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Better Living Through Economics John Siegfried, Vanderbilt University Better Living Through Economics 1. Economic research has had a profound effect on our way of life and material well-being affecting income and wealth, as well as mortality, health, happiness, and welfare. 2. The products of economics research are not well recognized. No chorus of testimony or news articles singing praises Most economic research produces public rather than private goods Patents and the history of science do not include economics Process of moving from innovative economic science to human welfare improvements via policy change is largely a mystery Book documents economic research successes in 12 case studies 1. Tradable pollution permits Tom Tietenberg 2. Price index reform Michael Boskin 3. Antitrust reform (entry considerations) Lawrence White 4. Matching physicians and students Al Roth 5. Spectrum auction design Preston McAfee, John McMillan, Simon Wilkie 6. Airline deregulation Elizabeth Bailey 7. Welfare to work reform Rebecca Blank 8. Earned Income Tax Credit Robert Moffitt 9. Trade liberalization Anne Krueger 10. Saving for retirement 11. Monetary policy David Laibson, Brigette Madrian, John Beshears, James Choi, Brian Weller John Taylor 12. Voluntary military force Jim Miller, John Warner, Beth Asch Emissions Permit Trading Main idea: • Bureaucrats do not have sufficient information to identify least-cost pollution avoiders. • A market for pollution permits causes high-cost pollution avoiders to buy permits and low-cost pollution reducers to sell them, so long as they receive more for the permits than their cost of reducing pollution. Having sold their permits, low-cost pollution avoiders cut pollution, and high-cost pollution avoiders still pollute. Emissions reduction is achieved at minimum cost. Key economic insights: • Ronald Coase (1960): if property rights are explicit and transferrable, markets will assure that pollution is controlled at the least cost. • William Baumol and Wallace Oates (1971): a uniform pollution tax achieves an environmental target cost-effectively, as lower cost abaters choose abatement, and higher-cost abaters pay the tax. That leaves (only!) to identify the optimal tax. A market for tradable permits does that. What encouraged the adoption of tradable permits? • Empirical cost-effectiveness studies showed that reduced ambient standards could be attained at much lower cost with cap-and-trade than command and control when 1970s growth required larger emissions cuts. • 1976 “offset policy” allowed new businesses into local areas (and sustained economic growth) if established firms reduced pollution by 120% of the new pollution that would be added by entrants. New firms had to secure credits for offset. The 20% was “retired.” • Sulfur allowances for controlling electric utility emissions contributing to acid rain traded since 1980. The allowances now are traded on the Chicago Board of Trade (which lowers costs of locating buyers and sellers). • Caps can be tighter and pollution reduced if abatement is allocated more efficiently, pleasing environmentalists. Remaining issue is how to distribute permits. Deferred Acceptance Algorithms: Matching Main idea: • Matching people in transactions when each has rank order preferences among those on the other side is challenging. E.g., marriage, school admissions. • In a deferred acceptance algorithm (one side makes a proposal to agents on the other, proposing first to their first choice), those who receive more proposals than they can accept reject the least preferred, but don’t immediately accept the best received; instead, they hold it without commitment, deferring acceptance until they see all options by the end of the choice period. This produces a match that is better than matches produced by less centralized marketplaces they replace. • This idea has been applied in recent years to match medical school graduates to hospitals seeking residents, and to allocate students among high schools in New York City and Boston by Al Roth and colleagues. Key economic insight: • Gale and Shapley (1962) developed an algorithm for two-sided matching, in which men and women in a marriage market each have preferences over individuals of the opposite sex. It has the attribute that each individual is matched to his or her preferred person among those on the other side of the market that find the individual acceptable, after learning of their options. This is called a stable match, in that no individual can find someone else on the other side of the market that they prefer and who will have them. • Roth (1982) showed that there is no stable matching mechanism that makes stating true preferences always best for each agent, no matter what preferences are stated by others. Roth also showed that it is possible to design the mechanism so that one side of the market can never do any better than to state its true preferences. What encouraged the adoption of deferred acceptance algorithms? • Medical residency placement used such an algorithm since 1952 to replace a process in which many hospitals whose residency offers were rejected were unable to land their second choices, because the second choices had accepted offers from other hospitals. • The problem that arose in the 1980s is married physician couples, who want to locate in the same place. Roth (1985) showed that if couples were modeled with preferences over pairs of positions, the National Resident Match could be improved. In 1995, he was invited to redesign the resident match. • The school choice problem. In New York, a deferred acceptance algorithm replaced a system that used preferences for only 100,000 of 130,000 students each year. The remainder was allocated administratively, without regard to preferences. Because those who did not get their first choice were allocated arbitrarily, parents often did not state their true first choice, but would substitute a lower acceptable choice where they had a higher probability of success. This led to inefficiencies. The re-designed algorithm avoids this problem. Airline Deregulation Main issue: • Question in early 1970s: could the airline price and entry regulation of the 1930s be relaxed in favor of reliance on competition, to create higher quality air service at lower prices for both passengers and cargo shippers? • Answer hinged on how airlines behaved in a regulated environment in contrast to what they did absent regulations. Key economic insights: • Richard Caves (1962) found no evidence of economies of scale in airline systems, undermining natural monopoly as a basis for regulation. • Michael Levine (1965) and William Jordan (1970) showed that unregulated intrastate air passenger fares were lower by half than comparable regulated interstate fares. The carrier (PSA) was profitable. • George Douglas and Jim Miller (1974) developed a model of airline competition, showing that price regulation without flight frequency controls led to too many flights and load factors that were too low. Customers might prefer lower quality service but with lower prices. They also exposed peculiar effects of pricing based on distance: higher price cost margins on longer flights, causing less use of flights with worse substitutes. • Contestability theory (Baumol, Bailey, Panzar, Willig) argued the threat of entry keeps fares low even if actual concentration is high. Sunk costs in the airline industry are government-owned airports and traffic control systems. How did economics affect airline deregulation? • In 1975, Stephen Breyer (on-leave from Harvard, now Supreme Court Justice) organized hearings held by Senator Kennedy, asking whether prices were too high. • Hearings focused on the price differential between the LA to SF route and a comparable Boston to Washington route used by Senator Kennedy flown on the same aircraft. The former was unregulated, as it was intrastate; the latter was regulated. Average fare on the former: $18.75; average fare on the latter: $41.67. • Reform became bi-partisan. Ford Administration CEA chair Alan Greenspan and member Paul MacAvoy argued forcefully for deregulation in 1975 and 1976. • Existing regulation often granted duopoly authority over routes, and price setting control by duopolists. Because there was no control over flight frequency, if price was set above costs, flight frequency increased until load factors declined enough to extinguish all profits. Airlines made no money, planes were half full, and prices were twice what they might have been. Douglas and Miller (1974). • Charismatic economist Fred Kahn chaired CAB in 1977. He authored the premier regulation treatise. He added economist Elizabeth Bailey as a Commissioner, and economists Michael Levine and Darius Gaskins as senior staff. • Cargo deregulated in 1977 because no flight attendants union or passenger groups were afraid of losing jobs or service. Cargo carriers’ stock prices rose, ending passenger carrier opposition. • CAB provided two experiments: allow discounted fares for up to 35% of capacity, and allow entry to underserved airports like Newark, Baltimore, Midway in Chicago, San Jose. Fares dropped; service expanded. • Passenger air service was deregulated in October 1978; the CAB disappeared in 1985. Fares are about 30 percent lower than what they would have been under regulation. Consumer welfare gain: $28 billion per year. Fares fell more on long than short flights. • Success of Southwest Air served as a catalyst. Today fares are 40 percent lower where Southwest is likely to enter (where it is already at one end of a point-topoint route), supporting contestability theory. Autosave Features of 401(k) Savings Plans Main idea: • In 1970 70% of US pension plans were defined benefit, employers making contribution level and portfolio decisions. By 1990, 70% were defined contribution. • Because of potential liability for choices, employers required employees to opt-in to defined contribution plans. About 30% of employees opted in. • Behavioral economists discovered the power of inertia—most employees elect the default option, either because it is less costly to do so or because they believe it is endorsed by their employer. • Through research showing that employees elect the default more frequently, economists persuaded Congress to change the law in 2006, limiting employer liability for investment returns in 401(k) plans, and requiring that employees affirmatively opt-out if they do not wish to participate. This largely reversed participation from 70% opting out to 70% opting in. Key economic insights: • Richard Thaler and others discovered that individuals do not make rational economic decisions like homo economicus as modeled by economists. Instead they often use rules of thumb, and make choices based on procedures rather than outcomes. • Laibson, Madrian, and other Harvard colleagues produced empirical evidence that individuals are not saving sufficiently for retirement, and that many are passive in their retirement choices, deferring the choice to their employer. What encouraged the adoption of the Pension Protection Act of 2006? • Elimination of defined contribution pension plan participation from the non-discrimination test between highly compensated (above $105,000 in 2008) employees and other employees in order for taxes on contributions to be deferred. This allowed employers to require participation, but at a very low level compared to preferences of high income employees, to reduce complaints of low income employees. • Peter Orzag of Brookings (now Director of OMB) personally lobbied Congress to get the PPA passed. Clear evidence that default enrollment was an effective way to increase savings, without limiting freedom of choice. Orzag personally lobbied Congress hard. Monetary Policy Main idea: • Real economic welfare is greater if GDP grows faster and inflation is lower. • Businesses and investors make better decisions, thus increasing real GDP and reducing inflation, if the volatility of GDP and prices is lower. • Making policy predictable reduces uncertainty, making it easier for the private sector to plan, thereby reducing the volatility. Key economic insights: • Lucas (1976) argued that decision makers rationally anticipate future policy in current decisions. Their decisions are better if future policy is transparent, because there will be fewer changes reacting to surprises. Policy can be transparent if it follows rules to minimize the (often weighted quadratic) combination of the volatility of real GDP and inflation (Sargent and Wallace, 1975; Kydland and Prescott, 1977; Taylor, 1979). • Firms set prices and hold them steady for some period of time. Prices do not adjust instantaneously, as naïve economic models imply. They are staggered and unsynchronized. With a current price decision expected to last into the future, some prices set in the future are relevant for today’s decision. Thus future inflation affects current price decisions. In other words, future inflation affects the current inflation rate, giving credibility to a central bank commitment to price stability and inflation targets. How the economic ideas became policy: • Regime change catalyst was Paul Volker’s commitment in 1981 to break inflation expectations because it was causing poor decisions by investors and consumers. • The new regime came from economics: inflation targeting, based on models and empirical results devised by economists, including FED research economists. • The models revealed how the policy instrument—first the money supply, and later the interest rate—should be targeted. The models, solved with calculus of variations and estimated with data, showed policy should be more responsive to fluctuations than it had been. The money supply, and interest rates, should not remain fixed (as Friedman had argued). Since 1980 FED policy has about doubled the responsiveness to changes in the inflation rate. • Professional economists at the FED read economics, and communicated with academic monetary economists. Many economists served on the FED since 1980—Lawrence Meyer, Alice Rivlin, Janet Yellen, Edward Gramlich, Roger Ferguson, Fredric Mishkin, Michael Moskow, William Poole, Charles Plosser, Randall Kroszner, Gary Stern, Lawrence Lindsay, Alan Blinder, etc. The FOMC used economic research to make decisions. • The result was reduced volatility of real GDP, and inflation from 1982 through 2007, called the “great moderation.” Coterminous with the new monetary policy emphasizing inflation targeting. • Central banks around the world now inflation target, causing predictable, rule-like decision making, enhancing transparency. • Today the FED announces its interest rate decisions immediately, and tries to explain its thinking about the future. Before 1980 the FED thought it had to keep monetary policy a secret and surprise markets to be effective. Growth Rate of real GDP (annual rate) Decline in the Volatility of the Growth Rate of Real GDP The All-Volunteer Military Main idea: • A conscripted soldier’s military pay does not reflect his or her opportunity cost because the occupation was not chosen voluntarily. A voluntary force, while costing more compensation to attract volunteers, costs less in real terms because it attracts people with lower opportunity costs than conscripts. • Because pay must rise sufficiently to attract volunteers, those who serve do not incur economic losses just because of their bad luck to be drafted. Others pay higher taxes to compensate the volunteers, taxes that recognize the opportunity costs of soldiers. This confronts the military with proper relative costs of capital and labor, makes the cost of military transparent, and improves decisions on the size and use of military. Key economic insights: 1. Opportunity cost of a volunteer force is less than opportunity cost of a conscripted force. 2. A volunteer force eliminates the costs of avoiding conscription. 3. A voluntary force has lower turnover, and lower training costs. Eliminating some training initially saved 6 percent of total force. 4. The change in relative input costs encourages substitution of capital for labor, especially capital requiring fewer operators and less maintenance, which in the long run saves lives. 5. Economic burden of a voluntary force is shared more fairly ex post. 6. The explicit cost of the military rises, discouraging military adventurism abroad (analyses by Tollison, Wagner, 1972) What encouraged the adoption of an all-volunteer military force? • Controversy over the war in Viet Nam was a catalyst. An economist working at Department of Defense in 1964, Walter Oi, described the feasibility of a volunteer force in publications (1967). • Lee Hansen and Burt Weisbrod (1967), Stuart Altman and Alan Fetcher (1967), Anthony Fisher (1969) and Bob Barro (1971) contributed. University of Virginia Ph.D. students wrote a collection of essays advocating a volunteer army (James Miller [later Director of OMB], 1968). • Martin Anderson, an economist at Columbia, suggested ending the draft to the 1968 Nixon presidential campaign. Impressed by arguments, Nixon advocated ending the draft in an October 17, 1968 campaign speech. • Once elected, Nixon established the President’s Commission on an All-Volunteer Armed Force. Milton Friedman, who advocated a volunteer military in Capitalism and Freedom, Allen Wallis, economist and president of University of Rochester, and Alan Greenspan were members. Economists William Meckling, Walter Oi and Robert Barro were staff. • In November 1970 the Commission recommended abolishing the draft, increasing military pay, and improving living conditions. • Congress was skeptical. In April 1971 Nixon sent bill to Congress, which held hearings. Walter Oi’s testimony was persuasive. “His candor, knowledge, and willingness to challenge DOD’s data about the negative consequences of a volunteer force undoubtedly helped Committee members feel more comfortable with an allvolunteer approach” (John Ford, staff director of House Armed Services Committee at the time, 2004). • The Committee voted 32-4 to extend the draft two years, then switch to a volunteer force. The bill passed Congress, was signed in September 1971, and the volunteer military commenced in 1973.