example: The LOTR and “The One Ring”

Note two things about the one ring.
1) Rival good
2) Excludable

(Later in the course we will be talking about Public goods, which are exactly the opposite)

III) Opportunity Cost – The value of the next best alternative foregone i.e. what you had to give up!

The two examples to give to the students are Jack Bauer and 24. Relate the time he had to choose between saving the life of the Chinese ambassador who knew where the terrorist bomb was or the life of his girlfriend’s ex-husband. The doctor represents scarcity and the death of Paul Raines was the “opportunity cost” of stopping the terrorist threat.

Then talk about coming to class. Scarcity here is the students time while the opportunity cost is what they would have been doing if they did not come to my class. Pass around the paper about how much more money they would make if they stayed in school and got their diploma

If you are running early talk about this:

1) Marginalism – Marginal Benefit vs Marginal Cost.

Sumo Wrestling: the 7-7 and 8-6 fight vs the other ones. The marginal benefit of the 15th win is very large for the 7-7 fighter. But the benefit to the 8-6 fighter is low. If they collude, the 7-7 fighter can pay the 8-6 fighter to cover the cost of losing the fight plus a little extra and both would be better off (from their perspective, but not the sport!)

Another Application: Should I eat the 3rd Big Mac?