Tuesday, July 31, 2007

Diddy On Asymmetric Information

I've heard that P. Diddy (or just "Diddy" if you are up on the culture) recently put a wanted ad for a new assistant on You Tube. After getting countless responses he's had to make people be aware of other requirements, among them a college degree.

The casual observer might wonder why an assistant to a rap mogule would ever need a college degree--what does Shakespearean literature or chemical theory have to do with getting cheesecake at three in the morning? But my students would know better. Diddy is making use of both screening and signalling.

A college degree is a signal to others that the holder is smart, mature, and dedicated (as well as possessing Diddy's lofty requirements of being able to read and write). Knowing that such a degree genuinely conveys this critical information, Diddy has decided to screen out anyone who doesn't have a degree. It is not that someone who doesn't have a degree isn't automatically smart, mature, and dedicated (and literate). Indeed, he is surely excluding valuable people by making this requirement. But his time is scarce and a degree requirement is an easy way to eliminate a great number of candidates.

The other screening he does (watching all the video applications, later phone interviews, etc) will be made much easier. And as the number of candidates narrow, the signals that they must send will become much more potent than being able to read. But these two common strategies to combat adverse selection will surely play a prominent role in Diddy's search.

Don't Panic

Yesterday on NPR I heard an interview with an author (I didn't hear the name) about his new book (I didn't hear the title, either). What caught my attention was that the author implored listeners and readers to reduce the amount of resources people use. That grocery stores give away plastic bags for free should be a crime, he said. Most economists have a different view: don't panic.

For example, one should ask why do stores give away plastic bags? They certainly didn't get them for free--why give them away? The answer is pretty obvious (customers demand it) but the lesson is not. Plastic bags are clearly cheap (if they costed a dollar each, I'm sure most stores wouldn't give them away) and because they are so inexpensive the resources that made them are relatively abundent. (Plastics take very little oil to make and tend to be made out of the part of crude oil that's low quality.) If some component of plastic bags becomes more scarce, the price of bags rises and people adapt. Stores might charge people for bags, creating an incentive for customers to bring in their own cloth one (something this author suggested everyone do even though this scarcity is not yet occuring).

People have a very hard time understanding that as long as people have an incentive to innovate, we will always be able to solve new resource problems that come our way. That has been the great trend of human history. Every time doomsayers claim we've reached a limit to technology, they've always been proven wrong. The author noted that all animals when they've used up their resources start dying out. He proposed that since humans are no different more countries should start exploring a one child policy to reduce "overpopulation." But people are fundamentally different than animals. We have the capacity to create (farm, invent, etc) the resources we need for our survival. This fundamental difference insures us against ourselves. Mandating we all conserve now takes away from that capacity and diminishes the incentive (fewer inventors and less profit opportunity). The best thing you can do for the environment and the future of humanity is, in the words of a great book, Don't Panic.

Thursday, July 26, 2007

US Government Sends Sheep to Death

The U.S. Fish and Wildlife Service might be setting aside 400,000 acres of habitat for the endangered Sierra Nevada bighorn sheep. The land will be a de facto commons--officially protected but in practice much too hard to enforce. I'd wager that this graceful animal is in for a rough time: with only a handful of rangers protecting it and legions of men with guns wanting to kill it before their competition does, it appears the US government is setting up a classic tragedy of the commons.

But this historically disastrous set up is not the only problem the sheep faces. One of the reasons it's numbers fell was because the herds would intermingle with domestic sheep and disease would pass from the farm animals to the wild ones, causing mass deaths. With nobody owning the bighorns, nobody was there to care what the sheep did to them (though there was certainly those that were watching their domesticated herd for signs of problems). In this case, the sheep farmers were externalizing a cost onto the wild. But nobody owned the wild so nobody noticed. Not until it was too late.

Instead of preventing the average person from wanting to protect these animals, the US government should look into allowing to own, kill, and profit from them. That way there will be legions of those making sure the bighorn stays around for a long time, instead of legions trying to beat each other to the last one.

Socially Optimal

Ever since the green revolution there's been a great deal of talk about the need for firms to be "socially responsible." I'm honestly not sure what that means and I'd venture most people don't, either. Perhaps it means that companies should not pursue only profits but also, say, protect the environment even if it's very costly. That might make conventional environmentalists feel good inside but not the rest of society, who has to shoulder those costs. What people often don't recognize is that pursuing profits can protect the environment; one just needs to adjust the incentives.

The Star Online, for example, applauds the growing trend that electronic companies are adding recycling programs to reduce waste. But what is strangely missing from the article is the fact that firms have reasons to recycle beyond making their customers feel good or in the pursuit of some good feelings/PR. The real issue is that often people (and this usually extends to firms, at least in my experience) are charged a flat rate (or no rate) every month or year to throw all their garbage away. Sending three tons a month to the dumpster costs exactly the same as sending one ton (my students would recognize this as a fixed cost). It costs essentially nothing for a firm to send those two tons to the landfill. But recycling those two tons is expensive--sorting, cleaning, and special trips is costly. Is it any wonder that widespread corporate recycling is newsworthy?

Instead of municipal dumps charging a flat rate for throwing things away, why not charge per ton? This landfill in Salinas Valley does (though it notably charges nothing for electronics, what the article in the Star focuses on). That way when a landfill becomes crowded, the price will go up and people will recycle more. But when a landfill is mostly empty, the price will be low and we can avoid those costly activities recycling demands (such as the second or third truck that has to drive around the city). But no matter what, we can depend on firms being socially responsible.

Monday, July 23, 2007

Below the Minimum Logic

During the YouTube debate for the Democratic candidates a woman asked if the candidates support a higher minimum wage. At the same time, most of them strangely agreed that they would work for the minimum wage.

What escapes most people that support such legislation is that the minimum wage hurts poor people. Let me say that again: the minimum wage makes it more expensive for employers to hire those that have few skills. The argument seems absurd at first until you realize that firms want to make money. Those that have the hardest time getting a job will not be helped by a law making it more expensive to hire them. Those that need the most help in our society--the very people that minimum wage seeks to help--are those most harmed by it.

Sunday, July 22, 2007

Monopolies and Economies of Scale

A student asked me Saturday about the difference of economies of scale and high fixed costs concerning the justification of monopolies. Monopolies originate in many ways and two of those ways--costs decrease as output increases for the entire market (also known as a natural monopoly) and requiring a lot of investment to get started--seemed completely entangled to him. I sympathize--it's hard to imagine an industry that has economies of scale but low fixed costs. Aren't they really the same thing?

In truth, they are distinct, though subtly so. A natural monopoly can provide for the whole of the economy at decreasing costs. Even if a firm could overtake the fixed costs of entry, the existing firm could undercut the challenger. And even if we assume that the reason the existing firm has economies to scale for the whole market is open to anyone, competition will not last. The demand is simply not large enough to support more than one firm and eventually only one company will remain. True, under rare circumstances it may not be the monopoly that existed beforehand. But a monopoly will naturally appear.

Monday, July 16, 2007

Restricted Trade Talks Continue

According to a U.S. trade official, the Malaysia-U.S. free trade talks are now expected to be completed in June of 2008. No, that's not a typo. These talks--already over a year old--could go on for another year. That's how we know these talks really aren't about free trade.

Free trade--or the absence of government restrictions on international exchange--does not require two years to negotiate. It doesn't require two minutes of negotiation. But each government's interest in avoiding true free trade drags these talks on for years.

It's all so wasteful. Eliminating barriers to trade not only enhances the well-being of whom you trade with, but it helps you as well. It is rightly very easy for New York City to trade with Los Angeles. Why shouldn't the Big Apple trade as easily with Malaysia?

Broken Chairs

I hope my micro students can answer the following:

Suppose a deli owner values a $20 chair at $100 and plans to buy a $20 pair of boots which he values at $50. Now suppose a child breaks the chair and the owner must replace it. Calculate society’s economic profit of the incident, indicating if it was better for society or not that the child broke the chair.

Friday, July 13, 2007

The Surplus That Surrounds Us

I've noticed that people (in general) have a strange bias when they measure wealth. They tend to count only physical objects. This is not an inherently bad way to count happiness (it's certainly better than counting just currency). But merely counting objects runs the danger of missing another aspect of wealth: utility (aka satisfaction or happiness). If two people each own the same computer, but one enjoys it much more than the other, one is wealthier than the other, even though they have the same amount of stuff.

In my class's first homework assignment, I asked them to indicate a time when they experienced what economists call consumer surplus, or utility minus the cost of getting a good. The point is we experience consumer surplus all the time--most goods we buy are ones we would have been willing to pay more for, but didn't have to. Rarely is the price we pay our maximum price.

Measuring wealth is a very difficult thing to do. Wages is a convenient quick and dirty way to do it and works pretty well until people start thinking countries should stock pile gold bricks instead of importing cars. Stuff/cargo/consumer goods is generally how economists define wealth. But in rare cases, such as the computer example, people focus only on stuff and ignore consumer surplus. Two things you sort of want is not strictly better than one thing you really want. The mechanism of the free market tends to sort out such preferences and make sure everyone gets the most consumer surplus they can. But it's worth pointing out that everyday we are surrounded by wealth we cannot see or touch.

Wednesday, July 11, 2007

Insecure Incentives

Political agents have a notoriously hard time admitting they've made a bad decision. The basic incentives they face mean honesty is punished if it ruins a perception. Companies sometimes face this world--they are often fearing for the integrity of their brand--but it usually takes a back seat to the truth. Customers aren't stupid and bad have to be temporary. The political world has no such profit motive and thus no such reality check.

Enter a recent test by federal inspectors revealed TSA a dismal failure in security.
In one test, TSA inspectors hid the components of a fake bomb in carry-on luggage that also contained a bottle of water. Passengers are prohibited from carrying containers holding more than three ounces of liquids, gels or aerosols through airport checkpoints.

The screeners at Albany International confiscated the water bottle but missed the bomb. In all, the inspectors slipped four banned items through the main checkpoint during the test, sources said.
On the release of these failures Ann Davis, a TSA spokeswoman, defended the organization
We don't discuss the results because they tend to paint an inaccurate picture of the competency of our work force. The tests are designed to be incredibly difficult and TSA does anticipate a fair level of failure.
Which is sort of like Google saying "Well, the test we have to ensure the security of our information are hard so it's ok if we don't pass. It's not like hackers are smart."

I know I'd feel safer.

HT: Mike Mills

Sunday, July 08, 2007

The Civilization of Wal-Mart

San Diego's looking to keep Wal-Mart out of its--er--small town, to be holding a ballot next year. According to an editorial by Gerry Braun, some have suggested that the ballot read: "Would you undermine civilization as we know it in exchange for some cheap groceries?" One must wonder what those voices propose for other ballots.

There is no doubt that the presence of a Wal-Mart changes a community. Some stores disappear. Other stores take their place. But undermine civilization? It certainly changes civilization, but the same can be said for cars, the Internet, and cell phones. "Undermines" suggests something sinister. Now you might complain that the changes are undesirable (as Robert Putnam claims changes in technology are), but one must wonder: if the result is so awful, why are people voluntarily making that change happen?

At its core, economics is the study of choice. That study requires that we recognize people do not choose simply between the ideal and the imperfect. It is not a matter of either utopia without Wal-Mart or an apocalypse with it. Otherwise, no one would shop at Wal-Mart. Clearly there is something to gain. The continued success of the company (as well as the continued attempts to remove it as an option) suggests people like the civilization it creates more than the one they would otherwise have. The only thing truly undermining civilization is the misguided thinking that what people actively pursue shouldn't be allowed if others don't want it.

Saturday, July 07, 2007

Supreme Elasticity

Today in microeconomics we discussed how people respond to price changes. The recent Supreme Court ruling on if manufacturers could sell to retailers on the condition the retailers sell at that price. We could not, however, exactly recall what the existing law was. And we were confused why a manufacturer would want to rob a particular retailer of flexibility.

As it turns out, the court overturned the existing rule that retailers could not be locked into a price. (I mistakenly thought the reverse was happening.) The case was brought by Leegin Creative Leather Products who wanted to establish a minimum price on its goods sold. These seems to confirm one of the more plausible arguments mentioned in class concerning why a maker would want high prices: to maintain the brand. I doubt it would look good for a maker of "creative leather products" if that creativity saw its way to the discount bin.

And yet we should remember that most goods are elastic: manufacturers generally want to keep prices low because the increase in quantity demanded more than makes up for the lower price. Revenue increases. Let us also remember that this is an option, not a universal decree. Manufacturers don't have to set a retail price. I doubt many will because retailers would be less inclined to buy goods where they have to agree on such a control. (I imagine only high-end quality manufactures will be truly upset if their high end goods hit clearance.) If those leather products aren't selling, the store has to throw them away to make room in the warehouse. They can't cut losses and would be much less willing to take a chance.

The laws were originally couched in anti-trust logic. One cannot allowed one company to have pricing influence over the other, contract or no. Consumer groups are worried by the ruling and think the price on all goods will immediately rise. Such conclusions might have a bit of truth to them but they forget the basic substitute that all goods have: you don't have to get it and that includes the retailer.

HT: Matt Huber

Tuesday, July 03, 2007

Tell Me the Secret of the Hurricane

Tonight during my introductory economics class, I made mention of the story of Hurricane Fran after it swept through Raleigh, NC in 1996. In the aftermath of Fran, power was out, trees were down, and the heat was devastating.

In nearby Goldsboro four guys decided to rent a refrigerator truck, loaded it with ice and chain-sawed their way to the city center. Once there, they charged the locals $12 a bag--more than 10 times what it cost them to buy it. Anti-gouging laws took effect and the police arrested the men. (The trucks were impounded and turned off. The ice melted.)

We discussed how the pricing mechanism will sort out those who want ice for cold drinks and those who want it for their insulin or to ward off heat stroke. Prices do that. They are not perfect, but it is far better than a first-come-first-serve basis, where the fast or the healthy or the merely well placed get ice, leaving nothing for those that need it.

But the most powerful element of the pricing mechanism is that it creates the incentive to increase the supply and bid it down. At $12 a bag, others in Goldsboro have a reason to send more ice there and sell it for $11 or $10. Still, that's a high price and encourages yet more to come: $9, $8, $7. Lower, and lower. It's a strange paradox in economics: The only way to guarantee low prices is to allow sellers to charge high prices. But when you understand the role and power of incentives, it makes perfect sense.

For the full and deeper story, see this EconTalk.