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.”

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)

Scarcity
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
Externalities
a) negative
b) positive
Public Good
elasticity
a) Price
b)Cross Price
c) Income
d) Supply
Asymmetical information
Moral Hazard
Rational Ignorance.

In class Quiz 4

You can view a copy of last Nights Quiz here

The answers are

A
C
C
A
A
D
A
B
D
D

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.

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.

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).

Blogs as a positive externality

We will be learning (probably later tonight) about externalities in the market place. Externalities are costs or benefits not captured in your basic supply and demand analysis (for example, pollution is a negative externality). But can economic blogs be considered a positive externality? Greg Mankiw muses here

Lastly let me note blogs such as yours and marginalrevolution.com provide positive externalities for those of us at teaching schools. I can check them and then alert my students to the "day's headlines." If you're interested, here is the link.

Am I underutilized as a blogger? Should I be paid because I offer a benefit not captured in the market? Hmmmmm....

Update: Wikipedia has a useful article on externalities. A positive externality would be graphed as follows:

As you can see, the market is underproviding this good because the private demand curve is lower than the social demand good. In reference to blogs, the private demand curve is where we are now. The social benefit of economic blogs, it is suggested, should be higher.

Please provide checks or cash payments when you have a moment.

Price Controls In Venezuela

I posted on ordinary price controls in Venezuela a little while ago. But a new development is occurring with the exchange rate, which is pegged.

Toyota's Venezuela unit will halt production for 15 days beginning March 1 because the government has not sold it enough dollars to import the components it needs, a company executive told Reuters.
The government of Venezuelan President Hugo Chavez has maintained strict currency controls since 2003 as part of his self-styled socialist revolution that has broadened government involvement in all aspects of the OPEC nation's economy.
"We are going to shut operations, we expect for 15 days, as of March 1," Toyota Venezuela Planning and Marketing Manager Felix Orta said in a telephone interview on Tuesday. "This is because we still have not received hard currency to produce the vehicles."

Venezuela pegs their exchange rate at 2,150 bolivars to the $ (meaning you need 2,150 Bolivars to purchase one dollar). However, the black market trades bolivars closer to 4,000 to the $. This means the government is keeping the currency stronger compared to what would exist on the open market (technical term: the bolivar is overvalued). Pressure exists for the Bolivar to weaken (i.e. more bolivars to purchase dollars) due to concerns over nationalization of key companies and worries over inflation, which is expected to push above 20%y/y tomorrow.

(The way to think of this is to think in terms of price. The Price of buying USD should be rising. It should take more bolivar's to purchase one dollar. It is not because the government has pegged the currency at a lower price (stronger) than it should be).

For a law abiding company like Toyota that does not go to the black market there is a problem in that there is a shortage of USD available on the market (since price controls are keeping the bolivar artificially strong). Hence they have to shut down production for (hopefully) 2 weeks.

I admit that the opposition to controls on exchange rate is not as unanimous as opposition to price controls on goods is. However, given the recent experience of Latin American currencies with pegged exchange rates (cough cough, Argentina, cough cough), maybe it should be!

Greenspan talks, the market walks

Greg Ip has an article discussing the recent Greenspan speech where he said a US Recession in 2007 was "possible."

Mr. Greenspan told an audience via satellite early Monday, Hong Kong time, that a U.S. recession was possible. "When you get this far away from a recession, invariably forces build up for the next recession, and indeed we are beginning to see that sign," he said, according to Dow Jones Newswires. "For example, in the U.S., profit margins... have begun to stabilize, which is an early sign we are in the later stages of a cycle."
Mr. Greenspan didn't say a recession was likely; indeed, he noted that most forecasters think it unlikely. He called the global environment "benign" and said there has been no "major spillover" from the contraction in housing activity. His comments appeared more aimed at questioning the conviction of many investors that because each of the last two expansions each lasted a decade, this one will, too.

The fact that Greenspan did not say a recession was likely is a major point. Many traders were passing around headlines that did in fact say Greenspan thinks 07 recession likely. Nevertheless, it is interesting that Greenspan still has this much influence on the markets, even though he retired over a year ago.

Reason # 20309434 why you shouldn't day trade

I don't think to many day traders foresaw this today

Read Yahoo for a recap of what happened today.

My response: I think it is very hard to blame this whole thing on expectations for a slowdown in growth. There was a large market panic component (technical language: contagion) associated with the drop off. For example, it is very hard to explain a 200 point drop right at 3pm on market fundamentals. Rather, it is triggered by computers programmed to sell once the index falls below a certain level. Still, it makes for a headache heading into tomorrow.

Where should you invest your money?

I have been getting a couple of e-mails from current and former students asking for some investment advise (these are the ones who paid attention and realized I was a financial analyst by trade). The short answer to any questions is: you are young, put your money in a diversified index fund.

Usually you will get bad advise on investing if you listen to the talking heads on CSPAN (especially Jim Cramer). You will also, apparently, get bad advise listening to Suze Orman as well.

You basically want to avoid 2 things.

1) You don't want to be too conservative. Suze Orman invests all her money in low risk municipal bonds. Bonds indeed have little risk, but they also have a lower return to compensate. by putting all your money in bonds over a long period you will miss out on financial gains that you could have enjoyed. Remember if you invest your money in stocks over the long haul, risk is minimized to just overall market risk. Take a look at the S and P over a long period of time. (or the Nasdaq. Google has an excellent resource with some graphs here.

2) Don't be stupid aggressive. You are young so you should be weighted more heavily into stocks than bonds. But this does not mean you should dump all your money into GM or GOOGLE or whatever. Granted, there is the potential for large gains, but by putting all your eggs in one basket you increase your risk. (Remember return is positively related to risk....and cliches are sometimes accurate).

Rather, you should put your money in a broad index fund that contains a mix of stocks and bonds. The diversification eliminates the risk that you get burned if Google goes under or if oil collapses (rises). You can still enjoy large gains as well. More than Suze Orman.

One caveat: Do not be lured into the trap that if you put your money in the hands of a money manager you will earn a larger amount of money than if you put your money into index funds. Read this for some sobering coffee

A second caveat: The specific weighting of stocks and bonds depends in part on how young you are but also on how long of a time frame your investment is. Generally, the younger you are and the longer you plan on investing, more more you should weight towards stocks (greater risk) than bonds (lesser risk). Time lowers the overall risk level.

Is this why more people don't go to college?

I thought this post was apt considering that we are on vacation this week.

"In technical terms, my claim is that our currently high return to education is a compensating differential. As demand for educated labor has gone up, the marginal college student has rapidly become a person who hates school, and has to be paid a ton of compensation for the pain and suffering of listening to people like Brad and me for hours on end."

Hopefully this is not my class!

Class Cancelled

Class for tonight has been cancelled due to the bad weather. Watch the price of tissue boxes, they may be going up on increased demand......

Price Controls in Venezuela

In case you didn't think Supply and Demand had any application to the real world, read this

"President Hugo Chavez's administration blames the food supply problems on unscrupulous speculators, but industry officials say government price controls that strangle profits are responsible. Authorities on Wednesday raided a warehouse in Caracas and seized seven tons of sugar hoarded by vendors unwilling to market the inventory at the official price...

Shortages have sporadically appeared with items from milk to coffee since early 2003, when Chavez began regulating prices for 400 basic products as a way to counter inflation and protect the poor."

Hyperinflation

If you want to read about life in Zimbabwe, a country that is currently experiencing hyperinflation, click here.

One point here is that prices are rising faster than wages can adjust.

"The trigger of this crisis — hyperinflation — reached an annual rate of 1,281 percent this month, and has been near or over 1,000 percent since last April. Hyperinflation has bankrupted the government, left 8 in 10 citizens destitute and decimated the country’s factories and farms.
Pay increases have so utterly failed to keep pace with price increases that some Harare workers now complain that bus fare to and from work consumes their entire salaries. "

And to provide a source as to why even moderate levels of inflation, say 5-10% can be problematic, click here.

News Articles that use Economics

The WSJ has two good articles that employ the principles of Economics this weekend.

First is an article on the economics of modelling, where they describe plummeting wages for models due to a sharp increase in supply (this is something we can model using the supply and demand graph.)

Second is an article on the rising prices of parking meters, which are being used to provide an incentive for less parking around peak parking spots as well as greater churn. This dovetails nicely with incentives and quantity demanded. Remember: The higher the price the less quantity demanded there will be. They also work in the concept of elasticity when they say that the quantity demanded is still very strong despite the increase in prices, suggesting that demand is inelastic.