Nova workboard

a blog from young economists at Nova SBE


Landowners: Should I invest or should I save now

From the point of view of a landowner, as I am for example, should I invest in October/November in my land so it is prepared for a warm summer? Or should I risk my land and increase the probability of having losses in the summer due to fires? Invest now or save for higher consumption in the future?

My family, as other Portuguese families owns a piece of land in the North of Portugal.  It is a region where only 4 or 5 houses exist, if that much. Most of these houses are from the 19th and XXth century and abandoned. Houses and lands are abandoned because people don’t even know that they own a property, due to lack of information, or if they do know it is very costly/time consuming to maintain such property in shape. The lands may be a source of income, depending on the size, and therefore an incentive to better manage them. The more common option is abandonment, which means no income but also no expenditure. Other possible option is afforestation.

Afforestation can be done by collecting what the property produces and no investment and management are needed. But it can also be done by investing in an intensive management program and therefore the probability of my land surviving to a fire will be higher.

The return on productive land is higher if the withdrawn products have markets with interesting prices and efficiency can come from a better management.

The tricky point here is for me to choose whether I want to take the fire risk, making no management investment today, or investing now to have higher return in the future.

If the risk is high, as it is in most areas with greater forest productive capacity, the option seems to be more rational and manage risk more actively, seeking to adopt management measures to limit the likelihood of fires.

But the risk of fire is not just a function of my management skills, but also management capacity of my neighbors, since most fires do not occur initially within the properties but enter the property from the outside. So either the property is large enough and I can manage the fire with my resources or my investment in management is fairly useless if neighboring properties do not adopt the same management model.

Hence the small owners are conducted for two options: the production of fast-growing products, to increase the probability of collecting production before the next fire, and a softer management program, with less investment but much smaller risk (since there is no investment).

If all responsibly run more intensely their properties, the return was higher, the lower the risk of fire and thereby more efficient production.

But if one does, will tend to push up their costs without the risk decreases and the probability of loss increases significantly.

Solutions might be found in two ways: 1) aggregate economic units in order to have bigger areas so fire can be managed, with higher intensity, in a sustainable way, (this is the pulp companies approach); 2) Find ways to manage fuel in a better cost/ benefit relation, namely prescribed fires or targeted grazing.

Francisca 680

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At the 1st of October, Financial Times released an article: “Surge in Iraq violence raises fears of return to sectarian civil war” by Borzou Daragahi. This news stated that political violence attacks in Iraq have rise this year between the two major denominations of Islam, Shia and Sunni, especially in the past few months, due to conflicts in Iraq’s neighbour, Syria.

As we know, one of the most important and lucrative businesses in Iraq is the oil industry (Iraq is the second biggest OPEC producer, after Saudi Arabia), which suffers a relatively small impact from this kind of violence, mostly because oil industries are located in isolated and well-protected encampments in the middle of Iraq’s southern desert, far away from conflicting towns.

However, these new attacks and political tensions have begun to affect oil production and the respective exportation, which are vital for Iraq’s economy and are becoming increasingly important to global supply.

Regarding this shock on oil production, one of the most important inputs on Iraq’s economy, it is possible to understand how this may affect this country’s whole economy.

Firstly, analysing the impact of the shock on oil producers, through the General Equilibrium model, their overall annual output forecasted for this year will decline. Producers’ problems are to maximize profits and minimize their cost functions. When occurs a militant attack on oil pipelines, which connect Iraq to its neighbours, it is going to affect both production infrastructures and producer’s profits. Iraqian oil producers’ get their production and distribution facilities damaged, causing an increase in the production costs, declining the possibilities of minimizing their production cost function, with extra expenditures. Their profits are also very affected, in a negative way, because this reduces their volumes of production (less output) and consecutively, their exportations begin to reduce as well (less profit). For example, there was an attack in August, on a pipeline from northern Iraq to southern Turkey that reduced by half the export volumes during that month. Overall annual output for 2013 is forecasted to decline, after two years of constant increasing, mostly because of the insurgence of this kind of violence.

Secondly, we can analyse the impact of the increase in political attacks, on a government’s perspective. Considering the General Equilibrium model, this political context of violence affects government expenditures and international trade. Within this scenario, Iraqian government expenditure is heavily fuelled to health expenditure, making impossible not to increase expenditure. Meanwhile, international trade is very affected by the decrease in production, causing an export cut proved by the stagnation of Iraq’s oil exports compared to last year’s levels (Iraq’s current account surplus has decreased from 26365.4 USD Million to 17581.2 USD Million, due to a decrease in exports from 79680.5 USD Million to 46609.0 USD Million). Government could either subsidize oil production or attract international investment to reach past year’s levels of exports.

Finally, let’s see how Iraqian consumers react to these security problems, taking into account the previous model. Consumers’ problem within this model is to maximize their utility, taking into account price levels, income and technology. Inflation rate in Iraq was reporting a decrease in 2013, since January until June (from 3.61 per cent to 1.1 per cent); but in the last 2 months when these violence attacks reappeared in a larger scale, the inflation rate started increasing again reaching 2.5 per cent in August 2013. These may cause some constraints to consumers if their income did not increased with inflation, letting them worse off, because with higher prices and with some income their optimal consumption point will be in a lower level of consumption.

In conclusion, these security problems with political and militant attacks end up affecting Iraq’s economy, reducing domestic production and stagnate its economy while the violence lasts.

 

 

Francisco Delerue

#635


Heavy Taxation felt in France

All Europe is living an unprecedented economic reality, where economic growth is almost a mirage for the majority of countries. Governments are trying to shorten their budget deficits and public high debts, companies are trying to survive, making almost no profits struggling with high taxation, family’s income have been decreasing diminishing their purchasing power…

Let’s take the France example for instance, France government, as much as almost any other in the Eurozone, is struggling to fight his high level of debt through the continuous and aggressive raise in taxes, that in total have been raised by €60bn, about 3 per cent of French national income, since 2011 until now. This tax rise has the purpose of reducing the budget deficit and France’s high debt, however, with the recession felt all over Europe, France’s efforts weren’t sufficient and the deficit remains high, with public debt set to top 95 per cent of next year’s GDP.

Reacting to this entire tax situation lived in France, French business leaders have been clamouring for a relief from the aggressive increase in the tax burden, demanding an aggressive cut in public expenditure (57 per cent o national GDP) and in taxes. They claim to pay more €50bn in taxes and social charges than Germans do. This affects competition within the euro market, as we see French companies will be worse off, because of the higher taxes to paid, disallowing them to have higher profits, that could be channelized to develop the company, develop their products, reach out for international markets.

Regarding families’ income, it also drops with the continuous increase in taxation, making them worse off, now they can consume less with the same amount of income, as they paid more taxes without any compensation. Consumption will decrease affecting companies profits once more.

Even though, French government projections reveal that taxes will continue to rise, the government is aware of how companies and consumers feel about taxation and are presenting new tax proposals: tax smartphones and tablets to fund French culture; introduce a discount for families at the lower end of income tax scale; increase in pension contributions (offset €2bn in new employer pension contributions); introduction of a tax credit on employees; introduction of a 75 per cent marginal rate paid for companies paying salaries above €1m. Additionally, the government started cutting their expenses, rather than being imposing continuously tax raises. If we take a look to French government savings prospects to be included in the 2014 budget, are around €18bn, where €15bn of the total savings will come from government spending cuts. This will serve the government’s intention of reducing its debts, and at the same time alleviate taxation on consumers and companies, increasing both their incomes.

Proposals like these ones reveal a preoccupation on the government side, on trying to relief the French economy, giving support to companies and family households, as well as bearing their costs, in order to increase their welfare.

 

Francisco Delerue


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These days Economists, business leaders and politicians celebrate the renaissance of the theories of Schumpeter and do not tire highlighting the importance of “Entrepreneurship” and “Innovation. But what does it actually take to be an innovative Entrepreneur? One road to success can simply be a profound understanding of the dynamics of consumer preferences.

An excellent example is Catarina Portas, the founder of “A Vida Portuguesa”, a shop concept offering nearly forgotten, traditional Portuguese brands.

During Salazar’s regime the Portuguese domestic markets were largely shielded from outside. But with the end of the regime and the upcoming economic reforms accompanied by the increasing integration of the European markets imported products were flooding the consumer goods market. After centuries of relative monotonousness in the offering the upcoming diversity was highly appreciated by consumers, resulting in a high preference for imported products. The observant reader might picture the preferences for market baskets by the average consumer defined by the share of domestic (x-axis) and imported goods (y-axis) by an indifference curve: When looking at the shape of the curve it can be observed that the consumer is willing to give up considerable amounts of domestic goods for additional imported goods. To put it simple: It seemed that a small tube of back then fancy “Colgate” toothpaste brought the same satisfaction as a XXL tube of “Couto” toothpaste.  Of course, shopkeepers and international retail chains recognized the high demand for imported goods, moreover, they were enhancing the trend and by the end of the 90ies century traditional Portuguese brands were almost entirely vanished from the ordinary retailer’s storage racks.

Though, while conducting research for a book on 20th century domestic life Catarina Portas found out about several Portuguese brands still using their traditional logos and design. Hence, she discovered a customer segment possessing of indifference curves contradicting the one’s of the mainstream market. However, retail chains didn’t provide these goods, which left the manufactures struggling to survive and the consumers struggling to purchase them. As a consequence, in 2007 Catarina Portas created a store concept exclusively responding to this segment. The first shop located in Lisbon was named “A vida portuguesa” and became a huge success, and was soon followed by more shops pursuing a similar concept of selling Portuguese brands such as “Renova” toilet paper (9,90 €) or “Claus Porto” Lavender Soap (8,90 €).

One could assume that the nostalgic trend must have declined as the upcoming crisis caused increasing budget constraints and that these rather expensive goods inherited a high income elasticity in demand. However, it did not decline. Sales kept on growing steadily as more and more people showed interested into specifically buying products from Portuguese manufacturers. In 2009 “A vida portuguesa” opened a second shop as well as an online shop. Hand in hand with the increasing arising of nostalgic shops more and more products explicitly marked by signs “made in Portugal” appeared also in supermarkets attracting not just a specific segment of Portuguese suffering “saudades” for past times but also the average customer. Following that, it is to say that consumer’s indifference curves regarding domestic vs. foreign goods have changed while managers didn’t recognize.

There is no doubt that the crisis has had some influence in the changes of preference additionally politic and industry associations [1] are making use of this to strengthen the domestic industry, however, there is surely nothing bad about this development.

Hans Kaufmann


[1] E.g. the campaign “COMPRO o que é nosso”  conducted by the Câmara de Comércio e Indústria


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In the New England of the 19th century ice was a luxury good exclusively targeting the upper class able to afford its own ice houses. Enjoying a drink cooled by natural ice harvested from the lakes of New England, Frederic Tudor was feeling pity for the colonists in the West Indies unable to enjoy the same amenity. To make up for that, in 1806 he shipped tons of Ice to the Caribbean (of course, he was accused of being mad), and made the expensive experience that the supply was not meeting any demand. Tudor first had to create the demand by changing consumer preferences from warm to cold drinks (see fig. 1). He did such a good job in doing so during the next two decades that by 1833 he was not just supplying all parts of America with ice, shifting it from being a luxury good to a normal good, but that he was even shipping ice to Calcutta, India. However, with this move competition had entered the marketplace causing decreasing profits for Tudor. In order to keep his monopolistic advantages he made use of his market power– in highly competitive regions he simply dropped the price that low that competition was forced to leave the marketplace – they knew that he could balance out losses with his other operations (he already seemed to have a great understanding of what later got to be formalized as a strategy derived from game theory, see fig. 2). As if that was not enough, Tudor recognized that ice could not just be used to run stationary ice houses but that mobile ice houses could be used for transportation. As a result, he used the ice he was not able to sell in the West Indies to cool down fruits on the way back, which he then sold in New England. Thus, he found out about the interdependence of markets as shortly after the meat, fish, fruit and even the beer market (as now ice allowed to produce lager beer all year long, not just in the winter) experienced remarkable growth as prices were decreasing caused by the improvement of transportation and storage methods (see fig. 3). California was enjoying the gold rush, and Rockefeller was about to discover oil in the Mid-East. But for now, ice from New England was the biggest export industry of the US. However, the global demand for New England’s “frozen water” was increasing too fast; supply was not able to keep up. To do so, production processes and sources were to be improved, some amendments were more, others less successful (horse-pulled ice cutters proved to be efficient, harvesting from passing icebergs did not, neither was it reliable). Additionally, to improve transportation and durability of the ice  (one should note the long sea routes to Calcutta, Rio de Janeiro, Hong Kong or Sidney) other methods attracted attention such as making use of mechanical equipment to lower temperatures. Furthermore, some innovative thinkers were even experimenting with producing “artificial” ice (of course, they were accused of being mad). Indeed, by the end of the 19th CE technological innovations increased efficiency, facilitating to produce artificial ice at competitive prices. Thus, one could assume that the established producers from the north were quickly adapting the new method – but they did not. Instead, they waged a war of technologies by focusing on the improvement of their old-fashioned methods.  However, the new technology proved to be a disruptive technology (see fig.4), and by the mid of the 19th CE not a single natural ice company was still in the market, not even the Tudor Ice Company [1] (Frederic Tudor, who forever will be known as the “Ice King”, might have recognized the new opportunity, but unfortunately he had already died in 1864 as a mad, but rich man).

Hans Kaufmann


[1] Remark: The observant reader might recognize similarities to Apple’s Iphone/Smart Phone being a disruptive technology pushing former market leaders nearly to bankruptcy, since for instance Nokia didn’t believe in the new technologies. However, Philips or Siemens lighting branches, for instance, did understand the concept of disruptive technologies by heavily investing in F&E activities regarding LED or OLED technology, now starting to benefit from these wise investments.


The Time Traveller’s Choice; Or: How I learned to stop worrying and love the Portuguese Government Swaps

One of the hot-topics of the past few months has been the discovery of a set of damaging   contracts involving the Portuguese State Swaps. These swaps were created with the goal of hedging against a continual rise of the Euribor. As evidenced by the chart, the rise in the interbank market was quickly quenched due to the actions of the ECB to reanimate lending in the European Economy.

Euribor

As the Euribor reached new lows the costs associated with the swaps continued to rise and eventually led to the public scandal. The government is now trying to reverse these contracts. To achieve this they are expending resources now, be it money with lawyers, reputational costs, among many others, so they can reduce the current losses. In the interest of this article I wanted to create a very simple general deduction regarding what would be a good trade-off between these costs and the gain in interest.

This general problem likens a situation where a theoretical time traveller would pay a cost (T) in order to return to the past and exploit the interest rates with his new found knowledge. Returning afterwards to the future and finding that his investment choices out-performed the market. I reinstate that this is a very simplified deduction, but it may provide some small insight into the choices by the government.

Euribor

This is a typical budget restriction for a two-period model. To model the so called time travel we must include an additional cost (T) at the second period that will allow the consumer to go back in time and improve their interest rates by (1+phi). We only know that when T=0; phi=0.

1

This implies that by going back in time, at cost T, the consumer will obtain an additional (1+phi) from their savings.

3

This implies that the maximum price a consumer would be willing to pay for time travel is the savings interest with the increased knowledge plus the available resources in the first period minus the consumption in the second period. If equality in (3) is verified (commonly through welfare maximizing agents), then:

4

This means that an increase in f allows the consumer to pay an additional f times the savings in the first period. The value of time travel then increases with savings and decreases if consumers prefer goods in the first period. It is important to also take into account that the existence of this mechanism may allow for extraordinary consumption in future periods. For this analysis it would be necessary to include assumptions regarding the utility function of agents.

What can this tell us about the Swaps? Knowing that the losses the government stands to sustain without any prior agreement are of about €2.000M, with current discussions of a payment of €500M. If the government was working in equilibrium we would understand that these agreements probably give an additional €1.500 M in value to the counterparties, be it in lessening the risk of default or in assuring future contracts between both parties. Another example of a time-travel dynamic is when the stock market cancels orders or effectively reverses it. This cost of time travel is essentially the cost of obtaining privileged information. By obtaining information ahead of the market it is possible to increase future earnings through additional savings and as such it may be possible to improve the agent’s welfare.

– Manuel Costa Reis, 614


FDIs – Simply refreshing!

 

 “Living under a dictatorship, with limited choice of products, makes you hate copies and love authenticity.”[1]

 

As a feature of globalization, increasing international foreign direct investments (FDI) during the last two decades have to be mentioned. Especially the impact of FDI on labor markets has been of growing concern. The micro-economic effects on employment are largely determined by the motivations underlying the decision of the firms to invest abroad. Coca Cola is one of the most famous internationally oriented companies and for years there were only three countries in the world that didn’t officially sell the drink: Cuba, North Korea and Myanmar. After US- and EU-sanctions regarding the former military regime were lifted in 2012, Coca Cola is back in the country after more than 60 years by opening a plant close to Yangon. Unlike to the rest of the world, Coca Cola has the extent of fame like a fairytale or legend in Myanmar because most locals never had a zip and missed the worldwide advertising just as these cute polar bears. In general, people seem to remember the brand because cans were smuggled from Thailand and Singapore during the sanctions to be sold at a hefty mark-up in hotels and posh cafes. Because of the impression that Coke was an elite product, this brand recognition created a big challenge regarding market penetration. As a reaction Coca Cola went back to the roots and promotes the drink by using the slogan from a 1800s advertising campaign – Simply refreshing! During the next five years the concern is planning to invest US$ 200 million in the country, which will create 22,000 jobs across the Coca-Cola value chain.[2] Myanmar is described as unique in terms of a country being isolated for many decades and opening up, trying to make changes very fast. Just as shown in this example, many companies are going to follow with expected FDIs of $100 billion during the next two decades.[3] By adapting this example to the labor market, FDI may constitute a plausible explanation for impacts regarding job opportunities, increasing earning and wage dispersion as well as the use of skilled labour caused of technology spillovers, occurred from foreign to domestic firms. In order to ensure the increasing welfare, the Government of Myanmar released the “Foreign Investment Law” in November 2012 to guarantee the integration of local labour force into the transition process. It is required, that foreign companies in the high-tech sector hire local employees with relevant skills in increasing percentages over time. Locals must make up at least 25% of the workforce in the first two years, 50% in the next two years and 75% in the third two-year period. Furthermore, the foreign companies need to provide trainings for locals[4] and ensure knowledge spillovers by doing so. By releasing this policy, the government is trying to counteract against abuse of cheap labor forces and supports a sustainable growth in knowledge through workshops.

 

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Yearly Approved Amount of Foreign Investment [1]

 
Svenja Telle #656


When Microeconomic undertakes attempt to find ones feet after 5 decades of dictatorship.

Since you mention the country Myanmar, there is a lack of knowledge for most of the people as it was a dictatorship for the last 5 decades and mostly isolated from the rest of the world just like North Korea. With it’s population of almost 60 Mio., it represents the biggest country in the South-East-Asian region and provides plenty of opportunities regarding investment and development. During the legislative period of brutal military rule from 1962 until 2011, free market economy was unthinkable just as foreign trade, caused by economic sanctions on part of the US and EU. SIM-card prices give an example for a particularly serious form of restriction, which prevented technical progress in the Least Developed Country (LDC). When democratization and, as an effect, transformation started in the year 2011, prices decreased from 1500$ (2010) to 1.60$ in 2013,[1] which is a degression of 99,98%. After the decline in price, they became more affordable in terms of the average GDP per capita of 835,00$ in 2012 (528,27$ in 2010).[2] Even demand actually existed in the past, Myanmar’s mobile-phone penetration rate of 9% is among the lowest in the world.[3] For the future it can be assumed that the drop in SIM prices certainly opens the way for increasing consumption.

 

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Figure 1: Typical prices of SIM card in Myanmar during 1998 and 2014.[4]

 

To counter booming demand, the new government was arranging a lottery to distribute only 650.000 SIM-cards[5] at the new price. One reason is the poor radio technology infrastructure in the country, which has only 1.500 transmission towers (e.g. Thailand: 20.000). Until 2015 the mobile-phone penetration rate is expected to expand up to 80%, which demonstrates the effect of governmental price regulation policies regarding consumption, while existing demand in a pure monopoly. During the last years, the government was the only single seller, which is the polar opposite of perfect competition.

        

To approach the case from a microeconomic point of view it’s necessary to suppose that SIM cards represent “discrete goods” which means, that they naturally come in discrete units and if the price is very high, it is preferred not to consume. If the price is low enough, it’s strictly preferred to consume only one unit of SIM cards. Furthermore it might be assumed that at some price (reservation price), consumers are indifferent between consuming the good or not and as the price decreases further, more units of the discrete good are going to be demanded to maximize the utility. On the basis of presumptions of logic, the reservation price measures the incensement in utility, which is necessary to cause the consumer to choose an additional unit of the good. Regarding usually assumed convex preferences, sequences of reservation prices should decrease, but the amount of consumption in good 2 is not relevant for the reservation price in view of a given quasilinear utility function. Furthermore the three properties of the preference–indifference relation don’t take place in this case because it has to be ensured that every bundle belongs to at least one indifference set and consequently, the reflexivity principle may not be invoked. In conclusion it can be said that the consumers are better off, because consuming SIM-cards became much more affordable and as the increasing demand reveals, the reservation price of many consumers was achieved.

 

Svenja Telle # 656


In-kind Transfers and Consumer Behavior

It is a known result in microeconomics that, when it comes to social welfare provision, cash transfers are preferable and more efficient than in-kind transfers. That is, it is preferable to provide low-income agents with cash subsidies and let them conduct their own choices according to their preferences than to distort the consumption patterns with in-kind subsidies, like food stamps, which restrict the consumers’ choices. This is easily derived from the basic economics of the consumer’s problem: agents are assumed to act rationally and to maximize their utility by choosing the bundle which suits them best given their budget constraint, so a deviation from the chosen consumption point may imply either a loss in efficiency or a loss in welfare.

However, some reasons why transfers are mostly provided in-kind are not hard to understand.  Welfare providers may take on this measure as a paternalistic way to ensure welfare money is spent in what is perceived to be essential for the well-being of the recipients. So, for instance, one of the reasons for the existence of food stamps is to ensure recipients allocate at least that specific part of their transfers in foodstuffs, thus attempting to distance agents from behaviors that may overlook what is best for them in favor of more attractive alternatives.

But do the food stamps completely solve the problem? Truth is that, as empirical evidence shows, welfare recipients spend a significant percentage of their food-stamp transfers in more expensive brands, rather than choosing generic, cheaper food products which would yield a higher caloric intake and would allow them to purchase more in quantity. So again, even though agents are being led in the right path, there is still room for improvement in terms of their choices, as there is a perceived loss in welfare – beneficiaries could consume more each period by resorting to cheaper products, but are choosing brands over quantity.

The problem now is what can be done get around these choices. Consumers are expected to make choices which maximize their welfare at the lowest cost, but seem to take a different road. Instead composing a bundle which allows them to attain the lowest possible cost, the low-income recipients choose to include expensive brands in their bundle, either out of taste or status. But consumers already have their choices restrained by the in-kind subsidy – should the providers restrain them even more, say, by making food-stamps exclusive to some cheaper brands?

There is no clear answer to this issue. While it may be advocated that recipients should be somehow taught to choose appropriately given their constraints, it can be also claimed that deviating agents from their previous bundle is immoral and implies a welfare loss, as they already choose optimally. The decision will then be left at the discretion of the policy makers, on whether they merely wish to provide cash transfers and allow agents to choose freely or to drive consumption to a certain desired path. 

 

#636


Driving Speed as an Externality

 

We often notice how many drivers tend to disrespect speed limits, while the existence of these limits means the State wants drivers to abide by them. This disparity can be seen as an externality, which arises when actions taken by one agent affect the welfare of others, without this being reflected in the decision of the former.

In general, drivers face a trade-off between safety and speed. Since the same increase in speed is more significant the lower the speed level, marginal private benefit (MPB) of speed is decreasing. Regarding marginal and social private costs (MPC and MSC), we can consider a positive slope. This can be justified by the fact that increasing speed not only increases the likelihood of an accident to happen, but it also increases the severeness of such an accident, in the event that it happens.

 

 

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The socially optimum level of speed is S*, where MPB = MSC. However, if there is no mechanism to correct the externality, the driver will choose S1, where MPB = MPC. Since S1 is different from S*, there is space for intervention. The goal here will be to make it more costly for drivers to overspeed. Ideally, the State should try to increase the MSC by the amount necessary to make it equal to the MPB at the socially optimal level of speed. Graphically, this means an increase in the MPC curve slope. There are several ways to achieve this, and they may be complementary to each other. Two of the most relevant will be explained.

First, by imposing a speed limit that reflects the socially optimal level, and imposing fines to those that do not respect this limit, the State can significantly increase the MPC for users that exceed the limit and, with this, deter them from doing so. For this to be effective, the value of the fine, adjusted to the probability that drivers expect to be caught in an infraction, has to be high enough so that it exceeds the marginal benefit of exceeding the limit. In general, the effectiveness of this method will increase with the fine value and with the number of speed controls. Since what matters is how drivers perceive the frequency of controls to be, it makes sense that law enforcement authorities tend to advertise increases in controls. (example here, in Portuguese).

Another way to reduce speeding is caused by incentives that insurance companies have to make their clients drive safer. An insurance contract opens way to moral hazard, i.e., since the insurance company cannot directly observe the actions from the driver, he has an incentive for being less careful than he would otherwise. The role of insurance companies in reducing excessive speeding is through the design of contracts aimed at reducing this moral hazard. Everything else constant, insurance companies will want drivers to reduce the risk they take. While their goal is not necessarily to bring drivers to the socially optimum level, they want to increase driver’s perception of the MPC, so their actions will result on a reduction of driving speed.

To sum up, if we think of speeding as a negative externality, actions should be taken to make its value closer to the socially optimal. While there are different ways to do this, all of them can be translated as an increase in the MPC of speeding, so the goal is for consumers to internalize the externality in their decision making process.

 

João Araújo no. 638

 

 


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Of Poetry, Fallacies and Micro-foundations

Often one sees communities or organizations being treated as individuals in many scopes of economic analysis. It is like this mostly in macroeconomic analyses (such as those of international trade or intertemporal consumption) but also at the micro level (for instance, in the study of intergovernmental grants); this post focuses on the former.

Such treatment can be inserted in the appeal for the macroeconomic models to have micro-foundations (as it was first advocated by Chicago scholars to criticize the at-the-time dominant Keynesian model), which should include mainly the features of optimizing behavior that characterizes the actions of rational agents. In my opinion, while such approach can sometimes yield important insights, it has gained exaggerated dimensions when it started to be used carelessly in public interventions by leading economists. The most well-known example are the shouts of moral hazard that arise each time one speaks about a sovereign bail-out.

Many prominent authors have studied the extent to which one can frame communities as individuals. The most seminal example is the one by Kenneth Arrow who, in his Impossibility Theorem, proved that dictatorship is the only social decision mechanism capable of presenting the three following properties: i) complete, reflexive and transitive preferences; ii) ability to translate a unanimous ranking of two alternatives correctly; iii) immunity to rank-order voting. Provided we take democracy as being here to stay (i.e., that we don’t allow all social rankings to be those of a single individual), there is no perfect way to aggregate individual preferences into one absolute social preference.

A contrasting result is the median-voter theorem, which states that community preferences can be represented by those of the median voter. However, this is contingent on single-dimensional decisions and on the assumption that voters always prefer alternatives closer to their most preferred outcome. If this is not the case, and most notably if people are called to decide on “bundles” of issues simultaneously, the outcome of a sequential voting process will depend on the order by which proposals are voted. This is the Condorcet Paradox and goes back to the third – and less essential – property of social preferences abovementioned.

“Democracy”, as Winston Churchill once put it, “is the worst form of government, except for everything else that has been tried.” The intransitivity of the process of aggregation of individuals’ (transitive) preferences is just one of its major drawbacks. Ironically enough, in the overwhelming majority of the times people are called to decide upon something, it is precisely a multidimensional choice, as between electoral programs. Voters, even if “microeconomically rational”, are (at least for now) unavoidably vulnerable to whoever has the power to set the political agenda. One field of Microeconomics, Industrial Organization, has a say on this: voters face very large search costs upon deciding their vote and may lead politicians to charge the “monopoly price” (i.e., governing in the most inefficient way), as Peter Diamond once predicted.

If one adds to this the obvious incapability that the standard citizen has to supervise his/her rulers (and here we have, in fact, hidden action) and very often even to assess their potential as political leaders from electoral campaigns (both because of hidden knowledge and of pure demagogy by the candidates), there are more than enough reasons why one shouldn’t apply microeconomic concepts at the macro level so laxly. Again, Industrial Organization has an answer: Harold Hotelling, in his seminal paper on product differentiation, actually discussed political differentiation to conclude the same as with firms: the optimal decision by politicians is to be as similar as possible. Later, when d’Aspremont showed that if firms were too close, they would always try to undercut each other and this would make an equilibrium impossible, he also provided a fascinating metaphor to what we see in politics each and every day.

Micro-foundations have done a lot for macroeconomics since they first were requested. Nevertheless, and like it can happen with any powerful toolset, it has also been used, notably over this sovereign debt crisis, to support fallacies in the political debate and to employ nice-looking metaphors with medical treatments and patients or with teachers and good and bad students. Eloquence should be promoted without lyrics. An economy is not just the sum of its markets, much like a country is not just the sum of its politics.

(I’m running out of words to discuss the topic, although I would still like to discuss whether elections are an aggregation of preferences or a delegation of decisions. I will outsource this to this guy, who suggests that democracy is too much of a burden for many electors who would rather just delegate the decision power to someone else).

João Garcia, #618

 

Sources: Lee S. Friedman, “The Microeconomics of Public Policy Analysis”

Hal Varian, “Intermediate Microeconomics”


Provision of Democracy

Since the 15th of September, the day the international community celebrates the International Day of Democracy, that my mind has been bothered with two questions. First, is Democracy a Public Good? And second, why is there so much pressure of the international community on governments to provide Democracy?

Just to be clear on what I am mean when I say Democracy, I am referring to article 21(3) of the Universal Declaration of Human Rights, “The will of the people shall be the basis of the authority of government; this will shall be expressed in periodic and genuine elections which shall be by universal and equal suffrage and shall be held by secret vote or by equivalent free voting procedures.” So the good provided is the will of the people through an elected governmentyou can argue that this is not Democracy, but that would be a completely different discussion.

A quick look into what is a Public Good tells me that a pure public good is a good that is non-excludable, meaning that if the good is supplied no consumer can be excluded from consuming it, and non-rival, which means that the consumption of the good by one consumer does not reduce the quantity available for consumption of this same good by other individuals.

Now, the question arises: Is Democracy a Public Good? No, or at least I don’t think it fits the definition that was just mentioned above. To state that the good is excludable, I would like to bring to attention that not everyones’ will is being taken into consideration. After participation in the voting, you either get your will in the government or you don’t, and that means that the authority vested in the government, excludes some members from having their own will putted in to place by government officials. To contest that Democracy is a non rival good, I identify the non existence of infinite liberty for individual will in the world, which means that someone is not going to get what he/she wants because there is a reduction in the quantity of will liberty available.

Keeping this in mind, my question is: why is there so much international pressure on getting governments to provide democracy? Why are we telling the institution responsible for the provision of public goods to provide something that is arguably a public good? Why is there no creation of an organism or company (or several companies) that invest in creating democracy? We have the tendency of putting the government correcting the flaws that exist in the market. Why don’t we start thinking the other way around? Let’s have people demand democracy from societies and wait to see if there is a market solution that betters provides will for the people.

Matilde Grácio, #84


The Savings of Child Workers

Bangladesh currently has around 55 million children and about 7 million of those have a need to work. Most of these children face a problem of how to safeguard their income. Bangladeshi laws do not allow for children under 18 to create a bank account. As such, many face difficulties in keeping their earnings safe from robbers, overspending and parents.

This issue brought a need into this sub-sector of the economy, the creation of a mechanism of protecting their early income. NGOs rallied to this call and started creating small savings banks accepting deposits from children. This way children were able to improve their saving capabilities and the success that these NGOs are having reveal the underlying need.

Imaging that the present time and the future are two markets where children consume goods and leisure. Work is remunerated and as such enables more consumption and savings in the present. In this model it is possible to save capital from one period to another but it is subject to a very high depreciation rate, i.e. saved money is eroded by inflation, robberies, among other things. This savings banks introduces a reduction in this depreciation rate greatly increasing the incentive to save. However this will also incentivize increasing labor in order to save more leading to more child labor. As such future income will be increased due to savings and with this these children can lead better lives in the future and possibly avoid future child workers.

This solution is less than optimal. The real interest rate on these deposits is still negative as inflation destroys the purchasing power of deposits. Next steps on this endeavor must be the introduction of interest in deposits. This way young savers can fully enjoy the compounding of interest and as such obtain a much better chance at financing future consumption or higher end investments, thus improving class mobility.

Child labor in of itself is a difficult subject matter to discuss but this case brings the question of whether or not institutions should accommodate for it in case of its prevalence. There is a difficult balance to strike between incentivizing labor at a young age and promoting the accumulation of human capital by society.

As is discussed by Baland and Robinson, among other papers, child labor is inefficient if the income received is less than the future earnings obtained from education. This paper does not exactly replicate conditions of the situation in Bangladesh but it does give a good approximation whilst considering the possibility of no savings mechanism in which child labor will most likely occur and be inefficient as it represents a less efficient borrowing mechanism that trades income today for less income tomorrow. The situation even appears to be Pareto inefficient but that could be attributed to other factors such as not including the wage reduction for high-skilled workers in a second period. What this means for this particular case is that by introducing a financial system, even if limited in scope, income in the future can be higher either through savings or through higher accumulation of human capital if the children end up studying more.

– Manuel Costa Reis, 614

Bibliography
Judah, Sam. “Making Time: Helping child workers save their earnings”. BBC World.
27th of September 2013. http://www.bbc.co.uk/news/magazine-24281511
Baland, Jean-Marie & James A. Robinson. “Is Child Labor Inefficient?” Journal of Political Economy, Vol. 108, No. 4, August 2000. University of Chicago Press


The public good and the city

During these past weeks, I read an article on Destak that stated that Maia (a Portuguese conselho) is an island because it is surrounded by tolled motorways. Although the point of the article was lost between the lines, it made me think of the influence that tolled motorways have on the level of attractiveness of a city.

The demand for cities is something that it is influenced by many factors. The amount of services, housing, leisure activities, commerce, and many others. Cities tend to specialize themselves in what they belief they can offer best. There is, nevertheless, one decision that is made at the central level and that unbalances the supply effort of the cities: price of tolls, and the location of tolls.

The case of Maia is not unique. South Hampton roads, in the US, the Oslo Toll Ring, in Norway also have a cluster of tolls that is equivalent of paying a fee to enter the city. This means that when making the decision of going to a city, people have to include the price of the tolls. Thinking in a very simple consumer behavior maximizing utility problem, this translates into an extra variable that increases the price of going or leaving one city, which means that an increase in the budget is necessary in order to attain the same utility level of that same city without the toll.

It seems only unfair that cities have an exogenous source of variation of their level of attractiveness. The provision of the good, road (that has to be payed with the tax, toll) should not set apart cities by influencing the i) price of commuting to and from the city, ii) the level of congestion of one city, iii) the value of living inside that city, iv) the amount of pollution of that city or area. The policy that would equalize this difference would be by having the same number of tolls and same price for each city that exists in a determined country. By this manner we would not create an exogenous source that sets apart cities.

Nevertheless, this seems counter intuitive to current pratical purposes of having a toll in the road, which are deviating traffic from a specific area or lowering levels of pollution. Still, the level of traffic or the level of pollution is a representation of the effort of the city supply. Moreover, there are other ways of charging for pollution and congestion with fees that don’t have to be located in an area that targets a specific city. You can simply pay your right to create pollution and congestion.

As the theoretical justifications for the toll payment are to repay the expenses incurred with the construction of the road, their maintenance, the construction of more roads, this tax could be payed as a centralized tax, like many others. Not differentiating the specific road and access to one city and not creating a distortion on the effort that the city makes to become attractive to the citizens.

Matilde Grácio, #84


Democratic Game

Revealed Preferences & Distortions on Public Choice

Voting is the most sensible expression of social will. It enables people to decide and reveal preferences about politicians’ acts, policies’ effects and different levels of public intervention. This post pretends to link some crucial concepts that we study in Microeconomics course, explain why sometimes democracy gives unexpected results and how important are the assumptions of revealed and well-behaved preferences.

Combining equity problems, behavioural distortions and market failures, the Public Choice analysis is one of the most challenging economic exercises which considers an interaction of three different levels:

  • Individuals who have preferences and want to maximize their welfare through public and private consumption (considering a budget constraint in which taxes are included as the indirect counterpart from public provision).
  • The Social Institutions that want to maximize Social Welfare and find an equilibrium, which can be different from the individual optimal solution.
  • Politicians, more benevolent or more selfish, who want to be infinitely re-elected by pleasing their voters (who can punish politicians if they deviate).

Although each politician has its own ideology and ethical belief, economists have tried to find a way to explain people’s desires and performances in the electoral game The rules are simple: citizens have different needs and they are willing to pay for welfare. However, payers and beneficiaries are seldom the same, moreover, free riders and externalities insist on stiffening our problem, which may lead to under-provision.

The most difficult analysis is to reveal preferences and to aggregate them in order to define the most important function, which tells us what people need and how they value it. In the real world, it is completely impossible to design a beautiful utility function or continuous indifference curves, linking bundles with the same value for citizens. Therefore, governments may ask voters to define their preferences (and the easiest way to do so is) by ranking bundles or options with the help of public surveys or referendums. Actually, politicians have the incentive to reveal citizen’s preferences in order to prepare persuasive speeches and move themselves to a good place in the Downs Avenue.

Nevertheless, even if we could solve all these problems and know exactly the marginal value of public provision for all individuals, democracy would still have distortions sorting out electoral choices and ‘right choices’. Therefore, it is relevant to present the most famous Electoral Paradoxes and their contradictory results:

Condorcet’s Paradox, the most popular of all, presents a situation in which a majority election over pairs of alternatives may have no clear winner. Suppose that A, B and C are possible choices and each voter orders his preferences as the following:

Captura de ecrã 2013-10-19, às 06.23.58

After beating the first winner (A), C becomes the final winner. However, would this result be the same if the fist election opposed A and C? No, because C would be the first winner and would lose against B (1+2 vs 3). In the Condorcet’s Election, the Voting Agenda determines the result (the winner is always the last voted choice).

Ostragorki’s Paradox involves the role of political parties as mediators of Public Choice. Supposing two parties (X and Y) and each individual voting for the party whose position is closest to his own:

Captura de ecrã 2013-10-19, às 06.24.06

Issue-by-issue, party X would win on every subject. However, if people choose parties to represent them, a majority of voters will elect party Y. This paradox presents one of the failures of the representativeness of parties.

The Additional Support Paradox considers strategic voting (of 21 voters) in a majority runoff election (the winner must have 11 votes, otherwise there is a second round between the two most voted).

Captura de ecrã 2013-10-19, às 06.24.14

In the first election, there is no absolute majority. Then, a runoff is held between choices B and C. It is easy to conclude that the winner is B (13 – 8).

Now, imagine that B receives the additional support from three ‘C-voters’. Still, we have no majority and the runoff will oppose choices A and B. Now, the final winner is A (11 – 10), despite of the additional support B has received.

When we think about Democracy, we will find many imperfections such as preference revelation problems, free-riding effects, electoral paradoxes, imperfect information problems, crowd psychological effects and general lack of trust on politicians. However, more than failures, these are challenges to solve with perseverance and always keeping in mind Winston Churchill’s words:

“Democracy is the worst form of government, except for all those other forms that have been tried from time to time.”

Dino Alves  # 607