Download Slide - Editorial Express

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.