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.