Tuesday, September 27, 2011

Garett Jones on Stimulus | EconTalk | Library of Economics and Liberty

Garett Jones on Stimulus | EconTalk | Library of Economics and Liberty

The first 10 minutes of this podcast does a great job connecting the principles of microeconomics (primarily the knowledge problem) with issues in macroeconomic theory, primarily topics related to recessions and stimulus policies.

Tuesday, September 13, 2011

Game Theory- From the Economist

More examples and applications of Game Theory

Saturday, September 10, 2011

Type II Error (from a public choice perspective)

We make the burden of proof so strict (analogously the 'alpha' level) that we seldom are able to reject the null hypothesis. As a result we are more likely to unknowingly accept the null hypothesis when it is false. This translates to 'overcautious' behavior.

See also Type II Error Bias and the Response to Hurricane Katrina and Type II Error Bias and the FDA or for the statistical concept of type II errors see here.

Friday, September 9, 2011

Comparative Advantage

Tuesday, September 6, 2011

Spontaneous Order

Models in Economics: Game Theory

From the movie, A Beautiful Mind.
Full Screen - click here

Rent Seeking in History and Hollywood

Government and the Economy in "The Aviator"

by Dirk Mateer

Rent seeking, the political pursuit of gains that would not be earned engaging in the market process, is a common theme in many films. With clips from the acclaimed 2004 film “The Aviator,” the discussion of rent seeking can be broadened to include the related concept of regulatory capture. After Pan Am leader Juan Trippe (played by Alec Baldwin) is unable to convince TWA’s Howard Hughes (portrayed by Leonardo DiCaprio) not to offer competing flights across the Atlantic, Trippe turns to Senator Owen Brewster (played by Alan Alda) to introduce a Civil Aviation Bill that would hamper TWA’s ability to compete with Pan Am. The clips illustrate the gains, in this case campaign contributions, prestigious committee chairmanship, and personal travel, that politicians can receive from pushing rent seeking legislation such as that favoring Pan Am.

Biotech and Rent Seeking

Bootleggers and Biotechs

Regulation | 2003| Summer

"From the claims of opponents of the new biotechnology, it would be easy to conclude that the biotech industry has vigorously fought government efforts to regulate its products. But in fact, the industry has been anything but a consistent opponent of extensive, and even unnecessary, regulation. It has lobbied for protectionism of various sorts — including public policy that makes regulatory costs excessive – and in the process has forsaken science and common sense. Since the 1980s, large biotech companies like Monsanto, Ciba-Geigy (now Syngenta), and Pioneer Hi-Bred International (now owned by DuPont), along with their trade associations, have actively and aggressively lobbied in favor of certain major regulatory or legislative initiatives that often are more restrictive even than those sought by regulators themselves. The industry’s goal is ostensibly to placate anti-biotech activists"

Rent Seeking and Biotechnology

Rent Seeking Behind the Green Curtain
Regulation 1996 No 4

"There is no reason to expect environmental regulations to be immune from the economic pressures that create rent seeking in other contexts. In fact, by their very nature, environmental regulations are conducive to rent seeking, for in the environmental context, both regulated firms and "public interest" representatives stand to gain from reductions in output and the creation of barriers to entry. Regulated firms and public interest groups may not always agree on the nature and design of specific regulatory programs, but they often share a common interest."

Rent Seeking and Markey Waxman (Cap and Trade Legislation)

From the Knowledge Problem Blog:

But as the legislation’s chances improve, corporations, environmentalists and other interest groups have worked to put their imprint on the bill. The Center for Public Integrity said its review of Senate disclosure records showed that more than 880 businesses and interest groups have registered to lobby on climate change in the first quarter of 2009 — up more than 14 percent over the same time last year.

The groups include coal companies, investment banks, wind and solar firms, state governments, auditing firms and technology companies that might be part of the proposed trading system for carbon. An item inserted at the behest of Rep. John D. Dingell (D-Mich.) would give the auto industry $1.4 billion worth of extra allowances starting in 2012 when the cap-and-trade system takes effect, according to an estimate by the Union of Concerned Scientists.

Monday, September 5, 2011

Homeland Security, The Knowledge Problem & Constitution Week

Below are excerpts from two economists (David Henderson and Sam Clovis) on faculty at the Naval Post Graduate School. Note, Henderson will be speakingat WKU this year during Constitution Week

September 12, 2011
8:00 pm - 9:30 pm

Grise Hall 235

 (special thanks to the BB&T Center For the Study of Capitalism at WKU).

"Central economic planning can't work, explained Hayek, because no small number of people at the top, however brilliant or informed, can aggregate all the trillions of pieces of data needed to plan an economy well. The main information that matters in real time is what Hayek called "knowledge of particular circumstances of time and place" and this information is necessarily decentralized: it exists only fleetingly in the minds of millions of people.....Hayek's argument applies whether the good being produced is food, steel, or internal security. In fact, in her testimony before the 9/11Commission, Dr. Rice explained the problems with centralization eloquently;

                  You have thousands of pieces of information . . . and you have to depend to a certain degree on the intelligence agencies to tell you what is actually relevant,
                 what is actually based on sound sources, what is speculative.

The lesson of September 11 is not that government should plan better and not that a Republican president plans better or worse than a Democrat president. The lesson of 9/11 is that central planning doesn't work and that government should not get in the way of our planning. "  LINK

In addition to the  'knowledge problem' discussed above, Sobel and Leeson have identified several other issues with the top down approaches in homeland security regarding incentives, the tragedy of the anticommons, and type II error policy bias. Absent market prices, how do we deal with these issues? Attempts to address these problems, to some extent, can be found in scholarship related to homeland security and federalism:

"an agency that forms partnerships with state and local governments instead of coercive top-down regulation-heavy regimes is an appropriate response on the part of the national government to deal with the particular needs of all the other governments in this country. Further, this agency should work at giving state and local governments as much flexibility as possible in dealing with own-source challenges. By facilitating cooperative networks of communities/jurisdictions a far more realistic and pragmatic approach to all hazards preparedness is a logical outcome. The national government should provide the organization around which such networking might take place." –Homeland Security Affairs VI, no. 2 (May 2010) – Sam Clovis

Efficient Markets and Prices

‎"I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge" - F.A. Hayek

"The financial crisis invalidated a naïve notion of "efficient markets," but the most sophisticated version is still viable. Whereas the invalidated version holds that markets never err and always adjust instantaneously, the sophisticated version, associated with the ideas of Adam Smith and F. A. Hayek, holds that markets mobilize individuals to realize gains from trade and to innovate and thereby produce generalized prosperity."

"In the 1940s, Hayek warned his fellow economists of the misleading standards of perfect competition and static efficiency in assessing the market economy. As he wrote in Individualism and Economic Order, "[T]hese adjustments are probably never 'perfect' in the sense which the economist conceives them in his equilibrium analysis. But I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency" (1948, 87)"

"The great free market economic thinkers from Adam Smith to F. A. Hayek never argued that individuals were hyper-rational actors possessed with full and complete information, operating in perfectly competitive markets.... Efficient markets are an outcome of a process of discovery, learning, and adjustment, not an assumption going into the analysis."


Pricing Carbon

"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." - Frederick Hayek

A basic application of climate economics:

What economists must do is take consensus science into account, and approximate what the price of carbon should be to limit economic damages from CO2. This level will be achieved where the marginal cost of reducing carbon emissions is equal to the benefits of decreased damages from climate change in the future.  

Nordhaus ( Using the DICE-2007 model, and based on the science of the IPCC Fourth Assessment Report) prices carbon at about $30/ ton, with the average person in the US generating about 5tons/yr, for a total of about $150/year, or .09 /gallon of gas and .01/kwh for electricity. However, the Stern Proposal(proposed by another economist in the U.K) estimates the damage from global warming to be closer to $300/ton carbon for the next two decades. In this case we are looking at increasing gas prices by about $1.20/gallon. (read more)

How can economics narrow the gap between these approaches? Should we question the idea of 'pricing carbon' or the assumption that the impacts of climate change (manmade or not) fail to be captured in market interactions? 

Carbon taxes and the climate change knowledge problem
The idea of pricing carbon is that given the assumption that CO2 production has a negative impact on climate change and so many goods and services are carbon intensive, if we can put a price on carbon (paid by corporations that trade carbon permits or a carbon tax)  to capture the value of the negative externality, this will 'trickle down' to the mirco level, such that when you buy an ice cream cone, gasoline, or a pencil, the impact of your choice on the climate will be captured in the price you pay for it.  This is the climate change knowledge problem. We have to get the initial price of CO2 correct so that the 'trickle down' economics works at the micro level and we ward off catastrophic climate change.

The correct price for carbon will balance the marginal cost of reducing carbon emissions with benefits of decreased damages from climate change in the future.  As Armstrong points out, there are few scientific forecasts related to these future damages. And technological change allows us to continually respond the volatile effects of climate change. Advances in biotechnology are allowing us to produce more climate resilient crops, all the while reducing our carbon footprint in agriculture.  How can we incorporate this knowledge into our calculus? When it comes to the costs of reducing carbon emissions, it isn't any easier. What are the opportunity costs of resources invested in emissions mitigation (voluntarily vs. those mandated or incentivised by government administered prices for carbon)?   
Tradeable Permits
Some will argue that instead of a tax, you can get similar or superior results by defining property rights in the form of carbon credits or tradeable permits. Then markets can solve the information problem via the price mechanism that manifests in the trading of permits. The problem still stands. Someone has to initially assign some quantity of permits to 'polluters.' This quantity has to be based on some determination of an 'optimal' quantity of CO2 emissions. This also requires the information necessary for determining the marginal benefits and costs of each associated unit if CO2.  The knowledge problem has not been solved, just reformulated in a way that is equivalently intractable for planners to solve. Unless planners get this quantity right, the price that 'trickles down' at the micro level for all goods and services will be too high or too low, based on the artificial scarcity or excess created by the planners' miscalculation. The classic exampleof the Coase Theorem solves the externality of pollution of common property like a lake by clearly assigning property rights. The optimal level or quantity of pollution is a separate problem solved by the price mechanism via subsequent exchanges of property rights or contracting. In the case of CO2, the assignment of property rights and the optimal quantity of pollution both have to simultaneously be determined. You have to determine some initial quantity of pollution in order to create the permits (which a are then traded to establish a price).

From the Capitalism Today Blog at Western Kentucky University there was recently adiscussion regarding macroeconomic equilibrium and the difficulties of knowing the micro-level equilibrium for something (seemingly) as simple as ice cream:

"They act as if not only there is equilibrium, but that they know where it is.  If anyone knows exactly how many ice cream cones the US needs to produce tomorrow, please raise your hands.  What no hands?  No one can know the "appropriate" amount of ice cream cone production for today let alone for tomorrow.  The $15 trillion US economy makes a lot more than just ice cream cones."
I think this analogy may also apply to pricing carbon. Ice cream comes in lots of varieties and flavors, produced and marketed various ways (natural, conventional, biotech, hormone free, organic, home made, store bought, ice cream trucks, retail outlets). Ice cream is pretty differentiated when you think about it. What about carbon?Noone knows how to set a 'national' or even a 'local' price for pencils, or the correct quantity of pencils that our complex world requires.  Why do we expect carbon to be any different than ice cream or pencils? Even if economists like Nordhous and Stern were in agreement, their solutions would not sufficiently deal with climate change's knowledge problem. 

Some will agree that planners are no match for markets in determining prices and quantities, but because we currently have no established property rights to the atmosphere there is no 'price' for carbon. As such, there are going to be consequences if we do nothing, and the next best solution is an attempt, even if not perfect, to price carbon because it is not considered in market transactions. 

Is that really the next best solution and is it true that the price mechanism totally ignores CO2? 

What is carbon really? 'Carbon' in an economy manifests itself in how we heat and cool our homes, how we manufacture goods and services, how we respond to emergencies, how we travel and transport goods, how we store and retrieve information. Leonard E. Read's essay I, Pencil demonstrates  the complexity involved in an economy that thrives on disaggregated information and processes with numerous feedback loops and interactions.  In a complex society, carbon is no different, and while it may not be explicitly and directly priced, it is hard to believe that its role is not part of the pool of knowledge characterized by the partial bits of information held by all individuals in society. 

In fact, while politicians and special interests argue over the politically optimal arrangement of regulatory protections and subsidies to 'combat climate change' markets have responded in much more meaningful ways without any bureaucratically administered price of carbon or cap on CO2.

As Dr. Don Boudreaux of George Mason University points out in a recent piece in the Wall Street Journal, in response to climate alarmists' connecting violent storms and climate change (and obviously calling for centralized solutons to combat it): (read more)

 "...because of modern industrial and technological advances—radar, stronger yet lighter building materials, more reliable electronic warning devices, and longer-lasting packaged foods—we are better protected from nature's fury today than at any other time in human history."

Perhaps the innovations in green technologies in agriculture provide the greatest example of mitigating climate change:

Total decreases in carbon dioxide as a result of using biotech crops was equivalent to removing 6 million cars from the road in 2007. The carbon footprint for a gallon of milk produced in 2007 was only 37 percent of that produced in 1944. For every 1 million cows, the reduction in global warming potential from rBST supplemented cows is equivalent to removing 400K cars from the roadways or planting 300 million trees. The use of grain and pharmaceutical technology in beef production has resulted in a nearly 40 percent reduction in greenhouse gases (GHGs) per pound of beef compared to grass feeding. Intensive agriculture has actually has a mitigating effect on climate change with a reduction of 68 kgC (249 kgCO2e) emissions relative to 1961 technology. (read more)


We are not really sure how to price carbon, and what we observe in all of these instances is that despite the absence of a centrally planned price or quantity of carbon, people are making choices that optimize its use or production. Because we don't have the knowledge to price carbon, we don't know that the resources expended in 1) lobbying lawmakers to tweak the proposed rules and regulations 2) mitigating the costs of a centrally planned price or quantity, would not have higher valued uses mitigating climate change in other ways (like investment in green technologies like biotech). T
he best approach for dealing with climate change or any environmental problem is to develop resilient market based economies that are able to invest in the technology necessary to adapt to ever changing resource constraints.

Friday, September 2, 2011

Taxes, Elasticity, Revenue, and Economic Activity

Romer, Christina and David Romer, (2010). "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks," American Economic Review, vol. 100(3), pages 763-801.

tax increases to be highly contractionary with a negative effect on investment

Alesina, Alberto and Silvia Ardagna (2010) "Large Changes in Fiscal Policy: Taxes versus Spending" In Jeffrey Brown, 2010. "Tax Policy and the Economy, Volume 24," NBER Books, National Bureau of Economic Research.

Fiscal stimulis based on tax cuts increases the probability of future economic growth greater than spending

Carroll, Robert, Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen (2000) "Income Taxes and Entrepreneurs Use of Labor," Journal of Labor Economics, 18 (2), April pp. 324-55

Increases in marginal tax rates reduce the probability of future increased hiring and are associaed with reduced growth in wages.

Gruber, Jon and Saez, Emmanuel, 2002. "The elasticity of taxable income: evidence and implications," Journal of Public Economics, vol. 84(1), pages 1-32.

Finds a very elastic response for incomes over $100k, (.57) with an elasticity of about .17 for incomes < $100k.

Gentry, William and Glenn Hubbard (2000) "Tax Policy and Entrepreneurial Entry" American Economic Review, vol. 90, pp. 283-287.

Finds a significant increase in entrepreneurial activity when tax rates are less progressive.

Djankov, Simeon, Tim Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Shleifer, (2010). "The Effect of Corporate Taxes on Investment and Entrepreneurship," American Economic Journal: Macroeconomics, vol. 2(3), pages 31-64, July.American Economic Association.

"our estimates of the effective corporate tax rate have a large adverse impact on aggregate investment, FDI, and entrepreneurial activity"

The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act Martin Feldstein Journal of Political Economy
Vol. 103, No. 3 (Jun., 1995), pp. 551-572

Estimates the elasticity of taxable income to range from about 1.0 -3.

Lindsey, Lawrence B. 1987. "Individual Taxpayer Response to Taxcuts, 1982-1984." J. of Public Economics 33 (July) 173-206

Found elasticity of taxable income by income category to be .728 for income > $50k, 1.023 for >$100k, 1.413 for >$250k, and 2.0 for > $1 million. Also derived the tax revenue responses to reductions in marginal taxes for those earning more than $200k / yr. Revenues increased by 19% in 1982, 35% in 1983, 56% in 1984.

Economic Inquiry, 2008, vol. 46, issue 2, pages 197-207


Why Do Americans Work So Much More Than Europeans?
Federal Reserve Bank of Minneapolis Quarterly Review
Vol. 28, No. 1, July 2004, pp. 2–13

Finds that taxes, and particularly higher marginal tax rates have a negative effect on labor hours.