Thursday, January 31, 2008

Competition for Thee but not for Me...

One aspect of political economy that I like to impress on my students is the following: If a business can erect a barrier to entry to limit competition, it will be happy to do so. Many individuals are under the impression that businesses are enamored with the free market and will resist any attempt at being regulated. However, there are many examples where firms DEMAND regulation because it will ultimately restrict entry and eliminate competition, thus raising profits for the incumbent firm.

Many businesses argue that regulation is necessary to protect consumers, protect the environment, or other laudable goals. The real goal, however, is to limit competition by any means necessary.

Another interesting fact about the erection of entry barriers is that governments at all levels have a hand in the process primarily because these barriers take the form of a regulation or mandate from government.

The Institute for Justice, a public-interest law firm that specializes in the removal of entry barriers for entrepreneurs, has a number of cases online available for viewing (available here).

Remember: Firms will demand regulation as long as it creates an entry barrier, stifles competition, and increases profits.

Monday, January 28, 2008

Cartels and Cartel Behavior

Today in class we examined how pricing decisions by firms can alter incentives. Specifically, we examined the OPEC cartel (as well as others). OPEC's mission, according to their website, "is to coordinate and unify the petroleum policies of Member Countries and ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital to those investing in the petroleum industry." Of course, this does not mean that OPEC isn't in the oil business to make money, and one of the problems associated with cartels is that is is difficult to maintain cohesive action. In other words, there is a huge incentive for individual members to cheat on the cartel agreement. This article explains the economics of OPEC nicely and the fact that cheating is very prevalent.

Sometimes the cartels are explicitly condoned by the Federal Government. Take for example the so-called "milk marketing" orders, which are essentially regulations that require certain pricing structures for milk. The CATO Institute has a nice op-ed on the topic here.

The next time you hear the word "cartel" be aware that there are powerful political interests behind the limiting of competition and that these interests may be operating in your backyard.

Wednesday, January 23, 2008

Applications of Supply and Demand

The supply and demand model is the workhorse of applied economics and is a topic that most students learn in a first-year course.

In our class, we discussed a couple of applications that showcase the use of the supply and demand model.

First up is the topic of rent control. There are many readable introductions (one from the Cato Institute is here) to the topic and the basic conclusion is simple: when price is held below the equilibrium price, we expect two offsetting effects. First, since the price is lowered, we expect the quantity demanded to increase. In other words, the number of rent-controlled units that will be demanded will increase. Note that this has nothing necessarily to do with housing "need": At a low enough price, people will move from homes to rent controlled dwellings, regardless if they "need" a place to live. On the other hand, the lower price induces producers (i.e. landlords) to under supply the market. The result: a deterioration of the housing stock.

Another topic of discussion is the application of supply and demand analysis to the redemption of slaves in Sudan. A nice book length treatment is provided here--Buying Freedom: The Ethics and Economics of Slave Redemption. The basic idea is that if redeemers are willing to pay a high enough price for a slave (to ultimately be released) is there now an incentive to capture more individuals and offer them up for redemption?

The study of supply and demand can be utilized to study a variety of topics with some surprising results.

Thursday, January 17, 2008

The Economics of Bad Bahavior

Chapter 5 of the previously mentioned book, The Economics of Public Issues, is devoted to the topic of illicit activity, namely prostitution, alcohol, and drugs. Our class discussed different policies for controlling these activities and what trade-offs may exist.

In our discussion of drug policy, for example, we noted that since there is no legal market, there are also no ways in which quality or consumer protection can take place. Consumers cannot contact the local police to complain that their drugs are of inferior quality and that they need a refund. Therefore, we may predict that violence may be used to adjudicate disputes. Bruce Benson and David Rasmussen have written several nice articles that consider the economics of drug markets (click here for a readable example).

Additionally, illicit markets can alter incentives to such a degree that local police and other officials react to incentives in perverse ways. Bruce Benson, Brent Mast, and David Rasmussen wrote a nice article in the journal Public Choice entitled "Entrepreneurial Police and Drug Enforcement Policy". Here is the abstract:

The hypothesis that drug enforcement is relatively high in local jurisdictions where state laws dictate that police retain seized assets is tested in the context of a reduced-form equation of the supply and demand for drug enforcement. The results are robust across model specifications, some of which directly control for the level of drug use: legislation permitting police to keep seized assets raises drug arrests as a portion of total arrests by about 20 percent and drug arrest rates by about 18 percent. Police bureaucrats apparently desire discretionary budget increases, and they have considerable discretion in determining resource allocation.

Mast, Brent D.; Benson, Bruce L.; Rasmussen, David W. "Entrepreneurial Police and Drug Enforcement Policy", Public Choice, vol. 104, issue 3/4, September 2000.

The implication of this type of research is clear: policies that affect illicit markets can also affect legitimate institutions, and the trade-offs for such policies are not always what one expects.

Tuesday, January 15, 2008

Institutions and Economics Growth

Question: Why is North Korea relatively poor and South Korea relatively rich?

If you ask people why some nations are rich and some are poor, you're likely to hear answers such as the type and amount of natural resources, the attributes of the population at large, and other factors. But the above question begs the question: North and South Korea are relatively homogeneous in terms of natural resource endowment and population, to a large what accounts for the difference?

In a word, institutions. Specifically, the institutions of private property rights and a stable legal regime.

Douglass North, one of the co-authors of the book we are reading, is a pioneer in the study of how institutions affect economic growth. Alas, even with the understanding we have today, some nations try and avoid the trade-off that exists between stable institutions and politically expedient solutions.

Case in point: Zimbabwe. Once considered the "jewel" of Africa, Zimbabwe is now experiencing economic stagnation, due largely to the abandoning of economic institutions that foster growth.

Question: Why would a nation voluntarily abandon institutions that foster economic growth? Is there a geographic pattern to this phenomenon? Discuss.

Monday, January 14, 2008

Ethanol at What Price?

Ethanol has for some time been advertised as an alternative fuel that is crucial for the United States so that we can "end our dependence on foreign oil" (See an article here from Arnold Kling on this issue).

However, many pundits have said that ethanol is neither good for the environment nor efficient from an economic policy perspective (see the following from the Cato Institute).

Why then do we subsidize this particular form of fuel additive instead of a (possibly) better alternative?

I tried to stress three points to students:

  1. The subsidies (which can be very substantial!) are concentrated to a few individuals (Archer Daniels Midland comes to mind) and the costs are dispersed amongst millions of consumers and taxpayers. No one will march on Washington to save a few dollars but companies will use vast resources to obtain these subsidies.
  2. Voters tend to not realize the extent of such subsidies because acquiring the knowledge can consume vast amounts of time. This is what public choice scholars refer to as rational ignorance (see this article by Walter Williams on the subject).
  3. Firms will engage in rent-seeking given points #1 and #2. Rent-seeking is the expenditure of resources to try and obtain government favors at the expense of others.
Environmental initiatives seem, at first blush, to be immune from the vagaries of rent-seeking but alas, they are not. I urge everyone to read Jonathan Adler's Rent Seeking Behind the Green Curtain. It was an eye-opener for me and I have assigned the reading to numerous students. I've had some almost break down in tears during class discussion because they perceived that there was nothing that could be done about the issue, something which we will explore later on in the quarter.

The Economics of the FDA

Our class is now knee-deep into The Economics of Public Issues an excellent book for those with little training in economics but who want to see how economists analyze social issues. We will be reading two chapters a day until we are finished. Highly Recommended!

The FDA's mission is to regulate the safety and efficacy of drugs and medical devices in the United States. We talked at length about the two different types of errors that can be made by Federal regulators:

  1. Type I Error--This occurs when the FDA approves an unsafe drug
  2. Type II Error--This occurs when a safe drug is rejected
* Assuming the null hypothesis is that all drugs are unsafe

This lead to a discussion of how regulating drugs will inevitably be bad for some people. Federal regulators are very sensitive to type I errors because they are visible, whereas type II errors mostly go undetected. The issue is then, what is the trade-off here? We can be REALLY safe by banning all drugs (which leads to some people dying because of non-availability) but this is hardly reasonable from a cost-benefit viewpoint. The question for economic efficiency is, "What is the appropriate level of safety that balances Type I and Type II errors?"

A nice website that explores these and related issues (such as, is the FDA really necessary?) is provided by Alex Tabarrok of George Mason University. FDA Review evaluates that costs and benefits of FDA policy and is a good source of information on how economists view these issues.