Class Notes

Category: Class Notes

The Price of Life

In this, the 500th post on the Lawrence Economics Blog, we bring you a story from the NYT on the statistical value of life.  Indeed, as anyone in an environmental economics or policy course knows, the “value” placed on saving a statistical life (VSL) is associated with reductions in risk levels that decrease the probability of being killed (i.e., from reducing the number of purple balls in your urn).

This VSL is pivotal in determining the benefits of many non-economic regulations, and many federal agencies have increased the value used in benefit assessment in the past few years.

The Environmental Protection Agency set the value of a life at $9.1 million last year in proposing tighter restrictions on air pollution. The agency used numbers as low as $6.8 million during the George W. Bush administration.

The Food and Drug Administration declared that life was worth $7.9 million last year, up from $5 million in 2008, in proposing warning labels on cigarette packages featuring images of cancer victims.

The Transportation Department has used values of around $6 million to justify recent decisions to impose regulations that the Bush administration had rejected as too expensive, like requiring stronger roofs on cars.

That is the salient point of the article; the rest mostly gets down to talking about the prospects and problems of using VSLs in the first place.  If you are reading this, you probably know already.

AER Top 20

The American Economic Association developed a list of the top 20 “most admirable and important articles” published in the American Economic Review in its 100 years in existence.   I use several of these in class (*) and have read a handful of others.  It would be interesting to know how many of these cross your desk as an undergrad here at LU.

Alchian, Armen A., and Harold Demsetz. 1972. “Production, Information Costs, and Economic Organization.”American Economic Review, 62(5): 777–95.(*Theory of the Firm)

Arrow, Kenneth J. 1963. “Uncertainty and the Welfare Economics of Medical Care.” American Economic Review, 53(5): 941–73.

Cobb, Charles W., and Paul H. Douglas. 1928. “A Theory of Production.” American Economic Review,18(1): 139–65.

Deaton, Angus S., and John Muellbauer. 1980. “An Almost Ideal Demand System.” American Economic Review, 70(3): 312–26.

Diamond, Peter A. 1965. “National Debt in a Neoclassical Growth Model.” American Economic Review, 55(5): 1126–50.

Diamond, Peter A., and James A. Mirrlees. 1971. “Optimal Taxation and Public Production I: Production Efficiency.” American Economic Review, 61(1): 8–27.

Diamond, Peter A., and James A. Mirrlees. 1971. “Optimal Taxation and Public Production II: TaxRules.” American Economic Review, 61(3): 261–78.

Dixit, Avinash K., and Joseph E. Stiglitz. 1977. “Monopolistic Competition and Optimum Product Diversity.” American Economic Review, 67(3): 297–308.

Friedman, Milton. 1968. “The Role of Monetary Policy.” American Economic Review, 58(1): 1–17.

Grossman, Sanford J., and Joseph E. Stiglitz. 1980. “On the Impossibility of Informationally Efficient Markets.” American Economic Review, 70(3): 393–408.

Harris, John R., and Michael P. Todaro. 1970. “Migration, Unemployment and Development: A Two-Sector Analysis.” American Economic Review, 60(1): 126–42.

Hayek, F. A. 1945. “The Use of Knowledge in Society.” American Economic Review, 35(4): 519–30. (*Micro Theory)

Jorgenson, Dale W. 1963. “Capital Theory and Investment Behavior.” American Economic Review, 53(2): 247–59.

Krueger, Anne O. 1974. “The Political Economy of the Rent-Seeking Society.” American Economic Review, 64(3): 291–303. (*Political Economy of Regulation)

Krugman, Paul. 1980. “Scale Economies, Product Differentiation, and the Pattern of Trade.” American Economic Review, 70(5): 950–59.

Kuznets, Simon. 1955. “Economic Growth and Income Inequality.” American Economic Review, 45(1): 1–28.

Lucas, Robert E., Jr. 1973. “Some International Evidence on Output-Inflation Tradeoffs.” American Economic Review, 63(3): 326–34.

Modigliani, Franco, and Merton H. Miller. 1958. “The Cost of Capital, Corporation Finance and the Theory of Investment.” American Economic Review, 48(3): 261–97.

Mundell, Robert A. 1961. “A Theory of Optimum Currency Areas.” American Economic Review,51(4): 657–65.

Ross, Stephen A. 1973. “The Economic Theory of Agency: The Principal’s Problem.” American Economic Review, 63(2): 134–39. (*I should use this in Economics of the Firm, but I don’t).

Shiller, Robert J. 1981. “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?” American Economic Review, 71(3): 421–36.

Happy Birthday Professor Coase

The intellectual founder of transaction cost economics, Ronald Coase, turns 100 today.  Coase is best known for two papers: “The Nature of the Firm” in 1937 and “The Problem of Social Cost” in 1960.  Both are about the importance of transaction costs.  The former shows that without transaction costs the firm doesn’t matter, and this serves as the starting point for Econ 450.  As The Economist‘s Schumpeter blog points out:

Today most people live in a market economy, and central planning is remembered as the greatest economic disaster of the 20th century. Yet most people also spend their working lives in centrally planned bureaucracies called firms.

Certainly, this has had a profound impact on organizational theory and industrial organization.

The latter paper shows that without transaction costs the law doesn’t matter, the foundation of the so-called Coase Theorem. , and this idea figures prominently in Econ 280. Indeed, the latter is one of the most heavily cited papers in all of social sciences, and is the centerpiece of the law & economics movement.

Coase also wrote the very provocative“The Market for Goods and the Market for Ideas,” arguing that the case for product regulation is no stronger than the case for regulating ideas — a good discussion starter to say the least.

For a pretty good portrait of Coasian ideas, check out his interview with Reason Magazine from back in the day.

Schumpeter and the Fashion Industry

Today we are treated to a discussion of the fashion industry from Ms. Richter & Ms. Li.   The first from the Schumptoberfest collection.  Enjoy!

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“The evolution of the capitalist style of life could be easily – and perhaps most tellingly – described in terms of the genesis of the modern Lounge Suit.” -Joseph Schumpeter

Creative destruction saturates the fashion industry; you must be the trend-setter otherwise the “foundation of your very life” will be in jeopardy. Large firms enjoy an advantage in spreading risk over many projects (e.g. inventions that never “catch” as a trend) and have the resources and brand power to set trends, thus helping their inventions turn into successful innovations, driving the fashion cycle forward through induced obsolescence. Due to lack of IP laws, large firms do not enjoy the monopolistic protectionism that IP rights provide, but they have other means justifying their investments. Schumpeter’s hypothesis suggests that large firms foment innovation for factors other than scale economies, and in the fashion industry, and the fashion cycle is a key example of this phenomenon.

The fashion industry, a $200 billion industry in the United States alone, is comprised of nearly 150,000 establishments, ranging in size from large fashion houses to smaller start-ups. Although there are a large number of firms competing in the industry, according to the 2002 Census, five percent of firms in the clothing industry accounted for twenty percent of total revenue and sales. These large firms, , also play an important role in the diffusion of new design trends and the continuation of induced obsolescence, the dynamic force driving the fashion cycle forward; the influence of large firms contributes to the top-down structure of the industry.

Consumers are not strictly motivated by price, but also pay attention to  brand, quality, design differentiation, or trendiness (flocking). Because of complex consumer decision-making, product differentiation and new designs are essential to driving the industry forward Raustiala and Sprigman (2009) argue that  induced obsolescence is the process by which designs, through copying and diffusion into mainstream fashion, become obsolete and therefore undesirable to fashion-forward consumers. These fashion-forward people then demand new designs, which are invented by top firms and diffused downward through trends, again, through copying. This process is called the fashion cycle. This cycle is very rapid and is completed each season.

Continue reading Schumpeter and the Fashion Industry

What Can Brownies Do for You?

After yesterday’s spirited discussion of the nature of the long-run supply curve, tomorrow we will kick off with the classic brownie problem:

Brownies sell for $12 a dozen and are available only in packs of a dozen.  You choose to buy two packs a month.  If sellers begin offering brownies at $1 each, what can you say about the quantity you will buy?

Check into Econ 300 Friday for the answer.

Schumptoberfest a Success

The Schumptoberfest celebration was a smashing success, with at least one of us understanding the Williamson debt-equity financing argument a little better at the end than at the beginning.  Thanks to all those who participated, especially Professor Galambos, who took time out from his sabbatical leave to read “100” pages and keep me in line.

As per usual with these events, we received word that there were some items left behind.  Here is a partial accounting: a set of dentures, a hearing aid, “a leather whip, a live rabbit, a tuba, a ship in a bottle, 1,450 items of clothing, 770 identity cards, 420 wallets, 366 keys, 330 bags and 320 pairs of glasses, 90 cameras and 90 items of jewellery and watches.”

Thanks to Tom for the tip.

Schumptoberfest Sunday

Describe the industrial structure and to evaluate the interrelationships between firm size, market structure, and innovation in your assigned industry. You should address the following questions:

  • What are the strengths and weaknesses of using a model of “perfect competition” (many firms, homogenous products, low switching costs, price competition) to characterize the industry?
  • What is the “structure” of your industry? Is it dominated by a few firms (concentrated)? Or are there many firms?
  • How would you characterize innovation in your industry? Is it particularly dynamic or innovative? Are we observing new products or new processes? Are the firms that come up with the ideas the same as those implementing these ideas?
  • Would you say your industry characterized by managerial or entrepreneurial capitalism?  That is, how is innovation funded in this industry?

Next, determine where you come down on the “Schumpeter hypothesis” in terms of market structure and innovation. Write down a thesis statement and three supporting points to argue for or against Schumpeterian-type arguments.  These might include:

  • R&D projects have high fixed costs that can only be covered by industry with robust revenue streams.
  • Economies of scale and scope foment innovation.
  • Diversified firms are in superior position to identify and exploit unforeseen innovation opportunities.
  • Large firms are able to spread the R&D risks across many projects.
  • Large firms have more favorable treatment in obtaining external financing.
  • Firms with market power make higher profits, and can use retained earnings to finance R&D from own profits.
  • Firms with market power have fewer rivals and thus are more able to appropriate returns from innovation, bolstering the incentive to innovate.

We will spend Sunday morning talking about these industries.  We will begin by going around and providing a brief description of each industry.  After that, each group will state its thesis and then discuss its supporting arguments.

William James Adams, (2006) “Markets: Beer in Germany and the United States,” Journal of Economic Perspectives, 20(1): 189-205

Emek Basker (2007) “The Causes and Consequences of Wal-Mart’s Growth.” Journal of Economic Perspectives, 21(3): 177–198

Kal Raustiala and Christopher Jon Sprigman (2009) “The Piracy Paradox Revisited,” Stanford Law Review, 61(5).


Schumptoberfest Readings: Galambos, Teece, and Blaug

Following up on Chapter VII of Capitalism, Socialism, & Democracy from last time, we move on to some rather more modern treatments of the economics of innovation.  We start with Professor Galambos’ and a slightly modified version of the primer he gives to his students in his excellent course, In Pursuit of Innovation (coming this winter).

Galambos wades through some basics of innovation policy and the industrial enlightenment before arriving at the question of allocative efficiency on pages 4 and 5. Again, the conventional treatment is that there is a tradeoff between the promise of monopoly profits and the efficiency properties of competitive industries.  And, recall, this is a tradeoff that Schumpeter explicitly rejects.

Continue reading Schumptoberfest Readings: Galambos, Teece, and Blaug

Global Climate Change, Political Climate Don’t

As I sift through material for my environmental economics course (Econ 280) this winter, I have found some very interesting material on the political economy of climate change.  Ryan Liazza in the New Yorker walks through the process by which an idea becomes a bill becomes a law — or, in this case, doesn’t become a law.  It is difficult to understand environmental economics and policy without knowledge of these tortured dealings, the underlying institutional rules, and that pesky electorate.

Over at the Economix blog, David Leonhardt has been doing yeoman’s work, provides another perspective on the political economics of climate change legislation,  looks at what EPA could reasonably do to curb CO2 emission without such enabling legislation, and has a couple of pieces (one here, one here) on so-called clean energy.

I will also use this paper on “carbon geography” to illustrate how economists go about these political economics questions.  I don’t think we as economists ever expected serious climate legislation, certainly nothing approaching the types of reductions needed to stabilize atmospheric concentrations.

Schumptoberfest Mark VII, The Gales of Creative Destruction

In the second post here, I will simply concentrate on Chapter VII of Capitalism, Socialism, and Democracy, and try to tie together some themes for the weekend.  For our purposes, I have numbered the paragraphs 1-13.

As we proceed into this chapter, it is probably useful to keep in mind that at the time of this writing, the national income accounts and measurement of economic output were even more primitive than they are today.  So, one question is how did economists in 1942 think about “growth” and “output”?

The null hypothesis is immediately stated in the opening sentence of the chapter — that there is some question that “capitalist reality” stifles economic growth.  I take “capitalist reality” to mean the consolidation of firms and increasing concentration of industries as they mature.  This is going to get at the essence of a “Schumpeterian Hypothesis,” (see the last sentence of paragraph two for a germination of this idea — “big business may have had more to do with creating that standard of life than keeping it down.” We’ll get to the efficiency implications of this in a bit, but for the moment note that he offers two possible rationales for the antagonism toward large firms.   One is the idea that growth occurs despite the “managing bourgeoisie” (that is, monopolists restricting output and jacking prices).  The second is that this worked for a while, but it cannot proceed indefinitely.

Continue reading Schumptoberfest Mark VII, The Gales of Creative Destruction

Introduction to Schumptoberfest

This is a first in a series of short posts to guide the Schumptoberfest readings.  I included these readings literally to give you an introduction to Schumpeter and the “Schumpeterian Hypotheses.”

These introductory readings shouldn’t take terribly long to read — perhaps an hour.  I will carefully go through Chapter VII of Capitalism, Socialism, and Democracy in my next post.

Paul J. McNulty “Austrian Competition,” From The New Palgrave Dictionary of Economics, 2nd edition

The first reading from Paul McNulty on how Austrian economists view competition immediately invokes Schumpeter as a critic of the model of perfect competition.  As many of you know, the model of perfect competition that I love and teach in price theory, is essentially an equilibrium construct.  That is, we expect to be moving toward a long run competitive equilibrium, where price = average costs for the marginal firm in the industry.  (Incidentally, the way that firms compete in the fourth paragraph is largely what Industrial Organization is all about).  Schumpeter, in contrast, espouses a “disequilibrium” theory, and argues that competition isn’t about allocative efficiency as much as it’s about, that’s right, creative destruction.

Continue reading Introduction to Schumptoberfest

The 300 Challenge, Parts 1 & 2

Hey, that's not Steven Landsburg

What is it with Steven Landsburg and apples?

PART 1: Audrey shops at Wegman’s supermarket, where she spends $20 a week to buy 10 apples and 5 bananas.  IF she bought the same 10 apples and 5 bananas at Top’s supermarket, she’d pay $30.   True or False:  Audrey is wise to continue shopping at Wegman’s.  (Hint: This is easy).

PART 2: You earn $100.  You can use your $100 to buy 100 current apples, 200 future apples, or any combination in between.

Consider a 50% tax on wages versus a 40% tax on all income (that is, wages and interest income)  and assume both taxes raise the same amount of revenue.

Which tax do you prefer?  Under which tax do you consume more (and save less) today? (Hint: I’m not sure if this is easy or not).

Schumptoberfest Sign Up Continues

I have logged several folks for the Schumptoberfest weekend weekend, October 22 to 24, at Björklunden.  If you are interested and would like IS credit, please sign up with me by Friday.  I have some IS forms tacked on the board outside my office.  it is best that you sign up by Friday.

Again, the requirements are:

  • Complete the assigned readings.
  • Travel to Björklunden over reading period (Friday evening until Sunday afternoon) and participate in our workshop.
  • Write a short response paper (3-5 pages) to the ideas and discussions from the weekend.

We would like to engage students who have a good understanding of micro theory and are interested in innovation and entrepreneurship. The readings dovetail nicely with my Economics 400 (IO) and 450 (theory of the firm) courses.

I am in the process of completing the reading list and will provide both PDFs and reading guides for the materials within the next week.

Ready or Not

The term is upon us and that means it’s time to start posting things that might actually have some utility for someone (for instance, me).

So let’s start out with an easy one — are you registered yet? No better time to start thinking about it. Here are some potentially useful links:

And, as long as you are registering, you might as well check out our offerings for the Fall term.  There is still room as of this posting, unless otherwise noted:

I will also be offering an independent study associated with Schumptoberfest™ weekend, October 22-24.  Check with me for details.

See you on Briggs 2nd.

Textbook Tuesday

I’m a big fan of Steven Landsburg’s approach to micro theory, and hence I have adopted Price Theory and Applications the times I have taught the course (HT: Charles Steele).  The 8th edition is about to come out, meaning that there is no viable used market to purchase the 8th edition.  This also calls into question paying full price for a new version of the 7th edition (currently north of $160).

Since most Econ 300 students are majors (the ones that survive, at least), I am not worried about the resale market, because I think someone walking around calling themselves “an economist” should have a solid micro theory book on the shelf.

So, with all of that said, I recommend that you either pony up for the 8th edition (which I have yet to get a desk copy of), or start scouring your used options now. Amazon doesn’t seem to be much help, but a quick search of Valore Books and  Big Words (< $40), eBay, and Chegg.com, indicates that you should be able to locate a copy at a pretty reasonable price.

Worth every penny.  But there’s no sense squandering the surplus.

Political Economy of Regulation, Final Exam Question

With new financial regulations (potentially, yes, potentially) imminent, today’s question is why Congress is delegating so much of the authority to regulators to craft the actual rules of governance:

Consumer and financial lobbyists alike are marshalling the troops on K Street to impact the decisions regulators make in setting new rules after Congress finished writing the Dodd-Frank Act on Friday. The 2,000-page financial overhaul bill is expected to face a final vote this week, but despite its length, it leaves many specific directives to regulators. Regulators are left with the freedom to decide what kinds of trading are included in the prohibition against banks’ investment of their own money and “how much money banks have to set aside against unexpected losses.”

Now, the first question is, why would Congress delegate so much authority? Is it in deference to regulators’ superior knowledge? Or do you think it has something to do with not taking responsibility? Or do you have another explanation?

The second question has to do with the relationship between industry and regulators. If you believe in the capture theory (and many of you do), what type of explanation would you give for delegation? And, what sort of outcomes might you expect from this round of legislative reform?

Wait, the term is over? What?

Take Stock in BP?

Here’s a provocative thought:

BP_wilts_smBP’s stock, which traded at a 52-week high of $62.38 on Jan. 19, 2010, closed on June 1 at $36.52 a share, down 15% on the day. The post-spill sell-off has wiped out some $68 billion of BP’s market value, knocking it down to $114 billion. With the stock now in the cellar, some speculation even has it that BP may attract a buyer.

There are a couple of things going on here.

First, the stock price reflects the value that “the market” places on a company.  One technique for evaluating the effect of some major event on a company’s value is to do an “event study.”  The idea is to try to use other factors (e.g., larger market trends, stock prices of other firms in the industry) to get at how important the event was. A spill like this could damage a company’s reputation, expose it to liability payouts, or make it susceptible to heavy fines.

Ben Fissel at Econbrowser put one of these together shortly after the spill.

When an event, such as this oil spill, impacts a company it will also impact its long run profitability. The divergence of the stock price from what we would have expected had the event never happened is a measure of the net present value of the cost incurred by the oil spill.

He finds big impacts.  The red line in the picture is his estimate of the time series of BP’s stock price without the spill, and the black line is the actual price.  Seems like a big effect.

At the time he did the study, the stock price had been between $50 and $60 for the previous three months.  As the AOL article shows, the price is now down closer to $35. Overall, the market’s valuation of BP has gone from more than $180 billion to about $114 billion.  Does that seem reasonable?

That is, in fact, the second point, that doesn’t seem all that reasonable, which is why BP’s stock is now so low that it might be attracting a buyer.  In other words, at current prices smart money might find BP stock such a bargain that it will swoop in and buy the company, liability exposure be damned. Does that seem reasonable?

I completely buy this logic.  Given that BP is the world’s largest oil producer, it is hard to believe that the long-term profitability of the company has really fallen 40% due to the oil spill. The linked article provides some reasons why a merger might be implausible, but on the fundamentals, this may well be an overreaction.

Further food for thought, what will happen to oil prices if there are significant steps taken to reduce offshore drilling and who stands to win and lose from those price changes?

Two Tales, One American Power Act

The American Power Act is the latest climate bill making its way through the Senate. For both of my classes this term we have talked about the tradeoffs between policies that economists like and policies that might have a chance of passing. Ted Gayer at Brookings definitely puts the APA in the latter camp:

The bill auctions only 24.8 percent of the allowances in the early years (the share devoted to auctions is highlighted in blue), the remainder of the allowances being given away to such things as electricity local distribution companies, trade-exposed industries, refiners, commercial developers of carbon capture and storage, and a National Industrial Innovation Institute. The auctioning ramps up to 79.5 percent of allowances in 2030, and then full auctioning only occurs in 2035

And concludes:

By failing to use a full allowance auction to offset economically harmful taxes and deficits, the Senate bill sacrifices economic gain for political support from interest groups.

Robert Stavins, on the other hand, seems to look up at the sky and see a different color.  Stavins is perhaps the most prominent environmental economist in the field, and he  seems pretty upbeat about the whole thing:

Over the entire period from 2012 to 2050, 82.6% of the allowance value goes to consumers and public purposes, and 17.6% to private industry. Rounding error brings the total to 100.2%, so to be conservative, I’ll call this an 82%/18% split.

I’m going to have to side with Gayer on this one.  It may well be the case that on average the “value” goes to some “public purposes,” but it sure doesn’t seem that way looking at the early splits (Here’s the blown up version for those of you preparing to squint).

Gayer Table

For the first 13 years of the program, more than half of the allowances are going to industry, it appears.  Not until 2025 do we see the industry percentage phased out (rapidly) and the auction percentage jump (also rapidly).  So, to put it another way, today’s Congress is committing the 2025 Congress to implement the tough changes that will accompany climate change. I am going to put the odds on this commitment being credible as “improbable.”

Continue reading Two Tales, One American Power Act

Handing out the Goodies

No, this isn’t a post about the goodies at this-coming Monday’s Econ TeaBA (where, rumor has it, Professor Galambos will explain the competitive market model to Professor Corry in 15 minutes.  Whether he can make good on this promise remains to be seen.  In either case, please, no wagering at the TeaBA).

This is a post about who will benefit and who will lose from the climate legislation.  We have been talking about the distributional issues in Economics 280 for a couple of weeks, that there are many ways to get the same “quantity,” but who wins and who loses can vary radically.  The projected shares are a big key to determining political feasibility — businesses like free permits much more than auctioned permits, and certainly much more than (egads) paying a tax.  On this front, we will be reading a paper called “Carbon Geography: The Political Economy of Congressional Support for Legislation Intended to Mitigate Greenhouse Gas Production” in our political economy course next week.  The basic idea here is that representatives from states with high per-capita carbon emissions are less likely to support costly carbon restrictions. (Actually, I haven’t read the paper yet, but I would have bet a dollar that’s what it says. That is, I would bet a if I hadn’t discouraged wagering in the previous paragraph).

As for the distribution front, Ted Gayer from Brookings has some preliminary estimates on who is going to capture the value of freely-allocated and auctioned permits over the first 20 years of the program.   The program will start with about 75% of the permits being handed out and more than half of the value of those permits accruing to electric utilities.  Less than 10% of the revenue will flow to deficit reduction or to offset other taxes.   Between 2026 and 2027, however, the percentage of auctioned permits jumps and ascends from 20% to a full 100%.    And, if you believe that is a credible commitment, I would encourage you to sleep it off and rethink your position tomorrow.  Consumer relief — that is, higher prices reduce consumer benefits — stays steady about 10% throughout.  Believe him or not, Gayer’s short brief is worth reading precisely because he hits the heart of the environmental policy debate.

Natural Resource Damage Assessment

It is too bad that as we begin looking at benefit assessment in my environmental and regulatory classes that we have this gusher gushing up the Gulf Coast providing us with such a vivid real-time example.  So how do we go about valuing environmental benefits? Well, here’s a recycled piece from Slate.com, here’s Trudy Cameron at at The New Palgrave Dictionary of Economics, and here’s the guys over at www.env-econ.net with some estimates of lost fishing value.  That should get you started.

As you know (or should know), there are a couple of ways of doing this.  One is through market-type valuations, and another is through “contingent” valuation methods.  We economists typically prefer watching what people do rather what they say they would do in some hypothetical situation, but sometimes we get what we get.

And for those of you who think this is no big deal, it would appear that you are wrong.