Sean Masaki Flynn

Cheat Sheet / Updated 09-05-2023

People have to make choices because of scarcity, the fact that they don’t have enough resources to satisfy all their wants. Economics studies how people allocate resources among alternative uses. Macroeconomics studies national economies, and microeconomics studies the behavior of individual people and individual firms. Economists assume that people work toward maximizing their utility, or happiness, and firms act to maximize profits.

Article / Updated 12-14-2022

The worldwide Great Recession of 2007 to 2009 began in the economy when a housing bubble in the United States popped in 2006. Trillions of dollars had been invested in the financial markets on the premise that residential housing prices would never decline significantly. As the bubble burst and home prices began to plummet, the economy took a hit as dozens of large banks as well as many hundreds of financial firms were threatened with bankruptcy. Lending ceased not only for home mortgages but for business loans, and if it hadn’t been for aggressive interventions by governments and central banks, the entire worldwide financial system might have collapsed, such that nobody would have been able to obtain a loan for any purpose. Because the world economy is highly dependent on borrowed money to finance everything from credit card purchases to factory construction, another Great Depression loomed just over the horizon. The Fed and other central banks to the rescue To calm the immediate crisis, the Fed and other central banks became lenders of last resort, ensuring that businesses could still obtain financing directly from the Fed even if banks were reluctant to loan. The Fed also protected banks from banking panics by increasing the insurance limits offered to checking account depositors. These and other steps limited the recession to only being moderately severe. Yet, the Great Recession was still much more severe than your typical recession. So it wasn’t surprising that the Fed and other central banks undertook innovative new monetary policy measures to stimulate the economy. These came to be known as unconventional monetary policy. Under conventional monetary policy, central banks like the Fed use open-market operations to purchase short-term (less than 1-year maturity) government bonds to increase the money supply and drive short-term interest rates toward zero in order to stimulate the economy. A strategy known as quantitative easing But given the severity of the Great Recession, the Fed and other central banks found that conventional monetary policy wasn’t going to be enough to drive short-term interest rates to zero. Additional stimulus was needed. So the Fed and other central banks began to purchase trillions of dollars worth of longer-term government bonds (with 5-year, 10-year, and 20-year maturities), private-sector bonds (including mortgage-backed securities), and even stocks. The goal in all cases was to increase the quantity of money available to be loaned out. It was hoped that more borrowing and lending would take place, thereby stimulating both consumption and investment. These policies became known as quantitative easing (or QE), since their goal was to ease the constraints on lending and borrowing by increasing the quantity of money in circulation. By contrast, conventional monetary policy targets not the quantity of money in circulation but rather the price of money — the interest rate. Conventional monetary policy attempts to simulate the economy by lowering the price of loans. Unconventional monetary policy (quantitative easing) attempts to increase the sheer volume of loans. Setting a target for inflation Another unconventional monetary policy was setting an explicit target for inflation, so that people would know how aggressive central banks were going to be with changes in the money supply. The inflation target was set at 2 percent in the United States, which could only be met if the Fed were increasing the money supply faster than any increase in money demand. By setting a 2 percent target, the Fed was committing itself to continually pushing the AD curve to the right and thus always attempting to stimulate the economy. This commitment was intended to give consumers and businesses confidence that the Fed would stimulate as long as necessary until the Great Recession was over and the economy had fully recovered.

Article / Updated 01-10-2022

When the economy encounters a negative demand shock, price flexibility (or lack of flexibility) determines both the severity and length of any recession that may result. If prices were infinitely flexible — if they could change within seconds or minutes after a shock — the economy would immediately move from Point A to Point C, and all would be right with the world. But if prices are fixed for any period of time, the economy goes into a recession as it moves from Point A to Point B before prices eventually fall and bring it back to full-employment output at Point C. In the real world, prices are indeed somewhat slow to change, or as economists like to say, prices are sticky. Interestingly, prices tend to be stickier when going downward than upward, meaning that prices appear to have a harder time falling than rising. The major culprit seems to be one particular price: wages. Wages are the price employers must pay workers for their labor. Unlike other prices in the economy, people are particularly emotionally attached to wages and how they change over time. Employees don’t like to see their wages cut. They have a strong sense of fairness concerning their wages and usually retaliate against any wage cut by working less hard. As a result, managers typically find lowering wages to be counterproductive, even if a firm is losing money and needs to cut costs. The following explains how firms’ worries about worker motivation lead to the sticky output prices that prevent the economy from rapidly recovering from recessions. When sales fall as a result of the recession, output prices can’t fall very much because firms choose to lay off workers rather than cut wages. Cutting wages or cutting workers in a tough economy During a recession, you see a large increase in unemployment but little decrease in wage rates. The fact that managers are unwilling to cut wages, however, has a nasty side effect: Not cutting wages makes it very hard for firms to cut the prices of the goods and services they sell. Suppose that a negative demand shock hits an economy and greatly reduces sales at a particular company. The firm is losing money, so managers need to figure out a way to cut costs. About 70 percent of this company’s total costs are labor costs (wages and salaries). Naturally, labor costs are an obvious target for cuts. But the managers of the firm realize that if they cut wages, employees will get angry and work less hard. In fact, their productivity may fall off so much that cutting wages may make the firm’s profit situation worse: Output may fall so much that sales revenues will decrease by more than the reduction in labor costs. Therefore, cutting wages isn’t really a good option. So instead, the managers lay off a large chunk of their workforce in order to reduce labor costs. For instance, if sales are down 40 percent, the firm may lay off 40 percent of the workforce. However, any workers who remain employed get to keep their old wages so that they aren’t angry and their productivity doesn’t fall. Adding up the costs of wages and profits in an economy headed for recession Obviously, firms need to turn a profit in order to stay in business. And that means making sure that the price per unit that they charge for their products exceeds the cost per unit of making them. During a recession, lower aggregate demand means that firms reduce production and sell fewer units. Wages are the largest component of most firms’ costs — in fact, they’re a full 70 percent of the average firm’s costs. If a firm can’t cut wages for fear of causing worker productivity to drop, it can’t reduce its per-unit production costs very much, either. In turn, the firm can’t cut its prices very much because prices have to stay above production costs if firms are to break even and stay in business. What does all this mean? When demand drops off, prices are typically sticky. They stay high even though there’s less demand for output in the economy. With prices sticky because firms can’t quickly or easily cut wages, the negative demand shock results in a recession, with output falling and unemployment rising because so many workers get fired. Worse yet, unless prices can somehow begin to fall, the economy won’t be able to move from B to C to get back to producing at the full-employment output level (Y*). Prices do eventually fall, but this process can take a long time, meaning that the negative demand shock can cause a long-lasting recession. One way around this slow adjustment process is for the government to try to offset the negative demand shock. Such attempts may be able to speed recovery by avoiding the need for prices to adjust to bring the economy back to producing at the full-employment output level.

Article / Updated 08-15-2018

For simplicity, economists often assume that people are fully informed and totally rational when they make decisions. You may think that gives people way too much credit, but economic models based on those assumptions work surprisingly well much of the time. However, in the real world, people aren’t always informed about the economic decisions they need to make, and they aren’t always as reasonable as economists assume. Here, you discover some of the limitations of the choice model and explain why they may not matter all that much in the long run. Understanding uninformed decision-making in the economy When economists apply the choice model, they assume a situation in which a person knows all the possible options, knows how much utility each will bring, and knows the opportunity costs of each one. But how do you evaluate whether it would be better to sit on top of Mount Everest for five minutes or hang-glide over the Amazon for ten minutes? Because you’ve never done either, you aren’t well-informed about the constraints and costs of the choice and probably don’t even know what the utilities of the two options are. Politicians touting novel new programs often ask voters to make similarly uninformed choices. They make their proposals sound as good as possible, but in many cases, nobody really knows what they may be getting into. Things are similarly murky with respect to choices involving luck or uncertainty. People buying lottery tickets in state lotteries have no idea about the eventual possible gain because the size of the prize depends on how many tickets are sold before the drawing is made. The people who choose to play lotteries also tend to have highly exaggerated “guesstimates” about their chances of winning. Economists account for this reality by assuming that when faced with uninformed decisions, people make their best guesses about not only uncertain outcomes but also about how much they may like or dislike things with which they have no previous experience. Although this may seem like a fudge, because people in the real world are obviously making decisions in such situations (they do, in fact, buy a whole lot of lottery tickets), the people in those situations must be fudging a bit as well. Whether people make good choices when they are uninformed is hard to say. Obviously, people would prefer to be better informed before choosing. And some people do shy away from less certain options. But overall, the economist’s model of choice behavior seems quite capable of dealing with situations of incomplete information and uncertainty about random outcomes. Making sense of irrationality and the impact on the economy Even when people are fully informed about their options, they often make logical errors in evaluating costs and benefits. Following are three of the most common economic errors. Don’t be alarmed if you find that you’ve made these errors yourself: After people have these choice errors explained to them, they typically stop making the errors and start behaving in a manner consistent with rationally weighing marginal benefits against marginal costs. Sunk costs are sunk! Economists refer to costs that have already been incurred and which should therefore not affect your current and future decision-making as sunk costs. Rationally speaking, you should consider only the future, potential marginal costs and benefits of your current options. Suppose you just spent $15 to get into an all-you-can-eat sushi restaurant. How much should you eat? More specifically, when deciding how much to eat, should you care about how much you paid to get into the restaurant? To an economist, the answer to the first question is “Eat exactly the amount of food that makes you most happy.” And the answer to the second question is “How much it cost you to get in doesn’t matter because whether you eat 1 piece of sushi or 80 pieces of sushi; the cost was the same.” Put differently, because the cost of getting into the restaurant is now in the past, it should be completely unrelated to your current decision of how much to eat. After all, if you were suddenly offered $1,000 to leave the sushi restaurant and eat next door at a competitor’s, would you refuse simply because you felt you had to eat a lot at the sushi restaurant in order to get your money’s worth out of the $15 you spent? Of course not. Unfortunately, most people tend to let sunk costs affect their decision-making until an economist points out to them that sunk costs are irrelevant — or, as economists never tire of saying, “Sunk costs are sunk!” Mistaking a big percentage for a big dollar amount Costs and benefits are absolute, but people make the mistake of thinking of the costs and benefits as percentages or proportions. Instead, you should compare the total costs against the total benefits, because the benefit of, say, driving to the next town to get a discount is the absolute dollar amount you save, not the percentage you save. Suppose you decide to save 10 percent on a mobile phone by making a one-hour round trip to a store in another town. You plan to buy the phone for only $90 instead of buying it at your local store for $100. Next, ask yourself whether you’d also be willing to drive one hour in order to buy a home theater system for $1,990 in the next town rather than for $2,000 at your local store. You do the math, and because you would save only 0.5 percent, you decide to buy the system for $2,000 at the local store. You may think you’re being smart, but you’ve just behaved in a colossally inconsistent and irrational way. In the first case, you were willing to drive one hour to save $10. In the second, you were not. Confusing marginal and average Suppose your local government has recently built three bridges at a total cost of $30 million. That’s an average cost of $10 million per bridge. A local economist does a study and estimates that the total benefits of the three bridges to the local economy add up to $36 million, or an average of $12 million per bridge. A politician then starts trying to build a fourth bridge, arguing that because bridges on average cost $10 million but on average bring $12 million in benefits, it would be foolish not to build another bridge. Should you believe him? After all, if each bridge brings society a net gain of $2 million, you would want to keep building bridges forever. What really matter in this decision are marginal costs and marginal benefits, not average ones. Who cares what costs and benefits all the previous bridges brought with them? You have to compare the costs of that extra, marginal bridge with the benefits of that extra, marginal bridge. If the marginal benefits exceed the marginal costs, you should build the bridge. If the marginal costs exceed the marginal benefits, you should not. For example, suppose that an independent watchdog group hires an engineer to estimate the cost of building one more bridge and an economist to estimate the benefits of building one more bridge. The engineer finds that because the three shortest river crossings have already been taken by the first three bridges, the fourth bridge will have to be much longer. In fact, the extra length will raise the construction cost to $15 million. At the same time, the economist does a survey and finds that a fourth bridge isn’t really all that necessary. At best, it will bring with it only $8 million in benefits. Consequently, this fourth bridge shouldn’t be built because its marginal cost of $15 million exceeds its marginal benefit of $8 million. By telling voters only about the average costs and benefits of past bridges, the politician supporting the project is grossly misleading them. So watch out anytime somebody tries to sell you a bridge.

Article / Updated 08-15-2018

Offering “free” healthcare, reduced-cost care, and health insurance all have drawbacks for the economy. However, Singapore has managed to create a set of medical institutions that delivers world-class healthcare while somehow spending 50 percent less than Canada and 70 percent less than the United States. Keep reading to find out their economic secret. Exploring cost-saving features and the impact on the economy The secret to Singapore’s success has been a unique blend of private and public medical funding that keeps costs down by paradoxically making people pay a lot of money out-of-pocket for their care. It also ensures that the poor will be cared for. Singapore’s healthcare system has three main cost-saving features: Government mandates to encourage competition: Singapore encourages competition by requiring hospitals to post prices for each of their services on the Internet. Armed with this information, patients can shop around for the best deal. The government also publishes the track record of each hospital on each service so that patients can make informed decisions about quality as well as price. High out-of-pocket costs for consumers: Singapore insists upon high out-of-pocket costs to avoid the overconsumption and high prices that result when insurance policies pick up most of the price for medical procedures. Indeed, out-of-pocket spending represents about 92 percent of all private healthcare spending in Singapore, compared to just 11 percent in the United States. Laws requiring people to save for future health expenditures: Having to pay for most medical spending out of pocket means that Singapore’s citizens are faced with having to pay for most of their healthcare themselves. How can this be done without bankrupting the average citizen? The answer is mandatory health savings accounts. Singapore’s citizens are required to save about 6 percent of their incomes into MediSave accounts. MediSave deposits are private property, so people have an incentive to spend the money in their accounts wisely. But the citizens of Singapore also know that they won’t be left helpless if the money in their MediSave accounts runs out. The government subsidizes the healthcare of those who have exhausted their MediSave accounts as well as the healthcare of the poor and others who have not been able to accumulate much money in their MediSave accounts. Singapore’s health ministry is still very much involved in policing doctors and hospitals for safety and in providing healthcare to the poor. In fact, about one-third of all healthcare spending in Singapore is paid for by the government on behalf of the poor. But Singapore restricts its direct management of the healthcare system by allowing high-out-of-pocket costs to ration care and direct the entrepreneurial efforts of medical researchers. Weighing costs and economic benefits of medical procedures Crucially, the prices patients pay in Singapore are not artificially low. Unlike in the United Kingdom, where healthcare looks free, or the United States, where it looks artificially inexpensive due to insurance’s picking up most of the bill, the residents of Singapore are faced with the full prices of medical procedures. This causes them to self-ration, voluntarily choosing not to go to the hospital for minor problems. That frees up resources for doctors and nurses to concentrate on treating serious cases. Singapore’s residents typically make very sensible decisions when weighing the costs and benefits of various medical procedures. In fact, having to pay high out-of-pocket costs encourages good-decision making because people who have to pay their own money for healthcare generally spend a lot more time educating themselves about their options. Supporting cost-cutting innovations in the economy Singapore’s system of individual self-rationing has meant that Singapore has not had to set up a bureaucracy to ration care. The absence of such a bureaucracy promotes innovation because instead of red tape, there are profit incentives. These incentives are especially helpful in motivating medical entrepreneurs to figure out innovative methods for reducing costs. To see the power of profits, consider the fact that a medical doctor in the United Kingdom who comes up with an innovation will get no reward from that country’s National Health Service. Indeed, her innovation will probably never be implemented, because dozens of committees would have to give their approval before her idea could be carried out. By contrast, a doctor with such an idea in Singapore could put it into practice quickly. Self-rationing affects the types of medical research in Singapore versus in other countries. With individual self-rationing, more research is devoted to reducing costs so that consumers can pay less. Typically, that has nothing to do with inventing a new way of treating a disease but rather with figuring out how to make an effective older treatment less expensive. Thus, some hospitals in Singapore can do an open-heart surgery for only $20,000, versus about $100,000 in the United States. By contrast, the incentives facing medical researchers in the United States are very different. In the United States, most research is funded by the government and directed toward developing new treatments. Success is measured by whether the new method works in the sense of curing the disease or healing the wound; whether it does so substantially better than currently available methods when costs are taken into account is not a high priority. The incentives facing the United States’ medical research system lead to a paradox: On one hand, they result in the United States having the world’s most cutting-edge medical technologies. On the other hand, many are hideously expensive and only marginally better than what was available before. From a cost-benefit perspective, the development of such technologies is wasteful. Trying to copy Singapore’s economic and healthcare success No other country has copied all three of Singapore’s cost-reducing policies. But recent experiments suggest that huge savings can result from implementing just one: high out-of-pocket costs. A couple of examples, one a state government and one a private company, show some promise. In 2007, Indiana introduced a new healthcare option for state employees. Any employee choosing this option received $2,750 in a health savings account plus an insurance policy that covers 80 percent of any medical expenses between $2,750 and $8,000 and 100 percent of any expenses above $8,000. Thus, any employee volunteering for the plan had to pay 100 percent of all spending up to $2,750 from his or her health savings accounts. These high-out-of-pocket expenses encourage prudence. Indeed, those who opted for the plan visited doctors and emergency rooms two-thirds less often than they did before, were half as likely to be admitted to a hospital, and spent $18 less per prescription than state employees who opted to stick with the state’s traditional health insurance option. These changes in behavior led to a 35 percent decline in total healthcare spending for those who volunteered for the new plan versus those who stuck with the traditional option. An independent audit showed that participants in the new plan weren’t cutting corners by skimping on cost-effective preventive care like annual physicals and annual mammogram screenings. Thus, the savings appear to be permanent and sustainable. The program is also popular, with positive personal recommendations causing voluntary participation to rise from 2 percent of state employees in the program’s first year to 70 percent of state employees in the program’s second year. Similar programs implemented by private companies like Whole Foods Market also show 30 to 40 percent cost reductions. Thus, it’s clear that substantial costs savings can be achieved by simply confronting consumers with nonsubsidized prices that must be paid for with out-of-pocket spending. Even greater savings can presumably be achieved by implementing Singapore’s two other cost-saving policies: encouraging competition and mandatory savings. Encouraging competition would likely lead to improved services at lower costs, and mandatory health savings would presumably make people even more cautious with out-of-pocket spending because they would be aware that they were very much spending their own money. Widely implementing Singapore’s innovations may be difficult, however. Many individuals and firms do very well financially under the healthcare systems currently in place. They may be reluctant to support innovations, as may the politicians who helped build the current systems.

Article / Updated 08-15-2018

A wonderful thing about free markets and competition in the economy is that output is produced at the lowest possible cost. This fact is extremely important because it means that free markets are as economically efficient as possible at converting resources into the goods and services that people want to buy. In addition, markets save society a lot of money because they produce efficiently without requiring human intervention. People don’t have to pay big salaries to experts to make sure that markets run efficiently; markets do the job in our economy for free. How does perfect competition actually work? The following four steps explain: The market price of the output sold by every firm in the industry is determined by the interaction of the industry’s overall supply and demand curves. Each firm takes the market price as given and produces whatever quantity of output will maximize its own profit (or minimize its own loss if the price is so low that it’s not possible to make a profit). Because each firm has an identical production technology, each will choose to produce the same quantity and will consequently make the same profit or loss as every other firm in the industry. Depending on whether firms in the industry are making profits or losses, firms will either enter or leave the industry until the market price adjusts to the level where all remaining firms are making zero economic profit. The fourth point in this process — firm entry and exit — is very important. To understand it clearly, let’s break it into two cases: one where every firm in the industry is making a profit because the market price is high and another where every firm in the industry is making a loss because the market price is low: Attracting new firms by making profits: If every firm in an industry is making a profit, new firms are attracted to enter the industry, too, in hopes of sharing the profits. But when they enter, total industry output increases so much that the market price begins to fall. As the price falls, profits fall, thereby lowering the incentive for further firms to enter the industry. The process of new firms entering the industry continues until the market price falls so low that profits drop to zero. When that happens, the incentive to enter the industry disappears, and no more firms enter. Losing existing firms when making losses: If every firm in an industry starts out making losses because the market price is low, some of the existing firms exit the industry because they can’t stand losing money. When they do, total industry output falls. That reduction in total supply, in turn, causes the market price to rise. And as the market price rises, firms’ losses decrease. The process of firms leaving and prices rising continues until the remaining firms are no longer losing money. The fact that firms can freely enter or leave the industry means that after all adjustments are made, firms always make a zero economic profit. In other words, if there is perfect competition, you don’t have to worry about firms exploiting anyone; they just barely make enough money to stay in business. The other important result of perfect competition — that competitive firms produce at minimum cost — becomes apparent if you flesh out the four-stage process of perfect competition by using cost curves.

Article / Updated 08-14-2018

In the United States, the economy is relatively stable and prices rise only a small amount each year. However, even moderate inflation causes problems by cutting into the practical benefits of using money instead of barter. You can get a better sense of this fact by looking at the four functions that economists generally ascribe to money and the ways in which inflation screws up each of them: Money is a store of value. If you sell a cow today for one gold coin, you should be able to turn around and trade that gold coin back for a cow tomorrow or next week or next month. When money retains its value, you can hold it instead of holding cows, or real estate, or any other asset. Inflations weaken the use of money as a store of value because each unit of currency is worth less and less as time passes. Money is a unit of account. When money is widely accepted in an economy, it often becomes the unit of account in which people write contracts. People start using phrases like “$50 worth of lumber” rather than “50 square feet of lumber,” or “$1 million worth of shirts in inventory” instead of “20,000 shirts in inventory.” This practice makes sense if money holds its value over time, but in the presence of inflation, using money as a unit of account creates problems because the value of money declines. For instance, if the value of money is falling fast, how much lumber, exactly, is “$50 worth of lumber”? Money is a standard of deferred payment. If you want a cow, you probably wouldn’t borrow a cow with the promise to repay two cows next year. Instead, you’d be much more likely to borrow and repay in terms of money. That is, you’d borrow one gold coin and use it to buy a cow, after promising to pay back two gold coins next year. The progressive devaluing of money during a period of inflation makes lenders reluctant to use money as a standard of deferred payment. Suppose a friend asks to borrow $100, promising to pay you $120 in a year. That seems like a good deal — after all, it’s a 20 percent interest rate. But if prices are rapidly rising and the value of money is falling, how much will you be able to buy with that $120 next year? Inflations make people reluctant to lend money. Potential lenders fear that when the loans are repaid, the repayment cash won’t have the same purchasing power as the cash that was lent. This uncertainty can have a devastating effect on the development of new businesses, which rely heavily on loans to fund their operations. Money is a medium of exchange. Money is a medium (literally meaning “something in the middle”) of trade between buyers and sellers because it can be directly exchanged for anything else, making buying and selling much easier. In a barter economy, an orange farmer who wants to buy beer may have to first trade oranges for apples and then apples for beer because the guy selling the beer wants only apples. Money can eliminate this kind of hassle. But if inflation is bad enough, money is no longer an effective medium of exchange. During hyperinflations, economies often revert to barter so buyers and sellers don’t have to worry about the falling value of money. For example, in a healthy economy, the orange seller can first sell oranges for cash and then trade the cash for beer. But during a hyperinflation, between the time he sells the oranges for cash and buys the beer, the price of beer may have skyrocketed so high that he can’t buy very much beer with the cash. During a hyperinflation, economies have to resort to cumbersome bartering. Another effect of inflation is that it functions as a giant tax increase. This seems strange because you normally think of governments taxing by taking away chunks of people’s money, not by printing more money. But a tax is basically anything that transfers private property to the government. Debasing the currency or printing more money can have this effect. Suppose that the government wants to buy a $20,000 van for the post office. The honest way to go about this is to use $20,000 of tax revenues to buy a van. But a sneakier way is to print $20,000 in new cash to buy the van. By printing and spending the new cash, the government has converted $20,000 of private property — the van — into public property. So printing new cash works just like a tax. Because printing new money ends up causing inflation, this type of taxation is often referred to as an inflation tax. Not only is the inflation tax sneaky, it unfairly targets the poor because they spend nearly all their incomes on goods and services, the prices of which go up greatly during an inflation. By contrast, because the rich have the opportunity to save a lot of their incomes, proportionately they’re less affected by an inflation tax. By investing their savings in assets whose prices go up during an inflation (such as real estate), the rich can insulate themselves from a great deal of the harm caused by inflation. Check here to find out what causes inflation.

Article / Updated 08-14-2018

Conventional 20th-century neoclassical economics makes many accurate predictions about human choice behavior and how it responds to financial incentives and incrementally changing prices. But when the decisions involve uncertainty and require the chooser to risk or commit or trust, neoclassical predictions often fail. The key underlying problem is that real people are often irrational. That’s problematic for neoclassical economics because neoclassical economics assumes that people are rational. Because rationality is at the heart of why neoclassical economics sometimes fails, let’s begin our review of behavioral economics by precisely defining rationality. Rationality is defined by economists as decision-making that avoids systematic errors. A systematic error is an error that you do over and over, as if you can never learn from your mistakes. A rational decision maker would not be subject to systematic errors. She would learn from her mistakes and figure out how to get what she wants for the least cost and effort. Outside factors might still derail things, but anything that the rational decision maker could have done to maximize her chances of success would have been learned and applied. If people were always rational, then standard, mid-20th century neoclassical economics would have always generated reliable predictions about human decision-making. But people regularly and repeatedly engage in behaviors that reduce their likelihood of achieving what they want. They engage in systematic errors. Behavioral economics attempts to explain these systematic errors by combining insights from economics, psychology, and biology. The goal is to develop theories that can deliver more accurate predictions about human choice behavior, including all the irrational stuff. Decades of research have allowed behavioral economists to develop theories that can explain why our brains employ error-prone mental shortcuts, why we don’t save enough for retirement, why we fall for marketing gimmicks, and why higher incomes rarely lead to permanent happiness. Armed with those insights, behavioral economists have in some cases been able to develop beneficial correctives. And, least dismally of all, behavioral economists have found extensive evidence that people are not purely self-interested.

Article / Updated 08-14-2018

An important economic problem that results from poorly defined property rights that don’t take account of negative externalities is called the Tragedy of the Commons. Here, you examine this problem in detail. The economic problem: Overgrazing on a commonly owned field The Tragedy of the Commons refers to a resource being overexploited due to the perverse incentives created by common ownership. Under common ownership, the resource is open for all to use as they please. These circumstances make rapid use and overexploitation likely because each person has an incentive to use up as much of the resources as possible before others can. To understand the Tragedy of the Commons, think of a farming town in which most of the land is privately owned. However, there’s one large field of common land where anyone can graze their cattle. In a private field, the owner has an incentive to limit the number of cattle that he puts out to graze. That’s because if he puts too many beasts in the field, they quickly eat up all the grass and ruin the field for later grazers. Consequently, the owner of a private field puts only a few cattle out to graze. Doing so reduces his short-run profits (because he restricts the current number of cows) but maximizes his long-run profits (because the field stays in good shape, and he can keep grazing cattle well into the future). With the commonly held field, however, everyone is going to put some cattle out there because the personal cost of doing so is nothing. Nobody has a personal incentive to preserve the field’s future usability. The incentives are actually horribly perverse because if the common field is currently lush with grass, your incentive is to put as many of your cattle out there as quickly as possible to eat all the grass before the field is ruined. Everyone else sees things the same way, so there is a mad rush to put as many cattle out to graze as quickly as possible. The result, of course, is that the field is rapidly ruined for everyone. So although there’s no personal cost to putting a cow out to graze on a common field, there is a social cost. Each additional cow causes damage to the field that reduces the future productivity of the field. The difference between what happens to the private field versus the common field is totally the result of the different property rights governing the two types of land. In the case of privately owned fields, farmers have an incentive to weigh the costs as well as the benefits of putting more cattle out to graze. In particular, they take into account how much future profits will be reduced if current overgrazing ruins the future usability of the field. Extinctions and poor property rights in the economy Many environmental problems are caused by Tragedy of the Commons situations in which nobody owns the property rights to a given resource. Notably, most animal extinctions are the result of an absence of property rights. For instance, think of tuna swimming in the open ocean. By international treaty, nobody owns the open ocean. Hence nobody owns the tuna swimming in the open ocean. On the other hand, if you catch a tuna and pull it up onto your boat, you then have a property right over it and can sell it for money. That is, the only way to economically benefit from a tuna is to kill it. The result is that tuna and many other fish species are hugely overfished, with many near extinction. That’s because each fisherman has the incentive to harvest as many fish as quickly as possible before anyone else. This quickly leads to an extinct species, and fishermen are very aware of the problem. But because of the way that property rights are set up in this case, no individual fisherman can do anything to prevent the calamity. If one guy decides to hold back and take fewer fish in the hope that by doing so the species will survive, someone else just comes in and catches the fish that he spared. The species will go extinct anyway. As a result, nobody has an incentive to hold back. Avoiding the economic tragedy When an economist sees a Tragedy of the Commons situation, his first instinct is to change the property rights system governing the resource in question. Instead of commonly held property rights in which each person has an incentive to take as much of the resource as possible before anyone else does, economists suggest private ownership so there will be an incentive to preserve the resource. Here are a couple of solutions: Area-based property rights: In the case of overfishing, one solution has been to give fishermen private property rights to an entire fishing ground — to all the fish in an area while they’re still alive. That gives the new owners the proper incentive to manage the stock on a sustainable basis. Furthermore, because only one person has the right to fish in a given area, there’s no longer a mad rush between competing fishermen to harvest as many fish as possible before anyone else can get to them. Permits: For fish species that migrate freely between different areas, a different solution has been developed. In such cases, biologists first determine the maximum number of fish that can be sustainably harvested each year. The government then auctions off fishing permits for exactly that amount of fish. This method prevents the Tragedy of the Commons by creating a new sort of property right — the fishing permit. It also has the nice benefit of creating a self-sufficient government program. The money raised from auctioning off the fishing permits can be used to hire game wardens to prevent unlicensed fishing, as well as for conservation and wildlife management programs. Local collective management: Nobel Prize–winner Elinor Ostrom studied instances in which the resource-users in particular areas were able to prevent the Tragedy of the Commons by developing local collective-management systems that restrained overuse. Herders sharing pastures in Africa and farmers sharing irrigation water in Nepal have been able to avoid overexploitation by setting up systems in which outsiders can be excluded from exploiting the resource, insiders can be monitored against overuse, mechanisms exist for punishing those who take more than their allotted shares, and collective-choice arrangements allow most insiders to participate in the decision-making that regulates the system.

Article / Updated 08-14-2018

In some industries, cartels are effective at reducing output and raising prices in the economy. Typically, these are industries where one firm is large enough and powerful enough to truly threaten other firms with bankruptcy. In some cases, the industry will be broken up into even more firms to promote competition in the economy, but in others, regulations may be installed that regulate the prices firms can charge or the quantities they can produce. The specific policy often depends intimately on the circumstances of the firms in the industry and what policymakers think will best promote the general welfare. Breaking up dominant firms in the economy One important strategy for regulating an oligopoly is for the government to break it up into many smaller companies that will then compete with each other. In the 19th century, cartels were called trusts — for example, the Sugar Trust, the Steel Trust, the Railroad Trust, and so on. Therefore, laws that broke up monopolies and cartels were called antitrust laws. The most famous of these in the United States was the Sherman Anti-Trust Act. Most countries have now passed similar legislation to break up monopolies and cartels. In U.S. history, the Standard Oil Company run by John D. Rockefeller during the 19th century dominated an oligopoly industry. It controlled something like 90 percent of the oil sold in the United States, and if a competitor didn’t do what Rockefeller wanted, he would simply bankrupt the other firm by offering oil at a ridiculously low price that the competitor couldn’t match. Rockefeller would lose money temporarily while taking this action, but by bankrupting the competitors who disobeyed him, he was able to convince the remaining firms to help him restrain output and make huge profits. Indeed, because Standard Oil exerted so much control, its industry was much more like a monopoly than an oligopoly. Rockefeller’s effectiveness, however, soon brought a governmental response. Standard Oil was broken up into dozens of smaller, independent oil companies, none of which was large enough and powerful enough to dominate its industry and enforce collusion the way that Standard Oil had. Attempting to apply antitrust laws to economics A big problem with antitrust laws is deciding when to regulate oligopolies or break them up to promote competition. The first sign that there may potentially be a cartel is, of course, when you see only a few firms in an industry. But because of the Prisoner’s Dilemma, in some cases even a two-firm industry won’t be able to form an effective cartel. Consequently, prosecutors typically have to do more than just show that there aren’t many firms in an industry. Typically, there has to be concrete proof of collusion. In other words, if one day every firm in an oligopoly industry decides without coordination to cut its output in half and thereby raise prices, that may not be illegal. But if even a single text message from a manager of one firm to a manager of another firm is found saying that the firms should enter into a cartel, that is illegal and enough for a prosecutor to hang a case on.