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Wednesday, May 20, 2015

60 years of urban change

The Institute for Quality Communities at the University of Oklahoma has a neat collection of maps that allow you to view cities from all over the country both before and after highways were constructed. It is troubling to see how many people were displaced by eminent domain and the highway system. Atlanta in particular was heavily impacted by I-85.

Tuesday, May 19, 2015

Federalism and economic growth

In a recent paper by J.W. Hatfield ("Federalism, taxation, and economic growth." Journal of Urban Economics, 2015. A draft version can be found here.) the author shows that federalism and the resulting competition for capital leads to a tax policy that maximizes economic growth. From the conclusion:

"Our work shows that federalism, and the attendant competition for capital, will drive tax policy to the growth maximizing level, while a centralized government will choose tax policy that does not maximize growth....When many districts exist, competition will drive the districts to choose tax policies that maximize the private rate of return and hence the growth rate of the economy. A centralized government, by contrast, will choose to maximize its own objective function, the welfare of the median voter..."

Their model does make some important assumptions that do not exactly match reality, namely that labor is completely immobile and that all capital is mobile. Neither assumption is true, since labor i.e. workers are able to move to new locations and some capital, such as buildings and roads, are immobile once they are built. But a lot of capital is relatively more mobile than labor, which is the primary reason countries often tax capital gains at lower rates than labor income. Because there are international capital markets capitalists are able to invest their capital where it will get the highest rate of return.

What this paper does show is that municipal and state competition is an important condition for generating economic growth. Just like in the business world, competition encourages governments to produce the stuff that people want. When people are able to vote with their feet government officials must be attentive to the needs of their constituents. If people are unable to exit the jurisdiction of a bad government there is less of an incentive for the government to change course. The federal government can afford to be less attentive than the state governments, and the states less than the cities, towns, and villages, because it is harder to leave the US than it is to leave South Carolina or the city of Clemson.

Competition is also important because it fosters innovation. Economist and Nobel Prize winner F.A. Hayek noted that competition is a discovery process. He explained that we need competition to help us discover what are the best ways of doing things. Because firms have to compete with each other for customers they are continuously looking for new and better ways to provide a good or service that already exists or create a new good or service that satisfies a consumer want. Firms need to provide consumers with value, and that means giving them what they want at the lowest possible cost. Competition ensures that firms are always on the lookout for new ways to create more with less, which keeps prices low and conserves resources that can then be used on other things. Competition between governments fosters similar outcomes.

In the business world it is well known that monopolies stifle innovation, reduce output, and charge high prices. But it is less understood by the general public that a government monopoly leads to these same bad outcomes. Federalism is important and needs to protected. It helps create the conditions necessary for innovation and economic growth, both of which make us all better off.

Tuesday, May 12, 2015

The Rise of American Big Government

Here is a paper by Michael Dahlen that provides a brief history of how the US government became so large and intrusive. It is a good paper that anyone can understand and everyone should read.

Monday, May 11, 2015

Robert Reich and his faulty argument for a higher minimum wage

In a recent video Robert Reich makes the case (albeit a bad one) for a $15 minimum wage. I have addressed several of his argument's flaws in other posts (a "virtuous" cycle of demand is nonsense, the least skilled and least productive do get pushed out of the labor market, corporations already do their part) so in this post I want to highlight his misleading statement at the 1:35 mark that "many" of the workers who would be helped by a higher minimum wage are key breadwinners.


The chart above was taken from the whitehouse.gov website. This chart shows how many of each type of person would see a direct pay increase due to a higher minimum wage. Keep in mind that only 3.6 million workers, or 4.7% of the hourly paid workforce, made at or below the federal minimum wage in 2012. Because the Whitehouse's plan is to raise the wage from $7.25 to $10.10 it claims that 19 million people would be directly affected. But out of these 19 million, only 26% of the workers who would experience a direct increase have kids. 26% doesn't seem like "many" to me. 12% are in fact teenagers trying to earn pocket money, as Mr. Reich puts it, which as a group is almost as large as the married-with-kids category that Mr. Reich seems so concerned about (16%) and larger than the unmarried-with-kids group (10%). 62% of those who would be directly affected are adults over the age of 18 with no kids. So while it may be difficult to support oneself on a minimum wage job, the current situation is hardly the family-with-children crisis that Mr. Reich is making it out to be.

If we want to help working parents with children there are other, better ways to do that. One way is to increase the earned income tax credit (EITC). The EITC only applies to the working poor and does not create the same barrier to employment that the artificially high minimum wage does. It would be better if the people who wanted a job could get one at some wage and then programs like the EITC chipped in to raise their total income. Then the lowest skilled people could gain skills and move up the income ladder over time rather than being priced out of the labor market right from the start.

Tuesday, May 5, 2015

How subsidies for higher education contribute to the higher cost of tuition

The rising cost of college is routinely noted by politicians, college administrators, reporters, college kids and parents. Politicians often insist that the solution for rising costs is more government aid. Many of them insist that increasing the amount of Pell Grants and subsidizing student loans are necessary in order to make college affordable for most people. But basic economic theory shows us that while subsidies can increase the amount of education that people consume and lower the cost to the people who get the subsidies, the subsidies also raise the true cost and can create a feedback effect that involves granting increasingly larger subsidies.

Research by economists Claudia Goldin and Stephanie Riegg Cellini looked at the cost of for-profit colleges that are eligible for federal financial aid and the cost of for-profit colleges not eligible for aid.

"They found that for-profits that get federal subsidies charge, on average, 78 percent more than for-profit institutions that are not eligible for aid. The price difference is almost identical to the value of the subsidy. “It’s hard not to infer that federal student aid system is kind of allowing that to happen,” Professor Cellini told me."

So how does a subsidy contribute to higher tuition? Lets analyze this starting with the diagram below.


Ignore the MB + subsidy line right now. Without a subsidy, a person will consumer education up to the point at which their marginal benefit of another unit of education is equal to their marginal cost. In the diagram above that is at the price of P1 and the amount E1. If we want this person to consume more education, we can give them a subsidy. In this case the subsidy is the amount Ps - Pc. The effect of the subsidy is that it shifts the marginal benefit curve up by the amount of the subsidy (MB + subsidy line). Now the person will consume E2, they will pay a price of Pc, but the cost of supplying E2 is Ps. The difference of Ps - Pc is the portion of the cost that is paid for by the subsidy. So the subsidy increases the amount of education that this person consumes by lowering the cost to them, even though the marginal cost of supplying the education has gone up from P1 to Ps.

If a lot of people are awarded a subsidy and start consuming more education, say by going to college rather than getting a job after high school, the total demand for college can shift to the right like in the diagram below.


The original demand for college, prior to the subsidy, was D1. Tuition cost was T1 and quantity Q1 was supplied. After the subsidy, as more people attend college, demand shifts to the right to D2. The new tuition cost is T2 and Q2 is supplied. So the subsidy can raise the cost of tuition by increasing the demand for college. How does this new higher tuition price impact the recipients of the subsidy?



I know there is a lot going on in this diagram but bear with me. Prior to the demand shift and immediately after the subsidy our college attendee was paying Pc and consuming E2. After a lot of other people start doing this as well the demand curve for college shifts to the right and tuition goes up. This impacts the individual college attendee as it increases the cost of more education. This is depicted in the diagram as a shift in the marginal cost curve from MC1 to MC2. When the costs curve shifts up the subsidy is no longer large enough to help the attendee consume E2. In fact, as drawn the subsidy recipient only consumes E1 again (where the MB + old subsidy line intersects the MC2 line). The price is P2 but they only pay P1 as the subsidy makes up the difference.

If E2 is a college degree and that is the goal of providing the subsidy, then with the new higher cost curve (MC2) the subsidy has to be increased to get a person to consume E2 again. The new subsidy amount is Ps2 - Pc. The larger subsidy increases the marginal benefit curve from MB + old subsidy to MB + new subsidy. The person will consume E2 again and they will pay Pc with the difference being covered by the subsidy (Ps2 - Pc).

This is a stylized example but it helps explain how subsidies contribute to the rising cost of college. The initial subsidy led to an increase in demand for education, which raised the cost, which meant a larger subsidy was required. If the new, larger subsidy induces some additional students who were not affected by the original, smaller subsidy to purchase more education then the process will start all over again. The new students will increase the demand for college, which will increase tuition, which will then need to be covered by a larger subsidy etc.

This video from Learn Liberty talks about the effect of subsidies and other reasons for why college costs keep rising.

So the next time you hear a politician say that we need larger subsidies to offset the cost of college, remember that those subsidies are partly to blame for the rising costs.

Tuesday, April 28, 2015

A letter to Sen. Sherrod Brown (OH) about free trade



Dear Sen. Brown,

As an Ohioan I find your anti-trade demagoguery frustratingly dimwitted. Voluntary trade is a mutually beneficial act from which both parties benefit. Your argument for restricting trade ignores all of its benefits such as lower prices, a wider variety of goods and services to choose from, and increased cultural awareness. What our world needs is more trade between countries, not less. 

If you are truly concerned about the balance of trade then you will be glad to know that when the US trades with other nations it not only increases our imports but necessarily increases our exports as well. That is because it takes exports to receive imports. Unless of course you think that countries like China are sending us goods and services and asking for nothing in return. Trade is a two-way street.

And while it is true that opening up new avenues for trade may result in the loss of some jobs, it also creates many more. That is because the people who lose their job in one sector of the economy are now able to use their talents in a more productive sector of the economy where the US has a comparative advantage. Labor is a scarce resource and countries are made poorer, not richer, when they squander it on relatively unproductive activities.

If we as society want to help our fellow Americans who are negatively impacted by free trade we can devote more resources to training programs so that the displaced workers can gain the skills needed to be productive at some other activity. But do not blame trade for the ills of our economy. Trade makes Americans wealthier on average and the movement towards more free trade will make us all wealthier still. 

Sincerely,
Adam Millsap

Monday, April 27, 2015

The efficient size of a public good and why voting doesn't always work

Many people, particularly in the US, are under the impression that voting leads to the proper outcome in so far as it is the outcome that is preferred by the majority. But voting is not a panacea, and in the case of the provision of public goods it often leads to non-optimal outcomes. In this post I provide a simple example illustrating this point.

In the quest for economic efficiency neo-classical economics leaves two broad areas open to government intervention: the provision of public goods and mitigating externalities. Public goods have a specific definition in economics; they are goods that are both non-rival and non-excludable. Non-rival means that one person's enjoyment of the good does not infringe on another person's enjoyment and non-excludable means that once the good is produced it is impossible, or at least prohibitively costly, to prevent anyone from using it. National defense is usually offered up as the quintessential public good.

Some other goods that are not quite public goods but better fall under the category of club goods are often still treated as public goods for the sake of simplicity. One such example is a park. Parks can be both excludable (e.g. some national parks charge an admission fee) and rivalrous (parks can become congested). Nevertheless, parks are often examined in a public goods framework and that is what I will do here.

In the chart below I have listed three people and their willingness to pay per acre at various park sizes. Sam, Kate, and Clark all live in the same community and thus there will only be one park built, so they need to collectively decide how large to make it.


Each person has their own downward sloping demand curve that represents their willingness to pay (WTP) per acre at different park sizes. For example, Sam is willing to pay $25 per acre for a 10 acre park but only $10 per acre for a 75 acre park. The last column is society's demand (WTP) for the various park sizes. That column is the sum of each individual's willingness to pay at each park size e.g. at 10 acres $25 (Sam) + $30 (Clark) + $105 (Kate) = $160. For this example I am going to set the marginal cost of providing an acre of park land at $75. Below is a graph showing the individual demand curves, society's demand curve, and the marginal cost curve (click to enlarge).


From society's standpoint the optimal size of the park is 40 acres because that is where society's demand curve intersects the marginal cost curve of providing an acre of park land (the blue line intersects the yellow line).

At 40 acres, Sam is willing to pay $15 per acre, Clark $20, and Kate $40. But in real life people are rarely charged their willingness to pay since it is hard for the government to know exactly what that amount is. So let's suppose that the government simply divides the $75 by 3 so that each person is charged $25 per acre. At a price of $25 per acre Sam really wants 10 acres, Clark wants 25 acres, and Kate wants about 80 acres (this is where $25 intersects each of their individual demand curves).

Suppose the three of them show up to the ballot box and the question reads, "For a $25 per acre fee, how large of a park would you like?" followed by a choice of 10 acres and 25 acres. How will they vote? In this case, Sam will vote for 10 acres, Clark for 25, and Kate will also vote for 25 even though she would really like 80. So 25 acres will win.

What about a choice between 25 acres and 40 acres? Now Sam will vote for 25 acres since it is the amount closest to 10, Clark will again vote for 25, and Kate will vote for 40. So again 25 acres will win, even though from society's standpoint 40 is the optimal amount. The reason 25 wins though is because the government is not charging each person their WTP, but instead charging them all the same amount. Even if the government offered to build a very large park, say 80 acres, 25 acres would still win when paired against 80 since only Kate would vote for the 80 acre park.

Only if the choice is between 40 acres and some larger amount over 40 acres will 40 acres win. For example, if the choice is between 40 acres and 60 acres, Sam and Clark will both vote for 40 acres if the are charged $25 per acre while Kate will vote for 60 acres. In this case 40 wins. (One thing to note; this example is assuming that everyone votes on each pair of choices. In real life people can abstain from voting which would change some of the outcomes depending on who abstains. I am ignoring this complication here.)

Thus in order to get the efficient park size when charging the same amount to everyone the government will have to be strategic about the choices it offers. Providing the optimal size of a public good is difficult when the government does not know the preferences of its constituents.

So the next time you vote on a government provided good and you are given a finite amount of choices, remember that the chances of getting the optimal amount are low. Only if the government has some idea of the preferences of their constituents are they likely to provide an appropriate set of choices such that the efficient amount will be provided.

For another example about how voting does not always lead to the best outcome watch this video about Condorcet's paradox and how to rig a majority vote.