Thursday, June 02, 2005

Introductory econ lecture #6-7 

(I was going to put #6 up last night but I was proofreading a report until 10:45 and then graded homework; I was ready to surrender to Morpheus at 12:45 only to find Littlest in my place in bed after consuming too much of a ghost story. So I started this and then fell asleep. It looked a lot worse when I opened it up this afternoon.)

We got off on many tangents today, as students seemed interested in playing with the new toys of supply and demand, and understanding how incentives motivate behavior and from whence incentives come. Some of the lessons I've done on this blog in the past, like the minimum wage or higher education, came into play. But much time was devoted to this question from the textbook:

Federal law currently prohibits the sale of human organs for transplant purposes. At the present time, people are dying while waiting for suitable organs to become available. It seems almost certain that more organs would become available if financial incentives were offered to prospective donors. Would you be in favor of allowing this? What consequences would you predict?
I had no idea things would careen so far out of control. Students somewhat reasonably expected I favored selling organ transplants. I think a majority of economists do not, though Alex Tabarrok argues in favor of providing financial incentives. (See also this post.) That's not to say the current system is perfect. William Anderson and Andy Barnett argue that while you can hold the price of the organ itself to zero, you can't hold the cost of the transplant there: Hospitals and organ provider organizations can simply raise their prices to capture the value added of the donated organs. A shortage of organs also limits the number of hospitals providing transplant services, they say, though the limiting factor there might be the AMA. Students worried that it provided an incentive for organ theft. That's a fine argument, I countered, but then you'd have to be consistent and say making heroin and cocaine illegal also encourages theft.

The point of the story, however, is that exchange is supposed to be a cooperative activity. You favor markets because they allow those with the best information about the value of the particular trade to these particular particiapnts to agree to terms of trade. In class I referred to this as part of the question of "informed consent". If a seven-year-old catches Manny Ramirez' 74th homerun in October (a guy can dream, can't he?) and someone offer the seven-year-old candy for every day for the next two years in return for the ball, would you honor the trade if the kid agrees? I doubt it; the kid doesn't know what the value is and doesn't have the capacity to provide informed consent. It is likewise difficult to imagine that two families, one with a member in need of a transplant and the other grieving the loss of one of its members, can provide consent. Informed consent of course has legal meaning in contracts; I'm not talking about that. What I am asking is whether those people in that situation can engage in rational economic calculations? It's a hard question, made no easier by the fact that because we are not encouraging more use of cadaveric organs we are putting live donors at risk for kidneys and parts of livers. (There isn't much question that paying for organs would increase their supply. People respond to incentives.) In the end I find myself saying 'no' still.

I spent the latter part of class talking about economic versus accounting costs. Two simple rules apply:
  1. The only costs that are relevant for economic decisionmaking are future costs.
  2. Future costs include the value of the next-best opportunity foregone in taking the action.
Accountants will count up revenue and explicit costs and ignore implicit costs. That's not wrong, but there are many times where a business owner does something with his or her property that is decided by something more than what the accountant presents as profit or loss. The text and I agree that the function of profits is to induce people to work under conditions of uncertainty. Profits that are a sure thing dissappear when others learn about them. (You don't have to be French to understand that about entrepreneurs.)

Entrepreneurs are residual claimants: The private enterprise system allows the owners of the other factors of production -- land, labor and capital -- to transfer risk of production to someone willing to accept it in return for the claim on anything earned by the enterprise after rent, wages and interest are paid. This has the wonderful benefit that entrepreneurs who use resources well are encouraged to expand, but those that do not are punished with losses. One lesson my students learn: Whenever you hear someone with antipathy to markets call it "the profit system," say in return "I don't support the profit system; I support the profit and loss system." Efficienct resource allocation requires both. This is probably the key reason you hear economists who are supposed to be "right wing wingnuts" vehemently oppose corporate welfare. It often comes as a shock to liberal non-economists.

What does market power mean? For one thing, a cool blog. But importantly, it's a matter of degree and not quality. We all have some amount of it, some of us much more than others. We get market power by persuading others that there are no good substitutes for what we are selling. Everyone can be persuasive at some point in time to some degree. The more persuasive we are, the less elastic is the demand for that which we are selling, and the more market power we hold.

We talked about so as to discuss price searching. Price searching is what those with market power do: they seek a price that allows them to maximize their net benefits. Those who want to see the analytics of this process can look here. We spent a good deal of time talking about the behavior of price sellers, such as differentiating profit margins on different goods they sell (grocers putting the advertised beer in the back of the store; camera retailers selling cameras at cost but marking up accessories 100%.) We talked as well about how many businesspeople will tell you their "markup rule" for pricing goods; economics would say that businessowners do not use simple markup rules.

We left on this thought: These models are simply that, models. You won't walk into a mom-and-pop grocery store, or Coca-Cola, or any other firm and find someone drawing the demand curve on a boardroom easel pad. Therefore we do not believe that someone actually calculates MB=MC at any point in time. But the models point out some realities, such as the fact that price searchers -- even those with lots of market power -- face a demand curve, and thereby a marginal benefit curve. They are limited by consumers' preferences and their own ability to persuade.