Proposed SLC Infrastructure Projects

The nation's mayors have made their request for federal stimulus dollars. You can view their report here.

There are 8 Utah cities that list projects here: Brigham City, Herriman, Holladay, Murray, Orem, Provo, Salem, and Salt Lake City.

I didn't realize we had a Salem; seems to be down in Utah County. (They want a sewage treatment plant.)

The reasoning behind the stimulus package is to get jobs created. Construction is a good candidate for this sort of package, because the technology is fairly simple, and we can put people to work quickly.

Salt Lake City makes the biggest request among Utah cities, with almost $800 million in projects. The big dollars are for trains --- Sugarhouse trolley, Trax, other stuff.

The strangest SLC request? $350,000 for an Iron Sponge at the Water Reclamation Plant. What the heck is that? I thought sponges were made of, well, ... I have no idea what sponges are made of.

Utah Demographics

I hinted in the last post about Utah's interesting demographics. Everything I've learned about that subject comes from Pam Perlich --- Here's a link to her latest report on how Utah's population is changing.

Utah Salaries

A reporter asks about salaries for professional occupations in Utah.

First, some facts:

Here is data on average salaries for some professional occupations in a few western metro areas. This is from the Bureau of Labor Statistics' Occupational Employment Statistics Survey. You can get to this data here.

Accountants and Auditors
Phoenix $55,050
SF Bay $72,340
Denver $67,450
SLC $60,570

Computer Software Engineers, Systems Software
Phoenix $79,220
SF Bay $101,490
Denver $90,550
SLC $78,720

General and Operations Managers
Phoenix $99,060
SF Bay $123,850
Denver $107,880
SLC $95,140

Financial Managers
Phoenix $89,020
SF Bay $130,370
Denver $112,330
SLC $94,590

Compensation and Benefits Managers
Phoenix $68,550
SF Bay $106,820
Denver $92,480
SLC $93,660

You can see that for the most part, salaries are lower than SF and Denver. But higher, mostly, than Phoenix.

I think there are a few reasons for this:

(1) Composition of employers. I think there may be fewer corporate headquarters here than in Denver and SF, so on average managers here may not be as high on the corporate ladder.

(2) Our area is quite differentiated. What I mean by this is that people tend to have strong opinions one way or the other about Utah. For many of us, there is no place else we'd want to live. For individuals who value the strong LDS community or the very easy access to skiing, there is almost nowhere else on earth that offers comparable amenities.

For others, the cultural conservatism of our area can be off-putting. Think here of a non-religious, wine connoiseur who doesn't ski. For such individuals, our area might not be a good match.

What does this mean in terms of the labor market?

It means there is a set of workers that is going to live here even if wages are low. It is also means there's a substantial set of workers who wouldn't move here even if wages were much higher.

This means that local demographics matter a lot, or at least relatively more than in other parts of the country. If we have excess demand for managers, then wages will rise... but this increase in managerial wages won't draw workers from around the country to the same extent as it would in a less differentiated region. Similarly, if we have excess supply, wages will fall, but this might not push workers out of Utah to the same extent as it would in other locales.

Interesting, the demographic trends in Utah are quite different from those in other states, due to high fertility rates and the like. Pam Perlich is the U's expert on this stuff.... Maybe she'll guest blog for me someday on this. (Are you out there Pam?)

Talk on "The Economy"

I'm giving a talk downtown tomorrow on "The Economy". Kind of a big topic for 50 minutes, but I'll do my best. Here's a link to my slides.

Sugar Bowl

There is some economics at the end of this post... Just wait.

Utah is going to the Sugar Bowl, where they will have no shot at winning the NCAA football championship, despite the fact that they may finish the season as the only team without a loss.

The NCAA says it supports sportsmanship. But is it sporting or fair to tell a team that it cannot win the championship, no matter how well it performs on the field? Of course not.

The real reason we don't have a college football playoff can be found in the work of one of the 2007 Nobel Prize winners in economics. Roger Myerson and Mark Satterthwaite's paper on bargaining shows that two parties can fail to reach an agreement even if it is common knowledge that gains from trade exist. The necessary ingredient is asymmetric information.

That's exactly what's going on here. Everyone --- everyone --- in college athletics knows that a college football playoff would be a huge moneymaker. Huger (is that a word? if not, it should be) even than the current bowl system. It's common knowledge that a playoff could make everyone better off.

We don't have it, for the following reason. Suppose the current system nets $9 Zillion for the BCS conferences, and $1 Zillion for the non-BCS conferences. Suppose everyone knows that a playoff would result in at least $10 Zillion, but that nobody knows exactly how much.

The extra money needs to be split among the schools. But how? Should the non-BCS schools get half? Should they get a 10%? Should they get a payment that's proportional to their current revenues?

It's simply not clear how this extra should be split. The BCS conferences want a large share of it. So do the non-BCS schools. So no one is willing to make a deal.

Auto Bailout

JB points out that much of the discussion about the auto bailout centers on promises by the car companies that they'll innovate to produce more fuel efficient cars. It's related to my earlier point that ExxonMobil might not be best able to make investments in renewable energy.

One interesting wrinkle in the auto business is that innovation in fuel efficiency complements existing auto technology. What does this jargon mean? The innovation we need is new, more fuel efficient engines. But those new engines then need to be paired with wheels and tires and doors and steering wheels and all the other stuff that's in cars.

This makes the innovation game tricky. Detroit is really good at internal combustion engines. This suggests that Detroit might not be that good at developing technologies that replace internal combustion engines.

But Detroit is also really good at doors and wheels. And this means that anyone who does develop an economically viable electric drive train will want to combine that innovation with Detroit's skill at wheels and doors and other car stuff. An electric-car entrepreneur would be (a bit) at the mercy of Detroit in terms of capturing the value of this innovation.

To put it back into jargon, an electric engine would substitute for Detroit's knowledge of internal combustion. This suggests that Detroit might not be good at developing electric engines. But an electric engine would complement Detroit's knowledge of wheels and doors. This suggest that Detroit might be good at developing electric engines.

So it's not clear to me whether our car innovations are going to come from Detroit, or from non-Detroit entrepreneurs like Tesla. There was an interesting 60 minutes piece on this a couple months ago.

My colleague Lyda Bigelow studies this sort of stuff, using historical data from the auto industry in the 1920s.

Black Friday

I was watching the 9 pm news on Fox last night. Sandy Riesgraf was doing a live shoot from a Wal-Mart parking lot in Taylorsville (?) talking about Wal-Mart's Black Friday deals.

Wal-Mart is offering to match any competitor's price on any item Wal-Mart sells. Sandy was telling us how great this is for consumers.

But is it?

Think here about how such price-matching commitments --- which are commonly referred to as "most favored customer clauses" --- might affect the incentives for Wal-Mart's competitors to offer discounts in the first place.

Firms discount because they are trying to steal business from rivals. But if Target, for example, knows that customers will just take Target's advertisement to Wal-Mart and Wal-Mart will match the price, then Target doesn't gain when it offers a discount. It hasn't stolen any customers from Wal-Mart as a result of offering the discount.

So the only effect of Target's discount is to give a lower price to the customers who would have shopped at Target anyway. No business-stealing happens, and so there's no benefit to offering a discount.

So, they don't. This means that consumers don't benefit from most favored customer clauses... But you have to think all the way through firms' strategic choices to see why.

Do Incentives Work?

In a November 20 New York Times Op/Ed, economist Dan Ariely argues that pay-for-performance incentives --- of the type given to commonly given to CEOs through bonuses --- simply don't work. He bases this claim on a number of experiments in which subjects are asked to perform simple tasks. Some subjects are paid more when task performance is better and some are paid the same regardless of performance. In many such experiments, performance is actually worse when pay is tied to performance.

A group of banking executives were, apparently, not convinced that Ariely's "incentive plans cannot work" conclusion would hold in the real world. Ariely offered to perform experiments on the employees of these banking firms to settle this "real world" question. But it seems this kind offer was declined.

Fortunately, however, a large number of executives have allowed economists to examine this question. Researchers in the expanding field of Personnel Economics have performed dozens of real experiments in real firms, on real workers, changing real pay plans, with real money at stake. These are actual controlled experiments where researchers randomly assign workers to "treatment" and "control" groups, just like you would do to test a new drug against a placebo. Accounts of these experiments are published in the leading peer-reviewed economics journals.

Here are some samples: Stanford economist Ed Lazear --- currently on leave from teaching while serving as Chairman of the President's Council of Economic Advisors --- worked with auto-glass installer Safelite Glass to structure a pay-for-performance plan for windshield installers. Randomly selected groups of workers were shifted from hourly pay plans to piece-rate plans in which installers were paid based on how many windshields they installed. The result? Productivity rose. About 44 percent.

Oriana Bandiera, Iwan Barankay and Imran Rasul tested a similar hypothesis on managers at an English fruit farm. At the farm, fruit-picking workers were paid piece rates, but managers received hourly wages that were independent of overall output. When managers' pay was shifted to being performance-based, overall fruit picking productivity rose. How could this be, given that managers themselves picked no fruit? Bandiera and colleagues show when managers were paid a simple hourly wage, they spent their time helping the employees they liked. When managerial pay depended on overall output, managers showed less favoritism, and instead seemed to allocate their "help" activities more productively. As with the Lazear study, the economic magnitudes of the impact of incentives are substantial.

There are many such studies. The broad conclusion is that, in real firms, incentives change behavior. Ariely's argument --- that tying pay to measured performance won't lead to improvements in measured performance --- is therefore not supported by the available real world evidence.

So, incentives work, right? Well, perhaps. If we take the question of "Do incentives work?" to mean "Do incentives improve performance on measured dimensions?", then I think the consensus of personnel economists is that it does. But if we instead interpret this question as "Does the use of incentives lead to higher profits or better organizational performance?", the answer is less clear.

Here's why: Incentives motivate employees to shift effort toward improving performance on _measured_ dimensions. Performance on dimensions of the job that are harder to measure is likely to slip as a result. If, for example, a banking executive is paid based on his firm's earnings for this year, then he may work to raise this year's earnings even if doing so worsens the firm's long-term prospects. If the performance measure fails to capture everything that a firm wants an employee to do, then it's not necessarily the case that using strong incentives will increase profits.

Measuring performance for bankers is hard specifically because these individuals make many short-term decisions that have long-term economic consequences. And it is problems with devising appropriate performance measures that contributed to our recent credit crisis, not Ariely's claim that using incentives does not improve measured performance.

The broader danger of Ariely's point, however, is that it gives academic credibility to those who would want to limit the ability of firms to use pay-for-performance incentives. Providing incentives for bankers is hard, and it may well be appropriate for government to play a role in determining how such incentives are structures. But the case for such regulation rests on problems with performance measurement and externalities from the financial sector on the rest of the economy, not on the unsupported-by-real-world-evidence claim that incentives just don't work.

Health Care Reform

The broad outlines of likely national health care reform are taking shape, and it's looking like there will be an attempt to do something roughly along the lines of the Massachusetts plan that was put in place by then-Gov Mitt Romney.

Two features of the likely plan are closely linked. The first is so-called "play-or-pay" taxes. These are taxes on firms that choose NOT to provide health insurance for employes. The second is a subsidy for working poor (people who don't qualify for Medicaid but still have trouble affording insurance).

So why are these linked? When people think about taxes, they think about "government revenue." But we should also think about "incentives" when we think about taxes. The role of the play-or-pay tax is to make it costly for firms to drop the employee health insurance they currently offer.

To understand why firms would drop, we need to think about why firms choose to offer insurance in the first place. Firms offer insurance because it's a form of compensation that employees value. If a firm drops insurance, some employees would likely quit their jobs, and try to find a job with an employer who did offer insurance. The "cost" to a firm of dropping insurance is the cost of the lost employees.

Now think about how this changes once the government starts offering a subsidy. A firm that drops insurance would find that some of its employees could apply for the subsidy. These employees might not quit. This means the "cost" to a firm of dropping insurance will be lower.

And if the cost of anything goes down, people do more of it.

So, we might worry about more firms dropping insurance after the subsidy goes in. This would increase the amount of people who have to be subsidized, and raise the price tag for taxpayers.

The play-or-pay tax is there to make it less attractive for firms to drop coverage.

One potential problem though: This tax will raise the cost to firms of hiring workers. For firms that don't offer benefits, the cost of hiring a worker is pretty much just the wage. If this tax is implemented, the cost will be the wage plus the play-or-pay tax. And if the cost of hiring a worker goes up, firms will hire fewer workers.

The trick will be to give firms incentives to not to drop insurance, while at the same time NOT giving them incentives to stop hiring.

Sissies

Reading today about ExxonMobil in the Sunday Business Section of the New York Times.

The article (print version) is titled "Green is for Sissies."

It's interesting for students of management (like me) for two reasons. First, it gives a nice account of Exxon's "corporate culture" (and take Fin 6250 if you want to know what I think about that...) and promote-from-within policy.

Second, the article quotes some who are critical of ExxonMobil for not investing more in alternative energy.

While I do think we (as a society) need to find cleaner ways to produce energy, I think it's not obvious we should be expecting ExxonMobil to lead us there.

There's ample evidence that it's difficult for firms to invest in products that destroy their own markets. Go read Clayton Christensen's book "The Innovator's Dilemma" for more on this.

From society's point of view, investments in alternative energy should be made by whoever is going to make the best investments. If that's not ExxonMobil, then let's not bash them for not investing. Instead, let's tell them to be the best hydrocarbon company they can be, and hope that they distribute their profits to shareholders, who can then invest those funds elsewhere. And if the returns for investing in alternative energy are high, that's exactly where ExxonMobil's profits will flow, through reinvestments made by the the firm's shareholders.

(And please don't read this as an endorsement of everything ExxonMobil has done.... I'm saying ONLY that perhaps we should perhaps not expect them to be best able to invest in new technologies).

Anyway it seems like ExxonMobil is doing exactly this --- trying to be efficient in producing hydrocarbons, and then returning profits to shareholders for reinvestments.

The key to getting better energy technology is to make sure the returns to investing in alternative energy are high. And how do we do this? Tax carbon.

Utah's Four-Day Work Week

One of the article discussion assignments I received from this year's MBA class dealt with the four-day work week.

As you may know, over the summer Utah Governor Jon Hunstman announced that state agencies would henceforth be open only four days per week. Rather than five eight-hour days, state employees are now asked to work four ten-hour days. The idea is so save energy and commuting time.

One of the most interesting things about this to a human resources economist has been watching the reactions.

One the one hand, we saw some state employees complain bitterly about this. On the other hand, some people who don't work for the state were completely mystified by the state-employees' complaints.

I'm paraphrasing here, but some state employees said "You're wrecking my life! Now I need ten hours of day-care!"

Some folks who don't work for the state said they'd love it if every weekend was a three-day weekend, and so state employees should stop whining.

The economic point that's illustrated here is self-selection.

What does this mean? First, note that individuals all have different preferences. Some of us like three day weekends. Others like eight hour days and longer work weeks.

Second, note that employers offer different bargains to their employees. Some employers offer lots of flexibility in scheduling. Others don't. Some employers offer a job where there's never any overtime. Other's don't. Some employers offer lots of vacation time. Others don't.

So which employees work where? Well, generally speaking employees are going to try to find the employers who offer a bargain that they like. Many people are willing to accept somewhat lower wages in order to get other workplace features that they like. So employees are trading off wages with other workplace features, and also trading off workplace features against each other. Employees self-select; that is, they choose where to work based in part on the job characteristics that an employer offers.

What does this mean for the four-day work week? Let's think about what sort of job characteristics the state was offering prior to last summer. State work is steady (obviously I'm generalizing here, but go with it). There's not much of a chance at overtime. Employees come at 8 and leave at 5. It's not the sort of job where there are going to be a lot of work-related intrusions into personal life. Some people really like that, and so we'd expect the state's work force would be disproportionately composed of people who value that sort of predictability.

So it's no surprise that such a sharp shift in hours would lead to problems.

The more general lesson for management is that employees are going to self-select to any workplace feature you offer. As a result, your employees are going to like any feature you offer much more than the average person likes that feature.

To give a concrete example, suppose some people really like three-day weekends and some don't. If your firm offers three-day weekends every week, then your firm is going to attract a workforce of folks who really value the long weekends. This effect makes it hard to change workplace features once your workforce has self-selected to them. If your workforce signed on specifically because they want a three-day weekend, they're going to be really mad if you change --- much more so than a randomly selected person would be.

This gives rise to a sort of inertia in workplace features.

This sort of self-selection is actually one of our best recruiting tools for faculty at the David Eccles School of Business. For the most part, our school pays below-market wages. That is, many of our faculty could earn a higher salary at working at another university. So why do faculty stick around? Many professors really value the workplace features. And by workplace features I mean things like proximity to world-class outdoor recreation, or proximity to the LDS community.

Pink Post-It Notes and Education Reform

In an editorial on November 7, the Salt Lake Tribune suggests using students'
evaluations of teachers to determine, in part, teacher pay. The
reasoning goes like this: We're all former students. And most of us
can recall a handful of teachers who really impacted our lives. So
students can identify excellent teachers, and this means student
evaluations will be a good measure of teacher performance.

This reasoning is not quite right, and I'll try to explain why in a
minute. But first I'll explain why a business professor, of all
people, might know something about this. It's because this problem
--- how to reward good job performance by employees --- is faced by
pretty much all organizations. Economists study financial incentives,
and so business economists have put a lot of thought into whether ---
and if so, when --- financial incentives work inside organizations.
I've been trying to help MBA students here and elsewhere think through
these issues for nearly 15 years.

The Tribune assumes that if a measure is correlated with good job
performance, then it's a good performance measure. This is not
necessarily true, for the following reason: Once a performance measure
is used to set pay, employees start to think about ALL of the possible
actions that might make the measure go up. And in some settings,
employees can do lots of things to make measured performance improve,
but that aren't actually associated with good work.

Here's an example from the private sector: 3M Corporation, inventor of
the ubiquitous Post-It Notes, used to require that each of its
operating divisions earn 25% of its sales from "new" products, i.e,
products that had been introduced in the past four years. The firm
felt that innovation was a key driver of success, so this measure was
in place to drive employees to innovate. The result? Employees
innovated. But employees also began to think about all the possible
ways to achieve the 25% target. One division found that changing the
color of an existing product was enough to qualify as a new product:
thus, Pink Post-It Notes were born. When a new CEO took the reins of
3M in 2001, he dumped the 25% rule, citing high costs of employees'
attempts to boost the measure without actually innovating.

Of course, 3M's goal is to generate profits, while our education
system's goal is to generate, well, "education." Does the same
reasoning apply?

Let's ask: Are there actions a teacher can take that might boost
student evaluations, but that we wouldn't call "good teaching"? How
about offering an easy class? High grades? Light homework? Lax
classroom discipline? Movies in place of boring readings? Pizza
every Friday?

The fact is that learning new things can be hard. And while there are
some teachers who can inspire us at the same time they drive us to new
achievements, these are likely the exceptions rather than the rule.
Unless we're very certain that students know what's best for
themselves, we may not want to pay teachers based on how well they
cater to student desires.

More broadly, performance measurement issues are central to education
reform. Measuring the job performance of educators is hard, and as a
result the financial incentives for outstanding job performance have
historically been weak. But tying teacher pay to poor measures of job
performance --- ones that reward "good teaching" but also actions that
we wouldn't call "good teaching" --- might be even worse.

I agree with the Tribune that rewarding good teaching is a worthy
social aim. But any plan to do so must carefully weigh the benefits
and costs of the selected measures of teacher performance.

Stimulus Question

A former student writes "The government issued the economic stimulus package a number of months back. I am wondering your opinion as to whether stimulus packages like this actually work and have a positive effect?"

Checks sent to individuals (like what we saw earlier this year) don't help the economy that much. The reason is that individuals tend to save the money, not spend it.

Spending money on bridges and roads helps more.

Bang for your Stimulus Buck

(See also the "commentary" links at the bottom of this page.)

My view is that we can shorten the recession by spending money on roads and bridges. The problem now is that (1) people are losing jobs, (2) this causes them to spend less, which (3) causes more people to lose jobs. It's a downward spiral that feeds on itself.

If we give money to everyone, then a lot of that money goes to people who haven't lost jobs. They won't spend it, so that money won't help break this cycle. Public works will help more, because that money will go to create construction jobs. The money will go to people who would otherwise be unemployed. These people will keep spending instead of stopping, and this will help break the cycle.

Fiscal Stimulus and Renewable Energy

Here's a question I've heard twice in the last few days.

If the federal govermnent is going to spend money on a fiscal stimulus package, why not spend it on investments in renewable energy?

So let's break this down. A fiscal stimulus package is likely in the works. It will entail (probably) investments in infrastructure: Roads, bridges, schools. Stuff like that. The idea is that we're in a period of falling employment. The falling employment means people have less disposable income. So consumer expenditures fall. Which causes firms to cut back more on production and investment. Which means more falling employment. It's a downward spiral.

The idea behind the stimulus is this: Use road construction to put some people back to work. These people, who would otherwise be unemployed, will take their paychecks and spend them. This spending will help keep businesses afloat, and will mean fewer job losses elsewhere in the economy. That is, building roads will mean, for example, fewer layoffs at Ford.

But why roads? Why not spend the money on sources of renewable energy?

The answer is this: We know we need roads. We know there are bridges and schools that need replacing. So, the payoff to investing in roads and bridges and schools is known. In other words, it's not hard for the government to answer the questions of "What roads should we build?" Or, "What schools should we replace?"

With renewable energy, it's much less clear (I think) which investments will pay off and which will not. As a result, it would be more difficult for the government to determine what to invest in. And before you say that we should invest in all forms of renewable energy, consider this: We have limited resources to invest. So we should be careful to invest in the forms of alternative energy that appear to be most promising.

Governments are pretty bad at "picking winners" when it comes to making investments. This is something markets are better at. Entrepreneurs, who have their own personal wealth at stake when making business decisions, are motivated to figure out which forms of alternative energy investments are likely to pay off. This is a setting where markets are likely to make better investments than governments.

We need a fiscal stimulus package to pull the economy out of its spiral. Government should invest in something in order to achive this aim. But if the government is going to invest, it should invest in the things that it's comparatively good at investing in. Roads.

So how can we stimulate private investments in alternative energy? Simple: Tax carbon.

Doctors and Health Care

Interesting column in the SLTrib today about health care:

Doctors No Longer Control Quality of Health Care in the United States

It's especially timely given that Gov Huntsman easily won re-election last night, and one of his second-term priorities is health care.

Anyway, the central theme of the column is captured pretty well in the title (but you should still read it).

My thought is this: Do we want doctors to control the quality of health care?

And before you answer "of course", consider this: As with all products and services, higher quality health care costs more than lower quality health care. And as with all products, it's important that somebody weigh the benefit of higher quality (in terms of consumer willingness-to-pay) against that cost.

We'd all like to drive fancy cars or live in bigger houses, but most of us choose not to --- because the cost to us is bigger than the benefit we derive.

Things are a bit different in health care, though, because the patient typically does not pay the full cost of the health care he or she consumes. If you're insured, then your insurer pays most of the cost, and this means incentive conflicts. The patient gets the benefit of health care, but doesn't pay the full cost. The insurer doesn't get the benefit, but pays most of the cost. Importantly, there's nobody who's directly weighing costs and benefits to try to come to the right balance.

What's the role of doctors in all this? Well, doctors advise patients on the likely benefits of various courses of treatment. But the doctors aren't motivated to think about the cost side of things any more than the patient is. So, letting doctors (in consultation with patients) make decisions about health care quality means we're likely to get quality that's too high, in the sense that the benefit is smaller than the cost.

Many people have valid complaints with managed care, and it is not my intention to suggest that managed care or the current health care system is the best we can do. But health economists have found that managed care succeeds at reducing costs. (Whether it succeeds at striking the right balance between quality and cost remains unclear.)

But the big point is this: It is essential that as a society we carefully weigh costs and benefits. Giving decision-making rights over quality to people who see only the benefit side --- that's not the way to do it.

(More on weighing costs and benefits within organizations when information is widely distributed in Fin 6250. Everyone should take it.)

What Good Are Economists, Anyway???

Scott Adams, creator of Dilbert, thinks he knows.

(This isn't a link to comic strip, it's a link to a blog post about why economists might be worth listening to, even if it seems like they're often wrong.)

I think Adams got it about right....

Grades

One of the worst parts of academic life is assigning grades to students. And that's what I've spent much of the last week doing.

No fun for me. No fun for the students.

I don't look it, but I am still young enough to know how it feels to be disappointed in a grade. I am still smarting from the B- that Val Hartouni gave me in Western Culture in 1987. (It's funny --- I could not tell you the name of one professor I had freshman year of college... except for Val Hartouni....)

So does grading have an economic purpose? Or is it just some hazing-like ritual of university life?

I can think of two potential purposes:

First, it's an incentive mechanism. Learning new things is actually hard, and it's useful if we have incentives to learn. Grades help serve that function.

Second, grading helps with information asymmetry in labor markets. And it's important to note that in labor markets it's often not so much that employers are trying to separate lemons from plums. Instead, it's often matching rather than sorting that needs to be done.

Let's explain: Pretty much all the MBA students at the DESB are plums. We have standards with regard to GMAT and undergrad GPA, so employers know that certain quality standards are met when they see "DESB MBA" on a resume.

So if everyone's a plum, what's the information asymmetry? Turns out that people have different strengths. Some are great at marketing. Some are better at finance. Others at negotiations.

Consider an employer who thinks "I know all these MBAs are smart, but I need to pluck the smart MBA who happens to be particularly good at marketing." How is that employer going to find that MBA?

One approach is to ask candidates during the interview: "Are you good at marketing?" To which each candidate responds: "Yes". So that's not too informative.

Another approach is to pick the one who took a bunch of marketing classes, and did well in them. So think of grading as a way to show off to employers what your particular strengths are.

Public Universities

A couple weeks ago I wrote about public universities and market failure.

I'll return to this topic, but right now The Economist magazine is hosting an on-line debate on a related question.

Check it out!

Journalists: Learn Economics!

One of my favorite news articles from the past year is this:

What an Arrow Shaft Has to Do With a $700 Billion Rescue Plan

It's great for a bunch of reasons.  First, it ties directly in to a big public policy issue.  The big bailout bill had everyone talking, so it was great for getting people interested in economics.

Second, it tied in directly to material I cover in my MBA classes. This is great for motivating why MBA students should try to master economic thinking.  

Third, there's something a little sneaky going on... and everyone likes a good coverup.

The story is this: The bailout bill included a bunch of stuff that was completely unrelated to the bailout.  One was an elimination of the 43-cent excise tax on "natural-wood, unreinforced arrow shaft(s) suitable for use with bows with peak draw weights under 30 pounds."

What was this doing in the bailout bill?  The Senate needed to get House votes, so the bill was stuffed with a bunch of tidbits intended to make House members happy.  Peter DeFazio, an Oregon Democrat, had voted no on the bill --- and Rose City Archery is a big arrow maker, located in DeFazio's district. 

But the really great thing is this quote, from Rose City Archery CEO Jerry Dishion:  "'We don't get a penny,' he said, disputing reports that removing the tax would mean a windfall for Rose City Archery."

Dishion argues that the only beneficiaries of the tax reduction will be "school districts and the Boy Scouts and Girl Scouts organizations that buy his company's arrows."

Whaaaaaaat?

Simple analysis of demand and supply curves is enough to tell us that Rose City Archery will almost surely benefit.  If schools and scouting organizations don't pay this tax, then the price buyers pay will be lower... and they'll demand more arrows.  And this will mean more business for Rose City, and higher profits.  The only exception is if demand for arrows is perfectly inelastic --- this would mean that the quantity of arrows demanded doesn't increase when the tax goes away.  But I doubt this is going on here.  Seems to me that school districts and scouting organizations might have (a) limited budgets, and (b) lots of choices about what sorts of activities to put in front of kids. A reduction in the price of archery would probably mean more of it. 

I wish the reporter had followed up with this question:  "Mr. Dishion, what you said about not getting a penny is true only if demand is perfectly inelastic.  Can you provide us with some evidence on this point?"

Eat Global, Vote Local

A colleague from graduate school --- I won't name him but he's a well
regarded economic theorist --- somehow stumbled upon my blog post
about voting and commented:

> Presumably the probability that the
> decision ends up in court declines in the margin of victory. Thus, by
> voting one reduces the probability of the decision being made by
> courts.

(Oh, and a shout-out to my Stanford homies --- is that what the kids
are saying these days?)

This point is certainly right, so it's not the case that the benefit
of voting is literally zero as I argued below.

To offer my own add-on to his point, suppose that the burden of proof
in a court case is likely to be on on the side that lost the vote
count. So even if I'm in a 5-4 majority that's reviewed by the
courts, my side may have an easier time prevailing in court on account
of my vote.

But I think it's still the case that the pundits are misinterpreting
Florida 2000.

I think they argue that the lesson that from Florida 2000 is that
"Every vote counts because look how close Florida was."

My response to that is that I already knew that vote tallies could be
close --- that's the whole reason I voted in the first place. But
the Florida experience suggests that what REALLY matters is the view
that the courts take of close elections, not the tally in the close
election itself. So my lesson from Florida 2000 is that my vote
matters even less than I thought it did.

Sad, I know.

But the whole reason to revisit this is the following: Think about
the elections where you ARE likely to be pivotal. Those are the ones
where your vote matters most.

And which elections are those?

Local elections.

If you have a vote for a mayor, a city council person, a zoo bond,
whatever... Those are the elections where your vote will matter. Your
vote --- especially if you are voting in Utah --- is really, really,
really unlikely to affect the presidential election. So don't waste
your time getting informed about the McCain vs. Obama tax plans.
Instead, spend your time getting informed about the city council, the
state legislature, the aviary. That's where your vote is likely to
actually matter.

(I'll return to "Eat Global" in an upcoming post, don't worry.)

Auctioning Football Seats

A couple of PMBA groups submitted this article:

Jets to Auction Seats on eBay

This article is a good answer to a question I often get: "How can I price optimally if I don't know what the demand curve is?"

The Jets get to sell these seat licenses once and only once, so it's not possible for them to do pricing experiments to determine the elasticity of demand. So an auction is a good alternative.

This is pretty similar to what Google did with their IPO a few years back. As with the selling of seat licenses, Google gets to sell these shares once and only once. In a typical IPO, a firm will set a price. If the set price is lower than the market clearing price, then the IPO is "oversubscribed." In this case, the underwriter (usually a big investment bank) will determine which of the potential buyers are allowed to buy.

Oversubscribed IPOs have two big problems. First, the firm is selling its shares for less than the market thinks the shares are worth. This means the firm is leaving money on the table. Second, oversubscribed IPOs have the potential for abuse, as investment banks would often allocate the underpriced shares to favored clients.

If the set price is too high, then the issue is undersubscribed, and all heck breaks loose.

Google circumvented all this using an auction. Google asked investors to submit something like a personal demand curve. Investors gave a list of how many shares they were willing to buy at each price.

Example: I'm willing to buy 100 shares if the price is $50 each. If the price is $40 each, then I'll buy 120. If the price is $30, I'll buy 140.

Then Google took the demand curves and said "We have X shares to sell... What's the price at which quantity demanded (given these demand curves) is equal to quantity supplied?" That was then the price that each buyer paid.

Article Discussion Assignment

Each year in Fin 6025, I assign an "Article Discussion Assignment." Roughly speaking, the idea is this: Groups of MBA students have to identify a news article that relates in some way to material from class. Then the group has 200 words to explain how the article relates to class. The articles and discussions are then read by me and by other students.

I like this assignment because I always learn something when reading the articles and discussions.

So I thought I'd summarize some of the articles (and the economics underlying) here.

From a group of PMBA students, I got this one:

Health Groups Pushing for Tax Hike on Cigarettes

The plan is to raise Utah's cigarette taxes from 69.5 cents per pack to $2. That's a big increase!

One notable feature of cigarette demand is that it's somewhat inelastic. This means two things. First, the deadweight loss associated with this tax is likely to be small. Second, the cigarette tax is paid mostly by consumers. Because the poor are disproportionately likely to smoke, we might worry about the distributional implications of this tax.

Compare to the tax on gasoline, as we discussed in class. There, supply is inelastic, so again we have small deadweight losses but the tax burden falls primarily on the suppliers.

Comparative Advantage

My colleague (and friend) Pam Perlich is making fun of my blog because I haven't yet written a lot that's specific to Utah.  This despite my claim that that Utah-related stuff is my comparative advantage.

While I think that making fun of my blog is a perfectly worthy activity, I think maybe Pam needs a lesson in what comparative advantage means.

You can have a comparative advantage at Task A and still be horrible at it....  as long as you're less horrible (relatively) at Task A than than you are at Task B.  

So there's nothing inconsistent here.

(Comparative advantage is one of the really big (and really old) ideas in the economics of international trade.  Paul Krugman's recent Nobel Prize was given in part because Krugman observed that comparative advantage didn't seem to explain all of the world's trade flows --- he then developed theories that helped economists understand was was missing.)

UT and MA?

What do Utah and Massachusetts have in common?

(Other than an affection for Mitt Romney?)

These are the two surest bets in the nation when it comes to the upcoming presidential election, according to Intrade.

Here's how it works: Intrade offers a security that pays off $1 if the Republican nominee wins, say, North Carolina's electoral votes.  Then it allows trading in that security.  If the current market price of that security is 50 cents but you think the probability McCain wins North Carolina is actually 60 %, then you can make money (in expectation) by buying the security.  

How does this work? 

If you think McCain will win with probability 60%, then the security is worth

0.60 * $1 = 60 cents.

If it costs you 50 cents to buy it, then you've just made 10 cents in expectation. 

The actual price of the "North Carolina Republican" security on Intrade right now is 44 cents.  This means that there isn't anyone in this market who's willing to buy at a price higher than this --- so there must not be anyone in the market who thinks the probability McCain will win North Carolina is much higher than 44%.  

The 44% is therefore the market's current assessment of the probability McCain will win North Carolina.  These market assessments have been shown to do better than polls at predicting winners of elections.  Unlike people answering poll questions, these traders have real money at stake, so they're motivated to figure out which way the wind is blowing. 

---

What does all this have to do with Utah and Massachusetts?

The "Utah Republican" security is trading at 98 cents.  The "Massachusetts Republican" security is trading at 2 cents.  These are the highest and lowest values among the 50 states and the District of Columbia.  

UT and MA might be the two most different states in the union politically --- it's pretty remarkable that Mitt Romney could be so popular here and an ex-governor there. 

Why You Shouldn't Vote

One of my goals with this blog is to help people to use economics to think through problems.  One way to do that is to just apply economic reasoning to everything in sight, with the idea that the more applications we see the more we'll internalize this way of thinking.

So here's an application of economic reasoning to voting.  (And I caution you that I don't necessarily believe everything I write.  This is brain exercise intended to get you think differently about a problem.)

(And is it ok to write things you don't necessarily believe?  Well, sure, as long as you don't intend to run for office.  Academics exist to try to provoke the rest of the world into thinking hard.)

When should you vote?

Obviously, when the benefit of voting exceeds the cost.  The cost is a time cost --- it can be a hassle to get to the local polling place.

The benefit is that you might influence the outcome.  When will your vote influence the outcome?  Your vote influences the outcome if and only if your vote is pivotal. 

Example:  Suppose there are nine voters:  you and eight others.  When does your vote matter?  Your vote matters in exactly the case where the other eight voters end up split 4-4.  In that case, your vote is pivotal --- it has determined the outcome.  If the other voters split 5-3, or 6-2 or 7-1, then your vote isn't pivotal.  For example, if the others split 5-3, then your vote will make it 6-3 or 5-4, but the outcome isn't changed.  (The TV game show "Survivor" is a really interesting context to use to think about strategic voting...)

So, in trying to figure the benefit of voting, you should try to figure the probability that it's a tie in the absence of your vote. Given the current polls, it's unlikely that any one person's vote will influence this year's gubernatorial race in Utah --- that race looks like a Huntsman landslide.  So the benefit of voting is pretty small. 

But what if you're voting for president?  And what if you live in Ohio or Florida?  One lesson people claim to take from from the 2000 Florida recount is that "every vote matters."  The margin there was so small that it seems reasonable that one vote really could matter for picking a president.

But I think that's the wrong lesson to draw.   Here's why.  Let's suppose you live in Ohio.  Let's suppose you think it's reasonably likely that the election will end up tied and that your vote will determine the winner.   Then maybe we'd conclude that it's really important for you to get out there and vote.  

But what did we learn from Florida 2000?  We learned that close elections are decided not by the voters, but by the courts deciding what ballots to count.  To put this another way, suppose McCain wins Ohio by one vote.  And suppose that the electoral college is so close that the Ohio winner is guaranteed to win the election.  In that case, did the one Ohio voter's vote matter? Well, in an election that close, the dems will litigate and the courts will decide. 

So the probability that a single Ohio voter can determine the outcome isn't almost zero.  It's literally zero.  The benefit of voting is zero, and the cost is positive.  Don't vote.

Economics and Health

Story in today's Salt Lake Tribune about how the economy can impact your health.  The theme is that current economic difficulties might be causing some people to skimp on health care.

While I don't doubt the specific examples given by the Trib reporters, evidence on the link between the overall economy and health is not as clear as this article would have you believe.  

Also, think about applying the notion of opportunity costs to preventive health care --- are you more likely to go get that colonoscopy when you're super busy at work, or when you're not?  More generally, it's useful to think of the "cost" of health care as both the "dollar cost" and the "time cost".  People have fewer dollars now for sure, but they might have more time.  And it's not clear which "cost" has a larger effect on preventive care. 

For the insured (which is most people), the dollar cost might not be so relevant.  

Politics = Economics (of course...)

For those who haven't seen this, go check out the Iowa Electronic Markets.  

Watch, in particular, how the Obama "winner-take-all" price has changed over the last month.

Some firms are setting up prediction markets internally, and we'll hopefully get a chance to talk about why in Advanced Managerial Econ  this term.  

More on Bubbles

In a comment below, DESB alumnus Kyle Roberts asks about how you'd know when you're in a bubble.

There are such things as market fundamentals. What you're buying when you buy stock is a claim on the future cash flows of the firm. If the stock price gets too far from the NPV of those cash flows, then you need to wonder what's going on.

The difficulty is that it's hard to predict what the NPV of cash flows will be. Reasonable people can disagree about whether a firm's business model is sound (and therefore will lead to growing cash flows). So it's not always (ever?) clear what a firm's stock price should be.

Another difficulty is that in bubble times people often start arguing that "fundamentals don't matter any more." Example: About eight years ago, a friend told me that NPV of cash flows had nothing to do with demand for stocks. People bought stocks, he argued, because they liked the company and wanted to be associated with it. If true, then investing in Apple is sort of like rooting for the Utah Jazz.

If you're interested in an economist's view on these questions, go read "Irrational Exuberance" by Robert Shiller.

Public Universities (Continued)

Sticking to the previous post on public universities...  

One possible source of market failure is market power.    If we recall how a monopolist sets prices, the monopolist is looking for the place where marginal revenue is equal to marginal cost.  This means prices are above marginal cost, and not all gains from trade are realized.

So would for-profit universities have market power?  

Well, maybe.  There are certainly substantial economies of scale in the provision of education.  The marginal cost of educating a student is probably very close to zero.  Once a university has set up labs and classrooms, hired faculty and staff, built a football stadium, and made other essential investments, the cost of adding one more student is small.  So maybe the economics of education aren't that different from the economics of a regulated utility, such as Rocky Mountain Power?

But one important difference between a university and a utility is customer switching costs.  It would be hard for a Salt-Lake-based homeowner to buy power from another utility if the local utility raised prices. But students could easily travel out of state for education bargains if Utah's universities raised prices.  

Another notable feature of education is this line from the Trib article:

"It costs about $6,000 per year to educate one full-time college student in Utah, with tuition covering about 40 percent, according to William Sederburg, Utah's commissioner of higher education."

This is unlike the market for electricity, where the state mandates that Rocky Mountain power can charge prices that cover cost but just barely.  So why the subsidy?

Public Universities

Big story in the Tribune today about declining funding and increasing enrollments at Utah's public universities.

It's a nice illustration of how changes in opportunity costs lead to changes in behavior. The opportunity cost associated with action A is the value associated with the thing you can't do because you're doing A.

If you're going to school, you can't work (at least not as much). So the total cost of going to school is tuition plus opportunity cost --- that is, tuition plus the money you don't make because you're going to school instead. And people compare this total cost to the benefit of education when making choices. When the economy slows, the opportunity cost of education falls --- and classes fill up.

But the whole issue of state funding for public universities raises a bigger question --- what's the rationale for governmental involvement in education? To remind you how economists view government involvement in markets, the case for governmental involvement usually rests on market failure. If markets fail to allocate resources efficiently, then there may be a role for collective action via government to try to improve efficiency.

Is there a market failure here that needs to be addressed? (I can think of two...)

Credit Crisis Explained

A colleague forwards this not-far-from-the-truth description of the subprime credit crisis.

CAUTION:  PROFANE!!!

Click to see it. 

Short Sales

Patrick Byrne, CEO of Overstock, was speaking on campus yesterday. I

went and listened. I'll probably have more to say about his talk on

another day.

For today, I'll say this. Patrick Byrne and I agree on at least one thing: Short-selling is a good thing. Now, Byrne is a well known critic of naked shorting, but he was clear to state in his talk that he's fine with short-selling as long as the person doing the short does so on a "pre-borrow" basis. This means that the person who shorts the stock has to arrange to actually borrow the share prior to the short.

So for today let's focus on what short-selling is, and why it's a good thing.

What is it? Let's start by looking at a graphic:

Amazon's Stock Price

Take a look at Amazon between 1998 and 2001. That's the period of the so-called dot-com-bubble. Technology stocks went way up, and then they went way back down.

Now suppose you were a super-smart market analyst, and you knew that the 1999 Amazon market prices were too high. How could you profit from this knowledge? The answer is that you could short the stock. To do this, you follow these steps:

1. Find somebody who currently owns a share of Amazon.

2. Politely ask if you can borrown their share.

3. Sell that share in the market. If, for example, you sold that share on April 16, 1999, you'd have received $95 cash from selling that share.

4. Wait.

5. Buy the share back at a later date, when (hopefully) the share price has fallen. If you bought the share on October 12, 2001, you'd have paid $8.

6. Return the share to the person you borrowed it from.

7. Pat yourself on the back --- you just made $87.

So that's what short-selling is: It's a way for people to profit when shares prices go down.

It often strikes people as odd that investors can profit when shares fall. Don't we all want share prices to rise? The answer is that if we hold stock, then we profit when shares rise in value. So in that sense we want share prices to rise.

But more generally, we want prices to be "right". That is, we want share prices to reflect the actual value (that is, net present value of cash flows) to be captured by the firm's shareholders. The reason is that people make decisions about what to do based on what prices are. And if the prices are wrong, the what-to-do decisions will be wrong.

Here's an example. In the summer of 1998, I was an assistant professor at the Kellogg School of Management at Northwestern. It's one of the world's top management schools, so an MBA from Kellogg is a really valuable stamp to have on your resume. But here's what happened that summer. First-year MBA students went away to their summer internships in Silicon Valley... and then didn't want to come back. We started geting phone calls from students --- and not a few such calls --- asking if they could defer their second year. 

The reason? Their dot-com internship employers were offering them hundreds of thousands of dollars to stay. Those salary offers were way in excess of what our graduates were being offered only 18 months prior. And the students were being offered these huge salaries to do marketing and business development for business with no earnings.

Where was all the money coming from? From firms that had either gone public or were hoping to go public. Because of the dot-com bubble, businesses with not-very-good prospects were selling shares and getting huge cash infusions. And using the cash to buy first-year MBAs out of returning to school.

Do I fault the students who didn't return for school? Of course not --- they're just responding to the price signals that the labor market is sending them. Ordinarily, if a worker is offered a huge salary to do some work, it's because the work to be done is valuable. But here, labor-market price signals were wrong because the financial-market price signals were wrong. The financial market was rewarding entrepreneurs with not-very-good business models, and so the entrepreneurs were rewarding employees to do not-very-valuable work.

So, to summarize this chain: Financial-market prices affect choices in labor (and other) markets. To get the right people in the right jobs, we need financial-market prices to reflect the actual value that firms will create. This is why bubbles are a bad thing. (And think here about all the bad decisions that have been made because of the housing bubble --- it's the root cause of most of our current troubles...)

So how do we pop a bubble? In order to get a bubble popped, we need to provide incentives for the popper to pop it. That is, we need to have a way for someone to profit by making stock prices go down. That's what short-selling does, and that's why it's a good thing.

If the Bailout is the Solution, What's the Problem?

The problem isn't that consumer spending is down. The problem isn't that the stock market is down. The problem is the TED spread.

Huh? The TED spread is an obscure difference between two obscure interest rates. So let's explain what it is and why you should care. The TED spread is the difference between the three-month LIBOR interest rate and the three-month T-bill rate. The LIBOR rate is a market-determined interest rate on bank-to-bank loans. It's the answer to the question of "What interest rate will I get if I'm a bank and I loan money (for 3 months) to another bank?" The three-month T-bill rate is the answer to the question of "What interest rate will I get if I loan money (for 3 months) to the US Federal Government?"

The TED spread is the difference between these interest rates. Money lent to the US government is safe (historically). Money lent to banks might not be --- the bank could fail. The difference in these rates tells you about market perceptions of the risks of lending to a bank.

The TED spread is usually less than half a percent. Banks are seen as safe, so banks can easily borrow money. This is a good thing, because the role of banks in our economy is to get money from lenders to borrowers. It's unusual that the TED spread gets much above 1.5%. As I type this, the TED spread is 3.34%. That's really high, and it means people are afraid to lend money to banks. People are thinking "Gee, even though the LIBOR rate is a lot higher than the T-bill rate, I'm better off going with the safe option."

You can see what the TED spread is by clicking here.

If lenders are afraid to give money to banks, then banks have a harder time lending money to everyday people. This could make it harder to get a mortgage, harder to get a student loan, harder to get a credit card, harder for entrepreneurs to keep small businesses going. How much harder? It's hard to say. But this is the risk we face unless we can get the TED spread down.

It's been rightly pointed out that regular people are still able to get credit. So why all the alarm bells? The reason is that short-term disruptions in the supply of a good usually aren't noticed by consumers. Firms usually keep enough inventory on hand to be able to cover short-term supply issues. As an example, consider what happens when one of the North Salt Lake oil refineries has a technical problem (say, a pipe explodes). This reduces the supply of gasoline available, but we consumers hardly notice. The reason is that refiners keep a stock of inventory on hand just in case. During a refinery disruption, refiners draw down inventory, keep the supply out there, and motorists aren't greatly affected.

Same for the supply of money available to be lent by banks. Banks keep extra cash around just in case they have some short-run supply issues. So, a short-run TED spike is probably as bad for borrowers as a short-run refinery closure is for drivers.

But now suppose the refinery is going to stay closed for a year. Or two refineries close. Or three. Inventory isn't big enough to compensate, and we'd see gas prices rise. Same with financial markets. If the supply disruption lasts for too long, then we probably will see a larger impact on main-street lending.

This is not to say that Monday's package was a panacea. It wasn't clear exactly how much that was going to help. But you'll know when this crisis is over when the TED spread comes down.

It's also important to note that the TED spread isn't our only economic problem. Whoever wins this election will have a lot of hard decisions to make. The current Congressional negotiations aren't intended to solve all problems; they are just intended to get money flowing to banks again.

So, keep an eye on the TED spread.

About This Blog

Since this is my first post, let me note that my objective with this blog is to summarize and digest the consensus view of economists on various topics. Then I'll try to explain that view in clear language. This being economics, I anticipate that I'll often fail at the "clear language" part. But I'll do my best.

I try to avoid having a partisan agenda, but when a politician is wrong about basic economics, I'll try to say so. I don't consult for banks or oil companies or interest groups or political parties. I'm paid by the University of Utah. So, I'm a public servant, but one who doesn't have to run for re-election. (Plus I have tenure, so I could even make my boss at the U mad if I felt like it.)

I'm also going to try to focus on Utah issues. There are a lot of other great econ blogs out there, and so Utah-related stuff is my comparative advantage.