Naked Economics

Wrong incentives lead to undesirable outcomes

"Perverse incentives", inadvertent incentives that can be created when we set out to do something completely different, intentioned proposal backfires, ignores incentives or fails to anticipate how rational individuals might change their behavior to avoid being penalized (Mexico City car pollution)

Summary

1) Govt has potential to enhance productive capacity of the economy and make us much better off as a result (govt creates and sustains legal framework that makes market possible, raises our utility by providing public goods that we are unable to purchase for ourselves, fixes rough edges to capitalism by correcting externalities) 2) Some govt activity shrinks size of pie but still may be socially desirable 3) Some govt involvement in economy is purely destructive (heavy-handed govt can lead to govt programs and regulations whose benefits are grossly outweighed by costs, intrusive tool that an be used for good or ill)

Lessons of markets

1.) The market economy is a powerful force for making our lives better (create new products, or take an existing product and make it cheaper and better, profit inspires some of our greatest work) 2.) Market is amoral (rewards scarcity which has no inherent relation to value—diamonds vs water, powerful force that derives its strength from rewarding the swift, strong, & smart) 3.) Uses prices to allocate scarce resources (finite amount of everything worth having-> most basic function is to decide who gets what, people who are willing to pay the most for Super Bowl tickets) 4.) Because we use prices to allocate goods, most markets are self-correcting (when gas prices are high, Americans bought smaller cars & drove fewer miles, climbed on public buses & trains) 5.) If we fix prices in a market system, private firms will find some other way to compete (for airlines use quality to distinguish themselves, sharp uniforms and good attendants at gas stations, clean bathrooms, etc. To attract customers) 6.) Every market transaction makes all parties better off (customers and firms act in own interest, workers take jobs in sweatshops because it is the best employment option they have)

Importance of Fed

Fed has tools with more direct impact on global economy than other institution in world (public or private), controls money supply and therefore credit tap for economy, can use monetary policy to counteract economic downturns or prevent them in the first place, and can inject money into financial system after sudden shocks, can also raise interest rates regulates commercial banks, supports banking infrastructure, generally makes plumbing of financial system work

Other "vital signs": unemployment, poverty, inequality, govt budget, deficit, current acct, national savings, demographics

Unemployment: unemployment rate is fraction or workers who would like to work but cannot find jobs, rate climbs during financial crisis, after years of recovery---unemployment rises, Okun's law: GDP growth of 3%/year will leave unemployment changed, faster or slower growth will move unemployment rate up or down by 1/2 percentage point for each percentage point change in GDP Poverty: amount of income necessary to buy basic necessities, the fraction of Americans of Americans whose incomes fall below poverty line Income Inequality: Gini Index--collapses income inequality into a single number (score of 0=total equality, 100=total inequality) Size of gov't: measured by ratio of all gov't spending (local, state, and federal) to GDP Budget deficit/surplus: budget deficit occurs when gov't spends more than it collects in revenues/surplus is opposite, gov't should run modest surpluses in good time and modest deficits in tough times, budget only need balance in long run (gov't runs deficit=must make up different by borrowing money, finite amount of capital in the world--the more the gov't borrows, the less that leaves for rest of us) Current account surplus/deficit: current account balance reflects difference between income that we earn from rest of world and income that they earn from us (bulk comes from trade in goods/services), balance of trade is largest component of current account (in deficit usually because country is not exporting enough to pay for all of its imports, current account deficit can be a sign of strength as money pours into countries that show a promising potential for future growth) National savings: savings necessary to finance investment-> investment is what makes us more productive as a society Demographics: bulk of gov't benefits (Social security) bestowed on Americans who are retired, works fine as long as there are enough workers on bottom to continue paying retirees at top Total national happiness

Principal-agent problem

a problem caused by an agent pursuing his own interests rather than the interests of the principal who hired him

Market Allocation

agreements in which competitors divide markets among themselves. Firms will specify a location and customers they want to sell to. ex. Coca cola gained a huge market in east germany by passing free coke's through the berlin wall. Thus establishing a market in that location.

Assumption of rational utility-maximizers

individuals act to make themselves as well off as possible (individuals seek to maximize utility, makes you better off in the long run, fulfilling preferences)

Firm screening

An attempt to combat adverse selection by eliciting info from potential customers. The party that knows less info tries to learn as much as possible to make up the gap of knowledge. may screen people based on race and sex but in a logical manner, firms do this to minimize employee turnover by playing the statistical averages. Firms use a deductible. Customers who consider themselves likely to stay healthy sign up for policies that have a high deductible and they are offered cheap premiums. Customers who know they have costly bills will avoid the deductible and pay a higher premium. Thus, customers sort themselves

Barriers to entry

Factors that make it difficult and costly for an organization to enter a particular task environment or industry, Barriers can be physical or natural (truffles can't be cultivated), legal barriers (patent), network effects (Facebook), airlines (80% of gates controlled by American & United)

Branding versus commodities

Branding: profitable strategy (in competitive markets, prices driven toward cost of production ) consumer views this as beauty of capitalism, producer sees this as commodity hell (a soybean is a soybean, farmer cannot charge even one penny above market price for his crop) Branding takes a simple commodity and attempts to convince the public that it is different. Once this is established, producers of branded goods can make a monopoly for themselves and price their products accordingly

Branding provides information

Companies spend enormous sums of money to build an identity for their products, solving problem for consumers (how do you select products whose quality of safety you can determine only after you use them?) Consistency Helps to provide an element of trust that is necessary for a complex economy to function

Adverse selection

Crucial asymmetry of information, attracts predominantly low earners -> repayment calculations based on avg postgrad salary no longer apply and program cannot recover its costs

Difficulty of policy decision-making

Fed Reserve mandate is to facilitate sustainable pace of economic growth, difficult because (1) guessing rate at which economy can expand w/o igniting inflation (2) Fed must reckon what impact change in interest rates will have and how long it will take (Fed has most control over short-term interest rates which may or may not move in same direction as long-term rates) While Fed is trying to use monetary policy to hit target, Congress may be doing things with fiscal policy (taxes and spending) that have different effect entirely Also there is obstacle course of world events (a financial collapse here, spike in price of oil there)

Deflation

Deflation: steadily falling prices, modest deflation can be economically devastating. Falling prices cause consumers to postpone purchases, consumers feel poorer and less inclined to spend. When consumers spend less, economy grows less-> economic death spiral

Fiscal & monetary policy

Encourage consumers & businesses to begin spending & investing again so that the economy's capacity no longer sits idle Fiscal policy: uses government's capacity to tax and spend as lever for prying economy from reverse into forward (if consumers won't spend, government will do it for them). Govt can also stimulate economy bu cutting taxes (consumers find more money n their paychecks, will decide to spend some of it, breaking back of recession) For Fiscal policy to happen: Congress & president must agree to a plan that contains an appropriate remedy, they must pass plan in timely manner, prescribed remedy must kick in fast (likelihood of nailing all three is slim) Monetary policy: Federal Reserve can raise of lower short-term interest rates (normal business cycles are best managed with monetary policy), cutting interest rates makes it cheaper for consumers to buy houses, cars, and other big-ticket items as well as for firms to invest in new plants/machinery

FOMC & monetary policy tools

Federal Open Market Committee makes monetary decisions (determination whether interest rates need to go up/down/stay same), consists of board of governors, presidents of Fed Reserve Bank Discount rate: interest rate at which commercial banks can borrow funds directly from Fed Reserve (when discount rate falls, bank can borrow cheaply from Fed and lend more cheaply to customers), Raises stigma that bank was not able to raise funds privately tho Federal funds rate: rate that banks charge other banks for short-term loans (sets target for federal funds rate, then manipulates money supply to accomplish its objective) Also creates new money: deliver new money to banks, trades new money for government bonds that banks own

Some regulations benefit business

Firms + industries benefit from regulation by using political process to generate regulation that helps them (Illinois teacher certification)

Profit maximization

Firms attempt to maximize projects (take inputs & combine them in a way that adds value)

GDP: importance, real vs nominal, per capita

GDP represents total value of all goods & services produce in an economy, decent measure of our well-being for the simple reason that what we can consume is constrained by what we can produce Real GDP: figure has been adjusted to account for inflation Nominal GDP: figure has not been adjusted for inflation GDP per capita: nation's GDP divided by its population, necessary to prevent wildly misleading conclusions

Externalities

Gap between private costs and social costs of some behavior, can also affect third-parties that aren't involved When externality is large, individuals have incentive to do things that make them better off at the expense of others—the market fails in sense that it encourages individuals and firms to cut corners in ways that make society worse off as a result (picking up after dogs???, pollution by cars)

Public goods

Government provides wide array of goods that make use better off but would not otherwise be provided by private sector (firms cannot force consumers to pay for public goods no matte how much utility they may derive from them or how often they use them, will always fall prey to free riders) 1)Cost of ordering the good to additional users is very low or even zero (once anti-missile is operational for one person, it an serve thousands more at no extra cost) 2)It is very hard to exclude people who have not paid for the good from using it Includes basic research (NASA, NIH), parks and open space, law enforcement (private security firms only defend property against trespass, will not proactively seek out criminals)

Redistribution

Government redistributes wealth, collect taxes from some citizens and provide benefits to others (most government benefits go to middle class sin form of Medicare and Social Security)

Effects of regulation

Government regulation interferes with process of market (resources flow to where they are valued most) Regulation can disrupt movement of capital and labor, raise costs of goods and services, inhibit innovation, otherwise shackle the economy. At worst, can become powerful tool for self-interest as firms work political system to their own benefit Can cause tolls, licensing, vehicle emissions testing, citizenship testing "Heavy handed regulation/excessive regulation" pushes entrepreneurs into underground economy

Govt makes market economy possible - rights, laws, regulations

Government sets rules, develop & sustain institutions necessary to support market economy. Government defines and protects property rights (can make investments, copyright, ownership of ideas, home, car, etc.) Government lowers cost of doing business in private sector in all kinds of ways (providing uniform rules & regulations (contract law), rooting out fraud, circulating sound currency) Builds and maintain infrastructure—roads, bridges, ports, and dams, makes private commerce less costly Enforces these rules in a reasonably fair and efficient manner Enforces antitrust laws that forbid companies from conspiring together in ways that erase benefits of competition (form the tracks on which capitalism runs, FAA, FDA, IRS, etc)

Political pressure to allow inflation

Governments often owe large debts (troubled gov'ts owe even more), inflation is good for debtors because it erodes value of money they must pay back, govt's control inflation rate so gov'ts can cut their own debts by pulling inflation rip cord Also tax indirectly from inflation tax--not physically take money, but you've done it by devaluing the money that stays in their wallets Political independence is crucial if monetary authorities are to do their jobs responsibly, countries w independent central banks have lower avg inflation rates over time. If firms believe that central bank will not tolerate inflation, they will not feel compelled to raise prices, and if firms do not raise prices then there will be an inflation problem

Govt allocation vs private allocation

Govt shouldn't be sole provider of good or service unless there is compelling reason to believe that private sector will fail in that role (private firms shouldn't issue driver's license bc they would have powerful incentive to attract customers by issuing licenses to drivers who won't deserve them) That being said, gov't shouldn't provide mail (USPS assisted underdeveloped regions of country by guaranteeing mail delivery at subsidized rate) but FedEx and UPS proved private firms are capable of building delivery infrastructures Even if gov't has important role to play in economy, does not follow that govt must actually do the work (govt can plan or finance new highway, then project will go to form that can do best work at lowest cost) public good is delivered in way that harnesses all benefits of market Private allocation: markets tell us where to devote resources, allocates resources where they will earn the highest return Gov't control economy-> scarce resources allocated by autocrats or bureaucrats of politicians rather than by market (Soviets put more emphasis on rockets/steel rather than contraceptives to detriment of citizens), tax money is squandered when projects that never should have been funded in first place go bust, economy does not develop as quickly or efficiently as it might because credit is channeled away form worthwhile projects

Govt inefficiency

Govt=one very large monopoly, monopoly stifles any need to be innovative or responsive to customers Described as inefficient, operate exactly as we would expect given incentives (DMV: why bother grant driver's licenses, make customers confortable, none of these things will produce even one more customer!)

Tyranny of the status quo

If small groups get what they want out of the legislative process, they can stop what they don't want (but problem is that we don't get benefits of new economic structure if politicians decide to protect old one) Therefore, suggested that we offer hand to those mowed over by competition Designed some institutions to help greater good prevail over narrow interests (through fast-track authority, cannot exempt trade agreement that offers protection to few special interests) WTO strictly defines barriers and tears down interest groups by defining things countries must do in order to join: open markets, eliminate subsidies, phase out tariffs

Prisoners dilemma

People don't trust each other well enough to coordinate an outcome that would make them all better off, Insight into real-world situations in which unfettered self-interest leads to poor outcomes

Efficient markets & index funds

Index funds: mutual funds that do not purport to pick winners, buy and hold predetermined basket of stocks (S&P 500) Efficient markets theory: markets may do irrational things, but doesn't make it easy to make money off those crazy movements (bidding up prices of underpriced stocks until they aren't underpriced). Average investor can't beat market and shouldn't try Market efficiency refers to how well current prices reflect all available, relevant information about the actual value of the underlying assets. A truly efficient market eliminates the possibility of beating the market, because any information available to any trader is already incorporated into the market price. As the quality and amount of information increases, the market becomes more efficient reducing opportunities for arbitrage and above market returns.

Inflation & effects

Inflation: average prices are rising, inflation rate: change in consumer price index, government's attempt to reflect changing prices with a single number Most instructive way to think about inflation is not that prices are going up, but rather that the purchasing power of the dollar is going down (a dollar buys less than it used to) Massive inflation distorts economy massively (workers rush to spend cash before it becomes worthless, fixed-rate loans become impossible bc no financial institution will agree to be repaid a fixed quantity of money when money is at risk of becoming worthless). Even savings accounts and certificates of deposit are vulnerable to less obvious risk that their low interest rates may not keep up with inflation Inflation also redistributes wealth arbitrarily-- unexpected bots of inflation are good for debtors and bad for lenders, also distorts taxes Modern inflation (constant or predictable rate) would have very little effect, but inflation is not constant or predictable

Job creation

Jobs are created anytime an individual provides a new good service of finds a better (or cheaper) way of providing an old one, more jobs are created than lost & new workers create new demand for other products As we become richer, we create demand for new jobs elsewhere in the economy

Easy money causes inflation

Limits to how fast any economy can grow, low interest rates (easy money) causes consumers to demand more, which means more production->more workers (becomes difficult or impossible to find new inputs), simply cannot satisfy consumer demand and begins to raise prices (all resources have natural constraints, workers & capital are scarce) Cause consumers to demand more than the economy can produce-> the only way to ration excess demand is with higher prices -> inflation Once started, inflationary cycle is hard to break-> firms and workers everywhere begin to expect continually rising prices-> causes continually rising prices

Creative destruction

Market economy rewards hard work and progress not only because it rewards winners, but because it crushes losers (opening of Wal-mart with cheaper prices puts out other businesses), something that must happen (people that could have been farming are now fixing our cars, designing computer games, etc.), positive force in the long run

Money

Money (tiny subset of wealth), merely a medium of exchange, something that facilitates trade & commerce (not even necessary), evolved to make trade easier. Serves as means of exchange, serves as unit of account so that costs of all kinds of goods and services can be measured and compared in one scale, must be portable and durable, must be relatively scarce so it can serve as a store of value dollar is piece of paper whose value derives solely from our confidence that we will be able to use it to buy something we need in the future (has no inherent, depends on purchasing power)

Prices allocate resources

More demand for tuna-> wholesale price will go up-> fishermen will get paid more for their tuna catch-> switch to more expensive fishing methods that can NWT be justified by higher price their catch will fetch

Opportunity costs

More than just money—the real cost of something is what you must give up in order to get it: time, effort, gas, quality, anything there is to sacrifice (ex: smoking & standing outside an office building when it is seventeen degrees outside, quitting neurologist job to raise a kid (it's expensive))

Purposes of financial instruments

Must create some value (both buyer and seller must perceive themselves as better off by entering into deal). Based on four simple needs: Raising capital: companies & govt's borrow directly from public by issuing bonds (Individuals, firms, and gov'ts need capital do to things today that they could not otherwise afford) Storing, protecting, and making profitable use of excess capital: individuals, companies, and institutions with surplus capital rent it to others and make more productive use of it, enable us to smooth consumption over out lifetimes, we don't have to spend income at the same time we earn it (income and spending are divorced-> much more flexibility) Insuring against risk: Pay predictable amount (even one that is more than we expect to get back) in order to protect ourselves agains the unpredictable, provide an array of other products that look complicated but basically function like an insurance policy (futures contract), Big purchasers of commodities can benefit from being on the other side of trade (lock predictable price for jet fuel), spread risk and eggs around generously (some assets will perform well at same time others are doing poorly) Speculation: can use futures market to mitigate risk

GDP misses social progress

No value judgements attached to traditional GDP calculations (usual methods of GDP make destroying the environment look good for the economy) GDP does not count any economic activity that is not paid for (work done around the house, taking care of kids) GDP does not account for environmental degradation (destruction of a father) Green GDP figures: seek to evaluate the true quality of economic growth by subtracting the costs of environmental damage GDP does not take into account the distribution of income, can mask enormous disparities between rich and poor Human Development Index: broader indicator of national economic health (measures life expectancy, literacy, educational attainment), good tool for assessing progress in developing countries

Income inequality

Our economy is evolving in ways that favor skilled workers, Skilled workers in America have always earned higher wages than unskilled workers; that difference has started to grow at a remarkable rate. Human capital has become more important, and therefore better rewarded, than ever before International trade puts low-skilled workers in greater competition with other low-skilled workers around the globe, Globalization creates more opportunities for skilled workers and more competition for unskilled workers Income inequality sends important signals in the economy (motivate many students to get college degrees), spectacular wealth earned by entrepreneurs provides an incentive to take the risks necessary for leaps in innovation. We should not care about the gap between rich and poor as long as everybody is living better

Recessions

Periods of economic downturns that stem from some shock to the economy (something bad happens), whether that be from collapse of stock market or property bubble, steep rise in price of oil In developing countries, shock may come from sudden fall in price of commodity on which economy is heavily dependent (coffee) Great Recession of 2007: shock originated from sharp drops in stock & housing, left American households poorer. When consumers sustain shock to income, they spend less, which spreads the economic damage. Spending can generate confidence that generates spending that causes recovery Can spread quickly across international borders. If other powerful economies fall into recession, they stop buying one goods and services—vice versa Recessions may actually be good for long-term growth because they purge economy of less productive ventures, just as a harsh winter may be good for long-term health of a species

Market price, pricing decision & price discrimination

Price is dependent on supply & demand, price will settle at point where # of products for sale matches # of products consumers wants to buy// stores will attempt to pick a price that leads to the quantity of sales that earn the company the most money// when a firm attempted to sell the same item to different people at different prices (will become more prevalent as technology enables firms to gather more info)

GDP growth & wage growth

Rapidly rising standard of living-> As GDP increases, so does our wages Productivity has increased (which makes both prices and wages increase)

Govt solutions to externalities

Role of government is to deal with externalities (in cases in which individuals or firms engage in private behavior that has broader social consequences), soda tax: imposed tax on sugary beverages, climate change policy (not adequately addressed by market because firms emit large amounts of greenhouse gases pay only small share of cost of emissions), mobile phone use under strict scrutiny Government regulates affected activity: regulations on groundwater contamination to poultry inspection (forbid private property owners from impinging on their neighbors by constructing buildings that may be unsafe) Taxes offending behavior rather than banning it: when private cost is lower than social cost, raise private cost (gas tax, emissions tax, weight tax) (private cost of driving Hummer to grocery store is far lower than social cost), taxing essentially creates good incentives (limits behavior so people who ar still driving them are paying full cost are actually those who value driving the SUV the most, encourages cities to build more fuel-efficient cars)

Investment guidelines

Save. Invest. Repeat: capital is scarce, more you save -> more rent you can command from financial markets. If you spend more cash then you earn-> rent difference somewhere, and pay for that privilege. save early, save often, and pay off credit cards Take risk, earn reward: Riskier investments offer higher expected return in order to attract capital Diversify: all investments have outcomes that are truly independent of one another Invest for the long run: Odds are stacked in your favor if you are wiling to be patient and endure occasional setback, longer your hold your diversified investments, the longer you have for probability to work its magic

Effects of taxation

Taxes exert cost on economy, "fiscal drag" 1) Taxes take money out of pockets, diminishes our purchasing power and therefore utility 2) Taxation causes individuals to change their behavior in ways that make economy worse off without necessarily providing any revenue for govt (individuals who prefer to work if they were taking home every dollar they earn may decide to leave the labor force when marginal tax rate is 50%, everybody loses in this situation), "deadweight loss"makes you worse off without making anyone else better off Taxes discourage investment (entrepreneur considering risky investment when expected return is 100 million may not because of return diminished by taxation that is now 60 million) and work (cutting taxes and rolling back regulation unleashes productive forces in economy)

Tax & govt program disincentives

Taxes provide incentive to avoid/reduce activity that is taxed (high taxes discourage income, stop or start working especially if worker involved is family's second earner), higher taxes lower firm's return on investment, providing less incentive to invest in plants, research, other activities that lead to economic growth. (raising taxes to provide benefits to disadvantaged people can simultaneously discourage kinds of productive investments that might make them better off) Gov't benefits also create perverse incentives (unemployment benefits diminish incentive to find work), Regressive taxes: where burden falls more on poor because larger fraction of income goes to tax, Progressive taxes: equal fraction of income rich vs poor

Productivity

The efficiency with which we convert inputs into outputs (how good we are at making things) The more productive we are, the richer we are (productivity is more affected by technology, specialization, and skills, all of which as a function of human capital, America is rich because Americans are productive) Productivity growth is what improves our standard of living, makes ur richer, regardless of what is going on in the rest of the world Productivity growth depends on investment (in human capital, physical capital, research and development, more effective government institutions), high taxes, bad government, can diminish or eliminate incentive to make productive investments, also depends on innovation and technological progress

Interest groups & politicians' incentives

The groups that represent one specific interest. Politicians use interest groups to buy votes. Small well-organized groups are the most successful in the political process because the costs of whatever favors they wrangle out of the system are spread out over a large, unorganized segment of the population. (the large group subsidizes the smaller group) Pork barrel policies: lavishing money on small projects that cannot possibly be described as promoting the national interest (mohair farmers) but ensure votes.

Signaling mechanisms

firms will do whatever they can to "signal" their own quality to the market (aesthetics, interior decor, etc.), idea that one party credibly conveys some info about itself to another party (trappings of success) Harvard: does Harvard add great value to its students, or does it simply provide an elaborate signaling mechanism that allows bright students to advertise their talents to the world by being admitted to Harvard?

Effects of human capital on standard of living

our total stock of human capital defines how well off we are as a society // the stock of education, training, skills, and even the health of people constitutes ~75% of the wealth of a modern economy in which human capital is by far the most important form of capital in creating wealth and growth There is a striking correlation between country's level of human capital and economic well-being, striking LACK of correlation between natural resources & standard of living. (Japan and Switzerland are rich, Nigeria has enormous oil wealth but it has done little for the nation's standard of living) High levels of human capital creates virtuous cycle (well-educated parents invest heavily in human capital of their children)

Human capital

the knowledge and skills that workers acquire through education, training, and experience Also includes perseverance, honesty, entrepreneurial flair, creativity—virtues that lend themselves to finding work