Month: August 2004

I think my law students understood my first-class example about contracts, incentives and hot water. But Kevin Drum, Matt Yglesias and others are having some difficulties. No problem. I will make it simpler. Suppose we have a law that says that at the end of every year landlords must rebate their tenants $50 for every month of rent paid. Good for tenants, right? Perhaps in the very short run but in the near future we can expect to see rents rise by $50 per month and the old equilibrium will be restored in all essentials. Now suppose that instead of being required to rebate the $50 the landlords are required to spend the money on shoes for the tenants. Now both tenants and landlords are almost certainly worse off since the tenants would almost certainly have used the rebate to buy something other than shoes. The hot water example hardly differs.

Of course, we could add in some other features that might make the law a good idea. Suppose, for example, that hot water encourages bathing which reduces the transmission of disease. Tenants won’t take the external benefit of hot water into account and thus hot water will be underprovided – a hot water requirement or better yet a subsidy might be justified in this situation.

An alternative explanation for laws like this is that they are supported by people who want to keep the poor out of their neighborhood – this is an externality argument also but one quite different from that above. Whatever the explanation, note that these arguments are quite different than the naive one which assumes that the requirement transfers wealth from the landlord to the tenant. Contracts are multi-dimensional, force one part to change and the others will adjust. More bonus points: What implications does this have for the study of price controls?

As I told my students, understanding the basic analysis is the first-step on the path to wisdom, it is not the end of the path. But you have to understand the first step if you are going to reach the final destination.

A recent paper by Aaron Edlin and Pinar Karaca-Mandic has focused my attention on the potential of toll roads. The basic question is whether,

…driving entail[s] substantial accident externalities that tort law does not internalize? …If so, this implies that a one percent increase in aggregate driving increases aggregate accident costs by more than one percent.

This may seem obvious. Any error in tort judgments would reduce deterrence enough to make it suboptimal. But, argue Edlin and Karaca-Mandic, its not so simple;

The reverse, however, could hold. The riskiness of driving could decrease as aggregate driving increases, because such increases could worsen congestion and if people are forced to drive at lower speeds, accidents could become less severe or less frequent. As a consequence, a one percent increase in driving could increase aggregate accident costs by less than one percent, and could even decrease those costs.

Edlin and Karaca-Mandic find that

…traffic density increases accident costs substantially whether measured by insurance rates or insurer costs. …a typical extra driver raises others’ insurance rates (by increasing traffic density) by the most in high traffic density states. In California, a very high-traffic state, we estimate that a typical additional driver increases the total insurance premiums that others pay by roughly $2231 ±$549 each year.

What is the best way to internalize the externality? Gas taxes are, as Edlin and Karaca-Mandic point out, politically untenable. They propose

…requir[ing] insurance companies to quote premiums by the mile instead of per car per year? This simple change could reduce driving substantially by moving a fixed cost to the margin without raising the overall cost of driving.

To some extent insurance companies already do this. Nonetheless I’m not sure that this solves the problem. A friend of mine lives in Riverside, CA and commutes to LA at 3 am. He would get hit by the Edlin premium but is in fact reducing the externality. Even in LA he is really only a risk to himself at 3 am. Another option is toll roads. The problem is that currently most toll roads do not congestion price or differentiate by vehicle size (beyond trucks); a factor White [2002], for example, finds significantly affects accident costs. The transaction costs of internalizing this externality via toll roads may be too high. But technology, according to the Economist, is changing. Toll roads can now congestion price and change higher fees to SUV. The Economist notes that a Swiss toll system which charges for the distance driven

“.. seems to be an unmitigated success. To general surprise, it was up and running on time. And it achieved its main objective: reducing truck traffic across Switzerland, which increased by 7% during the late 1990s. In the year after the system’s debut in 2001, the number of trucks on Swiss roads fell by 5%. What is more, transport companies now try much harder to ensure that their trucks do not cross the Alps empty. Financially, things appear to work, too. Operating costs amount to only 6% of revenues, estimated at €575m last year.

Addendum: Tyler and Alex debated this issue you can follow the debate here.

The Islamic Bank of Britain, the first sharia-compliant bank in that country will soon open its doors. Ironically, Islamic banks may do better in the West than in the present Muslim world. The natural alternative to interest-bearing loans is a profit-sharing contract but that only works if accounting standards are clear and the courts can enforce the contract. Consider, if Taghi lends Amir money based on interest it’s clear what Amir owes, but if Taghi gives Amir money for a share of a profit-making enterprise then he is at the mercy of Amir’s bookkeeper. Writing in the NYTimes, Virginia Postrel writes:

…Islamic banks learned the hard way that risk sharing does not work in countries where businesses keep false accounting records. “Many people came to borrow money with wonderful ideas, and they just walked away with the money,” Professor Kuran said. The banks could not reliably audit the books, and if they took a client to court, the business would just claim a loss.

Consequently, the banks all started charging what amounted to interest for loans…A minuscule portion – generally well under 5 percent – of the assets of Islamic banks consist of loans based on genuine profit and loss sharing,” writes Professor Kuran..

Substitutes for interest-bearing loans are not hard to find, however.

The most common way around the interest ban is known as murabaha. The bank buys a capital good, a computer, say, for a client, who agrees to buy it back, with a markup, at a particular time in the future. In effect, the markup represents interest.

Islamic banks also invest in debt securities and pay depositors returns that fluctuate with prevailing interest rates. They act like money market funds.

Postrel’s article is based on Timur Kuran’s book, Islam and Mammon. I haven’t read the book yet but I know Timur’s work and feel safe in recommending it to anyone interested in these important issues. Here is chapter one.

Or, two men with really big feet.