Markets, Incentives and a Krugman (et al.) Fail

Pity the poor teenager taking an AP Economics course whose father is an economist. Especially when the local school district has adopted a text that is based on Paul Krugman’s Economics (3rd ed., coauthored with Robin Wells). Even more especially when the father-economist has a fundamental disagreement with much of what Mr. Krugman has become since surrendering his academic credentials for political punditry. Yeah, that’s my lucky kid.

So of course, I had to thumb through the text. I suppose I shouldn’t have been too surprised to find on only the third page of Module 1 a gross error in explaining the trouble with command economies. After explaining the failed history of command economies, the text asserts (p. 3):

At the root cause of the problem with command economies is a lack of incentives, which are rewards or punishments that motivate particular choices.

Where to start? How about with the simple fact that incentives always exist, no matter the type of economy. And there were plenty of incentives in the former Soviet Union (the textbook example of a command economy–literally in this case). I remember the late Nobel Prize-winning economist James Buchanan sharing the story of his visit to Moscow shortly after the fall of the Soviet empire during which he was surprised to learn of a market for burned out light bulbs — because people could use them to steal working light bulbs from their workplaces when they couldn’t get light bulbs in the stores. People responding to incentives. It’s The Basics 101. The problem with command economies is not a lack of incentives–but a lack of incentives that are based on the wants of consumers themselves and a lack of incentives for innovation or efficiency. In short–the absence of the incentives created by a free market economy.

More importantly, the focus on incentives misses the point in a way that has significant implications for what the text goes on to say about economic policy. At the root of the problem with command economies was the lack of information available to decision-makers about the wants and desires of an entire population of individual consumers with different tastes and preferences and about the conditions of scarcity and desires in dispersed local markets across the society’s economy. As F.A. Hayek (another Nobel Prize winner) explained, the fundamental role of markets is to discover and reveal information based on the complex interactions of individuals across product types and geographic space.These interactions result in prices that reflect the relative scarcity and value of goods across society. Those prices create incentives, and those incentives are fundamentally important in guiding individuals to use their resources in ways that innovate, create value, and serve consumers. But the incentives are secondary–derived from the information discovery role of the market that cannot be replicated in a command economy.

Why is this such an important distinction? Because of the way the text goes on to describe the objective of policy making. After (fairly accurately) explaining how prices create incentives, the authors state (p. 3):

In fact, economists tend to be skeptical of any attempt to change people’s behavior that doesn’t change their incentives. For example, a plan that calls on manufacturers to reduce pollution voluntarily probably won’t be effective; a plan that gives them a financial incentive to do so is more likely to succeed.

The implication? All we need to do is create incentives (implicitly, in the form of taxes, fines or subsidies) to create financial incentives for manufacturers (or people) to do what we want them to do. But this line of argument ignores the more fundamental question of determining whether the plan makes social or economic sense in the first place. What is the economic basis for whether we uses fines or subsidies and how large they should be? At what point, if any, would doing nothing be economically more efficient than doing something? By taking away the fundamental information function of the market and jumping immediately to incentives, we skip the whole messy discussion of the information requirements by legislators, bureaucrats and policy makers in coming up with “the plan” to begin with. All we need to do is trust the omniscience and beneficence of policy makers to know what the “right price” is–and to set arbitrarily the incentives to get the outcomes we want. But that’s exactly why command economies fail.

The root problem of a command economy is not that there are no incentives, but that there are socially inefficient incentives. The incentives are socially inefficient because it is impossible for a central authority to know the value individual citizens place not only on existing goods and services, but on the latent value of potential goods and services that can only be discovered by innovation and experimentation–and a central planner cannot think beyond her own imagination in the realm of possibilities. And it’s not only true of Soviet-style planned economies, but of any central decision-making authority–including the US federal government–even in the context of a heavily market-dominated economy.

Note: AP Economics students (and teachers), remember….the correct answer on the test may not be the right answer in reality. Answer the questions from the textbook based on the information in the textbook. But in your real life as a consumer of information and participant in the market place of ideas and politics, be sure to get to the fundamentals rather than the superficial.

TOTM Symposium Honoring Josh Wright

My once-and-future colleague at Truth on the Market, Joshua Wright, resigned this week from the Federal Trade Commission. While a Commissioner, Josh was a voice of economic reason that shaped significant policy decisions and illuminated shortcomings. TOTM is hosting a blogposium this week on the legacy of Josh Wright’s tenure at the FTC, including some significant players in the area of law and economics. It’s definitely worth checking out and following along.

How Federal Student Loans Increase College Costs

A recent paper by researchers at the Federal Reserve Bank of New York shows how increases in federal student loan programs–intended to make college more affordable–actually increase the cost of college. As with other markets, when the supply of money available to pay tuition increases, the price of tuition rises. The abstract reads:

When students fund their education through loans, changes in student borrowing and tuition are interlinked. Higher tuition costs raise loan demand, but loan supply also affects equilibrium tuition costs—for example, by relaxing students’ funding constraints.To resolve this simultaneity problem, we exploit detailed student-level financial data and changes in federal student aid programs to identify the impact of increased student loan funding on tuition. We find that institutions more exposed to changes in the subsidized federal loan program increased their tuition disproportionately around these policy changes, with a sizable pass-through effect on tuition of about 65 percent. We also find that Pell Grant aid and the unsubsidized federal loan program have pass-through effects on tuition, although these are economically and statistically not as strong. The subsidized loan effect on tuition is most pronounced for expensive, private institutions that are somewhat, but not among the most, selective.
But the effects don’t stop with rising tuition. This increased demand for college education also exacerbates income inequality by inflating the supply of college graduates. (See this piece by George Leef for a full overview of both the NY Fed paper and the income inequality effects).
It’s not rocket science. It’s pretty simple supply-and-demand stuff, actually. No matter how good the intentions, policies that ignore these effects tend to do more harm than good. In this case, generous federal student loan programs not only lead to increases in tuition that result in even higher loans, but reduce the earning power of graduates (on average) and decrease their ability to repay those loans. A pretty perverse circle of effects indeed.

Tesla, Dealer Franchise Laws, and the Politics of Crony Capitalism

About a year ago I posted a couple of pieces (here and here) related to auto dealers’ attempts in various states to shut down Tesla’s direct-to-consumer distribution system. Dan Crane (Michigan Law) has a recent paper on the issue available at SSRN. Below is the abstract:

Tesla Motors is fighting the car dealers’ lobby, aided and abetted by the legacy Detroit manufacturers, on a state by state basis for the right to distribute its innovative electrical automobiles directly to consumers. The Tesla wars showcase the important relationship between product innovation and innovation in distribution methods. Incumbent technologies may block competition by new technologies by creating legal barriers to innovative distribution methods necessary to secure market acceptance of the new technologies. While judicial review of such special interest capture is generally weak in the post-Lochner era, the Tesla wars are creating new alliances in the political struggle against crony capitalism that could contribute to a significant re-telling of the conventional public choice story.

Bye-Bye Bookstores

When you read a story about a local bookstore going out of business, you kind of expect the culprit to be lost business to on-line retailers (e.g., Amazon), e-book sellers (e.g., Amazon’s Kindle or Apple’s iBooks), or maybe, just maybe, a large brick-and-mortar bookstore (e.g., Barnes & Noble ). And while it may make one sad, at least one can understand the consequences of competition.

What you wouldn’t normally expect is that the store’s loyal customers and local citizens voted to shut it down–without even knowing it. But apparently that’s exactly what happened to the beloved Borderlands Bookstore in the Mission District of San Francisco according to the Bay Area’s ABC 7 News. As a result of the voter-approved increase in minimum wage, the bookstore can’t afford to remain open and has announced it will close at the end of March.

“You know, I voted for the measure as well, the minimum wage measure,” customer Edward Vallecillo said. “It’s not something that I thought would affect certain specific small businesses. I feel sad.”

The San Francisco Board of Supervisors seemed to have expected it though, but they forwarded the initiative to the voters nonetheless:

“I know that bookstores are in a tough position, and this did come up in the discussions on minimum wage,” San Francisco supervisor Scott Wiener said.

Apparently Wiener takes comfort that it was the will of the people, with 77% voting in favor of the increase. But this just really points out a problem in what is often a democratic-wannabe, spineless-republican form of government. Legislators pander to interests and ideas they know are bad for the economy, but pass the buck on responsibility by “letting the voters decide”.

And while Jonathan Gruber was mocked for saying Obamacare supporters had to hide the details because of the stupidity of the American voters, time and again local (and state-wide) referenda on things like minimum wage give credence to his claim. The average voter either has no clue about how markets really work or is tremendously myopic in thinking through the consequences of the policies they support…most likely, both. (Although, if voters were more economically competent, Obamacare supports would have had even more reason to hide the details.)

So the chickens have come home to roost in San Francisco. If you go there, plan to leave your heart…and your money…but don’t plan on enjoying the beloved local bookstores. Or the many other small, local businesses that can ill-afford an arbitrary (in this case, 50%) increase in their labor costs. Because that’s what minimum wage laws do.

The Moral Heart of Economics

That’s the title of Edward Glaeser‘s Economix blog post in the New York Times today. In it, Glaeser points out that beneath the mathematics of modern economics is a fundamental moral core of individual freedom. It’s a great read for understanding that economics is more than a set of mathematical models and calculations. The conclusion (below) captures it well, but I suggest you click through and read the whole piece.

Economists are often wary of moral exhortation, as many see the harm so often wrought by arguments that are long on passion and short on sense. But don’t think that our discipline doesn’t have a moral spine beneath all the algebra. That spine is a fundamental belief in freedom

The Price and Quality of Wine, Part II

After my previous post on the relation between the price and quality of the top red wines and the top wines under $50 in Vivino’s 2014 “People’s Choice” rankings, I got curious about the price-quality relation for the top white and sparkling wines. And I must say, i was a bit surprised.

For the Top 100 white wines, there is actually a moderate correlation between the quality rankings and prices; with a correlation coefficient of 0.51. Price isn’t a perfect signal for quality. In fact, the seventh best white wine cost only $27, just more than half the average price of $52.48. But price and quality are at least somewhat related overall, with the top five wines ranging from $244 to $404 and 21 of the last 25 wines below $50. As expected, the variance in price relative to the average was less than for the reds (std dev of 63.84).

However, if you’re looking for sparkling wine, it’s much safer to let price be your guide in judging quality. Price and quality rating have a correlation coefficient of 0.715, suggesting a fairly strong correlation between the two. This is completely opposite the case of the reds (recall, the price-quality correlation for those was just 0.053). And while the range of the Top 100 sparkling wine prices was considerable, from a high of $476 to a low of $10, the variance was lower relative to the average than for either the reds or the white (std dev = 95.779, average = $126.78)

Now, there are some caveats one should make about inferring too much from such a simple comparison. But the basic lesson is pretty straight-forward: if you’re shopping for quality sparkling wines, let price be your guide–at least in an ordinal sense. You’ll have to judge for yourself how much the additional quality is truly worth (i.e., is the quality of a top 10 wine five times better than the quality of the lowest 25, as their price difference would suggest?). If shopping for whites, price is a bit less reliable a guide, but not wholly unrelated. If shopping for reds, however, be careful about reading too much into the quality of the wine from the price on the bottle.