The Joy of Economics:

Making Sense out of Life

Robert J. Stonebraker
Emeritus Professor of Economics
Indiana University of Pennsylvania and Winthrop University

May 15, 2017

Permission to reproduce or copy all or parts of this material for non-profit use is
granted on the condition that the author and source are credited.
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Feel the joy!

What fun.

I once worked with a group of high-school students who knew no economics. They
associated it with stock markets and inflation rates, things peripheral to their everyday
lives. They were wrong. Economics is about choice, all kinds of choice. We make economic
choices about whether to buy ice cream or potato chips. We also make economic choices about
love and marriage, about life and death, about crime and punishment, even about faith.

I taught a few simple economic tools and used them to explain how I murdered people
while vacationing at the Grand Canyon, why some co-eds can be coerced into granting sexual
favors they would prefer not to grant, and why more husbands are doing laundry these
days. The next morning a student came to me wide-eyed and exclaimed, "I keep thinking about
what we did yesterday. Everything we do is really economics, isn't it?" It is.

My goal is to provide an accessible book that reflects this theme of choice and conveys a
sense of the breadth and power of basic economic analysis. It assumes no prior knowledge of
economics and can be read and appreciated by anyone. While some parts of the book cover
conventional material, others do not. I've ignored many traditional topics and substituted ones
that apply economics in unusual and often provocative ways. The chapters are not meant to be
definitive, they are meant to raise questions. If they do not make you think or ruffle an
occasional feather, I have failed.

Most chapters use a story-telling approach that has served me well in the classroom. I am
accustomed to a tough audience. Every semester I stare into the fresh faces of college students
who would rather be at the beach, students who challenge me to make them care. I use stories to
grab their attention, to show how economics affects their everyday life, and to give them a new
and deeper appreciation of what drives their behavior.

The design of the book

The book is divided into three sections. The first takes a traditional, though non-technical,
approach to develop such core economic concepts as comparative advantage, demand and
supply, and economic efficiency. The second section applies these concepts to a wide range of
microeconomic issues and the third section tackles macroeconomic issues. These last sections,
especially the microeconomic one, are less traditional. Rather than trying to explain economics,
their emphasis is on using economics to explain everyday phenomena. The recurring theme is
that differences in behavior across individuals and/or across time are the result of differences in

1
perceived costs and benefits. To understand behavior, both good and bad, we must uncover the
underlying costs and benefits that create it.

The chapters are very short. Short chapters and books are easier to write; they are also
easier to read. My best reading is at the breakfast table, after downing my egg sandwich, but
before heading to the shower. It is about fifteen minutes. My writing strategy was simple: create
readings that can be consumed in ten to fifteen uninterrupted minutes. Time is scarce. If I
cannot find more than ten or fifteen uninterrupted minutes at a time, most of you cannot either.

The economic theory underlying this book comes from many sources. Gary Becker
pioneered much of the material on the economics of marriage and the economics of
crime. Larry Iannaccone's path-breaking work on the economics of religion is reflected in
several chapters. I also have borrowed heavily from the insights of George Akerlof, Bob Frank,
Tom Schelling, Tibor Scitovsky and Gordon Tullock. These may not be household names to
general readers, but they are to professional economists and I owe them a great debt.

I also owe a debt to the thousands of students who have served as unwitting guinea pigs
for my off-beat approach. Their feedback and encouragement have been a critical component of
this venture. Many passed my essays along to their non-economist friends and encouraged me to
write more. One even exclaimed that he caught his twelve-year-old daughter laughing aloud
while reading my work.

Note to potential instructors:

Permission to reproduce or copy all or parts of this material for non-profit use is granted
on the condition that the author and source are credited. Instructors interested in using all or
parts of this book for their classes are free to do so as long as appropriate citations are made,
including a reference to this website.

This material can be used successfully as the basic text for introductory economics courses
with an applications or issues emphasis, and individual chapters or sections can be used as
supplementary reading in other courses.

The chapters are self-contained. Although the concepts in the first section are critical for
students in their first economics course, the rest of the chapters can be read (or skipped) in any
order. Instructors adapting this material for their courses can pick and choose any combination
of chapters without loss of continuity.

Suggestions and comments are welcomed.

Read on. Feel the joy.

2
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Contents

SECTION I: Basic Concepts: Markets and Efficiency

A. Scarcity and choice

1. Costs and benefits
The Joy of Economics
What to Produce
2. Comparative advantage and trade
How to Produce
International Trade

B. How do we choose?
1. Demand and supply
Demand and Supply
Demand and Supply Applied: Sample Problems
Demand and Supply Applied: Exchange Rates
Demand and Supply Applied: Buy Low and Sell High
Demand and Supply Applied: Housing Bubbles
2. Elasticity
Elasticity of Demand and Supply
Demand and Supply Applied: Oil Prices

C. Efficiency and competition

1. Marginal Cost and Supply
2. Market Efficiency
3. External Effects
4. Public Goods
5. Rational Ignorance
6. What's Fair is Fair
7. The Role of Government

SECTION II: Microeconomic Issues

A. Love and marriage

1. Costs and benefits of marriage
The Untied Knot: Marriage on the Skids
Monogamy: A Cure for the Modern Arms Race
2. Love, sex, and affection
Older Men; Younger Women
Exploitive Relationships
3
 3. Children and families
Empty Cradles
Moral Decay

B. Sickness and death

1. Economics of life and death
Priceless Life?
Saving Lives Can be Dangerous
2. Health care issues
Health Care
Not Enough Hearts
Where There's Smoke, There's Controversy
The Economics of Eating

C. Crime and dishonesty

1. Crime and punishment
Costs and Benefits
How Tough is Too Tough?
Safety in Numbers
2. Cheating and lying
The Economics of Cheating
3. Breaking the law
Does Speed Kill?
Supply-Side Drug Policy: Will it Ever Work?
Discrimination: It isn't Easy Being Green

D. Higher education
1. Prices, quantities, and qualities
Funding Options
Attendance Policies
Why Don't They Learn?
Educational Lemons
2. Issues in teaching and learning
Never Again; Again
Grades: Too High or Too Low?
Consumption Skills

E. Religion
1. That Old-Time Religion
2. Risk and Religion
3. Sacrifice and Stigma

F. Shopping
1. Bah, Humbug
2. The Winner's Curse
3. In Search of the Perfect Christmas Tree

4
 4. Automobiles: Different People, Different Prices
5. Good Intentions Gone Awry

G. Happiness
1. It's All Relative
2. Lots of Stuff versus More Stuff
3. Too Much to Do
4. Starving Artists

SECTION III: Macroeconomic Issues

A. GDP: Equilibrium and growth

Equilibrium GDP and economic growth

B. Unemployment and inflation

1. Causes and effects
Unemployment and Inflation
2. Fiscal policy
Government Finance: Just the Facts
Spending and Tax Policy
3. Money and monetary policy
What is Money?
Role of Money
A Dear Abby Quiz

C. Government budget deficits and debt

1. Debtiphobia
2. Riches to Rags: Where Did the Surplus Go?
3. Social Security: Apocalypse Soon?

About the Author

Robert J. Stonebraker holds a Ph.D. in Economics from Princeton University and taught
economics for many years: first at Indiana University of Pennsylvania, and then at Winthrop
University. In addition to earning several teaching awards, he has published research articles in
such professional journals as the American Economic Review, the Review of Economics and
Statistics, and the Journal for the Scientific Study of Religion.

He and his wife Annie-Laurie Wheat live in Rock Hill, South Carolina where he wrestles
with his addiction to hot dogs and pursues a life-long dream of catching a foul ball at a
professional baseball game.

5
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Section I-A: Scarcity and Choice

"Please sir," said Oliver, "may I have some more?"

.... Charles Dickens

Oliver Twist shocked his fellow orphans when he asked for more, but we echo his simple
request every day. Alas, we often cannot have it. Life is beset with scarcity and unfulfilled
wishes often haunt us to the end.

Scarcity forces us to choose, but what choices are best? Every choice to pursue one goal is
a choice to sacrifice another. And how should we pursue our goals? Should we go it alone, or
should we cooperate with others? And which others? Should we stick to our family and friends
or should we extend a cooperative hand to our neighbors across the street? Across the
state? Across the country? Across the world?

If disappointment is our fate, we at least should learn to disappoint ourselves efficiently.

I-A. Scarcity and Choice

1. Costs and benefits
The Joy of Economics
What to Produce
2. Comparative advantage and trade
How to Produce
International Trade

6
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

The Joy of Economics

Economics is a way to give boring people jobs.

....anonymous graffiti on college classroom desk

Feeling ill, a young professional visited her physician and received a depressing
diagnosis. The physician reported that the patient had contracted a very rare disease and
probably would live only another six months. Understandably shocked, she sought a second
opinion from a leading specialist. After completing the exam, the specialist looked the patient
squarely in the eye and said, "My advice is to move to Kansas and marry an economist." Startled
at this advice, the young woman asked, “Will that cure me? Will I live?" The specialist
hesitated, and then replied, "No. You still have only six months to live. But in Kansas, married
to an economist, those six months will seem like an eternity."

As an economist I have been the butt of such jokes for most of my life. I am accustomed
to them and even enjoy them. But they are wrong, all wrong. Economists may be boring, but
economics is not. Economics is vibrant. Economics is alive.

From love to religion, every decision we make can be understood and described with
economic principles. A healthy dose of economic logic can illuminate an impressive array of
social and behavioral issues -- issues that few people would typically associate with economics.

Scarcity and choice

The first day of class in introductory economics, I ask students who have everything they
could possibly want to raise their hand. No one ever does. I explain that they are victims of
scarcity; that because goods and services are costly, we cannot have unlimited amounts. Scarcity
would vanish only if goods and services were completely free; if we could have unlimited
amounts at no cost. I continue and ask: “Is everything scarce? Are there exceptions? Can
anyone give an example of a free good -- a product of value for which we can have all we could
possibly want at no cost?” Ah. The hands shoot up. Someone volunteers: "What about air?" I
demur and then ask: "Is any air valuable? Or is only clean, breathable air valuable?" They
stop. They know that clean, breathable air is costly. Many of my former students were reared in

7
Appalachian high-sulfur coal country. The costs of clean air were evident in each month's
unemployment queue.1 Yet they cannot come up with a better answer. They cannot identify a
single product of value that is completely free. Neither can I.

We are surrounded by scarcity. And scarcity does not stop at the door of Wal-
Mart. Seemingly "non-economic" goods and services suffer the same fate. Do we enjoy
unlimited amounts of love? What about laughter? Would we prefer more or better friends? Are
we content with the depth of our religious faith?

Economists define resources as anything used in the production of something else. We

typically define four categories of resources: land (including all naturally occurring resources
such as water, minerals and timber), labor (workers), capital (manufactured resources including
physical capital goods such as tools, machines, equipment, and buildings as well as intangible
human capital such as skills created through training and education), and entrepreneurship (the
ability to combine the other resources into productive goods and services). Goods and services
are scarce because the productive resources we have at our disposal are scarce. Outputs are
limited because productive inputs are limited. Land and natural resources are limited. Capital
resources are limited. Labor and entrepreneurial resources are limited.

Since resources are limited, we must carefully shepherd those that we have. We must
make choices. Which uses of our limited resources are best? Which uses generate the most
value? You have made a choice to read this introduction. Why? It is costly. There is no
monetary cost. A book is not a vending machine that requires additional coins for each page you
read. But there is a cost. You are sacrificing your scarce time; time that you never will have
again. Whoops, there goes another three seconds. Gone forever.

Is reading these paragraphs the best use of your scarce time? If not, chuck these pages on
the floor and do whatever else is better. Do not waste scarce time resources. Stop reading
immediately.

Costs and benefits

Are you still here? If so, you must expect the benefit of reading these lines to exceed the
cost. You must expect the benefit of reading these pages will exceed what you might gain from
any alternative pursuit. Wow. Thank you. I have two children and am not accustomed to such
respect.

It is all costs and benefits. Every decision we make involves a comparison of costs and
benefits. Usually the comparison is not explicit. Even economists seldom take out pencil and
paper to calculate the relative costs and benefits of washing the dinner dishes versus watching
Jeopardy! on television. Yet, implicitly, those calculations are made.

The true costs and benefits are not always known in advance. None of us is
omniscient. After the fact we are often surprised by how costly or how beneficial an actual
choice turns out to be. And costs and benefits often cannot be measured objectively. We know
that $10 is better than $8, but is a blonde better than a brunette? Mistakes can be made and

8
subjective measures can be wildly inaccurate. Nonetheless, the comparisons are made; decisions
are made.

An important corollary follows: behaviors change only when

their underlying expected costs and benefits change. Very few of us
awaken at 3:00 a.m. and, with no cause, spontaneously proclaim
ourselves reborn. We change when we perceive it to be in our best
interest to change. Not any sooner. Not any later. Scarcity
necessitates choice. Choices hinge on costs and benefits. Costs and
benefits determine behavior.

That costs and benefits drive corporate activity is no

surprise. We expect Microsoft to weigh costs and benefits before setting software prices. We
expect Disney to weigh costs and benefits before launching a new theme park. However, if
economic models can illuminate corporate price and product decisions, why not other decisions
as well? If expected costs and benefits drive every choice, then economic models and analytical
tools should yield insights into every choice.

Are you ready to start? Read on. Feel the joy.

___________________________

Notes:

1. To comply with environmental legislation, many electric utilities switched from burning
high-sulfur coal to cleaner-burning fuels such as natural gas. This led to cleaner air, but
has lowered the demand for coal and pushed many miners out of jobs.

_________________________

Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1. Explain why things are scarce.

2. What is a free good? Can you give an example?
3. What is a resource? Identify and describe the four major categories of resources.
4. What is economics about?

9
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

What to Produce

You have brains in your head. You have feet in your shoes.
You can steer yourself any direction you choose.
.... Dr. Seuss

Every economy must answer three basic questions: what goods and services to produce,
how to produce them, and for whom to produce them.

What to Produce

Remember that resources (land, labor, capital, entrepreneurship) are scarce or

limited. We cannot have everything; we must make choices. Which ones are best? For
allocative efficiency we should choose the combination of goods and services that creates the
most value or utility.

Every choice bears a cost. We cannot choose one option without forfeiting
another. Suppose the choice is to produce either a bag of potato chips or a tube of lipstick. If we
choose the potato chips, we lose the lipstick. If we choose the lipstick, we lose the chips. To an
economist, true costs are what we must sacrifice or give up to get something. In this case, the
cost of the potato chips is the lost lipstick, and the cost of the lipstick is the lost bag of
chips. The professional jargon calls these opportunity costs. Opportunity costs are the value that
must be sacrificed or given up. They also are the value of our next best alternative or
opportunity. Why? Every time we make a choice, what we sacrifice is our next best alternative.

Rational decision makers will compare the relative values of potential goods and
services. Or, in the jargon of economics, they compare the benefits and opportunity costs of that
choice.

First steps

The first step in rational choice is to consider possible options. What choices are
feasible?

As an example, suppose that Susan can produce only two possible goods: she either can
dig ditches or learn economics. Of course, the more time that she spends digging ditches, the

10
less she has for learning economics. Suppose that Susan has the ability to dig one ditch per hour
or learn three units of economics per hour. The opportunity cost to Susan of digging a ditch is
the loss of three units of economics. Or, because she can produce 1/3 as many ditches as units of
economics in a given period of time, her opportunity cost of learning one unit of economics is
the loss of 1/3 of a ditch.

That is:

Cost of 1 ditch = 3 units of economics

Cost of 1 unit of economics = 1/3 ditch

Given that Susan can get three hours of economics for ditch sacrificed, we can calculate
what she can produce in an eight-hour day. The possible combinations include:

Ditches dug Units of economics learned

8 0
6 6
4 12
2 18
0 24

Economists often depict concepts in graphs. In this case we use a Production

Possibilities Curve (PPC) that shows the maximum combinations of goods and services can
possibly be produced given the available resources and technology. For Susan, all of the
possible combinations listed above would be points on her PPC.

Susan’s PPC looks like the following:

Her PPC is a straight line starting at 8 units on the “ditches” axis (eight is the maximum
amount of ditches she can dig in an eight-hour day) and going to 24 on the “units of economics
learned” axis (24 is the maximum number of units she can learn in a day). Note that the slope of
the PPC represents that opportunity costs that Susan faces. Test yourself. Can you picture how
the PPC would look if she could learn four units of economics per hour instead of only
three? What if she could dig two ditches per hour instead of only one?

11
 Remember that PPC shows the maximum combinations Susan can produce. She cannot
get beyond her PPC. No combination of goods above or to the right of her PPC is
feasible. Could she fall inside or beneath her PPC? Yes. If she wastes time or produces
inefficiently, she will produce less than she possibly could and drop inside her PPC.

We have simplified by assuming that her opportunity costs are always the same. The real
world can be more complex. For example, suppose that after six hours of studying economics,
Susan begins to tire of economics [I realize that is difficult to believe, but use your imagination].
If so, her efficiency at studying might drop and the amount of economics she can learn per hour
will fall. If so, her actual opportunity costs will vary depending upon how much of either good
she actually produces. Textbook authors typically draw PPCs as concave non-linear curves to
reflect this possibility. However, we will ignore the possibility of changing opportunity costs
and assume that all PPCs are straight lines.

What we have done for Susan also can be done for an entire economy. Economies face
the same opportunity costs and trade-offs between possible goods and services. In an economy
comprised of 100 “Susan’s” the PPC would look the same as Susan’s except that the numbers
would be 100 times larger.

The "what to produce" question is simply a question of where on the PPC Susan (or an
entire economy) will produce. The point of allocative efficiency or maximum value will depend
upon our tastes and preferences. Should we move to the left or to the right along our PPC? What
are costs and benefits of such a move? For allocative efficiency we should make any moves for
which the benefits cover costs.

Economic growth

Since we are constrained by our PPC, long-run growth is possible only if the PPC grows.
What might cause such growth? There are two (and only two) possibilities. We either must get
additional resources or find new technologies that allow us to produce more with the same
numbers of resources. Both factors have been historically important, but technological change
seems to be the more important of the two.

Can we add new resources? Barring intergalactic travel, the amount of land or natural
resources available ultimately is fixed. We are not likely to be adding significant quantities in
the long run. We do add labor every day as population grows, but this is of limited
value. Adding more people can increase total output, but is not likely to increase output per
person and, therefore, is not likely to raise living standards. Adding capital has more
potential. Since, by definition, capital is a manufactured resource, societies can create more at
will. Of course, capital creation is not free; societies must be willing to sacrifice other goods and
services in the short run to get it. Every dollar invested in the creation of new capital goods is a
dollar not used to create alternative products. Nonetheless, new capital has been a significant
source of growth in per capita output over time.

What about entrepreneurship? Remember that land, labor and capital do not
spontaneously combine to create new goods and services. Entrepreneurs must take the initiative

12
and the risk to do it. While we cannot manufacture entrepreneurs, we certainly can create
conditions that encourage their development. For example, entrepreneurs more likely will thrive
in countries that guarantee and protect private property rights. If their profits and assets can be
confiscated at will by others, including the government, entrepreneurs will have no incentive to
risk their time and resources to create them.

In addition, entrepreneurs often must borrow funds to develop their businesses and invest
in new capital goods. Without secure property rights, they have no assets to offer potential
lenders as collateral. For example, in 2004 Zimbabwe’s government announced a plan to
confiscate private land holdings and abolish all deeds. The land would become government-
owned and then be leased back to farmers. However, without ownership rights, the farmers will
have less incentive to invest in new technologies and capital improvements. Those who do want
to invest in better equipment and technologies cannot raise the money to do so. Because they do
not own the land they work, they have no assets to offer local banks as collateral for loans. And
without collateral, they cannot get the loans they need to invest and prosper.1 As might be
expected, agricultural productivity in Zimbabwe quickly fell.

_______________________________

Notes:

1. For more details, see “Zimbabwe Announces a New Plan to Seize Land,” New York
Times"", June 9, 2004.

_______________________________

Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1. Identify the three basic allocative questions an economy must answer.

2. Explain the concept of allocative efficiency.
3. Explain, identify and, where appropriate, calculate opportunity costs.
4. Define and draw production possibility curves (PPCs).
5. Identify the factors that can cause a PPC to shift and explain.
6. Explain the role of secure property rights in helping to promote economic growth.

13
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

How to Produce

Waste not, want not.

...anonymous proverb

To reach our production-possibilities curve (PPC) we must get the most we can from our
limited resources. If we waste resources or use them inefficiently, we will produce less than we
possibly could and drop inside or beneath our PPC. In other words, we need to produce with
technical efficiency. That is, we need to use the least-cost methods of production. Using $5 of
resources to produce what could have been made with $4 of resources is throwing away the
potential output we could have gotten from the wasted resource.

What method is best? There is no so single answer. It will depend upon the particular
good and particular resources in question. However, the best methods almost always will
involve significant specialization.

We are very specialized producers. For example, I specialize in economic lectures. I

produce lectures, earn income from doing so, and use my income to trade for goods and services
produced by others. This specialization makes us all interdependent. We need others to produce
the goods that we do not make ourselves.

Why do we choose to specialize and trade with others rather than being self-
sufficient? Simple. Specialization and trade raise our standard of living. We reap gains from
specialization and trade for two major reasons.

First, specialization allows us to practice and learn to become more proficient. If we

spread our time and effort trying to play all sports, we never become expert in any one. If we
specialize in baseball we can practice baseball skills repetitively. The practice helps us improve.
The saying “practice makes perfect” certainly exaggerates, but practice does make us better.

Second, specialization allows us to take advantage of our particular talents. People differ.
Specialization allows us to concentrate on what we do best. Some of this is obvious. If Annie

14
excels at cleaning and Laurie at cooking; it makes intuitive sense that Annie should specialize in
cleaning and Laurie in cooking. If Annie can then trade some of her cleaning efforts to Laurie in
return for Laurie’s cooking, both women should gain.

For example, suppose Annie and Laurie can produce either good A or good B in the
amounts listed below.

A B

Annie 8 units/day 8 units/day

Laurie 2 units/day 10 units/day

Because Annie can produce eight units of good per day compared to Laurie’s two, Annie
has an absolute advantage in the production of A. Similarly, Laurie has an absolute advantage
over Annie in the production of B.

Restate this is terms of opportunity costs. Annie can produce equal amounts of goods A
or B in a day; she produces them in a one-to-one ratio. That means that the opportunity cost to
Annie of producing A is the loss of an equal amount of B. Thus, her opportunity cost of
producing one unit of A is one unit of B and her cost of one unit of B is one A. The ratios for
Laurie differ. Laurie can produce five times more B per day than A so it will cost her five units
of B to get an A. Similarly, she produces only one fifth as much A as B, so it will cost Laurie
1/5 of an A to get one unit of B. Annie has the lower opportunity cost of producing one unit of
A (one B for Annie compared to five B for Laurie) and Laurie has the lower cost of producing
one unit of B (1/5 of an A for Laurie compared to one A for Annie). To get least-cost
production, Annie should specialize and produce A, while Laurie specializes and produces B.

Specialization requires trade. Annie is not likely to want to consume only good A, nor is
Laurie likely to want only good B. There must be a way for Annie to trade some of her extra A
to Laurie and get some of Laurie’s B in return. What sorts of trades are mutually beneficial?

By herself Annie can get one unit of B for every unit of A she gives up. She will gain
from specialization and trade if it enables her to get more than one unit of B per A. By herself
Laurie must sacrifice five units of B to get an A. Laurie will gain from specialization and trade if
she can get a unit of A for less than five units of B.

What trade ratio might help both women? Any trade ratio between 1A to 1B and 1A to
5B will work. Pick a ratio of 1 to 3. That is, suppose Annie agrees to trade a unit of A for three
units of B and Laurie agrees to trade three units of B for one unit of A. Annie gains. She now
gets three units of B per unit of a through trade, but could only get one unit of B per A by
herself. Laurie also gains. By herself she needed to sacrifice five units of B to get an A. Now,
by specializing and trading B to Annie, she needs to give up only three units of B to get a unit of
A.

Is this exciting, or what? Wait, it gets even better! It turns out that absolute advantages
are not needed for this to work. Only comparative advantages matter. Check the example

15
below. In this new example, Annie has an absolute advantage over Laurie in both products. She
can produce ten units of A per day to Laurie’s five and five B per day to Laurie’s one.

A B

Annie 10 5
Laurie 5 1

Despite Annie’s across-the-board absolute edge, both women still will gain from
specialization and trade. The key is that Annie’s advantage over Laurie is relatively bigger for
good B than for good A. Annie can produce five times more B per day than can Laurie (five
compared to one). Annie can also produce more A per day than Laurie, but only twice as much
(ten compared to five). Therefore, Annie’s relative or comparative advantage is in producing
B. Similarly, Laurie is at an absolute disadvantage in both, but she can produce one-half as
much a as Annie and only one-fifth as much B as Annie. Laurie has a relative or comparative
edge at good A.

Think in terms of opportunity costs. Annie can produce one-half as much B as A per
day. Her opportunity cost for producing one unit of A is 1/2 of a B while her cost of producing
one B is 2 units of A. For Laurie, the cost of producing one unit of A is 1/5 of a B and her cost
of producing one unit of B is five units of A.

Opportunity Costs Cost of one A Cost of one B

Annie 1/2 B 2A
Laurie 1/5 B 5A

Do you see it? Least-cost production still requires specialization. It is cheaper to have
Annie produce the B (her cost is 2A compared to Laurie’s cost of 5A) and to have Laurie
produce the A (her cost of 1/5 B is less than Annie’s cost of 1/2 B). Even though Laurie cannot
produce as A per day as can Annie, Laurie is still the low-cost producer. The opportunity cost of
producing A is lower for Laurie than Annie. Even though Annie can produce A in less time than
can Laurie, it costs her more. Annie must sacrifice 1/2 of a B to get an A, Laurie sacrifices only
1/5 of a B.

What trades will complete the gains? In the example, Annie can produce twice as much
A as she can produce B in a day (a 2A per B ratio) and Laurie can produce five times more A
than B in a day (a 5A per B ratio). Any trade using a ratio between 2A per B and 5A per B
works. For example, a ratio of three A for one unit of B will work for both. This 3:1 ratio
allows Annie to get three units of A per B through specialization and trade with Laurie while she
could get only two units of A per B by herself. Similarly, the 3:1 ratio allows Laurie to get a B
for three units of A through specialization and trade while it would have cost her five units of A
to get a B by herself.

16
 Think about it. Even when Annie has an absolute advantage in
the production of both goods, she still benefits by specializing and
trading with Laurie. Opportunity costs are driven by relative or
comparative abilities, not by absolute abilities. Because their relative
or comparative abilities to produce A vs. B differ, their opportunity
costs must also differ. As long as the ratio of possible production of
the two goods differs for Annie and Laurie, there will be a ratio
between them at which the women can engage in mutually beneficial
trade.

Is it magic? No, it’s merely gains from trade.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the concept of technical efficiency.

2. Explain two reasons why specialization tends to be efficient.
3. Given productivity data for two individuals (or two countries):
a. calculate opportunity costs.
b. identify absolute and comparative advantages and explain.
c. identify mutually beneficial trade ratios.
d. clearly explain how such trade ratios benefit both.

17
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

International Trade

Free trade, one of the greatest blessings a government

can confer on a people, is in almost every country unpopular.
...Thomas Macauley, English historian and statesman, 1824

More than 150 years later, nothing has changed. Free trade remains unpopular – except
among economists. We love it.

Modern countries rely heavily on international trade. We in the U.S. import from other
countries about 15 percent of the goods and services we buy. We export a similar proportion of
what we produce to other countries. While we trade with almost every nation in the world,
because of its geographical proximity, Canada is our primary trade partner. Although this trade
is a critical component of our economic success, it does create controversy, and many countries
(including the U.S.) actively restrict international trade by imposing tariffs (taxes) and quotas
(physical limitations) on imports.

Why? We make no attempt to limit trade between cities or states. Indeed, the U.S.
Constitution forbids states to pass laws restricting trade with other states. Why not expand the
“free trade zone” we enjoy within the U.S. to encompass the rest of the world?

Think back through the Annie and Laurie examples in the last section. By finding their
comparative advantages, specializing and trading, both women improve their lot. The same logic
holds for two countries. Substitute Austria and Liberia for Annie and Laurie. The examples still
work. Both participants still gain from specialization and trade. Specialization and trade among
countries creates the same benefits as specialization and trade among individuals. The logic of
gains from trade does not stop at an international border.

We have made some strides toward freer trade in decades. After much rancorous debate
Congress finally did approve our entry into the 1994 North American Free Trade Agreement
(NAFTA) that mandates a phased elimination of all barriers to trade between the U.S., Canada,
and Mexico, but opponents still abound.

18
Low wages vs. low productivity

Why? Trade critics most often play the cheap foreign labor card. During the 1990s
debate on NAFTA, critics especially worried about the prospect of free trade with Mexico. After
all, Mexican wages are much lower than those in the U.S. Would not Mexican firms, with
access to so much cheap labor, be able to sell their goods at much lower prices than could U.S.
firms? Trade critics warned that no American producers possibly could compete with Mexican
firms. They warned that free trade with Mexico would create massive unemployment in the U.S.
as American firms folded or moved south of the border to compete. Surely, they insisted, we
must protect ourselves against cheap foreign labor.

No. We need no such protection. In fact, while American workers were frightened by
the prospect of having to compete with the Mexicans, Mexican workers were equally afraid of
having to compete with Americans. After all, American workers enjoy many advantages.
American workers benefit from better education, better training and better health. American
workers have access to more and better technology, to better communication systems, better
roads and better community services. These make American workers more productive and
enable us to turn out more goods and services per hour. While U.S. workers worried about low
Mexican wages, Mexicans worried about high U.S. worker productivity.

The two factors cancel each other out. Work through an example. Suppose a Mexican
worker can produce one bag of potato chips per hour and is paid $1 per hour. Suppose that an
American worker is paid $10 per hour but, thanks to better technology and training, can produce
10 bags of chips per hour. Labor costs in both countries are the same: $1 per bag. The low
Mexican wage is offset by lower productivity, and the high U.S. productivity is offset by the
higher wage. Neither country has an advantage.

In reality, wages across countries are very similar when adjusted for productivity
differences. When adjusted costs do differ, it typically is because of a comparative
advantage. For products in which a country has a comparative advantage, its per unit costs will
be lower. However, by definition, a country cannot have a comparative advantage in
everything. If Mexico is comparatively better than the U.S. at one thing, the U.S. must be
comparatively better than Mexico at another. Mexican prices will be lower than ours for
products in which they have a comparative advantage; U.S. prices will be lower than Mexican
prices on products for which the comparative advantage is ours. With free trade, each country
will end up producing the products for which they have a comparative advantage; they will
specialize and trade.

Winners and losers

Remember that the problem of economics is not to create jobs, it is to allocate scarce
resources as efficiently and fairly as possible. Workers are a scarce resource. There always are
more potential jobs to be done than there are workers to fill them. There always are more things
that could be produced, if only we had the resources to do so. If the Chinese or the Peruvians or
the Somalis are willing to sell us a product for less than it would cost to produce in the U.S., it

19
should be cause for joy, not hand-wringing. Buying from abroad allows us to free up domestic
workers to produce other products instead. It allows us to expand our consumption possibilities.

Free trade does not cost jobs, it reallocates jobs. That has been our experience. As we
move toward free trade, we gain jobs in sectors for which we have a comparative advantage and
lose jobs in those sectors for which we have a comparative disadvantage. For
example, if the U.S. has a comparative advantage in farm equipment and Mexico
has a comparative advantage in textiles, then farm equipment production will
migrate to the U.S. and textile production to Mexico. U.S. textile workers would
switch to farm equipment, and Mexican farm equipment workers would change
to textiles. Unfortunately, people don't reallocate as easily in the real world as on
a classroom chalkboard. Older workers who are displaced from textile jobs in
the U.S. may be unable or unwilling to retrain and/or relocate to produce farm
equipment instead.

Should we protect these potentially displaced workers from foreign competition? No.
Trade will certainly create losers in this scenario, but trade remains the efficient option. The
message of comparative advantage theory is that the winners win more than losers lose.

Suppose we do impose tariffs on Mexican textiles, what will happen? The U.S. textile
industry will benefit. The tariffs will raise the price of foreign textiles and secure the market for
American producers. U.S. textile firms will gain profits, U.S. textile workers will keep their
jobs, and communities built around U.S. textile mills will enjoy more vibrant economies.

Unfortunately, the rest of America will lose. U.S. consumers will be hit with higher
textile prices. This hurts individual consumers, but also hurts corporate consumers. For
example, U.S. clothing manufacturers now must pay higher prices for their raw materials. This,
in turn, will force them to raise clothing prices and put them at a competitive disadvantage with
respect to clothing firms in other countries that have access to cheaper textiles. In other words,
saving U.S. textile jobs might cost us clothing jobs. Moreover, to the extent that U.S. consumers
must now spend more on textiles and related products, they will spend less on other
products. Perhaps the increased prices of textiles mean we can no longer buy as much ice
cream. If so, ice cream jobs will be lost as well. Statistical studies inevitably show that tariffs
create more economic losses than economic gains.

Do you want another defense of free trade? Consider the following parable told in Greg
Mankiw's Principles of Economics text (based on an idea originally attributed to economist
David Friedman):1

An American invents a way to produce steel at minimal cost. The only input needed is
wheat. After building a state-of-the-art mill in Iowa, she floods the market with new, low-cost
steel. The cheap steel cuts production costs in many basic industries and spurs productivity
growth and higher standards of living across the economy. Former steel workers are displaced,
but eventually find jobs raising wheat or working in other, spin-off agricultural firms. The
inventor becomes an instant celebrity and is feted by Democrats and Republicans alike.

20
 Curious about this new technology, an investigative reporter sneaks into the mill and
discovers the inventor is a fraud. The mill is empty. The "inventor" has simply been shipping
the wheat abroad and using her proceeds to import low-cost steel illegally from other
countries. When the true story hits the streets, government trade officials shutter the mill and
throw the erstwhile celebrity in prison. Steelworkers return to their former jobs, production
costs rise, and standards of living revert to earlier levels.

Congressional representatives send disclaimers to all constituents and media pundits

heap scorn upon the now-disgraced hero. She was, they remind the masses, not the genius they
thought. She "was just an economist."

_____________________________

Notes:

1. Perhaps the most famous defense of free trade was provided by French economist
Frederic Bastiat. His 1845 tongue-in-cheek Petition of the Candlestickmakers provides a
classic spoof of the cheap foreign labor fallacy. The petition can be read
at http://bastiat.org/en/petition.html

______________________________

Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1. Identify the percent of goods and services the U.S. imports and exports and identify our
major international trading partner.
2. Critique the argument that tariffs are needed to protect American workers from cheap
foreign labor. Discuss the role of productivity differences across countries.
3. Explain why tariffs on foreign goods benefit some Americans and hurt others. Who
wins? Who loses? Why? How can tariffs on textiles throw ice-cream employees out of
work?
4. Explain how we might efficiently produce steel with wheat.

21
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Section I-B: How Do We Choose?

You pays your money and you takes your choice.

How shall we choose what, how, and for whom to produce? How can an economy weigh
the disparate views and values that flourish among us? Shall we defer to Democrats, rely on
Republicans or listen to balding old men?

In most economies, people vote with their wallets. How does it all all work?

I-B. How do we choose?

1. Demand and supply
Demand and Supply
Demand and Supply Applied: Sample Problems
Demand and Supply Applied: Exchange Rates
Demand and Supply Applied: Housing Bubbles
2. Elasticity
Elasticity of Demand and Supply
Demand and Supply Applied: Oil Prices

22
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Demand and Supply: An Overview

If you can't pay for a thing, don't buy it. If you can't get paid for it, don't sell it.
...Benjamin Franklin

In most economies, prices determine what, how, and for whom goods are produced. Firms
will produce whatever goods can be sold at a profitable price and will choose resources on the
basis of what prices must be paid to employ them. The consumers willing to pay the price will
be the ones for whom goods are produced. Given the importance of prices, we need to know
how they are determined. Why are some high and others low? Why do some rise while others
fall? It’s all demand and supply.

Demand

Economists use the term demand to indicate willingness to buy. While the demand for a
product depends upon many different factors, one obvious determinant is price. Price has a
negative effect on willingness to buy. All else equal, as the price of a product falls, the quantity
demanded will rise.

It is often useful to illustrate these relationships graphically. We

draw a demand curve to show the relationship between the price of the
good and the quantity that consumers are willing to buy. For example,
suppose people are willing to buy 20 pounds of strawberries at a price of
$2, but are willing to buy 30 pounds if the price falls to $1. The relevant
demand curve is drawn below. Because a change in price will always
push the quantity demanded in the opposite direction, all demand curves
will have a negative slope.

23
 The price of good is not the only factor that impacts willingness to buy. Other
important factors include:

1. consumer tastes and preferences (or the perceived value of the product)
2. consumer income
3. prices of substitute and complementary goods
Note: Substitute goods can be used in place of one another (like corn and green
beans); complementary goods are used together (like cars and gasoline).
4. consumer expectations
5. number of potential consumers in the market or population

These factors often are called demand shifters. If any of them changes, the entire demand
curve will move or shift. For example, suppose new research indicates that eating strawberries
will make you more attractive to members of the opposite sex. Will consumers react to this
news? Of course. It will change the perceived value of strawberries and increase the quantity of
strawberries people are willing to buy at every price. Using the above numbers, suppose this
new research triples the quantities people are willing to buy at each price. In other words,
consumers are now willing to buy 60 pounds (rather than 20) at the $2 price and 90 pounds
(rather than 30) at the $1 price. The demand curve will shift to the right. As shown below, the
original demand curve (D1) has shifted to become a new demand curve (D2).

Changes in other demand shifters can have similar effects. The following will cause the
demand curve to shift to the right (i.e. larger quantities will be demanded at each price).

24
 1. an increase in perceived value of the good
2. an increase in consumer income
Note: This is true only for normal goods. Increased income will lower the demand
for what we call inferior goods. Inferior goods are those we would buy less of if
our income rose. Low-quality (but inexpensive) cuts of meat might be an
example. Can you think of others?
3. an increase in the price of a substitute good
4. a decrease in the price of a complementary good
5. an increase in the number of potential consumers in the market

Opposite changes in the above factors will cause the demand curve to shift down or to the
left (i.e. less will be demanded at each price than before).

Be careful not to confuse a movement along a demand curve with a shift to a new demand
curve. It is a common mistake. Remember that the demand curve already shows the negative
effect of price on quantity demanded. If the price of the good changes, we simply move to a new
point along the existing demand curve. We call this a change in quantity demanded. If there is a
change in a factor influencing demand, other than the price of the good, the entire demand curve
moves or shifts. We term this a change in demand.

Supply

Supply indicates willingness to sell. Like demand, the supply of a product depends upon
many different factors and, like demand, one obvious factor is price. However, while high prices
discourage buyers, they are likely to encourage sellers. Price has a positive effect on willingness
to sell. All else equal, as the price of a product rises, the quantity firms are willing to sell will
rise as well.

A supply curve illustrates the relationship between the price of the good and the quantity
that firms are willing to sell. For example, firms might be willing to sell 600 bushels of wheat at
a price of $3, but be willing to sell 900 bushels at a price of $4. The relevant supply curve is
drawn below. Because a change in price will push the quantity supplied in the same direction,
supply curves will have a positive slope.

Price is not the only factor that impacts willingness to sell. Other important factors
include:
25
 1. cost of inputs
2. available technology
3. profitability of other goods
4. number of sellers in the market
5. producer expectations

These factors are supply shifters. If any of them changes, the entire supply curve will
move or shift. For example, suppose new technology lowers the cost of growing wheat. How
will farmers react? The new technology increases the profitability, and therefore the willingness
to sell at every price. Suppose the new technology doubles the quantities people are willing to
sell at each price. In other words, firms are now willing to sell 1200 bushels (rather than 600) at
the $3 price and 1800 pounds (rather than 900) at the $4 price. The supply curve will shift to the
right. As shown below, the original supply curve (S1) has shifted to become a new supply curve
(S2).

Changes in other supply shifters can have similar effects. The following will cause the
supply curve to shift to the right (i.e. larger quantities will be supplied at each price)

1. a decrease in the price of inputs

2. a increase in technological efficiency
3. a decrease in the profitability of producing other goods
4. an increase in the number of sellers in the market

Opposite changes in the above factors will cause the supply curve to shift to the left (i.e.
less will be supplied at each price than before).

As above, be careful not to confuse a movement along a curve and a shift to a new
curve. Remember that the supply curve already shows the positive effect of price on quantity
supplied. If the price of the good changes, we simply move to a new point along the existing
supply curve. We call this a change in quantity supplied. If there is a change in a factor
influencing supply, other than the price of the good, the entire supply curve moves or shifts. We
term this a change in supply.

26
Equilibrium

At last we return to the initial question: how does a market economy determine prices?
The answer is that every market has a stable equilibrium where the quantities supplied and
demanded are equal. Use your common sense for a minute. If you have supplied 100 pounds of
strawberries, but consumers are willing to buy only 70, what will happen? How do real-world
firms react when they are faced with products sitting on their shelves that no one wants to
buy? They have a sale. They lower the price. After all, it’s better to sell products at a reduced
price than to not sell them at all. In other words, if the quantity supplied exceeds the quantity
demanded (a surplus), prices will fall.

Change the example. This time, suppose consumers are clamoring

to buy 100 pounds of strawberries, but you have only 70 to sell. Might
you raise the price? In fact, consumers probably will offer a higher
price. If you were one of the 100 potential customers, how could you
make sure that the firm sold the scarce strawberries to you rather than
someone else? Offer to pay a higher price! In other words, when the
quantity demanded exceeds the quantity supplied (a shortage), prices will
rise. Prices will be stable or in equilibrium only if the quantities supplied
and demanded are equal.

No doubt you are eagerly awaiting a graphical illustration. Since both supply and demand
curves are drawn with price on the vertical axis and quantity on the horizontal axis, we can put
both curves on the same graph. Pretty exciting, right? The point at which the curves cross or
intersect is the equilibrium.

In the example below, P1 is the equilibrium price and Q1 is the equilibrium quantity. Any
price above P1 (such as P2) will create an excess supply or surplus. The quantity supplied (as
shown by the supply curve) will exceed the quantity demanded (shown by the demand curve). In
light of the surplus, firms will lower price to P1 to sell their extra goods

Any price below P1 (such as P3) will create an excess demand or shortage. The quantity
demanded will exceed the quantity supplied. Because of the shortage, firms will soon discover
that they can sell all they have even at a higher price. As a result, the price will rise to P1. In the
long run, the price always moves to the equilibrium.

27
Changing equilibriums

In the real world, prices change every day. Why? Perhaps it is because of a shift either
in demand or supply. If either the demand or supply curves shifts or moves, the equilibrium
price and quantity will move as well. As an example, suppose there is an increase in the costs of
inputs needed to produce a good. This lowers the profitability of production and causes a
decrease in supply (i.e. the supply curve shifts to the left showing that less will be supplied at
each price).

The initial equilibrium price is P1, and the initial equilibrium quantity is Q1. When the
supply curve shifts left from S1 to S2, consumers still want to buy Q1 but, given the new supply
curve, firms are only interested in selling Q3. The gap between Q1 and Q3 represents a temporary
shortage of the good. The shortage causes the price to rise to the new equilibrium with price P2
and quantity Q2.

To test yourself, try shifting a demand curve. Can you trace out what happens to
equilibrium price and quantity? Can you explain the underlying economic logic?

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Define demand; draw a demand curve and explain its shape.

2. Distinguish between substitute and complementary goods, between normal and inferior
goods, and give examples.
3. Identify factors that will cause demand curves to shift. Illustrate graphically and explain.
4. Distinguish between a change in demand (a shift in the curve) and a change in the
quantity demanded (a movement along the curve) and give examples.
5. Define supply; draw a supply curve and explain its shape.
6. Identify factors that will cause supply curves to shift. Illustrate graphically and explain.

28
7. Distinguish between a change in supply (a shift in the curve) and a change in the quantity
supplied (a movement along the curve) and give examples.
8. Explain why prices above or below the equilibrium level are not stable in the long run.
9. Illustrate how shifts in supply and demand curves will affect equilibrium prices and
quantities and explain.

29
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Demand and Supply Applied:

Sample Problems

Try and complete the questions below. The answers are listed at the end. Don't
peek.

1. Indicate whether the following statement is true or false and explain why.
An increase in the price of bananas will shift the demand curve for bananas to the left.

2. Draw typically shaped supply and demand curves for hot dogs and indicate the equilibrium
price and quantity. Use the graph to illustrate what will happen to the equilibrium price and
quantity of hot dogs if there is an increase in income in the economy and explain.

3. Suppose a fleet of alien vessels carries away a large percent of the beef cattle on earth. Use
supply and demand to illustrate the impact of this on the following. Label your diagrams
clearly and explain each briefly.

a. The price and quantity of beef on earth.

30
 b. The price and quantity of hamburger rolls.

c. The price and quantity of chicken (assuming that chicken is a substitute for beef).

d. The price and quantity of vegetable beef soup.

4. Suppose that the profitability of growing corn to produce ethanol rises sharply. Use supply
and demand to illustrate the impact of this on the market for wheat. Label your diagram
clearly and explain.

5. Suppose that both consumers and producers expect prices of plywood to be much higher in
three months. Use supply and demand to illustrate the impact of this on the current market
for plywood. Label your diagram clearly and explain.

31
Are you peeking??

Answers to demand and supply problems:

1. This is false. The price of the good is not a demand shifter. The negative slope of the
demand curve already shows how a change in price will affect the quantity demanded. A
change in the price moves us to a new point along the same demand curve. The curve does
not shift. Did I catch you on this?

2. The effect of the increase in income depends upon whether hot dogs are a normal or inferior
good. If hot dogs are a normal good, the increase in income will cause an increase in the
demand for hot dogs. This increased demand will raise both the equilibrium price and
quantity.

However, some undiscerning families might perceive of hot dogs as an inferior good. They
might look at the increase in income as an opportunity to eat fewer hot dogs and shift to more
expensive foods instead (a plausible although gastronomically unfortunate choice). If so, the
demand for the hot dogs will shift to the left and both the equilibrium price and quantity will
fall.

3a. This decreases the supply of cattle and, therefore, of beef. The supply of beef shifts to the
left (less is supplied at each price). The equilibrium price rises and the equilibrium quantity
falls.

32
3b. Since beef now is scarce and more expensive, consumers will eat fewer hamburgers and,
therefore, demand fewer hamburger rolls (rolls are complementary goods to hamburgers).
This decreases the demand for the rolls (less is demanded at each price). The equilibrium
price and quantity of rolls both fall.

3c. Because beef now is scarce and more expensive, consumers will look for a substitute -- like
chicken. The demand for chicken will rise or shift up and to the right (more is demanded at
each price). This increased demand raises both the equilibrium price and quantity of chicken.

3d. Beef is an input into the production of vegetable beef soup. Since beef is now more
expensive, the cost of producing the soup will rise. The increased costs make soup
production less profitable at each price. The supply of vegetable beef soup shifts to the left
(less is supplied at each price). This raises the equilibrium price of the soup and lowers the
equilibrium quantity.

33
4. The increased profitability of ethanol will cause farmers to plant more corn. However, to
plant more corn they must plant less of alternative crops such as wheat. This will lower the
supply of wheat (less will be supplied at each price). This raises the equilibrium price of the
wheat and lowers the equilibrium quantity.

5. If consumers expect future prices to be higher they will try to stock up on plywood now
while the price still is low. This will increase the current demand (more will be demanded at
each price) and shift the demand curve to the right. Producers will react as well. Since they
also expect prices to be higher in three months, they have an incentive to hold onto their
inventories and wait until the prices rise to sell. As a result, the current supply of plywood
will drop or shift to the left. The combination of higher demand and lower supply will drive
the price up. The effect on quantity is unclear and will depend upon which of the curves
shifts the most. In the graph below, the curves shift by the same amount and the quantity
stays the same.

34
Note that the expectations of a higher price actually cause a higher price. Economists say that
such expectations of higher future prices often are "self-fulfilling".

35
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Demand and Supply Applied:

Exchange Rates

Let's go someplace else.

.....my wife after seeing the exchange rate

My wife loves London. In her earlier life she often led student tours to London. Though
her days of herding undergraduates through Westminster Abbey ended after marrying me,
London remains a favorite vacation destination. When she suggested a return trip a few years
ago, I did what any economist would do; I checked the exchange rates. Because London hotels
naturally price their rooms in terms of British pounds (₤) rather than American dollars, our travel
costs depend upon the exchange rate: how many dollars will it take to trade for a pound.

When last we traveled, it took only $1.44 to buy ₤1. Alas, when I checked for this trip, it
took $2.00 to buy that same ₤1.1 That's a 39% change. A London hotel room renting for 100₤ a
night would have cost us $144 at the old exchange rate, but would cost $200 at the new exchange
rate. Using econ-speak, the British pound had appreciated or gained value with respect to the
U.S. dollar while the dollar had depreciated or lost value with respect to the pound.

After hearing that a stay in London would cost an extra 39%, my wife quickly began
exploring alternative vacation plans. Even for my non-economist wife, the quantity demanded
goes down when the price goes up. Recognizing that powerful economic forces were at work,
she excitedly bubbled: "Will you please show me the graph?"2

Exchange rates and international trade patterns

Hang on, the graphs are coming soon. But first, for even more excitement, let's do some
arithmetic.

Suppose that a wool sweater can be purchased in the U.S. for $90
and that an equivalent sweater is available in London for ₤50. Ignoring
transportation costs, which sweater is less expensive? Is $90 more or less
than ₤50? It depends. What's the exchange rate? If the exchange rate is
$1.50 = ₤1, the British sweater is the less expensive. At $1.50 = ₤1, the
London sweater would cost an American only $75 [₤50 would cost
(1.50)(50) = $75] as opposed to $90 for the U.S. sweater . Similarly, at that
same exchange rate, a London shopper would have to part with ₤60 for the

36
U.S. sweater [$90 would "cost" 90 ÷ 1.5 = ₤60] instead of only ₤50 for the local sweater. At
these prices, Americans will be importing sweaters from Great Britain. Alternatively, the British
will be exporting sweaters to the U.S.

Next, suppose the exchange rate shifts to $2 = ₤1. The British pound has appreciated and
is more valuable (it's now worth $2 instead of only $1.50) while the dollar has depreciated or lost
value (it now takes more dollars to buy the same British pound). More interestingly, trade
patterns will reverse. At the $2 = ₤1 rate, U.S. sweaters become the better buy. American
consumers now must pay $100 for the British sweater [50₤ now cost (2)(50) = $100], but can get
the U.S. sweater for only $90. Similarly, British shoppers now can get the American sweater for
only ₤45 [$90 now cost 90 ÷ 2 = ₤45] while the local version costs ₤50. At the new exchange
rate, Americans will export the sweaters and the British will import.

Do you see the pattern? Appreciation makes your country's currency (and products)
more expensive on world markets. You will export less and import more. Depreciation does the
opposite. It makes your currency (and products) less expensive on world markets. You export
more and import less.

Is one scenario better than the other? Not really. It depends upon whether you are a
buyer or a seller. As a buyer, I want my currency to appreciate; it gives me more buying power
in other countries. Appreciation means that I can get more foreign currencies, and more foreign
goods, for my dollars. But sellers prefer depreciation. A depreciated dollar means that it is less
expensive for people in other countries to buy U.S. dollars and, therefore, U.S. products.
Depreciation allows U.S. firms to sell more products in the international marketplace.

Equilibrium Exchange Rates

What determines exchange rates? What causes currencies to appreciate or

depreciate? Aha. It's demand and supply. Graphs at last.

Like most nations, the U.S. and Great Britain allow the value of their currencies to float
in the international markets. The equilibrium prices of the currencies depend upon demand and
supply; just like the prices of other goods and services. The demand for a currency on the
international exchange markets depends upon the demand for that country's products in the
international markets. Why would an American want British pounds? Primarily to buy British
products that are priced in terms of pounds. The greater is our demand for British goods, the
greater will be our demand for British pounds.

Similarly, the supply of a country's currency on the international markets depends upon
the willingness its people to buy foreign products. Why would the British want to supply
Americans with their pounds? Primarily to be able to buy something from the U.S. The more
foreign products the British demand, the more British pounds they will be willing to supply.

The demand and supply curves for currencies have the familiar shapes. Check the graph
below:

37
 As always, the equilibrium price will be where the curves intersect (an exchange rate of
$1.50 = ₤1 in the above graph). At any higher price there would be an excess supply of British
pounds that would drive the price down. And, at any lower price, there would be an excess
demand for pounds that would drive the price up.

And, as always, shifts in the demand or supply curves will change the equilibrium price
or exchange rate. For example, suppose that Americans decide to go on an international
spending spree and stock up on British tea sets. What will happen? How will exchange rates
move? Can you picture the graph?

The answer is below. The new demand for tea sets will increase demand for the British
pounds needed to buy them. This shifts the demand for pounds from D0 to D1 and, at the original
exchange rate (ER0) creates an excess demand for pounds. How do we induce the British to part
with their pounds? We offer them a better deal. The new demand drives up the equilibrium rate
to ER1. With the dollar price of the pound rising, the British pound has appreciated and the
dollar has depreciated.

38
 To a large degree the example above describes what has happened in recent years. Rising
American demands for foreign-produced goods and services has increased the demand for
foreign currencies and caused the dollar to depreciate in international markets.

How about another example? One is never enough. Suppose that London financiers
learn that interest rates being earned on financial assets in America are higher than those Great
Britain. Can you predict the outcome?

To purchase American financial assets, the British first must trade in their pounds to get
U.S. dollars. This increases the supply of pounds on the international exchange markets (the
supply of pounds rises from S0 to S1 in the diagram below). In turn, the increased supply of
pounds will drive down the price and the exchange rate moves from ER0 to ER1. Since
Americans can now pay fewer dollars to buy the pound, the pound has depreciated and the dollar
has appreciated.

Are you still with me? The prices or values of currencies are determined by demand and
supply, just like other products. And, just like other products, those equilibrium prices do not
change spontaneously. They change if and only if there is a change in the underlying factors that
determine demand and supply. Factors that make us want more foreign goods, services and
assets more attractive (eg. more income, lower foreign prices, greater perceived value of foreign
goods, higher foreign interest rates, etc.) will increase the demand for the foreign currency and
cause it to appreciate. Factors that make foreign goods, services, and assets less attractive to us
will lower the demand for the foreign currency and cause it to depreciate. Similarly, factors that
make U.S. products and assets more attractive to foreigners will increase their willingness to
supply their currencies and cause their currencies to depreciate, while factors that make U.S.
products and assets less attractive to foreigners will induce them to cut their willingness to
supply their currencies and cause them to appreciate.

39
Dollars in and dollars out

This is pretty exciting, right? Relax a minute and take a deep breath. It gets even better.
Note that at the equilibrium the quantity of a currency demanded equals the quantity
supplied. The value of British products that Americans want exactly equals the value of
American products that the British want. The value of what we export to the British equals the
value of what we import; trade between our countries automatically is balanced.

Think through an example similar to the first one we considered. Suppose that British
products suddenly drop in price and, as a result, Americans decide to buy more. Work through
the steps:

1. As we try to import more, the initial effect is to push us toward a trade deficit with Great
Britain. We want to buy more of their products than they want of ours.3

2. Our new demand for British products will cause an increase in our demand for British
pounds.

3. With increased demand, the British pound will appreciate; the pounds will become more
expensive for Americans to buy.

4. As the British pounds become more expensive, British products (that are priced in pounds)
also will become more expensive for us.

5. The increased expense cuts our desire to buy British products and brings our imports back
into line with exports.4

Did you catch on? Exchange rate markets always drag trade between countries back into
balance. A drop in the price of British products can cause an initial trade imbalance, but the
imbalance will be only temporary. The British pound will appreciate, this will make British
goods more expensive to us, and balance will be restored at a new equilibrium exchange rate. At
equilibrium, the value of products being exported always equals the value being imported.

While we have stuck to a two-country U.S. vs. Great Britain example, the same concepts
hold for trade in a multi-national world. What applies to trade between the U.S. and Great
Britain, also applies to trade between the U.S. and China, and between Great Britain and China.

Wait. Can that be true? Media reports are filled with tales of trade imbalances with
countries such as China. Doesn't the U.S. run huge trade deficits with China?

Yes and no. It's a matter of definition. If we look only at trade of currently produced
goods and services, the U.S. does run international trade deficits with China and with many other
countries as well. We import more currently produced goods and services than we
export. However, there also is a healthy trade in assets across international boundaries. We can
buy and sell currently produced items like oil, textiles, and automobiles on international markets;
we also can buy and sell assets like real estate, corporate stocks and bonds, and other financial

40
assets on international markets. In recent decades the U.S. has run consistent deficits in the
international trade of currently produced goods and services, but surpluses in the trade of
assets. In effect, imports of products such as oil and textiles are balanced by exports of
assets. We import Saudi Arabian oil and Chinese textiles; we export ownership of U.S. real
estate and financial assets. It may not be the type of trade balance we prefer, but it is a balance
nonetheless.

_______________________________________

Notes:

1. The $1.44 = ₤1 rate was in 2001. The $2.00 = ₤1 rate was in 2008. The current
exchange rate between any two world currencies can be found at
http://www.oanda.com/convert/classic.
2. Just kidding.
3. Importing more than we export is said to create a trade deficit. Exporting more than we
import creates a trade surplus.
4. Strictly speaking, the appreciation of the British pound will cause an increase in our
exports to Great Britain as well as a decrease in our imports. As the pound appreciates,
the British can buy more dollars with their pounds. This makes American goods less
expensive to them and enables us to sell more in Great Britain.

________________________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Explain which country will import and which will export a product given an exchange
rate and prices in the respective countries. For example, if Mexican tomatoes cost 10
pesos per pound and American tomatoes cost $1 per pound, explain where the tomatoes
are less expensive if the exchange rate is 12 pesos = $1.
2. Explain how and why appreciation and depreciation of currencies can change trade
patterns between countries.
3. Identify which groups benefit from an appreciation of their currency, which benefit from
a depreciation, and explain why.
4. Use supply and demand curves to illustrate and explain how exchange rates are
determined.
5. Explain what factors might cause currencies to appreciate or depreciate and use supply
and demand curves to illustrate.
6. Explain how exchange rates will ensure that the value of imports entering a country will
roughly equal the value of exports leaving the country.

41
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Demand and Supply Applied:

Buy Low and Sell High

If stock market experts were so expert, they would be buying stock, not selling
advice. .....Norman Augustine

Spam crams my electronic mailbox every week. It comes

in waves. Nigerians asking my help in shady international fund
transfers, ads for gambling and porn sites, offers for cheap drugs
and, recently, "sure thing" stock tips.

Luckily I'm an economist; I know better. Taking

unsolicited investment advice ranks right next to juggling loaded
guns on the stupidity scale. Corporate stocks are a sensible
component of almost any investment portfolio, but speculative
trading has flushed countless nest eggs down the proverbial
toilet.

What are stocks?

Stocks are ownership shares. Entrepreneurs who need funds to start or expand a business
have three basic options. They can pony up their own dollars, they can borrow and go into debt,
or they can sell ownership shares (stock) in the venture. If a corporation has issued 100,000
shares of stock and you own 5,000 of them, you own 5% of the corporation. Five percent of its
current assets (and liabilities) belong to you. So do 5% of its future profits (or losses).

Suppose that you buy into an initial stock offering and purchase 5,000 shares for $100
each. Your $500,000 goes to the corporation and, as a part owner, your vote will help elect the
Board of Directors that oversees what the firm does. You can hold that stock as long as you like,
but you also have the opportunity to sell. You can sell privately or, more commonly, sell over an
organized stock exchange such as the New York Stock Exchange (NYSE) or the NASDAQ
exchange. If the stock has risen in value since your initial purchase, you can make a profit; if the
value has fallen, you lose.

Demand and supply

42
 What determines the price of a stock? Demand and supply. As in any other market there
is an equilibrium price where the quantity demanded equals the quantity supplied. Any higher
price creates an excess supply that will drive the stock price down. Any lower price creates an
excess demand that will drive the stock price up.

Stock prices change only when there is a shift in the underlying demand and supply
curves. The most likely cause is a change in expectations. Remember that stocks are ownership
shares. Because they give you a share of future profits, their value depends upon the how much
future profit the firm is expected to earn. An increase in expected future profits of a firm will
drive the demand and price of its stock up; a decrease in expected future profits will drive the
stock price down.

Imagine Merck announcing progress on the development of a new anti-obesity drug or

Nike introducing a shoe that enables an athlete to jump 30 percent higher. Each of these would
change the expected value of the firm, increase the demand for its stock, and drive up the
equilibrium price. Similarly, a new scientific study showing that Merck's current best-selling
drug product causes dangerous side effects or the discovery that Nike shoes cause foot fungus
would quickly send the demands and prices for their respective stocks into a downward spiral.

Take a minute to reflect on this. If the current price of a

corporate stock depends on the future profitability of the firm, then most
of our financial wealth is based on nothing more tangible than our
expectations or hopes of what lies ahead. Much of what many consider
their financial wealth, as economist Uwe Reinhardt once remarked, is
little more than a figment of our imagination.1 If people suddenly become
less optimistic about future corporate profits, stock prices will plummet
and billions, perhaps trillions, of dollars of paper wealth will vanish into
thin air. Or, if we imagine that firm profits will soar, we'll bid the stock
price up. That's why the stock market can be so fickle. Small changes in
people's subjective feelings translate into real changes in stock values.

Can you beat the market?

Over the long haul, stock prices tend to rise. On average, investors earn very respectable
rates of return. Some will buy the right stocks at the right time and earn even more; they will
beat the market. But not all stock prices rise, and not all investors make profits. For every
investor who beats the market and earns above-average returns, others walk away with losses or
below-average returns.

The trick is to know what direction prices will move; to buy before prices rise and to sell
before prices drop, to buy low and sell high. Buying shares at $10 and reselling at $30 will fatten
financial fortunes quickly. If only it could be you. If only you could predict which way prices
will be moving. If only you could know when to buy and when to sell. If only pigs could fly.

It's fantasy. It's a pipe dream. We can observe how prices have changed in the past, but
past values are poor indicators of future values. Despite the claims of fast-buck scam artists,

43
there is no statistical way to predict future stock prices on the basis of historic patterns. There is
no scientific pattern of buying and selling that will enable someone consistently to beat the
market. Think it through. If someone discovered a sure-fire method to beating the stock market,
would they not already be rich? If they already can make unlimited sums playing the market,
why are they hustling to sell us their system? Average Americans might think otherwise, but
every economic expert surveyed in a 2012 poll agreed with the statement "it is hard to predict
stock prices."2

Remember that stock prices are driven by expectations. Work through an

example. Suppose that Exxon stock currently sells for $100 a share. Suppose next that Exxon
implements a new refining technology that will boost future profits by 30%. What should
happen? If profits rise by 30%, a share of stock should be 30% more valuable. That $100 share
price should rise to $130. 3

Wait. Suppose that professional market analysts already knew that Exxon was working
to develop this new refining technique. Suppose they expected this to happen. If they expected
this to happen, they should already have been buying up Exxon stock in anticipation. And, if
they already were buying up Exxon stock, that already should have been driving the stock price
up. Think about it. If the current price was $100 and you expected it to rise to $130, what would
you do? You would buy. But this increases the demand for the stock and drives up the price. If
the price rises to $110, what will you do? You would keep buying. As long as the price is below
$130 it's still a good deal. You should keep buying until the price goes all the way to $130. At
that point, it's no longer a good deal and the process stops.

Do you see what's happening? If financial analysts predict that future profits are going to
rise, they quickly will drive up the demand for the stock. If they expect the future stock value to
be $130, they will bid the price up to that $130. In other words, the current price of a stock
should always reflect the expected profits of the firm.

Do you want to beat the market? There only are three ways to do it.

1. Outsmart the professionals.

If the best guess of market analysts is that expected profits warrant a $130 stock price,
they will push the price to that $130. But suppose you are smarter than the
professionals. Suppose you predict that future profits will exceed the market estimates and that
the stock price will go to $150. In this case you should buy at $130, wait for the higher profits to
emerge, wait for the market price to rise to $150, and sell at a profit. Can you do it? Can you
outsmart the professional analysts? Probably not. Even the professionals cannot do it. Some do
beat the market for years at a time, but no more than we would expect from random chance.

2. Break the law.

Perhaps your uncle works for Exxon and passes along inside information that analysts do
not know. Perhaps he tells you about the secret new refining technology Exxon is ready to
unveil. You’ll have an edge. Your inside information might enable you to predict future profits
more accurately than can outsiders. There’s just one small problem. Trading on inside

44
information is illegal. It’s why Martha Stewart spent five months in jail. Of course, you might
not be caught…..

3. Get lucky.
Suppose someone offers you the following deal: flip a coin twenty times with a payoff of
$1 for each head and negative $1 for each tail. On average you’ll flip similar amounts of heads
and tails and break even. But suppose you’re just plain lucky. Suppose you take the deal and flip
20 heads in row. You’ll walk away with a new $20. Of course your profit did not result from
some superior ability to flip heads, it resulted from luck. Could you do the same with stocks?

Safety first

As for me, I cannot outsmart the professionals, I am unwilling to risk breaking the law,
and my gambling luck is average at best. I cannot beat the market. I stopped trying years
ago. Instead I am content to match the market. I invest in mutual funds that own a broadly
diversified set of corporate stocks. Some stocks in the mutual fund’s portfolio perform better
than average, others worse than average. I may never make a financial killing with such a fund,
but I minimize the chance of a financial bath. Over the long haul, my fund profits will match the
market.4

_______________________________________

Notes:

1. See Reinhardt, Uwe, "Where All That Money Went",

http://economix.blogs.nytimes.com/2010/04/30/where-all-that-money-went/, accessed
July 20, 2010.
2. These data were reported in The Economist, January 12, 2013, page 66.
3. Readers with financial expertise might see that this is strictly true only if interest rates
equal zero. Otherwise we should look at discounted present values of expected future
profits.
4. Economists report a variety of stock market indexes that track price changes for groups of
stocks. The Dow Jones Industrial Average is the most widely reported and tracks what is
happening to stock prices for a sample of 30 major corporations. Professionals often pay
more attention to broader indexes such as the S&P 500 (it tracks 500 major stocks) and
the NASDAQ (it tracks all stocks traded over the NASDAQ exchange). Many investors
choose to buy Index Funds that contain all of the stocks tracked by an index. For
example, an S&P 500 Index Fund would contain representative shares of all firms
included in the S&P Index. As a result, if S&P 500 Index were to rise by 14%, the value
of the index fund would increase by the same 14%. It will match the market exactly.

________________________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

45
1. What is a stock?
2. Explain why current stock prices respond to expected future profits.
3. In what sense is much of our "financial" wealth little more than a figment of our
imagination?
4. Identify and explain the three possible ways an investor might beat the market and earn
higher than average returns.

46
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Crash: The Anatomy of a Housing Bubble

What goes up must come down.
....anonymous

As a young, married college professor I

began my professional life living in a small,
moderately priced apartment. After four years
of careful financial planning, we had saved
enough to make the requisite 20% down
payment on a modest seventy-year-old wood-
frame house priced well-below the average for
our small town. After verifying my salary and
our credit scores, a local bank gave us a
conventional, fixed-rate thirty-year mortgage
loan to finance the other 80% of the cost.

Mortgages such as mine provided lenders

with safe and predictable rates of return. Even if
borrowers could not make their monthly payments and defaulted on the loan, the bank could
foreclose on the house. Since the bank only had loaned 80% of the home's value, it easily could
sell it for more than enough to recover all of its money.

Things changed.

Increased housing demand

The demand for housing rose rapidly during the last part of the twentieth century as baby
boomers married and began raising families. Not content with the apartments and one-bathroom
dwellings of their parents, boomers aspired to more. As the boomers demanded more and larger
homes, prices rose predictably. By the mid 1990's the average home price sold for about three
times more than it had 20 years earlier.

Years of continual price increases affected consumer expectations. If prices had risen for
twenty years in a row, surely they would continue to rise. Right? Television hucksters began
promoting real estate as a quick and easy way to riches and real estate agents, eager for more and
bigger commissions, assured consumers that prices would rise forever. Hooked on the idea that
houses were sure-fire, risk-free investments and not just a place to live, people kept buying more

47
and bigger houses. These new expectations, grounded in wishful thinking rather than history,
accelerated the increased demands and prices.

Financial innovations

Changes on the lending side had even more impact. Instead of holding on to the
mortgages and collecting monthly payments, local lenders began selling mortgages off to other
financial institutions. These institutions would pool hundreds of mortgages into packages and
then sell securities backed by those packages to other financial institutions and to individual
investors. Because mortgages traditionally offered safe returns, investors saw these "mortgage-
backed" securities as risk-free ways to earn nice profits.

The local lenders earned handsome fees each time they sold off a mortgage and, in time,
they found that originating loans to resell was more profitable than holding and collecting
payments for the loans. They responded predictably; they tried to originate as many loans as
possible. To encourage potential buyers, banks lowered or eliminated required down payments
and offered loans to borrowers with poor credit histories (subprime borrowers).

Banks also developed new types of mortgages. Borrowers could choose loans with initial
payments that were very low and affordable, but that would "balloon" to higher levels later. For
example, popular "pick-a-pay" mortgages gave borrowers the option of making minimum
payments that did not even cover the interest that was due. Like those who make only minimum
payments on their credit card debt, people who chose this home mortgage option found their
indebtedness rising rather than falling each month.

These loans were far riskier than traditional mortgages. People with questionable credit
were borrowing $250,000 to buy $250,000 homes and committing to future mortgage payments
that would be difficult to meet. But bankers (like everyone else) were convinced that home prices
would continue to rise. If borrowers did default in the future, the homes always could be sold to
recoup their investments. More importantly, the banks planned to sell these mortgages off to
other investors. If losses occurred, the unsuspecting people who bought the mortgages and
mortgage-backed securities would ultimately be on the hook, not the originating lender. To the
originating bank, risk was relatively unimportant. To make matters worse, because "respectable"
financial agencies such as Moody's and Fitch gave these mortgage-backed securities AAA
ratings -- the highest possible for safety -- investors bought up these assets as fast as banks could
create them. Some experts believe that the ratings agencies themselves were fooled by how risky
these assets were. However, the agencies were paid by the banks to rate the safety of these assets
and agencies that proclaimed the assets as "unsafe" risked angering their bank clients and losing
profits. As a result, some experts have claimed that the ratings agencies deliberately misled the
investing public to protect their bottom lines.

These easily available, low-cost mortgages fueled even more demand for houses and,
from the mid 1990s to 2006, housing prices shot up at record rates. Can you draw the graph? It
should look like the one below.

48
Crash

It could not last. Economists began warning of an unsustainable bubble in home prices
and Yale's Bob Shiller estimated that 2006 prices were 30% above what could be justified on the
basis of rental prices, construction costs and historical trends.1 Unfortunately, what cannot last
does not last. The bubble burst.

The first prick came from the supply side of the housing market. When prices soared
after the mid 1990s, contractors rushed to take advantage of them. New housing developments,
filled with McMansions, sprang up all over the country in the middle of erstwhile fields and
forests. Unfortunately, there was not enough new demand to buy them and housing gluts began
to appear. As unsold houses sat on the market for longer and longer periods of time it put
downward pressure on prices. I can't resist one more graph:

After increased supply started the price slide, other factors kicked in as well. First,
falling prices started to change consumer expectations. Perhaps real estate was not such a sure-
fire way to riches after all. If so, perhaps consumers and investors should stop plowing every
available dollar to more and bigger houses. As a result, the demand for housing began to
fall. Second, after enjoying years of artificially low mortgage payments, homeowners were hit
with higher balloon payments. Many found themselves unable to make their monthly
payments. Those who used no-down-payment loans were in particular trouble. They might have
borrowed $250,000 to buy a $250,000 house. But, in a world of falling prices, their $250,000
house might have dropped in value to $220,000. If so, they now had "negative equity"; they
owed more money than their homes were worth.2

49
 Families unable to make their payments defaulted on their
loans. Even some who could afford their payments defaulted as
well. Many with negative equity saw no sense in continuing to pay
on a home that was worth less than they owed and simply walked
away. But, as banks foreclosed on the delinquent loans and tried to
sell the houses, they often were unable to sell them for enough to
recover the loan value. Moreover, this aggravated the glut of homes
on the market and drove prices down even more.

Financial Chaos

With housing prices falling, banks now found themselves saddled with collateral (houses)
that did not cover the amounts they were owed. Mortgages and mortgage-backed securities,
once thought of safe investments, suddenly began losing money rapidly. As the losses mounted,
lenders and investors pulled back. The market for mortgage-backed securities dried up. Lenders
reinstated large down payment requirements and were reluctant to give mortgages to any but the
most credit-worthy applicants. However, with buyers unable to get new mortgage loans, the
demand for housing tanked even faster, sending home prices into another downward spiral.

The financial fallout has been unprecedented in modern times. The financial institutions
that had purchased billions of dollars of mortgage-backed securities were highly leveraged. In
other words, they had borrowed most of the funds used to buy these securities. Leverage creates
huge profits when prices are rising, but leads to disaster when prices tank. As an example,
suppose a firm puts up $50,000 of its own money and then borrows the other $950,000 needed to
purchase a $1 million security. If the value of the asset rises by five percent (to $1,050,000), the
firm doubles its money. After it repays the borrowed $950,000, it still has $100,000 left over:
that's double the $50,000 it put up to begin with. By using borrowed funds, the firm has
"leveraged" the five percent gain in the value of the security into a 100% profit. Unfortunately,
the same process works in reverse. If the value of the security falls by five percent (to
$950,000), the firm is wiped out. After paying back the borrowed $950,000, nothing is
left. The five percent drop in the value of the security now is leveraged into a 100% loss to the
firm.

As home prices fell and mortgage-backed securities began to lose value, these highly-
leveraged firms began dropping like flies sprayed with insecticide. Bear Stearns and Lehman
Brothers, both respected investment banking firms, went belly up. The Federal National
Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Federal
Mac), firms that guaranteed trillions of dollars’ worth of mortgages and mortgage-backed
securities, were thrown into insolvency and taken over by the federal government. Citicorp, one
of the largest commercial bank operations in the world, needed a massive federal bailout to stay
afloat and Wachovia, another giant U.S. bank, flirted with bankruptcy before giving up the ghost
in a fire sale to Wells Fargo. The venerable Merrill Lynch averted disaster with a similar fire
sale to Bank of America.

The mounting losses in the housing and financial sectors soon spread to other
markets. Homeowners struggling to meet balloon mortgage payments are unlikely to buy new

50
cars and construction workers who lose their job in a housing market collapse are unlikely to
treat their children to two weeks in Disney World. What began as a housing crisis quickly led to
a worldwide economic slowdown.3 Governments and central banks have rushed to prop up shaky
financial markets with assorted bailout and stimulus programs, but the short-term pain has been
significant.

Supply and demand matter.

_______________________________________

Notes:

1. Shiller, Robert, panel discussion on "The Subprime Mortgage Crisis", Annual Meetings
of the American Economic Association, New Orleans, 2008.
2. As many as 10-20% of all homeowners are estimated to have negative equity in 2009.
3. Because financial markets and trade are international in scope, other countries have
suffered the same fate.

________________________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Explain why housing prices rose through the last part of the 20th century,
2. Explain what happened to make banks want to originate more home mortgages, discuss
what they did to encourage this and how it affected risk.
3. Explain why securities rating agencies might have given risky mortgage-backed
securities high ratings for safety.
4. Explain how these new bank practices impacted home prices and illustrate with an
appropriate graph.
5. Why did the housing bubble begin to burst? Illustrate with an appropriate graph.
6. Explain the concept of negative equity.
7. Explain why home foreclosures have risen in recent years and how this has affected home
prices.
8. Explain how falling home prices have affected financial firms.
9. Explain the concept of leverage and how it leads to bigger profits and losses when asset
prices fluctuate.

51
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Elasticity of Demand and Supply

In spite of the cost of living, it's still popular.

...author Laurence Peter

We know that when the price drops the quantity demanded will rise and the quantity
supplied will fall. In many cases, the directions of these changes are all that matter. However, in
other cases, the magnitude of the change matters as well. Will a change in price have a large
impact or only a small impact on consumer and producer behavior?

Economists use the concept of elasticity to measure the changes. The price elasticity of
demand is measured as the percentage change in quantity demanded divided by the percentage
change in price, and the price elasticity of supply is measured as the percentage change in
quantity supplied divided by the percentage change in price. For example, if a 10 percent
increase in price causes consumers to cut their willingness to buy by 12 percent and producers to
increase their quantity supplied by 6 percent, then the elasticity of demand = 12/10 = 1.2 [Purists
will note that the elasticity is actually negative 1.2, but we will worry only about the absolute
value] and the elasticity of supply = 6/10 = 0.6. If the elasticity numbers exceed one, we say that
demand and/or supply is elastic. If the numbers are less than one, we say that demand or supply
is inelastic. If elasticity equals one, we say that demand or supply is unit elastic. In this example,
demand is elastic and supply is inelastic.

The essential idea is that elasticity measures how sensitive we

are to changes in price. If prices matter very little, changes in price
only will have small impacts on our willingness to buy or
sell. Because the percentage change in quantities demanded and
supplied will be small, the elasticity calculation will also be small
and we will get inelastic results. On the other hand, if we are very
sensitive to prices, even small changes in prices will cause large
changes in our willingness to buy or sell. The large changes in
quantity will give us large elasticities. Think of stretching. We think
of something that is elastic as something that stretches easily. It's the
same with elasticity here. For example, if our willingness to buy a

52
product stretches a lot when the price changes, its demand is very elastic. If our willingness to
buy does not change or stretch much when price changes, its demand is inelastic.

Determinants of elasticity

While both demand and supply elasticities matter, most analysis focuses on the demand
side. What determines elasticity? The primary factor is the availability of close substitutes. For
example, suppose a Sunoco station raises the price of its gasoline by 10 percent. Most
consumers treat rival brands as almost perfect substitutes and will quickly switch to other
suppliers. Sunoco is likely to lose far more than 10 percent of its volume. There will be a big
stretch in our willingness to buy; an elastic response. But, suppose that the Sunoco station is the
only one in town; suppose that no other brands are available. In this case, consumers are stuck.
Without an alternative, they will continue to patronize the Sunoco station despite the higher
price. Consumers might cut back on unnecessary driving to save money, but the drop in quantity
demanded is likely to be quite small -- an inelastic response.

How much of our income we spend on an item can be a second factor that impacts
elasticity. For example, I never comparison shop for shoe laces. The price does not concern me.
I spend so little on laces that even a doubling of their price would have no noticeable impact on
my annual budget. Shopping for a better deal would cost me more than it realistically could be
worth. However, while saving five cents on a pair of laces is insignificant to me, it's not to Nike
or New Balance or Adidas. For a firm that is selling millions of pairs of shoes per year, five
cents per lace really matters. It may not pay an individual to shop around for a better deal on
laces, but it certainly will pay Nike to do so. All else equal, the more we spend on item, the
more elastic our demand will be.

Time is a third factor that affects elasticity. Given more time we can make more
substitutions. Suppose the price of gasoline rises. In the short run consumers will continue to
feed their voracious SUV's. But, when they next shop for a new car, many will shift to more
fuel-efficient options. The more time we have to shift our purchasing patterns, the more elastic
our demands will be.

In terms of the graphs, larger demand elasticities translate into flatter or more horizontal
demand curves. Smaller elasticities translate into more vertical curves. Work through an
example. Imagine that a small 10 percent increase in the price of Sunoco gasoline causes a large
50 percent drop in the quantity demanded. On a graph, the price increase (measured vertically)
would be small, but the quantity decrease (measured horizontally) would be huge. The curve
would be very flat. On the other hand, suppose that the Sunoco station was the only one within
500 miles and that even a large 50 percent increase in price caused only a small 10 percent drop
in the willingness of consumers to buy. This time the vertical or price change would be huge and
the horizontal or quantity change small. In this instance the demand curve would be very steep.

Elasticity and total revenue

Extend the Sunoco example above. If the Sunoco station does raise price, what will
happen to its total revenue? Total revenue (TR) is simply price multiplied by quantity [TR =

53
PQ]. In our example, price rises by 10 percent. What happens to TR will depend upon whether
demand turns out to be elastic or inelastic. If demand is elastic and more than 10 percent of the
station’s customers jump ship, the Sunoco station will find TR dropping. Its 10 percent increase
in price will be more than offset by the larger drop in quantity. However, if demand is inelastic
and the station can maintain most of its customers at the higher price, its TR will rise. The effect
of the higher price will more than offset the small drop in volume.

Do you see the relationship? If demand is elastic, the percent change in quantity will
exceed the percent change in price and TR will move in the same direction as quantity. But if
demand is inelastic, the percent change in quantity will be smaller than the percent change in
price and TR will move in the same direction as price.

Understanding elasticity is far more than an intellectual exercise; it makes or breaks

commercial ventures. For example, the blockbuster musicals Avenue Q and Rent both closed on
Broadway when they no longer could attract enough patrons to fill the theatres and cover their
costs. Subsequently both shows moved to smaller Off Broadway venues and, instead of charging
the $120 typically paid for seats at Broadway hits, slashed prices to $80. The lower prices
attracted droves of new and repeat customers and both shows thrived in their new environments.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Define and know the formulas for the price elasticity of demand.
2. Differentiate between elastic, inelastic, and unit elastic demand.
3. Identify and explain the three factors that determine whether demand is likely to be
elastic or inelastic and give examples.
4. Explain why curves with more elastic demands at a particular price are more horizontal
than those with less elastic demands.
5. Understand and explain the relationship between elasticity of demand and total revenue;
explain why elasticity determines whether TR will rise or fall as a result of a price
change.

54
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Demand and Supply Applied:

Oil Prices

Genius is nothing but a great aptitude for patience.

.....George-Louis De Buffon

My elderly friend loves to reminisce about the good old

days. He tells the same stories over and over again. He tells of
watching Sammy Snead1 hitting towering drives while playing
exhibitions at his local golf course; he tells of betting $20 on
Seabiscuit in his 1938 match race with War Admiral2; and he
tells of buying six gallons of gasoline for a dollar.

Six gallons for a dollar? During the summer of 2008 I

paid $4.36 a gallon while vacationing in Montana, but in
January 2015 I paid $1.92 in South Carolina. How could this happen? How can oil prices
skyrocket at one point and then plunge back to earth at another? Some want to blame the forces
of evil, but economists prefer explanations based on demand and supply.

Erratic gasoline prices are nothing new. It's all old hat to those of us with enough gray
hair to remember the energy crisis of the 1970's. Prices climbed rapidly in the 1970's, soaring
from about $3 a barrel in early 1973 to over $35 a barrel in 1980. They then took a long slide
through the 1980's and 90's, falling to almost $10 a barrel in 1998 before rising again over the
last decade, diving back and then spiking again. If we adjust these prices for inflation3 we get an
even more interesting perspective. Look at the chart below. It traces the price of a barrel of oil
over the last 50 years in terms of 2012 prices. In this case, the price increases of the 1970's look
remarkably similar to those of the 2000's. And wild price fluctuations, even when adjusted for
inflation, have been the rule.

55
Elasticity and prices

While these price changes have been controversial, they are the inevitable results of shifts
in demand and supply. First, we need some background information. Both the demand and
supply of oil are relatively inelastic in the short run: changes in price have little impact on either
the quantity demanded or the quantity supplied. When oil prices rise we spend considerable time
and energy complaining but, at least in the short run, spend almost no effort in trying to adjust
our habits to consume less. Similarly changes in price do little to spur new supplies in the short
run. Exploring for, drilling, and bringing new sources on-line can take many years. Since the
quantities demanded and supplied change very little as prices rise and fall, both curves are
relatively vertical as shown below:

Because quantities are relatively fixed in the short run, any shifts in demand or supply
will cause large changes in prices. For example, suppose that supply falls. The decreased supply

56
creates a temporary shortage that will begin to drive up price. If demand is elastic, only a small
increase in price will be needed to get consumers to cut purchases enough to meet the new
reduced output. However, if demand is inelastic, it will take a much larger price increase to
generate the needed cut in quantity demanded. You want more graphs, don't you?

The graph on the left below illustrates the elastic demand case. The demand curve is
relatively flat and the drop in supply (from S to S') causes only a small increase in price (from P0
to P1). However, if the demand curve is less elastic or more vertical (as in the graph on the
right), the same cut in supply causes a much larger increase in price.

Do you have the concept? When curves are elastic, shifts in demand and supply cause
only small changes in price, but when curves are inelastic, those same shifts cause much larger
price changes.

Apply this to oil markets. For many years members of the Organization of Petroleum
Exporting Countries (OPEC) controlled most of the world's oil market.4 In the early 1970's,
partly reacting to political turmoil in the Mideast, OPEC oil ministers voted to deliberately cut
production. As illustrated above, this shifted the supply curve for oil to the left and drove up
prices. Because demand was inelastic, the price increase was significant. The higher prices
OPEC countries received more than offset the lower sales and their oil revenues rose rapidly. In
1979 a bitter war between long-time enemies Iran and Iraq shut down more oil fields and caused
additional price increases.

Wait?
Much weeping and gnashing of teeth in non-OPEC countries ensued and, in the wake of
the media hysteria that followed, economists were thrust into the national limelight. How could
this energy disaster be fixed? What should be done? Never very good at giving answers that
people or politicians want to hear, most economists replied: "Don't do anything; just wait."

The answer was both unpopular and correct. Demand and supply are far more elastic in
the long run than in the short run. After oil prices rose, firms began shifting to less energy-
intensive ways of manufacturing goods and services. Similarly, consumers started to conserve as

57
well. They insulated homes heated by oil furnaces and shifted to alternative energy
sources. More importantly, they began buying different types of cars. They gradually ditched
the gas guzzlers they purchased in 1971 when fuel prices were not an issue and bought smaller,
more fuel efficient vehicles. As we shifted from cars getting 12 miles per gallon to ones getting
28 miles per gallon, the demand for gasoline (and its price) began to fall.

Supplies adjusted as well. The increased prices of the 1970's unleashed a frenzy of
successful new exploration and drilling. New oil fields came on line all over the world in places
such as Mexico, Russia and the North Sea. Fields that were not profitable to develop when oil
was $4 per barrel proved to be veritable bonanzas at $35 per barrel. The combination of
conservation and new supplies gradually drove prices down until, in inflation-adjusted terms,
they returned to 1972 levels.5

Regrettably it did not last. Prices began to inch up again after the
turn of the century and recently have climbed well above historic
levels. Why? What happened? Was it still demand and supply?

It was. First, demands rose rapidly during the first decade

of the 21st century. Consumers, lulled by low prices, abandoned
their fuel-efficient Hondas and Toyotas for behemoth trucks, vans,
and SUVs. Perhaps more importantly, strong economic growth in countries such as China and
India created more factories and more cars that need more oil to run them. Supplies also have
suffered. During the U.S. invasion many Iraqi oil fields were destroyed and production there
remains well below pre-war levels. Production in other countries also has been disrupted, most
recently when militant attacks in early 2008 closed major oil fields in Nigeria. Rising tensions in
the Mideast added to the problems. Fearing that current pressures might rekindle armed conflict
between Iran and Iraq and cause further cuts in supply, many oil brokers increased purchases in
an attempt to lock in supplies at current prices. Not surprisingly, this speculative buying
increased demand and drove up prices still more.

Do you see it? Increased demand from U.S. motorists, from other countries, and from
speculators worried about even higher prices in the future, coupled with supply cuts in Iraq and
Nigeria caused oil prices to increase. However, by late 2008 problems in U.S. mortgage lending
set off a crisis in global financial markets that led to a global economic slowdown. The
slowdown, in turn, caused a drop in demand for oil and began pushing the price of oil back
down. [Can you picture how a shift in the demand curve can do this?] Once prices began to fall,
speculators who had purchased large volumes of oil expecting to be able to resell at a higher
future prices, began to lose money rapidly. To cut their losses they dumped their supplies on the
market hoping to unload them quickly before prices fell further. Of course, this increased market
supply and drove down prices even more rapidly. Oil prices that peaked above $140 per barrel
in July 2008 had fallen to a mere $40 by December. Waiting worked.

Of course it did not last. Unrest in the Middle East, accentuated by popular uprisings in
Tunisia, Egypt, Libya, Yemen, Bahrain and Syria refueled speculative fears that lengthy civil
wars across the region would destroy oil fields and shut down pipelines. As firms rushed to lock

58
in supplies, demand surged and prices soared back above $100 per barrel. By May 2011
domestic gasoline prices once again approached $4.00 per gallon. Then in 2014 prices
plummeted once again. Economic slowdowns in China and Europe caused part of the drop, but
increased supplies, largely the result of new technologies being used in the U.S. and Canada,
were the primary drivers.6 The price cuts have been a windfall to consumers across the world,
but are wreaking havoc in countries such as Russia and Iran that rely on oil exports to prop up
their domestic economies.

What now? Will the current low prices continue? Probably not. Given the political
instability in many major oil-exporting nations, coupled with inelastic demands and supplies in
the short run, the roller coaster price rides of recent decades are likely to continue.

Lower prices?
Some argue that the government should step in and mandate permanently lower
prices. Such schemes pander to populist preconceptions, but make little economic sense. Are
you ready for one last graph? Suppose the government decides to lower gasoline prices by
decree and forbids firms from charging any price higher than P1 in the graph below. In economic
jargon, P1 becomes a ceiling price. Consumers immediately react to the lower price by
increasing their quantity demanded from Q0 to Q2. However firms react in the opposite
way. Stuck with a lower price they reduce their quantity supplied from Q0 to Q1 and a shortage
results. The quantity demanded (Q2) now exceeds the quantity supplied (Q1).

Some consumers do get gasoline for a lower price, but others get no gasoline at all. Since
output has been cut from Q0 to Q1 there is less gasoline to go around. It simply is not profitable
to produce as much at the lower price. Who gets the gasoline and who does not? In a free
market consumers would compete for the scarce gasoline by offering higher prices; those willing
to pay the most would get the gasoline. However, with a price ceiling in effect, paying higher
prices is illegal. Firms and consumers must find a different way to decide who gets the gas and
who does not.

The traditional alternative is first-come-first-served. Those who get to the station first get
the limited supplies; those at the end of the line do not. The gas is gone by the time they get to
the pump. But think about this. If the product goes to those in line first, what will you
do? That's right. You'll try to be first in line. Unfortunately, everyone else will be doing the

59
same thing. The result will be long lines (and short tempers) at the pump. Those who "win" and
get to the pumps first will get their gas at a lower price, but they must pay a higher price in terms
of time and energy spent waiting in line. Those at the end of the line lose twice. They lose by
having to wait in line and lose again by seeing the gas run out before they get to the pump.

Could this actually happen? Readers who remember the 1970's know that it could and
that it did. To "protect" consumers, we did slap price ceilings on oil and gas products, only to be
slapped back with the long lines and shortages described above. It was ugly.

If prices do soar up again, most economists will offer the same advice they gave in the
past: wait. High prices are painful, but they serve a very real economic purpose; they discourage
consumers from using a scarce resource and encourage suppliers to produce more. In the long
run higher prices will cause consumers to shift back to more fuel-efficient cars and adopt other
measures of conservation. In the long run higher prices will cause firms to increase exploration
and drilling to bring more supplies to the market. And, more importantly, in the long run higher
oil prices will create incentives to develop cleaner and more renewable energy sources. OPEC oil
ministers understand this quite well. Saudi officials often have pushed for moderation in oil
prices precisely because they fear prices that rise too much too quickly will drive consuming
nations to get serious about conservation and alternative energy programs. They understand that
this could destroy the long-run market for oil and, in turn, damage their future economic growth.

Despite their bad rap, rocketing gasoline prices actually can have very beneficial side
effects. Evidence suggests that the low gas prices of the past caused an increase in driving
which, in turn, led to more pollution, more traffic-related deaths and more obesity.7 As the pinch
of higher pump prices causes us to cut back our highway mileage, the likely result could be a
cleaner, safer and leaner America. Calls for patience may not win elections, but may be sensible
policy nonetheless.

____________________

Notes:

1. Sam Snead was the Tiger Woods of his day and still holds the record for most lifetime
wins on the PGA tour.
2. Termed the most famous match race in history, Seabiscuit pulled away from heavily
favored War Admiral in the stretch. You can view a video of the race on the web.
Seabiscuit's life also inspired an acclaimed 2003 movie starring Jeff Bridges and Toby
Maguire.
3. A later chapter will discuss how such calculations can be made. As an example, suppose
that average prices doubled from 1985 to 2008 (which is approximately true). If the
1985 price was $14, it would be twice as high (or $28) when restated in terms of 2008
prices.
4. The members of OPEC in 1973 were Algeria, Ecuador, Indonesia, Iraq, Iran, Kuwait,
Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela.
5. Readers familiar with cartels and game theory will recognize that this and subsequent
explanations, though largely true, are simplified.

60
6. "Fracking" technologies in the U.S. have enabled drillers to extract huge volumes oil and
natural gas from previously uneconomic sources and led to energy booms across the
Dakotas and the through much of Appalachia. Similarly, new technologies have allowed
Canadians to extract oil from tar sands and shale formations.
7. Carey, John, "Should Oil be Cheap?", Business Week, August 4, 2008, p. 56.

________________________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Explain and illustrate why shifts in demand and supply cause larger price changes when
the curves are relatively inelastic than when they are relatively elastic.
2. Explain why oil prices rose in the 1970's but then fell through most of the 1980's and
1990's.
3. Explain what demand and supply shifts might have caused oil prices to change in recent
years.
4. Use demand and supply curves to illustrate the effect of a price ceiling. Explain in words
what happens and why economists tend to oppose such ceilings.
5. Explain the beneficial effects high oil prices might create.

61
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Section I-C: Efficiency and Competition

The highest and best form of efficiency is the spontaneous cooperation of a free people.
... Woodrow Wilson

Every economist learns to parrot "supply and demand," but does it work? Does it drive
firms to produce efficient combinations of outputs in efficient ways, or does it toss concern for
the common good under the relentless wheels of individual greed? What if one person's freedom
of choice impairs that of another? Should government arbitrate the conflict? When is collective
government action needed? Should we trust it? What about fairness?

Let's see.

I-C. Efficiency and competition

1. Marginal Cost and Supply
2. Market Efficiency
3. External Effects
4. Public Goods
5. Rational Ignorance
6. What's Fair is Fair
7. Role of the Government

62
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Marginal Cost and Supply

As long as people will accept crap, it will be financially profitable to dispense it.
...former TV talk show host Dick Cavett

Economists often ask about the additional or

marginal effects of an action. For example, if
producing one more item raises a firm’s total costs
from $120 to $125, the marginal cost is $5. Marginal
cost (MC) is the change in total cost from producing
one more unit. Similarly, marginal benefit (MB) is the
change in total benefit or value we get from consuming
one more unit of an item.

Remember that costs to an economist are opportunity costs -- the value of what we must
sacrifice. Let's illustrate the concept of marginal costs in more detail. Assume that you have five
possible activities, each of which will take exactly one hour, that have the following values:

Activity Value

A $1
B $3
C $5
D $7
E $9

Given these numbers, what is the cost of sleeping late? Sleeping late will force you
sacrifice additional activities. For each additional hour of sleep you must sacrifice one more
activity. You would sacrifice the least valuable activities first. That is, if you were to sleep one
additional hour you would choose to sacrifice activity A because A is less valuable than the
others. Since Activity A is worth $1, the MC of sleeping that first extra hour is $1 -- the value
lost by sacrificing activity A for the sleep.

63
 Do you see how to do this? What is MC of sleeping a second extra hour? To sleep a
second hour you must sacrifice a second activity. Which will you sacrifice next? Activity B; it
is the next least valuable activity. The MC of the second extra hour of sleep is $3 -- the value
lost by sacrificing activity B. Similarly, the MC of sleeping a third extra hour is $5, a fourth
extra hour is $7 and a fifth extra hour is $9. Be careful not to confuse marginal cost with total
cost. The marginal cost of the second hour is $3, but the total cost of sleeping two additional
hours is $4 ($1 for the first hour plus $3 for the second hour). Similarly, the total cost of
sleeping five extra hours is 1 + 3 + 5 + 7 + 9 = $25.

Note that MC is rising as the quantity of sleeping rises. This is typical. You must
sacrifice increasingly more valuable options as the quantity of sleep rises. The same concept
holds for producing other types of products. For example, some oil deposits are relatively
inexpensive to tap. These deposits are large, close to the surface, in easily accessible
areas. Other deposits are more expensive to tap. They are smaller, require drilling deeper into
the earth, and are located in less accessible areas. If we want only a small quantity of oil we
could tap the cheaper deposits first. But to produce more oil, we must start tapping the more
expensive sources. The MC of oil will rise as output rises. Got it?

Add another piece. How many extra hours should you sleep? Rational students will
sleep only if the expected benefit is at least as great as the expected cost. If the expected benefit
of extra sleep is $0.50 per hour, will you sleep in? Hopefully not. The MC of sleeping the first
extra hour in our example was $1; that’s more than the $0.50 benefit. What should you do if the
expected benefit of extra sleep is $7? A rational student would sleep an extra four hours. The $7
expected benefit per hour covers the MC of hours one through four. However do not sleep the
fifth extra hour. The fifth extra hour involves a MC of $9, greater than the expected $7 benefit.

Oil producers react the same way. If the price of oil is $30 per barrel, they will want
to keep producing as long as the $30 they get for each barrel covers the MC of the oil. They will
produce as long as the price or benefit they get from selling the oil covers the MC.

Look at this with the graph below:

If firms can sell their goods at a price of P0 they will find it profitable to keep producing
as long as the price covers the MC. Q0 will be their most profitable output. Or, if you can get a
benefit of P0 for each extra hour of sleep, Q0 is the optimal number of extra hours you should

64
sleep. Of course, we could draw a similar line for any price. If the price rises, so will the optimal
quantity to be produced. Can you draw an example?

Wait. Does this seem familiar? We are taking a price and drawing a line over to the MC
to see what will be produced. That’s exactly what we did for supply curves. In fact, MC
determines how many units a firm will supply. The MC curve is the supply curve! All those
supply curves we drew earlier were nothing more than MC curves in disguise. Wow. You might
want to take a few deep breaths to calm down before proceeding further.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the concept of marginal cost.

2. Explain why marginal costs tend to rise as output rises.
3. Explain why marginal cost curves are supply curves.

65
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Market Efficiency
Efficiency of a practically flawless nature may be reached naturally in the struggle for
bread.
..... author Joseph Conrad

Free markets allocate most resources in the U.S. economy, but do they do it
efficiently? The answer often is: “yes.”

Allocative and technical efficiency

To get the most valuable combination of goods and services -- what he have called
allocative efficiency -- goods and services should be produced only if their marginal benefit
(MB) is greater than or equal to their marginal cost (MC). This occurs automatically in many
competitive markets. We already know that competitive markets produce where the demand
curve intersects the supply curve. This also is the point at which MB = MC.

Check out the table below. Four units should be produced for allocative efficiency.
Units one through three all add more benefit than they cost -- their MB exceeds their MC -- so all
increase net value. Unit #1 creates $24 more benefit than cost; unit #2 creates another $16 of
extra benefit, and unit #3 another $8. The fourth unit adds $25 of both benefit and cost. It does
not add any net value. It does not make us better off but, since its MB does cover its MC,
economists advocate producing it as well. However, units five and six each cost more at the
margin than they are worth. They make us worse off; neither should be produced.

Unit # MB MC surplus value of unit (= MB-MC)

1 $40 $16 $24
2 35 19 16
3 30 22 8
4 25 25 0
5 20 28 -8
6 15 31 -16

Remember that a demand curve shows the prices we are willing to pay. And the price we
are willing to pay reflects the dollar value or MB we expect to get from that good. For example,
if a consumer expects to get $35 of MB from the 2nd unit of a good, then he/she will be willing

66
to pay anything up to $35 to get it. Or, if consumer is willing to pay $30 to buy the 3rd unit of a
good, then he/she must expect to get $30 of MB from it. Since the demand curve shows prices
we are willing to pay, and these prices reflect our MB's, then the demand curve is a MB curve.

We also know that the competitive supply curve reflects MC's. Since competitive firms
assume they can sell all they want at the going price, they are willing to supply additional units
as long as that price covers their marginal costs.

Since demand represents MB and supply represents MC, the competitive equilibrium
where the quantity demanded equals the quantity supplied is also the point at which MB =
MC. In the graph below, allocative efficiency occurs at output Q0. At this point we are
producing all units for which MB covers MC. This also is the equilibrium output toward which
any perfectly competitive industry will eventually move.

No other output is allocatively efficient. If we produce less (output Q1 in the graph

below), we forego potential gains. All units from Q1 to Q0 bring a MB that exceeds their MC;
these units generate surplus value. If we fail to produce these units, we lose the surplus value
they would have created. For example, using the table above, failure to produce the third unit
means that we would lose the eight units of surplus value it would have created. If we produce
more (output Q2 in the graph below), the opposite problem occurs. Since the units past Q0 cost
more than they are worth to consumers at the margin, they generate a net loss to society. Or,
again using the table above, producing the 5th unit would cost us $8 more than the unit is worth.

Remember that there are two types of efficiency. Allocative efficiency means producing
the most valuable combination of goods and services and that occurs if we always produce at

67
point where MB = MC. But we also want technical efficiency; we want
those units produced in the least-cost way. Firms should not use any
more scarce resources than is absolutely necessary.

A perfect result!

Since competitive markets produce where demand (or MB) hits

supply (or MC), we know they are allocatively efficient. They also are
technically efficient. Competitive pressure forces firms to adopt least-
cost technologies. If higher-cost methods are used, new firms using the
better methods could enter and drive high-cost producers out of the
market. Only least-cost producers will survive in the long run. This
result that firms in competitive markets produce the most valuable combination of goods and
services in the most efficient way is remarkable.

Think about it. In a free, unregulated market, firms have license to earn as much profit as
they can. They are free to pursue self-interest and produce what and however they
want. Potential consumer greed is unleashed as well. Consumers can freely pursue self-interest
and buy whatever they want. Yet, this unabashed pursuit of self-interest by both buyers and
sellers combine to produce a result that maximizes the value society gets from its scarce
resources. We end up with the best combination of goods and services produced in the best
way. Competitive markets turn the unfettered pursuit of self-interest or greed into a socially
efficient outcome. Absolutely remarkable.

But not always

If only it worked all of the time. Alas, it does not. Markets often are less competitive
than we might like. And firms that face limited competition can exploit their market power. In
competitive markets, firms that fail to produce efficiently what consumers want do not
survive. If one grocer refuses us the best possible deal, we can cross the street to
another. However, none of us wants to be the wayward tourist whose car self-destructs 1,000
miles from home in an isolated town with a single auto repair shop. Falling prey to potentially
predatory monopoly power is not the road to efficiency.

Even when markets are competitive, a second demon might

impede efficient results: external effects. What if my actions impact
others? What is efficient for me might not be for them. For example, in
a truly free world I might be allowed to play music as loud as I like --
even at 3 a.m. when the residents of adjacent apartments are trying to
sleep. In a truly free world I might be allowed to dispose of my trash
however I like -- even if it means throwing it on my neighbor's
lawn. Allowing citizens to pursue self-interest in these cases will not
necessarily advance the public interest. One person's freedom can
impinge on another's.
_______________________________

68
 Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain why marginal benefit curves are demand curves.

2. Use a table of MB and MC values to find the allocatively efficient output and explain.
3. Draw a graph to explain and illustrate why allocative efficiency occurs where the MB (or
demand) and MC (or supply) curves intersect.
4. Explain why outputs higher than or lower than the equilibrium create lost welfare for
society.
5. Explain how and why competitive markets often create technical efficiency.

69
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

External Effects

We have always known that heedless self-interest was bad morals; we know now that it is
bad economics.
..... Franklin D. Roosevelt

Competitive markets fail to produce efficient results when external or spillover effects
occur. The intuition is simple. Suppose Alice considers only her own personal best interest in
choosing what to produce and buy. She rationally will choose to produce or buy only as long as
the MB she gets covers her MC. From her private perspective, this is an efficient result.

However, suppose that Alice is not the only one affected by her decisions. Suppose some
of the benefits or costs of her choices spillover to other, external parties. If so, what is best from
Alice’s private perspective is not necessarily best from the group’s perspective.

External costs

For example, suppose Alice will receive a $10 benefit from producing some product or
action and estimates her MC at $7. From her perspective, production makes sense; it will create
$3 of new surplus value for her. But suppose her production will cause $5 of damage to
others. The MC to Alice may only be $7, but the MC to overall society is now $12 [$7 to Alice
and $5 to others]. Since the MC to society [$12] exceeds the MB Alice will receive [$10],
production is inefficient. The $3 private surplus Alice can create will be more than offset by the
$5 cost imposed upon others. Even though Alice has a private incentive to produce, society will
be worse off if she does.

Can we trust Alice to sacrifice her $3 private surplus to avoid damaging

others? Perhaps. There certainly are many examples of individual who sacrifice personal gain
for the good of the group. But we should not hold our breath. Self-sacrificial behavior does
occur, but it rarely is the norm. More often than not the Alice’s of this world act to maximize net
personal benefit rather than net social benefit. If so, Alice will overproduce the product or
action in question.

Can you think of real world examples? How about pollution or

litter? When we dump refuse into a river or throw litter out of the car
window we are trying to minimize inconvenience to ourselves at the
expense of others. When we turn up the volume on our music to the

70
chagrin of those around us, we are creating external costs. When we rob, rape and pillage, we
create external costs for others. In each of these cases, allowing individuals the “freedom” to act
as they wish damages others.

Do you see the point? Allowing individuals the freedom to allocate resources in any way
they want works quite well if those individuals are the only ones affected. Individual freedom is
efficient. But when the choices of one individual negatively impact others, private self-interest
can conflict with social interest and individual freedom of choice no longer is a good
thing. Hmmm. Maybe that’s why society has laws. After all, laws do restrict our personal
freedoms. They take away our freedoms to pollute, to play our music too loudly, and to rob, rape
and pillage. If written correctly such laws can increase social efficiency.

No doubt you are eager to see a graphical representation of this concept. Let’s try
it. When external costs are present, the MC to society exceeds the MC to the private decision-
makers. For example, if the per-unit production of a good or action creates a $25 external cost,
then the MC to society is $25 higher than the MC to the individual producers.

Remember that the supply curve for competitive firms is nothing more than the MC curve
faced by the producers. As before, the competitive market equilibrium occurs at the point where
supply [MC to producers] intersects demand [MB]. Output Q0 in the graph below is the
equilibrium. But for allocative efficiency we should produce only as long as MB covers the MC
to society. In the graph below, allocative efficiency occurs at output Q1. The competitive
equilibrium is not efficient; it creates an inefficiently large output of the good or action.

When actions create external costs, allowing free individual choice is not efficient. Government
programs designed to decrease output from Q0 to Q1 make good economic sense.

71
Property rights

External cost and pollution issues are most likely to arise when property rights are not
clearly defined. For example, no one “owns” the air or the oceans. As a result, no one has the
incentive to care for them efficiently. If I owned the air, I would be more reluctant to
pollute. After all, the pollution would damage my air and lower its value. Air pollution would
no longer create an external cost; it would create an internal cost to me. Similarly, vandalism
occurs in college residence halls around the country. This vandalism typically occurs in
“common” areas such as bathrooms, hallways, elevators, and study lounges. We simply do not
care for commonly owned resources as effectively as we care for our own private property. This
tendency to misuse such resources often is termed the tragedy of the commons.

External benefits

Some spillovers create benefits rather than costs for others. If

Alice plants flowers she will have a more beautiful view to admire,
and so will her neighbors. If she installs a streetlight by the road she
will be able to better navigate the neighborhood at night, and so will
her neighbors.

Will she plant efficient quantities of flowers and install

efficient quantities of streetlights? Not necessarily. If Alice acts only
out of self-interest and ignores the benefits that spill over to her
neighbors, she will perceive flowers and streetlights to be less valuable than they really are and
be less willing to create them.

For example, suppose the flowers create a MB of $10 to Alice and $5 to her
neighbors. Suppose also that there is a $12 MC to Alice in planting and caring for the
flowers. Will she plant? The $15 MB to society [$10 to Alice plus $5 to her neighbors] more
than covers her $12 MC. Planting is allocatively efficient for society. But planting is not
allocatively efficient to Alice. Her $12 MC exceeds her $10 MB. Planting may create $5 of net
benefit to her neighbors, but it creates a $2 net loss to Alice. Will she sacrifice for the good of
the neighborhood? Probably not.

In this case of external benefits Alice has a tendency to underproduce the good or action
in question. Inefficiently small quantities are likely to be produced. Check out the next graph.

72
 When external benefits are present, the MB to society exceeds the MB to individual
buyers. Q0 is the free-market equilibrium output, but is not allocatively efficient. Because the
units from Q0 to Q1 all generate MB to society in excess of MC, Q1 is the allocatively efficient
output. Because the units from Q0 to Q1 are not produced, society loses the surplus value they
would have created.
_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the concept of external costs, give examples, and explain why markets will tend
to produce more than the efficient amounts of goods that create such effects. Illustrate
this inefficiency with numerical examples and with an appropriate graph.
2. Describe and explain the tragedy of the commons; apply it and the concept of undefined
property rights to the problem of pollution.
3. Explain the concept of external benefits, give an example, and explain why markets will
tend to produce less than the efficient amounts of goods that have such effects. Illustrate
this inefficiency with numerical examples and with an appropriate graph.

73
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Public Goods
All for one, one for all.
...Alexander Dumas

Fireworks rock. My wife loves the colors, I love the noise. I even
proposed on July 4th; just before the pyrotechnics began.

Regrettably, we've seen relatively few professional displays. We

lived for years in a somewhat rural area with no fireworks
extravaganzas. An area mall ran a show briefly, but the effort was pitiful
and consisted only of about 20 rockets set off at thirty-second intervals. It folded after a few
years. A local service club then took up the challenge, rented out the county fairgrounds and put
on a decent display for a $5 entrance fee. We went one year and enjoyed the show, but got stuck
in a traffic jam trying to exit the parking lot through a single exit onto a single narrow road. The
next year we watched the show from a neighboring field; we saw the display just as well but
avoided both the $5 fee and the subsequent traffic. Others caught on. Within three years, the
neighboring fields were filled with spectators and the fairground stands were almost empty. The
sponsoring club went belly up financially and the fireworks ended. Oops.

I should have known. Fireworks displays never will be produced efficiently by private
markets. They are public goods; they require collective action for efficient production.

Public good characteristics

Public goods have two main characteristics. The first is non-exclusion. Once the good is
produced, it is accessible to all comers, whether or not they pay. Non-buyers cannot be excluded
from reaping benefits from the good. Once the local service club set off the fireworks, it could
not prevent spectators in nearby fields from watching. We could see and hear even though we
did not pay the $5 fee. In the jargon of economists, we were free riders, people who were
enjoying products paid for by others. We consumed external benefits provided by paying
customers.

The motive to free ride is strong. Imagine walking through your

neighborhood grocery, filling your cart with hot dogs and other essential items,
heading to the checkout line, and then having the clerk declare that you have the
option either of paying for the groceries or taking them for free. Which option
would you choose? Me, too. But if all of us choose to free ride, to walk out
without paying, how will the grocery remain in business? Similarly, if all of us

74
free ride on fireworks displays, how will the local providers recoup expenses? Do you see the
problem? When producers cannot exclude non-buyers, we free ride. When we free ride,
suppliers cannot recover costs and will not produce.

The second characteristic of public goods is non-rivalrous consumption. In most cases,

one person's consumption competes with others'. If I eat an ice cream cone, the cone no longer is
available for you. We both cannot consume the same cone; we are rivals for its
consumption. However, suppose I sit in a field and watch fireworks. Does that stop you from
doing the same? Of course not. My consumption of the fireworks does not interfere with
yours. We can enjoy them simultaneously; our consumption is non-rivalrous. Can you think of
other examples? How about using a traffic light at a busy intersection? Or reading an exit sign
along an interstate highway? Or listening to your favorite music on the radio? Many consumers
can simultaneously use the same traffic light, read the same exit sign, and listen to the same
tunes.

Think about that. If consumption is non-rivalrous, the marginal cost of allowing one
more consumer to use the product often is zero. Allowing one person to use the traffic light or
exit sign or radio station adds nothing to the total cost of these operations. That means even if
we could exclude non-buyers, it would be inefficient to do so. For example, suppose we
electronically monitor each person who tunes into a radio station and send them a bill of $2 per
hour for their listening enjoyment. If Jamal's marginal benefit is $1.20 per hour he would not
listen. Why spend $2 for listening worth only $1.20? Yet, from society's view, there is no
reason to exclude Jamal. His MB of $1.20 exceeds the MC to society of zero. Excluding him
saves society nothing, but costs $1.20 in lost benefits to Jamal.

Collective action

Collective action offers an escape. Suppose that a fireworks display costing $20,000 will
create $3 of benefit for each of 10,000 community residents. Collectively the $30,000 of
community benefits exceeds the $20,000 cost, but no individual gets enough benefit to justify
paying the $20,000 cost unilaterally. And because of free-rider problems, no one can effectively
charge others for the show. Even though the display is socially efficient, no one has an incentive
to produce the display.

Luckily, goods that make collective sense can be produced through collective action. If
the 10,000 residents get together, form a "government" and then vote to impose a $2 per person
tax they could raise the $20,000 for the display. Each resident would win; each gains $1 of
surplus value from the deal (the $3 of MB minus the $2 tax). The mandatory tax forces each
resident to pay his/her fair share of the expense; the tax stops us from being able to free ride. The
government acts as our collective representative in providing goods that are in our collective best
interest.

Think for a moment about what real-world governments buy. First, they do finance
fireworks displays. Major cities routinely devote public funds to Fourth of July events. More
importantly they buy police protection, fire protection, national defense, street lights and
highway systems. All of these have at least some public good characteristics. For example,

75
when a police officer arrests a drunken driver, everyone on the highway benefits whether they
help pay for the police or not. Non-buyers cannot be excluded. Similarly, once national defense
is supplied, there is no way to exclude any person or group from its protection -- its benefits
accrue to all and cannot be sold to individuals. Toll roads theoretically could keep free riders off
our highways but, given current technology, turning all roads into pay-as-you-go highways is
impractical. As a result, we rely on government agencies to provide such goods. We impose
taxes on ourselves to raise the needed funds (and to avoid free-riding) and purchase the goods
collectively.
______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Describe and discuss the characteristics of public goods and give examples.
2. Explain "free riders" and why they occur with public, but not private, goods.
3. Explain why public goods cannot be produced without collective or government action.
4. Explain why charging people to use products with non-rivalrous consumption is not
efficient.

76
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Rational Ignorance

.....where ignorance is bliss, 'tis folly to be wise.

.....Thomas Gray

German was my worst college subject. I lacked

both aptitude and interest in memorizing vocabulary and
grammatical rules. One particular semester I earned "A"
grades in every class, except for a "C" in German. Could I
have done better? Of course. I chose to limit my efforts in
German. Was it a mistake? Was it an irrational step in a
misspent youth? No. I have no regrets. I would make the
same choice again.

Brainpower is a scarce commodity. As with Ben

and Jerry's ice cream and Utz's potato chips, I never
will have enough. I could have learned more German, but such knowledge is not cheap. It takes
time and energy -- time and energy that could be spent in other pursuits. And it clogs neural
pathways -- pathways that could deliver alternative pleasures and information. Rational
economic agents pursue knowledge only if they expect the benefits to exceed the costs. I chose
ignorance.

I am not alone. We all choose ignorance. I choose ignorance about German syntax. I
also choose ignorance about quantum mechanics (a choice that dismays my astronomer son),
about architectural features of Turkish mosques, and about WrestleMania. I recognize the
potential benefits of knowledge in such areas but, to me at least, those benefits pale in relation to
the associated costs. My ignorance is rational.

Classroom strategies

As a college instructor, the shoe is on the other foot. Just as I choose to be ignorant about
German, my students often choose to be ignorant about economics. And I must grudgingly
admit that part of this chosen ignorance could be rational. Even my most brilliant lectures, my
most clever insights and most exquisite chalkboard graphs elicit little more than ho hum
reactions in some students. Impassioned exhortation might successfully raise their effort levels

77
in a few cases, but is not a reliable strategy. The way to alter behavior is to alter its perceived
costs and benefits.

Devising ways to make learning easier is one approach. Better teaching methods can
lower the cost of learning and, therefore, increase the quantity demanded. However, the method
is far from foolproof. Better teaching enables students to learn the same material with less time
and effort. Knowing they can now get their desired course grade with less effort, students might
rationally choose to spend less time studying economics. Rational students, whose primary
interests lie elsewhere, might simply divert their energies to other pursuits -- perhaps German. If
so, their knowledge of German will rise, but they will remain rationally ignorant about
economics.

The alternative approach is to raise the cost of ignorance. This is the major purpose of
giving exams. Students who choose ignorance are penalized. Exams do not always deliver the
goods, but they do have an effect. Comments such as "this will be on your next exam" can shake
even the most dissolute student out of a sullen stupor.

The uninformed electorate

Similar problems arise in elections. Voter turnouts typically

are slim. In presidential elections, barely 50 percent of eligible voters
cast their ballots.2 Less critical contests like those for student
government officials on college campuses can engender even less
enthusiasm than my chalkboard graphs in introductory economics.

Perhaps worse, those who vote often are ill informed. Even
the most diligent voters encounter unfamiliar names on the
ballot. How many of us truly understand political issues? What stand
have our Congressional candidates taken on acid-rain legislation? What bills are pending in the
state legislature and what amendments might potential state representatives support? Will
county commissioner hopefuls raise or lower the budget for softball field maintenance? And
what is a prothonotary anyway?

Even economists cannot answer these questions! Should we be surprised that most of the
electorate is uninformed or even misinformed? Should we be surprised at voter apathy? No. It
is rational ignorance. We pursue information only if the benefits we expect exceed our
costs. And the benefits of such information are negligible. New information may not affect my
choice of candidates, and even if it does, so what? My vote is irrelevant. The last election in
which my vote was decisive occurred when Jeff Bailey captured the hall monitor position in my
fifth grade classroom. The chance of my vote affecting the outcome of a national, or even local,
election is essentially zero.

Why become informed? Why spend the time and resources needed to be politically
involved if the benefits I will receive in turn are negligible? As long as the marginal cost of
producing the information exceeds my personal benefits, political ignorance is rational.

78
 However, self-interest may conflict with social interest. Even if I do not spend the time
to be well informed, I still want others to do so. If everyone else becomes well informed, the
"right" people will be elected, and the "right" policies will be enacted whether or not I
participate. This is a classic example of what economists term external effects. As other voters
become more informed, we all are made better off. Their information benefits them (private
benefits), but it spills over and benefits us as well (external benefits).

Individually, I have an incentive to let others do the work, to take a "free ride" on their
efforts. However, if we all wait to free ride on the efforts of others, political information and
activism will be in critically short supply.

Special interests

Of course, not everyone will be apathetic. Those with a strong personal stake in an
election or issue will participate. Pending legislation to subsidize chicken ranchers in the East
may not attract much attention from vegetarians in Oregon, but it certainly will get the attention
of chicken ranchers in the East. When people's "special interests" are on the line, the benefits of
political involvement can exceed the costs and otherwise apathetic voters can be transformed
into political activists writing letters, gathering petitions and promising campaign contributions
to officials voting in their favor.

Imagine that you are a legislator considering a bill that would create $100 million of
benefits. If these benefits are widely dispersed -- perhaps $1 to each of 100 million people -- few,
if any, voters will take notice. With only $1 at stake, the benefits will be too small to warrant
active participation. Very few of your constituents will know about the bill, and even fewer will
care. But suppose those $100 million of benefits are more concentrated. Suppose the bill will
create $1 million in benefits for each of 100 people. You should expect to see each of these100
beneficiaries forcefully lobbying to get the bill passed.

If only those with special interests become involved, they will dominate the political
process. Unfortunately, the "special interests" of such people may conflict with the "public
interest." If so, the "wrong" candidates may be elected and the "wrong" policies enacted. For
example, suppose the bill creating $100 million of benefits also will cost $101 million. The bill
should be voted down. However, if the benefits are concentrated in the hands of just 100 people,
you will have 100 people banging on your door urging you to vote "yes". And, if the $101
million of costs are evenly dispersed across 100 million people, none will have enough at stake
to lobby against the bill's passage. A "yes" vote will bring you the loyalty, support and campaign
contributions (!) of 100 happy people. True, you will impose costs on 100 million others. But
they will not know and, even if they do find out, they will not care -- the impact on each is too
small. Although the costs of the bill exceed its benefits, such bills often pass.

Ideally legislators will push us toward allocative efficiency by passing the most valuable
set of laws and regulations possible. But legislators cannot know which potential laws and
regulations we believe to be the most valuable unless we tell them. If we fall prey to rational
ignorance and remain silent, we should not be surprised if legislators fail to do our bidding. If

79
those with special interests are the only ones talking, they will be the only ones that legislators
hear. Rational ignorance might be in our best self-interest, but it often is not in our best social-
interest.

What is the solution? How do we induce consumers to "purchase" information and

political involvement that is not in their self-interest? Economists normally advocate
government intervention to correct such problems. Programs that increase the private benefits or
decrease the costs of political involvement might work. But in this case, the government has
little incentive to fix things. Why should special-interest groups want to change a political
process they dominate? Why should they support reforms that will increase the involvement of
others, thereby cutting their own influence? Those with the power to fix the market failure are
precisely the ones who benefit from it.

No, I don't have the answer; I just have the question. I'm counting on you for the answer.

____________________________________

Notes:

1. See McKenzie, Richard B. and Tullock, Gordon, The Best of the New World of
Economics, fifth edition, Irwin, Homewood, Illinois, 1989, chapter 21, for an extended
discussion of these tradeoffs.
2. The 1960 contest pitting Richard M. Nixon against John F. Kennedy attracted one of the
highest percentage turnouts in history with votes from 63 percent of eligible
citizens. Turnout for the 2016 election was 58 percent. Off-year elections generate
smaller turnouts, typically around 35 to 40 percent of potential voters.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the concept of rational ignorance and why it occurs.

2. Explain why special-interest groups dominate the political process.
3. Use the concept of rational ignorance to explain why government policies are not always
the best or most efficient ones possible.

80
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

What's Fair is Fair

Life isn't fair. It's just fairer than death, that's all.
…..William Goldman

Economists play games. No, not games like baseball, Final Fantasy or Uncle Wiggily;1
we play experimental games designed to analyze human behavior.

In the well-known Ultimatum Game, an administrator gives a player temporary control of

$1,000. The player is told to offer a second player some part of the money in a take-it-or-leave-it
ultimatum. If the second player accepts the proposed split, the $1,000 is divided as per the
agreement and both players walk off with a portion of the loot. However, if the second player
rejects the ultimatum, the game ends. The administrator pulls the entire $1,000 off the table, and
neither player gets a dime.

If you are the first player, what should you offer? If you are the second, what should you
accept? The simple self-interest solution seems clear. Suppose you are the second player. Since
you get nothing by rejecting an offer, you should accept any positive amount. Even if the first
player offers only $1; $1 is better than the nothing you would get by saying no. Of course, the
first player should understand this as well and, knowing that you are likely to accept any positive
proposal, should offer as little as possible -- perhaps a mere dollar or even less.

Interestingly, when the game actually is played, the results differ markedly. Players
routinely reject offers they consider unduly lopsided or unfair. Players willingly shoot
themselves in the foot (or wallet) to keep another player from making a disproportionate
gain. Taking a small "free" payoff might be efficient, but most of us happily will sacrifice a
small gain in efficiency to protect what we consider to be a more equitable distribution of
dollars. Fairness matters.

Distribution of income

Regrettably, fairness is a slippery

concept. What seems fair to me might seem unfair to
others. Indeed, Republicans and Democrats routinely
skirmish about how a fair distribution of tax burdens
might look. Like pornography, we insist that "we know
it when we see it," but we all see it though different
eyes.

81
 While economists have no monopoly on defining how a distribution of income should
look, we at least can paint a picture of how it does look. The picture is not necessarily a pretty
one. Despite a few pauses, the U.S. economy has grown steadily since the early
1980's. However fortune has smiled on some far more brightly than on others. Our economic
tide keeps rising, but the seas have been rough. Well-appointed economic boats have crested to
record levels, but those less seaworthy have capsized. Median incomes are up, but so is income
inequality.

Check out the following table.2 It lists shares of total U.S. income by quintile. If income
was distributed equally, each 20 percent of households would control exactly 20 percent of U.S.
income. What we find, however, is that the richest 20 quintile has cornered half of the U.S.
income and that the richest five percent reaps almost twice the annual earnings of the bottom 40
percent. U.S. income is distributed unequally; more unequally than in most other developed
nations. For example, the richest quintile in the European Union controls less than 40 percent of
national income (compared to more than 50 percent in the U.S.), while the poorest quintile
receives about eight percent of national income (compared to less than four percent in the U.S.).

* * * * * * * * * * * * * * * * * * *

Shares of Total U.S. Income

Household 1970 1980 1990 2015

Poorest 20% 4.1% 4.3% 3.9% 3.1%

2nd quintile 10.8% 10.3% 9.6% 8.2%
3rd quintile 17.4% 16.9% 15.9% 14.3%
4th quintile 24.5% 24.9% 24.0% 23.2%
Richest 20% 43.3% 43.7% 46.6% 51.2%

Richest 5% 16.6% 15.1% 18.6% 22.1%

* * * * * * * * * * * * * * * * * * * *

And, the degree of inequality has increased. Since 1980 the share of the poorest 20
percent has slid steadily while the share of the richest 20 percent has climbed. Moreover, the
entire gain in this top group has been cornered by the very richest five percent of households. In
fact, almost all of the recent income gains in the U.S. have been cornered by the richest one
percent of U.S. households. Pay packages of corporate chief executive officers (CEO's) have
grown especially fast. Cash compensation received by CEO's in 1970 averaged about 20 times
what average production workers earned. By 2000, CEO cash compensation had risen to almost
300 times what average production workers received.3

Increased wage differentials

Most analysts agree that increased wage inequality is the cause. According to recent
research, increased wage differentials account for almost all of the increased income differentials

82
between the rich and the poor. Highly skilled and educated workers have prospered; less-skilled
and less-educated workers have not.4 Why?

Can we blame those foreigners? Some have. Globalization forces countries to specialize
in those sectors in which they have a comparative advantage. For the U.S. that means
concentrating on products that make intensive use of skilled labor while importing goods and
services produced primarily by unskilled labor. The result? Increased globalization and trade
should create increased demands and wages for skilled workers in the U.S., and decreased
demands and wages for unskilled workers.

It does sound reasonable. Unfortunately, the evidence will not cooperate. If trade is the
culprit, unskilled workers in industries besieged by imports should be especially hard hit. They
are not. Do we travel to Venezuela to shop for chewing gum or swimsuits? Do we call
Malaysian contractors when soliciting bids to re-roof our garage? No. Sectors such as retail
trade and construction are relatively immune to foreign competition. Yet unskilled workers in
these sectors have fared no better than those producing traded manufactured goods. Moreover,
unskilled workers in other countries have fared just as poorly as those here at home. We cannot
trace any significant part of the blame to international trade.

Immigrants provide another possible culprit because they tend to be concentrated in the
very top and bottom of the distribution. Some enter with very little education and poor English
skills. They subsist with meager wages earned by cleaning motel rooms, harvesting seasonal
crops, and trimming hedges. Others, however, come from among the best and brightest of their
countries. They teach astrophysics at MIT, head medical research teams at Johns Hopkins, and
play first base for the Los Angeles Angels; and they rake in enormous salaries. One recent study
suggests they account for about five percent of the increased inequality.5

Changing family dynamics also matter. It is increasingly common for both husband and
wife to be employed and, since college-educated, successful men tend to marry college-educated,
successful women, the combined household income of such a couple can easily dwarf that of a
family headed by two high-school dropouts. The trend toward single-parent families exacerbates
this effect. Single mothers face very difficult economic circumstances, especially if they,
themselves are not well-educated. And, unfortunately, that often is the case. More than 90% of
college-educated women giving birth are married while less than 40% of those with only a high-
school diploma or less giving birth are married. 6

Changing technology

Technology offers a more satisfying answer. Much of the technological change in recent
decades has been skill-based; it impacts skilled and unskilled workers differently. For example,
the computer revolution has increased the productivity of skilled workers, but blown unskilled
ones out of the water. Skilled, computer-literate applicants job hop to ever-increasing
salaries. Former clerks and assembly-line workers, now displaced by computers and robots,
pound the pavements unable to replace their former wages. In almost every market and
occupation, those workers with the education and skills to adapt and take advantage of new
technologies have prospered relative to those who cannot.7

83
 Cornell's Bob Frank suggests that technology might increase inequality through other
channels as well; it might increase the importance of winner-take-all markets.8 In most markets,
a worker who is five percent more productive than another might expect to earn a salary which is
five percent higher. But in winner-take-all markets, very small differences in absolute
productivity translate into enormous pay differentials.

Professional sports are an obvious example. Think of the

tennis player who loses the U.S. Open final in a fifth set tie-
breaker or the golfer who loses the Master's by a stroke as his
final putt rolls an inch past the cup. The performance gap
between them and the winners is insignificant, yet who
remembers the runners-up? The gap in fame and fortune is
enormous.

In the Darwinian struggle for survival, a small relative

edge can make all the difference. The rabbit who survives doesn't have to be very fast, as long as
he is faster than the fox in pursuit. My attorney doesn't have to be very talented, as long as she is
more talented than the one who represents my adversary. The local baker might turn out only
average bagels, but still can corner the market if those of its competitors are worse.

Winner-take-all markets breed inequality, and technology breeds larger winner-take-all

markets. In the not-too-distant past, most markets were local. Because travel and
communication were both time-consuming and expensive, comparison shopping was relegated to
visiting a few local suppliers. A vendor in the next town might offer a better product or a better
deal, but with limited transportation and information very few consumers knew about them or
could take advantage of them. Not anymore. Technology has transformed markets. People,
products and information now flow easily across physical and electronic space. With a few
strokes on a keyboard, consumers have the world at their fingers. Are shoes cheaper in
Baltimore? Order them on-line and have them delivered tomorrow. Are graphic artists better in
New York? Check their web pages for samples and have them e-mail new designs to you. Why
watch the local minor-league baseball team when the major league champion beams its games
over satellite TV? Why pay to hear a local singer when Lady Gaga's latest hit is available on
iTunes?

The effects on income are predictable. In the past a better manager or a better product
might have given us a small relative edge that allowed us to corner the local market. Now that
better manager or product can bring us national or even international dominance. The stakes
have changed. The potential values of the very best managers and designers and athletes and
singers have soared. Instead of many moderately-successful and moderately-wealthy stars in
distinct local or regional markets, we now have a handful of fabulously successful and filthy-rich
stars in national markets. This small group of "winners" has outdistanced the pack.

Rabo Karabekian, the protagonist of Kurt Vonnegut's Bluebeard put it

brilliantly. Reflecting on ancient days in which each community had its own story-tellers, its
own artists, and its own musicians, Karabekian laments:

84
 .....a scheme like that doesn't make sense anymore, because simply
moderate giftedness has been made worthless by the printing press and radio and
television and satellites and all that. A moderately gifted person who would have
been a community treasure a thousand years ago has to give up, has to go into
some other line of work, since modern communications put him or her into daily
competition with nothing but world champions. The entire planet can get along
nicely now with maybe a dozen champion performers in each area of human
giftedness.9

Of course, as Vonnegut's handful of world champions begins to grab a disproportionate share of

our markets, it also grabs disproportionate share of income.

Should we care?

Is it unfair? Should we worry about increasing inequality? To some degree, concerns

about fairness involve value judgments that we are free to reject. For example, many would
argue that those who work harder should "fairly" earn more than those who choose to loaf; that
equality of opportunity is more important than equality of outcomes. While many economists
would agree with this notion, opportunities themselves are quite skewed in America. Where one
starts in life is critically important to where one ends up. In fact, it is more difficult for someone
who starts in a low-income family in the U.S. to escape poverty than it is in many other
countries. We like to think that America is the land of opportunity, but the data suggest
otherwise. It is easier to achieve the American Dream in Canada or Australia or France or
Germany or Japan or Sweden than it is in America.

This is caused by a variety of factors. First, whom you know matters more than we might
like to think. Social links to the "right" people can make an enormous difference in terms of
access to all types of opportunities, and children raised by wealthy professionals a significant
edge in this regard. Second, richer communities provide their children with educational
opportunities that poorer communities cannot afford. Education in America typically is funded
by local property taxes. As a result, wealthy communities with lots of valuable properties find it
relatively easy to raise large sums of tax revenues with which to fund their local schools. On the
other hand, poor communities, with little valuable property to tax, do not have equivalent funds
to plow into education. The predictable result is that inequality inhibits the development of
human capital for those at the bottom of the income distribution and, therefore, leads to slower
economic growth.10 Indeed, Golden and Katz maintain that much of the U.S. success during the
20th century resulted from our early provision of free public education to all children.11

Inequality can breed other problems as well. Several scholarly studies link inequality to
social instability and conflict.12 Inequality also seems to increase the number births to unwed
teenage girls. Apparently those stuck at the bottom rungs of the distribution see little chance of
economic advancement and, as a result, see no reason to stay in school and develop their human
capital. For such girls, early childbearing becomes the path of choice.13

85
 Finally, inequality can create health problems as well. Some biologists contend that
inequality can lead to chronic stress that, in turn, can lead to hormonal imbalances damaging to
both the brain and the immune system. Inequality also has been linked a drop in the secretion of
hormones associated with interpersonal trust and bonding. If these views prove to be correct, we
could be heading for a meaner and sicker society.14

Solutions?

If we choose to do so, we can moderate these effects through increased government

transfers to low-income families. Many U.S. taxpayers do favor government assistance to low-
income families, but resist those that tax the middle class to do so. Many feel that taxing the rich
is acceptable; squeezing the middle class is not. Of course, that's because most families are
convinced that they are middle class and that someone else is rich. Redistributing someone else's
wealth always is more popular than redistributing your own.

Unfortunately, many of us have distorted notions about what it means to be rich. Look at
the data.15 What does it take to be rich? In 2015, median U.S. household income was
approximately $56,000. Households with incomes below $22,800 fell into poorest 20 percent or
quintile. Those with incomes above $117,000 broke into the richest quintile. Households with
incomes in excess of $215,000 ranked in the richest five percent.

Hmmm. These are not disgustingly large numbers. Some of my teaching colleagues at
Winthrop University earn enough to propel them into the richest quintile. Others with lower
salaries make into the top group with the help of a working spouse. The average salary for a
public school teacher in the U.S. exceeds $58,000. That means that my neighbors down the
street, both of whom teach in the local school system, probably squeeze into the richest 20
percent of households in America. Since college students are drawn disproportionately from
families with above-average incomes, many come from families that rank in this same top 20
percent. I often tell my colleagues and students that they are rich. I explain they are among the
richest households in the richest country the world has ever seen. They are not amused. They do
not feel rich. They do not want to be thought of as rich. Yet they are rich. So are, or will be,
many of you.

Can we assist the poor without squeezing the middle class? It depends on whether we
define "middle class" honestly. If we persist in assuming that only those who live like Donald
Trump should be squeezed, hopes for significant change are dead in the water.

___________________________________
Notes:

1. Uncle Wiggily is an underappreciated children's board game in which I inevitably fall

prey to the bad Pipsisewah.
2. The data are from http://www2.census.gov/programs-surveys/cps/tables/time-
series/historical-income-households/h02ar.xls.
3. See Stiglitz, Joseph E., "Inequality is Not Inevitable", New York Times, June 27, 2014

86
4. See "The Polarization of the U.S. Labor Market," by David Autor, Lawrence Katz and
Melissa Kearney, American Economic Review, volume 96, number 2, May 2006, pp. 189-
194.
5. Card, David, "Immigration and Inequality", American Economic Review, volume 99,
number 2, May 2009, pp. 1-21.
6. DeParle, Jason, "Two Classes, Divided by 'I Do'", New York Times, July 14, 2013.
7. Card, op. cit.
8. Frank, Robert H. and Philip J. Cook, The Winner-Take-All Society, The Free Press, 1995.
9. Vonnegut, Kurt, Bluebeard, Delacorte Press, New York, 1987, page 75.
10. See Perotti, R., "Growth, Income Distribution, and Democracy: What the Data Say",
Journal of Economic Growth, volume 1, 1996, pp.149–187; Galor, Oded and O. Moav,
"From Physical to Human Capital Accumulation: Inequality and the Process of
Development", Review of Economic Studies, volume 71 (2004), pp. 1001–1026; Herzer,
Dierk and Sebastian Vollmer, "Inequality and Growth: Evidence from Panel
Cointegration", Journal of Income Inequality, February 2011, (published online at
http://dx.doi.org/10.1007/s10888-011-9171-6)
11. Claudia and Larry Katz, The Race Between Education and Technology, Harvard
University Press, Cambridge, 2008.
12. For example, see Estaban, Joan and Debraj Ray, "Linking Conflict to Inequality and
Polarization", American Economic Review, volume 101, number 4, June 2011, pp. 1345-
1374. Golden,
13. Kearney, Melissa S. and Phillip B. Levine, Why is the Teen Birth Rate in the United
States So High and Why Does It Matter?", Journal of Economic Perspectives, volume 26,
number 2, Spring 2012, pp. 141-166.
14. "Unbottled Gini", The Economist, 1/22/2011, pp. 71-72.
15. See http://www2.census.gov/programs-surveys/cps/tables/time-series/historical-income-
households/h01ar.xls.
_____________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Describe the Ultimatum Game; explain the self-interest solution to the game, and explain
why we seldom observe this solution.
2. Describe the major changes in the U.S. distribution of income since 1980.
3. Critique the claim that "foreigners" have caused the increase in inequality.
4. Explain how skill-based technological change might cause increased income inequality.
5. Explain the concept of a winner-take-all market and why relative rather than absolute
ability matters in them.
6. Explain how changing technology can increase the importance of winner-take-all markets
and how this might affect the distribution of income.
7. Explain how inequality of incomes can lead to inequality of opportunity and other
problems.

87
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

The Role of Government

If men were angels, no government would be necessary.

.....James Madison

What role should government play in an economic system?

Perhaps no other issue has been so divisive in U.S. history;
especially in recent years. While economists cannot definitively
answer what has become an ideological -- almost theological --
battle, we can shed scientific light on the rhetoric.

The U.S. Constitution constructed a government in which

democratically elected representatives carry out the collective will of the people. In this sense,
the government is not some alien entity apart from the people; it is the people. The relevant
question then is when the collective will of the people should trump the will of individual buyers
and sellers.

Let’s review. Remember that every economic system must answer three basic questions:
what to produce, how to produce, and for whom to produce. Ideally these would be answered
efficiently and fairly.

 What to produce: The goal should be to produce the feasible combination of goods and
services that creates the most value for society. That is, we want allocative efficiency. This
occurs when all goods and services are produced to the point at which their marginal benefit
(MB) equals their marginal cost (MC).
 How to produce: The goal should be to produce any given set of goods and services in the
least-cost (or technically efficient) way. That is, we do not want to use more resources than
necessary; we do not want to waste any scarce resources.
 For whom to produce: The goal should be to divide or distribute the goods and services
equitably among members of society. That is, each person should get his or her “fair” share
of output.

Advantages of free markets

As discussed in previous sections, free markets provide very good results in some cases,
but not in others.1 In a perfect world in which markets are filled with lots of competing firms
and no external effects exist, free markets do create allocative and technical efficiency. Free-

88
market firms have a built-in incentive to produce the goods and services that we value the most,
because these are the ones for which we are willing to pay. As long as the MB we get from a
product -- and therefore the price we are willing to pay -- exceeds the firms’ MC of production,
they will profit from supplying it. Similarly, free-market firms have a built-in incentive to
produce goods and services in the least-cost way. Every unnecessary dollar spent on production
is a dollar of potential profits thrown out the door. Alternatively, firms that fail to minimize
costs will be undersold and driven out by those that do.

In these cases no government regulation or intervention is needed. The profit incentive

automatically drives firms to produce the most valuable combination of goods and services in the
least-cost way. In effect, market competition harnesses the self-interest of producers and
consumers and creates a result that is in the public interest of society at large. [Readers who are
free-market enthusiasts should cheer and fist-bump now.]

Market Failures

Unfortunately free markets do not always work so smoothly. Three basic types of market
failures occur.

1. Poor competition:
First, not all markets are competitive. Many are dominated by one or a few firms. When
facing few or no rivals, firms are free to raise prices above competitive levels. While this often
pads corporate profits, it leads to socially inefficient results. If firms in competitive markets fail
to offer the best products at the best prices, consumers can go elsewhere and get more value for
their dollars. Alas, in non-competitive markets, consumers often are stuck.

2. External Effects:

Even in competitive markets, external effects scuttle efficiency. If transactions that benefit
both buyer and seller impose costs on others, problems occur. For example, a barrel of oil worth
$100 that costs a firm only $70 will be produced in a free market. The buyer and seller can share
the $30 of surplus value created. But what if this transaction causes $50 of damage to others?
Perhaps it pollutes the air or destroys a town’s water supply. The $50 external cost more than
offsets the $30 private gain to the buyer and seller and the free-market transaction makes society
worse off. In this case, allowing firms the freedom to buy and sell whatever they want destroys
the freedom of others to enjoy clean air or safe water. In this case, free markets burden society
with inefficiently large amounts of oil production. Or, suppose I prefer mugging strangers in
back alleys to earning dollars through gainful employment. Such muggings might be in my
personal best interest, but victims might forcefully argue that they are not socially efficient.
Even though the mugging benefits to me (free money!) might exceed the costs to me, my
personal benefits probably would not exceed the social costs (those to me plus the external costs
to those being mugged).

External benefits create similar problems. Suppose that cleaning trash from a local beach
is worth $1 to each of the town’s 12,000 residents and will cost $10,000. Since the $12,000 total
benefit exceeds the $10,000 cost, cleaning is socially efficient. But who will do it? Will you?

89
Your efforts will create $12,000 of value, but $11,999 of that accrues to others; it is external.
Will you spend $10,000 for something worth only $1 to you? Probably not. We typically care
only about our personal benefits and ignore those benefits that spill over to others. And, because
others will benefit from your efforts whether or not they contribute, others are not likely to chip
in to help. They will free ride. As a result we systematically underproduce goods and services
that create such spillovers. Free markets will fail to produce efficient quantities.

3. Fairness:

For whom do free markets produce? The simple answer is: “those with the most income or
buying power”. Firms eagerly line up to produce for the Bill Gates of the world. But, if you are
broke, forget it. No free-market firm will give you a second thought.

Is this fair? Maybe. Maybe not. The system does have its advantages. It gives each of us
the incentive to work hard, to develop our skills, to invent new products and processes. After all,
the more successful we become, the more income we can earn and the more goods and services
we can command. However, much of this is beyond our control. Luck matters.

Some of us are lucky enough to be born into loving homes where we carefully are
nurtured, and some of us are not. Some of us are lucky enough to be born with a genetic
disposition to good health, and some of us are not. Some of us are lucky enough to be blessed
with highly-demanded intellectual and/or athletic talents, and some of us are not. Anyone who
believes that a person’s income perfectly mirrors their work effort needs to spend time in the
shoes of the female custodian working two jobs at minimum wage trying desperately to feed the
two children left to her care when her sister and brother-in-law died in an auto accident.
Beyonce might work hard, but there are legions of others who work harder and yet struggle
every day to keep their financial ships afloat. Even when free markets do deliver allocative and
technical efficiency, they might fail to distribute goods and services fairly.

Government's role

Market failures provide the wedge to justify government

regulation and intervention. They highlight cases in which a
democratic government that substitutes our collective will for that
of individual buyers and sellers can benefit society.

For example, if free markets will fail to work effectively if competition is weak, perhaps
government can set rules to limit anti-competitive behaviors. If free markets ignore external
effects, perhaps government programs to account for these can make us better off. And, if free
markets fail to distribute goods and services in ways that society deems fair, perhaps government
redistributive schemes can help.

Interestingly, these are precisely the things that governments do. Take a look at their
budgets. Major items include defense, education, and highways (external benefits), crime
prevention and pollution control (external costs), antitrust laws (encourage competition), and

90
Social Security, Medicare, Medicaid and welfare (redistribution/fairness). And, to raise the
funds needed to pay for these items, we impose collective taxes on ourselves to ensure that all
pay a fair share and cannot simply free ride on the contributions of others.

In other words, through governments, we can correct the failures of free markets to
achieve efficient and equitable results. We can increase market competition, offset the
inefficiencies created by external effects, and achieve a distribution of income that we consider
to be fair. [Readers who love big governments should cheer and fist bump here.]

But…

Free markets unfettered by government rules and restraints often will not operate
efficiently and/or fairly. However, governments themselves can fall prey to market failures. For
example, because many of us fail to vote intelligently or even vote at all, political choices often
are dominated by special interest groups that push private agendas at the expense of the general
public.2 And, we know that a private monopoly firm can get away with producing inefficient
combinations of goods and services in inefficient ways. So can a government. If the
government court system operates inefficiently we cannot easily take our legal business to a
competing system. There is no competing system. Similarly, government-run highway
departments or armed forces or social service agencies face little or no competitive pressure and,
as a result, can waste resources and still thrive.

Rats. No system works perfectly. Free markets often deliver inefficient and inequitable
results; so do government-run systems. Would you rather live with the imperfections of free
markets or the imperfections of government? What balance provides the best outcomes? These
are critical and divisive questions; but are questions better answered through scientific inquiry
than through ideology.
_______________________________________

Notes:

1. Check out the chapter on Market Efficiency.

2. The chapter on Rational Ignorance develops this in more detail.

________________________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Identify the three basic types of market failures and explain the problems created by each.
2. Describe the types of government actions that might cure each of the market failures and
explain.
3. Explain why government itself might be inefficient.

91
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Section II-A: Love and Marriage

I love the idea of there being two sexes, don't you?

.....James Thurber

Few issues give more pain or more pleasure than love. It vexes and delights every
generation. But all is not well.

Fewer people marry and more people divorce. Headlines trumpet stories of domestic
violence and abuse. Out-of-wedlock birth rates have soared. Is it all falling apart? Is morality
on the wane? Have we lost love in the labyrinth of modern life? And what does economics have
to do with love and marriage? The callous logic of economics surely cannot explain affairs of
the heart.

Or can it?

II-A. Love and marriage

1. Costs and benefits of marriage
The Untied Knot: Marriage on the Skids
Monogamy: A Cure for the Modern Arms Race
2. Love, sex, and affection
Older Men; Younger Women
Exploitive Relationships
3. Children and families
Empty Cradles
Moral Decay

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

The Untied Knot: Marriage on the Skids

Love and marriage, love and marriage,

Go together like a horse and carriage.
....songwriter Sammy Cahn

Is that right? Could the classic song be

correct? Yes and no. When Frank Sinatra
crooned "Love and Marriage" back in the
1950s, the analogy was apt. But times have
changed. Love still blooms, but fewer couples
are saying "I do," and many who tie the knot
quickly backpedal and cut loose when the
honeymoon limo hits a pothole. Check the
table below: the percentage of Americans that
marry has been falling for many years.1

U.S. Population: Age 18 and over

Year % married % never married % widowed % divorced

1970 71.7% 16.2% 8.9% 3.2%

1980 65.5% 20.3 8.0 6.2
1990 61.9% 22.2 7.6 8.3
2000 59.5% 23.9 6.8 9.8
2013 55.9% 27.7 6.1 10.3

Part of the trend results from couples postponing marriage until a later age -- often
because of increased years of schooling. However, the percentage of people married in every
age group has taken a dive (see the next table).2

93
 Percentage of U.S. Population Married (by Age)

Age 1970 2013

15-19 7.6% 1.7%

20-24 62.5% 12.5%
25-34 89.7% 47.8%
35-44 86.9% 67.5%
45-54 84.5% 68.9%
55-64 82.6% 67.8%
65 and older 61.0% 59.0%

What is happening? Is it a decline in family values? Moral turpitude? No. You can't get
off that easily. I have two more pages to go in this reading. Such exhortations may suffice for
election-year sound bites, but they don't cut the scientific mustard. Changes in marital patterns
cannot be explained by hushed references to some media catchphrase. Economists demand
substance.

What does economics have to do with love and marriage? Plenty. Economics explains
everything. It is not just about trade deficits, taxes and unemployment rates. It's about choices,
all kinds of choices. The same logic used to set wages and prices can be applied to decisions
about marriage and divorce.3

Costs and benefits

It's all costs and benefits. Every decision we make involves an implicit comparison of
costs and benefits. If expected benefits exceed costs we act; if not, we don't. That innocuous
statement has powerful implications. If people make decisions on the basis of costs and benefits,
it follows that behaviors change only when their costs and benefits change. In other words,
changes in marital patterns must be driven by changes in the underlying costs and benefits of
marriage. Two significant changes have occurred, and both have had the same impact; both have
cut the willingness of women to marry.

The first change has been women's increasing success in the labor market. The ability of
women to earn competitive wages has fundamentally altered the costs and benefits of marriage,
especially from the women's perspective. With the potential for successful careers, women need
not depend on male partners for economic security. If women can earn their own way in the
market, they consider marriage as less beneficial and more costly. When women had no
lucrative prospects outside of marriage, the opportunity cost or sacrifice in assuming traditional
housewife roles was minimal. With few other options available, women looked to marry. But
when career opportunities emerged, many women chose to embrace them. The marriage market
was transformed.

The marriage market? Sure. If a Florida frost drives down the supply of oranges, we
know we'll see fewer oranges on the shelves and a higher price tag slapped on those that remain.
Marriage markets work the same way. When attractive alternatives to marriage evolve for

94
women, the supply of women to the marriage market drops. This lowers the quantity of women
available for men to purchase and raises the market price.

Purchase? Prices? Yes. When women face increasingly attractive job opportunities,
men must bid more -- up the ante -- if they want women to choose them over these
alternatives. Of course, the price is rarely explicit. Very few men shop for wives as they shop
for oranges. Women seldom are arrayed on grocery store shelves in quite the same way as
fruit. When last I checked, not even Wal-Mart listed a spouse selection aisle.

Nonetheless, implicit prices do rise. Men must now accept wives whose ambitions reach
beyond the front yard, wives who expect their spouses to share in activities from peeling onions
to scouring toilets. To most men, for better or for worse, such change is costly.

Are you ready to see the graph? Do I care?

The increase in job opportunities has shifted the supply curve of wives to the left (from S0
to S1) causing a drop in the equilibrium quantity of wives from Q0 to Q1 and an increase in the
equilibrium price from P0 to P1.

Economic logic would predict that changes in the percentage of women who marry
should mirror changes in the ratio of female-to-male wages. The more that women can earn
relative to men, the less likely they should be to marry. And that is exactly what we find. As
this ratio has risen over time, the percent of women marrying has fallen. Simple
economics. This also can shed light on racial differences. Because the female-to-male wage
ratio is higher for African-Americans than for whites, the economic model successfully predicts
that white women are more likely to marry than are African-American women. African-
American women earning high salaries often charge "prices" for marriage that relatively few
African-American men can afford to pay.

Racial differences in incarceration rates also seem to matter. Due to changes in

mandatory sentences for drug offenders, the percent of young men in jail rose rapidly in the
1980's and 1990's. Since these sentences were most severe for those caught with crack cocaine --
used disproportionately by non-whites -- incarceration rates jumped much faster for African

95
American men, especially those with low levels of education and income. The predictable result
is that African-American women, especially those with more education and earnings potential,
found it increasingly difficult to find African-American mates of similar caliber.4

The availability of better contraception and abortion have magnified this

effect. According to rumor, sexual relationships can be enjoyable for women and men alike;
even if they are unmarried. But sex also carries the risk of an unwanted pregnancy, a cost
disproportionately paid by women. An unmarried male partner easily can walk away from such a
pregnancy; an unmarried woman cannot. Not surprisingly, since women bear more of the cost of
unmarried sex, women traditionally have been more reluctant to engage in such practices. At
least in the past, no marriage often meant no sex.5

The introduction of birth control pills in the 1960s launched women into a new
world. Unlike prior methods of birth control, women could choose to use the pill without the
consent or even knowledge of their sexual partners. By providing a safe, reliable, and convenient
method of avoiding unwanted pregnancy, women suddenly could participate in unmarried sex
with little risk of pregnancy. The pill dramatically lowered the cost to women of unmarried
sex. And, with the pleasures of sex more readily available without marriage, the willingness of
women to supply their services as wives declined. In effect, the pill lowered the cost to women
of waiting for marriage. Once women gained access to the pill and, to a lesser extent, abortion,
the age of their first marriage and their overall marriage rates fell.6

Shifting employment patterns

The plot thickens. Why have job opportunities for women risen? Why has the female-to-
male wage rate risen? Again, economists are not satisfied with arguments like "gender
discrimination is falling." An economist will ask why this is happening now rather than in 1723
or in 2223. To an economist, gender discrimination is not likely to change without some
underlying change in the costs and benefits of such discrimination.

Luckily, such changes are easy to find. First, the nature of

work has changed. We have moved rapidly from an economy
that depends on muscle power to one that depends upon
brainpower. Men have a comparative biological advantage in
muscle power, but not in brainpower. It is far less costly to
exclude women from a "muscle-power" workplace than from a
"brainpower" workplace.

Second, industrialization slashed the need for women to

work within the home. In the not-so-distant past, in-home and
burdensome production of such staples as food and clothing were
essential. However, once technology began to free women from many of basic household
chores, traditional patterns changed. For example, technological advances have made factory-
produced food and factory-produced clothing less and less expensive, By the middle of the
twentieth century it was becoming cheaper to buy ready-made food and clothing in the
marketplace than to produce them within the home. As a result, it became more profitable for

96
women to enter the workplace and earn income to buy such commodities than to stay at home
and produce them themselves. A wife and mother who can earn $100 a day at work would be
wasting her time if she spent all day sewing clothes she could buy for $60. She would be
throwing $40 of scarce resources down the drain.7

Better contraception has been a third factor.8 In the pre-birth-control-pill world, women
faced costly obstacles in their quest of equal employment status. The threat of pregnancy meant
that women often were less willing to build the needed human capital. Why invest in a grueling
and lengthy education if an unexpected pregnancy might cut short their careers? Abstinence
provided the only sure way to earn a long-term return from their educational efforts. Not
surprisingly, few women thought of this as an attractive option.

But with the introduction of effective contraception, women became able to pursue
professional careers without risk of pregnancy. In effect, the pill cut the cost to women of long-
term career investments and increased their supply in the marketplace. The pill indirectly raised
the demand for women in the market as well. Prior to the advent of the pill, those women who
did invest in education faced a second barrier: employer discrimination. Employers were
reluctant to hire and train young women who might become pregnant and leave the
firm. However, with better contraception and less probability of unexpected pregnancies,
employers became more willing to hire female applicants.

Interestingly, the same factors that make marriage less attractive to women make divorce
more attractive. When the relative benefit of marriage falls, the relative costs of divorce also
fall. Lucrative employment opportunities create attractive alternatives for single women; they
also enable women trapped in unhappy relationships to escape more easily. However, while
marriage rates continue to decline, divorce rates which rose for many years have been falling
slowly since their peak in the late 1970's. Becoming choosier about when and if to marry
apparently means that fewer marriages have been ending in divorce.
_________________________________________________
Notes:

1. The 2013 data reported in the table are derived from U.S. Bureau of the Census, Table
A1. Marital Status of People 15 Years and Over, by Age, Sex, Personal Earnings, Race,
and Hispanic Origin: 2013, that can be accessed at:
http://www.census.gov/hhes/families/data/cps2013A.html. Earlier data were calculated
from earlier releases.
2. The 2013 raw data can be found at
http://www.census.gov/hhes/families/data/cps2013A.html. For 1970 raw data see
http://www2.census.gov/prod2/statcomp/documents/CT1970p1-02.pdf.
3. Much of this literature stems from the work of Nobel Prize-winning economist Gary
Becker. The traditional reference is Becker, Gary, A Treatise on the Family, Cambridge,
Harvard University Press, 1981.
4. Charles, Kerwin Kofi and Ming Ching Luoh, "Male Incarceration, the Marriage Market,
and Female Outcomes", Review of Economics and Statistics, volume 92, number 3,
August 2010, pp. 614-627. The authors also note that the lack of marriageable men can

97
 prompt women to to invest more heavily in education and training than they otherwise
might.
5. Of course, pre-marital sex frequently did occur, but it often did so with an implicit
promise of marriage should pregnancy result. See Moral Decay chapter.
6. Goldin, Claudia and Katz, Lawrence F., "The power of the pill: contraceptives and
women's career and marriage decisions," Journal of Political Economy, August 2002,
volume 110, number 4, pp. 730-771.
7. Miles, Carrie A., "A Testimony to Motherhood: LDS Response to Changing Women's
Roles, 1940-2006," paper presented at the annual Meetings of the Association for the
Study of Religion, Economics, and Culture, Portland, OR, October, 2006. Also see
Chiappori, Pierre-Andre, Murat Iyigun and Yoram Weiss, "Investment in Schooling and
the Marriage Market," American Economic Review, December 2009, 99:5, pp. 1689-
1713. Interestingly, this decreased need to produce items such as food and clothing
within the home also led to the demise of home economics as a popular college major for
women. See Stevenson, Betsey and Juston Wolfers, "Marriage and Divorce: Changes and
their Driving Forces," Journal of Economic Perspectives, Spring 2007, volume 21,
number 2, p. 43.
8. See Goldin, Claudia and Katz, Lawrence F., op. cit.

_________________________

Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the two major reasons why women’s willingness to supply themselves as wives has
fallen in recent decades and illustrate with an appropriate graph.
2. Explain how and why women today charge higher “prices” in marriage than they did in the
past.
3. Explain why marriage rates for African-American women are lower than those for white
women.
4. Identify three different reasons for why job opportunities for women have risen over time
in the U.S. and explain each.

98
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Monogamy: A Cure for a Modern Arms Race

Marriage, if one will face the truth, is evil, but a necessary evil.
.....Menander

We were good friends: Donnie, Steve and I. We were nine

years old and were lined up waiting to board the school bus to
Fountaindale Elementary School. And we had a problem: a bus
seat could accommodate only two children. The first two of us
would sit together; the third would have to sit apart. Even worse,
given the children who would enter at the next stop, the empty seat
beside the solo member of our trio was likely to be filled by a girl --
an unimaginable humiliation for a nine-year-old boy.

We begged the bus driver that we be allowed to cram together in a single seat, but to no
avail. He hid behind "district rules." What could I do? The only way out was to avoid being
that third member; to get to the bus stop early. After all, only the last of our three risked a close
encounter with the opposite sex. So, I went early. I sped through my cinnamon toast -- eggs
were far too slow -- and hustled out the door a full ten minutes before usual. My reward? I was
first in line and got to sit with either Donnie or Steve every day.

But Donnie and Steve were no dopes. Within a week they caught on to my strategy and
began arriving early themselves. So I arrived even earlier. Within three weeks each was running
out of the house a full 30 minutes before the bus was due. Our early morning sprints to the bus
stop were costing us both sleep and breakfast, but none of us could afford to end our mini-
version of an arms race by ourselves. We were trapped. What could we do?

Luckily, our mothers did it for us. Recognizing the no-win battle for what it was, they
joined together and imposed a cartel solution. By parental decree, enforced by threat of
household violence, we left our homes at the same time and rotated the dreaded number-three
spot in line. Thank God for mothers.

Investment: good and bad

Donnie, Steve, and I invested much time and energy into our mini-arms race. It all was
wasted. Normally, investment is touted as the key ingredient of economic growth; it creates the

99
new products and new technology that drive increases in our standard of living. But not all
investment is equally valuable. Not all investment creates socially valuable output.

Rational individuals will invest time and effort into an endeavor only if they expect a
profitable rate of return. Unfortunately, what looks like a profitable investment to the individual
may not be equally profitable to society as a whole. For example, my efforts in arriving early at
the bus stop were "profitable" to me. The expected benefits outweighed their expected costs to
me. However, my efforts created offsetting costs for Donnie and Steve. My gain was offset by
their loss. Our mutual investments in an early arrival were costly, but they created no new
products or benefit for the group.

Defense investments provide a more consequential

example. As weaponry has progressed from broadswords to bows,
from muskets to missiles, nations have spent fortunes on
developing new and improved instruments of war. To what
avail? Individually, potential combatants have little choice. If my
enemy might invest in weapons research, I must be willing to
match her efforts. Unilateral decisions to limit such investment are
perilous. Yet the social value of such rivalrous expenditures is
questionable. Are battles fought with smart bombs more humane than those fought with rocks
and clubs? What is in the interest of individual participants may have limited, or even negative,
payoffs to society as a whole.

Imagine that two countries with a combative history (Demoland and Repubistan) are
locked in a military stalemate. Each must decide whether or not to spend $30 billion to build and
deploy new weapons in an attempt to gain over the other. If both build weapons, the stalemate
will continue, but both will be out the $30 billion. If one builds and the other doesn't, the
country that builds will take over the one that does not. The vanquished country will lose $100
billion and the victor will win $70 billion (that's the $100 billion from the losing country minus
the $30 billion spent for the weapons).

The possible outcomes can be illustrated in a "payoff matrix" like the one below.
Demoland's payoff is listed first in each cell and Repubistan's payoff is listed second.

If Demoland expects Repubistan to build weapons, its best strategy is to build as well.
Although it will lose $30 billion if it builds, a $30 billion loss is better than the $100 billion loss

100
it incurs if it does not build. Interestingly, Demoland's best strategy also is to build if Repubistan
chooses not to build. If it builds it will be able to conquer Repubistan and earn a payoff of $70
billion – far better than the zero payoff it gets if neither builds. In other words, Demoland's best
strategy is to always build weapons, regardless of what it expects Repubistan to do. However,
since the payoffs are symmetrical, Repubistan faces the same incentives. Repubistan also will
want to build weapons. In "equilibrium" both countries will build and both countries will lose
$30 billion. The arms race is mutually destructive.

Do you want more examples? World-class athletes wage similar arms races. Knowing
that only a fraction of a second or a few centimeters separate winners and losers, competitors
continually try to one-up their rivals. An extra hour or an extra day of training might make the
difference. The result is an all-consuming training regimen that few of us could imagine. And
for what? The individual rewards for victory can be very substantial, but the social return is
dubious. Despite the grueling regimens, despite the pain endured by winners and losers alike,
the pleasure a spectator gains from watching a mile run in 3:46 is little different from that
watching a mile run in 3:56.

How about student recruitment efforts by colleges and universities? High-school

students are inundated by unsolicited and often unwelcome brochures, viewbooks, letters, and
phone calls. Admission officers scurry around the country to high schools and college fairs,
lugging suitcases crammed with promotional literature, banners, and videos. No single
institution can afford to leave the field to its competitors. Yet, in the end, the billions of dollars
spent in this academic arms race have precious little impact on the numbers of students pursuing
higher education or the types of institutions they attend.

Economists Bob Frank and Philip Cook term these cases positional arms races.1 The
investments of time and money are geared to improve the relative position of the participant in
the market or contest and have little impact on the quality of the final goods and services
produced. Much of the investment, from society's perspective, is wasted.

Frank and Cook also contend that wasteful positional arms races are most common in
winner-take-all markets. These are markets in which success depends upon relative rather than
absolute performance, and in which the payoffs accrue primarily to a handful of top participants.
For example, the Olympic men's sprint champion who wins by the slimmest of margins will
capture all of the glory. No one remembers the runner-up or offers him television endorsement
deals. Even though he collected the most popular votes, Samuel Tilden lost the U.S. presidency
by a single electoral tally. Did you ever hear of him? Americans only barely eked out a victory
in the Revolutionary War, but that narrow edge changed the course of history.

Curbing positional arms races

Participants in positional arms races understand that every investment they make to gain
a relative edge might merely induce offsetting investments by their competitors. They
understand this can be wasteful and mutually draining. Yet no one can afford to stop by him or
herself.

101
 Collusion might be a way out of the box. Perhaps
participants could mutually agree to limit
investments. For example, countries could enter
voluntary arms agreements to limit the numbers and types
of nuclear weapons produced and stored. Unfortunately,
such agreements are not always legal.2 And such
agreements are difficult to enforce. Even when I pledge
to limit arms, I still have an incentive to develop and
stockpile weapons secretly. People cheat.3

A better remedy is to have investment limits imposed by an outside agency with the
power to monitor the agreement and discipline violators. In the school bus illustration, mothers
effectively enforced the agreement. But other agencies can be equally effective. Are you
worried that junior high students will overspend trying to impress their classmates with the latest
fashion attire? Have school officials impose a dress code. Do you want to ensure that colleges
do not overspend trying to recruit football players? Have the National Collegiate Athletic
Association (NCAA) limit the numbers of scholarships and recruiting visits coaches have in their
arsenals. Do political advertisements drive you up a wall? Petition Congress to tighten
campaign spending laws.

Monogamy

Positional arms races also are evident in the contest for love and marriage. Who among
us has not invested time, energy, and money trying to outbid a rival in pursuit of a mate? The
process is expensive and emotionally wrenching. But it could be much worse.

Consider most mammalian species. Reproduction is far more costly to females than to
males. Females bear the burden of both long pregnancies and the initial care and feeding of the
young. Once conception has occurred, from a biological perspective, males are home free. As
Frank and Cook note:

This asymmetry means that any single male is capable, in principle, of siring an almost
unlimited number of offspring. And since, in the Darwinian scheme of evolution by natural
selection, each individual's goal is to transmit as many copies of its genes as possible to the next
generation, the result for males is a genetic tournament with enormously high stakes.4

In other parts of the animal kingdom, dominant males often service entire herds of
females and zealously protect their turf from potential rivals. Lesser males are shut out of the
reproductive loop altogether. As should be expected, the competition to be top dog in such
markets can be savage, even to the death.

Humans are not immune to such battles but, historically, have attempted to limit them
whenever possible. In polygamous societies dominant males do commandeer harems of the most
desirable females, but the battles for domination are limited by social convention. Typically it is
only those males with high social or political rank, often chosen by birth, who can aspire to
multiple wives. A former student from a rural Liberian village regaled our class with stories of

102
his great uncle, a chief with almost 100 wives. However, if one man takes 100 wives, there
probably are 99 very unhappy men left with none.

More recently, a controversial Utah religious sect that separated from the Church of Jesus
Christ of Latter-day Saints many years ago, teaches that men without at least three wives cannot
reach heaven. Sect leader Warren Jeffs was convicted of arranging polygamist unions with girls
as young as 13 and, to eliminate excess males, apparently expelled hundreds of teen-aged boys
and young men from the community.5

Conventional wisdom often assumes that women dislike polygyny. 6 While it is true that
many women would prefer not to share a husband, women actually can fare very well in such
systems. They will enjoy increased bargaining power. They have the option to marry a powerful
and/or well-to-do man who already has one or more other wives, but they also can choose among
less successful males who might be very eager to please them in order to attract any mate at all.

The alternative approach, adopted by most Western civilizations, is legally enforced

monogamy. When the dominant male is allowed only a single bride, many beguiling mates
remain available for others. Of course, competition still occurs and contests for the best mates
can get ugly. The casualties of romantic combat litter the Internet with "in search of" ads and
messages. Has monogamy completely eliminated positional arms races in love and
marriage? No. Has it reduced socially wasteful competition to more acceptable
levels? Absolutely.

Interestingly, the difference in reproductive costs also can explain why males tend to be
more competitive than females. Because the cost to males is low, they tend to seek multiple
partners and compete with rival males for the opportunity to do so. In an evolutionary sense,
those most successful at such competition were the genetic winners. On the other hand, because
reproduction is very costly to females, they tend to limit their number of sexual partners. As a
result, females often tend to be less competitive, but choosier in the sexual market place.7

Faster economic growth?

In addition to creating more reproductive opportunities for many men, monogamy might
fatten their wallets as well. Polygyny can be expensive. Allowing people to consume multiple
bags of potato chips should push up both the demand and equilibrium price for chips. Allowing
multiple wives should create the same result. The demand for wives should rise, and the
equilibrium bridal price should rise right along with it.8

In Sub-Sahara Africa where polygyny remains common, these prices often take the form
of explicit payments from the prospective husbands to the fathers of their future brides.
Unfortunately, if the well-to-do men spend their fortunes buying multiple wives, they have little
left to invest in the capital goods that might increase their countries' productive capabilities. (Do
you want to review those shifting PPC's discussed in the What to Produce chapter?) They end up
with lots of wives who can produce lots of children, but very little of the machines and
technology needed to produce other goods and services. Not surprisingly, those countries that

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practice polygyny also tend to have very low rates of economic growth and very low levels of
per capita income. Ouch.

Wait. There's more. Remember that the beneficiaries of the high bridal prices in some
countries are fathers rather than the brides themselves. Fathers who themselves paid high prices
for their wives will want to recoup their costs. The easiest way to do that is to have lots of
daughters who, in turn, can profitably be sold. The result? Polygynous countries typically are
saddled with explosive rates of population growth as well.

Monogamy sounds better all the time.

_________________________________________

Notes:

1. Frank, Robert H. and Philip J. Cook, The Winner-Take-All Society, The Free Press, 1995.
The reasoning that follows and many of the examples were originally developed by Frank
and Cook.
2. Agreements to limit wasteful spending might be useful, but many other types of
agreements among potential competitors are not. For example, agreements to jointly fix
prices or to divide markets are clearly anticompetitive and violate the Sherman Antitrust
Act.
3. Institutions and countries also cheat. Members of the Organization of Petroleum
Exporting Countries (OPEC) sign elaborate agreements limiting oil production enough to
keep prices above competitive levels. But, in their attempts to gain relative advantage,
OPEC members routinely cheat and exceed their agreed-upon production quotas.
4. Frank and Cook, op. cit., p. 183.
5. The expelled youth are known as "the lost boys." See
http://www.guardian.co.uk/usa/story/0,12271,1505997,00.html.
6. The terms can be confusing. Polygamy refers to a world of multiple spouses. It can occur
either through allowing men to have multiple wives (polygyny) or the less common case of
women having multiple husbands (polyandry).
7. Gneezy, Uri and Aldo Rustichini, “Gender and Competition at a Young Age,” American
Economic Review, May 2004, pp. 377-381. Muriel Niederle and Lise Vesterlund cite
additional experimental evidence that women are less competitive in "Do Women Shy
Away from Competition," NBER Working Paper #11474, 2006.
8. See Schoellman, Todd and Michele Tertilt, "Marriage Laws and Growth in Sub-Saharan
Africa," American Economic Review, volume 96, number 2, May 2006, pp. 295-298. This
section is based on their analysis.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

104
1. Describe positional arms races and explain how they might lead to wasteful spending and
competition.
2. Explain why it is difficult to control wasteful spending in positional arms races.
3. Explain how monogamy might benefit men.
4. Use the concepts of differential costs to explain why men might have evolved to be more
competitive than women.
5. Explain how and why polygyny is likely to affect a country's rates of economic growth and
population growth.

105
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

The Economics of Courtship

When the candles are out, all women are beautiful.

.....Plutarch

In high school and college, I avoided sitting in the front

row. I aimed for a seat about three-fourths of the way back by the
windows. Windows always are a desirable diversion, but I was
interested in something else. I was interested in girls.

From my vantage point almost all of the coeds in the room were arrayed in front of
me. Ones in the very back were hidden, but girls rarely sat there. I could face the chalkboard,
pretend to be looking at the instructor, and ogle away.

I would select ones I might like and ask them for a date. In fact, I asked lots of them for
dates. I had to. Most turned me down, so I kept trying new and different ones. I squandered
many years mooning over girls who repeatedly rejected my advances. Friends gleefully teased
that my low romantic batting average was caused by deficient animal magnetism. It was very
depressing.

Then I learned some economics. With the help of some very attractive equations and
graphs, I discovered that it wasn't me at all. The cause of my distress was not inadequate
amorous aptitude; I simply was the innocent victim of powerful economic forces beyond my
control.

Economics and romance? Of course. Remember, economics is about choices, all kinds
of choices. The same maximization models that elucidate corporate pricing policy can explain
the romantic rejections of my youth. Simple. The girls I coveted were in my school classes;
they were my same age. Regrettably, girls my age were not interested in boys my age. They
wanted older men. They still do. Sixteen year-old girls are far more likely to accompany 18-
year-old boys than the reverse. Women marry older men; men rarely marry older women.

Why? The 16-year-old girls claimed it was "a maturity thing." Girls matured faster and,
therefore, needed more mature male companions. Bunk. Even if the argument is valid at age 16,
it certainly is not valid at age 35. Scientists would be hard-pressed to prove that 35-year-old men

106
are less mature than 35-year-old women. Yet the same older-man bias exists at age 35 as at age
16. Moreover, if maturity were an important trait in a mate, why wouldn't men be drawn to more
mature, older women just as women are drawn to more mature, older men?

Costs and benefits

An economist needs more substance. An economist wants an argument about relative

costs and benefits. And we have one, one that springs from the role of men and women in the
economic marketplace.

Let's face it. Both men and women want a successful mate. Nobody wants a dog. In a
traditional world women specialized in childbearing and in-house production, while men
specialized in outside market production. As a result, men wanted women who would be
successful mothers and cooks. Women wanted men who would be successful breadwinners.

However, the requisite talents for such success are not manifest at the same ages. A
woman's likely proficiency at childbearing and cooking often are apparent as soon as she reaches
physical maturity. Not so with men. The eventual fortune of a Bill Gates or a Tom Hanks could
not have been predicted at age 16. A man's ability to be a successful breadwinner is likely to be
evident only after years of experience.

If so, women will not want to risk tying the knot with an untried youth. Why gamble
with a mere child when older men are safer marital bets? Less talented women may have little
choice, but the most enticing ones will be able to command the attention of seasoned market
veterans. The most sought-after women will mate with older men. Similarly, the men most
confident of eventual market success will not marry at early age. They understand that, if they
hold out, their future financial feats should enable them to snare far more alluring partners.

Does it make sense? Do I have a good excuse for my substandard success in pitching
woo? Yes. Economists Ted Bergstrom and Philip Bagnoli examined marital age gaps in 90
countries from 1950 to 1985.1 The average age for husbands exceeded that of their wives in
every country during every time period. More importantly, the patterns in age gaps are precisely
what the above theories would predict. For example:

1. The age difference between husbands and wives should be falling over time as labor
market opportunities for women increase. As women specialize less in raising
families and begin to compete in the labor force, the age difference between men and
women in marital relationships should shrink. As the market success of women becomes
a more valuable piece of the marital pie, men -- like women -- will find it advantageous
to look for a proven veteran rather than an unproven child. The data support this
hypothesis. The age gap between husbands and wives fell over the 1950 to 1985 period in
almost every country.

2. The age difference between husbands and wives should be smaller in developed
countries where women have better labor-market opportunities. In the U.S., the
average age difference was 1.9 years in 1985. The average for Western Europe, Canada

107
 and Australia was 2.5 years. However, in less industrialized and more traditional
societies, the age gap was higher. Men were an average of 3.5 years older than their
wives in the sample countries from Latin America and Asia, and 5.7 years older than
their wives in the African countries studied.

3. Men with the least chance of economic success should marry at an earlier age. Men
expecting to be a financial flop have no incentive to wait for marriage. The longer they
wait, the clearer their lack of pecuniary prospects will become -- better to marry quickly
before potential mates catch on. Indeed, Bergstrom and Bagnoli discover that, all else
being equal, men at the lower end of the U.S. income distribution married at an earlier
age.

Subsequent researchers have argued income inequality matters as

well.2 If women expect all potential husbands to earn similar levels of
income, waiting to see which might be more successful makes little
sense. The risk of marrying a younger, unproven mate is minimal.
However, if the wages of potential husbands are likely to differ widely,
waiting to see which ones will earn more becomes a better strategy. In a
world of increased income inequality, women should be increasingly
reluctant to marry before the financial winners are able to distance
themselves from the losers.

Interestingly, income inequality in the U.S. has risen in recent decades. Most economists
chalk it up to increased returns to higher education. Wage differentials between college
graduates and non-graduates have soared, presumably because graduates are better able to take
advantage of new technologies.3 Unfortunately, because it now takes more years of education
before men can signal their financial success, it also takes more years before they can attract the
most desirable women.

By the way, I did, eventually, catch on to the game. I gave up on females my own age
and married a younger woman.

___________________________________________
Notes:

1. Bergstrom, Theodore C. and Bagnoli, Philip, "Courtship as a Waiting Game," Journal of

Political Economy, volume 101, number 1, February 1993, p. 185(18).
2. Gould, Eric D. and M. Daniele Paserman, "Waiting for Mr. Right: Rising Inequality and
Declining Marriage Rates," Journal of Urban Economics, volume 53, number 2, March
2003, pp. 257-281.
3. Readers might want to review the material on income inequality in What's Fair is Fair.

_______________________________

Testing Yourself
108
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain why men typically have preferred to marry younger rather than older women
while women have preferred older rather than younger men.
2. Explain how and why age gaps between husbands and wives vary over time and between
richer and poorer countries.
3. Explain which types of men are likely to marry at an early age and why.
4. Explain how increased income inequality and increased returns to higher education might
affect the age at which men can attract a desirable wife.

109
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Exploitive Relationships

Almost all of our relationships begin and most of them continue

as forms of mutual exploitation, a mental or physical barter, to be
terminated when one or both parties run out of goods.
...W. H. Auden

In ninth grade, Sally was the proverbial knockout. And she

knew it. And she flaunted it. Especially around my friend Ted. Under most circumstances Ted
displayed as much rational behavior as one reasonably could expect from a 15-year-old
male. But, the sight and scent of Sally overwhelmed his hormonal equilibrium. He was, in a
word, gaga. And she knew it.

Girls of Sally's status typically ignored Ted. Oh, he was bright enough. But, a bit gawky
with a loopy stride and a face marred by repeated bouts with acne, Ted was not especially
attractive nor athletic nor charming. Like the rest of our group, he was a nerd. His major talent
was algebra. Ted was the Michael Jordan of quadratic equations. Though appreciated by his
friends, such talent did little to inflame the passions or catch the attention of budding femme
fatales.

Except Sally. In any other context, Sally would not have given Ted the time of day. But
in algebra, Sally's desk was next to Ted's and Ted had something Sally wanted: answers. And
she got them. Coy smiles. Flirtatious winks. Provocative postures. Ted was putty in her
hands. At Sally's request, Ted did her homework, coached her for exams, even tilted his test
sheets so they could be more easily read from her angle.

Ted anguished over his actions. He knew he was wrong. He knew she was using
him. We protested to Ted. Ted protested to Sally. But, Sally met each protest with a new
request accompanied by a sexy smile, a seductive shift of her hips, a tantalizing touch. And Ted
was dead in the water.

Rational behavior

110
 How does this happen? How can people be coerced into actions they oppose? Why do
people allow themselves to be exploited? The answers can be found in simple economics.1

Rational people normally pursue activities only as long as the expected additional or
marginal benefit (MB) of the activity is greater than or equal to the expected additional or
marginal cost (MC). Should you consume another slice of pizza? Only if the expected benefit of
the marginal piece covers its expected cost. Should you sleep an extra hour Saturday
morning? Only if the benefit you expect to receive from that marginal hour of sleep covers its
cost. Such comparisons of MB and MC are implicit rather than explicit, but they determine
behavior nonetheless.

Consider the simplified example below. Suppose that for each hour Laurie sleeps, she
must sacrifice some activity that would have created four units of happiness or utility for her
[measured as four warm fuzzies].2 The MB of sleep is likely to decline as the number of hours
slept rises. The first few hours per night are critical to her health and wellness, the 14th hour per
night is of questionable value. For simplicity, suppose the MB of her sleep fall linearly as in
Table I.3

TABLE I
Hour of sleep MB MC Surplus Value of Unit Total Surplus Value

1 6.5 fuzzies 4 fuzzies 2.5 fuzzies 2.5 fuzzies

2 6.0 4 2.0 4.5
3 5.5 4 1.5 6.0
4 5.0 4 1.0 7.0
5 4.5 4 0.5 7.5
6 4.0 4 0.0 7.5
7 3.5 4 -0.5 7.0
8 3.0 4 -1.0 6.0
9 2.5 4 -1.5 4.5
10 2.0 4 -2.0 2.5
11 1.5 4 -2.5 0.0
12 1.0 4 -3.0 -3.0
13 0.5 4 -3.5 -6.5
14 0.0 4 -4.0 -10.5

In Table I, Laurie's optimal decision is to sleep six hours per night. The MB of received
from each of the first five hours exceeds her MC of four and creates surplus value (the surplus
value created by a unit is its MB minus its MC). The MB of the sixth hour equals its MC and so
it also is efficient. But, after the sixth hour, the MC of sleep exceeds the MB. If she sleeps the
seventh hour, she will gain an additional 3.5 warm fuzzies, but will lose an additional four. That
seventh hour costs Laurie 0.5 of a fuzzy -- it creates a surplus value of negative 0.5.

Of course, Laurie receives positive net benefits overall. Hours one through six all
generate benefits greater than or equal to cost. Her total cost of six hours of sleep is 24 fuzzies,

111
but her total benefit is 31.5 fuzzies.4 She receives what economists term 7.5 units of surplus
value -- the difference between the 24 units of cost and 31.5 of benefit.

Exploitation

Are you still with me? Are you wondering what any of this has to do with
relationships? Change the example. Instead of hours of sleep, imagine measuring "gifts to your
romantic partner." Relationships, after all, are built upon gifts, and not just tangible gifts like
candy and flowers. The gifts that matter most are gifts of time, gifts of caring, gifts of loving
attention. Each gift we contribute to our partner generates marginal benefits to us through our
relationship; but each gift also imposes costs. Just as with slices of pizza and hours of sleep,
each rational partner will give as long as the expected MB covers MC.

This time, imagine that Laurie freely grants her partner six gifts and receives, in turn, a
surplus value of 7.5 fuzzies. If her partner asks for a seventh gift, she should refuse; its cost
would exceed its benefit. However, suppose her partner issues an ultimatum. Suppose he
threatens to walk out and end the relationship if Laurie fails to deliver that seventh gift. Should
she give in? Should she allow herself to be exploited? Maybe.

Remember, Laurie is getting 7.5 surplus fuzzies from the relationship. These go down
the tube if her partner takes a hike. If his threat is credible, Laurie might well decide to supply
that seventh gift. She loses 0.5 of a fuzzy by doing so. But that's a small price to pay if it allows
her to keep the other surplus fuzzies. She's still seven fuzzies ahead.

What form might such exploitative demands take? One obvious form of demand is
sexual. Perhaps Laurie's ideas of acceptable sexual practices are more limited than her partner's.
Many a woman has reluctantly risked unwanted pregnancy for fear that withholding her sexual
favors would cause a potential mate to leave the relationship. Physical and/or mental abuse is a
second possibility. Might Laurie accept such abuse if she estimates its net cost to be less than
what she would lose if the relationship ended?5

Limits

There are limits. If Laurie's partner demands too much, she'll let him walk. Using Table
I numbers, her partner could not successfully demand more than ten gifts. With ten gifts,
Laurie's total benefits would equal 42.5 and her total costs 40. Her surplus value is a mere 2.5
fuzzies, but 2.5 still exceeds zero. However, the eleventh gift would push her over the edge. Her
benefits would rise by 1.5 to 44, but her costs would rise by four to
44. At that point, her surplus value is gone and ending the relationship
costs her nothing.

Such exploitation can occur in any relationship. Sally's demands

of Ted were for algebra homework -- a clear prerequisite for her
continued attentions. There are other examples. Students often place
exploitive demands on their friends [let me copy your homework, or I
won't be your friend]. Children can exploit parents [give me candy, or I'll

112
throw a tantrum]. And parents can exploit children [if you want to stay in this house, you'd
better eat that cauliflower].

Why? Exploitation is common, but not universal. Why are some relationships exploited
and others not? Easy. It's competition. If Pepsi tries to exploit me, I will switch to Coke. If
Wendy's makes exploitive demands, I will drive to Burger King. The consumer surplus I can
enjoy with one product will nearly match what I could get from the other. If no other soft drinks
or hamburger joints are available, Pepsi and Wendy's have me by the throat. But close
substitutes make exploitation impossible.

The same holds with personal relationships. If Laurie is confident of finding another man
who can give her an equal amount of consumer surplus, she will rebuff any exploitive demands
her current partner may make. However, if she despairs of finding a suitable replacement, she
will hold on more ardently to the one she has -- even if it means accepting exploitation. All else
equal, the higher is Laurie's self-esteem, the more confident she will be of finding a close
substitute relationship, and the less likely she will allow herself to be exploited.6

A man with violent tendencies, subconsciously at least, might understand these

competitive constraints. Wanting to find a partner willing to tolerate his destructive behavior, he
might deliberately seek out women with few perceived alternatives. Just as Wal-Mart scours the
country for towns with no competing discount stores, a potentially abusive husband will find it
profitable to seek mates with no competing beaus.

Competition is good for those of who consume soft drinks and hamburgers. It is also
good for those of us who "consume" relationships.

___________________________________________
Notes:

1. The initial concept was developed in Schmidt, Wilson E., "Charitable Exploitation,"
Public Choice, volume 10, Spring 1969, p. 103(2). The notion was later developed in
more detail and popularized by McKenzie and Tullock. See McKenzie, Richard B. and
Tullock, Gordon, The Best of the New World of Economics, 5th ed., Homewood, IL,
Irwin, 1989, chap. 8.
2. Economists typically measure utility in the equally illusory concept of "utils."
3. The assumption that each additional hour has less marginal benefit is an application of
what economists term "diminishing marginal utility."
4. The total benefit is simply the sum of the benefits received for each of the six
hours. Thus, 6.5 + 6 + 5.5 + 5 + 4.5 + 4 = 31.5
5. As McKenzie and Tullock point out, op. cit., women also can exploit men.
6. There also is some evidence that women's increasing economic independence makes
them less prone to exploitation and domestic violence. Their independent income creates
substitute options. See The Economist, April 16, 2005, page 50.
_______________________________

113
 Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Using a table of MB and MC data, find the allocatively efficient output and explain.
2. Explain the concept of surplus value and know how to calculate it from MB and MC
data.
3. Explain how one partner in a relationship can exploit the other; explain what limits the
amount of exploitation possible.
4. Describe the circumstances under which exploitation is most likely to occur in a
relationship and why.

114
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Empty Cradles

Never have more children than you have car windows.

.....Erma Bombeck

Baseball rules. One evening last summer I was

sitting in a section along the third-base line, penciling the
game's starting line-ups on my score card, trusty oiled glove
by my side, when a family with six children filed in and took their seats a few rows away. Six
children. Normally, nothing distracts my attention from the game. I've been known even to
ignore attractive women marching up the aisle beside me just to watch a curve ball nipping the
outside corner of the plate. But the six children caught my eye that night. In addition to souvenir
hats and stuffed mascot replicas, they consumed impressive amounts of food: hot dogs, drinks,
nachos, cotton candy, pizza, and ice cream. It was a veritable blur of commercial activity. And it
was expensive.

Now this was not Yankee Stadium sporting New York City prices. It was a AAA minor
league contest pitting the home-team Charlotte Knights against the visiting Toledo Mud Hens.1 I
made it through the entire evening for a total of $15: that was $4 for parking, another $11 for my
lower-reserved seat, and a container of bottled water that I smuggled in for free. But the parents
of the six children had shelled out more than $100 for concessions alone before the seventh-
inning stretch. Kids are costly. No wonder I stopped with two of my own.

Of course, families with six children are an exception these days. Large families were
more common in the past, but even among those families with children, only about one in 20
now has more than three.2 In 2013 the average number of children per family in the U.S. was
1.88, down from 3.58 in 1970.3 U.S. families are small, and are getting smaller.

Children and income

Wait. This is strange. For the most part, family incomes keep rising through time. For
most products, our demands rise as we become richer. With more income we demand more
automobiles and more shoes and more television sets and more vacations. Why does this not
happen with children as well? Children are expensive, but with our increased incomes we can
more easily afford them. Why is our demand for children falling over time rather than rising? 4

115
 What we see over time in the U.S. also is apparent across countries. Although there are
exceptions, we find a strong negative correlation between birth rates and income. The higher a
country's per capita income, the lower is its birth rate. The relationship is so pronounced that it
once prompted Indian statesman Karan Singh to proclaim that economic "development is the
best contraceptive." Although population pressures continue to haunt many developing nations,
fertility rates in every Western European countries have fallen below replacement levels. While
Chinese politicians have imposed draconian policies to limit population growth, those in
countries such as France, Italy and Chile have begun subsidizing children in an attempt to halt
population declines.5

Improved contraception explains part of the trend. Better contraception could allow more
accurate family planning, but there is a second angle as well. Remember that women bear most
of the cost associated with birth and child-rearing. Since they incur higher costs, women might
reasonably opt for fewer children than their male counterparts. Prior to the advent of birth-
control pills, condoms were the most common form of contraception. But condom use was
controlled primarily by men who had less interest in limiting births. Birth-control pills, for the
first time, gave those bearing the cost of children control over conception.

While contraceptive technologies clearly matter, they cannot explain much of what we
see. Even where access to these technologies is equal, significant differences in birth rates occur
across time and across countries. How might economists explain these variations? Take a wild
guess. That's right. If different couples make different choices about family size, it must be
because they perceive different benefits and costs. If economic development affects fertility
patterns, it must be because that development changes the fundamental benefits and costs of
children.

Benefits and costs

Kids just aren't worth what they used to be. First, in the
days of high infant mortality rates, additional children were needed
to ensure that a reasonable number would survive. If half were
likely to die, each family tried to produce twice as many as they
wanted. As medical advances raised survival rates, they also cut
the number of wanted births. Second, in the agrarian days of the
past, children could serve as cheap farm labor -- a benefit lost in a
modern urban society.

But there has been a more important and less obvious change afoot. In poorer economies
children act as a surrogate welfare system. For modern U.S. families government-funded
programs for unemployment compensation, Social Security, and medical/disability insurance
provide a public safety net. But these programs did not exist in the U.S. of the past nor do they
exist in many poorer countries today. With no government programs, your extended family
provided this net. Your children were your unemployment compensation. Your children were
your Social Security system. Your children were your medical insurance. Of course when
children provide economic security, the incentive is to breed like rabbits -- the more children, the

116
greater the security. But when couples go forth and multiply, women often stay home to feed
and mind the kids. As economies grow and develop, large families are less useful. A social
system that encourages women to stay at home makes less economic sense.

Not only are children today less useful, they also are more costly. First, children
consume enormous amounts of time, especially for mothers. In economist-speak, children are
time-intensive commodities; commodities that require large amounts of time to appreciate
appropriately. In the distant past the cost of a mother's time was much smaller. In a society that
offers women no significant career opportunities in the marketplace, the opportunity cost of
staying at home and raising large families is small. However, because economic development
increases job opportunities for women, there is a related feedback impact on the cost of large
families.6 As better career opportunities for women evolve, their opportunity cost of staying
home and raising large families also increases. The more developed the country, the more costly
are the kids.

Evolutionary biology offers a second reason for increased

costs. Think fish. How does a fish species perpetuate itself? The strategy
is simple. Drop as many eggs as possible and run. Most hatchlings will
be eaten, but if there are enough of them, some will survive long enough
to mate and renew the cycle. Fish parents do not nurture their young; they
do not educate their young. Since so many will die, investing time and
energy in rearing any particular one becomes economically
inefficient. However, when mortality rates fall, the optimal strategy
changes. If offspring are likely to live, genetic survival becomes less a
matter of sheer numbers and more a matter of how well your offspring can compete with
others. The optimal strategy becomes having fewer children and investing in each more heavily.

That's what we are seeing today. As survival rates rise we shift our emphasis from the
quantity of children to the quality of children. Alas, raising high-quality offspring is more costly
both in terms of time and of money. It means spending increasingly scarce time with them. It
means teaching them to read and write; it means sending them off to college; and it means taking
them to baseball games. Benefit-cost calculations affect the size of our families, just as they
affect the size of our automobiles.

_________________________________________

Notes:

1. Older readers may recall that Corporal Max Klinger donned a Mud Hens hat in numerous
episodes of the classic television series M*A*S*H.
2. In 2013, only 5.7% of families with children under the age of 18 had four or more. See
http://www.census.gov/hhes/families/data/cps2013F.html Table F1.
3. See https://www.census.gov/hhes/families/data/families.html Table FM-3. Average
Number of Own Children Under 18 Per Family, By Type of Family: 1955 To Present.

117
4. You may recall that demands and incomes move in the same direction for normal goods,
but in opposite directions for inferior goods. According to this terminology, surprisingly,
children appear to be inferior goods.
5. See "Persistent Drop in Fertility Reshapes Europe's Future" by Frank Bruni, New York
Times, December 26, 2002 and "Autumn of the Patriarchs", The Economist, June 1, 2013,
page 40. The typical U.S. woman will bear about 2.1 children, almost exactly what is
needed to maintain a stable population. The fertility rate for native-born U.S. women is
below that level, but the rate for immigrant women is higher.
6. See The Untied Knot: Marriage on the Skids for more on how economic growth creates
job opportunities for women.
7. "Why there is a perplexing shortage of rich kids," The Economist, February 22, 1997, pp.
89-90.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Describe the relationship between birth rates and economic growth and development.
2. Explain why the benefits of additional children are lower in the U.S. now than in the
distant past.
3. Explain two important reasons for why the costs of additional children are higher in the
U.S. now than in the distant past.

118
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Moral Decay

Give me chastity, but not just now.

....Saint Augustine

Not long ago a young co-ed approached me to explain that she

would miss Monday’s class. “I’m getting married that day,” she
bubbled. Before I could inject my congratulations, she
continued. “And I’ll be missing class at the end of next month as
well. I’m having a baby.”

Economists have strong math skills. I quickly could calculate that "the end of next
month” was less than nine months from her wedding. Why, this woman had engaged in pre-
marital sex!

A few generations ago such admissions would have been scorned. Pregnancies of
unmarried women were concealed. The couple involved rushed to the altar as quickly as
possible, hoping that the birth could later be explained as “premature.” No longer. Not only are
such marriages often postponed, many never occur at all.

In 1960 fewer than one out of ten births were to single mothers. By the year 2010 that
number had rocketed to 41 percent of all births. More than one-half of all births to women under
30 are to single mothers and, among women under twenty years of age, 88 percent of all births
are to single mothers.1 Although the increases have occurred across all demographic groups,
significant differences persist. Almost 3/4 of black children are born to single mothers compared
to about 50 percent of Hispanic children and 30 percent of whites. Women with only a high
school degree or less are far more likely to bear children outside of marriage than are women
with college degrees.2 Unfortunately, a considerable body of evidence indicates that children
born out of wedlock are more likely to suffer a variety of ills. Out-of-wedlock birth seems to
increase a child's propensity for ill health, for poverty, for criminal activity, for being a school
dropout, for being a welfare recipient, and for being a single parent him/herself. Boys apparently
are especially disadvantaged when raised by single mothers. 3 In short, out-of-wedlock births
often create spillover costs for both society and for the children themselves.

119
 What is causing this trend? The demagoguery of the day blames moral decay. The
conservative Wall Street Journal once dubbed the out-of-wedlock birth rate as the most accurate
indicator of our nation's moral deterioration. But such explanations do not wash with
economists. Moral decay, if it has occurred, is a symptom, not a cause. Economists assume
people have always pursued self-interest. If people's behavioral patterns shift, there must be an
underlying shift in costs and benefits that caused such a shift. Morals do not spontaneously
combust. Moral decay furnishes great sound bites for the media, but it is scientifically empty.

Besides, the rise in out-of-wedlock births is not confined to Americans. It is a broad

trend that has occurred across countries, across classes, across ages, and across religious and
ethnic groups. While out-of-wedlock birth rates in some countries such as Japan are lower than
ours, the rates in others are higher. For example, more than 50 percent of births in Sweden and
France are out-of-wedlock while rates in Great Britain mirror our own. Iceland, where two-
thirds of births are out-of-wedlock, currently tops the list. Although the rate of out-of-wedlock
births is relatively high in many European countries, the potential problems they cause tend to be
smaller than in the U.S. Many of these European children are born into stable, two-parent (albeit
unmarried) households. That is less likely to be true in the U.S.4

Possible causes

How about welfare? Can we pin the blame for out-of-wedlock births on handouts to the
poor? The argument is plausible. Welfare payments do make it easier for unmarried women to
support themselves and their children without marriage. But the data do not cooperate. If
welfare is a major culprit, changes in out-of-wedlock birth rates should mimic changes in the real
value of welfare payments. They do not. The real value of welfare payments has been falling
steadily since 1975, the same period in which out-of-wedlock birth rates have soared. More
surprisingly, although out-of-wedlock births still are disproportionately common among low-
income women, the greatest rate of increase has occurred among relatively affluent women, not
among welfare recipients. Serious statistical studies conclude that changes in welfare benefits
have little or no impact on out-of-wedlock births.5

Interestingly, the increase in out-of-wedlock births is

apparently not the result of increased births. The change is in
marriage patterns, not fertility patterns. When single women found
themselves pregnant in the past, they typically demanded -- and got
-- a shotgun wedding. No more. Shotgun marriage rates for both
whites and blacks have fallen quickly over the last three
decades. According to economists George Akerlof, Janet Yellen
and Michael Katz (AYK hereafter), nearly 2/3 of the increase in
out-of-wedlock births is attributable to this decrease in shotgun
marriages.6

Why? One explanation is changing job opportunities for women. As the economy shifts
from muscle-power to brainpower occupations, women have found more lucrative employment
opportunities. With the ability to earn high wages and salaries themselves, women are less
dependent upon men. They can afford to raise children without a husband. Similarly, knowing

120
that their monetary contributions are less crucial, men are more apt to duck their responsibilities
and skip out.

Although changing employment roles are a likely factor, AYK identify a second culprit:
technology. They finger contraception and abortion. They argue that the very technologies
intended to lower the incidence of unplanned births paradoxically has led to more. According to
AYK, the ready availability of contraception and abortion transformed the competitive nature of
the market for sex.

Competition and sex

Prior to the 1960's, most women refused to engage in pre-marital sex without an explicit
or implicit promise of marriage in the event of pregnancy. With women presenting a united
front, men were willing to make and hold to such promises of marriage; they had few
competitive alternatives. If pregnancy occurred, marriage followed quickly. Researchers have
estimated that 30% of U.S. brides in 1960 gave birth within eight and a half months of the
wedding.7 Shotgun weddings were expected and were common.

Easily available contraception and abortions dramatically altered this process. With new
technology to lessen the threat of unwanted children, the cost of pre-marital sex to women fell
rapidly. When costs drop, prices should follow suit. And they did. Without the threat of
unwanted children, many women no longer demanded promises of marriage in the event of
pregnancy. In essence, they lowered the price charged to men for pre-marital sex. Not
surprisingly, when the price went down, the quantity demanded by men went up.

But not all women embraced these changes. What happened to those women who tried to
cling to the earlier technology; those who wanted marriage and/or who opposed contraception or
abortion? Just what an economist would predict in a competitive market -- they were undersold
and driven out of business. They lost their bargaining power. With pre-marital sex readily
available elsewhere, they no longer could extract promises of marriage in the event of pregnancy.
Many responded exactly as any other competitor trying to protect market share; they lowered
their prices to compete. When unplanned pregnancies did occur, they absorbed the loss. They
bore children out of wedlock.

Men's reactions reinforced the trend. Many men reasoned that they were not to blame for
unwanted births. After all, women had access to contraceptives and to abortions. If women
choose not to avail themselves of contraceptives or abortions, they should bear the consequences
of that choice. Many men felt absolved of guilt, absolved of responsibility. When pregnancies
occurred, they walked away.

Once a dam begins to leak, floods are not far behind. As out-of-wedlock births began to
increase, the social stigma associated with them started to ease. When the unwed mother is your
sister or your daughter or your close friend, it becomes far more difficult to cast her out of polite
society. As the stigma eased, so did the cost to women of bearing children out of wedlock.
Lower costs meant more such births, which meant less stigma, which meant more such births, et
cetera.

121
 What now? Should we roll back the technology? Probably not. The technology has
increased choices and options for millions of men and women. Denying access to it at this point
would probably increase the number of unwanted births significantly. Cuts in welfare benefits
are not likely to have much impact either. Despite their political pizzazz, such cuts will do little
other than to further impoverish the recipients.

A more appropriate policy would reverse the competitive position of men and women in
the market for sex. If the new technology disadvantaged "women of virtue," policies that
disadvantage men could restore balance in the market. For example, heavy taxes on men for
fathering children and/or aggressive child-support programs might alter the terms of trade and
change male behavior.

________________________________________

Notes:

1. See "Births: Preliminary Data for 2010", National Vital Statistics Report (volume 60,
number 2), Table 7 at http://www.cdc.gov/nchs/data/nvsr/nvsr60/nvsr60_02.pdf
2. deParle, Jason and sabrina Tavernise, "For women Under 30, Most births Occur Outside
Marriage", New York Times, February 17, 2012.
3. Bertrand, Mairanne and Jessica Pan, "The Trouble with boys: Social Influences and the
Gender Gap in Disruptive Behavior," American Economic Journal: Applied Economics,
2013, 5(1): pp 32-64.
4. Jayson, Sharon, "Out-of-Wedlock births on the Rise Worldwide: But U.S. Moms are
more Likely to be Single", USA Today, May 14, 2009, page 6D.
5. See Grogger, Jeff and Stephen G. Bronars, "The Effect of Welfare Payments on the
Marriage and Fertility Behavior of Unwed Mothers: Results from a Twins Experiment",
Journal of Political Economy, volume 109, number 3, pp. 529-545.
6. The original study appeared as Akerlof, George A., Yellen, Janet L. and Katz, Michael L,
"An Analysis of Out-of-Wedlock Childbearing in the United States", Quarterly Journal
of Economics, volume 111, number 2, May 1996, p.271 (41). A less technical synopsis
subsequently appeared as Akerlof and Yellen, "New Mothers, Not Married," Brookings
Review, Fall 1996, volume 4, number 4, p. 18(4). The analysis and data used in this
article are largely derived from these sources.
7. "Men Adrift", The Economist, May 30, 2015.
_________________________
Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Discuss why many economists are reluctant to blame the increase in out-of-wedlock
births on moral decay in America and/or our welfare system.
2. Explain how growing employment opportunities might impact the quantity of out-of-
wedlock births.
3. Explain how increasing access to contraception and abortion impacts the quantity of out-
of-wedlock births; discuss the impacts on both women and men.

122
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Section II-B: Sickness and Death

The hour of departure has arrived, and we go our ways -- I to die, and you to
live. Which is better God only knows.
.....Plato

Sickness and death are real. At some point they will be staring each of us squarely in the
eyes. How will we respond? What choices will we make? To what lengths will we go to
preserve our life? How about someone else's life? What sacrifices are we willing to
make? What costs are we willing to bear? If life is priceless, why do we persist in unhealthy and
dangerous life styles?

The issues are sticky and the arguments contentious. Yet, like it or not, decisions must be
made. How much is a life worth? How many people should be saved? How shall we save
them? At root, these are economic choices in which costs and benefits must be carefully
weighed.

Shall we try?

II-B. Sickness and death

1. Economics of life and death
Priceless Life?
Saving Lives Can be Dangerous
2. Health care issues
Health Care
Not Enough Hearts
Where There's Smoke, There's Controversy
The Economics of Eating

123
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Priceless Life?

Although human life is priceless, we always act as if

something had an even greater price than life...But what is that
something?
.....Antoine de Saint-Exupery

Prices matter. If the price of hamburger rises, I switch to chicken. Charge more for
bagels and I buy cereal instead. When prices rise, the quantity demanded falls.

It sounds simple, but does it always work? Might we be willing to buy some products
regardless of price? How about gasoline? Will higher prices reduce how many gallons we
buy? Yes, they will. High gas prices in the 1970s stampeded an entire generation to smaller,
more fuel-efficient cars. Recent price hikes have been causing similar shifts. What about
water? We need water. Won't we continue to buy water even if the price goes up? Perhaps, but
how much water do we need? At $50 a gallon, might we take shorter showers?

Substitution is the key. Chicken substitutes for hamburger, cereal for bagels, small cars
for gas-guzzlers, short showers for long showers. If substitutes exist, higher prices always will
reduce the quantity demanded. Price up, quantity demanded down.

Exceptions?

However, suppose no substitutes exist? For example, consider medical care. Not
cosmetic or elective care; people routinely reject these if the price is too high. But consider
critical care such as insulin for a diabetic or surgery for a burst appendix. Such care is essential
for life. There is no substitute for life.

Or is there? If the price of insulin rises to $5,000 per day, what will the diabetic do? If
surgeons will remove your burst appendix only for an up-front payment of $2 million, what will
you do? There is a substitute for life; it is death. Death is a substitute thrust daily upon destitute

124
and low-income individuals who cannot afford the food or the medical care necessary to
live. When price rises, the quantity demanded falls.

Taxpayer dollars might offer a solution. Can't afford to eat? Have the taxpayers feed
you. Can't afford needed medical care? Have taxpayers cover your bills. Will taxpayers do
it? What is a life worth?

These are not idle musings. If a $5 million highway improvement can save a life, should
we make it? If $32 million of new pollution controls can save three lives, should we buy
them? These are real decisions that must be made by real people every day of every year.

Imagine that a random person is to be plucked from the earth tomorrow and
killed. Luckily, the executioner is corrupt and can be bribed to spare the life. You do not know
who the victim will be. It's not likely to be you or anyone you know. It probably will be
someone of a different country, a different race, a different religion. Will you bribe the
executioner? How much would you pay? What is this unidentified life worth?1

Would you pay $1 million? Don't try the "I don't have $1 million" defense. Most of you
will earn in excess of $1 million during our working lives. Borrow it. Dash to the nearest bank
and offer your future earnings as collateral. Will you do it? What percent of your future
earnings are you willing to sacrifice? If $1 million is too much, would you pay $100,000? How
about $10,000? Maybe $500? Entire families live on less in some countries. Would you pay
$500 to save a family? Are you nodding "yes"? If so, think a minute. What did you do with
your last $500? Did you use it to save lives? Actions speak louder than words.

The Grand Canyon

Some years ago my sons asked to vacation at the Grand Canyon -

- a stunning spectacle, but expensive. With four round-trip airline tickets,
a rental car, food, lodging, and souvenirs, a ten-day trip could easily run
over $2,000. We had a choice: ten days at the Grand Canyon or, at $500 a
shot, save four families. What should we have done? What would you
do?

We chose the Grand Canyon. We had a glorious time. It was even

more awesome than I had imagined. But, by the time we returned, four families were dead. Did
we kill them? Am I a murderer? Their lives were in our hands, and we let them go. We had the
opportunity to save them, and we let them die. Wait. It gets worse. I had such a good time that
I went back a second time. More families are dead, but I did take some great photographs. I do
feel guilty, but know that many of you would have made the same choices. You would have
been just as guilty, and that makes me feel better.

We pretend that life is priceless, but it is not. If we believed life was priceless, we would
behave very differently. When push comes to shove, the price we are willing to pay to save a
life is not very high. Our lips say life is priceless, but our actions say life is cheap. When price
rises, the quantity demanded falls.

125
Closer to home

Of course, we would pay more to save a loved one than to save a stranger. If my wife's
life was at stake, or my own, I quickly would pony up dollars I never would offer to save a
stranger. However, even when our own lives are on the line, there are limits to what we will
pay. If we truly thought our lives were priceless, we would never risk losing them. Yet we take
such risks every day.

My mother smokes. She knows it is dangerous; she has seen friends die from lung
cancer. But still she smokes. She hopes it will not harm her, but knows that it might. She
refuses to pay the price of kicking the habit, even though it may save her life. And she is not
alone. People smoke, even though they know it can kill them. They drink to excess, even
though they know it can kill them. They exceed speed limits on highways, even though they
know it might kill them. Some do all three simultaneously.

Such choices often are not foolish or irrational. We know what we are doing. Risks are
all around us. Should we stay off the highway to avoid a potentially fatal accident? Should we
not visit our sick friends in the hospital for fear of contracting a deadly airborne virus? Should
we keep out of the woods to avoid being struck by a falling tree?

No. Risking premature death makes sense. We all die; the only issue is when. Our
choices are not between life and death; they are between the quantity and quality of life. We can
avoid risks and maximize the quantity of years lived, but only if we sacrifice the quality of those
years. To avoid risks we must shut ourselves off from the people and the activities that make life
worth living. Given the choice between 90 years of life in an isolated, but safe, padded cell, and
75 years of happy, fulfilled living, most of us would grab the latter. Extra years of life are surely
tempting, but not at any price. When price rises, the quantity demanded falls.
__________________________________________

Notes:

1. This exercise in "willingness to pay" is often identified with economist Tom

Schelling. See Schelling, Thomas, "The Life You Save May Be Your Own," in Chase,
Samuel B., Jr. (ed.), Problems in Public Expenditure Analysis, Brookings Institution,
Washington, D.C., 1968, pages 127-162.
_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain why economists are unsympathetic to the claim that “life is priceless.”
2. Describe a circumstance in which policymakers must decide how much a life is worth.
3. Explain why risking death might be a rational choice.

126
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Saving Lives Can be Dangerous

Guns aren't lawful, nooses give,

Gas smells awful, you might as well live.
.....Dorothy Parker

In the halcyon days of my youth, I suffered repeated tennis

thrashings at the hands of my friend Jimmy. A brilliant, albeit
mercurial player, Jimmy had a nasty habit of smashing his wooden
racquet1 against hard surfaces when his serves and volleys failed to
behave appropriately. The consequent result was a succession of
fractured frames.

No matter. Jimmy's parents always came through with the

funds for a new racquet. Of course, that explains why he was willing to unleash his temper at the
drop of a double fault. Jimmy never wanted to break his racquets; there always was a
transitional between-racquets phase he disliked. However his parent's pocketbook provided an
insurance policy that minimized his potential loss. It's simple economics. When parents lower
the cost of broken racquets, the quantity of broken racquets produced will rise.

Moral hazard

If insuring against racquet breakage increases the number of broken racquets, might other
insurance programs have similar effects? Of course. Insurance companies are all too familiar
with the quandary. Insurance alters incentives. Once we are heavily insured against an adverse
event, we have less incentive to avoid that event.

It is the problem of moral hazard. When the insured no longer bears the full cost of a
disaster, fewer precautions will be taken and the likelihood of disaster increases. For example,
theft insurance might induce us to take fewer safeguards with our valuables. Similarly,
government flood insurance might allow victims to rebuild homes on flood plains where they are
likely to be re-flooded.

The more heavily we insure against an event, the more likely that event becomes. When
urban riots lowered inner-city property values in the late 1960s, many undamaged buildings
ended up with market values that were significantly below their insured values. At the same
time, urban fire losses rose rapidly.2 Was it a coincidence? Or was it moral hazard in action?

127
 Insurance companies try a variety of ways to combat the problem. A company that offers
fire insurance might require safety inspections and threaten to drop coverage for those not
meeting certain standards. Offering discounts for homeowners who take such precautions as
installing smoke alarms also is common. Using deductibles and co-payments that force insured
individuals to bear part of the cost of accident or theft can help as well. If I must pay the first
$500 of a loss out of my own pocket, I'm more likely to be careful. However, as long as
insurance bears part of the cost, part of the problem will remain.

That theft insurance might lower precautions against potential burglary is relatively easy
to see. But does the problem extend beyond property insurance? What about harm to life and
limb? Might people with heavy health and life insurance behave more recklessly than those
without? Does moral hazard extend to life and death decisions?

Saving lives

It does. When the cost of harm goes down, people's willingness to risk life and limb goes
up. Suicide offers an extreme illustration. To avoid problems of moral hazard, firms routinely
exclude life insurance claims for individuals committing suicide. But other, less obvious,
examples abound.

Few actions seem so noble as rescue operations. Workers,

often unpaid volunteers, risk their own lives to pull injured or
stranded victims from countless perils. Is it worth it? What if rescue
operations reduce the risk of dangerous activities? What if the
expectation of rescue induces more people to engage in risky
behavior? Might the expectation of Park Service rescue encourage
more ill-prepared hikers to venture into dangerous back
country? Might Coast Guard rescues encourage more boaters to sail
more brazenly into the open sea under storm clouds?

The impact of such rescues could be perverse. Suppose rescue operations lower the risk
of mountain climbing by 40 percent. The increase in perceived safety will raise the demand for
climbing mountains. More people will climb and probably take fewer precautions when they
do. The net effect is ambiguous. If the increase in risk-taking is less than 40 percent, the rescue
operations will lower overall fatalities. However, if the increase in risk-taking exceeds 40
percent, fatalities will rise. Rescues lower the probability that any single individual will die, but
if the number of climbers increases enough, total fatalities increase. Well-intentioned rescues
can kill.

According to economists J. R. Clark and Dwight Lee, government attempts to rescue

climbers on Mt. McKinley illustrate the point.3 Prior to rescue attempts, only the most expert
and best-prepared mountaineers braved its slopes. And in the initial years, none died. When
deaths did begin to occur, the government responded with increasingly aggressive rescue efforts.
The result, unfortunately, was more and more poorly prepared climbers, and more deaths.

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 At least one professional guide blames a change in attitude. Initially, "...there was more
of an understanding that people were on their own. They didn't rely on others for help. But,
[after] word got out that the National Park Service would pay for rescues, the prevailing attitude
seemed to be 'Don't worry. If we get in trouble, the Park Service will rescue us.'"4 The advent of
cell phones has aggravated the problem. Not long ago, a 59-year-old man fell while climbing a
Welsh mountain by himself. Too badly injured to move, the man placed a phone call to the
regional police who, in turn, dispatched a Royal Air force helicopter that honed in on his cell
phone signal to locate the stranded man and complete the rescue.5 Similarly, after three
inexperienced college students were rescued after becoming lost in a Texas cave, one explained
that they did not worry because they knew they could count on being rescued as a result of
having left cell-phone messages for friends and a trail of litter on their way into the
cave. Another, undeterred by the expensive man-hunt and community trauma he had caused,
commented that he planned on returning to the cave at a later date.6

Unfortunately, such rescue efforts chew up scarce public resources. Oregon, where local
officials often are called to pull stranded climbers from Mt. Hood, is among a small handful of
states that asks those rescued to share the costs. But the maximum charge is a mere $500 for
searches that can cost more than $6,000 per hour.7 Might taxpayers might save more lives per
dollar if such resources were shifted to alternative programs such as infant nutrition? Maybe.

Safety regulations

Government safety regulators suffer similar dilemmas. If regulations make our products
safer, they might also induce us to take more risks with them. Safer power saws will help little if
they simply create more and less-cautious users.

There is evidence that drivers become more aggressive when protected by anti-lock
brakes, seat belts8 and air bags.9 Safety caps have not solved the problem of accidental aspirin-
related poisonings. Imaginative toddlers can defeat the protective mechanisms, and consumers,
lulled into a false sense of security, are more apt to leave medicines with safety caps where
children can reach them.10 Despite massive efforts, the Occupational Safety and Health
Administration has had little apparent impact on overall workplace safety.11 Offsetting worker
behavior could be a contributing factor.

Saving lives is an admirable ambition, but be careful. When we change the costs or
probability of harm, we also change people's behavior. Saving lives can be dangerous.
_________________________________________

Notes:

1. In my distant, pre-composite past youth, all tennis racquets were constructed of wood.
2. See Stiglitz, Joseph E., Principles of Microeconomics, 2nd edition, W.W. Norton, New
York, 1997, page 135.
3. Clark, J.R. and Lee, Dwight R., "Too Safe to be Safe: Some Implications of Short- and
Long-Run Rescue Laffer Curves," Eastern Economic Journal, volume 23, #2, Spring
1997, pp. 127-137.

129
4. Guide Jim Hale quoted in ibid. page 129.
5. "Injured climber saves life with cell phone," Indiana Gazette, May 21, 2001.
6. Ross, Winston, "The Price of Survival," Newsweek, web edition, February 20, 2007.
7. "Texas Cave Rescue," WJBF.Com web news, October 18, 2007
8. "A Hazardous comparison", Economist, March 1, 2008, pp 61-62.
9. Peterson, S., Hoffer, G. and Millner E., "Are Drivers of Air-Bag Equipped Cars More
Aggressive? A Test of the Offsetting Behavior Hypothesis," The Journal of Law and
Economics, October 1995, pp. 251-264.
10. Viscusi, W. Kip, "The Lulling Effect: The Impact of Child Resistant Packaging on
Aspirin and Analgesic Ingestions, American Economic Review, volume 74, #2, May
1984, pp. 324-327. In addition, because safety caps are so bothersome to adults,
especially those with arthritis, the medicines are more likely to be left open.
11. See Viscusi, W. Kip, Vernon, John M., and Harrington, Joseph E., Jr., Economics of
Regulation and Antitrust, 2nd edition, MIT Press, Cambridge, MA, 1995, pp. 816-824.

_________________________
Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the concept of moral hazard and discuss examples.

2. How do insurance companies try to combat the problem of moral hazard? Explain.
3. Explain the implications of moral hazard for the effectiveness of government regulations
designed to promote safety and health and give examples.

130
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Health Care

Why? Your insurance will cover it.

...dentist upon hearing that your author

would seek a second opinion regarding the need for
recommended oral surgery

Health care accounts for a large and growing proportion of all spending and production in
the United States. We currently spend close to 18 cents of every dollar on health-related items,
up from only five cents in 1960. Why such an increase?

First, we keep getting older. Life expectancy is up and the percent of Americans who are
75 years or older is increasing rapidly. That’s good news for those who need more birthday
candles than a typical cake can accommodate, but it comes at a cost. The older we get, the
poorer our health becomes. That means more aches and pains, more disease, more trips to the
doctor, more medications, and more days in the hospital. As the population ages, medical
expenses rise.

But the primary cause of higher medical costs is technological change. In fact, it's why
we keep getting older. In the not too distant past we spent almost nothing on cancer or heart
disease or kidney disease or even infections. We spent nothing because we had no treatments to
offer. Physicians could do little more than verify illness and wait for patients to die. CAT scans,
MRIs, kidney transplants, chemotherapy, hip replacements, heart bypasses – common procedures
in modern hospitals – were unknown in the past. In a world in which we could neither diagnose
nor treat most medical ailments, health care was cheap.

Mounting medical costs now have forced countries to confront a critical question: who
should pay? Should we treat medical care like potato chips and allow individual consumers and
producers make free choices about what and how much to buy and sell? Should we allow
market supply and demand to allocate medical resources?

131
 Health care systems differ significantly across countries, but all can loosely be
categorized as either government-run or privately-run. In every developed country except the
United States citizens view basic health care as a “right” of all citizens and provide universal
access to everyone either through a taxpayer-financed government-run system or mandated
private insurance with government subsidies. For example, Canadians visit government clinics
or government hospitals that are staffed by government-paid physicians, nurses, technicians and
pharmacists. The services provided are “free” to the patient. All costs are covered by
government (taxpayer) funds.

The U.S. has chosen a very different route. We rely more on free-market supply and
demand. Private health-care professionals and organizations offer services and compete for
patient business. Individual consumers visit the health-care providers of their choice and pay for
whatever services are provided. Some consumers pay out of their own pockets, but most have
medical insurance that covers major expenses. Medical insurance often is part of the package
paid by our employers.

Even though government does not provide medical care directly in the U.S. (with the
exceptions of medical care to military personnel and some veterans), it impacts the system
nonetheless. All health care professionals, hospitals and medical schools must meet government
licensing standards. All drugs must pass Federal Food and Drug Administration (FDA) testing
for safety and efficacy. Also, the federal government gives tax breaks for employer-provided
insurance, provides heavily subsidized health insurance for elderly citizens through Medicare
and covers many medical costs for eligible low-income families through Medicaid.

Although countries vary widely in the way medical care is provided, they share one
important characteristic: discontent. Citizens throughout the world express frustration with their
respective health care systems. Unfortunately, U.S. citizens are more frustrated than others.
Surveys repeatedly show that Americans are less satisfied with their health care system than are
those in other countries. We do lead the world in medical spending; no other country spends
nearly as large a percent of income on health. Regrettably, despite this disproportionate
spending, we lag behind in life expectancy and other measures of health outcomes. While some
still proclaim that our free enterprise health care system is the best in the world, the data clearly
show that it is not, and loud protestations will not make it so. The U.S. system falls far short of
attaining the economic goals of efficiency and fairness and is plagued by problems on the both
the demand and supply sides of the market.

Demand-side inefficiencies

First, many Americans demand inefficiently high levels of health care. Remember, most
of us have medical insurance that covers a large chunk of the costs. The net cost to consumers is
well below the true marginal cost of providing the care.

Check the graph below. For allocative efficiency, we should produce care as long as the
marginal benefit covers the marginal cost (Q0). However, suppose that our health insurance

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covers 80 percent of the expense. Because this lowers the net MC to the patient, the rational
consumer will want to purchase Q1 units of care – considerably more than the efficient level.

Stop and listen. Is your memory calling out moral hazard, moral hazard? It should
be. It’s exactly the issue we discussed with saving lives. The more we insure against the effects
of something, the more likely it is to occur.

Tax policy aggravates the problem. Most Americans receive health insurance as a
"fringe benefit" of their job. Providing this insurance is quite expensive and costs more than
$18,000 to cover an employee and his/her family.1 Of course, employers providing health
insurance cannot afford to pay as much in wages. In effect, employees are opting for "free"
insurance rather than higher paychecks. But why? It's because the value of this health insurance
benefit is not taxed. If an employer pays a worker $100 in straight wages or salary, the $100 is
subject to both Social Security and income taxes. Only part of that $100 will end up in the
worker's pocket after tax. But if the employer "pays" the worker by buying her $100 of medical
insurance, the entire value goes to the worker. The $100 escapes taxation. Without that tax break,
a worker in a 30% tax bracket who wants to buy medical insurance on her own would need $142
of pre-tax earnings to get the needed after-tax $100. In effect, the tax laws make health insurance
less expensive for the workers. And, like everything else, when the effective price goes down,
the quantity demanded goes up. We buy more and better insurance than we normally would.2

While insured Americans probably seek inefficiently large amounts of care, those without
insurance demand too little. Unable to afford visits to the doctor, uninsured patients face two
possible options. Some forego routine check-ups for preventative care and ignore medical
difficulties hoping that they will disappear in time. This strategy sometimes proves effective, but
too often the uninsured end up with major medical problems that could have been cured far less
expensively or prevented altogether had they seen a physician earlier. Other uninsured patients
do seek medical care for minor ailments but, because they cannot pay private physicians, they
flock to hospital emergency rooms that face various legal obligations to treat patients regardless
of ability to pay. Unfortunately, the earache that could have been treated for a few dollars in a
doctor's office sucks up thousands of dollars of expensive ER resources and creates bottlenecks
for those truly needing emergency assistance. In both cases the costs can be excessive -- so
excessive that providing them with insurance could sometimes be less expensive in the long run.

Supply-side inefficiencies

133
 More problems arise on the supply side of the market. Just as insured consumers tend to
demand inefficiently large quantities of care, health-care providers traditionally have eagerly
supplied inefficiently large quantities.

Imagine walking into a boutique and explaining to the sales clerk (working on
commission) that you have been a bit blue and are thinking about some new clothes. If you ask
the clerk whether or not new clothes will boost your spirits, what response should you expect? Is
the sales person likely to say “no” and send you on your way? Of course not. Next, imagine
explaining that you will buy whatever clothes the clerk recommends. Should you expect the
clerk to point you toward the clearance rack? Of course not. The clerk has a financial incentive
to sell you as large and as expensive a wardrobe as possible. The more you spend, the more
commission the clerk earns.

Historically, the patient-doctor relationship was quite

similar. Patients seldom decided what and how much care to buy; their
doctors made those decisions. Patients would ask their doctors what
they needed and then purchase whatever the doctor recommended. With
this traditional fee-for-services provided arrangement, just as with the
sales clerk on commission, the more tests and visits and procedures the
doctor would recommend, the more income the doctor would earn. The
incentive was to recommend or supply as much as possible without scant
attention to relative costs and benefits. Could health care providers be so
crass? Would they actually prescribe medical care that cost more than it
was worth just to pad their own wallets? Some would not, but many
would.

Such oversupply provided another benefit to physicians as well – protection against

malpractice suits. As long as they were provided with everything possible, unhappy patients had
few legal grounds on which to sue for malpractice. Besides, as many doctors might reason, the
extra expenses will be paid by insurance companies, not by the patients themselves. So, why
worry?

The predictable result is an unusually expensive system with huge amounts of

unnecessary care. But, in addition to inefficient quantities of care, Americans are beset by
inefficiently high prices. Indeed, Americans pay almost twice as much for medical care than do
residents in other developed countries and, what's worse, with no evidence that it has resulted in
better overall care. A 2012 report by the International Federation of Health Plans found that U.S.
prices for medical procedures and drugs were higher, often much higher, than those in other
countries for every category and country studied. For example, a one day hospital stay in the U.S.
cost an average of $4,287 compared to the $782 in Australia, $408 in Canada and $231 in Spain.
The total hospital and physician cost of heart bypass surgery averaged $73,420 in the U.S.
compared to $17,729 in Switzerland and $14,061 in the Netherlands. The average cost of Lipitor,
commonly prescribed for high cholesterol, was $124 in the U.S. compared to $43 in the United
Kingdom and $6 in New Zealand. We also find huge variations in prices across U.S. hospitals

134
for identical services. For example, 25% of U.S. facilities charged $525 or less for a diagnostic
MRI while 5% charged more than $2,800 for the same test.3

Why do Americans pay so much more? Limited competition is one reason. The big
bucks go to hospitals and, in most markets, consumers have very few hospitals to choose
among. In fact, often their doctors are affiliated with only a single hospital. Would Walmart
prices be so low if it did not have to lure shoppers away from Target and K-Mart? Of course
not. Would McDonald's offer a Dollar Menu if it was not competing with Burger King and
Wendy's? Of course not. Firms facing little or no competitive pressure are free to raise prices
well above the true cost of service. Monopoly power drives up prices in medical care, just as it
would it in retailing and restaurants.

But, wait. Aren't the numbers of available hospitals limited in other countries
also? Why don't those hospitals charge higher prices as well? Simple. Governments do not
allow it. In other countries governments regulate health-care prices and/or pressure the providers
to hold prices down. We do that in some markets in the United States. For example, the local
electric company and the local water company and the local natural gas company typically
cannot raise prices without approval from some government agency. Recognizing that there
often will be only a single electric or water or gas company in an area, governments routinely
regulate their prices to avoid monopoly exploitation. Although other countries regulate medical
prices as well, in the United States, we do not.

The lack of price transparency aggravates the problem. Even where competition might
be possible, consumers cannot easily shop for a better deal. Kroger's blasts it food prices
through multiple ads every week and the Exxon station down the street posts it prices on huge
signs easily visible to drivers. If those prices do not match the ones advertised by Publix and
Sunoco, they quickly will lose business. Amazon.com and similar sites enable us to compare
prices for socket wrenches, video games, pajamas and clarinets. Vendors offering good deals
prosper; others either must match their prices or fold their tents. Not so in medical care. Prices
for medical services are almost impossible to find. Clinics and offices in other countries
routinely post or advertise prices for common procedures but, in the United States, such prices
are treated like trade secrets. U.S. hospitals and other providers frequently cannot or will not
reveal their charges until after the services are provided. Even physicians often do not know
what their patients will be charged. In a world in which consumers find comparison shopping
almost impossible, health-care providers have little or no incentive to keep prices low.

Controlling costs

As expenses mounted over time, pressure to control costs mounted as well. Trying to
moderate cost increases in its Medicare program, the federal government acted first. It modified
the traditional fee-for-services provided system and began paying hospitals set amounts for
treating a specific ailment. For example, if the government decided that $18,000 should be
enough to cover the costs of an appendectomy, it would agree to pay $18,000 for the procedure,
regardless of what actual costs were incurred. This radically altered incentives for hospitals. If
the hospital was to receive a flat $18,000, it had no incentive to hold on to patients any longer
than absolutely necessary. If the $18,000 was enough to cover three days in the hospital,

135
administrators had no incentive to let a patient stay a fourth day. Longer hospital stays now
meant fewer profits rather than more profits for the institution. In fact, pushing such patients out
after two days would be even better. Hospitals would still get the same $18,000 revenue, and
would save the expense of caring for the patient the third day.

Private insurers followed by pushing patients into managed care programs that monitored
services more closely. They directed patients to "network" providers with whom they negotiated
discounted rates, forced patients to get second opinions for elective surgeries and limited access
to specialist services. To some extent the reforms were successful. The rate of cost increases did
slow in the 1990's and billions of dollars were saved. However, the fee-for-services provided
system continues to dominate U.S. health care and the quantity of services provided to well-
insured patients remains inefficiently high. However, the reforms were not without controversy.

Some of the savings were partially offset by a drop in quality. Patients often assert that
necessary care and access to specialists is withheld “to save money.” Numerous patients
complained that they were released from hospitals prematurely and were forced to hire private-
duty nurses and other professionals to care for them at home. Since these home-care
professionals often are not covered by insurance, cost savings for the insurers often meant higher
costs for the patients.

Is this drop in quality a bad thing? Not necessarily. Like other products, higher quality is
efficient only when its marginal benefit exceeds its marginal cost. In daily life we willingly
choose lower quality options when the dollar savings are large enough. We choose cheap
generic foods over higher quality brands to save money. We choose cheap used cars over new
luxury models to save money. We choose cheap coach seats over first-class seats on airlines to
save money. If the cost savings are large enough, people rationally will choose lower quality
medical care as well. Nonetheless, cost containment measures in health care have not been
free. Some health care quality has been lost.

New concerns about fairness subsequently came to the fore. First, people with serious
medical conditions found it increasingly difficult to get insurance. Insuring healthy people is far
more profitable than insuring sickly ones. As cost pressures mounted, insurers reacted by
denying coverage to anyone with "pre-existing conditions". For those with histories of cancer or
heart problems or diabetes, medical insurance was almost impossible to find or else prohibitively
expensive. Moreover, knowing that their insurance premiums will skyrocket, firms often are
unwilling to hire workers with poor medical histories. As one pundit has written, "the business
model of private insurance has become, in part, to collect premiums from healthy people and
reject those likely to get sick -- or, if they start out healthy and then get sick, to find a way to
cancel their coverage."4

Second, in the past, uninsured patients who were unable to pay for care often were treated
as charity cases. Hospitals covered the costs of this care by charging those with insurance a bit
more and state and local governments kicked in dollars as well. In essence, patients with good
insurance (and taxpayers) were indirectly subsidizing care for those who could not afford
it. However, as government programs and private insurance firms clamp down, hospitals
increasingly are unable to raise the extra dollars to cover the costs of charity care. It is not

136
unusual for sick, uninsured patients to find themselves being pushed from hospital to hospital --
like the proverbial hot potato – seeking needed care.

Attempts to manage care also have added to the bureaucratic red tape health-care
suppliers must endure. Providers must complete additional forms to convince government and
private insurers that all care supplied is medically necessary. And, since each insurer has its own
unique regulations for what is covered under what circumstances, the administrative paperwork
burden is enormous.

Less government or more?

Perhaps the most contentious element of competing reform proposals involves the role of
the federal government. Political liberals advocate moving more toward a system in which the
government takes a more active part in financing care and ensures that that every citizen is
covered. They argue that such systems are inherently fairer than our current one and also can
control costs more effectively. First, government power can effectively force pharmaceutical
firms and other private providers to lower prices. Indeed, patients in single-payer systems such
as Canada's typically pay far less than do Americans for identical drugs and medical
procedures. Second, dealing with a single government system as opposed to a complex
patchwork of private insurers can slash administrative costs by hundreds of billions of dollars
annually. For example, on a per-patient basis, the U.S. system employs 44% more
administrative staff than does the Canadian system and, in addition, U.S. physicians spend more
time on administrative issues than their Canadian counterparts.5 One estimate suggests that these
administrative savings alone are enough to finance the cost of covering all currently uninsured
patients in the country.6

Political conservatives recoil in horror at such a government "takeover" of the private

market system. They contend that only competition among suppliers and insurers can create the
quality of care Americans deserve. Just as competition compels auto companies continually to
strive to produce better vehicles at better prices, competition in medical care markets creates
better and more efficient health care. Where, they ask, will firms find the incentives to develop
better products and processes if government controls suck potential profits out of the
system? Conservatives also warn that government-run plans will ration health care -- that they
will deny important services to contain costs. 7

Both sides offer valid arguments. However, it is worth noting that surveys suggest that
Americans served by Medicare, a government-run single payer system for the elderly, typically
express more satisfaction with their health care than those with private insurance. Amusingly, at
the politically charged town hall debates about proposed health care reforms in 2009, a number
of senior citizens railed heatedly against government-run "socialized" medicine while, at the
same time, warning legislators to keep hands off of their (government-run, socialized)
Medicare. While far from perfect, many experts in the field conclude that Medicare seems to
deliver care more cost-effectively than do private insurance systems. By primarily relying on
private rather than government-funded medical care U.S. residents save some dollars by having
lower taxes, but often end up paying even more dollars by having to cover higher medical bills
out of their own pockets.

137
Affordable Care Act

An ideal system would provide high-quality care to all in a cost-effective manner.

However, those goals often conflict. Providing high-quality care to all increases costs, and
attempts to control costs inevitably results in high-quality care being withheld from at least some
patients. The controversial 2010 Patient Protection and Affordable Care Act, typically called the
Affordable Care Act (ACA) or Obamacare, attempts to blend these disparate goals.

First, to improve access to care, it moves the United States toward universal coverage by
requiring everyone (with some exceptions) to purchase medical insurance and by providing
government assistance to low-income families that might otherwise be unable to afford it. It also
stops private insurers from cancelling coverage for those who fall sick or denying coverage to
those with pre-existing conditions, and allows dependent children to be covered under their
parents' policies up to age 26. It also sets minimum standards for what insurance plans must
cover.

Second, it contains a variety of measures to contain costs. For example, private

individuals traditionally have been forced to pay much higher premiums for health insurance that
those covered by group policies from employers with the power to negotiate better rates. Under
the ACA, everyone can benefit from "group" rates by buying policies through state-run insurance
exchanges. It also creates a board of independent medical experts able to push providers into
using those medical strategies found to be most effective and funds a variety of innovative
experiments to find still better approaches.

Perhaps more importantly the ACA further shifts the U.S. away from the fee-for-services-
rendered system and attempts to reward quality rather than quantity of care. It moves us closer
to a system of "accountable care" in which providers are paid on the basis of health-care
outcomes (or outputs) rather than what services (or inputs) they delivered. As one example, 20%
of Medicare patients discharged from a hospital are readmitted within 30 days. Under the ACA
hospitals whose patients must be readmitted multiple times for the same problem will face
financial penalties. As a result, many hospitals now are implementing unorthodox policies to
limit such expensive readmits. Mt.Sinai Hospital in Boston has cut its readmission rate in half
by doing things such as dispatching teams of social workers to ensure that discharged patients
have the needed home assistance, take medicines as prescribed, and get to follow-up visits with
their physicians.8 The ACA has also encouraged the creation of Accountable Care
Organizations (ACO's) that can participate in Medicare's shared-savings program. If an ACO
can hold cost increases below prevailing rates while providing quality care, Medicare will share
its savings with the organization.

Some argued that bringing health insurance to more people would create more demand
for medical care and drive up costs, but the initial results have been promising. Despite a shaky
technological start, millions of additional Americans have signed up for health insurance through
the state exchanges and ACA costs, thus far, have been below the original estimates provided by
the non-partisan Congressional Budget Office. More importantly, overall health-care cost

138
increases have slowed dramatically. While several factors are at work, many experts agree that
the ACA push toward accountable care and payment reform has been a major cause.

Despite its successes, the ACA remains controversial, especially its mandate that almost
everyone must buy health insurance or be fined, and President Trump and the Republican-
controlled Congress have pledged to repeal the act and replace it with "something
better." Unfortunately, the "something better" remains undefined and Congress will find it
difficult to retain the popular provisions of the ACA without keeping the less popular ones as
well. For example, large majorities of Americans favor the ACA rule that forbids insurance
companies from denying coverage to people with pre-existing medical conditions, and politicians
have promised to keep that rule intact. However, firms lose money insuring patients with these
conditions and they cannot afford to do this unless they also insure healthy people that do not
submit claims. If there is no mandate that forces everyone to buy, many healthy people will opt
out of the system and the system will collapse.

What about the future?

The ACA and other reforms might help eliminate some of the waste and inefficiencies in
the system and bring down the level of costs, but the upward trend in medical costs is driven
primarily by technological change, not by waste. If technology continues to enable us to
diagnose what we previously could not diagnose and to treat what we previously could not treat,
the slowdown might be short-lived; cost increases might revert to their long run trend, albeit at a
lower level. Indeed, pessimists do believe that new technologies will again cause costs to
skyrocket in the future. As one medical researcher has proclaimed, the “capacity of medicine to
provide ever-advanced technology is endless. No matter how much you spend, you can always
spend more.” 9

But, others disagree. Optimists predict that payment reforms will alter the course of
technology. Because the fee-for services provided model rewarded those using more and
expensive technologies, firms had an incentive to develop more and expensive
technologies. Why worry about the costs when providers could easily charge prices high enough
to cover those costs? But, in an accountable care world with payments that reward efficient
outcomes, providers will be more reluctant to adopt costly technologies. As a result, firms might
respond by designing more cost-effective technologies. If so, optimists argue, future
technologies might lower the costs of care rather than increase it.
_________________________________________________
Notes:

1. http://kff.org/health-costs/report/2016-employer-health-benefits-survey/
2. The tax break only goes to those receiving insurance from their employers. Self-
employed workers and/or those working for firms that do not provide insurance are less
fortunate. They must buy their own insurance (without benefit of the tax break) or do
without.
3. See http://www.slideshare.net/brianahier/international-federation-of-health-plans-price-
report

139
4. Reinhardt, Uwe E., "Why Does U.S. Health Care Cost So Much? (Part II: Indefensible
Administrative Costs)", New York Times, November 21, 2008.
5. Cutler, David M. and Dan P. Ly, "The (Paper)work of Medicine: Understanding
International Medical Costs", Journal of Economic Perspectives, volume 25, number 2,
Spring 2011, pp. 3-27.
6. Reinhardt, op. cit.
7. Some argue out of both sides of their mouth. When proponents of the recent health
reform legislation boast of providing more care, critics blast it for running up extra costs.
When proponents praise the cost-cutting measures of the legislation, critics blast it for
cutting care.
8. Orszag, Peter, talk delivered at the annual meetings of the American Economic
Association, Philadelphia, January 5, 2014
9. Kristof, Nicholas D., "Health Care That Works", New York Times, September 3, 2009.
_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain why Americans are spending an increasingly large percent of income on health
care.
2. Describe the major ways in which the government impacts the U.S. health care system.
3. Explain why, for most Americans, the quantity of health care demanded is inefficiently
high and illustrate with an appropriate graph.
4. Explain why the quantity of health care historically supplied by most U.S. health-care
providers has been inefficiently high.
5. Explain why we started paying hospitals a fixed fee for treating Medicare patients with a
specific diagnosis and how that changed incentives.
6. Explain the disadvantages of managed care systems.
7. Discuss why Americans typically pay more than people in other developed countries for
identical medical procedures and pharmaceuticals.
8. Discuss the major provisions of the ACA and why its proponents feel it they will move us
closer to a system that provides high-quality care to all in a cost-effective manner.
9. Explain why we cannot expect insurance companies to offer coverage to people with pre-
existing conditions unless we also mandate that everyone must buy insurance.
10. Explain why the ACA might be more successful in cutting the level of medical costs than
cutting the upward trend in medical costs.

140
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Not Enough Hearts

And when your heart begins to bleed,

You’re dead, and dead, and dead, indeed.
…..Mother Goose

You gotta' have heart. A liver, lungs, and kidneys

help, too. Some of us are blessed with healthy organs
ready to carry us through a long and active life; some of
us are not. For most of human history, the consequence was straightforward: diseased organs
meant death.

That no longer is true. Modern medical maestros transplant thousands of organs

annually. Just as your auto mechanic can replace a damaged carburetor; your surgeon can
replace a damaged heart -- if one is available. Ah, there's the rub.

In June 1993, Pennsylvania's then-Governor Robert P. Casey announced that without a

double transplant, he would soon die from amyloidosis, a rare, and typically fatal, genetic
disease. Within days he was recuperating in the University of Pittsburgh Medical Center with a
new heart and new liver -- compliments of Michael Lucas, a 34 year-old man who had just died
from a gang beating in nearby Monesson, PA.1

Controversy erupted immediately. The average waiting time for hearts exceeded six
months. For livers, it was over two months. How did a governor beat the odds and get both in
two days? Was it favoritism for the rich and famous? No apparent improprieties occurred, but
eyebrows were raised from Fairbanks to Fort Lauderdale.

Shortages

To economists, the curious issue is not the Byzantine set of rules used to allocate scarce
organs; it is that there is a shortage of organs at all.

141
 The shortage is real. Over 115,000 Americans were waiting for assorted organs in
2013. Those waiting for kidneys survive on dialysis, a painful process even more expensive than
kidney transplants. Those waiting for other organs often die. In 2012, more than 6,000 died
while waiting; more than twice as many as died in the 9/11 attacks. And the gap between
quantities supplied and demanded is growing. Dramatic strides in medical technology continue
to make transplants safer and more successful. With insurance covering much of the bill, the
demand keeps growing. But supply does not. Despite educational programs and impassioned
pleas, organ donations simply have not kept pace.2 Recent studies estimate that almost 200,000
Americans will have died as a result of organ shortages by the year 2015.3

Prices eliminate shortages in most markets. Excess demands drive up prices. The higher
prices elicit increases in quantities supplied and dampen quantities demanded until shortages
disappear. Is there a shortage of minivans? No problem. Competition for the scarce vans will
raise their price. The higher price both discourages consumption and encourages extra
production. The process continues until the quantity supplied meets the quantity demanded and
the shortage disappears.

But the market price of organs cannot rise. The National Transplant Act of 1984
prohibits any compensation for those who supply organs. The price for organs, by law, is kept at
zero. A policy of free minivans would surely create a shortage of minivans. That a policy of
free hearts and kidneys might create similar shortages should be no surprise.

The impact on costs and quality is less obvious. Given the excess demand for organs,
access to them can be very profitable for hospitals and surgical transplant teams. In fact,
transplants are so profitable that hospitals all over the country have crowded into the market
seeking a piece of the action.4 However, the entry of new transplant centers has not been
accompanied by an increase in the number of donated organs available for transplant. The result
is fewer transplants per center. Transplant centers must invest in sophisticated and expensive
technology. When the fixed costs of these assets are spread over many transplants, the cost per
operation is low. But, when the number of transplants per center fall, the cost per transplant
rises.5 More important, the success of a transplant often hangs on the experience of the
transplant team. With fewer transplants per center, experience levels drop and success rates are
jeopardized.6

Here's the summary. Voluntary donations have not kept pace with the demand for
transplantable organs. Large and increasing shortages exist. We end up with fewer transplants,
poorer-quality transplants, more costly transplants, more dialysis, and more deaths. Not a pretty
picture.

Markets for organs

Can we fix it? Can we generate more organs for transplant? When we want more
minivans produced, we need only raise the price. Why not do the same for hearts and
kidneys? That's right. Sell them. Create a market in human organs. Despite legal obstacles and
international pressures, open trade in human kidneys flourishes in many poorer areas of the
world. Humans need only one healthy kidney to survive and in 2006 a living donor in Iran could

142
expect to sell a spare kidney for $3,000 to $4,000.7 Iran is the only country that explicitly allows
donors to be paid and, not surprisingly, is the only country without a waiting list.

Living donors are not possible for many organs, but payments to surviving relatives
might elicit additional donated organs. Or, for a lump sum, individuals could sell contracts to
brokers for permission to harvest any usable organs at their death. Individuals who change their
minds later in life could repurchase the contracts. Even modest prices might dramatically
increase the quantity of organs supplied.8

Are you ready for the graph? The graph below pictures supply and demand curves for
transplantable organs. The demand curve is likely to be relatively inelastic (can you explain
why?). The quantity supplied is more likely to be responsive to changes in price. At the market
equilibrium, organs would sell for a price of P0 and a total of Q0 organs would be bought and
sold. However, by restricting the market price to zero, the quantity supplied falls to Q1 , well
below the quantity demanded, and a shortage appears.

Is a market for organs abhorrent? Is it morally reprehensible? Some believe it to

be. Does it devalue life if we allow organs to be bought and sold? Maybe. But might it devalue
life even more to let patients die on a waiting list? Will not such markets prey on the desperately
poor who see selling their organs as their only escape from wretched deprivation? Maybe. Will
LeBron James and Bill Gates be first in line to trade their kidneys for $1,000? Don't hold your
breath. Low-income individuals are more likely to sell hearts and kidneys, just as they are more
likely to sell blood in current markets. But these are voluntary transactions. Assuming
individuals can make rational choices, they will sell organs only when convinced that such sales
are in their self-interest; when the benefits they will receive exceed any costs they must
bear. The shame, if any, is not in the transaction. The shame, if any, is in allowing citizens to
reach such desperate conditions in the first place.

What about costs? Will an open market drive up the cost of transplants and make
transplants less accessible to low-income patients. Probably not. Under the current system,
shortages make transplants inaccessible to the rich and poor alike. If markets increase the
quantities of organs supplied, the number of transplants going to both the rich and the poor can
increase. Even if the price rises, there is no necessary need to ration poor patients out of the
market. Since kidney transplants are cheaper than dialysis, society's savings could be redirected

143
into subsidies to low-income recipients. Moreover, economist David Kaserman, himself a
kidney-transplant recipient, estimated that the organ shortage could be eliminated with a price as
low as $1,000, a mere fraction of the overall cost of a transplant operation.9

On the other hand, free markets are not always efficient. Consumers sometimes make
irrational or uniformed choices. Might that occur in organ markets? And the decisions of some
might harm others. Might relatives "pull the plug" prematurely on Uncle Fred to get a crack at
potentially valuable organs?10 Philosopher Simon Rippon suggests that depriving even rational
people of an option sometimes can benefit them. For example, if legal markets were available,
kidneys might become viewed as any other economic asset. Perhaps
those in poverty be expected to sell their kidneys in order to pay their
rent; perhaps they be expected to sell their kidneys before being eligible
for government safety-net programs.11 No system is likely to be
perfect. Interestingly, the prohibition of payment for organs does not
apply to blood for which local blood banks routinely pay a fee. Such
payments have increased the quantities supplied enough to eliminate
domestic shortages and allowed the U.S. to export plasma to other
countries that provide no compensation to their donors.12

What do you think? Anyone want to bid on my heart?

__________________________________________________

Notes:

1. The transplant afforded Gov. Casey seven more years of life. He died in June 2000. His
son Robert Casey, Jr. currently serves as a U.S. Senator from Pennsylvania.
2. See Beard, T. Randolph; Kaserman, David L. and Saba, Richard P., "Limits to Altruism:
Organ Supply and Educational Expenditures," Contemporary Economic Policy, volume
22, number 4, October 2004, pp. 433-442. Up-to-date data can be found at
http://organdonor.gov/about/data.html.
3. Beard, T. Randolph, John D. Jackson and David Kaserman, "The Failure of U.S. Organ
Procurement Policy," Regulation, Winter 2008, pp. 22- 30.
4. See Barnett, A.H. and Kaserman, David L., "The 'Rush to Transplant' and Organ
Shortages," Economic Inquiry, volume 33, July 1995, pp. 506-515.
5. Ibid. pp. 507-508.
6. Ibid. pp. 508-509
7. "Your part or mine?" The Economist, November 18, 2006, pp. 60-62.
8. See Blair and Kaserman, op. cit., pp. 422-424.
9. Kaserman, David L. and Barnett, A. H., "The U.S. Organ Procurement System: A
Prescription for Reform," AEI Evaluative Studies, June 2002. Also, remember, shortages
have driven the cost of transplants up. It is plausible that a free market for organs could
lower transplant costs enough to offset the additional expense of having to purchase the
organ.
10. Although he later was aquitted, a California surgeon once was charged with speeding a
patient's death to harvest his organs. See "Doctor Cleared of Harming Man to Obtain

144
 Organs," NYTimes.com, December 19, 2008,
http://www.nytimes.com/2008/12/19/health/19doctor.html?_r=0
11. Rippon, Simon,"Imposing options on people in poverty: the harm of a live organ market",
Journal of Medical Ethics, 2014 (40), pp. 145-150.
12. Sablik, Tim, "Money for Marrow?" Region Focus, Federal Reserve Bank of Richmond,
2012(1), p. 9

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain why there is a shortage of human organs available to be transplanted and

illustrate with an appropriate graph.
2. How has the shortage of organs affected the cost and quality of transplants? Explain.
3. Discuss the pros and cons of allowing human organs to be bought and sold.

145
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Where There's Smoke, There's Controversy

Tobacco is a filthy weed,

that from the devil does proceed,
It drains your purse, it burns your clothes
and makes a chimney of your nose.
.....Benjamin Waterhouse

As a child I lived on the edge of town with a gas station at

the end of my street. Nestled between the station and the fields
beyond was a small wooded area strewn with large boulders. It
was a perfect hide-away. Hunkered down between the rocks and trees, we were invisible from
the road, invisible from the gas station, and invisible from our mothers. It was just the place for
young boys to curse and belch and play poker. And it was just the place for young boys to
smoke.

I would hang around the soft drink cooler playing pinball in the gas station with my older
brother and his friends1. When the employee left to attend an arriving vehicle2 we quickly would
drop our coins in the cigarette machine, pull the lever for a pack of filtered Winston’s, and head
for the woods. What a life.

Eventually, just before my first child was born, I did kick the habit. But in those early
days, cigarettes were a symbol of maturity. With a cigarette dangling from my lip, with smoke
rings wafting through the air, I was a real man. Just like Bogart. Just like Brando. I was grown
up. And I was worthy of any girl on the block. Tobacco was king.

No more. Tobacco has come under increasing fire from all sides. Heavily taxed and
barred from television advertising for years, the industry now faces strident opposition to print
ads as well. Child advocacy groups have raked Joe Camel over the coals and minority activists
have lobbied to oust cigarette billboards from inner city neighborhoods.

Smokers encounter overt hostility when they reach for a cigarette. Shut out of airlines
and quarantined to restaurant ghettos, they find NO SMOKING signs everywhere they
look. State governments are banning tobacco from all public buildings and huddled clusters of

146
smokers can be found shivering by back doors on any cold winter day. Even McDonald's has
turned a cold shoulder to its erstwhile smoking customers. Happy Meals for smokers are take-
out only.

Righteous indignation is the order of the day. According to a New York Times book
reviewer, "only slavery exceeds tobacco as a curse on American history." And an especially
virulent tobacco plaintiff has painted cigarette producers as "the most disgusting, sadistic,
degenerate group of people on the face of the earth."3 The Marlboro Man is on the run.

Legal challenges

Recent court cases may be the coup de grace. After years of legal victories, tobacco
companies hit the judicial ropes. Noting that taxpayers often end up footing the bill for tobacco-
related health costs, several states filed suits demanding reimbursement for all such
expenses. Other states quickly jumped on the gravy train and the legal free-for-all eventually
extracted some $200 billion in settlement payments from tobacco firms.4

In addition to the settlement payments, several legislators have pushed for a massive
increase in the federal excise tax on tobacco products. This tax has climbed rapidly in recent
years -- from $.08 per pack in 1982 to $1.01 per pack by 2011. As of August 2010, state excise
taxes tack on another $1.57 per pack on average and range from $4.35 in New York to $.17 in
Missouri. New initiatives could drive the total tax burden far higher.

Why this bandwagon for increased sin taxes? Changing political winds offer part of the
answer. Tobacco taxes always have been popular among non-smokers (is anyone
surprised?). When large percentages of American adults smoked, and when cigarettes were
hawked by Hollywood's finest, smokers held the upper hand. But as health concerns move more
and more voters into the non-smoking section, tobacco becomes an increasingly vulnerable
target.

Does it make sense? Anti-tobacco activists explain that smoking is dangerous, that high
taxes are needed to drive the price up and discourage consumption. Will it
work? Possibly. While veteran smokers may be unaffected, there is some evidence that
potential new smokers will be deterred.5

Why do we care? People make choices; and, when they perceive their benefits will
exceed their costs, they often choose dangerous activities. They choose to skydive, they choose
drive motorcycles, they choose to explore unmapped caves, and they choose to smoke. We do
not interfere in decisions to skydive and we do not try to discourage spelunking. What is
different about smoking?

External costs

An economist's first response is external costs. Unsuccessful skydivers or motorcyclists

or spelunkers harm only themselves.6 If the benefits of skydiving to participants exceed the

147
costs, and no one else is affected, skydiving is an efficient activity. There is no reason to
interfere.

However, smokers impose costs on others -- what economists term external

costs. Cigarette smoke can irritate others and many studies list second-hand smoke as a threat to
the health of innocent bystanders. More important, the medical costs of tobacco-related illnesses
often are heavily subsidized by government programs. Smokers are a drain on the public
coffers.

If smokers fail to consider the costs they impose on others, they will perceive smoking to
be less costly than it truly is. The result is too much smoking, an inefficiently high level of
smoking.7 To the extent that high taxes can reduce such inefficient smoking, society will be
better off. And the extra tax revenue can be justified as fair compensation for the extra costs
smokers impose on our medical care sector. The graph below illustrates the problem..

The market equilibrium equates the quantities supplied and demanded at price P0 and
quantity Q0. However, the allocatively efficient output that equates MB and MC to society is
Q1. Imposing taxes on cigarettes will raise the cost of production, shift the industry supply curve
to the left, and push the equilibrium output back towards the efficient Q1.

Are we sure?

The argument rests on the assumption of external costs. Are they real? Not everyone is
convinced. No one doubts that second-hand smoke can be an aromatic irritant to others, and
most scientific studies now find it responsible for a variety of health problems, especially in
children and those with respiratory illnesses.8 However, these damages are a function of where
people smoke rather than whether they smoke. Such impacts do not call for multibillion dollar
taxes. They can be handled more effectively by segregating smokers in well-ventilated areas.9

What about health costs to the smokers themselves? Surely, tobacco is implicated in a
variety of serious health problems, and these are treated partly with taxpayer dollars. But
tobacco is not alone. Poor dietary habits may be more hazardous, yet we hear few political cries
for chocolate cheesecake or Twinkie taxes. More important, the costs may be

148
illusory. Calculations used by state attorneys general to bolster their tobacco lawsuits omit a
critical factor. Smokers die sooner than non-smokers. Smokers do use more medical resources
per year, but they live fewer years. Smokers are less likely to run up costly nursing home bills,
and are less likely to collect on their government Social Security
pensions. Economist Kip Viscusi estimates that nursing home care and
pension savings more than offset the extra medical bills. Smokers do not
drain the public coffers; they actually add to them. According to Viscusi
taxpayers save more than 30 cents per pack.10

If second-hand smoke is not a serious health hazard and if

smokers are less expensive than non-smokers to taxpayers, where are the
external costs? If there are no external costs, why do we slap such heavy
taxes on tobacco products? Why are we imposing multibillion dollar
penalties on cigarette producers and consumers?

Got me.

____________________________________

Notes:

1. Older brothers have ruined many an innocent child.

2. Self-service gas stations had not yet been invented.
3. Quoted in The Economist, December 20, 1997, page 59.
4. The funds are being funneled to states on through a series of annual payments. The states
initially argued that the a large percent of the funds would be used to combat youth
smoking but, not surprisingly, that has not occurred. Most of the dollars have
disappeared into the states' general operating budgets with little or no effect on anti-
tobacco program funding. See Rhodes, Karl, "Up in Smoke," Region Focus, Federal
Reserve Bank of Richmond, Spring 2003, pp. 21-25.
5. Economist Kip Viscusi estimates that a 10 percent increase in price might cause a 12-14
percent drop in teenage consumption of cigarettes. See Viscusi, W. Kip, "Smoke and
Mirrors: Understanding the New Scheme for Cigarette Regulation," The Brookings
Review, Winter 1998, page 16.
6. Strictly speaking, this is untrue. The untimely death of a young skydiver will adversely
impact her friends and family. A more accurate statement would be that such activities
have relatively little impact on others.
7. As a hypothetical example, suppose a rational young man correctly estimates that he will
receive $20,000 of lifetime benefits from smoking at a personal cost of $18,000. In
addition, suppose that his decision to smoke will impose $3,000 of external costs on
others. To the young man, smoking is efficient. It will generate $2,000 of benefits over
and above costs. However, in this example at least, smoking is not efficient to society as
a whole. His net gain of $2,000 will be more than offset by the $3,000 cost he is
imposing on others.
8. O'Neil, John, "A Warning on Hazards of Secondhand Smoke," The New York Times, June
28, 2006.

149
9. Recent initiatives have stressed the possibility of "litter" externalities. One study
estimated that the cost of cleaning up discarded cigarette butts tops $10 million in San
Francisco alone. See McKinley, Jesse, "Cost of Cigarette Litter May Fall on San
Francisco's Smokers", New York Times, May 19, 2009.
10. See W. Kip Viscusi, "The New Cigarette Paternalism," Regulation, Winter 2002-2003,
pp. 62-63.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the rationale for taxing cigarettes and illustrate the effect with an appropriate
graph.
2. Explain why cigarette taxes are more politically popular than in the past.
3. Explain the economic argument against raising cigarette taxes further.

150
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Too Fat: The Economics of Eating

I have flabby thighs, but fortunately my stomach covers them.
.....Comedienne Joan Rivers

My pants are tight, too tight. Especially after eating dinner,

especially a large dinner. Especially one followed by a bowl of ice cream,
especially a large bowl. Especially one topped with chocolate sauce, with
potato chips for crunch.

Larger pants would help, but I prefer to ignore the problem. That surplus flesh surely is a
fleeting phenomenon that will vanish next month. So I tell myself. Is there self-deception
afoot? Of course. Purchasing larger pants would explode my preferred self-image. Larger pants
are a blatant admission of one's true girth. Purchasing that next size signals resignation. It
signals defeat. It lends a sense of finality to it all. Delusion is more fun.

Why did this happen? While some might plead genetic misfortune, I cannot. I checked
the family photo album. My ancestors bear no blame. I did it to myself. Why? It's
economics. It's costs and benefits, supply and demand.

Growing obesity

Obesity is growing, and not just around my personal belt. The percent of American
adults considered officially obese now tops 34 percent, compared to 15 percent in the late
1970's. More than 20 percent of U.S. men and 30 percent of U.S. women are actively trying to
shed pounds and "losing weight" perennially leads the parade of New Year's resolutions. Other
countries suffer similar trends, but the U.S. seems to lead in excess poundage. Americans now
rate obesity as the country's second most important health problem -- behind only
cancer. Obesity already accounts for 20 percent of all medical costs and continues to grow.1

Why? The biology is straightforward, a simple matter of calories consumed versus

calories burned. We who consume more calories than we burn end up with tight
pants. America's collective belly has bulged because we eat more and we exercise less. And that
is the result of basic economic principles.2

Calories Coming In

151
 Quick. What has happened to the price of food over time? That's right. Technology has
lowered the cost of production and increased the supply of food (see graph below). Technology
drives food prices down. With better equipment, better seed, better fertilizer, and better
techniques, farmers continue to produce more with less. Since World War II farm productivity
has soared at almost twice the rate in the rest of the U.S. economy. Even though we eat out more
often, the relative cost of food continues to fall. Americans now spend less than 10 percent of
disposable income on food, down from almost 25 percent in 1929. In short, food is cheap and
getting cheaper. The lower price means more quantity demanded. American caloric
consumption has risen between 10 and 15 percent over the last 30 years.3

Interestingly, calories consumed at meals have shown no

significant trend in recent decades. We do seem to be packing away
more calories at breakfast and lunch, but these have been offset by a
drop in the number of calories gobbled during dinners. Restaurant
portions may have inflated, but our swollen bellies cannot be blamed
on swollen dinner offerings. In other words, the problem is not what
we consume during meals; the increased calories come almost entirely
from a single source: snacks.

This makes good economic sense. The improved technologies

for growing food have been dwarfed by improved technologies for preparing foods. Innovations
in mass production, cooking, packaging and food preservation have rapidly lowered the prices of
prepared foods relative to the price of raw foods, and flavor-enhancing chemicals have increased
their sensory appeal.

Two major changes result. First, we snack more often. Prepared foods and microwave
ovens have slashed the time and energy needed to snack. Popcorn that once required long and
vigorous shaking, singed fingers and an ugly clean-up, now can be cheaply and cleanly
microwaved in three minutes. No mess, no fuss. Cookies that once took hours to bake now can
be purchased for a few pennies. No mess, no fuss. Second, we snack differently. We substitute
the relatively cheap prepared snacks for raw fruits and vegetables. Instead of an apple from the
fridge, we grab packs of potato chips and crunchy cheese doodles from the vending machine.

152
 How about another example? Consider the ubiquitous French fry. Despite our pleas, my
mother refused to serve them when I was young. They simply were too difficult and too time
consuming to prepare. Peel the potatoes. Slice the potatoes. Heat the oil. Cook the
potatoes. Clean up the mess. To my mother, preparing French fries was about as much fun as
scrubbing and disinfecting our bathrooms (and was far less essential). No longer. Mass
produced fries are flash frozen and shipped quickly to stores hundreds of miles away. From
there they are purchased and microzapped in mere minutes. No mess, no fuss. Once a rare
extravagance, French fries now are America’s most-consumed vegetable.

Soft drinks share the blame. A relative luxury in the days of my long-ago youth, today's
teenagers come attached to 32 ounce cups of soda purchased for $ .89 at the corner convenience
store. The average American now consumes almost 200 calories a day from soft drinks
compared to 70 calories a day 25 years ago. According to the Center for disease control, this
accounts for almost one-half of the overall increase in average daily caloric intake over that
period.4

Government policies bear part of the blame as well. Heavy federal subsidies to grain,
dairy, and meat products have lowered the price of these foods relative to unsubsidized (and
healthier) fruits and vegetables. Because U.S. subsidies to corn growers lowers the cost of corn
syrup (a major ingredient in soft drinks and many processed snacks), at least one researcher
claims they have accentuated the unhealthy shift in American eating habits.5

Hmm. Where do Americans consume all of these extra snacks; those French fries and
soft drinks? At home? Yes. At the corner convenience stores? Yes. At fast food
restaurants? Double yes. One recent study found that the presence of a fast food restaurant
within one tenth of a mile from their school was associated with a 5.2% increase in obesity of 9th
grade students. It makes good economic sense. If we lower the cost of getting to a fast food
restaurant (and it's less-than-healthy fare), we increase the quantity of less-than-healthy after-
school snacks consumed.6

Calories Going Out

Increased eating could be offset by increased exercise. Even a

bag of crunchy cheese doodles could be counterbalanced by
appropriate penance on a treadmill. But don't bet the ranch on it
happening. Food may be cheaper, but exercise is more
expensive. Our great-grandparents had no need of treadmills or lap
pools or rowing machines. Work was work and everyday activities
afforded ample exertion to keep their tummies tucked. Exercise was
not something one consumed at the health spa after work; it was part of work. Sweat was not a
recreational expense; it was how people earned a living. Would you be surprised to learn that
when prices rise, quantities demanded fall? Is it any wonder that we exercise less?

Current students think work is sitting in a computer lab doing a web-search for a research
paper. At the same age their grandfathers were swinging a pickaxe at a coal seam 500 yards
underground. The caloric expenditures differ. New technologies even impact play. Years ago,

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our parents flocked to the playgrounds and ball fields for recreation; our own offspring sit
mesmerized by Nintendo games.

Rolling down hills and splashing through creeks chasing tadpoles can be fun, but are
more likely to be chosen when no affordable alternatives are available. In the distant past, that
often was the case. Now, television, video games, and the Internet create seductive options. The
opportunity costs of outdoor adventures rise when we must sacrifice an hour with Big Bird or
SpongeBob SquarePants to enjoy them. A friend recently chided his nine-year-old son for
playing computer games instead of exercising outside. The son, holding his game controller
aloft, replied with a smile, "Don't worry Dad, my thumb's in great shape."

European waistlines are less expansive than ours. A colleague in another department
chalks this up as additional evidence of Europe's cultural superiority. I chalk it up to
economics. Europeans do walk more than Americans. Given their greater population density
and higher gas prices, this makes good economic sense. And Europe seems less infested with
couch potatoes. But, this too has economic roots. Sofa spuds specialize in television
viewing. While the costs of such leisure activity are low both here and abroad, the benefits differ
widely. Have you ever surfed channels in Europe? There's nothing to surf. With competition
and content long-stifled by government bureaucrats, European broadcasts are no match for either
the quality or quantity of U.S. offerings.

In other words, America's battle with the bulge does not stem from some recent
depravity. Our collective weight gain does not signal some senseless lack of self-
control. Rather, it is a rational economic response to the changing prices of foods and
exercise. Stick that on your plate and eat it.

Interestingly, medical researchers find similar results -- obesity is a natural biological

response to abundant food. The Economist recently reported on a series of experiments led by
Luciano Rossetti from the Albert Einstein College of Medicine.7 Working with rats, Rossetti
found that appetite patterns adjusted quickly to environmental changes. Rats allowed to feast
freely for three days actually pursued additional eats more aggressively than those on restricted
diet.

Rossetti's explanation comes from evolutionary biology -- and economics. When food is
abundant, animals are programmed to eat as much as possible and to store excess fat for potential
famines to come. The bodies of those rat coming off a three-day caloric coma were apparently
screaming, "food is abundant, forage and eat while you can." However, poorly fed rats hear very
different biological signals. Expecting little food, they turn off their appetites. Why expend
scarce energy to forage if no food is to be found? In other words, when "nutrients are available,
a sensible animal will hoard them. If they are not, it will get on with other things."

The same economic forces that create collective corpulence determine how we fight it as
well. Have you ever tried to slim down? Go ahead; raise your hand. Mine is already in the
air. Now, think about battle plans. Did you rely primarily on diet or on exercise? If you said
"diet," join the crowd. That's the dominant approach. Why? Could it be because exercise costs
us scarce time and dollars while dieting saves them? Could it be more economics?

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Hope on the horizon?

Are we doomed? Will our bellies balloon indefinitely? Not necessarily. Philipson and
Posner claim that as incomes continue to rise, demands for healthier foods and exercise rise as
well. Obesity is not concentrated at the top of the income distribution. Indeed, it is less prevalent
among the well to do. Health foods and health clubs require fat wallets. Wealthy CEO's can
afford personal trainers and spinach salads at the local spa; Joe Six-Pack cannot. Joe settles for
bowling, burgers, and beer. More wealth could mean more health.

Better education can help battle bloat, but U.S. schools have less than impressive track
records.8 We continue to push activity courses out of the curriculum in favor of more academic,
and more sedentary, substitutes. More importantly, colleges and universities lure students to
campus with increasingly well-stocked, all-you-can-eat cafeterias. In effect, we drive up the
price of exercise and drive down the price of food. I recently asked a group of economics
majors, "what do you get when you are offered unlimited food at no extra cost?" Their
response? "Stuffed."

Perhaps colleges will someday begin to subsidize exercise instead of overeating.9 Perhaps
someday increased wealth will save the day. Perhaps someday the Chicago Cubs will win the
World Series. Should I hold my breath? Until then…..burp.
_______________________________
Notes:
1. See http://news.cornell.edu/stories/2012/04/obesity-accounts-21-percent-medical-care-
costs.
2. See The Long-Run Growth in Obesity as a Function of Technological Change by Tomas
Philipson and Richard Posner, Working Paper W7423, National Bureau of Economic
Research. Much of the following discussion is based on this work.
3. “Why Have Americans Become more Obese?” by David M. Cutler, Edward L. Glaeser
and Jesse M. Shapiro (Journal of Economic Perspectives, Summer 2003, pp. 93-118)
contains detailed data on caloric consumption patterns.
4. Leonhardt, David, "Sodas a Tempting Target", Economic Scene, New York Times, May
20, 2009.
5. See Gerena, Charles, "The Fattening of America," Region Focus, Federal Reserve Bank
of Richmond, Fall 2004, page 23.
6. Currie, Janet, Stefano Della Vigna, Enrico Moretti and Vikram Pathania, "The Effect of
Fast Food Restaurants on Obesity and Weight Gain," American Economic Journal:
Economic Policy, August 2010.
7. Economist, July 31, 1999.
8. Currie, et al, op.cit. report that while the presence of nearby fast food restaurants does
increase obesity among pregnant women, the effect disappears for women with a college
degree.
9. The recent trend to "trayless" cafeterias might be a start. Without trays students cannot
carry as much food to their tables. And, when they carry less food to their tables, they eat
less. See Foderaro, Lisa W., "Without Cafeteria Trays, Colleges Find Savings", New
York Times, April 29, 2009.

155
_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the economic logic of why we eat more food, especially more prepared foods,
than we did in the past; give examples.
2. Explain the economic logic of why we burn fewer calories than in the past; give
examples.
3. Explain why we tend to rely on diet rather than exercise to lose weight.
4. According to Philipson and Posner, what impact will increased economic growth have on
obesity? Why?
5. Explain how college meal plans impact obesity.

156
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Section II-C: Crime

Evils draw men together.

....Aristotle

Crime is bane of society. Few slogans can match "law and order" for political aphrodisia,
yet who among us has never broken a law? Have you ever littered? Coasted through a stop
sign? Jaywalked? Are we not all criminals, differing only in degree?

Why do we break the law? Why do some of us transgress more than others? How
serious do we want to be about cutting crime? What policies might be most
effective? Economists have no easy answers, but we do have food for thought.

Let's take a look.

II-C. Crime and dishonesty

1. Crime and punishment
Costs and Benefits
How Tough is Too Tough?
Safety in Numbers
2. Cheating and lying
The Economics of Cheating
3. Breaking the law
Does Speed Kill?
Supply-Side Drug Policy: Will it Ever Work?
Discrimination: It isn't Easy Being Green

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Crime: Costs and Benefits

Who knows what evil lurks in the minds of men?
...the Shadow

Presidents commit crimes; priests and pastors commit

crimes. Why should you be any different? Why should I? I
commit uncountable crimes; jaywalking is a particular favorite.

Economists treat crime as a rational act. Certainly some crime does result from
unthinking, irrational behavior driven by blind rage or passion, but I make choices about
jaywalking, and I am not alone. Perceived costs and benefits can trigger criminal acts just as
they trigger decisions to buy vanilla rather than rocky road ice cream.

The benefits of committing a crime include a variety of monetary and psychic pleasures,
but there are costs as well. Even in a world without laws, criminals incur opportunity costs for
the time and energy devoted to their activity. The rational criminal will choose to pursue crime
as long as its marginal benefit (MB) covers its marginal cost (MC); that's Q0 in the graph below.

Of course, the most important costs are external. The victims of crime pay a heavy
price as does society at large. Crime burdens us all with the cost of police, prisons, courts,
security devices and, perhaps worst of all, with fear. Because criminals largely ignore these
costs to others, they produce inefficiently high amounts of crime. Should I steal $100 from
you? If the MB of theft to me is $100 and I estimate my MC as $80; I'll steal. The theft creates
$20 of net value for me. My $20 gain is more than offset by your $100 loss, however that does
not necessarily enter my calculations. The thievery is not socially efficient, but my private gains
outweigh my private costs.

158
Using the model

What should we do? The obvious choice is to shift the perceived costs and benefits of
crime. That is precisely what the criminal justice system is designed to do. By imposing
penalties we raise the MC of crime to its suppliers and decrease the equilibrium quantity.

More interestingly, if this economic view is correct, then differences in crime across time
or across individuals should be directly attributable to differences in the costs and benefits of
crime. After a steady rise during the 1950's, 60's, 70's and 80's criminal activity fell significantly
in the 1990's. This drop occurred in almost every category of crime in every part of the
nation. According to economist Steven Levitt, shifts in costs and benefits tell much of the
story.1

Levitt argued that the strong economy of the 1990's explains a small but significant part
of the decline. Gainful employment can be considered a substitute for crime. If we flood the
market with Pepsi, we lower the demand for Coke. Similarly, if we flood the market with jobs,
we lower the demand for crime. As the economy grew and the job opportunities multiplied,
potential criminals shifted from illegal to legal means of support.

Levitt also suggested that crime rates fell because we

stuffed huge numbers of Americans into jails. The incarcerations
impact crime both by removing potential criminals from the streets
and by acting as a potential deterrent to others. By 2011 the U.S.
led the world in terms of the percent of its population behind
bars. We imprisoned 716 per 100,000 residents; a rate more than
five times higher than the median rate across the world. As a
comparison, the rate in Canada was 114 prisoners per 100,000 and
rates in Western Europe ranged from 60 (Finland) to 149 (Spain).2

Levitt identified a third and far more controversial factor

for decreased crime rates: legalized abortion. Citing evidence that unwanted children are more
likely to commit crimes, he argues that legalized abortion has cut the number of unwanted
children. The historical timing is what we should expect. Roe vs. Wade, the landmark case that
led to increased abortion, was settled in 1973. If abortion cuts crime, the effect should begin to
appear about 18 years later; this is exactly what happened. Moreover, differences in abortion
rates across states correlate with differences in crime rates in subsequent years.3 Levitt does not
tout abortion as a particularly efficient weapon against crime; he clearly prefers additional police
officers for that. He merely notes that increased abortion accounts for a significant chunk of the
slowdown in criminal activity.

While all of these potentially matter, subsequent research finds that other factors must
also be at play. For example, if job opportunities matter most, crime rates should have reversed
when the unemployment rate soared after 2007. But they did not; they continued to
fall. Increased incarceration might have mattered in the U.S., but it cannot explain why crime
rates also fell in almost every developed nation, including countries such as Canada and the

159
Netherlands where prison populations were falling. And, similarly, changes in U.S. abortion
laws cannot account for crime drops elsewhere in the world.

Changes in MC of crime seem to have been more critical. First, there were significant
increases in the number of police officers on the streets. While this was expensive, the benefits
seem to have exceeded the costs by a wide margin. Levitt's research fingers increased police
presence as being the more cost effective approach. He estimates that dollars spent on police
protection create five times more bang for the buck than dollars spent on imprisonment.4
Second, not only has police presence increased, law enforcement tactics also have become more
efficient. Computerization now allows police to identify "hot spots" where their presence is
likely to have larger impacts and technologies such as DNA testing and cell phone tracing have
enabled them to build evidence more effectively.

Private anti-crime efforts also have increased dramatically. Gated communities, home
security systems and private security guards have burgeoned, and robbers that typically used
stolen cars for their getaways now are thwarted by car alarms and circuits immune to hot-
wiring.5 Pillaging and plundering simply is more difficult and costly than in the past.
_________________________________
Notes:

1. For an overview of his work, see Levitt, Steven D., "Understanding Why Crime Fell in
the 1990's," Journal of Economic Perspectives, Winter 2004, volume 18, number 1, pp.
163-190.
2. Data are collected by the International Centre for Prison Studies. See
http://www.prisonstudies.org/info/worldbrief/wpb_stats.php?area=all&category=wb_pop
rate.
3. Levitt, op. cit., pp. 181-183. Not all researchers agree. For an opposing view see Joyce,
Ted, "A Simple Test of Abortion and Crime", Review of Economics and Statistics,
volume 91, number 1, February 2009, pp. 112-124.
4. Ibid., p. 179.
5. "Where have all the burglars gone?", The Economist, July 20, 2013, pp. 21-23.
_________________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Describe the benefits and costs of crime; explain why in a world without laws individuals
will create more crime than is socially efficient.
2. Explain why Levitt thought that strong economic growth, incarceration and abortion were
factors in why U.S. crime rates fell in the 1990's. Also explain why these cannot be the
entire explanation.
3. Explain how the MC of crime has changed in recent decades and why this probably has
been the most critical factor in declining rates of criminal activity.

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

How Tough is too Tough?

Off with their heads!

.....Queen of Hearts in Lewis Carroll's Alice in Wonderland

Wayne, a faculty acquaintance in another department,

complains that our university is too soft on crime1. Students
lie. Students cheat. Students steal. Students violate all sorts of
university rules and local statutes.2 According to Wayne, the
proximate cause is wimpy governance: too many touchy-feely faculty members and
administrators who are too lenient and impose sanctions which are too mild.

His solution is to get tough. Residence hall theft? Automatic expulsion. Underage
drinking? Automatic expulsion. Cheating or plagiarism? Automatic expulsion. According to
Wayne, it's simple cause and effect. If penalties go up, crimes will come down. I am not so
sure.

Optimal Crime

First of all, I'm not sure campus crime should drop. Heresy? No. To an economist,
crime prevention is like any other activity. It creates undeniable benefits, but also creates
costs. Think of hot dogs (yum!). Few foods can match the splendor of freshly grilled hot
dogs. They are a true culinary delight. But even fanatic frankfurter fans like me have limits. Do
I want lots of hot dogs? Yes. Do I want all that I can possibly produce? No. Am I willing to
trade in my wife, my home, or my car for one more bite? No. I only want hot dogs as long as
the benefit they bring covers the cost they impose, no matter how much ketchup might be
slathered over them.

Hot dogs are not free, neither is crime prevention. Do I want all the crime prevention I
can possibly produce? No. Am I willing to trade my wife, my home, or my car for one more
piece of crime prevention? No. Like hot dogs, crime prevention should not be produced unless
its benefit covers its cost.

Even if harsher penalties reduce crime, they are not always desirable. How far should we
go? Should we advocate public flogging for jaywalkers? Should we execute those who
litter? At what point does the cost exceed the benefit? At what point do we reduce too much

161
crime? I do not know the answer. But just we can have too many hot dogs, we can have too
much crime prevention.

Probability of conviction

Emulating Wayne's sentiments, many U.S. states have moved to increase criminal
penalties in recent decades. Many have enacted "three-strike" laws that impose mandatory life
sentences on those convicted of three felonies. Others have enacted "truth-in-sentencing" laws
that restrict the ability of law enforcement officials to release criminals on early parole.

These harsher penalties might help satisfy society's urge for revenge or retribution, but
they may not reduce crime. Potential criminals certainly consider possible penalties, but they
also consider the probability of being caught and convicted. Imagine zooming along a highway
at 10 miles-per-hour above the speed limit. Which is more likely to slow you down: a sign
promising harsh penalties for speeders, or the sight of a police cruiser in your rearview
mirror? Me, too. Penalties matter, but likely apprehension matters more. Even capital
punishment is no deterrent if the chance of being caught and convicted is zero. When pushing
for stiff sanctions, people like Wayne ignore a critical drawback: stiffer sanctions lower the
chance of conviction.

Why? First, stiffer sanctions change the behavior of police officers. At the college level,
professors prefer to be seen as mentors rather than as disciplinarians. Rightly or wrongly, many
are reluctant to get students "into trouble." A professor who might happily administer a light
slap-on-the-wrist to a suspected plagiarist could recoil at the thought booting the student out the
door. If reporting the incident means certain expulsion, many incidents will go
unreported. Professional police officers face similar dilemmas. When the only other option is
punitive punishment, officers might choose to handle more offenses "off-the-record."

Second, stiffer sanctions change the behavior of criminals. When potential penalties rise,
potential criminals become more vigilant. Among college students, underage drinkers will avoid
public venues and/or pay for more sophisticated forged ID cards. Plagiarists will be more
creative and more carefully cover their tracks. Vandals will choose later hours and, perhaps, use
disguise. Costly precautions that will be ignored in a slap-your-wrist regime become efficient
strategies in an automatic expulsion regime. And, if they are apprehended, criminals will fight
harder to defend themselves. Faced with a potential letter of warning, few criminals mount
expensive and intricate legal game plans. But when sanctions stiffen, so does the
defense. Students faced with expulsion routinely enlist private attorneys to do battle with
university judicial boards. Criminal defendants facing a potential death sentence expend all
available resources.

Third, stiffer sanctions change the behavior of

jurors. Reasonable doubt is a slippery concept. As jurors, our
demand for evidence will vary with potential penalties. Give
me a traffic case with a maximum $25 fine and I can be tough
as nails. Convicting an innocent defendant is relatively

162
costless. I can live with a possible mistake. But give me a murder trial with pending capital
punishment, and I will back off. If I ever want another night of restful sleep, I will demand
incontrovertible proof before penning "guilty" on a ballot.

Finally, stiffer sanctions change the behavior of prosecutors. Prosecutors have

considerable discretion with respect to what charges are pursued in court. In states with three-
strike laws in effect, prosecutors might be less inclined to bring felony charges to trial; perhaps
because they worry about the chance of conviction and perhaps because they feel the potential
penalty is too severe. At any rate, prosecutors in such states are twice as likely to lower a felony
charge to a misdemeanor.3

In short, getting tough might backfire. Harsher penalties are less likely to be
imposed. We wimp out. Fewer criminals are charged, fewer are apprehended, fewer are
convicted.4 Potential scoundrels might shrink at the sight of stiffer sanctions, yet salivate at the
lower probability of conviction. If the first effect dominates, Wayne's get tough policy will
work. If the second effect dominates, stiff penalties are counterproductive; crime will increase. If
the second effect dominates, more lenient penalties make sense.

Unintended Consequences

Harsher sentences might backfire in other ways as well. For example, what happens to
prisoners when they are released? A 28-year-old who has spent the last ten years in jail will find
very few opportunities for gainful employment but, after years of living among other convicts,
will be well-versed in criminal activities that offer alternative paths of financial support.5 It
should not be surprising that many end up back behind bars. Recognizing that arresting students
for minor infractions limits future student opportunities for jobs, the military or even financial
aid for higher education, a number of school districts have backed away from "zero tolerance"
policies. Instead of throwing first offenders in jail, thereby increasing the chance of more crime
in the future, they have begun offering counseling and other rehabilitative programs.6

Perhaps more importantly, "getting tough" can change the types of crimes
committed. Suppose the penalty for stealing $5 million is the same as for stealing $5. Would
you be surprised if people were more interested in stealing $5 million than $5? Suppose the
penalty for violent crime was no more severe than that for less violent crime. Would you be
surprised if some criminal opted for violent activities? Three Strike Laws can have the same
effect. Since a third felony conviction will trigger mandatory sentence
regardless of the nature of the crime, those who already have "two strikes"
often shift to more violent crimes.7

Similar patterns occur elsewhere. For example, after the U.S.

raised the legal drinking age to 21 in 1984, the amount of binge drinking
by teenagers increased. Without easy, legal access to a constant flow of
liquor, teenagers apparently have decided to "make the most" of the
opportunities that do come along. Buying a six-pack and quietly downing
one beer at a time is risky: too much incriminating evidence is sitting in
the refrigerator. Instead they too often opt for drinking the entire six-pack

163
at once. Many college presidents, once advocates for increased liquor controls, now advocate
cutting the legal drinking age as a way to decrease binge drinking.8

Patterns of illegal immigration also are affected by tougher controls. When sneaking
across the border was relatively easy, Mexican males routinely would migrate to the U.S. each
spring to harvest crops and return home when the season ended. But, when increased
surveillance and fences drove up the cost of border crossings, illegal immigrants changed their
patterns in response. Rather than crossing and re-crossing every season, it made more sense to
cross once and then stay. And, since the immigrants were more likely to stay, it made more sense
to bring their families with them.9

Which approach is better? Should we rally behind the cry of law and order? Or should
we preach compassion and forgiveness? According to economist James Andreoni, the answer is
neither. Examining eleven different categories of criminal activity, Andreoni could find no
significant impact in either direction. Stiffer penalties had no net deterrence effect. But neither
did they increase criminal activity.10 Andreoni's message seems simple. Let well enough alone.

________________________________________

Notes:

1. The names have been changed to protect the innocent; or are they the guilty?
2. Faculty and staff, even Wayne, also break the law. However, Wayne seems less
concerned about his own transgressions.
3. Bjerk, David, "Making the Crime Fit the Penalty: The Role of Prosecutorial Discretion
under Minimum Mandatory Sentencing," Journal of Law and Economics, volume 48,
number 2, October 2005, pp. 591-626.
4. See Andreoni, James, "Criminal Deterrence in the Reduced form: A New Perspective on
Ehrlich's Seminal Study," Economic Inquiry, volume 33, number 3, July 1995, pp. 476-
483. Andreoni finds that an increase in the average length of prison sentences causes a
significant decrease in the probability that an individual defendant will be convicted.
5. Bayer, Patrick , Randi Hjalmarsson and David Pozen, "Building Criminal Capital Behind
Bars: Peer Effects in Juvenile Corrections", Quarterly Journal of Economics, volume
124, number 1, February 2009, pp. 105-147.
6. Alvarez, Lizette, "Seeing the Toll, Schools Revise Zero tolerance", New York Times,
December 2, 2013
7. Iyengar, Radha, "I'd rather be Hanged for a Sheep than a Lamb: The Unintended
Consequences of 'Three-Strikes' Laws", NBER Working Paper No. 13784, February
2008.
8. See Amethyst Initiative at http://www.theamethystinitiative.org/
9. "Good Neighbors Make Fence", Economist, October 4, 2008, pp. 25-27.
10. Andreoni, op. cit. The estimated impacts were positive in six categories and negative in
five. However, none of the impacts were statistically significant.

_______________________________

164
 Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Do we want as much crime prevention as possible? Explain why or why not.

2. Other than by imposing stiffer penalties, how might we effectively deter crime?
3. Identify and explain four different ways in which stiffer penalties might impact the
probability of conviction.
4. Explain why "getting tough" on crime might cause a shift to more dangerous crimes and
give examples.

165
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Safety in Numbers

You will be safest in the middle.

.....Ovid

I speed. I routinely set my cruise control at three miles per hour

(mph) above the posted speed limits, and routinely am ignored by the
police. At only three mph above the limit, I am among the slowest
drivers on the road. Why would a police officer bother with me when
others are traveling even faster? How many cars can an officer
stop? There is safety in numbers.

Speeding is not the sole example. As a pedestrian, I am reluctant to cross against a light
except when in New York City. In Manhattan, no one pays attention to DO NOT WALK
signs. Neither do I. They cannot arrest us all. There is safety in numbers.

Consider the looting that often occurs in the aftermath of riots or earthquakes. Store
windows have been smashed, alarm systems are down, doors are knocked in. Even with
television news cameras rolling, looters swarm through the aisles grabbing as much as they can
carry. Why? When interviewed most looters appear to be average law-abiding citizens with no
particular economic need nor grudge. Yet when the looting began, they joined the fray. After
all, the police could not arrest them all. There is safety in numbers.

Costs and benefits

Of course, it is all economics. Choices are not made in a vacuum. We compare expected
costs and benefits. Should I eat another hot dog? Only if the additional benefits exceed the
additional costs. Should I stuff one more scoop of ice cream into the bowl? Only if the
additional benefits exceed the additional costs.

The same process is at work in decisions about such scofflaw behavior as speeding,
jaywalking and looting. The benefits of these activities are easy to identify: saving time, saving
time, and a free flat-screen television set respectively. The costs depend upon potential legal
penalties and, more importantly, on the probability of being caught. Even a draconian penalty
such as hot dog deprivation is no deterrent if the chance of being caught is zero.

166
 The above examples share a common thread. In each case the number of criminal actions
swamp what law enforcement agents can reasonably bring to trial. The sheer volume of crime
congests the system and lowers the likelihood of being caught. This cuts the expected costs of
crime and encourages even more criminal activity. In other words, once congestion occurs and
apprehension rates drop, crime begets crime. There is safety in numbers.

Are you still with me? Will you acknowledge that such nefarious behaviors as speeding
and jaywalking can fit an economist's model of rational choice? Will you concede that even
criminals might accede to calculations of costs and benefits? If so, will you take one more
step? Will you apply the same concepts to murder?

Bloody murder

Yes, murder. Murder as in bang, bang, you're dead. If New York's reputation for
jaywalking is poor, it is even worse for such violent crimes as murder. The Big Apple homicide
rate is three times that of the U.S. in general. Why? Perhaps it is because the justice system is
congested with jaywalkers. Or, maybe it is just too much spicy
food.

Colombia is worse. No matter how daunting a dark dash

through Central Park may seem, compared to one in the country of
Colombia, it is like a Sunday afternoon stroll down main street
Mayberry. Homicide rates in Colombia, generally considered
among the world's most violent countries, are quadruple the NYC
level and are some 50 times higher than those generally found in
Europe. Colombian rates for carjackings, kidnappings and thefts are
similarly high.

Until the late 1970s Colombia was relatively peaceful. It was democratic with few racial
or religious tensions to fuel violent conflicts. Television commercials often would depict Juan
Valdez and his burro ambling through mountain fields, carefully picking only ripest Colombian
coffee beans for your morning brew. Juan's modern counterparts are likely to be toting
automatic weapons.

What happened? The easy answer is cocaine. After a right-wing military coup drove
drug traffickers from Chile in the 1970s, the displaced dealers shifted operations to
Colombia. Violence erupted as rival firms vied for market share. Bullets to the brain proved a
quick and effective way to eliminate both competitors and uncooperative government officials.
However, once cartel power became firmly established, drug violence subsided. With all
competitive threats literally buried, the market stabilized.

Colombian violence remains high, but relatively less is associated with drugs or the
continuing rebel insurgent groups fighting the government. A study by economist Alejandro
Gaviria reports that more than 80 percent of Colombian homicides are unrelated to major drug or
rebel organizations.1 The problem, according to Gaviria, is that the earlier drug violence
congested the law enforcement system and lowered the probability of being caught. The low

167
chance of apprehension lowered the cost of murder and attracted an increased supply of
assassins. By the time drug violence had subsided, non-drug-related homicides had increased.

Other crimes in Colombia also rose, but only after the increase in homicides. Once
murder investigations congested the system, enforcement officials had little time or energy to
pursue less serious crimes. As an economist would predict, this lower likelihood of prosecution
sparked an increase in infractions from petty theft to kidnapping. It becomes a vicious
cycle. Crime creates law enforcement congestion. Congestion lowers the probability of being
caught and convicted which, in turn, lowers the cost of crime and creates even more crime.

Multiplier effects

Economists often discuss the multiplier effects of macroeconomic policies. Changes in

government spending or taxes can create additional effects that ripple through the economy. For
example, an increase in government spending for economics professors creates new income for
economics professors. They use the new income to buy additional cartons of Breyer's Ice Cream
(vanilla). This creates new income for Breyer's employees and owners who, in turn, spend their
new income for tickets to see the Pittsburgh Pirates. This increases income for the Pirates, who
then shell out the big bucks needed to hire a free-agent center-fielder. The center-fielder spends
his new income to buy hot dogs and fries. This creates new income for the hot dog vendors,
etcetera, etcetera, etcetera. The initial burst in government spending is multiplied into a much
larger amount of private spending. Spending begets more spending.

The multiplier effects of crime are similar. Crime creates enforcement congestion, and
congestion creates additional crime. The policy message is clear. To avoid spiraling crime, nip it
in the bud. Hit it hard. Hit it early. Swift and sure justice. Get it before any self-propagating
multiplier effects take root.

Simple enough? Maybe not. The day

after drafting this article I found myself driving in
downtown Pittsburgh. After a matinee at the
Pittsburgh Public Theater, my wife and I turned
down Penn Avenue. We reached Heinz Hall just
as the symphony crowd was beginning to exit. An
elderly couple, walking with canes, began to cross
the street. They were in the middle of the
street. They were jaywalking. Incipient
crime. My brain is yelling: "Nip it in the bud. Hit it hard. Hit it early. Swift and sure." But,
what do I do? Should I run them down? I envision the local TV news flash: "Elderly couple
leveled by crazed economist. Graphs at eleven." So I slow. I slow to a crawl to let them
pass. But the moment I slow, forty others see their opening and lurch into the street with the
elderly couple. Two are multiplied into forty. And I wait. There is safety in numbers.

_____________________________

Notes:

168
1. Gaviria, Alejandro, "Increasing Returns and the Evolution of Violent Crime: The Case of
Colombia," Journal of Development Economics, February 2000, volume 61, number 1, pp. 1-25.
Colombian crime rates have fallen since 2002, but remain very high by world standards.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain how an increase in crime can create a multiplier effect that creates even more
crime.
2. Use this crime multiplier effect to explain the continued violence in Colombia.

169
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

The Economics of Cheating

There's one way to find out if a man is honest - ask him. If he

says, 'Yes,' you know he is a crook.
.....Groucho Marx

Memorization stinks. A waste of time. Things

memorized are soon forgotten without frequent use. And
things used frequently need not be consciously memorized;
they become habitual.

I loved singing in school choirs, but hated to memorize music. Subjects that involved
logic (like economics) were right up my alley, but those requiring memorization (Latin and
German) rated on a par with gutting rancid fish. Mathematics was a mixed bag. Ask me to
derive a formula, and I was home free; ask me to memorize one, and I was dead.... which was no
problem except on exams. On exams I had too little time to derive the needed formulas from
scratch and too little brain to memorize. What to do? Cheat.

Yes, I cheated. Not often. Very rarely. But I cheated. Especially with those trig
functions in calculus. I mean, really. Why should anyone have to memorize that (d/dx)
cotangent u = - cosecant2 u (du/dx)? I could never remember that one. I always confused it with
the derivative of the cosecant. Or was it the derivative of the arctangent? I cannot remember; I
never could. The solution was simple: just write it in pencil (very lightly) on the edge of the
desk prior to the test. It would be there if needed and could easily be smudged out quickly in a
pinch. If the desk didn't work, there was always the ankle (under my sock) or the wrist (under
my watchband).

Are you shocked? Should a college professor admit to such crimes of his
youth? Perhaps not. Cheating was not my finest hour. I am not proud of it; I do not recommend
it to others. But professors are people, too.

Don't worry; it all came back to haunt me. I spent three years on a University Senate
Academic Committee leading a drive to rewrite my institution's policy on academic
dishonesty. Irony? Penance? It was deadly stuff -- eight pages of single-spaced legalese about

170
due-process-this and hearing-board-that. I endured interminable discussions, plowed through a
dozen draft versions, consulted with every constituent group under the sun, and tried to work
with a university attorney who considered our policy about as important as the derivative of
cotangents.

Why do we cheat?

The early debates were the worst. A former committee member, a non-economist, would
launch into moralizing that drove me right under the table. The laments about moral decay
brought visions of the chorus in a Greek tragedy, actors standing to the side wailing and beating
their breasts. I did not want to hear moral invective. Morals are not the primary issue. Students
do not cheat because they are moral incompetents; they cheat because the marginal benefit of
cheating exceeds the marginal cost.

Wait. Costs and benefits? Not morals? Is there any hard evidence to support
this? Yes. Study after study find that large percents of students cheat at least occasionally. For
example, economists Cliff Nowell and Doug Laufer1 reported on an experiment with 311 college
students. The students were given multiple-choice quizzes that were collected and secretly
photocopied. The originals were returned at the next class. Students were instructed to grade
them and report their score to the instructor. The instructors would then grade the photocopies
and compare results. Did anyone cheat? Had any students changed answers while grading their
own quizzes? Yes. Even though the quizzes accounted for only ten percent of the course grade,
one-fourth of the students cheated at least once.

Nowell and Laufer then used demographic data collected at the beginning of the semester
to analyze which students cheated and why. Their results are exactly what an economist would
predict: Students with the highest expected benefits and lowest expected costs were the most
likely to cheat. In particular:

1. Grades: Students with the highest grades prior to the quiz were the least likely to
cheat. With a high grade already intact, the benefit of cheating was minimal.

2. Jobs: Students holding down jobs were more likely to cheat than those without
jobs. Students working 40 hours per week were more likely to cheat than those working
part-time. A major benefit of cheating is to reduce necessary study time. Students
working the most hours gain the most benefit from such a time saving.

3. Class size: Students in large classes cheated more often than students in small
classes. Because it is harder to monitor cheating in a larger classroom, the chance of
being apprehended -- and, therefore, the cost of cheating -- is smaller.

Other researchers find similar results. Activities such as heavy drinking and participation in
time-intensive organizations such as fraternities or varsity athletics tend to increase the
probability of cheating, while extra hours of study and an increased probability of being caught
decreases it.2

171
 In other words, students often cheat, and they make rational choices about when and where
to cheat. Studies that search for correlations between cheating and measures of morality or
religiosity often come up empty. Those that relate cheating to costs and benefits do
not. Students who study long hours with high grades and no outside jobs and who are taking
courses with small class sizes where there is a high probability of being caught cheat less than
others. Is it because they are morally superior? Or is it because they face different costs and
benefits?

What should be done?

Cheating is not socially efficient. Those cheating consider only the costs and benefits to
themselves. They ignore the external costs they impose on others. And others are harmed. Non-
cheating students suffer by comparison on exams, and taxpayers, who are paying much of the
financial freight of education, end up with graduates who are less knowledgeable than
advertised. Promoting academic integrity makes perfect economic sense. Cheating inflicts
serious damage on society; just like driving 80 mph when the legal limit is 60.

How can we reduce the incidence of cheating? My committee colleague urged

exhortation. Instill good values in our students, wave the flag of integrity, appeal to their
conscience, convince them to be good citizens of the world.

Hogwash. In another study comparing student-graded papers to secretly graded

photocopies, the instructors found exhortation was counterproductive. After making an
impassioned moral appeal to students to grade their quizzes honestly, the amount of cheating
actually rose. Exhortation is not the answer. The key is to raise the expected costs or lower the
expected benefits.

Unfortunately, with the emergence of the Internet and cell phone technologies, many
types of cheating are less costly than ever. Complete research papers on every imaginable topic
are available for purchase online at the touch of a
keystroke. And almost every modern student comes
equipped with a cell phone that can photograph and
instantly e-mail any exam or homework answer to
waiting comrades. Teachers fight back with programs
such as Turnitin designed to catch plagiarism, but such
efforts are costly and imperfect.

Most policies aim at raising costs to cheaters,

primarily by penalizing those who are caught. Sanctions run from a slap on the wrist for minor
violations to expulsion for more serious cases. But penalties have limited value. Penalties
cannot be imposed without working through rather cumbersome procedures to ensure due
process for the accused. Such procedures are necessary, but costly. Paperwork, testimony, and
hearings take an emotional toll on both plaintiff and defendant. If only minor sanctions are at
stake, instructors may decide the cost of following through on an accusation exceeds any
possible gain. They may let it slide.

172
 Raising the stakes with stiffer penalties creates other problems. When the severity of the
penalty rises, the likelihood of it being imposed falls; penalties can be too tough. And seldom-
imposed penalties provide little or no deterrent effect. Instructors, by and large, are a forgiving
lot. We want to punish cheaters, not ruin their lives. We are reluctant to bring charges that
might result in excessive consequences. Even if we try, we may not get far. Students facing
possible suspension or expulsion will not stroll submissively to their doom. The cost of
confessing a violation that carries a slap on the wrist is minimal; the cost of confessing a
violation that gets you expelled is not. Moreover, members of hearing boards are not so quick to
convict when sanctions are severe. They will demand more incontrovertible evidence before
abandoning "reasonable doubt" of guilt. When penalties stiffen, fears of convicting an innocent
person -- and fears of lawsuits soar.3

Policies that make it costly to cheat in the first place are better. We can shuffle test
questions so that students in alternate seats must answer different questions in different
orders. We can patrol the aisles, searching for unauthorized papers and stalking potential
miscreants with our steely glares, and we can rearrange desks to maximize the distance between
chairs.4

Alas. These methods can be as costly as they are effective. Multiple test versions are
tedious to compose and grade, vigilant surveillance is draining and can unnerve innocent
students, and rearranging desks probably violates union work rules.

A final alternative is to cut the marginal benefit of cheating. How? Eliminate

grades? Award A's to everyone? A former colleague tried a different approach. He encouraged
students to bring a 3"X 5" index card to each exam, filled with whatever material they wanted to
write on it -- sort of like legalized "cheat sheets." With legal cheat sheets, students have less
incentive to smuggle their own into exams, or even to strain to see someone else's answers. In
addition, the effort in deciding what information is critical and painstakingly writing it out by
hand helps students learn the material. He reported that it did work. It changed the costs and
benefits of cheating.5 Interestingly, it also changed the types of exam questions he
asked. Instead of questions that could be answered with material that could easily be put on an
index card, he asked questions that required students to analyze and use that information.

Cheating in society

Of course cheating afflicts all segments of society, not just education. Athletes use
performance enhancing drugs, huge corporations deliberately report false data, taxpayers
"forget" to report the $200 earned at a yard sale, and motorists drift through stop signs. Even
presidents and priests cheat. Unfortunately, the damage done in these cases often dwarfs that
caused by an errant student writing the formula for the derivative of a cotangent on the edge of
his desk. Think for a minute about the costs of cheating. If people never cheated we could
eliminate most of our law enforcement and criminal justice system, we could eliminate IRS and
corporate auditors, we even could eliminate referees and umpires at sporting events. But,
perhaps most importantly, cheating tears at the fabric of trust so necessary for meaningful human
interaction.

173
 Has cheating increased? It probably has, but explanations must address changing costs
and benefits rather than moral decay.

First, the cost of cheating probably has been falling. Cheating is least likely when you
must interact repeatedly with the same people. Those you cheat today may retaliate the next time
you meet. For example, the proverbial traveling salesman who easily can cut and run is less
trustworthy than the local merchant who must rely on repeat business to survive. Similarly,
drivers who routinely jump in front of strangers to avoid freeway delays might never consider
butting in front of a longtime neighbor. However, in increasingly large and transient
communities, we often are surrounded by people we neither know nor expect to see again.
Without repeated interactions, there is less chance of retaliation. With less chance of retaliation,
cheating becomes a more profitable strategy.

Second, the emergence of markets in which a relatively few top performers can grab
enormous rewards has increased the benefit of cheating. Technology has transformed markets.
People, products and information flow easily across physical and electronic space. With a few
strokes on a keyboard, consumers have the world at their fingertips. Small, local markets have
morphed into global ones. In the past, cheating to achieve a small competitive edge might have
allowed us to corner the local market. Now it can bring national or even international dominance.
The stakes have changed, and the potential payoff of cheating has soared.

People do cheat, and cheating does damage the fabric of society. However, if we want to
change behavior, let's skip the moral invectives and breast-beating. We will be better served by
careful studies of how to alter the benefits and costs.
________________________________

Notes:

1. Nowell, Clifford and Laufer, Doug, "Undergraduate Student Cheating in the Fields of
Business and Economics," Journal of Economic Education, Winter 1997, pp.3-12.
2. See Burrus, Robert T., KimMarie McGoldrick and Peter Schumann, "Self-Reports of
Cheatiug: Does a Definition of Cheating Matter?", Journal of Economic Education,
Winter 2007, pp. 3-16 and Bispring, Timothy O., Hilde Patron and Kenth Roskelley,
"Modeling Academic Dishonesty: The Role of Student Perceptions and Misconduct
Types", Journal of Economic Education, Winter 2008, pp. 4-21.
3. This could explain why several studies have failed to find any evidence that harsher
penalties discourage cheating. See Bispring, op. cit.
4. Policies such as increased vigilance and multiple versions do seem effective deterrents.
See Kerkvliet, Joe and Charles L. Sigmund, "Can We Control Cheating in the
Classroom", Journal of Economic Education, Fall 1999, pp. 331-343.
5. The approach is not foolproof. Students have been caught trying to smuggle multiple
index cards into tests.

_______________________________

174
 Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Identify factors that are likely to impact the amount of cheating on an exam and explain
the economic logic of each.
2. Explain why inefficiently high amounts of cheating probably would occur if penalties
were not imposed on cheaters.
3. Identify potential policies that might change the costs and benefits of cheating and
explain their likely effects.
4. Explain why cheating might be more prevalent today than in the past.

175
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Does Speed Kill?

There is more to life than just increasing its speed.

.....Mahatma Gandhi

Like other red-blooded Americans, I speed. Not too much. Whizzing along a highway
posted at 65 miles-per-hour (mph), I set my cruise control at 69 miles per hour. I'm four mph
above the limit, but am among the slowest drivers on the road.

In the ancient years of the 1970s, speed limits dropped precipitously. In the throes of the
energy crisis in the early 1970s, with mandatory gas rationing waiting in the wings, President
Nixon declared a nationwide maximum of 50 mph in December 1973. OPEC, not safety, drove
the initial legislation. Fifty is Thrifty slogans soon hit the airwaves, but Congress substituted the
more palatable 55 mph limit in the 1974 Emergency Highway Energy Conservation Act.

And it stuck. Congress extended the limit with 1975 legislation that denied federal
highway funds to any state exceeding the 55-mph level. By this time, lower speeds were also
credited with saving thousands of lives. Traffic fatalities plunged by 9,100 in the first year
alone. The measure was so popular that it passed the Senate with a unanimous 85-0 vote.

But the bloom began to wither and in the early 1980's the energy crisis was history and
average speeds were inching up. Pressure mounted to restore the higher pre-OPEC speed limits
and several rural states all but refused to enforce the federal 55-mph mandate. For example,
wide-open Montana kept the 55-mph limit on the books, but dropped the fine for violations to $5
and ignored all but the most egregious speeders. With falling oil prices and abundant gasoline,
proponents of the 55-mph limit ditched their conservation arguments and stressed safety
instead. What about the thousands of lives saved by lower speeds? Did they not matter? After
all, speed kills.

Speed kills?

Or does it? Fatalities were down, but were those lives saved by lower speeds or were
other factors at work? When gas prices rose in the 1970s, motorists responded by staying home
and/or using public transport. With fewer cars on the road, fatalities would have dropped
176
regardless of speed limit changes. Similarly, safer vehicles and highways could have cut
fatalities. Studies trying to identify the importance of lower speeds gave mixed statistical results.

Economists added theoretical fuel to the fire. According to Sam Peltzman, regulatory
attempts to improve safety often are counteracted by offsetting consumer behavior. For
example, drivers routinely become more alert and cautious in potentially dangerous
situations. Could the reverse also be true? Might not drivers be less alert and/or less cautious at
seemingly safer lower speeds? If we become more careful at high speeds and less careful at low
speeds, changes in legal limits may have very little impact.1

Charles Lave added that high speeds are less dangerous than variable speeds.2 If
everyone travels at 65 mph, everyone is relatively safe. If all travel at the same speed, the risk of
collision is small. However, if some travel at 70 mph while others plug along at 40 mph, risks
rise rapidly. Brake lights fly on, drivers weave in and out of lanes trying to pass, and dangers
mount. Slow drivers are as great a hazard as fast ones. According to Lave, lowering speed
limits in the 1970s aggravated variability problems. While conservative, law-abiding motorists
slowed to the lower 55-mph limit, others continued to drive at the older, suddenly-illegal
speeds. If people are more apt to stick to a 65-mph limit than to a 55-mph limit, the faster speed
limits might actually reduce variability and increase safety.

Bowing to the shaky statistical and theoretical support for the 55-mph limit, Congress
reversed course. In 1987 it allowed states to opt for 65-mph limits on rural interstates and, in the
mid 1990s, eased restrictions further. Although many states raised legal limits quickly, others
chose to wait and see. Would safety be compromised? Would fatalities rise?

The impacts appear minimal. Economist Patrick McCarthy found that safety was
compromised when speed limits on interstates in the state of Indiana rose, but that safety on
other Indiana highways and roads improved.3 When speed limits on the interstates rose, more
motorists chose to take the interstates rather than alternative routes.
The added congestion did cause more accidents on the
interstates. However, the drop in traffic on alternative roads meant
fewer accidents elsewhere. The net effect was zero. A second study
by Ted Keeler found that higher speed limits did impair safety slightly,
but only in congested, urban areas.4 A third study by Lave and Elias
concluded that adopting the 65-mph limit actually dropped fatality
rates by three to five percent.5

If lower speed limits do not decrease highway fatalities, what will? Must we accept the
continuing carnage? Maybe. We have no easy solutions. Keeler found that fatalities rise rapidly
with alcohol consumption, but attempts to eliminate drunk driving have met with only marginal
success. Interestingly, Keeler discovered that fatalities fall as education levels rise. College
graduates, all else equal, are less likely to be involved in fatal accidents. He also found that
requiring frequent testing for license renewals increases safety, but these effects are
quantitatively small.

177
 Any other ideas? Economist Gordon Tullock once floated what he considered a
foolproof proposal, but did not hold his breath for it to be adopted. Using the Peltzman notion of
offsetting consumer behavior, Tullock offered a cheap and easy solution to reckless
driving. Simply affix a sharp dagger on every steering wheel -- a dagger that is pointed directly
at the heart of the driver.6 Would it work? Should we do it?

_______________________________________

Notes:

1. Peltzman, Sam, "The Effects of Automobile Safety Regulation," Journal of Political

Economy, volume 83, July/August 1975, pp. 677-725.
2. Lave, Charles A., "Speeding, Coordination, and the 55-MPH Limit," American Economic
Review, volume 75, number 5, December 1985, pp. 1159-64.
3. McCarthy, Patrick S., "Highway Safety and the 65-mph Speed Limit," Contemporary
Policy Issues, volume 9, number 4, October 1991, pp. 82-92.
4. Keeler, Theodore E., "Highway Safety, Economic Behavior, and Driving Environment,"
American Economic Review, volume 84, number 3, June 1994, pp. 684-93
5. Lave, Charles, and Elias, Patrick, "Resource Allocation in Public Policy: The Effects of
the 65-MPH Speed Limit," Economic Inquiry, volume 35, July 1997, pp. 614-
620. However, see Greenstone, Michael, "A Reexamination of Resource Allocation
Responses to the 65-mph Speed Limit," Economic Inquiry, April 2002, volume 40,
number 2, pp. 271-279 for a different reading of the evidence.
6. McKenzie, Richard B. and Tullock, Gordon, The Best of the New World of Economics,
5th edition, Richard D. Irwin, Homewood, Illinois, 1989, pages 40-41.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain why the U.S. imposed lower speed limits in the 1970’s.
2. Explain Peltzman’s argument of why cutting speed limits might not cut highway
fatalities.
3. Explain Lave's argument of why cutting speed limits might not cut highway fatalities.

178
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Supply-Side Drug Policy: Will It

Ever Work?

No opium-smoking in the elevator.

.....sign in New York City's Hotel Rand, 1907

Television and big-screen detective dramas replay the

scene endlessly. Drug deals are "going down." Police officers arrive and suspects
scatter. Unable to chase everyone, the officers, with a quick calculation of how to allocate their
scarce "chase" resources, ignore the would-be buyers and light out after the pusher. After
dodging bullets and diving over oncoming cars, the police hero captures the scurrilous miscreant
with a flying tackle that scatters back-alley garbage cans. But the drama does not end. After all,
the street peddler is a mere pawn. The real targets are the suppliers, the smugglers. A deal is
struck: immunity from prosecution in return for the name of Mr. Big.

For better or worse, such cinematic stereotypes have influenced U.S. drug policy. Our
policy has been "supply-oriented," concentrating on reducing supply more than on reducing
demand. Penalties for users exist, but they are relatively mild. The real vermin are the
suppliers, and we reserve our harshest penalties for them. Addicts may breed our indignation,
but the kingpins of drug cartels foment true outrage.

It has not worked

Most economists criticize this supply-side emphasis in drug enforcement. In the first
place, it has not worked. Despite the billions of dollars spent every year, illegal drugs still
cascade over our borders. If we seal off California, they flow through Texas; if we seal off the
water, they come in by air. If we build fences along our borders, traffickers simply knock them
down, tunnel under them or, in at least one case, build catapults to throw hundred-pound sacks of
drugs over them.1

Nor have we been able to cut off supplies at their source. International drug traffickers
wield enormous political and military clout. Illicit drugs are the major cash crop for thousands
of poverty-stricken peasant farmers and crop eradication programs meet tremendous popular
resistance. And, if we break the hold of one drug cartel, what is to prevent other entrepreneurs
from jumping into the void? Cocaine pushed out of Peru still easily can be run through

179
Colombia or Ecuador or Bolivia. Poppy fields eradicated in Afghanistan easily can be replaced
by others in Myanmar. Meth labs wiped out of West Virginia easily can be relocated to
Mississippi or to Mexico. Too many different drugs can be grown in too many different
countries and all compete for a slice of the lucrative American market. The technological
barriers to entry are small and the siren call of profits is alluring. In 2012 a kilo (about 2.2
pounds) of cocaine costing $2,000 in Peru could bring more than $100,000 at retail on the streets
on U.S. cities.2

Even worse, our efforts might prove counterproductive. A major reason for controlling
drugs is to stem the crime and violence -- the external costs -- associated with them. Drug-
related violence has claimed some 50,000 lives in Mexico since 20063 and put large sections of
major cities under virtual siege, as addicts loot the populace to support their habits and as rival
suppliers compete for turf. Estimates suggest that the social cost of drug-related crime is double
the health-related costs of drug usage.4 The amount of crime is at least partly related to the flow
of dollars through the illegal markets. An addict must commit more crime to support a $50 per
day habit than a $10 per day habit. By restricting the amount of drugs hitting the streets,
government policy decreases the supply and creates a temporary shortage. This does reduce the
quantity of illicit drugs bought and sold but, as in any other market, the shortage drives up the
equilibrium price. The below graph illustrates the effect.

With quantity down and the price up, the effect on total revenue flowing through the
market is ambiguous. Remember that total revenue (TR) is price times quantity. If the
percentage increase in price is smaller than the percentage cut in quantity of drugs demanded
(what economists term elastic demand), TR will fall. But if the percentage increase in price
exceeds the percentage drop in quantity (inelastic demand), TR will rise.

Unfortunately, addicts are not especially sensitive to price. Their overall demand for
drugs seems inelastic (can you explain why the demand curve drawn above is relatively
steep?). If so, the higher price will more than offset any cut in volume. Total revenue in the
market will rise. For example, suppose government policy successfully cuts the daily quantity of
cocaine sold in an area from 100 to 80 grams (by 20 percent), and that addicts, bidding against
each other for the now-scarce substance, drive prices from $50 to $100 per gram (up 100
percent). Addicts, who originally spent a combined $5,000 for their habits (100 grams at $50 per
180
gram), now spend $8,000 (80 grams at $100 per gram). Might addicts who
collectively need $8,000 to support their daily habits commit more crime
than those needing $5,000? Of course. Government policies that
"successfully" cut drug supplies might actually create even more muggings,
murder, and mayhem. Oops.

Demand-side approaches

There is an alternative approach. Instead of trying to choke off drug

supplies, focus on demand. A drop in the demand for drugs will create a
temporary glut or surplus on the market; a surplus which will drive street
prices down instead of up. Policies that slash demand result in lower
quantities and lower prices. With quantity and price both down, total
revenue and the associated crime, should drop as well.5

The idea of attacking demand is not new. Foreign officials have

argued for years that if anyone is to blame for international drug trafficking, it is the American
users. As long as there is a demand for illicit drugs, someone will provide the supply. But how
can we do it? What policies can shift demand?

Rhetoric and education might help. Anti-drug commercials and "just say no" campaigns
might deter some potential users. Drug treatment programs are a second possibility. Since a
small number of addicts can consume huge quantities of illegal drugs, a relatively few successful
rehabilitations might create a relatively large drop in demand. Dollars spent on drug treatment
might be considerably more effective than incarceration in reducing drug-related
crime.6 California has experimented with a program that offers non-violent drug abusers
treatment rather than imprisonment. While not all users referred to treatment follow through
successfully, the early results are encouraging. According to a UCLA study, the initiative has
saved taxpayers $2.50 for every $1 spent.7

Economists routinely think in terms of taxes and subsidies. To decrease the demand for
bananas, we would advocate heavy taxes on banana buyers, or else large subsidies to make
substitute fruits more attractive. Presumably we could try the same things with illegal drugs.

A tax approach might mandate harsher sanctions against users, even casual or first-time
users. A subsidy approach would try to create attractive alternatives for potential drug users and
dealers: perhaps more job training and economic assistance for unskilled youth that see drugs as
either a way out of the ghetto, or as a way to forget it. As a former student wrote, "In Mexico,
Colombia, and the streets of the inner-city there is a population that finds prison or death an
acceptable risk in the struggle for the good life they see on television....At least the drug trade
offers the potential for advancement if one is intelligent and ruthless enough." The key "is to
make alternate occupations more accessible." The problem will persist, especially in low-
income areas, until people can expect "reasonable employment commensurate with their
intellectual potential... a lifetime flipping burgers just doesn't fill the bill."8 Education and
treatment should not be abandoned, but are not likely to be enough. Without taxes or subsidies
to change user incentives, they may have little effect.

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Legalization?

A more radical approach is legalization. Although quite controversial, legalization does

offer potential gains. Much of the current drug-related crime occurs as rival suppliers battle for
turf and market share both within the U.S. and along supply routes throughout Central and South
America and Asia. In a legal market, suppliers are likely to enforce contracts by recourse to law
rather than violence. Moreover, law enforcement officials, free from having to chase down drug
offenders, could reallocate their time and efforts to reducing other types of criminal activity.
Drug safety might also improve. Retail stores that offer branded products meeting government-
certified standards could replace back-alley vendors who offer drugs of unknown
purity. Legalization also might create financial benefits. In addition to the potential tax
revenues states might collect on the sale and use of controlled substances, billions of dollars now
being spent on drug enforcement and prisons could be saved.

Legalization certainly would increase the supply of currently illegal substances and bring
down prices. The interesting question is what might happen to demand. Opponents are
convinced that legalization would cause the demand for drugs to soar as hordes of new users
"experiment." Since many of these might subsequently become addicted, the costs to society
would quickly multiply. On the other hand, proponents contend that quantities consumed will
not rise significantly. Stripped of their illicit cloak, drugs would be less alluring to rebellious
youth. If so, the demand for drugs might actually plummet. And, if we fear that lower prices
will push usage up, governments can raise those prices by imposing appropriate
taxes. Moreover, alcohol can be a substitute for products such as marijuana or cocaine. If so, an
increase in drug usage might create a similar decrease in the consumption of alcohol and its
related costs.

Since 2001, Portugal has used a novel, but related, approach. While possession and use
of drugs remains officially illegal, they have been "decriminalized". The police can stop anyone
they find using illegal substances and confiscate the drugs but, instead of imposing criminal
penalties, they send the users to "dissuasion commissions" that offer therapy. There are no fines
and no prison sentences. The initial results have been encouraging. Usage rates for most
substances seem to have fallen or remained constant and, with the fear of prosecution removed,
the numbers of users seeking treatment has risen significantly.9 Similarly, Uruguay has much
lower rates of drug usage than the U.S. despite the fact that possession of drugs for individual
use in that country never has been illegal. Several other Latin American countries now are
considering similar policies.10 Although several U.S. states recently have moved to
decriminalize marijuana, at least for medical purposes, the approach remains controversial.

Who is right? It's your call. Interestingly, drug abuse is not limited to homo
sapiens. Biologists have recorded many animals, all the way from horses to yellow ants,
"tripping out" on naturally occurring narcotics. Even cuddly koalas suffer chemical
dependency. They cling so endearingly to eucalyptus trees because they are addicted to the
leaves they are munching.

______________________________________

182
Notes:

1. Keefe, Patrick Radden, "Cocaine Incorporated", New York Times, June 15, 2012
2. ibid.
3. ibid.
4. Dobkin, Carlos and Nancy Nicosoia, "The War on Drugs: Methamphetamine, Public
Health and Crime", American Economic Review, volume 99, number 1, March 2009, p.
340.
5. Graphically, such policies shift the demand curve for drugs to the left, thereby lowering
both equilibrium price and output. Can you illustrate this change?
6. The Economist, August 10, 2002, page 27 cites a 1997 RAND study that draws this
conclusion.
7. The Economist, April 22, 2006, page 30.
8. Personal correspondence from James Cricks.
9. The Economist, August 29, 2009, page 43.
10. The Economist, June 30, 2012, pp. 37-38.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Describe the external effects associated with drugs such as heroin and cocaine.
2. Use supply and demand curves to illustrate the effects of current U.S. drug policy and
explain the problems that it creates.
3. Explain why economists might prefer demand-oriented demand policies, illustrate with
an appropriate graph and list examples.
4. Explain the possible impacts of legalization on the market for currently illicit drugs.
5. Discuss Portugal's experience with decriminalization of drugs.

183
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Discrimination: It Isn't Easy Being Green

It isn't easy being green.
...Kermit

The Muppet Movie, one of history's great cinematic achievements, opens in a deep
swamp. The camera pans to Kermit the Frog perched on a lily pad strumming his guitar and
singing:

It isn't easy being green;

Having to spend each day the color of the leaves.
When I think it could be nicer being red, or yellow or gold
or something much more colorful like that.

Kermit's lament does turn upbeat. He ends with:

I am green and it'll do fine, It's beautiful!

And I think it's what I want to be.

Kermit is correct; it isn't easy being green. Although he dreams of

being a famous Hollywood producer, Kermit's film adversaries refuse to take his ambitions
seriously. After all, frogs belong skewered in a frying pan, not sitting behind a camera. Kermit
does persevere. With luck and considerable help from a cast of mildly maniacal friends, Kermit
sheds his stereotypical frog mold and breaks into Hollywood.

Alas, other stereotypes are not so easily shattered. It isn't easy being green. And it isn't
easy being African-American or Hispanic or female. For many Americans, equal opportunity is
still more dream than reality.

Job discrimination

The traditional U.S. response to perceived inequities is to pass a law. So we have. We

have passed a long series of civil rights and anti-discrimination statutes over the last
century. Discrimination in the workplace is illegal and no one would ever violate the
law. Right? In these days of affirmative action and preferential hiring policies, minorities enjoy
equal access to the labor market. Right?

The traditional answer, at least by many middle-aged white males with secure, well-
paying jobs (like me), has been: "yes". Hard evidence answers: "no". Economists Genevieve
Kenney and Douglas Wissoker have studied the extent of job discrimination faced by young
184
Hispanic males.1 They culled through a list of volunteers and formed two-man teams, each with
one Hispanic and one Anglo male. The team members were carefully matched with respect to
age, size, amount of education, job history, and personality. Team members differed only in
race. Once the teams were selected, members were sent out to apply for a series of low-skill,
entry-level jobs advertised in Chicago and San Diego newspapers. Team members applied for a
total of 360 employment positions.

The results were striking. Applying for the same positions less than one hour apart,
Anglo team members were 4.4 percent more successful in being allowed to fill out application
forms, 30.0 percent more successful in getting interviews, and 53.6 percent more successful in
being offered employment (see Table I)

Table I

Success Rates In: Anglos Hispanics % Difference

Being allowed to complete

application forms 95% 91% 4.4%
Obtaining interview 65% 50% 30.0%
Getting job offer 43% 28% 53.6%

Although Hispanic applicants were less successful across the board, the amount of
discrimination varied depending upon the type of neighborhood or firm or interviewer
involved. As we might expect, the apparent discrimination was more severe in white and high-
income neighborhoods as opposed to Hispanic and low-income neighborhoods. Interestingly,
discrimination also seemed more pronounced when candidates were interviewed by males rather
than by females (are men more prone to bias?) and when they were seeking jobs in local rather
than national firms (might national firms have more to lose if they are found running afoul of
discrimination laws?).

This does not necessarily mean that the interviewers and employers are biased. Perhaps
employers perceive their customers to be biased. If officials at Burger King or K-Mart suspect
that their customers prefer to deal with Anglos rather than Hispanics, their profit motive would
push them to discriminate against Hispanics, even if they themselves were racially and culturally
ambivalent. Profit-maximizing employers in a competitive environment must hire with customer
preferences in mind, not their own.

We can check this out. If perceived customer bias is the root cause, the observed
discrimination should vary with the amount of customer contact. If my customers are biased, it
might be profitable to grant prejudicial favor to Anglos for front-door cash register
positions. What about the man working alone in the basement counting inventory after hours? If
an employee never sees a paying customer, customer bias should be immaterial. No
dice. Customer interaction is irrelevant. The observed discrimination in jobs with little or no
customer interaction was just as great as that with jobs involving significant
interaction. Employer bias is the apparent culprit.

185
What about names?

In a more recent study, economists Marianne Bertrand and Sendhil Mullainathan studied
the impact of applicant names.2 Although many names are clearly race-neutral, others are
strongly identified with a particular race. For example, research shows that most people assume
that females with names such as Allison, Jill and Emily are White, while those named Keisha,
LaTonya and Tamika are African-American. Similarly, people typically assume that males
named Brad, Todd and Brett are White, while those named Jamal, Rasheed and Darnell are
African-American.

Do names make a difference in the job market? Bertrand and Mullainathan ran a
test. They developed a file of fictitious resumes and randomly assigned either "White" or
"African-American" names to each. They then mailed samples of the resumes to employers that
were advertising job vacancies in Boston and Chicago newspapers. Their question was
simple. When resumes indicate that applicants are of similar quality and have similar types of
education and experience, will an application from a Jamal be treated differently than one from a
Todd?

Not surprisingly, the answer is: "yes." Applications bearing "White" names were 50
percent more likely to get a callback from the prospective employers than those bearing
"African-American" names. On average, applicants with "White" names needed to send out
about 10 resumes to get one callback, but those with "African-American" names had to send out
15. Interestingly, that 50 percent gap was nearly identical for both males and females in both
Boston and Chicago. The racial gap persisted for all types of jobs studied: executives,
supervisors, sales representatives, sales workers, secretaries, and clerical workers. The gap
persisted even for employers that specifically advertised themselves as Equal Opportunity
Employers. In short, for every type of job and every type of employer, names mattered.

Americans apparently are not unique. Intriqued by the lack of employment success of
skilled immigrants in Canada, Philip Oreopoulus ran a similar study using matched resumes to
apply for thousands of job openings in the Toronto area. Those resumes with names popular in
China, India, Pakistan or Greece (all major sources of immigration into Canada) received
significantly fewer callbacks than those with English-sounding names. The differences persisted
even when the resumes with foreign names showed Canadian university degrees and Canadian
work experience. The differences also persisted for jobs in which language skills would be less
important.3

What about beauty?

It isn't easy being green, or female or African-American or Hispanic or a member of any

other ethnic or linguistic minority. What about ugly? Is discrimination confined to race and
gender? If racism and sexism exist in the marketplace, what about lookism? Well-wishers often
assert "it's what inside that counts." Do job markets agree? Apparently not. Raw physical
beauty bestows a major employment edge on both men and women.

186
 Drawing on three surveys encompassing more than 7,000 respondents, economists Dan
Hamermesh and Jeff Biddle tried to statistically isolate the impact of beauty on earnings.4 In
addition to gathering data on employment and earnings, the interviewers rated the respondents'
physical attractiveness. Respondents were categorized as either strikingly beautiful or
handsome, above average for age, average for age, below average for age, or homely. Overall,
34 percent of the respondents were rated as striking or above average while only eight percent
were rated below average or homely. [The interviewers must have been generous.]

Even after adjusting for such factors as education, experience,

age, race, and occupation, the authors find that beauty has a
significant impact on earnings. The impact is not as great as that of
race or gender, but it is significant nonetheless. Respondents rated as
striking or above average earned a wage premium of about five
percent, while those rated as below average or homely suffered a
wage penalty of about nine percent. The total earnings gap between
the two groups was about 14 percent. Interestingly, the impact of
physical appearance was somewhat greater for males than for females,
though the difference was not statistically significant.

Of course, attractive workers might be more productive in

some industries. Fashion modeling is an obvious example, but there are many others. If
customers prefer dealing with good-looking employees, attractive sales representatives might
bring in extra revenue for the firm and attractive waiters/waitresses might lure more paying
clients into a restaurant. In these cases, higher productivities could justify higher earnings. The
authors do find some evidence that attractive employees gravitate to those occupations in which
physical beauty is most likely to matter, but the quantitative importance of this occupational
sorting seems quite weak. Employer bias, again, seems a likely suspect.

An earnings gap between beauties and beasts has another important potential
implication as well: crime. If less attractive individuals find it more difficult to earn high wages
in legal occupations, they might be more likely to turn to illegal ones. Economists Naci Mocan
and Erdel Tekin report finding that people judged to be unattractive are more likely to have
committed crimes and those deemed more attractive than average are less likely to have
committed crimes. Indeed, one man's explanation of why he had been committing robberies was
quite straightforward: "I am too ugly to get a job." 5

Solutions?

Economists have no magic bullet to slay bigotry; but our arsenal is not
empty. Remember that discrimination takes a bite out of employers' profits as well as the pride
and pocketbooks of those on the receiving end. Indulging our prejudice can be expensive. If
firms pass up minority applicants to hire less-qualified white males, their bottom lines ultimately
will suffer.

Managers in protected environments can afford lost profits, but those in dog-eat-dog
markets cannot. A monopolist can hire Uncle Louie's inept son-in-law and survive. A perfectly

187
competitive firm cannot. Less efficient workers mean higher costs that rival firms are poised to
exploit. Firms facing cutthroat competition live continually on the edge, knowing that the
slightest strategic lapse might unlock the door holding the competitive wolves at bay.

Competitive firms in competitive markets have no freedom to discriminate. When

survival depends upon productivity, bias takes a back seat. Such firms seek the best workers
regardless of race and gender or, in the long run, they pack it in. More and better competition
will not prevent bigotry, but it will certainly constrain firms' ability to act on it. Discrimination is
less likely to occur in competitive markets than in non-competitive ones.

_____________________________________________

Notes:

1. Kenney, Genevieve M., and Wissoker, Douglas A., "An Analysis of the Correlates of
Discrimination Facing Young Hispanic Job-Seekers," American Economic Review,
volume 84, number 3, June 1994, p.674 (10).
2. Bertrand, Marianne and Mullainathan, Snedhil, "Are Emily and Jane More Employable
than Lakisha and Jamal? A Field Experiment on Labor Market Discrimination,"
American Economic Review, volume 94, number 4, September 2004, p.991 (23).
3. Oreopolulus, Philip, "Why Do Skilled Immigrants Struggle in the Labor Market? A Field
Experiment with Thirteen Thousand Resumes", American Economic Journal: Economic
Policy, volume 3, number 4, November 2011, pp.148-171.
4. Hamermesh, Daniel S. and Biddle, Jeff E., "Beauty and the Labor Market," American
Economic Review, volume 84, number 5, December 1994, p. 1174 (19).
5. Mocan, Naci and Erdal Tekin, "Ugly Criminals", Review of Economics and Statistics,
volume 92, number 1, February 2010, pp. 15-30.
_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Describe the results of the Kenney and Wissoker experiment and how they compare to
later studies using different names and appearance.
2. Explain the difference between customer bias and employer bias and how a researcher
might determine which is the more likely cause of discrimination.
3. Explain why discrimination might impact the likelihood of criminal behavior.
4. Explain how the amount of competition in a market might affect the prevalence of
employer discrimination and explain why.

188
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Section II-D: Higher Education

Training is everything.... Cauliflower is nothing by cabbage with a college degree.

....Mark Twain

Education holds the key to our future. Want to get a better job? Get a college education.
Want a clearer understanding of the social and political issues of the day? Get a college
education. Want a broader appreciation of culture and the arts? Get a college education. Want
to appear more attractive to potential mates? Get a college education.

Despite its critical importance, funding systems are controversial and doubts about
educational quality persist. Even more importantly, students often resist learning. They
procrastinate when they should be studying. They try to avoid challenging classes that might
result in low grades. They skip classes and deliberately choose to limit their efforts. Is it their
fault? Or is it the fault of poor instructors? Should we care? Are we teaching the right skills?

Can economics explain such phenomena?

II-D. Higher education

1. Prices, quantities, and quality
Funding Options
Attendance Policies
Why Don't They Learn?
Educational Lemons
2. Issues in teaching and learning
Never Again; Again
Grades: Too High or Too Low?
Consumption Skills

189
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Education Funding Options

There is something noble about giving money to talented young people who could not
pursue their education without it.
...former Major League Baseball Commissioner Fay Vincent

Because college educations create external or spillover benefits,

free markets will produce inefficiently small amounts. You might want to
review the reading on external effects to refresh your memory about the
concept and graph. Governments routinely provide subsidies to increase
the number students attending, but the types of funding remain
controversial.

Public colleges and universities

Most government funding comes through annual budget grants to

state colleges and universities. These state subsidies drive down the
prices charged and, consequently, increase the quantity of students willing
to attend. In 2012-13 tuition and fees for an in-state student at a public four-year college or
university averaged $8,655 (Tuition and fees at my own institution Winthrop University were
$13,026). Tuition and fees at private colleges and universities that received no annual grants
averaged $29,056.1 Quite a difference.

Though state subsidies certainly increase the number of students in public colleges and
universities, their impact of overall attendance is less clear. To some extent, the subsidies simply
shift which schools students attend. Students who otherwise might have attended a private
school enroll in a public university instead. Private schools might be out of the financial reach of
low-income students, but relatively few students are truly “low-income.” College students in
general are drawn from families in the top half of the income distribution. Think back to your
high-school classmates. Which were more likely to continue on to college: those from well-to-
do families or those from the poorest families? Correct. Financially challenged students are
more apt to enroll in subsidized public colleges than in private ones, but the same holds for
students from richer families. Bargain prices attract the rich and poor alike.

190
 Unfortunately, if large chunks of the state subsidy go to students who might have
attended college anyway, taxpayers get less bang for their bucks. Middle class taxpayers end up
subsidizing children of upper middle-class families to help purchase college educations they
would have purchased anyway.

Need-based aid

An alternative approach would plow more funds into need-based aid. Grants to public
colleges lower tuition for students of all income levels, whether they need it or not. Need-based
aid goes only to low-income students who otherwise might not attend. It allows taxpayers to get
the same boost in overall enrollment at less cost.

States do provide need-based aid, and the federal government

tosses in more, but the amounts are relatively small compared to
general state subsidies to public colleges and universities. Increased
reliance on need-based aid does have advantages, but there is a
drawback as well. How do we measure “need?”

Government officials currently collect data provided on the

Free Application for Federal Student Aid (FAFSA) and, using a
complex formula, calculate the amount a family should be expected to
contribute to a college education. Schools then use this value to
compute “need” and, in turn, eligibility for need-based aid. Because
two families with similar income may have very different abilities to pay, the formula takes into
account more than a family’s current income. It also considers family size and the number of
other children in college as well as the amount of home equity and financial assets such as
stocks, bonds, and savings accounts.

The approach seems reasonable, and many economists do favor a significant funding
shift that would substantially increase need-based aid and decrease the annual grants that lower
tuition to all. However, need-based aid suffers one glaring economic flaw. It changes
incentives. Families quickly learn that if they diligently save money to finance their children’s
education, their children will qualify for less financial aid. The more assets the family builds
through saving, the less financial need their children will demonstrate. Compare two families
with $50,000 annual income. The one that scrimps and saves for years to help finance its
children’s education will qualify for little, if any financial aid. The one that fritters away its
income on fancy cars, country club memberships, and extravagant vacations will have no assets
to report and, consequently, will be rewarded with government assistance. Since assets count
against them in the need-based aid game, families have an incentive to spend rather than to save.

You’re trying to imagine how to picture this in a graph, aren’t you? Let me help.
Families would normally consider both the marginal benefit (MB) of saving and the marginal
cost (MC). The MC can be thought of as the value of goods and services you can no longer
buy. The efficient family would save as long as the MB covers the MC. Since each dollar a
family saves will result in it receiving less need-based aid, the system effectively lowers the MB
of saving. Check out the graph below.

191
Merit-based aid

My own state of South Carolina has shifted funds into merit-based aid. Modeled after a
system instituted in Georgia in 1993, South Carolina has poured tax dollars raised through its
state lottery into an expanded LIFE scholarship program. To be eligible for a LIFE grant, South
Carolina high school students must achieve two of the following: a 3.00 high-school GPA, a
ranking in the top 30% of the graduating class, 1100 on the SAT (or 24 on the ACT).

LIFE recipients currently receive grants of $5,000 per year that may be used at any
accredited college or university in the state. LIFE scholarships can be renewed up to four years
if the student maintains a 3.00 college GPA and completes 30 semester hours per year. Most
first-year students entering my own institution (Winthrop) enjoy either LIFE or similar assistance
from the state of South Carolina.

These grants presumably serve two purposes. First, they keep top high school graduates
in the state. Because many of South Carolina's colleges and universities are less prestigious than
those in other parts of the country, many of the its strongest students historically have chosen to
attend out-of-state schools. Since LIFE grants can only be used within South Carolina, the out-
of-state exodus should slow. Second, the grants are designed to increase student incentives to
succeed. The lure of scholarships is supposed to encourage high-school students to earn higher
grades, and the need to maintain a 3.00 college GPA should do the same for undergraduates.

Does the system work as advertised? Yes and no. The first goal certainly is being
achieved. Student demand for South Carolina colleges and universities rose significantly right
away. Applications to attend Winthrop and other in-state schools quickly soared to record
levels. Georgia’s experience was similar. Formerly known to many primarily as a party school,
the University of Georgia quickly found the academic quality of its applicants rising to new
levels.

So what? Remember that the reason for government subsidies is to expand

enrollment. There is considerable evidence that merit-based aid reallocates enrollment, but none
that it increases it. First, most of the merit aid is going to students from upper income families
who would have attended college anyway. South Carolina schools, like those in Georgia, will
enjoy increased enrollments, but they will come at the expense of lower enrollments in out-of-

192
state schools. South Carolina’s gain might simply be North Carolina’s loss. If so, there is no
benefit to society as a whole. Moreover, students enticed to stay in state for college do not
necessarily remain there after college. At least one study has concluded that such merit-based
aid has no significant impact on whether these students will stay in-state after graduation.2

More importantly, the jump in merit-based aid has given the state legislature an excuse to
cut the annual grants to public schools such as Winthrop. Faced with less state funding,
Winthrop (like other schools in the state) has increased tuition to compensate. As a result, tuition
increases have eaten away a significant part of the gains LIFE recipients would otherwise have
enjoyed. Students who receive and renew their grants still will be in good financial shape, but
others will not. Low-income students without access to merit-based aid will find even public
colleges increasingly out of their financial league. If so, the net effect could be for overall
college enrollment to fall.

What about student incentives to succeed? The evidence seems mixed. High-school and
college grades in Georgia did rise after implementing its merit-based plan. Proponents claim this
supports their contention that students are working harder and learning more. However, critics
contend that grades rose for other reasons. Knowing that students cannot get needed
scholarships without high grades, teachers might become more lenient and relax their
standards. Pressure from students and parents could easily accentuate such grade
inflation. Shifts in student course schedules also might account for the
higher grades.

Research on Georgia's program shows that the scholarships made

students less likely to enroll in demanding majors such as math and
science that typically award low grades and more likely to enroll in
majors such as education that often award higher grades. Students also
reduced course loads to maintain higher grades and shifted credits toward
summer classes that often enroll weaker students with less competitive
records.3 All of these views are plausible. Potential scholarships should
have the effect of increasingly the incentive for higher grades. Whether
the higher grades are more likely to be attained through harder work or
more pressure on teachers to relax standards or through shifts away from more difficult courses
and schedules still is an open question.

Experience with merit-based aid suggests that it reallocates, but not necessarily increases,
college attendance; that it probably skews assistance more towards academically talented
students from financially able families and less towards students from low-income families; and
that it may or may not lead to increased study effort and learning.

_________________________________________
Notes:

1. See " http://advocacy.collegeboard.org/sites/default/files/college-pricing-2012-full-

report_0.pdf.
2. Rampell, Catherine, "Freebies for the Rich", New York Times, September 24, 2013.

193
3. See "Evaluating HOPE-Style Merit Scholarships" by Christopher Cornwell and David
Mustard, Proceedings, Federal Reserve Bank of Cleveland, 2005, pp. 33-37.
_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the economic rationale for government subsidies for college educations.
2. Explain why economists might prefer need-based aid to government grants that lower
tuition for all.
3. Explain the economic disadvantage of using need-based aid.
4. Explain and discuss the possible advantages and disadvantages of South Carolina’s merit-
based aid plan.
5. Discuss why grades might rise as a result of merit-based college scholarships even if
students are not working harder and/or learning more.

194
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

To Attend, or Not to Attend

Eighty percent of success is showing up.

.....Woody Allen

When alumni return to visit a college campus, they

often ask the same question: have students changed? I always
answer: "yes". Most instructors on most college campuses
agree. "Students just aren't as good anymore," is a common
refrain. And it's true.

Be careful. Do not quickly malign the intelligence of contemporary

collegians. Individual students are every bit as able as in the past, but the average student is
probably less able. Why? Each year more and more students attend college. If larger and larger
percentages of the population attend, the average ability level will inevitably fall. If we want to
send everyone to college instead of only the academically elite, the average student simply will
not be as bright. When ability levels fall, faculty members must either award lower grades or
lower their standards. Most have lowered standards. Students who graduated with a "C"
average twenty years ago should take heart. In today's classrooms, similar efforts might bring
B's and A's.

Yet the drop in innate ability is small. Most students continue to be very able and
creative. To lessen the tension of final exams, I often include nonsensical trivia questions (for no
credit, of course). One semester I asked my Principles of Microeconomics students to identify
heffalumps. Many students ignored the question -- after all, it offered no credit -- and several
answered it correctly (a hallucinatory character from Winnie-the-Pooh). But the incorrect
answers were wonderfully imaginative. Do you want to see a sample? Heffalumps are:

....... yesterday's special at the cafeteria.

....... things that accumulate on your head after turning in final exams. They are caused by
pounding your head on the wall after remembering the correct answers.
....... the accumulations of cut grass deposited on the ground after the lawn mower has passed
over a particular spot.
....... knots you get on your fingers after holding a pencil through a two-hour exam (ouch!).
....... the fuzz balls around my room by the end of the semester.
....... very portly puffalumps.

195
....... contagious disease, usually caused by economics.

These are creative young people. They have ability; what's often missing is effort.

Where's the effort?

Numerous studies verify that current students log fewer study hours per week than their
predecessors. A typical student takes 16 credit hours per semester with about 14-15 hours of
physical class time per week. If we think of being a full-time student as a full-time job, the
typical student should be devoting about close to 30 hours outside of class to study each
week. That translates into the oft-heard rule of thumb: two hours of study for every one hour of
class time. Regrettably, a typical student reports spending only 15 hours per week preparing for
class -- about one-half of the recommended amount. Predictably, students in more difficult
majors such as engineering and STEM fields reported more hours of study.1

Why? Are students lazier than in the past? Probably not. More likely the change in study
habits simply reflects a change in the relative costs and benefits. First, the marginal cost of study
has been rising over time. With the relative price of higher education increasing each year, more
and more students are forced to work at part-time (or even full-time jobs) to earn enough income
to stay in school. But these jobs take time, and each additional hour on the job is an additional
hour that cannot be spent attending class or hitting the books. The need to work additional hours
raises the opportunity cost of calculus homework.

Second, for a variety of reasons, there has been an explosion of extra-curricular

opportunities available on most college campuses. In addition to the traditional varsity athletics
and Greek societies, students can participate in an increasing array of clubs, interest groups and
activities. At my own relatively small institution, students can choose to participate in more than
100 different organizations. Moreover, our university activities calendar lists concerts, lectures
and other miscellaneous events and performances for every night of the week. These groups and
activities do generate important benefits. They broaden the range of student experience, develop
leadership skills and enrich the college experience. However, they also put increasing demands
on student time and raise the opportunity cost of study.

Third, many students see less benefit to study than in the past. Historically, students
faced a wide variety of promising career paths that did not require a college degree. Students
unexcited by scholarly pursuits opted out of academia. But employees without diplomas today
often are stuck in unchallenging low-paid positions with little or no hope of advancement.
Today's students understand that college degrees have become the price of admission to good
jobs, even those jobs that don't require mastery of college-level material. They understand that
often what matters is the degree, the credential, not the knowledge. Many still come because
they want to learn, but more and more come because they see it as their best hope in avoiding
dead-end employment. Unfortunately, if such students care more about the credential than the
knowledge, they have little incentive to study more than is absolutely necessary to squeeze
through the system. They want to minimize the cost of obtaining the degree and, consequently,
study as little as possible. The motivation to learn suffers.

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Go to class!

Naturally, unmotivated students are less likely to learn. They also are less likely to attend
class regularly and, for many, this lack of attendance is a primary cause of poor performance. If
you're not there, you can't get it. Borrowing a classmate's notes might help, but it is a pitiable
substitute for your notes written in your own words.

Attendance matters. Measures of ability such as College Board

Scholastic Aptitude Test results or high school class rank are very poor
predictors of exam scores. In tests I once ran on my own students,
differences in ability explained very little of the differences in their
exam grades. On the other hand, differences in class attendance were a
very significant factor in performance and explained nearly one-half of
the differences in their exam averages. Each class a student missed
lowered his/her final average by about three percentage points. Since the "typical" student
missed almost 20 percent of the classes, that added up to a mess of D and F grades. Other
researchers report similar results.2 Even when detailed class notes and other materials are
available on a class website, attendance still matters.3

Each semester I warn students they are likely to fail if they skip more than an occasional
class. My colleagues do the same. Yet, each semester some students skip anyway, and each
semester they fail. What should we do? We can try to make our classes interesting and
worthwhile, but even the most popular instructors sometimes find themselves staring at empty
seats. Should we require attendance? Should we force students to come to class? Many faculty
members prefer a laissez faire policy and grade solely on such factors as test scores, quizzes and
papers. Others impose penalties for non-attendance per se.

Appropriate policy?

Some people contend students are irresponsible and that we should require attendance to
protect them from themselves. Economists are skeptical. Poor attendance might be perfectly
rational behavior. Perhaps a student can master course material merely by reading the
textbook.4 Perhaps a student has family or job obligations that are more important than class
attendance. Perhaps some instructors ramble incoherently or simply read "lectures" from the
text. In these cases, attendance may confer few or no benefits. Should we force students to
attend anyway? Moreover, learning to make choices and to accept the consequences of those
choices is part of growing up. If we wipe out students' freedom to choose, will an important
lesson be lost?

Economists generally advocate markets in which consumers make free choices about
what to buy or not to buy. We frown on restricting choice unless there is some compelling
reason to believe that free choices will damage others and create external effects. Might such
damage occur in the "market" for class attendance?

Maybe. Sporadic attendance can impede class discussions and slow the pace at which
material can be covered. The best classrooms are those in which students and faculty share in

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the pursuit of knowledge. But a sense of shared exploration is difficult to build or maintain when
students pop in and out at will. Students who skip classes, ask off-the-wall questions that were
answered last week, and then mooch missed notes and material from conscientious classmates
can poison the academic environment.

Taxpayers share the damage. State appropriations cover many of the educational costs at
public colleges and universities, and government-funded financial aid underwrites additional
student costs at both private and public institutions. Students who sleep in and blow off class are
wasting taxpayer money. If colleges and universities want the government gravy train to
continue, they had better ensure that the dollars are used wisely.

Are there good arguments to protect the students' freedom to choose? Yes. Attendance
by all students in all classes is not necessarily efficient. Are there also good arguments to restrict
that choice? Yes. Students may ignore the adverse effects they impose on classmates and
taxpayers when choosing whether or not to attend. Decisions to cut class that a student perceives
to be in his/her self-interest are not necessarily in the best interest of society. What should we
do?
____________________________________________

Notes:
1. See http://nsse.iub.edu/NSSE_2015_institutional report/pdf/Means/Mean%20-
%20SR%20by%20Carn.pdf, page 5.
2. See Romer, David, "Do Students Go to Class? Should They?", Journal of Economic
Perspectives, volume 7, number 3, Summer 1993, p. 167 (8). Marburger, Daniel R.,
"Does Mandatory Attendance Impact Student Performance," Journal of Economic
Education, volume 37, number 2, Spring 2006, pp. 148-155, also concludes that
attendance matters.
3. Stanca, Luca, "The Effects of Attendance on Academic Performance: Panel Data
Evidence for Introductory Microeconomics", Journal of Economic Education, volume
37, number 3, Summer 2006, pp. 251-266.
4. Stanca, op. cit., finds that the marginal return for an hour of classroom attendance is far
greater than the return for an extra hour of self-study.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Describe what has been happening to the average academic performance of college
students and explain the economic logic; include a discussion of the changing marginal
costs and benefits of study.
2. Discuss the economic arguments for and against requiring students to attend class.

198
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Why Don't They Learn?

An Educator's Lament

You teach a child to read and he or her will be able to pass a literacy
test.
...President George W. Bush

Every politician needs a whipping boy: someone to blame for

society's woes; someone at which to aim partisan ridicule and rhetoric.
Conservatives sling invectives at foreign terrorists and godless pro-
choice advocates, while liberals prefer targeting corporate fat cats and assault rifle enthusiasts.
Both groups eye teachers with increasing suspicion.

Education spending dominates state and local government budgets. Educational outlays
increase each year with no end in sight. Student performance apparently has not kept
pace. Despite additional dollars, American students seem to be losing ground to students in
other countries. Parents and employers complain that students have not mastered basic concepts
in grammar and arithmetic. Johnny can't read, Mary can't add, and neither can find Bangladesh
on a map.

As performance lags, politicians and parents clamor for more accountability, for better
results. State after state has developed performance standards, required schools to implement
outcome assessment plans, and mandated standardized testing to measure results.

Will it work? Not necessarily. Test scores usually do rise, but this often is the result of
teachers "teaching to the test" at the expense of other important material. Many classroom
instructors resent having to follow lockstep state-mandated curricula and lament being unable to
tailor classroom instruction to the needs and interests of their particular students. Others insist
that the time and money spent on developing standards and tracking assessment detracts from
their ability to concentrate on actual classroom instruction. Critics argue that what we need
better and more innovative ways of teaching, not state standards and assessment mechanisms.

Better methods?

What are those more effective techniques? What teaching methods will enable students
to learn more effectively? We do not know. It is not for lack of trying. Researchers have

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carried out innumerable experiments and filled professional journals with the results. But the
studies are remarkably inconclusive. Very few attempted innovations show any consistent
impact on learning.

Why are the results so poor? Perhaps the innovative methods work for some but not all
students. Students do learn in different ways. Some are more visual, others prefer to
listen. Some need hands-on work, others prefer reading books. An experimental method that
helps one student learn more effectively might cause problems for another. If so, the class as a
whole may show no improvement.

Economists see logic in this explanation, but doubt that it accounts for all that we
observe. Even if the new methods do prove to be more effective, they may not improve learning
or test results. Even the best innovations might be scuttled by what I call the Mileah Effect.

The Mileah Effect

Mileah graduated with a B.A. in Economics. No slouch, she took challenging courses,
challenging instructors, worked hard, and graduated with honors. But Mileah dreaded science
and, ignoring the continued warnings of her academic mentor, postponed taking her required
course as long as possible. In her last semester Mileah finally bit the bullet and enrolled in Dr.
Sutter's Oceans and Atmosphere class. It was a relatively popular course and Dr. Sutter was one
of the university's best instructors. A genuinely caring woman, Dr. Sutter continually sought
new and better ways to help her students learn.

Grudgingly Mileah set about her appointed task. She

attended class, took voluminous notes and studied. She studied
just enough to get a C on the first exam. She could have done
better but, in Mileah's eyes, a C was good enough. Besides,
she insisted, other students did even worse as the class average
fell well below normal levels.

Ever the concerned professor, Dr. Sutter responded by

asking students how she might help them learn the material
more effectively. Several replied that they found it difficult to
take good lecture notes and listen attentively at the same
time. Dr. Sutter, in turn, placed detailed class notes on the Internet so that students could
concentrate on following the material in class without worrying about trying to copy everything
down at the same time.

Mileah's academic mentor concurred that class attendance could now promote more
learning. Mileah agreed but, with a smile, responded that since class notes were available over
the Internet she could now earn the C she wanted without attending at all. After a quick
recalculation of the relative costs and benefits, Mileah promptly skipped 21 of the remaining 24
class periods and still got her C. Dr. Sutter's innovation did make it easier for Mileah to learn,
but Mileah failed to learn more. Techniques that facilitate learning do not always create
increased learning.

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Trade-offs and graphs

Economists stress that people respond to incentives; they insist that when we change the
incentives, people rationally change their behavior. That's exactly how Mileah
responded. That's exactly how all students respond.

Think of a student trying to choose between learning science and producing some
composite good called all else. The all else good might include such things as learning other
subjects (like economics!) and volunteering at the local soup kitchen, or it might also include
options such as playing video games and partying with friends. The opportunity cost of learning
more science is being able to produce fewer units of all else. Suppose our student faces the
production possibilities curve drawn below and decides that her most valuable combination is to
produce A0 units of all else and learn S0 units of science (at point X).

Next, assume that the student's science professor develops a new teaching technique that
facilitates learning. The new technique increases the potential amount of science the student can
learn and causes the production possibilities curve to swing out along the science axis (see the
graph below).

How will our student react? It depends. If she continues to spend the same amount of
time studying science, she will now learn more as a result of the new technique. She will
continue to produce A0 units of all else, but the amount of science she learns will rise to S1 (see
next graph). She moves to the right on the graph to point Y.

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 Alternatively, like Mileah, she could react very differently. She could reason that
because she now can learn the science she needs in less time she can spend less time studying
science and more on all else. If so, the amount of science learned stays at S0, while the amount of
all else produced rises to A1. She moves up vertically on the graph to point Z (the Mileah
Effect).

Even though the professor's new technique successfully enables learning and increases
production possibilities for our student, it does not necessarily increase the amount of science
learned. A chemistry major that sees value in learning science probably will use the innovation
to learn more science. However, students like Mileah who care little for science might simply
shift production to alternative products. The outcome of improved technology for teaching
science might well turn out to be better grades in economics or more hours volunteered at the
local soup kitchen, or better video game scores and more hours spent partying. Despite the
political rush to embrace them, outcome assessment plans and standardized test results might
easily be confounded by the Mileah Effect.

Note: Mileah moved to Louisiana just before Hurricane Katrina devastated the state in 2005.
She says that she now regrets wasting the chance to learn more about Oceans and Atmospheres.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain (without graphs) why improved teaching techniques do not necessarily increase
student learning.
2. Use a production possibility curve to show the effect of an improved teaching
technology, illustrate the potential student responses and explain.
3. Explain what types of students are likely to use the new technology to learn more and
what types will not.
4. Explain the implications of this analysis for educational outcomes assessment plans.

202
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Educational Lemons

He who can, does. He who cannot, teaches.

.....George Bernard Shaw

The alleged decline of American education

always is a hot topic. U.S. students are being
outperformed by students abroad in a wide variety of
fields. Theories abound, but one oft-heard explanation
blames low U.S. teaching salaries. Low wages create
shortages of high-quality teachers, particularly in math
and sciences, and the educational process suffers.

There is some truth to this. Some teachers

undoubtedly are underpaid, especially those in fields
for which high-paying non-academic jobs are
available. Most public schools offer one-size-fits-all
salary packages; instructors with the same rank and the same experience are paid equally. A
$50,000 salary might seem generous to an art teacher with few alternative occupations. But if
physicists can command $120,000 salaries in the corporate sector, it is folly to expect large
numbers to be interested in teaching for $50,000. If physics teachers are paid no more than art
teachers, shortages of physics teachers ultimately will surface.

Is it fair to pay physics teachers more? Don't art teachers work just as hard and,
therefore, deserve the same pay? Not necessarily. Work effort is largely irrelevant. It is quite
possible that the school custodian, who moonlights at the local Holiday Inn to make ends meet,
works harder than either the physics or the art teacher.

What about equal pay for equal work? Don't all teachers do the same work and,
therefore, deserve the same pay? Not necessarily. What matters is the result, not the
effort. Should a student who studies three hours for an exam and earns a 39 percent be "paid"
with the same grade as another who studies three hours and scores a 93 percent? If I train and
practice my basketball as hard as LeBron James, should I be paid an equivalent salary?

In addition, instructors in different fields do different work. A physics teacher needs

different training, different skills, and faces different challenges in getting the material across to

203
students. More important, the physics teacher faces different opportunity costs. The typical cost
in terms of foregone opportunities of becoming a physics teacher far exceeds that of becoming
an art teacher. Higher wages are essential in such cases.

What about other fields? Are teachers underpaid in general? Would higher salary scales
attract better-quality teachers? Perhaps. But recent studies suggest that changing the system of
teacher compensation might be more effective than changing the level of compensation.

Lemons: a digression

Many real-world markets are characterized by asymmetric information; that is, sellers
have better information than buyers about product quality. Used cars are an obvious example.

Imagine that you are in the market for a used car -- a 2002 Honda Accord. You know
that the going price for a "typical" '02 Accord is $4,000, but lack the mechanical sophistication to
judge the relative quality of a particular car you find for sale. The seller or owner will naturally
insist that the car is a "creampuff" even if she knows otherwise. As a cautious buyer unable to
judge whether the car is of above or below-average quality, you are not likely to offer more than
$4,000 for the car.

According to economist George Akerlof, sophisticated sellers will know this ahead of
1
time. If I own an unusually good Accord worth $6,000, I will understand that potential buyers,
because of poor information, will not pay more than $4,000. As a result, I will either keep the
car myself or else sell it privately to a relative or friend who knows (and will pay for) the car's
true value.
On the other hand, suppose I own
an '02 Accord that is a real "lemon." It
breaks down every third Tuesday on the
freeway and is worth only $1,500. If
you know my car's history, you would
never pay more than $1,500. But you do
not know. There is asymmetric
information; you cannot differentiate
between the clunkers and the
creampuffs. With a going price of $4,000, I have every incentive to sell, and you, lacking the
needed information to scare you off, are willing to buy. In a nutshell, Akerlof argues that when
prices are based on average quality, high-quality items will be withheld, and only the low-quality
items will be sold in the open market.2 Lemons squeeze out the creampuffs and, in the long run,
quality and prices will fall.

Unless. Unless sellers can find a way to signal buyers that their products are of higher-
than-average quality and, therefore, warrant higher-than-average prices. What signals might
work? Warranties are a common ploy. Sellers are less likely to market lemons if they assume
all repair expenses. Building brand-name reputations are another solution, especially in markets
with frequent repeat purchases. Lemons could destroy a reputation and wreck future sales.

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Lemons in academia

What does this have to do with teaching? Have you caught on yet? What if teachers are
lemons?

As with used cars, teacher quality is very hard to measure. How effective was your third-
grade teacher? How can we know? Should we measure comparative student performance on
exams? Not necessarily. The exams might be biased, some students might be brighter than
others, and current knowledge might not reflect long-term retention and use of that
knowledge. Moreover, as a result of what I term the Mileah Effect, the performance of students
in one subject might critically depend upon the quality of their teachers in other, seemingly
unrelated fields. For example, students whose math teacher explains concepts especially well
will be able to grasp algebra more quickly. With less need to spend long hours studying math,
they can spend more time trying to decipher the poorly crafted lessons of their less-than-
competent history teacher. If so, their improved history performance will owe more to the
abilities of their math teacher than their history teacher. And what about intangibles? How
important is the classroom enthusiasm a teacher might generate? How might it impact future
learning? How can it be measured?

Since administrators will inevitably make mistakes in judging performance, teachers have
resisted efforts to base their salaries on questionable measures of merit or productivity. Rather
than risk a mistaken assessment of their talents, they opt for a safer system that pays them
uniformly. Potentially strong teachers do try to establish brand-name reputations by earning
degrees from prestigious institutions, but this has little impact. In a world of union-scale salaries,
a teacher with an Ivy League pedigree can be paid no more than one with a degree from the
proverbial Podunk State.

And we are right back at Akerlof's model. If teachers are paid

uniformly on the basis of average productivity, those with above-
average abilities will be underpaid. Where possible, the most-
proficient instructors will relocate to occupations with merit-based
pay scales that will appropriately reward their superior talents. On the
other hand, "lemon" teachers, knowing that they are overpaid, will be
content to continue teaching. As in the used-car market, the best
products/people will leave. Both teacher quality and their long-run
price (or wage) will fall. Economists John Barron and Mark Loewenstein do find supporting
evidence.3 Average wage rates are higher in occupations with merit-based pay than in
occupations, like teaching, with little or no merit pay. They conclude that the current one-size-
fits-all pay structure:

...not only causes teachers to reduce their work effort, but it also results in a
sorting of high ability workers out of the teaching occupation. One consequence
is lower earnings in the teaching occupation. A second is less capable teachers.4

If this analysis is correct, raising the level of pay across-the-board will not solve the
problem. As long as teachers resist merit pay, the lemon model will remain applicable. Moving

205
to a system, albeit an imperfect one, of higher pay for better performance, might be more
effective.
_______________________________________

Notes:

1. Akerlof, George A., "The Market for Lemons: Qualitative Uncertainty and the Market
Mechanism," Quarterly Journal of Economics, volume 84, 1970, pp. 488-500.
2. Think of another example. Many people are reluctant to look for mates at singles bars or
through match-making services. They reason that the best potential mates, the ones who
are worth more than the average, already have taken themselves off the open market and
are marketing themselves privately. Those who remain in the open markets of bars and
dating services are more likely to be lemons.
3. Barron, John and Loewenstein, Mark, "On Imperfect Evaluations and Earning
Differentials," Economic Inquiry, volume 24, October 1986, pp. 595-615.
4. ibid., page 613.
________________________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Critique the arguments that all teachers should be paid the same salary because they work
equally hard and do the same job.
2. Explain the concept of asymmetric information and give an example.
3. Explain why lemons might dominate the used-car market.
4. Use Akerlof’s lemons model to teaching and explain the pros and cons of merit pay for
teachers.

206
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Never Again, Again

Procrastination is the art of keeping up with yesterday.

.....Donald Robert Perry Marquis

Every semester it is the same. The day after returning an exam, a student sheepishly slips
into my office to discuss an embarrassingly low grade. The student protests, "I understood the
material. But when I got into the exam, all that information just got jumbled together."

Why? To unearth the cause, I pose the expected questions. Did you read the assigned
chapters in the textbook? "Yes." Did you study your lecture notes? "Yes." Did you complete
the homework problems? "Yes." I probe more deeply. When did you read the text? "The night
before the exam." When did you start studying your notes? "The night before the exam." When
did you complete the homework? "The night before the exam." How much sleep did you have
the night before the exam? "None."

One mystery is solved, but another is waiting. Why did you wait until the night before
the exam? Why did you procrastinate? "I don't know." To drive home the message, I
continue. Have you learned your lesson? "Yes." Will you wait to study until the night before
the next exam as well? "No. Never again."

Should I believe the student? Would you?

Rational behavior

Economists assume that people make rational decisions, logically balancing the costs and
benefits of every action. We portray economic men and women as maximizing agents, carefully
rearranging consumption and production patterns until all possible "gains from trade" are
exhausted. Ignoring an unexploited gain, like leaving a $100 bill lying on the sidewalk, would
be irrational.

207
 This depiction of rational economic agents is a powerful tool. It allows us to harness
deductive logic and mathematics to derive behavioral predictions under an enormous range of
circumstances. It has spawned the development of an impressive array of quantitative and
statistical techniques to construct and test and refine hypotheses. It allows us to explain in a
systematic way what makes an economy tick. In short, it has created a scientific rigor often
absent from our sister social science disciplines.

But is it correct? Are people truly rational? Perfectly rational people do exist in
fiction. Star Trek's Spock is slavishly devoted to cold, hard logic and The Next Generation's Lt.
Commander Data is never swayed by emotion. Do real-world counterparts exist?

Never again

Not long ago, with my wife out of town, I bought a "family-sized" bag of crunchy cheese
doodles. That evening during a commercial break in Jeopardy!, I wandered into the kitchen,
pulled out the doodles, and ate them. All of them. Soon after, just as the Atlanta Hawks were
making a run at the Seattle Supersonics, my digestive system discovered the enormity of my sin -
- and made me pay. In the midst of my discomfort I vowed "never again!"

"Never again!" is exactly what I vowed the last time I gorged on crunchy doodles and, no
doubt, is exactly what I will vow the next time. In other words, I knew it would happen. As
soon as I pulled those luscious orange morsels from the grocery store shelf, I knew I would
overeat, and I knew I would make myself sick. I bought them anyway. I have vowed to never
do it again. But I will.

My colleague's office is in chaos. The debris has spilled off his

shelves and desk onto the floor. Two-year old post-it notes dot the side of his
desk and an eight-year-old planning calendar adorns the wall. With mounds
of boxes, books and papers effectively blocking any entry, he works and
holds "office hours" in the department lounge. One summer, during a rare
foray into the mess, he discovered a long-lost hairbrush buried under an
avalanche of papers on his desk. Beside it were the remains of a large
Hershey bar (no almonds), almost completely consumed by the office mouse. Only a small
corner of the bar and wrapping remained. We suspect the mouse is still there, happily living out
his years amidst the clutter.

In the midst of disarray, he vowed "never again!" That is exactly what he said the last
time this happened and, no doubt, is exactly what he will say the next time. His "I'm going to
clean my office" cry has echoed around the department for years, without measurable results. He
is no more likely to clean his office than I am to resist crunchy doodles or my students are to
study early for the next exam.

And we are not alone. Those of you with broken resolutions to cut back on smoking or
caffeine or ice cream or alcohol should sympathize with my craving for crunchy doodles. And

208
what about the faucet that still leaks (you promised to fix it weeks ago), the photos that need to
be arranged in the family album, the tax return sitting on your desk?

It is not that we want to wait until the last minute or want to overeat or want the office a
mess. We don't. We fully expect to be better off if we study early or no longer overeat or clean
the office or fix the faucet or arrange the photos. We fully intend to stop, clean, fix, arrange, or
whatever. We just never get around to doing it, and the potential gains are lost.

The role of salience

Why? Can this pathological behavior be reconciled with our textbook picture of
reasoned analysis of costs and benefits? Yes.1 Borrowing the psychological concept of
"salience", such behavior can be explained, and even predicted.

In a nutshell, people place disproportionate weight on vivid or "salient" events relative to

less vivid or "pallid" information. For example, even if Consumer Reports lists Mazda as the
most reliable car on the market, we are unlikely to buy one if a neighbor bends our ear every
week about the enormous repair bills her own Mazda runs up. Our neighbor's experience does
not alter Mazda's excellent overall record, but its salience or prominence will influence our
decision. Similarly, the loss of a single family member or friend to AIDS will have far more
impact on our perception of danger than all of the pallid data the U.S. Surgeon General can
muster. The AIDS-related death of famed tennis star Arthur Ashe had no more statistical
relevance than the death of an unknown victim, but its salience made a disproportionate impact
on public opinion and policy.

The same concepts can explain procrastination. The events and emotions of the day are
immediate and pressing, those of the future are vague and less vivid. The costs of dieting or
cleaning today are painfully salient; the costs of starting later are pallid.

Suppose a clean office is worth $1 per day, and the time and aggravation of cleaning has
a cost of $100. A rational agent should clean. The continuing $1 benefits per day will easily
outweigh the one-shot $100 cost over the long run.2 But suppose salience adds to the cost of
cleaning today rather than later. Suppose the salience of immediate pressures makes us assess
the current cost at $102 as opposed to the normal $100 cost on some future day. That small two
percent difference is all that it takes. If we think we can save $2 by waiting a day, and we value
a clean office at only $1 per day, it will always seem rational to wait. We will procrastinate
forever! Salience drives a wedge between current and future values. Rational agents are
supposed to foresee the impact of current decisions on their future well-being. But the salience
of short-run pressures can make us systematically act contrary to our own long-run best
interests.

Extensions

Salience can explain more than dirty offices and postponed diets or study. It can explain
more critical economic failures as well. It can explain our preoccupation with short-run profits at

209
the possible expense of long-run growth, and our passion for consumption at the expense of
saving.

According to conventional economic theory, workers voluntarily save whatever they

deem necessary for future retirement income. Saving anything less would be
irrational. Throwing such workers into mandatory pension programs should have no impact on
total savings. If workers already have saved the appropriate amounts, forcing them to save $100
in a mandatory pension should simply cause them to reduce their voluntary saving by
$100. Saving more than is necessary is just as irrational as saving less.

But that is not how real-world workers behave. Studies indicate that mandatory pension
plans do increase total savings. This result is not consistent with some theories of consumption,
but is easily explained by salience. The immediate pleasures of consumption are salient. Saving,
like office cleaning and study, can always be postponed until tomorrow.

What about deadlines? Deadlines can limit our ability to

procrastinate. We can wait forever to start a diet, but not to file our
taxes or complete a project for school or job. Salience can prompt us
to postpone such chores, but as the deadline approaches, the benefit
of quick completion begins to dwarf the cost of further
procrastination. The salience of current leisure activity is eventually
offset by the salience of impending doom. Students routinely wait
until Wednesday to prepare for Thursday's exam, but cannot
procrastinate until Friday. Non-students routinely wait until the
April 15 deadline to file tax forms.

Does it matter? After all, as procrastinators will insist, the homework is completed; the
taxes are filed. Nevertheless, procrastination can create real costs. The exam material studied at
the last minute is never mastered as thoroughly, and the paper written at the last minute never
flows as coherently. And taxes? Procrastinators due tax refunds sacrifice the interest they could
have earned with quicker action. Tax specialist Joel Slemrod estimates their annual loss at over
$1 billion.3 Additional administrative costs are incurred when the IRS must correct errors made
in hasty attempts to meet the deadline, and local post offices extend hours to accommodate last-
minute filers.

Slemrod and his colleagues also suggest a second explanation for procrastination. They
note that the cost of action will vary from day to day. Poring over taxes or studying or cleaning
an office is very costly on a sunny day on which you are offered box seat tickets to see the New
York Yankees hammer the Boston Red Sox. The same chores are much less costly when
inclement weather limits alternative pursuits. Suppose the cost of spending time to calculate
taxes on any given day is drawn randomly from a normal, bell-shaped distribution of possible
values. In this case, we must balance the cost of action today against the likely cost of action
tomorrow. Even if salience is unimportant, rational agents will postpone action if they anticipate
drawing a lower cost of action in the future. In their words:

210
 ...people do not leave $100 bills lying around on the sidewalk forever. However,
they may leave them there for some time while they wait for a moment when
bending over to get the bill is relatively painless.4

______________________________________

Notes:

1. See Akerlof, George A., "Procrastination and Obedience," American Economic Review,
volume 81, number 2, May 1991, pp. 1-19. Much of this section draws on his perceptive
analysis.
2. This example ignores the possibility of investing the $100 and earning interest. A more
complex example that allows such investment easily could be constructed to illustrate the
same concept.
3. Slemrod, Joel, Christian, Charles, London, Rebecca, and Parker, Jonathon A., "April 15
Syndrome," Economic Inquiry, volume 35, October 1997, pp. 695-709.
4. Ibid., page 708.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the concept of salience.

2. Use the concept of salience to explain inefficient procrastination and inefficient savings
patterns.
3. Use the concept of salience to explain the impact of deadlines.

211
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Grades: Too High or Too Low?

I met my goal; I didn't cry when I saw the test.

....anonymous student commenting
on an economics exam

Final exam week creates trauma for professors,

too. Confronted by the sins of their semester, students
storm our offices seeking pardon and absolution. We are
beset with pleas for mercy, with tales of anguish and
affliction (not to mention dead grandmothers). While some faculty members are more
benevolent than others, those of us in economics typically are judged to be an unforgiving lot
with brutal exams, unreasonable standards and demonic grading scales.

It is all true. We economists deserve our villainous reputation. We dish out some of the
lowest grades of any departments. For example, in a recent semester at my former university,
economists awarded 30 percent more D and F grades in introductory courses than did other
social science departments.

Economics is tough

My colleagues were not unique. A survey of nine prestigious schools found that certain
departments (economics, math and chemistry) consistently awarded lower-than-average grades,
while others (art, English, philosophy, political science, and psychology) bestowed
higher-than-average grades.1 Surprisingly similar patterns can be found across a broad range of
colleges and universities.

Why? Low grades might make sense if students in a department were especially thick-
headed. But no one believes the typical economics or math or chemistry student is less able than
one in art or English or political science. If anything, "low-grading" departments attract brighter
students than do "high-grading" departments.

It is tempting to blame the lower grades in economics, math and chemistry on their
inherent difficulty. If it is tougher to learn some fields than others, the grades should be
lower. But this begs a deeper question -- why is it tougher. Is economics more difficult than
political science because of inherent differences in the disciplines, or because we choose to make

212
 it more difficult? What if I choose to cover less material in less
depth? What if I choose to show videos in every other class
instead of filling the chalkboard with graphs and equations? What
if I choose to construct simpler exams or adopt more lenient
grading curves? What we expect students to master is largely a
matter of professional choice. We could make economics and
math and chemistry less difficult (or art, English, etc. more
difficult). The real question is why some professions choose to
make their disciplines more demanding than others.

Is it genetic malevolence? Probably not. It is more likely the result of simple supply and
demand. In free markets, prices rise and fall as necessary to keep the quantities supplied and
demanded in balance. Increases in demand drive prices up and decreases in demand drive them
down. Suppose Kandinsky paintings suddenly become more fashionable.2 The ensuing
consumer scramble will drive up the price of his available works. The price will keep rising until
it becomes high enough to choke off the excess demand.

Alas, markets for college courses do not work so well. Colleges and universities use very
unimaginative price systems; departments are not free to raise and lower course prices at
will. With few exceptions, a three-credit course in economics or math is priced the same as a
three-credit course in English or psychology. These uniform prices might make sense if
demands were also uniform, but they are not. Students often prefer courses and curricula that
lead to high-paying jobs. Where starting salaries are high, the demands for courses are also
high.

Suppose departments were allowed to charge prices that reflected the demand for their
courses. Because of strong demand, the free-market prices for courses in high-salary fields like
chemistry would be driven up. The demand for courses in low-salary fields like English would
be lower, and these departments would cut prices to entice students into signing up. However,
when colleges and universities impose uniform across-the-board prices for all courses, price
adjustments cannot occur. As illustrated below, the uniform price is likely to be below the
equilibrium in high-salary fields and above the equilibrium in low-salary fields. This creates
excess demands in high-salary fields and excess supplies in low-salary fields.

213
Non-Price Rationing

When prices cannot rise to ration out excess demand in a market, non-price rationing
devices typically emerge. For example, when local governments enact rent controls, apartment
owners often cut maintenance to reduce costs. Unable to increase rents, landlords cut quality
instead to protect their profits. However, college professors cannot do that. If they cut course
quality to ration out excess students, they jeopardize their chances for tenure and promotion. But
professors have another option: low grades.

By raising standards and lowering grades, professors in high-salary fields can wipe out
the excess student demand. Similarly, if professors in low-demand disciplines cut standards and
raise grades, they can increase their number of students and fill otherwise empty seats. If the
hypothesis is correct, professors in fields leading to high-paying jobs should award low grades
and vice versa.3

That is precisely what we find. Table I lists average job offers from the Spring 2009
survey conducted by the National Association of Colleges and Employers.4 The low-grade
departments identified are the same ones with the highest starting salaries and vice versa.

Table I
Low-Grade Departments:

Chemistry: $43,694
Economics: $52,027
Math/Statistics: $47,584

High-Grade Departments:

English: $32,733
Political Science: $38,284
Psychology: $34,942
Visual and Performing Arts: $36,997

Unable to raise or lower explicit monetary prices, departments apparently use grades to
adjust implicit prices instead. High-salary departments apparently use low grades to drive excess
students out while low-salary departments use high grades to raise demand and lure students
in. If colleges and universities scrapped uniform fees and let prices equate quantities supplied
and demanded, grade differentials might disappear. Food for thought.

Of course, salaries are not the only factors that might affect course demands and, in turn,
grading standards. Whether or not a course is required can have the same effect. For example, if
all students in a university are required to take History 101, the demand for that course will
remain strong, regardless of what salaries history majors might expect to earn. All else equal, we
should expect that grade distributions in required courses will be lower than those in electives.

214
Masking comparative advantage

The system is not efficient. First, if salaries are higher in economics and math than in
English and art, it must be because society values training additional students in these disciplines
more highly. If so, we should channel more, not fewer, students into these fields. Yet the lower
grades awarded in economics and math classes discourage such shifts. Students respond to
grades. Those earning A grades in introductory courses often schedule additional courses; those
getting D and F grades do not.

Second, we want students to study the fields in which their relative abilities are strongest,
fields in which they have a comparative advantage. A young woman who learns mathematics
more efficiently than English, should major in math. Ideally her relatively abilities in math
would generate higher grades which, in turn, would signal her to study more math. But if some
departments are "tougher" than others, these signals become distorted. For example, suppose
math professors set higher standards than do English professors. Suppose, as a result, that her
near-the-top-of-the-class performance in math garners only a B while her more mediocre
performance in English still is enough for an A. Confronted with a B in math and an A in
English, she might mistakenly assume that her comparative advantage is in English and schedule
additional courses accordingly. Even if she knew the grades were inaccurate signals, she might
succumb to the lure of the "easy A" and pursue English rather than math.5

How do we fix this? Should we push math grades up or pull English grades
down? Unfortunately, as average grades rise, the dispersion of grades tightens. And dispersion
is what we need to signal the relative or comparative advantage of individual students. Suppose
we assign everyone in the top half of our classes an A, and assign everyone else a B. Many good
students will get straight A grades and weaker students straight B grades. But a student report
card with only A's, or one with only B's, will give no indication of where their comparative
performance was best. If we want to guide students to the disciplines in which their relative
productivity is highest, a low-grade regime might make more sense. Grades indicate
comparative advantage more accurately in a world of low-grade departments than in one of
high-grade departments.

__________________________________________

Notes:

1. Sabot, Richard and Wakeman-Linn,John, "Grade Inflation and Course Choice," Journal
of Economic Perspectives, volume 5, number 1, Winter 1991, p. 159 (12). A more recent
study by Kristin butcher, Patrick McEwan and Akila Weerapana ("The Effects of an
Anti-Grade-Inflation Policy at Wellesley College", Journal of Economics Perspectives,
volume 28, numeber 3, Summer 2014, pp. 189-2-4) finds similar results for
Wellesey. Students taking math, science, and economics received lower-than-average
grades while those taking English, visual and performing arts, psychology and political
science were among those receiving higher-than average grades.
2. Wassily Kandinsky, a Russian living from 1866 to 1944, generally is credited as being
among the foremost artists of the twentieth century.

215
3. Economist George Chressanthis first developed this argument in correspondence to the
author.
4. See http://www.docstoc.com/docs/7400170/NACE-Salary-Survey-2009-Top-Employers-
for-Graduates. The data were accessed July 23, 2010.
5. Sabot and Wakeman-Linn (op. cit.) estimate that the Department of Mathematics at
Williams College could generate an 80 percent increase in the number of students taking
at least one additional math course if it used the same grading scale as the Department of
English.
_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Can you identify academic departments that typically award lower-than-average

grades? Higher-than-average grades?
2. How might grading standards be related to salaries? Illustrate with demand and supply
curves and explain.
3. Explain how different grading standards across disciplines can lead to inefficient student
choices.

216
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Consumption Skills

All human evil stems from one fact alone: man's inability to sit
still.
...Blaise Pascal

Charlie Schneider did it. Charlie lived down the hall in my

University of Maryland dormitory1 and loved opera. Majoring in
French, he also had taught himself Italian and German by listening,
libretto in hand, to Puccini and Wagner.

Me? I was double majoring in mathematics and sloth, and gritted my teeth at the mere
thought of foreign languages. I did enjoy music, but my tastes began and ended with Dick
Clark's American Bandstand -- a sort of prehistoric MTV. Opera, complete with overweight,
melodramatic sopranos and bearded, red-faced tenors, was not for me. That I had never seen nor
listened to an opera did not matter. Opera was not for me.

I was wrong. Charlie lured me with the legend behind Wagner's The Flying Dutchman
without hinting that it had any connection with opera.2 Once I rose for the bait, he sprung the
trap. Oh treachery. He began with a single song -- the Sailors' Chorus. It was accessible,
rousing, and vaguely familiar. I nibbled. Moving in for the kill, Charlie set his hook with
Senta's melodic ballad Traft ihr das Schiff, and reeled me in with the finale: the Dutchman, Erik,
and Senta in an exhilarating trio. It was over. Opera was for me.

I do still enjoy more popular songs. When flicking through the channels, I still pause to
look at current artists -- especially when Shakira or Carrie Underwood flash across the
screen. But, they do not compare favorably. The emotional range of Justin Bieber's voice pales
beside that of Luciano Pavarotti, and nothing that Lady Gaga has ever recorded can match the
beauty or pathos of Madame Butterfly's Tu piccolo Iddio. Thank you, Charlie.

The economics of boredom

What's my conversion to opera got to do with economics? Plenty. Economists assume

that consumers try to maximize their happiness or utility. We often highlight products like food

217
and shelter, goods that create comforts. However, people cannot live by bread alone -- or even
hot fudge sundaes. We need stimulation; we need excitement. The real economic problem of
our era might not be unemployment or even physical poverty. The real problem might be
boredom.

In The Joyless Economy, economist Tibor Scitovsky insisted that we are restless and
unable to use our leisure time in a constructive or satisfying manner; that we "are unskilled and
unprepared for making enjoyable and socially acceptable use" of the leisure modern civilization
has afforded us.3 To him, the challenge of modern society is not to produce more intelligently,
but to consume more intelligently.

Physical activity is one way of relieving boredom, mental

stimulation is another. We need both. Many of us find ample challenge
and stimulation in our day-to-day work, but many do not. Boredom is
most apparent among the unemployed elderly and youth. Retirement
homes struggle to ease the boredom of their residents, a boredom that can
destroy the physical health as quickly as the mental health of its
victim. The idle youth of America seem more successful in finding
activities that provide excitement. Unfortunately, as media reports remind
us daily, not all of them are constructive.

Since stimulation and excitement are basic human needs, it behooves us to channel them
in beneficial directions. If we expect people to consume leisure intelligently, we had better start
teaching them the necessary skills. Consumption skills do not occur naturally and, according to
Scitovsky, people who are "devoid of those skills tend to restrict their choice to sources of
stimulation and excitement that require no special skills, such as sex, rape, drugs, violence, and
crime."4 That's not a pretty picture.

The role of culture

Constructive and satisfying ways to consume leisure often fall under the rubric of
culture. The contemplation of art, music, literature, history, and even economics, can offer
endless hours of potential joy and stimulation. But, they are skilled consumption activities; they
require education. Those who never have studied painting will not be stunned by the National
Gallery of Art. Those who never have struggled to produce music themselves cannot appreciate
the full power and beauty of a Bach Requiem. Those who never have progressed beyond pulp
fiction will not be moved by the words of Albert Camus. Those who never have studied
macroeconomics will not be able to vote intelligently on deficit reduction plans.

To be pleasurable, a stimulus must contain the right mix of redundancy and

novelty. Experiences that are too familiar or redundant are boring; we need an element of
surprise or novelty to hold our attention or interest. But experiences can be too new as
well. Those we perceive as totally foreign can bewilder, even frighten. A film such as Alien III
might delight a teenager accustomed to Hollywood horror, yet terrorize a younger child with no
prior exposure to movie mayhem.

218
 Movies are not the only examples. Scitovsky argues that art cannot fully be appreciated
unless it is in a reasonably familiar style, and successful literature must portray characters and
dilemmas to which we can relate. Similarly, conversation, even gossip, must be about people or
places we know if it is to hold our interest. Even jokes are funny "only if the surprise or
unexpected twist of its ending follows a familiar and unsurprising beginning." 5 Or consider
opera. A neophyte thrust into the audience of Gotterdammerung might be in misery -- too much
novelty. But careful tutelage at each step might supply the redundancy needed to understand and
appreciate the performance. A Charlie Schneider might make all the difference.

To Scitovsky, culture is "the preliminary information we must have to enjoy the

processing of further information;" it provides the redundancy needed to appreciate additional
experiences. Culture is the source of skilled consumption. The greater the initial cultural
background, the greater will be the demand for, and the benefits from, additional culture.

In other words, to channel our search for stimulation in constructive directions, we need
skilled consumption. To get skilled consumption, we need culture. And to get culture, we need
education. Do our schools and universities produce the culture we need? Not necessarily. The
numbers of high school and college graduates has mushroomed, yet no parallel boom in cultural
pursuits is apparent. Recent trends in educational curricula have not pushed consumption skills;
they have pushed production skills instead.

Consumption or production?

On the surface, emphasizing production skills seems reasonable. After all, growing
economic complexity requires ever-increasing technical skills. Employees without college
degrees often are stuck in unchallenging, low-paid positions with little or no hope of
advancement. With the gap in average earnings between college and non-college graduates
widening, students understandably clamor for "practical" education, something to give them an
edge in an increasingly competitive job market. However, the “practical” skills students often
demand can become outdated quickly. Even assembly line jobs today are far different than they
were 20 years ago. Concentrating on a narrow set of practical skills often is the first step to
obsolescence.

Paradoxically, while college degrees are more critical than ever in the workplace, most of
the specific information learned in college is surprisingly irrelevant. Few graduates ever use
much of the technical material so carefully crammed prior to exams. I regularly require
macroeconomic students to reproduce sophisticated diagrams that illustrate the impact of an
exchange rate appreciation on interest rates and output. But I have yet to find a graduate who
used similar graphs on the job. And economics is not alone. Will former math majors ever again
prove the Cauchy-Schwarz Theorem? Will former English majors ever again deconstruct
Beowolf?

Although most of the specific pieces of information learned for a college exam soon are
forgotten, the thinking, problem-solving and communication skills students practice and develop
in preparing for and taking these exams are not. And developing those thinking, problem-
solving and communication skills are what ultimately matter. Those are the skills that employers

219
want. In this sense college is the training ground that forces students to build the "general" skills
of communication, problem-solving, etc. needed to succeed in any career path. That's why
employers look for that degree. What a student learns in college may be much less important
than whether or not a student graduates. While a college degree raises average earnings by
almost $20,000 per year, what a student studies has remarkably little impact. Over the long run
those who major in the liberal arts seem to fare about as well as those in more "practical" majors
such as accounting or engineering or nursing. Real job training still occurs on the job, not in the
classroom.

According to economist Joseph Stiglitz, graduation provides a signal. It signals that the
potential employee has the qualities needed for success in the modern job market. Stiglitz agrees
that what students learn in college does make them more productive; but, in his view, the role of
college is not so much to teach as to screen people with scarce abilities.6

Because employers use a college degree to screen applicants, students wanting a shot at
the best jobs must attend college. The result is a glut of graduates. With the number of new
graduates increasing faster than the number of new jobs, many end up in occupations that did not
previously require a college degree. One study estimates that 35% of recent graduates will end
up in jobs that do not "require" a college degree. Millions of college students struggle to master
production skills they will never use. They can be over-trained, over-qualified, and frustrated.

What should colleges teach? If production skills are over-supplied, what is the
alternative? Consumption skills? As Scitovsky put it:

There would be nothing wrong with sales clerks...having, or even being required to have,
B.A. degrees if those degrees enabled them to better enjoy the books they read or music
they listen to while waiting for customers. Mostly, however, their diplomas give them
production skills which lie fallow and whose acquisition crowded out the education that
would have prepared them for the better enjoyment of their increased leisure.7

Notre Dame's Gary Gutting writes that "the fruits of college teaching should be measured
not by tests but by the popularity of museums, classical concerts, art film houses, [and] book
discussion groups... These are the places where our students reap the benefits of their
education." More importantly, he argues that those unaware or unappreciative of our
"intellectual culture" lack the primary source for new ways of seeing and thinking. In this sense,
it is culture that generates the creativity that ultimately fuels economic growth.8

__________________________________________

Notes:

1. In the 1960's we did not yet know to call them "residence halls."
2. His choice was particularly effective in that, as a die-hard baseball fan, "The Flying
Dutchman" was already a familiar expression. It was the nickname of Honus Wagner,
perhaps the greatest shortstop ever to have played the game.

220
3. Scitovsky, Tibor, The Joyless Economy, revised edition, Oxford University Press, New
York, 1992. The remainder of this section draws heavily on this classic treatise.
4. ibid., p. 300
5. ibid., p. 225
6. Stiglitz, Joseph E., Economics, W.W. Norton, New York, 1993, p. 297-299.
7. Scitovsky, op. cit., p. 230
8. Gutting, Gary,"Why Do I Teach?" New York Times, May 22, 2013.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Identify groups that are likely to suffer from boredom and explain the problems this can
cause.
2. Explain the concept of consumption skills? Why must such skills be produced?
3. Explain the signaling function of colleges and universities.
4. Explain the disadvantage of stressing production rather consumption skills.

221
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Section II-E: Religion

I shall never believe that God plays dice with the world.
....Albert Einstein

Americans claim to be a religious lot. Collectively, we plunk down billions of dollars and
over a billion hours -- all voluntarily -- in support of worship and faith-related activities every
year. That's major stuff.

Religion is not bought and sold like potato chips, but there are parallels. Religion is
marketed in firms called churches, or maybe synagogues or mosques. Some prosper; others
die. Why? Consumers make choices about which brands of religion to consume and how much
religion to consume. Some of us choose to "believe," and others not. Why? Some of us choose
to be Catholic, others Baptist, other Muslim. Why?

Is it the hand of God? Is it economics?

II-E. Religion
1. That Old-Time Religion
2. Risk and Religion
3. Sacrifice and Stigma

Material from these readings have been published in part in "Economics of Religion," by Robert
J. Stonebraker in Economics Uncut: A Complete Guide to Life, Death, and Misadventure, edited
by Simon Bowmaker, Edward Elgar Publishing, 2005.

222
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

That Old-Time Religion

There is only one religion, though there are a hundred versions

of it.
.....George Bernard Shaw

Economists stick their collective noses everywhere. We

hold nothing too sacred to invade with supply and demand
curves. Not even matters of faith.

We treat religion as a differentiated commodity produced

and consumed in a competitive marketplace. Consumers purchase religion in a way that
maximizes utility, and churches produce religion in a way that maximizes profit. Most
theologians and sociologists are well aware of the economics of religion, but the politicians,
preachers, and media toil in the dark.

A casual observer of most religious TV shows will hear that America has lost its spiritual
way. Those listening to political rhetoric about "family values" might reach a similar
conclusion. Former President George H. Bush insisted that the omission of the word "God" in
the 1992 Democratic Party platform verified our fall from grace. Members of the erstwhile
Moral Majority claim that our best hope for salvation lies in recapturing the values and the faith
of our fathers. These, we are told, are values and faith that still stand rock solid in the rural
heartland of America, but have been lost in the urban sprawl of our modern decadence.

Religion on the rise

Lunacy. Objective measures indicate that Americans are as religious as ever. For
example, Roger Finke and Rodney Stark find that U.S. religious adherence and church
attendance (as a percent of population) have risen almost continually over time1. Percentage
church attendance during the heyday of Cotton Mather in Boston around 1700 pales relative to
that of modern day Las Vegas. In addition, religious participation is higher in our cities than
down on the farm. According to data presented by Finke and Stark, rural America has never
been as religious as urban America.2

223
Percent of Americans Who Belong to a Local Congregation

1776 17%
1850 34%
1870 35%
1890 45%
1906 51%
1916 53%
1926 56%
1952 59%
1980 62%
1990 64%
2005 69%

In several surveys since 2005 the number of Americans claiming no particular religious
identity has increased. But even these religious “nones” often are quite religious; they simply
do not adhere to a specific dogma. Most believe in God, and pray and attend religious services at
least occasionally. Indeed, a significant minority of the nones profess that religion plays an
important role in their lives.

Not only is American religiosity strong -- especially in urban areas -- it exceeds what can
be found in many other countries of the world. Economist Laurence Iannaccone compared a
wide variety of religious measures across 18 industrialized nations3. The U.S. ranked at or near
the top in every one. If the moral fabric of America is in decay, a lack of religiosity is not to
blame. Politicians had better look elsewhere for explanations. Why this strong religiosity? To
economists, the answer is simple; it is pluralism.

In colonial America, as in many modern nations today,

religion was dominated by a single church. Congregational churches
dominated colonial New England, just as Catholicism dominates
modern Italy and Lutheranism dominates modern Scandinavia. But
consumers have differentiated tastes in religion. Just as a Baskin-
Robbins that sells only vanilla ice cream will lose sales, a country
that offers only one brand of faith will lose religiosity. Anything the
monopoly faith does to please one market segment is likely to
alienate another. But, in a pluralistic market with many diverse
choices, more consumers can find a "flavor" of religion that appeals
to them. Choice matters.

In addition, an ice cream seller that faces no competitive pressure could easily become
lazy and opt for the easy life. Why try to improve your product and service when customers
have no alternatives? Why try to market your brand aggressively when no other brands are
available? Monopolies in the sacred realm are just as prone to sloth as those in the secular
world. Monopoly power is likely to sap the evangelical fervor of the dominant faith over time.

224
 Competition changes the game. It forces existing religious providers to stay on their toes
and provide better products. It also allows new faiths to emerge through time; some of which
will capture the minds and hearts of the heretofore heathen. Competition creates both more
efficient and more varied versions of religion. This explains the increase in U.S. religiosity over
time, and explains why church attendance is higher in the more pluralistic urban areas than in
rural areas where residents typically face fewer choices.

Government barriers

If monopoly faiths are evangelistically inferior, why have they survived? Adam Smith
had the answer more than 200 years ago. He knew that if clergy are confronted by competitive
pressure "their exertion, their zeal and industry" must rise.4 He knew that, like other producers,
churches would fight to insulate themselves from the rigors of such competitive pressure; that,
barring natural economic entry barriers, they would seek refuge in protective government
regulation. And they did. The religion of the king became a national, state-endorsed religion,
and alternative faiths were repressed through both legislation and violence. As Iannaccone puts
it, "From Old Testament Israel to contemporary Iran, religious uniformity has arrived on the
edge of the sword, and only the sword has sufficed to maintain it."5

Although the American colonies were settled by refugees seeking to avoid monopoly
church repression, they were intolerant themselves. They quickly set up government-backed
religions of their own. The U.S. Constitution prohibits any federally backed religion but, as
originally interpreted, it did not prevent individual states from establishing preferred
religions. Early colonists and citizens happily used state power to erect entry barriers against
new, upstart faiths that disagreed with their own. For example, Congregational churches
received revenues from colonial New England taxes, and itinerant ministers from other faiths
were banned from preaching without the prior approval of local clergy. As you might expect,
local clergy members routinely denied permission. They opposed new preachers trying to
encroach on their turf just as vehemently as do modern day merchants who might try to block
Wal-Mart from opening a new store down the street.

Successive waves of immigrants from diverse faith backgrounds helped erode

government barriers in the U.S. over time. Irish Catholics, Polish Jews, Pakistani Muslims and
Vietnamese Buddhists all have been stirred and simmered into America's melting pot. But, in
many European countries state-established and state-protected churches endure. For example, the
German government still subsidizes congregations through state-imposed membership taxes and
several Scandinavian governments continue to pay Lutheran pastors as civil servants. However,
as economic theory would predict, the established churches of Europe suffer from woeful
attendance and display considerably less evangelistic zeal than their American counterparts. For
example, while a large majority of Swedes are members of the official Church of Sweden, "very
few have more than occasional contacts with the church, and attendance at worship services is low
that the number of parishes is rapidly declining."6

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 Government policy seems to be the key element. When governments favor a particular
religion, or a particular brand of religion, religiosity falls. According to one recent study, when a
government establishes an official state religion, attendance falls by between 15 and 20
percent. On the other hand, when governments treat all religions equally, especially when all
brands of religion enjoy equal constitutional protection, faith tends to flourish.7 The evidence is
clear: monopoly production restricts output in religion just as in railroads. If greater religiosity is
the goal, laissez faire market competition is the means.

___________________________________

Notes:

1. Finke, Roger and Starke, Rodney, The Churching of America 1776 - 1990: Winners and
Losers in our Religious Economy, New Brunswick, Rutgers University Press, 1992. Data
for 2005 are taken from Rodney Stark, What Americans Really Believe, Baylor
University Press, Waco, Texas, 2008, p.12.
2. Ibid., pp. 203-207.
3. Iannaccone, Laurence R., "The Consequences of Religious Market Regulation,"
Rationality and Society, volume 3, number 2, April 1991, pp. 156-177.
4. Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776,
reprinted by Modern Library, New York, 1965, p.740.
5. Iannaccone, Laurence R., op. cit., p. 159.
6. Hamberg, Eva M., "Religious Monopolies, Religious Pluralism, and Secularization: The
Relationship Between Religious Pluralism and Religious Participation in Sweden,"
Interdisciplinary Journal of Research of Religion, Volume 11, 2015, p 8.
7. See North, Charles M. and Gwin, Carl R., "Religious Freedom and the Unintended
Consequences of State Religion," Southern Economic Journal, volume 71, number 1,
July 2004, pp. 103-118.

________________________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain two ways in which religious pluralism might impact the percentage of the
population that attends worship services.
2. Explain why religious participation in many Western European countries is lower than
that found in the U.S.

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Risk and Religion

Let us weigh the gain and loss in wagering that God is....If you gain, you gain all; if you
lose, you lose nothing. Wager then, without hesitation that He is.
.....Blaise Pascal, Pensees, 1660

Generations of students have studied Pascal's wager. To Pascal, choosing to believe in

God was elementary logic, a no-brainer. If we choose not to believe, we risk eternal
damnation. If we choose to believe, we risk nothing. If God does exist, believers will be
rewarded. If God does not exist, believers end up in the same boat as non-believers. Belief
creates no risk, no possible loss.

Alas. If only it were so simple. In the sacred, just as the secular, the devil is in the
details. Which God? Whose vision of God? Which religion? Shall we choose
Islam? Judaism? Buddhism? Christianity? If Christianity, shall we choose to be Roman
Catholic? Greek Orthodox? Protestant? If Protestant, shall we become
Lutheran? Baptist? Mormon? Jehovah's Witness? Perhaps Seventh Day Adventist?

The prerequisites for salvation vary markedly among religions. Different faiths demand
different and often mutually exclusive beliefs and actions. The official dogmas of a Shiite
Muslim and a Southern Baptist each condemns the other to an eternal hell. Pascal prods us to
believe. But believe what? Every belief, every choice, every path paints the potential of both
paradise and perdition. There is no safe belief.

Diversified portfolios

Wow. It's almost as bad as the stock market. Financial pundits prod us to buy. But buy
what? Potential rewards are countervailed by risk. Should we pack our portfolios with shares of
Amazon.com? If so, will internet sales soar and wing us to paradise, or plummet and plunge us
to perdition?

Don't ask me. I'll happily gamble $2 on a long-shot horse

in a six-furlong sprint, but I gave up selecting stocks long
ago. After all, I'm a guy who bought into Union Carbide just
before a 1984 disaster at its Bhopal, India facility killed thousands
of people and flushed its stock price down the toilet. I learned my
lesson; one that can be found in every principles of economics
text. The lesson is diversify. I'm still in the market, but only in

227
mutual funds, funds that track a broad-based market index. No more all-my-eggs-in-one-basket
flyers for me.

Hmmm. Diversify. If diversified portfolios can minimize financial risk, might they
minimize religious risk as well? Might investing in a variety of religions bring the same benefits
as investing in a variety of corporate stocks? Maybe. If we're not sure we've chosen the right
faith, can we hedge our bets and throw a few nods at alternative credos as well?

It's not a new idea. Do you remember your Roman history? Ancient Rome offered a
profusion of potential deities. Concerned about matters of the heart? Throw a few coins to
Venus, the goddess of love. Wheat crop look a bit sickly? Give a few bows to Ceres, the
goddess of agriculture. Trying to beat back the barbarians? Talk to Mars, the god of war. None
of the above appeal to you? How about astrology? What about the mystical cults of Isis or
Mithris? In the words of economist Laurence Iannaccone:1

All these existed, side by side, in an atmosphere of mutual toleration. Adherence

to one did not preclude involvement in another. Citizens could, and many did,
participate in multiple cults -- sacrificing to several gods, worshipping the
Emperor, and undertaking a variety of different rites and initiations.

Ancient Romans knew how to diversify, how to hedge their religious risks by patronizing
multiple faiths. And they are not alone. Indians might worship a variety of Hindu gods, while
Japanese families might claim both Buddhism and Shintoism, and yet rent a Catholic church for
their daughters' wedding.2 Closer to home, travel to the Arizona desert and visit Sedona or some
similar New Age Mecca. What do you want? Tarot readings? Meditation lessons? Astrological
charts? Trips to a mystical energy vortex? Crystals? Pyramids? Witch's covens? They're all
there. Take your pick. Or take several picks. Diversify.

Exclusive religion

Despite its potential, religious diversification remains the exception in the U.S. Most
adherents choose a specific brand of faith and consume it exclusively. Methodists seldom read
the Torah on the sly, and Unitarians are unlikely to frequent Holiness Revival Meetings. Why is
religious diversification not more common?

No firm wants its customers to diversify. Does Wal-Mart want us to shop at K-

Mart? Does Pepsi want us to diversify with Coke? Of course not. Every supplier lusts after
brand loyalty. But secular firms rarely command the fierce customer devotion enjoyed by
churches. Why? What enables a particular religious faith to command the sole allegiance of its
worshippers?

Secular firms wanting exclusive consumer allegiance first must diversify

themselves. They become full-line merchandisers and market themselves for one-stop
shopping. If you do not want consumers to shop elsewhere, you had better offer products that
cover all the bases. It works the same way in the sacred world. Because gods in the Roman
panoply specialized, none could command exclusive devotion. Centurions who may have paid

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homage to Mars before battle still were likely to invoke Venus in their bedrooms. But the Judeo-
Christian God is an all-encompassing, full-service deity. Faithful flocks in this tradition provide
a full range of cradle-to-grave services; services that include a comprehensive theological system
and a broad network of fellow travelers-in-the-faith to meet both social and emotional needs.

Comprehensive services are a necessary but not sufficient condition. My favorite local
supermarket offers comprehensive grocery services, yet I quickly will jump if a competitor runs
a special on Breyer's ice cream. Consumers will grant exclusive allegiance only if they find it
efficient to do so.

Strategies for exclusivity

Exclusive technology is one strategy. Do you want Sony's Play

Station game platform? You had better buy Sony games as well;
Nintendo's are not compatible. Similarly, Macintosh users cannot
easily diversify into Windows-based software; it is not compatible.
Similar ploys succeed in religion. While the Greco-Roman gods
tolerated multiple allegiance, the Judeo-Christian tradition demands
exclusivity. When Moses descended Mount Sinai, those stone tablets
were quite explicit. You shall have no other gods before me, and You
shall not make yourself a graven image...you shall not bow down to
them or serve them; for I the Lord your God am a jealous God [Exodus 20: 3-4]. Polytheism and
Christianity are far less compatible than Macintosh and Windows.

The first two commandments forbid Christians to shop for alternative gods, but they
place no restrictions on sampling different traditions within Christianity. They explain why
Christians do not diversify into Hinduism, but not why Mormons do not diversify into
Catholicism.

Perhaps such diversification is costly. Perhaps strategies that reward allegiance and/or
penalize defection might work. For years a local Giant Eagle grocery store won my allegiance
each November by offering a free Thanksgiving turkey if I spent at least $250 in the preceding
month. Although competitors ran similar offers, I was stuck. If I patronized one store
exclusively, I could make the $250 level. But if I diversified and split my grocery purchases
among several stores, I could not ring up enough sales in any one to qualify for the turkey. US
Airways grabbed my allegiance the same way with its Dividend Miles program. If I patronized
US Airways exclusively, I could run up enough frequent-flier miles to qualify for free trips. If I
split my flights among carriers, I never could make it.

Competing Christian groups pursue similar strategies. Christianity largely is a communal

faith. Worship, sacred rites, and other services are produced and consumed collectively within a
congregation of believers. Consumers not spliced into the intricate social networks within these
congregations derive few benefits. But these network connections seldom arise naturally; they
must be cultivated carefully over time. Those who split their shopping among several
congregations are unlikely to be successful.

229
 To drive home the point, many Christian faiths forcibly evict members intent on
comparison shopping. The Catholic who strays into Mormonism risks ex-communication,
separation from the family of faith. Mormons who regularly seek absolution from Catholic
priests risk an analogous sacred sacking.

Credence goods

If we cannot diversify, what next? If a specific choice must be made, a specific religion
chosen or not, how can we choose wisely? How can we limit risk?

The generic economic answer is "gather information." For search goods (those for which
quality can be determined easily by inspection), the process is trivial. Selecting the correct-sized
mailing envelope or the dress shirt of appropriate color requires little stress. The process for
selecting experience goods is messier. Their value cannot be evaluated easily until after they
have been consumed. Will the plumber we hire do a good job? We cannot be sure until after the
job is complete. to evaluate experience goods we seek advice from others. We ask friends about
which plumbers they have hired and consult Consumer Reports to assess which autos are likely
to be most durable and which wrinkle-free slacks are truly wrinkle-free.

Within limits, we do the same for religion. We seek testimonials, especially from our
friends, and especially from those with no financial stake in our choice. But, ultimately, the
information is inadequate. There are some goods -- credence goods -- whose quality we cannot
objectively measure, even after use. We took the pill our doctor prescribed and then
recovered. Was it the pill or would we have recovered, anyway? We never can be sure. What
about that new cologne? She said "yes" when we wore it. Was it the cologne or might she have
consented, anyway? We never can be sure. Credence goods.

Religion is the consummate credence good. We may not, at least in this life, ever know if
we picked a winner. Pascal aside, there is no safe choice. In the end, we pays our money, and
we takes our chance. Step right up.

_________________________________________

Notes:

1. Iannaccone, Laurence R., "Risk, Rationality, and Religious Portfolios," Economic

Inquiry, April 1995, volume 33, number 2, p. 285(11). Ideas presented in Iannaccone's
article provide the basis for much of this section.
2. See Ono, Yokimo, "Here Comes the Bride All Dressed in a Kimono," Wall Street
Journal, June 9, 1998, page A25.

________________________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

230
1. What is Pascal's wager? Explain.
2. People typically diversify to limit risk, why does this typically not happen in modern
religions? Explain.
3. Differentiate among experience goods, search goods and credence goods and give
examples of each. Which type of good is religion? Explain.

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Sacrifice and Stigma

The greatest vicissitude of things among men is the vicissitude of sects.

.....Sir Francis Bacon

My former Lutheran congregation once voted to call an Assistant Pastor. The meeting
was mercifully short and the vote predictably lopsided. A known curmudgeon citing financial
concerns voiced the lone dissent. Could our budget handle this extra expense? Would weekly
offerings be adequate? Treasurer Thorsen took the floor and assured us not to
worry. Parishioners would rise to the challenge and plans for a new stewardship campaign,
including an Every Member Visit, already were underway.

Begging for bucks

Every Member Visit. Even typing the phrase curls my toes and sparks
involuntary facial tics. As a young adult I agreed to join my congregation's
campaign. The goals were simple: visit every household in the congregation,
deliver offering envelopes for the coming year, and secure a financial
pledge. After a brief training session, I was assigned four households. A
cinch. Armed with pledge cards, boxes of envelopes and copies of budget
plans, I marched into battle on the appointed Sunday.

To ease into the fray, I began with an easy mark. I chose an elderly
parishioner who lived down the block and with whom I often shared
pleasantries on evening walks around the neighborhood. Big mistake. My
sheaf of pledge cards might as well have been a semi-automatic weapon. I could not get past the
front door. Her normal smiles hardened into open hostility and I unceremoniously was routed
from her porch. No admittance. No pledge. It was months before she again returned my evening
greetings.

Couple number two was wary, but let me through the door. They invited me to sit down
and listened politely before refusing to make a pledge. "We don't do that," was their response,
followed, as I stood to leave, by a "the church wastes too much money" zinger. The husband
began muttering something that about "long-winded sermons," but I continued toward the door
dodging deftly lest other barbs be hurled in my general direction.

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 My third visit went more smoothly. The family chose not to answer the door. I left the
offering envelopes inside the storm door with an "I'm sorry I missed you" note. Were they
out? Or were they lurking in the den waiting for me to leave? I will never know. But the family
cars all were in the garage.

The day did end on a more positive note. The Lacey's, my last family, welcomed me
warmly, offered me freshly baked goodies, engaged in an animated discussion of congregational
mission, and made a generous financial pledge. If only the other families had welcomed me so
enthusiastically. If only our other parishioners were as committed as the Lacey's. If only.

Large congregations

My congregation was a moderately large one. We had over 1,000 members, but were
lucky to find 300 at worship on a particular Sunday. Ushers scrambled to set up extra chairs for
overflow crowds each Christmas Eve and Easter but, on other Sundays, attendance dipped and
choir anthems bounced off rows of empty pews.

Being large does bring benefits. Multiple staff members support a diversified menu of
programs and interest groups that smaller congregations can only imagine. And there are cost
advantages as well. Attendance at liturgies, Sunday school classes, youth groups, and Bible
studies rarely approaches physical capacity. Stuffing in extra participants almost always lowers
the cost per person. Even when capacity is strained, constructing larger facilities often generates
economies of scale. A building large enough to handle 1,000 parishioners is not likely to be
twice as expensive as one built to accommodate 500.1

But bigness can be a bane as well as a blessing. Religious groups are often beset by free
riders, members who happily consume services but who run for cover when Every Member Visit
volunteers knock at the front door. Large congregations are especially vulnerable. The larger
the group, the easier it is to hide. Shirking one's proportionate responsibilities is tough in a group
of two, but easy in a group of 2,000. For those interested in marginal commitment only, large
churches are the place to be.

Free riders create at least two distinct problems for a religious congregation. First, free
riders can be expensive; they raise costs for the more committed members. Free riders might
duck when the offering plates pass by, but they seldom are shy about demanding services, and
often complain the loudest when such services are slow in coming. Clerics of every stripe can
identify dysfunctional families that rarely attend services or contribute funds, yet place
disproportionate demands on their time and energy. Second, free riders demoralize other
members of the congregation. If all members were as committed as the fore-mentioned Lacey's,
Every-Member-Visits would be a breeze. It is the uncommitted free riders who cause me to
equate such stewardship drives with root canals.

And there's more. Worship services are not discrete spectator events. They are chapters
in a congregation's continuing and collective journey of faith. Free-riding members who deign to
drop in sporadically impede that journey. Occasional participants do not appreciate where the
congregation has been or where it is going. Like derelict students who have skipped two weeks

233
of class, they sit in the back row with dazed expressions of confusion. They do not sing with
enthusiasm because the melodies and responses are unfamiliar. They do not pray with
conviction because their own commitment is marginal. They do not seek out and greet new
visitors because they cannot identify which people are visitors. Committed believers add
excitement to worship. Free riders suck it right back out.

Sacrifice and stigma

What can a church do? How can it create a congregation of committed and enthusiastic
members? To an economist, the answer is obvious. Change the relative price. When the price of
Pepsi rises, its less-committed adherents switch to Coke. When the price of tickets to Disney
World rises, the less-committed stay home and watch television. So it is with religion. Want to
weed out less-committed members? Raise the price.

What? Prices? Religion? Churches do not charge prices. Or do they? Congregations

may not herd members through check-out aisles at the exits, but they do charge prices. The
prices charged are not in the usual monetary terms. According to Laurence Iannaccone, they are
charged in terms of sacrifice and stigma.2

Do you remember the Hare Krishnas? Shaved heads and saffron robes? Handing flowers
to strangers along busy sidewalks and airport entries? No twice-a-year back-pewers there. Or
how about the Jehovah Witnesses? Door-to-door evangelism and no blood transfusions.
Ugh. Only the most committed adherents would pay such a
price. Orthodox Jews with side curls and yarmulkes? Amish
with no cars or electricity? Not easy to free-ride there
either. Rest assured, members of these religious groups pay a
very real price. When congregations impose prices like
these, the uncommitted jump for safety. Free-riders vanish
quickly.

Sacrifice and stigma serve a second function as

well. Not only do they keep free-riders out, they keep
committed members in. Pepsi is a substitute for Coke. If
Pepsi executives somehow could drive up the price of Coke, they could more easily lock in
current customers. Pepsi buyers will not stray if Coke becomes more expensive. Similarly,
secular activities are a substitute for the sacred. If a congregation can raise the price its members
pay to participate in secular activities, they can more easily lock these members into sacred
activities instead.

Stigma and sacrifice fill the bill. In the words of Iannaccone:

Distinctive diet, dress, grooming and social customs constrain and often stigmatize
members, making participation in alternative activities more costly. Potential members
are forced to choose: participate fully or not at all.3

234
 Presbyterians can easily interact with the secular world and people of other faiths. The
Amish cannot. Presbyterians can easily free ride. The Amish cannot. With free riders out of the
game, strict churches enjoy more loyal participation and higher financial contributions per
member.4

Iannaccone's sacrifice and stigma thesis also explains an intriguing paradox of church
growth. Conventional wisdom would predict that making membership easy would increase a
group's rate of growth. However, those faiths which demand the most sacrifice and stigma are
among the fastest growing. For example, Mormons have enjoyed exponential growth, yet place
heavy demands upon members. Anyone for a ten percent tithe and a two-year
mission? Similarly, Pentecostalism has grown very rapidly despite, or because of, the high
commitments of time, energy and money expected of its members.

On the other hand, mainstream Protestant denominations place minimal demands upon
members. No weird apparel. No bizarre customs. No onerous financial
requirements. However, these are precisely the denominations which have been losing members
and market share in recent decades. Membership is cheap, but so is free-riding. Have marginal
members sapped the strength and fervor from such churches?

In recent years megachurches have taken this message to heart and used it to their
strategic advantage.5 Congregations such as Willow Creek Community Church and Saddleback
Church, each with more than 20,000 weekly attendees, have been spectacularly successful in
targeting "seekers" who may never have belonged to a church or who dropped away because of
dissatisfaction with another religious organization. Because many of these seekers have been
turned off by prior experiences, charging a high price might easily discourage them ever from
trying out a new congregation. How then can such seekers be attracted? By cutting the price; at
least initially. Just as the local fitness center or cable system might offer low introductory rates
to attract new customers, the megachurches often charge a very low -- even zero -- initial price to
visitors. For example, worship leaders at Saddleback explain that donations are not expected
from non-members when the offering plates are passed. Visitors are allowed to "shop" in relative
anonymity with little or no pressure to give or contribute. However, once the visitor feels that he
or she has found a good religious fit and chooses to join the congregation, prices escalate
rapidly. Members are expected to participate in small group ministries, to maintain faithful
lifestyles, and to give generously of their time and money. Just as the low, introductory rate at
the fitness center evaporates after a few months, so do the minimal expectations for attendee
commitment.

Different strokes for different folks

Sacrifice and stigma are not foolproof strategies for enhancing church growth. Not all
potential members will be persuaded, and not all current members will stay. After all, sacrificing
secular alternatives is costly, at least for those with attractive secular alternatives.

The types of alternatives available are critical. Who is more likely to toss a secular career
in the can and join a commune in the woods: the middle-aged corporate leader with a six-figure
salary and four children approaching college, or the unemployed teenager next door with no

235
family to support? Costs and benefits still matter, and the cost of a religious commune life to the
corporate leader dwarfs that paid by her teen-aged neighbor. The data agree.6 The strictest and
most demanding religious groups do tend to attract those with the least attractive secular
options: the less educated, the less well-to-do, the young, women and minorities. And these
groups also experience cyclical swings. When the economy drops into a recession and
unemployment rates rise, membership in strict religious groups also tends to rise. When the
economy recovers and job opportunities improve, memberships in these same groups fall.

What is the result? To discourage free-riders who might otherwise poison your groups'
evangelical ardor, sacrifice and stigma make sense. But, if you want to attract the rich and
famous, forget about a demanding theology and behavioral norms. Sacrifice and stigma are too
costly for most to bear. Most will opt out for other, less demanding faiths.

_________________________________________
Notes:

Part of this reading was published in Robert J. Stonebraker, "Should Members be Required to
Participate in Ministry," Episcopal Life, February 2003.

1. As the number of members in a congregation rises, the cost per member tends to fall. See
Robert J. Stonebraker, "Optimal Church Size: The Bigger the Better?" Journal for the
Scientific Study of Religion, volume 32, number 3 (September 1993), pp. 231-241.
2. Laurence R. Iannaccone, "Sacrifice and Stigma: Reducing Free-riding in Cults,
Communes, and Other Collectives," Journal of Political Economy, volume 100, number
2 (April 1992), pp. 271-291.
3. Ibid., page 276.
4. See Olson, Daniel V. A. and Perl, Paul, "Free and Cheap Riding in Strict Conservative
Churches," Journal for the Scientific Study of Religion, June 2005, volume 44, number 2,
pp. 123-142.
5. This paragraph draws heavily on the analysis of Marc von der Ruhr and Joseph P.
Daniels, "Examining Megachurch Growth: Free Riding, Fit and Faith", International
Journal of Social Economics, 2012, volume 39, issue 5, pp. 342-356.
6. See Iannaccone, op. cit., pp. 283-289, for a review of the statistical evidence.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain the problem of free-riding in religious congregations.

2. Explain how sacrifice and stigma can counteract free-riding.
3. Explain how and why some megachurches adjust "prices" to attract members and still
avoid free riding.
4. Describe the types of people most likely to join strict religious groups and explain.

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Section II-F: Shopping

Those who say money can't buy happiness don't know where to shop.
.....Anonymous

Shop 'til you drop. We have all heard it. We have all done it. Shopping is one of
America's true passions. Mall to mall. Store to store. Up and down the aisles. But does it truly
quench our acquisitive ardor?

In reality, the results are often disappointing. How often do we return with that perfect
item at that perfect price? When shopping for others, we often end up buying unappreciated
gifts. Even when shopping for ourselves, we often cannot find the right product or belatedly
discover we have overpaid. If practice makes perfect, we should be efficient shoppers. But
often we are not.

I wonder why?

II-F. Shopping
1. Bah, Humbug
2. The Winner's Curse
3. In Search of the Perfect Christmas Tree
4. Automobiles: Different People, Different Prices
5. Good Intentions Gone Awry

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Bah, Humbug

Christmas won't be Christmas without any presents.

.....Louisa May Alcott

A family friend tells the story of his younger brother who, as a

child, once gave their mother a coconut for Christmas. When asked
why he chose such an unusual gift, the young boy replied that he liked
coconuts and knew that his mother would share. Smart kid.

Christmas is big business. We know that. We know that its sacred message is often
swamped by a secular marketing barrage. What is less appreciated is that this commercialization
extracts enormous economic costs as well. Not only does the frenzy of card and gift giving
detract from the religious spirit of the day; it throws big bucks down the economic toilet.

Each Christmas millions of Americans hit the malls looking for that perfect gift. We
roam the aisles and thumb through catalogues. The pressure is to avoid the overly practical; only
the most prosaic among us can savor a Christmas morning spent unwrapping underwear. Most
of us search for something special that our intended recipients wouldn't buy for themselves.

Occasionally we hit the jackpot and uncover that unique, special gift. But it takes
luck. It usually means we found something the other person did not know existed, a difficult
chore since our friends and family usually roam the same aisles and thumb through the same
catalogues as do we. More often our search for something special fails. We often do buy
something they would not have bought for themselves, but only because they did not want
it. Despite the stress, bother and additional hair loss, our gifts often are the wrong size, the
wrong color, the wrong style, or the wrong flavor. Gifts so lovingly picked and graciously
received end up being unused, abandoned, or relegated to attic shelves and basement
boxes. Bah, humbug.

Welfare losses

None of this will surprise an economist. Economists assume that consumers always
allocate their income in an optimal way; that they always buy the items generating the most

238
value per dollar. And that makes life very difficult for someone choosing a gift. For example,
suppose I am willing to spend $60 on a gift for my son. What should I buy? Certainly I want
my money's worth; I want something he values at least at $60. Should I buy a video game priced
at $60? Only if the game is worth at least $60 to him. And there is the rub. If the game is worth
$60 to him, would he not already have bought it?

Perhaps you object. Perhaps you want to argue that my son did not buy the game because
he was broke. Maybe. But, if so, might it better for me just to hand him $60? An efficient $60
gift would be one that gives him the most possible pleasure for the $60. And that is exactly what
he would buy for himself if he had the $60. If I am lucky enough to choose the best-possible
gift, I merely duplicate what he would have purchased himself with the $60. If I choose
anything else, I am buying something he would not have bought; something that he must think is
less valuable.

That's the economic cost. If I spend $60 for a gift that my son values only at $56, I've
created what economists call a net welfare loss of $4. I've tossed $4 of potential economic value
into an irretrievable black hole.

After surveying his microeconomic students at Yale (an admittedly unrepresentative

sample), Joel Waldfogel contends that this loss is surprisingly high.1 His students estimated that
the 1992 holiday gifts they had received cost family and friends an average of $438 (remember,
these were Yale undergraduates), but that they would have paid only $313 for them -- that's a
$135 loss per student! A subsequent study with a larger and more varied sample revealed
smaller gaps, but Waldfogel still concludes that the total loss is close to 10 percent of the value
of the holiday gifts purchased.2

That's big bucks. Although estimates vary, U.S. families probably spent about $80
billion on Christmas and Hanukkah gifts in 2008. If ten percent of that was wasted, we flushed
almost $8 billion down the tubes. And that's only Christmas and Hanukkah. It ignores similar
costs for Valentine's Day (Do women really want all those heart-shaped boxes of candy?), Easter
(How many stale chocolate bunnies and jelly beans are tossed out three weeks later?) and
birthdays (Wouldn't you rather have the cash?).

Of course, not all gifts generate the same losses. The losses grow as the "social distance"
between the givers and recipients grow. Waldfogel found that gifts from close friends and
significant others had the smallest losses, followed by gifts from parents and siblings. Gifts from
grandparents, aunts and uncles had the largest losses, which explains why well-meaning distant
relatives more often choose cash gifts instead.

When cash gifts are considered unacceptable, gift cards

can serve as a reasonable compromise. Many of us who
would never consider slipping our father a $50 bill for
Christmas, might happily present him with a $50 gift
certificate to his favorite home improvement store. The use of
such cards has mushroomed in recent years from a paltry $12

239
billion in 1998 to an estimated $126 billion in 2014.3 With good reason. Modern magnetic strip
technology makes them far easier for consumers to use and for retailers to track. They can be
bought and redeemed online. They can be personalized: a Barnes and Noble card for the book
lover, Best Buy for the video gamer, Godiva for the chocolate lover and BabyGap for the
expectant mother. And they minimize angst for increasingly harried working moms who still
carry the major share of Christmas shopping duties.

Interestingly, while such cards are touted to be as good as cash, many recipients behave
otherwise. Because the magnetic coding does not identify a specific individual, the cards easily
can be transferred; they can be sold. As a quick trip to eBay.com will verify, a robust market for
"previously-owned" gift cards now exists, and the cards typically sell at significant
discounts. Earlier in the day this was written, sharp bidders snapped up a $100 Barnes and
Noble gift card for $81.25, a $50 Best Buy for $44.02, a $85 Godiva Chocolate card for $65,
and a $50 BabyGap card for $41. If $50 gift cards truly were worth $50 to the recipients, they
wouldn't be selling for $40. In a more systematic study, economist Jennifer Offenberg estimates
that these remarketed gift cards are worth on average about 20 percent less than their face
value.4 In other words, they create welfare losses quite similar to those of other gifts identified
by Waldfogel.

Missing utilities?

Should we abandon non-cash gift-giving? Not necessarily. First, remember the old "it's
more blessed to give than to receive" adage. The above analysis ignores any possible value or
utility the giver might receive. Yet givers clearly can get pleasure from the process. If this
shopping pleasure is high enough, there still might be positive net benefits.5 For example, if
Angelina gains $20 of happiness while shopping for a present to give Brad, the process creates
new net value even if it creates a $10 welfare loss. Second, non-cash gifts might send an
important signal to the recipient. We all like to think we are important to others, that we are
worth spending time and effort upon. A gift of cash could be seen as being "too easy" and send a
signal that we do not value the recipient enough to expend effort in choosing an appropriate
present.

Sentimental value throws another wrench into the mix. Waldfogel deliberately asked
students to ignore any sentimental value of their gifts. What if we attach extra value to gifts
because they are gifts? Could the sentimental value offset any welfare loss? A subsequent study
argued that accounting for sentimental value might indeed turn the welfare loss into a welfare
gain.6 Nonetheless, sentiment itself does not invalidate the conclusions. A new sweater from my
wife takes on added value because it is from my wife. Even if I do not like the sweater, I value it
because it is from her. But sentimental value accrues to sweaters I do like as well. Given the
choice between a sentimental sweater I like and one I do not like, I will choose the one I like
every time. I like the sentiment, but the welfare loss of the ugly sweater still exists.

Economist Rob Toutkoushian identifies a more important scenario.7 What if the amount
of sentimental value depends upon the nature of the gift? What if part of the purpose of the gift-
giving game is to prove how well we know the tastes and preferences of the recipient? What if
gift-giving is a test?

240
 Toutkoushian notes that spouses typically have the most at stake. For example, suppose
Annie, who drinks only tea, receives an assortment of coffees for a gift. If the gift is from her
great uncle, twice-removed, she may simply laugh. But if the gift is from
her husband, all h*** might break loose. Husbands are supposed to
know better. A loving husband should anticipate her desires. A loving
husband should expend the necessary time and energy to find a more
appropriate gift. The perfect gift affirms the closeness of the relationship;
it pollinates the marriage with warm fuzzies. The sentimental value rises
when the gift manifests the effort and understanding necessary to nurture
relationships. Coffees -- and cash -- fall short of the mark.

______________________________________________

Notes:

1. Waldfogel, Joel, "The Deadweight Loss of Christmas," American Economic Review,

volume 83, number 5, December 1993, pp. 1328-1336.
2. Waldfogel, Joel, "Gifts, Cash, and Stigma," Economic Inquiry, July 2002, volume 40,
number 3, pp. 415-428.
3. The data and discussion about gift cards are drawn from Offenberg, Jennifer Pate, "Gift
Cards," Journal of Economic Perspectives, Spring 2007, volume 21, number 2, pp.227-
238 and Barro, Josh, "An Economist Goes Christmas Shopping," New York Times,
12/19/2014.
4. Ibid., pp. 232-235.
5. Waldfogel does admit this possibility.
6. See List, John and Jason Shogren, "The Deadweight Loss of Christmas: Comment,"
American Economic Review, 1998, volume 88, number 2, pp.1350-1355.
7. These arguments were first supplied in correspondence by Toutkoushian to the author.

________________________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Explain Waldfogel's argument that Christmas giving creates large welfare losses.
2. Explain why the size of the welfare loss might vary with the "social distance" between
the giver and the recipient of a gift.
3. Explain why economists think that even gift cards create welfare losses.
4. Explain why giving gifts might be efficient even in light of the potential welfare losses.

241
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

The Winner's Curse

For all we take we must pay, but the price is cruel high.
.....Rudyard Kipling

Auctions are a venerable economic tradition. College

students furnish their apartments with purchases from local estate sales, museums and
connoisseurs build their collections through art and antique auctions, and farmers study the latest
livestock quotes. Auctions have even gone high-tech; thousands of auctions are run on-line
every day over the World Wide Web offering everything from stuffed aardvarks to antique
zithers.1

We all are looking for the golden goose, the undiscovered treasure available for pennies
on the dollar. My own auction purchases include a piano stool, two chests of drawers, a designer
teddy bear, a 1956 Ted Williams baseball card, and a house. Occasionally we are
rewarded. Occasionally we come across "a steal," and make a real
killing. Most often we do not.

Imagine the following scenario. Randy Johnson, star pitcher for the
Arizona Diamondbacks, tires of sunshine and salamanders and enters
baseball's free agency market. After a spirited bidding war among Major
League clubs, the New York Yankees land Johnson with an offer of $250
million plus five percent of the Yankee's annual gate revenues. Yankee
management and fans are ecstatic about their good fortune. Should they
be? Although there have been exceptions, most free agents turn out to be far
less valuable than their employers had anticipated.2 The winners in free
agent bidding often turn out to be losers.

Baseball moguls are not the only ones to experience such disappointments. Oil
companies that win bidding contests for off-shore drilling leases often lose money on
them. Book publishers that "win" the rights to publish potential best-sellers are often
disappointed with subsequent sales. Winners in corporate take-over struggles frequently end up
swimming in red ink. All have fallen prey to what economists call...the winner's curse.3

242
 The basic message is simple, yet powerful. In any auction there is some uncertainty
about the true value of the item up for bid. Each bidder will estimate what she thinks is the true
value. Given the uncertainty, some people will underestimate the true value while others will
overestimate. Since the person with the most optimistic assessment of the object's value will be
the high bidder, the auction winner is likely to have overbid. In other words, if you have no
inside information, yet outbid 100 other people on an item, you should worry. If you paid for
than anyone else was willing to pay, you probably paid too much.

Suppose you are a real estate developer contemplating a $200,000 bid for a parcel of
land. Most of us might ask: "Am I willing to pay $200,000 for this land." However, the winner's
curse cautions us to ask: "If no other developer is willing to pay $200,000, am I still willing to
bid $200,000.

Of course, things change if you are the only developer. If no other bidders appear, very
conservative bids are enough to walk off with the prize. Theory suggests, and experiential
evidence corroborates, that the winner's curse is more like to emerge in auctions with large
numbers of bidders. The more people you must outbid, the greater is the probability that you
will overbid.4

Is it rational?

How widespread is this phenomenon? A former student, always alert to the possibility of
a clever insult, noted that universities bid for faculty. If winners overbid, as the winner's curse
suggests, then all professors, including me, must be overpaid. Whoa. That sounds a bit
distressing.

The larger issue involves rational behavior. Why would rational people continue to
participate in auctions in which the winners lose? Would not rational people eventually catch on
to the problem, and either lower their bids or drop out altogether? They should. And in many
cases, they do. However, information is costly to obtain and digest. If it were not so, students
would score 100 percent on every exam without study. Rational economic agents pursue
additional information only when they perceive the likely benefit of the information will exceed
the cost of learning it. The result? People will make mistakes; unsophisticated bidders will
overbid.

In the mid-1990's the Federal Communications Commission (FCC) decided to allocate a

largely unused part of the electromagnetic spectrum to firms wanting to provide personal
communication services (PCS), services which would compete with cellular phone and paging
systems already in operation. Knowing that the number of potential providers would exceed the
number of available slots in the frequency spectrum, the FCC announced it would auction the
available licenses to the highest bidders. The FCC reasoned that such an auction would allocate
the scarce frequencies to their most valuable uses. Those seeing the frequencies as being the
most valuable would outbid others. In addition, the auction could raise big bucks for the
agency.

243
 The initial result was hugely successful. The auction attracted hundreds of interested
buyers, and firms bid over $10 billion in the scramble for scarce licenses, well in excess of what
FCC officials had projected.

Could sophisticated communication firms have irrationally overbid? Some of these firms
actually hired professional economists to advise them on biding strategy. Could such firms fall
prey to the winner's curse? Yes. A number of several successful bidders hit the financial skids
within months and, hats in hand, petitioned the FCC for relief. FCC officials, trying to thwart
potential bidder-bankruptcies, agreed to ease payment terms.5 People do make mistakes; even
sophisticated bidders will sometimes overbid.

Try it yourself

Hungry? Need some lunch money? Economist Richard Thaler

suggests trying the following experiment. Fill a large jar with pennies -
- make sure you count how many you insert. Next, auction off the
contents of the jar. In case bidders have an aversion to pennies, offer to
pay the winning bidder in currency and larger coins instead. What
should happen? First, the average bid should be significantly less than
the value of the pennies (most bidders are cautious or risk
averse). Second, the winning bid should exceed the value of the jar
(the winner's curse).

I tried a similar experiment with mid-career MBA students. I filled a jar with 298
marbles and offered a prize of one cent per marble to the highest bidder. Students passed the jar
around the class and examined it from all angles trying to estimate the correct number of marbles
residing inside. They considered this far more interesting than listening to my lecture. Each
student then submitted a written bid based upon their individual appraisals. The results? Just
what Thaler predicted. The average bid was $2.57, a conservative $0.41 below the true
value. The high bid was $3.50, enough to give me a net gain of $0.52 that I gleefully collected
from the winning (losing?) bidder. My students learned a valuable, first-hand lesson about the
winner's curse, and I gained a hot dog at the local convenience store. What a deal.

_______________________________________

Notes:

1. Check out www.eBay.com, one of the more popular electronic auction sites.
2. Baseball fans will know that the Yankees did indeed trade for Johnson before the 2005
season and sign him for two years at $32 million. As we might expect, Johnson's
performance was below expectations. For a statistical analysis of winner's curse issues in
baseball free agent markets, see Burger, John D. and Stephen J.K. Walters, "The
Existence and Persistence of a Winner's Curse: New Evidence from the (Baseball) Field",
Southern Economic Journal, volume 75, number 1, July 2008, pp. 232-246.good
discussion

244
3. These examples, and much of the following logic, can be found in Thaler, Richard H.,
The Winner's Curse: Paradoxes and Anomalies of Economic Life, Free Press, New York,
1992, pp. 50-62.
4. See Thaler, ibid., page 55.
5. See "FCC Offers New Options for Wireless Licenses," New York Times, September 26,
1997.

________________________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Explain the concept of a "winner's curse" and give an example.

245
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

In Search of the Perfect Christmas Tree

Can’t we just buy this one and go home?

…..shopping-wearied husband to wife

My former hometown of Indiana, Pennsylvania sat

smack in the middle of the self-proclaimed Christmas Tree
Capital of the World. Pine, fir and spruce varieties thrive in
the soil above played-out coal mines, and local growers
export millions of perfectly-trimmed specimens all over
Eastern U.S. and Canada each holiday season.

When my sons were young, I made an annual and obligatory trek to a "cut your own"
Christmas tree farm. What a great experience. Biting December winds would make my eyes
water and freeze the tears to my cheeks. Ground snow would work its way around my boots,
drip down my ankles and wrap my toes in icy molds. After about ten minutes and/or one
hundred yards of arctic chill, the boys would plead to cut down the closest conifer and return to
the cozy comfort of the car.

Regrettably, children have short memories. Each year, forgetting red noses of the past,
they begged to repeat the ritual. So we did. Each year I returned to the farms with a saw in one
hand and a child on the other, looking for the perfect tree.

And that was the problem. The perfect tree was hard to find. Christmas trees were
everywhere, but most were too short or too tall, too scrawny or too full, with bulges or holes in
all the wrong places. You could not just walk into the field and cut the first available tree. You
had to hunt...and hunt...and hunt. And get colder...and colder...and colder. By time fathers like
me hit the fields, the best trees were gone. The best trees had already been harvested and trucked
off to distant cities. Shipped out.

At least I knew why. Armen Alchian and Robert Allen nailed it many years ago with
their "Shipping the Good Apples Out" theory.1 Alchian and Allen correctly noted that demand
patterns are determined by relative prices, not absolute prices. Changes in relative prices cause
consumers to substitute among goods and services. When the relative price of a good rises,
consumers shift purchases to other substitute goods and vice versa. As a result, Alchian and
Allen reasoned that high transportation costs cause consumers to substitute toward higher-valued
goods. Why? I am glad that you asked.

246
The price of apples

Imagine that an orchard stand outside Kalamazoo, Michigan charges $1 for a bag of
"standard" apples and $2 for a bag of "premium" apples. The premium apples are twice as
expensive. In economic terms, the opportunity cost of a premium apple is two standard apples.
However, consumers in Phoenix must pay to transport the apples to their local stores. If
transportation costs are $3 per bag, those same Michigan apples will be
costlier. The standard apples will cost $4 per bag and the premium apples
will cost $5 per bag.

Are you catching on? Transportation costs raised the absolute

price of premium apples in Phoenix, but lowered their relative price. The
premium apples were twice the cost of standard apples in Kalamazoo [$2
versus $1], but are only 25 percent more expensive in Phoenix [$5 versus
$4]. A premium apple cost two standard apples in Kalamazoo, but only
1.25 standard apples in Phoenix. Premium apples are relatively cheaper in Phoenix than in
Kalamazoo! Similarly, standard apples are relatively cheaper in Kalamazoo. The standard apple
costs only 1/2 of a premium apple in Kalamazoo [$1 versus $2], but cost 4/5 of a premium apple
in Phoenix [$4 versus $5].

Aha! If premium apples are relatively cheaper in Phoenix, the relative demand for
premium apples in Phoenix should be greater. The profit-maximizing orchard will ship the
premium apples out to Phoenix and stock their local stands with standard apples. Kalamazoo
will ship the good apples out, Boise will ship the good potatoes out, and Indiana will ship the
good Christmas trees out.

Does the same principle hold in other countries? Yes. To limit traffic congestion the
Singapore government imposed extensive taxes on automobiles in the early 1990s. These
complex levies had the effect of driving up the prices of low-cost vehicles proportionately more
than the price of more expensive cars. In fact, as a result of the charges, a Mercedes Model E
was only twice as expensive as a humble Honda Civic. The result was exactly what Armian and
Alchian would have predicted; the Mercedes became the best-selling new model in Singapore.2

As another international example, I recently heard a public radio commentator lament his
inability to find a good cup of coffee while traveling in the country of Colombia.

Shipping the buyers

The theory also works when consumers travel to the product. It should not matter if the
goods are shipped to the buyer or the buyer is "shipped" to the goods. Those of you with young
children -- after contracting to pay $20 for a babysitter, do you head to McDonald's? Probably
not. Hiring the babysitter lowers the relative price of an outing to a more elegant eatery. A $40
meal in a nicer restaurant would normally be four times the expense of a $10 McDonald's outing.
But, after tacking on the $20 babysitter fee, a trip to the more expensive eatery costs $60; only

247
twice the McDonald's cost of $30. Couples hiring babysitters, all else equal, are more apt to dine
in style.

As another example, suppose that a choice seat at a college football game costs $40 while
a standard seat costs $20. To a local fan, the choice seat is twice as expensive, but to the fan who
spends $80 to travel 300 miles to see the game, a package with the choice seat is only 20 percent
more expensive than one with a standard seat [$120 versus $100]. If the relative price of the
choice seat package is lower, the relative demand should be higher. Indeed, economists at
Clemson University found that fans who travel the farthest to Clemson Tiger games buy the best
seats.3

Football itself offers a final example.4 Teams with strong-armed quarterbacks and fleet
receivers will opt to throw the ball while those with 250-pound tailbacks who can run the 40-
yard dash in 4.0 seconds will rely on a ground game. If the Pittsburgh Steelers average five
yards per running play and four yards per passing play, the team will clearly choose to run more
often than it passes. Runs, on average, are 25 percent more productive than passes. But, what if
it rains? During a downpour, running backs lose their footing and fumble. However,
quarterbacks and receivers find it more difficult to hold onto the ball. Should the Steelers run
more? Should they run less?

Suppose the rain cuts average yardage for both running and passing plays by two
yards. The average running gain per Steelers play is now three yards and the average passing
gain is now two yards. Although running still has the same one-yard-per play absolute
advantage [three yards versus two yards per play] it had in dry weather, its relative advantage has
increased. Running is now 50 percent more productive [three is 50 percent larger than two],
rather than only 25 percent more productive. The result? The Steelers should run even
more. Do you believe it? Check out those game summaries and see for yourself.

__________________________________________

Notes:

1. Alchain, Armen, and Allen, William, University Economics, Belmont, CA, Wadsworth
Publishing, 1964.
2. Toh, Rex S. and Phang, Sock-Yang, "Cubing Urban Traffic congestion in Singapore,"
Transportation Journal, Winter 1997, volume 37, number 2.
3. Bertonazzi, Eric P., Maloney, Michael T., and McCormick, Robert E., "Some Evidence
on the Alchain and Allen Theorem: The Third Law of Demand," Economic Inquiry,
volume 31, number 3, July 1993, pp. 383-393.
4. This example is adapted from McCormick, Robert E., Managerial Economics,
Englewood Cliffs, Prentice Hall, 1993, p. 165.

________________________________________

Testing Yourself

248
To test your understanding of the concepts in this reading, try answering the following:

1. Explain why premium apples are relatively more expensive than standard apples in
Michigan than in Arizona.
2. According to the article, "couples hiring babysitters, all else equal, are more apt to dine in
style." Explain why.

249
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Automobiles: Different People, Different Prices

You can't find a better deal!

…..local automobile dealership ad

My friend Laurie is a shopper supreme. She refuses

to pay full price. In the local mall she ignores any rack or
counter not bedecked with a sign crying: Final Clearance:
75% Off. She combs through thrift shops, yard sales and
factory closeouts. She bargains with clerks and
managers. And it works. She finds unimaginable bargains:
a $250 dress marked down to $8 because of a ripped seam
she can mend in five minutes, a $75 pair of shoes for
$3.50. She loves the chase; she loves the challenge. The
mere mention of a shopping trip can make her nostrils flare
like a thoroughbred being led into the starting gate.

She loves to shop. She lives to shop. But not for cars. Dragging her into a car dealership
is like dragging her in for a root canal. She demands Novocain for both.

It was not always so. Some years ago, with her Volkswagen Rabbit mired in terminal
decay, she plunged eagerly into the hunt for a replacement. She did all the right things. She
studied consumer guides. She prowled area dealerships and talked to current owners. She
quizzed mechanics about reliability. She took test drives in a variety of models. And, after an
exhaustive search, she made her choice. A Nissan Altima. A red Nissan Altima. Only one step
left: close the deal.

Disaster. The sales staff would not budge on price. She cajoled. She threatened. She
begged. She tried other dealers. No soap. Defeated and deflated, she quit.

A few days later, after a mournful recitation of her trials, a friend -- a young, male friend
-- offered his assistance. He offered to negotiate a better deal. A better deal? Not possible.
Laurie’s retail record was unblemished. Surely this young man could do no better. But he could.
And he did. Within a week he had negotiated a deal that saved Laurie over $1,000.

250
 How did he do it? How could he extract concessions that eluded such a shopping
maestro as Laurie? Simple. He was offered a better deal because he was a male. Women and
minorities face discrimination in the labor market. Often they fare no better as consumers.

Economists Ian Ayres and Peter Siegelman trained nineteen pairs of test buyers for
automobiles who were closely matched in terms of age, education, and attractiveness. The test
buyers dressed in similar yuppie-style attire and drove similar cars into the dealerships. They
worked from identical bargaining scripts and gave comparable answers to questions about their
professions and address. The members of a pair differed only with respect to sex and/or race.

Pair members bargained independently for the same model car in the same dealership,
usually within three days of each other. The test buyers negotiated prices for over 300 cars at
more than 150 dealerships in the Chicago area.

The results were striking. Both initial and final offers supplied to females and/or
African-Americans were significantly higher than those given to their white male
counterparts. African-American males fared the worst. They were socked with prices some
$1,000 greater than those quoted their white counterparts. The actual differentials are listed in
Table I.

Table I

Average Price Differentials

(Prices in excess of those offered to white males)

Buying Group Initial Offer Final Offer

White females $109 $ 92

African-American females 318 246
African-American males 935 1,101

All females and non-whites 407 481

Why? Are the owners bigoted? Do dealership owners push their salespeople to
discriminate? Or is the salespeople themselves? Car salesmen have never ranked among the
most respected American professionals. They are the butt of almost as many scurrilous jokes as
are economists. Is racial and/or gender discrimination another layer of ooze on their already
slimy image?

Perhaps. But if owner and/or salesman bigotry were the cause, women and non-whites
should be treated most poorly in dealerships owned and operated by white males. They are
not. African-American buyers were charged the same price differentials by African-American
dealers as they were by white dealers. Female customers were treated just as poorly by female

251
salespeople as they were by male salespeople. Neither the race nor the gender of dealers and/or
salespeople seemed to matter.

Ayres and Siegelman conclude that statistical discrimination is the real culprit. Blatant
bigotry is not the cause. Rather, dealers and salespeople use race and gender to make statistical
inferences about the consumer's sensitivity to price -- what economists term price elasticity.2

Price discrimination

Firms often employ price discrimination. They try to segment their markets and charge
different prices to customers with different demand elasticities. The theory is simple. Identify
those customers with highly-elastic demands (they're the ones who are very sensitive to price and
will be driven into the arms of your competitors by high prices), and cut prices. Next, identify
customers with less-elastic demands (they're the ones who are insensitive to price and are likely
to buy anyway), and drive the price to them up. In other words, charge $40 for a new tire in your
shop, but charge $60 for the same tire to the motorist stranded on the highway.

Such discrimination is fairly common. Discounts for children and/or senior citizens and
special introductory rates for new magazine subscribers are more benign examples. But
segmenting the market is not easy. Safeway cannot easily identify which customers will
acquiesce to a higher price for broccoli; nor can K-Mart easily detect which customers have an
inelastic demand for batteries.

Car dealers practice haggle-every-time discrimination. They try to guess the maximum
price each individual customer is willing to pay, and charge accordingly. They ask strategic
questions about occupation, address, family, and what other dealerships shoppers have
visited. All are designed to help predict what a consumer might be willing to pay.

Consumers play the same game. They hide information and deliberately mislead dealers.
You may recall an old Cosby Show television episode in which Dr. Huxtable, trying to hide his
true income, dons his rattiest clothes before entering the auto showroom. But it's tough to hide
your race or gender, and car salespeople regularly use racial and gender stereotypes to infer
demand elasticities.

While dealers and/or salespeople may know little or nothing about a particular customer,
they know quite a bit about statistical differences among races and genders. They know that
women and African-Americans typically enter the showroom with less information and less
proclivity to bargain. Although white males often salivate at the chance to lock horns with car
dealers in a bargaining struggle, females and African-Americans may be unaware that bargaining
is even possible. Ayres and Siegelman cite a Consumer Federation of America survey that
discovered that many female respondents, and more than one-half of African-American
respondents, believed that sticker prices were non-negotiable.3

Armed with such knowledge, salespeople will rationally adopt a more stubborn stance
while bargaining with female and African-American customers. Their stern posture may not be
the result of bigotry, but the results are the same. Women and non-whites pay more.

252
________________________________________

Notes:
1. Ayres, Ian and Siegelman, Peter, "Race and Gender Discrimination in Bargaining for a
New Car," American Economic Review, volume 85, number 3, June 1995, p. 304 (18).
2. Price elasticity measures how sensitive consumer demands are to changes in
price. Specifically, it measures the percentage change in quantity demanded for a given
percentage change in price. When consumers are very "price-sensitive," demand is
highly elastic: a small percentage change in price will unleash a large percentage change
in the quantity demanded. If price is only a minor concern to consumers, a price change
will cause only a small percentage change in sales and demand is less elastic.
3. Ayres and Siegelman, op.cit.

________________________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Explain the economic logic of why women and minorities are often charged higher prices
for new cars than are white males.
2. What strategies might someone adopt to get a car dealer to offer a lower price?

253
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Good Intentions Gone Awry

Hell is paved with good intentions, not with bad ones.

....George Bernard Shaw

I am a picky eater. Plain meat and potatoes. No

sauces. Nothing that would appear on a menu written in French,
nothing that needs "presentation," and nothing with bright colors
(except m&m's). My mother repeatedly tried to broaden my culinary
range, but to no avail. My father more sympathetically claims it is a
genetic flaw, inherited from paternal lineage.

At a recent church potluck dinner an elderly woman across the

table, Mrs. Bittlemyer, urged my wife and me to try her rhubarb
pie. Since I understood that rhubarb pie was merely a vegetable in
disguise, I quickly declined. But my considerate and kind wife took a piece. Although she does
not particularly care for rhubarb pie, she devoured it eagerly and, to the delight of the cook, with
effusive praise.

Knowing my wife's culinary proclivities I was surprised, but held my tongue. Later that
evening I asked if she had truly enjoyed the pie. She replied, "No, but I could not disappoint
Mrs. Bittlemyer. I nodded in cautious concurrence and admiration. For a while. However, a
few weeks later we heard a knock at our front door. It was Mrs. Bittlemyer carrying a rhubarb
pie. She explained that my wife had enjoyed the first piece so much that she baked a new pie,
just for her. Now what? Do we fess up? No, it was too late. We accepted the pie with smiles
and thank you's -- just as we have done for each of the rhubarb pies that have steadily been
arriving on our porch ever since.1 Good intentions gone awry.

I should not have been surprised. After all, I know economics. I know that when people
get a good price for their efforts -- either in terms of cold cash or warm fuzzies -- their eagerness
to supply goes up. When potential buyers appear, sellers queue up quickly. It is like mail-order
purchases. We cannot expect to buy one mail-order item without being flooded with catalogues

254
from others. Or charitable gifts. A $50 check to one deserving group prompts a deluge of calls
and mailings from others.

As a ten-year-old I sold raffle tickets to help support my cub-scout troop. When word
leaked out that Mrs. Hartbuckle2 down the street had bought an entire book of tickets from our
friend Steve, every boy in our troop began lining up, raffle tickets in hand, at the Hartbuckle's
front door. A firm "yuch" from my wife would have stopped Mrs. Bittlemyer dead in her
tracks. A firm "no" to my friend Steve from Mrs. Hartbuckle could have saved her many
dollars. They chose to be kind. Good intentions gone awry?

Sudanese slaves

Let's get serious. Rhubarb pies and Cub Scout raffle tickets are small potatoes. Slavery
is not. And slavery persists in several pockets of the world, including Sudan. A poor country to
the south of Egypt, Sudan has been ravaged by a brutal civil war between the Muslim-led
Khartoum government in the north and rebellious, largely Christian and animist tribes in the
south. The war and attendant famines have claimed more than two million Sudanese lives since
1983.3

Beginning in the early 1990s, government-backed militias began raiding southern

villages to burn homes, steal food and animals, and slay the men. With husbands and fathers
dead, the women and children are captured, shipped north and sold as slaves. Ugly stuff.

As word of Sudanese slavery leaked out into the international community, a predictable
moral outrage began mounting. What could be done? The war was an internal struggle caused
by ethnic and religious tensions that had been burning for many generations. Military
intervention by the United States or the United Nations was not likely to be either effective or
welcomed. As long as the war raged, there was little that could be done to stop the slave raids.

Could the effects at least be muted? Perhaps the slaves could be freed. Sudan is a
woefully poor country and the going price for a slave was a mere $15 in most northern markets.
To a comparatively well-to-do American, $15 is nothing, not even the price of a single meal at a
reasonably fashionable eatery. Perhaps the freedom of Sudanese slaves could be bought.

Humanitarian and Christian groups in the United States and Europe mobilized quickly to
raise monies for slave redemption. Christian Solidarity International (SDI), a group based in
Switzerland, has freed some 10,000 slaves by itself. Other groups have freed more. Church
groups, schools, and private individuals from around the country have joined the effort.

Supply and demand

While noble in spirit, the redemption effort has split the human rights community and
prompted scathing criticism from international agencies such as UNICEF. Why? Supply and
demand. The redemption effort has raised the demand for slaves. As with any other product,
increased demands create shortages. Shortages, in turn, drive up prices. In the below graph, the
increased demand drives price from P1 up to P2.

255
 So it is with Sudanese slaves. The demand from redemption groups has driven the going
price for slaves from $15 to anywhere from $50 to $100 per slave. Using the appropriate
economic jargon, humanitarian redemption efforts have increased the demand for
slaves. Because of this increased demand, the equilibrium price for slaves jumped from $15 to
$100. Who gets the financial spoils of the increased price? The slave traders. And, for what do
they use their ill-gotten gains? According to opposition groups in the field, it is to buy more
guns with which to conduct more raids and capture more slaves.

Can you see what happens to quantity? Check the graph one more
time. Increased demand drives up the equilibrium quantity as well. As a
result of the increased demand, the quantity of slaves captured and sold
rises. That's right. The redemption effort has backfired. When the price
goes up, the quantity supplied rises as well. If you praise Mrs. Bittlemyer's
pie, she will bake more pies. If you pay high prices to redeem slaves, the
slave traders will eagerly capture more slaves to be sold.

And capture they do. Redemption sales have invigorated the market. Since redemption
agencies often prefer to buy slaves in large groups, raiders have responded by capturing larger
numbers of slaves at a time. One observer notes that they have turned slaving technology from a
cottage industry into mass production. Moreover, in past years, slaves who became old or sick
lost value to their captors and were released. Continued provision of food and shelter was not
efficient. Not anymore. It now makes more sense to hold on to such slaves until they can be
sold to a redemption group.

The silver lining is that the number of slaves kept in captivity does eventually go
down. At the new, higher $100 price Sudanese buyers ultimately choose to keep fewer slaves in
captivity. The others are sold to the redeemers and ultimately released. However, the release
process is often slow and, in the meantime, captured slaves are often subject to abuse, torture and
mutilation. Perhaps more importantly, the raids themselves are violent and result in the brutal
deaths of adult males in the targeted villages. Instead of curbing slavery, redemption efforts may
merely have fueled additional violence, capture and death. Good intentions gone awry.

________________________

Notes:

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1. Yes, Mrs. Bittlemyer is a fictitious name. And, the food in question was not rhubarb pie
(which for some strange reason my wife actually enjoys). I changed the example to
protect the feelings of the cook. You know, good intentions…
2. Yes, Hartbuckle is another fictitious name.
3. Miniter, Richard, "The False Promise of Slave Redemption," Atlantic Monthly, July
1999, volume 284, issue 1, pp. 63-71. Much of the following analysis draws on Miniter's
account.

________________________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Explain how attempts to buy the freedom of Sudanese slaves have affected the
equilibrium price and quantity of slaves captured.
2. Explain what has happened to the quantity of slaves in captivity as opposed to the
quantity of slaves captured.

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Section II-G: Happiness

Pleasure is the beginning and the end of living happily.

.....Epicurus

Economists assume that the pursuit of happiness or "utility" motivates behavior. But what
makes us happy? What fulfills us? Money and success are surely important, but do we care
more about them in an absolute sense or in a relative sense? Is it better to be a big fish in a little
pond or a little fish in a big pond?

We have unmatched access to goods and services, but do we enjoy them? Do we know
how to enjoy them? We have unmatched opportunities for leisure, yet feel crushed by pressures
for more time. While increased wealth should enable us to devour cultural activities on an
unprecedented scale, the live performing arts are in financial chaos.

I wonder why?

II-G. Happiness
1. It's All Relative
2. Lots of Stuff versus More Stuff
3. Too Much to Do
4. Starving Artists

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

It's All Relative

If winning isn't everything, why do they keep score?

.....Vince Lombardi

As a young man I joined our church softball team. Early in the season, playing squads
loaded with fleet teenagers and burly coal miners, we suffered several successive defeats. We
played well, but our opponents played better. As the losses mounted, our spirits sank.

Finally, we met Curry Creek Presbyterian, a small rural church

that fielded a team without fleet teenagers or burly miners. We smashed
them. After five innings we had run up a lead of 30 runs and the game
was called for darkness. More importantly, I hit my first home run. It was
only an average fly ball, but it eluded the elderly woman playing left field
and rolled to the fence as I chugged around the bases. We didn't play
particularly well that evening, and my "home run" was a routine out
against another team. But we returned to our families with a victory
under our belt and smiles on our faces. Now, many years later, I still
remember the thrill of crossing home plate.

The Curry Creek players soon tired of continued annihilation and dropped out of the
league. They found two other rural churches that played elderly women in the outfield, formed a
new league, and spent many evenings enjoying friendly, more equally matched, games of
softball. With Curry Creek out of the league, my home run production plunged.

The key to victory often is not how well we perform in some absolute sense; it's whether
we can drub our opponent. We may hold our heads high after a well-played loss, but we'd rather
win. We have an inherent distaste for being at the bottom of the barrel, no matter how nice a
barrel it may be.

Relative vs. absolute

This drive to win, to be "number one," seems hard-wired into our behavioral
circuits. Biologically, that's not surprising. After all, relative and not absolute performance
determines which species win the Darwinian struggle for survival. The slow-afoot can survive

259
and prosper as long as predators and prey are even slower. Competitive economic survival
depends on the same relative success. I can produce a lousy pizza, but if it is the best pizza on
the market, I still will flourish.

Apply this same concern with relative standing to income. First, imagine opening your
pay envelope and finding a $20 bonus. How do you feel? Next, imagine finding that your
co-workers received $500 bonuses. Now how do you feel? Your absolute income is up. You
have an extra $20. Theoretically, you should be happier. Are you? Which is more important,
the value of the $20 or your wrath at getting less than the others?

Economists teach that happiness depends upon the quantities of goods

consumed. Common sense suggests that what others consume might also matter. I can feel
fortunate driving a run-down 1996 Chevrolet in a developing country where cars are an unusual
luxury. But if you make me drive that same Chevrolet in a community where my neighbors are
driving late-model BMWs, I will sulk. The Chevrolet might be an effective status symbol in
Bangladesh, but not in Palm Springs.

Economist Robert Frank argues that our obsession with winning and with our relative
standing in the community (what he calls local status) profoundly affects economic
behavior1. Frank suggests that status, like any other scarce commodity, has a demand, a supply,
and an equilibrium price. Those who most value the status of being "top dog" will compete for
the spot and drive up its price.

Who supplies this status? According to Frank it is the losers. After all, we cannot
continue to win unless we can find others who are willing to lose. We cannot be the biggest fish
in our pond unless the smaller fish agree not to leave. Remember, no one wants to lose; no one
wants to be the smallest fish. If we are always at the bottom of our barrel, we are going to look
for a new barrel. Like Curry Creek Presbyterian, we will want to change leagues (or ponds). If
we want someone to hang around and play the patsy, we had better be prepared to pay.

Paying for status

The payments could be explicit -- we could have bribed Curry Creek to stay in the
league, thus boosting our batting averages and keeping us out of the cellar. But the payments are
typically disguised. As an example, consider how wages are set in a typical business. Wage
structures within firms are more egalitarian than labor economists might predict. In competitive
markets a worker who is three times more productive than other workers should be paid three
times as much. 2 Yet, this rarely happens. If you are employed, consider your co-workers. Are
they paid in strict accordance to their productivities? Or are some paid more than they are worth
and others less?

Firms seldom base their pay rates exclusively on productivity. Many salaries, including
those at my former university, follow negotiated formulas based on education, experience, and
seniority. In almost every firm there are significant productivity differences between workers
earning the same wages. The least productive workers usually earn more than they are worth,
while the most productive workers are paid less than their true value.

260
 Why? Why would a firm pay an employee $50 if he were only worth $30? And why
would an employee worth $100 stick around if she were paid only $80? In a competitive world
she could find another employer willing to pay her the $100. Earlier economists assumed this
meant that labor markets did not function competitively. But the differentials between pay and
productivity might reflect the value of status in the firm's hierarchy.

Suppose the value of local status in a firm is $20. If so, those at the top can be paid $20
less than the value of their productivities. The employee worth $100 might willingly stay for an
$80 wage if she can also enjoy $20 worth of local status. Similarly, the employee at the bottom
may be worth only $30, but being at the bottom is no fun. To induce him to accept such an
ignoble position, you might have to pay him more. The $20 becomes a disguised bribe that those
at the top of the heap must pay those at the bottom. Without such a bribe, those at the bottom --
like Curry Creek -- will change ponds. They will go to a smaller pond where they won't be stuck
at the bottom of the hierarchy. The $20 is the compensation paid by those wanting to win to
persuade others to be willing to lose.

Who will sell?

If some of us want to buy status, others must be willing to sell. We can create intriguing
predictions about how the price of status will vary among people and organizations. Just as
those who value status the most will be the buyers, those who value it the least will be the
sellers. Who will these sellers be? Which people will willingly sacrifice local status? Quite
likely, it will be those who enjoy status elsewhere.

For example, if you are the state racquetball champion you might be
willing to accept a low-status job. You might be more willing to accept a
position beneath mine at the office if you know that you can thrash me on the
racquetball court. Similarly, my inability to match you at racquetball may make
it more imperative that I rank above you at work. I might need high status at
work to compensate for my low status at the racquetball club. In other words,
those people who are "big fish" in their lives away from the job may be more
likely to accede to being the "small fish" at work -- and vice versa.

Where opportunities for "off-the-job" status are plentiful, it should be easy to find people
willing to take low-status jobs. If so, the equilibrium price for status will be low. However, if
opportunities to excel outside of work are scarce, the number of employees willing to accept low
status jobs will drop. Without compensating status available elsewhere, it will be difficult and
expensive for those at the top to induce others to accept the "small fish" roles. According to
Frank, this explains why salary structures in the armed forces -- where military personnel are
somewhat sequestered and have few off-the-job opportunities to excel -- are more egalitarian
than those in the private sector.

This notion that status is an important economic commodity -- that we might care about
our relative standing as much as our absolute standing -- is still controversial. But researchers in

261
recent years have been developing an impressive array of supporting evidence. Even that
economic sage Marge Simpson has jumped on the bandwagon. In one cartoon episode, her
husband Homer laments, "I think we're the worst family in town." Marge replies, "Maybe we
should move to a larger town."

________________________________________

Notes:

1. Frank, Robert H., Choosing the Right Pond: Human Behavior and the Quest for Status,
Oxford University Press, 1985. Much of this section is based upon Frank's work.
2. Traditional economic theory predicts that each worker in a competitive world will be paid
the value of his/her marginal productivity. This equals the additional or marginal revenue
that each worker creates for the firm. For example, if by hiring me firms can produce
enough extra output to bring it $100 of new revenue, I will be paid $100. A firm would
be foolish to pay me more and, in a competitive world, cannot get away with paying me
less. If I am offered only $90, a competing firm, seeing my true $100 value, will offer
me more.

________________________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Why might people care more about relative rather than absolute performance?
2. Use the concept of local status to explain why wage structures within firms are more
egalitarian than labor economists might predict.
3. What types of people are most likely to be most willing to sacrifice local status for an
appropriate price? Explain.

262
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Lots of Stuff vs. More Stuff

Life is short. Live it up.

.....Nikita Kruschchev

My first child cried frequently as an infant. It was draining. It was

frustrating. How can we fix a problem we cannot understand? If only he
could talk. If only he could tell us what was wrong. Or so I thought.

An older and wiser colleague warned that frustrations would not end
when my child learned to speak. He explained that raising children never gets easier. He
explained that parenting follows a sort of Newtonian logic: For every problem solved (action),
there is an equally intractable problem created (reaction). Parenting problems never go away;
they just become different. He was right on the money. Parenting is tough.

Children are insatiable. Even children with lots of stuff want more. As an experiment,
follow a mother and child through a toy store or grocery store and count the number of "I wants"
you hear. Should parents acquiesce? We want children to be happy. But how do we make them
happy? Should we haul out our wallets? Should we buy the candy bar, the toy, the video game?
If not, how should we handle the inevitable tears and tantrums?

When my own children were young, I was a patsy. Although they might tell a different
story, my resistance to their pleas was minimal. Was I right? Was I wrong? Will I ever
know? The complexities of differential calculus cannot hold a candle to those of raising
children.

Happiness is....

Will more "stuff" make children happy? What does make people happy? Is it income or
wealth? By most measures, an average U.S. family is better off than one in Portugal. Yet there
is no evidence that the U.S. family is happier.1 Lottery winners should be elated by their new-
found fortunes, and initially they are. But given time to adjust, they report no surge of long-run
bliss. Could health be the key? Not necessarily. Victims rendered paraplegic by accidents do
suffer initial depression. But given time to adjust, they report normal levels of
happiness2. Why? What's going on?

263
 Psychologist Daniel Kahneman and economist Richard Thaler think that the answer is
adaptation3. We each develop a reference level based upon what we deem
normal. Improvements from this level are "good" and regressions are "bad," but the reference
level itself is neutral -- neither good nor bad.

Apply this to income. Salary increases push income above our reference level and make
us happy. However, in time we adjust. In time we begin to think of our new salary as normal
and raise our reference level accordingly. What begins as "good," after adaptation, becomes
"neutral." Kahneman and Thaler point out that "if people quickly adapt to whatever they are
being paid, then no matter how high their salary rises, they never stay happier for long."4

What works for salaries works in other contexts as well. Given time to adapt, people in
diverse situations -- lottery winners and paraplegics, families in the U.S. and families in Portugal
-- regard their status quo as neutral and report similar levels of happiness.

If adaptation occurs, and psychologists can marshal an impressive array of supporting

data, it has profound implications for economics. Intuitively we think that happiness or utility
should rise with income and consumption. But adaptation calls this into question. According to
adaptation, happiness or utility is driven by changes in consumption, not levels of consumption.

Economist Tibor Scitovsky reached a similar

conclusion. Scitovsky differentiated comforts from
pleasures. Comforts include items like color television,
dishwashers, and air-conditioned shopping malls --
things we would miss if withdrawn, but take for granted
on a day-to-day basis. On the other hand, pleasures are
deviations from routine activities -- vacations, birthday
parties, and World Series tickets.

Scitovsky insisted that Americans should be spending less money on comforts and more
on pleasures.5 Why? Adaptation. Consumers adapt to comforts and, after an initial burst of
temporary glee, view them as neutral. But pleasures, being non-routine, are less subject to
adaptation and will continue to generate new excitement or happiness each time they are
enjoyed.

A bonus from bonuses?

Kahneman and Thaler draw an even more intriguing implication from their analysis. If
their adaptation theory is correct, paying workers through bonuses rather than salaries might
increase utility at no extra cost.

Suppose that we want to increase workers' pay by ten percent. We have two options. We
can raise salaries by ten percent, or we can keep salaries fixed and pay the ten percent through a
lump-sum bonus. Although both scenarios generate the same total income, they may not
generate equal utility. If workers quickly adapt to the ten percent increase, they soon will be no

264
happier than they were before the increase. However, spikes in income like one-shot bonuses
might not alter reference levels in the same way. Each yearly bonus might be seen as extra pay
that generates extra utility. Embedding the ten percent increase in weekly checks drives up
happiness only in the short run until workers adapt. Paying the ten percent through bonuses
might cause continuing increases in happiness each time the bonus is paid.

The bonus system also might increase pleasures. Most of us restrict routine expenses to
what our weekly paychecks can cover. These routine expenses will include many comforts; but
comforts, after adaptation, do not increase happiness. On the other hand, bonuses are gravy and
are more likely to be used for pleasures, pleasures that give continuing increments of happiness
each time they are enjoyed.

Parenting redux

And this returns us to the trials of parenting. Have you seen the connection? After
reading and reflecting upon Kahneman and Thaler's adaptation theory, I revised my parental
approach. I toughened up. I peppered my children with answers of "no."

Did I suddenly turn cheap? Perhaps. But that was never my story. I told them it was for
their own good. I explained that if they got what they wanted, they would soon adapt and then
need even more. After all, happiness comes from rising consumption, not from than high
consumption. I explained that it was my solemn parental duty to depress their current
consumption. Only by keeping current consumption low could they enjoy the eventual increases
so essential to their well-being. The best way to ensure their future happiness was by depriving
them now.

Do you think they believed me? Do you?

_______________________________________

Notes:

1. Easterlin, Richard, "Does Economic Growth Improve the Human Lot?" in David, Paul
and Reder, Melvin (ed.), Nations and Households in Economic Growth: Essays in Honor
of Moses Abramovitz, Academic Press, New York, 1974.
2. Brickman, P., Coates, D., and Janoff-Bulman, R., "Lottery Winners and Accident
Victims: Is Happiness Relative?" Journal of Personality and Social Psychology, August
1978, volume 36, pp. 917-27.
3. Kahneman, Daniel and Thaler, Richard, "Economic Analysis and the Psychology of
Utility: Applications to Compensation Policy," American Economic Review, May 1991,
volume 81, #2, pp. 341-346. Most of this essay is based upon Kahneman and Thaler's
analysis.
4. Ibid., page 341.
5. Scitovsky, Tibor, The Joyless Economy, Oxford University Press, 1976.

________________________________________

265
 Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Use Kahneman and Thaler's arguments to explain why rising income might create more
happiness than sustained levels of high income.
2. Explain why Scitovsky argues that we should spend less money on comforts and more on
pleasures.

266
The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

So Much to Do, So Little Time

Nobody sees a flower really -- it's so small -- we haven't

time, and to see takes time, like to have a friend takes time.
.....Georgia O'Keeffe

Vacations are exhausting.

My wife and I take a red-eye flight to London. We try to sleep on the plane, but it is long
past midnight when we slide into an all-too-brief slumber – just before our flight attendants, now
on London time, are rousing us for breakfast. We land. Barely conscious, we drift through
customs, exchange dollars for the requisite British pounds, drag our luggage onto the subway for
central London and find our hotel. Sleep? There is no time for that. There is too much to do.

Quick, buy the theater tickets. My wife considers drama an indispensable ingredient of
any London evening.1 During the day it’s museums. See the crown jewels and Henry VIII's
armor at the Tower of London. Check out the costumes in the Victoria and Albert
Museum.2 The British Museum easily can consume three days, but we can allot only three
hours. The National Gallery of Art suffers the same fate with a quick gallop past the
highlights. After all, we still must tour the National Portrait Gallery around the corner and the
Rothko exhibit at the Tate Gallery across town. The pigeons in Trafalgar Square are a must, and
a walk by Buckingham Palace and Big Ben. Go to Bloomsbury and find the former house of
famed economist John Maynard Keynes.3 Shopping? How about a run through Harrod's and
Liberty of London, and a hurried stroll along Carnaby Street? What about day trips to
Greenwich or Oxford or Stratford or Stonehenge or Windsor Castle? Out of the question. No
time.

Flying home offers no relief. We are greeted by an avalanche of newspapers, magazines,

and assorted mail. There are bills to pay, e-mail and phone messages to answer, grass to mow,
gardens to weed, friends and relatives to visit. Life went on without us; we must catch
up. Hustle bustle. Huff puff.

267
The role of wealth

In the words of economist Staffan Linder, my wife and I are members of the harried
leisure class.4 We are always on the run, always busy. Even our vacations are hectic. And, it's
all because we're rich. No, we are not rich in the Bill Gates or the Jed Clampett sense. But with
two professional incomes, we are comfortably among the top twenty percent of U.S. households
in terms of annual earnings.5 The activities that keep us on the run are expensive. Flights to
London, theater tickets, museums; these are not cheap. If we were poor we could not afford such
a vacation. We would stay home and smell the roses, assuming we could afford a yard in which
to grow roses. No money, no play.

Economic growth certainly has its "up" side. We can purchase more and better food,
more and better health care, more and better educational and cultural opportunities, more and
better recreational activities. But all this consumption involves a hidden cost: time.
Consumption requires time. We cannot "consume" a London vacation without spending time in
London; we cannot enjoy a round of golf without spending several hours on the course. Even
savoring an especially succulent Nathan's hot dog takes time. Economic growth creates more
goods and services, but it does not create additional time for us to consume them. Time is the
ultimate scarce resource.

How valuable is time? It depends. In a modern world with endless opportunities, it is

precious. Yet, if there is nothing to do, time is worthless. When no alternatives are available,
the opportunity cost of idleness -- what must be sacrificed or given up to consume it -- is
zero. Linder notes that cultures with a surplus of time can be found among the poorest citizens
of the poorest countries, regions with abysmal productivity and employment and recreational
opportunities.

Such cultures have no great need of precision and reckoning of time. We find
there a manana attitude, with no detailed planning for either today or
tomorrow. In fact, what we in rich countries mean by time is a concept difficult to
translate into the languages of these cultures.6

On the other hand, growth has created unprecedented prospects for work and play in
more prosperous nations. Once-in-a-lifetime opportunities slip through our fingers with every
moment of sloth.

Punctuality has become a virtue that we demand from those around us. Waiting
is a squandering of time that angers people in rich countries....People are
dominated by their awareness of the clock. They are haunted by their knowledge
that the shining moments are passing without things having been done.7

Economizing on time

268
 Cramming more goods and services into the same amount
of time requires imagination. One path is to pack each available
hour as tightly as possible. We multitask. We watch TV and read
simultaneously; we tune to our favorite radio station while
jogging. We talk on the phone while surfing the web. Students
even cram for 11:00 a.m. exams during their 10:00 a.m. class.

More interestingly, the shortage of time causes us to

consume different types of goods and services. We give up time-
intensive pleasures (those that swallow large amounts of time) and substitute commodity-
intensive pleasures instead. For example, we buy more books but read them fewer times -- if at
all. My shelves are littered with once-read novels that I vow to pick up again. I do want to read
them again; one cannot truly absorb good literature in a single reading. But, when push comes to
shove, I always choose a new novel to re-reading an old one. Other casualties include good
cooking, and good eating. Dumping frozen foods in the microwave may not constitute gourmet
dining, but it's convenient. Dining out? Haute cuisine has not vanished, but it has lost market
share to Taco Bell.

Holidays have been transformed. Quiet, stay-at-home family days have been supplanted
by hurried jaunts to the local water park or theme park where non-stop activity is the order of the
day. And sports. While inner-city youths might still spend all day shooting hoops in a T-shirt
with a ratty $3.98 basketball from the local thrift store, affluent suburbanites have gone high-
tech. They head for the slopes, loaded with $700 skis and $500 boots; they head for the
Bahamas outfitted with the latest scuba gear. Yuppie closets are crammed with expensive, yet
rarely used, equipment of every stripe.8

Increasingly scarce time cramps human relationships as well. Relationships take

time. Intimate one-on-one discussions are nice, but cocktail parties that allow the simultaneous
consumption of food and multiple guests are more popular. Regrettably, when we economize on
time in this way we end up with many acquaintances but few friends. Even love can be
threatened. The painstaking development of a long-term marriage can offer unmatched psychic
rewards, but casual sex is quicker.

Should we abandon economic growth? No. But we should acknowledge that time will
become increasingly scarce.

________________________________________

Notes:

1. No, I don't consider theater to be an essential activity every night, either. However, my
wife is a costume designer and such compromises are a critical component of marital
happiness.
2. No, the Victoria and Albert costumes do not excite me, either. See note #1.
3. Payback for every-night-theater and the costume exhibits.

269
4. Linder, Staffan B., The Harried Leisure Class, Columbia University Press, New York,
1970.
5. In 2013, an annual income of $106,000 placed a household among the top twenty percent
in terms of annual earnings. See What's Fair is Fair for more details.
6. Linder, op. cit., page 17.
7. Ibid., page 24.
8. The cost of time will vary across individuals. Yuppie attorneys earning $200 per hour
sacrifice relatively more per hour of leisure than do busboys at local family
restaurant. That means that attorneys and other high-wage earners have the greatest
incentives to avoid time-intensive commodities. See Lazear, Edward P., "Economic
Imperialism," Quarterly Journal of Economics, volume 115, February 2000, pp. 106-107.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain how economic growth can increase the opportunity cost of time.
2. Explain how we economize on time and how this impacts the types of goods, services,
and relationships we choose. Give examples.

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Starving Artists

It is through art, and art only....that we can shield ourselves from the sordid perils of
actual existence.
.....Oscar Wilde

Artists rarely starve, but they do get hungry. More

accurately, many are waiting tables to keep food in their
bellies. Although Will Smith and Mariah Carey provide
powerful exceptions, performing artists are not among our
economic elite. Average income levels are well-below
average and lengthy spells of unemployment between gigs
are commonplace. For every Will Smith there are hundreds
of aspiring actors fighting for bit parts in regional stage productions; for every Mariah Carey
there are hundreds of musicians vying to provide background music in local restaurants and bars.

It's all supply and demand. Members of performing arts earn relatively less because their
supply relative to demand is large. The dancer/designer/actor/composer who holds out for a
higher price is quickly replaced by a talented aspirant waiting in the wings. And, the talented
aspirants are there. Listen to the principal flutist in a small-city orchestra, the lead in a regional
production of Fiddler on the Roof, even the paid soloist in the local church choir. The talent is
there, just lusting for a shot at the big-time.

Too much supply

Why do they try? Young performers know their chances for fame and fortune are
slim. Dancers put their bodies through incredible stress. Why endure the physical pain of ballet
training when plumbing is more lucrative?

Non-monetary rewards are an obvious factor. Gliding across the stage in Tchaikovsky's
Swan Lake and playing Hamlet to a packed house offer an allure that emptying septic tanks
cannot match. Just as workers must be paid more to attract them into dangerous and/or
unpleasant occupations,1 workers willingly accept lower wages to enter occupations which
provide enjoyment, self-expression, and potential adulation. As long as performing arts markets
are flooded with starry-eyed youth, wage rates and employment opportunities will remain low.

Self-delusion swells the oversupply. In most occupations our abilities are easy to
evaluate. For example, plumbing performance is transparent; either the leaking pipe is fixed, or

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it is not. Assessments in the arts are less objective. Is my sonata soothing? Is my soliloquy
stirring? Few people misjudge their chance of success as electrical engineers but, for some of us,
five minutes alone in the shower can conjure visions of Broadway fame. If the glut of talented
performers is bad, the glut of untalented performers is worse.

An increased consumer appetite for performing arts might ease the problem, but don't
hold your breath. Prime seats for Broadway musicals already can fetch $300 and up, and even
the nosebleed seats in the Metropolitan Opera House will cost you more than several nights of
bowling. High prices have driven low and middle-income buyers out of the market and chased
many live performance groups into oblivion.

In search of technology

Do not expect any changes. Ticket prices for the live performing arts have risen faster
than most other prices in the past, and are likely to do so in the future. The relative price of these
performances is on a relentless tear.2 Why? In a word, it is technology.

Quickly. Name a product that is less expensive than it was in the past -- a price that has
fallen over time. What did you identify? Computers? Calculators? Long-distance telephone
service? Those are all good answers. Now ask what those products have in common. The
answer is rapid technological change. Whether the relative price of a good rises or falls over
time depends critically on the pace of technology. When technology advances rapidly,
productivity improvements cut costs and relative prices will fall. But, when there is little or no
technological change to keep costs down, relative prices will rise.

Imagine you were a visitor from the year 1850. The changes you'd find would blow you
away! Current manufacturing techniques and robotics would look like science fiction; modern
communication and transportation systems would be incomprehensible; and even agricultural
methods, replete with pesticides, mechanization, and genetic engineering would astound you. In
each of these areas, technological advancements have lowered costs, increased supplies and
encouraged growth and expansion.

Yet, should you venture into a theatrical or concert performance, you would recognize it
immediately. You would see some minor changes -- electric lights and new sound systems -- but
the basic technology is unchanged. You would see the same performers playing to the same
audiences in the same rows of seats. More importantly, you would find little or no increase in
productivity. Computers have enhanced the speed with which sets and costumes can be designed
and built, but it still takes the same number of musicians the same amount of time to play
Beethoven's Fifth Symphony; it still takes the same number of actors the same amount of time to
perform Othello.

In short, there has been no significant technological progress and no significant increase
in productivity. With no increases in productivity to hold costs down, the relative price of live
performing arts has risen.

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 The arts must compete with other industries for skilled personnel. As technology drives
productivity and wages up in other sectors, arts producers must match those higher wages to
attract needed performers and other workers. But having to pay higher wages, without the
benefit of higher productivity to offset them, is a sure-fire recipe for escalating costs. As long as
the arts remain in the technological backwaters of the American economy, their relative costs
will inexorably rise. Unless violinists or ballerinas find a way to churn out more performances
per hour, the relative prices of such live cultural pursuits will inevitably rise.3

One segment of the arts has been transformed by technology: broadcast and recorded
performances. Through the magic of movies, a single Tom Hanks performance can play to an
audience of millions. Recordings expand the potential market for the New
York Philharmonic and MTV videos did the same for Mariah Carey. The
relative expense of live performances may be rising, but technology has
lowered costs enough to make broadcast and recorded performances more
accessible than ever.

Electronic technology has created immense riches for top movie stars
and recording artists, but has done little or nothing for most
performers. Indeed, the new technology might even have lowered the
median economic status in the occupation. Technology-induced riches are highly concentrated
in the pockets of a few superstars. After all, if we are to own a recording of Puccini's La
Boheme, we want the best. Given a choice between a recording by the supremely gifted Luciano
Pavarotti as the lead tenor, or by moderately-gifted Bill Kennedy from the local Lutheran church
choir, we will choose Pavarotti every time. And so will everyone else. Pavarotti's recording will
sell to the masses; Kennedy's will sell to his friends.4

The big money is in the electronic media, not live performances. Top actors earn more
from single movie than from years of nightly Broadway performances. As a result they often
relegate live theater to downtimes in their movie careers. Not only do superstars crowd less-
talented performers from the electronic media, they are likely to crowd them from the live-
performance market as well. Why attend a live recital by less-talented local tenor when Pavarotti
is available on compact disk 24 hours a day, seven days a week? Why pay to see the local
repertory's version of Hamlet when you can see Laurence Olivier's Hamlet on video instead?

Other examples

The cost disease that besets live performance is not unique. Handmade items have
suffered the same fate. If we continue to craft such items as we did in 1850, their relative
expense can only rise. Suppose that artisans in 1850 could produce either one earthenware jar or
ten metal cans in a day. The opportunity cost or "price" of the jar would have been ten cans (or
the monetary value of ten cans). Suppose the same worker, due to technological change, could
turn out 100 metal cans per day in 2015. The opportunity cost of producing the hand-crafted
earthenware jar just increased by 1000 percent! The price of the jar -- just ten cans in
1850 -- would be 100 cans in 2015. Given such changes, it is not surprising that so few
hand-crafted items are still available at reasonable prices.

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 Similar trends are evident in many service industries. The opportunity cost of time for a
doctor's house call and a milkman's home delivery have risen so rapidly that they are too
expensive for most of us to afford. Restaurants that have not shifted to "fast food" techniques
have lost ground. The opportunity cost of the time spent in preparing fresh meals for each
customer is greater than most of us are willing to pay.

Education offers a final example. As with live theater, the basic technology has changed
little over time. We still rely on the same teachers lecturing to the same students taking notes
with the same pencils in the same desks. Teachers cannot talk any louder or any faster; they
cannot turn out any more students per hour than they did one hundred years ago. Productivity
increases have been minimal and its relative cost has risen. Do you think a college education is
expensive now? Barring some unforeseen technological breakthrough, just wait and see how
pricey it becomes fifty years down the road.

_______________________________________
Notes:

1. Economists term these higher payments compensating wage differentials.

2. As measured by the Consumer Price Index, average prices rose by a factor of about 15
from 1938 to 2015. What would have cost $1 in 1938 typically would cost about $16 in
2015. Over the same period, top tickets for Broadway dramas rose from $2.50 to $140
(more than a fifty-fold increase). A top ticket for Verdi's Aida at New York's
Hippodrome or Metropolitan cost $1.50 in 1938. An equivalent ticket in 2015 cost $550
(more than a three hundred and fifty-fold increase).
3. This phenomenon is often termed "Baumol's cost disease." See Baumol, William J. and
Bowen, William G., Performing Arts - The Economic Dilemma, The Twentieth Century
Fund, New York, 1966.
4. Movie stars and recording artists often operate in the winner-take-all markets discussed
in What's Fair is Fair. See Frank, Robert H. and Cook, Philip J., The Winner-Take-All
Society, The Free Press, New York, 1995.
_______________________________

Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:

1. Explain how and why the relative prices of tickets for the live performing arts have
changed over time; make sure you discuss the role of technology.
2. Explain how technology has created performing arts superstars who earn
disproportionately large incomes.
3. Explain how and why the relative price of education is likely to change in the future.

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Robert J. Stonebraker

Section III-A: GDP: Equilibrium and Growth

Tall oaks from little acorns grow.

...anonymous

Some acorns grow into oaks, others are eaten by squirrels. Some squirrels prosper, others
get flattened by semi-trailers on the highway. In a similar vein, some economies grow while
others become international road kill.

Growth matters. Small changes in annual growth rates can make an enormous difference
in standards of living. An economy growing at just 2% annually will quadruple in size over a
lifetime of 70 years. Measuring economic growth is tricky; creating it can be more difficult still.

What are the issues?

III-A. GDP: Equilibrium and growth

Equilibrium GDP and economic growth

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Robert J. Stonebraker

Equilibrium GDP and Economic Growth

There are few sorrows, however poignant, in which a good income is of no avail.
....author Logan Pearsall Smith

The United States economy produces more goods and services than any other economy in
the world. Output per person in the poorer countries of the world might average less than five
percent of what we in America enjoy. Why? Why are some countries rich and growing and
others not? What determines the overall level of output in an economy?

Gross domestic product

The concept of total or aggregate output can be tricky. If we produce one pound of hot
dogs and one personal computer, does total output equal two? No. Hot dogs are not the same as
computers. Adding hot dogs and computers makes little sense. Instead of measuring physical
units of output, we measure values of output and then ask about the total or aggregate value of
output.

Economists use the term Gross Domestic Product (GDP) to measure aggregate
output. Specifically, GDP is the value of all final goods and services produced within the
country during a year. GDP for the U.S. in 2016 will top $18 trillion. Megabucks.

Note that GDP measures only the value of final goods. Intermediate goods that are
reprocessed in some way are excluded. For example, if $50 of flour, sugar, eggs and flavorings
are turned into $80 of cookies, only the cookies will appear in the GDP calculations. Why? The
value of the intermediate goods is already reflected in the value of the cookies. The prices
charged for the cookies reflect the costs of the raw materials and intermediate goods needed to
bake them. Counting the cookies and the flour, sugar, eggs and flavorings essentially double-
counts the value of the intermediate goods.

Although the actual methods of measuring GDP are quite complex and constantly are
being tweaked by government statisticians, the basic process is straightforward. We calculate
the total revenue earned by firms producing final goods and services and add them up. If we
produce and sell one pound of hot dogs at $3 and one computer at $1,200, then GDP =
$1,203. Not only can we say that total output equals $1,203, we can also say that total spending
and total income are $1,203. The concepts of output, spending and income are identical at this
level. If we produce and sell $1,203 of output, then people must have spent $1,203 to buy
it. And if one group is spending $1,203, then another must be receiving it as income.

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Nominal versus real GDP

Measuring total output in terms of dollar values creates an additional problem. GDP can
rise for at least two reasons. It can rise because of an increase in real production (which we like),
or because of an increase in prices for the same amount of real production
(which we do not like). To determine which is which, we differentiate the
concepts of nominal GDP (that values products in terms of prices of that
year) and real GDP (that adjusts for any price changes).

Consider an economy that produces only pizza and ice

cream. Suppose that last year it produced 9 pizzas @ $8 [for a total of $72
of pizza] and 14 units of ice cream @ $2 [for a total of $28 of ice
cream]. Last year’s nominal GDP was an even $100 [$72 of pizza + $28 of
ice cream]. Next, suppose that this year’s production is 10 pizzas @ $12
and 20 units of ice cream @ $4. This year’s nominal GDP is $200 [$120 of
pizza + $80 of ice cream]. Nominal GDP doubled from $100 to $200, but
real production did not. Part of the nominal increase was not “real,” it was
the result of higher prices.

To calculate “real” changes we must adjust for price changes. We ask what GDP would
have been if prices had not changed. For example, suppose prices had remained at last year’s
levels. If prices had not changed, this year’s output of 10 pizzas would be worth $80 [10 pizzas
@ $8] and this year’s output of 20 units of ice cream would be worth $40 [20 units of ice cream
@ $2]. In other words, if prices had not changed, this year’s GDP would have been only $120
[$80 of pizza + $40 of ice cream] rather than $200. Thus "real" GDP rose only from $100 to
$120, an increase of 20 percent. The rest of the nominal increase was the result of higher prices
or inflation.

The amount of inflation is measured by price indexes. These indexes measure the level
of prices today relative to those in a base year. One common way of calculating a price index
(PI) is dividing the cost of goods in terms of current prices by the cost of same goods in terms of
prices in the base year (and then multiplying by 100 to eliminate the decimal). Or:

PI = (cost of goods in terms of current prices/cost of same goods in terms of base

prices)(100)

In the example above, this year’s nominal GDP was $200. But, if pizza and ice cream
prices had remained at their earlier level, current GDP would only have been $120. In other
words, what cost $200 in current prices would have cost only $120 at the old prices. If we use
the past year as the base year, then the price index is (200/120)(100) = (1.67)(100) = 167. The
167 means that prices on average have risen 67% since the base year, or that what would have
cost $100 at base year prices would cost $167 at current prices.

In practice, the federal government calculates these prices indexes every month. The rate
of inflation over any specific period is simply the percentage change in the price index over the
same period.

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Aggregate demand and supply

What determines the overall level of output in an economy? With only slight fudging we
can adapt familiar demand and supply concepts to the macro or aggregate economy. The graph
will look quite similar; however the definitions of the variables measured change somewhat.
Instead of measuring the output of a single product on the horizontal axis, we now measure the
real, inflation-adjusted value of all final goods and services (real GDP). And instead of
measuring the price of a single product on the vertical axis, we measure the average price level
of all goods and services (a price index). Finally, instead of looking at the demand and supply of
a single product, we use the notions of aggregate demand or AD (the demand for all final goods
and services summed together) and aggregate supply or AS (the supply of all final goods and
services summed together).

Aggregate demand often is divided into four components. The demand for U.S. goods
and services comes from four different groups: (1) from domestic consumers for consumption
goods (C), (2) from domestic businesses for investment in new capital goods such as machines,
equipment and factories (I), (3) from federal, state and local governments for spending on new
goods and services such as military equipment, highways, police protection, education, etc. (G),
and (4) from people and organizations in foreign countries (F). Symbolically, AD = C + I + G +
F. Statistically, C is the largest component by far. An AD curve should have the conventional
negative slope. As prices fall, all else equal, the value of real goods and services demanded will
increase

Similarly, an AS curve should be positively sloped. Higher prices, all else equal, should
generate a greater real supply of goods and services. However AS ultimately is constrained by
the economy’s production possibilities curve (PPC) that depends upon the number of resources
available in the economy and the technology with which to use them. [If you want to brush up
on PPC’s, you might review the What to Produce reading.] Once an economy reaches its
potential output, no more real supply can be created. At that potential level of output all
resources are fully and efficiently employed and the AS becomes vertical. No matter how high
prices might go, no additional output can be produced.

Equilibrium in the aggregate economy looks just like it does for a single product. The
intersection of AD and AS creates an equilibrium overall level of prices and an equilibrium real
GDP. Price levels above the equilibrium will create aggregate surpluses and drive prices down;
price levels below equilibrium will create aggregate shortages and drive prices up.

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. Check out the graph below. Does it look familiar? It should. The AS and AD intersect to form
an equilibrium at price level P and potential GDP.

Economic Growth

Of course AD and AS curves shift over time and, therefore, move the equilibrium. If we
start with an initial equilibrium that is below the potential level (like GDP0 in the below graph),
an increase in AD will increase the equilibrium level of real GDP. For example, if AD rises
from AD0 to AD1, the level of real GDP will rise from GDP0 to GDP1. But ultimately growth is
constrained by production possibilities and AS. No matter how many goods and services might
be demanded, we cannot produce more in the long run than our resources and technology allow.
If AD rises from AD1 to AD2, there is no change in real GDP; it remains at GDP1. The only
effect is to raise prices to P2.

We cannot go past the potential level of real GDP. In the long run, an economy can grow only if
increased production possibilities shift AS to the right. That means we either must increase the
available resources or else improve the technology with which those resources are used.

279
 Do you remember the four types of economic resources? They are land, labor, capital,
and entrepreneurship. Which of these can we increase? Not land. In the long run we can make
more effective use of our natural resources, but we cannot create more. Labor and entrepreneurs
certainly increase with population over time, but the value of these
might be limited. Growth in output per person is the type of growth
that matters. Plunking more bodies into an economy can create more
output, but normally will not increase output per person. What
remains? Capital or manufactured resources. Along with improved
technology, increases in capital hold the key to long-run economic
growth.

If increased capital and technology drive economic growth,

from where do they come? Primarily from investment. Firms invest
in new capital goods; they invest in new technologies. From an AD
standpoint, increasing I rather than increasing C, G or F is more likely to create growth.
However, private I is not the only source of capital and technology. G also is a potential
source. Government spending to develop the transportation and communication infrastructure of
the economy can be considered public investment. Similarly, government spending to improve
educational opportunities might be considered an investment in human capital. Such public
investment might be every bit as critical as private investment for economic growth. In addition,
government spending on education and basic research could help drive the development of new
technologies.

Regrettably, both private and public investment carry a price tag. If we expect to push
more resources into the production of new capital and technology, we must be willing to devote
fewer resources to consumption. Resources tied up in the production of compact discs, golf
clubs and tanning lotions are not available to generate productivity-enhancing capital and
technology. If we want to grow enough to boost future consumption, we must be willing to
reduce current consumption. We must be willing to save. A political slogan that exhorts citizens
to consume less so that resources can be diverted into investments may not win any elections, but
probably would spur long-run economic growth.
_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Define Gross Domestic Product.

2. Explain why only "final" goods and services are included in GDP.
3. Explain why the sum of expenditures for final and goods and services must always equal
the sum of incomes.
4. Differentiate between real and nominal GDP and be able to calculate either from data.
5. Understand how to calculate and interpret a price index.
6. Describe the four types of aggregate demand and know their relative sizes.

280
7. Identify when increases in AD will increase real GDP and when they will not. Illustrate
graphically and explain.
8. Identify and explain the critical variables for increasing per capita output in the long run.
9. Explain the disadvantage of policies that might spur long-run economic growth.

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Robert J. Stonebraker

Section III-B: Unemployment and Inflation

Practical men, who believe themselves to be quite exempt from any intellectual influences,
are usually the slaves of some defunct economist.
...John Maynard Keynes

Economies rarely behave properly. Like soups in the Goldilocks tale, some are too hot and
some are too cold. Very few are "just right."

When economies overheat, inflation rages. When they cool too rapidly, workers get tossed
from their jobs. How does this happen? Is it inevitable? Should governments actively intervene
to counter these business cycles? What policies might make sense?

Let's look at some options.

III-B. Unemployment and inflation

1. Causes and effects
Unemployment and Inflation
2. Fiscal policy
Government Finance: Just the Facts
Spending and Tax Policy
3. Money and monetary policy
What is Money?
Role of Money
A Dear Abby Quiz

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Robert J. Stonebraker

Unemployment and Inflation

It's the economy, stupid.
.....James Carville, political strategist for Bill Clinton

Rapid growth in aggregate supply (AS) enables economic

growth, but what about aggregate demand (AD)? If shifts in AD fail
to match those in AS, other problems can occur. Mismatches between
AS and AD cause unemployment and inflation.

Unemployment

Think first about unemployment.1 Of course unemployment

will never be zero. Even in the best of times some workers will find
themselves temporarily between jobs (frictional unemployment). Suppose an electrician quits his
job today and begins looking for a new employer. Even if several firms make quick offers, it
may take the worker several weeks to choose a new firm, relocate, and resume working. During
that interim period of time the electrician would be counted as unemployed.

In other cases, plenty of jobs are available, but there may be a mismatch between jobs
and workers either in terms of geographical location or skills (structural
unemployment). Openings for medical technologists in Oregon are of little help to an
unemployed textile worker in South Carolina.

As a rough approximation, about one in twenty workers (or five percent) is likely to be a
victim of these inevitable frictional and structural issues at any point in time. Thus, the
unemployment rate will be at about five percent even in a "fully employed" U.S. economy.
Economists often term this five percent as the natural rate of unemployment.

However, during an economic downturn or recession the rate of unemployment soars

above that five percent level. During such downturns there are simply more people looking for
work than there are jobs available.

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 What causes a recession or economic downturn? Cuts in AD are the most common
cause. Look at the graph below. Suppose the initial equilibrium (GDP1) is at the potential level
of output at which resources are fully employed (we have only the natural rate of
unemployment). If AD falls to AD2 the equilibrium level of real GDP or income falls as
well. With less demand, there is less need for production and less need to employ workers.

Imagine you run a successful bakery that sells 1,000 doughnuts per day that employs 50
workers. The doughnuts cost you $2 a dozen and you resell to the public for $2.25. If
consumers decide to stop eating your doughnuts, what will you do? With excess doughnuts
piling up on your shelves you probably will cut the price of your products to stimulate
sales. Suppose that by cutting prices to $1.95 per dozen you can get sales back to 1,000 dozen
per day. Your sales are back to normal, but your profits are not. Baking doughnuts at $2 a dozen
and selling at $1.95 is hardly a path to fiscal fitness. What now?

Cut production. You can no longer sell 1,000 dozen per

day at a price that covers your $2 costs, but you might be able to
sell 900 or 800 or 700 at such a price. However, less production
means less need for workers. What will you do with the workers
who are no longer needed? You will unload them. Call it a
layoff, call it retrenchment, call it downsizing, the effects are all
the same: unemployed bakery workers.

If demand for other products remains strong, the

unemployed workers might relocate in other sectors quickly. But, if the demand for goods and
services is down across the economy, the workers are stuck; the unemployment will persist. In
other words, if the demand for doughnuts drops, output and employment in bakeries will also
drop. If aggregate demand across the economy drops, output and employment across the
economy will also drop. Too little demand means too much unemployment.

Will unemployment persist forever unless demand picks back up? Probably not. Falling
wage rates eventually should restore full employment. Return to the bakery example. If workers
were willing to accept a wage cut, the lay-offs could be avoided. Remember that you unloaded

284
workers because your costs were too high to make a profit at the $1.95 price needed to continue
selling 1,000 dozen doughnuts. If wages dropped far enough, your costs could easily fall far
enough to make that $1.95 price a profitable one.

However, in the real world, workers aggressively resist wage cuts. For example, suppose
you offered your bakery employees the following options: (1) keep wage rates constant but lay
off ten percent of the workers (presumably those with the least seniority) or (2) maintain
everyone’s job but cut wages across the board by ten percent. Note that both options will save
ten percent of your labor costs. Which option will your employees prefer? Probably the first
option. Option number two does avoid layoffs, but requires that more senior employees -- who
are in no danger of being laid off -- be willing to accept wage cuts to save the jobs of others. The
workers who stand to lose their jobs will certainly prefer option number two, but the other ninety
percent are better off with option number one.

Inflation

If AD lags behind AS, we get unemployment. What happens if AD exceeds AS? We get
inflation.2 Think again of the bakery. Suppose that customers clamor for more doughnuts than
you are baking. What will you do? You have two choices. You can try to meet the new demand
by expanding output and hiring more workers or you can choke off the new demand by raising
prices. If the economy is in the midst of a recession and new workers are easy to find, expansion
is a logical choice. But suppose the economy is already sitting at or near full employment. If
everyone willing to work is already employed, you are stuck. You cannot expand; you can only
raise prices.

What is true for an individual firm largely is true for the economy as a whole. If
increases in AD outpace what a fully employed economy can produce, the extra demand will
drive up prices or cause inflation. Too little demand causes unemployment, too much causes
inflation.

______________________________________

Notes:

1. The U.S. Bureau of Labor Statistics counts as unemployed: "All persons who had no
employment during the reference week, were available for work, except for temporary
illness, and had made specific efforts to find employment some time during the 4 week-
period ending with the reference week." In other words, the unemployed are persons
who have actively looked for a job within the past four weeks but are not working
currently.
2. Inflation is defined as rising prices. If prices rise by four percent on average during a
year, we have a four percent rate of inflation.
_______________________________

Testing Yourself

285
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain why unemployment will exist even in strong economies with ample job
opportunities.
2. Define the concept of the natural rate of unemployment.
3. Explain how recessions can create unemployment, how flexible wages might combat this
unemployment, and why wages are not always flexible.
4. Describe the cause of inflation.

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Robert J. Stonebraker

Government Finances: Just the Facts

Taxes are what we pay for civilized society.

...former chief justice Oliver Wendell Holmes, Jr.

Tables of numbers rarely elicit wide-eyed excitement

among students. Too bad. Without a basic overview of the
sources and uses of government funds, none of the
macroeconomic policy issues that dominate the political
landscape can be discussed intelligently. The data referenced all can be found in the latest
annual version of The Economic Report of President. Read on.

Federal Government Revenues

The table below lists the revenues of the U.S. federal government for fiscal 2015. All
amounts are in billions of dollars.

Personal income tax $1,541 47%

Social security tax 1,065 33%
Corporate income tax 344 11%
Other 300 9%
Total: $3,250 100%

The same three taxes (personal income, corporate income, and social security) have
dominated federal revenues for many decades and the personal income tax has accounted for the
largest percentage of revenue ever since the end of World War II. In recent decades there has
been a gradual increase in the relative importance of social security, and a relative decline in the
importance of corporate income taxes.

Federal Government Expenditures

The table below lists the expenditures of the U.S. federal government for fiscal 2015. All
amounts are in billions of dollars.
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 Social Security/Medicare $1,434 39%
Defense/veterans 749 20%
Income Security 509 14%
Health 482 14%
Interest on debt 223 6%
Education/training 122 3%
Transportation 90 3%
All else 79 2%
Total: $3,688 100%

The most significant change in recent decades has been the increase in social security and
Medicare spending. After the end of the Cold War, defense spending leveled off and actually
fell in real, inflation-adjusted terms. However, social security and Medicare expenses have
soared as the population has aged. Prior to the early 1990’s, spending for defense exceeded that
for social security and Medicare. Thirty years ago (1986), defense and veterans programs
accounted for almost 30 percent of federal spending while Social Security and Medicare
accounted for only about 20 percent.

Interest on debt has accounted for the other significant change. The national debt has
more than tripled over the last 30 years. However, because interest rates have been unusually
low in recent years, the net interest being paid on the debt is almost exactly the same as it was in
1995. If, as is likely, interest rates move back up to more typical historic levels, expect interest
expenditures to rise rapidly.

Federal Deficits and debt

Remember that the U.S. federal government is not required to balance its budget. It is
free to spend more than it receives (a deficit budget) or to spend less than it receives (a surplus
budget). Since 1950, deficits have been the rule. We ran deficits during seven of the ten years of
the 1950’s, during eight of the ten years of 1960’s, during every year from 1970 until
1998. After four straight years of surplus budgets (1998-2001) we returned to steady deficits in
2002.

Look back at the data above. In fiscal 2015, we spent $3,688 billion, but brought in only
$3,250 billion in revenues. In other words, we ran a $438 billion budget deficit (3,688 - 3,250 =
438).

How can we do this? How can the government continue to spend more than it collects in
revenues? It’s easy. The government borrows; it goes into debt. If Congress wants to spend $10
billion more than it has, the U. S. Department of the Treasury borrows the needed $10 billion by
issuing or selling $10 billion of new government bonds. These bonds are nothing more than
IOU’s through which the government promises to repay the bond owner with interest at some
point in the future. Since these bonds are obligations of the national government, we call the
sum of the outstanding government bonds the national debt. Because federal budget deficits

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require new borrowing, they raise the national debt. Federal budget surpluses can be used to
redeem government bonds and reduce the national debt.

State and Local Government Revenues

Although we often focus on federal finances, state and local governments also can be a
powerful economic force. The table below lists the revenues of combined state and local
governments for 2013. All amounts are in billions of dollars.

Property taxes $456 17%

Sales and excise taxes 496 18%
Personal income tax 338 13%
Corporate profit tax 53 2%
Grants from federal government 585 22%
Other 762 28%
Total $2,690 100%

Although tax structures vary considerably among states and among local governments,
three taxes tend to dominate overall: sales and excise taxes (the major source of tax revenue for
state governments), property taxes (the major source of tax revenue for local governments), and
personal income taxes (which often flow to both state and local governments). State and local
governments also receive a significant chunk of revenue through grants from the federal
government. There have been relatively few changes in these categories in recent decades.

State and Local Government Current Expenditures

The table below lists the current expenditures of the combined state and local
governments during 2013. All amounts are in billions of dollars.

Education $877 33%

Public welfare 516 19%
Highways 159 6%
Other 1,091 42%
Total: $2,643 100%

State and Local Deficits

The combined state and local governments in the U.S. ran a $47 billion surplus in 2013
[2,690 - 2,643 = 47]. Unlike the federal government, most state and local governments face
constitutional prohibitions against running deficits in their current expenditure budgets. Note
that there is a difference here. The table above lists only current expenditures at the state and
local level. Most state and local governments cannot borrow to support current expenditures, but
they can and do borrow to finance long-term capital projects such as the construction of schools

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and sewage systems. If capital projects were included, state and local government budgets
would show deficits as well.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Identify the two major sources of federal government revenue in the U.S.
2. Identify the two major expenditure items of the federal government.
3. Explain why the “interest on debt” federal expenditure item has not risen in recent years.
4. Explain the relationship between federal budget deficits, surpluses, and the national debt.
5. Identify the major source of tax revenue at the state government level in the U.S. and at
the local government level in the U.S.
6. Identify the major expenditure item of state and local governments in the U.S.

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Spending and Tax Policy

The chief business of the American people is business.

...Calvin Coolidge

Aggregate demand (AD) in the economy grows over time, but it rarely grows at exactly
the same rate as aggregate supply (AS). Changes in AD generally are more erratic, or more
cyclical, than changes in AS. Cyclical downturns in AD create recessions and
unemployment. Cyclical booms in AD often result in inflation. More steady and controlled
increases in AD might eliminate much of the cyclical instability that plagues economic growth.

Macroeconomists historically argued that cyclical swings were best left alone. Such
swings are inevitable and eventually cure themselves anyway. If AD zooms up too quickly, the
resulting inflation will eventually choke off excess demand and bring the process to a halt. If
demand drops and throws workers out on the streets, wages will eventually fall far enough to
give firms the incentive to rehire the workers and return us to full employment.

Keynes and fine-tuning AD

The Great Depression of the 1930’s blew this consensus out of

the water. British economist John Maynard Keynes led a cadre of
young economists who argued that discretionary government policy
could cure and prevent cyclical instabilities. Is AD too low? Is
unemployment building up? If so, have the government raise demand
and restore full employment. Is AD too high? If so, have government
lower AD and wring any inflationary pressure out of the economy
quickly. By fine-tuning AD so that it always keeps exact pace with AS,
government policy-makers could relegate our cyclical bouts with
unemployment and inflation to the dusty pages of ancient history.

Political liberals who favored more government involvement in the economy quickly
championed this new Keynesian economics. Although conservative free-market proponents who
distrusted government did their best to ignore Keynes and his ideas altogether, even Republican
President Richard Nixon admitted in the 1970’s that “we are all Keynesians now.”

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 Alas. The promise of fine-tuning proved more elusive than early Keynesian proponents
predicted. Government manipulation of AD proved to be far more difficult in practice than in
theory. No serious modern macroeconomist believes that cycles can so easily be
cured. Nonetheless, the basic notion that government policy makers might moderate or ease the
more severe cycles remains firmly entrenched among most members of the profession.

Discretionary fiscal policy

How can the government impact AD? Fiscal policy offers one possible avenue.

Do you remember the four categories of aggregate demand? They were consumption
(C), investment (I), government spending on goods and services (G), and net foreign demand
(F). Government clearly controls G and, by changing taxes, can impact C easily as well.

Suppose that the economy has plunged into a recession with high rates of unemployment.
An increase in AD could create new spending, jobs and income and help us regain full
employment. Government has two obvious approaches to this.

1. Increase government spending. New G directly raises demand for the goods and services
purchased. More spending on military aircraft means new jobs and incomes for defense
contractors, employees and suppliers. More spending on highways means new jobs and income
for road contractors, suppliers and engineers. Such spending can indirectly benefit other as well.
Suppose the Department of Defense orders new military blankets from a local textile firm that, in
turn, hires previously laid-off employees to complete the work. The newly hired employees
clearly benefit, but they are not alone. As they spend their new income in the local groceries and
movie theaters and restaurants and malls, these businesses benefit as well. The initial
government dollars create ripple effects or multiplier effects as they flow through other firms and
are spent over and over again.

2. Decrease taxes. If government slashes your tax bill by $100, how will you react? Will
you spend all or most of the $100? Most of us will. Tax cuts put additional dollars in our
wallets and increase our consumption. This new consumption, in turn, creates new demands,
new jobs and new incomes -- complete with ripple or multiplier effects -- through the economy.

Although increased government spending and/or decreased taxes can help pull an
economy out of a recession, they do not promise the proverbial free lunch. Caution is always
advised. For example, if the economy is already operating at or near full employment, the
increased G and/or C will have little or no impact on real income or production. In a fully-
employed economy we cannot produce more of one thing without producing less of something
else. In these cases, resources needed to support new government or consumer demands must be
taken away from other sectors of the economy. For example, suppose the government awards an
extra $100 billion in defense contracts to Boeing. If Boeing has no excess capacity and cannot
find new workers, it can increase its defense production only by cutting its production of aircraft
for the private sector. The new spending and production for government contracts simply
crowds out spending and production for other private markets. Fiscal policy can raise real output

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and cure a recession only if it can mobilize resources that otherwise would have been
unemployed and idle.

To cure inflation, the appropriate fiscal policies reverse: decrease government spending
and/or increase taxes. Both should cut overall AD: the former by cutting G and the latter by
taking additional dollars from taxpayers who, in turn, will decrease C. The drop in AD should
wring out any inflationary pressure and stabilize prices.

Government budget balances

We have assumed that government budgets need not always be in balance. The
expansionary fiscal policies of more spending and/or less taxation might help in fighting a
recession, but both will push government budgets into a deficit. The contractionary policies of
less spending and/or more tax used to fight inflation tend to create a surplus in government
accounts. Is this a problem? Not necessarily.

First, the U.S. Constitution does not mandate a balanced budget. Budget deficits and
budget surpluses are perfectly legal at the federal level.1 If the U.S. Congress wants to spend
$100 more than it has in tax revenues, it empowers the Department of the Treasury to borrow the
$100 by issuing or selling $100 of government bonds. The bonds basically are a contract in
which the government promises to repay the $100 plus interest
after some specified period of time. In other words, federal budget
deficits are financed by borrowing or by going into debt. Similarly,
government surpluses can be used to retire or pay off any debt.

Theoretically, governments could run deficits to stimulate

new demand during lean economic years and then run surpluses to
cool off demand and inflation during boom periods. Any debts
accumulated during recessions could be wiped off the books by running surpluses during
booms. However, for a variety of reasons, most governments have accumulated substantial debts
by running far more deficits than surpluses -- a controversial practice examined in another
reading.

_______________________________________

Notes:

1. Most state constitutions require a balanced budget for current operations, but allow
legislatures to borrow to finance long-term capital projects.

______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

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1. Explain how fiscal policy can be used to counter problems of inflation and unemployment.
2. Explain why initial changes in aggregate demand might create multiplier effects.
3. Explain why expansionary fiscal policy can raise output only during a recession with
unemployed or idle resources.
4. Explain the impacts of discretionary fiscal policy on government budgets.
5. Explain how the government can spend more than it receives in taxes.

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

Money: What and Why

I have enough money to last me the rest of my life. Unless I buy something.
...comedian Jackie Mason

It’s about time we got to money. Isn’t that what economics is supposed to be about?

No. Economics is about scarcity and choice, not money. In a very simple economy,
there would be no need for money. Think about that for a minute. In a one-person “Robinson
Crusoe” economy, would money exist? What is money, anyway?

What is money?

Economists define money as a medium of

exchange. More simply, money is what we use to buy
goods and services; it is the “medium” we use to
“exchange” for things we want. We exchange money for
hot dogs at Food Lion, we exchange money for CD’s at
Wal-Mart, and we exchange money for admission passes at
Disney World. In short, money is what we spend.

Be careful not to confuse money with income; it’s an easy mistake to make. Income is
the flow of dollars we earn over a period of time; money is the amount of spendable assets we
hold at a point in time. For example, a wealthy executive might earn an income of $200,000 a
year, but she may have only a few thousand dollars of money. She may own an expensive house
in a ritzy gated community, but a house is not money. She may own a new Mercedes and have a
closet crammed with designer dresses, but cars and clothes are not money. Houses, cars and
clothes are valuable assets, but they are not spendable assets.

To an economist, assets vary in terms of liquidity which is a measure of how easily

something can be spent or traded for other assets. Since money is defined as the medium of
exchange, only the most liquid assets can be categorized as money.

For the most part, only two assets can be directly spent. Cash is the most obvious. Most
suppliers happily accept cash in return for goods and services. Checking deposits are the
other. We can write a check or, with a swipe of our debit card, can transfer funds electronically

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from our checking deposits to the merchant as payment. What about credit? Can’t we buy
things with our credit cards? Not really. I’ve tried it many times. Every time I do the same
thing happens: about a month later I receive a bill that I’m expected to pay. Credit merely
allows us to postpone payment. Eventually we must pony up the real thing: cash or a checking
deposit.

The official government measures of money must account for a variety of obscure
possibilities and can be quite complex. For example, how should we handle U.S. cash that is
being held by people in other countries? How should we treat a deposit that can be used to write
checks under some circumstances but not others? However, at this level it is easiest to think of
money as being cash plus checking deposits. In most cases, other assets such as cars, clothes,
bonds, stocks, and certificates of deposit must be converted to either cash or checking deposits
before they can be spent.

Evolution of money

Money only has value in an economy in which we trade with others. Suppose that you
were the sole inhabitant of an economy (what economists often call a Robinson Crusoe
economy). Would you need money? What would you do with money? There are no stores from
which to buy and no potential trading partners. Money would be worthless.

Even in rudimentary multi-person economies money may be unnecessary. If people live

in self-sufficient clans, there would be no trade and, therefore, no need for money. If trade with
other groups occurs on limited scale, bartering commodities directly will probably suffice. For
example, my clan could trade two cows to yours in return for a dozen axes and three beaver
pelts.

As trade grows, direct barter becomes more difficult. Barter butts heads against the
problem we call double coincidence of wants. Not only must we find someone who has what we
want, that person also must want what we have. For example, suppose I grow blueberries but
want to supplement my diet with the potato chips produced by my neighbor. If my neighbor
enjoys blueberries, we can deal. Unfortunately, if blueberries create an allergic reaction for my
neighbor, I’m in trouble. She’s got the potato chips that I want, but does not want the blueberries
that I have to trade. Not only must I find someone with potato chips, I must find someone who
has potato chips and also wants my blueberries. Bartering cannot support an increasingly
complex and specialized world. Imagine Tiger Woods wandering the streets offering to hit a few
golf shots in return for new shoes. Imagine Brad Pitt knocking on doors offering to recite a few
lines of Shakespeare in return for a bowl of macaroni and cheese.

As economies grew, and as specialization and trade became more entrenched, the need
for money also grew. With money, a Tiger Woods could charge spectators money to watch him
play, and then exchange money to others for shoes and other products.

Societies initially chose already existing commodities as means of payments. Animals

were an early example. Some societies would price goods in terms of cows or chickens. A
product might cost five chickens or a new plot of land might cost four cows. However, some

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commodity monies proved to be more successful than others. Specifically, the following
characteristics were essential:

1. Portable
Oak trees make dreadful money. How do you get them to the store to spend? Portability
was an advantage for animals, most are self-propelled.

2. Durable
Because we need the option of saving money for the future, money must long-
lasting. That was a drawback of animal money. Animals die. Savers always ran the risk
of having their money destroyed by disease or old age.

3. Divisible
We must be able to make change. Suppose a product costs 1/5 of a cow. How do we
divide it up? What happens to the other 4/5?

4. Limited in supply
Limited supply proved to be the most elusive and most critical element. The value of
money, like that of other commodities, ultimately rests upon supply and demand. If we
flood the markets with new supplies of bananas, the value of bananas will drop. The same
will happen to money. If we flood the market with new supplies of money, the value of
money will drop.

Do you want an example? In the early 1600’s several American colonies used tobacco as
their primary medium of exchange. Tobacco was portable, durable and divisible, but was not
limited in supply. Early colonists immediately understood that they could grow their own
money. And so they did. Predictably, the number of acres planted in tobacco rose and, also
predictably, the price of tobacco fell. Of course, if the price of tobacco is cut in half, then
shoemakers will demand twice as much tobacco in return for a pair of shoes: the “price” of shoes
will double. In other words, as the value of money falls, the amount of money needed to buy
other goods (the “price” of those goods) will rise. That’s inflation! After a number of
unsuccessful government attempts to restrain the supply of tobacco, colonies adopted other
monies in its stead.

Over time metals proved to be the most successful candidates. They

were portable, durable, divisible and limited in supply. Initially, buyers and
sellers used scales to weigh out specific amounts of metals to make
purchases. But scales were controversial. Even in the 21st century some
scales assert that I weigh more than do others. Medieval technology was
even less reliable and many merchants were eager to use scales that skewed
payments in their favor. To ease disputes and increase convenience,
governments soon began minting coins that contained specific quantities of
metal.

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 Depending upon which ones were available in a particular region, countries adopted
many different metallic metals. However, trading across borders was much easier when both
countries used the same metal as money. To facilitate international trade, countries eventually
began adopting similar metals. Gold and silver were the popular choices, primarily because they
could be found in many different parts of the world and were easily worked into coins.

Although gold and silver worked well in many respects, carrying large sums required
considerable effort. They were heavy; so heavy that countries began seeking lighter
alternatives. They found it in paper. Toting $10,000 in gold was difficult, but $10,000 of paper
currency could easily be carried in a few pockets. Paper was portable, paper was durable, and
paper was divisible. Paper had only one problem: it was not necessarily limited in
supply. However, governments easily could limit the supply of paper money if they tied it to the
supply of something that was limited in supply: something like gold. That’s what they
did. Governments bought up the available gold and then issued paper notes in its place: $1 of
paper for each $1 of gold. Governments often allowed citizens to redeem the paper for gold on
demand but, because the paper currency was so much more convenient, few ever did.

In this world, paper satisfied all the necessary criteria: portable, durable, divisible, and
limited in supply. Alas, another “problem” arose. Economies grew. As economies grew and
more people were making more transactions, the need for money grew as well. Unfortunately,
the supply of gold did not keep pace and shortages of money soon appeared. Governments
reacted by moving to fractional backing. By holding only $.90 of gold for each paper dollar
issued, governments could issue additional sums of money to meet the needs of their growing
economies. As economic growth continued over time, governments met the continued needs for
more money by gradually lowering the fraction of gold held per dollar. The smaller was the
fraction of gold governments needed to hold, the larger was the number of paper dollars
governments could issue.

In the end, governments decided to eliminate all gold backing. They began issuing the
amount of money they thought appropriate, regardless of the amount of gold available in
government vaults. In modern economies, currency supplies are determined by government
policy, not by the supply of gold. In modern economies, gold is no different from other metallic
assets.1

What now “backs” the U.S. dollar? Nothing. Dollars are

fiat money; they are money because the government declares them
to be money. Is that dangerous? Not necessarily. Remember that
the only reason we tied currency to gold was to limit the supply of
currency. Too much money will cause money to lose value and
create inflation. But too little money can crimp the needed
transactions in a growing economy. We want the amount that is just
right: enough to facilitate growth, but not so much that it creates
inflation. The relevant question is which system is more likely to create that “just right”
amount. Should we shackle monetary growth by tying it to the supply or gold, or should we
allow government policy makers the discretion to create the amount of money they deem best.

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 If we trust government do a respectable job, gold backing is both unnecessary and
potentially damaging to long-run growth. If governments are incompetent, gold backing can
provide a useful check to power that might otherwise be abused. For the most part, government
policy makers have performed admirably in the U.S. Our monetary system has accommodated
sustained and steady real growth in real GDP. Regrettably, not all countries have fared as well.

_______________________________
Notes:
1. The U.S. government still holds huge stores of gold in vaults, but it is no longer used to
back currency. The gold simply represents a government asset, like forested land in
Alaska that the government could sell at any time. It does sell a few tons now and then,
but if it tried to sell it all, the increased supply would swamp world markets, drive down
the price, and destroy the value.

_______________________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Define money, list the assets we officially count as money, and explain.
2. Explain the concept of liquidity.
3. Explain why money would be useless in an economy in which all people or families were
self-sufficient.
4. Explain why bartering works less and less effectively as an economy grows and
specializes.
5. Describe the characteristics that a commodity to be used as money should possess.
6. Explain why gold was originally used to "back" money and why it is no longer used in
this way.

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The Joy of Economics: Making Sense out of Life
Robert J. Stonebraker

The Role of Money

Money…is, in its effects and laws, as beautiful as roses.

…Ralph Waldo Emerson

In the official jargon of economics, money is

a medium of exchange. In everyday words, money is
what you spend. Nickels are money. Quarters are
money. Twenty-dollar bills are money. But for large
purchases we typically do not use any of these. For
large purchases (and to pay those ugly credit card
bills) we write checks. Checking deposits are
money. In fact, checking deposits comprise the bulk
of the money supply in the U.S.

The government clearly controls the number of nickels, quarters and twenty-dollar bills
in circulation. Through the Federal Reserve System, the government also controls the amount of
bank deposits.

The Federal Reserve System, commonly known as The Fed, began in the early 1900’s to
oversee and regulate the banking system in the U.S. To minimize political chicanery, Congress
created the Fed as an independent agency controlled by a Board of Governors rather than
Congress or the President. Members of the Board are appointed to their fourteen-year terms by
the President and subject to Senate approval, but once appointed they largely are free from
partisan pressure. The Chairperson of the Board of Governors, currently Janet Yellen, wields a
disproportionate amount of clout and is probably the single most powerful voice in the U.S. if
not the world, economy.

Open market operations

How does the Fed operate? What does it do? The Fed has a wide array of regulatory
powers and functions, but its primary impact comes through its open market operations. Open
market operations are simple enough on the surface, they are transactions in which the Fed either

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 buys or sells government bonds “in the open bond market.” However
these transactions affect the supply of money in the economy, the level of
interest rates in the economy, and the equilibrium levels of aggregate
demand and GDP.

How does it all work? First, consider the market for government
bonds. Most government bonds are in the form of short-term, large
denomination Treasury Bills that can be bought and sold through brokers
just like corporate stocks. Corporations, especially banks and financial
firms, frequently buy these bonds to earn interest on short-term funds. If
Prudential has access to $10 million for three days, it might buy $10
million of bonds. It can hold the bonds for three days and then resell, essentially earning interest
for three days. Though less often in the news than stock markets, billions of dollars of
transactions regularly flow through these government bond markets.

By buying and selling government bonds, the Fed effectively can create or destroy bank
deposits; that is it can create or destroy money. Think through an example. Suppose the Fed
buys $10 million of government bonds in the open market from Prudential. The Fed writes out a
check for $10 million and gives it to Prudential in return for the bonds. What will Prudential do
with the check? Prudential will do just what you do when receiving a check; it will deposit the
check in its bank account. Ah. Magic. A new $10 million checking deposit ($10 million of new
money) has suddenly appeared out of nowhere. Every time the Fed buys government bonds, it
creates new money in the economy. It pulls an asset called a government bond out of the
economy and puts in another asset called a checking deposit. But the bond was not directly
spendable; it was not money. The checking deposit is spendable; it is money.

Your initial reaction might be, “so what?” No one is any richer, no new wealth or
income has been created. The Fed merely has swapped one asset worth $10 million for another
worth $10 million. The magic continues.

What does a bank do with deposits? If you deposit $100 in your account, does the bank
tuck that $100 in a drawer waiting for you to return and reclaim it? No. Banks are private firms
pursuing profits; they earn their profits by using your deposits. They do keep part of the deposits
on reserve to meet anticipated withdrawals, but they lend most of the dollars we deposit to other
customers. Some of those loans will go to individual consumers as home loans or car loans, but
most go to local and regional businesses. The dollars we deposit might be repackaged as a loan
to a local manufacturer to expand its factory or to a local builder to finance his inventory. The
difference between the interest the bank earns on these loans and what it pays us for our deposits
provides the bank profit. A bank with no loans is a bank with no income.

Are you still with me? Return to the Prudential example. The Fed has written a $10
million check to Prudential that is deposited into Prudential’s bank account. Prudential’s bank is

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not about to sit on those dollars. Prudential’s bank is going to
scout out new lending opportunities to turn those idle deposits into
profit-making loans. How can the bank convince someone to
borrow? The same way that Wal-Mart convinces you to buy new
socks -- it offers a good deal. In this case, the bank will offer a
good rate of interest on the loan. In economic parlance, those new
deposits are loanable funds. The new surplus of loanable funds
drives down the price (or rate of interest) until someone is willing
to buy (or borrow).

What’s next? Suppose Prudential’s bank decides to keep

$1 million on reserve and then lends the other $9 million to Exxon
to expand a refinery. Exxon takes the $9 million and spends
it. Exxon’s $9 million refinery expansion is $9 million of new investment (I) demand that, in
turn, can raise the equilibrium level of GDP.

Do you see the linkages? Follow them through once more. First, the Fed buys bonds in
the open market. It pays by writing a check that is then deposited in the banking system. This
new deposit is new money and creates loanable funds for the receiving bank. To induce
someone to borrow, the bank cuts the rate of interest. As the rate of interest falls, local firms are
encouraged to borrow and invest. The new investment raises AD and the equilibrium level of
income or GDP.

In short, Fed open market purchases raise the supply of money, and ultimately the levels
of AD and GDP in the economy. Can you guess the effect of open market bond sales by the
Fed? Yes. Exactly the opposite.

When the Fed sells bonds, the buyer writes a check and gives it to the Fed. This pulls
deposits out of the banking system (and into the Fed instead). This cut in the supply of deposits
(or money) creates a shortage of loanable funds in banks. The shortage drives up the price (or
the rate of interest) for loans that, in turn, makes firms less willing to borrow and invest. A cut in
investment pulls down AD and lowers the equilibrium level of GDP.

Monetary policy

We already learned that Congressional fiscal policy could change AD by changing taxes
and government spending. Fed monetary policy can accomplish the same thing through open
market operations.

Fiscal policy shifted the G and/or C components of AD, monetary policy’s initial impact
is on I. If the Fed sees the economy sinking into a recession it can increase the supply of money
by buying government bonds in the open market. This new money creates a surplus of loanable
funds, drives down the rate of interest and raises investment demand. Similarly, if inflationary
pressure is beginning to build, the Fed can cut the supply of money by selling bonds. This pulls
deposits out of the banking system, creates a shortage of loanable funds, drives up rates of
interest and decreases investment demand.

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_______________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Describe the basic structure and functions of the Federal Reserve System and identify its
chairperson.
2. Explain the processes through which the Fed can increase or decrease the supply on
money.
3. Explain the process through which changes in the supply of money create changes in the
demand for real goods and services and, in turn, equilibrium GDP.
4. Identify and explain the monetary policies that might be used to counter problems of
inflation and unemployment.

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The Impact of Money: a Dear Abby Quiz

The letter below, which appeared in June 1992 newspapers, is typical of the off-the-wall
questions economists are asked by the general public. Afraid of an errant reply, Abby consulted
an "expert" at the U.S. Department of Treasury (who asked to remain anonymous). Abby could
not answer it by herself; could you?

DEAR ABBY:

Could you please answer this question we are baffled over at work: Why
doesn't the U.S. Mint simply print enough money to just pay off our
government's debts, feed the hungry, and house the homeless? We know
there must be a logical answer. We just don't know what it is.

-BAFFLED

[A detailed answer follows.]

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Extended answer to Dear Abby quiz:

First, the U.S. Mint does not print money, it manufactures coins. Currency is printed by
the U.S. Bureau of Printing and Engraving (BPE), a division of the U.S. Department of the
Treasury. The BPE website at http://www.moneyfactory.com/ offers more information than
you’ll ever want to know.

Second, the BPE does not control the supply of currency; the Federal Reserve System
does that. It is the Fed that distributes currency into the economy. The BPE only prints what the
Fed orders. No orders; no printing.

Third, the currency operations typically have no impact on the overall supply of
money. Remember that most of the nation’s supply of money is in the form of bank deposits, not
cash. When you and I are short on cash, we go to the bank and ‘buy” more by writing a check or
using an ATM to transfer funds out of our deposits. In effect, we trade one type of money (our
checking deposits) for another (cash). The form in which we hold the money changes, but the
overall amount of money remains the same. Local banks do the same. Just as you and I hold
deposits with a bank, the banks hold deposits with the Fed. When local banks are short of cash
they turn to the Fed for more. They trade in their deposits with the Fed for cash. The form of
money changes, but not the amount. [How does the Fed change the supply of money? You
should be able to explain that one!]

Fourth, and most importantly, we cannot cure the economic woes of the world by
increasing the supply of money. Increasing the supply of money can increase the aggregate
demand for goods and services [Can you explain how?], but it does not affect aggregate
supply. If we are mired in a recession or depression and are suffering from unemployment, the
increased demand can be quite useful. The new demand will prompt firms to hire additional
workers and utilize idle capacity. But, eventually we reach full employment; we reach the edge
of our production possibilities curve. And that’s the end. Without new resources or new
technology, we can produce no more. We can flood the economy with money, but money is not
a resource. It is not land, labor, capital or entrepreneurial ability. It’s just paper.

Increasing the supply of money does raise aggregate demand, but in a fully employed
economy we cannot get additional goods and services. The increased demand will drive up
prices and cause inflation, but can create no gains in real purchasing power or real GDP.

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Section III-C: Deficits and Debt

In general, the art of government consists in taking as much money as possible from one
class of citizens to give to another.
... Voltaire

Government budgets can agitate even the calmest of citizens. The U.S. federal
government expects to spend more than $3.5 trillion in fiscal 2010. Try to appreciate the size of
that number. If you began counting immediately and counted one number each second of every
waking moment of every day it would take you more than 100,000 years to reach 3.5 trillion.
Even counting by thousands, you would be dead long before you approached 3,500,000,000,000.

Of course what is spent by government rarely equals what is received by

government. Most years federal budgets run deeply into the red. Why? Does it matter? Are
budget deficits dragging us into fiscal oblivion? We'd better decide soon. When the baby
boomers begin to retire in a few years, the costs of our current Social Security and Medicare
programs will soar.

Should we invest in worry beads?

III-C. Government budget deficits and debt

1. Debtiphobia
2. Riches to Rags: Where did the Surplus Go?
3. Social Security: Apocalypse Soon?

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The National Debt: So What?

A national debt, if it is not excessive, will be to us a national blessing.

...Alexander Hamilton

For many years my father has suffered from a curious

malady called Debtiphobia, an abnormal fear of the National
Debt. I have tried to administer various treatments, but none has
been successful. The condition may be chronic.

His disorder occasionally lapses into remission, but is

apparently triggered by the sight of an economist and flares up
when I visit for Christmas or other festive occasions. It typically
strikes when I am in a weakened condition--collapsed on the sofa
in front of the television, turkey-stuffed abdomen extending
gently over my belt, gearing up mentally for a frontal assault on
the butterscotch brownies my mother has lovingly baked for
me. It starts innocently enough. Muffled phrases like "irresponsible spending" and "national
disgrace" begin to percolate through the after-dinner air from my father's direction. By the time
we get to "mortgaging the future" and "pay the piper," my wife has pulled out a book to read, my
mother has excused herself and returned to the kitchen and I am left alone to weather the
onslaught.

I don't really mind. In fact I much prefer deficit harangues to my father's alternative
passion of playing checkers. I've got a fighting chance at discussing economics, but I'm dead in
the water with checkers. He's kicked my butt at that game for years.

A large and growing debt

Of course, my father is not debtiphobia's only casualty. Although virtually ignored in

medical literature, the disease is widespread. On the surface, debtiphobia seems justified. The
national debt IS big and currently is approaching $20 trillion or about $60,000 for each man,
woman and child in America. And every additional government deficit drives it higher.

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 Most economists agree that occasional budget deficits do no harm and, if used to push an
economy out of a recession, can be quite useful. However, while traditional fiscal policy
prescribes budget deficits during a recession, it also prescribes budget surpluses to slow inflation
during economic booms. That rarely happens. Instead of running budget deficits during
economic downturns offset by surpluses during good years, governments tend to run deficits in
every year. Despite lip service to balanced budgets, we often run for the exits at the sight of tax
increases or spending cuts large enough to achieve them. An almost unending string of red ink
that piles up more national debt each year results.

Yet, as the data below show, the size of the national debt relative to GDP was falling
until 1980. The huge annual deficits in recent decades -- and especially in recent years -- drove
the ratio up, but the current level is well within historical bounds and also stands well within the
normal range of other industrialized nations. It has not thrust us to the brink of bankruptcy.

Year National Debt National Debt

($ billions) as % of GDP

1940 $51 50%

1945 260 122
1970 381 38
1980 909 33
1990 3,206 56
2000 5,629 57
2010 14,025 92
2015 18,825 99

Moreover, the national debt is not like debts you and I might incur. It is money that we,
through our collective representative the government, have borrowed from ourselves. Our
personal debt is external; it's owed to others. Most of the national debt is internal; it's money we
owe to ourselves. Although some of the debt is owned by foreign interests, two-thirds of it is
held by U.S. creditors. In fact, the largest creditor of the government is the government
itself! Over 40 percent of the national debt is owned by government
agencies -- mostly federal, but some state and local.

The national debt need not be repaid in the same sense that private
debt must be repaid. Most government debt is in the form of short-term
Treasury bills that mature every 90 days. When one set of Treasury bills
matures, the government simply pays them off by selling more. As long as it
offers competitive rates of return on "safe" bonds, the government will be
able to refinance or "roll over" its debt indefinitely. As a result, we need not
worry about burdening our children with repayment. They won't repay the
debt. Like us, they will refinance and pass it on.

More importantly, the official data badly misstate the true importance of the debt. The
government does have debts, but it also has assets. If I can borrow $500 and buy a capital asset
worth $600, I'm better off, not worse off! What matters is government net worth, not the value
of its debt. The numbers are somewhat subjective (how can we measure the value of the Capitol
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or Yellowstone National Park?), but researchers calculate that our government net worth remains
solidly positive.

Crowding out

Does that mean deficits and debt pose no economic problem? Not necessarily.
Government borrowing impacts credit markets and pulls dollars and resources into the public
sector. If the economy is in a recession and these resources otherwise would have been
unemployed, no damage is done. In fact, deficit spending designed to put these resources back
to work is the traditional fiscal policy recommendation to stimulate the economy and eliminate
the recession. But, if the economy is already at or near full-employment, deficits will "crowd
out" private investment.

When the government borrows, it competes for scarce loanable funds with private firms
that also want to borrow. Like any other market, increased demand creates a shortage that, in
turn, drives up prices. When the government wants to borrow, its new demand creates a shortage
of loanable funds that drives up the rate of interest. The higher interest rate makes borrowing
more costly and discourages private firms from borrowing and investing. The would-be private
borrowers are crowded out of the market. Monies that might have been loaned to finance
research and development or new manufacturing capacity in the private sector are loaned to the
government instead. Unfortunately, with less research and development and less manufacturing
capacity, productivity and long-run economic growth will suffer. As a result, current fiscal
prolificacy can lower the standard of living our children will enjoy.

On the other hand, crowding out does not always cause lower productivity and growth.
Suppose the government borrows $100 million that would have been borrowed by General Mills
to modernize its cereal factories. We lose the $100 million of private investment, but what do
we get in return? What does the government do with its $100 million? If the $100 million is
wasted on unproductive Congressional junkets to Bermuda, future generations are harmed. They
inherit a smaller and less productive stock of capital with which to work. But, suppose the $100
million is used to educate a new work force or to rebuild our transportation infrastructure. These
are productive investments and are indispensable building blocks for our future economic well-
being.

The critical question is which project will benefit future generations the most--
modernized cereal factories or new education/infrastructure. As long as the government spends
its borrowed dollars on investments at least as productive as the private investments it crowds
out, no damage is done.

_______________________

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

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1. Explain the concept of National Debt; explain what it is, who holds it, and how federal
deficits and surpluses affect it.
2. Describe historical trends in the U.S. national debt and our debt-to-GDP ratio since 1940.
3. Discuss why our national debt, unlike private debt, may never be paid off.
4. Explain how, and under what circumstances, the creation of a national debt can harm or
be a burden to future generations.

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Robert J. Stonebraker

Riches to Rags: Where did the Surplus Go?

Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income
twenty pounds, annual expenditure twenty pounds ought and six, result
misery.

...Charles Dickens

When Bill Clinton waltzed out of the White House in

2001, he bequeathed an incredible windfall to the Bush
Administration: a federal budget that was running its fourth
consecutive annual surplus. Washington had eked out a $69
billion budget surplus in fiscal 1998, another $126 billion in
1999, $236 billion in 2000, and $128 billion in 2001. It was a
phenomenon that had not been seen since the 1920's.

Fiscal Bliss

Tax hikes and budgetary reforms that stopped Congress from enacting new spending
plans not accompanied by a matching source of funding were partly responsible, but an
unexpectedly robust economy helped since increased incomes pour increased tax revenues into
the public coffers. The baby boomers did the rest. At the peak of their earning years, boomers
were dumping more taxes into the social security system than current retirees were pulling out.
The combination of these factors created the budget surpluses.

When the surplus first appeared, President Clinton pushed for saving it to protect social
security. But that was not possible. A surplus cannot be saved for the future in any meaningful
way. In the normal course of a month, billions of dollars’ worth of outstanding government
bonds mature. The Department of Treasury routinely issues new bonds to raise the funds needed
to repay those that are maturing. With the initial $69 billion surplus, the Treasury simply issued
$69 billion less in new bonds. The result was a $69 billion drop in the value of outstanding
government bonds; a $69 billion drop in the National Debt. But nothing was "saved".

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 What should be done? Most analysts expected the surpluses to continue. The non-
partisan Congressional Budget Office (CBO) projected future surpluses large enough to
eliminate the entire National Debt by 2010.1 At the time Congress faced three basic choices:

1. Keep 'em coming: Stay the course. Let the surpluses roll in and whittle down the
National Debt.

2. Go shopping: Break out the checkbook. Spend the would-be surplus funds on new
government projects. Whose pet projects should be expanded? Everyone had the same
answer...."mine."

3. Give it back: Wipe out future surpluses with a tax cut. Which taxes should be
cut? Everyone had the same answer...."mine."

Many economists favored the keep 'em coming option. They argued that budget surpluses
would spur increased economic growth and lead to higher standards of living in the future. For
growth we need investments in technology and new capital goods; investments that enhance
labor productivity and increase output per person. To finance the investments, firms must borrow
the needed funds from financial markets. The funds can be supplied by private savers, but they
also can be supplied by government.

If Congress runs a $100 billion budget deficit, the Department of the Treasury must
borrow $100 billion by selling $100 billion of new government bonds. This pulls funds out of
the financial markets and makes it harder for private businesses to borrow and invest.
Conversely, if Congress runs a $100 budget surplus, the Treasury redeems $100 billion of
government bonds and plows those funds back into the financial markets. In other words, every
dollar of federal budget surplus becomes a dollar available for private firms to borrow and invest
in new capital and technology; capital and technology that can raise future production and
standards of living.

What happened?

Nobody listened. The economists lost. The Bush Administration, with the consent of
Congress, opted for the go shopping and the give it back options instead. Multiple tax cuts and
prolific spending, coupled with the deepest economic recession since the
1930's, turned those multi-trillion projected surpluses into multi-trillion
dollar deficits. The $800 billion budget surpluses once forecasted for each
fiscal year from 2009 to 2012, turned into annual deficits in excess of $1
trillion.

Who is to blame? Take your pick. Republicans, Democrats and bad

luck all share responsibility. According to analysts, responsibility for the
projected swing breaks down as follows:

1. Bad Luck:
The post-2007 housing crisis and the subsequent economic crash drove tax revenues well

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 below normal levels and increased mandated spending for unemployment compensation,
welfare, and other safety-net programs.

2. Bush Policies:
The Bush Administration pushed multiple tax cuts through Congress and increased
spending for a wide variety of domestic and foreign initiatives including new prescription
drug benefits for Medicare recipients and war in Iraq and Afghanistan. To circumvent
budget rules the tax cuts originally were designed to expire at the end of 2010, but
Congress later extended them. Most analyses claim that these tax cuts account for the
largest part of our current budget deficits.

3. Obama Extension of Bush Policies:

Several costly Bush policies have been extended: most notably the wars in Iraq and
Afghanistan as well as most of the tax cuts.

4. New Obama Initiatives:

Obama's economic stimulus package accounted for a small percent of deficits from 2009
to 2011 and his new initiatives in health, energy and education add another small amount.

The graph below depicts the results. Federal spending, which had been fluctuating
around 20% of GDP spiked up to almost 25% of GDP when the recession hit. Federal receipts
dropped rapidly as a percent of GDP after the Bush tax cuts starting in 2001 and then again after
the recession in 2007. By 2011 federal spending as a percent of GDP stood at a 60-year high and
federal revenues as a percent of GDP were at a 60-year low. The predictable result was the
largest federal budget deficits as a percent of GDP since World War II. The deficit peaked in
fiscal 2009 at just over $1.4 trillion or almost ten percent of GDP. Since 2009 the deficit has
been shrinking. As the economy recovered and income and employment rose revenues rose as
well. Similarly, spending moderated as expenditures for social safety-net programs. By fiscal
2015 the deficit had fallen to $438 billion or 3.3 percent of GDP.

Federal Spending and Revenues as a Percent of GDP

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What's Next?

The good news is that the deficits have fallen rapidly in recent years. Unfortunately,
other problems loom on the fiscal horizon. Medical costs continue to soar and, as the baby
boomers begin to hit retirement in a few years, the government tab for Medicare and Social
Security will soar even faster. Recent analyses by the Congressional Budget Office project
annual deficits again exceeding $1 trillion by 2022.2

Small annual budget deficits create few problems, but $1 trillion annual deficits are
unsustainable. There is little doubt that they will crowd out private investment and drag down
long-run economic growth. Yet controlling them will require difficult and unpopular
choices. Both higher taxes and lower benefits will be needed. Such policies make sense for the
long-run health of the economy, but voters (and therefore politicians) are focused notoriously on
the short run. Our grandmothers encouraged us to look to the future; to willingly accept short-
term pain for long-term gain. Our grandmothers were right. Will we listen?

________________________________________

Notes:

1. See Congressional Budget Office, The Budget and Economic Outlook: An Update,
August 2001, Table 1-8.
2. Congressional Budget Office, Summary of the Budget and Economic Outlook: 2016-
2026, January 19, 2016

Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain what caused the budget surpluses during the late 1990’s.
2. Identify the three basic options politicians had in dealing with budget surpluses.
3. Explain why budget surpluses might help spur economic growth.
4. Explain why the budget surpluses projected earlier became large budget deficits and why
those deficits have moderated in recent years.
5. Explain why future federal budget deficits are likely to increase.

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Robert J. Stonebraker

Social Security: Apocalypse

Soon?

Will you still need me, will you still feed me,
When I'm sixty-four?
Beatles

Social Security always has stirred intense

passions. Although billed as old age "insurance" when
signed into law in 1935, it never has been run as
such. Instead of salting payments away in individual accounts to be repaid at retirement, the
program has been financed on a pay-as-you-go basis. Payments from current workers
immediately are recycled as benefit checks to retirees.

Moreover, benefits received have never been based on payments in any meaningful
way. Congress has used the system to generate massive redistributions of income across
generations and across income classes. Despite the official rhetoric, Social Security has been
administered as a program in which current workers (rich and poor alike) redistribute dollars to
current retirees and their spouses (rich and poor alike).

Is that bad? Not necessarily. The program successfully has shored up the incomes
enjoyed by elderly citizens and has enjoyed enormous popular support. Not that many years ago,
the elderly were a generally impoverished lot with average standards of living well below those
of their younger counterparts. Now, thanks largely to Social Security, income levels of most
elderly citizens have reached or surpassed national averages.

Despite its success, the system has come under increasing fire. Social Security, along
with its associated Medicare program, is the largest item in the federal budget -- far surpassing
the runner-up lines for national defense and interest on the national debt. As Congress struggles
to balance the budget, escalating costs in Social Security have squeezed other federal programs
into oblivion. Can we afford it?

The issues:

1. The shrinking trust fund.

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 The early years were a piece of cake. In 1940 there were 159 workers paying into the
system for each beneficiary drawing payments out. Tax rates were low and financing non-
controversial. This allowed Congress to legislate benefits to early recipients that far exceeded
the value of their contributions plus interest. Ida Fuller, the first American to draw a Social
Security check, ultimately received $20,940.85 from a system to which she had contributed a
mere $22.

Later recipients enjoyed similar largesse. However, as the number of retirees grew and
life expectancies lengthened, problems began to mount. By 1960, the number of workers per
beneficiary had plunged to five. It currently stands at about four and, by 2030 when the final
baby boomers will hit the retirement in full force, we expect the number to fall almost to two
workers per beneficiary.

As the number of workers per beneficiary falls, a pay-as-you-go Social Security System
becomes increasingly untenable. Early retirees reaped exorbitant rates of return from the Social
Security System, far greater than what they could have obtained themselves with their
contributions earning a reasonable rate of return. Of course if past recipients received more than
the value of their contributions plus a reasonable return, someone eventually must receive
less. In effect, the overly generous payments to past recipients have created a legacy debt that
eventually must be paid by either current or future workers.1 That means that negative rates of
return are likely for current or future workers. It was relatively easy for past retirees to live off
of the contributions of the huge baby-boom generation. The boomers will find living off their
less numerous children far more difficult.

Realizing the dilemma, Congress phased in several tax increases to build a trust fund and
return the system to a sound actuarial footing. Even though these increases have created a large
and growing trust fund, it's not enough. Now that the baby boomers have begun to retire, the
annual surpluses already have turned to deficits. In 2010 the Social Security Administration paid
out more in benefits than it received in revenues. By about 2034, the trust fund will be empty
and system will be bankrupt. At that point, projected revenues will be sufficient to cover only
about 80 percent of promised benefits.2

Or so goes the rhetoric. But it's all a ruse, a red herring. There
is no real trust fund to deplete. Oh, it does exist on paper; but the trust
fund is only an accounting artifice, an illusion. By law, all trust fund
monies are invested in special non-marketable government bonds. In
effect, the current Social Security surpluses are given back to the
Treasury Department each year for bonds -- interest-bearing IOU's
with no tangible assets or collateral to back them. In other words, the
current surpluses are not being squirreled away in a protected account
somewhere; they simply are loaned back to a Congress that, in turn,
spends the monies to finance ongoing government operations.

When the annual surpluses become deficits down the road, the trust fund will begin
cashing in its bonds and ask Congress to fork over the needed dollars. But where will Congress
get the dollars? It has no storeroom of tangible assets to tap into; no real reserve exists. With no

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tangible asset -- only government IOU's -- the fund is an illusion. When the trust fund tries to
redeem its bonds, Congress either must raise taxes or borrow the needed funds. Of course,
Congress could always renege and not pay the promised benefits. But as the number of retirees
and their political clout grows, this becomes less and less likely.

We can build a bigger trust fund, but it would not solve the problem. It does not matter if
we have a $10 trillion trust fund or a $10 trust fund. As soon as annual outlays begin to exceed
annual tax receipts, Congress either must raise taxes, cut benefits, or borrow the additional
monies. The size of the trust fund is irrelevant. The "expert" wringing his/her hands over the
vanishing trust fund is an "expert" to ignore.

2. Economic Growth

The claims of retirees ultimately are claims on the output being produced by current
workers. If retirees claim an increasing share of the pie, current workers necessarily must inherit
a smaller share. No conceivable financial arrangement can alter that fact. Fundamentally, the
problem is that of economic growth. If productivity rises and economic growth is robust,
disaster will be averted. With a rapidly rising GDP, "baby busters" could enjoy a higher absolute
standard of living despite consuming a smaller share of output. The best way to "fix" Social
Security is to generate more economic growth.

How? Most macroeconomists insist increased saving and investment is the key. The
more we save, the more resources we can plow into new technology and productivity-enhancing
investments. More savings translates into more productive capacity for future generations; more
capital per worker. In general, countries with the highest savings rates have the highest
standards of living. A recent estimate by economists at the respected Brookings Institution pegs
the needed increase in national savings at an extra five percent of GDP per year. That amount of
new savings should generate enough new growth to finance the projected increase in spending on
the elderly.

Unfortunately we are not moving forward; we are backpedaling. Savings rates have
fallen below historical levels and show no sign of recovery. As expected, productivity growth
has suffered a similar fate. Although the causes are still hotly debated, it appears that the Social
Security System itself may have been part of the problem. Guaranteeing elderly citizens a
minimum standard of living has reduced the needs of workers to save for retirement. More
importantly, the system has reallocated massive amounts of dollars from middle-aged workers,
whose savings rates are relatively high, to retirees, whose savings rates are very low. Ironically,
Social Security has undermined the very behavior needed to insure its long-run success. Rats.

The proposals:

Politicians, economists, and government advisory committees have jumped into the
middle of this fray with abandon. Experts agree that the current system is unsustainable, but
disagree on the appropriate fix. Two basic types of proposals have been put forth: (1) making
reforms within the current system structure and (2) shifting toward a privatized system with
mandated personal accounts.

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Proposal #1: Reforms within the current structure

Advocates of this approach oppose any radical change of the system. They opt to cover
the legacy debt and return the system to long-run balance through various combinations of cuts
in benefits and higher taxes. They note that the projected long-term shortfall, while large in
absolute terms, amounts to less than one percent of projected GDP over the same period. The
extra tax revenue needed to close the gap is far smaller than the amount of tax revenue lost by
the 2001 and 2003 tax cuts passed by Congress at the behest of President Bush.3

In its 2010 report, President Obama's bipartisan National Commission on Fiscal

Responsibility and Reform (often referred to as the Simpson-Bowles Commission) concluded
that, with a few "minor" changes, the system could regain fiscal balance. Among the suggested
possible changes were:

1. Increase the retirement age. Today’s workers can expect far more years of robust health
and productivity than could their grandparents. When Social Security began, average life
expectancy in the U.S. was a mere 62 years (life expectancy for men was even lower);
barely half expected ever to live long enough to receive a single retirement check.5 But
by 2009 average life expectancy at birth had edged past 78 -- an increase of 16 years. To
bring down costs, the normal retirement age could be increased. Those retiring now
qualify for full benefits at age 66 and those born after 1959 will qualify for full benefits at
age 67. If we were to raise that to age 70, the projected shortfall would be
eliminated. While this option does have a number of proponents, others note that this is
simply a disguised cut in benefits. Gary Burtless has noted that "Increasing the age for
full benefits by one year has the effect of lowering workers' monthly checks by 6% to
7.5%, depending on the age when a worker first claims a pension."4 Moreover, because
low-income workers tend to die at an earlier age, raising the retirement age will hurt them
relatively more than their affluent bosses.

2. Make all wages subject to the Social Security tax. Under current law, social security
taxes are imposed only on the first $118,500 of annual wages or salary.6 Wages and
salaries above that are not subject to the social security tax. While relatively few workers
earn more than this cap, those that do often earn millions more. About 15% of total
wages in the U.S. escape the social security tax. Gradually removing the cap and making
all wages taxable could raise substantial sums of revenue and close as much as 70% of
the projected revenue shortfall.7

3. Revise the cost-of-living calculations. Social Security benefits increase automatically

each year to keep up with changes in the overall cost of living. However, economists
agree that the current statistical methods overestimate the true amount of price inflation
that occurs. Using a more accurate method of measuring inflation would decrease the
annual cost-of-living adjustments and save many billions of dollars in the long run.

4. Reduce the relative benefits to the wealthiest retirees and increase them to low-income
retirees. Retirees with low incomes collect benefits for fewer years since they typically

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 die much sooner than those with high incomes. Shifting annual benefits toward those at
the bottom would save money and also would help even out lifetime benefits received.

Proposal #2: Personal Accounts

Personal account proposals represent a more radical

approach that makes more fundamental changes in Social
Security. These proposals divide Social Security taxes into two
pieces. One part of the taxes paid would go into the current system
and would continue to fund a smaller, fixed safety-net pension. A
second part would go into personal accounts controlled by each
individual. Registered investment firms offering a smorgasbord of
portfolio options for their individual clients would manage these
personal accounts. Because this would move some Social Security
funds out of the federal government and into private hands, many brokerage firms and mutual
funds have been salivating at the thought.

Upon retirement, employees would receive the smaller safety-net benefit given to all,
plus an annuity based upon the success of their personal account. Those whose accounts earn
high rates of return will receive more than those whose accounts are less successful. In effect,
this would move the Social Security System away from a defined benefit plan in which benefits
are guaranteed, toward a defined contribution plan in which contributions are fixed, but the
benefits vary with the return on pension investments. The proposal reduces the role of the federal
government to running the safety-net fund and allows individuals the freedom to invest the other
monies as they see fit. In this respect, personal accounts are a step toward privatization of Social
Security.

By themselves, personal accounts can neither repay the system's legacy debt nor change
the system's long-run fiscal imbalance. They simply move dollars from a government-run Social
Security account to a privately-run account. However, under current law, the Social Security
Trust Fund is invested entirely in government bonds and earns only paltry rates of
return. Personal account advocates claim that individual accounts can be invested more
aggressively in corporate stocks and similar financial instruments that historically have earned
higher rates of return. If so, we could we could cut Social Security benefits and use the higher
returns on personal accounts to offset the loss.

As an example, suppose that by investing in corporate stocks Jorge could earn $100 more
in a personal account than the Social Security Trust Fund would earn on its government
bonds. If so, we could cut Jorge's Social Security benefits by $100 without lowering his
retirement income. In other words, every additional dollar that individuals could earn in a
personal account is a dollar that could be cut from Social Security benefits. If the additional
earnings in personal accounts are large enough, benefits could be cut enough to return the system
to long-run fiscal balance.

While some have rallied behind the privatization that personal accounts promise, others
recoil in horror. Defined contribution plans like personal accounts shift investment risks to

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employees. What if the accounts do not generate the high rates of return that proponents
predict? What if financial markets take a dive just as a worker is ready to retire and needs to
cash in his/her personal account? Will employees -- especially unskilled, uneducated employees
-- be able to make intelligent investment decisions? Or will unscrupulous money managers take
many to the cleaners?

Transition issues are even more problematic. Workers in my generation have already
paid for our parents' retirements. In this scenario our children will be paying for their own
retirements via personal accounts. Who will foot the nearly $2 trillion bill to finance ours? The
legacy debt built in the past would remain unpaid. Unless we are ready to add another $2 trillion
to the national debt, large tax increases would be needed to raise the necessary monies.

Where are we now?

The plans and their many variants are complex and controversial; none are easily
explained through commercial sound bites to the electorate. More importantly, neither aims
directly at increasing economic growth -- the only sure-fire solution. We cannot pay Social
Security benefits to larger number of retirees without a larger pool of resources and
output. Growth is the key. Growth requires more saving, more investment, more productivity
growth. And, that means sacrifice. Ouch, what an ugly word. But, it's a necessary word. We
cannot save more unless we are willing to consume less. Proposals that ignore the need to
sacrifice are both dishonest and useless.

Conservatives push a combination of benefit cuts and personal accounts. The benefit cuts
are designed to bring expenditures into line with projected revenues and move the system toward
solvency. They tout the personal accounts as a way to "soften the blow." If personal accounts
perform as well as their proponents hope, the increased returns will offset some or all of the lost
benefits. Opponents reply that personal accounts will create unacceptable risks for many
workers. Indeed, recent returns earned by savers have fallen far below what would have been
forecast a decade earlier. Many also fear that personal accounts are a first step toward attempts
to dismantle the entire Social Security System. Many liberals favor reforms that would raise
taxes and protect current benefit levels. They argue that Social Security pensions already are 30
to 40 percent below the norm in other developed nations and that many U. S. retirees rely almost
entirely on Social Security income.8

Many who do favor personal accounts argue that they should be added on top of the
current system rather than replacing it. For example, current Social Security tax rates would
remain the same, but those who want to do so could pay an additional sum each month that
would be used to create a personal account. Keeping the current tax rates would help us repay
the legacy debt hanging over the system and, adding personal accounts on top of the system
might encourage the extra savings needed to boost long-run economic growth.9

Although almost all proposals address only the retirement part of the Social Security
System, many experts worry that the financial problems facing Medicare are even more thorny.
Although the rate of increase in Medicare expenses has apparently slowed since the
implementation of the Affordable Care Act (or Obamacare), the long-run outlook still is unclear.

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Whatever the solution, the stakes are high. If we expect to avoid intergenerational warfare, we
must do what we can to ensure that baby-buster incomes will be high enough to afford the tab
they will be asked to pay.

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Notes:

1. The legacy debt term was coined by economists Peter Diamond and Peter Orszag. See
Diamond, Peter A. and Orszag, Peter R., "Saving Social Security," Journal of Economic
Perspectives, Spring 2005, volume 19, number 2, pp. 11-32.
2. See Gary Burtless, "Raising everyone’s retirement age undercuts a key goal of Social
Security", October 22, 2015
3. Diamond and Orszag, op. cit.., pp. 7 and 25.
4. Gary Burtless, "The growing life-expectancy gap between rich and poor", February 22,
2016
5. The Economist, June 27, 2009, page 10.
6. The $118,500 was the cap on maximum taxable earnings for 2016. The cap is adjusted
annually based the national wage index.
7. Currently both workers and employers pay a 6.2% tax on earnings up to the cap. To
close this much of the revenue gap, the cap would have to be removed for both groups.
8. Henry J. Aaron, "Triumph and Tribulation: How Progressives Might Approach Changes
to Medicare, Medicaid, and Social Security", January 20, 2014
9. Sweden moved to a similar system in the 1990's. See "Social Security Smorgasbord?
Lessons from Sweden's Individual Pension Accounts," by R. Kent Weaver, Brookings
Policy Brief #140, 2005.

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Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:

1. Explain why people are worried about the long-run health of our Social Security System.
2. Explain the origin of the system's legacy debt and how this affects the rate of return likely to
be earned by future generations on monies paid into Social Security.
3. Explain why generating more economic growth is the best way to solve the Social Security
problem and how the Social Security System itself might have lowered growth rates.
4. Discuss and explain the types of reforms within the current system that might create a long-
run fiscal balance to Social Security.
5. Explain how proponents of private social security accounts expect to bring long-run fiscal
balance to the Social Security System.
6. Explain the disadvantages of allowing individuals to put Social Security tax dollars into
personal or private accounts they can manage as they wish.
7. Distinguish between defined benefit and defined contribution retirement plans.

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