The 2009 Nobel Prize in Economic Sciences

A few weeks ago, the committee that awards the Nobel Prize in Economic Sciences announced the winners of the 2009 award. The prize winners were Elinor Ostrom of Indiana University and Oliver Williamson of the University of California, Berkeley. The committee awarded this year’s prize to these economists for their work in economic governance. For Ostrom, the committee cited her research on the methods that actors use to avoid over utilization of common property resources. Williamson’s research provided theory on the conditions under which firms are better suited for economic organization than markets.

Ostrom found numerous examples in which actors had successfully avoided the “tragedy of the commons.” Standard theory had found that common property resources are too often exploited to the point of inefficiency and depletion. Ostrom examined numerous case studies in which actors avoided resource depletion through various governance structures. Much of her insight involved applying theories of repeated games in which actors may punish others who over extract common property resources.

Williamson provided theory to explain firm organization and conditions under which economic activity is better suited to take place within a firm than in a competitive market. An important basis for his theory involved the timing of work and bargaining. For instance, agreements made prior to work being performed can break down once the work is completed due to a change in the bargaining position of the actors. When the work is highly firm-specific then the actor who completed the work may find himself in a weak market position with only a single prospective buyer. In contrast, by arranging activity within a firm, the ex-ante and ex-post market issues are avoided. Similarly, the firm provides a clear hierarchy of authority which can help to clearly dictate the work that must be done. However, Williamson’s research also highlights an important disadvantage of firms: authority is prone to abuse.

The research of both Nobel Prize winners provided a richer framework for analyzing economic activity through its insight into governance. To learn about their research in greater detail, see the scientific background paper provided by the Nobel committee.

Discussion questions:

1. Describe some ways in which common property resources may be governed for the long term benefit of stakeholders. What are some of the difficulties involved in such governance?

2. What are some of the other advantages or disadvantages of firms, when compared to markets, which are not described above?

3. What other economic governance issues do you observe? Are these issues dealt with in a way that improves or worsens economic efficiency?

Towards Gasoline Market Efficiency

For the past year or so, I’ve been using the same website to save money on gasoline. The parent site of the one I use is Gas Buddy. Commuting to work I spend about $130 per month on gas, or roughly $1,550 per year. There are several reasons for this. Gasoline is one of my biggest work-related expenses, California gas prices are consistently among the highest in the nation, and I’m also an economist. I feel impelled to fill up at the station offering gasoline at the cheapest price, without going significantly out of my way to get there, of course.

Economic theory would typically classify a local gasoline market as a competitive market, yet, I often see differences of 20-25¢ per gallon for the same gasoline grade among nearby stations. Why does the standard model of competition not seem to apply here? Because most consumers probably accept the notion that gasoline of the same grade is nearly identical regardless of the station, competition should drive prices to the same competitive market clearing price. However, gasoline retailers often try to differentiate their product through methods such as affiliated credit cards, which give the holders a discount when they purchase gas with the card from a retailer that is part of the corporate chain. Another strategy they use is to offer a discount on a car wash to consumers who have purchased gas at their station. Nevertheless, it doesn’t seem like such differentiation would be important enough to keep the market from a perfectly competitive equilibrium.

What else might explain these facts? One possibility is that some gas stations employ a strategy of luring customers into their stores with gasoline sold below cost, to sell them high margin convenience goods. Another possibility is that some stations enjoy location advantages that allow them to command higher prices, such as the first station located off of a high traffic freeway exit. Nevertheless, the explanation that I prefer is that gasoline consumers do not have all of the information regarding prices of gasoline in surrounding areas. Websites like Gas Buddy help alleviate this informational deficiency in a nearly costless way thanks to its gas price maps and price lists. As more people use the site, the local gasoline markets covered should theoretically approach a perfectly competitive equilibrium.

Where does the website get its price information? People who are interested in either winning gas cards or making the gas market more efficient have accounts on the site and post gas prices there. Although there are obvious benefits to the information provided by Gas Buddy, there may also be drawbacks to the site. Besides the obvious damage to the profits of gas station companies, there are likely to be people who misuse the information. For example, imagine the user who drives several miles out of his way to fill-up on gas that is only 5 cents cheaper per gallon than the nearest station. This person may save $.75 or so, but environmental costs of the extra driving distance, the cost of the additional gasoline used and vehicle wear, and the value of the person’s extra driving time are likely to sum to significantly more than $.75. So, while getting the cheapest gas is great, remember that there are more to costs than just retail prices.

Author’s note 10/19/09: During her review of this post, Kasie Jean mentioned the possibility that consumers may have gasoline brand loyalties. The author found this unlikely but later received advice from a trusted mechanic regarding the benefits of Chevron with Techron gasoline. The author owns no securities issued by the Chevron corporation.


Discussion Questions

1. Now that you are aware of a gasoline price website, would you use one to locate the cheapest nearby gas prices? Why or why not?

2. Think about the characteristics of perfectly competitive markets. Do you believe that gasoline markets are perfectly competitive? If not, what are some aspects, besides those described above, that keep them from perfect competition?

3. In 2007, a study concluded that the optimal tax on gasoline was $2.10 per gallon. What is your opinion of this conclusion? Do you think that gas price websites would be viewed more if gasoline taxes were significantly higher?

4. In what other ways has the internet made markets more efficient or perhaps less efficient?

Bovine Intervention

A couple of weeks ago, economist Greg Mankiw pointed to an interesting story about so-called cow tax proposals in Europe. The taxes would apply to farmers and ranchers, based on the number of animals they raise—the more cattle in your herd, the larger the tax bill. Thus far, lawmakers in Ireland and Denmark have struck such measures down. The defeated Irish proposal put the tax at €13 for each dairy cow and the Danes were considering a tax as high as €80 per cow.

Why tax livestock? In a word, flatulence. (In two, enteric fermentation.) Cows belch and otherwise discharge their way to about 14% of the world's methane emissions. Like carbon dioxide, methane is a greenhouse gas. Although methane accounts for a relatively small share of all greenhouse gas emissions, it is alarmingly effective at preventing heat from escaping the planet. Compared to carbon dioxide, a little bit of methane goes a long way toward raising the potential for climate change. Reducing methane emissions would help Denmark and Ireland meet their EU climate policy commitments.

Raising livestock generates a negative externality: the costs of methane emissions are born by the general public rather than those directly involved in the production and consumption of meat and dairy. The emissions cause the marginal social cost of producing a pound of beef to exceed the marginal private cost.

The proposed taxes are an attempt to force farmers and ranchers to internalize the heretofore external costs of the methane emissions, bringing the private costs of raising livestock closer inline with the social costs. The tax would raise the costs of producing meat and dairy, reduce the supply of such products, and, consequently, lower methane emissions.

While a tax based on the number of cattle in a herd would undoubtedly reduce farming-related green house gas emissions, it would do so in rather blunt fashion. To see why, consider two ranchers. The first uses specialized cattle feed to reduce the methane emissions of his herd. The second sticks to traditional methods with the typically methane-intensive results. The cow tax, however, is levied equally on each head of cattle, failing to account for the methane reduction efforts of the first rancher.

While the cow tax provides an incentive to cut back on cattle, it doesn't encourage ranchers to adopt any of the promising technologies devised to reduce methane discharge from individual cows. Ideally, climate change policies should focus on the amount of methane emitted rather than the number of cows.

Discussion Questions

1. Can you think of policies to incentivize the adoption of methane-reducing technologies in farming and ranching?

2. Governments in Europe and the United States heavily subsidize the farming and ranching sectors of their economies. How would the removal of such subsidies impact methane emissions in Europe and the U.S.? What about methane emissions from less developed countries?

Recent Land Reform in China

The Chinese Communist Party (CCP) collectivized—or assigned ownership to a collective rather than to individuals—all land in 1950s. In a second round of land reforms 30 years ago, the CCP assigned small plots of land to each rural family. Families could use the land as they saw fit and sell the resulting crops but the state maintained ownership of the land itself. Selling the property was therefore out of the question.

Last week, the CCP announced a third round of land reforms, allowing farmers to "subcontract, lease, exchange or swap" their land-use rights. Although farmers cannot sell their land, they can lease their land to other farmers for up to 70 years in exchange for cash. For China, the reform represents another step away from communism and another step toward a market-based economy.

Proponents of the policy hope for four positive effects. First, exchange of land among farmers should lead to a more efficient allocation of resources. Previously, people who wanted to leave the farm for work in the cities left their plots of land in the care of elderly parents. Under the new policy, those people can subcontract their land-use rights to farmers who place a higher value on the rights to use the land.

Second, the reform should allow farmers to enjoy economies of scale—the cost reductions that result from higher levels of output. Before the reform, each rural family had a small plot of land, limiting the use of machinery and technology in farming. As a result, agriculture in China remains labor-intensive. The exchange of land-use rights will allow the development of more commercial-scale, larger farms, where farmers can take advantage of more advanced agricultural technology. As farming yields rise, so will China's total contribution to the world food supply.

Higher yields may contribute to the third potential benefit: higher incomes for families in the Chinese countryside. The incomes of some farmers will rise along with the output per acre. Those who would rather leave the countryside can now cash in their land-use rights and pursue better paying opportunities in the cities. The rising incomes should lower the income gap between rural and urban households, easing a social tension.

Finally, the new policy should provide more property protection to farmers. Before, without the rights to lease state-owned land, land grabs by local authorities left many rural families with little to nil in the way of compensation.

Of course, there is no guarantee that the policy will work as intended. Opponents of the measure worry about the effects of the reforms. They argue that the policy will force some farmers to lease property and join the ranks of cheap labor in the cities, increasing the income gap even more as land-use rights become concentrated in the hands of well-off farmers.

Discussion Questions

1. Do you believe that the new policy would provide adequate property protection for small farmers? Could land grabs still occur? Why or why not? Can you think of other economic or political challenges the reforms will create?

2. What new pressures will the cities face if many farmers lease their land and move to urban areas?

3. The ongoing financial crisis in developed countries overshadows the ongoing food crisis in developing countries. The food crisis refers to rising prices for basic food like rice and wheat. If China's land reforms work as intended, how might they affect the global food crisis?

Too Darn Hot

It’s 85 degrees and sunny on this October day in the Bay Area, and this morning’s review of the New York Times brings a trio of stories related to heat: the tragedy of the fires raging in Southern California; a long article in the Magazine section on decreasing supplies of fresh water due to global warming; and a really interesting article on the effect of lower water levels in the Great Lakes on shipping. There are lots of good economic applications in all three of these articles.

It’s clear that there are winners and losers from warming. For example, the people who lose their homes in Southern California—and their insurance companies—are clearly losers. But others win—think of the windfall that’s about to benefit construction companies in Southern California, which were suffering recently because of the downturn in the housing market. Don’t the fires create rebuilding jobs for them? And don’t they, in turn, spend that money, benefiting others? Could we view the fires as a stimulus to the economy? Maybe there’s insufficient drought in the world after all!

If this argument rings false, that’s because it is. To see why, read one of the most brilliant three-paragraph synopses of economic theory ever written: the first application in Economics in One Lesson by Henry Hazlitt. (Clicking to the next page, “The Blessings of Destruction,” is also worthwhile. Oh, heck, just read the whole book—it will take you an hour.)

Discussion Questions

1. Suppose we assume that global warming is caused by humans, and that it is an example of the tragedy of the commons: everyone suffers because of global warming, but nobody has an individual incentive to stop the behavior that causes it. As Economics in One Lesson demonstrates, Hazlitt was skeptical of government interference in markets beyond the enforcement of property rights. Can you think of any appropriate responses to global warming that involve little to no government interference?

2. Suppose we assume instead that global warming is not caused by humans, but that humans can do things—for example, produce less carbon dioxide—to reduce its effects. How does that change your response to question 1? Does it, in fact, change your response? Why?

3. The article on the Great Lakes says that “for every inch of water that the lakes lose, the ships that ferry bulk materials across them must lighten their loads by 270 tons—or 540,000 pounds—or risk running aground, according to the Lake Carriers’ Association, a trade group for United States-flag cargo companies.” What effect is this likely to have on the structure of the shipping market in the short run and the long run?

The 2007 Nobel Prize: Mechanism What?

The 2007 Nobel Prize in Economics went to Leonid Hurwicz, Roger Myerson, and Eric Maskin for “having laid the foundations of mechanism design theory.”

Mechanism design isn’t covered in the typical introductory economics class. The narrative of your first econ class usually goes something like this: “The ‘invisible hand’ of the free market is the most efficient way of answering the fundamental economic questions: what to produce, how to produce it, and who consumes it. Sometimes the market doesn’t work—for example, in the case of externalities or public goods.”

In short, a single mechanism—the “market”—is usually the topic of discussion for intro courses. But there are lots of other mechanisms for answering these fundamental questions. And unlike the market, which is a decentralized mechanism (meaning it is not run by a central authority), there are plenty of man-made institutions that are centralized mechanisms. One example of such a mechanism is an auction, which allocates goods according to bids. Another is a political election, which allocates political power according to the preferences of the electorate. Both auctions and elections have rules, and these rules determine the optimal behavior of bidders and politicians.

One of the biggest challenges of designing an economic mechanism is that people have private information about their own preferences. One of the most famous examples of a mechanism design problem is the provision of public goods. Suppose a small town is considering the establishment of a public park in the town square. Should it ask the citizens how much each of them would value the park, and ask them to contribute that amount? Clearly, each of the citizens would have an incentive to “free ride” on their neighbors by understating their own value of the public good—so as a mechanism, just asking for voluntary contributions leaves a lot to be desired.

We will be creating a news analysis assignment about mechanism design for professors who use Aplia in their classrooms. In the meantime, here are some discussion questions to get the ball rolling.

Discussion Questions

1. “Market failure” often occurs when dealing with things other than purely private goods—for example, public goods, common resources, or goods with externalities. One solution to market failure can be broadly categorized as “market solutions.” An example of such a market solution is the levying of a Pigovian tax, which keeps the basic mechanism of the market but alters the incentives of participants. Another solution to market failure would be to replace the market with another institution entirely. For example, the right to use a specific frequency of the wireless spectrum is allocated by the Federal Communications Commission using an auction mechanism. Can you think of other examples of market failure that we address by using centralized mechanisms? What are the advantages and disadvantages to centralized mechanisms as opposed to market solutions?

2. The term “asymmetric information” refers to cases in which parties hold private (or hidden) information about their preferences or costs. One of the core challenges of mechanism design is to encourage people to reveal their private information in a truthful and credible way. For example, it is easy to show that the optimal strategy for a bidder in a Vickrey auction like eBay is to bid one’s true value. Think of a situation in which asymmetric information causes problems. What kind of mechanism could you design to elicit truthful information from the participants in that situation?

3. A recent Washington Post article has provoked a fair amount of discussion about the effectiveness of torture in acquiring information from prisoners. The most heavily quoted passage of the article reads:

“We got more information out of a German general with a game of chess or Ping-Pong than they do today, with their torture,” said Henry Kolm, 90, an MIT physicist who had been assigned to play chess in Germany with Hitler’s deputy, Rudolf Hess.

What do you think the economic study of mechanism design would have to say about torture? Is it an effective method for eliciting private information? How would an economist interrogate a suspected terrorist?

Speculating about the Nobel

Next week, we can expect the winner to be announced for this year's Nobel Prize in Economics. (Last year, the Aplia Econ Blog posted an article about the previous winner, Edmund S. Phelps.) This weekend will see lots of speculation over who will take the prize. Proving there's a market for everything, Intrade posted its odds on this year's prospective Nobel laureates, and allows speculators to bet on who they think will win (thanks to Greg Mankiw for finding this site). The early favorite on Intrade (though trading has been extremely light) is the University of Chicago's Eugene Fama. Truth be told, Professor Fama is my favorite for this year's Nobel (at least, my favorite non-Aplian!).

It's a challenging matter determining how to judge academics relative to each other, especially when they may publish in significantly different fields. The number of citations an academic receives is probably the gold standard for measuring performance in academia. An author receives a citation when a later author recognizes the original author's work as contributing to the later author's own research. This site seeks to objectively measure economists' citations, but applies a weighting scheme to control for individually authored papers relative to co-authored papers and for the time elapsed since papers were cited. Eugene Fama also resides at the top of this list (though a lot of us at Aplia think number 21 on the list deserves a good look too).

Professor Fama has made major contributions to the finance field with his work on market efficiency and asset pricing. He is regarded by many as the father of the efficient market hypothesis. In the early 1990s, he published a series of papers with Kenneth French in which they challenged the Capital Asset Pricing Model's assertion that a stock's market beta is the primary determinant of variations in stock returns. They argued that the market and its participants are too complex to be encapsulated by a single factor. In an article entitled "The Cross-Section of Expected Stock Returns," they developed a three-factor model that tried to explain stock returns using two observed anomalies. They incorporated the fact that small companies tend to outperform big companies, while value stocks (with higher book/market ratios) tend to outperform growth stocks (with lower book/market ratios). Since the paper's publication, Fama-French's three-factor model has become a fundamental evaluation tool in the portfolio management industry.

Discussion Questions

1. Why is an economist's number of citations a relevant measure for his or her impact on the field?

2. The citation list weights recent citations more heavily than older ones. Why might this distinction be relevant when judging an academic?

3. Are markets efficient?

4. There have been a few times in stock-market history when crashes (huge stock-price declines) occurred, such as the stock-market crashes of 1929 and 1987 and the burst of the Internet bubble. What would an analyst who believes in market efficiency say to explain these events?

U.S. Food Aid Practices: Help or Hindrance?

A recent article in the New York Times and a subsequent editorial suggest that U.S. food aid policies are good for American farmers and charitable nongovernmental organizations, but bad for the people in low-income countries the charitable groups aim to assist. How can this be the case?

For simplicity, let's assume that U.S. agricultural price subsidies take the form of price supports. The U.S. government effectively sets a price floor for certain agricultural commodities, such as crude soybean oil. At the guaranteed price, U.S. agribusinesses produce more soybean oil than consumers wish to purchase. The U.S. government purchases the excess supply and donates it to charitable organizations operating in low-income countries like Kenya. The charitable organizations then sell the surplus crude soybean oil in Kenyan markets in order to finance anti-poverty programs aimed at Kenyans.

The charitable organizations represent additional sellers in the Kenyan market for soybean oil. The supply of soybean oil in the Kenyan market rises, leading to a reduction in soybean oil prices. The lower price of soybean oil can impact local farmers in a couple of different ways. If a local farmer produces soybeans, the decrease in price obviously reduces her profit margin and directly lowers her income. However, the impact need not be so direct. A local farmer producing a substitute for soybean oil, such as sunflower seed oil, will see the demand for his product decline as well due to the decrease in soybean oil prices.

The result is the same—lower income for Kenyan farmers producing products that somehow compete with the subsidized commodities that the charitable groups sell to raise funds. Keep in mind that the percentage of the Kenyan population employed in agriculture is much higher than in the United States.

Discussion Questions

1. At worst, food aid programs like those described in the article lead to higher food product prices in the U.S. and lower incomes for people employed in the agricultural sectors of low-income countries. Considering how the costs and benefits of the programs accrue to different parties, why do you think such programs have met with little to no political resistance in the U.S.?

2. In what way does the current system of financing aid undermine the efforts of charitable organizations that teach farmers in low-income countries to use more productive agricultural methods?

3. CARE's decision to quit the business of selling surplus U.S. commodities to raise funds is a source of controversy among charitable operators in less-developed countries. Charities that continue to endorse the practice argue that they bring food price stability to low-income countries without compromising the ability of local farmers to earn income. Even if we assume this argument is correct, what can you say about the efficiency of the current system compared to a system where the U.S. government forgoes farm subsidies and passes the cash savings directly on to the charitable organizations that currently sell subsidized U.S. farm products abroad?

4. CARE has decided to stop accepting donations of food from the U.S. government altogether. But what if they just stopped selling it, and instead gave the food away for free? What would the effects of that policy be?

The Doctor Will See You Now. Seriously. Right Now.

Where smoothly functioning markets exist, they generally do an efficient job of answering the fundamental economic questions—what gets produced, how it gets produced, and who receives it. Not everyone will be happy with those answers, but there is efficiency in the sense that to make any person better off would require making at least one other person worse off.

Such grandiose notions of efficiency may seem quaint when you're waiting, say, two months for a doctor's appointment. The market does not allocate when each patient is seen by a doctor—that scheduling is done by someone in the doctor's office, or (shudder) a bureaucrat working for the government or an HMO. No wonder, then, that scheduling nightmares are common.

But even when markets cannot be brought in to answer questions—do you really want to have to bid to see a doctor in a timely manner?—other systems can be designed to achieve better efficiency. In a recent article in Slate, Marina Krakovsky discusses innovations in the way doctor's appointments are allocated among patients. In particular, a new system called "open access" or "same-day scheduling" reserves a large chunk of each doctor's time for patients who want to come in on the same day.

If you were just starting a medical practice, using this new system would be easy. But the transition from the old system, which was plagued by weeks of waiting, is difficult. In economic terms, it means switching from an inefficient equilibrium to an efficient equilibrium. What does this mean? Well, think about the normal supply and demand model: strong market forces pull the system toward the equilibrium where supply and demand intersect. Similarly, trying to shift away from an equilibrium in which patients wait for months in advance means overcoming powerful forces. It means working overtime for several months to work down the backlog, and potentially turning away patients that would otherwise have been seen.

Discussion Questions

1. Suppose you ran a small medical practice and read this article. How would you go about deciding whether the benefits of the new, more efficient system would be worth the cost of transitioning to that system?

2. In a blog post about this article, Joshua Gans points out that "the no-waiting equilibrium is also fragile unless you have sufficient slack in the system—that is, on average more slots available than there is demand. This is because if you have a bad day, that creates a backlog, and this can feed back on itself so that waiting times slowly increase." What kind of "slack" can medical practices build into their system? How could they go about finding the optimal amount of slack?

3. The discussion of shifting from a system with a backlog to one without a backlog is somewhat applicable to the case of Social Security. The way Social Security works is that employees pay Social Security taxes, which go directly to retirees; the money isn't saved for the employee's own retirement. Many people believe that it would be more efficient to have individuals own personal retirement accounts. As in the doctor's office example, though, this would entail massive transition costs—the equivalent of all doctors working overtime to reduce their wait times, but on a much larger scale. Even if we assume that it would be better for people to have personal retirement accounts, how could we measure the benefits of increased efficiency against the transition costs?

Taxing Traffic

In a bold speech delivered on Earth Day, New York City Mayor Michael Bloomberg proposed broad changes to improve the environment in the city. A centerpiece of this proposal, sure to be controversial, is an attempt to deal with traffic problems by imposing congestion charges on drivers who enter Manhattan. By charging motorists, the mayor aims to reduce pollution and relieve driving difficulties in the city. The plan would result in payments of up to $8 per day for drivers ($21 for trucks) who enter the busiest sections of the city—what the report calls the “Manhattan Central Business District.” The revenues generated by the fees would be used to fund transportation programs throughout the city, including road improvements, expansion of public transit, promotion of cycling, and increased enforcement of traffic laws.

While Bloomberg’s proposal is innovative, New York is not the first city to consider such fees. Congestion charges have been in place since 2003 in London; and Stockholm, Singapore, and Toronto (among others) employ similar types of fees. The results in London have been fairly dramatic: the number of automobiles in the city decreased by more than 30%, traffic delays declined by 20%–30%, and average road speeds increased by nearly 20%. Opponents of the London plan—and there were many—argued that it would “strangle retailers,” but the feared drop in sales has not materialized.

City traffic imposes dual externalities on residents and commuters—there is the pollution produced by the vehicles in the area, but there is also the effect of traffic itself on drivers. Each driver represents only a small proportion of the actual traffic, but when all of the drivers are added in, the impact can be dramatic, slowing commute times substantially. Congestion charges represent a direct application of what is referred to as a corrective tax—forcing drivers to internalize the external costs that they impose on other drivers. For example, if the average commuter’s opportunity cost is $16 per hour, and the presence of an additional motorist increases the driving time of all other drivers by a total of 30 minutes each day, then the proposed charge of $8 per day could be interpreted as an appropriate tax.

Discussion Questions

1. How would drivers who pay the fees benefit from this program?

2. Beyond the expected benefits of reduced pollution and traffic congestion resulting from the congestion charges, are there other effects that could result from the imposition of these fees?

3. How would the benefits and costs of such a program be distributed?

Harold Elder is a professor of economics at the University of Alabama. His research and teaching focuses on applied microeconomics, including law and economics, public sector economics, and a range of public policy topics. He regularly teaches Principles of Microeconomics in the College of Commerce and Business Administration and is the advisor for his university's master's and Ph.D. programs.

John, Paul, George, Ringo, Steve, and Ronald

For the past two decades, there has been a legal fight over whether consumers have had a difficult time comparing Apples to Apples. More specifically, Britain's Apple Corps Ltd.—the company started by the Beatles and currently owned by Paul McCartney, Ringo Starr, John Lennon's widow Yoko Ono, and the estate of George Harrison—was at odds with America's Apple Inc., maker of Macintosh computers and iPods, over who had the rights to the Apple name.

It may seem odd to trademark a fruit's name, although no odder, perhaps, than trademarking Sun, Amazon, Staples, or any other noun. But especially in the information age, the value of a brand name can be crucially important. Suppose I wrote a program, called it "Windows Vista," and sold it online for $30. If it looked just the same as Microsoft's Windows Vista, customers might very well be confused as to which one was the genuine article. This confusion would harm Microsoft. Similarly, argued Apple Corps, the existence of Apple Inc. using the Apple name and logo had an adverse impact on Apple Corps' business.

According to Nobel Prize–winning economist Ronald Coase, the appropriate solution in the case of externalities like this is to have a strong system of property rights. As long as the two parties can bargain with one another, an efficient solution will be reached. Today, an efficient solution was reached—although it was hardly cost-free. According to the terms of the deal announced today, Apple Inc. will own the entire Apple trademark, and will "license certain trademarks back to Apple for continued use," according to Reuters.

In many ways, this is a textbook application of the Coase Theorem. The usual example used to illustrate the Coase Theorem is that of a factory and a fishery that operate along the same river. The factory pollutes the river, which has an adverse effect on the fishery. If the two firms act separately, the factory doesn't take the costs of its pollution into account when figuring out the optimal amount to produce. If the fishery buys the factory, or vice versa, then the combined company is hurting itself when it pollutes, and so is more likely to cut back pollution to the efficient amount: that is, the amount where the marginal benefit of additional pollution to the factory is equal to the marginal cost to the fishery. Similarly, now that Apple Inc. owns the rights to both trademarks, it will presumably be careful not to diminish the Beatles' Apple image—if, indeed, being associated directly with iPods would be considered a negative in today's world.

Discussion Questions

1. Apple's Steve Jobs released a statement saying, "We love the Beatles, and it has been painful being at odds with them over these trademarks." If this dispute was essentially friendly, why did it take 20 years, and huge sums in legal fees, to resolve?

2. Many analysts are now predicting a deal that would make Beatles music—which has so far not been available on any online music service—available via Apple's iTunes. According to the Reuters article, "A source familiar with the situation told Reuters at the time that it was 'safe to assume that something sooner rather than later will happen.'" What effect, if any, do you think the prospect of selling Beatles music on iTunes had on resolving the dispute between the two Apples?

3. The two Apples had reached an agreement in 1991 stating that Apple Inc. could use the Apple logo as long as it didn't enter the music business. When Apple Inc. launched iTunes, Apple Corps sued, saying that Apple Inc. had violated that agreement. Apple Inc. countered that iTunes was just a "data transmission service." Do you think iTunes constitutes a move into the music business? Why or why not?

And...what about Naomi?

Every morning on my way to work, I pass an odd billboard of Abraham Lincoln in front of what appears to be a garage door. The only words I can see on the ad are a URL: http://www.theymissyou.com/. This morning I entered the URL and, voila--it's a rather clever website for a sleep aid medication.

Abe and friends are part of what is called a "teaser" advertising campaign. These campaigns consist of media objects--ads, videos on YouTube, fake MySpace pages--that get one's attention by being a little mysterious. The New York Times has a nice article about how the Lonelygirl15 phenomenon on YouTube has galvanized the teaser ad trade.

(Lonelygirl15 was the screen name of a young woman who posted videos on YouTube like the one above, and who attracted hundreds of thousands of visitors and even some academic speculation. In the end, it turned out to be a film project that might very well become a movie, and its creators have encouraged their fans to "stay tuned.")

The economics of advertising is interesting. Advertising improves economic efficiency by lowering search costs and providing information to consumers, but it also reduces economic efficiency because it is inherently non-productive.

The economics of teaser ads are doubly interesting. Some questions that they bring to my mind are:

1. Teaser ads do not provide any information. Does this mean that they unambiguously decrease economic efficiency? (I don't think so, but I think there's an argument that they do.)

2. One of the difficulties with advertising is that you don't know how many people see an ad. When a teaser ad requires that you go to a website to get the information from the ad, there is a record of how many people view the website. Does this help improve the efficiency in the market for advertising?

3. Many of these ads--in particular the McDonald's Lincoln Fry campaign--are actually quite humorous. Is there a consumption value to advertising? Are ads like works of art? Could it be possible that there are too few ads out there? (Or at least too few good ones?)

(And by the way -- the title of this post comes from the "teaser" question from each episode of the soap opera "Love of Chair.")

An End to "Early Decision"

Harvard University announced Tuesday that it would cease its early admission program. Early news reports, including an editorial in The New York Times, lauded the University for leading the way in dismantling an aspect of the college admissions process that favors the rich and the well-connected. Greg Mankiw, himself a Harvard professor, celebrates this move and declares on his blog that it's "Time for Princeton and Yale to Sneeze."

Economists typically evaluate any policy change in terms of how it affects efficiency and equity. Normally, economic efficiency means that all profitable trades have taken place. For example, if I value a certain item at $30 and you value it at $50, it is inefficient for me to own the item because you could pay me between $30 and $50 for the item and we would both be better off.

However, one class of economic models, called two-sided matching models (a good introductory read is Al Roth's page at Harvard), defines efficiency somewhat differently. In a two-sided matching model, economic agents don't trade things; they match with one another. Economists use two-sided matching models to analyze college admissions, job search, and even marriage. As proposed by Gale and Shapley in a 1962 paper entitled "College Admissions and the Stability of Marriage," two-sided matching models achieve efficiency when everyone cannot be made better off by rearranging who was matched with whom.

Consider a college admissions scenario with two students, Bart and Lisa, and two colleges, Yale and Harvard. Suppose Bart prefers Yale to Harvard, and Lisa prefers Harvard to Yale. Suppose further that Harvard and Yale are indifferent between the two. Then it would be inefficient for Bart to go to Harvard and Lisa to go to Yale: everyone would be at least as well off, and some would be better off, if they matched up the other way. (This is called a "Pareto improvement.")

In such a scenario, early admission programs improve efficiency. Such a program would allow Bart to signal to Harvard that it was his top choice, and allow Lisa to do the same for Yale. The universities would be better off, too, because they could raise tuition. After all, by definition, universities would be accepting students with the highest willingness to pay.

However, early admission programs increase efficiency at the expense of equity. With many early admissions programs (though not the one that Harvard just ended), a student commits to attending the school if they are accepted. Consequently, students who were admitted early could not compare financial aid offers from multiple schools. Students from low-income families are therefore at a distinct disadvantage, since they are more likely to be sensitive to price relative to other factors in making their college choices. In the words of Harvard's interim president, Derek Bok, "the existing process has been shown to advantage those who are already advantaged."

So, we might think that Harvard's move will decrease economic efficiency but increase equity. But there's one more catch: Harvard is one of the very top schools in the country. As a consequence, it may be very certain that all students would rank it as #1. In this case, it doesn't need an early admissions program to extract the preferences of applicants -- it can just go ahead and choose the students it likes the best, knowing that they too will generally accept its offer. Indeed, according to one study by Christopher Avery, Mark Glickman, Caroline Hoxby, and Andrew Metrick, Harvard does not need to engage in "strategic admissions practices," while even Yale and Princeton do. (See the graph on page 7, and the discussion on page 6. UPDATE: A New York Times article over the weekend elaborates on this point.) So while Harvard certainly deserves credit for shifting to a more equitable policy, it remains to be seen how contagious its sneeze will be.

1. Does Harvard's move make the admission process completely equitable? Why might low-income students still be at a disadvantage in college admissions?

2. Suppose all colleges were to abandon their early decision programs. Would students be better off? Would colleges? Why?

3. Suppose all students were to submit a ranking of all the colleges they applied to along with each of their college applications. If you were a college admissions officer, how would you use that information in deciding whom to admit, and what kind of financial aid package to give them?

4. A similar problem to the college admissions problem is the assignment of medical students to residency programs. Unlike college admissions, this is arranged through a centralized process called the National Residents Matching Program. It works like this: students submit a list ranking their prospective programs, and residency programs submit a list ranking students. A computer algorithm then matches students to programs. Do you think a similar program would work well for college admissions? Why or why not?

Net Neutrality

The Internet presents a challenge for economic thinkers. Because it's new and changing rapidly, economists struggle to draw substantive conclusions based on data. As a result, they are largely left to argue over which of the economic models designed to describe the "old economy" are most appropriate for examining the "new economy."

The economic question stirring the most debate right now has to do with network neutrality, or "net neutrality." (Someone asked a ninja recently about it. Someone also asked Greg Mankiw. The ninja had an answer, and Mankiw didn't.) In a neutral network, internet service providers (ISPs) give equal weight to all websites. Suppose AT&T provides your internet service. AT&T recently merged with SBC, which has a partnership with Yahoo. Under the current neutral network, you can conduct searches with Yahoo or Google, and neither Yahoo nor Google have to pay AT&T for delivering their content to you.

Suppose, though, that AT&T could charge websites for the speed of content delivery. If Google doesn't agree to pay for faster delivery of its search results, videos, and other content, AT&T might make the Yahoo site--a business partner--load up a lot faster than Google. Does it have the right to do so? A bill working its way through Congress would give it that right; this has led to a revolt among Internet users and Internet companies like Google.

The opposing sides of the debate use different economic models to support their respective positions. According to supporters of the legislation, sites offering content that uses lots of bandwidth, like youtube.com, currently use ISP-maintained infrastructure for free, and such sites should have to pay for that bandwidth. Because bandwidth is scarce (or becoming scarce as the Internet becomes more congested), the argument goes, allowing ISPs to charge for it will ensure that bandwidth goes to those who can use it most profitably. For example, Robert Litan of the Brookings Institution, argues that using the Internet to deliver health care to disabled people would amount to nearly $1 trillion of cost savings--but only if doctors can be sure that the data they get is uncorrupted by, say, a video broadcast of "Ask a Ninja." Without a market for broadband, those kinds of cost savings will not be realizable. Similarly, Robert Hahn and Scott Wallsten argue that "mandating net neutrality, like most other forms of price regulation, is poor policy." All of these economists treat broadband access as a private good, subject to the usual laws of supply and demand.

Opponents of the legislation are organized on http://www.savetheinternet.com/. They claim the more appropriate model is that of monopoly or oligopoly: ISPs are so large that they would have market power and charge excessively high prices for broadband in order to maximize their profits. Consequently, the number of websites would dwindle, and the Internet would be a much less varied place. More insidiously, this would have a cascading effect on other Internet innovations: the fact that access to Internet users has been relatively cheap up until this point has allowed a myriad of new Internet startups to take risks by creating or entering new markets.

1. Which economic models that you have studied are most applicable to the market for broadband? Why?

2. Hahn and Wallsten argue that as long as the market for ISPs is competitive, the market for broadband will be as well. They suggest that the better way of fostering competition is to ensure that the market for ISPs is indeed competitive. Is this reasonable?

3. Both sides of the debate argue that their position is better for innovation. What kind of innovations might not occur if net neutrality is maintained? What kinds of innovations might not occur if a market for broadband were to exist? Is there any way of weighing the pros and cons of those kinds of innovations?

Family Values

School's out for summer. For lots of college students that means moving back in with the parents. It may seem uncomfortable, having led the hedonistic college life, to move back into the room with your old little league trophies. But something even weirder may await you in a few years.

Your parents may move in with you.

According to an article in the New York Times, "multigenerational households"--those with three or more generations under one roof--are the fastest-growing type of housing arrangement in the United States, especially in places like California where skyrocketing housing costs force families to pool their resources. Also driving multigenerational household growth are working single mothers, whose own mothers often move in to care for the children during the workday.

Housing markets are responding to the demand for multigenerational households. Architects are designing larger houses with separate entrances, big kitchens for "social networking," and lower light switches "so they can be reached both by those in wheelchairs and by children."

In many ways, this trend corrects the inefficiency of living arrangements in the latter part of the twentieth century. Consider a family with three generations: a husband and wife who each have jobs, their two children, ages 1 and 3, and the wife's parents. Suppose the family has two options:

1) The grandparents live in a 900-square-foot apartment that costs $1,200 per month; the married couple and their kids live in an 1,800 square foot house that costs $2,000 per month; the children are in day care at a total cost of $800 per month.

2) They all live together in a 4,000-square-foot house that costs $3,000 per month; the grandparents look after the children, so they don't need to go to day care.

Which is more efficient? The total cost of the first option is $4,000 per month, and the total living space is 2,700 square feet. The total cost of the second option is $3,000 per month, and the total living space is 4,000 square feet. At first glance, therefore, it may seem that the second option, with more space at less cost, is more efficient.

Does that mean that the grandparents should move in with their daughter? Not necessarily. It's not unreasonable to assume that people derive utility from being the head of their own household; sharing a living space isn't easy under the best of circumstances. Couples and their parents often have differing views on the best way to raise children/grandchildren, and these tensions will probably intensify if they live under the same roof. By the same token, people may prefer to have their own parents watch their children, rather than hire a nanny or send the kids to all-day preschool. The saved money can be used for other things--like a vacation away from home. In short, it's only efficient for the grandparents to move in if the net psychic costs and other inconveniences are worth the benefits of the extra living space and saved cash.

1. Suppose that, as housing prices rise, more people form multigenerational households. What implication does this have on the demand for apartments? For large homes? If you were to speculate in the real estate market, how would this article affect your optimal long-term portfolio?

2. Some of this phenomenon is driven by the fact that the baby boomers are retiring. What is likely to happen to the housing market in twenty years, as the boomers pass away? How might this affect their children's willingness to share a large house with them now?

Topics: Housing markets, Efficiency