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.

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.