Economic Policy & Analysis

Week Five – Case Study:

Seven Important Ideas

I) Public Goods

Public goods are goods or resources which are unlimited and would be difficult to exclude anyone from using. Air is probably the best example to communicate the point. Air is virtually unlimited; it is something that I can use (via breathing) and it does not limit how much you can use; it would be very difficult to exclude you from using (except through death). That is the basic definition of public goods.

Some public goods are not as easy to identify, roads for example. In some cases roads have been turned into private goods (toll roads), but most roads are public goods. They fit the definition as is demonstrated. If I drive on the road I am not eliminating anyone else from driving on it. I do prefer if other people do not drive in the same space I am occupying, but there are alternatives to the space I am using (like the next lane over). Also, it would be difficult to exclude people from driving down 9^th st (or any street). If people needed to go to my house they must drive down 9^th St, just before turning into my driveway.

II) Externalities

Externalities are the effects of actions that are not seen from the perspective of the buyer or seller in some market. These effects may be positive or negative. A negative example is the exhaust fumes of my neighbor’s lawn mower blowing into my window on a warm spring day. Neither he nor the grass that he was mowing think about the pollution that was being created in an effort to cut the grass, but the externality was seen by me while the blue cloud rolled through my house while I was allowing “fresh air” into my living quarters. A positive externality would be the benefit I might receive while walking though the park for an evening stroll and hearing the music of a concert going on in the amphitheater across the soccer field.

One externality that is often overlooked is the sound pollution near airports. Although it is something not considered, trying to enjoy some lemonade on a hot summer day while talking with friends is hard to do with 80dB of jet-wash screaming overhead every 90sec.

III) Indirect Effects of Government Policy

Most policies are enacted to cause some event or reaction but they also have much broader effects than is anticipated. One example of an indirect effect is enacting a price cap on any good, gasoline for example. Now the government is looking out for its constituents and hears the angry cries when gas prices start to climb. One strategy that was used in the 1970’s was to limit the amount that could be charged for a gallon of gas. This seemed a great solution because then we would not have to continue to pay higher and higher prices for gasoline. It is just a constant (higher) price for fuel.

The indirect result was that with this steady price for gas, came a problem that some companies who were previously supplying fuel were not able to supply it for that price. That meant that there was a shortage of fuel because fuel producers who could not afford to supply, didn’t. This shortage was in part caused by the price cap, although it was not the intent.

IV) Supply & Demand

Supply and demand have an inverse relationship in terms of price and quantity. That is to say that as the price of goods (or service) increases the supply is expected to increase. The reasoning behind this is that with higher prices more people are able to produce the good and sell it for a profit. Inversely, as price decreases the demand increases. This is because more people are willing to purchase the good (or service) when the price is low.

This concept is demonstrated well in the previous example of gas prices and the government cap placed on them. When the price was limited to a point that would be lower than the natural market would place it, suppliers were forced to remove themselves from the market. That means that the supply would decrease. When there is a shortage of a product like gas, people who need it are willing to pay more for the good.

V) Market Risk

Risk is needed for markets to be successful and efficient. The ability of people and firms to develop new improved ways of carrying out their business is what creates competition and rewards those who put resources on the line to make the improvements. When we look at risk it is the investment of resources (money, time, land, etc.) to make improvements. These risks may or may not pay off. That is the risk; you may lose all the resources invested because someone else made better improvements or has a better understanding of what the market wants. Free markets use risk (thus competition) to demand efficiency. If you as a supplier are not producing at your most profitable level a competitor may make some improvement that allows them to produce more at a lower cost. With the lower cost they would be able to steal some (if not all) of your customers. By forcing all competitors in the market to make improvements and become more efficient, consumers will also be getting more for less, thus freeing up money to enrich themselves with more (or other) products.

VI) Government's Responsibility in Market Protection

The government has the responsibility to ensure the welfare of its citizens as a whole. The government will not (or should not) step in when individuals or firms take on risk and fail. But when a market is at risk the effects can destroy entire nations (think Great Depression, partially caused by the stock market crash of 1929). When the failure is on this level the government will do what it takes to ensure as soft a landing as possible.

Risk is a huge factor in markets that keeps them efficient. But what happens when this risk that is taken on by a market is so high that not just firm failure happens but entire markets collapse? Although risk is encouraged to increase efficiency sometimes it kills markets, when too much risk is accepted. The government will inflate the value of money or place temporary limits on different goods. It may also give subsidies to encourage producers or consumers to behave in a way that it believes will most benefit the market.

VII) Impacts of Incentives

Incentives are a way in which to manipulate individuals, firms and markets to behave in desirable ways. Incentives can be any creative use of resources to encourage a desired behavior. One common incentive is for firms to make some of an employee’s compensation dependant on the profit level of the company. This incentive makes the individual as well as the owner of the company focus his attention and work on making the company to be successful.

McKenzie and Lee (2006). Microeconomics for MBA's: the economic way of thinking for managers. New York: Cambridge University Press.

Economic Policy & Analysis

Week Four – Case Study:

Food Cost Crisis

1. When the relative price of food to other goods and services increases, how do consumers respond?

As the price of commodity foods rise other related foods also rise. This causes food prices to rise in general. When the cost of food rises more quickly than the cost of other common goods, people and markets must adjust. One of the immediate adjustments made is that people purchase food with lower quality or just lower quantity (Ki-Moon). Consumers will most likely opt to reduce quality first because the marginal cost of purchasing the added unit of quality is not worth the benefit (McKenzie & Lee, 319). However, in some cases the consumer is already purchasing the lowest level of quality so must, by lack of other options, reduce the quantity (Ki-Moon). To further demonstrate this point Ki-Moon states:

When people are that poor, and inflation erodes their meager earnings, they generally do one of two things: They buy less food, or they buy cheaper, less nutritious food. The U.N. World Food Program is seeing families that previously could afford a diverse, nutritious diet dropping to one staple and cutting their meals from three to two or one a day.

Consumers will also look to find substitutes. When the food they normally purchase has an increased cost, they may look to find a close substitute that can take its place at a lower cost (McKenzie & Lee, 277).

We must ask why the price has increased disproportionately. One interesting point that should be considered is that since the last major food cost increase, 1974, “global food prices tumbled dramatically; from 1974 to the early 2000s, real food prices, on average, fell 75 percent” (Garber). This is not a cause of the recent increase but only a notable point of reference. Ki-Moon and Garber all point to three major contributors; higher oil prices, ethanol production and increased demand from overseas. Higher oil prices increase the cost of shipping crops, food and fertilizers; Ethanol production competes with food and reduces the supply; higher demand by emerging countries, namely China and India. One additional factor as noted by Ki-Moon, is the weather related crop problems of recent years, destroying crops and reducing the supply.

2. What role does increasing wealth in developing nations play in increasing the demand for such commodities as corn?

The complexity of the economics of demand on this food issue run from ethanol production to cattle feed to cars. As countries such as China and India gain more wealth, the demand for raw commodities, such as corn, increase locally. The demand for more high quality foods like beef, pork and chicken increase (Garber). Chicken and beef demand increases cause the supplies needed to raise them to also increase. In this case beef, pork and chicken all need corn and grain to be produced at a high quality. They will also demand more food in general. As more food is demanded the cost is pushed higher. Middle class consumers who are now demanding more food do not necessarily use it efficiently. For example in the U.S. we waste large amounts of food because it is considered a luxury to do so. This has likely been caused by the very low priced food supply we have been enjoying for many years (Garber).

Now the complexity is increased when we look at the developing nations now having more money to spend on luxury items like automobiles (Forney). With an increased demand for automobiles, the demand for fuel to operate them also increases. This added demand for fuel (along with many other reasons) has increased the cost of oil. Now the cost for oil is high enough that people are looking for substitutes (McKenzie & Lee, 277). What is the most popular substitute? Ethanol, made from corn, soybeans etc. Now the food and fuel are in competition, and people are willing to pay more for fuel than food.

3. What short-term effects and long-term effects can we anticipate in agriculture?

Some of the short term effects that we will see are already apparent; high priced commodities (Ki-Moon), increased profits for farmers (Washington Post), government price restrictions (Kingsbury) and a need for additional charitable contributions (Ki-Moon, Washington Post). Government price restrictions are probably the most harmful to the efficiency of the economic market (McKenzie & Lee, 64) because, unless there are additional government subsidies, there will be fewer suppliers willing to produce food at the lower price and will further reduce the supply. The charitable contributions may also pose a problem if the relative cost of food has increased. There may be people who were willing to give additional gifts to charity but must now redirect that money toward food.

Long term effects will be changed government policy (Washington Post), more farmers entering the food market, a drive to increase crop productivity in poor countries, develop programs to reduce the impact of natural disasters and improve market efficiencies (Ki-Moon). The last three suggestions will obviously increase the food supply and reduce prices. The more interesting effects are the drive for more farmers to start producing food crops. Because the price demanded now is higher the profit of farmers is up and therefore the marginal cost of producing another unit of that crop are lower. For this higher profit of each marginal unit produced, it is of higher benefit to produce more (McKenzie & Lee, 319-320). The effects of government policy change are sometimes counter intuitive. As mentioned above with price caps (implemented to reduce the cost on constituents) the cost will actually increase because the willing suppliers will be diminished. However, by subsidizing the appropriate crops (and their uses), it is possible to increase the supply of food stuffs and make the current suppliers more efficient in the US and around the world.

4. Is there an ethical dimension to the U.S. government subsidizing the use of corn for ethanol production? As Christians, what do we have to say about this program? Use Biblical references as well as economic theory to address the issues involved.

Again we are back to the question of substitutes. When looking only at the U.S., Where food is still relatively low priced, corn is valued less. However, fuel prices are very high. So the shortsighted government saw that it was in the best interests of our country trade some of the (low cost) corn for (high cost) fuel. Now the ethical question comes because at the cost of having reduced fuel cost hundreds of thousands of people in other countries (the closest being Mexico) not able to feed themselves. This means that you and I will save several cents each time we fill our tanks and other people (women, children and elderly people) eat only one meal each day in place of three (Ki-Moon).

What is the responsibility of us, as believers? Titus 3:1 tells us to be subject to our rulers and Romans 13:1 encourages us that God appointed the rulers. That is only one side though, the other side is our responsibility to feed the hungry. Jesus reminds us in Mathew 25:35 “For I was hungry, and you gave me something to eat.” This is an avenue for us to display our love for Christ.

Forney, Mathew (October 18, 2004). China's quest for oil. Time. Retrieved March 14, 2008 from: http://www.time.com/time/magazine/article/0,9171,501041025-725174,00.html.

Garber, Kent (2008). The Growing Food Cost Crisis: Sharp price hikes are hurting the poor and sparking violence. U.S. News & World Report. March 7, 2008.

Kingsbury, Kathleen (November 16, 2007). After the Oil Crisis, a Food Crisis? Time. Retrieved March 14, 2008 from: http://www.time.com/time/business/article/0,8599,1684910,00.html.

Ki-Moon, Ban (March 13, 2008). Food price crisis grows. The Hartford Courant. Retrieved March 14, 2008 from: http://www.courant.com/news/opinion/op_ed/hc-ki-moon0313.artmar13,0,5949087.story.

McKenzie and Lee (2006). Microeconomics for MBA's: the economic way of thinking for managers. New York: Cambridge University Press.

Washington Post (March 14, 2008). Food Crisis. Washington Post (online) Retrieved March 14,2008 from: http://www.washingtonpost.com/wp-dyn/content/article/2008/03/13/AR2008031303347.html.

Economic Policy & Analysis

Week Three – Case Study:

Mortgage Market Meltdown

1. Does the logic of group behavior give us any insight into how lenders and borrowers may have behaved in the run-up of real estate values in the U.S.? What role has the secondary market (where the initiators of mortgages quickly sell them to other investors rather than holding them for the long term) played in potentially fueling "irrational" increases in real estate values and inevitable "adjustments" downward?

Lenders and borrowers behavior can be explained to some extent by the rational behavior exhibited by large groups. Lenders were being very lenient in who they lent to (Sloan 2007). They all have standards but they became more relaxed so that they could benefit from the astronomically rising home prices. There were large numbers of mortgage companies who looked around at others in the mortgage community and saw that each one was willing to exploit the market and take higher risk (lower credit scores) but gain more business (more mortgages). Even though for the mortgage industry, it was in their common (long term) interest to have good mortgages, there was little accountability. McKenzie and Lee (2006) state: “a [firm] may reason that although he agrees with the...common interest, his contribution will have no detectable effect in achieving it.” In short, the bystander effect will allow each individual to participate in the profits to be gained, but not stand up for the long term success of the mortgage industry because his individual effort will not noticeably help. The firm may see how his efforts can help, but there is not enough personal incentive to make it worth loosing the profits to be made in the short term.

Borrowers have a similar problem, using their home as an ATM (Coy 2008). It became the mindset of many home owners that the value of their home would always increase. So borrowing money against their homes was nearly free. Many people were caught in this trap and continued to borrow until recently when their homes started to decrease in value leaving them owing more on their homes than they are worth.

The secondary market has fueled the pricing inflation by creating a market for existing mortgages. If a mortgage turned out to be more risky than the originators had initially thought, there was a different market where they could sell them. Higher risk mortgages will have a lower value in the secondary market but there are firms willing to accept that risk in hopes of a higher payoff. Originators will lose less money by selling high risk mortgages to these entrepreneurs who are less risk averse than if the mortgage went into default. Effectively, the secondary markets reduce the risk for mortgage originators and creates money making opportunities for the third tier businesses.

2. Does government action to "bail out" borrowers or lenders who have been hurt by the adjustment in real estate and mortgage values have economic consequences for the future? Discuss the possible effects on incentives and prices when government offers implicit guarantees regarding private contracts.

Realistically, the question should be, what are the future consequences of the government bailout for lenders. Slone (2007) states that:

It's the "too big to fail" syndrome. In a world in which big players make incredibly large and complex deals with one another-that's what derivatives are-regulators don't dare let a big or important institution fail for fear that the collapse of one would lead to "cascading failures," and other institutions wouldn't be able to collect what the collapsed institution owed them.

To summarize, if nothing is done then the national (if not world) financial system may collapse without the bailout. Realistically, it is in essence removing the accountability of firms to be efficient in their business. It allows them to take more and more risk at the expense of the taxpayers and small businesses.

The incentive is for lenders to take more risk at the possibility of making more money. This added incentive increases the perceived benefit and allows more cost to be overcome in the cost-benefit analysis. This incentive is effectively the removal of risk for both lenders and borrowers.

Other policy actions that the government engages in (including one this week of increasing the lending caps of government/private entities) may be helpful to overcome short term problems of borrowers. There are always costs associated with bail-outs. For borrowers the policy changes may stabilize the market quicker, but it will artificially increase the demand for housing and allow prices to be artificially high. The best scenario would be to hold the market prices steady until they return to the long term trend line (Coy 2008).

3. What are the advantages and risks of large firms such as "Fannie Mae" and "Freddie Mac" (you may have to look these up to fully understand what they do) having a large role in the mortgage market? Does having lots of government involvement in the rules and regulations of mortgage lending have beneficial or harmful effects?

These types of companies, from what I understand, act as a middleman for lenders and Wall Street, they are part of the secondary markets (Freddy Mac). They provide a distinct advantage of improving liquidity of the mortgage market. They increase the supply of cash that can be lent to borrowers. Buy increasing supply of cash, they lower the cost of borrowing (McKenzie & Lee, p60). This enables more people to afford the cost of purchasing (or renting) a home.

One risk that is coming to the forefront of every market analyst is that the secondary market is now weakening because of poor understanding of actual risk of the securities that were purchased in the secondary market by Wall Street. The secondary markets are not performing well and that has in turn, made borrowing more costly. This additional cost reduces demand (McKenzie & Lee, p55) and drops the market price of housing. This is precisely what we are seeing today.

Government involvement helps reduce the effects of the large markets being inefficient and destroying all other markets. The government's responsibility is to “protect the financial system” (Sloan 2007). That does not mean that it should step into markets to protect individuals or firms. The competitive market deals with individuals and firms ruthlessly when mistakes are made, that is what makes them efficient. But when large markets (real estate for example) are failing because of lack of controls, the government has a responsibility to it's taxpayers and citizens to stabilize with as little negative impact as possible.

Coy, Peter (2008). Housing Meltdown: Why home prices could drop 25% more on average before the market finally hits bottom. Business Week. January 31, 2008. cover story.

Freddy Mac. Corporate Profile: Our role in the secondary market. Retrieved March 7, 2008 from: http://www.freddiemac.com/corporate/company_profile/our_role_secmkt/index.html

McKenzie and Lee (2006). Microeconomics for MBA's: the economic way of thinking for managers. New York: Cambridge University Press.

Sloan, Allan (2007). The Escape of the Enablers. Fortune 156, (5).

Economic Policy & Analysis

Week Two – Case Study:

CEO of an HMO

1) A proposal to put a cap on physician compensation. Some members of Congress feel that health care expenses are rising because doctors are overpaid. They propose to limit physician salaries at HMO’s and hospitals receiving Medicare and Medicaid insurance payments to a national standard for each specialty.

Although some people feel doctors are overpaid, what is the reality? Pay is set by the market. Specialized doctors are paid more on average because there are fewer people who are knowledgeable in these specific areas. General practice doctors get a lower wage in comparison because they have more competition. The market for doctors (and the services they provide) is, in general, near the competitive market equilibrium point (McKenzie & Lee, p66). Doctors do get paid more than other professions, but they also have different requirements; more school, higher tuition, higher insurance costs, higher risk/stress activities, etc.

By putting a ceiling on physician compensation will result in a shortage of doctors willing to perform their services (McKenzie & Lee, p64). The market for the services provided to Medicare and Medicaid insured patients, will become backlogged. There will be many more patients needing service than doctors willing to provide the service. Limiting their pay will also decrease the earnings potential for people who are considering a career as a doctor. The costs associated with becoming a physician will shift the supply of new doctors to a lower level and may increase the shortage of doctors throughout the industry. This shortage will, in the long term, increase the compensation of all remaining doctors whether they are supporting the Medicare, Medicaid or private insured patients. This increase in wage will increase the cost of health care expenses; opposite of the desired effect.

We must ask what is the true reason for the increasing health care costs. According to Weelan, the reasons include: “Nobody shops for value..., Medical innovations are usually more expensive, not less...,We don't pay for what we consume..., the Uninsured... and Malpractice...”. These arguments agree with most of the literature that I ran across and not one of the top reasons mentioned in my research indicated the overpayment of doctors as a contributor to rising health care costs.

2) A proposal to subsidize the training of nurse practitioners and physician assistants to increase the supply of these para-professionals. This program would also mandate that hospitals and HMO’s utilize more of these staff to perform routine procedures not requiring an MD, such as physicals, treatments of common, non-life-threatening ailments, etc.

By subsidizing the training of nurses and physicians assistants, we would effectively reduce the cost or barriers to the training. This would allow the cost benefit analysis for those evaluating their future careers, to be weighted more toward the benefit side for more people. Because the benefits of the education would outweigh the cost, the supply would increase. Further mandating what jobs were accomplished by the new additional supply of nurses, would free up some of the less value added tasks of doctors. The physicians would be able to give more of their time to the non-routine, critical tasks. This would effectively reduce the demand on the time of doctors and would reduce the cost of doctors performing their services.

We must also look at the cost of subsidizing the education of these “para-professionals”. At Oregon Health & Science University, the average tuition each year for the nursing program is $12,000. For a bachelors degree it will take 4 years to complete and upon completion students average $28,000 of debt (OHSU). When subsidizing we must also consider that some students who received subsidies will not finish their education. This reduces the benefit associated with subsidies. A comparison of cost and benefit should be weighed so that the system as a whole can benefit (McKenzie & Lee, p105).

To fully understand the costs further study would be required of both the potential long term impact of subsidies and how long the subsidies should remain active. It is possible that by reducing the cost of becoming a nurse we would also reduce the benefit of becoming a doctor and end up with a shortage of doctors. This plan does not make any suggestion of supplementing physicians education. However, it will give the same benefit by freeing up the time of the current doctors and in effect increasing the supply.

3) A proposal to give the poor a voucher grant each year sufficient to purchase basic health insurance for each member of their family. The voucher would amount to $200 per month per person in the low-income family which could only be redeemed for health insurance coverage. This voucher would only be available to those living below the official poverty line.

This health care voucher would cause the cost to some low income individuals to be zero. It would effectively increase the demand for health care. As demand increases, cost decrease when the market is competitive. Since the voucher will be used by each person to select an insurance provider, competition will be increased. With the voucher model the insurance companies will face a lower risk collecting money than from non-sponsored customers. Additionally one of the top reasons for increasing health care cost are the uninsured (Wheelan). By reducing the risk of uninsured people to the system overall costs will also be reduced.

What is the cost to the country and is the line drawn in the best place? What happens to those who are just over the poverty line? This will become a disincentive to those people who are earning near the poverty line. Consider a family earning $1000 over the official poverty line. For a four person family the vouchers may represent $9600 dollars of extra spendable income. Now because this family makes an extra $0.50 each hour worked (assuming 40hrs each week for one person) they will effectively loose $8600. So there is an incentive to work less or find a lower paying job (McKenzie & Lee, p109). There needs to be a mechanism to address this issue to prevent the cost from ballooning and to encourage people to continue to be as productive as possible.

The groups most benefiting from this voucher system will be the most poor Americans, while the middle earners take the biggest hit as demonstrated above. Middle and higher wage earners will benefit slightly because of the increased demand and resulting lower cost. This method may be used as long as it is accompanied by effective mechanisms to control disincentive and other abuse.

McKenzie and Lee (2006). Microeconomics for MBA's: the economic way of thinking for managers. New York: Cambridge University Press.

Wheelan, Ph.D. (2006). The Naked Economist. The Top 10 Reasons for Soaring Health-Care Costs. Retrieved March 1, 2008 form: http://www.nonprofithealthcare.org/documentView.asp?docID=340

Oregon Health & Sciences University (OHSU). OHSU School of Nursing, Retrieved March 1, 2008 from: http://www.ohsu.edu/ohsuedu/about/foundation/schools_nursing.cfm