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.

The Ethics of Greed

The Economist reports this week that CompartamosBanco, a Mexican bank, is making a killing in micro finance. Trail blazed by Nobel Peace Prize winners Muhammad Yunus and his Grameen Bank, micro credit loans very small amounts (a few hundred dollars) to entrepreneurs in developing countries. Usually done by nonprofits, CompartamosBanco is a notable exception.

Lending to those in developing countries is expensive because the social, legal, and physical infrastructure is so lacking. The Mexican bank spends about a $152 a year per client. No wonder its interest rates run 79%--usury to most developed countries. But the customers gladly accept the rate. CompartamosBanco has nearly one million borrowers--a far cry from Grameen Bank's seven million but impressive nonetheless.

CompartamosBanco's success encourages new entrants risking their own money (seven new competitors in Mexico alone) while Grameen continues to rely on subsidies and donations. As the economy of scales takes into effect, interest rates fall (seven years ago it used to be 115%) and yet more people rise out of poverty. Not only is this yet another example of how profit seeking helps us all, it reminds us of one of the strange lessons of economics: the only way to get low prices is to allow people to charge high ones.

In Praise of Spectators

Diane Rehm agreed with a caller today that speculators are to blame for rising oil prices. Her guests (J. Robinson West, Athan Manuel, Stephen Power, Chris Oynes) offered no serious dissent and often repeated the concerns that these investors are acting irrationally, irresponsibly, and at the expense of the people.

Yet we should celebrate their acts. By pushing oil up now rather than later, we sooner get an accurate price meaning we sooner get adaptation to that price. As everyone on today's show recognized it takes a long time to move oil from the ground to the pump. Without spectators oil would move up slowly and sometimes dip down, making investments in production far less likely.

It is the job of an investor to gather all the information from all over the world (including places you wouldn't expect) and come up with an unbiased prediction. It's how they earn their livelihoods. That doesn't mean they never panic or are subject to emotions. We're all human after all. But their irrationality is much more rare than the uninformed panic of the voting public.

Pillsbury ND: Where the Marginal Vote Matters

Pillsbury North Dakota is a small town. So small that in a recent election for mayor no one voted, not even the candidates. Here is a case where voting definitely would have changed the election, although it might not have changed the outcome of the town rule:

The council meets about five times a year, Brudevold said. Members are each paid $48 annually, and a good portion of that goes for doughnuts at the meetings or gas to get there, he said.

Pachelbel For the Modern Rocker

Art Carden wonders if this is art. I bet it is, but I ultimately don't care. It rocks.

Welcome To the Jungle

Paul Krugman argues America's food quality is what it was a century in the time of Upton Sinclair's The Jungle. A lax FDA (and its industry cohorts) is to blame for the recent "tainted spinach, poisonous peanut butter and, currently, the attack of the killer tomatoes."

Economics is a strange discipline because it really just requires people to take lessons they follow in their everyday life and apply them consistently. The lesson here is that we don't want zero risk when it comes to food. Do you boil every glass of water that comes your way? Demand tests on meat that you get in a restaurant? Grow your own food? Avoid eating at authentic restaurants abroad? Failure to do these things puts us at risk but we gladly accept it. Avoiding that risk is too costly: zero risk is not optimal.

Ensuring consistency does a lot for a good argument. Krugman scoffs at the free-market argument against the FDA--that "private companies would avoid taking risks with public health to safeguard their reputations and to avoid damaging class-action lawsuits." And yet he warns that a lack of regulation for ensuring solid food safety is not "just bad for consumers, it’s bad for business." So firms won't ensure safety on their own because they are too greedy but if the food quality is poor then it's bad for business? I bet he doesn't take a UV light to restaurants, either.

People Are Not Passive

Are there limits to growth? That's what people tell me while citing higher food prices, a planet of 6.7 billion, and cities often exceeding ten million. "There are too many people," they say. What nonsense.

Eleven years ago, Nobel Prize winner Norman Borlaug wrote that with current technology we could feed 10 billion people (a population we're not going to reach until around 2050). With 21st century technology we can surely feed more. Alex Tabarrok reminds us that US land use for crops has been steady from the late 1930s to the late 1980s, a trend likely continuing right now.

Whenever people make note of the resource usage of developed countries or the "carrying capacity" of the planet, they always ignore that people are not passive. We are not infants, sucking thoughtlessly away at the tit of the world. We create more than we consume. Our inventions exceed our immolations (at least in today's world). For every mouth to feed there is a mind to think, hands to work, and feet to move. We cherish our lives, our wealth, and our hope for a better future and we will lash out with every appendage to maintain our true and steady course.

Are there limits to growth? Probably, but we're not going to encounter then in our lifetime. Or even in our grandchildren's grandchildren's lifetime. History is replete with doomsayers and prophecies of cataclysm. And as seductive as their wild-eyed claims are, as invincible as they seem, they're always wrong. Never forget that.

When To Recycle and When To Not

There are four plastic bags near the front door of my parents' house each stuffed with a few weeks worth of newspaper bags. This is my mom's latest attempt to save the world. In her infinite foresight she's gathering these bags to "keep them out of the landfill." She plans to send them back to the newspaper company so they can reuse them. I somehow doubt they will.

Plastic bags are tremendously cheap, evidence in that are giving them away to customers. They still cost the company something but I doubt it'll be worth sorting through the bags to reuse them. Recycling's expensive and often not worth the time and effort. Though in some cases, like recycling cans, it is. People are willing to pay for the savings it brings. Note soda cans are one of the few places you are paid to recycle.

Recycling reduces space used in a landfill but so what? Is landfill space really so scarce that this is worth it? If it is, why aren't we charged per bag or per pound thrown out? Part of this is due to the city-run industry but the a bigger factor is that landfills aren't hurting for space, particularly out here in Iowa.

If you're not being charged to throw it out and if no one's willing to compensate you for your time it's not worth recycling. See a past post on this subject here.

Asbestosis Gone Wild

A court in New Jersey recently ruled Spanish citizens can now sue Owens-Illinois and other asbestosis-related firms based on exposure from U.S. ships. This does not have to translate into actual harm from the exposure. Like most asbestosis litigation, post hoc ergo propter hoc works just fine in the court of law. Indeed, the even possibility of harm is enough to cost Owens-Illinois. To punish firms so overwhelming cheapens our society in two ways.

First we get too little asbestosis. Asbestosis is not evil and its optimal amount is not zero. It's useful and safe in many areas of our society. (Indeed, its wide application is why asbestosis litigation never seems to go away.)

Second we lose good ideas in the process. This is not limited to opportunity costs coming from litigation-related expenses. The possibility of similar attacks can destroy a development before it even starts. If asbestosis litigation can completely ruin an industry, companies are less willing to engage in ideas that they think could be twisted down that same route. Sometimes this is good but the level of asbestosis litigation likely makes firms so risk averse that the net effect is undesirable.

This second issue is critical but often ignored because this lost opportunity is never seen (be definition). It makes it difficult to estimate the true cost of asbestos litigation. But if the technological and economic progress in the past few decades is any indication, that cost is a lot higher than most people might think.

Order At A Bargain

This week on EconTalk Allan Meltzer poetically reminded us that

A country that won't experience a small recession will end up having a big one.

Free markets are messy things and it won't be perfect all the time. Nothing will be perfect all the time. We must remember that slowdowns and corrective recessions are the price we pay for the benifits of a dynamic and enriching society. And we're getting a damn good deal.

If You Build It, They Will Ride

Paul Krugman claims Americans face a paradox as we adapt to higher oil prices and away from our suburbia lifestyle.

Public transit, in particular, faces a chicken-and-egg problem: it’s hard to justify transit systems unless there’s sufficient population density, yet it’s hard to persuade people to live in denser neighborhoods unless they come with the advantage of transit access.

This is not really a big problem if you remember your marginalism. Extend a single rail line through a residential area. If oil prices are as high as everyone says they are, people will move to that area. Apartment buildings will replace townhouses (and if you're smart, you bought some of that land around the rail before the construction was announced).

Firms solve this problem all the time. Wal-Mart constructs its stores in the middle of no where. It doesn't fret about the low population density (it prefers it, actually) because it knows people will come to it. Same goes with any large scale project that people will want. Assuming, of course, they want what you're building.