Category: Economics

The importance of the growth rate increases, the further into the future we look. If a country grows at two percent, as opposed to growing at one percent, the difference in welfare in a single year is relatively small. But over time the difference becomes very large. For instance, had America grown one percentage point less per year, between 1870 and 1990, the America of 1990 would be no richer than the Mexico of 1990. At a growth rate of five percent per annum, it takes just over eighty years for a country to move from a per capita income of $500 to a per capita income of $25,000, defining both in terms of constant real dollars. At a growth rate of one percent, such an improvement takes 393 years.

That’s me quoting me, from a book I am just starting to write. The tentative title is “The Welfare Economics of Human Tragedy: A New Approach to the Theory of Economic Policy.”

If I had to explain, in one sentence, the reason I am not on the political left, I would cite the enormous long-run benefits of economic growth. Of course it still can be argued that various left-wing policies, properly understood, will contribute to long-term growth. But in my view, if you are not supporting growth-maximizing economic policies, you better had a pretty good reason in your pocket.

My post on hot water (and followup here) is drawing more hot air than I expected. Daniel Davies over at Crooked Timber is often very good so I am frankly surprised that he gets this one very wrong. Davies thinks the argument falters if you assume the landlord has monopoly power.

Even if there is a slight oversupply of rental units for sale, time is almost always on the landlord’s side, because waiting is typically much more inconvenient for the party that has to wait without a house to do wait in [sic]. In general, when tenants and landlords are negotiating over the potential Pareto gain that could be made from renting the house, the landlord ends up capturing most or all of the surplus. The hot water and habitability laws are simply aimed at skewing things a bit in favour of the tenant and putting a floor on how bad a deal the tenant can end up accepting.

Wrong. Assume that a rapacious landlord owns the only apartment in the entire universe and you want it. The landlord is therefore going to extract all of your consumer surplus. Without the hot water the apartment is worth $500 a month to you – so that’s the rent. With the hot water it’s worth $550 – so that’s the rent. There is no skewing in favor of the tenant because the law doesn’t change the landlord’s bargaining power one iota. All it does is raise the landlord’s costs so that he may, in fact, quit the business making you worse off.

Daniel has not absorbed the lesson of my post, the rent will go up. He would have an argument if we added rent controls thereby squeezing the landlord from both ends. [Addendum: Glen Whitman gets the analysis exactly right.]

On a different note, many people have focused undue attention on hot water, something that most of us (in this country) really do want in an apartment. The principles involved, however, don’t change much with the good. If you like, think air conditioning instead. Eric Kilby kindly sends me an editorial from a few years ago in the Philadelphia Inquirer (registration required). Here’s what it says:

The zoning board under Thomas Kelly, president of Sheet Metal Workers Local 19, has required some developers of subsidized housing to install central air conditioning – a pricey, discouraging requirement for what are supposed to be low-cost projects. AC, in case you haven’t guessed, is installed by sheet-metal workers.

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.

Last week I presented twelve ideas for a domestic economic policy Republican vision for a Bush second term. I appreciate all those who wrote with additional ideas, or who suggested they might write in my name for President.

I will add one additional proposal:

13. Cut the number of pages in the daily Federal Register by half.

The American economy is drastically overregulated. But do not get me wrong here. I do not wish to gut important environmental regulations, many of which supply valuable public goods. To take one example, my benefits from the ban on low-quality gasoline probably exceed the costs I pay for all other regulations. Try spending a week in Mexico City in December if you are not convinced.

But I do wish to gut the median regulation issued by the Department of Agriculture, or by the Federal Communications Commission, to name two examples. Browse through a typical issue of the Federal Register to find other candidates for elimination.

It is fair to ask where I would make regulation stronger. First, I would do more to tax pollution. Taxes on purely productive activities should be correspondingly lower.

Animal cruelty also leaps to mind; currently we do very little to limit cruelty to animals in factory farms. I don’t take an extreme animal rights point of view, but animals do count for something. There are billions of them held in captivity, and our treatment of them counts as a great shame.

Here is a nice graphic from the NYTimes explaining the Dutch auction IPO. I think Google’s IPO will be a success, it will raise more money for Google than a traditional IPO with its high transactions costs (which flow to the investment banks). Remember the standard to measure success is the cost per dollar of raised funds it is not whether the stock price hits a predefined target and not whether the stock pops. Indeed, Google’s stock price is unlikely to pop. The success of a traditional IPO is often counted by the size of the pop but that is ridiculous. A pop means the firm left money on the table – money which was transferred to a handful of insiders who were allocated stock at the low IPO price. A pop is thus the sign of a bad IPO not a good one. The Dutch auction method ensures that the initial price is a market price (thus Google’s price is unlikely to plummet either). There has been a lot of negative publicity about the Google IPO but my guess is that this was stirred up by the investment banks who are fearful that their halcyon days are ending.

Russ Roberts gets some satisfaction from the NYTimes. Way to go Russ!

Hey, I bet you never expected to see the U.S. Postal Service pop up under this heading. But in fact they have allowed PhotoStamps.com to test their new feature of personalized postage stamps. You can pay $16.99 for a sheet of 20 37-cent postage stamps, designed by you.

So far pictures of babies and families make up two-thirds of the total. Pets are popular too. Unlike with regular stamps, living people can be featured. But nudity, violence, controversial images, and politically partisan stamps are banned (people will quickly develop coded messages). Nor can you use copyright-protected material.

Here is one account, here is another.

When someone sends me a letter with a “MarginalRevolution” stamp, then I’ll be impressed.