Instant Economics en-us Nucleus CMS v3.22 © Weblog http://backend.userland.com/rss /nucleus/nucleus2.gif ?itemid=269
It starts with the shortest course in economics I have been able to devise so far. It doesn’t take long but you may have to return to it more than once.

The rest of this area covers a multitude of bits and pieces traceable through the categories (left hand side bar), the search facility (upper left) and the Resources category in the Tools section.

If you are after economic statistics, macro economics or attempts at economic forecasting you are in the wrong place.

The Course

There are only three parts to the course and each one is to be found in the Categories in the sidebar:

1. Critical themes – a realistic way to approach the world, people and behaviour
2. Critical concepts – the ideas boiled down
3. Myths and Delusions – what the media, politicians and others get confused about.

There are then a series of examples which get added to all the time. Typically they illustrate points made above.

Use the Categories in the sidebar to access these in sequence.

All three should be mastered and applied – often.

Other material in various categories is also helpful - but will make more sense once the basics are familiar. Try them first....

For references and more information see the resources pages throughout the site.
For economics in action, i.e. the application of these ideas, see the economics section.

I set out below the gist of economics and the economics story, for it is a story, but a story which, if properly understood and thought about, is one of the most useful stories ever devised to explain human behaviour.

To follow the course go to the Categories in the side bar to the left, start with "1. Critical Themes" and work through...]]> A Rationale ?itemid=269 Fri, 11 Apr 2008 22:23:00 +1200 ?itemid=582
N.Z. has got rid of most tariffs and the remainder are on their way. So far its been 28 years and we still haven't dumped them all. One remaining tariff is on whiteware. Its 7% so every washing machine, clothes dryer and other like appliance is 7% more expensive than it needs to be. Buy a Westinghouse - pay 7% more. Want a European import? Cough up 7%.


Gentle who ????

the 7% washer

Where does the money go? Well apparently its to protect the good folks at Fisher and Paykel. N.Z. jobs don't you know. They have 1,000 of them there. There are of course more than 2.0 million other workers in the country who also consume whiteware - but hey they can afford it, can't they, at the margin?

Where on earth would the mandate for this come from? Who on earth would empower the state to use its coercive power to swipe your 7%?

Surprise, surprise your friendly Chief Executive from F&P was the dude being interviewed about what a shocking situation it was having to compete against the Chinese. F&P are good at it - I worked for one of their C.E.s in 1987 - a great guy as it turns out and an absolute expert lobbyist - that's why they still take 7% off consumers and sprinkle it on their shareholders, workers and suppliers.]]> trade ?itemid=582 Fri, 11 Apr 2008 22:22:37 +1200 ?itemid=577
Apr 5, 2008 (yesterday)
Piracy’s hidden treasures
from Tim Harford by Sophy, for Tim

What should top record labels, software giants and other media companies do about digital piracy? There are two obvious options: get tough and defend intellectual property rights with every legal and technological trick in the book, or tolerate some illegal copying in the hope of generating buzz and making money in some other way.

Piracy...

This is a debate that generates strong opinions, and where you stand seems to depend on whether you’re an industry accountant or a new economy guru. (Chris Anderson, editor-in-chief, Wired magazine, coined the phrase “Freeconomics” to describe giving cheap things away for free in order to create buzz.)

But look closer..... and you realise that the corporate suits aren’t all adopting the same strategy. The music industry doesn’t seem able to make up its mind: first it turned a blind eye to traditional mix-tape piracy, then it cracked down on illegal file-sharing while raising the price of CDs, and finally it slashed the price of CDs in an attempt to compete head-on with downloads, legal and illegal.

Even more perplexing, Microsoft seems to hold two opinions at once: doing its best to prevent piracy on the Xbox console, but (as far as this outsider can tell) accepting that piracy of its Office suite of software is a fact of life.

Karen Croxson is a young economist at Oxford University who claims that there is method in the madness. She argues that there will never be a single correct trade-off between sales lost to piracy and sales generated by the buzz from pirated copies in circulation. That is because there are different kinds of potential consumer in different markets, or even in the same market at different times. A company’s most profitable response to piracy depends on what sort of consumers it is facing.

For example, the consumers who would pay for console games if given no alternative are probably the type of consumers who are happy to use pirated copies: tech-savvy youngsters. That means that an extra pirated copy in the console market is quite likely to mean a lost sale.

But the customers who will pay most for corporate software are, well, corporations. They won’t want to risk being caught and sued for piracy, so an extra pirated copy in the corporate software market probably isn’t a lost sale at all. The guilty party isn’t a customer, but a home-user or a student who would never have stumped up full price. Thanks to piracy, though, that home user is now learning how to use Word and PowerPoint and making the legal copies of Microsoft Office more valuable.

Croxson can even make sense of the record industry’s apparent volte-face with the pricing of CDs. When Napster was starting up and piracy was still a marginal activity, it made sense for record labels to write off a few cheapskate customers as a marketing expense and raise average prices to everyone else – presumably the older, more prosperous customers who were willing to pay for legal music. But as the pirated sector embraced even those customers, the best strategy was to fight back by slashing prices.

In Croxson’s world, then, “promotional piracy” is an alternative to discounted pricing. Both approaches are a way for companies to advertise their products or expand their user base. And as with discounted pricing, promotional piracy only makes sense if there is a decent supply of customers who will eventually pay full price, which is not always true.

Corporations may be able to do more to maximise the gains or minimise the losses from piracy. Why not offer two versions of the product: a cheap-to-pirate, lower-quality product, and a high-end offering incorporating tight security? If Croxson is right, for some industries, piracy is a wonderful distribution channel.]]> Pricing ?itemid=577 Sun, 6 Apr 2008 22:28:06 +1200 ?itemid=567 here (Browser back button to return).]]> Economic Impact Analysis ?itemid=567 Tue, 25 Mar 2008 15:29:16 +1300 ?itemid=552 Website The article is quite long but a must....
(see also Coase for Policy)

The Swedes Get It Right

When the Swedish Academy awarded the Nobel Prize in Economics to Ronald Coase this year, it was a surprise for two different groups of people. The larger group consisted of people who had either never heard of Coase, or heard of him only as the author of something called the "Coase Theorem," generally presented as a theoretical curiosity of no practical importance. The second and much smaller group consisted of people who were familiar with the importance of Coase's work--and assumed that the Swedish Academy was not.Some people get the Nobel prize for complicated and technical work that is difficult for an outsider to understand. Coase is at the other extreme. His contribution to economics has largely consisted of thinking through certain questions more carefully and correctly than anyone else, and in the process demonstrating that answers accepted by virtually the entire profession were false. One side effect of his work was a new field of economics: economic analysis of law, the attempt to use economic theory to understand legal systems. While there would probably be something called economic analysis of law if Coase had not existed, it would be a very different field.

One of Coase's important contributions to economics was to rewrite the theory of externalities--the analysis of situations, such as pollution, where one person's actions impose costs (or benefits) on another. His ideas are sufficiently simple to be understood by a layman, as I will try to demonstrate in the next few pages, and sufficiently deep so that they have not yet been entirely absorbed by the profession; to a considerable extent what is still taught in the textbooks is the theory as it existed before Coase.

To understand the significance of Coase's contribution to the theory of externalities, it is useful to start with the theory as it existed before Coase published "The Problem of Social Cost," the essay that first introduced the Coase Theorem to economics. The basic argument went as follows:

In an ideal economic system, goods worth more than they cost to produce get produced, goods worth less than they cost to produce do not; this is part of what economists mean by economic efficiency. In a perfectly competitive private property system, producers pay the value of the inputs they use when they buy them from their owners (wages to workers in exchange for their labor, rent to land owners for the use of their land, etc.) and receive the value of what they produce when they sell it. If a good is worth more than it costs to produce, the producer receives more than he pays and makes a profit; if the good is worth less than it costs to produce he takes a loss. So goods that should be produced are and goods that should not be produced are not.

This only works if producers must pay all of the costs associated with production. Suppose that is not the case. Suppose, for example, that a steel producer, in addition to using iron ore, coal, etc., also "uses" clean air. In the process of producing a ton of steel he puts ten pounds of sulphur dioxide into the air, imposing (say) $100 worth of bad smells, sore throats, and corrosion on people down wind. Since he does not pay for that cost, he does not include it in his profit and loss calculations.

As long as the price he sells his steel for at least covers his costs it is worth making steel. The result is inefficient: Some goods may be produced even though their cost, including the resulting pollution, is greater than their value. It is inefficient in another respect as well. The steel producer may be able to reduce the amount of pollution by various control devices--air filters, low sulphur coal, high smokestacks--at a cost.

Calculated in terms of the net effect on everyone concerned, it is worth eliminating pollution as long as the cost is less than the pollution damage prevented--in our example, as long as it costs less than $10 to prevent a pound of sulphur dioxide emission. But the steel producer, in figuring out how to maximize his profit, includes in his calculations only the costs he must pay. So long as he does not bear the cost of the pollution, he has no incentive to prevent it. So the fact that air pollution is an external cost results in both an inefficiently high level of steel production (it may be produced even when it is not worth producing) and an inefficiently low level of pollution control.

There are two obvious solutions. One is direct regulation--the government tells the steel company how much it is allowed to pollute. The other is emission fees--referred to by economists as Pigouvian taxes (named after A. C. Pigou, the economist whose ideas I am describing).

Under a system of Pigouvian taxes, the government charges the steel company for the damage done by its pollution--$10 per pound in this example. By doing so it converts the external cost into an internal cost--internalizes the externality. In deciding how much steel to produce and what price to sell it at, the company will now include the cost of its pollution--paid as an emission fee--along with other costs. In deciding how much pollution control equipment to buy, the company balances the cost of control against its benefits, and buys the optimal amount. So a system of emission fees can produce both an efficient amount of steel and an efficient amount of pollution control.

In order to achieve that result, the government imposing the fees must be able to measure the cost imposed by pollution. But, unlike direct regulation, the use of emission fees does not require the government to measure the cost of preventing pollution--whether by installing air filters or by producing less steel. That will be done by the steel company, acting in its own interest.

I have just described the theory of externalities as it existed before Coase. Its conclusion is that, as long as externalities exist and are not internalized via Pigouvian taxes, the result is inefficient. The inefficiency is eliminated by charging the polluter an emission fee equal to the damage done by his pollution. In some real world cases it may be difficult to measure the amount of the damage, but, provided that that problem can be solved, using Pigouvian taxes to internalize externalities produces the efficient outcome.

That analysis was accepted by virtually the entire economics profession prior to Coase's work in the field. It is wrong--not in one way but in three. The existence of externalities does not necessarily lead to an inefficient result. Pigouvian taxes, even if they can be correctly calculated, do not in general lead to the efficient result. Third, and most important, the problem is not really externalities at all--it is transaction costs.

I like to present Coase's argument in three steps: Nothing works, Everything works, It all depends.

Nothing Works

The first step is to realize that an external cost is not simply a cost produced by the polluter and born by the victim. In almost all cases, the cost is a result of decisions by both parties. I would not be coughing if your steel mill were not pouring out sulfur dioxide. But your steel mill would do no damage to me if I did not happen to live down wind from it. It is the joint decision--yours to pollute and mine to live where you are polluting--that produces the cost.

Suppose that, in a particular case, the pollution does $100,000 a year worth of damage and can be eliminated at a cost of only $80,000 a year (from here on, all costs are per year). Further assume that the cost of shifting all of the land down wind to a new use unaffected by the pollution--growing timber instead of renting out summer resorts, say-- is only $50,000. If we impose an emission fee of a hundred thousand dollars a year, the steel mill stops polluting and the damage is eliminated--at a cost of $80,000.

If we impose no emission fee the mill keeps polluting, the owners of the land stop advertising for tenants and plant trees instead, and the problem is again solved--at a cost of $50,000. In this case the result without Pigouvian taxes is efficient--the problem is eliminated at the lowest possible cost--and the result with Pigouvian taxes in inefficient.

Moving the victims may not be a very plausible solution in the case of air pollution; it seems fairly certain that even the most draconian limitations on emissions in southern California would be less expensive than evacuating that end of the state. But the problem of externalities applies to to a wide range of different situations, in many of which it is far from obvious which party can avoid the problem at lower cost, and in some of which it is not even obvious which one we should call the victim.

Consider the question of airport noise. One solution is to reduce the noise. Another is to soundproof the houses. A third is to use the land near airports for noisy factories instead of housing. There is no particular reason to think that one of those solutions is always best. Nor is it entirely clear whether the "victim" is the landowner who finds it difficult to sleep in his new house with jets going by overhead or the airline forced by a court or a regulatory agency to adopt expensive sound control measures in order to protect the sleep of people who chose to build their new houses in what used to be wheat fields--directly under the airport's flight path.

Consider a simpler case, where the nominal offender is clearly not the lowest cost avoider. The owner of one of two adjoining tracts of land has a factory, which he has been running for twenty years with no complaints from his neighbors. The purchaser of the other tract builds a recording studio on the side of his property immediately adjacent to the factory.

The factory, while not especially noisy, is too noisy for something located two feet from the wall of a recording studio. So the owner of the studio demands that the factory shut down, or else pay damages equal to the full value of the studio. There are indeed "external costs" associated with operating a factory next to a recording studio--but the efficient solution is building the studio at the other end of the lot, not building the studio next to the factory and then closing down the factory.

So Coase's first point is that externalities are a joint product of "polluter" and "victim," and that a legal rule that arbitrarily assigns blame to one of the parties only gives the right result if that party happens to be the one who can avoid the problem at the lower cost. Pigou's solution is correct only if the agency making the rules already knows which party is the lower cost avoider. In the more general case, nothing works--whichever party the blame is assigned to, by government regulators or by the courts, the result may be inefficient if the other party could prevent the problem at a lower cost.

One of the arguments commonly offered in favour of using Pigouvian taxes instead of direct regulation is that the regulator does not have to know the cost of pollution control in order to produce the efficient outcome--he just sets the tax equal to damage done, and lets the polluter decide how much pollution to buy at that price. But one of the implications of Coase's argument is that the regulator can only guarantee the efficient outcome if he knows enough about the cost of control to decide which party should be considered the polluter (and taxed) and which should be considered the victim.

Everything Works

The second step in Coase's argument is to observe that, as long as the parties involved can readily make and enforce contracts in their mutual interest, neither direct regulation nor Pigouvian taxes are necessary in order to get the efficient outcome. All you need is a clear definition of who has a right to do what and the market will take care of the problem.

To see how that works, let us go back to the case of the steel mill and the resorts. Suppose first that the mill has a legal right to pollute. In that case, as I originally set up the problem, the efficient result occurs immediately. The lowest cost avoiders are the owners of the land downwind; they shift from operating resorts to growing timber.

What if, instead, the legal rule is that the people downwind have a right not to have their air polluted? The result will be exactly the same. The mill could eliminate the pollution at a cost of $80,000 a year. But it is cheaper to pay the landowners some amount, say $60,000 a year, for permission to pollute. The landowners will be better off, since that is more than the cost to them of changing the use of the land, and the steel mill will be better off, since it is less than the cost of eliminating the pollution. So it will pay both parties to make some such agreement.

Now suppose we change the numbers in the example, to make pollution control the more efficient option--say lower its cost to $20,000. In that case, whether or not the mill has the right to pollute, it will find that it is better off not polluting. If it has the right to pollute, the landowners will pay more than the $20,000 cost of pollution control in exchange for a guarantee that it will not exercise its right. If it does not have the right to pollute, the most the steel mill will be willing to offer the landowners for permission to pollute is $20,000, and the landowners will turn down that offer.

The generalization of this example is straightforward:

If transaction costs are zero--if, in other words, any agreement that is in the mutual benefit of the parties concerned gets made--then any initial definition of property rights leads to an efficient outcome.

It is this result that is sometimes referred to as the "Coase Theorem." It leads immediately to the final stage of the argument.

It All Depends (On Transaction Costs)

Why is it, if Coase is correct, that we still have pollution in Los Angeles? One possible answer is that the pollution is efficient--that the damage it does is less than the cost of preventing it. A more plausible answer is that much of the pollution is inefficient, but that the transactions necessary to eliminate it are prevented by prohibitively high transaction costs.

Let us return to the steel mill. Suppose the mill has the right to pollute, but that doing so is inefficient--pollution control is cheaper than either putting up with the pollution or changing the use of the land down wind. Further suppose that there are a hundred landowners down wind.

With only one landowner, there would be no problem--he would offer to pay the mill for the cost of the pollution control equipment, plus a little extra to sweeten the deal. But a hundred landowners face what economists call a public good problem. If ninety of them put up the money and ten do not, the ten get a free ride--no pollution and no cost for pollution control.

Each landowner has an incentive to refuse to pay, figuring that his payment is unlikely to make the difference between success and failure in the attempt to bribe the steel mill to eliminate its pollution. If the attempt is going to fail even with him, then it makes no difference whether or not he contributes. If it is going to succeed even without him, then refusing to contribute gives him a free ride. Only if his contribution makes the difference does he gain by agreeing to contribute.

There are a variety of ways in which such problems may sometimes be solved, but none that can always be expected to work. The problem becomes harder the larger the number of people involved. With many millions of people living in southern California, it is hard to imagine any plausible way in which they could voluntarily raise the money to pay all polluters to reduce their pollution.

This is one example of the sort of problem referred to under the general label of "transaction costs." Another would occur if we reversed the assumptions, making pollution (and timber) the efficient outcome but giving the landowners the right to be pollution free. If there were one landowner the steel mill could buy from him the right to pollute. With a hundred, the mill must buy permission from all of them. Any one has an incentive to be a holdout--to refuse his permission in the hope of getting paid off with a large fraction of the money the mill will save from not having to control its pollution. If too many landowners try that approach the negotiations will break down, and the parties will never get to the efficient outcome.

Seen from this perspective, one way of stating Coase's insight is that the problem is not really due to externalities at all, but to transaction costs. If there were externalities but no transaction costs there would be no problem, since the parties would always bargain to the efficient solution. When we observe externality problems (or other forms of market failure) in the real world, we should ask not merely where the problem comes from, but what the transaction costs are that prevent it from being bargained out of existence.

Coase, Meade, and Bees

Ever since Coase published "The Problem of Social Cost," economists unconvinced by his analysis have argued that the Coase Theorem is merely a theoretical curiousity, of little or no practical importance in a world where transaction costs are rarely zero. One famous example was in an article by James Meade (who later received a Nobel prize for his work on the economics of international trade).

Meade offered, as an example of the sort of externality problem for which Coase's approach offered no practical solution, the externalities associated with honey bees. Bees graze on the flowers of various crops, so a farmer who grows crops that produce nectar benefits the beekeepers in the area. The farmer receives none of the benefit himself, so he has an inefficiently low incentive to grow such crops. Since bees cannot be convinced to respect property rights or keep contracts, there is, Meade argued, no practical way to apply Coase's approach. We must either subsidize farmers who grow nectar rich crops (a negative Pigouvian tax) or accept inefficiency in the joint production of crops and honey.

It turned out that Meade was wrong. In two later articles, supporters of Coase demonstrated that contracts between beekeepers and farmers had been common practice in the industry since early in this century. When the crops were producing nectar and did not need pollenization, beekeepers paid farmers for permission to put their hives in the farmers' fields. When the crops were producing little nectar but needed pollenization (which increases yields), farmers paid beekeepers. Bees may not respect property rights but they are, like people, lazy, and prefer to forage as close to the hive as possible.

The fact that a Coasian approach solves that particular externality problem does not imply that it will solve all such problems. But the observation that an economist as distinguished as Meade assumed Coase's approach was of no practical significance in a context where it was actually standard practice suggests that the range of problems to which the Coasian solution is relevant may be much greater than many would at first guess.

Coase, Property, and the Economic Analysis of Law

"The Problem of Social Cost" provides more than merely a revolutionary rethinking of the question of externalities. It also suggests a new and interesting approach to the problem of defining property rights.

A court, in settling disputes involving property, or a legislature in writing a law code to be applied to such disputes, must decide just which of the rights associated with land are included in the bundle we call "ownership." Does the owner have the right to prohibit airplanes from crossing his land a mile up? How about a hundred feet? How about people extracting oil from a mile under the land? What rights does he have against neighbors whose use of their land interferes with his use of his? If he builds his recording studio next to his neighbor's factory, who is at fault? If he has a right to silence in his recording studio, does that mean that he can forbid the factory from operating, or only that he can sue to be reimbursed for his losses? It seems simple to say that we should have private property in land, but ownership of land is not a simple thing.

The Coasian answer to this set of problems is that the law should define property in such a way as to minimize the costs associated with the sorts of incompatible uses we have been discussing--factories and recording studios, or steel mills and resorts. The first step in doing so is to try to define rights in such a way that, if right A is of most value to someone who also holds right B, they come in the same bundle.

The right to decide what happens two feet above a piece of land is of most value to the person who also holds the right to use the land itself, so it is sensible to include both of them in the bundle of rights we call "ownership of land." On the other hand, the right to decide who flies a mile above a piece of land is of no special value to the owner of the land, hence there is no good reason to include it in that bundle.

If, when general legal rules were being established, we somehow knew, for all cases, what rights belonged together, the argument of the previous paragraph would be sufficient to tell us how property rights ought to be defined. But that is very unlikely to be the case. In many situations a right, such as the right not to have noises of more than X decibels made over a particular piece of property, may be of substantial value to two or more parties--the owner of the property and the owner of the adjacent factory in my earlier example, for instance. There is no general legal rule that will always assign it to the right one.

In this case, the argument underlying the Coase Theorem comes into play. If we assign the right initially to the wrong person, the right person, the one to whom it is of most value, can still buy it. So one of the considerations in the initial definition of property rights is doing it in such a way as to minimize the transaction costs associated with fixing, via private contracts, any initially inefficient definition.

An example may make this clearer. Suppose that, in the pollution case discussed earlier, damages from pollution are easy to measure and the number of people downwind is large. In that case, the efficient rule is probably to give downwind landowners a right to collect damages from the polluter, but not a right to forbid him from polluting. Giving the right to the landowners avoids the public good problem that we would face if the landowners (in the case where pollution is inefficient) had to raise the money to pay the steel mill not to pollute. Giving them a right to damages rather than giving each landowner the right to an injunction forbidding the steel mill from polluting avoids the holdout problem that the mill would face (in the case where pollution is efficient) in buying permission from all of the landowners.

A full explanation of how Coase's argument can be applied to figuring out what the law ought to be (more precisely, what legal rules lead to the best outcome from the standpoint of economic efficiency) would require a much longer article--perhaps a book. I hope I have said enough to make clear the basic idea, and enough to show the unique and extraordinary nature of one of Ronald Coase's principal contributions to economics.

He started with a simple insight, based in part on having read cases in the common law of nuisance--the branch of law that deals with problems such as noisy factories next door to recording studios. He ended by demonstrating that what everyone else in the profession thought was the correct analysis of the problem of externalities was wrong, and, in the process, opening up a whole new approach to the use of economics to analyze law.

There is at least one more thing worth saying about "The Problem of Social Cost." Economists, then and (to some degree) now, tend to jump from the observation that the market produces an inefficient result in some situation to the conclusion that the government ought to intervene to fix the problem. Part of what Coase showed was that, for some problems, there is no legal rule, no form of regulation, that will generate a fully efficient solution.

He thus anticipated public choice economists, such as James Buchanan (another Nobel winner), in arguing that the real choice was not between an inefficient market and an efficient government solution but rather among a variety of inefficient alternatives, private and governmental. In Coase's words: "All solutions have costs and there is no reason to suppose that government regulation is called for simply because the problem is not well handled by the market or the firm."



One version of this article was published by Reason Magazine, and a slightly different version by the University of Chicago Law School Record--their alumni magazine.)



References

Cheung, Steven N. S., "The Fable of the Bees: An Economic Investigation," Journal of Law and Economics XVI (1973), 11-33.

Coase, R.H. , The Problem of Social Cost, Journal of Law and Economics 3, 1-44 (1960).

Friedman, D., The Machinery of Freedom, 2nd Edn., Open Court: La Salle, 1989, Chapters 41-43.

Johnson, David B., "Meade, Bees, and Externalities," Journal of Law and Economics XVI (1973), 35-52.

Meade, J. E., "External Economies and Diseconomies in a Competitive Situation," 52 Economic Journal 54 (1952).

Pigou, A.C., Wealth and Welfare (1912) and The Economics of Welfare (1920).

Posner, R., Economic Analysis of Law, 3rd Edn., Little Brown & Co. Boston, 1986.]]> Property Rights ?itemid=552 Fri, 14 Mar 2008 21:44:18 +1300 ?itemid=549 The Supreme Court concludes that most government agencies should be out of business.
By Steven E. Landsburg
June 4, 2002, Slate Magazine, www.msn.com

OK, it's official. The Supreme Court has declared that most local government activities are prohibitively expensive. The routine business of issuing building permits, investigating crimes, maintaining health codes, regulating land use—these are all unjustifiable luxuries. In a world of honest reckoners, there would be almost no government at all.That's the thrust of the court's April opinion in the Tahoe case. The case harks back to the early '80s, when local governments around Lake Tahoe formed a regional planning agency to develop a strategy for ecologically sound growth. While the agency was devising its plan, the governments imposed a moratorium on economic development. If you wanted to build a strip mall, you had to wait.

Sound prudent? Not according to Justice Stevens, who, speaking for a majority of the Supreme Court, declared pretty much all land-use planning—and for that matter, pretty much all government activity—an extravagance.

Well, OK, that's not exactly what Justice Stevens said. But it follows inexorably from what he did say. When local landowners requested compensation for moratorium-related losses, the court turned them down. Why? Because, according to Justice Stevens, land-use regulation—and for that matter most other government activity—would be prohibitively expensive if governments bore all the costs.

But if a regulation is too expensive when governments (i.e., taxpayers) bear the costs, then that same regulation is too expensive, period. If a development moratorium costs landowners $10,000, then the cost of that moratorium is $10,000, whether or not the landowners are compensated. Without compensation, the landowners are out $10,000; with compensation, the taxpayers are out $10,000; either way, the $10,000 cost is the same.

And is $10,000 a prohibitive expense? That's like asking whether $10,000 is too much to pay for a car; the answer depends on how much you want the car, or in this case on how much you value the benefits of land-use regulation (which we haven't yet accounted for, and which might come to either more or less than $10,000). But shifting that $10,000 burden from taxpayers to landowners can't change the size of the burden, so it can't change the expense from reasonable to unreasonable.

This was a lesson that economists hammered into public consciousness in the bad old days of the military draft. Back then, the pro-draft lobby used to argue that a volunteer Army would be prohibitively expensive. Economists took to the airwaves and the op-ed pages to argue that a draft is just as expensive as a volunteer Army. To hire David Letterman as a soldier, you'd have to pay him the same $30 million he earns at CBS. But if you draft him, you cost him $30 million in lost salary. Either way, the cost is $30 million, and he should be in the Army only if he provides at least $30 million worth of military service.

I believe, though I cannot prove, that through their persistence in making that argument, economists had a lot to do with swaying influential opinion against the draft. But that was a long time ago, and the lesson has apparently been forgotten. So let me reiterate it: Anything that's too expensive for the government to pay for is too expensive, period.

In the Tahoe case, that leaves only two possibilities. Either a) the justices—having concluded that paying compensation would transform routine government activity into "a luxury few governments could afford"—are prepared to draw the logical conclusion that routine government activity is not worth the cost, and therefore local governments should for the most part be out of business; or b) the justices are incapable of employing enough elementary logic and economic analysis to understand the implications of their own opinion.

What if the court had ruled differently, requiring governments to bear the costs of their own regulatory activities? Then those governments would be forced to think hard about which regulations are worth preserving. That's all to the good. We should encourage policy-makers to be reflective. Instead, the court has encouraged policy-makers to ignore the costs of their own decisions; that's a recipe for bad decisions.

In his decision, Justice Stevens expresses quite explicitly the belief that if governments had to pay for the costs they impose on landowners, then in almost every case, a sufficiently reflective policy-maker would opt for almost zero government. I'm not sure whether that's true or false, but if it's true, then it follows that we should have almost no government. So the court's position comes down to this: We should exempt governments from compensating landowners because that's the only way we can continue having more government than we ought to.]]> Policy ?itemid=549 Fri, 14 Mar 2008 21:09:31 +1300 ?itemid=546
With parliament considering "degree of murder" legislation and Ministers telling judges to use their "full sentencing powers" there is a little bit of financial economics we might draw from that seems to be ignored regularly. That relates to what I call here "the time value of sentences".

Timely sentences ???

What is the value or utility of a gaol term? What is the disutility imposed on a criminal by a sentence of this or that amount of time spent in gaol.There is nothing sociological, psychological or legal in the points below but they are worth a thought. They rest on the fundamental notion that a year now is not the same in value terms as a year starting 20 years from now. In short, seen from today, each period of time making up a gaol sentence has a different value depending on when it is considered from.

Just the same as a dollar today is worth more than a dollar which is only available this time next year so it is with a year of "freedom" available now versus the same year but available only at some time in the future. This is the origin of sayings such as "eat, drink and be merry for tomorrow we die", or "you only live once" or "life's too short".

So, we can think about the value or disutility (loss of freedom) inherent in a gaol sentence in the same way as we think about cashflows. We have to express all of the years in a sentence taking account of their diminishing value over time. Year 20 of a 20 year gaol term does not have the same value seen from today as year one. How could we do this?

Simply apply the same mathematics to the problem as we do with cashflows. A dollar available in one years time is worth 10% less, ie, $0:90c if the interest rate is 10%, than a dollar today since a dollar today can be invested for the year and earn 10 cents. It works the same with each year in a gaol sentence - a year lost down the track is worth less than one lost now. I'm leaving aside the detail of old age complications just for the moment but even then a year lost when you are dead may be worth a good deal less than one lost now (hence "you're dead a long time").

What discount rate do we use? A topic of vast debate is the appropriate discount rate for the value of life. One reasonable consensus is that the real social discount rate may be 3% (look elsewhere for the reasoning behind this!). Using an average inflation rate of 2% we could plausibly say that an appropriate rate to discount gaol terms at is therefore 5%.

Applying the analysis produces some interesting results. A judge dishing out a 5 year gaol term is in fact handing out a 4 year term in present value terms. If he doubles the sentence to 10 years he is not in fact doubling it to 10. He is increasing it to 8. If he wants to double it he would have to sentence the convicted to 15 years to get this effect in present value terms.

With sentences such as "life" defined as 20 years, the penalty is actually 12 years (leave aside good behaviour etc...more of that later). Even a 90 year term, well beyond the average life expectancy, produces only a 20 year term. A "retirement age" term of 60 years is actually 19 years.

What has all this got to do with anything. Quite a bit - even if we only consider a few situations. Lets take incentive or deterrent effects. If (and I'm told it's a big if [and maybe I know why]) the theory that longer sentences will deter criminals then the policy debate might suggest longer sentences will help reduce crime. Debates over the appropriate sentences for certain sexual crimes have over recent years been debated with moves such as "increasing sentences from 10 up to 15 years" being the kind of reform advocated.

For our purposes here it matters little whether the numbers "10" or "15" are the ones in question. Of greater interest is the fact that this increase is, in present value terms not an increase of 5 years but an increase of just 2 years. Since deterrent effects would have to work in the present (ie, now, immediately before the crime being contemplated is considered) it is the present value of the sentence which is of relevance.

Accordingly a reform increasing the sentence by 5 years only delivers 2 years "worth" of increased deterrence. You would need a reform to go to 30 years to get a "15 year" effect. So, while I imagine numerous scholars and researchers would tell us deterrents of this nature "don't work", even if they did our analysis says the reformers are probably not even dishing out anything like as much deterrent medicine as they think.

While it is not fashionable to speak of gaol terms as "revenge" by society, there seem to be some who believe they are or should. Leaving aside the (in my view highly questionable) merits of this view, here it can be pointed out that the "time value of sentencing" analysis means that those adopting this view are being short changed by sentence increases too.

A flipside is that we may get too upset about parole and reduction of sentences for good behaviour. Reversing the inferences drawn from the analysis suggests that years "lost" off the back end of a sentence may not be as important in impact as early years. Again there could well be impacts for reform.

There are many other implications. There are numerous ways we could measure the loss in utility, e.g., foregone income, lost educational opportunity etc.., and the usual plethora of discount rate arguments. Work from my own discipline of financial economics would say even the discount model may be inferior to option valuation models in this application.

The debates aside, the general point that time decay in sentencing is a significant characteristic of the policy instrument remains. It appears that random often emotive cries for longer sentences or cries of achievement by politicians that they have achieved longer sentencing may regularly be wrong in fact and invalid.

A final curiosity is that this concept does not appear to have a central place in the law. Strange because concepts such as "justice delayed is justice denied" are central to legal systems and, recently and topically, elements of what might be called the "Pinochet Defence" - such as it was a long time ago and now I'm crook - all depend on notions about time and its differing value relative to the present.
]]> everyday economics ?itemid=546 Fri, 14 Mar 2008 17:04:47 +1300 ?itemid=545 The essence of trade and negotiation:

In the film "Pretty Woman" Julia Roberts and Richard Gere are establishing what price will be paid for her to spend the night with him.

Julia: "Ok, $2,000."
Richard: "Ok, so its $2,000"

Julia: "Aha gotcha, I would have done it for $1,500."
Richard: "Yes, but I would have paid $2,500."

This is well worth thinking about carefully….]]> trade ?itemid=545 Fri, 14 Mar 2008 16:56:45 +1300 ?itemid=543
Torts

Acts that injure others.

Negligence

A defendant’s failure to take precautions whose cost is less than the damage caused by an accident multiplied by the probability that the accident will occur.

Contributory Negligence

A plaintiff’s failure to take precautions whose cost is less than the damage caused multiplied by the probability that the accident will occur.

Strict Liability

Liability that exists regardless of whether the defendant or the plaintiff has been negligent.

Efficiency Implications of Each Rule

Negligence

Your barbeque has a 25% chance of setting the neighbours shed on fire. Damage caused by the fire would be $1,000. You are negligent and therefore liable if you could have taken precautions which would have cost less than $250.

This encourages low cost prevention while discouraging wasteful prevention in which cost of prevention exceeds its value.

But:

Perhaps the neighbour can fire proof the shed for $100 while precautions you could take would cost $200. In this case the negligence rule is inefficient.

Contributory Negligence

The rule would modify a straight negligence rule by recognising that the neighbour can take precautions and so should not collect the full liability.

But:

If the neighbour – the plaintiff - cannot collect there is a lower incentive for the defendant to take precautions since he will not be found negligent. Then the rule is inefficient.

As well as these two problems:

It may be that the least cost solution lies in not cooking outdoors at all – precautions taken by you or precautions taken by the neighbour are both more costly than you moving indoors.

Only you, of course, know the true cost of giving up barbeques and moving indoors.

Strict liability

This would say you are liable for all barbeque fires regardless of negligence including who is or isn’t being negligent.

This efficient if more damage is expected than barbeque cooking is worth and you give it up voluntarily but less efficient in that there is no incentive for the neighbour to take precautions.

Is there a general conclusion?

- negligence provides incentives once activities have commenced

- strict liability provides incentives to make efficient decisions about whether to commence

Steven Landsburg “Price Theory and Applications” 5th Edition, 2002, South Western College , Thomson Learning, Ohio . Pp 474.]]> law and economics ?itemid=543 Fri, 14 Mar 2008 16:34:57 +1300 ?itemid=507 An Allegory on Congestion Pricing (thanks to David Haarmeyer)

Many years ago in the small kingdom of Rhodes, the King declared that henceforth everyone was to have free access to freshly baked bread. It became known as the “King’s Loaf” and the provision of free bread became part of the island’s tradition.
Over the years, various rules developed. For example, to qualify as fresh the bread had to have been baked within two hours of sale. Fresh bread had to be available 24 hours a day, although the most popular times for collecting the bread were early morning, in time for breakfast, and early evening, when the workers came home for their supper. This created production problems. Large ovens were installed to cope with the morning and evening peak requirements, and these were only lightly used at other times. Despite investment in bigger and bigger ovens, there were always queues at peak times.

The cost of providing the bread came out of the government coffers, and it was substantial. In fact the government always had a problem finding the dough. So it introduced a tax on butter. People complained, as they do for any tax, but it was generally accepted as being a fair way of “raising the dough”.

Arguments still arose. Some people felt that a greater proportion of the butter tax should be spent on providing additional ovens, while some economists argued that introducing a charge for bread at peak times would reduce the queues. Politicians knew that such a charge would be very unpopular so the idea never caught on. Anyway it was thought too difficult to charge for the peak - even the economists disagreed amongst themselves on how to calculate the socially optimal peak charge. Many felt that the idea would only be accepted if the peak charge was used for building more ovens and subsidising dry biscuits.

The government did what it could. A hypothecated fund was established under the control of a bread board (Grains Fund) to clarify the relationship between the butter tax and the provision of new ovens. A subsidy was introduced for dry biscuits to encourage people to buy those instead of taking free bread at peak times. GrainsFund developed funding criteria for alternatives to bread. Government legislated for flexible working hours so that some people might get their bread earlier or later in the day. And it allowed some bakers to sell hot bread at a higher price so people buying hot bread didn’t have to queue. Yet, demand for more peak bread-making capacity still grew.

Economists calculated that the economic burden of having people queuing for hours for their bread cost the country millions a year. In some places the queues took hours to clear, and everyone agreed that it was a serious problem. But suggestions to charge for peak bread were still dismissed as unworkable. Instead proposals were developed for building more dry biscuit factories in the hope that bread eaters could be tempted away from their loaf.

Then somebody said “we must stop talking about charging extra for peak bread”. No one wants an extra tax, but no extra taxes are needed. What we must do is abolish the butter tax, and let the bakers sell bread at the market price.

So that was done. It still took a fight because the idea of the King’s Loaf was so ingrained. But there was already a precedent. The government had already sold the railways and the phone company. So the butter tax was abolished and the price of bread was set by the bakers. No one had to calculate the socially optimum price as the prices were set by supply and demand, just like train tickets and phone calls. When the price of bread rose, bakers invested in new ovens. People couldn’t imagine why they hadn’t thought of it before.

]]> Market Processes ?itemid=507 Fri, 25 Jan 2008 09:22:36 +1300