Uber as a substitute for ambulances

When a new, cheaper substitute to an existing good or service becomes available, we can expect the demand for the existing good or service to decline. Importantly though, 'cheaper' refers to the full cost of obtaining the good or service, not just the monetary cost. So in the case of ambulance services, the cost may partly be monetary (such as in the U.S.), but also includes the cost of waiting to receive treatment (which is probably a more important component of the cost in New Zealand, although in some cases ambulance services will charge for a call-out. For example, see here).

Are there cheaper substitutes for ambulances? In a country such as the U.S., where the monetary cost of calling an ambulance could easily be in the thousands of dollars, ride-hailing services like Uber or Lyft could easily be a less costly option overall. However in New Zealand, where the monetary cost of calling an ambulance is not as high, the evaluation is not quite as straightforward. If you call an ambulance for something serious, then you benefit from treatment from the ambulance officers as soon as they arrive at your location. But if you call an Uber, the driver probably arrives at your location quicker than an ambulance would (since they have less far to travel), but then you have to wait until you get to the hospital in order to receive treatment. So, for Uber to be cheaper than an ambulance in New Zealand, the monetary cost savings would have to offset the (likely) longer time to receive treatment.

So, we would expect to see Uber having some effect on ambulance services in the U.S., but less so in New Zealand. But how big an effect? In a recent paper, Leon Moskatel (Scripps Mercy Hospital) and David Slusky (University of Kansas) investigate the impact of UberX on ambulance call-outs. Using U.S. data on the timing of UberX's entry into various cities and the number of call-outs in each city, they find that there is:

...at least a 7% decrease in the ambulance rate from Uber entry into a city.

Moskatel and Slusky's paper is short and not particularly detailed. The analysis is fairly straightforward, and perhaps a little too much so. They claim that their analysis "follows a generalized difference-in-differences framework at the city-quarter level", but I don't think it does because they use only a simple dummy variable to test for the effect of Uber.

A 'difference-in-differences' analysis involves computing the difference between two differences (there's no mystery in the naming of this technique). Essentially, in this case you calculate the difference in ambulance call-outs between the period before UberX became available and the period after UberX became available (treatment cities), and then you calculate the difference in ambulance call-outs between the period before and the period after for control cities (where Uber did not become available). The problem with the analysis in this paper is that there are no control cities - all cities in their analysis had UberX become available. This doesn't bias their results, but it does affect how you interpret them, since they are really only testing for a difference in mean ambulance call-outs between cities with and without UberX.

If you have time series data but no control, you could run an interrupted time series analysis instead, which is very similar to difference-in-differences but simply tests whether the time trend in the data changes between the period before UberX became available and the period after. The results that they present in Figure 2 in the paper suggest to me that their analysis is probably under-stating the impact of UberX, since there appears to be a clear break in the time trends between the period before and the period after UberX became available.

Anyway, that is a fairly technical critique of a paper that tells us something interesting. Although, I wouldn't expect there to be as large an effect of Uber on ambulance call-outs in New Zealand.

[HT: Marginal Revolution]

Why honey thefts are on the rise

Last week, the New Zealand Herald reported:

"Theft of beehives has become a growing issue over the last few years. Where once there was the odd, isolated regional incident, today we're seeing theft occur more often," [Apiculture New Zealand chief executive Karin] Kos said.

"A lot of hives are in isolated areas and it seems to be small groups or individuals who have some knowledge of bees and how to transport them.

"We believe most of the activity happens at night," she said. That's also the time when the bees are in the hives and quiet.

An increase in honey value, particularly manuka honey, appears to be a key factor behind the rise in crime throughout New Zealand, but most occurs in central North Island, Bay of Plenty and Northland, Kos said.

Why the increase in honey thefts? The 1992 Nobel Prize winner Gary Becker identified that rational criminals would weigh up the benefits and costs of their actions, in his economic theory of crime (see the first chapter in this pdf).

A similar way of thinking about it is represented in the diagram below. Marginal benefit (MB) is the additional benefit of engaging in one more honey theft. In the diagram, the marginal benefit of honey thefts is downward sloping - the more honey thefts a criminal engages in, the more likely they are to get caught and the harder it is to 'fence' their stolen honey the less they can sell their stolen honey for (because it is harder to 'fence' greater quantities of stolen honey). Marginal cost (MC) is the additional cost of engaging in one more honey theft. The marginal cost of honey theft is upward sloping - the more honey thefts a criminal engages in, the higher the opportunity costs (they have to give up more valuable alternative activities they could be engaging in, and as well, they are more likely to get caught and it becomes harder to 'fence' their stolen honey). The 'optimal quantity' of honey thefts (from the perspective of the thief!) occurs where MB meets MC, at Q* honey thefts. If the criminal engages in more than Q* thefts (e.g. at Q2), then the extra benefit (MB) is less than the extra cost (MC), making them worse off. If the criminal engages in fewer than Q* thefts (e.g. at Q1), then the extra benefit (MB) is more than the extra cost (MC), so conducting one more theft would make them better off.

Now consider what happens in this model when the value of honey increases (because of increased demand from China or elsewhere). The benefits of honey crime increase. As shown in the diagram below, this shifts the MB curve to the right (from MB0 to MB1), and increase the optimal quantity of honey thefts by criminals from Q0 to Q1. Honey thefts increase.

So, how do you combat honey crime? Becker's model suggests that you can reduce crime by either increasing the costs of crime (e.g. by either increasing the probability that criminals are caught, or increasing the penalties for criminals who are caught, or both), or by decreasing the benefits of crime (e.g. by making it difficult for stolen honey to be traded, such as by having some sort of registration and tracking system for legally-traded honey). If you increase the costs of crime by increasing policing and enforcement or increasing punishments, this shifts the MC curve up and to the left, decreasing the optimal quantity of honey thefts. If you decrease the benefits of crime by making it difficult to trade in stolen honey, this shifts the MB curve down and to the left, also decreasing the optimal quantity of honey thefts.

Which is better? Both alternatives are not without cost - more policing or longer prison sentences are both costly, as is the setup and maintenance of a system of registration and tracking of honey. To really work out which is more cost-effective, we'd need to know their costs, as well as how responsive criminals are to changes in the costs and/or benefits of crime. Given police resources can become rather stretched though, perhaps the honey industry should be looking at developing a solution themselves (and at their own cost)?

Loss aversion, ideology and the peer review process

Last month, Andrew Gelman wrote an interesting blog post about peer review, or more accurately about how researchers steer their papers through the peer review process:

...researchers are taught to be open to new ideas, research is all about finding new things and being aware of flaws in existing paradigms—but researchers can be sooooo reluctant to abandon their own pet ideas...

My story goes like this. As scientists, we put a lot of effort into writing articles, typically with collaborators: we work hard on each article, try to get everything right, then we submit to a journal.

What happens next? Sometimes the article is rejected outright, but, if not, we’ll get back some review reports which can have some sharp criticisms: What about X? Have you considered Y? Could Z be biasing your results? Did you consider papers U, V, and W?

The next step is to respond to the review reports, and typically this takes the form of, We considered X, and the result remained significant. Or, We added Y to the model, and the result was in the same direction, marginally significant, so the claim still holds. Or, We adjusted for Z and everything changed . . . hmmmm . . . we then also though about factors P, Q, and R. After including these, as well as Z, our finding still holds. And so on.

The point is: each of the remarks from the reviewers is potentially a sign that our paper is completely wrong, that everything we thought we found is just an artifact of the analysis, that maybe the effect even goes in the opposite direction! But that’s typically not how we take these remarks. Instead, almost invariably, we think of the reviewers’ comments as a set of hoops to jump through: We need to address all the criticisms in order to get the paper published. 

Gelman argues that there is a problem with the way that researchers are trained to deal with peer review. Researchers deal with peer review by making the minimal number of changes necessary in order to ensure publication, Gelman argues that that needs to change. I don't disagree. However, I think he is missing something important about researchers, as real people.

People are loss averse. We value losses much more than equivalent gains (in other words, we like to avoid losses much more than we like to capture equivalent gains). Loss aversion makes people subject to the endowment effect - we are unwilling to give up something that we already have, because then we would face a loss (and we are loss averse). Or at least, there would have to be a big offsetting gain in order to convince us to give something up that we already have. The endowment effect applies to objects (the original Richard Thaler experiment that demonstrated endowment effects gave people coffee mugs), but it also applies to ideas.

I've thought for a long time that ideology was simply an extreme example of the endowment effect and loss aversion in practice. Haven't you ever wondered why it's so difficult to convince some people of the rightness of your way of thinking? It's because, in order for them to agree with you, that other person would have to give up their own way of thinking, and that would be a loss (and they are loss averse). It seems unlikely that the benefits of agreeing with you are enough to offset the loss they feel from giving up their prior beliefs, at least for some people. Once you consider loss aversion, it's easy to see how ideologies can become entrenched. An ideology is simply lots of people suffering from loss aversion and the endowment effect.

Now, back to peer review. Researchers are also loss averse, and when they submit an article for publication, the article includes their own ideas, analysis, and conclusions. They don't want to give those up, since that would be a loss (and researchers, like everyone else, want to avoid losses). So, it is natural for researchers to deal with reviewers' comments in a way that minimises the sense of loss that they feel from making the necessary changes (while preserving the gains from getting the article finally published). Making small, incremental changes to a research paper minimises the loss the researchers feel, and so that is the way that researchers deal with peer review.

How to solve the problem? Gelman's solution appears to be better training for researchers. However, I can't see how you can train someone out of being loss averse, which means that we are stuck with researchers who will, as Gelman says, "respond to legitimate scientific criticism in an angry, defensive, closed, non-scientific way". Maybe instead it's time to reconsider peer review? Maybe peer review should exist only to screen out the most egregious errors and not to quibble over minor details (most of which can easily be quibbled over later in online commentary on the paper)?

[HT: Marginal Revolution]

Some further notes on rent increases

Rent increases have been in the news a lot recently, especially in Wellington (see my post from earlier in the week). Based on some discussions with students, I thought I would make a few notes.

First, some have suggested that rents have increased by $50 because student allowances and Student Loan living cost payments have increased by that much (e.g. Grant Robertson's Facebook post on this). This is possible, but unlikely. If our incomes increase, we will be willing to pay more for rental housing (rental housing is what economists call a 'normal good'). That shifts our demand curve for housing up and to the right, as in the diagram below (from D0 to D1). The equilibrium rent will increase from R0 to R1. How much more will be willing to pay, and how much will the equilibrium rent increase by? Certainly our willingness-to-pay will not increase by the whole additional $50 of our income, because when our incomes increase we are also willing to pay more for food, clothing, entertainment, and all of the other normal goods that we like to buy. Our willingness-to-pay for rent will increase by some proportion of the $50 increase in income. So, I think it's extraordinarily unlikely that an increase in demand, driven by the increase in incomes, is solely behind the increase in rent.

Second, prices increase when there is excess demand. Is excess demand driving the increase in rents by $50? I covered this in my post on Monday and Eric Crampton also covered it. It's possible that rents are currently below the equilibrium rent, as shown in the diagram below. At the rent R0, there are Qd tenants looking for a house, but only Qs houses available to rent. There is excess demand for housing. Some tenants are missing out on housing. Landlords and tenants both recognise the excess demand, and tenants might start approaching landlords and offering a bit more in order not to miss out, or landlords might increase rents knowing that tenants will be willing to pay a little bit more in order not to miss out. Either way, rents start to rise and eventually the market ends up at the higher equilibrium rent R1. However, we seem to be in a perpetual state of excess demand in the rental market (if you doubt that, look at any of my past posts on housing). I've mused that maybe landlords are offering 'efficiency rents' - rents that are deliberately below the equilibrium rent, because that allows them to have the pick of applicants. So, I think it unlikely that excess demand is a big factor in increasing rents.

Third, and something that I haven't seen anybody considering, is that the accommodation supplement will increase on 1 April. Landlords signing rental agreements now must know that the accommodation supplement will increase during the term of the tenancy agreement, and that this increase in subsidy works sort of like the increase in demand shown above. However, in the case of the accommodation supplement, we can be fairly sure that it does increase willingness-to-pay for housing by $50, because it can't be used for anything else. [*] Why adjust rents now, when the accommodation supplement doesn't change for two more months? Because the rent that is agreed now can't be changed for several months after April - it makes sense to build this increase in now. This is shown in the diagram below. The accommodation supplement is a subsidy, paid to the tenant, so we show this with the D+subsidy curve, which is above the demand curve (for simplicity, the diagram doesn't show an increase in an existing accommodation supplement, which is actually what is happening, but making the diagram a bit more complex doesn't change the story at all). Another way of thinking about this is that, once the accommodation supplement increases by $50, households are willing to pay the same as before (shown by the demand curve), plus the extra $50 of the increased accommodation supplement. The rent before the increase in the accommodation supplement is R0. After the increase in the accommodation supplement, the rent that households pay to the landlords increases to RL, and the effective rent (after subtracting the increase in the accommodation supplement) falls to RT. Notice that most of the benefit of the increased accommodation supplement is captured by landlords. This is because of the very steep (inelastic) supply curve in the rental market - when rents increase, there aren't a lot of additional landlords rushing to make their houses available for renting.

So, my feeling is that the increase in rents we are observing now is the effect of landlords recognising that the accommodation supplement will soon increase, and they are trying to capture that increase early. And not the effect of the increase in student allowances, or excess demand for rental housing. Or maybe it is a little bit of all three? Of course, the easiest way to find out whether this explanation is the right one would be to ask landlords. But given the potential for a media beat-up, would you really expect them to come clean about this?

Finally, some dimwits have been advocating for rent controls (see Anna Mooney of Renters United quoted here). No. Just no.

Read more:

• That January tradition... rent increases, Wellington edition
• This is what happens when you have shortages of rental property
• Students, rental shortages, and renting over the summer
• January tradition continued... Rent increases again
• A January tradition - complaints about rising rents
• Out-of-control rent increases in Auckland - why?

*****

[*] You may be thinking here that income is fungible (it can be used for other things besides housing). That means that, when the accommodation supplement increases by $50, households' willingness-to-pay for housing might not increase by $50, because they might re-direct some of their other intended spending away from housing. However, in a world where people are quasi-rational and affected by mental accounting, it turns out that fungibility may actually be reasonably low (I'm currently reading Richard Thaler's excellent book Misbehaving: The Making of Behavioral Economics - more on that when I review it soon). Quasi-rational decision-makers have a household budget for rent, and when the accommodation supplement increases by $50, they may be thinking that means they can spend $50 more on rent (rather than other things) and act accordingly.

That January tradition... rent increases, Wellington edition

It's January, so that means house rental increases are in the news (if you doubt me, here's my 2017 post on the topic, and 2016, and 2015). It starts with Dan Rowe's piece in the Spinoff a couple of weeks ago, in which the details are not at all surprising:

The nightmare that is renting in this country continues to bring new horrors, with reports from Wellington that landlords are explicitly operating tender processes on their rentals in a bid to drive up prices...

Because what tenants aren’t free to do is escape the market altogether – already flat viewings across the city are attracting hordes of applicants, thronging in the streets and clamouring for a place to sleep as much as a full month before university begins for the year.

“I was at one the other day and there were people everywhere streaming up and down the street. Someone came out and asked us what was going on on their street because apparently there’d been like a hundred people walking up and down. It’s been pretty hectic.”

When you have "hordes of applicants" that suggests to me that there is excess demand (a shortage), and when there is excess demand you would expect prices (in this case, rents) to increase (a point that I have made before). However, Eric Crampton has a slightly different take, explaining why we wouldn't necessarily expect the rent to rise so far that it would eliminate the excess demand:

Suppose it's hard to evict a bad tenant. It'll take a long time, it'll be a hassle, and the tenants might destroy the place while you're going through the tenancy tribunal. If you set a high price and if it's hard to monitor and police what's going on in the flat, you might have problems. The high bidder might be the one expecting this to be a short-term game.

Landlords would want to evaluate a potential tenant's bid across a pile of hard-to-specify and possibly illegal-to-specify (but impossible to police unless you're dumb enough to write it in the ad) non-price margins. If you want that, you want to have excess demand at the posted money price so that you can clear on the other margins.

This idea of landlords offering 'below-market' rents in order to have the pick of tenants could be termed an efficiency rent (the rental equivalent of an efficiency wage - see here for more on efficiency wages), which I wrote about back in 2016:

As noted above, there is a moral hazard problem for landlords - tenants' incentives (to look after the property) are not aligned with the landlord's incentive (to keep the property in top condition). If the landlord instead offered an efficiency rent (a rent below the equilibrium market rent), then they would have many potential tenants applying for the property, allowing the landlord to pick the best (the least likely to damage the property). It also gives the tenants an incentive to look after the property after signing the tenancy agreement, because if they don't they get evicted and have to find another place to live at a much higher cost.

Maybe landlords offer efficiency rents already and we just don't realise it? There is certainly plenty of evidence for excess demand for rental properties (see here or here for example), so maybe rents are below equilibrium (though they are rising quickly so it's possible that the observed below-equilibrium rents are simply in transition to a higher equilibrium level). Excess demand by itself is pretty weak evidence for efficiency rents. I'd want to hear landlords telling us they offer lower rents to attract good tenants before I found it believable. There's not a lot of evidence in the academic literature on efficiency rent either (see this paper by Basu and Emerson as one example, ungated here).

I'm still waiting for some clear evidence that efficiency rents are a good characterisation of what drives excess demand in rental housing markets. In the meantime, we are left to ponder the situation. What is clear though, is that by now no one should be surprised that house rents increase in January.

Read more:

• This is what happens when you have shortages of rental property
• Students, rental shortages, and renting over the summer
• January tradition continued... Rent increases again
• A January tradition - complaints about rising rents
• Out-of-control rent increases in Auckland - why?

Professional tennis players are optimisers

With plenty of action in Melbourne at the Australian Open this week, it seems timely for me to write a post about tennis. I've already noted in an earlier post that tennis players appear to be loss averse. But are they optimising nonetheless? Do they make decisions that maximise their chances of winning (which would also be consistent with loss aversion)?

A recent paper by Jeffrey Ely (Northwestern University), Romain Gauriot (University of Sydney), and Lionel Page (Queensland University of Technology), published in the Journal of Economic Psychology (sorry I don't see an ungated version) provides us with some answer. The authors look specifically at the risk behaviour of servers on first and second serve:

When serving, players can opt for risky serves which are more likely to fail but are harder to return if successful or more conservative serves which are less likely to fail but are also easier to return.

The key is whether players behave differently on first and second serves (more on that in a moment). However, simply comparing first and second serves is not so straightforward. The authors correctly note that there is:

...a potential caveat with raw data on tennis serve: it can be characterised by a selection problem. First serves are always observed while second serves are only observed when the first serve failed. This means that second serves may be more likely to be observed when serving is harder than usual either for natural reasons (e.g wind conditions), fitness (e.g. tiredness late in the match) or strategic reasons (e.g. opponent having learned how to return the player’s serve).

Their solution is quite ingenious:

To cleanly compare first and second serves one ideally wants to observe some random events which determines in a given situation whether a serve is going to be a first or a second serve. We argue that such a situation occurs when the ball hits the tape (top of the net) on the first serve. The impact with the net gives the ball an unpredictable trajectory leading the ball to be either in or out. It introduces the required randomness as a first serve follows a ball let which lands in the court and a second serve follows a ball which lands outside the court.

The serve immediately following a 'let serve' is randomly either a first serve (if the 'let serve' landed in) or a second serve (if the 'let serve' landed out). Ely et al. use a dataset from 3,188 matches, involving over 690,000 serves, of which 7,605 follow a 'let serve' and are the core sample of interest. They test four conditions which would imply that players are correctly maximising their chance of winning:

1. That first serves are more risky than second serves (the probability that a serve lands in is lower for first serves);
2. That first serves are harder to return than second serves (players are more likely to win the point on their first serve);
3. Using two first serves is a suboptimal strategy (it leads to a lower probability of winning the point); and
4. Using two second serves is also a suboptimal strategy.

They find that:

...the serves from professional tennis players meet four conditions which make them consistent with the optimal strategy of risk taking between first and second serves. This result is observed both overall and when splitting the sample by gender and ranking.

So, it appears that professional tennis players are optimisers. Which we should expect - they are trained professionals who have developed skills in strategic play over many years.

Read more:

• Is Roger Federer more loss averse than Serena Williams?

Dolphins, incentives, and unintended consequences

In ECON110, when I teach about incentives and unintended consequences in the first week of class, one of the tutorial examples involves a story about paleontologists in China, who offered to pay peasant villagers for each dinosaur fossil fragment they found. The villagers responded to the incentive by giving the paleontologists lots of fossil fragments. However, they obtained the fossil fragments by breaking larger fossils into smaller fragments. Incentives can (and often do) lead to unintended consequences.

Now, it turns out, at least one group of dolphins is responding in a very similar way to a similar set of incentives, as the Guardian reports:

At the Institute for Marine Mammal Studies in Mississippi, Kelly the dolphin has built up quite a reputation. All the dolphins at the institute are trained to hold onto any litter that falls into their pools until they see a trainer, when they can trade the litter for fish. In this way, the dolphins help to keep their pools clean.

Kelly has taken this task one step further. When people drop paper into the water she hides it under a rock at the bottom of the pool. The next time a trainer passes, she goes down to the rock and tears off a piece of paper to give to the trainer. After a fish reward, she goes back down, tears off another piece of paper, gets another fish, and so on. This behaviour is interesting because it shows that Kelly has a sense of the future and delays gratification. She has realised that a big piece of paper gets the same reward as a small piece and so delivers only small pieces to keep the extra food coming. She has, in effect, trained the humans.

Her cunning has not stopped there. One day, when a gull flew into her pool, she grabbed it, waited for the trainers and then gave it to them. It was a large bird and so the trainers gave her lots of fish. This seemed to give Kelly a new idea. The next time she was fed, instead of eating the last fish, she took it to the bottom of the pool and hid it under the rock where she had been hiding the paper. When no trainers were present, she brought the fish to the surface and used it to lure the gulls, which she would catch to get even more fish. After mastering this lucrative strategy, she taught her calf, who taught other calves, and so gull-baiting has become a hot game among the dolphins.

No one who creates an incentive will ever be as smart as all the people (or dolphins) out there scheming to take advantage of the incentives.

[HT: Marginal Revolution]

Increases in the minimum wage are effectively paid by consumers, but they lower inequality anyway

This post includes some good news, and some bad news, about increases in the minimum wage. Tobias Renkin's (University of Zurich) job market paper, co-authored with Claire Montialoux (UC Berkeley), and Michael Siegenthaler (ETH Zurich), has the details. In the paper, Renkin et al. estimated the pass-through of increases in the minimum wage into grocery store prices. In other words, they estimate whether it is consumers (full pass-through), grocery stores (no pass-through), or some combination of the two, that faces the costs of increases in the minimum wage for grocery store employees. Why care about grocery stores? The authors explain:

Grocery stores employ a substantial number of minimum wage workers, and their marginal costs are therefore likely affected by minimum wage hikes. Moreover, groceries make up a large share of consumer expenditure, especially in poor households and grocery prices thus substantially affect the real incomes of workers.

Most studies of the minimum wage look at hospitality (e.g. restaurant) workers, so it's good to have an alternative. Their price data contains U.S. data on:

...weekly prices and quantities for 31 product categories sold at grocery and drug stores between January 2001 and December 2012. On average, the sample covers 1,916 stores and 60,600 products over this period... Stores are located in 530 counties, 41 states and belong to one of about 90 retail brands... The data covers 17% of US counties which are home to about 29% of the overall population.

Unlike previous studies though, the authors argue that the date at which grocery stores make their price adjustments is the date that the minimum wage increase is announced, rather than the date it takes effect (which is usually some time later). Their analysis seems to back this up, with statistically significant effects on and around the date of the legislation, and less so around the date of implementation, of minimum wage increases.

The key results are for the minimum wage elasticity of grocery prices. That is the percentage change in grocery prices divided by the percentage change in the minimum wage, and can be interpreted as the percentage increase in grocery prices that would result from a one percent increase in the minimum wage. The results suggest that this elasticity is around 0.02. That is, a 1 percent increase in the minimum wage would increase grocery prices by around 0.02%. That doesn't sound like a lot, but the authors explain that:

In our sample, the average minimum wage legislation increases the minimum wage by about 20% in several steps. Our estimates suggest that such an increase raises prices in grocery stores by about 0.4% over three months at the time when legislation is passed. By the time the minimum wage has actually risen to the level set in the new legislation, price adjustment is already long complete.

There are lots of robustness checks that demonstrate the result is fairly robust. To work out how much of the minimum wage increase is passed through to consumers though, we need to also know what the minimum wage elasticity of grocery store costs is. That is, we need to know how much grocery store costs increase by when the minimum wage increases by one percent, and then compare that to the minimum wage elasticity of grocery prices. They authors find that:

Our estimate for pass-through based on our baseline specification amounts to 1.1. We cannot reject the hypothesis that pass-through is equal to 1...

In other words, all of the increase in the minimum wage is passed through to consumers. Grocery stores essentially pay none of the cost of the minimum wage increase. That is the bad news.

That might make you wonder then, since low income households spend the highest proportion of their income on food, and minimum wage increases are passed through in higher prices to those households (and richer households, of course), is the minimum wage increase entirely eaten up by higher prices? The authors address this question as well, and find that:

Expressing the costs as a percentage of annual household incomes reveals the regressive impact of the price response. The costs make up about 0.2% of annual income for households in the poorest bracket, and just one tenth of that, i.e. 0.02% for households in the richest bracket.

As a percentage of household income, the increase in grocery store prices are disproportionately borne by lower income households. However, the good news is that:

As expected, minimum wages reduce income inequality... In terms of nominal gains, households in this bracket gain an additional 1.5% of household income over an inequality neutral policy. Taking into account the price response in grocery stores reduces the additional gains to 1.34% and further taking into account restaurants reduces the gains to 1.15%.

Even though lower income households spend a higher proportion of their income at grocery stores than higher income households, they also benefit proportionately more from the increase in the minimum wage, and the increase in household income is not all eaten up by increases in grocery prices.

[HT: Marginal Revolution]

Social contracts, nation-building, and war

Social contract theory suggests that people have willingly given up some of their freedoms to the State and in exchange, the State agrees to protect their remaining rights. One conception of this is that we give up the freedom to retain all of our income (i.e. we grant the State the right to tax us), and in exchange the State protects our life, liberty and property. We submit to this because the State can provide for our collective needs things that could not be provided by each of us individually or through exchange with others. In other words, public goods.

So, I found this NBER Working Paper from last year (ungated version here) by Alberto Alesina (Harvard), Bryony Reich (Northwestern) and Alessandro Riboni (Ecole Polytechnique) really interesting. The paper is very theoretical and maths-heavy. However, it was of interest to me nonetheless because it explains the process of nation-building that occurred progressively as nation states and their armies increased in size, and why the nation states moved increasingly towards providing public goods. The authors write:

Mass warfare favored the transformation from the ancient regimes (based purely on rent extraction) to modern nation states in two ways. First, the state became a provider of mass public goods in order to buy the support of the population. Second, the state developed policies geared towards increasing national identity and nationalism...

The citizens face punishment from illegally avoiding conscription and the soldiers from defecting or cowardice; however it is hard to imagine that wars can be won by soldiers who are fighting only to avoid punishment and citizens who are uncooperative. So, when war became a mass enterprise, the elites had to reduce their rents and spend on public goods which were useful to the populations.

Providing public goods was one way for the elites to ensure that citizens would cooperate with conscription. Where does nation-building come in? The authors explain that:

Besides promising monetary payoffs, the elites have two means to increase war effort. One is to provide public goods and services in the home country so that soldiers would lose a lot if the war is lost. This would lead to investment in "peaceful" public goods and contribute to state building from a different angle relative to the need to collect taxes to buy guns. Second, the elite may need to homogenize or indoctrinate the citizens to make them appreciate victory and dislike living under foreign occupation.

Engaging in nation-building instilled in the citizens a sense of nationhood and a dislike for other nations, thereby increasing war effort. Alesina et al. conclude with:

A key implication of our analysis is that as warfare technologies led to a military revolution with larger armies, the elite had to change the way it motivated the soldiers: from the loots of wars for relatively small armies of mercenaries to public goods and nation building and/or nationalism for large conscripted armies.

Like the paper I discussed on Monday about queens, it made me wonder if there are business implications that can be drawn from this paper. Can CEOs induce more effort from their workers by providing them with public goods and instilling in them a dislike for the competitors? Is this already what tech firms are doing when they install ping-pong tables, and take employees away for all-staff conferences?

[HT: Marginal Revolution, back in May last year]

The economics of ticket scalping

In yesterday's post about the increasing role of economics in sports, I mentioned this 2009 article by Ross Booth (Monash University), published in the Australian Economic Review. In the article, Booth discusses some of the key topics he teaches in sports economics, one of which is the economics of ticket scalping, and how ticket scalping increases economic welfare. For example, this article from September published in The Conversation, by Paul Crosby and Jordi McKenzie (both Macquarie University) notes that:

...there is an argument that ticket scalping actually enhances the total welfare of concert goers and sports fans. Scalpers act to distribute tickets to those who value them the most, or, as economists’ would say, they increase the allocative efficiency of the market.

Secondary markets for tickets allow potential buyers to indicate how much they want to go to the event – their “willingness to pay”. If tickets can only be bought at a single price on a first come first serve basis, then some people who really want to go will be left out. Secondary markets permit these mutually beneficial exchanges to take place.

Online platforms for buying and selling tickets actually increase this allocative efficiency. 

However, this traditional view that is used by many economics teachers is not correct, as I have explained before (see here and here). However, this point bears repeating.

Consider the diagram below. The supply of tickets to some event S0 is fixed at Q0 - if the price rises, more tickets cannot suddenly be made available because the capacity of the venue is fixed (note the diagram assumes that the marginal cost of providing tickets up to Q0 is zero).

Demand for tickets is high (D0), leading to a relatively high equilibrium price (P0). However, tickets are priced at P1, below the equilibrium (and market-clearing) price. At this lower price, there is excess demand for tickets (a shortage) - the quantity of tickets demanded is Qd, while the quantity of tickets supplied remains at Q0.

With the low ticket price P1, the consumer surplus (the difference between the price the consumers are willing to pay, and the price they actually pay) is the area ABCP1. Producer surplus (essentially the profits for the venue or the seller) is the area P1CDO. Total welfare (the sum of producer and consumer surplus) is the area ABCDO. At the higher price P0 due to the actions of scalpers (buying at P1 and selling at P0), the consumer surplus decreases to ABP0, while producer surplus remains unchanged. The scalpers gain a surplus (or profit) of the area P0BCP1, and total welfare (the sum of producer and consumer surplus, and scalper surplus) remains ABCDO. So the ticket scalpers don't increase total welfare - their actions don't affect total welfare at all, just the distribution of that welfare between the parties.

However, the above analysis allows us to think about what would be required for ticket scalping to increase total welfare. That would happen if the higher price induced more events (since each event has a fixed number of tickets, the only way to increase total welfare is to have more events). However, that would only happen if the sellers (not the ticket scalpers) received a higher profit from each event (incentivising them to schedule more events). As shown above, the action of the scalpers doesn't affect producer surplus (it stays P1CDO with and without scalping), and so those incentives for the sellers don't materialise.

Crosby and McKenzie do correctly note that online platforms for re-selling tickets:

...arm buyers and sellers with ever increasing amounts of information, and the time and expenses associated with the purchase of each resold ticket (known as “transaction costs”) are greatly reduced.

The main downside of ticket scalping is that some (previously very lucky) consumers could earn a huge consumer surplus by buying their tickets at a much lower price than what they were willing to pay for them, but must now pay a higher price. You might think this unfair, but as I pointed out in an earlier post:

...you probably also think that the high price of milk is unfair, the high price of petrol is unfair, the high price of electricity is unfair, etc.

Despite the actions of ticket scalpers having little effect on economic welfare (they just re-distribute it), governments do seek to clamp down on it. Crosby and McKenzie briefly discuss technology as a means of reducing scalping, but a more recent Conversation article by Keith Parry, Aila Khan, and Blair Hughes (all Western Sydney University) lays out the future of ticketing in more detail:

Internationally, there have been some interesting developments amongst teams, venues and ticketing companies that may eliminate scalping and improve the ticketing experience.

It may not be long before all fans can take advantage of innovations such as mobile-only tickets, biometric access, and even microchipped tickets...

Looking to the future, it may not be long until tickets are physically linked to individuals and our iconic sporting venues are accessed with the swipe of an appendage.

In such a world, paper tickets will become a thing of the past.

One cannot feel that something is lost without the physical memento of a sporting event provided by a ticket stub. The scalpers and bots have much to answer for.

It's not the scalpers or bots that have much to answer for, it's the ticket sellers who consistently under-price event tickets. If they didn't do so, then the scalpers and bots would have no opportunity to profit.

Read more:

• The Super Rugby final and ticket scalping
• Harry Potter and the chamber of scalpers

The unintended consequences of China's coal ban

Internationally, pollution is a problem, but is more of a problem in some countries than others. When it comes to dealing with the problem of pollution, policy-makers have two options: (1) a command-and-control policy, where pollution is heavily restricted (and backed by enforcement mechanisms such as fines for firms that fail to comply); or (2) a market-based solution, such as an environmental (Pigovian) tax or tradeable pollution permits (see my earlier post discussing these two options).

It is well-known that China has a severe pollution problem, and it is also well-known that when China has a problem the solution is often heavy-handed. In this case, that means a command-and-control policy that restricts pollution, in this case implemented by local officials who banned the use of coal (I might add, this is a policy favoured by some in New Zealand as well, and in place in some areas and under some conditions already). The main problem with command-and-control policies is that they are very inflexible to market conditions. However, they can also come with other unintended consequences.

So, it came as little surprise to me when South China Morning Post reported this week:

Clearly [Chinese president Xi Jinping] is highly sensitive to the anger of ordinary people at China’s sky-high levels of pollution. And clearly his message struck home with party officials. After local government officials either restricted or simply banned coal use across much of Northern China, the residents of Beijing enjoyed unseasonably blue skies and fresh air through November.

But the centrally dictated clean-up came at a heavy price. Coal is not only the main source of fuel for power stations and industry, accounting for about two-thirds of China’s electricity generation, it is also burnt to heat millions of households through Northern China.

So when officials imposed their ban on coal use in line with Xi’s concern for the environment, they triggered a price surge and supply squeeze in substitute clean energy, notably natural gas. And millions of poorer households and many towns and villages unconnected to the gas supply grid were left out in the cold.

Over the past couple of months, natural gas prices have jumped by 70 per cent, hurting energy-intensive businesses, many of which were already operating on razor thin margins. Some have been forced to shut down. That’s bad enough, but even more embarrassing as far as government officials are concerned, are the tales of personal hardship that have spread across the internet and through the media, complete with stories about schoolchildren suffering frostbite because of the lack of heating in their classrooms.

The sad thing is that none of this should have been particularly surprising. When you ban the use of coal, how are households where coal is the only heating option supposed to respond? In terms of industry and electricity generation, coal and natural gas are substitutes. When you ban the use of coal, the demand for natural gas will rise, and so will its price.

You can't just legislate away the trade-offs in decisions like these. A market-based solution, such as a tax on coal, would reduce (but not eliminate) coal use, but would also create incentives for firms and households to switch to cleaner-burning fuels. However, those changes take time. If the government wants to push through change more quickly by imposing a ban, then there are clear human costs that will have to be borne. There is no overnight fix for China's pollution problems that avoids these costs, and it appears that the government has backtracked:

Now the government is using the same mechanisms of central control to reverse its policy. That should help to solve its immediate troubles. But in the longer run the underlying problem will remain in place. As long as Beijing continues to govern by diktat, attempting to manage the supply side of the economy in order to hit arbitrary and often impractical targets, it will continue to encounter similar difficulties.

Indeed. The longer term problem is best solved by creating the right incentives.

[HT: New Zealand Herald]

The living wage may need an urgent look, but it needs to be a balanced one

In a story entitled "NZ living wage needs urgent look, Massey University and AUT researchers say", the New Zealand Herald reported today:

What could a New Zealand living wage look like?

A team of researchers have begun investigating the concept, which they say could help struggling, low-paid workers and tackle mounting challenges regarding poverty and productivity.

Massey University psychologist Professor Stuart Carr, who is co-leading the new three-year study, said living wages usually refer to higher minimum wage rates, derived from calculations of the material cost-of-living needs of a hypothetical household unit.

"However, the broader concept of living wages goes much further," he said...

The research team saw an urgent case to examine the area.

They said working poverty had "soared" due to low pay, insecure work that provided interrupted or insufficient hours of paid employment and rising housing, energy and food costs – all of which disproportionately affected women, younger and older people, and Maori and Pacific people in particular.

Researchers say that while a national minimum wage is a legal floor intended both to provide protection for workers and encourage fair competition among employers, minimum wages were now widely recognised as failing to provide sufficient cost-of-living income.

"This is due not only to the growth of informal work, poor awareness and weak enforcement of wage laws, but mainly to minimum wage rates not matching increasing living costs and the realities of precarious work," said Professor Jim Arrowsmith, of Massey's School of Management.

 Investigating the living wage is important, but it's difficult to see what canvasing four employers ("a city council; a public-sector Maori organisation; a Pacific social enterprise; and a local small or medium-sized enterprise") will tell us. Especially when there is already a wealth of research on the effect of higher minimum wages.

Much of the theoretical background (and some of the evidence) was summarised by Jim Rose (of the Taxpayers' Union) in an interesting report on the living wage earlier this year (full report here; summary here). While much of the report is a rebuttal of points made by the living wage movement (their report is available here), there are some general points that need to receive a bit more air, starting with:

The economics of a unilateral living wage policy by an individual employer is different to that of a minimum wage increase.

This is a point I have made before. The living wage may be good for employers, but not if all employers pay a living wage. That effectively increases the minimum wage, which is probably not a good idea.

The main reason that most people use to support imposing a living wage is to help reduce poverty, or especially child poverty. However, if you hold that view then you need to confront the fact that:

The Treasury (2013) estimated that 79% of households earning pay below the living wage rate have no children; 6% are sole parents; the remaining 15% of households are couples with children (see graphic below). Almost all teenagers and majority of adults in their twenties earn below the living wage; 29% of low income workers live in families whose income exceeds $60,000...

This is a point that Eric Crampton has made before too (see for example here). So, a living wage would not be well targeted, and as Eric has also pointed out, increasing Working for Families would be a better option than increasing minimum wages. The reason is that a lot of the increase in the living wage would be lost to tax. According to Rose:

The living wage increase has a much smaller effect on the take-home pay of employees with families because of a reduced Working for Families tax credit. In its 2015 Minimum Wage Review, the Ministry of Business, Innovation and Employment (2015) calculated that a couple working 60 hours between them on the minimum wage lose over 40% of a living wage increase to reduced Working for Families and to tax...

Ok, so let's leave the higher minimum wage aside, and consider individual employers (rather than all employers) paying a living wage:

Any employer who unilaterally introduces a living wage is simply raising their hiring standards. The workers who previously won the jobs covered by the living wage increase will not be shortlisted because the quality of the recruitment pool will increase. The Council must by law hire on merit so only those who currently earn $18- $20 in other jobs will be shortlisted for living wage vacancies. These recruits are on about the living wage now so they do not benefit from the living wage policy...

Workers who would not have previously applied for council jobs because they can earn more elsewhere will now apply because of the higher pay. These better paid applicants will crowd out the applicants of the minimum wage workers who currently win these jobs. Living wage advocates do not discuss what becomes of these low-paid workers who are no longer shortlisted. They should.

This is a point that we don't see raised nearly enough. A rational employer will employ labour up to the point where an additional hour of wages costs the same as the revenue it generates. So, if you pay a higher wage, then workers need to be more productive (see also this post). Rose's report addresses this point in some detail, providing a range of evidence (including New Zealand evidence) that suggests a living wage raises hiring standards. The key point is that employers want to be sure that the higher wages will be justified by higher worker productivity (as measured by higher revenues to offset the higher wages).

But what about public sector employers, where revenue is (arguably) less of a consideration? Rose writes about an Auckland Council proposal for a living wage:

Mayor Goff said he could pay for the living wage increase by cutting costs elsewhere... If these expenditures such as on better fleet management and group procurement are of low enough value to be reprioritised to fund a living wage policy for no loss of service, ratepayers are entitled to ask why the expenses were incurred in the first place.

Indeed, if there are cost savings that can be made (with no loss of service) in order to afford a living wage, then why are those cost savings not already being made? Was Auckland Council simply wasting ratepayers' money previously? In reality though, most 'cost savings' are mythical so I'm not sure we can really buy the argument that a living wage would be paid from cost savings anyway. Nevertheless, productivity is still a consideration for public sector services, and the New Zealand evidence in the report does seem to demonstrate that hiring standards increased when Wellington City Council became a living wage employer.

There's a lot of interesting points made in Rose's report, based on a range of theory and research in labour economics. If you're not familiar with the literature, it's well worth a read for that alone.

Coming back to the future research by Carr et al. that led this post, I'll be interested to see what they find. However, I'm not holding my breath that it will be a particularly balanced view, given how it has been reported so far.

Read more:

• Want a living wage for everyone? Raise productivity first
• The living wage is good for employers; unless lots of employers pay a living wage

Uber drivers taking advantage of their riders (again)

Earlier this week, I wrote a review of Brad Stone's book, The Upstarts, about Airbnb and Uber. I'ver blogged about Uber several times before, including this post about Uber drivers gaming the system by logging off in order to induce surge pricing. It turns out that is not the only way that Uber drivers can game the system, as Quartz reported last month:

Some Uber drivers in Lagos have been using a fake GPS itinerary app to illicitly bump up fares for local riders.

Initially created for developers to “test geofencing-based apps,” Lockito, an Android app that lets your phone follow a fake GPS itinerary, is being used by Uber drivers in Lagos to inflate the cost of their trips.

The drivers claim that they use the Lockito app in order to make up for Uber slashing fares earlier in the year:

Williams*, an Uber driver who asked his real name not to be used, says he heard about Lockito a while ago but initially had no interest in using it. “Uber was sweet, until they slashed the price,” he says. “They did not bring back their price up, so the work started getting tough and tougher.”

“When the thing was just getting tougher, I had no choice but to go on Lockito.”...

The funny thing is that Uber is clearly aware of Lockito, but allows drivers to continue using it:

Perhaps most surprisingly, drivers accuse Uber of not only knowing about app, but purposely not doing anything about it because they still want to maximize their profits.

“If you’re using Lockito [with] Uber [it] will tell you “fake location detected”…they will tell you [the driver],” says Williams. “Sometimes when I run it [Lockito], Uber will tell me, “your map of your location…is fake,” you’ll now click OK…and still yet, I take my money…”

I guess that way, Uber can claim that their fares are low and it is the actions of the drivers, not Uber, that results in high fares for passengers. If Uber raised their fares, it seems unlikely that drivers would now stop using Lockito. They've discovered a way to raise their incomes at essentially no cost to themselves, in a similar way to drivers in London and New York who were gaming the surge pricing algorithm.

As we note in the very first topic of ECON110, no individual or government will ever be as smart as all the people out there scheming to take advantage of an incentive plan [*]. This is just another example.

*****

[*] I've borrowed this point from the Steven Levitt and Stephen Dubner book, Think Like a Freak, which I reviewed here.

Lobbyists, rent seeking and deadweight losses

The rise of lobbying in New Zealand has been in the news recently, as Bryce Edwards explained in his regular Political Roundup column in the New Zealand Herald a couple of weeks ago:

Political lobbying is a growth industry in New Zealand. And lobbyists are going to be particularly busy over the next year.

Edwards charts the rise of 'hyper-partisan' lobby groups Hawker Britton and its right-wing counterpart Barton Deakin. It's an interesting read, along with the many links to other articles embedded within it.

Of course, lobbyists are ultimately being employed by firms that are seeking favourable policy settings. Perhaps they are looking for lighter-handed regulation for themselves, or more regulation of their competitors. Economists refer to this sort of activity as rent-seeking, and in ECON100 and ECON110 I discuss it as one of the key reasons that we might consider monopolies (or firms with market power more generally) to be unfavourable for society. Those firms make large profits, and therefore have a large incentive to use some of those profits to protect their market position through lobbying. If government is seeking to regulate their industry or to open it to more competition (or the firms are worried that the government might contemplate doing so), then those firms will employ lobbyists to dissuade governments from those policies that won't favour the firm.

When I was an undergraduate student, I struggled to see how rent seeking was negative for society. Obviously, it seems ethically problematic. But if you take a general equilibrium framework, then if the firm spends some of its profits on lobbyists, that simply becomes income for the lobbyists, and total welfare remains effectively the same (or maybe it even increases due to the producer surplus in the labour market for lobbyists).

However, that position forgets that the market operates across multiple periods. The firm with market power is generating a deadweight loss (for an explanation of why, see the first part of this earlier post). That deadweight loss arises because the firm with market power is able to price above marginal cost. If the government was to open the market to more competition or to regulate prices, then that would force the price down and increase total welfare in the market. Therefore, if the actions of the lobbyists prevents the regulation or the competition, then it has a cost to society that can be measured by the future deadweight losses that continue to accrue. So, lobbying does potentially have real negative consequences for society, and so as a society we should care about the actions of lobbyists and their interactions with our politicians.

CEO pay is not all about CEOs' performance, or company performance

While I was away overseas CEO pay was back in the news, mostly courtesy of the continuing fallout from Theo Spiering's $8.32 million salary-plus-benefits package announced back in September. In the New Zealand Herald, Helen Roberts (University of Otago) argues for greater transparency in CEO pay:

We are continually told seven figure sums are needed to retain top executives, without any substance or proof that it needs to be that high.

The reality is that it is the independent third-party remuneration advisers who set the expectations. Compensation consultants use median pay levels from the previous year to determine the median pay level for the current round of contracts; as pay levels increase the median pay level also goes up, driving all CEO pay levels up in that industry.

So the decisions are effectively being made based on the recommendations of only a few.

This becomes a never-ending cycle of artificially inflated salary packages, irrespective of company performance or any parity with pay for salaried workers- companies are effectively being held to ransom.

She then goes on to talk about how loosely CEO pay is related to actual company performance (read the whole article, it's interesting). However, there is a key point about CEO pay that is missed from Roberts's discussion, and also from arguments in favour of high CEO pay, such as this earlier article by Jim Rose, who focused more on superstar effects and essentially argues that if CEOs weren't earning their large salaries, they wouldn't keep their jobs.

That missing point is that the market for executives is a tournament (which I have written about earlier, also in the context of CEO pay). In tournaments the winner is not only paid for their own performance, but paid a high bonus as an incentive for those lower down (e.g. the next tier of executives, in the case of CEO pay) to work harder.

Tournament effects were first described by Sherwin Rosen and Ed Lazear in the early 1980s. In labour markets where there are significant tournament effects at play, workers are paid a 'prize' for their relative performance - maybe a raise or a promotion. The tournament 'winner' only needs to be a little bit better than the second best worker in order to 'win' the tournament, and claim the prize.

However, if winning the tournament is mostly about luck rather than good performance, then the prize needs to be very large in order to incentivise the workers to work hard to 'win' (otherwise, if the prize is small, why work hard if winning comes mostly down to luck?). The large role of luck in performance could be argued to be true of top executives (the tier below CEOs), where their performance can only be measured by metrics that they probably have only small positive influence over (and are more driven by economy-wide factors, especially in the case of large companies). [*] So, because companies want to incentivise their (non-CEO) top executives to work hard, ensuring that the CEO pay is a large step up is one way to do so. [**]

So, the focus on the lack of clear relationship between CEO pay and company performance, and calls for increasing transparency of CEO pay setting, are at least a little misplaced. Unless we first disentangle the incentive effects that are directed at other top executives.

*****

[*] I say positive influence here, because I'm sure that a really bad executive can have considerable negative influence on a company's performance, but it isn't at all clear to me that for a broad range of competent executives, there is much to choose between them.

[**] I do wonder how vulnerable this theory is to the extent of internal vs. external appointments as CEO, since it seems to rely on internal appointments being the norm. On the other hand, the threat of external appointments could increase the incentive effects for internal top executives, since they would have to compete on performance with potential hires from outside the company.

Read more:

• CEO pay and tournament effects

The value of exams as a signal

Exams have been in the news this week for all the wrong reasons. However, last week Michael Lee (University of Auckland) wrote an article in the New Zealand Herald on the real value of exams as a teaching tool rather than just an assessment:

We use exams as an encouragement tool to compel greater engagement with the material. That is actually where the real value of an exam is. When students feel the stakes are high and are unsure of what exactly will be asked, they are incentivised to take a look at everything seriously.

That's why teachers should never tell students exactly what will be examined, because 99 per cent of students will then focus only on that material, which defeats the true purpose of the exam.

In exams and in the real world, the first step to topic mastery is a general overview of key concepts and facts with as much detail as one can remember. Clearly, exams reward students that can do these things in a relevant way to answer a specific question.

A more advanced stage of mastery is the ability to creatively apply, integrate, and challenge the knowledge you have been taught. But it is difficult to get to that level if you haven't got enough base material to work with.

I have a slightly different take on the value of tests and exams. I agree with Lee that they are useful as learning exercises, especially if organised well. I disagree that we shouldn't tell students what will be examined (although I will admit that when asked what will be examined my usual answer is "everything we have covered", which is true!). However, I see tests and exams as having another important function for students, as an important signal that students can give to future teachers and employers. This relates to solving the employers' adverse selection problem that I have written about before:

Students are engaging in a sophisticated array of signals, on multiple levels. It's not possible to avoid signalling in this case, since trying not to provide a signal is itself a signal. The problem that this signalling is trying to avoid stems from private information about the quality of the student - students know whether they are high quality (intelligent, hard working, etc.), but employers don't. Employers want to hire high-quality applicants, but they can't easily tell them apart from the low-quality applicants. This presents a problem for the high-quality applicants too, since they want to distinguish themselves from the low-quality applicants, to ensure that they get the job. In theory, this could lead the market to fail, but in reality the market has developed ways for this private information to be revealed.

One way this problem has been overcome is through job applicants credibly revealing their quality to prospective employers - that is, by job applicants providing a signal of their quality. In order for a signal to be effective, it must be costly (otherwise everyone, even those who are lower quality applicants, would provide the signal), and it must be costly in a way that makes it unattractive for the lower quality applicants to do so (such as being more costly for them to engage in).

Qualifications are an effective signal (they are costly, and they are more costly for lower quality students, who face having to expend more time and effort to complete the qualification). Exams are also an effective signal for exactly the same reason (though not at the same level as the whole qualification). Because exam performance is an effective signal, high quality students can use their performance in exams to separate themselves from lower quality students, because it is very difficult for lower quality students to pass themselves off as higher quality students in the exam format. The quality of the signal is much lower for other types of assessment such as take-home tests, assignments, or group projects, where lower quality students can easily get additional help (often from the high quality students!) to boost their grades.

To me, that is one of the key reasons why we shouldn't eliminate high-stakes tests and exams from student assessment. Take-home or open-book tests, online tests, group projects, and the myriad of other assessment types that are used all have their place, and can all be valuable as learning exercises if used well. But they'll never be able to provide the same quality of signal of student quality as a test or exam.

Read more:

• Why all students need to understand adverse selection and signalling

[HT: David, one of my ECON100 tutors]

Raising the minimum wage to $20

The new New Zealand government has proposed raising the minimum wage from $15.75 to $16.50 next April, and eventually to $20 by 2021. Eric Crampton at Offsetting Behaviour covered the main points on this last month:

This isn't an end of the world bad idea, but it isn't a good idea.

The government has been targeting a minimum wage of about 66.7% of the median wage. That's already very high by international standards. If we assume median hourly wage growth continues at 3.4%, then the median wage in 2021 would be $27.43. A $20 minimum wage in 2021 would be 72.9% of the median wage...

That would put New Zealand way out in front in the OECD in terms of the ratio of minimum wage to median wage. Crampton argues that Working for Families is a better option as it is better targeted at those in need (to which I would add that there are a whole lot of middle class teen hospitality workers who will benefit from the higher minimum wage, but I don't think that's who the government really wants to benefit), and it is better supported. On the latter point, Crampton explains:

The burden of minimum wage increases is shared among disemployed workers, purchasers of the goods and services produced by minimum wage workers, and owners of firms employing minimum wage workers. The burden of WFF falls heavily on households in the 8th, 9th and 10th deciles. Both versions will have negative effects on the overall economy, but spreading it through the tax system at least tries to minimise the overall deadweight costs of raising that next dollar of wage subsidy.

A higher minimum wage isn't going to result in Armageddon (but equally, in contrast to Branko Marcetic's take, it won't be all unicorns and rainbows either). I'll be interested to see how it plays out. However, I will reiterate that the latest international research (including research on youth minimum wages in Denmark, and the recent increase in the minimum wage in Seattle) suggests that minimum wages do lead to decreases in employment (see here and here). That contrasts a lot of earlier work that called into question the simple labour market supply-and-demand model.

At least though, there is some policy consistency. If you believe that higher minimum wages are a good thing (because presumably you believe that any resulting decrease in employment will be small), you should also be in favour of reducing immigration to boost the wages of unskilled or semi-skilled workers (see my post on that point here). And on that score, the new government is making the right noises (albeit with inconsistency between the Labour and New Zealand First party positions).

Read more:

• The latest evidence supports negative employment effects of the minimum wage
• Latest research suggests the minimum wage DOES reduce employment

School uniform monopolies

I recall many years ago having an argument with a school administrator about uniform requirements (if I recall correctly, this was about school shorts that were the correct colour, but were not allowed because they didn't have the school logo embossed on them). My side of the argument was that the school was using its market power over uniforms to create a monopoly (there was only one uniform provider who sold the school shorts with that particular logo) and unfairly price gouge parents. So, I was interested to read this story in the New Zealand Herald last week:

The new Education Minister has planned action to stamp out "covert" fundraising by schools such as marking up uniforms to make a profit.

Chris Hipkins told the Herald the new Government's overall objective was to make sure a state school education in New Zealand was free...

"At the moment, particularly around things like the big mark-ups on uniforms, schools are finding ways of getting around the rules that they shouldn't be asking parents to pay. We are going to be taking a much firmer line on that..."

A Weekend Herald price comparison carried out earlier this year found parents with a boy and girl at secondary school could pay $700 for just the uniform basics.

The Commerce Commission has received complaints about the costs of uniforms and stationery and issued procurement guidelines, recommending schools make the supplier-selection process transparent and tell parents why deals were entered into. It is illegal to enter an agreement that substantially lessens competition in a market.

With school uniforms, there are few substitutes. If your child is going to School A, you need the appropriate uniform for School A. This gives the school considerable market power (the ability for the seller to set a price above the marginal cost of the uniform). Since most schools are not uniform producers or sellers themselves, they instead transfer that market power to a uniform provider. Usually this takes the form of an exclusive deal with the uniform provider, where that provider is the only one that can sell the school's uniforms, and in exchange the school receives some share of the profits. This creates a monopoly seller of the uniforms, and the monopoly maximises its uniform profits by raising the price. The result is that parents must pay higher prices for uniforms, which must be purchased from the exclusive uniform provider.

One might argue (as the Herald article does) that this is a covert way of increasing school fundraising, in the absence of the ability for schools to do so through higher school fees. A rational school would want to maximise this source of revenue, and they can do that by ensuring that there are few substitutes for the uniform (because, when a firm has market power, the mark-up over marginal cost can be greater if there are fewer substitutes for what they are selling). When I was at school, any shorts of the correct colour were acceptable for my school uniform. However, one way that rational schools can ensure that there are few substitutes for uniform items is to require each item to have the school logo printed or embossed on it. So now, every child must wear not just the correct colour item, but the correct colour item endorsed by the school (and sold by the exclusive monopoly uniform provider).

However, you might not be concerned with high uniform costs if you believe that the additional money you pay is going to the school. But this is probably not the case at all, because schools probably cannot capture all of the excess profits that they create through this market power. If there are many potential uniform providers, then ultimately the school can probably receive the entire profits from the market power, since they could play uniform providers off against each other until they get the best offer (equal to the entire profits from selling uniforms). But if there are few potential providers, this is not the case, and the successful bidder will capture at least some of the profits. And that is what my argument with the school administrator was about, all those years ago. I had no problem with giving the school extra money, but objected to enriching the exclusive monopoly uniform provider.

An idealistic solution to this problem would be to 'adequately' fund schools, so that they don't feel the need to create market power in the uniform market in the first place. However, that would ignore the fact that any school would be better off with a little bit more funding, and so a rational school would always engage in this practice regardless of the level of government funding they receive. The only way to prevent this practice then is to regulate against it. Labour has pledged to draw up 'guidelines' for schools. If they are enforceable, then that might be the best we can hope for, unless school uniforms were abolished entirely.