Knowing Is Half the Battle

Asymmetric information is a phrase economists use to describe scenarios when one party has more information than another. Examples are abound: actors know more about the quality of movie they're selling than movie goers; workers know more about how they spend their time than their bosses; borrowers know better than banks how likely they will pay back the loan.

One of the problems that erupt in asymmetric information is adverse selection: when someone chooses something that started off being a bad idea, such as eating a sandwich that the waiter dropped on the floor. But because the customer doesn't have the same information the waiter does, they take a bite. Hence the name--people will select something that isn't in their interest to select.

Many of my students, however, read this as when people choose things that are bad for them, such as driving drunk or smoking. In this latest homework assignment, people would even mention "everyone knows that such and such is bad for you." Then it's not asymmetric information and adverse selection doesn't apply. If you know smoking's bad for you and you still smoke, you are including the health risk as a cost. People might regret this choice later in life, but it's still not adverse selection. Just because you don't agree with their choice doesn't mean its a problem.

The other major issue from asymmetric information appears after the choice is made: moral hazard. When people make an agreement and then one of them figures they can take the other for a ride, that's moral hazard. There's an element of treachery here hence the name: deciding to take advantage of another's trust presents an ethical quandary for the person to overcome. National health care is a classic example. If you give free health care to everyone, you can bet people will visit the doctor a lot more even if it's unnecessary. They'll be less careful, too. More people would smoke.

It's sometimes hard to tell the difference between adverse selection and moral hazard: was this person planning on betraying me or did it just occur to them after I stuck me neck out? But they are real issues that occur in your everyday life and economists have noted several ways people mitigate these problems (especially when hiring and lending). Hopefully, with just five hours before their final, my students understand their application as well.

Decrees from the Bishop

Bill Bishop on The Daily Show tonight frets over people choosing to live with like-minded people or read like-minded sources. Bishop is missing the bigger picture: this "Big Sort" is the product of a wealthier people choosing to live the life they've always wanted to. Past generations didn't like their personal beliefs challenged by their neighbors; they just couldn't afford to move away because of something so small.

It would be nicer if people were interested in challenging values they dare not challenge. But being wrong is a cost they shoulder alone. Unless, of course, they vote: a problem that decreases as the scale of government retreats. Go ahead and be irrational. Just don't make me be irrational with you.

Knowledge is Disperse

This week's Economist notes

And just 6% [of Americans] view the economy positively. Yet many Americans combine despondency about the big picture with personal contentment. More than 80% say they are satisfied with their own circumstances. Even more are satisfied with their jobs.

In other words, the concerns about the economy are overblown.

Skeptics of the positive outlook should tread carefully. One of the core rules of economics--knowledge is disperse--tells us to trust the local claim over the big picture perception. What is an individual more likely to accurately estimate: their personal circumstances or the budgets and incomes of millions of strangers?

Coase on the Coast

Russ Roberts muses about applying Coase to traffic accidents while he's in California. Pedestrians, he notes, run wild in a way they wouldn't in DC because in traffic accidents the driver of the car is usually to blame. What a wonderful coincidence that we covered Coase on Monday in my principles of microeconomics course.

Coase notes the problem is not (in the case of traffic accidents) the car when it hits the pedestrian. The problem is that both the pedestrian and the car tried to occupy the same space at the same time. Remove one of these elements and you remove the problem (like all externality issues).

In brief, the question we should focus on is who is the least cost avoider--who is in the better position to avoid a collusion? Given the car extends well beyond what most grew up maneuvering in (ie, their body) and cars move much faster than people, pedestrians are the least cost avoider. The legal action should be to make pedestrians liable for being hit by cars.

This is not, of course, meant to be a hard fast rule. If you're hit while on the sidewalk or curb or crosswalk, that would still be the drivers fault. Again, the least cost avoider holds: it's less costly for drivers to stay in the street and watch lights than for pedestrians to be forever vigilant about where every car in the vicinity is. But in cases where a pedestrian crosses the street without warning, blame should lie with them.

Remember, economics is not about good guys and bad guys. It's about a bunch of people facing costs and benefits.

Have You Hugged a Spectator Today?

A student once asked me if I thought lower gas prices would help the economy. "Not inherently," I said. "So what should they be?" I responded: "They should be at the price that accurately reflects the conditions of the market."

Economists know genuine growth doesn't come from high wages or cheap oil. It lies in efficiency because that allows us to do more with less. And the best way to get efficiency is to get everyone acting appropriately based on the conditions of the market. Thus the importance of accurate prices.

As Megan McArdle explains, this is where speculators come in. Because they believe gasoline is going to be more expensive, the price of oil today is higher than it would be and the price of oil later is lower than it would be. This allows us to better prepare for the future and adapt more smoothly than we otherwise would.

Speculators aren't "gambling." They aren't even "guessing," as McArdle suggests they are. They're estimating. They're smart people working very hard to get reality right--that's how they get paid--and they've independently agreed that prices are just going to get higher. Thank your spectator because now you'll more smoothly consume gas and you won't be caught off guard by a sudden jump in prices. Now you can plan.

HT: Mike Mills

The Island of Doctor Hayek

For the third homework assignment I asked my principle of microeconomics students the following question:

Suppose anyone could legally practice medicine regardless of their educational background. Keeping the ideas of emergent order in mind, explain the implications of such a change. Would this change be desirable or undesirable? Explain why or why not.

The vast majority (about 70%) claimed this would be, "of course," disastrous. It reminded me of F.A. Hayek's observation:

Much of the opposition to a system of freedom under general laws arises from the inability to conceive of an effective co-ordination of human activities without deliberate organization by a commanding intelligence.

To see what I mean, here's a sampling of the responses:

...there would be a significant decline due to a lack of knowledge ad resources to apply appropriate medical treatment. This would cause a decrease in recovery, trust in the medical professionals, an increase in malpractice suits, and inappropriate treatment...

The quality of healthcare would plummet. The doctors [sic] offices would be jam packed with people who may not even need medical attention.

Without medical schools people would learn how to practice medicine directly from other doctors....without the proper tests and knowledge from medical school many doctors may be ill-informed and overall perform more poorly than they would of if they learned all the rules and regulations from medical school.

There's no doubt, as I mentioned to the class, that decentralized order is messy. In this case, people will surely suffer and even die by the hand of someone with less knowledge than a typical doctor. But so much of the chaos mentioned here wouldn't happen. The danger of medical malpractice and the desire to get a good doctor will make true quacks few and far between. A "jam packed" waiting room would encourage entry or prices would increase. Medical schools would still exist and, because good doctors are still in demand, people would still attend. More might attend because you don't need to finish to practice medicine.

Most of the reasons people go to a doctor are routine concerns. Do you really need a veteran doctor to give you a physical? Or tell you that you have the flu? You're either wasting his time or spending too much on him. As Arnold Kling argues, this "Crisis of Abundance" is one of the big reasons health care costs are so high. You don't need experts on every little cough and sneeze.

Yet students rarely mentioned any benefits such deregulation would bring and some mentioned the lower salary of doctors as a negative (though in reality only the bad doctors would see their wages fall, as per the compensating wage differential, a concept that was covered in the question right before this one).

It's not obvious if this institutional change is desirable or undesirable. But the relative metric is comparing the costs of the risk and additional suffering thanks to quacks with the benefits of getting the same job done for less. And since the costs are temporary and rare (bad doctors don't last long) and the benefits are permanent, I personally lean to the favorable interpretation.

Think Before you Blame

Richard Bitner appeared on The Daily Show tonight promoting his new book, Confessions of a Subprime Lender. Jon Stewart wondered why the people who have the toughest time paying a mortgage are charged the highest rates. Bitner's reply--that they are riskier--is correct but unsatisfying.

We want it to be higher for them. High payments discourage those who have little chance of paying them back. It not only reduces default risk, it generates the incentive for banks to offer these loans in the first place.

America's financial system is not perfect, but it makes a lot more sense than it appears when you take a moment to think about it.

The Joker's Lesson on Free Trade

When I saw the midnight showing of The Dark Knight I doubt my fellow moviegoers were learning something about free trade. I didn't see the lesson at first but once I noticed it, it became painfully obvious.

***Spoiler Alert***

At the climax of the movie the Joker scares the population of Gotham to evacuate, leading to two ferries packed with people trying to escape the city. The Joker places a bomb on each ferry and then gives the two captains the detonation device for the other bomb. Ferry A can blow up Ferry B and vice versa. They have fifteen minutes to decide what to do or the Joker will blow them both up.

This is obviously a prisoner's dilemma game with the standard Nash equilibrium (the captains pull the triggers at the same time, killing each other). But that's not what happened. Each crew was overwhelming in favor of blowing the other up (confirmed by a vote), but no one was willing to actually do the deed. In other words, there's a very real morality cost that altered the payoffs. People would rather die than kill someone but they would rather have someone else kill than die.

If you look at polls Americans are mostly against free trade. (Last week's Economist cited only 33% of Americans think free trade is good for the economy.) Yet that's not how they act at the market. A choice between a cheap import and a more expensive domestic leads to people favoring the import. We don't of course need government action to limit free trade--people could just refuse to buy imports. But, as in the ferries, no one is willing to shoulder the cost of doing it themselves. They want someone else to do the deed.

Bryan Caplan notes there's a big difference between voting and buying. In buying you internalize all the costs and benefits of your actions. In voting such considerations are externalized onto someone else. Your gut feelings of xenophobia, survival, or old ideas are a lot easier to hold on to. But when faced with the true costs of your action, revealed preferences are quite different than the cheap talk from a voting booth.

Inferiority Complex

Upon grading principles of microeconomics homework I come across too many students (ie more zero) incorrectly identify an inferior good as a low quality good. This is emphatically not always true (though a correlation probably exists). An inferior good sees fewer buyers as incomes rise. Here's a few examples of inferior goods that are not low quality:

-Bikes. There's a lot of high quality bikes out there, but, as China reminds us, increasing incomes sees fewer bikes bought.

-Personal education. Most of the time people go to school to get a degree so they can earn more money. Of course if you're already making a lot you're less likely to hit the books. Bill Gates never did finish his undergraduate degree but I doubt I'll see him in class. (Note this is personal education. The opposite it true for the education of, say, your kids.)

-Studio apartments. There's nothing inherently low quality about a studio apartment. Indeed the amenties and location could be tremdously nice (in the middle of downtown, hardwood floors, new appliances).

Quality is a relative concept, of course. This makes refering to "low quality" items in an absolute context sloppy thinking. A 42-inch television is low quality compared to a 50-inch but no one's saying the 42-inch is an inferior good. An inferior good is not "good" or "bad."

In of World of Constant Opportunity Costs....

After grading the first homework of the semester semester, I thought I should take some time to clarify a bit about our old friend, opportunity costs. Most, I'm pleased to say, understood the concept (at least so far as the question is concerned). But most is not all.

Here's the question:

People often claim that hurricanes are good for the economy they affect because it creates a great deal of economic activity. While citing (and defining) opportunity costs, offer a challenge to this argument.

Opportunity cost occurs in two ways in these disaster scenarios: was the disaster economically beneficial and is it worth cleaning up?

The first question should always be answered with a no. If the disaster did not happen, infrastructure would still be intact and people would still have their lives and health. Thus resources spent to replace items or mitigate pain would instead be used to enrich an existing society. It's strictly better. Instead of losing a house and paying to rebuild it, you can keep the house and pay to expand on it (or buy a boat, or send a kid to college, or whatever).

The second question's answer is less certain. Perhaps it's not worth rebuilding. If a tornado destroys an obscure ancestral home and restoring it would benefit us by $1 million, but we could build a new school that would bring a benefit of $10 million, restoration is clearly not worth it even if we would be better off had not the building been destroyed. Just because it was worth having does not mean it is worth replacing.

People understand this distinction all the time. If a board game is destroyed in a flood, the family will certainly count it as a loss (having a game is better than not having one, all other things equal). But we wouldn't be surprised if they don't leap to replace it with the same game. They might buy a different game or buy something else entirely.

This distinction--the opportunity cost of a disaster and the opportunity cost of fixing--resolves the seeming paradox of why economists sometimes regret destruction while simultaneously refusing to repair damage. If we can stop disasters cheaply, that's great. But they are almost as unavoidable as opportunity costs and letting ruins stand is not always bad.