Sunday, August 16, 2015

Market wages are fair wages

Pittsburgh Steeler's linebacker James Harrsion recently returned two participation trophies that his sons received. Below is why he did it:

"While I am very proud of my boys for everything they do and will encourage them till the day I die, these trophies will be given back until they EARN a real trophy. I'm sorry I'm not sorry for believing that everything in life should be earned and I'm not about to raise two boys to be men by making them believe that they are entitled to something just because they tried their best...cause sometimes your best is not enough, and that should drive you to want to do better."

I support Mr. Harrison's decision and I think that there is too much trophy inflation, grade inflation, etc., all designed to make everyone feel like they are better at something than they really are. I think this does children a disservice in the long run since it makes them more likely to pursue an activity that they are not relatively good at, which sets them up for a bigger disappointment once the world outside of their family and friends lets them know that they are not good at it (think of all those American Idol contestants from the audition episodes who are truly convinced they can sing...)

But that aside, the thing I want to talk about here was inspired by a comment on the article linked to above. One commenter wrote:

"And you get paid millions of dollars for doing what? Playing a game. How about returning the money because you didn't really do anything for it except play a game? Give it to the police or fire department that risks their lives everyday. When you do that, you can return your sons' trophies. Your sense of what is deserved is quite unbalanced."

The second to last sentence is a non sequitur, but the commenter hits on a point that I hear all the time -- that some professions are systematically "underpaid". "James Harrison makes millions to play football while the average policeman makes $47K per year and this is unjust", the thought goes. But this reasoning is flawed because it ignores how wages are determined in a market economy.

People value police work, i.e. there is some demand for police, and people are willing to be a police officer for the right price, i.e. there is some supply of potential police officers. The value that the residents of a town put on police work at the margin determines how much they are willing to pay for each officer and the people who are willing to accept that wage (or lower) and who qualify for the job become police officers.

There is nothing unfair about this process. No one is forced to be a police officer. Current police officers are free to quit their job at any time and pursue a different occupation that pays more if that is what they want. If a town is unable to hire the amount of police officers it wants at one wage the taxpayers have to raise the wage to induce more people to become police officers or be content with less officers patrolling their streets. All of these decisions are voluntary though, and no one is forced to do anything that they don't want to do. While there may be some individual police officers who are underpaid due to a variety of reasons, to say that police officers as an occupation are underpaid does not make any sense.

The market that determines the wages of workers does not make any judgement about the moral quality of the various occupations. Individuals have different preferences over police work and are willing to pay an amount that corresponds to their preferences. All the market does is provide a venue for aggregating these preferences into a wage.

If police officers are "underpaid" in some sense it is because society undervalues them. That is not Mr. Harrison's fault though. What is not fair is to imply that Mr. Harrison is somehow stealing from police officers because he makes millions and they don't. Again, Mr. Harrison does not force anyone to pay him money. Steelers fans could quit coming to games at anytime. We all could quit caring about the NFL and start caring more about police work and then relative wages between the two occupations would adjust appropriately. But we don't -- society loves the NFL. Mr. Harrison has made a voluntary choice to give Steelers fans what they want and they in turn have voluntarily chosen to compensate him for his services.

What is unfair is to blame Mr. Harrison for his wealth, as if he did something morally wrong to obtain it, and then imply that the "fair" thing to do is to take the fairly earned money from Mr. Harrison via force = taxation and give it to the police officers who have not earned it. As long as Mr. Harrison is paying his local taxes he has compensated the police officers for their services according to their mutually-agreed-to terms and he owes them nothing more. The same goes for the rest of us.

People who think like the commenter are mistaken and unfair, not Mr. Harrison.

Tuesday, July 14, 2015

Is your state in poor fiscal health?

Here is a link to my recent op-ed in US News and World Report about the fiscal health of the 50 states. Here is a snippet:

"States that mishandle their finances over a long period of time are often forced to make tough choices about their budget: Should they contribute to the state pension fund or spend more on infrastructure such as bridges and roads? Often these debates take place in local newspaper op-eds and news interviews, but without a frame of reference, the average taxpayers don't know if the problem is unique to their state or if it is something that all states are going through. The Mercatus Center's fiscal rankings allow taxpayers, business owners and local politicians to see how their state is doing relative to the other states along several different dimensions."

Tuesday, July 7, 2015

Obama's new overtime rule will hurt some workers but I don't think he cares

President Obama recently announced plants to issue an executive order that will require employers to pay salaried employees who earn up to $50K/year overtime pay. This rule encroaches on the fundamental right of a person to negotiate the terms of their labor with an employer. And just like the minimum wage and other restrictive labor laws, this new regulation will make it harder for relatively low-skill workers to climb up the income ladder.

As an example, when I worked at Chase Bank after college I earned a salary of $45K/year. I was not subject to overtime pay rules and this gave my boss and I the freedom to create a schedule that worked for the both of us. During the busy times, such as enterprise IT releases, I would work 50 hrs a week in order to make sure the job got done. When the work slowed down, I would leave early on a few days. Over the course of a year I am sure my work week averaged 40 hrs, but it would have been unnecessarily burdensome to both me and my boss to make sure that I only worked 40 hours exactly every week (or 80 hours every two weeks if that is how the rule is designed) or else be subjected to overtime rules. Why should the government intrude on a voluntarily reached agreement such as the one my boss and I made?

Also, the workers who are less productive and who make up for that by working harder and longer will be unable to differentiate themselves along this dimension. It is ironic that some of the same people who praise the "gym rat" - the less talented athlete that puts in the extra work in order to be better on game day - want to deny this same opportunity to people who earn less than 50K/year based on their elitist idea about what a "fair" salary is. If Obama's supporters think that overtime pay for work over 40 hours is such a good idea, I see no reason why it shouldn't apply to athletes, presidents, CEOs, etc. Why should people making less than $50K/year be the only ones who have to deal with this burdensome regulation?

It is important to remember that overtime pay only affects the cost of labor, not the output. What I mean is that a worker who produces $20/hr of output and earns $40K/year for that output does not suddenly start producing $30/hr of output when overtime kicks in. Companies will be reluctant to let workers work more than 40 hours per week even if the worker wants to, since the additional output of the worker will not be worth the additional cost. Thus workers who enjoy their job, such as myself at Chase, and who want to keep working on a day when they happen to be right in the middle of something will be forced to leave so that the firm does not have to pay them overtime. This also applies to the "gym rat". It does not appear to me that either the worker or the employer benefit in either case.

Obama is an interventionist; he thinks that his view of the world is the correct one and thus everyone should conform to that view. He doesn't appreciate the many differences that shape individual lives, nor does he appreciate the individual freedom that is required to deal with such differences. He hears one story about a hotel manager who worked 55 hours one week and only made their (voluntarily agreed to) salary and he immediately thinks that the situation calls for the heavy hand of government. I don't think he believes that people are capable of making their own decisions, or that people have different preferences about their work/life balance. In The Theory of Moral Sentiments, Adam Smith referred to someone who thinks this way as "the man of system":

     "The man of system, on the contrary, is apt to be very wise in his own conceit; and is often so enamoured with the supposed beauty of his own ideal plan of government, that he cannot suffer the smallest deviation from any part of it. He goes on to establish it completely and in all its parts, without any regard either to the great interests, or to the strong prejudices which may oppose it. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it. If those two principles coincide and act in the same direction, the game of human society will go on easily and harmoniously, and is very likely to be happy and successful. If they are opposite or different, the game will go on miserably, and the society must be at all times in the highest degree of disorder."

Obama is the man of system: To him we are all just chess pieces, to be moved around as he sees fit. Our own principle of motion is of little concern to him. This causes disorder but Obama does not see it because he is blinded by his own arrogance.

Monday, June 22, 2015

Labor force participation rate still down and that's bad for all of us

The U.S. unemployment rate is down to 5.5% but the labor force participation rate for prime age workers (age 25 - 54) is also still down: In 2002 it was 83.3% and in May, 2015 it was only 81%. But what does this mean in terms of actual workers?

A decline of 2.3 percentage points doesn't seem like a lot, but when the eligible working population is over 100 million people it makes a big difference as the chart below shows (click to enlarge). (2015 data here, other data here)

The first line in the chart is the age 25 - 54 labor force participation rate. The second line is the 25 -54 civilian non-institutionalized population. This population number excludes people who are incarcerated or on active duty in the armed forces and is the one used by the Bureau of Labor statistics to calculate the labor force participation rate. The third row is the population in the labor force in that year e.g. in the 1992 column row 3 is the population in the labor force in 1992. The 4th row is the population in the labor force for all years using the 1992 rate e.g. in the 2012 column, if the labor force participation rate had been 83.6% instead of 81.4%, 103,960,780 people would have been in the labor force instead of 101,224,970 (2012 column, row 3). The 5th row does the same thing as the fourth only it uses the 2002 rate for all years and the last row takes the difference between the potential amount of workers at the 2002 rate and the actual amount of workers (5th row minus 3rd row for all columns, which is why it is 0 in the 2002 column).

What this chart shows is that if the labor force participation rate had been 83.3% in May, 2015 instead of 81% there would have been an additional 2,875,345 people in the labor force. Now perhaps not all of these people would have been employed since the labor force includes both employed and unemployed people who are looking for work. But if even 75% of them had a job that would be an additional 2,156,508 workers!

Those additional workers would be making cars, making airplanes, making hamburgers, serving food, driving trucks, cleaning houses, teaching kids, working at a bank or any number of other things. They would be actively engaged in the economy, producing stuff for others and earning a paycheck. So where are they?

Hopefully they are working in the underground economy. Perhaps they are being paid under the table to do yard work, freelance construction work, business consulting, or some other job that allows them to earn a living but keeps them out of the official statistics. This is still not good for the rest of us, since in the underground economy workers don't pay taxes, which means they don't contribute to the goods and services provided by the government, which means a higher tax burden for the rest of us.

In an even worse scenario those workers are not working at all. Instead they are relying on family members or friends to support them or they are receiving government aid in the form of food-stamps and other benefits. Either way, they are not supporting themselves but instead relying on other productive people to support them.

This makes us all worse off. The people who aren't working don't get the satisfaction of feeling useful and contributing to society while the rest of us not only have to support them, but we also miss out on the opportunity to purchase the goods and services that they could have produced. It's a lose-lose situation.

Now if some of these people left the labor force for private reasons e.g. they won the lottery and simply retired there is nothing wrong with that. But remember that this is the prime working age labor force participation rate, people age 25 - 54, so widespread early retirement should not be a big factor. If instead there are too many regulations and taxes and just general economic uncertainty, hindering entrepreneurs ability to create and produce their products which drags down job growth, then that is a serious problem that is hidden by low unemployment numbers. I think that this latter explanation is what is happening and I think it is a problem for the economy and will continue to be going forward, despite what the unemployment figure suggests.

Wednesday, June 17, 2015

Eugenics and the minimum wage

One of the more tragic ideas to catch on during the progressive era (late 19th and early 20th century) was eugenics. According to Diane Paul (2001) “Eugenics” describes a movement to improve human heredity by the social control of human breeding, based on the assumption that differences in human intelligence, character and temperament are largely due to differences in heredity.

Many prominent economists were supporters of eugenics. Thomas C. Leonard wrote an article that was published in the Journal of Economic Perspectives in 2005 that re-introduced some of the most prominent economists who supported eugenics. For example:

     “If we could leave out of account the question of race and eugenics,” Irving Fisher (1921, pp. 226–227) said in his presidential address to the Eugenics Research Association, “I should, as an economist,be inclined to the view that unrestricted immigration . . . is economically advantageous to the country as a whole . . . .” But, cautioned Fisher, “the core of the problem of immigration is . . . one of race and eugenics,” the problem of the Anglo-Saxon racial stock being overwhelmed by racially inferior “defectives, delinquents and dependents.”


     “Social progress is a higher law than equality,” said Simon Patten, economist at the Wharton School and American Economics Association (AEA) president in 1908, and the only way to progress was the “eradication of the vicious and inefficient.” Frank Fetter (1899, p. 237), who was to serve as president of the AEA in 1912, also worried that “the benefits of social progress are being neutralized by race degeneration” owing to the “suspension of the selective process.”

And even though the moral character of these economists was dubious, their understanding of economic theory was sound. In fact, it was better than many of the progressive economists of today. For though their ends were detestable, they recognized the appropriate means for getting there; make the lower classes unemployable. After all, if a person can't work they can't afford to raise a family. What is a good way to ensure that the least productive, lowest class of people are unemployable and can thus be recognized by society as such? Increase the lowest wage at which people are allowed to be hired. From the article:

     Sidney and Beatrice Webb (1897 [1920], p. 785) put it plainly: “With regard to certain sections of the population [the “unemployable”], this unemployment is not a mark of social disease, but actually of social health.” “[O]f all ways of dealing with these unfortunate parasites,” Sidney Webb (1912, p. 992) opined in the Journal of Political Economy, “the most ruinous to the community is to allow them to unrestrainedly compete as wage earners.” A minimum wage was seen to operate eugenically through two channels: by deterring prospective immigrants (Henderson, 1900) and also by removing from employment the “unemployable,” who, thus identified, could be, for example, segregated in rural communities or sterilized.


     Columbia’s Henry Rogers Seager, a leading progressive economist who served as president of the AEA in 1922, provides an example. Worthy wage-earners, Seager (1913a, p. 12) argued, need protection from the “wearing competition of the casual worker and the drifter” and from the other “unemployable” who unfairly drag down the wages of more deserving workers (1913b, pp. 82–83).

I encourage you to read the whole article. It is an informative read.

It would be wise of the modern progressives to remember the roots of the minimum wage. It is not a tool to lift people out of poverty; rather it is a tool to keep people in it. The effects of a minimum wage are the same today as they were back then: It makes the least educated, lowest skilled people unemployable by raising the cost of their labor above the value it produces. If you want to ensure that those types of people remain in poverty, a high minimum wage is a good place to start.

Wednesday, May 27, 2015

A higher minimum wage in one area may harm low-skill workers in other areas

The Los Angeles' city council recently passed a anti low-skill worker bill minimum wage increase that will increase the city's minimum wage from $9/hour to $15/hour. This ill-advised, and I would argue cruel, increase in the minimum wage will banish the least productive workers of LA - teens, the undereducated, the elderly - from the labor market. For LA teenagers in particular it will now be more difficult to find their first job. In light of LA's actions, Don Boudreaux at Cafe Hayek asks all minimum wage supporters a very appropriate question: if the minimum wage was enforced by fining and arresting employees who voluntarily work for less than the government mandated wage rather than the employers who pay them, would you still support it? He states that:

"If a minimum-wage policy is both economically justified and morally acceptable, you should have no problem with this manner of enforcement."

I agree with him. And when the question is phrased in the way he poses it a minimum wage sounds even worse.

And if punishing LA's low-skill workers by preventing them from negotiating their own wage with employers isn't bad enough, there is reason to believe that a higher minimum wage in places like LA, Seattle, and San Francisco will also eventually affect the employment opportunities of low-skill workers in other areas of the country.

Profit maximizing firms are always on the lookout for ways to reduce costs holding quality constant (or in the best case scenario to reduce costs and increase quality). Since there are many different ways to produce the same good, if one of the factors of production, say labor, increases, firms will have an incentive to use less of that factor and more of something else in their production process. For example, if the price of low-skill workers increases relative to the cost of a machine that can do the same job firms will have an incentive to switch to the machine. It is easier to demonstrate this using some simple math.

To set the stage for this post, lets think about a real life example; touch screen ordering. McDonald's is currently installing some touch screens for patrons to order their meals and at Clemson University one of the food courts also has a touch screen ordering system for the grill portion of the restaurant. The choice facing a restaurant is touch screen or cashier. If a restaurant is currently using a cashier and paying them a wage, they will only switch to the touch screen if the cost of switching and the future discounted costs of operating and maintaining the touch screen device are less than the future discounted costs of using workers and paying them a wage. We can write this as

D + K + I + RK  < WL

Where D represents the development costs of creating and perfecting the device, K represents the costs of working out the kinks/the trial run/adjustment costs, I represents the installation costs, and RK represents the net present value of the operating and maintenance costs. On the other side of the inequality WL represents the net present value of the labor costs. (In math terms RK and WL are: RK = [ (rk) / (1+i)^n from n=0 to N ] where r is the rental rare of a unit of capital, k is the number of units of capital, and i is the interest rate and WL = [ (wl) / (1+i)^n from n=0 to N ] where w is the wage and l is the amount of labor hours. But if this looks messy and confusing to you don't worry about it as it's not crucial for the example.)

The owner of a restaurant will only switch to a touch screen device rather than a cashier if the left side of the above inequality is less than the right side, since in that case the owner's costs will be lower and they will earn a larger profit.

If the cashier is earning the minimum wage or something close to it and the minimum wage is increased, say from $9 to $15, the right side of the above inequality will increase while the left side will stay the same (the w part of WL is going up).  If the increase in the wage is enough to make the right side larger than the left side the firm will switch from a cashier to a touch screen. Suppose that an increase from $9 to $15 does induce a switch to touch screen devices in LA McDonald's restaurants. Can this impact McDonald's restaurants in areas where the minimum wage doesn't increase? In theory yes.

Once some McDonald's restaurants make the switch, the costs for other McDonald's to switch will be lower. The reason for this is that the McDonald's who switch later will not have to pay the D or K costs: the development or kinks/trial run/adjustment costs. Once the technology is developed and perfected the late-adopting McDonald's can just copy what has already been done. So after the McDonald's restaurants in high wage areas install and perfect touch screen devices for ordering, the other McDonald's face the decision of

I + RK < WL

This means that it may make sense to adopt the technology once it has been developed and perfected even if the wage in the lower wage areas does not change. In this scenario the left side decreases as D and K go to 0 while the right side stays the same. In fact, one could argue that the RK will decline for late-adopting restaurants as well as the maintenance costs decline over time as more technicians are trained and the reliability and performance of the software and hardware increase over time.

What this means is that higher minimum wages in areas like Seattle, LA, and San Francisco can lead to a decline in low-skill employment opportunities in places like Greenville, SC and Dayton, OH as the technology employed to offset the higher labor costs in the former cities spread to the latter.

Also, firm owners and operators live in the real world. They see other cities and local governments raising their minimum wage and they start to think that it could happen in their area too. This also gives them an incentive to switch since in expectation labor costs are going up. If more cities make the same bad policy choice as LA and Seattle firm owners around the country may start to think that resistance is futile and that it is best just to adapt in advance of a minimum wage increase by preemptively switching to more capital.

And if you think that touch screen ordering machines aren't a good example, here is a link to an article about an automated burger-making machine. The company that created it plans on starting a chain of restaurants that use the machine. Once all of the bugs are worked out how high does the minimum wage need to be before other companies license the technology or create their own by copying what has already been done?

This is just one more way that a higher minimum wage negatively impacts low-skill workers, even if the workers don't live in an area that has a relatively high minimum wage.

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 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. 

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.

Wednesday, April 22, 2015

How exclusionary zoning keeps people out and harms the poor

The Washington D.C. zoning commission just gave us a classic example of how a government undermines itself with bad policy.

"The D.C. Zoning Commission took its first action this week against developers of the city’s growing number of “pop-up” homes, voting to reduce the maximum by-right height of ­single-family rowhouses from 40 to 35 feet in some of the city’s gentrifying neighborhoods, including Capitol Hill, Shaw and Columbia Heights."

So called "pop-up" homes are simply tall homes being built in some of the city's most expensive neighborhoods. In order to make room for these homes developers are tearing down older, less desirable homes and then building the new homes on the empty lots. But the residents of the area don't really like this:

"Many residents in those neighborhoods get angry when developers buy an old two-story rowhouse and plop a third story on top, or when they raze the rowhouse and construct a brand new three-story residence. Longtime residents argue that pop-ups clash with the established character of their communities, or simply block their sunlight, their solar panels, or even their chimneys."

So established residents want to use the power of the government to keep a certain type of housing out of their neighborhood. This is a form of exclusionary zoning and it is used to do just that, exclude people.

The developers would also like to be able to split up the homes into multiple units that can be rented out. This would increase the supply of housing in these neighborhoods by replacing single family homes with multiple units. A simple supply and demand model can show that when you increase the supply of housing the equilibrium rent will decrease, all else equal. Lower rent in some of the city's most desirable neighborhoods would be a good thing for the relatively poor residents of one of the nations most expensive cities. In fact, the D.C. zoning commission appears to agree that the city needs more housing for relatively poor residents:

"In a split vote Monday night, the five-member commission decided to allow developers to convert their pop-ups into condominium buildings with up to four units, with one reserved for families that earn no more than 80 percent of the Washington region’s median family income of $109,200."

So on the one hand the city artificially limits the size of the buildings and number of units by capping their height and the number of stories, and on the other hand they acknowledge that poorer people need a place to live.So they increase the price of rent by artificially restricting the supply of housing and then they throw some scraps to the people most harmed by this policy by mandating that if developers want a fourth unit it must go to a lower income family. (Note that this policy does not mandate that developers actually build this 4th unit, so it is not clear whether any will be built.).

Government officials of all types do this far too often; they intervene in a market, cause a problem, and then try to fix the problem with more intervention, never giving any thought to the idea that maybe things would be better if they just got out of the way.

Much of the relatively high price of housing in cities like D.C. is due to government restrictions on building. Less onerous zoning rules would lead to an increase in the supply of housing, which would lower rents and help poorer families find better housing. Government officials realize this but ultimately they are concerned with staying in power, not helping people.

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 dam 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 they 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.