2. Theory of perfectly competitive markets
2.1
Economist article
Vanilla thriller
2.2
Biofuelled
2.3
2.4
Destitution not dearth
The great Manhattan rip-off
2.5
On your bike
2.6
Even in Texas
2.7
Unbottled Gini/The rise and
rise of the cognitive elite
Hedging against the
horseman
The price of entry
Half cocked
2.8
2.9
2.10
Concept
Demand/Supply +
Comparative statics
Demand/Supply +
Comparative statics
Demand/Supply
Government regulation –
Maximum price
Government regulation Quota
Government regulation Subsidy
Demand/Supply +
Comparative statics
Market design
Market design
Market efficiency
Economist Work-out 2.1
Read the attached article ‘Vanilla thriller’, The Economist, April 20 2002. The article
describes changes in supply conditions in the market for vanilla flavouring due to weather
effects on the crop of vanilla pods in Madagascar, and technological change in artificial
vanilla flavouring.
Some questions to try:
1. For the purposes of analyzing movements in price and quantity traded of the types of
vanilla flavouring described in the article, what separate markets would you identify?
2. Use the model of demand/supply in a perfectly competitive market to explain why the
price of vanilla pods has increased after the tropical storms in Madagascar.
3. What would you predict would be the effect of the tropical storms on the artificial vanillin
products?
4. Suppose labeling laws were changed to allow Zylepsis’s vanillin to be stated as a ‘natural’
product. How would this affect the price and quantity traded of vanilla pods and the various
types of flavouring?
This article (‘Vanilla Thriller’, The Economist, April 20 2002) is reproduced with kind
permission of The Economist for use only for teaching purposes (www.economist.com).
Vanilla thriller
“Tropical storms in 2000 and 2001 badly damaged Madagascar’s hugely valuable vanilla
production …The best quality vanilla pods can fetch thousands of dollars a kilo, but the stuff
more typically sells for around $200 a kilo, five times the level before storms ravaged crops
and stocks. As prices have risen, food manufacturers have turned to cheaper vanilla flavours
that are produced artificially…But there is a tension between low-grade chemical vanillas and
their better quality natural competitors.
One problem is the complex series of rules governing what can be labeled as ‘natural vanilla’.
Vanillin, the main flavour of vanilla, can be produced in a laboratory, but it then must be
classified as an artificial additive. Picky consumers tend to avoid the chemical version,
preferring natural flavours. Thus, food companies have looked for ways to make ‘natural’
vanilla without relying on actual vanilla pods.
Pure crystals of vanilla can be produced biologically by bacteria that munch waste. Only
recently, however, have a few such processes been commercialized. Zyplesis, a private
British company, has pioneered vanillin production using bugs and has obtained high quality
results, although its product remains relatively expensive. It also confounds current labeling
rules. Zylepsis’s vanillin is a natural product, rather than a chemical one, but it does not
qualify as such in America because it contains no actual vanilla extract.”
Economist Work-out 2.1
Solutions
1. Making an economic model is a subjective process – Whether we have the correct model is
a matter of judgement. What we are always aiming for is to have a representation of the
situation we are studying that is sufficiently detailed to allow us to answer questions we are
interested in, but does not include detail or complexity that is not necessary for that purpose.
In this situation it would probably make sense to have a model that identifies three markets –
for vanilla pods, for Zylepsis vanillin, and for other types of artificial vanillin. (For
answering question 3 it is probably just sufficient to identify two markets – for vanilla pods
and for artificial vanillin, but for answering question 4 it is useful to make the extra
distinction between Zylepsis and other types of artificial vanillin.)
2. Tropical storms in Madagascar will decrease supply of vanilla pods. This will increase the
equilibrium price of vanilla pods. This is shown in Figure 1.
3. Zylepsis vanillin, and other types of artificial vanillin, are substitutes for vanilla pods for
producing vanilla flavouring. Hence we would expect that the increase in the price of vanilla
pods after the tropical storms would increase demand for Zylepsis vanillin and other types of
artificial vanillin. An increase in demand will increase the equilibrium quantities traded and
price of artificial vanillin. The extent of increase in demand for artificial vanillin will depend
on the degree of substitutability for vanilla pods. The article seems to suggest that Zylepsis
vanillin – due to being a natural product – may constitute a closer substitute than other types
of artificial vanillin. In this case there would be a larger effect on demand for (and hence on
quantity traded and price of) Zylepsis vanillin than other types of artificial vanillin. This is
shown in Figures 2a and 2b.
4. If Zylepsis is classified as a ‘natural’ product, then the inference that can be made from the
article is that this would increase demand for Zylepsis vanillin. This would increase
equilibrium quantity traded and price of Zylepsis vanillin. Effects on vanilla pods and
artificial vanillin would then be determined by two factors: first, there would be a decrease in
demand as the ‘quality’ of Zylepsis has increased relative to these products; but second, the
increase in the price of Zylepsis would be expected to increase demand for these products.
The overall effect on demand for vanilla pods and artificial vanillin will depend on which of
these factors is larger. (Probably we would expect the ‘quality’ effect to dominate so that
demand for vanilla pods and Zylepsis vanillin would decrease.)
price of vanilla pod effect of storms
S2 S1 P2* P1* qty of vanilla pods traded Figure 1 price of Zylepsis vanillin effect of increased price of vanilla pods price of other artificial vanillin S1 S1 P2* P2* P1* P1* D2 D1 Figure 2a D1 qty of Zylepsis traded Figure 2b D2 qty of other artificial vanillin traded Economist Work-out 2.2
Read the attached article ‘Biofuelled’, The Economist, June 23 2007. The article describes
changes in crop prices that have occurred in the United States in recent years.
Some questions to try:
1. Use the demand/supply model of competitive markets to explain why in markets in the
United States there has been:
a) An increase in the price of grains such as corn and wheat?
b) An increase in the price of meat (for example, poultry) and eggs?
2. Use the demand/supply model of competitive markets to predict the effect of an increase in
the availability of ethanol-based fuels on the price of oil. Why does the article suggest that in
reality the price of oil has hardly been affected?
3. The article states that:
a) “There is also quite a bit of fallow land to be sowed…But those countries [with the fallow
land] are far from the biggest markets and their idle land tends to be found in areas with poor
transport links. A strong price signal will be needed to overcome such obstacles…”
b) “Since high oil prices and government subsidies ensure that biofuels are profitable, any
extra grain will be used to make more of the stuff.”
How could you use the benefit-cost principle to explain what is being suggested in each of
these statements?
This article (‘Biofuelled’, The Economist, June 23 2007) is reproduced with kind permission
of The Economist for use only for teaching purposes (www.economist.com).
Biofuelled
Every morning millions of Americans confront the latest trend in commodities markets at
their kitchen table. According to the United States Department of Agriculture, rising prices
for crops--dubbed "agflation"--has begun to drive up the cost of breakfast. The price of
orange juice has risen by a quarter over the past year, eggs by a fifth and milk by roughly 5%.
Breakfast-cereal makers, such as Kellogg's and General Mills, have also raised their prices.
Underpinning these rises is a sharp increase in the prices of grains such as corn (maize) and
wheat, both of which recently hit ten-year highs. Analysts are beginning to ask, as they have
of oil and metals, whether higher prices are here to stay.
On the face of it, that is an odd question. After all, if the world runs short of corn or wheat,
farmers can simply grow more, weather permitting. That is exactly what they have been
doing. In the coming year, the International Grains Council, an industry group, estimates that
global production of grains will reach a record of 1,660m tonnes, well above last year's figure
of 1,569m. But demand for grain is growing even faster. The council reckons it will reach
1,680m tonnes this year. In three of the past four years, demand has exceeded supply.
The culprit is the growing use of grains to make biofuels, such as ethanol. Most grains are
used as food either for people or for livestock. But the increase in human consumption has
been slowing for decades as population growth moderates. Demand for animal feed,
meanwhile, has grown steadily, as more people in booming countries such as China grow rich
enough to afford meat.
Demand for biofuel feedstocks, by contrast, is soaring. The amount of corn used to make
ethanol in America has tripled since 2000; ethanol distilleries now consume a fifth of the
country's corn crop. And America is only one of 41 countries where governments are
encouraging the use of biofuels to reduce oil consumption.
As a result, demand for grains has accelerated. During the 1990s, when oil was cheap and
biofuels unheard of, demand grew by 1.2% a year, according to Goldman Sachs. But in
recent years, it has increased by 1.4%, and over the next decade, Goldman projects, it will
rise by 1.9% annually.
Farmers are struggling to keep up. The Economist Intelligence Unit, a sister company of The
Economist, projects that demand for corn, at least, will continue to exceed supply until at
least 2009. Moreover, even to produce as much corn as they are now, farmers are growing
less soya and wheat, and so pushing up the prices of those crops too. With all the main grains
to feed poultry and livestock becoming more expensive, the cost of meat and eggs is rising,
and so it goes on.
When demand was growing more slowly, farmers could meet it through gradual
improvements in their yields. But to cope with today's boom, yields will have to rise much
faster, or farmers will have to bring more land into production.
Both are possible. Greater adoption of genetically modified strains of corn and wheat, for
example, could improve yields. But they are expensive and politically controversial. There is
also quite a bit of fallow land to be sowed, especially in developing agricultural powers such
as Brazil and Ukraine. But those countries are far from the biggest markets and their idle land
tends to be found in areas with poor transport links. A strong price signal will be needed to
overcome such obstacles and induce extra supplies.
But even if new land is planted, argues Jeffrey Currie of Goldman Sachs, it will not
necessarily reduce the cost of grains. Since high oil prices and generous government
subsidies ensure that biofuels are profitable, any extra grain will be used to make more of the
stuff. That will not dent the oil price, since the volumes remain tiny compared with global oil
consumption. Instead, the price of biofuels has risen to that of petrol, and the price of corn
and crude oil, the main feedstocks for the two, have converged (see chart on previous page).
For grain prices to fall, Mr Currie argues, either governments must pull the plug on biofuels
programmes, or the oil price must fall.
Neither seems very likely in the near future. This week America's Congress is debating
whether to double its targets for biofuel production. At the same time, the oil price rose to its
highest level in ten months, thanks to a strike and other disruptions in Nigeria. The chaos in
the Niger delta, it turns out, has a surprising amount to do with the price of eggs.
Economist Work-out 2.2
Solutions
1. a) The article explains that prices of grains such as corn and wheat have increased because
of increases in demand. An increase in demand for wheat has occurred due to higher demand
for feed for livestock. The greater demand for feed for livestock has been due to higher
demand for meat in countries such as China and India (due in turn to growth in income in
those countries). An increase in demand for corn has occurred due to growth in demand for
feed for livestock; and as well, there has been a large increase in demand for corn to be used
as an input for making ethanol.
P S1 Increase
P*2 in P*1 D1 D2 Q Markets for corn/wheat b) The increase in demand for livestock feeds such as corn and wheat has increased the price
of these commodities. Since feed is an input to production of poultry, and hence eggs, there
is therefore an increase in the cost of production or poultry and eggs. Hence supply decreases,
and this explains why the prices of poultry and eggs have risen.
P S2 S1 ↑cost of production P*2 => ↓supply
P*1 D1 Q Markets for poultry/ eggs 2. Increased availability of a substitute for oil, for example ethanol-based fuels, should (if it
has any effect) cause a decrease in demand as some consumers substitute towards the
alternative fuel. This decrease in demand would be expected to decrease the price of oil. In
reality, there has not been any observed effect on the price of oil. The explanation that is
suggested in the article is that the volume of ethanol-based fuels produced has been so small
relative to the volume of oil consumption, that there has not been any appreciable effect on
demand for oil.
3. a) Any land-owner or farmer who is considering commencing producing grains on a new
area of land will, if they are rational, make a decision whether to do this taking into account
the marginal benefits and marginal costs of commencing that extra farming activity. The
article describes how the marginal benefits of this extra farming activity are now much higher
than before, because of the increase in grain prices. But the quote also makes the point that
the marginal cost of bringing into cultivation land that is currently unutilised is also likely to
be relatively high. This is because the land is a long way from locations where grain is
consumed and tends to be in regions where there are poor transport services. Hence costs of
transporting the grain from new farming areas would be very high. Therefore, one way to
interpret what the quote from the article is saying that: Because the marginal cost of bringing
new areas of land into cultivation is so high, there would need to be a large increase in prices
(that is, the marginal benefit of growing grains) in order to induce farmers to commence
cultivating the new land. (Another way of saying this is that supply of grains is relatively
own-price inelastic.)
b) Suppose a land-owner or farmer has put extra land into cultivation producing grains. A
rational land-owner or farmer will then want to sell that grain where it is going to maximize
total benefits minus total costs. It seems reasonable to assume that the costs of selling the
grain do not vary depending on the buyer to whom it is sold (that is, costs are the same
whether the grain is sold to a buyer who will use it for producing biofuels, or who will make
breakfast cereal). Hence the land-owner will maximize total benefits minus total costs by
selling the grains to the buyer who will pay the highest price. The quote suggests that
producers of biofuels will pay the highest price for grains, and hence we’d expect that a landowner applying the benefit-cost principle would want to sell to biofuel producers. For the
same reason, where the land-owner faces an initial choice about what type of grain to plant,
total benefits minus total costs are likely to be maximised by choosing grains that can be used
for biofuel production. (This assumes that the total cost of producing different types of grains
is similar.) Therefore we can interpret the quote from the article to be saying: Land-owners
or farmers who increase the quantity supplied of grain by bringing new areas of land into
cultivation are likely to plant grains that can be used for biofuel production, and to sell their
grain to biofuel producers rather than to buyers who would use it for other purposes. These
decisions are consistent with application of the benefit-cost principle; as the total benefits
from selling grains for biofuel production are higher than for any other purpose, and total
costs of selling to alternative suppliers are similar.
Economist work-out 2.3
Read the attached article ‘Destitution not dearth’, The Economist, August 20, 2005.
The article describes why there is a famine in Niger at the time the article was written.
1. Why is it suggested that the prices of millet and sorghum has increased in Niger?
2. Why is it suggested that the price of livestock has decreased? ; ii) Use a standard
demand/supply model to represent this effect; iii) How would you represent the decrease in
the price of livestock in a demand/supply model that incorporates the idea that ‘…a
pastoralist’s supply curve might actually bend back on itself…’?
3. How does this article illustrate the argument of the Nobel Economist, Armartya Sen, that
‘…some of the worst famines have taken place without any significant fall in the supply of
food’.
This article (‘Destitution not dearth, The Economist, August 20 2005) is reproduced with
kind permission of The Economist for use only for teaching purposes (www.economist.com).
Destitution not dearth
Niger's harvest last year was not so terrible. Why is the country now so hungry?
"MUCH about poverty is obvious enough," wrote Amartya Sen, one of the world's bestknown and most respected economists, in his 1982 classic, "Poverty and Famines". "One
does not need elaborate criteria, cunning measurement, or probing analysis to recognise raw
poverty and to understand its antecedents." But the thesis Mr Sen propounded in that book
was not obvious at all: some of the worst famines, he argued, have taken place without any
significant fall in the supply of food.
One of the examples Mr Sen chose to illustrate his thesis was a famine that gathered force
from 1968 to 1973 in the Sahel region of Africa. The Sahel, from the Arabic word for
"shore", typically refers to a group of six countries on the western fringes of the Sahara,
where the desert sands lap up against the vegetation of Africa's semi-arid zones. The
countries worst affected by this disaster 30 years ago were Mauritania, Mali, Upper Volta
(now called Burkina Faso)--and Niger.
Niger is once again in the grip of a food crisis, if not a full-blown famine. The distress sales
of livestock, the heavy migration and the deprivation the country suffered in the early 1970s
have all revisited it again this year. How well does Mr Sen's thesis explain the country's latest
encounter with mass hunger?
Much about Niger's current crisis appears obvious enough: the rains last year ended early; the
locusts were rampant. Who can be surprised that the country is short of food? But Niger's
harvest last November was merely mediocre, not disastrous. Although the rains ended early,
the country's cereal production was only about 11% below its five-year average, according to
the UN's Food and Agriculture Organisation (FAO). It was 22% greater than the harvest of
2000-01, a year that passed without alarm. The locusts did more damage to the region's
fodder than to its food, prompting pastoralists and their herds to begin an early migration to
greener pastures in Niger's coastal neighbours.
Purchasing powerlessness
Niger's distress shows up most clearly in prices, not quantities. A pastoralist's terms of trade
depend on two prices in particular: the price of what he can sell (his livestock) and the price
of what he must buy (food). In Niger this year, the latter has soared; the former has
plummeted. According to one report, the price of millet and sorghum rose to 75-80% above
its average for the last five years. By June, the sale of one goat bought half as much millet as
it had six months earlier. It is precisely this kind of cruel twist in the terms of trade, Mr Sen
argued, that can bring a community to its knees. These unfortunates will suffer a lack of
power to purchase food, even if there is no lack of food to purchase. Why did prices move
against Niger's pastoralists so far and so fast?
The spike in the food price may have reflected high foreign demand as much as low domestic
supply. Traditionally, during the lean months before their harvest, Niger's farmers import
cereals that are cheaper to grow in wetter, coastal neighbouring countries than in their own
country. But according to CILSS, an intergovernmental body responsible for the region's
food security, significant amounts of grain have this year been flowing in the opposite
direction. Ghana, Benin, Cote d'Ivoire and Nigeria have all been buying up grain in the
region.
This is partly because these countries' own harvests were disappointing. But in Nigeria's case,
the FAO thinks that government policies were also to blame. Nigeria has imposed controls on
imports of rice and wheat products; it has also taken steps to protect and promote its millers
and poultry farmers. Both of these policies have raised demand in the country for millet and
sorghum, which provide alternative sources of flour as well as chicken-feed. As a result,
Nigerian cereals that might have found their way to Niger are instead being consumed at
home. Nigeria has twice Niger's income per head and more than ten times its population. Its
powerful market pull may have helped to undermine the purchasing power of Niger's
pastoralists. "In the fight for market command over food," Mr Sen noted in his book, "one
group can suffer precisely from another group's prosperity, with the Devil taking the
hindmost."
Nigeria, with Burkina Faso and Mali, has also restricted grain exports to Niger this year,
violating its trade treaties with the country. Such restrictions have often played an ignoble,
supporting role in the history of famine. A ban on cereal exports between India's provinces,
for example, condemned Bengal to ruinously high prices in its great famine of 1943.
What of the other term in the terms of trade? Livestock prices have fallen in the past year,
partly because northern pastures were damaged and animals were emaciated as a result. But
the deterioration in the terms of trade can also generate its own momentum. Higher cereals
prices prompt herdsmen to sell more of their livestock. These distress sales drive the price of
animals down further, forcing pastoralists to sell still more of their herd. In his book, Mr Sen
raised the theoretical possibility that a pastoralist's supply curve might actually bend back on
itself: as the relative price of livestock falls, a hungry pastoralist might supply more animals
to the market, not fewer as elementary economic principles would imply.
If mass hunger were simply the result of there not being enough to eat, the remedy would be
obvious: more food. The emergency rations now being shipped, flown and trucked into the
Sahel are indeed necessary and urgent by the time hunger and destitution are acute and
widespread. But if mass hunger begins with a collapse in purchasing power, rather than a
shortage of food, it does not take an airlift to prevent it. What is needed is a way to restore
lost purchasing power by, for example, offering employment, at a suitable wage, on public
works. The market respects demand, not need. But give the needy enough pull in the market,
and the market will do most of the rest.
"Destitution not dearth; Economics focus." The Economist [US] 20 Aug. 2005.
Economist work-out 2.3
Solutions
1.Why is it suggested that the prices of millet and sorghum has increased in Niger?
The explanation for the increase in prices of millet and sorghum appears to be a decrease in
supply of these foodstocks in Niger. The source of the decrease in supply is a smaller flow of
imports from neighbouring countries, rather than a decrease in supply from within Niger.
The causes of the decreased supply of imports from Niger’s neighbours are reduced harvests
in these countries, but also in the case of Nigeria, government polices that have increased the
price of rice and wheat, and thereby caused an increase in domestic demand for millet and
sorghum that has thereby restricted the quantity available for export to Niger.
2. i) Why is it suggested that the price of livestock has decreased? ; ii) Use a standard
demand/supply model to represent this effect; iii) How would you represent the decrease in
the price of livestock in a demand/supply model that incorporates the idea that ‘…a
pastoralist’s supply curve might actually bend back on itself…’?
i) It is suggested that there have been two causes for the decrease in the price of livestock –
first, that the quality of livestock decreased; and second, that a decrease in price caused
farmers to increase the quantity supplied (due to a minimum threshold amount of income
being required for food to survive), causing a further decrease in price.
ii)/iii)
P S P*1 Effect of quality
P*2 D1 D2 Q P S P*1 D1 P*2 D2 Q 3. How does this article illustrate the argument of the Nobel Economist, Armartya Sen, that
‘…some of the worst famines have taken place without any significant fall in the supply of
food’.
The famine in Niger illustrates Sen’s point in two main ways. First, the underlying causes of
the famine, higher prices for millet and sorghum, and lower prices for livestock, cannot be
attributed to a significant degree to a decline in production of millet and sorghum in Niger (or
even in the region more generally). Second, to deal with the famine it is not necessary to
increase the amount of food in the region. What is instead necessary is to redistribute the
available food in the region towards Niger and away from countries such as Nigeria. This
seems to primarily require an increase in incomes of the Niger population (to allow them to
compete with higher income consumers in Nigeria for available food).
Economist Work-out 2.4
Read the attached article ‘The great Manhattan rip-off’, The Economist, June 7 2003. The
article describes rent control regulations in New York, and their consequences on outcomes
in the rental market and housing construction.
Some questions to try:
1. Use the demand/supply model to show the predicted effect on price and quantity traded
that would occur once a maximum rental price is imposed that is below the equilibrium price
that would otherwise prevail in New York.
2. What might be longer-run consequences of the rent ceiling? How could you represent
these effects in the demand/supply model?
3. The article suggests that the ‘…city’s poorer folk…receive little or nothing’ by way of
benefit from the ceiling on rental prices. How could a policy that lowers the price of rental
housing disadvantage the low-income households? Can you suggest a better policy to
improve access to housing for low-income households?
This article (‘The great Manhattan rip-off’, The Economist, June 7 2003) is reproduced with
kind permission of The Economist for use only for teaching purposes (www.economist.com).
The great Manhattan rip-off
IT WAS one of many price controls brought in during the grim, panicky period between the
attack on Pearl Harbour in 1941 and America's move to a full wartime economy in 1943. The
housing market was seen as another thing that needed to be rationed or, at least, regulated-alongside rubber, petrol, coffee and shoes. By 1947 all these controls were phased out, except
property-price regulations. Most cities have since scrapped these market distortions; the
capital of capitalism has not.
Only one-third of New York City's 2m rental apartments are free of some kind of price
restraint. A city board sets annual increases and administers an ever more complicated
system. In some buildings, people live in similar apartments but pay wildly different levels of
rent. In others, lone grandmothers sit in huge apartments, aware that moving would mean
paying more for a smaller place elsewhere.
The oldest controls cover pre-1947 buildings (including any number of lovely houses on the
city's most fashionable streets): these have average rents of $500 a month. A second tier,
covered by rent stabilisation, rent for $760. Unregulated apartments cost an average of $850,
but this number is deceptive, since it includes the worst buildings in the outer boroughs.
Technically, new construction is free from these constraints. In fact, a complex system of tax
inducements persuades most clever builders "voluntarily" to agree to rent-stabilisation
restraints. Not surprisingly under these conditions, building is anaemic; even with the largest
surge in construction since the 1960s, the number of building permits issued in the past year
will add less than 1% to New York's housing supply. Needless to say, in such a sclerotic
system, the poor suffer most.
On June 15th, 60 years after this "temporary" measure was introduced in New York City, rent
control once again comes up for renewal by the state government in Albany. It will almost
certainly pass. Back in 1997, the then free-market-friendly Republican state Senate and the
then free-market-friendly state governor, George Pataki, tried to get rid of rent restraints, but
ran into fierce resistance from the Democrat-controlled assembly. "What exactly is 'homeland
security' if your homes are not secure?" cried Sheldon Silver, the Assembly speaker, at a
recent rally.
A compromise "reform", won in 1997 against the odds, removed only 23,000 renters from a
pool of almost 1m. The wretched 23,000, cruelly deprived of price controls, qualified for this
punishment either by having income of more than $175,000 for two consecutive years and
living in apartments whose rent was above $2,000 a month, or by moving into empty
apartments costing more than $2,000 a month.
Buried in the 1997 agreement, however, was a detail that moved the next re-approval date to
a time when no elections were due. If any time was right for debating the issue on economic
rather than emotional grounds, it should be now.
In the intervening years, however, New York's politics have changed. A grinding recession
and the sharp drop on Wall Street seem to have blunted state politicians' enthusiasm for
market forces. The same governor and state Senate that fought for the cause in 1997 have lost
their nerve. At best, they will keep the reforms won six years ago. Truly opening up New
York's housing market is no longer on the table.
This is odd, because there is growing evidence that the transition from a strictly regulated to
an unregulated market is less painful than people like Mr Silver make out. The most striking
example has been in Cambridge, Massachusetts, where tight restrictions were lifted in 1994
after 23 years. A study by Henry Pollakowski, an economist at the MIT Centre for Real
Estate, shows no dire consequences. Instead there has been a huge surge in housing
investment, even allowing for the 1990s housing boom.
It is hard to find any economist who supports rent restraints. Price controls, even if
laboriously tweaked, inevitably produce inefficiencies, reduce supply and cause bad sideeffects. Black markets and bribery thrive. Building maintenance is often ignored. Landlords
and tenants find themselves in poisonous relationships, since they are linked by law rather
than by voluntarily renewable contracts. Unscrupulous property owners go to dangerous
lengths to evict tenants in order to get higher-paying replacements; as a result, tenantprotection laws have been enacted that make it almost impossible to evict even a scoundrel.
Meanwhile, a vast bureaucracy has grown up to administer the price controls, supported by
volunteers and litigators. The property owner who misses a filing deadline, or has his
paperwork mislaid, can be blocked from even permissible rent increases. Given all this, most
sane New Yorkers would rather eat their money than join the rentier class.
Oddly enough, for those landlords adept at navigating the system, returns are likely to be
unaffected by price caps, as long as properties were acquired after they had been imposed and
the potential for income is understood. Indeed, although the press depicts the fight over price
restraints as tenants versus landlords, it is more accurate to see it as tenants paying a belowmarket rent versus tenants who, in effect, pay the cost of this subsidy, says Peter Salins, the
provost of the State University of New York and co-author of a book on New York's housing
market ("Scarcity by Design", Harvard University Press, 1992).
Who, then, are the lucky tenants? According to another study by Mr Pollakowski, most
benefits go to tenants in lower and mid-Manhattan, where the residents are relatively wealthy.
The city's poorer folk, most of whom live in the outer boroughs, receive little or nothing.
Perhaps the strongest argument offered by supporters of rent control is that it promotes
stability; but, typically, long-term tenants in unregulated markets receive similar concessions,
since it is in a property-owner's interest to retain dependable renters in his buildings.
Mr Salins says the members of the state legislature are well aware of all the basic arguments
about the evil effects of price controls on the property market. They believe even more
strongly, however, that voters do not like getting socked with rent increases. For New York's
politicians, it is a time of small thoughts.
Economist Work-out 2.4
Solutions
1. Imposition of a maximum rental price that is below the equilibrium price will reduce the
price at which trade occurs, and hence reduce the quantity traded. The quantity traded is
reduced since, with a lower price, suppliers will reduce the quantity traded. This is shown in
Figure 1.
2. The answer to question 1 describes the ‘impact’ or ‘short-run’ consequences of imposition
of a maximum rental price. In the short-run, supply may be relatively inelastic with respect
to price (since it is difficult to change the stock of rental housing in a short period of time),
and hence the effect of the maximum rental price on the quantity of rental housing traded
may be relatively small. But in the longer run we would expect a larger effect on the quantity
of rental housing traded. Over time, existing owners of rental housing may sell some of their
stock of housing in response to the lower return to this type of investment due to the
maximum rental price. As well, as the article describes, there is likely to be little new
construction of rental housing. In the demand/supply this would be represented by a supply
curve that displays greater price elasticity in the long run than short run. Hence there will be
a larger decrease in quantity traded due to the maximum rental price in the long-run than
short-run. This is shown in Figure 2.
[The other long-run effect of maximum rental prices is that ‘black markets and bribery thrive’.
That the price is below the equilibrium price implies that there will be excess demand for
rental housing. This means that rental property owners must have some means for rationing
supply. One method is for rental property owners to ask for extra ‘side-payments’; another is
to lower the quality of rental housing by for example not doing maintenance – and lower
quality housing will reduce demand.]
3. Under the maximum rental price policy the quantity of rental housing traded is reduced,
and there is excess demand. Hence rental property owners must have a method for rationing
supply. Where this involves an extra payment then it will disadvantage low-income
households; alternatively, rental property owners may use household income as a method for
determining who should be rented housing. One suggestion for a better policy would be to
provide a voucher or income supplement for low-income households that can be spent on
housing. This would increase the affordability of housing for low-income households, but
would not create the disincentives for supply of rental housing created by the maximum
rental price.
Rent S
excess demand
P* Maximum rental price
D
Q*
Qmax. price Figure 1
Qty of rental housing
Sshort‐run Rent Slong‐run P* maximum rental price
D
LR
Qmax
SR
Qmax
Q*
Figure 2
Qty of rental housing
Economist Work-out 2.5
Read the attached article ‘On your bike’, The Economist, April 21 2007. The article
describes proposed regulation of pedicab markets in New York and London.
Some questions to try:
1. Use a demand/supply model to predict how limiting the number of pedicabs in New York
to 325 would affect the quantity of pedicab rides provided and the price of pedicab rides in
New York.
2. In New York the number of taxis allowed to operate is already limited, and the article
describes how taxi licenses (medallions) can cost US$400,000. Do you think the need to
obtain a license to operate a pedicab will make it more expensive in the future to operate a
pedicab?
3. Suppose New York City Council is trying to decide how to assign the initial 325 pedicab
licenses. Do you think it could sell the licenses? What method of sale might obtain the
greatest amount of revenue for the Council? Apart from the price it obtains for the licenses,
what other factors might the Council want to take into account?
4. Use a demand/supply model to show how introduction of licenses for pedicabs in New
York would affect the market for taxis in New York.
This article (‘On your bike’, The Economist, April 21 2007) is reproduced with kind
permission of The Economist for use only for teaching purposes (www.economist.com).
On your bike
A PEDICAB borrowed from a friend for a conference on pedestrianisation in 1990 got Steve
Meyer pedalling what is now a fast-moving business. Hoping to liven up the often-deserted
streets of downtown Denver, his hometown, he bought two of the bicycle taxis. But they did
not work very well, so he started building what has since become the industry standard, with
21 gears, hydraulic brakes and so on. His firm, Main Street Pedicabs, now caters to rising
demand both in America and abroad.
Alas, regulation in two of the biggest markets for pedicabs threatens to puncture Mr Meyer's
upbeat mood. Last month New York's city council voted to impose onerous rules on the
hitherto unregulated pedicab industry and to limit the number of pedicabs to 325. A protest
prompted Michael Bloomberg, New York's mayor, to veto the new rules, apparently out of
entrepreneurial fellow feeling for the pedicab drivers, but the city council is likely to override
his veto, perhaps as soon as next week.
Pedicabs first started operating in New York in the mid-1990s, but their numbers soared from
around 100 to over 500 after they featured in an episode of Donald Trump's business realitytelevision contest, "The Apprentice", in 2004. For the sort of fit youngster who wants a
flexible job--many drivers in New York are actors or students--it pays well: $300 on a good
day, though typically half that. The cost of entry is low, perhaps $4,500, compared with
$400,000 for a yellow-taxi medallion.
Pedicabs are under attack in London, too, where an estimated 400 operate. Transport for
London, a regulatory body, is reviving its controversial claim that pedicabs should be
regulated as "hackney carriages", like the city's black cabs. Chris Smallwood, chairman of the
London Pedicab Operators Association and boss of Bugbugs, a 60-strong pedicab firm, says
treating pedicabs like black cabs would impose unbearable costs on the industry. He has
helped to draft an amendment to a bill now before the House of Lords that would introduce
lighter pedicab regulations.
There is striking agreement between the pedicab trade groups in both London and New York
that some sort of regulation is needed, not least to deter rogue operators. But current
proposals seem to serve the interests of motor-taxi drivers, who want their rivals off the road.
The irritation is that pedicabs do not compete much with motor-taxis, say Messrs Meyer and
Smallwood. Pedicab journeys tend to be the short trips that drivers of gas-guzzling taxis hate
most. Pedicabs' main competition is walking, says Mr Meyer, who points out that if New
York's 12,000 yellow cabs were replaced with pedicabs, "there would be a lot less
congestion". Here's hoping that politicians on both sides of the Atlantic cast their votes for
pedal power.
Economist Work-out 2.5
Solutions
To answer questions about the effects of regulation of the number of pedicabs it’s useful to
think of there being two markets – the market for pedicabs and the market for pedicab rides.
In the market for pedicabs what is being traded is the ‘right’ to operate pedicabs in New York.
What is being traded in the market for pedicab rides is simply rides between locations in New
York using a pedicab.
a) Prior to the limit on the number of pedicabs being imposed the only cost of entry to the
pedicab market in New York was to own a Pedicab. Hence we can show the supply curve as
being equal to the cost of buying a pedicab, which is assumed to have been constant. The
effect of limiting the number of pedicabs in New York will then be to make the supply curve
for pedicabs vertical at that number. These supply curves are shown respectively as Sno quota
and Squota in the diagram below.
b) Limiting the number of pedicabs will limit the potential number of rides that can be
provided by pedicabs. This is likely to decrease supply of pedicab rides compared to where
there is no limit on the number of pedicabs. It would be possible to represent this decrease in
supply by a supply curve that becomes vertical at some number of rides that is the maximum
possible number of rides for the specified number of pedicabs. However it is probably more
reasonable to think of each pedicab having a supply curve that is positively related to price;
and hence when the number of pedicabs is reduced this shifts the market supply curve
leftwards due to the smaller number of suppliers. These supply curves are shown
respectively as Sno quota and Squota in the diagram
below.
P P
Squota Squota Sno quota
Sno quota
cost of buying 325 Q
Market for pedicabs Q
Market for pedicab rides
1. Using a demand/supply model that shows the effect of the limit on the number of pedicabs
on the market for pedicab rides, it would be predicted that the number of pedicab rides will
decrease, and the price for a pedicab ride will increase.
P Squota Sno quota P*quota P* D
Q*quota Q* Q 2. Using the demand/supply model above that shows the effect of the limit on the number of
pedicabs on the market for pedicabs, it would be predicted that the price of the right to
operate a pedicab will increase. Previously this price just reflected the cost of buying a
pedicab; any potential operator with a willingness to pay greater than the cost of a pedicab
would be expected to have entered the market. Whereas after the imposition of the limit on
the number of licenses the price will reflect both the cost of buying a pedicab, and rationing
of the right to operate pedicabs. With the limited number of licenses to operate pedicabs,
we’d expect potential operators with the highest willingness to pay to bid up the price of
licenses. More precisely, with 325 licenses, we’d expect the price to increase to be equal to
the willingness to pay of the potential operator with the 325th highest willingness to pay.
P Squota P*quota P* Sno quota D
Q*quota
Q* Q 325
3. Based on the argument made in question 2 the New York City Council could certainly sell
the licenses. For example, any potential operator would be willing to pay up to the difference
between their willingness to pay to operate a pedicab and the cost of buying a pedicab in
order to obtain a license. One method of sale would be to use an auction. For example, the
Council might sell the 325 licenses to the bidders making the 325 highest bids at a price equal
to the 325th highest bid. This auction gives potential operators an incentive to submit bids
equal to the willingness to pay for the right to operate a pedicab. Hence the Council would
make revenue equal to 325 times ( pquota - P*) (using notation from the diagram above). Apart
from price the Council would probably also want to make sure that each operator to whom it
provides a license is going to be able to supply a service that is of appropriate quality.
4. Reducing the availability of a substitute for taxis (that is, pedicab rides) will increase
demand for taxi rides. Hence the equilibrium price and quantity traded of taxi rides would be
expected to increase. This is shown in the diagram 4 below.
P ↑D due to less S availability of P2* P1* D1 Q1* Q2* D2 Q Economist Work-out 2.6
Read the attached sections from ‘Even in Texas’, The Economist, January 6 2007. The
article describes the effects of the introduction of subsidies for production of ethanol-based
fuel in the United States. [Some background: Corn is an input to production of ethanol. Corn
is also an input to production of livestock such as cattle. Ethanol-blend fuel is a substitute for
fuel that is derived entirely from oil. At present the United States government is providing
large subsidies for production of ethanol.]
Some questions to try:
1. Show the effect of the subsidy to ethanol on the price and quantity traded of ethanol. Show
how the incidence of the subsidy can depend on the elasticity of demand for ethanol.
2. Use the demand/supply model to predict the effect of the subsidy to ethanol production on
the equilibrium price of oil.
3. Use the demand/supply model to predict the effect of the subsidy on the equilibrium price
and quantity traded of livestock.
This article (‘Even in Texas’, The Economist, January 6 2007) is reproduced with kind
permission of The Economist for use only for teaching purposes (www.economist.com).
Even in Texas
IT'S best to hold your nose when visiting the Bar G Feedyard near Hereford (the "Beef
Capital of the World") in the Texas Panhandle. Some 125,000 cattle are here, black dots
huddled in pens as far as the eye can see. The manure--some 675m lb (300m kg) annually-piles up and gets carted away for fertiliser.
Soon there will be a new use for the cow dung. Ten miles away, Panda Ethanol, a Dallasbased company, is building one of America's largest ethanol plants, capable of producing
100m gallons (380m litres) a year. Manure from Bar G will be trucked down the road, at
Panda's expense. There, with the aid of sand and heat, the manure will be gasified. The
synthetic natural gas will then be burned, creating steam that will heat up corn--40m bushels
(1m tonnes) a year--and help turn it into ethanol. The plant is ringed by a double railway line
that will bring in Midwestern corn and take ethanol out.
With the ethanol craze in full swing in America, good times lie ahead for corn-belt towns.
Hereford is actually getting two ethanol plants: White Energy, a rival Dallas company, is
building its own 100m-gallon refinery just down the road. It will be powered by more
conventional natural gas (not manure) and will also be operational by the end of the year. In a
few years there should be at least half a dozen working ethanol plants in Texas, up from none
at the moment.
The construction boom is mirrored elsewhere. According to the Renewable Fuels
Association, America already has 110 ethanol refineries, with 73 more under construction.
Once they are finished, capacity should more than double, to 11.4 billion gallons a year.
Federal subsidies are encouraging the enthusiasm, despite worries that running cars on
ethanol blends has drawbacks. Critics note that it takes enormous amounts of energy to grow
and harvest corn, and that ethanol, though cleaner than petrol, gets fewer miles to the gallon.
And ethanol production is still a drop in an ocean. Americans guzzle almost 400m gallons of
petrol a day.
For American farmers, ethanol seems a boon so far, and Midwestern politicians have rushed
to embrace it. But some worry that demand for corn is driving up prices for livestock feed
(which is often corn-based). "Cattle, hog and chicken producers are taking it on the chin with
the increase in grain prices," says Johnny Trotter, president of Bar G. He is delighted,
however, that hauling away cow dung will no longer cost him more than $350,000 a year
once Panda's manure-fired plant is finished.
A partial solution is at hand, in the form of protein-rich distillers grain. This is a byproduct of
producing ethanol from corn, and cattle can eat it, though pigs and chickens can't. In theory
this means that operators such as Mr Trotter should not suffer too much of a price jolt from
the diversion of corn into ethanol. In practice, however, switching over will be a big
adjustment for cattle operations. So Mr Trotter, like many others, is looking forward to
technological breakthroughs that will lead to the production of cellulosic ethanol--which can
be made efficiently from switchgrass, rather than inefficiently from corn kernels.
Economist Work-out 2.6
Solutions
1. A subsidy to ethanol will increase the price for ethanol received by suppliers, decrease the
price for ethanol paid by consumers, and increase the quantity traded of ethanol. See diagram
1 below (In this diagram it’s assumed the subsidy is paid to consumers.)
P per unit subsidy S(PS) PS P* PC D(PC) Q* Qsubsidy D(PS) Q Where demand is relatively price-inelastic, consumers will receive a relatively larger share of
the benefit from the subsidy ( P*-Pc ) > ( Ps -P* ); whereas where demand is relatively priceelastic, producers will receive a relatively larger share of the benefit from the subsidy ( P*-Pc )
< ( Ps -P* ). These cases are illustrated in diagram 2 below (again for the assumption that the
subsidy is paid to buyers). Hence we can say in general that: the greater the own-price
elasticity of demand, the larger the share of the subsidy that is received by suppliers and the
smaller the share that is received by consumers.
P P
S(PS)
S(PS)
PS
PS P*
PC
P* PC D(PS) D(PC) Q* Qsubsidy Q
Q* Qsubsidy Q
2. A subsidy to ethanol will reduce the price of ethanol for buyers – such as fuel suppliers.
Hence the production cost of ethanol-blend fuel will decrease, so that supply will increase,
and there would be a decrease in the equilibrium price of ethanol-blend fuel. Ethanol-blend
fuel is a substitute for fuel derived entirely from oil, so a decrease in its price would be
expected to cause a decrease in demand for oil-only fuel. Hence we would expect a decrease
in demand for oil. The lower demand for oil will decrease the equilibrium price, and
equilibrium quantity traded. See diagram 3 below.
P P
S1
S S2
P*1 P*1
P*2
P2* D1
D2 D
Ethanol‐fuel
Q
3. A subsidy to ethanol will reduce the price of ethanol for buyers – such as fuel suppliers;
and hence will increase the quantity traded. A higher level of production of ethanol will
require a greater quantity of corn as an input, and hence demand for corn will increase. This
will raise the price of corn. Since corn is also an input to production of livestock, the higher
price of corn will increase production costs for livestock, and hence decrease supply. Thus
Q
the equilibrium price of livestock will increase, and equilibrium quantity traded will decrease.
This is illustrated in diagram 4 below. P P
S
S2 S1
P2* P*2
P*1 P*1
D2
D D1
Corn
Q
Livestock
Q
Economist work-out 2.7
Read the attached article ‘Unbottled Gini’ (The Economist, January 22 2011, page 58) and
‘The rise and rise of the cognitive elite’ (The Economist, January 22 2011, page 8). The
articles describe changes to the distribution of income in the United States.
1. Use the demand/supply model to show how changes in demand for low-skill workers due
to automation of blue-collar trades and globalisation can explain why wages of low skill
workers have declined in recent years.
2. Use the demand/supply model to explain why wages of high skill workers have increased
in recent years.
3. Apart from changes in the returns to high and low skills, do the articles suggest other
factors that have increased inequality in the distribution of income?
4. Why do the articles suggest that we should be concerned about increasing inequality?
This article (‘Unbottled Gini’, The Economist, January 22 2011, page 58) is reproduced with
kind permission of The Economist for use only for teaching purposes (www.economist.com).
Unbottled Gini
Inequality is rising. Does it matter--and if so why?
FOR the head of the IMF to quote Adam Smith may seem unremarkable. But here is
Dominique Strauss-Kahn citing the great man in November 2010: "The disposition to admire,
and almost to worship, the rich and the powerful and neglect persons of poor and mean
condition is the great and most universal cause of the corruption of our moral sentiments."
Mr Strauss-Kahn then bemoaned "a large and growing chasm between rich and poor-especially within countries". He argued that inequitable distribution of wealth could "wear
down the social fabric". He added: "More unequal countries have worse social indicators, a
poorer human-development record, and higher degrees of economic insecurity and anxiety."
That marks a huge shift. Just before the financial crisis America's Congress was gaily cutting
taxes for the highest earners, and Tony Blair, Britain's prime minister, said he did not care
how much soccer players earned so long as he could reduce child poverty. So why has fear of
inequality stormed back into fashion? Does it matter in some new way? Does it have
previously unknown effects?
The most obvious reason for the renewed attention is inequality's apparent increase. A
common yardstick is the Gini coefficient, which runs from 0 (everyone has the same income)
to 1 (one person has all the income). Most countries range between 0.25 and 0.6.
The Gini coefficient has gone up a lot in some rich countries since the 1980s. For American
households it climbed from 0.34 in the mid-1980s to 0.38 in the 2000s. In China it went up
even more, from under 0.3 to over 0.4. But this was not universal. For decades, Latin
America had the world's worst income inequality. But Brazil's Gini coefficient has fallen
more than five points since 2000, to 0.55. And as poor countries are on average growing
faster than rich ones, inequality in the world as a whole is falling.
Getting richer quicker
Greater inequality can happen either because the wealthier are getting wealthier, or the poor
are falling behind, or both. In America it has had more to do with the rich. The income of the
wealthiest 20% of Americans rose 14% during the 1970s, when the income of the poorest
fifth rose 9%. In the 1990s the income of the richest fifth rose 27% while that of the poorest
fifth went up only 10%. That is a widening income spread, but not a drastic one. Robert
Gordon, an economist at Northwestern University in Illinois, reckons that for the bottom 99%
of the population, inequality has not risen since 1993.
The problems at the bottom are reasonably well understood: technology enables the
automation of blue-collar trades; globalisation lets unskilled jobs move to poorer, cheaper
countries; shrinking trade-union membership erodes workers' bargaining power. But
inequality is rising more sharply at the top, among what George Bush junior called the "haves
and have-mores". Here the causes are more mysterious.
The economists Emmanuel Saez and Thomas Piketty studied the incomes of the top 0.1% of
earners in America, Britain and France in 1913-2008. America's super-rich, they found, were
earning about 8% of the country's total income at the end of the period--the same share as
during the Gilded Era of the 1920s and up from around 2% in the 1960s. A study by the
Economic Policy Institute, a think-tank in Washington, DC, looked at the ratio of the average
incomes of the rich and the "bottom" 90% of the population between 1980 and 2006. It found
that the top 1% earned ten times more than the rest at the start of the period and 20 times as
much at the end--ie, its "premium" doubled. But for the top 0.1% the gain rose from 20 times
the earnings of the lower 90% to almost 80-fold.
You can understand why people might regard this as unfair: the top 0.1% do not seem to be
working 80 times as hard as everyone else, nor are they contributing 80 times more to
welfare. But that is a matter of public opinion, and mostly of politics. The question of the
economic impact of extreme inequality is separate. Recent evidence suggests it may not be as
damaging as many imagine. Our special report after page 56 casts doubt on the widespread
view that inequality causes (or is associated with) a host of social problems. But recent
research does suggest two other reasons why the rise in inequality is a problem. One is that
rich economies seem to provide disproportionate and growing returns to the already wealthy.
The other is that inequality may literally be making people miserable by increasing stress and
the hormones it releases.
In a recent series of lectures at the London School of Economics, Adair Turner, the chairman
of Britain's Financial Services Authority, cited several factors that appear to be pushing up
the incomes of the rich. First, financial, legal and health services have increased their shares
of GDP in most rich economies--especially Anglo-Saxon ones--and these professions contain
some of the richest people in the country. Financial services' share of GDP in America
doubled to 8% between 1980 and 2000; over the same period their profits rose from about
10% to 35% of total corporate profits, before collapsing in 2007-09. Bankers are being paid
more, too. In America the compensation of workers in financial services was similar to
average compensation until 1980. Now it is twice that average. Rich bankers really are all
around you.
Turner turns the screw
Next, argues Lord Turner, as people get wealthier they tend to devote more discretionary
income to what are called "positional goods"--items such as limited-edition, celebrityendorsed sneakers whose main value lies in their desirability in the eyes of others. The
willingness of people to buy such stuff, combined with the vast new markets of millions of
emerging middle-class consumers in China, India and elsewhere, has boosted the stars'
brands beyond anything that was possible in the past. Bobby Jones, the best golfer of the
1920s, was an amateur. Tiger Woods earned $90m in 2009, before sex scandals wrecked his
image. Writing children's novels used to keep authors in chintz and twinsets. J.K. Rowling,
author of the Harry Potter books, is a billionaire.
Admittedly, truly global celebrities are few in number. But they have a penumbra of agents,
lawyers and image-makers. As Lionel Robbins, a British economist, once said, "a substantial
proportion of the high incomes of the rich are due to the existence of other rich people."
The growth of celebrity rents explains more than just why there may be more rich people
around. The point about positional goods--and of fashion and brands in general--is their
relative attractiveness. Owning the latest gadget or garment is particularly attractive when
others don't have it, rather as buildings are valuable because of their location: ie, how
desirable they seem to others. With such goods, a rising tide does not lift all boats. You yearn
to be not merely richer, but richer than your neighbours. So the more brands, fashion and
houses become important, the more relative income and inequality matter.
This would seem to qualify one of the commonest justifications for being relaxed about
inequality: that it is not a big concern if the rich are getting richer so long as the poor are
doing well too. That view was shared by Margaret Thatcher and Ronald Reagan and more
recently by Mr Blair and Ben Bernanke, the Fed chairman. But if positional goods are taking
a larger share of people's salaries, then relative income does matter and so do income
disparities between rich and poor. Positional goods do not affect material welfare, as do poor
schools or substandard housing. But they do affect people's quality of life and well-being.
That leads to a second reason for worrying about inequality: its physiological and physical
consequences.
In "The Spirit Level", a bestselling book of 2009, Richard Wilkinson and Kate Pickett argue
that inequality "gets under the skin" and makes everyone worse off, not just the poor. They
mean "gets under the skin" literally. The argument is that inequality causes chronic stress,
and makes people secrete too much of a hormone called cortisol. This normally has benign
metabolic and other functions. Produced in large quantities it can harm among other things
the brain and the immune system. So cortisol may be a direct link between inequality and bad
health.
Another is that inequality impairs the production of a second hormone, oxytocin. Sometimes
referred to as the "cuddle hormone", this is secreted in childbirth and during breastfeeding,
and seems to encourage pair-bonding and trust in others. The claim is that people living in
unequal societies secrete less oxytocin, hence they have lower levels of trust. These accounts
might be dubbed the medical, as opposed to material, explanations for inequality's bad
effects.
The hypothesis is plausible. Humans are social animals and have been refined by evolution to
be extremely sensitive to social interactions. Though intuitively attractive, the link is not yet
well established. Most studies of hormonal stress markers have focused on particular groups
subject to huge, chronic woes, such as carers of patients with Alzheimer's disease. Little
research so far has dealt with the general population. A recent review of the scientific
literature found little consistent evidence of a link between bio-markers of stress and social or
economic status.
Nor is it certain that income inequality is the right problem to focus on. What seems to affect
levels of stress hormones is not income, but competition for status, a broader, fuzzier notion.
Evolution has primed humans to seek high status. Losers in competitions for esteem may well
suffer. Societies with fierce status competition may well be unhealthier and more violent. But
it is the disparities of status, not of income, that matter.
Often the two go together: Nordic countries have low income inequality and not too much
status competition. But one can also imagine societies with narrow income disparities that are
riddled with status conflict. The old Soviet Union is a vivid example. The inverse is
conceivable too: countries with large income disparities but less status conflict, perhaps
because competition is smoothed by social mobility. Arguably America fitted that description
until recently. Overall though, it is true that in most places growing income disparities are a
reasonable proxy for growing status competition.
Economists have long argued that inequality is a much less important problem than poverty.
The recent research linking inequality to widespread social ills has not decisively overturned
that view: the evidence is still mixed, at best.
The claim that inequality now matters more because of brands and status competition may
turn out to be more robust. Such concerns could seem peripheral compared with global woes
such as poverty. But inequality is local. As Adam Smith also once wrote, "if he was to lose
his little finger tomorrow, he would not sleep tonight; but provided he never saw them, he
would snore with the most profound security over the ruin of a hundred million of his
brethren."
This article (‘The rise and rise of the cognitive elite’, The Economist, January 22 2011, page
8) is reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
The rise and rise of the cognitive elite
WHEN the financial crisis struck, says a prominent banker, the women he knows stopped
wearing jewellery. "It wasn't just that they were self-conscious about the ostentation. It was
because it didn't look good to them any more." He goes on: "There were blogs that had my
name, my family's names, my address. There were death threats. You'd think this could be
some pimply kid in a basement, but John Lennon met some pimply kid from a basement. And
the kid shot him."
The crash sparked a wave of public ire against financiers, and against rich people in general.
It also intensified the debate about inequality, which has risen sharply in nearly all rich
countries. In America, for example, in 1987 the top 1% of taxpayers received 12.3% of all
pre-tax income. Twenty years later their share, at 23.5%, was nearly twice as large. The
bottom half's share fell from 15.6% to 12.2% over the same period.
Jan Pen, a Dutch economist who died last year, came up with a striking way to picture
inequality. Imagine people's height being proportional to their income, so that someone with
an average income is of average height. Now imagine that the entire adult population of
America is walking past you in a single hour, in ascending order of income.
The first passers-by, the owners of loss-making businesses, are invisible: their heads are
below ground. Then come the jobless and the working poor, who are midgets. After half an
hour the strollers are still only waist-high, since America's median income is only half the
mean. It takes nearly 45 minutes before normal-sized people appear. But then, in the final
minutes, giants thunder by. With six minutes to go they are 12 feet tall. When the 400 highest
earners walk by, right at the end, each is more than two miles tall.
The most common measure of inequality is the Gini coefficient. A score of zero means
perfect equality: everyone earns the same. A score of one means that one person gets
everything. America's Gini coefficient has risen from 0.34 in the 1980s to 0.38 in the mid2000s. Germany's has risen from 0.26 to 0.3 and China's has jumped from 0.28 to 0.4 (see
chart 2, next page). In only one large country, Brazil, has the coefficient come down, from
0.59 to 0.55.
Surprisingly, over the same period global inequality has fallen, from 0.66 in the mid-1980s to
0.61 in the mid-2000s, according to Xavier Sala-i-Martin, an economist at Columbia
University. This is because poorer countries, such as China, have grown faster than richer
countries.
….
As technology advances, the rewards to cleverness increase. Computers have hugely
increased the availability of information, raising the demand for those sharp enough to make
sense of it. In 1991 the average wage for a male American worker with a bachelor's degree
was 2.5 times that of a high-school drop-out; now the ratio is 3. Cognitive skills are at a
premium, and they are unevenly distributed.
Parents who graduated from university are far more likely than non-graduates to raise
children who also earn degrees. This is true in all countries, but more so in America and
France than in Israel, Finland or South Korea, according to the OECD. Nature, nurture and
politics all play a part.
Children may inherit a genetic predisposition to be intelligent. Their raw mental talents may
then be nurtured better in some homes than others. Bookish parents read more to their
children, use a larger vocabulary when they talk to them and prod them to do their
homework. Educated parents typically earn more (see chart 3), so they can afford private
schools or houses near good public ones. In America, where residential segregation is
extreme, the best public schools are stuffed with college-bound strivers, whereas the worst
need metal detectors. School reform helps, but cannot level the playing field.
"Assortative mating" further entrenches inequality. Highly educated men are much more
likely to marry highly educated women than they were a generation ago. In 1970 only 9% of
those with bachelors' degrees in America were women, so the vast majority of men with such
degrees married women who lacked them. Now the numbers are roughly even (in fact women
are earning more degrees) and people tend to pair up with mates of a similar educational
background.
Women have made immense strides in the workplace, too. For example, in 1970, fewer than
5% of American lawyers were female. Now the figure is 34%, and nearly half of law students
are female. So highly educated, double-income power couples have become far more
common. The children of such couples have every advantage, but there are not many of them.
The lifetime fertility rate for American high-school dropouts is 2.4; for women with advanced
degrees, it is only 1.6. The opportunity costs of child-rearing are far higher for a woman who
earns $200,000 a year than for one who greets customers at Wal-Mart. And raising elite
children is expensive. A lawyer couple can easily afford to put one child through Yale, but
perhaps not four.
The cost of higher education has contributed to plummeting birth rates among pushy parents
in other rich countries, too. Greens may rejoice at anything that curbs population growth, but
the implications of these trends are troubling. Demography makes it harder for people who
start at the bottom of the ladder to climb up it. And that has political consequences.
Economist work-out 2.7
Solutions
1. Use the demand/supply model to show how changes in demand for low-skill workers due
to automation of blue-collar trades and globalisation can explain why wages of low skill
workers have declined in recent years.
Automation and globalisation have both caused a decrease in demand for low-skill workers.
Automation involves substituting capital equipment and machines for low-skill workers; and
globalisation involves increasing imports of goods that are produced using low-skill labour
(such as textiles, clothing and footwear, and motor vehicles). The decrease in demand for
low-skill labour will cause a decrease in wage rates of these workers.
wage LS w1
w2
LD1 LD2 Labour
2. Use the demand/supply model to explain why wages of high skill workers have increased
in recent years.
The article on ‘The rise and rise of the cognitive elite suggests that: ‘As technology advances,
the rewards to cleverness increase. Computers have hugely increased the availability of
information, raising the demand for those sharp enough to make sense of it. In 1991 the
average wage for a male American worker with a bachelor's degree was 2.5 times that of a
high-school drop-out; now the ratio is 3. Cognitive skills are at a premium, and they are
unevenly distributed.’
This suggests that there has been an increase in demand for high skill workers. An increase
in demand for high skill workers will cause an increase in wage rates of these workers.
wage LS w2
w1
LD2 LD1 Labour
3. Apart from changes in the returns to high and low skills, do the articles suggest other
factors that have increased inequality in the distribution of income?
The articles suggest a variety of other influences on the distribution of income. One is intergenerational influences: that children with well-off parents are likely to receive better
education and hence themselves earn high incomes. Another is greater differences in the
quality of schooling between regions - so that children from well-off families are now more
likely to benefit from high quality schooling and children from poorer families are
increasingly likely to experience poor quality schooling. A final example is what is known as
assortative mating – whereby males and females with similar jobs and incomes are more
likely to marry each other than to marry someone in a different type of job and income class.
This means that the distribution of income between households is made more unequal than
the individual-level distribution of income; and this is being made more so by increasing
female labour force participation.
4. Why do the articles suggest that we should be concerned about increasing inequality?
The main reason for concern about increasing inequality that is discussed is that may cause
adverse physical consequences – for example, that inequality (making unfavourable
comparisons with the well-being of others) is a source of stress via greater release of cortisol
that reduces well-being and potentially causes poor health. However, as the article notes, it
seems reasonable to think that it is status rather than income that is ultimately of concern to
humans – and it is possible to think of societies with low income inequality where stress
about status is greater than in high income inequality societies.
Economist Work-out 2.8
Read the attached article ‘Hedging against the horseman’, The Economist, December 11 2004,
page 66. The article describes ideas for how scope to trade in a new financial instrument
could improve well-being of the populations of poorer countries that are adversely affected
by weather conditions such as drought.
Some questions to try:
1. What problems does the article describe for the population of a country such as Ethiopia
that are caused by variable rainfall?
2. What are the proposals that are suggested in the article to alleviate these problems?
3. Can you think of these proposals as market-based solutions? What is the source of the
addition to social well-being that could come from implementation of the proposals? Why
might market-based solutions be better than simply providing aid when bad outcomes occur
in poor countries?
4. Can you think of other market-based solutions that might assist alleviating the problems
caused by variable rainfall?
This article (‘Hedging against the horseman’, The Economist, December 11 2004, page 66) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Hedging against the horseman
ASK an Ethiopian peasant what would most improve his life, and he is unlikely to mention
weather derivatives. Nonetheless, some brainy people at the World Food Programme (WFP),
the UN body charged with saving the starving, think they could save more people by using
arcane financial instruments.
A typical famine might unfold like this. First, the rains fail. Then the harvest fails. Then
people start to go hungry. After a while, the television cameras arrive. Western donors,
moved by pictures of swollen-bellied tots, reach into their pockets. Eventually, truckloads of
food aid arrive. But they arrive too late for many.
This is slightly over-simplified, but it illustrates a real problem. If help arrives before people
start starving, fewer will die. But it is only when people start to die that the money to save
them starts flowing in.
Some kind of catastrophe insurance ought to help. Commercial farmers already buy insurance
against bad weather. Peasants cannot afford to, but a body such as the WFP could do so on
their behalf.
This could work in one of two ways. The WFP could buy an insurance policy that paid out
when, say, the rainfall in Ethiopia was below a certain level. Or it could issue "catastrophe
bonds". In years of good or mediocre rainfall, the WFP would pay interest, out of its income
from donors, but when drought came, bondholders would lose their principal.
Should disaster strike, the WFP would have ready cash. The WFP thinks its ideas would be
cost-effective, though you might think investors would demand a stiff return for what looks
like a high risk of losing money. Big reinsurance firms in rich countries may be tempted
because they currently have very little exposure to the weather in the southern hemisphere,
and it is always wise to diversify one's portfolio. Richard Wilcox, the man at the WFP
assessing the scheme's feasibility, says he thinks it could be up and running by 2007.
Sceptics may grumble that the real cause of famine is bad government, not bad weather. This
is true, in the sense that well-governed countries cope much better with the effects of drought,
whereas ill-governed ones are more likely to collapse into civil war, which tends to spoil the
harvest. But bad government is hard to measure, and therefore hard to insure against.
Rainfall, by contrast, is easy to measure. It also varies enormously from year to year. In
Ethiopia, for example, where some 90% of people rely on rain-fed agriculture, household
incomes rise dramatically when the rain falls and fall dramatically when it does not.
In bad years, families sell their possessions to buy food. Worse, they sell their means of
production, such as tools and livestock, so even if the rains are better the next year, they may
not be able to take advantage of this. Even worse, they all tend to own the same types of
goods and they all try to sell them at the same time--ie, as soon as they can see that the rains
will fail--so they receive low prices for them.
All this makes it excruciatingly hard for Ethiopian peasants to break out of poverty. They
may accumulate a surplus in good years, but they tend to lose it all in bad ones. But
supposing they knew that food aid would arrive promptly when the rains fail? In that case,
the WFP argues, they might not rush to sell their ploughs, so they would be better able to take
advantage of good weather the next year. Famine insurance, in other words, could offer
more than a Band-Aid for the poorest.
Economist work-out 2.8
Solutions
1. The main problem caused by variable rainfall for the population of a country such as
Ethiopia is the effect on food supply. Variable rainfall causes fluctuations in availability of
food across years – of most concern are shortages of food and famine that occur in periods of
low rainfall. The article suggests that the variability in food supply cannot be completely
resolved by stock-piling of food in periods of high rainfall. It also suggests that the
variability of food output has a deleterious effect on overall output of food – for example,
farmers sell their equipment like ploughs or farm animals in periods of low rainfall and
famine to pay for food, but then this reduces the capacity to produce food in subsequent
periods when rainfall and potential food output are higher.
2. The proposals suggested in the article are:
(a) Purchase of ‘weather insurance’ where aid agencies would purchase an insurance contract
that would pay money for expenditure on food relief when rainfall in a country such as
Ethiopia was below some specified level; or
(b) Issue of ‘catastrophe bonds’ by aid agencies that would pay interest to those purchasing
the bonds in time periods when rainfall was above a specified level but where the principal
from the bonds would be used for expenditure on food relief when rainfall in a country such
as Ethiopia fell below that level.
3. Both proposals are market-based in the sense that both involve some type of market
transaction – purchase of an insurance contract by the aid agency from an insurer, or sale of
bonds by aid agencies to investors. To think about the improvement in social well-being
from these proposals consider the example of the weather insurance contract. The aid agency
derives benefit from being able to buy this insurance contract from the extra funds that are
then available to spend on food relief and the increase in well-being of populations in
countries such as Ethiopia that thereby results. The insurer will have an opportunity cost of
supplying funds for this type of insurance (equivalent to next best use of those funds for
another type of insurance). Provided that the benefit to the aid agency from having the
insurance is greater than the opportunity cost of supplying the insurance, then there will be
scope for mutually beneficial trade, and an increase in well-being of both the populations
represented by the aid agency and the insurer. The main problem – as the article suggests – is
that weather contracts may be seen by insurers as very risky, so that the opportunity cost of
supplying the insurance would exceed the value to the aid agency of the contract. But the
article also suggests that – as part of their portfolio of risks – having insurance contracts that
have payoffs linked to weather conditions in the southern hemisphere may be attractive to
insurers. The main benefit of the market-based solutions compared to current arrangements
for provision of aid appears to be the certainty that this would give to populations in countries
such as Ethiopia that they would receive financial support during periods of low rainfall.
This certainty about support should prevent the necessity of selling equipment and animals
during periods of low food production. However, as the article suggests, there is still the
problem – even with the market-based mechanisms for funding - of ensuring that aid funds
get to the parts of the population who need support rather than lining the pockets of corrupt
government members and officials.
4. There are probably a range of good ideas here, and I’d be interested to see any you think
of – you can email them to me at [email protected]. One possibility might be a HECS
type scheme. Aid agencies could commit to make loans to farmers during periods of low
rainfall and food production that would allow them to buy food without needing to sell
equipment and animals. Then the farmers could repay the loans during periods of higher
rainfall and food production, with the rate of repayment reflecting in some way the personal
circumstances (output) of each farmer. Another possibility might be to provide incentives
and training for farmers to adopt crops and farming practices that are most ‘resistant’ to
variable rainfall.
One idea proposed is at:
http://treasury.worldbank.org/bdm/pdf/Handouts_Finance/Financial_Solution_WeatherHedge
_Malawi.pdf
(Thanks to Kathryn St.John)
Economist work-out 2.9
Read the attached article ‘The price of entry’ (The Economist, June 26 2010, page 82). This
article describes a proposal by Gary Becker for the US to create a market for migration to the
United States, and some criticisms of this proposal.
Some questions
1. Suppose the government specifies the quantity of immigration it will allow in a year. (a)
What would you expect to happen in a system where there is a zero price for immigration and
the government assigns migration places randomly to those who apply? Who will receive the
benefits of (surplus from) immigration in this system?
(b) What would you expect to happen in a system where the government sells migration
places at a price that equalises the supply of migration places and the demand (by residents of
other countries) for those places? Who will receive the benefits of (surplus from)
immigration in this system?
2. Why might a system where the United States government sells migration places not
maximise total surplus from immigration to the United States?
This article (‘The price of entry’, The Economist, June 26 2010, page 82) is reproduced with
kind permission of The Economist for use only for teaching purposes (www.economist.com).
The price of entry
A new proposal from Gary Becker to make a market in immigration
NORTH AFRICANS risk their lives to try to cross the Mediterranean to southern Europe.
Mexicans pay "mules" to get them across the border with the United States. Afghans camp
outside Calais in filthy surroundings, waiting to cross into Britain. Everywhere, it seems,
there are people trying to get into another country. Even those who seek to move legally in
order to work face huge barriers to entry in certain countries. People on work visas account
for 70% of legal migrants to Germany, for instance, but only 5.6% of those entering America,
the original land of opportunity. Most of the rest get in because a member of their family is
already in the country. America's annual quota of visas for the highly skilled can run out in a
matter of weeks. More people want to move to rich countries than are able to.
In a lecture delivered on June 17th at the Institute of Economic Affairs, a think-tank in
London, Gary Becker proposed a "radical solution" to this messy problem. Fittingly for a
Nobel laureate who pioneered the application of economics to areas such as discrimination,
crime and the family, his answers involved market mechanisms. Mr Becker argued that
immigration was out of kilter because of the absence of a price that would match supply and
demand. Governments, he suggested, could use economic principles to allocate visas, either
by selling the right to migrate at a price that called forth a desired number of migrants, or by
auctioning immigrant visas.
As with any price, one for immigration would allocate the ability to migrate to those who
desired it most. Successful migrants, Mr Becker argued, would still be better off, even after
paying a hefty fee for the privilege. But the receiving country would benefit, too. Adjusting
the price from year to year would allow governments to retain control over how many
immigrants came while responding to changing labour-market conditions. And the revenue
raised might go some way to assuaging the concerns of those who oppose immigration,
especially now when clever thinking is needed about ways to improve public finances.
Charging $50,000 for the right to immigrate would net America $50 billion if it let in 1m
immigrants, roughly as many as it currently admits legally.
More importantly, the immigrants most tempted by such a fee-based system would be those
who would garner the biggest economic benefit from migrating, such as those whose wages
would increase by the largest amount. Mr Becker reckons that such people would have other
desirable qualities. They would be the kind of innovative, hard-working go-getters countries
want to attract, such as the engineers of Indian or Chinese extraction who received 14% of
the patents awarded in America between 2000 and 2004, even though these ethnic groups
make up less than 5% of the population. The young, he argues, would also be more interested
than the old, because they would have more years to recoup the costs of the visa. An
attractive idea, perhaps, in a rapidly ageing Europe.
What about people who are talented but unable to pay? Mr Becker proposes a system where
potential migrants could borrow from the government, under something like a student-loan
scheme. Or perhaps employers could lend foreign workers the visa money, which the worker
could pay back out of his wages over time. But if governments had to lend immigrants the
money, the idea would not do much at first to reduce budget deficits. And the idea of people
bonding themselves to a foreign employer in return for the costs of getting to their place of
work, and then repaying the debt through labour, has been tried before. In the 19th century it
was called indentured servitude. Among its legacies are the many Caribbean descendants of
Indians who migrated to work on plantations. Just as Mr Becker proposes that a worker
would be able to buy his loan off his present employer if he decided to change jobs, the bond
in the Caribbean could also be bought off.
Even if employers do not resort to the tactics used by Caribbean sugar-plantation owners,
Abhijit Banerjee of the Massachusetts Institute of Technology thinks the system would still
have problems. A firm importing a worker under such a scheme would presumably pay him a
lower wage than it would pay an equivalent local (otherwise why not just hire a native?). A
mutually beneficial contract could be entered into, since the worker would still make more
than at home. But having arrived the immigrant's best option would be to get fired (perhaps
by not working) and get a new job at the market wage. To prevent this, the employer would
need to threaten the worker with things like deportation. The very existence of such a threat
would allow the employer to reduce wages further.
Migrant migraine
Sendhil Mullainathan of Harvard University points out another problem with the idea. Prices
lead to allocative efficiency when the benefit of what is sold (in this case, a visa) accrues
entirely to the individual who buys it. But the entry of an immigrant has effects on the wider
society--what economists call "externalities". When the private and social benefits of a
person's presence in a new country differ, basing admission decisions on willingness to pay
may not be the best approach. America may want lots of scientists, for instance, but could
wind up instead with an excess of Indians near retirement age, tempted by the idea of using
their accumulated savings to buy free Medicare for the rest of their lives.
If the benefits of immigration depend more on people's characteristics than their willingness
to pay, the answer may already exist. Countries like Britain and Canada use a "points"
system, which aims to select migrants who have educational levels or specialised skills that
are deemed economically desirable. The politics of immigration in rich countries are too
poisonous for Mr Becker's radical rethink. But it is not clear one is even needed.
Economist work-out 2.9
Solutions
1. Suppose the government specifies the quantity of immigration it will allow in a year. (a)
What would you expect to happen in a system where there is a zero price for immigration and
the government assigns migration places randomly to those who apply? Who will receive the
benefits of (surplus from) immigration in this system?
With a zero price for immigration anyone who obtains a benefit of greater than zero from
migration to the United States would want to obtain a migration place. Hence it is likely there
will be excess demand for migration places to the United States. When the government
assigns available migration places randomly then each applicant will have a probability of
obtaining a place equal to (Available number of migration places)/(Number of people with
benefit from migration greater than zero) (equal to Qquota/ Q ). All of the surplus from
migration will go to those people who obtain migration places to the United States. The
expected value of the amount of surplus to immigrants can be measured as the probability of
obtaining a place divided by the total area (A+B).
$ Supply of migrant places
A B Qquota Demand for migrant places
Q
Number of migrants to US (b) What would you expect to happen in a system where the government sells migration
places at a price that equalises the supply of migration places and the demand (by residents of
other countries) for those places? Who will receive the benefits of (surplus from)
immigration in this system?
Where the government sells migration places to immigrants to the United States at a price
that equates quantity demanded and quantity supplied of places, the price will be P*. Places
are allocated to just those potential immigrants with a benefit from migration greater than or
equal to P*. In this system the surplus from migration is shared between migrants (area A)
and the US government (area B).
$ Supply A P* Demand B Qquota Number of migrants to US 2. Why might a system where the United States government sells migration places not
maximise total surplus from immigration to the United States?
The article suggests two main reasons why selling migration places may not maximise total
surplus associated with migration to the United States. First, the benefits to individuals from
migrating to the United States may not reflect the benefits to the United States. For example,
young educated immigrants may obtain a smaller private benefit from migration than older
immigrants who might benefit from US healthcare standards. This pattern of private benefit,
and a system where individuals pay for migration places, is likely to mean that there would
be more old immigrants compared to young highly educated immigrants. Yet if young
educated immigrants provide extra benefits to society in the United States (for example, from
positive spillover effects associated with having highly educated workers), it is possible that
the social benefit to the United States from young highly educated immigrants is greater than
for older immigrants. However this pattern of social benefit will not be reflected in the
proportion of each type of immigrant to the United States. Second, even in the absence of
positive external effects, where it is socially optimal for immigration to reflect private
benefits (because they are equal to social benefits), there may be a problem. Private benefits
from migration are likely to be associated with employment in the years after migration. But
these benefits may not be correlated with an individual’s capacity to pay for a migration place.
(For example, think of a new university graduate who has no savings, but has is likely to have
high earnings when employed in the United States.) Hence, outcomes in a market for
migration places may reflect capacity to pay for a place, rather than the long-term economic
benefits of migration for the United States.
Economist work-out 2.10
Read the attached article on ‘Half-cocked’ (The Economist, December 8 2007, p.68). The
article describes about the illegal market for handguns in two Chicago neighbourhoods.
1. In what ways can outcomes in the illegal market for handguns be regarded as inefficient?
2. What do you think the article means by a ‘thin’ market? How could a thin market be the
cause of inefficient market outcomes? How does the article describe the problems caused by
thin markets being overcome in legal markets?
3. The article seems to suggest that outcomes in the illegal cocaine market are efficient, or at
least closer to an efficient outcome than the illegal market for handguns. How does a
comparison between the illegal market for handguns and the illegal market for cocaine
demonstrate the authors’ argument that: ‘Markets can overcome thinness…they can also
overcome illegality. But they cannot overcome both”?
This article (‘Half-cocked’, The Economist, December 8 2007, page 68) is reproduced with
kind permission of The Economist for use only for teaching purposes (www.economist.com).
Half-cocked
As Americans digest the news of another gun atrocity, a mall shooting in Nebraska on
December 5th, they cannot be blamed for thinking that guns are in too ready supply. But an
article in the latest Economic Journal* suggests that the demand for illegal guns, at least, is
not met as easily as people might fear. Sudhir Venkatesh, now of Columbia University, has
talked to 132 gang-members, 77 prostitutes, 116 gun-owning youths, 23 gun-dealers and
numerous other denizens of Chicago's Grand Boulevard and Washington Park
neighbourhoods. He did not find many satisfied customers.
Chicago has unusually tough restrictions on legal handguns. Even so the black market is
surprisingly "thin", attracting relatively few buyers and sellers. The authors reckon that the
48,000 residents of the two neighbourhoods buy perhaps 1,400 guns a year, compared with at
least 200,000 cocaine purchases. Underground brokers sell guns for $150-350, a mark-up of
perhaps 200% over the legal price. They also demand a fee of $30-50 for orchestrating the
deal. Even then, 30-40% of the transactions fall through because the seller cannot secure a
gun, gets cold feet or cannot agree on a location for the deal.
Buyers also find it hard to verify the quality of the merchandise. They often know little about
the weapons they covet. "Tony", who owns a .38 calibre handgun, learnt how to use his
weapon by fiddling with it. He even put a stone in it. "Did it fire?" Mr Venkatesh asked. "I'm
not sure. I think it did," Tony said.
Fortunately for Tony and his peers, their rivals and the victims of crime cannot tell if their
guns work any better than they can. Often, showing the "bulge" is enough to gain the respect
of rival gangs. In robberies brandishing the weapon will usually do. Storekeepers do not wait
for proof that it works.
Markets can overcome thinness, the paper says; they can also overcome illegality. But they
cannot overcome both. A thin market must rely on advertising or a centralised exchange:
eBay, for example, has dedicated pages matching sellers of imitation pearl pins or Annette
Funicello bears to the few, scattered buyers that can be found. But such solutions are too
cumbersome and conspicuous for an underground market. The drugs market, by contrast,
slips through the law's fingers because of the natural density of drug transactions. Dealers can
always find customers on their doorstep, and buyers can reassure themselves about suppliers
through repeated custom. There are no fixed and formal institutions that the police could
easily throttle.
Indeed, the authors argue that the gun market may be threadbare partly because the drug
market is so plump. Gang-leaders are wary of gun-dealing because the extra police scrutiny
that guns attract would jeopardise their earnings from coke and dope. Even Chicago's gangleaders have to worry about the effect of crime on commerce.
* "Underground Gun Markets", by Philip Cook, Jens Ludwig, Sudhir Venkatesh and
Anthony Braga.
Economist work-out 2.10
Solutions
1. The market for illegal hand-guns can be regarded as ‘inefficient’ to the extent that the
quantity traded in the market is less than the quantity that would maximize private surplus to
the buyers and sellers of illegal guns. There are several pieces of evidence from the article to
suggest the quantity of illegal guns traded is less than ‘efficient’. First, the number of guns
traded is relatively low. Second, guns in the illegal market sell at a price that is significantly
higher than in the legal market. This suggests that the costs of trading in the illegal market
are very high, and hence, in the same way as if an indirect tax was imposed, the price of the
item being sold is increased and the quantity traded thereby reduced. Third, it is suggested
that there are deals where a buyer and a seller initially agree to trade, but then that trade does
not occur. (Of course, it could be argued that from society’s point of view, the efficient
quantity of guns traded in the illegal market is zero; and that this is why there are laws that
are supposed to prevent this trade. I think the article though in this case is using the term
efficiency to refer to the quantity of trade that would maximize private surplus to buyers and
sellers. Nevertheless, the issue that this may not really be what we have thought of as
efficient in our analysis of well-being in Intro Micro, is why I have placed apostrophe marks
around ‘efficiency’.)
2. (i) What is meant by a thin market? A ‘thin’ market is one where there are not a large
number of potential buyers and sellers for a product at any point in time.
(ii) How could a thin market be the cause of inefficient market outcomes? Trade can only
occur where buyers and sellers, who can gain by trading, are able to ‘meet’ each other. This
is generally more difficult in a thin market, as with few buyers and sellers, it will be more
difficult for them to become aware of each others’ existence. More formally, economists
sometimes describe buyers and sellers as incurring ‘search costs’ prior to trading. Search
costs represent the costs, for example for a buyer, of finding a seller with whom they want to
trade. In a legal market this might include costs such as visiting stores where the product the
buyer wants is being sold, or advertising to find a seller who is willing to sell to them. Search
costs are likely to be higher in thin markets because a buyer will have to make more effort to
find potential sellers. Hence in thin markets there is a greater chance that a buyer will decide
that the search costs outweigh the potential gains from trade, and not attempt to find a seller
with whom to trade. Therefore not all trades that would make buyers and sellers better off
will occur.
(iii) How are the problems caused by thin markets overcome in legal markets? In thin
markets the problems for buyers and sellers in finding each other can be alleviated by: (a)
Mechanisms that increase information for buyers and sellers about potential trading partners;
or (b) Introducing a centralized method for matching buyers to sellers. Businesses such as
eBay can be thought of as increasing information to buyers and sellers about each other. By
reducing search costs and by significantly enlarging the geographic areas across which buyers
and sellers can trade, eBay makes it more likely that buyers and sellers who can gain by
trading will be able to identify each other. Similarly, requiring trade in a market to occur
through some centralized process in which all buyers and sellers must participate, rather than
buyers and sellers attempting to match in a decentralized manner, ensures that all potential
trades between buyers and sellers in a market are considered. Examples of markets where
centralized matching of buyers and sellers takes place are for clinical trainee positions in
hospitals, graduate positions in the Victorian public sector, and for two-way exchange of
kidney transplants.
3. Both the markets that the article describes - for handguns and cocaine – are illegal. The
difference between the markets however is that the market for handguns is thin, whereas the
market for cocaine is a ‘thick’ market with a much large number of potential buyers and
sellers wanting to trade at any time. (For example, a hand-gun buyer may only ever want to
buy one gun, compared to a cocaine buyer who may make weekly or more frequent
purchases.) Therefore, for potential buyers and sellers in the market for cocaine,
notwithstanding the illegality of trade, it is much easier to find potential trading partners.
Moreover, the greater number of buyers gives sellers an incentive to develop institutions,
such as ‘drug-selling corners’, that facilitate trade, even though that trade is illegal. Hence
the quantity of cocaine traded is likely to be much closer to the efficient quantity than in the
illegal market for handguns.