Category Archives: City Life

Why the lack of labor mobility in the U.S. is a problem and how we can fix it

Many researchers have found evidence that mobility in the U.S. is declining. More specifically, it doesn’t appear that people move from places with weaker economies to places with stronger economies as consistently as they did in the past. Two sets of figures from a paper by Peter Ganong and Daniel Shoag succinctly show this decline over time.

The first, shown below, has log income per capita by state on the x-axis for two different years, 1940 (left) and 1990 (right). On the vertical axis of each graph is the annual population growth rate by state for two periods, 1940 – 1960 (left) and 1990 – 2010 (right).

directed migration ganong, shoag

In the 1940 – 1960 period, the graph depicts a strong positive relationship: States with higher per capita incomes in 1940 experienced more population growth over the next 20 years than states with lower per capita incomes. This relationship disappears and actually reverses in the 1990 – 2010 period: States with higher per capita incomes actually grew slower on average. So in general people became less likely to move to states with higher incomes between the middle and end of the 20th century. Other researchers have also found that people are not moving to areas with better economies.

This had an effect on income convergence, as shown in the next set of figures. In the 1940 – 1960 period (left), states with higher per capita incomes experienced less income growth than states with lower per capita incomes, as shown by the negative relationship. This negative relationship existed in the 1990 – 2010 period as well, but it was much weaker.

income convergence ganong, shoag

We would expect income convergence when workers leave low income states for high income states, since that increases the labor supply in high-income states and pushes down wages. Meanwhile, the labor supply decreases in low-income states which increases wages. Overall, this leads to per capita incomes converging across states.

Why labor mobility matters

As law professor David Schleicher points out in a recent paper, the current lack of labor mobility can reduce the ability of the federal government to manage the U.S. economy. In the U.S. we have a common currency—every state uses the U.S. dollar. This means that if a state is hit by an economic shock, e.g. low energy prices harm Texas, Alaska and North Dakota but help other states, that state’s currency cannot adjust to cushion the blow.

For example, if the UK goes into a recession, the Bank of England can print more money so that the pound will depreciate relative to other currencies, making goods produced in the UK relatively cheap. This will decrease the UK’s imports and increase economic activity and exports, which will help it emerge from the recession. If the U.S. as a whole suffered a negative economic shock, a similar process would take place.

However, within a country this adjustment mechanism is unavailable: Texas can’t devalue its dollar relative to Ohio’s dollar. There is no within-country monetary policy that can help particular states or regions. Instead, the movement of capital and labor from weak areas to strong areas is the primary mechanism available for restoring full employment within the U.S. If capital and labor mobility are low it will take longer for the U.S. to recover from area-specific negative economic shocks.

State or area-specific economic shocks are more likely in large countries like the U.S. that have very diverse local economies. This makes labor and capital mobility more important in the U.S. than in smaller, less economically diverse countries such as Denmark or Switzerland, since those countries are less susceptible to area-specific economic shocks.

Why labor mobility is low

There is some consensus about policies that can increase labor mobility. Many people, including former President Barack Obama, my colleagues at the Mercatus Center and others, have pointed out that state occupational licensing makes it harder for workers in licensed professions to move across state borders. There is similar agreement that land-use regulations increase housing prices which makes it harder for people to move to areas with the strongest economies.

Reducing occupational licensing and land-use regulations would increase labor mobility, but actually doing these things is not easy. Occupational licensing and land-use regulations are controlled at the state and local level, so currently there is little that the federal government can do.

Moreover, as Mr. Schleicher points out in his paper, state and local governments created these regulations for a reason and it’s not clear that they have any incentive to change them. Like all politicians, state and local ones care about being re-elected and that means, at least to some extent, listening to their constituents. These residents usually value stability, so politicians who advocate too strongly for growth may find themselves out of office. Mr. Schleicher also notes that incumbent politicians often prefer a stable, immobile electorate because it means that the voters who elected them in the first place will be there next election cycle.

Occupational licensing and land-use regulations make it harder for people to enter thriving local economies, but other policies make it harder to leave areas with poor economies. Nearly 13% of Americans work for state and local governments and 92% of them have a defined-benefit pension plan. Defined-benefit plans have long vesting periods and benefits can be significantly smaller if employees split their career between multiple employers rather than remain at one employer. Thus over 10% of the workforce has a strong retirement-based incentive to stay where they are.

Eligibility standards for public benefits and their amounts also vary by state, and this discourages people who receive benefits such as Temporary Assistance for Needy Families (TANF) from moving to states that may have a stronger economy but less benefits. Even when eligibility standards and benefits are similar, the paperwork and time burden of enrolling in a new state can discourage mobility.

The federal government subsidizes home ownership as well, and homeownership is correlated with less labor mobility over time. Place-based subsidies to declining cities also artificially support areas that should have less people. As long as state and federal governments subsidize government services in cities like Atlantic City and Detroit people will be less inclined to leave them. People-based subsidies that incentivize people to move to thriving areas are an alternative that is likely better for the taxpayer, the recipient and the country in the long run.

How to increase labor mobility

Since state and local governments are unlikely to directly address the impediments to labor mobility that they have created, Mr. Schleicher argues for more federal involvement. Some of his suggestions don’t interfere with local control, such as a federal clearinghouse for coordinated occupational-licensing rules across states. This is not a bad idea but I am not sure how effective it would be.

Other suggestions are more intrusive and range from complete federal preemption of state and local rules to federal grants that encourage more housing construction or suspension of the mortgage-interest deduction in places that restrict housing construction.

Local control is important due to the presence of local knowledge and the beneficial effects that arise from interjurisdictional competition, so I don’t support complete federal preemption of local rules. Economist William Fischel also thinks the mortgage interest deduction is largely responsible for excessive local land-use regulation, so eliminating it altogether or suspending it in places that don’t allow enough new housing seems like a good idea.

I also support more people-based subsidies that incentivize moving to areas with better economies and less place-based subsidies. These subsidies could target people living in specific places and the amounts could be based on the economic characteristics of the destination, with larger amounts given to people who are willing to move to areas with the most employment opportunities and/or highest wages.

Making it easier for people to retain any state-based government benefits across state lines would also help improve labor mobility. I support reforms that reduce the paperwork and time requirements for transferring benefits or for simply understanding what steps need to be taken to do so.

Several policy changes will need to occur before we can expect to see significant changes in labor mobility. There is broad agreement around some of them, such as occupational licensing and land-use regulation reform, but bringing them to fruition will take time. As for the less popular ideas, it will be interesting to see which, if any, are tried.

Decreasing congestion with driverless cars

Traffic is aggravating. Especially for San Francisco residents. According to Texas A&M Transportation Institute, traffic congestion in the San Francisco-Oakland CA area costs the average auto commuter 78 hours per year in extra travel time, $1,675 for their travel time delays, and an extra 33 gallons of gas compared to free-flow traffic conditions. That means the average commuter spends more than three full days stuck in traffic each year. Unfortunately for these commuters, a potential solution to their problems just left town.

Last month, after California officials told Uber to stop its pilot self-driving car program because it lacked the necessary state permits for autonomous driving, Uber decided to relocate the program from San Francisco to Phoenix, Arizona. In an attempt to alleviate safety concerns, these self-driving cars are not yet driverless, but they do have the potential to reduce the number of cars on the road. Other companies like Google, Tesla, and Ford have expressed plans to develop similar technologies, and some experts predict that completely driverless cars will be on the road by 2021.

Until then, however, cities like San Francisco will continue to suffer from the most severe congestion in the country. Commuters in these cities experience serious delays, higher gasoline usage, and lost time behind the wheel. If you live in any of these areas, you are probably very familiar with the mind-numbing effect of sitting through sluggish traffic.

It shouldn’t be surprising then that these costs could culminate into a larger problem for economic growth. New Mercatus research finds that traffic congestion can significantly harm economic growth and concludes with optimistic predictions for how autonomous vehicle usage could help.

Brookings Senior Fellow Clifford Winston and Yale JD candidate Quentin Karpilow find significant negative effects of traffic congestion on the growth rates of California counties’ gross domestic product (GDP), employment, wages, and commodity freight flows. They find that a 10% reduction in congestion in a California urban area increases both job and GDP growth by roughly 0.25% and wage growth to increase by approximately 0.18%.

This is the first comprehensive model built to understand how traffic harms the economy, and it builds on past research that has found that highway congestion leads to slower job growth. Similarly, congestion in West Coast ports, which occurs while dockworkers and marine terminal employers negotiate contracts, has caused perishable commodities to go bad, resulting in a 0.2 percentage point reduction in GDP during the first quarter of 2015.

There are two main ways to solve the congestion problem; either by reducing the number of cars on the road or by increasing road capacity. Economists have found that the “build more roads” method in application has actually been quite wasteful and usually only induces additional highway traffic that quickly fills the new road capacity.

A common proposal for the alternative method of reducing the number of cars on the road is to implement congestion pricing, or highway tolls that change based on the number of drivers using the road. Increasing the cost of travel during peak travel times incentivizes drivers to think more strategically about when they plan their trips; usually shifting less essential trips to a different time or by carpooling. Another Mercatus study finds that different forms of congestion pricing have been effective at reducing traffic congestion internationally in London and Stockholm as well as for cities in Southern California.

The main drawback of this proposal, however, is the political difficulty of implementation, especially with interstate highways that involve more than one jurisdiction to approve it. Even though surveys show that drivers generally change their mind towards supporting congestion pricing after they experience the lower congestion that results from tolling, getting them on board in the first place can be difficult.

Those skeptical of congestion pricing, or merely looking for a less challenging policy to implement, should look forward to the new growing technology of driverless cars. The authors of the recent Mercatus study, Winston and Karpilow, find that the adoption of autonomous vehicles could have large macroeconomic stimulative effects.

For California specifically, even if just half of vehicles became driverless, this would create nearly 350,000 additional jobs, increase the state’s GDP by $35 billion, and raise workers’ earnings nearly $15 billion. Extrapolating this to the whole country, this could add at least 3 million jobs, raise the nation’s annual growth rate 1.8 percentage points, and raise annual labor earnings more than $100 billion.

What would this mean for the most congested cities? Using Winston and Karpilow’s estimates, I calculated how reduced congestion from increased autonomous car usage could affect Metropolitan Statistical Areas (MSAs) that include New York City, Los Angeles, Boston, San Francisco, and the DC area. The first chart shows the number of jobs that would have been added in 2011 if 50% of motor vehicles had been driverless. The second chart shows how this would affect real GDP per capita, revealing that the San Francisco MSA would have the most to gain, but with the others following close behind.

jobsadd_autonomousvehicles realgdp_autonomousvehicles

As with any new technology, there is uncertainty with how exactly autonomous cars will be fully developed and integrated into cities. But with pilot programs already being implemented by Uber in Pittsburgh and nuTonomy in Singapore, it is becoming clear that the technology’s efficacy is growing.

With approximately $1,332 GDP per capita and 45,318 potential jobs on the table for the San Francisco Metropolitan Statistical Area, it is a shame that San Francisco just missed a chance to realize some of these gains and to be at the forefront of driving progress in autonomous vehicle implementation.

Fixing decades of fiscal distress in Scranton, PA

In new Mercatus research, Adam Millsap and I and unpack the causes for almost a quarter of a century of fiscal distress in Scranton, Pennsylvania and offer some recommendations for how the city might go forward.

Since 1992, Scranton has been designated as a distressed municipality under Act 47, a law intended to help financially struggling towns and cities implement reforms. Scranton is now on its fifth Recovery plan, and while there are signs that the city is making improvements, it still has to contend with a legacy of structural, fiscal and economic problems.

We begin by putting Scranton in historical context. The city, located in northeastern Pennsylvania was once a thriving industrial hub, manufacturing coal, iron and providing T-rails for railroad tracks. By 1930, Scranton’s population peaked and the city’s economy began to change. Gas and oil replaced coal. The spread of the automobile and trucking diminished demand for railroad transport. By the 1960s Scranton was a smaller service-based economy with a declining population. Perhaps most relevant to its current fiscal situation is that the number of government workers increased as both the city’s population and tax base declined between 1969 and 1980.

An unrelenting increase in spending and weak revenues prompted the city to seek Act 47 designation kicking off two decades of attempts to reign in spending and change the city’s economic fortunes.

Our paper documents the various recovery plans and the reasons the measures they recommended either proved temporary, ineffective, or simply “didn’t stick.” A major obstacle to cost controls in the city are the hurdle of collective bargaining agreements with city police and firefighters, protected under Act 111, that proved to be more binding than Act 47 recovery plans.

The end result is that Scranton is facing rapidly rising employee costs for compensation, health care and pension benefits in addition to a $20 million back-pay award. These bills have led the city to pursue short-term fiscal relief in the form of debt issuance, sale-leaseback agreements and reduced pension contributions. The city’s tax structure has been described as antiquated relying mainly on Act 511 local taxes (business privilege and mercantile business tax, Local Services Tax (i.e. commuter tax)), property taxes and miscellaneous revenues and fees.

Tackling these problems requires structural reforms including 1) tax reform that does not penalize workers or businesses for locating in the city, 2) pension reform that includes allowing workers to move to a defined contribution plan and 3) removing any barrier to entrepreneurship that might prevent new businesses from locating in Scranton. In addition we recommend several state-level reforms to laws that have made it harder to Scranton to control its finances namely collective bargaining reform that removes benefits from negotiation; and eliminating “budget-helping” band-aids that mask the true cost of pensions. Such band-aids include state aid for municipal pension and allowing localities to temporarily reduce payments during tough economic times. Each of these has only helped to sustain fiscal illusion – giving the city an incomplete picture of the true cost of pensions.

To date Scranton has made some progress including planned asset monetizations to bring in revenues to cover the city’s bills. Paying down debts and closing deficits is crucial but not enough. For Pennsylvania’s distressed municipalities to thrive again reforms must replace poor fiscal institutions with ones that promote transparency, stability and prudence. This is the main way in which Scranton (and other Pennsylvania cities) can compete for businesses and residents: by offering government services at lower cost and eliminating penalties and barriers to locating, working and living in Scranton.

Loyalton, CA and the cost of faulty actuarial assumptions

The New York Times has an interesting piece on the pension troubles facing the small town of Loyalton, California (population 769). Loyalton has seen little economic activity since its sawmill closed in 2001. In 2010 the city made a decision to exit Calpers saving the city $30,000. The City Council thought that the decision to exit would only apply to new hires and for the next three years ceased paying Calpers. Four of the the pension plan’s participants are retired and one is fully vested.

In response, Calpers sent the town a bill for $1.6 million – the hypothetical termination liability – for exiting the plan. For years Loyalton operated under the assumptions built into Calpers’ system which values the liability based on asset returns of 7.5 percent. This actuarial value concealed reality. Once a plan terminates Calpers presents employers with the real bill: or the risk-adjusted value of its pension promises based on a bond rate of 3.25 percent.

To see how big a difference that makes to the bottom line for cities, Joe Nation, Stanford professor, has built a very helpful tool that compares the actuarial liability of pension plans with the market value for individual governments in California.

The judge in the Stockton bankruptcy case Christopher Klein characterized the termination liability as presenting struggling towns with a “poison pill” for leaving the system. Another way to look at it is that the risks and costs that were hidden by faulty accounting assumptions based on risky discount rates are coming due as Calpers fails to hit its investment target. The annual costs may start to be shifted, and in the case of termination, fully imposed on local employers.

The four retirees of Loyalton are facing the possibility of drastically reduced pensions. In a town with annual revenues of $1.17 million, Calpers’ bill is far beyond the town’s ability to pay. Negotiations between Calpers and Loyalton are likely to continue. Some ideas floated include putting a lien on the town’s assets or revenues.

 

Privatizing Water Facilities Can Help Cash-Strapped Municipalities

In my latest Forbes piece I discuss water privatization in the U.S. and why it is often a good idea.

“A public-private partnership has several benefits versus a completely public system. First, private firms often operate in many different jurisdictions, which means they have more experience and are able to institute best practices based on their accumulated knowledge.

Second, there is more oversight. The firm has an incentive to provide the specified water quality in order to maintain their business with the city and to avoid being sued for breach of contract. Local government officials can easily monitor the firm since they only need to focus on water quality and availability. If either the government or the firm fail to do their job, the other entity can alert residents.

Third, private companies are often better situated to maintain the infrastructure than public ownership, and public choice analysis helps explain why. Under complete government ownership, rate increases are a political decision rather than a business decision. There is a strong incentive for government officials to keep rates low, especially during election years, since rate increases rarely lead to votes.

Moreover, it’s difficult for politicians to commit to making necessary infrastructure improvements since the deterioration of a city’s water infrastructure is a long process that’s hard for the average voter to notice. A politician can get more votes by allocating tax dollars to conspicuous things like additional policemen or shiny, new fire trucks—it’s hard to trot out a new water main at a campaign rally.”

New York’s Buffalo Billion initiative has been underwhelming

New York’s Buffalo Billion plan has come under fire amidst an ongoing corruption probe looking into whether some contracts were inappropriately awarded to political donors. The investigation has led to funding delays and there are reports of some contractors and companies rethinking their investments. But even without these legal problems, it is unlikely that the Buffalo Billion initiative will remake Buffalo’s economy.

Buffalo, NY has been one of America’s struggling cities since the 1950s, but before then it had a long history of growth. After it became the terminal point of the Erie Canal in 1825 it grew rapidly; over the next 100 years the city’s population went from just under 9,000 to over 570,000. Growth slowed down from 1930 to 1950, and between 1950 and 1960 the city lost nearly 50,000 people. It has been losing population ever since. The Metropolitan Area (MSA), which is the economic city, continued to grow until the 1970s as people left the central city for the surrounding suburbs, but it has also been losing population since then. (click to enlarge figure)

buffalo-population

Buffalo’s population decline has not escaped the notice of local, state and federal officials, and billions of dollars in government aid have been given to the area in an effort to halt or reverse its population and economic slide. The newest attempt is Governor Andrew Cuomo’s Buffalo Billion, which promises to give $1 billion of state funds to the region. The investment began in 2013 and as of January 2016, $870.5 million worth of projects have been announced. The table below lists some of the projects, the amount of the investment, and the number of jobs each investment is supposed to create, retain, or induce (includes indirect jobs due to construction and jobs created by subsequent private investment). This information is from the Buffalo Billion Process and Implementation plan (henceforth Buffalo Billion Plan).

buffalo-billion-projects

The projects listed have been awarded $727 million in direct investment, $150 million in tax breaks and $250 million in other state funds. The total number of jobs related to these investments is 9,900 according to the documentation, for an average cost of $113,859 per job (last column).

However, these jobs numbers are projections, not actual counts. This is one of the main criticisms of investment efforts like Buffalo Billion—a lot of money is spent and a lot of jobs are promised, but rarely does anyone follow up to see if the jobs were actually created. In this case it remains to be seen whether reality will match the promises, but the early signs are not encouraging.

Executives of the first project, SolarCity, which received $750 million of benefits and promised 5,000 jobs in western New York, appear to have already scaled back their promise. One company official recently said that 1,460 jobs will be created in Buffalo, including 500 manufacturing jobs. This is down from 2,000 in the Buffalo Billion Plan, a 27% decrease.

The SolarCity factory is not scheduled to open until June 2017 so there is still time for hiring plans to change. But even if the company eventually creates 5,000 jobs in the area, it is hard to see how that will drastically improve the economy of an MSA of over 1.1 million people. Moreover, page eight of the Buffalo Billion Plan reports that the entire $1 billion is only projected to create 14,000 jobs over the course of 5 years, which is again a relatively small amount for such a large area.

Contrary to the local anecdotes that say otherwise, so far there is little evidence that Buffalo Billion has significantly impacted the local economy. Since the recession, employment in Buffalo and its MSA has barely improved, as shown below (data are from the BLS). There has also been little improvement since 2013 when the Buffalo Billion development plan was released. (City data plotted on the right axis, MSA on the left axis.)

buffalo-employment

Real wages in both Erie and Niagara County, the two counties that make up the Buffalo MSA, have also been fairly stagnant since the recession, though there is evidence of some improvement since 2013, particularly in Erie County (data are from the BLS). Still, it is hard to separate these small increases in employment and wages from the general recovery that typically occurs after a deep recession.

buffalo-county-wages

The goal of the Buffalo Billion is to create a “Big Push” that leads to new industry clusters, such as a green energy cluster anchored by SolarCity and an advanced manufacturing cluster. Unfortunately, grandiose plans to artificially create clusters in older manufacturing cities rarely succeed.

As economist Enrico Moretti notes in his book, The New Geography of Jobs, in order for Big Push policies to succeed they need to attract both workers and firms at the same time. This is hard to do since either workers or firms need to be convinced that the other group will eventually arrive if they make the first move.

If firms relocate but high-skill workers stay away, then the firm has spent scarce resources locating in an area that doesn’t have the workforce it needs. If workers move but firms stay away, then the high-skill workers are left with few employment opportunities. Neither situation is sustainable in the long-run.

The use of targeted incentives to attract firms, as in the aforementioned SolarCity project, has been shown to be an ineffective way to grow a regional economy. While such incentives often help some firms at the expense of others, they do not provide broader benefits to the economy as a whole. The mobile firms attracted by such incentives, called footloose firms, are also likely to leave once the incentives expire, meaning that even if there is a short term boost it will be expensive to maintain since the incentives will have to be renewed.

Also, in order for any business to succeed state and local policies need to support, rather than inhibit, economic growth. New York has one of the worst economic environments according to several different measures: It’s 50th in overall state freedom, 50th in economic freedom, and 49th in state business tax climate. New York does well on some other measures, such as Kauffman’s entrepreneurship rankings, but such results are usually driven by the New York City area, which is an economically vibrant area largely due to historical path dependencies and agglomeration economies. Buffalo, and western New York in general, lacks the same innate and historical advantages and thus has a harder time overcoming the burdensome tax and regulatory policies of state government, which are particularly harmful to the local economies located near state borders.

Buffalo officials can control some things at the local level that will improve their economic environment, such as zoning, business licensing, and local taxes, but in order to achieve robust economic growth the city will likely need better cooperation from state officials.

State and local policy makers often refuse to acknowledge the harm that relatively high-tax, high-regulation environments have on economic growth, and this prevents them from making policy changes that would foster more economic activity. Instead, politicians invest billions of dollars of taxpayer money, often in the form of ineffective targeted incentives to favored firms or industries, with the hope that this time will be different.

Discovering an areas comparative advantage and creating a sustainable industry cluster or clusters requires experimentation, which will likely result in some failures. Local and state governments should create an environment that encourages entrepreneurs to experiment with new products and services in their region, but they shouldn’t be risking taxpayer money picking winners and losers. Creating a low-tax, low-regulation environment that treats all businesses—established and start-up, large and small—the same is a better way to grow an economy than government subsidies to favored firms. Unfortunately the Buffalo Billion project looks like another example of the latter futile strategy.

Local governments reluctant to issue new debt despite low interest rates

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.

Congestion taxes can make society worse off

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.

Pokémon Go Represents the Best of Capitalism

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 somehow destroying the economy) we wanted to offer a different perspective to some of the points made in the article.

In fact, we think that Pokémon Go actually represents the best of capitalism. In less than a week the game has topped 15 million downloads and the 21 million active daily users spend an average of 33 minutes a day playing. That amounts to over 11.5 million hours of playing per day, and those numbers only look to increase. The app doesn’t cost anything to download and play, which means that Nintendo and Niantic (the game developer) are essentially giving away tens of millions of dollars of value to the eager players.

We know that’s a bold statement. But this is why it’s true: A person’s time is scarce and valuable. Every moment they spend playing Pokémon Go they could instead be doing something else. The fact that they’re voluntarily choosing to play means that the benefit of playing is more than the cost.

Economists call this “consumer surplus” – the difference between a customer’s willingness to pay for a good or service and the price that it actually costs. It’s a measurement of the dollar value gained by the consumer in the exchange. If a person was to buy a game of bowling for $5 that they value at $7, instead of playing an hour of Pokémon that they value at $3 for free, that person would lose out on value that would have made their life better.

So even if the average consumer surplus is only a measly dollar an hour, consumers are getting $11.5 million dollars of value each day. The fact that customers are buying special items to use in the game, spending upwards of $1.6 million each day, implies that the value players receive from the game is actually higher.

The article laments that local economies are harmed because people are turning toward forms of entertainment that don’t have high production costs, like movie theaters or bowling alleys that need expensive buildings or numerous employees selling buckets of popcorn. What the article misses is that the economic activity associated with traditional entertainment options represent the costs of providing the entertainment. The reality we have now is much better, since we not only gain the value of the entertainment, but we have the money we would have paid for it to purchase other things as well. It’s almost like getting something for nothing, and our lives – and the economy in general – are better as result.

This is the core of economic growth – decreasing the scarcity of goods and services that limits our lives. The article makes it seem as if economic growth comes from simply spending money. This view can lead us astray because it ignores the importance of entrepreneurs, whose role is critical in the creation of new products and services that improve everyone’s well-being.

Pokémon Go is actually a great example of this. The game developers and their investors thought that they could make something that customers might like and they took the entrepreneurial risk to create the game without the certainty that it was going to be a success. Obviously, it was a good gamble, but I’m sure that even they are amazed at the results. Imagine if the game development funds had been used to build a couple of bowling alleys instead. Wow. What fun.

Think of what would have been lost to society if entrepreneurs didn’t have the funds and the freedom to take that gamble. And their success has spawned a sub-industry of “Poképreneurs” who are selling drinks and providing rides to Pokémon players. Economic growth – and our increased social well-being – depends on this kind of permissionless innovation.

In short, Pokémon Go represents the very best of capitalism because it’s premised on voluntary exchange – no one is forced to download the game, players can stop playing at any time they like, and if they value the special items available in the game store they can buy them to enhance their fun. Furthermore, the entrepreneurs who had the foresight and the guts to dare to make the world a better place are being rewarded for their accomplishment. Most importantly, that success only comes about because they have made people’s lives better in the process. That’s something Team Rocket could never learn to do.

About the Authors:

Michael Farren is a Research Fellow in the Study of American Capitalism at the Mercatus Center at George Mason University. He’s a proud member of Team Instinct, because he likes a challenge.

Adam A. Millsap is a Research Fellow in the State and Local Policy Project at the Mercatus Center at George Mason University. No team will allow him to join, because all he can catch is Pidgeys.

*The title and opening sentence of this article has changed since it was originally published.