Econolympics

As a recurring Winter Olympics viewer, I am counting down the days until the games begin on February 12. As an economist, however, I am intrigued by the number of tools an introductory economics course provides students with to analyze the effects of the Olympic games on the local economy of Vancouver. Three topics in particular come to mind that most students will encounter in a basic economics course: consumer spending, negative externalities, and cost-benefit analysis.

A recent article reports that the winter games are expected to boost travel-related spending by $800 million in Vancouver thanks to the incoming surge of general spectators, friends and families of competing Olympians, and athletes themselves to the metro area. But where does this spending go? Hotels, restaurants, and transportation are the likely candidates to benefit from such a surge, so the leisure and tourism industry should receive the largest boost. Although this positive shock to the industry is temporary, Olympics-related spending in 2010 is expected to account for 0.8% of Vancouver’s economic growth, trailing only housing investment and government spending.

However, accompanying this boost in tourism are some negative externalities on locals. While you may not always need a reservation to your favorite restaurant on a normal weeknight, the increase in the number of visitors to the metro area is likely to cause long lines for restaurant-goers. Even getting to your favorite watering hole might be no small feat, as traffic congestion and parking dilemmas are likely to pick up due to the additional vehicles on the road at any given time. Finally, increased pollution and trash creation are also likely to impose a negative externality on residents during the winter games.

Setting up shop for the winter games comes at a high price. Holding the Olympics requires that the host city build the necessary facilities, hire additional security, and provide extra health care in the case of injury to athletes or spectators. This is likely to weigh on the spending budget for Vancouver’s economy. Therefore, standard cost-benefit analysis would require you to determine whether the benefits gained from having the Olympics in a particular city outweigh the costs.

In short, there is a plethora of economic topics you could use as a conversation starter regarding the Olympics. So pick your favorite concept, and analyze away!

Discussion Questions:

1. How would you value having the Olympics in your hometown? Would the benefits you receive from this outweigh the negative externalities imposed on you by the winter games?

2. How do you think the Olympics will affect things like hotel and menu prices during the winter games? Do you expect such a short surge in demand to affect other local pricing? Why or why not?

3. State how the following introductory economic concepts could be used to analyze the effect of the Olympics on Vancouver: the multiplier effect, the Tragedy of the Commons, and demand shocks.

ARRGGHH... The Stakes Be High, Says I!

When you pay ransom to a hostage-taking pirate, traditional economic theory suggests that you increase the returns to piracy, encouraging more of it. If you kill a hostage-taking pirate, you increase the cost of piracy, which should discourage would-be pirates from taking to the seas.

The response by the Somali pirates to the U.S. Navy's recent killing of three pirates has been just the opposite though. These gangs say they are now devoted to revenge-taking over more ships and taking more hostages than ever. The cost of doing business has risen, and yet they want to do more of this business than ever. Why do you think this is?

Discussion Questions

1. In order to quickly obtain large ransoms, pirates must signal a credible threat to cargo ship owners. How might this credibility issue play into the pirates' response to the actions of the U.S. government?

2. The pirates killed by U.S. Navy snipers were holding an American captain of an American boat with an American crew. Might governments respond differently in situations involving multi-national crews?

3. The pirates who were killed were likely just henchmen with little power in the criminal organization. Did the "cost of doing business" really rise very much for the pirates running the organization?

4. In what ways does the government provision of naval security in international waters resemble a public good? Might the current allocation of security (both private and public) in international waters be inefficiently low?

5. From the standpoint of ransom maximization for a small individual gang of pirates, what is the optimal amount of piracy? What is the ransom maximizing strategy if the piracy off the Somali coast is coordinated by a cartel of gang lords?

Scrooge's Economic View of Christmas

We all know how easy it is to get caught up in the Christmas spirit and gift-giving frenzy. A lot of time and energy is spent thinking of the "perfect gift" for friends and family. While I'm sure many are successful in this endeavor, there are undoubtedly a large number of gifts given that people would rather trade in for cash—even if that cash amount is less than the retail price of the good.

Thanks to eBay's anonymous online service, consumers can now do just that! According to a recent study from eBay, more people than ever will sell unwanted items this year. The ongoing recession is partly to blame: many people can probably use the cash from selling gifts to lower their credit card debt, pay their mortgage, or simply cover the bills. But people's general preference for cash to gifts can be explained using the economic fundamentals of utility.

Now that the holiday season has come and gone, many of us find ourselves thinking, "What will I do with another FM transmitter for my iPod?" Oftentimes, both the gift giver and gift receiver could be made better off (that is, receive a higher level of utility or happiness) if a cash exchange had taken place instead. To understand the economic rationale behind this, we turn to the basic consumer theory model of budget constraints and indifference curves.

Recall that an indifference curve maps out all the possible consumption bundles of goods that yield the same level of utility to a given consumer. Indifference curves tell us nothing about what we can afford, but rather how happy a particular bundle will make us. On the other hand, budget constraints show the consumption bundles that we can buy given our income and the prices of goods. Similarly, budget constraints say nothing about what we would like to buy, but rather what we can afford. A consumer's optimal bundle of goods is located where the budget constraint is tangent to the highest possible indifference curve.



But what happens to your budget constraint when you receive a gift? Consider the following simplistic example. You consume only two categories of goods: books and food. You have $80 each week to spend on these two goods. The price of a book is $10, and the price of each unit of food is also $10. Suppose that without receiving a Christmas gift, you would consume 2 books and 6 units of food. This is represented by the graph below:



But now suppose that your grandmother gives you 5 books for Christmas. This means that you can now afford 8 units of food and 5 books without spending any money on books, and you could afford 13 books if you don't spend any money on food. Assume that you cannot return or immediately sell the 5 books your grandmother has given you. If you have a high preference toward food over books, you may find that there is no indifference curve tangent to your new budget constraint in the region where you can now consume-between (4 books, 8 units of food) and (13 books, 0 units of food):



In this case, the optimal consumption bundle does not satisfy the tangency condition because there is no tangency in this restricted region of the budget constraint; we call this a corner solution. In other words, if instead your grandmother gave you the cash she spent on the books (5 books x $10 per book = $50), your budget constraint would also include the grey, dashed region below, and you would be made better off since you can now consume 3 books and 10 units of food.



Discussion Questions

1. How much money could your relative have given you, instead of the present, that would leave you at least as well-off as if you had received the present (that is, with the same level of utility)? Draw this on a standard budget constraint-indifference curve diagram.

2. What elements of real life does standard consumer theory ignore?

3. What gifts, if any, could your grandmother have given you instead of 5 books that would be just as good as if she had given you the cash she spent on them?

Precious News

News of Barack Obama's historic election on November 4 dramatically increased demand for newspapers on November 5. Tall, bold headlines announcing the nation's new president transformed copies of the daily paper into collector's items. Though many publishers printed thousands of extra copies in anticipation of higher demand for their post-election issue, at newsstand prices, supply simply couldn't keep up with the surge in demand. On Wednesday morning, many looking to own a piece of history found only empty news boxes and long lines in front of newsstands.

Not surprisingly, copies of major newspapers' November 5, 2008 issue began selling for as much as $200 on eBay and Craigslist.

This is a classic example of how a market responds to an increase in demand. The market equilibrium on a normal day for newspapers is at point A with price P1 and quantity Q1. As the demand curve for newspapers shifts rightward from D1 to D2 (people want more newspapers at any given price level), both equilibrium quantity and equilibrium price of newspapers increase as a result—from P1 to P2, and Q1 to Q2. On November 5, the quantity of newspapers supplied increased in part because publishers anticipated higher demand and in part because they scrambled to reprint when demand was even higher than expected. In the end, more newspapers appeared in the market, and at higher prices. The new market equilibrium for newspapers on November 5 is now at point B.



Though the consequences of the sudden shock in demand for November 5 newspapers are pretty much as expected, the reasons behind this shock are not so clear.

Though newspapers received renewed attention after the election, newspaper circulation has fallen steadily across the country for years. The ease of instant access to up-to-date information and the accessibility of free content have turned many readers to the Internet for news. The spike in demand for newspapers after the election raises interesting questions about the value of the daily newspaper in a digital world.

Discussion Questions

1. With the prominence of the Internet, why do you think people still wanted physical copies of newspapers with news they probably already knew? What factors do you think drove up the value of newspapers after the election? What do paper newspapers have that websites do not?

2. Some newspapers also raised the price of their November 5 issue. The Washington Post, for example, increased the price of their special post-election edition from $0.50 to $1.50. Considering the huge mark-ups for copies of November 5's newspaper on the Internet, why didn't newspapers raise their own prices even more, to, say, $20 per copy?

3. Does scarcity exist on the Internet? If so, how does it compare to scarcity offline? If not, how does that affect the value of virtual goods as compared to physical goods?

Do You "Appreciate" Wendy's Super Value Menu?

Despite your possible love for the Double Stack burger found on Wendy's $.99 Super Value Menu, the claim made in a recent Wendy's commercial that the burger "appreciates" in value after being purchased is seriously flawed on many levels according to standard economic theory.

Of the many economic fallacies in the commercial, the immediate one that comes to mind is the mix-up between the notions of appreciation and consumer surplus. Recall from your introductory economics courses that consumer surplus is the difference between what a consumer is willing to pay for a good and what he or she actually pays for it. Obviously, you would never buy something if its valuation to you as a consumer was less than the price you must pay. Therefore, according to standard economic theory, consumer surplus must always be at least zero—though it is typically positive for an individual consumer since it is unlikely that you actually pay the true valuation for any good you purchase.

That said, it is not surprising that the "Student" in the commercial won't accept exactly what he paid for the burger since that is not his true valuation of the good. For example, it's possible that his demand curve is of the following shape:

This demand curve implies that Student will pay up to $3 for one Double Stack burger, but then nothing beyond that. This also represents his value for the first Double Stack burger. In this case, Student would receive roughly $2 (= $3 – $1) in consumer surplus by purchasing the Double Stack burger for nearly $1. Obviously, there are an infinite number of possibilities for Student's demand curve, but the one thing we know for certain is that his value of the Double Stack burger is AT LEAST the cost of the burger—but there is nothing preventing his valuation from being higher.

Thus, the idea that Student would not accept a dollar in exchange for his burger has absolutely nothing to do with the proposed "appreciation" of the burger—in other words, Student's valuation of the Double Stack burger has not changed. Rather, this scenario is more reasonably explained by the gains in trade that the buyer receives from purchasing the good at a given price below his private valuation.

Discussion Questions

1. In economics, the notion of a shoe-leather cost—the cost to consumers of actually going to wherever the good is being sold—often plays a role in consumer and producer theory. How would your willingness to accept a dollar for a Double Stack burger change depending on whether you are currently at Wendy's or at home a few miles from the nearest Wendy's?

2. How would this discussion change if Wendy's was able to practice perfect (or first degree) price discrimination?

3. Wendy's often claims that their burger is underpriced and is therefore a value buy. If this were truly the case, why do we not see secondary markets for this good? Is Wendy's really charging the right price?

4. The endowment effect is the idea that people value a good or service more once their property right to it has been established. Is this example of such an effect? Why or why not?

Export Restrictions and the Food Crisis

Rising food prices, particularly prices for grains like rice, wheat, and corn, gave way to a global crisis over the past year. For many Americans, the crisis amounts to paying extra for a side of rice with their chicken masala. For the world's poorest citizens, however, the sharp increase in prices seriously hampers health and well-being.

As Paul Krugman outlined in April, the factors behind rising grain prices include growing demand for meat (the production of which requires grain-based animal feed), growing demand for oil (a key input in the production and transportation of grains), some bad luck with weather, and massive public subsidies for biofuels such as the U.S. government's support for corn-based ethanol.

The crisis posed unusual challenges for middle-income countries, like India, that are also major grain exporters. In such countries, higher prices jeopardize the food security of low-income families even as they substantially boost the incomes of farmers. Faced with this predicament, India, Argentina, Russia, Vietnam, and many other countries chose to curb rising prices at the expense of farmers' incomes, imposing export restrictions on key crops such as soybeans, wheat, and rice.

As expected, the export restrictions reduced the incomes of farmers in the restricting countries. Without access to global markets and foreign buyers, domestic farmers ended up receiving lower prices and selling less than they would have in the absence of the restrictions. The restrictions did provide some relief to domestic consumers who ended up paying less and buying more than they would have in the absence of restrictions.

To see why, consider a graph showing the domestic supply (Sd) and demand (Dd) curves for a wheat exporter. Before the restriction, domestic consumers buy 2 million bushels of wheat per month at the going world price (Pw) of $7 per bushel, but domestic farmers sell 8 million bushels of wheat per month. The difference between domestic consumption and production represents exports to the rest of the world (6 million bushels per month). If the government restricts exports to 2 million bushels per month, the domestic price of wheat falls to $5 per bushel (Pr). After the restriction, domestic farmers sell fewer bushels (6 instead of 8 million) at lower prices and domestic consumers buy more bushels (4 instead of 2 million) at lower prices. Domestic farmers lose and domestic consumers gain.

The export restrictions may have kept food prices down in domestic markets of major grain exporters, but from a global perspective, the restrictions undoubtedly prolonged the food crisis. As major grain exporters restricted the amount of grain leaving their borders, the global supply of grains declined, leading to higher grain prices and reduced availability in the rest of the world.

Discussion Questions

1. Recently, several major food exporters have decided to scale back their export restrictions. How will these decisions impact food consumers and farmers in the countries that are removing the restrictions? How will these decisions impact global food prices and availability?

2. Clearly, biofuel subsidies played a role in destabilizing global food markets. Even with biofuels subsidies, though, we might expect higher food prices to give farmers an incentive to bring more land into production or use existing land more efficiently. How do food export restrictions dampen those incentives?

3. How can countries ensure food security for people who are vulnerable to rising food prices without contributing to the food crisis at the global level?

California's Foil Balloon Problem

A helium-modified voice is good for a laugh, but the joke is risky. Inhale too much helium from the balloon and you'll pass out. It turns out that helium balloons can black out more than just the overzealous prankster. As recent news stories point out, foil helium balloons can get caught up in power lines and cause outages. California utilities reported hundreds of balloon-related outages last year: 211 for northern California's PG&E and 478 for southern California's Edison. California Senate Bill 1499 proposes to deal with the problem by banning foil balloons and fining violators. Though foil balloons can be a problem, a bit of economic analysis suggests that the heavy-handed ban may not be the best remedy.

By increasing the odds of costly power outages, helium balloon consumption imposes external costs on society. The vast majority of electricity consumers outside of the helium balloon market may nonetheless end up incurring some costs when errant balloons make their way into nearby power lines. Since helium balloon consumption imposes external costs, the social benefit of helium balloon consumption is considerably less than the private benefit. When the social value of a good is lower than the private value, there will be an inefficiently high level of consumption in the private market.

So rather than banning the balloons altogether, the California legislature may want to consider a corrective tax. Taxing the consumption of helium balloons would force buyers to internalize the heretofore external costs that the balloons impose on everyone else. The tax would reduce both foil balloons purchased and balloon-related power outages while giving buyers and sellers an incentive to shift toward less disruptive party favors.

To analyze the issue more closely, we need to define some costs and benefits in the market for foil balloons. Because helium balloon consumption generates external costs, the marginal social benefit from a helium balloon will be less than the marginal private benefit:

Marginal Social Benefit (MSB) = Marginal Private Benefit (MPB) – External Cost

In the foil balloon market, the supply curve represents the marginal private cost (MPC) of selling balloons and the demand curve represents the marginal private benefit (MPB) of consuming balloons. The marginal social benefit (MSB) curve lies below the demand curve, since the social value of foil balloons incorporates the external costs. The socially optimal output level occurs where the marginal private cost of producing the balloons is equal to the marginal social benefit of consuming them—well below the market outcome at the intersection of our standard supply and demand curves. At points above the socially optimal output level, the marginal social benefit of the balloons will be less than the marginal cost of producing them. As a result, at least some of the current balloon consumption is inefficient.

Discussion Questions

1. According to our diagram of the hypothetical helium balloon market, what is the size of the tax necessary to achieve the socially optimal output level? Can you think of other markets where corrective taxes have been used or might be used to curb the external costs of consumption or production?

2. Is a ban more costly than a corrective tax in this case? Not all helium balloon buyers are careless with their purchase. Is the tax fair?

3. While a corrective tax has the potential to move a market closer to its social optimum, the use of government revenue from such taxes may be socially inefficient and wasteful. The correction of a market failure may simply beget government failure. Can you think of ways to prevent the government from wasting corrective tax revenues?

4. How would you go about estimating the external costs of helium balloon consumption?

5. What can you say about the price elasticity of the demand for and supply of helium balloons? Many party supply stores claim that any disruption to helium balloon sales will threaten jobs. What do you make of this?

Oil Prices and Expectations

Harvard economist Martin Feldstein's latest opinion piece in the Wall Street Journal argues that we can implement policies today that will impact the current price of oil. Current oil production responds to expectations about the future, Feldstein explains. Any significant change in expectations about the future price of oil will have an immediate impact on the current supply of oil. Broadly speaking, the expected price of oil changes for one of two reasons:

1. Changes in expectations about the growth of oil demand; and
2. Changes in expectations about the growth of oil supply.


How might changes in expected oil demand lead to higher current prices? As Feldstein points out, "when oil producers concluded that the demand for oil in China and some other countries will grow more rapidly in future years than they had previously expected, they inferred that the future price of oil would be higher than they had previously believed." If oil producers expect higher future prices for oil, they will curb production today (leave some oil in the ground) in hopes of extracting it at higher prices in the future. On the graph, the current supply of oil shifts to the left, to S1, causing the current price of oil to rise to P1 and the current quantity of oil to decline.

How might changes in expected oil supply lead to higher current prices? Again, from the editorial: "[C]redible reports about the future decline of oil production in Russia and in Mexico implied a higher future global price of oil." If producers expect oil supply growth to weaken in the future, the expected future price of oil rises, and oil producers leave some oil in the ground today in order to extract it at higher future prices. Once again, we'd expect the supply curve for oil to shift to the left, causing the price of oil to rise (to P1) and the quantity of oil to decline.

An increase in expected oil supply or a decrease in expected oil demand would lead to lower current oil prices. If oil producers think that future cars will be much more fuel-efficient than previously believed, they'd expect relatively weak growth in oil demand, and correspondingly lower future prices. In this case, producers respond by pumping more oil today in an effort to avoid lower future prices. Similarly, as Feldstein points out, "increasing the expected future supply of oil would also reduce today's price."

Discussion Questions

1. Although Feldstein points out that a significant increase in expectations about the future supply of oil would put downward pressure on today's price of oil, he does not explicitly endorse a policy of drilling in currently protected areas of the United States. The crucial question is whether or not future drilling in currently protected areas would have a large enough impact on worldwide oil supply to trigger production changes today. What do you think?

2. There's much discussion in the news about how to develop alternative sources of energy that would reduce the future demand for oil. What are some policies that would reduce the future demand for oil and oil-derived products, like gasoline? Would government commitment to these types of policies be credible enough to lower expectations of future oil prices?

3. Not all economists agree with Feldstein about the ability of current energy policies to impact current oil prices. Many (though not necessarily most) believe that there is very little the government can do to achieve lower oil prices in the next few months or years. Why might this be the case?

Scarlet and Gray (And a Little Green, Too)

I don't know what I did to deserve such good fortune, but for some reason, God saw fit to allow me to be born in the state of Ohio. Growing up a Buckeye, you learn early in life that blue is a four-letter word (maize might as well be also), and that all good things come packaged in red sweater vests.

It is also my good fortune that Ohio State will be playing the college football national championship game in New Orleans this January, as I will be in town attending the ASSA meetings*, and thus will naturally be attending the game shortly thereafter.

The teams are set: OSU vs. LSU. The only big question left is—what will I pay for the privilege of watching them duke it out? I'm not counting on getting a ticket from the lottery drawing, so I plan to buy a ticket from a reseller. For your typical fan, buying tickets from resellers is the norm for big games like this. It is not uncommon for these tickets to be sold for 5 to 10 times their face value in the resale market.

Some games are unexpectedly good (see Browns vs. Bills this Sunday in an unlikely battle for a playoff spot, or the recent Missouri vs. Kansas game as #1 and #2). With these games, it's easy to see why the resale market would dominate—most tickets were sold cheaply early in the season before anyone realized the game would be so meaningful. When demand rises, so do prices.

The explanation isn't so straightforward, however, for games that are guaranteed to be important (like the national championship). In this article, ESPN writer Gregg Easterbrook discusses some reasons why tickets are still sold by sports teams at face value, regardless of expected market rates.

*A big economics conference. There is a good chance your professor is going. Maybe they'll buy you a hat.

Discussion Questions

1. Fairness is always an issue with pricing decisions. Easterbrook calls it a “public relations move” to keep prices standard. Might raising prices for important games create resentment that could extend forward into the months and years to come?

2. In his autobiographical Fever Pitch, Nick Hornby writes that club owners would be daft to raise prices beyond what their rabid fans can readily afford, since the marginal fan comes to games as much to see and experience these crazed fans as to see the action on the field. How would raising the price affect the demographics of those who could attend? Do rabid fans confer a positive (or negative) externality on the rest of the crowd?

3. Last Monday night, Michael Vick and the Falcons took on Reggie Bush and the Saints in an epic battle for the NFC South. Oh, wait, nevermind—neither of these once-great teams is likely to even smell the playoffs this year, and neither of those players were even on the field to try and help the cause (Bush is injured, Vick is in prison). How might setting prices upfront allow teams to capture more total revenue on games that turn out to be duds?

Tricky Truths in the Health Care Debate

Economist Greg Mankiw recently took aim at three misunderstood truths in the health care debate. Consider the truths:

1. Canada, a country with national health insurance, has a longer life expectancy and a lower infant mortality rate (measured in deaths per 1,000 births) than the United States.

2. Forty-seven million Americans lack health insurance.

3. Health care costs account for an ever-growing share of American incomes.

Whether the U.S. health care system should look more like Canada's is a big open question. Mankiw asks us to look at these three truths more closely to see how much clarity they actually add to our national debate on health care. Read his column to learn more.

Discussion Questions

1. According to the column, how do the incidences of accidents, homicide, and obesity in the United States help to explain the differing life expectancies in Canada and the U.S.? How would changing the U.S. health care system address the incidence of accidents, homicides, and obesity in America? Can you think of alternative policies that might close the life expectancy gap by reducing the incidence of accidents, homicide, or obesity?

2. According to Mankiw, the prevalence of low-birth-weight babies in the U.S. contributes to its relatively high infant mortality rate (infant mortality is universally higher among low-birth-weight babies than it is among babies born at normal weights). What factors explain the higher rates of low-weight births in the United States? Will an overhaul of the U.S. health care system address the number of low-weight births in the U.S.? What alternative policies might reduce the number of low-weight births in America?

3. Approximately 47 million Americans (of about 300 million total) lack health insurance. For what reasons does Mankiw argue that this number significantly overstates the problem of the uninsured in the United States? How do uninsured people receive care under the existing health care system? What policies might provide insurance to the group of American citizens who simply cannot access health insurance? How would national health insurance change the pool of the uninsured and the cost of treating them?

4. Why do we spend a larger share of our incomes on health care than previous generations? Clearly, health care is a normal good (increases in income lead to increases in the quantity of health care we demand). But is it also a luxury good (increases in income lead to relatively large increases in quantity demanded)? Is the growing share of income that we devote to health care a bad thing? In what way are increasing health care costs associated with increasing health care benefits? Read this David Leonhardt column for more on this topic.

5. Hopefully, a closer look at the three truths above will help to clarify the debate over health insurance in the United States. That said, understanding how a change to our health insurance system can or cannot influence these outcomes doesn't point to a specific policy prescription. What do you think?

The Ethanol Bubble?

The New York Times reports that in less than one year, ethanol prices have plummeted over 30%. As a result, there is even talk of a government bailout for ethanol producers in case the price of ethanol falls too low!

So, why did price spikes in last year's ethanol market give way to falling prices this year? To understand the price fluctuations, we need to know how the short-run behavior of firms in competitive industries (such as ethanol) differs from their long-run behavior. In the textbook model of perfectly competitive industries, an increase in demand causes the equilibrium price of ethanol to increase in the short run—from P1 to P2 in the diagram below. In the short run, higher ethanol prices lead to higher profits for ethanol producers.

In the long run, the lure of profits attracts new ethanol producers. The long-run entry of additional ethanol producers expands the supply of ethanol, causing the price to fall back to its initial level:

Notice that economic profits converge to zero in the long run. As explained by most textbooks, zero economic profit does not mean that ethanol producers barely have enough to eat. Zero economic profit means that ethanol producers are earning incomes that compensate them for the next best salary they had to give up to go into producing ethanol.

Ultimately, in competitive environments, a surge in demand causes an initial spike in prices, but the equilibrium price gradually falls back toward initial levels. In the end, the long-run price of ethanol may not even change, but more ethanol will be produced than before.

Discussion Questions

1. Referring to the diagram on the left above, why does it take only a short period for prices to spike, but a long period for prices to fall again?

2. Referring to the diagram on the right above, why is the quantity of ethanol fixed for a period in the very short run?

3. Corn is a key ingredient to the production of ethanol. The New York Times article points out that corn prices have remained high over the past year even as the price of ethanol has declined. How might developments in the ethanol market have contributed to the rising price of corn?

The Dollar and the Drug Trade

The value of the U.S. dollar (USD) is falling against a number of foreign currencies, including the Canadian dollar (CAD), also known as the loonie. As the dollar weakens against the loonie, imports from Canada, including illegal drugs like marijuana, become more expensive. As American dope-smokers get priced out of the market for high-quality Canadian marijuana, they increasingly turn to lower-quality Mexican varieties and, as this Reuters article points out, Mexican growers become more willing to assume the risks of planting on American soil.

To see how the weakening dollar leads to change in the drug trade, consider the change in the CAD–USD exchange rate over the past year:

October 2006: 1.12 CAD per USD
October 2007: 1 CAD per USD

The value of the USD in October 2007 (1 CAD) is lower than it was in October 2006 (1.12 CAD). The exchange rate between the Mexican peso (MXN) and the U.S. dollar has changed a bit over the past year, but for simplicity, we'll assume it remained constant at 11 MXN per USD. Now that we've got some exchange rates, let's take a look at marijuana prices.

Let's assume that the prices of Canadian and Mexican marijuana remained roughly constant from October 2006 to October 2007. Suppose that 1 pound of top-quality Canadian marijuana sells for 3,500 CAD, while 1 pound of not-so-top-quality Mexican marijuana sells for 19,250 MXN. In October 2006, the price Americans paid for top-quality Canadian marijuana was:

3,500 CAD per pound x (1 USD / 1.12 CAD) = 3,125 USD per pound

Over the past year, the value of the USD declined against the CAD. The two currencies reached parity in September of 2007. As a result, the price Americans paid for Canadian marijuana increased to 3,500 USD by October of 2007 [3,500 CAD x (1 USD / 1 CAD) = 3,500 USD]. Given the roughly constant exchange rate between the peso and the U.S. dollar, the price Americans pay for lower-quality Mexican marijuana would remain the same:

19,250 MXN per pound x (1 USD / 11 MXN) = 1,750 USD per pound

The relative price of a good is the number of other goods that you can purchase for the same amount of money. Consider how the change in the exchange rate affects the relative price of top-quality Canadian marijuana. In October 2006, Americans could purchase approximately 1.8 pounds of lower-quality Mexican marijuana for the same price as 1 pound of higher-quality Canadian marijuana (3,125 USD per pound / 1,750 USD per pound). By October 2007, Americans could purchase 2 pounds of Mexican pot for the price of 1 pound of Canadian pot. As the value of the U.S. dollar declines against the loonie, the relative price of Canadian marijuana increases and the Mexican alternative becomes increasingly attractive.

Discussion Questions

1. What factors explain the decrease in the value of the U.S. dollar against the Canadian dollar? Why do you think the value of the dollar is not declining as quickly against the Mexican peso?

2. How does the oil boom in Western Canada impact the marijuana industry in British Columbia?

3. The Reuters article mentions the expansion of marijuana cultivation inside the U.S. by Mexican criminal groups. How does the rising price of Canadian pot contribute to the expansion of marijuana cultivation within the U.S.?

Same Problem, Different Solutions

Recently, both U.S. and British farmers have faced the problem of a labor shortage. How can a labor shortage occur when the unemployment rates of both countries have remained positive? Effectively, a labor shortage is the same as any other type of economic shortage—it occurs whenever the price (in this case, the wage) is lower than the equilibrium price, leading to a situation where the quantity of labor demanded exceeds the quantity of labor supplied. Since labor is one of the main factor costs in the agricultural industry, farmers in both countries are reluctant to raise the wages of their workers, as this would raise costs and reduce profits.

The wages of farm workers in Britain and the U.S. have been kept low by the influx of immigrant farm workers. Immigration increases the labor supply in the host country, shifting the labor supply curve to the right. As a result, the equilibrium wage for farm workers in the host country falls.

So what are the sources of the farm labor shortages in the U.S. and Britain?

According to the Department of Labor, more than half of the 2.5 million farm workers in the U.S. are illegal immigrants. The recent crackdown on employers of illegal immigrants poses a threat to many U.S. farmers who rely on immigrant workers. With a tighter immigration policy, the U.S. farmers would have to rely on domestic instead of immigrant workers. As the labor supply decreases with fewer immigrants (the supply curve shifts to the left), the farmers have to pay a higher wage. If they are reluctant to raise the wage, they will face a shortage of willing workers at the initial wage.

Britain did not tighten its immigration policy against Europeans. Nevertheless, the number of Europeans going to Britain for farm work has decreased due to better job opportunities in booming European economies. At the same time, many European workers are beginning to find other types of British jobs preferable to agricultural work. As fewer immigrant workers make the trek to Britain, and those that do choose non-agricultural jobs, the supply of farm workers in Britain declines. In Britain, as in the United States, reluctance to offer higher wages leads to a shortage of willing workers. Only when British and American farmers offer higher wages will the labor shortages disappear.

Interestingly, the farmers in these two countries have adopted completely different approaches to dealing with the problem. While some U.S. farmers chose to avoid the immigration issue by offshoring their operations to Mexico, the British farmers lobbied the government to bring in more Ukrainian workers under a special scheme. How well do these two approaches address the agricultural labor problem in the two countries?

Discussion Questions

1. As observed by Julia Preston of the International Herald Tribune, what impact does the offshoring of farm operations have on the U.S. economy as a whole?

2. According to the Economist, what is the best way to provide incentives for immigrant workers to work hard? Why?

And You Think Low Prices Are Always Best?

With persistent hyperinflation, money has become worthless in Zimbabwe. The official inflation rate in May was 4,500%, but according to estimates, the real rate had already reached 9,000%. In response to the continuously rising prices, President Mugabe of Zimbabwe ordered the prices of all commodities be cut by at least half. This type of price control by the government is referred to as a price ceiling, with the selling price set below the equilibrium price. Let's examine the effect of a price ceiling using the supply and demand diagram to the right.

Let Pe and Qe be the equilibrium price and quantity of a commodity. A price ceiling that regulates the commodity to be sold at Pc leads to an increase in quantity demanded to Qd. At the same time, producers reduce the supply of the commodity at Pc, thereby lowering the quantity supplied to Qs. Hence, there will be excess demand, or shortage (Qd – Qs) for the commodity. This is exactly what the Zimbabweans are experiencing in the wake of Mugabe’s price cuts. Many commodities were swept from the shelves and disappeared from sale as producers refused to supply more at the regulated price.

The story does not end here, though. From the supply and demand model, we see that at Qs, some people are willing to pay as much as Pb to obtain the commodity. Therefore, informal markets emerge with people buying and selling commodities at prices much higher than the regulated or market equilibrium prices.

Read Chris McGreal’s article in The Guardian to learn more.

Discussion Questions

1. According to the article, what might be the reasons behind President Mugabe’s price cuts?

2. Who stands to benefit from the price controls in Zimbabwe? Who stands to lose?

3. What could the Zimbabwean government do to save the economy?

Who Wants to Be a Harvard Grad?

It's getting tougher and tougher to get into Harvard. The admissions rate—that is, the fraction of applicants who are accepted—has been declining for decades. And you don't need an 800 on your math SATs to figure out why: the number of spots at Harvard has remained roughly the same, while the number of applicants has soared. But why has the number of applicants soared? And should it be soaring?

As with all economic questions, the answer comes down to costs and benefits. The social and economic benefits of attending Harvard are large. To spend four years among the "best of the best" (by some measures, anyway) is an exhilarating experience. And in what Robert Frank calls our "winner-take-all society," going to an elite school may be a necessary first step if you want to compete for the kind of positions (Supreme Court justice, CEO, Nobel Prize winner) that only a microscopic proportion of the human population ever obtain. But these benefits are roughly the same as they have always been: indeed, students can now choose from many more excellent colleges than they could in the past.

In the meantime, what has happened to the cost of getting into Harvard? Harvard alum Michael Winerip recently wrote an essay in the New York Times on how the young people applying to his alma mater now are, on paper at least, much more accomplished than he was at their age. But many of their accomplishments—from a string of 5's on AP tests to touring Europe with youth orchestras—are the result not of increased inner drive among college-bound students, but rather of a nascent industry designed to help students get into college. Winerip writes that, as an alumni interviewer, he interviewed a girl who worked at NASA doing research on weightlessness in mice; his project in high school, by contrast, was a shoebox with soil and bean sprouts. And while some of the students he has interviewed take 10 AP courses and get top scores on all of them, he took a single AP course and scored a 3. However, he writes,

Of course, evolution is not the same as progress. These kids have an AP history textbook that has been specially created to match the content of the AP test, as well as review books and tutors for those tests. We had no AP textbook; many of our readings came from primary documents, and there was no Princeton Review then. I was never tutored in anything and walked into the SATs without having seen a sample SAT question.

As for my bean sprouts project, as bad it was, I did it alone. I interview kids who describe how their schools provide a statistician to analyze their science project data.

Reading Winerip's essay, it may seem as though the costs of getting into Harvard have skyrocketed—but in fact, if one thinks about this like an economist, it quickly becomes clear that the opposite is true. The price of preparing any one element of one's résumé has in fact decreased: for example, one can now buy a textbook that is keyed to the AP test, whereas before, students didn't have access to those resources.

However, total expenditure on college preparatory activities has increased dramatically. This is because, as the law of demand would predict, the lowered cost of achieving specific goals leads to more people attaining those goals—and therefore drives up the number of people applying to Harvard. Furthermore, as more people do the things that used to get you into Harvard, students have to do more and more to set themselves apart from the rest of the crowd.

Discussion Questions

1. Winerip laments the fact that many of these driven students are missing out on the fun of childhood. Is it efficient (in the economic sense of the word) for so much effort to be devoted to getting into college? What are the costs and benefits of this kind of competition?

2. Use a supply-and-demand model to illustrate what has happened in the market for college preparatory activities (tutoring, mentoring, test prep). Note that the probability of getting into Harvard is both dependent on the outcome of that market and a determinant of demand in that market. How is an equilibrium reached that takes both of those factors into consideration?

3. What effect does increased competition for elite schools have on other schools? Is it easier or harder to get into a good state school because of all the competition to get into Harvard? What about the effect on tuition, both at elite schools and other schools?

Harvey's Milk

On June 9, new rules governing organic dairy farming will take effect. The Harvey rule—so named for the Maine blueberry farmer whose lawsuit prompted the change—will increase the cost of converting a conventional dairy operation to an organic one. Under the old rules, obtaining the organic designation required nine months of feeding cows a blend of 80% organic and 20% conventional feed, followed by three months of 100% organic feed. The Harvey rule requires farmers to feed cows 100% organic feed for the entire conversion year. In essence, the new rule makes the conversion process "more" organic.

The expectation of a more expensive transition, combined with relatively high organic-milk prices, caused many farmers to "go organic" under the old rules last spring in order to avoid the Harvey rules. As a result, the supply of organic milk should increase this spring as more organic farms enter the market. Read Andrew Martin's article in the New York Times to learn more about the Harvey rule's impact on the market for organic dairy.

Discussion Questions

1. Even with surging organic-milk supply, the article argues that

…consumers probably will not see lower prices. Several manufacturers and retailers said they did not plan to reduce prices, in part because the oversupply would be quickly absorbed by increasing demand.

The graph above illustrates the scenario where rising demand for organic milk neutralizes the price effect of an increase in supply. Do you think this is a likely scenario? In the absence of sufficiently strong demand, do you think organic dairy manufacturers and retailers have the market power to keep prices from falling?

2. How will the increase in the supply of organic milk affect the market for products like organic yogurt and cheese, for which organic milk is an input? As more and more dairy farmers go organic, how will the reduction in the number of conventional dairy farmers affect the price of conventional milk?

3. According to the article:

The challenge of making a dairy farm organic is that the farmer’s costs rise during the conversion year, but they are not yet offset by the higher income from selling organic milk. The high cost of feed corn is a big factor; corn farmers see few incentives to go organic because they can make so much money selling their crops to make ethanol.

How will the rising number of organic dairy farmers and the imposition of the Harvey rule affect the incentives faced by corn farmers when deciding whether to go organic? Conversely, how might further growth in the ethanol industry affect incentives for dairy farmers to go organic?

4. Governments often announce new legislation well before it takes effect—sometimes with unintended consequences. For example, the federal government might announce that it intends to impose land-development restrictions in areas inhabited by endangered species. Developers will face an incentive to initiate development before the costly rules take effect—potentially ruining the habitats the legislation was intended to save. Did the sizable lag between the Harvey rule's announcement and its imposition in any way compromise its intent?

Click here for another Aplia perspective on organic foods and resource allocation.

Fueling Protests and Cars

Tortillas—a central component of the Mexican diet—have been a source of recent uproar in Mexico. Rising tortilla prices fueled protests in Mexico City two weeks ago. Many people in Mexico earn only $5 per day, and with the price of tortillas approaching $0.45 per pound, protests were inevitable.

Tortilla prices may be fueling the protests, but it's the growing demand for corn among American ethanol producers that's fueling the rise in tortilla prices. As more and more ethanol plants come online in the U.S., the number of buyers in the corn market increases, putting upward pressure on corn prices. Rising corn prices mean rising input prices for tortilla makers and rising tortilla prices for consumers. So does fueling your Honda Accord with ethanol-laced gasoline take tortillas off the plates of Mexicans? The answer depends on the time horizon: the short run or the long run.

Three characteristics in the market for corn make it highly competitive. First, there are many corn producers in the United States, Mexico, and the rest of the world. Second, corn tastes about the same no matter which farmer sells you the corn. Third, there are few barriers to new corn producers entering the market in the long run.

In the short run, however, firms cannot exit or enter the market. Rising ethanol production in the U.S. creates a higher demand for corn. The market demand for corn shifts to the right from D1 to D2, increasing the price of corn from P1 to P2. Corn producers react to the higher price by producing more corn (moving from q1 to q2). The higher demand for corn also causes corn producers to earn an economic profit.

How does this affect the tortilla market in Mexico? Corn is a major input for tortillas—as corn prices rise, the cost of tortilla production rises. The supply of tortillas shifts to the left from S* to S**. The price of tortillas increases and the quantity of tortillas consumed decreases. The reduction in tortilla supply causes the price of tortillas to rise sharply in Mexico because tortillas are essential to the Mexican diet (the demand for tortillas is fairly inelastic). As a result, the financial burden of higher corn prices falls on tortilla consumers more so than the producers.

Fortunately, as the Los Angeles Times reports, help is on the way for the people of Mexico. In the long run, firms may exit or enter the market. Unusually high short-run profits in the corn market will undoubtedly cause more farmers to plant corn in the long run. As they do, the supply of corn will shift to the right from S1 to S2. As more farmers plant corn in the long run, profits return to normal and the price of corn falls. In the long run, as the diagrams suggest, it's possible that the higher demand for ethanol will have no effect on corn and tortilla prices.


Click here for another Aplia perspective on food prices and ethanol.

Discussion Questions

1. How would a price ceiling at P* affect the Mexican tortilla market?

2. Should the Mexican government subsidize tortilla producers until corn prices fall back to previous levels? How would a subsidy—or voucher—for tortilla consumers affect the tortilla market in the short-run?

3. Are Mexicans worse off or better off due to the increase in U.S. ethanol production?

California Freezing

Freezing temperatures destroyed significant portions of fruit and vegetable crops in California over the weekend of January 13. An article from the LA Times documents the cold snap's immediate impact on wholesale prices for citrus. The cold snap will be felt in other markets as well: an article in the Seattle Times assesses potential impacts on apple and pear prices, and a USA Today piece considers the fallout in the labor market for farmhands in California.

Discussion Questions

1. According to the LA Times article: "The freeze has left the nation with about 14 million 40-pound cartons of California navel oranges—less than half of what America would eat between now and next season…" The sharp reduction in the supply of navel oranges will cause prices to rise, but by how much? To what extent will consumers substitute away from citrus towards other fruits in response to higher prices? Is demand for navel oranges relatively unresponsive to price changes (less elastic), or will consumers simply switch from citrus to alternative fruits when prices rise (more elastic)?


2. As the LA Times article mentions, California is the major producer of navel oranges for domestic consumption and also exports a significant amount of fruit. Fruit distributors will try to import as much citrus as possible from places like Mexico and Chile. That is, the supply of citrus exports from the U.S. will plunge and the demand for citrus imports will rise. What do you expect to happen to world citrus prices?

3. The USA Today article notes that many California farmhands will be laid off in the wake of the freeze. What will happen to farmhand wages and employment levels in California? Given that undocumented migrant workers will not be eligible for unemployment insurance, what do you expect to happen in markets for low-skilled labor in other parts of the United States?

4. How, according to the Seattle Times article, is the reduction in citrus supply affecting the demand for apples and pears?

Tiger Conservation Revisited

Can we save wild tigers by selling off the parts of their domesticated cousins? Aplia Econ Blog wrote about a New York Times op-ed by Barun Mitra several months ago (see archived link here). Citing the failure of poacher crackdowns and bans on traditional medicine products made from tiger parts, Mitra argued that legalizing trade in tiger parts would eliminate the strong black-market incentives to poach wild tigers. For example, Mitra wants to legalize the sale of body parts taken from farm-raised tigers in China after the tigers pass away. The Chinese tiger "farms" are zoos of sorts, where tourists pay to snap pictures during feeding time.

The basis for Mitra's controversial proposal? Supply and demand. Legalizing the sale of parts from domesticated tiger carcasses would lead to a sharp increase in the supply of such parts to the traditional medicine market, and a subsequent decrease in the prices of products containing tiger parts. The lower prices for tiger-based products, argues Mitra, could significantly weaken the incentive to poach wild tigers. Revenues from the legal market for tiger-based products could even go toward anti-poaching efforts and habitat conservation.

Not so fast, replies Australian economist Richard Damania.

In a recent NPR story on Mitra's proposal, Damania argues that Mitra forgot to consider the demand side of the market. Follow the link to read NPR reporter John Nielsen's write-up of Mitra's proposal and Damania's rebuttal.

Graph I shows the effect of legalizing the sale of body parts from tiger-farm carcasses in the absence of any demand-side effects. As Mitra suggests, the injection of legitimate supply would lower tiger-part prices and weaken the incentives to poach wild tigers. Damania, however, reminds us that the legalization of a formerly banned product would likely increase the demand for that product, since black-market consumption poses legal risks for buyers as well as sellers.

Graph II shows one possible outcome in the event that Mitra's legalization proposal affects both supply and demand in the tiger-parts market. Because more people demand the legal product, the demand shifts to the right and, in this case, wipes out any downward price pressure from the initial increase in supply.

Discussion Questions

1. Taking the demand-side effects of Mitra's proposal into consideration, how do the potential impacts on poacher incentives change? How would the proposal affect poacher incentives if the demand-side effects were stronger than the supply-side effects? That is, how would the incentive to poach change if the proposal caused a bigger shift in demand than in supply? What if the demand-side effects were relatively weak compared to the supply-side effects?

2. Mitra and Damania echo arguments made whenever policymakers consider legalizing a hitherto illegal good or service that many people view as distasteful, dangerous, or taboo. For example, proponents of legalizing drugs argue that the legal drug trade will be safer than the illegal trade. Opponents argue that legitimizing drug use will increase demand--wiping out potentially positive effects on safety.

How is the market for marijuana different from the market for tiger parts? Do you think the legalization of marijuana in the United States would have a greater impact on the supply side or the demand side of the marijuana market? How do penalties for marijuana consumption differ from those for distribution? How do the differences affect your analysis of legalization in the market for marijuana?

3. According to the NPR story, Damania claims that the cost of poaching wild tigers will always be lower than that of raising domesticated tigers on a farm. According to Damania: "That gap is so wide that it can never be closed, even if you factor in the cost of hunting down a tiger in the wild."

Recall that the tiger farms currently exist to attract camera-laden and somewhat bloodthirsty tourists hoping to see the animals feed on live prey. When the domesticated tigers die, their carcasses are destroyed, since the sale of parts is illegal. Is it accurate for Damania to count the entire expense of raising a domesticated tiger as the cost of providing tiger parts in the marketplace? How do you think the costs of poaching wild tigers compare to the marginal cost of providing tiger parts from a carcass on a tiger farm?

4. As the NPR story suggests, poaching is not the only thing threatening wild tiger populations. Habitat encroachment by humans puts pressure on wild tigers as well. Do you share Mitra's optimism about using proceeds from a legal market in tiger parts to finance habitat conservation? If not, what other types of incentive-based policies might help the tiger?

The Organ Shortage

Newspaper ads on every college campus beckon cash-strapped students to sell their plasma, sperm, or eggs to the appropriate medical intermediaries. It's Adam Smith's invisible hand at work: People need plasma for blood transfusions; students with excess plasma need cash. Plasma banks facilitate the transaction and everyone's better off.

The enterprising student will wonder whether he can collect on other spare parts--say, a kidney. He cannot. The sale of human organs, whether it benefits a living kidney donor or the family members of a recently deceased heart donor, is illegal in the United States. Why, asks the latest Freakonomics column, is selling a kidney illegal in a country where thousands of people die each year waiting for kidney transplants? Read the column to see what Stephen Dubner and Steven Levitt have to say about the organ shortage.


1. Suppose the graph above represents a market for transplantable kidneys from live donors. Under current law, the price of a kidney is restricted to zero. At a zero price, 15,000 people (most likely friends and family of the recipients) supply a kidney to eligible patients each year. What's the shortage of kidneys at a zero price?

2. Beyond the 15,000 charitable donors our hypothetical supply curve takes a more familiar, upward-sloping shape. Each point on the supply curve represents the seller's cost of providing a transplantable kidney. According to Dubner and Levitt, what are some of the costs that influence the supply decisions of living kidney donors? (Think about forgone wages, medical risks, and the fact that supplying a kidney is a one-time event.)

3. In our hypothetical market for kidneys shown in the graph, what price clears the transplantable kidney market? (See an actual economic estimate of kidney prices in this paper by Gary Becker and Julio Jorge Elias.) Notice that closing the kidney shortage with a free market adds to the cost of a transplant (already upwards of $200,000). Might the additional cost of procuring a kidney price some patients out of the market altogether? That is, would an increase in the price of a transplant reduce the quantity of transplants demanded? Do you think the quantity of transplants demanded is sensitive or insensitive to price (is the price elasticity of demand for transplants perfectly inelastic)?

4. If you're like most normal people, the prospect of a market for kidneys raises all kinds of moral and ethical questions. According to the column, Alvin Roth helped devise a program that uses incentives to elicit organ donations from strangers, but stops short of a free market for organs. How does the New England Program for Kidney Exchange align the incentives of non-related donors and recipients without monetary incentives?

5. Kidneys from living donors are preferable from a medical perspective, but usable organs from the recently deceased are important as well. Of course, doctors can't just go around harvesting organs every time someone dies. Americans, usually at the Department of Motor Vehicles, have to sign-up if they wish to donate usable organs upon death. What would happen to the organ shortage in the United States if all Americans were donors by default?

Check out the Freakonomics website for more about creative solutions to the organ shortage.

Oil Shock, Part I: The Microeconomic View

Economists use the term "supply shock" to refer to an unexpected event that causes a sharp change in the supply of a good. A classic example occurred recently when BP closed down the Prudhoe Bay oil field after finding "unexpectedly severe corrosion" in a pipeline. Pumping about 400,000 barrels per day, the pipelines from Prudhoe Bay carry about 8% of the nation's domestic oil production.

The chain of events that followed the announcement of the shutdown present a textbook example of economics in action. According to the New York Times:

Word of the shutdown rattled global commodities and equities markets. In the United States, oil prices rose more than two dollars a barrel. The benchmark contract for light, sweet crude to be delivered next month rose as high as $77.30 a barrel before settling at $76.98 a barrel in New York trading. Prices rose even higher in London, where Brent crude for September delivery closed at a record $78.30 a barrel…

Stocks, meanwhile, fell in American trading and slid across Europe. Major indexes in Britain, Germany and France all posted substantial declines for the day.

In microeconomic terms, the Prudhoe Bay closure shifts the supply curve of oil to the left, increasing the equilibrium price and decreasing the quantity of oil in the market (Figure A). Because oil is so important for the production of goods and services, an increase in its price will increase business costs worldwide (Figure B). Because higher costs reduce firms' profits, investors bid down stocks in equity markets.

See Part II of this post for the macroeconomic impact of this supply shock.

1. Why do unexpected changes, such as this one, impact the stock market so much more than expected changes?

2. Which goods and services are most affected by changes in the price of oil? Draw a supply and demand diagram for one of those goods. How will the closing of the oil field affect the market you chose?

3. BP has been plagued by safety problems in the past few years. Like any company, it faces a tradeoff between safety and profitability. Using cost-benefit analysis, how would you find the optimal level of safety? Do you think BP chose the optimal level, or do you think it spent too little on safety? How could you find out the answer to that question?

China's Demographic Dilemma

As growing numbers of elderly Chinese workers retire from the workplace to the mahjong table, China's pension system and labor markets are in for disruption.

Aplia Econ Blog readers know about the difficulties facing public pension systems in aging OECD countries (archived entry here). But the falling ratio of active Chinese workers to retirees highlights another dilemma: labor shortages and rising wages in China's labor-intensive manufacturing sector. A few months ago, Aplia Econ Blog examined a New York Times article detailing the demand-side contribution to rising wages in the Chinese labor market (archived entry here). A recent Times article explores the effects of an aging Chinese population on the supply side of the labor market.


1. China adopted a planned birth policy in 1979. The "one-child policy" made it very financially unattractive for parents to have more than one child. The planned birth policy significantly lowered the fertility rate (the average number of child births per woman of child-bearing age) in China's urban areas. How do China's population policies help to explain the looming pension and labor market dilemmas?

2. The article mentions that China's household registration system restricts internal migration. The planned birth policy had a much smaller impact on fertility rates in China's rural areas. As a result, many young workers reside in the countryside where average wages are below urban levels. How would abolition of the household registration system affect urban labor markets? Might relaxing internal migration restrictions (short of total abolition) relieve the pressure on wages in China's urban industrial centers?

3. Urban prosperity in China continues to widen the income gap between urban and rural Chinese. In the absence of any internal migration reforms, what will happen to income inequality as the ratio of workers to retirees continues to fall in urban areas?

4. According to the article, how will rising wages in China's urban areas affect industries in Vietnam, Bangladesh, and India? What will happen to America's yawning trade deficit with China if the aging urban population causes wages in China's manufacturing industries to rise?

Topics: China, Labor markets, Aging populations, Trade, Income inequality

Chain of Fools

Did you get the chain email urging you to join the ExxonMobil boycott? If not, here's the letter. Why boycott ExxonMobil? Seedy dealings with corrupt government? Repugnant disregard for the environment? Nope. The chain mailers are simply engaged in what has become a rite of spring in America: whining about high gas prices.

Are you outraged by the prospect of four bucks per gallon? Well, don't click the forward button just yet. Take a moment to consider the economics behind the chain mail gas proposal. Here's the strategy according to the chain mailers. First, millions of boycotters stop buying gas from ExxonMobil stations. Next, freaked out ExxonMobil executives slash gasoline prices in an attempt to lure back customers. Then, other gas stations freak out too and slash their prices in order to keep their customers from going to ExxonMobil. And, Shazam! We're back to driving our suburban assault vehicles for a dollar per gallon.

Let's give the chain mailers the benefit of the doubt and assume that they can muster the social networking required to pull off a massive boycott of ExxonMobil gas stations. (Successful boycotts typically need an extremely important issue for protesters to rally around.) Ask yourself some questions in order to think about the pitfalls of the chain mail scheme:

1. If, miraculously, lots of people stopped going to ExxonMobil for gas, where would they buy gas? What would happen to gas prices at other stations as people substituted away from ExxonMobil toward other brands in order to comply with the boycott? Would gas prices rise or fall?

2. How long is the boycott supposed to last? That is, how much does Exxon have to cut prices before boycotters can buy Exxon gas and trigger a price war? (Boycotters will have to go back to Exxon to trigger the price war--if other stations knew that no one would buy gas from Exxon, they'd have no incentive to cut their prices.) If ExxonMobil reacted to the boycott by making small price cuts, would some people abandon the boycott early?

3. Suppose ExxonMobil cuts prices by a lot and the boycotters allow themselves to go back to Exxon. Some gas stations might drop prices a bit in order to stem the flow of traffic back to Exxon, but as people went back to Exxon in order to reap the rewards of cheaper gas, what would happen to gas prices at Exxon stations? When the dust settles on the whole boycott would gas prices be any lower than they were before?

4. Ohio State University economist Tim Haab has a message for would-be boycotters who'd like to see lower gas prices: don't drive so much. Listen to his Morning Edition interview on NPR. Who keeps oil prices high: demanders or suppliers? President Bush said the United States has an oil addiction. What energy policies would effectively ween us off of our oil habit?

Want more on the economics of gas boycotts? Check out Tim Haab's blog posts.

Bee County, Texas went so far as to pass a resolution in support of the chain email's scheme.

Jacob Weisberg's Slate column discusses the Congressional stupor created by rising gas prices.

Topics: Gas prices, Supply and demand, Incentive

Do Renewable Fuels Mean World Hunger?

Sky-high oil prices and concerns over global warming have sparked a debate about renewable energy sources. One such alternative is to use biological fuels (rather than fossil fuels like oil) to power automobile cars. Willie Nelson has started selling BioWillie, a form of diesel made in part from vegetable oil. And ethanol, a form of gasoline made from corn, has begun to take off as a viable alternative to traditional gasoline in cars.

The possibility of using corn to produce fuel is one that is obviously attractive to the nation's corn growers. But if the United States were to start using corn as a significant source of energy, would that mean that the rest of the world would have less to eat? Would poor children go starving just so yuppies could drive their SUVs? This article in the New York Times examines that possibility, but some simple economic analysis shows that these fears are unfounded.

Consider the market for corn in Iowa. Usually, demand in the market comes from animal feed producers and food processors, who make the corn into corn syrup for use in things like Danish pastries. However, this year, demand for corn increased because there are more buyers in the corn market: namely, ethanol producers.

In the short run--that is, after the corn has been harvested in a given year--the supply of corn is fixed. This is sometimes called a momentary supply curve. (You can see the fixed supply of corn in the picture in the article--it's that giant 35-foot pile in the main photo!) Therefore higher demand translates into higher prices, as is shown in Figure 1.

In the long run, though, higher prices for corn will mean that more corn will be produced. (In fact, as the article mentions, the U.S. government actually pays corn farmers NOT to farm 35 million acres of corn.) Because of these agricultural subsidies, in fact, third-world farmers are priced out of the market--so they don't plant corn. Higher demand for corn, in the long run, would mean that both U.S. producers and world producers would have more incentive to plant corn. Therefore, the long-run supply curve of corn is much more elastic (i.e., much flatter) than the momentary supply curve--so the same shift in the demand causes a smaller increase in prices, and enough corn to be planted to satisfy the need for food and fuel, as shown in Figure 2. In the long run, an increase in the demand for corn increases the amount of corn produced and consumed in the world.

1. The article quotes Lester R. Brown, an agriculture expert in Washington, D.C., and president of the Earth Policy Institute, as saying, "We're putting the supermarket in competition with the corner filling station for the output of the farm." Draw a PPF showing how much food and fuel an economy can produce with a given amount of corn. What aspect of your drawing represents the tradeoff that Mr. Brown describes? Now draw another PPF showing how much food and fuel an economy can produce if twice as much corn is planted. In what sense are short-run tradeoffs different from those in the long run?

2. Draw a supply and demand graph of the market for corn. What would happen in this diagram if the United States stopped paying corn farmers NOT to farm that 35 million acres of corn?

3. Much of the corn grown in the United States is used for animal feed. What effect would an increase in the price of Iowa corn have on the market for hamburgers?

4. What other short-run tradeoffs might be rendered irrelevant by long-term market adjustments