POEC 250 FINAL
Okun: Where do equality and efficiency not trade off?
1. Measures that soak the rich so much as to destroy investment and hence impair the quality and quantity of jobs for the poor could worsen both efficiency and equality. - 2. Techniques that improve the productivity and earnings potential of unskilled workers might benefit society with greater efficiency and equality. An example of this would be public education. Public education is accessible to anyone, so it satisfies the equality criteria. Education produces better workers by providing them with a more diverse skill-set so that they can transition easily into the workforce and be productive. - 3. Historically speaking, caste positions, feudal obligations, entailed land, and guild memberships - 4. Okun also discusses the development of an American economic system where large enterprises are owned and managed by workers (i.e. Yugoslavian socialism). In theory, profit sharing and participatory decision-making by workers would strengthen work-ethic and the incentives of employees in the firm if they had skin in the game.
Absolute demand vs. effectual demand
Adam Smith: Absolute demand is just the desire for something—a very poor man has the absolute demand for a "coach and six", but this demand is not effectual because the commodity will not be brought to the market in order to satisfy it. Effectual demand is the demand that is sufficient to "effectuate the bringing of the commodity to market". Necessary to find the market price, as the market price is regulated by the proportion between that which is brought to the market, and the demand of those who are willing to pay the natural price of the commodity (whole value of rent, labour, and profit which must be paid in order to bring it thither). Effectual demand stands as the impetus for competition, as demand rises and supply falls, consumers will be willing to give more than the natural price, the magnitude of which depends on the eagerness and wealth of the competitors. Then more people will produce that good. Effectual demand = willingness x ability
The "Invisible Hand"
Adam Smith: The idea that because individuals are profit-maximizing and operate in their own self-interest, the economy will work well in a free market. One will invest close to home if there are nearly equal rates of profit to minimize risks. One will maximize value added, which is the enhancement given to a good or service when there are nearly equal goods in the market, and profits are proportional to value-added, the sum of which is equivalent to GDP. So, maximizing value added and profits will result in GDP being maximized.
Division of Labor/Extent of the Market
Adam Smith: Division of labor leads to more productivity, with more output with the same number of workers. Specialization/dexterity, saving time between switching tasks, technological innovations become possible (when a task gets so simplified that you can devise a machine to do that one task) Pin factory - one person could not make one pin per day, but ten people specializing in the eighteen different steps could make 48,000 pins per day = more wealth The division of labor depends on the extent of the market, which depends on location/geography (population density) and geographical features such as reasonable proximity to trade because with low shipping costs, transport by water becomes cheaper than by land. Extent of the market also depends on the certainty/order of trade (the judicial system must be enforced), and provide transportation and infrastructure.
What people really seek when they strive for wealth
Adam Smith: People want esteem, and they can either earn this through wisdom and virtue or via wealth. The wisdom/virtue path is more difficult and subjective. Taking the wide path isn't worth it because we lose more in pursuit than we gain in utility, but this delusion aids society by creating lots of income. The desire for esteem is selfish in aim, and other-regarding in its content.
Why self-interest does not necessarily lead to strife or dishonest judges
Adam Smith: Self interest doesn't necessarily lead to strife because if we were to commit an injustice, it would excite the resentment of many others. You want to prevent resentment because it can incite death. Resentment is the safeguard of justice and the security of innocence. Judges are drawn from those who choose the narrow path to the esteem of others, that of wisdom and virtue, and pursuing wealth won't achieve judge's desire for esteem.
Free trade and the Navigation Acts
Adam Smith: Free trade is generally good because it increases productivity. Almost at competitive advantage, but talks about the opportunity cost (Scottish wool for French wine), therefore tariffs aimed at creating a wine industry would just waste resources). The Navigation Acts were a series of acts passed in the 1600s that were designed to regulate colonial trade and Enabled England to collect taxes in the Colonies. The Navigation Acts were the doctrine of what Smith deems as the "mercantile system", in which imports were restrained and exports encouraged, to protect against foreign competition (Holland).
Adverse selection and luck egalitarianism as they apply to health insurance
Adverse selection - the fact that insured individuals usually know more about their risk level than insurers do. This can lead to collapse of the insurance market. Only those for whom insurance is actuarially fair will buy insurance. Thus in some cases only those with higher risk will purchase insurance and this will make insurers raise premiums, forcing even more healthier people out of the market (and soon). This is a death spiral. How can adverse selection be remedied? One option is to offer different levels of coverage at different prices, which forces consumers to reveal their relative levels of risk. However, this separating equilibrium is a market failure because it leaves many not fully covered. According to luck egalitarians, inequality due to brute luck should be eliminated. Genetics play a significant role in health but are entirely out of the control of an individual. Therefore, the luck egalitarian like Roemer would argue that individuals with high risk of illness due to factors out of their control (genetics) should not have to pay higher premiums for their insurance. However, its very difficult to separate the extent to which genetics and conscious decisions cause health problems. Equal insurance premiums for all creates a moral hazard. Moral hazard occurs when people respond to the insurance by changing their behavior in a way that makes the insured-against event more likely or more expensive.
Hirschman vs. Milton Friedman on school vouchers
As an economist, Friedman favors exit over voice as the best tool for the improvement of schools. The underlying problem is the lack of option for exit - most individuals have only one public option, so there is no competition between schools. Thus school vouchers would be an equitable method of creating competition between schools and therefore improving them. Hirschman argues that exit will not be a effective tool for improving schools Education is a connoisseur good, which means that individuals with greater consumer surplus are more concerned with quality. Thus, wealthier parents tend to be more concerned with their children's education and therefore more likely to utilize voice. Thus the same differences in quality of schools will occur even with vouchers, for wealthier parents will simply utilize the exit option and the school they left will decline without their voice. In the sense that education is a public good, such exit by wealthy parents is an imperfect exit. The quality of public schools affects them and their children indirectly. However, this is unlikely to play a large role for most parents in the decision whether or not to exit a declining school.
Milton Friedman: capitalism, discrimination, and voluntary exchange
Believes in proportional representation in the market so everyone can vote with their money (as long as they have it). Exchange is only truly voluntary if people have a credible and similar alternative, suggests people should be able to produce goods (like electricity?) themselves rather than buy from monopoly supplier. In this sense we are not as free as he would like. Considers protections against discrimination unnecessary and dangerous. Spouts absolute bullshit about how only allowing whites into a restaurant is a preference like opera or jazz.
Hirsch: positional striving and the moral foundations of capitalism
Capitalism relies on some sort of social morality. However, the communal aspect of any system of social morality is undermined by the individualism of capitalism. Historically, the system of social morality underlying capitalism was religion. "Trust, trust, acceptance, restraint, obligation...play a central role in the functioning of an individualistic, contractual economy." However, capitalism has undermined religion. The central economic management in the last few centuries has been intended to allow individualism to continue to flourish without socially harmful consequences. Religion was very effective at enforcing economic cooperation, and the liberal state is not nearly as effective as an enforcer of laws as God. A sense of community obligation is necessary for many of the functions of a capitalist nation (e.g. war). There is a suggestion that without religion, perhaps redistribution is necessary in order to quell the grievances of the poor.
Chang vs. Adam Smith on the "infant industry" protection
Chang: believes that there should be infant industry protection Incentives and capabilities of the industry are the two most important factors Author gives the example of if son was given $20m reward or threatened with a bullet to the head, he wouldn't be able to do brain surgery if he had quit school at the age of six Likewise "industries in developing countries will not survive if they are exposed to international competition too early. Need time to improve their capabilities by mastering advanced technologies and building effective organizations." But protection should not be used to shelter firms from competition forever, only needs protection while accumulating the capabilities to compete in the industry - always a chance of wasting energy on firms, but that happens just like over protecting a child happens Adam Smith: developing country producers need to be exposed to as much competition as possible right now, so that they have the incentive to raise their productivity in order to survive. Free trade economists believe that protection creates complacency and sloth "By means of such regulations, indeed, a particular manufacturer may sometimes be acquired sooner than it could have been otherwise, and after a certain time may be made at home as cheap or cheaper than in the foreign country. But through the industry of society may be thus carried with advantage into a particular channel sooner than it could have been otherwise, it will by no means follow that sum total, either of its industry, or of its revenue, can ever be augmented by any such regulation. The industry of the society can augment only in proportion as its capital augments, and its capital can augment only in proportion to what can be gradually saved out of its revenue." Wealth of nations 458 - on infant industries
Why doesn't competition fix inefficiencies in the healthcare market?
Competition predicated on choice, ability to choose the best deal and have options, and ultimately the choice to not buy/spend anything Most healthcare spending occurs when people are very sick, can't wait for care, and have no bargaining power Buyers at a disadvantage, sellers at an advantage Prices for most healthcare products rarely posted Consumers not informed enough to make real shopping work, and insurers have not stepped in to substitute for them Information about what care is in fact high value (comparative effectiveness) would help but such info a public good, so it is underprovided by the market Not just one market for healthcare, but several layered ones on top of each other, and the sellers in one are often the buyers in another Weakening the power of sellers in one market to curtail their ability to raise prices also tends to weaken their position as buyers in another market, which makes them less able to demand further prices down the line Ex. insurance company: sellers of insurance but buyers when they contract with doctors, hospitals, drug companies, and medical labs Existence of moral hazard with insurance: patients consume more healthcare when the cost is lower Promotes greater consumption than allocatively efficient and also interacts with provider-side incentives to undermine productive inefficiency by dampening the market discipline that price-sensitive customers would provide Markets would dictate that the old and sick pay higher premiums and pay a bear the higher costs of their care
Pick what you see as the most compelling conservative objection to a carbon tax, explain it, and consider how and advocate of a carbon tax could best respond
Conservatives 5 big objections to a carbon tax: 1) The price is set too high (Compelling, decided to argue 2 & 3) 2) The tax would never actually be revenue-neutral The Whitehouse-Schatz carbon tax would make the use of oil, gas, coal, and other fossil fuels more expensive to compensate for the environmental damage they cause and people would have proper incentive to reduce emissions. Tax fossil fuels at $45 per ton of carbon dioxide, which would raise about $2 trillion in 10 years à this revenue would be used to cut the corporate tax rate, provide workers, retirees, veterans, and disabled with annual credit, and gives grants to poor/rural areas hit by rising energy costs. Conservatives objection: Size of government will increase "I cannot envision a public choice model in which we raise energy costs for everyone and cut corporate taxes" "You'll end up spending more than 100% of the revenue to subsidize groups" Distrust that an economically efficient tax swap would ever be politically sustainable Carbon tax advocate response: British Columbia has a real-life carbon tax that managed to pull off a straight swap - it started at $10 per ton and the proceeds went toward cutting corporate taxes and tax rates on the bottom two brackets. Climate change is a global, long-term, irreversible, and uncertain environmental problem and a carbon tax is an effective way to reduce CO2 emissions 3) What if the US acts but China doesn't Conservatives: Unilateral action is essential because climate change is a global problem If the US imposes carbon pricing and take strides to combat climate change and other nations with high carbon emissions do nothing, free-rider problem, the US has implemented bad, costly policy that has a negligible effect on climate change Carbon tax advocate response The carbon tax could include a border adjustment levied on imports that would convince other countries to get on board Action must start somewhere for global agreement, "wait and see" does nothing to address the problem Europe has had a fully running carbon market since 2008, India has a $1-per-ton coal tax, China has experimented with carbon-pricing schemes, and Brazil had reduced carbon emissions from deforestation 4) Climate change isn't really a problem - or at least not as big a risk as bad policy (not compelling) 5) Conservatives don't trust Democrats (not compelling)
Why insurance is good
Diminishing marginal utility implies that on average, your expected level of happiness(utility) would be high if you could somehow ensure that you would always get the expected value of your consumption with certainty, instead of having consumption that was much low that its expected value in certain "bad luck" states of the world that might occur, and much higher than its expected value in other "good luck" states that might occur. basically that with diminishing marginal utility, your utility level/happiness is higher is the "good luck" and "bad luck" state of the world if the expected value of your consumption is protected - ie insurance protecting yourself from risk by buying actuarially fair full insurance makes you better off on average, not in each particular possible state of the world Economic surplus from insurance equals the sum of producer surplus and consumer surplus producer surplus: the price the insurance company receives for selling insurance, minus the marginal cost of supplying it. consumer surplus: consumers maximum willingness-to-pay for that insurance minus its price Insurance will only make you "better off" if (guaranteed consumption with the insurance) > (certainty equivalent consumption without the insurance) - pg 7 from "insurance and asymmetric information" by bakija intuitively: protects health, property, life etc
Discounting and climate change: economic efficiency and equity issues
Discounting enables us to compare benefits and costs that occur at different points in time. market discount rate: what we need to answer the question ""what is the economically efficient thing to do?" social discount rate: question of equity, and the ethical value of a dollar of benefits or costs in the future, relative to a dollar of benefits or costs today If people are risk averse, the the appropriate discount rate for determining the economic efficiency of a choice that exposes one to risk is higher than the risk-free interest rate - it must include a risk premium to compensate for the face that risk-averse people dislike risk. Conversely, the appropriate discount rate for determining the economic efficiency of a choice that reduces risk(ie a choice that provides us with insurance) is lower than the risk-free interest rate - a risk averse person should be willing to accept rate of return lower than the risk free premium in exchange for the benefits of being insured against other risks climate change: burning fossil fuels releases co2 into atmosphere, resulting in an increase in the avg global temp suppose we normalize one unit of fossil fuel to be the quantity of fossil fuel that emits 1 ton of carbon dioxide into the atmosphere each unit of fossil fuel that is consumed produces a marginal external damage. free market would lead to production of all units for which consumers marginal private benefits exceeds the producers marginal private cost, leading to production and consumption of Qmarket, at a price of PMarket, The economically efficient quantity is Efficient, where the demand curve interests the marginal social cost curve Economically efficient solution could be achieved if we impost a Pigouvian tax that equals the marginal external damage at the efficient quantity. If marginal external damage at "Qefficient" was $40, one unit of fossil fuels emits one ton of carbon dioxide, than the economically efficient tax would be $40 per unit. **Conceptually, marginal external damage caused by consuming one unit of fossil fuel is the discounted present value of all future dollar-valued damages of the carbon dioxide emitted when we burn that one unit of fossil fuel. If our goal is to compute the economically efficient pigouvian tax, we need to discount those future damages using the market discount rate. The dollar value of damages in each future year should be the marginal willingness to pay of people in the future to avoid the damage - that is, what is the discounted sum of the maximum amount that people around the globe, over all future generations, would be willing to pay to avoid those damages, if they could avoid paying them** What should the social discount rate be?: the rate at which the ethical value of a dollar declines over time. one example says that people will be richer over time' how much are we ethically obligated to do for the future? people argue that we should discount future external harms from climate change at the MKT discount rate and not social discount rate in order to decide what level of tax ethical considerations about the future should guide how much we do overall for the people who we are morally obligated to help or compensate, but should not determine which projects we do for them setting the tax on carbon by discounting damages at the social discount rate suffers from what weisbach called "climate change blinds" problem would only be social welfare maximizing if we assume that that actions to fight climate change are the only way to help intended beneficiaries. Best course of action: set Pigouvian tax at the economically efficient level, which is the marginal external damage discounted at the market discount rate that reflects the rick characteristics of the investment infighting climate change. Also increasing our overall level of saving for the future, and investing that saving in the best available investments with the highest risk adjusted rates of return
David Friedman and Uwe Reinhardt: what is an "economic improvement" (an improvement in economic efficiency), and is it a good normative criterion for evaluating public policy?
Economic improvement - any change that leads to an increase in the total sum of consumer and producer surplus. - This does not take into account utility, as it is incredibly hard to measure utility. Assumes away the value of money to a rich man and its value to a poor man and assumes away the possibility that people may not know what is in their own interest. It is also hard to take account of the consequences for everyone affected, and we toe a precarious line of being impacted by the availability heuristic when we make policy that would be beneficial to "the poor". Can easily end up favoring wealthier people.
Hirschman: exit, voice, and loyalty
Exit is leaving the situation, voice is expressing displeasure and working for change. Loyalty is subjective decline in substitutability, sometimes irrational: makes voice more likely. Example: exit is selling stock, voice is attending shareholders meeting and complaining. Increase in following makes voice more likely: cost of substitution, estimated ability to influence, transaction cost, sensitivity to quality declines.
Why worker ownership is supposed to be efficient, but is rare anyway
Factors that suggest that worker ownership would be efficient: (1) They have a greater stake in the success of the company. This implies that there will be: Less surveillance required. Workers will hold each other more accountable. Employees will put forth more effort. Employees will be more vocal and innovative in their suggestions for the company. Why isn't worker ownership more common? (1) Startup problem: it is difficult for them to acquire capital (because the asset neutrality proposition is incorrect. Startup problem: it is difficult to get managers to cede control. Giving employees stock options is not a good deal because if they aren't savvy, it ties the entirety of their wealth to one company (undiversified assets → RISKY). Risk losing not only their jobs but also their retirement savings if they firm fails. Asset neutrality proposition: capital markets are competitive enough that any entrepreneur with a good idea can find capital. This is clearly wrong, which implies that capital does not confer a great advantage on those who have it.
Rodrik: the gains from trade vs. the distributional effects of trade inside a country
From supply and demand curve normally given in econ classes, we've seen the diagram that represents gains from the economy and deadweight loss from a tariff. Rodrik believes Tariffs are a bad idea Income redistribution is on the other side of the gains from trade. If trade causes some activities to contract and others to expand - as it must if the full gains from trade are to be reaped - those groups whose economic fortunes are tied to shrinking sectors will necessarily take a hit. Losses are not transitory, if I have skills in garment production, I will suffer a permanent fall in my earnings even if I manage to avoid unemployment and find another job. Free trade advocates often grant that people only get hurt in the short run and will be better off in the long run. There is nothing in economics that guarantees this, and there is much to suggest otherwise. Actually the case that some groups will necessarily suffer long-term losses in income from free trade. In wealthy country like US those are likely to be unskilled workers like high school dropouts - renders notion of "gains from trade" suspect bc its not clear how we can measure a country as a whole when some people win and some lose Since economic restricting generates efficiency gains, and sectors with comparative advantage will expand while others contract, redistribution is often the necessary handmaiden of the gains of trade. People who say trade has huge benefits and only most distributional impacts do no know how trade really works. Gains from trade look "paltry" compared to the redistribution of income. It is not just that some win and others lose when tariffs are removed, its also the size of the redistribution that swamps the "net" gain Argument against free trade must overcome 2 hurdles: the economic gains from the freer trade must remain small compared to the distributional "costs"; and trade must entail practices that violate prevailing norms and social contracts at home.
Theory and evidence on the causes of the rising share of pre-tax income going to the top 1% of the income distribution, and implications for how leaky the bucket is
Government policies created an institutional framework that lead to increasing inequality Rise in income inequality coincided with drastically reduced progressive taxation, widespread deregulation of industries and services, particularly in the financial services industry, weakened unions, and an eroding minimum wage Trade and globalization increased the number of U.S. imports, causing job loss in industries that originally produced those goods in the U.S. Companies also moving production overseas because labor is cheaper (offshoring) Leads to declining employment, falling labor force participation, and weak inflation-adjusted wage growth Technology and education - growth in wage premium associated with higher education and cognitive ability Earnings premium for education has risen across a large number of advanced countries Rising real earnings income among college-educated workers and falling real earnings income among non-college-educated workers Wage inequality has risen throughout the earnings distribution, not merely at the top percentiles As physical labor has given way to cognitive labor, the labor market's demand for formal analytical skills, written communications, and specific technical knowledge (cognitive skills) has risen spectacularly Substantial economic immobility in the US Lack of mobility combined with rising inequality makes relative lifetime advantage of children born to low-high income families increase substantially Skill premium not a result of skills not being supplied at a rate to keep up with the demand
Planning vs. The Rule of Law
Hayek: Hayek views central planning as inherently undemocratic, as the will of the minority is being imposed upon the rest of the people. This destroys the rule of law and individualized freedoms. Rule of law: Government is bound by rules fixed and announced beforehand, assigning predictability to its actions and how it will use its coercive powers, giving certainty as to how to plan an individual's affairs. -individual is certain of the rules of the game -can operate freely and pursue personal ends without government frustrating efforts In direct conflict with planning: the decisions made depend on the circumstances in the moment, which must balance the interests of different groups and are not sustainable in the long-term. Rule of Law is providing signposts, central planning would be like commanding people with road to take. Rule of law is the legal embodiment of freedom, central planning not only produces poverty, but also destroys liberty and threatens democracy.
Hirsch: rising affluence and positional satisfactions
Hirsch argues that as societies become more affluent, an increasing proportion of the extra goods and services are not available to everybody. At an individual level, the satisfaction that we derive from goods and services is becoming increasingly dependent not only our own consumption, but on the consumption of others. We get utility from the consumption or use of goods that are scarce in some absolute or socially imposed sense or subject to congestion or crowding through more extensive use. These are what Hirsch refers to as positional goods, as they are fixed in supply and we gain utility by our consumption of them relative to that of others. In previous centuries, only the rich aristocrats had an income sufficient enough to "consume" a luxury good like a vacation home, but as our society has experienced rising affluence, "the country cottage or vacation home today is a symbol of the successful modern middle-class professional". The high demand for these luxury goods is both because they have high material value (you enjoy the scenery, the peace and quiet, etc.), but also give you positional satisfaction.
Coase: transactions costs and what they imply for government's role in addressing externalities
If transactions costs are high, then government's role in allocating property rights is important. Example: a train track runs through several farms and its sparks have the potential to set fires, railroad offers $100 in surplus and fires cause $200 in damage: a property right to the railroad would decrease overall surplus. This is hard to negotiate because of the many stakeholders, if it is one doctor and one candy-maker, the higher economic surplus activity will win out regardless of property rights because negotiating costs are low.
How would any one author from the class critique or respond to James Buchanan, and how would James Buchanan reply?
Kenworthy challenges the notion that government growth stymies the growth of the private sector by acknowledging that the growth rate of the US economy has remained "remarkably steady" since 1920, even as the size of government (as measured by government spending) has increased by 25 per cent. Kenworthy follows by using evidence from other countries to prove that government regulation doesn't have to come at the expense of economic flexibility and entrepreneurship. Specifically, he cites several Nordic countries with reputations for big government and political "interference" that actually score higher on measures such as the number of restrictions on the movement of capital and the right to establish and run an enterprise without interference from the state. Furthermore, though higher taxes and government regulation are often associated by people like Buchanan with reduced innovation, we see that the "cuddly capitalist" Nordic countries with large scale government are consistently at the same level as, if not ranked higher than, "cutthroat capitalist" countries like the United States on global innovation indexes. Buchanan also expresses the view that increased government economic involvement exposes policy up to lobbying as a form of rent-seeking, and that this a wasteful misallocation of resources. This would imply that the government is not operating at its peak efficiency—and while there is merit to this specific claim, Kenworthy uses data from a cross-country comparison that indicates this efficiency doesn't have to come at the price of decreased government economic involvement. Using the "government effectiveness" indicator from the World Bank as evidence, Kenworthy asserts that there is no association between the size of the government and its effectiveness. Therefore, the inefficiencies discussed by Buchanan might not be a result of government involvement outright, but how the government is structured to deal with economic regulation.
How do people make decisions in the face of uncertainty, and the difficulties of going against the herd in financial markets.
In the face of uncertainty, people look to others for guidance, trying to judge what others will do (beauty contest). People focus on the short-term because there is less risk involved, which leads to people putting too much importance on the present. The thus the market is driven by our "animal spirits", our instincts that influence our behavior. Real information is incorporated into stock prices very quickly and it is hard to beat the market. To go against the herd in financial markets requires a great deal of resources (to stay afloat while temporarily losing money) and patience. The market can stay irrational longer than most people can stay solvent.
Kenworthy: empirical evidence on whether or not big government is bad for economic growth
Kenworthy's evidence that big government is not bad for the economy: Theoretically: Government can facilitate business activity when it protects safety and property and enforces contracts. Enforcement of antitrust rules enhances competition Schools boost human capital and infrastructure facilitate business activity Empirically Countries with high government spending, like Denmark, Finland, and Sweden, score quite high on the ease of doing business (an average score of ease of business activity like starting a business, dealing with construction permits, flexibly employing labor, paying taxes, etc.) The revenue from the share of earnings collected from the individuals and firms via high taxes is used to enhance security and opportunity. Growth of per capita GDP United States Has gone from being a country with relatively small government to one with a medium-size government, and has suffered no slowdown in economic growth. Government taxing and spending rose about 35%from 1910-2000 with no apparent impact on economic growth. An analysis of the government revenue and the economic growth rate of rich, longstanding democratic nations reveals no association between government size and economic growth.
How does money make "Say's" law break down
Keynes: Say's law says that recessions are impossible because supply creates its own demand. People receive income for producing supply and must use that income to demand something, either consumption or investment. Interest rates regulate investment such that aggregate demand never actually drops. Say's law says that as consumption decreases, supply of loanable funds increases, resulting in a decrease in the nominal interest rates and an increase in income, therefore no recession. Drops in market confidence causes and increase in demand for money (liquid cash or checking accounts with no interest earned) that messes up this process by increasing interest rates right when we need them to fall in order to encourage investment. The money supply is fixed for countries on the gold standard, which was most for Keynes, which means that if they tried to adjust interest rates to fix money demand and increase investment, they did not have the monetary policy lever. Even in today's world with monetary policy, interest rates can still fall below the zero-lower bound, making monetary policy useless. Increased demand for money throws off the interest rates, neither investment nor consumption happen.
Akerlof: lemons, peaches, and markets
Lemons dry up markets (think car market) Asymmetric info means buyers don't know actual quality of car, so buyers offer a price lower than "good" car value. This pushes good cars out of the market and leaves only lemons for sales Grisham's Law: Bad money drives out good Peaches are quality cars Extensions: Insurance markets "Bad pooling," buyer has asymmetric info Loans Lendee knows more than lender Labor market signaling Responses: Car market - CarFax, etc. Brand name + trust = Better Business Bureau Credit markets - dividends vs. investment Guarantees - 3rd party guarantee + money back guarantee
Theories explaining the housing bubble and financial crisis of the early 2000s and empirical evidence that is consistent or inconsistent with the different theories.
Low interest rate policy of the Federal Reserve: -after the technology bubble of the late 1990s, central banks cut the short-term interest rates and the Fed cut the overnight rate on loans, keeping it as low as 1% in 2003. This prolonged period of low rates is regarded by some as a terrible policy mistake. -But there were good reasons for keeping the policy rate low, the recover from the 2001 recession was very slow, and the fact that the housing bubble was was a global phenomenon makes it hard to place primary blame for that bubble on interest rate policy. "Global Savings Glut" -a global imbalance in trade deficits and surpluses, with developing economies, running trade surpluses with advanced countries to accumulate large hoards of foreign assets as insurance against another financial crisis. Buying large amounts of America, Spanish, and British bonds and other assets--driving down long-term interest rates. These long-term rates are set by bond prices and are the ones that matter for spending and for housing prices. Financial innovations that disguised risk: -Originate-and-distribute model of banking. Mortgage originators made loans to buy houses, then quickly sold these loans off to other firms, which pooled them and sold shares of these pools of securities, and then rating agencies gave them the AAA rating. -The impression that Wall Street had no incentive to worry about the risks of subprime lending is mostly wrong, as the Wall Street firms kept the riskiest assets on their own books. -the housing bubble was matched by a simultaneous bubble in commercial real estate, which continued to be financed by old-fashioned bank lending. -The financial innovations made the effects of the housing bust more pervasive. Moral Hazard: If you are insured, you are less careful. It implies the less government intervention and produces a "too-big-to-fail problem" that promotes risky behavior. Fannie Mae and Freddie Mac, the two government-sponsored lending facilities, made mortgage credit easy to low-income borrowers, believed that the government would back them up if anything went wrong. -evidence against this: Fannie and Freddie were not in pursuit of social objectives, but in pursuit of profit. Sins of omission rather than commission. the huge growth was was underwritten by private mortgage lenders like Countrywide, Fannie and Freddie accounted for a sharply reduced share of the home lending market.
The world-historical role of capitalsim
Marx and Engels: 1840s Marx is writing. Capitalism destroyed feudalism by making people cosmopolitan, and increased the productivity of human beings. Population was growing in England profits were rising, resulting in new money among the common people. Occupational diversification proceeded alongside a growing polarization of wealth, creating a large group of wage-dependent laborers and an emerging, but increasingly assertive, middle class. Production for exchange, rather than use became the norm. Serfdom gave way to personal freedoms under the capitalist system. By the time Marx was writing, real wages were stagnant, and prices were going up creating a scenario in which the bourgeoisie could enter and "take over the whole thing", emphasizing productivity.
Milton Friedman vs. "Luck Egalitarians" on luck and income redistribution
Milton Friedman would argue that market forces and capitalist exchanges cause a just and desirable distribution of wealth. States that the ethical principle that would directly justify the distribution of income in a free market society is: "To each according to what he and the instruments he owns produces." Individuals are rewarded in proportion to how much the factors of production under their control contribute to total economic output. Because people have different preferences for leisure and risk-taking, the principle of "payment in accordance with product" will necessarily result in income inequality. Inequality resulting from differences in personal capacities, or from differences in wealth accumulated by the individual in question, are considered appropriate, or at least not so clearly inappropriate as differences resulting from inherited wealth. "Luck Egalitarians": Arenson and Roemer -Luck egalitarians generally believe that the government should be used to compensate maximally for poor luck and minimally for poor effort. -Will Kymlicka "When inequalities in income are the result of choices, not circumstances, the difference principle creates, rather than removes, unfairness" Stems from the idea that it would be unfair for the slackers in society to get maximal benefits (under a strictly utilitarian society) Dworkin: Infuses personal responsibility into the discussion Auction/Insurance Market idea: External resources are initially distributed via an auction in which all persons have equal bidding power and variability in people's endowments of personal resources is offset by a hypothetical insurance market in which individuals have the opportunity to insure against having low marketable talent and other hypothetical insurance market in which individuals can insure against being afflicted by handicaps. Advocates for a tax and transfer scheme that would allocate to people what they would have been entitled to according to the insurance choices that the average member of the community would have made if she had had the opportunity to purchase insurance. People should be held responsible for their preferences but not for their resources Resources includes goods that are morally arbitrary, such as genetic endowments and the social and familial circumstances of one's childhood. Roemer Advocates for increased funding in disadvantaged children to compensate them for their family's lack of resources. Holds a more radical view that the compensation should include genetic bad luck.
Milton Friedman on the market failures that justify government intervention
Neighborhood Effects: a stable and democratic society is impossible without a minimum degree of literacy and knowledge and without widespread acceptance of some common set of values. General education can contribute to both. There is a big neighborhood effect with education, because an educated person is a better citizen and is better for society. Friedman believes that a minimum level of education should be required, but instead of having strictly government funding, he proposed a voucher plan. With the voucher plan, you would take the current cost per pupil for public school, make it a coupon, and have that coupon be available for use at any school - public or private. Asymmetric Information: Friedman discusses the problem market failure of asymmetric information that comes with Vocational and Professional Schooling. He calls this type of schooling a form of investment in human capital precisely analogous to investment in machinery, buildings, or other forms of non-human capital, as the purpose of professional schooling is to raise the economic productivity of the human being. He believes there is something wrong in the market for loans to finance investment in human capital because of the lack of security that comes with it. He says that "the productivity of the physical capital does not in general depend on the co-operativeness of the original borrower. The productivity of the human capital quite obviously does." This is asymmetric information because the lender has no idea about the borrower's ability, energy, or motivation for the task.
Milton Friedman: public policy response to poverty
Neighborhood effect to poverty justifies intervention. Favors a proportional income tax above a certain threshold and a negative income tax below it. Poor individuals can maximize their utility better than any government can, so they should be given the money as income rather than as a mishmash of in kind benefits. Most social welfare measures do more harm than good: public housing projects have destroyed more housing than they have created and created concentrations of poverty. Minimum wage laws actually cause more poverty because they lead to greater unemployment. Farm price supports have helped industrial farmers and hurt small farmers. Poverty programs are acceptable if they don't target a specific group, and don't distort the market.
When do we need a nudge?
Nudging (aka libertarian paternalism) We generally need nudges when a choice is difficult, rare, unfamiliar, or has a poor feedback loop Examples: ▪ Difficult choice: choosing a mortgage (difficult) vs. choosing a loaf of bread (easy) ▪ Rare choice: marriage or home-buying (rare yet important) vs. buying gas (frequent) ▪ Unfamiliar / low information choice: shaping your retirement portfolio (unfamiliar) vs. making an order at 82 (familiar) ▪ Poor feedback loop choice: Hitting golf balls in the dark (poor feedback) vs. receiving grades for POEC 250 papers (frequent, good feedback) NUDGES only helpful if done by impartial entity (can gov be impartial?)
Hayek on winners and losers from economic change, social insurance, and what people deserve
People deserve: Economic Freedom -freedom to choose one's profession, and mobility to change professions. -free markets, competition left to function unobstructed. -freedom of entry into market and trade Comprehensive system of social insurance: -security against severe physical privation -security in the event of illness or accident -security from "acts of Gods" or natural disasters Government intervention during economic changes -people who lose their job through no fault of their own, but because of an invention should receive sympathy and support during this shift in the market. People don't deserve: Economic security- earning a certain income, protection against decreases in income, work should not be allotted by an authority.
Greater patient cost-sharing versus changing the incentives of physicians as responses to inefficiency in the healthcare market
Remodeling the provider compensation structure to encourage the most efficient and cost-effective physician practices is a more promising route for U.S. health care reform than increasing cost-sharing for patients. With the current payment mechanism, there is minimal incentive for physicians to provide low-cost care or to pursue cost-saving innovation (Baicker, Chandra, Skinner). David Cutler presented a variety of compensation methods used to control costs in the private health care system, and stressed the importance of prioritizing good care over just more care (Cutler). Initiatives that put providers at partial risk for the cost of care, such as accountable care organizations (ACOs) or partial capitation, are steps toward reforming the health care system in favor of the patient, as ACOs "decide on good care and work with patients to provide that care" (Fakt). Placing accountability on health care providers to deliver high quality medical treatment is an important step in lifting the value of care, but associating that level of quality with monetary compensation is the backbone of this method of reform. Today's ACOs "tie bonus payments to quality, a feature intended to mitigate against providers sacrificing quality for lower cost" (Fakt). Tying a physician's pay to their adherence to a standard of best practices, such as at Geisinger, encourages effective and quality treatment while reducing overall costs associated with complications or follow-up procedures (Cutler). At the theoretical level, promoting a system of cost-sharing would decrease the moral hazard associated with health care, and incentivize patients to "behave more like consumers in other parts of the economy" (Leonhardt). It follows that if one has to consider the price of their treatments, they will choose the most cost-effective health care services, or "only consume care that is sufficiently valuable to them" rather than choosing the expensive and only marginally more effective options, thus promoting a relatively more efficient allocation of health care services (Baicker, Chandra, Skinner). (Leonhardt). However, in practice there are a host of problems that make this a less promising solution to health care reform. Though it might lead to a reduction in unnecessary or cost inefficient care, requiring a higher deductible will mean that those who cannot afford health care services might skimp on important preventative protocols, leading to an increase in expensive, late-stage intervention and a less healthy population. Cost-sharing may also lead to adverse selection when the participating population has more complex medical needs that require more expensive medical solutions. This will be especially relevant if patients have discontinuous care because they cannot afford the cost of sharing the financial responsibility of life-saving medical treatments (Leonhardt). A system of cost-sharing requires more perfectly informed and rational public who is aware of a "patients may not always make optimal decisions about the use of services when faced with higher copayments and coinsurance" (Baicker, Chandra, Skinner).
James Buchanan: rent-seeking and profit-seeking
Rent - "the part of payment to an owner of resources over and above that which those resources could command in any alternative use." Rent-seeking - "behavior in institutional settings where individual efforts to maximize value generate social waste rather than social surplus." Rent seeking is sometimes difficult to distinguish from profit seeking. The two are motivated by the same desires. The system that distinguishes the two: Individuals/firms seek normal profit in the market. If a firm does successfully harness an opportunity to earn a normal profit, other firms will enter the market and erode away this normal profit until price = marginal cost (presuming there are no barriers to entry). This is socially beneficial - the profit-seeking creates value. Individuals/firms seek rent by acquiring advantages or benefits that impede the market. One way of doing this is through government lobbying. This is socially destructive because it destroys value. The level of rent-seeking is directly related to the size of government. The more the government intervenes in the market, the more opportunity there is for players in the market to lobby the government for advantage. It may become rational for them to do so even though it wastes resources. There are two ways that the government could eliminate the incentive to rent-seek: By confiscating the fruits of rent-seeking and redistributing them throughout the community. By distributing rights/preferential treatment randomly (is either one of the actually a viable solution in real examples of rent-seeking?) There are three levels of rent-seeking (illustrated by the taxicab example): (1) If the number of taxicabs is limited (barrier to entry), individuals will attempt to enter the taxi industry since they will be in greater demand. (2) However, if taxicab licenses are auctioned off, this first level of rent-seeking wont occur. Instead, individuals will attempt to enter political/bureaucratic positions in order to take advantage of the wealth generated by the auction. (3) If those in political/bureaucratic positions are restricted from taking advantage of these rents, then the rents may be dispersed throughout the community, but not necessarily evenly. This may cause some individuals to take socially destructive actions to recover the rents as they are dispersed - this is the "right to recover" All three types of rent-seeking may occur simultaneously.
Secular Stagnation: Evidence that it is a problem, and debate over what to do about it.
Secular stagnation is a condition of negligible or no economic growth in a market-based economy. This results from an increasing propensity to save and a decreasing propensity to invest, causing a drag on demand, reducing growth and inflation. Evidence that it is a problem: US and global financial crisis - low long term interest rates - slow economic growth - rising debt-GDP ratios - low inflation - increased saving, less investing - sluggish demand Greater saving has been driven by increases in inequality and in the share of income going to the wealthy, increases in uncertainty about the length of retirement and the availability of benefits. Reduced investment has been driven by slower growth in the labor force, the availability of cheaper capital goods, and tighter credit. What to do about it: Core problem is that the neutral real interest rate is too low. -can't be increased through monetary policy -fiscal policy: an expansionary fiscal policy can reduce national savings, raise neutral real interest rates, and stimulate growth. -but it could increase deficits and place larger burdens on future generations. Since the main constraint on the industrial world's economy today is demand, structural policies that would promote demand, such as regulatory reform and business tax reform, steps to accelerate investments in renewable technologies and support for unions and increase in wages. It is difficult to attain national and global agreement to diagnose the secular stagnation problem properly and make the appropriate repairs.
Does finance profit from extracting value from the nonfinancial economy?
Short answer - yes. Two new york times articles, one about Timken Steel and another about Twinkies, both illustrated how financial actors (specifically private equity and investment banking firms) suck income out of communities, especially from workers, for the benefit of the firms. This results in unemployment and lack of local investment. However, keep in mind that shareholders (who are part of the non-financial economy) can benefit from the actions of financial institutions. In addition, the actions of financial institutions can also result in the creation of new value, which may not have happened in the absence of their actions. To summarize, finance does extract value from the nonfinancial economy, however, it creates value elsewhere. It is probably easier to argue that the subtraction of value outweighs the addition.
Marx vs. Smith on the division of labor and human nature
Smith/Bourgeois thought that if society were a big factory, management costs would rise and competition would decrease. Decreased competition results in driving down wages and hurting laborers. Decreased mobility (govt. = one firm) and the necessity to produce more is bad for workers. Marx things that once productivity reaches a certain point, each job would have been so subdivided that we have less-skilled workers because they are only good at one tiny part of the process. Helping to contribute to class divides. Smith views division of labor as the means to more productivity, with more output with the same number of workers. Specialization/dexterity, saving time between switching tasks, technological innovations become possible (when a task gets so simplified that you can devise a machine to do that one task) Marx thinks that capitalism forces humans to become immoral and self-interested, so we create religion (the opiate of the masses) because we are frustrated with our inability to be the moral person we want to be. Smith thinks that self-interest is human nature, but it is not necessarily a bad thing because we have a natural tendency to truck barter and exchange in our self-interest, thus contributing to the capitalist system.
Noah Smith and Cochrane: the size of the financial sector
Smith: How finance took over the economy The financial sector has grown too big, it is not efficient, and this has hurt the real economy; finance's share of the overall economy has an increasing trend There are behavioral effects in play, simple ignorance by investors of middleman fees It has grown considerably since 1980 because of two reasons: 1) US asset markets rose in value A combination of rising asset values and unchanging management fees explain a large part of finance's growth and profitability People have put more money into assets markets, instead of banks or government bonds Amount of wealth in US economy has soared since 1980 (think rises in housing and stock market) Thus, middlemen acquire more money through percentage fees 2) Lending to households (People are borrowing more) US households borrowing more since 1980 → finance industry collecting interest and charging middlemen fees on lending transactions Banks extended credit to people with poor financial status (pre-2008) Cochrane: Finance - Function Matters, Not Size Size of finance increased in recent decades: increasing overall cost of asset management, due to proportional fees on expanding asset bases. Quantity of investments in mutual funds, etfs, and growth of housing and consumer credit shifted demand for financial services shifted out More people placed money into high-fee investments (hedge funds, private equity, venture capital) Recently we have seen a decline in wealth management fee services This happened despite the fact that it is extraordinarily rare for a money manager to outperform major index's over anything but the short run, especially if we calculate the return net fees House and stock prices rising don't have a lot to do with the structure of the finance industry → finance has contracted rather dramatically since 2007 The instability and regulation of the US financial system are more important than its mere size We should be asking questions: Is the finance industry functioning well? Are there identifiable market or government distortions? Will proposed regulations make matters worse? We should not be asking: What is the socially optimal size of the financial industry? Proportional management fees seem to be the best option Fee revenue is not a good measure of the size of finance Fees are a transfer, not a measure of resources consumed or output Fee incomes rise and fall with gains or losses Fee-payers (those paying the money managers) are no more naïve than politicians and regulators Money management industry is essentially a marketing industry We are paying for the same generic packaged securities, that we could buy and assemble on our own at e-trade, but instead we pay a money manager to do this Explains the persistence of active management and its fees
Temptation, dynamically inconsistent behavior, and self-control problems: evidence and policy implications
Temptation People's state of arousal changes over time Hot state (being hungry and smelling aromas of cooking in the kitchen) vs. cold state (thinking abstractly about # of cashews to eat before a dinner party) Something "tempting" if you consume more of it in a hot state than in a cold state Self Control problems arise because we underestimate the effect of arousal In a cold state, we don't realize how much our desires/behaviors will change when we are "under the influence" of arousal, so behavior reflects a naivete about the effects of context on choice Think of individual as two semi-autonomous selves, Planner and Doer Planner trying to promote your long term-welfare but must cope with the feelings, mischief, and strong will of the Doer, who is exposed to the temptations that come with arousal Combine with mindless choosing, or people putting themselves in "auto-pilot" mode in many situations, in which they are not actively paying attention to the task at hand? Dynamically inconsistent behavior (language of economics) Initially people prefer A to B, but they later choose B over A under the same conditions Disagreement between a person's two selves (present and future) about what actions should be taken/are desired Policy should be geared toward properly deploying incentives and nudges
Okun: dollars, rights, and equality before the law
We have a political system that promises fundamental equality before the law but legitimizes significant economic inequality, which seems like a fundamental contradiction but is also kind of a contract. Rights are supposed to be without monetary charge, and are non-exchangeable, making them economically inefficient. however, money can buy services that produce more or better rights. Examples include: Campaign financing and lobbying. Offers three reasons why we need a hard line between rights and dollars: 1) liberty: need to defend ourselves against state transgression, enable exchange and easy transmission of information 2) pluralism: we want a fair game, rules not tilted in anyone's favor, retains some legitimacy when some things can't be bought, practical consequences for functioning society 3) humanism: humans need dignity, rights provide that and need to be unalienable.
Pink on "free agents," compared to Coase
We want human progress that doesn't depend on someone getting rich by hurting someone else and the key to this is the pin factory's productivity that is why Smith puts it first Trading is different but also increases productivity here Smith says that this agrees with human nature We want productivity but also autonomy this is the contradiction that we want to fix in capitalism = there are different ways to fix this problem Get rid of firms or make firms more democratic PINK: "free agents" are the opposite of "organization guy" Independent contractor not employee you are an independent entity Hollywood example of how movies are made with different groups who band and disband for each project COASE: organizing in firm reduces transaction costs Internet decreases transaction costs -- decreases need for firms Internet and big firms allow for free agency Free agency might be more successful for simple jobs because surveillance costs are lower Independent contractor has more autonomy than employee because employee's cost to screwing up is greater
Akerlof and Shiller: why "phools" can--and will--be "phished"
phishing - getting people to do things that are in the interests of the phisherman, but not in the interest of the target Phool - anyone who is successfully phished "We are phishable because we want to reciprocate gifts and favors; because we want to be nice to people we like; because we do not want to disobey authority; because we tend to follow others in deciding how to behave; because we want our decisions to be internally consistent; and because we are averse to taking losses" People frequently make decisions that are not in their best interest Principle of equilibrium in economics, businesspeople pick off the best opportunities, which creates an equilibrium: meaning they are taken off the table and are hard to find Applies to phishing equilibrium: if we have some weakness or other--some way in which we can be phished for phools for more than the usual profit--in the fish equilibrium someone will take advantage of it Casting phishing for phools in an Adam Smith-style general-equilibrium framework, which is the benchmark for thinking for all economics, suggests its generality, cueing us into its inevitability Free markets do not just produce what we really want; they also produce what we want according to our weaknesses that cause us to make choices that differ from what is good for us Basic nature of the free market generates a supply of phishes for any human weakness
