Teaching at an international school affords me the privilege of encountering and learning from truly unique and diverse individuals. Last week, my Economics classes were lucky to have as a guest speaker one very interesting and inspirational young man named Andrew Cunningham. Andrew, originally from Vermont, graduated from Duke University in 2008 and has helped co-found a non-governmental organization (NGO) focused on promoting grassroots strategies for economic development. WISER (Women’s Institute for Secondary Education and Research) serves a community of 35,000 in Kenya’s Muhuru Bay, an area where the per capita income is around $1 a day and 38% of the population is HIV positive.

Traditionally, less than 5% of young girls complete primary school in Muhuru Bay. In the town’s history, only ONE girl has ever gone to university (she would become the only Muhuru Bay native to complete her PhD and would eventually co-found WISER with Andrew). A combination of tradition, culture, and most importantly poverty had prevented improvements in the plight of woman in this poor corner of Africa. What was needed, decided Andrew and his founding partners, was an all-girls boarding school where opportunities for young women were promoted and academic achievement encouraged and fostered. WISER opened the community’s first all-girls secondary school in 2010 to 130 local girls who had made it through primary school.

Beyond female education, WISER have embarked on several other development projects in the last year and a half. In his visit to our IB Economics class, Andrew told the story of human development in Muhuru Bay as occurring primarily in three realms.

• Education, 
• health, and 
• entrepreneurship.

I will briefly summarize the three main development strategies WISER has employed in Muhuru Bay, starting with education.

Education as a development strategy:

Education is a primary and fundamental strategy for eradicating poverty. A nation’s human capital is its most vital resource, and the road to prosperity requires an effective education system that does not discriminate based on race, gender, or socioeconomic status. In Muhuru Bay, which is 14 hours by car across un-paved roads from Kenya’s capitol, the education system had failed to achieve meaningful results, both for boys and girls. Student performance on national examinations across the primary grade levels had historically averaged around 11% passing rates. Boys out-performed girls, but as a whole only about one in ten Muhuru Bay children passed the examination required for admittance to secondary school in Kenya.

WISER wished to improve this dismal statistic. If they were going to build a secondary school for girls, they would need to first get girls to pass the national exam for entrance to secondary school, or else their new building would be full of empty desks.

Andrew first talked to my class about the traditional development community (think World Bank, UNICEF, USAID) approach to promoting education in Africa. You are probably thinking the way to help these kids is to give them resources to improve their education. Build better schools, give them textbooks and school supplies, maybe uniforms, build a library, electricity in the classroom, chalk boards, heck, how about we give them laptop computers! All of these ideas represent the traditional development community’s approach to improving education in poor countries. The problem is that these strategies focus only on the inputs into education, and completely fail to look at the output.

Inputs and outputs are common topics of discussion in any Economics class. To produce anything, three resources are required: land, labor, and capital. The traditional approach to improving education in Africa focused primarily on the land and capital. Things such as pens, notebooks, laptops, and new libraries are great, but they have little actual impact on what gets learned in a school. The neglected factor was the labor (i.e. the teachers!) In Muhuru Bay, teachers were paid so miserably and worked in such dismal conditions that the incentive to actually improve their students’ results was just too weak! With passing rates at 11% on national exams, WISER set about figuring out how to use incentives to improve the outputs of education in Muhuru Bay.

A simple and relatively low-cost plan was put into action. Teachers were told that if their students’ scores increased by only 15% on the exams, they would receive a 100% increase in their salary. Andrew and WISER worked with the national education ministry to develop interim exams that could be given quarterly to help the teachers measure their students’ improvement before the annual national examination.

With only minimal investments on the land and capital resources (i.e. textbooks and classroom materials) in Muhuru Bay schools, and by spending less than $10,000 on teacher raises, the passing rate among Muhuru Bay schools increased in one year from 11% to 36%. Hundreds of students, boys and girls, who would not have been able to enter secondary school the previous year, instead passed the exam and were eligible for a secondary education, a crucial step towards a better future!

The teachers’ incentive pay program was such a success in Muhuru Bay last year that the state government has taken notice and intends to implement it in other rural communities throughout Kenya. By focusing on the outputs (student learning), rather than the inputs (classroom resources) WISER has assured that when their all-girls school opens in January, its seats will be filled with qualified students who successfully completed their primary education.

Health as a development strategy:

The second topic of Andrew’s discussion with my IB Economics classes focused on health and sanitation, specifically solving the problem of open defecation (“OD” is a technical term used in the development community referring to the fact that in many poor communities basic latrines are non-existent, and therefore people shit in the open). OD in Muhuru Bay contributed to the poor health and low life expectancy of locals; According to Andrew an estimated 60 people were dying each year of cholera, a disease spread via human waste.

In the health realm of traditional economic development programs, the same basic dilemma between focusing on the inputs or the outputs had stymied previous attempts to reduce OD in Muhuru Bay. Recently, an outside aid organization had made loans to the community to build 30 public latrines. Within a year, however, the latrines had fallen into disrepair and were essentially useless. When Andrew and his team asked the community members why they had let the latrines fall into such a poor state, their answer was predictable. These were not their latrines, they belonged to the aid organization that had built the latrines. If they were broken, the aid organization could fix them! Such logic reflects a common problem in economics, that of the tragedy of the commons. Because the latrines were public, no one owned them. Because no one owned them, no one cared for them. When the latrines fell out of repair, people quickly reverted back to OD, and instances of cholera and other diseases increased once more.

WISER decided to tackle this problem using a similar approach as the one used to fix primary education in Muhuru Bay, by focusing on the output, rather than the inputs. In this case, the goal was simple: create incentives for people to build their OWN latrines, which they would then have an incentive to take care of and use. The strategy for promoting personal latrines they decided to employ is one that has been successfully implemented throughout the developing world, and is now funded by UNICEF, which trains facilitators to go into a community and in a very short time, and at a very low cost, incentivize the locals to take sanitation into their own hands and build their own latrines.

Community Led Total Sanitation (CLTS) is a mind-blowing and shockingly blunt way to promote sanitation. Rather than spending thousands of dollars to build public latrines, the CLTS approach brings community members together for an afternoon of discussion and education about sanitation issues. Locals are asked to take an index card and go to “where they shit” and collect a sample of their own waste. A large pile of human waste is placed on a table in front of a room full of locals right next to a large selection of delicious foods. The facilitator then goes about discussing basic facts related to OD in the community, such as “If you added up all the shit your community produces in a year, how many donkeys would it weigh as much as?” or, “How many bags of rice would you have to eat to create this much shit?” In the mean time, of course, hundreds of flies have descended on the pile of waste in the front of the room, and the community members look on in utter disgust as the flies jump from the feces to the food and back again.

At the end of the lecture, the facilitator turns to the food and says, “Well, it’s time for lunch, who’s hungry?” In utter disgust, the locals ask the facilitator if he has gone mad. The lesson, of course, is that the food and water the community consumes is most likely being contaminated by the waste they produce and deposit in the open around their village. Within a few weeks of the CLTS project in Muhuru Bay, 256 new latrines were built by the community members themselves. Whereas previously, only around 15% of the locals used latrines regularly, after the CLTS project around 75% had access to the “facilities”.

The total cost of the CLTS sanitation project? Around $55, a tiny fraction of the cost of building the public latrines that had previously been neglected by the community. By focusing on the outputs rather than the inputs, real development in the health of the community was achieved at a very low financial cost.

Entrepreneurship and micro-lending as a development strategy:

The final approach to human development in Muhuru Bay Andrew discussed with my classes focused on the economic empowerment of community entrepreneurs. Micro-lending is a much talked about and widely used development strategy that provides financial credit or technology loans to entrepreneurs in poor communities to create small businesses, ideally ones with a socially beneficial purpose. Watch the first 12 minutes of the video below to get a better idea of the history and purpose of micro-finance as a strategy for achieving economic development.

In Muhuru Bay, the micro-lending scheme Andrew has pioneered involved not financial capital, but physical capital (i.e. technology).

WISER was able to secure several technology donations, including a copy machine, several laptop computers with cellular internet connections, a foot pump for water, and a digital LCD projector. WISER then solicited loan requests from several “young entrepreneurs”. Young men and women wrote business plans outlining how they would use the technology loans to generate income for themselves and the community, and provide services that would benefit others in the Muhuru Bay community. The technology would not be donated to the recipients; rather they would be required to pay back the value of the capital through their business revenues.

It is simply amazing how a few pieces of second-hand technology, items that we in the rich North would take for granted as relatively common and thus of very little social or economic value, can completely change a poor community in Africa for the better. Here’s how some of the capital Andrew and WISER loaned to young entrepreneurs were put to use to achieve meaningful development in Muhuru Bay:

• The copy machine was installed and powered by a generator. It was the first such machine ever installed in Muhuru Bay. Local businesses, students, job seekers and other could now, for a few cents, photo-copy their documents locally, avoiding the two hour drive previously required for such a service.
• The laptops were installed in an internet café and made available to local students and businesses. Farmers and fisherman could check product prices in the cities hours away, increasing efficiency and bargaining positions when middle-men came to town to buy their produce. Job openings in the city newspapers’ classifieds could be printed and posted for the local community to see, improving information symmetry between the poor countryside and the cities where job opportunities existed. The cost of access to these services was cheap, yet the entrepreneurs who were granted the laptop loan were able to pay back the cost of the technology in no time at all, and the community as a whole benefited from their existence.
• My favorite entrepreneurial venture involved the LCD projector. This piece of technology, which now hangs from the ceiling of thousands of classrooms around the rich world, had never before been seen in Muhuru Bay. You may think it ended up in a classroom or in an office building, but no; the entrepreneurs who received the projector hooked it up to a satellite dish which captured and projected English Premier League football matches onto the wall of a large room in a local building. The business was to sell tickets to local football fans who were more than happy to pay to watch English football matches in full color on a wall-sized screen. Before the projector, dozens would have huddled around a tiny television with poor reception to watch football matches. The “football theater” business was the most successful of all, and paid back its loan fastest.

All three of these entrepreneurial endeavors were very low cost, using donated technologies. The reason for their successes, however, must be attributed to the model for implementation. They were not simply “given” to the community. Such a strategy would certainly have led to the same “tragedy of the commons” experienced when the outside aid organization funded the construction of public latrines. The capital would have been neglected and fallen into disrepair. By lending the technology to businesses, however, the incentive for innovative and socially beneficial ventures was created, and a business model was developed to best utilize the resources in a profit-earning, sustainable manner. With very little inputs, fantastic outputs were achieved, enriching not only the entrepreneurs, but the entire Muhuru Bay community.

Economic Development the WISER Way:

Andrew’s visit to Zurich International School was eye-opening in many ways. He brought to light both the successes of WISER and other community projects in rural Kenya, but also shined a light on the failures of the traditional development community’s agenda. When I think about the hundreds of billions of dollars that have been committed to economic development in Africa over the past decades, and on into future decades, I wonder whether the diplomats and the politicians in the “aid community” have any idea how much has been accomplished on the ground in places like Muhuru Bay thanks to community-based organization like WISER.

With so little, so much can be accomplished. The poor of Africa and the world need resources, but more importantly they need education, health and sanitation, and business opportunities so that they can enjoy the benefits of development from the bottom up. Development aid, as it has traditionally been distributed, comes from the top down, funneled through national governments. Waste and corruption are rampant, and typically only a fraction of what has been given ends up on the ground in places like Muhuru Bay. Even when it does, the tragedy of the commons often results in inefficiency and waste, as the “inputs” are managed and distributed from the top down, leading to uncertainty of ownership and misaligned incentives once the resources are on the ground.

Perhaps aid from the outside is still needed, but Andy’s visit showed me and my students that something much more basic lies at the core of successful economic development. Education focusing on outputs rather than inputs, sanitation focusing on outputs rather than inputs, and entrepreneurship that empowers business leadership, have improved the lives of thousands in one Kenyan community. What could such a re-thinking of development strategies do for the rest of Africa and the developing world?

Related posts:

1. Does economic growth = economic development? Not for China’s rural poor…
2. The “bottom billion”, aid, and strategies for achieving economic development
3. Introduction to Economic Development – Myths about Development, debunked

Fair trade schemes aim to get more of the money we spend on our stuff into the hands of the workers in less developed countries where they originate. Some examples of goods produces in fair trade cooperatives in poor countries include fruits, tea, coffee and cocoa. Some handicrafts and textiles are also available from Fair trade programs as well.

It is estimated that approximately 7.5 million producers in the developing world participate in fair trade programs, producing $5 billion worth of output.

According to the European Fair Trade Association, fair trade is

a trading partnership, based on dialogue, transparency and respect, that seeks greater equity in international trade. It contributes to sustainable development by offering better trading conditions to, and securing the rights of, marginalized producers and workers – especially in the South.

Fair Trade organisations (backed by consumers) are engaged actively in supporting producers, awareness raising and in campaigning for changes in the rules and practice of conventional international trade”.

Fair trade as a strategy for economic development is controversial, as many argue that either fails at raising the incomes of the farmers it is supposed to serave or that it incentivizes farmers to remain in the low-productivity agricultural sector rather than seeking higher productivity jobs in manufacturing, thereby contributing to poverty in poor countries.

Below are two videos that proclaim the benefits of free trade. After watching the videos, discuss the benefits of fair trade with your class.

On the other side of the issue are several economic arguments against the use of fair trade as a strategy for economic development. First listen to this 19 minute discussion between EconTalk’s Russ Robert’s and Duke University’s Mike Munger over the role that Fair Trade coffee plays in promoting economic development.

Next, read the two articles below a

• The poverty of Fairtrade coffee – Telegraph Blogs
• Fairtrade profits rise, but is the small farmer missing out? – This Britain – UK – The Independent

Discussion Questions:

1. Discuss the strengths and weaknesses of Fair Trade programs at promoting economic development.
2. Outline the possible advantages of a country specializing in manufactured goods instead of primary products.
3. What factors explain the growth in importance of multinational corporations over recent decades? Illustrate your answer where possible by making reference to your own or other countries. Do multinational corporations work in favor of or against the interests of Less Developed Countries?
4. To what extent has the international trading system contributed to economic growth and development in less developed countries?
5. Discuss the view that increased trade is more important than increased aid for less developed economies.

Related posts:

1. “Fair Trade” coffee and economic development
2. Free Trade Debate: to what extent has globalization based on free trade contributed to global economic growth and development?
3. Fair trade vs. free trade: the problem with “dumping”

The prevalence of income inequality in free market economies indicates that inequality may be the result of a market failure. Those who are born rich are more likely to become rich, while individuals who are born poor are more likely to live a life of relative poverty. In a “free” market, it is believed, all individuals possess an equal opportunity to succeed, but due to a mis-allocation of resources in a purely market economy, this may not always be the case.

The resources I refer to here are those required for an individual to escape poverty and earn a higher income. These include public and merit goods that those with high incomes can afford to consume, while those in poverty depend on the provision of from the state, including:

• Good education
• Dependable health care
• Access to professional networks and the employment opportunities they provide

Whenever a market failure exists, it can be argued that there is a role for government in regulating the market to achieve a more optimal distribution of resources. When it comes to income inequality, government intervention typically comes in the form of a tax system that places a larger burden on the rich, and a system of government programs that transfer income from the rich to poor, including welfare benefits, unemployment benefits, healthcare for low income households, public schools and support for economic development in poor communities.

Many politicians and some economists like to argue that income inequality is not as evil as many people make it out to be, and that greater income inequality can actually increase the incentive for poorer households to work harder to get rich, contributing to the economic growth of the nation as a whole. Allowing the rich to keep more of their income, in this way, leads more people to want to work hard to get rich, as they will be able to enjoy the rewards of their hard work.

Another common argument is that higher income inequality leads to social and economic disruptions that can slow economic growth and bring an economy into a recession or a depression, since the middle and lower income groups in the nation will not benefit from a relatively equal share of the nation’s output, and over time will see their living standards drop and their overal productivity and contribution to national output decline.

The debate over inequality and what government can or should do about it is at ther root of many other economic debates today. A recent study by the Political Economy Research Institute of the University of Massachusetts, Amherst, provides support for those who support the second argument above. Here are some of the main discoveries from the study, “Searching for the Supposed Benefits of Higher Inequality: Impacts of Rising Top Shares on the Standard of Living of Low and Middle-Income Families”.

Discoveries of the study:

Some believe that increase inequality leads to more growth, others argue that it leads to less growth.

A more interesting question is whether rising income inequality leads to a higher standard of living for everyone in society, or whether standards of living decline for those in the middle as the percentage of total income earned by the top 10% increases.

The study found that the higher the percentage of income earned by the top 10%, the incomes of those in the middle and bottom of the income distribution actually decreases. Not just the percentage of total income, but the actual incomes of these groups falls as the rich get richer.

The popular belief is that reducing taxes on the rich increases the amount of investment in the economy, creating more jobs and helping increase incomes of the middle and lower income households. This theory is sometimes referred to as “trickle down” economics, as the increased incomes and wealth at the top will “trickle down” and raise the incomes of the rest of society as well.

However, actual data shows that a 10% increase in the share of total income earned by the top 10% of income earners leads to a 2% decline in the incomes of households in the middle of the income distribution (based on data for the period between 1979 and 2005).

It’s not just that the rich get richer and the poor get poorer, rather that the rich getting richer makes the poor (and the middle income earners) poorer. This is a breakthrough discovery.

Possible explanations:

• The rich contribute to growth abroad, rather than at home: Rich households’ higher incomes allow them to consume more domestic output and imported goods and services, but it also allows them to save more, which sometimes translates into more investment. But more investment does not always translate into domestic economic growth, since investment is now global. A rich American saving more does not mean American firms will have access to cheaper capital, as domestic savings may fuel investment in emerging markets or elsewhere abroad. Foreign investment resulting from savings among rich Americans counts as a leakage from America’s circular flow of income, leaving less income within America for the middle and low income earners. Essentially, much of the income earned by the rich is saved abroad, contributing to employment and growth overseas, reducing incomes of the middle class at home.
• Reduced support for the provision of public goods: When examining living standards, more than just income must be considered, but also access to education, provision of health care and other public goods such as public safety and security. Richer households are less interested in things like public schools and social welfare programs, as they do not rely on these for their own well-being. Therefore, the richer the top 10% become,  the greater their incentive to work against efforts to fund public education, public health and public safety. The underprovision of these social welfare enhancing goods by govenrment further widens the gap between the living standards of the richest and the middle class. Economist Robert Reich refers to this phenomenon as “the secession of the successful”.
• Wage competition reduces incomes in the middle: Business owners, who make up a large percentage of the richest households in America, increase their own incomes to the extent that they can drive down the wages they pay their employees. In this way a higher share of national income is enjoyed by a smaller proportoin of society. The minimum wage has barely increased over time, and workers have less bargaining power as fewer workers than ever are members of labor unions; this has allowed business owners to pay lower wages over time, concentrating an increasing share of national income in business profits, and less and less in wages for workers.

In the video below, the study’s author shares some of the findings discussed above. Watch the video and respond to the discussion questions that follow.

Discussion Questions:

1. Summarize the argument against a government taking measures to redistribute its nation’s income to reduce the level of inequality between the rich and the poor.
2. Summarize the argument for a government reducing inequality.
3. Popular belief holds that “a rising tide lifts all boats”. In other words, if the total income of a nation is increasing, it does not matter if the rich are enjoying a larger percentage of the higher income than the poor and middle, because everyone is likely to be better off than if total income were not growing at all. Does the study discussed above support this popular view? Why or why not?
4. What measures can a government take to assure that higher national income leads to higher standards of living for everyone in society, including the middle class and the poor? Why might the highest income earners be opposed to such attempts by government?
5. Should government intervene to reduce the level of income inequality in society?

Related posts:

1. How do you support low income workers to reduce inequality? – A Singapore Case Study
2. The role of taxes in income re-distribution – another preview of my textbook
3. Final Market Failure Quiz – IB Economics

Last year, I argued that Christmas was the most inefficient time of the year due to the large loss of welfare that goes with the tradition of gift giving. This year I will argue that Santa Claus, as the tradition is embraced in the English speaking world, fails to provide children with strong enough incentives to behave nicely, thus resulting in too much naughty behavior, reducing society’s welfare in the months leading up to Christmas. We’ll explore a market-based solution to this market failure,  already being practiced across the European continent, which harnesses the power of incentives to improve children’s behavior, and the overall efficiency of the Christmas holiday.

The lyrics to the popular Christmas song, Santa Claus is Coming to Town, are a warning to little children that they better not act naughty, OR ELSE! Read them and see what I mean:

You better watch out, You better not cry
Better not pout, I’m telling you why
Santa Claus is coming to town
He’s making a list, And checking it twice;
Gonna find out who’s naughty and nice
Santa Claus is coming to town
He sees you when you’re sleeping, He knows when you’re awake
He knows if you’ve been bad or good, So be good for goodness sake!
O! You better watch out! You better not cry
Better not pout, I’m telling you why
Santa Claus is coming to town

“So be good for goodness sake,” a child will say, ” OR WHAT? What are you going to do Santa, if I am naughty? Are you not going to bring me a present that I really want?”

You see, this is the problem with the Santa I grew up with. He is all carrot, and no stick. Humans respond to incentives, and the Santa I grew up with is great at incentivizing nice behavior, but he’s really bad at disincentivizing naughty behavior. Consider the following:

• Santa sees me when I’m sleeping and knows when I’m awake, so he knows when I’ve been bad or good. If I’m good, the implication is that I will be rewarded with wonderful gifts from Santa come Christmas time.
• If I’m bad, however, I will experience no loss whatsoever. While I will not benefit as much as the good children, nothing will be taken away from me. I will be made no worse off by being naughty, rather the degree to which I will be made better off is reduced.

This is a classic incentive problem. Santa provides rewards for good behavior, but fails to dole out punishment for bad behavior. A culture which embraces this benevolent Santa will invariably produce too many naughty children. Such a market failure can be illustrated clearly using benefit and cost analysis:

As economists, we’re always exploring ways to improve efficiency in the markets for different goods, services, and human behaviors. Clearly, in the market above, in which children determine how naughty they will be based on their perceived private benefits and costs of their own behavior, there is a market failure.

Due to Santa’s hollow threat (“…you better watch out!”), children lack a strong disincentive to not act naughtily, and therefore choose to engage in naughty behavior to the extent that overall welfare in society is reduced. The marginal private benefits of naughty behavior are far greater than the marginal social benefits of naughty behavior (let’s face it, acting naughty is FUN!).

So how could Santa better harness incentives and disincentives (both the carrot and the stick) to reduce naughty behavior and increase overall welfare in society, thereby increasing the overall efficiency? Santa must do more than just encourage good behavior; he must also strongly discourage naughty behavior.

Well, as it turns out, the Santa I grew up with is not the only version of Santa Claus in the world, and in fact the Santa known to millions of children all over Europe is one with a fearsome, wrathful side that is not timid about doling out punishment to naughty children. Allow me to introduce the European Santa, and his evil alter-ego, known here in Switzerland by the ominous name Schmutzli (which translates loosely to “dirty face”).

img source: http://www.ricksteves.com

The Swiss news site Swissinfo.ch introduces the character Schmutzli:

This is not the Santa Claus known to English-speaking countries but the Swiss version – who is normally accompanied by a strange-looking individual with a blacked out face.

The Swiss Father Christmas was based on Saint Nicholas, whose feast day was celebrated on Saturday – his Swiss German name, Samichlaus, alludes to that. But the origins of his sinister companion are less easy to make out.

Known as Schmutzli in the German part of the country… Samichlaus’s alter ego usually carries a broom of twigs for administering punishment to children whose behaviour throughout the year has not been up to scratch.

You see, here in Switzerland, and in much of Western Europe, Santa brings gifts for the children who have been nice, but his partner Schmutzli delivers harsh punishments to those children who have been naughty. Schmutzli, who goes by different names in other parts of Europe, is known to throw naughty children in his sack, carry them into the woods, and administer a fierce beating with his birch stick, and for the naughtiest children, to eat them or throw their beaten bodies into a river.

Schmutzli, quite literally, provides the stick to accompany Santa’s carrot. In Europe, children not only receive wonderful rewards from Santa for good behavior, but fierce punishments from Schmutzli for naughty behavior.

From an economic perspective, Schmutzli’s existence increases the efficiency of the Santa character dramatically, and therefore improves overall welfare in society by giving children both an incentive to act nice and a strong disincentive to act naughty, thereby internalizing the negative social costs of naughty behavior. The outcome can be as illustrated as below:

As the graph illustrates, Schmutzli’s presence by Santa’s side come Christmas time forces children, in their decisions regarding naughty behavior, to account for the likelihood that Santa truly “knows when you’ve been bad or good”. For if he does know when you’ve been bad, Santa will unleash Schmutzli, his child-hauling sack and his birch stick on those whose behavior has been more naughty than nice.

Schmutli’s existence in Switzerland’s Santa story internalizes the external costs of naughty behavior among children, and thereby reduces the marginal benefits enjoyed by naughty children, reducing the actual number of naughty children and the size of the deadweight loss they impose on society. Fewer children will act naughty, the externality is reduced, and overall welfare in society improves.

There you have it. The deadweight loss of Santa. If you ever doubted that Economists could find the inefficiency in Christmas, I’ve shown you once again that it is indeed the most inefficient time of the year. By providing a balance of rewards and punishments, Schmutzli’s presence corrects the incentive problem of an always benevolent Santa. Society as a whole should therefore suffer from less naughty behavior among its children.

Once again, a little Economic analysis can help make Christmas more efficient for all!

Related posts:

1. Grinchonomics – or “how the Economist stole Christmas”
2. McJobs in America – under threat!
3. “Opulent in elegance. Bountiful in spirit”

Related posts:

1. Cut taxes on the rich! How else are they ever gonna catch up with the super rich?
2. The “teenager tax” – why expansionary fiscal policy just ain’t fair!
3. Understanding the difference between progressive and regressive taxes

This post is about how Switzerland has successfully employed an innovative system of incentives to encourage its citizens to reduce the amount of garbage they create. Just three weeks in this amazing country and I can already see why it earned the highest score in last year’s Environmental Performance Index.

In the AP and IB Economics units on market failure, we study the concept of negative externalities, which exist when the behavior of one individual or firm creates spillover costs to be faced by other individuals or society as a whole. A simple example is a factory that dumps waste in a river. Clearly, disposing of its waste in such a manner poses little or no cost on the factory owners, but significant costs on downstream users of the river’s water. A community that wishes to use the river for drinking water must now install expensive filtration and purifying systems just to make the water usable. The factory has kept its own costs down by externalizing the cost of filtration by passing it on to downstream users.

Spillover costs exist on micro levels as well. While it is easy to see how a large factory creates negative externalities, it is often harder to imagine how we as individuals create spillover costs for our neighbors and society in our everyday actions. The stark truth, however, is that an individual’s behavior, multiplied by millions upon millions of individuals making up a citizenry, can have as great if not greater negative impacts on the environment and society as the negligent behavior of one firm.

Here in Switzerland, the behavior of each individual citizen is subject to unusually strict scrutiny. No, Big Brother is not watching, as you may be thinking, (however, I have heard stories of snoopy neighbors alerting the police upon witnessing the most minor of infractions by a fellow citizen), rather, one finds it in his best economic interest to strictly monitor his own behavior down to the finest detail. Allow me to explain what I mean.

Let’s take garbage for example. The definition of garbage in Switzerland is very different from that in the United States. Where I’m from, garbage is anything that you can’t use anymore. You throw it “away”, put it on the curb and it disappears.

A garbage bag in the US is usually a 40 gallon (160 litre) plastic bag that could fit an entire family inside, and the typical American family probably produces two to three bags worth of “garbage” each week, which conveniently disappears in the wee hours of the morning to be taken “somewhere”, which most Americans don’t know or care to know where that is. How much does it cost an American household to dispose of this voluminous quantity of garbage? Well, the bags cost around 18 cents each, and monthly removal services vary depending on the community, but are typically a flat rate for almost any amount of garbage.

In the United States, it is very easy for individuals to pass the true cost of their garbage disposal onto society as a whole. It doesn’t matter all that much whether you put one tiny plastic bag on the curb or a half dozen 40 gallon bags on the curb, you are going to generally pay the same amount for collection regardless. The result of such a system is that the typical household has no incentive to reduce the amount of garbage that it produces. Logically, Americans are inclined to over-consume and produce copious amounts of garbage in the absence of any significant system of incentives in place to encourage waste reduction.

So, what’s different about Switzerland? It’s all about incentives. Let me explain. Here, you don’t pay a flat rate for garbage removal. In fact, you don’t HAVE to pay anything for garbage removal! Oh wow, you say, it’s FREE? In fact, quite the opposite is true. You don’t have to pay anything for garbage removal as long as you don’t create any garbage. In other words, you only pay for what you throw away.

Unlike in the US, here a typical garbage bag here is a 35 litre plastic sack, only slightly larger than a plastic grocery bag. Each village requires its citizens to buy official garbage bags for that community, and each individual bag costs anywhere from $1.50 – $2.50. A role of ten 35 litre bags can cost around $25.

When we consider that anything a household wishes to throw away must be put in an official village garbage bag which itself must be purchased for $2.25, and we know that a typical 40 gallon (160 litre) garbage bag in the US costs just $0.18, we can easily calculate and compare the costs of garbage disposal to both US and Swiss households.

• In Switzerland: 100 litres of garbage costs $6.40 to dispose of
• In the US: 100 litres of garbage costs a little over $0.11 to dispose of
• In other words, garbage removal costs Swiss households around 57 times as much per litre as it does Americans, when we consider the price of garbage bags alone.

Clearly, Swiss households are given a significant incentive NOT to create garbage. So what DO the Swiss do with lots of their waste? Recycle it, of course! See, here in Switzerland all recycling is free. The villages even offer free curb side pick-ups for all recyclable materials.

A simple system of incentives (and dis-incentives) is the secret to Switzerland’s environmental success. Other systems are in place to encourage citizens to use public transport, tread lightly while hiking in the outdoors, conserve energy and water at home, and behave in other environmentally friendly ways, but I’ll save my discussion of those items for another time, once I figure out how to reduce, re-use and recycle all my own “garbage” here in Zurich!

Discussion Questions:

1. How does Zurich’s system of garbage collection “internalize” the “externality” associated with household consumption?
2. Incentives matter. This is a basic economic concept that can be used to fix many of the environmental, social, economic and health problems faced in society. Identify one way your parents have used incentives to try to get you to do something or NOT do something they think you should or shouldn’t do.
3. Discourage what society want less of, encourage what society wants more of.  Identify and discuss one example of a market in which a government (local or national) uses incentives to discourage certain behaviors, and one example of a market in which incentives are used to encourage certain behaviors.

Related posts:

1. Reducing negative externalities – the European market for carbon emissions
2. An introduction to consumption externalities from a Singapore perceptive
3. Student post: A look at externalities in the labor market

Notice in the table above that the total tax paid by Americans at the top of each income bracket is NOT the simply the tax rate times income. Rather, the tax rate for each income bracket only applies to income earned above and beyond the upper boundary of the previous bracket. An American worker earning $8,000, for instance, will pay $800 in income tax. But if his income increases to $10,000 he will NOT pay 15% of the full $10,000, or $1,500. Rather, he will pay 15% on the income earned above $8,375. Such a worker would therefore pay 10% of his first $8,375 ($837.50) plus 15% on the additional $1,625 he earned, which is another $243.75. The marginal rate of taxation (MRT) is the change in tax (t) divided by the change in gross income (y_g). His total tax would therefore equal $1,081.25.

The marginal rate of taxation between the first and second income brackets above is found using the equation:

The average rate of taxation (ART) is equal to the tax paid (t) divided by the gross income (y_g):

The average rate for workers who fall in the second income bracket above can be found using the equation:

Marginal and average tax rates in the US

In other Western economies, progressive income taxes typically account for the largest proportion of total tax receipts by the government. America’s neighbor to the north, Canada, has an even higher top marginal tax rate than the US, and rather than applying to people earning above $370,000, as it does in the US, Canada’s top tax rate kicks in for workers earning just $100,000 per year. In Canada, personal income taxes account account for around 50% of total federal tax revenues, while the corporate tax and the national goods and services tax make up the next largest portions.

As mentioned, the highest marginal tax rates tend to exist in the social democratic nations of Northern and Western Europe. Denmark, a country with a Gini index of 29, has the highest tax rate on top income earners. More significant than the high rate, however, is the fact that it kicks in at such a low income level, around $50,000 per year. This means that a large number of Danish workers are paying a high marginal and average tax rate. The burden of the income tax in Denmark is born not by only the rich, but by the middle class as well. In contrast, Germany’s top marginal tax rate of 47% is only reached when a worker’s gross income exceeds $300,000 per year, meaning the income tax burden in Germany will be born more by the rich than those earning lower incomes, as is the case in the United States.

Marginal tax rates in OECD countrieshttp://www.oecd.org/document/60/0,3343,en_2649_34533_1942460_1_1_1_1,00.html#pir

Related posts:

1. Advice to Republican presidential nominee on taxes – “raise ‘em!”
2. Income inequality as a Market Failure
3. Understanding the difference between progressive and regressive taxes

YouTube - Chinas empty city – 10 Nov 09.

My buddy living in Shanghai posted this video to his Facebook profile today. It demonstrates how misaligned incentives in China lead local government officials to launch massive government infrastructure projects, all with the goal of meeting the growth targets handed down from Beijing.

Building roads to nowhere and cities that stand empty certainly creates jobs and new spending by the workers employed in their construction, so in that regard at least one goal of such projects is achieved. But whether or not all growth is good growth depends on whether efficiency in the economy is increase or decreased as a result of the growth strategies used.

Hundreds of billions of dollars worth of resources in China are currently being allocated by the government in Beijing towards massive public works projects such as this sparkling new city in remote Inner Mongolia. But it seems that government plans don’t always fall in line with the wishes of the nation’s people. A wise man once said, “build it… and they will come.” Apparently in China, that’s not always true.

I happen to have traveled in Inner Mongolia a few years ago with a group of students from my school in Shanghai. It was a sad thing in my opinion to witness the rampant development of the once pristine and culturally rich Inner Mongolian steppes. Ethnic Mongolians had been put on large reservations (not unlike the Native American people 150 years ago) and turned into tourist attractions. The cities were populated almost entirely with ethnic Han Chinese, there for the purpose of building more new cities, mining raw materials, and selling them to the rest of China’s industries.

Fiscal policy (the use of government spending and taxes to stimulate or reduce the overall level of demand in an economy) is a powerful tool for achieving the macroeconomic goals of full-employment, economic growth and price level stability. When used effectively, government spending can also improve efficiency in an economy by allocating society’s scarce resources towards socially and economically valuable projects. In China, it appears, the government’s incentives are aimed more towards pleasing the higher ups and continuing to inflate the speculative  bubble in real estate that has almost certainly formed, rather than pursuing socially desirable and allocatively efficient projects that actually help the Chinese people. Damn shame!

Discussion Questions:

1. What type of fiscal policy is the government in China pursuing? Expansionary or contractionary? What is the difference?
2. Why is government spending sometimes less efficient than private sector spending?
3. What would have been an alternative policy to allocating over $220 billion of public money into infrastructure projects that may have resulted in a more efficient allocation of China’s resources than projects such as the “empty city” in the video above?

Related posts:

1. Big trouble in little China – how slowing growth may mean major problems for the Chinese Communist Party
2. Does economic growth = economic development? Not for China’s rural poor…
3. Walking the fine line between good growth and bad growth in China

FT.com / Comment / Opinion – Magic and the myth of the rational market.

Imagine you’re a poor farmer who has always had just enough to feed your family, with no surplus left over to sell. Then one day the government decides to grant your family and your neighbors enough land to grow your own food and plenty more to sell on the market. The government’s intention, of course, is for you to cultivate all your land, sell your surplus, generate income for your family to improve your quality of life, send your children to school and save for the future.

You’re the farmer. You’ve just been given land. What would you do?

1. Plant crops on all your land, harvest the crops, sell the surplus and enjoy the profits from your surplus?

OR

2. Plant crops on only part of your land, grow enough food to feed your family, and let the rest of the land lie uncultivated. You have no surplus, nothing to sell, and continue to live the way you always have lived: poorly.

The science of economics assumes that individuals always act rationally in their own self-interest. Self-interest is the ultimate motive of economic actors: firms are profit-maximizers, individuals are utility-maximizers. The theory of rational behavior would lead one to assume that the farmer would pursue option 1 above. But in Papua New Guinea, where the government recently relocated thousands of displaced farmers to new plots of land, it is more common for farmers to chose option 2:

“If they see me planting too much cocoa, they’ll do things to my land and my family, and they won’t bear fruit; really bad things; puripuri and other witchcraft.”

Such an avoidance of profit maximisation might have appeared economically irrational. But from the perspective of those villagers, putting in extra work just to make oneself a target for the jealousy of one’s neighbours would be highly irrational behaviour.

Economists need to re-think their assumptions on rational behavior. What appears irrational to one person may be perfectly rational to someone else, as in the case of the Papuan farmers who only plant half their land. Humans, it seems, are a bit more complicated than the cold, calculating arithmeticians economists have long assumed them to be.

In the wake of the largest economic crisis since the great depression, the assumption of rational actors interacting in rational markets has come into question. A new field of economics blending the traditional study of resource allocation in the market place and human psychology has arisen to tackle the challenge of better understaning the seemingly irrational behaviors of investors, buyers and sellers in today’s global economy:

One response to the current crisis has been a rise in the popularity of behavioural economics, which examines the psychological and emotional factors behind transactions. These models drop the assumption of the rational actor yet implicitly keep the same model of economic rationality at their heart. We may diverge from the path of rationality for all sorts of psychological reasons but only because emotion, Keynes’s famous “animal spirits”, clouds our judgment.

To break human behavior down to the basic pursuit of profits by producers and utility by consumers neglects to acknowledge the “animal spirits” within us all. Economics is entering a new era, in which psychology and markets are intertwined. Rational behavior will remain a basic assumption of the science, but a re-defining of what it means to be rational will allow economists to better understand the behaviors of individuals, investors and firms as the economy emerges from a slump Alan Greenspan might say was ushered in on a wave of irrational exuberance.

Discussion Questions:

1. Are economists wrong to assume that individuals always act rationally? Why do the Papuan farmers only use half their land? Are they stupid or lazy?
2. Can you think of any examples in which you or someone you know has done something that was not in his best economic self interest?
3. Is charity irrational? What about gift giving? If you calculated that the chance of getting caught steeling something you REALLY wanted was 0%, wouldn’t it be irrational NOT to steal? What would keep you from stealing that thing if you deemed it rational to do so?

Related posts:

1. Rational ‘bee’havior
2. Rational behavior, opportunity cost, marginal analysis – An intro to the Economic way of thinking
3. SAS Economists Podcast #4: There can’t be too much of a good thing… can there?

Homo Economicus, the “Economic Man” is the concept underlying most economic theories. It holds that all humans are purely self-interested, rational actors who have the ability to make judgments that fulfill their subjectively defined ends. In modern economic theory, the end man seeks is generally accepted to be increasing monetary well-being and material wealth.

Philosophical foundations of “homo economicus“:

Aristotle (350 BC):

Again, how immeasurably greater is the pleasure, when a man feels a thing to be his own; for surely the love of self is a feeling implanted by nature and not given in vain, although selfishness is rightly censured; this, however, is not the mere love of self, but the love of self in excess, like the miser’s love of money; for all, or almost all, men love money and other such objects in a measure. And further, there is the greatest pleasure in doing a kindness or service to friends or guests or companions, which can only be rendered when a man has private property. These advantages are lost by excessive unification of the state.

• What does Aristotle think about the interference of government in the private property rights of man?
  

Adam Smith (1776):

In almost every other race of animals, each individual, when it is grown up to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer: and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher the brewer or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.

• How does Smith believe the pursuit of individual self-interest can lead to benefits for society as a whole?

John Stuart Mill (1836)

What is now commonly understood by the term “economics” is not the science of speculative politics, but a branch of that science. It does not treat of the whole of man’s nature as modified by the social state, nor of the whole conduct of man in society. It is concerned with him solely as a being who desires to possess wealth, and who is capable of judging of the comparative efficacy of means for obtaining that end. It predicts only such of the phenomena of the social state as take place in consequence of the pursuit of wealth. It makes entire abstraction of every other human passion or motive; except those which may be regarded as perpetually antagonizing principles to the desire of wealth, namely, aversion to labor, and desire of the present enjoyment of costly indulgences. These it takes, to a certain extent, into its calculations, because these do not merely, like our other desires, occasionally conflict with the pursuit of wealth, but accompany it always as a drag, or impediment, and are therefore inseparably mixed up in the consideration of it.

• According to Mill, labor is not something humans value for its own sake, but only because it allows us to do what?

Fredrick von Hayek (1930s):

We will benefit our fellow man most if we are guided solely by the striving for gain. For this purpose we have to return to an automatic system which brings this about, a self-directing automatic system which alone can restore liberty and prosperity.

• How would Hayek respond to those who argue that the government’s role in society and the economy is to promote fairness and equality?

Are you a “homo economicus“? - The Golden Balls Game

The prize: $1 million

How to play:

• Find an opponent from among your classmates.
• You and your opponent have never met before today, never spoken to one another, and will never see nor speak to one another again after the game ends.
• Since you do not know or care about your opponent, you must play this game with your own self-interest in mind, and assume that your opponent will play it with his or her self-interest in mind.
• You have in front of you two folded pieces of paper. One says “SPLIT” and one says “STEAL”
• You must decide which piece of paper to select, based on the following possible outcomes

The payoffs:

• If both players decide to “split”, each player will take home $500,000.
• If one player chooses to “split” and the other chooses to “steal” then the one who chooses to steel will take home $1 million, and the one who chose to split will get nothing
• If both players choose to “steel”, both players go home empty handed.

Let’s play!

• You only have one chance to play this game. Remember, you care only about yourself and should do what is best for you.
  
• On the teacher’s command, reveal your decision to your opponent.
  
• Take note of your payoff and report it to the teacher
  

Discussion:

• What was the outcome of your game?
  
• Was the outcome rational? Was it predictable?
  
• Did the outcome reflect the concept of “homo economicus“? Were you and your opponents’ decisions purely self-interested and coldly rational, intended to maximize your OWN payoff?
  
• Are you a homo economicus? What would homo economicus have done? Why?
  

Videos:

Golden Balls – the real gameshow: http://www.youtube.com/watch?v=p3Uos2fzIJ0&feature=player_embedded

Click here to view the embedded video.

• Which player was more like homo economicus? Sarah or Steve?
• Which player acts rationally? What makes it rational?
• Which player acts irrationally? What makes it irrational?

“The Trap”: Intro to game theory and rational self-interest in politics and economics: http://www.youtube.com/watch?v=qzNcY-gZdiA&feature=related

Click here to view the embedded video.

• John Nash’s Game Theory proved that “a system driven by selfishness did not have to lead to chaos”, that “there could always be a point of equilibrium in which everyone’s self-interest is perfectly balanced against each other”? How does such a theory support the concept of homo economicus?
• What is the Prisoner’s Dilemma? “The rational choice is always to betray the other person.” What does this say about humans in society? Is government regulation needed to prevent constant betrayal by greedy, self-interested individuals? Or are constant betrayal and self-interest themselves capable of achieving a socially optimal outcome?

Noam Chomsky on the inefficiency of markets and the threat posed by de-regulation: http://www.youtube.com/watch?v=QPl27BO7fHE&feature=related

Click here to view the embedded video.

• What is the “externality” of financial market failure that Chomsky identifies?
• Why is the failure of a financial market more worrisome than the failure of a market like that for used automobiles?
• How does Chomsky feel about the de-regulation of financial markets? Does he think markets are always rational and efficient?

Modern applications of the concept of Homo Economicus:

• Rational Expectations Theory (RET): This economic theory assumes that humans acting generally in their own self-interest will make rational decision based on the best available information. Therefore, it assumes that people (and therefore, markets, which are made up of rational people) do not make systematic errors when predicting the future.
• Efficient Markets Hypothesis (EMH): Rooted in Rational Expectations Theory, which itself is rooted in the concept of homo economicus, EMH says that prices in markets, particularly financial markets (whose collapse has caused the today’s global economic crisis) represent the best possible estimates of the risks attached to the ownership of various financial assets (stocks, shares, bonds, etc…) Asset bubbles are therefore impossible, since “bubble” implies an irrational and unsustainable increase in the value of an asset which will ultimately “burst”. Markets are “self-correcting”, and the most effective tool for assuring economic stability is free markets, rather than government regulation or oversight.
  

Connecting the dots – from Homo Economicus to today’s Economic downturn:

The general acceptance of theories rooted in the concept of homo economicus led to the de-regulation of financial markets, which allowed money and resources to go whichever way the “market” (rational or not) determined.

• During the last decade, the market decided that more and more money and resources should go towards particular assets, specifically the United States mortgage market (the market for new homes in the US).
• As money flooded the US home mortgage market, it became cheaper and easier for Americans to get loans to build a home. GREAT, RIGHT?! Well, only until it came time to pay back those loans.
• Trillions of dollars worldwide became tangled up in the US mortgage market, representing households’ savings from around the globe.
• When Americans suddenly found their loans coming due, they found it hard to repay them due to adjustable interest rates and falling home price (supply had grown more rapidly than demand).
• American and many Europeans began defaulting on their mortgages, meaning all that money that had been lent to home buyers literally disappeared.
• Banks and financial markets faced a “liquidity crisis”, meaning they had no money.
• Lending stopped to households, firms, and other banks , meaning spending on goods and services decreased, meaning jobs were lost and economies entered recession.
• How could any of this have happened if the concept homo economicus and the economic theories based on the concept are correct? Are humans always rational, calculating, perfectly informed, self-interested beings acting purely in their own self-interest?

Conclusion: The concept of homo economicus has formed the basis for economic theories for centuries and for major macroeconomic policies over the last 30 years. Policies of “market liberalization” (freeing the market from the guiding, regulatory hands of government) have led to great prosperity, but even greater risk and volatility as irrational exuberance over asset prices has led to inefficient market outcomes, bubbles, and financial shocks plunging the “real” economies of the world into recession.

Perhaps a more complete understanding of humans is needed as the human science of economics enters a new era. The human as a cold, rational, calculating creature interested in only his own gain is an over-simplification, and forming theories and policies on such an assumption is dangerous. The future of economics must incorporate a more complete and complex understanding of human behavior if the economic crises of the last two years are to be avoided down the road.

Related posts:

1. Understanding Oligopoly Behavior – a Game Theory overview
2. When is acting irrational the rational thing to do?
3. Rational behavior, opportunity cost, marginal analysis – An intro to the Economic way of thinking

This article was originally published on June 9, 2008

Asia Sentinel – Malaysia cuts fuel subsidy

One of the recurring themes of this blog is the conflict between good politics and good economics. Most of the time in government, smart economic policy is sacrificed in order to achieve political favor with voters. Whether it’s price ceilings on petrol in China, Zimbabwe’s slashing of food prices, harmful import restrictions to benefit domestic producers, or the proposed suspension of gas taxes in a time when fuel conservation is really what’s needed, politicians often act in economically stupid ways to bolster or hang on to their popularity.

So when a government makes a bold move that is economically sound, it sometimes comes as a surprise, as in the case of the Malaysian government this week. The government in Kuala Lumpur has for years subsidized domestic fuel prices, which at under 2 Malaysian Ringit per liter have been the equivelant of roughly $2.40 US per gallon, far below the average price in the west. Drivers benefited from this subsidy, but were not forced to bear any of the burden of rising oil prices, nor had they any incentive to conserve or switch to more fuel efficient automobiles or alternative forms of transportation. The Malaysian government, on the other hand, has had to allocate more and more of its limited budget towards subsidizing petrol prices.

Well, as of yesterday, all price supports for petrol are cancelled, and the effect will be sweeping in the Malaysian economy:

The government announced Wednesday evening that petrol prices would rise by 78 sen (US24¢) at midnight — a 41 percent jump from RM1.92 per liter to RM2.70. That means those spending RM2,000 per month to fill the tanks of their BMWs will now be paying RM2,820. Regardless of income levels, it is likely most Malaysians will feel the pinch.

The subsidy would have cost the Malaysian government 56 billion ringit (around $17 billion) this year. With the money it will now save by ending the subsidy, the government will begin making public transport cheaper and more convenient for commuters who wish to avoid paying for the more expensive petrol to fuel their personal automobiles:

The government hopes to channel the savings into improving public transportation, as it promised many years and elections ago but with little to show. In Kuala Lumpur, despite having a light rail train service and monorail, public transportation is expensive and inconvenient. Worse, intercity travel is still being serviced by old and slow trains, and accident-prone buses.

Malaysia is not the only country taking measures to end government fuel-price supports:

Indonesia has hiked fuel prices by an average of 29 percent, saving about 34.5 trillion rupiah and kicking off a series of street demonstrations… Similarly, after slashing subsidies, Taiwan will distribute US$659 million to middle and low-income families. The latest to raise oil prices is India, whose government announced Wednesday that gasoline and diesel prices will increase by 10 percent.

Related posts:

1. When markets work…
2. Beijing caves in to the indisputable power of the MARKET!
3. “Living” evidence of a determinant of demand at work in the deserts of Northern India

The $165 M in AIG bonuses that we have heard so much about this past week should have, in my opinion, been paid and then defended by Congress and the President!

As a former CFO, I can say with certainty that I have never paid an employee a bonus for poor performance. To underscore this point, I am 100% against any publicly-traded company ever making any bonus payment to an employee for poor performance regardless of the circumstances. The recently paid AIG bonuses are not an exception to my strong conviction. The true facts surrounding the $165 M in AIG bonus payments have not been made clear to the American public. Moreover, our cowardly American leadership (President, Treasury Secretary, Congress, AIG CEO) refuse to do what is right and defend the bonuses because, in my opinion, of their fear of public opinion.

The $165M in recently paid AIG bonuses, funded with a portion of approximately $170B in taxpayer “bailout” funding, are not PERFORMANCE bonuses being paid to the same AIG executives that got us into this financial mess in the first place. That is what most of America mistakenly believes. In fact, the senior executives, including the CEO, whose decisions caused the company’s collapse, are long gone. Moreover, the top 7 officials currently at AIG have agreed to forego all bonuses. The recent bonus payment outrage also excludes the next 43 highest ranking AIG leaders whose bonus payments are appropriately being linked to restructuring the company and paying back the taxpayers the $170B that has been already sent to bail them out.

So what exactly are these bonus payments for that all of America has gone mad over? The $165 Million in recent bonuses paid to AIG employees were RETENTION or STAY bonuses and not performance bonuses. AIG employees assigned to unravel the mess were offered retention bonuses to stay and work out the problems of AIG’s Financial Products division which has already been announced to be shut down. These retention bonuses were paid to incent remaining and new workers to stay until the billions of dollars of derivatives, still at risk, were unwound. Using basic common sense, which is why retention bonuses have been paid for decades, no reasonable, talented worker would agree to work in a discontinued division receiving hate mail and death threats without receiving a retention bonus. A retention bonus helps keeps top employees working on problems of a division being shut down rather than them resigning and moving on to another company.

As Congress tries to recover these just recently paid bonuses, either through the AIG employees paying them back or having them be taxed close to 100%, the tax payer is already losing as these employees working out the problems that they did not create are already starting to resign. Yes, America and the taxpayer will not save $165 M but rather lose far more than we save as those working the issues are resigning.

So, why didn’t the new AIG CEO, Edward Liddy, defend the $165 M in retention bonuses in front of Congress this past week and explain to Congress that these were not performance bonuses paid to the people that got us into this mess? Why didn’t Tim Gheitner, U.S. Treasury Secretary, defend his decision to allow the retention bonus payments as outlined in the recently passed stimulus bill? Why didn’t Ben Bernanke, Chairman of the FED, defend the retention bonuses that were know by him since last summer? And of course, where was our Harvard-schooled president when we needed his articulation skills the most as he could have clearly explained and defended these payments so we would not have to rehire new employees for all of the AIG employees who are now turning in their resignations for having to repay their contractual retention bonuses?

In summary, our U.S. government has increased the exposure to the American taxpayers by not supporting the AIG retention bonuses being paid to the workers that did not create the problem and who are assigned to fix up the mess. This is cowardly leadership, in my opinion. It is an easy path to for our leaders to keep the AIG bonus discussion at a very surface level and say “bonuses shouldn’t be paid to business leaders that fail”. Well, of course, everyone agrees with that! But that is not what is being paid at AIG.

Related posts:

1. McJobs in America – under threat!
2. America: Land of the free, home of “jackass” economists
3. Private Market Compensation: AIG CEO vs. Kobe Bryant

Inside Obama’s Green Budget – Forbes.com

Some say that Global Warming may be the greatest market failure of all. This podcast was originally broadcast in January of 2007 while George Bush was still in office. The commentator claims that global warming is “nothing but one giant market failure”, arguing that the United States therefore must get serious about tackling the problem.

The allocation of resources towards carbon emitting industries has almost undoubtedly contributed to the warming of the planet over the last half century. Only recently have governments begun taking active measures to reduce the impact of industry on the environment through greater regulation of polluting industries, employing corrective taxes in some instances and market-based approaches to pollution reduction in others.

US President Barack Obama, unlike his predecessor, appears to be serious about correcting the “market failure” represented by global warming:

Obama’s budget, announced Thursday, looks to fund a host of new energy programs, from carbon sequestration to electric transmission upgrades. It would also provide the EPA with a $10.5 billion budget for 2010, a 34% increase over the likely 2009 budget. Nineteen million dollars of that would be used to upgrade greenhouse gas reporting measures.

The Interior Department would get $12 billion for 2010. The agency would use part of the money to asses the availability of alternative energy resources throughout the country.

Funding comes from elaborate carbon “cap and trade” program, which puts a price on emitting pollution and is the core of Obama’s plans. Starting in 2012, the government would sell permits giving businesses the right to emit pollution, generating $646 billion in revenue through 2019.

During those years, the number of available permits would gradually decline, forcing businesses to buy the increasingly scarce, and costly, rights to pollute on an open market. Obama hopes that the rising cost of permits will encourage businesses to invest in clean technologies as a cheaper alternative to meeting pollution mandates, helping to cut greenhouse gas production to 14% below 2005 levels by 2020.

Below is a diagram that illustrates precisely how the Obama cap and trade plan is meant to work. Notice that between 2012 and 2020 the cost to firms of emitting pollution will increase dramatically, while at the same time the total amount of carbon emissions in the US economy will fall due to regular reductions in the number of permits issued to industry.

The Obama cap and trade scheme is not the first experiment with such a market based approach to externality reduction:

Europe established such a market in 2005. But some E.U. governments allocated too many credits at the outset, causing the value of some permits to fall by half and making it relatively easy for large polluters to simply buy credits rather than cut emissions. Overall emissions grew in 2005 and 2006. In 2008, E.U. emissions dropped 3%; 40% of that drop was attributed to the carbon trading scheme.

Europe’s cap and trade program took a few years before it began having any noticeable impact on the emission of carbon by European industry. While unpopular among the firms who are forced to pay to pollute, the fall in emissions in Europe shows that a market for carbon may be effective in forcing firms “internalize” the costs of carbon emissions, which until now have been born by society and the environment in the form of the negative effects of global warming.

Discussion Questions:

1. Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?
2. Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?
3. Is making firms pay to pollute a good idea in the middle of a recession? Do you think that we should even be worrying about the environment when millions of people are losing their jobs and entire industries are struggling to survive?

Related posts:

1. Reducing negative externalities – the European market for carbon emissions
2. Robert Reich on Obama’s “cap and trade” plan for the environment
3. Market Failure and the role of government in the economy ~ an introduction to Environmental Economics

FT.com | The Economists’ Forum | Will Americans demand the cars that Congress wants the big three to build?

It’s been driving me nuts, this whole bailout debate. My frustrations are definitely appartent to my students, who have had to put up with my occasional rants about the insanity of the whole affair since the issue came to the media forefront over a month ago. Here are some of the issues that just don’t add up from the perspective of a high school economics teacher:

The three companies asking for a bridge-loan supposedly want the money so that hundreds of thousands (some reports say as many as 2.6 million) jobs can be saved. But how could Ford, Chrystler and GM possibly maintain their labor force in a time of a recession when nobody is buying new cars in the first place? In the parlance of AP or IB Economics, automobiles are normal goods, ones for which demand falls as incomes fall. By definition, a recession in the United States means falling incomes. A government loan may allow the Big Three to keep making cars for the time being, but WHY WOULD THEY KEEP MAKING CARS when falling incomes point to falling demand in the immediate future? Making cars that nobody will buy represents a gross misallocation of the nation’s productive resources, not to mention taxpayers’ money. What is required of these industries is precisely what the government loan will prevent them from doing, DOWNSIZING, meaning the shrinking of their labor force as well as the number of plants in operation.

The US recession can not be avoided by allocating the nation’s scarce resources towards a bailout of the auto industry. In fact, it will be worsened because the capacity of any nation to emerge from a cyclical downturn requires the flexibility of the country’s labor force to adapt to the structural changes the country is experiencing in the era of globalization and free trade. America’s future does not reside in labor-intensive manufactured goods, especially in the production of a very expensive durable good for which demand falls drastically during recessions; specifically, automobiles.

The Finanacial Times Economists Forum approaches the issue of long-term falling demand for automobiles from another perspective. One of the conditions of the Big Three accepting a loan from the federal government is the mandate that Detroit will begin producing more fuel efficient automobiles to assure Americans more affordable, more environmentally friendly alternatives to the gas-guzzling SUVs that have dominated the industry for the last two decades. But here’s the problem, gasoline has fallen to a price as low as it was when SUVs were at their peak popularity back in the early 2000s! As any high school economics student knows, gasoline and SUVs are what we call complementary goods, or two goods for which demand and price are inversely related. As gas prices fall to their 2000 levels, demand for SUVs promises to rise once again, while demand for fuel-efficient automobiles will likely decline, creating market pressures for the Big Three to make not more fuel-efficient cars, but more SUVs instead! From the Financial Times:

The basic problem is that Americans like to drive sport-utility vehicles, minivans and small trucks when gasoline costs $1.50 a gallon…

Consumers may have regretted their behaviour when gasoline prices soared above $4 a gallon, but as gas prices descend, there is no reason to believe that left unchecked they will not return to their gas-guzzling ways.

Indeed, there is a distinct possibility that if they really do increase their small car production, in a few years the big three will be back asking for more help, on the grounds that they are losing money by doing exactly what Congress asked.

The only reasonable solution to this dilemma? If Congress DOES begin mandating that Detroit increase its production of fuel-efficient cars and phase out its manufacture of SUVs, any such requirement should be accompanied by a government-set price floor on gasoline. Several months ago, my colleague and fellow blogger Steve Latter blogged about a proposed price floor of $4 per gallon on gasoline. Such a scheme would likely prove nearly impossible to initiate politcally, but may be exactly what’s necessary to add legitimacy to any government requiremens of Detroit to manufacture fuel efficient automobiles. The FT appears to support such a scheme:

Congress should put their mouths where their money is. They should make binding commitments to ensure higher US oil prices and thereby sufficient demand for fuel-efficient cars and trucks in the future.

Discussion Questions:

1. What message does falling demand in the auto market send from buyers to sellers, and what contradictory message does a subsidy from the government send to auto makers?
2. If the auto makers receive a low-interest bridge loan (subsidy) from the government, how will this actually undermine the efficient functioning of markets in America?
3. Why would a price floor on gasoline be needed to accompany a government requirement that the Big Three make more fuel efficient automobiles after receiving a government loan?

Related posts:

1. Eight basic economic arguments against a bailout of the auto industry
2. Letting markets work: the Malaysia fuel subsidy goes bye bye
3. Is bicycle transportation an “inferior good”?

This week the CEOs of the “Big Three” US auto makers boarded their private jets in Detroit and touched down in Washington to beg and plead in front of Congress for a “low-interest bridge loan” from the US government to help them avoid bankruptcy. They are asking Congress for $25 billion of taxpayer money to give them the chance to re-structure and re-equip themselves for the future.

Click here to view the embedded video.

Below are eight arguments based on basic economic principles for why a bailout of the United States automobile industry is a bad idea and is bound to fail:

1. Incentives matter: A bailout of the US auto industry ignores the basic economic principle that incentives matter. Individuals and firms respond to incentives, pursuing behavior that is likely to bring them the greatest rewards. In the face of falling demand for their product and ever-increasing competition from more efficient foreign producers, providing a $25 billion bailout creates a disincentive to drastically reduce costs and increase competitiveness, and an incentive to continue using tired old techniques and providing the same old models for which demand has declined among Americans for over a decade.
2. Comparative advantage: The basic economic principle of comparative advantage states that in an era of free trade and globalization, countries should produce the types of goods for which they have the lowest opportunity cost. Since the average American car of a particular class costs the Big Three $2000 more in wages and benefits for workers than its Japanese counterpart, it makes sense that Japan (and other lower-cost countries) produce more cars, and the Big Three produce less.
3. Efficient allocation of resources: The United Auto Workers Union has a member ship of over 400,000 workers. Since the 1970s the union has lost over 1 million workers. Clearly the US auto industry has been in decline for decades, a fact that should be taken as a sign: resources employed in America’s car industry are inefficient and represent a over-allocation of resources. A drastic down-sizing of the auto industry, while resulting in short-run hardships for the hundreds of thousands whose jobs will be lost, will in the long run strengthen the US economy as labor and other resources will be freed up to be employed in sectors in which the US has comparative advantage.
4. Economic Darwinism or “the survival of the most efficient”: America has stood for free trade in the world since helping found GATT in 1948 and later the WTO. The gains from embracing free trade are shared among all stakeholders in the economy. Consumers enjoy lower prices (thus higher real income), firms enjoy access to cheaper inputs and larger markets for their products, and governments enjoy the increased tax revenues from rising incomes driven by export-led economic growth. To bail out an uncompetitive, inefficient, and long-declining industry is to spit in the eye of free trade and denies America any moral suasion it may hold in the future over potential trading nations in our attempt to open their markets to our nation’s products. To protect our own dying industry now will send a clear message to our trading partners. “America does NOT stand for free trade”. If we believe in free trade and the allocative power of markets, then we must let the dinosaurs of American industry meet the fate the natural selection of the marketplace has determined for it.
5. The benefits enjoyed by the few represent costs born by the many: A bailout by the US government of the auto industry will protect a few hundred thousand jobs for a few years at the most but spells a reduction in the disposable incomes and spending power of millions for years to come. The US does not have $25 billion laying around to give the Big Three, which means the money must be borrowed. Increased government borrowing raises interest rates now (further tightening the credit markets) and will result in increased taxes down the road. All government debt must eventually be paid off, and in the immediate future interest on this debt must be paid directly from tax revenue. A $25 billion bailout is the same as a subsidy, meaning it redistributes income and welfare from consumers to producers. Millions are asked to sacrifice for the continued survival of a few hundred thousand in an industry that has failed to evolve in a global auto market that has seen increased competition and efficiency from foreign firms for decades.
6. Moral hazard: Bailing out the Big Three today represent a classic case of moral hazard. When American industries fail to take steps to increase their efficiency and remain competitive in the face of increased global competition, they find themselves not surprisingly on the brink of collapse. To reward these firms by taking money out of Americans’ pockets and handing it to them to do as they will, we send the wrong message and create the wrong incentives in the American economy. The message is: “Don’t worry, the market doesn’t choose the winners and losers in the economy, the government does, and certain industries are too big to fail”.
7. Market failure, or Firm Failure?: The fate of the auto industry is in the hands of the US government. But so is the fate of the free market. My fear now is that the pendulum will swing too far to the left in America’s state of panic over the ill-fated downfall of the financial markets, rooted in the irrational exuberance and over-leveraging of big financial institutions. The failure of the financial markets, however, is an entirely different story from that of a dinosaur industry like automobiles. The Big Three have had decades to reform themselves, lower their costs, improve their products, and remain competitive. THEY have failed, NOT the market. Government intervention is necessary in instances of market failure, but NOT IN CASES OF FIRMS’ FAILURE TO COMPETE IN A WELL FUNCTIONING MARKET like the global auto industry.
8. Inflexible labor markets: I saw the president of the UAW on the news today giving 101 reasons why the government should approve a bailout deal for the Big Three. In fact, the unions that supposedly represent American Auto Workers are a big part of the problem the industry is facing. For decades the UAW has fought against wage and benefit cuts for auto workers, lobbying instead for higher tariffs and other barriers aimed at keeping foreign cars out of the country. This anti-competitive behavior is a major reason the Big Three cannot compete with European and Asian car makers today. Wage inflexibility leads to higher unemployment. Unions keep wages from going down, leaving the Big Three with one of two choices: Drastically downsize your workforce and employ fewer high paid auto workers, or beg the government for a multi-billion dollar subsidy to that the unions can be placated and you can survive for a couple more years until you’re in the same situation all over again. The unions helped cause the problem, now they should pay the price by experiencing the downsizing their demands inevitably foretold.

The US government should allow the free market to function and let the dinosaurs go extinct. Cars will still be made in America, they’ll just be made by the better, more efficient firms that emerge from bankruptcy when this is all over, as well as the numerous foreign firms already making cars in the US. Survival of the most efficient, that’s what markets are all about. Allowing the market to work will strengthen the US auto industry far more than a “short-term low-interest bridge loan” ever will, it will free up labor and capital resources to be employed by industries the country is better at, and make sure household income is NOT reallocated to inefficient firms to be squandered on the manufacture of a product for which demand has steadily declined for the last decade plus.

Related posts:

1. The questions no one seems to be asking about the auto industry bailout!
2. American auto makers insult the intelligence of high school Econ students!
3. A call FOR protectionism!