Thursday, March 29, 2007

An Economic explanation for Sanjaya.

Why is Sanjaya Malakar, widely considered the worst American idol finalist in history, continue to get voted through? How can the worst singer continue to be loved by Americans?. I can think of a few economic explanations.

1) Rational Ignorance - This is actually an extension of rational ignorance. It's not exactly voters are rationally ignorant (they don't know), its more that the aggregate of voters don't care one way or the other who wins. Most of the viewers either watch the show without voting or vote once or twice for a good contestant. But Sanjaya has a whole army of people dedicated to voting for him 100's of times each.

I give you this summary from Howard Stern:

Howard started by saying he stayed up last night to vote for Sanjaya after “American Idol,” while Robin noted she called in for him as well, while Artie admitted he went to bed to take a nap, just to be ready to vote, but ended up sleeping until 4:30 a.m. and therefore wasn’t able to help the cause. Artie did point out, though, how angry he thought Beth was about Howard’s Sanjaya campaign when she spoke about it as a co-host on “The View” yesterday. Howard went on to say he started voting for Sanjaya at 9:05 p.m. and that he got through only twice. However, Robin added she was able to vote “30 or 40 times” when she called. Robin also commented she felt like Simon Cowell was speaking directly to Howard and his fans last night when he told Sanjaya that nothing he said about his performance mattered if “they” wanted him to win.

There are even computer programs set up to dial his number 100's, even 1000's of times a night.

2) Marginal Benefit/Marginal Cost - Some of the less crazy people may nevertheless be phoning up to vote for Sanjaya because the marginal benefit of seeing him look like below outweighs the cost of losing one of the better singers in the competition (who are, let's admit, not exactly the best this year). In other words, watching Sanjaya is fun and makes for interesting water cooler talk.

Credit and Consumption Theory

Related to the worries over the subprime sector is some criticism over whether subprime loans (credit) should be extended in the first place. One way to defend credit lending is to extend the theory of consumption that we learned last night. Think of consumers as rational maximizer's of their utility. Since they are rational they will want to maximize their consumption over their entire life. That is, it is unlikely that they will consume all their income in one period but rather attempt to spread it out over their lifetime. One way to do this is to save. If you earn $100 dollars you spend $80 and then save $20 a paycheck. You then use your savings for future consumption.

Another way to smooth your consumption out is to purchase large items on credit. That is, instead of saving you purchase on credit and pay it off slowly but surely. Perhaps some people have done this for the Flat Panel TV purchases (via a credit card or a 0% credit offer. I know I have with my latest laptop). But I would venture to guess that any of you who own a house have a mortgage. You purchased the home on credit and then pay off a portion of it each month, with interest.

Sub prime lending is an extension of this type of theory, except that it targets low income borrowers. So while there may be some people complaining that supporters of sub prime lending are voo-doo economists, we can answer them by showing how these type of financial innovations actually allow consumers to smooth out their consumption or use their lifetime income to make a purchase now. Granted, their are problems with this type of development, but in the end it will work out.

Update: The New York Times has a good article on subprime lending here.

The money quote (which I was trying to explain above):

These economists followed thousands of people over their lives and examined the evidence for whether mortgage markets have become more efficient over time. Lost in the current discussion about borrowers’ income levels in the subprime market is the fact that someone with a low income now but who stands to earn much more in the future would, in a perfect market, be able to borrow from a bank to buy a house. That is how economists view the efficiency of a capital market: people’s decisions unrestricted by the amount of money they have right now.

And this study shows that measured this way, the mortgage market has become more perfect, not more irresponsible. People tend to make good decisions about their own economic prospects. As Professor Rosen said in an interview, “Our findings suggest that people make sensible housing decisions in that the size of house they buy today relates to their future income, not just their current income and that the innovations in mortgages over 30 years gave many people the opportunity to own a home that they would not have otherwise had, just because they didn’t have enough assets in the bank at the moment they needed the house.”

Tuesday, March 20, 2007

How to think about shifts in Supply

Some of you made a mistake on the quiz because you assumed that an increase in supply would shift the Supply curve "up." Don't use the word "up" if it confuses you. Think about it in terms of right or left. If a new production technology comes out and it makes producing an item more efficient, this is an increase in supply, otherwise called a "rightwards" shift in the curve, like below.

Key terms

Key terms to know for the exam on Wed are the following (we went over this in class, so this should just be a refresher)

Opportunity Cost
Demand - how it slopes and the reasons
a) substitution effect
b) income effect
c) marginal benefit
Supply - how it slopes and the reasons
a) marginal cost per additional unit
a) negative
b) positive
Public Good
a) Price
b)Cross Price
c) Income
d) Supply
Asymmetical information
Moral Hazard
Rational Ignorance.

Thursday, March 15, 2007

In class Quiz 4

You can view a copy of last Nights Quiz here

The answers are


After I grade I will probably put an explanation to questions that the class as a whole did not get. I already went over 9 and 10 in class.

Interesting Article

This bloomberg article describes the counter-intuitive result of rational expectations (the theory that the market is forward looking).

Here is her argument

I decided to test my hunch that expectations aren't always rational or even informed by hard knowledge. My simple survey consisted of four questions designed to determine the public's inflation expectations and the Fed's credibility. I posed four questions to 40 randomly selected people near Bloomberg's world headquarters at Lexington Avenue and 59th Street in New York:
1) What is the current rate of inflation or, in response to a blank stare, how fast are prices rising?
2) What is your expectation for economy-wide prices over the next 12 months?
3) Do you know what the Federal Reserve is?
4) Do you know how the Fed affects inflation?
I don't pretend that my survey was in any way scientific or conclusive. It was eye-opening, to say the least. When one considers the territory (a high-rent district) and sample selection (I avoided people who looked as if they were more interested in picking my pocket while I was picking their brain), the results were even more discouraging than I imagined.

I have a couple of follow up questions

1) What is the price of gasoline? If you don't know the precise number, has it been going up or down over the past 2 weeks?

2) How much do you spend on your food bill at the supermarket? Has it been stable? If you don't actually pay for your food, ask your parents or whoever else does.

3) For those flat screen freaks like me, how much on average is a 40-42 inch LCD 720p TV? For the mall rats, how much is a pair of Gap pants or (for the girls) express sweaters?

Chances are you either know the answer to these questions or, if you don't, you aren't interested in these markets. But I would bet a couple of bucks that for the markets you do follow (gas), you know the basics. You don't have to know who runs the Federal Reserve to be rational on the prices that pertain to your life. In fact, given the way the Fed has operated over the past 20 years, you probably don't really need to be following Bernanke's every move.

Further, you don't have to accept rational expectations completely. You can be the type of economist who believes that portions of the markets (Financial markets, for instance) are fairly forward looking while the consumer market (goods market) is more adaptive (that is, changes their expectations in respose to stuff that already happened).

But as the author said, her study was not scientific.

Wednesday, March 07, 2007

Are you a free marketer?

Charles Wheelan has an interesting way of applying market imperfections (externalities in particular) here

Read his questions/answers to see whether you would count as a "free market advocate."

This part was funny

"Absolutely. If you believe in markets when they work well, then you have to understand how they need to be tweaked when they don't. If page 10 of any introductory economics text explains the wonders of supply and demand, page 12 usually explains that markets don't deliver an efficient outcome when eager buyers and sellers impose some harm, or negative externality, on a third party."

Actually in our textbook it is not. But I teach it that way.

Public vs. Private Goods debated

Arnold Kling explains (correctly, in my opinion) why the public good argument is more supportive of national defense than national health care.

Friday, March 02, 2007

Is the Natural Rate of Unemployment Dead?

Warning: This post is Macro related, and I am going to go a bit deeper than introductory level here. It is not "testable"

The WSJ ran an interesting article a few days ago on the Natural Rate of Unemployment, which those of you who took Macro will remember as being structural + frictional unemployment (the type of unemployment the Fed cannot eliminate with their policy tools. The idea being is that there is no getting around the natural rate of unemployment. Economist's old (old) idea was that inflation and unemployment were inversely related. If inflation rose, real wages would fall and businesses would hire more workers, lowering the inflation rate. The argument works in reverse as well. However, work done in the late 1960's by two Nobel Prize winners (Edmund Phelps and Milton Friedman) suggested that this relationship is not permanent because eventually workers would realize that their real wages were falling, negotiate higher wages and lead to a decrease in employment back to the natural rate. This view has, for the most part, been consensus thinking in macroeconomics since then since the theory ended up predicting the great inflation of the 1970s.

Recently, however, higher employment levels have not led to an increase in inflation.

But Fed officials have rethought that notion. They believe it takes a far bigger change in unemployment to affect inflation today than it did 25 years ago. Now, when inflation fluctuates, they are far more likely to blame temporary factors, such as changes in oil prices or rents, than a change in the jobless rate.

What is my opinion on this?

The natural rate of unemployment is related to potential GDP ( the vertical Long Run Aggregate Supply Curve). Thus any demand side stimulus will not have any impact on output, but rather be fed directly through to prices. This theory is likely true over a 1-2 year time span.

In the short run, however, there may exist a short run aggregate supply curve that is upwards sloping. If we accept this hypothesis for a moment (and I recognize that economists get into fist fights over the existence of this), then a boost in demand side stimulus will increase both prices and output.

What I think the article is trying to argue is that the SRAS supply curve has gotten flatter (more Keynesian) in recent years. Thus a boost in demand side stimulus has led to more of an increase in output than prices, in the short run.

However, the ONLY reason the SRAS supply curve has become more Keynesian is because the Fed has focused (and been more successful) on containing inflation. Workers are not as sensitive to upside blips in CPI anymore because they do not expect them to be long lasting. Their inflation expectation is unchanged. Workers are confident that inflation, on average will be around 2-2.5%, thanks to the Fed.

An attempt to exploit this Keynesian SRAS curve will result in the curve reverting back. Worker expectations will be for higher inflation because they are no longer confident in the Fed's ability to hold inflation at around 2%. Therefore, I agree with Edmund Phelps that

Mr. Phelps says the new thinking on the Phillips Curve doesn't change the implications of his Nobel-winning work. If the Fed never responded to higher inflation, consumers and businesses eventually would begin to expect higher inflation, and "then the game is up."

Economists need to keep the Lucas Critique of Macro Economics in the back of their minds. Just because a relationship is appearing in the data does not mean that the relationship is fundamental. If we cannot explain this relationship using economic theory, then we should, at the very least, be highly suspicious about our ability to exploit it. Remember the lessons of the 1970's.

Note: I grant that I was not alive in the 1970's. I was, however, very good at history in high school and college.

Elasticity, Pigou Taxes and a gas tax

This post at Marginal Revolution makes an interesting (and little understand) point that a tax on gasoline is likely to fall more on producers than consumers. Why?

The result is a simple application of the theory of tax incidence. The burden of a tax falls on those who can least afford to escape the tax. The world's demand for oil is inelastic but the supply is even more inelastic. What is Saudi Arabia, for example, going to do with its oil except sell it? The oil is already fetching a price well above cost so if there is a world tax on oil that's like a tax on land - Saudi Arabian land to be precise - and a tax on land is born by land owners not by consumers

Perhaps a graph can help us here (note this is something we will be discussing shortly, either before or after test 1)

You can easily understand this concept with words, however. When supply and/or demand is elastic, a change in price has an effect on quantity demanded (supplied) that is greater than the change in the price level (remember from class). If producers have a more inelastic supply curve than the consumers demand curve, they are able to pass on less of the tax onto the consumer because consumers will repond by cutting back on consumption (quantity demanded).
In the case of gasoline, consumers may be inelastic but supply is even more elastic (as is pointed out, what else is Venezuela or Saudi Arabia going to produce).