Lawrence Economics Blog

Creative Instruction

Fermat’s Margin Call

For those of you who think passion is reserved for the humanities, check out this NOVA documentary on mathematician Andrew Wiles’ quest to solve Fermat’s last theorem. Wiles literally breaks down crying when thinking back to the moment when he thought he had it.

Fermat himself had said of the proposition, “I have a truly wonderful proof of this fact…. This margin is too small to contain it.”   Though he probably didn’t, what his claim unleashed is extraordinary, with the Wiles’ proof being the last chapter.

Perhaps not.

Professor Sanerlib regularly shows this to his Math 300 class, but why should they have all the fun?

Absolutely awesome.

UPDATE: Alex Tabarrok at Marginal Revolution also spotted this and offers this:

The plainspoken Goro Shimura talking of his friend Yutaka Taniyama, “he was not a very careful person as a mathematician, he made a lot of mistakes but he made mistakes in a good direction.” “I tried to imitate him,” he says sadly, “but I found out that it is very difficult to make good mistakes.” Shimura continues to be troubled by his friend’s suicide in 1958.

Friday Food for Thought: “I’m an Economist”

The Kruk Stops Here

John Kruk famously said, “I ain’t an athlete, lady, I’m a baseball player.”

For those of you who don’t know the (possibly apocryphal) tale, John Kruk was a rather fat man with a mullet, who could hit a baseball better than most people in the world.  Kruk’s view was that it wasn’t any “athletic” gifts, per se, that allowed him to hit so well, but rather his crazy hand-eye coordination and phenomenal reflexes.

After a game, a woman spotted him smoking a cigarette and she started to give him the business about how an athlete shouldn’t smoke, his body is a temple, to think about the kids, and on and on.

His infamous response is the title of his autobiography.

So, what does this have to do with Friday Food for Though?. Well, when people find out that I’m an economist, they will typically say things like, “Oh, this must be a really interesting time for you.”

Why is that?

“Oh, you know, because of all the things going on in the stock market and the economy and stuff like that.”

Lady, I don’t know about that sort of thing — I’m an economist.

Or perhaps that’s what we economists are supposed to do — study the economy. Well, I guess that’s one answer, but I don’t think it’s my answer.  I mean, I know something about what’s going on with the fiscal stimulus and the multiplier effect, but as Robert Barro points out, that it certainly not what I do.

Continue reading Friday Food for Thought: “I’m an Economist”

What Should Central Bankers Do To Address PLOGs?

Obviously, to answer this question begs another:  What’s a PLOG? or perhaps:  Should we view central bankers as plumbers?  PLOG, a term coined by IMF economist Andre Meier, refers to Persistently Large Output Gap  or positive deviation between potential GDP and measured GDP.  The big concern raised by the LEX column in today’s Financial Times regards whether central bankers should worry about a deflationary double dip recession.  As Lex puts it:

“The supposed PLOG-effect creates a dilemma: the Scylla of deflation or the Charybdis of extraordinarily easy monetary policy.”

Based on Meier’s study of 25 episodes in advanced economies, Lex argues that recessions slowly reduce inflation rates and generally stop prior to serious deflation.  Therefore,  central bankers should not become preoccupied with such a threat.  Indeed, attempts to further stimulate economies such as ours with monetary policy is likely to be ineffective (or to use the proverbial idea: it’s like pushing on a string.)

I find the final sentence of the opinion piece particularly instructive.

“And while a PLOG may not create deflation, it can only amplify the grim economic effects of over-indebtedness, whatever policies central bankers adopt.”

Journal of Economic Perspectives

For a limited time (I think), the American Economics Association is providing complimentary access to articles in The Journal of Economic Perspectives.  Each issue of the journal provides a series of short papers on one or more topics of common interest as well as other articles of interest to those who want access to the state-of-the-art economic thinking without needing to wade through  the sophisticated mathematics or economic arguments that  require graduate level training.  The Summer 2010 issue, for example, devotes one set of articles to approaches to economic development and a second set to President Bush’s “No Child Left Behind” program.  Sample early; sample often.

Good Intentions, Bad Policy

In today’s Economix Blog, Edward Glaeser reminds us of a paradox that William Stanley Jevons posed in the 1800s.  When public policy makes something more efficient (such as automobiles or electrical appliances), people may respond by expanded their use of the underlying product (gasoline or electricity).  For example,  CAFE standards, which seek to increase the gasoline efficiency of automobiles by requiring a higher miles per gallon standard for cars, may actually induce us to drive more.  It all depends upon how much cheaper it is to drive, and the price elasticity of demand.  We need to be sure that the adopted policy serves its ultimate objective, for example, to reduce an externality such as congestion or carbon emissions. As Glaeser puts it,

“Well-designed policies, like a congestion tax or carbon tax, can reduce social problems by getting the right sort of behavioral response; interventions that create an offsetting behavioral response can push the world in the wrong direction….The real lesson is that a change in the effective price of a commodity leads to a behavioral response, and, in some cases, that response can be so strong that it reverses the desired effect. As America considers new policies in public health, environmentalism and financial regulation, Jevons is as relevant as ever.”

Should Ideas Be Left to the Free Market?

The good folks at Organizations & Markets ask why economists haven’t paid closer attention to the economics of free speech. The classic piece on this is Ronald Coase’s “The Market for Goods and the Market for Ideas” (available from campus IP addresses).   Coase asks why the rationale for goods’ market regulation doesn’t carry over into the realm of the market for ideas. Here is how he characterizes the prevailing attitudes:

In the market for goods, the government is commonly regarded as competent to regulate and properly motivated. Consumers lack the ability to make the appropriate choices. Producers often exercise monopolistic power and, in any case, without some form of government intervention, would not act in a way which promotes the public interest.

Fair enough. But then,

In the market for ideas, the position is very different. The government, if it attempted to regulate, would be inefficient and its motives would, in general, be bad, so that, even if it were successful in achieving what it wanted to accomplish, the results would be  undesirable. Consumers, on the other hand, if left free, exercise a fine discrimination in choosing between the alternative views placed before them, while producers, whether economically powerful or weak, who are found to be so unscrupulous in their behavior in other markets, can be trusted to act in the public interest, whether they publish or work for the New York Times, the Chicago Tribune or the Columbia Broadcasting System.

Coase wrote the piece in the early 1970s, partly in response to federal regulation of commercial advertising, wondering whether there is a difference between firms schlepping products via commercial advertisements in the goods market is really any different than an article or an editorial in the New York Times.

Improbably, Time Magazine carried an article on Coase’s article and summarized his position nicely:

Coase challenged two assumptions that, he says, have created the distinction in public policy: 1) that consumers are able to distinguish good ideas from bad on their own, though they need help in choosing among competing goods; and 2) that publishers and broadcasters deserve laissez-faire treatment while other entrepreneurs do not.

It might be tempting for us to dismiss Coase’s argument as glib posturing, or as an example of economists being too clever for our own good. But how we define and constrain free speech is a central element of our political system.  President Obama, in fact, spent his weekly radio address admonishing the recent Supreme Court decision that removed many legislative controls of corporate campaign financing.  One would suspect that Coase was arguing to relax regulation of the goods market, not extend regulation to the ideas market, but the proliferation of the internet and other news sources has perhaps muddied the waters so much that the distinction is unrecognizable.

So, more to come, I suspect.

Should Efficiency Be Economists’ “Holy Grail?”

In today’s New York Times Economix Blog, Uwe Reinhardt poses the central question: “Is ‘More Efficient” Always Better?” In answer to the question he provides the basic definitions one would confront in an introductory economics course – including appropriate references to  Pareto – and proceeds to point out that some efficient points, such as R and U, are not necessarily better than some inefficient ones (any in the region bounded by X, Y, and Z).

Reinhardts Efficiency Graph

He then proceeds to link efficiency with optimality, which becomes his point of contention.

“One suspects that the term optimal came into widespread use among economists as a marketing device to promote their normative propositions based on efficiency. But as Professor Arrow warns his colleagues on this point:

A definition is just a definition, but when the definiendum is a word already in common use with highly favorable connotations, it is clear that we are really trying to be persuasive; we are implicitly recommending the achievement of optimal states.

Alas, it gets worse. Astute readers will have figured out by now that literally every point falling on the entire solid curve in the graph must be “Pareto optimal” by the economist’s definition of that term, not only those falling on line segment Y-Z. That circumstance makes the economist’s use of the word optimal even more dubious.”

In my view, Reinhardt stops in the wrong place.  Rather than “dis” the term efficiency,  he could differentiate between Pareto efficient (all points on the concave curve bounded by the two axes and called in this case the Happiness Possibility Frontier or HPF) and Pareto optimality (which employs Pareto’s notion that, at these points, to make someone better off, another person must be made worse off.)   So what’s the point?  Actually, there are two points to be made.

1.  For any point (or allocation) below the HPF, that is any Pareto inefficient allocation, there exist Pareto improvement possibilities, and economists should encourage taking advantage of such.

2. Once on the HPF, Pareto optimal allocations depend upon social preferences, about which economists have no unique judgment to contribute; however, each such social choice judgment does yield consequences with opportunity costs (foregone choices) that can be identified.  Stated differently, all Pareto efficient points are candidate points to be Pareto optimal under some set (of sometimes very curious) social preferences.

To conclude, the notion of efficiency is not a vague term, and it does reflect a value free standard.  In my view, one can claim that for any Pareto inefficient allocation, Pareto improvements exist.  Efficiency, however, says nothing about the optimal choice until preferences – in this case comparison of A’s vs. B’s happiness – is made.  Furthermore, economists should encourage those making such social preferences to be transparent rather than hide them in 2000 pages of legislation.

Fallout Friday

I had seen some headlines earlier in the week about teachers unions being up-in-arms about an LA Times investigative series on teacher quality, but I hadn’t seen anything concrete until I saw Alex Tabarrok’s post at Marginal Revolution this morning.

All I can say is, wow!

The basic storyline is that the Times accessed data on changes in student performance from year-to-year and was able to match that up at the individual teacher level.  The entire analysis isn’t published yet, but if you check out the snippet in the graphic below it is clear that the proverbial you-know-what is about to hit the you-know-where in the LA school system.  And, yes, that is the real Miguel Aguilar and the real John Smith in there.

Ouch.

This is the sort of thing that might get Mr. Smith (and his union) to go to Washington (or Sacramento) — to quash this kind of information being revealed.

Tabarrok sums up his thoughts and I will simply repeat them because I have trouble disagreeing:

I don’t blame the unions for being up in arms and I feel for the teachers, for some of them this is going to be a shock and an embarrassment. We cannot simultaneously claim, however, that teachers are vitally important for the future of our children and also that their effectiveness should not be measured…  Moreover, I see this as a turning point. Once parents have this kind of information who will allow their child to be in a class with a teacher in the bottom ranks of effectiveness? And if LA can do it why not Chicago and Fairfax?

Stay tuned on this one.

Freaky Thursday

For those of you too lazy busy to read the primary research, too lazy busy to read the book, the Freakonomics movie is here. Incentives matter seems to be the theme — schoolteachers correcting their student’s lousy tests to improve their scores, sumo wrasslers fixing their matches, real estate agents selling too soon at too low of a price due to a misaligned agency problem, it’s all here.

Of course, there is nothing particularly “freaky” about Freakonomics.  Levitt has a theory, gathers evidence, and evaluates his hypotheses.  His greatness stems on the one hand from identifying interesting problems and using data in ways no one has thought of before.  In my own experience, his work on traffic safety and drunk driving are two sterling examples where he was able to exploit a data set that many, many people had been using for years in very novel and important ways.

Perhaps we can preview this during Schumptoberfest.™

Windy Wednesday

Robert Bryce gets on his soapbox and Slate.com and takes his shots at wind energy.   He argues that wind is unreliable, and that the opportunity costs of installing wind generation displace other infrastructure investments.  He cites the situation in the Lone Star State, which has been at the fore of installing wind power:

On Aug. 4, at about 5 p.m., electricity demand in Texas hit a record: 63,594 megawatts. But according to the state’s grid operator, the Electric Reliability Council of Texas, the state’s wind turbines provided only about 500 megawatts of power when demand was peaking and the value of electricity was at its highest.

Put another way, only about 5 percent of the state’s installed wind capacity was available when Texans needed it most. Texans may brag about the size of their wind sector, but for all of that hot air, the wind business could only provide about 0.8 percent of the state’s electricity needs when demand was peaking.

Certainly, because wind power only works when the wind blows, building wind capacity doesn’t reduce the need for other base load capacity.

And the wind capacity isn’t cheap, either.  Professor Michael Giberson over at Knowledge Problem has tracked the incidence of negative prices paid for wind.

Negative prices? Wha? Isn’t that the definition of cheap?

Not exactly. I’ll let him tell you:

This seems a little crazy. During these negative price periods, suppliers are paying ERCOT to take their power. Consumers (at least at the wholesale level) are getting paid for using power, and the more power consumers use the more they get paid. These prices are a big anti-conservation incentive. You could, as a correspondent put it to me, build a giant toaster in West Texas and be paid by generators to operate it.

The giant toaster metaphor will be with me for a long time.

The logic is at the margin, of course.  If I pay (subsidize) a farmer $10 for every bushel he sells, we would expect him to be willing to pay, say, $5 to take it off his hands — a that is, he takes a price of -$5.  In 2008 in Texas, power prices were negative 20% of the time, indicating the power of prices to motivate behavior.  Indeed, producers were willing to pay up to about $3.50 per megawatt hour before shutting down.

But all hope isn’t lost.  This morning on NPR they talk about dealing with the “intermittency” problem (that is, the wind doesn’t necessarily blow when we need the power) with battery storage.  That is crucial.  If the wind blows a lot in March, but we use the energy in August, then it would be nice to be able to store what we have and use it when we need it.  An important question, then, is should we install this wind capacity before we crack the storage problem? Right now, the talk is of storing power for a couple of hours, not a couple of days or weeks, so, as we have seen in Texas, the baseload problem will remain acute even as renewable capacity rises.

I imagine this blog post will be recycled as more solar and wind generation come online.

Deficient Aggregate Demand vs. Structural Faults

Macroeconomists debate feverishly about the causes of a stagnant U.S. economy. Some such as Paul Krugman argue that demand deficiency (a Keynesian diagnosis) requires very aggressive monetary and fiscal policy until the economy reaches its potential.  Others, such as Edmund Phelps in an August 6th opinion piece in the New York Times argue that our macroeconomic problems are structural and not related to deficient demand.  He argues that

“The [aggregate demand] prescription will fail because the diagnosis is wrong.”  He goes on to argue that our focus on reviving demand “lulls us into failing to think structural.”  He cites such structural deficiencies as “short term” incentives employed by established businesses and financial managers, poor incentives for innovation, and a lack of inclusiveness in income gains that have arisen over the past two decades.  Phelps suggests a number of policy actions that might be taken to put the US economy back on a dynamic path essential for prosperity and growth.  In short, we need to move beyond short term demand stimulus to long term incentives to innovate.  In his view, “the economy needs a bit of ingenuity.”

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.

Free Market Monday

The air temperature here in Wisconsin has settled down to humane levels, signaling the school year is nigh. So, to kick off our Free Market Monday, let’s check in with Guy Sorman at the City Journal on the origin of our current financial crisis.

Sorman interviews many of the heavyweights — Calomiris, Fama, Zingales, Cochrane, Taylor, and a host of others (including James Hamilton at EconBrowser, who I’ve never thought of as a “free marketeer”). If you recognize some of those names, it is clear that the emphasis here is mainly on the role of the financial sector.

Some interesting thoughts, including this coda:

Every economist I interviewed agreed that ballooning American and European debt poses a huge threat to long-term prosperity. The debt will be paid either through inflation, which would make everyone poorer, or—a far better scenario—through economic growth that would increase both individual and government revenues. Unfortunately, by increasing taxes and imposing the wrong regulations, Western governments are hindering entrepreneurship and hence growth, Cochrane says.

Ah, entrepreneurship and growth.  It’s all coming back to me now.

A Welcome Prospective

Friday is a prospective student day and I will be giving a brief overview of the economics department in Briggs 217 at 2:10. I will be talking up our very solid curricular and co-curricular activities, including the Lawrence Scholars in Business program (video here), our Innovation and Entrepreneurship initiative(s), and the spectacular successes of many of our recent graduates.

And, of course, the Investment Club!

See you there.

Is BP on the Big Bounce?

When last we visited BP on June 3rd, it’s stock was down from $62 to$36 and appeared to be heading further south.  Indeed, by the end of the month it had bottomed out at $27.05 and it was dark days both on the water and in the markets (unless you had shorted it, of course).

Well, six weeks later and things are looking up.  The stock has risen back to $38, and even peeked its head about $40 recently.  And, there are more and more stories, especially on the financial pages, that the magnitude of the environmental damages simply aren’t going to be as grotesque as anticipated.  (Of course, this is not a consensus opinion).

So where does that leave the company’s fortunes?  There are still momentous uncertainties about the environmental damages and liabilities, which could add to the stock’s volatility.  But on the other hand, if the worst-case scenarios were internalized in the price, and those scenarios haven’t materialized,… this is why I buy index funds.

UPDATE: Evidently, the Financial Times is thinking about this, too.

No Laffing Matter

If a firm wants to increase its revenues, should it raise its prices? The answer, of course, depends on the elasticity of demand for its product. If consumers are very responsive to price changes, a price increase could lead to lower revenues.  Ack!

Now, if a government wants to increase it revenues, should it raise or lower tax rates?  In this case, the answer depends on (among other things) how sensitive workers are to marginal tax rates.  Arthur Laffer famously pointed out that it’s possible that taxes are so high that reducing them could induce people to work so much that lower tax rates could increase tax revenue.

Bend, Baby, Bend
Bend, Baby, Bend

The Laffer Curve rests on a simple conjecture — if tax rates are zero, then no tax revenue is generated.  Well, that’s not a conjecture, that’s true.  The conjecture is that if tax rates are 100%, then no one would bother to work because all wages would be absorbed into the government coffers. Because nobody would work, tax revenue would be zero.

Hence, we know two points of the Laffer curve — at tax rates of 0 and 100%.  A key empirical question, then, is where does the Laffer Curve bend? The figure shows tax rates increasing along the horizontal axis leading to various levels of tax revenues on the vertical axis.  The nice stylized version is symmetric with a nice revenue-maximizing peak, but there is no reason to believe the curve is symmetric (or even single peaked, really… at least I don’t think so).  However, it is critical to know what the curve looks like so as to understand the likely implications of a tax increase or decrease.  If we are to the right of C, an increase in tax rates will actually reduce tax revenues. Ack!

So where does it bend?  The ever-energetic Ezra Klein surveys some of the giants of economics and policy folks in the know (the policy folks are mostly right of center) to get some answers. For those who are willing to proffer a number, that number is generally much higher than our highest marginal tax bracket.  Tax guru Joel Slemrod, for example, is thinking its north of 60%.

Here are a couple of pithy responses:

Greg Mankiw: My guess is that that the short-run answer and the long-run answer are quite different. For example, if you raised the top rate from 35 to, say, 60 percent, you might raise revenue in the short run. Over time, however, you would get lower economic growth, so the additional revenues would fall off and eventually decline below what they would have been at the lower rate…. I will pass on offering a specific number, as it would require more time and thought than I can offer just now, but I will opine that I think the long-run answer is actually more important for policy purposes than the short-run answer.

Martin Feldstein: Why look for the rate that maximizes revenue? As the tax rate rises, the “deadweight loss” (real loss to the economy rises) so as the rate gets close to maximizing revenue the loss to the economy exceeds the gain in revenue…. I dislike budget deficits as much as anyone else. But would I really want to give up say $1 billion of GDP in order to reduce the deficit by $100 million? No. National income is a goal in itself. That is what drives consumption and our standard of living.

Short run, long run, deadweight losses.

Good stuff!

Manufacturing is the Answer But to Which Question

Recently, Andrew Grove (former CEO of Intel) and a number of policy makers have claimed that we need to keep our manufacturing sector vibrant as a way to sustain national economic security. In today’s Financial Times, Columbia University economist, and perennial Nobel Prize candidate, Jagdish Bhagwati contests that claim, and notes that we already subsidize American manufacturing in many ways.  Furthermore, he argues that such efforts have not been good value nor have they been the best way to increase employment or innovation.  He concludes as follows:

“In policy, sometimes Gresham’s Law operates – with bad policies driving away good ones. With no good argument in its favour, a preoccupation with manufacturing industries threatens yet one more example of such a perverse outcome. By promoting manufacturing of all kinds (as can be expected as the sector’s lobbies get down to work) at the expense of more innovative and dynamic service sectors, precisely when America is faltering in its recovery from the crisis, this unhelpful fascination promises to inflict gratuitous damage on an economy that can ill afford new wounds.”

Weekend Audio

Some interesting interviews for those of you out cleaning the garage this weekend.

The first is Raghu Rajan, a favorite of Professor Finkler (I’m guessing from this link), in a Vox interview, “Fault lines: how hidden fractures still threaten the world economy.” From the abstract:

Raghuram Rajan of the University of Chicago talks to Romesh Vaitilingam about his new book Fault Lines, in which he outlines the deep systemic problems in the world economy that threaten further financial crises – high US inequality, patched over by easy credit; excessive stimulus to sustain job creation in times of downturn; and the choices of Germany, Japan, and China to focus on export-led growth rather than domestic consumption. The interview was recorded in London in July 2010.

The second is a favorite of mine, Political Scientist David Brady, over at EconTalk.

David Brady of Stanford University talks with EconTalk host Russ Roberts about the state of the electorate and what current and past political science have to say about the upcoming midterm elections. Drawing on his own survey work and that of others, Brady uses current opinion polls to predict a range of likely outcomes in the House and Senate in November. He then discusses the role of recent health care legislation in the upcoming election as well as Obama’s approval ratings. The conversation concludes with Brady’s assessment of how Congress might deal with the demographic challenge facing entitlement programs.

Brady has a good sense of politics and political history, in addition to being an excellent social scientist. In my policy making institutions course at Carnegie Mellon, I used Brady & Volden’s Revolving Gridlock as an introduction to a simple spatial model and an overview of the past 40 years of American politics (Just don’t tell Professor Hixon).

And, I buried the lead here.  Laurie Santos talks about monkey decision making over at TED.  Who knew monkeys were so irrational? She does some monkey experiments and finds that monkeys consistently make the types of “irrational” errors that humans make.

Laurie Santos looks for the roots of human irrationality by watching the way our primate relatives make decisions. A clever series of experiments in “monkeynomics” shows that some of the silly choices we make, monkeys make too.

I coined the tag “monkeynomics,” not realizing that there actually was monkeynomics.  Click on the tag for more monkey business.

Which Planet Are We On? Indeed!

Given the information in the statement, I would call it a “Capital Loss” special.  Nothing has been said about what happened to the general level of prices or about the purchasing power of the asset.  Without such information, one can say nothing very interesting about the change in the price of one specific asset.  It’s certainly possible that the price of an asset (call it shares of Lehman or Enron stock) can  fall with or without inflation or deflation.  I can’t tell what the purpose of the example is; hence, as Professor Gerard points out, Planet Money needs help.

They may need as much help as the US Senate who rejected Fed Board of Governor’s nominee Peter Diamond because he allegedly was not a macroeconomist.

Ah, those discerning folks who man our legislature.