Sunday, 31 August 2014

Newsflash! Flying is more expensive than driving

The NZ Herald ran a story on Friday, comparing the cost of flying with the cost of driving from main cities to regional centres:
Massey University student Lauren Cornish is one of many who opt to drive because of what they see as unaffordable airfares.
The veterinary science student has been studying in Palmerston North city for six years but returns home to Auckland regularly.
In that time she has taken no more than five flights - instead opting for a seven-hour drive home more than 20 times.
"It is never economically viable to fly, ever," she said. "If I get Grabaseat deals, they can be okay, but they are obviously very inflexible and it is still around $120." Instead she pays $90 in petrol to drive one way.
Colour me unsurprised. The cost of travelling from Palmerston North to Auckland by plane has a higher monetary cost, sure, but you would save a hell of a lot of time by flying rather than driving. Unfortunately, the Herald's calculations undo their good work in setting up the problem with their example of the student from Palmerston North, because according to the table it is cheaper to fly than to drive from Palmerston North to Auckland:

Anyway, let's put that mis-step aside for the moment because there is a broader issue of rational choice at play. Flying and driving are substitutes, but the monetary cost is only part of the full cost of flying and driving, and the time saving needs to be accounted for as well.

To illustrate, let's take a different example - the Auckland to Taupo route. According to the table, you're saving around five hours by travelling by plane rather than car from Auckland to Taupo. Having driven that route many times, I can honestly say that's more than a bit over-conservative (I've never flown it though). Also, you need to factor in the time spent travelling to the airport, checking in, waiting for your bag (if you had checked luggage) on arrival, and travelling again to your final destination. So let's say the time saving is around two and a half hours. The monetary cost difference between driving and flying is around $213 according to the table. So, you are paying around $85 per hour of travel time saved. Rational travellers who value their time at more than $85 per hour would be better off to choose flying, and those who value their time at less than $85 per hour would be better off to choose driving. The traveller's choice involves evaluating a simple trade-off between time and money [*].

Since people place different intrinsic values on their time, we needn't worry about forcing Air New Zealand to charge lower fares in order to accommodate those people with a lower value on their time. We can tell a similar story about buses too, where the monetary cost is even lower but the time loss is greater. Is it fair though?

That depends on your conception of fairness. Air New Zealand must price according to demand and their operating costs. If demand for a certain route is higher, you can expect higher prices. However, we also need to bear in mind that Air New Zealand has no effective competitors on the flight route between the main cities and regional centres. Air New Zealand has a monopoly on those routes and can charge the price that will maximise profits, rather than the (lower) price that will maximise societal welfare. This leads to a deadweight loss - a loss of societal welfare compared with the welfare maximising point.

In such cases, the government could intervene to increase welfare, through imposing controls on the price. This re-distributes societal welfare from the firm (and by extension from the shareholders, which includes the taxpayer) to air travellers, in the process reducing the size of the deadweight loss. This is even simpler to do if the government controls the monopoly since in a simplistic sense the government can simply choose a lower price to charge. In the case of Air New Zealand, the government has a controlling stake and some maybe they are going to use that influence:
The Commerce Commission was evaluating a complaint on the issue and Prime Minister John Key said he had "made it clear" to chief executive Christopher Luxon the airline needed to cut prices to the regions.
That isn't the end of the story on fairness though. If Air New Zealand's regional flights are operating near capacity seating, lowering the airfares won't necessarily increase welfare. Lower airfares increase the quantity of seats demanded (it decreases the differential monetary cost between flying and driving and will induce at least some travellers to switch to flying instead of driving). However, if the number of seats is limited this will simply create excess demand for seats at the new lower price, and some of those who place a higher value on flying (rather than driving) may miss out on a seat to others who value flying less. Now, I have no idea of the average loading on Air New Zealand's regional flights, but those I have been on don't seem to have lots of spare seats. More flights could be put on to accommodate the extra demand, but that requires additional planes, pilots, and so on. So it seems that excess demand is a strong possibility if prices on regional routes were reduced substantially. Moreover forcing people who would rather fly to drive instead, even though they are willing to pay more than the current ticket price, hardly seems to be more fair than the current situation.

Update: Thomas Lumley on StatsChat looks at similar data for the U.S. Pacific Northwest, though "the impact of competition is clearer".


* OK, it's not totally a simple trade-off between time and money. There are other considerations, like aversion to flying, fatigue from long driving trips, etc. There are other bonuses to flying as well - I get an amazing amount of work done when trapped in transit lounges, waiting for flights, or on board aircraft, etc. I even once joked that the University would increase my research productivity by simply sending me on endless flights around the world.

Sunday, 24 August 2014

Why your anti-drug policies just might annoy your neighbours

A few weeks ago, Michael Clemens on the CGD Views from the Center blog alerted me to this recent CGD Working Paper by Juan Camilo Castillo and Daniel Meija (both of Universidad de los Andes) and Pascual Restrepo of MIT. In the paper, the authors attempt to evaluate the effect of cocaine scarcity on violence in Mexico. The authors begin with the Hobbesian argument that in situations where there is a lack of third party enforcement (of contracts, property rights, etc.) through the rule of law, then individuals (or groups) would have to use their own means of protecting their interests, such as through violence. This seems likely for illegal drugs, as the government isn't going to enforce contracts or protect property rights with regards to the actions of cartels. The authors argue that:
Our basic intuition is that scarcity increases violence if the demand for certain goods whose market is illegal is inelastic. In this case, a decrease in supply causes a larger increase in prices, therefore increasing total revenues and the stakes. This leads to more predation and violence.
Now, it's not a simple matter to evaluate the link between drug supply shortages and violence in a single country as there are two mechanisms at work simultaneously. The authors note above one mechanism that links the ongoing 'war on drugs' to violence in Mexico: an increase in attacks on cartels reduces the supply of drugs, raising prices, and increasing the returns to having control over market supply, which can be gained through violence. The second mechanism is more direct - if you fight a 'war on drugs' against the cartels, they fight back, which increases the levels of violence. They may also fight each other, especially if you are moderately successful in reducing the power of one of the rival cartels. So, in order to disentangle the two effects the authors instead look at the effects of anti-narcotic policy in Colombia (the main drug supplier to the Mexican cartels) on the degree of violence in Mexico. I like the authors' approach here, mainly because it doesn't rely on instrumental variables to isolate the effect of the supply shocks.

The authors argument relies on demand for cocaine in the U.S. market being inelastic - thus when prices rise, the quantity demanded decreases but by a smaller percentage than the increase in price, such that total revenue increases (if instead demand were elastic, the decrease in supply would still raise prices, but would reduce total revenue). This argument assumes that suppliers make their decisions about effort (including violence) based on revenues, rather than profits - quite a strong assumption, given that we would usually expect firms (including Mexican drug traffickers) to make decisions based on profits, not revenues. However, once the drugs have crossed the border from Colombia into Mexico, and been paid for by the Mexican cartels (no self-respecting Colombian drug lord is going to extend credit to the Mexican cartels), the cost of their purchase becomes a sunk cost - there is no way for the cartel to recover the amount they paid for the drugs if they are captured by a rival (or by Mexican authorities), and thus the cost of the drugs is not relevant to the decision about how much violence is optimal to pursue in order to translate the drugs into cartel profits. Thus, the decision about the optimal level of violence is likely to be based on drug revenues and the costs of violence, rather than the profits (revenues minus the cost of the drugs). Of course, this assumes that the cartels aren't subject to the sunk-cost fallacy.

If the Mexican traffickers instead made their decisions based on profits rather than revenues, then we would have to recognise that profits must fall for the Mexican traffickers. The cost of obtaining cocaine from Colombia has increased (analogous to a decrease in supply), so even though prices have gone up, producer surplus must have decreased. This happens irrespective of whether demand for cocaine in the U.S. is elastic or inelastic. So, why would violence increase if profits are falling? In this case you could argue that the traffickers would still have to meet their fixed costs (paying your network of large-scale logistics, drug mules, not to mention armed guards, etc. doesn't come cheap). If the cartels were rational, they might downscale their operations, but we know that decision-makers are subject to the sunk-cost fallacy and are willing to increase investment in order to avoid a loss. Cartels are unlikely to be any more rational that anyone else, so they increase their level of violence as they try to capture a bigger share of the cocaine trafficking market into the U.S.

The difference between increased revenue driving increased drug violence, and decreased profits driving increased violence isn't just a minor quibble. The policy implications of the two possibilities are the exact opposite of each other. If you believed that increased revenue was to blame, then in order to reduce violence you find some way of reducing drug revenues, but that would actually increase violence if it turns out that decreased profits were to blame.

Anyway, regardless of how you argue that the decrease in Colombian supply would affect the incentives for Mexican cartels to engage in violence and the appropriate policy remedies to that violence, the authors find that:
...violence increases in Mexico during months with supply shortages caused by seizures in Colombia. Moreover, violence increases especially in the north, and within the north specifically in places close to entry points to the U.S., as predicted by our model. Violence also increases more in northern municipalities that have historically voted for PAN, President Felipe Calderon's party, in which local authorities are more likely to support federal government efforts against cartels in their area, thus increasing the turnover of cartel leaders. Finally, violence increases more in places with cartel presence, especially in places with two cartels or with two rival cartels operating at the time of the supply shock...
Our estimates suggest that, for the period 2006-2010, scarcity created by more efficient cocaine interdiction policies in Colombia may account for 21.2% and 46% of the increase in homicides and drug related homicides, respectively, experienced in the north of the country. Thus, at least in the short run, scarcity created by Colombian supply reduction efforts has had negative spillovers in the form of more violence in Mexico during its so-called War on Drugs.
So, Colombia's anti-drug efforts may be responsible for over 20 percent of homicides in northern Mexico over 2006-2010. Of the 28,000 homicides to occur in the 5 percent most northern municipalities over those five years, Colombia's anti-drug efforts may be responsible for nearly 6,000 of them. Now that's a bad neighbour policy - Colombia's anti-drug efforts have created a pretty large externality for Mexico.

Friday, 22 August 2014

Try this: Who to vote for this (NZ) election?

Last week and the week before, my ECON110 class was looking at the economics of government, including topics like government intervention in markets, public goods, tax policy, and the theory of public choice. One of the extra credit tasks I get my students to complete is to answer the Political Compass test. The Political Compass is pretty interesting because it ranks us on two scales: Economic Left-Right, and Authoritarian-Libertarian (see here for more). I also like it because at the end it shows how you compare with famous world leaders.

The downside of Political Compass is that it is quite U.S.-centric in how it defines Economic Left-Right. This year, my entire ECON110 class was on the left of centre according to the test, which is a bit implausible (and drew some surprised comments from some of them who considered themselves to be on the right). In 2011 they had a page that showed where the main political parties in New Zealand fit, but I can't see something similar this time, and based on my experience all of those dots should be shifted significantly to the left of where they are on that chart.

This election cycle, there are two other tools that were brought to my attention by some of my alert students:

VoteCompass works like a political poll, and collects a lot of demographic information which is going to be used by some academics at Vox Pop Labs no doubt for some research project. However, it gives output on where you stand very similar to the Political Compass: Economic Left-Right, and Social Conservative-Social Progressive. My results were very consistent between VoteCompass and the Political Compass.

On the Fence is a bit more populist and fun, and asks where you stand on a bunch of issues before telling you which party your views are most similar to (VoteCompass does this too, but explicitly says it is not providing voting advice). I found that the party they aligned my preferences to was a bit implausible.

Try them both out, especially if you aren't sure who to vote for this election and you're already over the whole 'Dirty Politics' saga.

[HT: Zane and Debra from my ECON110 class]

Thursday, 7 August 2014

The Economics of Drug Development and Pricing

The week before last I spent a few days at the XXth International AIDS Conference in Melbourne. I couldn't be there for the whole conference because of my teaching commitments, which was a little disappointing because I appeared to miss a lot of the action. By action, I mean the inevitable protests that are a frequent sideline to these conferences.

However, I was at this session on "The Future of HIV and HCV Treatment - Patents, Pricing and Pharma" which was subject to a protest against the pharmaceutical company Gilead (see footage of the end of the protest here). The protesters were angry about the drug pricing for a new treatment for Hepatitis C, which costs around US$84,000 for a 12-week course of treatment in the U.S. You can see more about the pricing strategies of Gilead in this presentation from the same session. Gilead has negotiated a much lower price for the treatment in Egypt - US$900. However, in both cases (U.S. at $84,000 and Egypt at $900) the treatment is severely unaffordable for the majority of people with Hepatitis C. The protesters argue that this pricing strategy is costing lives.

What is Gilead doing? How can they justify such a wide variation in prices between the U.S. and Egypt? There are two key points here that relate to the economics of drug development and pricing.

First, drug development is very expensive (US$1.8 billion according to this source). Why so much? There are a lot of regulatory hurdles for drugs to overcome before they can be certified as safe and made available for patients, on top of the costs of research and development of the drugs themselves. Pharmaceutical companies have to be sure that they can recover the cost of development - otherwise it would make no sense for them to begin the drug development process. In fact, it's been argued that's the reason why there has been little in the way of development of new antibiotics in recent years - there's more money for pharmaceutical companies in researching drugs for orphan diseases than in developing new antibiotics. And this in spite of the impending doom of a "post-antibiotic era, in which common infections and minor injuries, which have been treatable for decades, can once again kill".

Once a new drug is developed, there is little in the way of ongoing costs and the marginal costs of producing the drug are fairly low. This means that pharmaceutical products are a form of natural monopoly - there are economies of scale, because the more that the company produces, the lower their average costs of production because the development costs can be spread over a greater quantity of production. Their natural monopoly is protected by the patents they are granted for the drugs. The protesters are effectively arguing that the pharmaceutical companies should be pricing at average cost, or even at marginal cost (or at least closer to those costs). In either case, this makes it much harder for the company to recoup their investment in development costs, much less any return on capital invested in the development process (see here for more on the problems of natural monopolies). So, the protesters are missing the point - if the pharmaceutical firms are forced to price their drugs low, they won't develop them in the first place.

The second point relates to the "variable pricing" scheme that the pharmaceutical companies use, where they price the drugs at low prices in developing countries and at much higher prices in developed countries. On the surface, this seems pretty unfair, but it is a straightforward application of price discrimination - where different consumers (or groups of consumers) are charged different prices for the same good or service, and where the difference in price does not arise because of a difference in cost (and which I've previously written on here). In price discrimination, the firm charges a higher price to groups of consumers that are willing to pay more for the good or service. For price discrimination to be effective, there must be different groups with different willingness-to-pay for the good or service, the firm must be able to determine which consumers belong to which group, and there must be no transfers between the sub-markets. It seems to me that patients (or health ministries, or health insurers) in developed countries are willing to pay more than those in developing countries, it's easy for the pharmaceutical company to tell the groups apart, and provided the firm negotiates a tight contract with developing country governments specifying no on-selling there will be little in the way of transfers between the sub-markets. So price discrimination is not only feasible, but likely, in this situation and should come as no surprise to us.

Drug development has also been in the news and blogosphere lately because of the Ebola outbreak in West Africa (see here and here and here). Two U.S. doctors received an untested (in humans) treatment, which is unlikely to be made widely available to public health authorities. Why? It hasn't gone through clinical trials yet, and as this news story notes:
Developing, trialling and licensing vaccines or treatments would cost significant amounts of money, and drugs companies argue there is not enough demand to justify the outlay.
“These outbreaks affect the poorest communities on the planet. Although they do create incredible upheaval, they are relatively rare events,” said Daniel Bausch, a medical researcher in the US who works on Ebola and other infectious diseases.
“So if you look at the interest of pharmaceutical companies, there is not huge enthusiasm to take an Ebola drug through phase one, two, and three of a trial and make an Ebola vaccine that maybe a few tens of thousands or hundreds of thousands of people will use.”
So, it seems unlikely that there will be a widely-available treatment or vaccine for Ebola in the near-term (see also here), because the costs of development outweigh the benefits of producing it for pharmaceutical firms. Of course, that ignores the substantial social benefits associated with saving lives (unless you are willing to argue that those benefits are captured in the willingness-to-pay for the treatment).

How do we get pharmaceutical companies to develop treatments, vaccines, or cures for diseases that mostly affect the developing world? It's stupid to wait until drugs are developed, and then protest and demand that pharmaceutical companies lower their prices - that reduces the incentives to develop the drugs in the first place.

A better option was laid out several years ago by Nobel Prize winner Joseph Stiglitz. Stiglitz argues convincingly that an alternative to the current intellectual property (patent) based regime is to offer prizes for firms that develop medicines, cures or vaccines for diseases that affect the poorest countries. Stiglitz says:
A solution to both high prices and misdirected research is to replace the current model with a government-supported prize fund. With a prize system, innovators are rewarded for new knowledge, but they do not retain a monopoly on its use. That way, the power of competitive markets can ensure that, once a drug is developed, it is made available at the lowest possible price - not at an inflated monopoly price.
The trade-off for firms collecting the prize money (which would be contributed to mainly by developed country governments), is that their drug would have to be made available in the public domain (i.e. not patented). Then, generic drug manufacturers would be able to produce the drugs at low cost to provide to poor countries and rich countries alike. One promising example of this approach is the Health Impact Fund. Advance market commitments are a similar idea.

So, perhaps the protesters' efforts are misguided - instead of banging on the doors of pharmaceutical firms, they should be joining with them to bang on the doors of government and potential donors, to generate funds for new drug development that would avoid the patent and monopoly pricing problems for all.

Tuesday, 5 August 2014

The Economics of the LEGO Movie

For the last couple of weeks in ECON110 we've been talking about the benefits of markets, and this week and next we are looking at the economics of government. Part of the latter includes looking at different economic systems, the economic functions of government, and what might be the optimal level of government involvement or intervention. Which made this video on the economics of the LEGO movie amazingly timely:

I don't necessarily agree with all aspects of what Andrew Heaton is arguing, which is pretty libertarian. After all, the market left to its own lightly-regulated devices led us into the Global Financial Crisis, for instance (see here or here, but the point about inadequate regulation and the GFC remains somewhat contested). So you could argue there is still a role for government even in markets that should in theory be able to operate independently.

I have to say though, that the video does a fantastic job of characterising the differences between the market economic system (or rather the mixed economic system) that is endemic across most of the western world, and the centrally-planned (command) economy as seen in the former Communist countries and pre-reform China (not so much nowadays, with economic reform even occurring in Cuba).

Actually the whole series of EconPop videos by EconStories is to be recommended. They are all pretty great. One warning though: if you watch the LEGO Movie, be prepared to have the theme tune (Everything is awesome) stuck in your head for days afterwards!

[HT: Eric Crampton at Offsetting Behaviour]