Return migrants are willing to accept lower wages in exchange for better institutional quality

Last year, I wrote a post about how return migrants to Vietnam prefer areas with higher-quality institutions. The post was based on the research of one of my PhD students, Ngoc Tran, myself, and Jacques Poot. Ngoc recently submitted her PhD thesis for examination, which is a great achievement. Along the way, she completed four research papers (see here, here, here, and here), and also has a forthcoming book chapter. In this post though, I want to focus on the fourth research paper, as it is the most novel.

In the paper, co-authored between Ngoc Tran, Jacques Poot and I, we looked at the intensity of migrants' preferences to high-quality institutions back in their home country. In other words, we asked how much things like absence of corruption, political stability, and the rule of law, mattered for migrants' decision-making about potentially returning home. To measure the intensity of preferences, we used a novel application of the contingent valuation method.

To do this, we first recognised that there are compensating differentials for working in different locations - in areas with higher-quality amenities (such as higher-quality institutions), wages will be lower than in areas with lower-quality amenities (such as lower-quality institutions). We can exploit this to work out what higher-quality institutions are worth, by looking at how much a migrant's income would have to change to make them indifferent between the area with lower-quality institutions and the area with higher-quality institutions.

We did this by asking Vietnamese migrants in New Zealand two questions:

1. Given your perceptions of the difference in institutional quality between New Zealand and Viet Nam, what would be the smallest level of weekly income before tax in Viet Nam where you would be happy moving back to Viet Nam permanently?; and
2. Now imagine that the institutional quality in Viet Nam changed so that it was equal to New Zealand in all ways (and everything else remained the same). If this happened, what would be the smallest level of weekly income before tax in Viet Nam where you would be happy moving back to Viet Nam permanently?

The first question allowed us to estimate the compensating different based on the current differences in institutional quality and other amenities between the two countries, as well as migration costs. The second question modifies the institutional quality in Vietnam so that it is equal to that in New Zealand, holding everything else (including migration costs) constant. The difference between the answer to Question 1 and the answer to Question 2 provides an estimate of the willingness of the migrant to accept lower wages in exchange for improved institutional quality in Vietnam.

Our estimates show that willingness to pay for an incremental unit improvement in institutional quality in Viet Nam is, on average, NZD 79.80 per week (approximately 33 percent of the average weekly wage in Viet Nam for the same period). Moreover, older migrants are willing to pay more, as are migrants who perceive institutional quality to be more important for the repatriation intentions.

As far as we know, this is the first paper ever to use contingent valuation to measure the intensity of preference for institutional quality, certainly among migrants if not among any population group. Notwithstanding the continuing debate on the use of the contingent valuation method (which I've written about here, here, and here), this was a really innovative piece of work.

Congratulations again to Ngoc on submitting her PhD thesis!

Read more:

• Return migrants to Vietnam prefer areas with higher-quality institutions

Alcohol minimum pricing vs. taxes

Let's say that there was some good, where the government thought the market provided too much. Consumers consume too much of this product, compared to some socially efficient level. Economists call this a demerit good. The government might want to find some way of reducing consumption of the good. A tax seems like an obvious solution, and has the bonus effect of increasing government revenue - a double win!

But now let's consider a specific demerit good - alcohol. If the government taxes alcohol, the effects on the market are shown in the diagram below. The price that the consumers pay increases from P0 to PC, and the effective price that the producers receive (after paying the tax to the government) falls to PP. The quantity traded (and consumed) decreases from Q0 to Q1. Notice that the demand curve is quite steep (inelastic), so the tax doesn't reduce consumption by much. Notice also that, because the demand curve is steeper (more inelastic) than the supply curve, the price consumers pay goes up by a lot, while the effective price that producers receive falls by only a little. That means that consumers end up facing the burden of the tax. But, at least, the tax has reduced alcohol consumption, which was the aim.

But will the tax really reduce alcohol consumption? Maybe consumers notice the higher prices and simply switch from higher quality (and more expensive) alcohol to lower quality (and less expensive) alcohol. Then, they could continue to drink the same amount as before (but they would just be drinking lower quality beverages). This argument has been made by Eric Crampton (see here, for example).

If the government is concerned about consumers switching to lower quality alcohol, an alternative is to introduce minimum pricing (which I have discussed before, here). Indeed, that is what Northern Territory is about to do, as John Boffa noted in The Conversation this week:

From October 1, 2018, one standard drink in the Northern Territory will cost a minimum of A$1.30. This is known as floor price, which is used to calculate the minimum cost at which a product can be sold, depending on how many standard drinks the product contains...

 The implementation of the minimum floor price is the result of legislation, recently passed to minimise alcohol-related harms in the NT. From October, the NT will become one of the first places in the world to introduce a minimum price for alcohol.

What effect would minimum pricing have on the market? Here's what I wrote back in 2016 on the same topic (but I've updated the diagram to match the diagram above):

The effect is shown in the diagram below. Without minimum pricing, the market equilibrium price is P0, and the quantity of alcohol sold (and presumably consumed) is Q0. But with a binding minimum price (above the equilibrium price) of PC, the quantity of alcohol demanded falls to Q1. In other words, alcohol consumption falls.

Notice that the effect is to reduce alcohol consumption, which is what the government wants. Eyeballing the data in Boffa's article, it definitely shows an increase in price, and it seems that there is the decrease in quantity sold, but the decrease might not be statistically significant. Although Boffa notes:

As expected, the ban on cheap cask and fortified wine led some drinkers to turn to other types of alcohol. But while there was a 70% increase in the consumption of more expensive full-strength beer, the decline in the consumption of cheap alcohol more than offset this. This led to the overall 20% decline in consumption.

An added benefit of minimum pricing is that consumers can't switch between categories to essentially minimise the effect of the policy on their drinking, since a minimum price has a greater effect on low-quality (and therefore cheaper) drinks.

Now let's consider another good that some people would like to see the government act to reduce consumption (although it is arguable whether it is a demerit good) - sugar. A tax on sugar-sweetened beverages (which I've previously discussed here) would have similar effects to the tax on alcohol described above (although whether demand for sugar-sweetened beverages is as inelastic as alcohol is a separate issue). It would even induce consumers to switch to lower quality drinks, as Eric Crampton has argued (see here and here, for example). So, if the anti-sugar brigade want to reduce sugar consumption, wouldn't it be better for them to argue for a minimum sugar price instead?

Read more:

• Alcohol minimum pricing, elasticity and profits

Is Trump vs. Xi a game of chicken, or a prisoners' dilemma?

There are several famous games that we use to teach game theory, one of which is the prisoners' dilemma (which I blogged on earlier in the week). Another is the game of chicken.

In the classic chicken game, two rivals line their cars up at opposite ends of the street. They then race directly towards each other. Each rival then has two options: (1) to swerve out of the way; or (2) to speed on. If one rival swerves and the other speeds on, the rival that sped on wins and the other driver looks foolish and loses some street cred. If both swerve, they both look a bit foolish. If both speed on, then there is a horrific accident and both may be severely injured or die. The game is presented in the payoff table below, for two drivers (Driver A and Driver B).

To find the Nash equilibrium in this game, we use the 'best response method'. To do this, we track: for each player, for each strategy, what is the best response of the other player. Where both players are selecting a best response, they are doing the best they can, given the choice of the other player (this is the definition of Nash equilibrium). In this game, the best responses are:

1. If Driver A speeds ahead, Driver B's best response is to swerve (since a loss of face is better than dying in a fiery crash - maybe not immediately, but certainly in the long term) [we track the best responses with ticks, and not-best-responses with crosses; Note: I'm also tracking which payoffs I am comparing with numbers corresponding to the numbers in this list];
2. If Driver A swerves, Driver B's best response is to speed ahead (since winning is better than looking a little foolish);
3. If Driver B speeds ahead, Driver A's best response is to swerve (since, again, a loss of face is better than dying in a fiery crash);
4. If Driver B swerves, Driver A's best response is to speed ahead (since winning is better than looking a little foolish).

Notice that there are two Nash equilibriums in this game - where one driver swerves and the other speeds ahead. Both drivers prefer the outcome where they are the one speeding ahead though, so if both try to get that outcome, we end up with both drivers dying in a fiery crash. The chicken game suggests that both players, acting in their own selfish best interest (or not considering the response of the other driver), leads to the worst possible outcome.

Which brings me to this article by Ambrose Evans-Pritchard in the Telegraph UK (gated, but there is an ungated version here):

The US and China are on a combustible escalation path that can end only when there is economic blood on the floor and the political pain threshold of one side or the other has been hit.

Both think they can withstand the longer siege. Neither can retreat easily...

China has in any case stated already that it will match each round of US tariffs with a riposte in kind.

Beijing must carry out this threat or lose face, and Trump has already vowed to escalate further when it does.

It is very hard to see how asset markets priced for perfection can ignore this deranged game of chicken for much longer. The mystery is that they have not crumbled yet.

Is this really a game of chicken? It turns out that it depends on how you define the payoffs. There are two players in the game (the U.S. and China), and two strategies (enact tariffs or hold off - the equivalents of speeding ahead or swerving). So, we can represent the game easily in a payoff table.

First, let's consider the payoffs to each country. If one country enacts tariffs and the other holds off, both countries are worse off than the status quo (they both lose some gains from trade), but the country that holds off probably loses less (their exporters are a bit worse off) [*]. We'll say that the payoff to the country enacting the tariffs is "bad", but for the other country the payoff is just "not so bad". If both countries enact tariffs then all of the bad stuff happens (exporters are a bit worse off, and there are lost gains from trade). We'll say that payoff is "very bad" for both countries. If both countries hold off, then the status quo prevails - the payoff is "OK" for both countries. The game is presented in the payoff table below.

Again solving for Nash equilibrium, the best responses are:

1. If China enacts tariffs, the U.S.'s best response is to hold off (since "not so bad" is better than "very bad");
2. If China holds off, the U.S.'s best response is to hold off (since "OK" is better than "bad");
3. If the U.S. enacts tariffs, China's best response is to hold off (since "not so bad" is better than "very bad");
4. If the U.S. holds off, China's best response is to hold off (since "OK" is better than "bad").

Notice that the best response for both countries is to hold off, regardless of what the other country does. Holding off is a dominant strategy. There is one Nash equilibrium here, which is for both countries to hold off (the status quo). It is also a dominant strategy equilibrium (because both countries have a dominant strategy). The equilibrium outcome of this game is the best outcome overall.

Clearly, that isn't the game that is playing out at the moment though, so how are things different? The current game is not a game about trade, it is a game about political posturing. The players are not the U.S. and China, but Donald Trump and Xi Jinping. They want to look strong, and not appear weak (to each other, or to their respective peoples). So, the payoffs and the players are different. The game that is actually being played looks more like the payoff table below. If both hold off, the status quo prevails (the payoff is "OK" for both. If one of them enacts tariffs and the other holds off, whichever of them enacted tariffs appears strong, and the other appears weak. If both enact tariffs, the payoff is costly to the economy.

Again solving for Nash equilibrium, the best responses are:

1. If Xi enacts tariffs, Trump's best response is to enact tariffs (since "costly" is better than "weak");
2. If Xi holds off, Trump's best response is to enact tariffs (since "strong" is better than "OK");
3. If Trump enacts tariffs, Xi's best response is to enact tariffs (since "costly" is better than "weak");
4. If Trump holds off, Xi's best response is to enact tariffs (since "strong" is better than "OK").

Notice that the best response for both leaders is to enact tariffs, regardless of what the other leader does! Enacting tariffs is a dominant strategy, and both leaders enacting tariffs is both the only Nash equilibrium and a dominant strategy equilibrium. The single equilibrium is also unambiguously worse than one of the other outcomes - this is an example of the prisoners' dilemma. Notice that it is not a chicken game.

How could this become a chicken game? If costing the economy was worse than appearing weak, then that would change things around. In that case, the best response to the other leader enacting tariffs would be to hold off. There would be two Nash equilibriums - where one leader enacts tariffs and the other holds off. However, both would prefer to be the leader enacting the tariffs rather than the one holding off.

So, whether this game is a chicken game or a prisoners' dilemma depends on how you think each leader feels about appearing weak. It seems to me that both want to avoid that at all costs. In my mind, this is a prisoners' dilemma, not a chicken game.

The repeated prisoners' dilemma can be solved for the optimal outcome (both holding off), but this requires cooperation between the two leaders. In order for this cooperation to arise, each leader must trust the other (because enacting tariffs is still a dominant strategy). If we want global trade to survive this showdown, somehow we need these leaders to develop a trusting relationship. It's a pity that Trump will not be at the APEC leaders meeting - it seems like a group hug is in order!

*****

[*] This might sound surprising. For the country imposing tariffs, tariffs lead to a deadweight loss (lost wellbeing). They make domestic sellers better off, but make domestic consumers worse off by more than the gain to domestic sellers. In contrast, the market in the country that holds off has no deadweight loss. The exporting firms in that country will be able to export a bit less, but that probably doesn't have as big of a negative impact as the tariffs do on the country that imposed them.

Safety concerns and strawberry markets

The economic model of demand and supply is remarkably robust in terms of explaining changes in prices, and as I show in my ECONS101 class, it even works (qualitatively) when the market is not perfectly competitive. Given that my ECONS101 class has a test coming up in a week and a half, I thought it might be timely to look at an example. Let's take the recent safety scares in Australia, as reported by the New Zealand Herald:

Fruit growers across Australia are reeling from 20 reports of needles found in punnets of berries, with isolated cases of banana and apple sabotage...

Mass harvests of fruit have been dumped as prices plunge, consumer demand evaporates and products are ripped from shelves.

A police operation involving 100 officers across multiple states is now under way to hunt down those responsible...

Up to 120 growers in Queensland alone — where the scare originated — have been hit by a slump in demand and a wholesale price collapse of more than 50 per cent.

Consider the market for strawberries, as shown in the diagram below. Before the sabotage, the market was operating in equilibrium with price P0, and Q0 strawberries were being traded. Following reports of needles in strawberries, consumers have product safety concerns (who wants to buy strawberries when there's a chance of a needle strike?), so demand decreases from D0 to D1. The equilibrium price falls from P0 to P1 (a "price collapse of more than 50 per cent"), and the quantity of strawberries traded falls from Q0 to Q1.

So far, so bad. But, if you're strawberry growers, what do you do with all those strawberries that aren't being demanded by consumers? You could dump them (and some have), so maybe you find someone else willing to take them. Consider the market for strawberry jam, as shown in the second diagram below. The market was initially operating in equilibrium with price PA, and QA units of strawberry jam were being traded. Then, sabotage hits the strawberry market. The price falls. Strawberries are now much cheaper to buy (not just for consumers, but for strawberry jam producers as well). The supply curve for strawberry jam shifts down and to the right (an increase in supply), from SA to SB. The equilibrium price of strawberry jam falls from PA to PB, and the quantity of strawberry jam traded increases from QA to QB.

That last implication is testable. Check the supermarket shelves in coming months, and expect to see cheaper strawberry jam.

The prisoners' dilemma and construction tenders

After my post on the construction industry yesterday, where I suggested that clients should adopt a second-price auction to reduce risk of construction firm failures, a student noted on Facebook:

Stop undercutting the competition so that companies can actually DO the jobs they claim they can do.

In yesterday's post, I neglected to elaborate on why the construction industry can't solve the problem of firms under-pricing bids by themselves. So, in this follow-up post, let's see why, using a little bit of game theory.

Consider an industry with just two construction firms (Firm A and Firm B). [*] Both firms are bidding for a construction contract, which they know will go to the lowest bidder. The firms can choose to bid high, or bid low. Both firms are choosing their bid strategy at the same time - this is what economists refer to as a simultaneous game. The game itself is laid out in the payoff table below. If both firms price low, they each have a 50% chance of winning the contract and earning a low profit (and a 50% chance of not getting the contract and facing the loss of the resources they spent preparing their bid). If both firms price high, they each have a 50% chance of winning the contract and earning a high profit (and a 50% chance of not getting the contract and facing the loss of the resources they spent preparing their bid). If one firm prices high and the other prices low, the low-price firm wins the contract for sure and makes a low profit, and the high-price firm misses out on the contract for sure and loses the resources they spent preparing their bid. Let's further assume that winning the contract for sure at a low price is preferred over a half chance of winning the contract at a high price. [**]

To find the Nash equilibrium in this game, we use the 'best response method'. To do this, we track: for each player, for each strategy, what is the best response of the other player. Where both players are selecting a best response, they are doing the best they can, given the choice of the other player (this is the definition of Nash equilibrium). In this game, the best responses are:

1. If Firm A bids high, Firm B's best response is to bid low (since winning the contract for sure at a low price is better than a 50% chance of winning the contract at a high price) [we track the best responses with ticks, and not-best-responses with crosses; Note: I'm also tracking which payoffs I am comparing with numbers corresponding to the numbers in this list];
2. If Firm A bids low, Firm B's best response is to bid low (since a 50% of winning the contract at a low price is better than certainly losing the resources spent preparing the bid);
3. If Firm B bids high, Firm A's best response is to bid low (since winning the contract for sure at a low price is better than a 50% chance of winning the contract at a high price); and
4. If Firm B bids low, Firm A's best response is to bid low (since a 50% of winning the contract at a low price is better than certainly losing the resources spent preparing the bid).

Note that Firm A's best response is always to bid low. This is their dominant strategy. Likewise, Firm B's best response is always to bid low, which makes it their dominant strategy as well. The single Nash equilibrium occurs where both players are playing a best response (where there are two ticks), which is where both construction firms choose to bid low.

Notice that both firms would be unambiguously better if they bid high. However, both will choose to bid low, which makes them both worse off. This is a prisoners' dilemma game (it's a dilemma because, when both players act in their own best interests, both are made worse off). Both firms will choose to bid low, and whichever firm wins the contract will be at risk of having bid too low and suffering the winner's curse, as I noted yesterday. This is why the construction industry cannot solve this problem on its own.

Of course, the simple example above assumes this is a non-repeated game. A non-repeated game is played once only, after which the two players go their separate ways, never to interact again. Most games in the real world are not like that - they are repeated games. In a repeated game, the outcome may differ from the equilibrium of the non-repeated game, because the players can learn to work together to obtain the best outcome.

However, cooperative strategies will not work in the construction firms' dilemma game, because such cooperation is illegal collusion. The firms would be subject to prosecution by the Commerce Commission for cartel behaviour.

So, to reiterate yesterday's conclusion, it is up to the clients of construction firms to solve this issue:

We need to ensure that sustainable contract prices are being paid, and the current system is clearly failing.

*****

[*] Limiting ourselves to two firms makes this example easy to follow, but it would work much the same if we had 20 or 200 firms (albeit being much harder to create a payoff table for!).
[**] This seems unlikely in the case of two firms, where there is a 50% chance of winning the contract, and a 50% chance of wasting time preparing the bid. However, if there are ten firms bidding, then there is a 10% chance of winning the contract, and a 90% chance of wasting time, which makes this preference seem more likely.

Read more:

• The winner's curse and construction tenders

The winner's curse and construction tenders

Finally, some sanity in terms of writing about the problems the construction industry is facing. John Walton wrote in the New Zealand Herald earlier this week:

Right now, of course, the construction industry is indeed booming - not just in housing, but also in commercial and infrastructure development. But companies are continuing to fail. Why?

The answer lies in the construction process and a misunderstanding of the roles of the participants. At its simplest, the owner provides the site, resource consents, designs and pays for the work. The contractor organises the work to the design and to the required legal standards, for the agreed price within the allocated time. Price and time are adjusted for unforeseen events and for changes instructed by the owner. To this extent, construction contracts legislate for uncertainty.

That uncertainty is exacerbated by an incomplete understanding of other project risks (ground conditions and supply chain issues like subcontractor and supplier pricing and availability) and unrealistic expectations on the part of owners, particularly that they can fill in the gaps in the design and instruct changes at their whim without cost consequences. The tender process encourages this opportunistic behaviour by forcing contractors to compete on incomplete, or simply unrealistic or unfair contract terms.

Contractors try to introduce some balance by excluding risks from their bids. They must then rely on the claims process to protect their margins.

This can turn the pricing process into something of a lottery. Typically, the cheapest price wins, which all too often is submitted by the contractor with the greatest appetite for risk, coupled with the most optimistic expectations for making claims under the contract.

Following contract award, managing design development, construction and capricious owner changes to the design becomes a considerable headache for contractors who need to be able to meet construction costs, pay subcontractors and protect their already slim margins.

Every time the issue of financially troubled construction companies comes up (and it seems to be coming up a lot lately), it makes me think of the winner's curse.

Consider a group of construction firms, tendering for a construction contract. Rational construction firms who have complete information about the project and associated risks (and with the same tolerance for risk) would all have the same expectations about the costs of completing the contract, so all would bid the same. However, not all construction firms have complete information (as Walton noted above) and not all firms have the same tolerance for risk. The construction firms may make random errors in determining their costs (or margins) and risks associated with the contract, so all of the construction firms will expect different completion costs (and margins and risks) associated with the contract. For firms with similar tolerance for risk, differences in expected completion costs (and margins) arise randomly - some will overestimate the completion costs (or underestimate the risk) of the contract, and some will underestimate the completion costs (or overestimate the risk or margins). Those who expect low completion costs will bid low for the contract, and those who expect high completion costs will bid high for the contract.

The real problem arises when the contract goes to whichever construction firm bids the lowest for the contract. This will be the firm that has most underestimated the completion costs, because they will be the firm that bid the lowest. The chances are high that, if there are enough construction firms entering bids, the eventual winner will have underestimated the completion costs compared with the true costs, and hence will not receive enough to cover their true costs. This is what we refer to as the winner's curse.

The problem is that consumers of construction firms' services are too focused on looking for the lowest bid. This virtually guarantees the problems we are facing in the construction industry. Walton's piece concludes:

The industry has a choice. Either it accepts that designs and prices will change and pay contractors accordingly, or take the time to remove contract uncertainties before fixing the price and instructing work to commence. Experience here and overseas would suggest that a combination of the two works best.

Walton is not very clear on his proposed solution. So, let me offer two options.

First, when a construction contract is put up for bids, the decision could be made independent of price. That removes the incentive to bid too low. Construction firms can then be realistic about the costs and risks they face, when preparing their bids, without worrying about a high bid ruling them out. Of course, it probably creates an incentive to bid too high, precisely because a high price won't rule the firm out of the process.

Second, adopt a variant of a second-price auction. Give the contract to the lowest bidder, but pay them the amount that was asked by the second-lowest bidder. Or, if the contract is not given to the lowest bidder, still pay an amount for the contract equal to the next highest bidder's offer. This ensures that the client isn't paying well over a 'fair' price for the contract (which would likely be the case for the first option), while providing some additional space for the successful firm, which has likely underestimated the completion costs. If second-price isn't enough, a third-price auction would further limit the chance of construction firms being underpaid because of their inability to accurately estimate costs.

Something clearly needs to be done. We don't want construction firms falling over mid-contract, and in a small market like New Zealand we can't afford to have the market dominated by only a couple of players. We need to ensure that sustainable contract prices are being paid, and the current system is clearly failing.

The fable of the bees for rent

Back in 2016, I wrote a post about one of the key examples many economists (including myself) use in describing the problems associated with positive externalities, being an example involving bees and apple orchards. I won't repeat all of that post here, but instead take this bit:

In 1973, Stephen Cheung wrote a follow up to the Meade paper in the Journal of Law and Economics (ungated here), where he pointed out that contracting solutions to the bees-and-trees problem were not observed in the real world, because the transaction costs of these agreements are too high (transaction costs in this case are the costs of negotiating a suitable agreement between the apple-farmer and the bee-keeper - if the costs are high, it will be more difficult for the parties to justify the expense of coming to an agreement). Instead, a social norm developed between apple-farmers and bee-keepers in terms of the number of bees per orchard, etc. Of course, a social norm is just an informal contract by another name.

Forget social norms though. An article in The Conversation by Manu Saunders (University of New England) earlier this year suggests that there actually is a thriving contractual market for bees as pollinators:

To optimise yields, most growers rent European honeybee hives during crop flowering season. Honeybees were first introduced to Australia from Europe in the early 1800s. Today, the beekeeping industry includes around 600,000 managed hives and is worth around A$100 million to Australia’s economy. But it’s not just about honey and beeswax products.

Managed crop pollination services have become big business in many parts of the world, including Australia. Although most beekeepers do still keep bee hives to produce honey or wax products, paid pollination services are becoming increasingly important to the industry...

Costs per hive vary depending on the crop, covering costs to the beekeeper such as how far they have to travel, the time of year (early season pollination can be more stressful for honey bees and require more feeding costs for beekeepers to maintain hive health), and the risks (e.g. chemicals) bees might face in the crop. For almond pollination, one hive can cost around $70-100 to rent. 

To recap from my earlier post, beekeepers create a positive externality for orchardists, when their bees distribute pollen incidentally in collecting it for making honey. Orchardists create a positive externality for beekeepers because their trees provide the pollen that the bees use for making honey. Left to its own devices the market produces too little of goods that have positive externalities - there would be too few bees to satisfy the needs of the orchardists, and too few trees to satisfy the needs of the beekeepers. As we discuss in my ECONS102 class, one way of solving this problem is for the two parties to negotiate a contract, specifying the number of bees, the number of trees, and some payment (in this case, from the orchardists to the beekeepers). And it appears to be working, almost exactly as described in class.

Read more:

• Uber for bees and trees

Industrial dust and bargaining over externalities

One of the most famous results in welfare economics is the Coase Theorem - the idea that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without the need for government intervention). An externality is the uncompensated impact of the actions of one party on the wellbeing of a bystander. For instance, a factory that emits air pollution creates a negative externality for people who live nearby - the reduction in air quality makes the neighbours worse off.

Ronald Coase (1991 Nobel Prize winner) argued that externality problems are jointly produced - even though one party creates the externality (e.g. the factory), the problem is also created by the neighbours - if they didn't live next to the factory, there would be no externality problem (or at least, there would be no problem for the neighbours, as they wouldn't be living next to the factory!).

One of the implications of the idea that externalities are jointly produced, and the idea that parties to the externality might be able to arrive at some agreement to deal with the externality problem, is that the same solution to the externality may arise regardless of our starting point. To see why, let's consider a specific example, from this New Zealand Herald article from earlier in the year:

For more than four years, residents and workers in De Havilland Way, Mount Maunganui have complained organic dust from a nearby industrial building was making them sick.

Business owner Colin Alexander had a severe allergic reaction that laid him up for months. Resident Skye Sloan has to take a tablet every day to keep flu-like symptoms at bay. Dozens of other complaints have been recorded.

With health officials and an air quality investigation now backing their claims, they want authorities to do something about 101 Aerodrome Rd immediately.

They argue the operations - bulk storage and handling of stock feeds including palm kernel expeller, a controversial palm oil industry byproduct - must stop until the fine, inhalable dust particles that regularly blew into the hangars can be prevented or contained. 

There is some disagreement in the article about whether industrial dust is creating health issues for nearby residents, but let's take it as a given. However, as Coase noted, the externality problem is jointly created by the bulk storage firm and the nearby residents (who, it should be noted, are living in an industrial-zoned area). But if we want to follow through on the Coase Theorem, how can this externality problem be solved without government intervention?

The solution to the externality problem depends on the distribution of entitlements - primarily the property rights, but also liability rules. There are two competing sets of property rights here. The bulk storage firm has the right to operate - it is located in an industrial zone. If the firm has to restrict its operations, that takes away some of its rights. The residents have the right to clean air. The industrial dust is taking away some of their rights.

To determine the potential bargaining solution to the externality problem, we need to start by considering which party has the overriding rights. That is, whose rights (the bulk storage firm's, or the residents') are more important to uphold? That isn't a question that economics can answer, but obviously there are two options (the bulk storage firm, or the residents). Let's consider both in turn.

If the residents have the overriding rights (their right to clean air is seen as more important to uphold than the firm's right to operate), then the default solution to the externality problem is that the firm shuts down (or it installs some type of filter to prevent the escape of industrial dust, or finds some other way not to reduce the air quality). That isn't the only solution under this set of entitlements though. The alternative solution to the externality problem is that the firm continues to operate as before, but compensates the residents for any reduction in air quality. For this alternative solution to work though, the firm would need to pay the residents more than the value of their lost air quality (however they value it), but less than the cost to the firm of shutting down (or the cost installing a filter, or the cost of whatever other option they can find for avoiding the reduction in air quality).

If the bulk storage firm has the overriding rights (their right to operate is seen as more important to uphold than the residents' right to clean air), then the default solution to the externality problem is that the residents have to put up with the dust (or they keep their hangar homes shut up to prevent dust getting in, or they wear dust masks, or something else). Again, there is an alternative solution to the externality problem, which in this case is that the residents compensate the firm for the cost of shutting down (or the cost installing a filter, or the cost of whatever other option they can find for avoiding the reduction in air quality). For this alternative solution to work though, the residents would need to pay the firm more than the cost to the firm of shutting down (or the cost installing a filter, or the cost of whatever other option they can find for avoiding the reduction in air quality), but less than the value of the improved air quality the residents gain (however they value it).

Notice that which set of default and alternative solutions is available depends crucially on which party has the overriding rights, which is determined by the legal environment (as I said, economics can't answer that question). Notice also that the default solution simply upholds the existing overriding rights, while the alternative solution always involves compensation from one party to the party whose overriding rights are being foregone.

Will a bargaining solution always work? No, because as noted above it depends on the relative costs and benefits. That issue aside, many economists argue that, because of the Coase Theorem, government involvement in dealing with externalities is almost never necessary. However, the Coase Theorem depends on the parties being able to bargain without cost, and that seems unlikely. In the case of industrial dust above, even if all parties sat around a big table to talk over the issues, agreement takes time and effort (and hence, transaction costs), and is made more difficult by there being many parties involved (a firm, and many residents). Many parties creates a coordination problem, since it may be difficult even to get all parties on one side of the problem (e.g. the residents) to agree. And even if the majority agree, a small minority might then try to hold out for a better deal. And even if an agreement is struck between the parties, there needs to be monitoring of the agreement to ensure the parties follow through, and some enforcement if they don't do so, both of which entail costs.

Finally, behavioural economics suggests that even if we manage to get through all of the above, arriving at a bargaining solution that suits both parties will be made more difficult because of the endowment effect. Whichever party has the overriding rights will be most unwilling to give up those rights, and will demand extra compensation (more compensation than what they would have been willing to pay to obtain the rights in the first place!) - a point that I made in this post last year.

All of this suggests that, while the Coase Theorem is good in theory, in practice it is very difficult to execute. Most of the time, if there is an externality problem, some government intervention (even if it is just covering the transaction costs and the costs of monitoring and enforcement) will be required.

Market power and milk prices

Domestic milk prices have been in the news again recently. For instance, Federated Farmers recently called for consumers to revolt against the market power of supermarkets and buy their milk from dairies:

Federated Farmers is calling on Kiwis to stage a revolt against supermarkets and buy their milk from dairies instead.

The call comes after Bodo Lang, a University of Auckland marketing professor, slammed milk pricing in New Zealand as "astoundingly high".

Federated Farmers' dairy chairman Chris Lewis told the Herald he avoids the supermarket altogether when buying milk for his family.

Instead he buys two 2 litre bottles of milk for $6 from his local Waikato dairy.

Lewis questions what goes on between the product leaving the farm and entering the supermarket for the prices to be quite as high as they are currently.

He said farmers got about 60 cents per litre of milk sold.

A Foodstuffs spokesperson said retail prices took into account the wholesale cost from suppliers, which could change according to the price they could achieve on the global market...

Mark Johnston also recently asked, Global Dairy Prices down but why does NZ have such high milk prices? Johnston concluded that:

Milk in Germany is much lower in price because of the high levels of competition with multiple [supermarket] chains operating there. In New Zealand however the price consumers pay reflects the concentrated nature of the market.

The argument is often made that New Zealand domestic milk consumers pay high prices because of two things. First, the supermarkets and other retailers must match the world price for milk. Second, because there are essentially two main players in the supermarket sector, the duopoly gives them market power and allows them to raise the price of milk (and other products as well). However, this argument ignores the fact that the supermarkets are not the only players in the market here with market power. Fonterra dominates the market for milk supply, giving it some market power as well.

Consider a market with international trade, as shown in the diagram below. If the domestic market was competitive and not open to international trade, the market would operate at equilibrium, with a price of PD and QD milk would be traded. The world price is PW - it is higher than the domestic price, which illustrates that New Zealand has comparative advantage in milk production, because it can be produced and sold at a lower price domestically than in the rest of the world. If the market was open to international trade, the price would increase to PW because the domestic sellers would prefer to sell at that price than the lower price PD. Domestic buyers have to match the higher price, so the quantity of domestic demand decreases to Qd0, while the quantity supplied increases to Qs. The difference between Qs and Qd0 (which would normally be excess supply), is exports.

Now consider what would happen if the domestic sellers in this market had some market power. Instead of operating at the world price PW in the domestic market, they can operate at the price and quantity that maximise their profits from the domestic market. This occurs where marginal revenue meets marginal cost, so they would restrict the quantity of milk sold in the domestic market to Qd1, and sell it at a higher price of PM. The quantity of milk supplied remains Qs, as Fonterra can simply supply more to the world market when it supplies less to the domestic market.

You might rightly ask, why wouldn't domestic milk consumers buy from the world market at the lower price PW, rather than from the domestic sellers at the higher price PM? Buying from the world market entails a higher transport cost than buying from the domestic market, so there's at least some reason to believe a premium on locally produced milk would be accepted. Fonterra's market power is limited by the availability of milk from the world market. However, that doesn't mean that Fonterra doesn't have some market power, and so the actions of the supermarkets (who clearly do have market power as well) is not the only source of high milk prices in New Zealand.

John T. Ward, 1927-2018

The University of Waikato flew its flag at half mast yesterday, to mark the passing of Emeritus Professor John Trevor Ward on Tuesday. John was Inaugural Professor of Economics (and one of the first full professors at the University), appointed in 1965. He was Head of the Department of Economics for 25 years, and was the founding Dean of the School of Social Sciences. When the Department of Economics de-camped to join the School of Management Studies (as it was then), John was briefly the Dean, and he served terms on the University of Waikato Council and as president of the New Zealand Association of Economists. John retired from the University in 1990, and was awarded the title of Emeritus Professor.

All of this was long before my time at Waikato of course (and even before I had finished high school!), but John maintained a long association with the Department of Economics. I met him at a number of functions, including at prizegivings for our students. John clearly wanted the best for our economics students, and he endowed two prizes for top students - the Foundation Professor's Prize, which goes to the top student in ECONS101 (previously ECON100); and the J.T. Ward Prize, which goes to the top student in ECONS302 (or previously ECON202).

John's research interests spanned wide, including land use, health economics, and cost-benefit evaluation. A quick search of Google Scholar demonstrates this, with his publications including: Economic principles of land use: A comparison of agriculture and forestry (in the New Zealand Journal of Forestry, 1963), Health expenditure in New Zealand (in Economic Record, 1972), and Compensation for Maori land rights. A case study of the Otago tenths (in New Zealand Economic Papers, 1986). He also published the very first paper for the Agricultural Economics Research Unit (AERU) at Lincoln College (it wasn't a university then) in 1964, entitled The systematic evaluation of development projects.

John is survived by his wife Anne, children Tony, David and Michael, and five grandchildren. His funeral is to be held tomorrow morning, at the Lady Goodfellow Chapel on the University of Waikato campus. He will be missed.

Trademarks as sources of market power

A key source of firm profitability is market power - the ability to choose your own price. Firms with market power are not trapped in a low-profit (or no-profit) perfectly competitive market. As I mentioned in my post yesterday, firms will go to great lengths to protect their market power.

How do firms get market power in the first place though? A key source of market power is barriers to entry into the market - something stops other firms from competing by selling an identical product. However, barriers to entry aren't strictly necessary, if the firm can find some way of convincing consumers that their product is different from that of their competitors. In other words, firms can gain some market power if they sell a differentiated product.

One of the ways firms can differentiate their product is to use trademarks. Trademarks will stop competitors from copying some of the key elements of the firm's product. The variety of products that are trademarked may surprise you, but some cool examples are summarised in this New Zealand Herald article from June:

US toy maker Hasbro recently secured a trademark for the smell of their iconic childhood toy Play-Doh.

In doing so they shone a spotlight on the wide-ranging and sometimes quirky power of intellectual property rights - raising the question: are there limits to what can be trademarked?...

The Warehouse owns a trademark registration for its jingle, "the Warehouse the Warehouse where everyone gets a bargain", and similarly, Pizza Hutt has a trademark for its famous phone number jingle, "oh eight hundred eighty-three eighty-three eighty-three".

McDonald's has a trademark registration for its french fries box design, and something to keep in mind next time you pass a building site is that Fletcher Building has a trademark for the pronunciation of "GIB"...

The United States leads the way as far as peculiar and eccentric trademarks go. Footwear chain Flip Flop Shops has a trademark for the coconut smell that they use in their stores. Similarly, Verizon has a trademark for the "flowery musk scent" they pump through their locations.

The Eddy Finn Ukulele Company has a trademark for the piña colada smell they apply to one of their ukulele models. They even ran into trouble with their international customers when the ukuleles lost their smell after being shipped overseas.

Gestures have been offered IP protection as well, and champion sprinter Usain Bolt has taken full advantage registering two trademarks for his signature "bolting" pose where he leans back with one arm to the sky and the other pulled back by his ear.

Even athletes could use some market power I guess. Not all trademark attempts are successful though, as Nestle discovered in attempting to trademark the shape of the Kit Kat. One thing is clear though - every time you see a little (TM), you should be thinking 'market power'.

De Beers may become its own biggest competitor

This week in my ECONS102 class, we covered monopoly and firms with market power (a topic we actually cover much earlier in the semester in my ECONS101 class). One of the examples I talk about is De Beers, which had a stranglehold over the diamond market up until the late 1980s, but still commands a high degree of market power today. It is interesting to see what they are doing to maintain their market power. Bloomberg reported last week:

De Beers hasn’t even opened its first synthetic diamond store, but its looming entry into the market for man-made gems has already shaken the industry.

The unit of Anglo American Plc said three months ago that it plans to sell lab-grown diamonds at a fraction of the going rate, undercutting rivals like Chatham Created Gems Inc. and Diamond Foundry Inc. That’s already cut the price of man-made gems, furthering De Beers’s aim of increasing the premium paid for the diamonds it mines in Botswana, Namibia, South Africa and Canada.

De Beers will target younger consumers with its lab diamonds, sold under the Lightbox name for about $800 a carat. That’s a fifth of the price of existing man-made stones and one-tenth of the cost of buying a similar natural gem.

This is an interesting example of rent seeking, where a firm attempts to build (or maintain) its market power. It is also similar to a tactic we discuss in my ECONS101 class, which is where firms try to crowd the market by competing with themselves. However, I don't think that is De Beers' strategy in this case.

Synthetic diamonds are a close substitute for natural diamonds, and natural diamonds represent a highly profitable business for De Beers. If some of De Beers' competitors (like Chatham or Diamond Foundry) start producing high-quality synthetic diamonds and selling them relatively cheaply, then some diamond consumers will be induced to switch from natural diamonds to synthetic diamonds, and De Beers will lose profits. By selling synthetic diamonds itself at a very low price, clearly De Beers' goal is to make it unprofitable for the synthetic diamond producers to operate, by seriously undercutting their prices - a tactic known as predatory pricing. The synthetic diamond competitors won't be able to compete with De Beers for long at the low prices, and will soon go out of business (at least, that is what De Beers is hoping). At that point, De Beers can quietly exit the synthetic diamond industry and resume claiming high profits from natural diamonds (having taken a bit of a hit to its profits from both synthetic and natural diamonds in the meantime).

There is a problem with this strategy though, and it's a problem with predatory pricing generally. Unless there is some barrier to entry into the synthetic diamond industry, undercutting those competitors and forcing them out of the market is only a temporary solution for De Beers. As soon as De Beers exits the market, or raises the price of synthetic diamonds, some other new competitor can come into the synthetic diamond market. Unless De Beers can keep new competitors out of the market.

Is there a barrier to entry? I don't know the synthetic diamond market well, but I suppose that the number of ways that you can create high-quality synthetic diamonds is probably limited, and that Chatham and Diamond Foundry, as well as De Beers, use technologies that are covered by patents. Patents can create a (time-limited) barrier to entry into the market, since no competitors can use the technology covered by the patent. So, if De Beers makes it untenable for their synthetic diamond competitors to operate, perhaps this is a cynical ploy by De Beers to capture the synthetic diamond patents, either by a hostile takeover of the firms that are struggling to be profitable in the wake of low prices, or by buying the patents in a fire sale of those firms' assets?

It will be interesting to see how this plays out in the long term.

Car insurance, adverse selection and gender

Car insurance has an adverse selection problem. The uninformed party (the insurer) cannot tell those with 'good' attributes (low-risk people) from those with 'bad' attributes (high-risk people). To minimise the risk to themselves of engaging in an unfavourable market transaction, it makes sense for the insurer to assume that everyone is high-risk. This leads to a pooling equilibrium - low-risk people are grouped together with the high-risk people and pay the same premium, because they can't easily differentiate themselves. This creates a problem if it causes the market to fail.

To see how the car insurance market fails, consider this from an earlier post about health insurance (it applies just as well to car insurance):

In the case of insurance, the market failure may arise as follows (this explanation follows Stephen Landsburg's excellent book The Armchair Economist). Let's say you could rank every person from 1 to 10 in terms of risk (the least risky are 1's, and the most risky are 10's). The insurance company doesn't know who is high-risk or low-risk. Say that they price the premiums based on the 'average' risk ('5' perhaps). The low risk people (1's and 2's) would be paying too much for insurance relative to their risk, so they choose not to buy insurance. This raises the average risk of those who do buy insurance (to '6' perhaps). So, the insurance company has to raise premiums to compensate. This causes some of the medium risk people (3's and 4's) to drop out of the market. The average risk has gone up again, and so do the premiums. Eventually, either only high risk people (10's) buy insurance, or no one buys it at all. This is why we call the problem adverse selection - the insurance company would prefer to sell insurance to low risk people, but it's the high risk people who are most likely to buy. 

In order to solve an adverse selection problem, the uninformed party can try to reveal the private information - this is referred to as screening. Car insurance companies engage in screening by collecting information about every person who applies for insurance, including their demographic details and accident and insurance history. The insurers know that this information provides some clues as to who is higher risk and who is lower risk to insure. They can then separate the higher-risk and lower-risk groups, and we move from a pooling equilibrium to a separating equilibrium. Higher-risk drivers will pay higher car insurance premiums, and lower-risk drivers will pay lower premiums.

One of the key demographic variables that is associated with car insurance risk is gender. Women drivers are less risky to insure. On average, they have accidents at lower speeds, which are less costly to repair. So, female car owners pay lower car insurance premiums on average. Gender works as one screening tool because it is difficult to fake. Or it was, until this story from CBC in Canada in July:

He wanted a brand new car — a Chevrolet Cruze with all the trimmings.

As a man in his early 20s, he knew his insurance costs would be high.

So he became a woman, though only on paper.

"I have taken advantage of a loophole," said the man — we're calling him David — who spoke on the condition that his identity be kept confidential because of the potential repercussions...

After doing some research, he realized he needed a doctor's note to show the government he identifies as a woman, even though he doesn't.

"It was pretty simple," he said. "I just basically asked for it and told them that I identify as a woman, or I'd like to identify as a woman, and he wrote me the letter I wanted."...

David shipped the note and other paperwork off to the provincial government. And, a few weeks later, he received a new birth certificate in the mail indicating he was a woman.

"I was quite shocked, but I was also relieved," he said. "I felt like I beat the system. I felt like I won."

With the new birth certificate in hand, he changed his driver's licence and insurance policy.

All to save about $91 a month.

"I'm a man, 100 per cent. Legally, I'm a woman," he said.

"I did it for cheaper car insurance."

"David" may have just raised the cost of car insurance for all women in Canada. If car insurers can no longer believe from a drivers licence that an insurance applicant is a woman, then every gender will be pooled together as being the same risk. That means higher premiums for women (and ironically, lower premiums for men, which is what David wanted!).

[HT: Marginal Revolution]

This bride needs a crash course in signalling

Back in 2014, I wrote a post about why weddings are expensive, and the main explanation comes down to signalling:

Why are couples willing to pay such high prices for wedding dresses? It may be because they are signalling as well. They are trying to reveal two items of private information to their wedding guests (friends, family, etc.): (1) the quality of their relationship; and (2) their social status.

Starting with (1), guests don't know the quality of the relationship that is about to be formalised, but the couple does (hopefully!). Does this create market failure? That is, can the couple take advantage of this information asymmetry to their advantage and to the detriment of their guests? Maybe, if we consider wedding gifts. Guests would probably give less valuable gifts if they believed the marriage wouldn't last (i.e. if the marriage is low quality), than if they thought it would last a long time (i.e. high quality). So, if guests can't be sure about the quality of the marriage, then they may assume the marriage is lower quality and buy less expensive wedding gifts (or no gift at all) as a result. So, high-quality couples need to find some way of signalling their quality, and this may be through the cost of the wedding. This may be an effective signal, because it is costly (obviously), and more costly to low-quality couples since they may expect to marry more than once over their lifetime. So, lower quality couples may be less willing to spend a lot on their wedding than high quality couples.

What about (2)? This isn't an adverse selection problem at all, since there is no market that will fail. However, there is still signalling here - the couple may want to signal their social status to the community. Higher social status is linked with wealth, which means that couples with high social status are likely to be able to afford a more lavish wedding celebration than couples with lower social status.

Which brings me to this story from a couple of weeks ago:

 "Susan" is causing quite the debate online after posting a bizarre Facebook rant about her now-canceled wedding. Yup, the couple called off the wedding just days before their I dos, after their guests refused to pay the $1,500 attendance fee Susan was demanding in order to pay for her CAD $60,000 ($46,020 USD) dream wedding.

In her long-winded, expletive-filled explanation, the (former) bride accused her friends and family of ruining her marriage and her life. “How could we have our wedding that we dreamed of without proper funding? We'd sacrificed so much and only asked each guest for around $1,500. We talked to a few people who even promised us more to make our dream come true," she reportedly wrote on Facebook.

Note the quote from my earlier post above. If wedding guests don't know about the quality of the relationship (it is private information), then having an expensive wedding is an effective signal of quality. It meets the two criteria for being an effective signal: (1) it is costly; and (2) it is costly in such a way that lower-quality couples would not attempt it (it is more costly for lower-quality couples, who may get married more than once in their lifetime).

However, having an expensive wedding but not paying for it yourself is not an effective signal, since it is no more costly for a lower-quality couple to do than for a higher-quality couple. In fact, it is more likely that a lower-quality couple would ask the guests to pay for the expensive wedding than a higher-quality couple. The invitees were probably right not to want to pay for "Susan" to have her dream wedding.

[HT: Marginal Revolution]

Book Review: More Sex is Safer Sex

I just finished reading Steven Landsberg's 2009 book More Sex is Safer Sex. The subtitle is "The Unconventional Wisdom of Economics", which pretty accurately sums up the content. It is unconventional, and uses the tools of economics. At the heart of the book is the premise that problems arise when we don't face all of the costs, or are unable to capture all of the benefits, of our decisions. Landsberg uses that premise to illustrate a number of surprising arguments, such as this from early in the book:

When you're splitting the dinner check, ordering dessert can be a lot like littering - you get the benefits and the costs spill over onto your friends. If the $10 double chocolate mousse is worth only $4 to you, you really shouldn't order it - and you won't, if you're paying your own way. But when you split the check ten ways, that mousse starts to look (to you) like a bargain.

I found a lot of the stories and examples in the book to be deliberately provocative. For instance, Landsberg argues that firefighters should be allowed to keep any property that they save from a burning building (they face all the costs of their actions, so they should be able to claim all of the benefits). Sometimes, provocativeness can be a good thing, but I feel like in much of the book Landsberg is over-playing his hand. And there are clearly cases where, in his zeal for revealing some surprising results, he over-stretches, such as this:

Any act of charity entails a clear moral judgment. When you give $100 to CARE, you assert that CARE is worthier than the Cancer Society. If that's your honest judgment when you give your first $100, it ought to be your honest judgment when you give your second $100. Giving to the Cancer Society tomorrow means admitting you were wrong to give to CARE today.

Of course, it is likely that there is diminishing marginal utility to giving to each charity. That means that each donation you give to a charity provides you with less satisfaction (or happiness) than previous donations you gave to the same charity. So it is by no means a given that if you receive more utility (or satisfaction) from your first $100 being given to CARE, that your second $100 would provide you with more utility if also given to CARE than if you gave it to the Cancer Society. Landsberg does acknowledge this, although not in as many words, and it is buried in the appendix to the book.

Overall, there are some interesting points made in the book, and if you want to see the application of economic costs and benefits to a wide range of (often surprising) situations, this book will provide you with that. I made a number of notes of things that will be helpful in my teaching. However, if you are sceptical about the use of economics, this book probably won't convince you. And to top it off, Landsberg's in-your-face style won't be to everyone's taste.

Does studying economics overcome misperceptions?

Many students are surface learners - they learn just enough to get through assessments, and then rapidly forget what they have 'learned' (because they never really learned it at all!). Other students are deep learners - they really try to understand, and they usually have an intrinsic motivation for learning. A third groups of students are strategic learners - they will employ whichever strategy (surface or deep learning) will allow them to achieve their grade goals in a given situation. This last group is the group that is most motivated by grades. You can read a very brief summary of these types of learners here (and click through to the linked video as well).

Surface and strategic learners present a real problem. We want students to take on board the key principles of economics, but students using surface learning strategies only want to do the minimum necessary to get by. That leads to some interesting outcomes, such as those in this 2017 article by Isabel Busom, Cristina Lopez-Mayan and Judith Panades (all from Universitat Autonoma de Barcelona, published in the Journal of Economic Education (sorry I don't see an ungated version online, but it may be open access).

Using data on 596 first-year college students in Spain, Busom et al. look at whether the students hold misperceptions about key economic concepts at the start of an economics principles class, and again at the end. Importantly, the questions were asked in an opinion survey format, which did not contribute to grades, so the students could feel freer to answer without necessarily trying to get the 'correct' answer. The results at the beginning of the course are mostly not surprising:

...most students (68 percent) believe that rent controls would allow more people to have access to housing, a belief that is not consistent with the model of demand and supply in competitive markets.

Students have not been exposed to economics principles yet probably wouldn't realise that rent controls actually decrease access to housing (especially for low-income tenants). However, it is a pretty straightforward result from applying the supply and demand model. Students who understand some economics should do better, but:

Having taken some course on economics in high school does not make much difference.

That's a little bit of a worry, but it gets worse when Busom et al. look at the data at the end of their course:

We observe a change in the right direction in the case of minimum wages but a change in the wrong direction in the case of rent controls.

In other words, students were more likely to agree that rent controls increase access to housing at the end of the course than at the beginning. And yet it gets even worse:

It is disturbing that course performance is uncorrelated with the statements on rent controls, minimum wages, or buying home-country products.

Students who did better in the economics course were no more (or less) likely to hold the correct opinion on rent controls than those who did worse in the course. Busom et al. conclude that:

These results suggest that students fail to integrate the newly learned economic tools into their thinking process after a semester of study, even if they do well in the course. This raises some concerns. If what we observe in our study generalizes to students taking economic principles in other universities and countries, we then should question our way of teaching and communicating economic knowledge. Even if some teaching methods have a positive effect on exam performance, this does not necessarily imply that students will revise important misconceptions. Successfully challenging laypeople’s misconceptions may be even harder.

They also suggest that:

Several hypotheses might explain the persistence of misconceptions: (1) one semester may be too short a period to let new knowledge sink in and enable a student to use it to analyze economic issues outside the classroom; (2) students’ dedication to study may be too low; (3) students may remain skeptical toward economic models (even if they understand them) for a variety of reasons, and (4) a combination of all the above.

I think they miss the fact that many students are simply employing surface learning strategies, as I noted at the start of this post. Those students won't change their misconceptions, because they aren't really taking in what they are studying beyond what is necessarily to get through their assessment. So, before we give up completely on trying to teach economics principles because we might be making students' misconceptions worse, we need to adapt teaching methods to better engage the surface learning students, or to dissuade them from surface learning strategies.

This is probably the most difficult task of all for a teacher, and there is no silver bullet. I've found that using lots of real-world examples and applications in class (and writing about them here), seems to help. So do assessment questions that are more applied and less theoretical, and where the assessment marks are weighted more heavily towards explaining why rather than answering the question of what is happening. It is a lot harder to explain why if you are simply a surface learner. In my ECONS102 class I take this a step further by asking some really open-ended questions, which can really only be effectively answered well by students who have done some deeper thinking about the economics concepts and models from class. Of course, these strategies don't work for all students.

I'd love to think that we could break down students' misperceptions about things like rent controls or minimum wages, in a single first-year economics paper. But Busom et al.'s research paper now has me a little worried. I wonder how my students would do in a similar opinion poll?

James Mirrlees, 1936-2018

It seems we can't go a full year lately without losing a great (often Nobel laureate) economist. The latest was James Mirrlees, aged 82, winner of the Nobel prize in 1996. I know of his work on information asymmetries, especially moral hazard, which I teach in my ECONS102 class (ironically, it is the topic we are covering this coming week).

He is also well known for his work on optimal taxation, defining the balance between equity and efficiency. That work has been used to justify reducing marginal income tax rates in most developed countries over recent decades.

There are good obituaries noting his life and key contributions at The Sunday Times (gated), the Washington Post, and the New York Times, but for a more personal tribute, read this piece by John Kay.

[HT: Marginal Revolution, here and here]