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This week, I’ve written two articles about different types of tradeoffs that economists think about when they evaluate the likely effectiveness of proposed public policies. One type of tradeoff relates to the costs that consumers and businesses incur in exchange for the benefits policies will achieve, while a second type of tradeoff involves countervailing risks that sometimes increase as policies aim to reduce other risks.

An example of the first type of tradeoff, involving benefits and costs, comes from energy efficiency regulations for appliances. These regulations do produce some benefits involving reduced emissions, but entire classes of very important costs are routinely overlooked by regulatory agencies. When an agency doesn’t count what consumers give up in exchange for the good things policies produce, there is a greater chance people will be made worse off by a policy. That’s bad news.

Here is a relevant portion of an op-ed I wrote published in the Washington Times:

The Department of Energy sets energy conservation standards that limit the amount of electricity that can be used by home appliances like refrigerators and air conditioners. These sweeping regulations affect nearly every American consumer. The department claims its rules address an imminent problem — environmental degradation — and argues that its conservation rules produce two main benefits: First, more energy-efficient appliances use less energy, so we all release fewer emissions into the atmosphere. Second, by using less energy, consumers may save money over time on monthly utility bills.

Sounds like a win-win situation, right? Not so fast.

We haven’t considered the costs of these regulations. Consumers care about their utility bills and the environment, but they also care about how well a product works, its appearance, whether the product comes with or without a warranty, the purchase price, and countless other things. When product attributes change as a result of regulations, these are costs to consumers. But the costs are ignored by regulators at the Energy Department. Regulators do consider some costs, like how much more appliance makers will have to pay when they are forced to comply with new rules, but the costs to consumers — whom we should care most about — are systematically overlooked.

In a second article, published in US News and World Report, I show how tradeoffs can involve more than just benefits and costs (which are valued in monetary terms). Tradeoffs can also involve risks. An example of a risk tradeoff comes from proposed legislation in New Jersey that targets distracted driving. The bill would ban drivers from engaging in “any” activity unrelated to driving that might interfere with the safe operation of a vehicle in the state. Some have said the bill’s language is so expansive that drinking a cup of coffee while driving would be banned.

The distracted driving bill has the potential to create what economists call “risk tradeoffs,” which occur when the mitigation of one risk simultaneously increases the risk of another. This bill addresses an all-too-real danger, but any law that prevents people from drinking coffee behind the wheel is going to increase at least one other risk: the risk created by drowsy drivers on the roads.

With fewer people drinking coffee on the roads, that means more sleepy truck drivers hauling sixteen wheelers at 2am. Is that a risk worth bearing in exchange for fewer distracted drivers? That’s a difficult question that will involve careful analysis to answer.

Risk tradeoffs are actually pretty ubiquitous, and involve far more than just Jersey drivers.

One of the most common ways new policies create risk tradeoffs is through “substitution effects.” For example, when a pesticide is banned, farmers usually switch to a different pesticide instead. The new chemical may be safer than the banned one, but it could also be more dangerous. Sometimes risks are simply shifted from one group of people to another. A new pesticide might reduce the risk from eating residue left on fruit in the supermarket, but at the same time, it could create new risks for farmers who work among the sprayed fruit.

Considering these kinds of tradeoffs—benefit/cost and risk/risk—is what rational decision making is all about. Any good economists is trained to think about these things when evaluating proposed policies. If legislators and regulators are going to use the resources we entrust them with wisely, we should all demand they think like economists too.

The Wall Street Journal reports that despite historically low interest rates municipal governments and voters don’t have the appetite for new debt. Municipal bond issuances have dropped to 20-year lows (1.6 percent) as governments pass on infrastructure improvements. There are a few reasons for that: weak tax revenues, fewer federal dollars, and competing budgetary pressures. As the article notes,

“Many struggling legislatures and city halls are instead focusing on underfunded employee pensions and rising Medicaid costs. Some cash-strapped areas, such as Puerto Rico and the city of Chicago, face high annual debt payments.”

The pressures governments face due to rising employee benefits is likely to continue. The low interest rate environment has already had a negative effect on public pensions. In pursuit of higher yields, investors have taken on more investment risk leaving plans open to market volatility. At the same time investments in bonds have not yielded much. WSJ reporter Timothy Martin writes that public pension returns are, “expected to drop to the lowest levels ever recorded,” with a 20-year annualized return of 7.4 percent for 2016.

The end result of this slide is to put pressure on municipal and state budgets to make up the difference, sometimes with significant tradeoffs.

The key problem for pensions is “baked into the cake,” by use of improper discounting. Linking the present value of guaranteed liabilities to the expected return on risky investments produces a distortion in how benefits are measured and funded. Public sector pensions got away with it during the market boom years. But in this market and bond environment an arcane actuarial assumption over how to select discount rates shows its centrality to the fiscal stability of governments and the pension plans they provide.

The figure below is from my latest Forbes column and shows the percentage change in each state’s labor force from June 2007, just before the recession started, to June 2016. There is substantial variation across the 50 states.

state labor force percent chg

Click here to read the whole thing.

A new paper by Jeffrey Brinkman in the Journal of Urban Economics (working version here) analyzes two phenomena that are pervasive in urban economics—congestion costs and agglomeration economies. What’s interesting about this paper is that it formalizes the tradeoff that exists between the two. As stated in the abstract:

“Congestion costs in urban areas are significant and clearly represent a negative externality. Nonetheless, economists also recognize the production advantages of urban density in the form of positive agglomeration externalities.”

Agglomeration economies is a term used to describe the benefits that occur when firms and workers are in proximity to one another. This behavior results in firm clusters and cities. In regard to the existence of agglomeration economies, economist Ed Glaeser writes:

“The concentration of people and industries has long been seen by economists as evidence for the existence of agglomeration economies. After all, why would so many people suffer the inconvenience of crowding into the island of Manhattan if there weren’t also advantages from being close to so much economic activity?”

Since congestion is a result of the high population density that is also associated with agglomeration economies, there is tradeoff between the two. Decreasing congestion costs ultimately means spreading out people and firms so that both are more equally distributed across space. Using other modes of transportation such as buses, bikes and subways may alleviate some congestion without changing the location of firms, but the examples of London and New York City, which have robust public transportation systems and a large amount of congestion, show that such a strategy has its limits.

The typical congestion analysis correctly states that workers not only face a private cost from commuting into the city, but that they impose a cost on others in the form of more traffic that slows everyone down. Since they do not consider this cost when deciding whether or not to commute the result is too much traffic.

In economic jargon, the cost to society due to an additional commuter—the marginal social cost (MSC)—is greater than the private cost to the individual—the marginal private cost (MPC). The result is that too many people commute, traffic is too high and society experiences a deadweight loss (DWL). We can depict this analysis using the basic marginal benefit/cost framework.

congestion diagram 1

In this diagram the MSC is higher than the MPC line, and so the traffic that results from equating the driver’s marginal benefit (MB) to her MPC, CH, is too high. The result is the red deadweight loss triangle which reduces society’s welfare. The correct amount is C*, which is the amount that results when the MB intersects the MSC.

The economist’s solution to this problem is to levy a tax equal to the difference between the MSC and the MPC. This difference is sometimes referred to as the marginal damage cost (MDC) and it’s equal to the external cost imposed on society from an additional commuter. The tax aligns the MPC with the MSC and induces the correct amount of traffic, C*. London is one of the few cities that has a congestion charge intended to alleviate inner-city congestion.

But this analysis gets more complicated if an activity has external benefits along with external costs. In that case the diagram would look like this:

congestion diagram 2

Now there is a marginal social benefit associated with traffic—agglomeration economies—that causes the marginal benefit of traffic to diverge from the benefits to society. In this case the efficient amount of traffic is C**, which is where the MSC line intersects the MSB line. Imposing a congestion tax equal to the MDC still eliminates the red DWL, but it creates the smaller blue DWL since it reduces too much traffic. This occurs because the congestion tax does not take into account the positive effects of agglomeration economies.

One solution would be to impose a congestion tax equal to the MDC and then pay a subsidy equal to the distance between the MSB and the MB lines. This would align the private benefits and costs with the social benefits and costs and lead to C**. Alternatively, since in this example the cost gap is greater than the benefit gap, the government could levy a smaller tax. This is shown below.

congestion diagram 3

In this case the tax is decreased to the gap between the dotted red line and the MPC curve, and this tax leads to the correct amount of traffic since it raises the private cost just enough to get the traffic level down from CH to C**, which is the efficient amount (associated with the point where the MSB intersects the MSC).

If city officials ignore the positive effect of agglomeration economies on productivity when calculating their congestion taxes they may set the tax too high. Overall welfare may improve even if the tax is too high (it depends on the size of the DWL when no tax is implemented) but society will not be as well off as it would be if the positive agglomeration effects were taken into account. Alternatively, if the gap between the MSB and the MB is greater than the cost gap, any positive tax would reduce welfare since the correct policy would be a subsidy.

This paper reminds me that the world is complicated. While taxing activities that generate negative externalities and subsidizing activities that generate positive externalities is economically sound, calculating the appropriate tax or subsidy is often difficult in practice. And, as the preceding analysis demonstrated, sometimes both need to be calculated in order to implement the appropriate policy.

Recessions Don’t Have The Same Impact On Every City

July 19, 2016

Here is a link to my latest piece on Forbes.com New research shows that some local economies avoid slumps during national recessions and that an educated population and flexible housing supply can help. Recessions Don’t Have The Same Impact On Every City  

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Pokémon Go Represents the Best of Capitalism

July 14, 2016

An article uploaded to Vox.com by Timothy Lee earlier this week, “Pokémon Go is everything that is wrong with late capitalism,”has caused quite a stir, since it was fairly critical of the “Pokémon Go economy.” Given the popularity of the game though (and our concern that some players would be alarmed that their lighthearted entertainment was […]

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Does the New Markets Tax Credit Program work?

June 29, 2016

Location-based programs that provide tax credits to firms and investors that locate in particular areas are popular among politicians of both parties. Democrats tend to support them because they are meant to revitalize poorer or rural areas. In a recent speech about the economy, presumed Democratic nominee Hillary Clinton spoke favorably about two of them: the […]

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Washington’s Legitimacy Crisis Presents an Opportunity for the States

June 28, 2016

You’ve heard it before. Americans are deeply unhappy with Washington, DC. Sixty-five percent say the country is on the wrong track. Confidence in institutions is near all-time lows. Congress’s approval rating is terrible, and the two major presidential candidates are viewed more negatively than any other mainstream presidential candidates in recent memory. Only nineteen percent of the public trust the government to do the right […]

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Does Tax Increment Financing (TIF) generate economic development?

June 20, 2016

Tax increment financing, or TIF, is a method of financing economic development projects first used in California in 1952. Since then, 48 other states have enacted TIF legislation with Arizona being the lone holdout. It was originally conceived as a method for combating urban blight, but over time it has become the go-to tool for […]

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Washington DC is set to become the latest city to make it illegal for low-skill people to work

June 8, 2016

In the latest example of politics trumping economics, Washington DC’s city council voted to increase the city’s minimum wage to $15 per hour by 2020. The economic arguments against a minimum wage are well-known to most people so I won’t rehash them here, but if you want to read more about why the minimum wage […]

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