Tuesday, April 14, 2015

Ohio cities: How are they doing?

As a native of the buckeye state I like to keep an eye on  what is going on there. As part of a paper I am currently working on I collected  GDP/capita data and population data for US Metropolitan Statistical Areas (MSA). As I was collecting the data I thought it would be interesting to examine the differences between Ohio MSAs. But first a brief background on MSAs.

A MSA is considered the economic city. A MSA usually consists of one large primary city and the surrounding urban counties, but some MSAs have more than one main city (e.g. Dallas-Fort Worth, San Francisco-Oakland, Minneapolis-St. Paul). Each MSA will contain many distinct political cities, where political cities are delineated based on government boundaries. The land area of an MSA is determined by economic forces rather than political ones. In particular, the commuting patterns of workers determine the geographic size of a MSA. If a certain proportion of workers in a county commute to one of the primary cities of an MSA then that county will be considered a part of that MSA/economic city. Thus distinct political cities (i.e. each city has its own government) that are economically intertwined will be part of the same MSA. Since economic activity often crosses political borders seamlessly it is more useful for economists to use the economic city as the unit of analysis rather than the political city. In fact, economists often use the term city and MSA interchangeably, which can be confusing to non-economists.

So now that we have a better understanding of what an MSA is, lets look at the data for Ohio MSAs. The first graph (below) shows the populations of eight major Ohio MSAs from 1990 - 2010 (click to enlarge)

Only the Columbus MSA and Cincinnati MSA experienced significant population growth over the last 20 years. Cincinnati was the largest city in Ohio in 2010, just surpassing Cleveland. The Cleveland and Youngstown MSAs experienced a decline in population while the remaining MSAs held fairly steady.

But even a steady population is good in a state like Ohio since overall the state shrank from 11.5 million people to 10.8 million people from 1990 - 2010. This means that Columbus and Cincinnati both contain a larger proportion of Ohio's population in 2010 than they did in 1990; i.e. the population of Ohio has become more concentrated in those two cities. In 1990 28% of Ohioans lived in Columbus or Cincinnati. In 2010 37% of Ohioans lived in Columbus or Cincinnati.

In the graph below I show the Real Gross Domestic Product (GDP)/capita in 2001 and 2011 for the same MSAs. 

The three largest cities - Cleveland, Columbus, and Cincinnati - were also the three wealthiest cities. Out of the three though, only Cleveland experienced an increase in GDP per capita from 2001 to 2011. Both Cincinnati and Columbus, the two fastest growing cities, experienced a decline.

One explanation for this could be that the people already in and moving to Ohio view Cincinnati and Columbus as places of economic opportunity. This means that poorer people may be inclined to move to one of those cities in order to improve their lives. Growing cities can appear poorer when looking at measures like average income or GDP because they are better at attracting relatively poor migrants who are searching for economic opportunities. An influx of relatively poor migrants will decrease the average GDP/capita. Columbus and Cincinnati may appear poorer when looking at averages, but we know by the population numbers above that whatever may be going on in those two cities it is not discouraging people from moving there.

Meanwhile, places like Toledo, Akron, Lima, and Cleveland appear to be getting richer on average , but they are also stagnant or shrinking. If lower income people are leaving those cities in order to find better opportunities elsewhere it can have the effect of increasing average GDP/capita in those cities.

Cities that are thriving economically will always attract relatively poor people who are looking for better lives. That is why it is important to look beyond average incomes and similar statistics in order to see what is really going on. I would have to do more research before I could conclude that the story I just told is really occurring in Columbus and Cincinnati but it is a plausible story.

Wednesday, April 8, 2015

How useful is cost benefit analysis?

Yesterday in the public economics workshop at Clemson University Dr. Arnold Harberger, Professor emeritus at the University of Chicago and current professor at UCLA, presented a paper that analyzes the appropriate social discount rate. The social discount rate is the rate that governments use to calculate the net present value (NPV) of a government project.

For example, suppose a government is trying to decide whether they should build a damn or not. For simplicity's sake, lets suppose that the damn will yield benefits of $50,000 per year forever. If the social discount rate is 6%, then the NPV of the benefits of the project is 50,000/0.06 = $833,333. If the cost to build the damn for the government is three annual payments of $300,000 the NPV of the cost is $300,000 + ($300K/1.06) + ($300K/1.06^2) = $850,018. In this case the costs outweigh the benefits so the damn should not be built. However, if the social discount rate is 4% rather than 6%, then the NPV of the benefits is $1,250,000 and the NPV of the costs is $865,828. So when the social discount rate is smaller the project makes economic sense, as it now provides a larger benefit than it costs to produce.

This is a simplistic example but it highlights why the social discount rate is important. Whether a government decides to accept or reject a project often depends on the magnitude of the social discount rate it uses in the analysis.

Now Dr. Harberger is an expert on cost benefit analysis; he has written numerous peer reviewed papers on the topic and has served as an advisor to several national governments. So it can be safely said that he knows what he is talking about. One thing that he stressed is that it is hard to calculate the appropriate social discount rate and that there is some disagreement among economists about which rate is the appropriate one. This has large implications for how tax dollars are spent. One government might use one rate and another might use a different one and thus they come to the opposite conclusion even though everything else is the same. What is even more troubling, as Dr. Harberger noted, is that within the same government different bureaucracies might use different social discount rates. So one bureaucracy might approve a project that another would have rejected.

 Some people incorrectly assume that if the government conducts a cost benefit analysis then whatever decision that results must be the correct one. That is simply not true. Cost benefit analyses are important and they have a role to play, but they are not perfect. Many different assumptions go into a cost benefit analysis, such as the appropriate discount rate, and these assumptions influence the outcome. 

Business also use cost benefit analyses to help them make decisions, but the private sector has an additional mechanism that helps ensure that the best economic decision is made; competition. Different firms may use different discount rates for evaluating their projects and thus they may come to different conclusions, but the market is there to sort out who made the best decision. If Apple decides to launch a new product that Dell calculated would be unprofitable we will eventually find out who made the right decision. If the product is a hit then Apple made the right choice and Dell blew it. If the product fails then Dell was right after all.

Cost benefit mistakes don't matter as much in the private sector because the firm who makes the mistake ultimately bears the cost. Unfortunately the Federal government doesn't have much competition. Sure US officials can learn from the mistakes of Canadian officials, but there are so many differences between countries even as similar as the US and Canada that it would be hard to convince people that what didn't work in Canada would also not work in the US. If the damn that I talked about above ended up being built, how would we ever know it was the wrong choice? Ex post, after it was built, maybe government officials will analyze the costs and benefits and admit that it made a wrong decision, but even if they do, then what? The fixed costs are sunk at that point so it likely will not make sense to quit operating it. Instead it will simply be a government mistake that resulted in wasted tax payer dollars. Perhaps the government will learn from that mistake but unless the mistake leads to someone being fired or voted out of office there isn't really much of an incentive for officials to change their behavior.

The market is the ultimate correcting mechanism. Without competition we are forced to rely on faulty cost benefit analyses that can never be perfect. Now the market is not perfect either and some resources will be wasted by firms that create products that people ultimately don't want. But profit and loss ensure that firms will be very careful when the do their calculations as well as ensure that firms learn from their mistakes. Governments are not concerned with profit and loss and political concerns usually outweigh economic concerns.

So while cost benefit analyses can be useful, they are not a panacea. It is important that people are aware of the limitations of cost benefit analyses so that the government does not abuse them. The fewer decisions that are made that rely solely on cost benefit analysis the better off our society will be.

Thursday, March 19, 2015

When labor gets more expensive firms don't use as much

Today I had lunch at Applebee's and on the table I saw something that I had never seen before; a small touch screen computer was attached to the top of the table. The computer allows the customer to order food and pay without a waiter/waitress.  Apparently Applebee's announced this back in 2013 (I guess I don't go to Applebee's often enough.)

Now today we still had a waitress, but I imagine that during off peak hours the restaurant can cut back on their staff and simply allow the customers to type in their own order, which is then sent to the kitchen. When the food is ready, a staff of 3 or 4 food runners can deliver the meals to the table for the entire restaurant. The computer also had a credit card reader so no waiter is needed to settle the bill.

Eventually the computer may allow the customer to alert the staff when they need a refill or if something is missing from the meal, etc. This will also cut back on the staff needed, since customers can directly state when they need something rather than wait for an assigned waiter to come to their table. If the servers know exactly what a table needs and when they need it they will not make as many wasted trips to tables and thus be more productive. More productive servers means that a restaurant can get by with less of them.

Capital, such as the on-table computer, makes labor more productive. When labor is more productive less workers can produce the same amount of output. If the price of low-skilled labor increases, perhaps due to a minimum wage hike, there is an incentive for the firm owner to use relatively more capital and less labor. The author of the Slate article above understands that:

"Then again, of course these businesses are saying they won’t use the tablets to replace employees. Announcing layoffs along with the tablet move would be begging for a backlash. The fact is, if the tablets work, they’ll make the ordering process more efficient and cut the amount of human labor that these restaurants require. At that point, do you suppose they’ll keep the extra waiters around out of charity?" (my emphasis)

Also, high minimum wage states can impact low minimum wage states. New capital is likely to be developed and perfected in places with high labor costs. In low wage states it may not make sense economically to spend the fixed costs necessary to develop new machines. But once the costs have been borne by firms in high wage states it may make economic sense to simply adopt the technologies.

If people try to tell you that a higher minimum wage will not impact low-skilled employment simply take a look around. The computers at Applebee's are one more sign of the movement towards less labor and more capital, and higher minimum wages certainly play a role in that process.

Monday, March 9, 2015

Crisis politics

This is from Vincent Ostrom's The Intellectual Crisis in Public Administration (3rd edition p. 110):

"Measures taken to solve problems by the rhetoric of warfare and crisis politics will exacerbate rather than alleviate many problems. Performance will radically diverge from expectations, and the illusion of perpetual crisis will permeate public affairs. If the illusion gives way to skepticism, the credibility gap will become an institutionalized feature of American public life. The rhetoric of warfare, crisis politics, and credibility gaps are unfortunate ingredients in the public life of people living in a potentially dangerous world. The rhetoric of crisis, like the cry of "wolf", will not be heeded if frequently used in inappropriate circumstances."

I think that we have reached this unfortunate point in American politics. Every social ill or foreign concern is described as a crisis of "epic proportions", "the issue of our time", etc. It is difficult to maintain a sense of perspective when pretentious politicians exaggerate nearly every situation they confront.

War and armed conflict are especially effective when it comes to enacting policies that erode liberty in the long run. As Alexander Hamilton noted in Federalist 8:

"Safety from external danger is the most powerful director of national conduct. Even the ardent love of liberty will, after a time, give way to its dictates. The violent destruction of life and property incident in war, the continual effort and alarm attendant on a state of continual danger, will compel nations the most attached to liberty to resort for repose and security in institutions which have the tendency to destroy their civil and political rights. To be more safe, they at length will become willing to run the risk of being less free."

It is not surprising that most government overreach has occurred during times of war. Something to be mindful of the next time the president proposes policies during a time of crisis.

Monday, March 2, 2015

A higher minimum wage does not make society better off or create jobs

I had a discussion today with a friend about the minimum wage and it gave me an idea for a thought experiment. Many pundits insist that a higher minimum wage will create jobs (see here for one example). The argument goes as follows (taken from the article linked to above):

"What critics of a higher minimum wage ignore is that, by putting more money into the pockets of the working poor — a group that necessarily spends nearly all its income on such locally provided basics as rent, food, transport and child care — an adequate minimum wage increases a community’s level of sales and thereby creates more jobs."

But can the minimum wage really create more jobs overall? The answer to this questions is most certainly no and a simple example will explain why.

Suppose there are two parts of a town; the owners of businesses live in one part and the workers live in another. These owners and workers produce widgets and everyone demands 1 widget per day. Owners are wealthier than workers. There are the same number of workers as owners.

In each area of town there is a pizza parlor that is owned by the government and uses no workers (the pizza is completely made by machines and has a perfectly elastic supply). Workers only go to their pizza parlor and owners only go to their pizza parlor. The equilibrium price of pizza is $9/pizza in each area. The equilibrium quantity for owners is 100 pizzas per month, while the equilibrium quantity for workers is 80 pizzas per month. (since owners are wealthier and they each demand the same amount of widgets owners spend the rest of their money on more pizza.) The graphs below represent the markets for pizzas in each part of town.


Now let's suppose the government passes a minimum wage increase in the widget factory. For the purposes of this example I will assume that the minimum wage increase is completely absorbed by the owners i.e. the owners take less money and pay the workers more; prices of widgets do not change (this is the preferred outcome of most minimum wage supporters as well).

This increase in the minimum wage will have an income effect on the demand for pizza for both the owners and workers. Since the workers now earn more money, the demand for pizza in their part of town will increase. The demand curve will shift out as in the following diagram.

The increase in demand will increase the quantity supplied of pizzas in the worker's pizza parlor; there will be a movement along the supply curve to the right.

But where do the inputs for the new pizzas come from? The increase in the minimum wage did not change the supply curves of pizza. There was no technology increase; no new way of making pizzas was created. In order to increase the quantity supplied of pizzas in the workers part of town the raw materials for pizza (dough, cheese, pepperoni, etc.) must come from somewhere.

And that is where the owners come in. Remember they are poorer now. So the demand for pizza in their parlor decreases, as in the graph below.

When the demand for pizza decreases in the owners parlor, the quantity supplied decreases and moves to the left. This frees up resources (dough, cheese, pepperoni) to be used for other things. In this case the pizza inputs that are no longer being used in the owner's parlor can be used in the worker's parlor.

This example illustrates a key point: society can not be made better off overall by moving money from one group of people to another. Wealth is created by more production, by figuring out ways to make more stuff using less resources. The minimum wage does not affect the supply curves of the products that workers demand. Yes they have more money, but all that does is increase their demand for certain goods while it decreases the demand of other goods that were bought by the people that used to have the money. 

A higher minimum wage does not increase output so it cannot make society better off overall. Increases in the minimum wage simply shift money around, resulting in higher demand for some goods and lower demand for others, just like in this pizza example. The net effect is 0, since the pizza resources freed up by the decrease in demand on the owner's side were the same pizza resources used to increase the quantity supplied on the worker's side. In a more complex economy the increases and decreases in demand will be spread out over more products and it will be hard for any one person to see exactly where the changes are taking place, but the result will still hold. Workers are an input, just like pepperoni, and if more workers are going to be used in one market following a demand increase then less workers must be used somewhere else following a demand decrease.

So the next time someone tells you that the minimum wage will increase jobs by increasing demand, ask them where the new workers are coming from. Just like pepperoni, workers can't appear out of thin air.

Tuesday, February 24, 2015

Sherrod Brown doesn't understand trade

In the most recent email I received from Sherrod Brown he makes a startlingly ignorant statement:

This month I joined my colleagues of both political parties to announce the introduction of the Currency Undervaluation Investigation Act, to stand up to Chinese currency manipulation.

This bipartisan plan could create five million jobs, increase our GDP by as much as $720 billion, and provide a shot in the arm to American manufacturing — all at no cost to taxpayers

(My italics and bold print)

No cost to taxpayers? If taxpayers import goods from China (and they do, check your labels) then this act will certainly cost them.

First let me explain what Mr. Brown means by "currency manipulation". Suppose that a Big Mac costs $2 in the U.S. and an identical Big Mac cost 8 yuan in China. For purchasing power parity to hold, $1 would have to equal 4 yuan. This would be the "correct" exchange rate in Mr. Browns view.

But China may want a different exchange rate, perhaps to maintain high levels of employment in China. So in the currency markets China tries to maintain a ratio of $1 = 5 yuan rather than 4 yuan. So what does this mean for the U.S.?

Well it means that the stuff we buy from China is cheaper than it otherwise would be. For example, suppose a tube of toothpaste that is made in China sells for 10 yuan. At a ratio of $1 = 5 yuan I would have to use $2 to buy 10 yuan, which I would then give to the Chinese manufacturer for the toothpaste. So the toothpaste would cost me 2 U.S. dollars. If instead the $1 = 4 yuan was the exchange rate, I would need to trade $2.50 for 10 yuan. So at the $1 = 4 yuan the toothpaste would cost me $2.50 instead of $2. If purchasing power parity held, then the tube of toothpaste would be more expensive.

China prefers the exchange rate of $1 = 5 yuan in this example because it makes the things that China produces relatively cheaper compared to their cost in the U.S. Remember, based on purchasing power parity the toothpaste should have cost $2.50, which is what American made toothpaste would cost int this example. But because China "manipulates" the exchange rate the toothpaste only costs $2 to buy from China while it costs $0.50 more to buy from a U.S. manufacturer. (Like any good, currency prices are based on supply and demand. China can affect the exchange rate i.e. price of dollars in yuan by buying and holding dollars, which reduces supply.)

(Note that the higher exchange rate ($1 = 5 yuan) makes American goods more expensive for the people of China than the $1 = 4 yuan rate. When the Chinese producer of the toothpaste trades his 10 yuan in for $2 he cannot buy the American made toothpaste that is priced at $2.50.)

This is a stylized example but it reveals that Mr. Browns policy does indeed COST U.S. taxpayers by making the things we buy from China more expensive. So if you spend $1000 per year on stuff made in China and prices go up by 2% on average than this policy would cost you $20 per year. If 50 million Americans had their costs of Chinese goods go up by $20, then Mr. Browns "no cost" policy would cost Americans in total $1 billion. I would need to do more research to get a better estimate, but I guarantee that the true cost is a number much greater than $0.

So don't let Mr. Brown fool you. If China is indeed manipulating their currency then they are doing U.S. consumers a big favor. Trade is about producers AND consumers and ignoring one of the groups to paint a better picture of a policy is dishonest. But I don't expect much honesty from politicians such as Mr. Brown anyway.

Thursday, February 19, 2015

The minimum wage can increase crime rates

In a 1972 article in the Journal of Political Economy researchers found a strong relationship between youth unemployment and crime rates. Other studies such as Fleisher (1966) and Freeman and Holzer (1986) found similar results. I am sure that there are more recent ones as well but I am not up to date on that literature.

Below is a chart showing the year over year, January unemployment rate for 16 - 19 year olds from 1990 to 2015 by year. (click to enlarge)

The most recent data available is for January 2015 and the rate was 18.8%. The rate increased drastically during the recession and peaked in 2010 at 26.1%.

There are many studies that show that higher minimum wages decrease the employment rate of unskilled, usually young, workers (see here, here, and here). I also showed the relationship between the real value of the minimum wage and white and black youth unemployment in an earlier blog post.

The negative outcome of increased crime rates is not usually brought up when increases in the minimum wage are being debated, but it is a real outcome. People who support a higher minimum wage need to be aware that they are pushing low skilled, often young, workers out of jobs and potentially into a criminal career. This is also consistent with economic theory, since the opportunity cost of committing a crime is lower for unemployed, low skilled people than for people with jobs and higher skilled people.

The U.S. prison system is already overcrowded; politicians don't need to create more criminals by making it harder for young people to find jobs and gain skills. Public policy needs to encourage economic growth so that young people are able to find jobs and gain experience that will help them lead productive lives. Having a job also makes it more costly to commit a crime. The minimum wage is a hindrance to youth employment and needs to be tossed on the scrap heap.