The Problem with the War on Drugs

There was once a time when Americans were concerned about issues other than the global economic meltdown and journal reported on sex, violence, wars, and drugs. It's the latter that I will touch upon today.

Basic economics classes, and even advanced, teach that a market looks like the diagram below with supply and demand having relatively similar slopes.
In this graph, when supply is shifted to the left (supply decreases), quantity will decrease and price will increase by roughly the same amount. Likewise, when demand is shifted left (demand decreases), both quantity and price decrease by roughly the same amount.

The graph below is what the market for illegal drugs looks like. It has a highly elastic supply curve and a highly inelastic demand curve. The demand curve is steep because of the high incidence of drug addiction which makes drug users relatively unresponsive to changes in drug prices.
In this graph, when supply or demand is decreased, price and quantity will change asymmetrically. This is essentially the problem of the war on drugs.

We must first identify the objective of the war on drugs, which I believe to be decreasing drug consumption in the US (rather than simply increasing the price of drugs). The US has chosen to accomplish this by attacking the supply of drugs. Money is spent checking for drugs smuggled in through ports and the borders, and helping fight drug wars in Mexico. The US government seems set on curtailing the supply of drugs in the US with the intended result of reducing consumption. Unfortunately, the market doesn't allow for such policies to work.

Take the market for drugs shown above. As the US tries to reduce supply, the supply curve will shift left and we will get the resulting graph. Notice that the blue-shaded area is much larger than the brown-shaded area. When you attack a market on the supply side with an elastic supply and inelastic demand, price increases dramatically with a very little drop in quantity. This is essentially what is happening in the US.
If, instead, the US were trying to reduce the demand for drugs, we would get a situation such as the graph below. Quantity and price would both decrease, but quantity would decrease many more times the decrease in price. As identified above, this is the supposed objective of the war on drugs.

So why doesn't the government do this? Well, it could be that it is harder to reduce demand than supply such that a dollar spent will decrease supply by 10 units but only decrease demand by 1 unit, and therefore we would see an inefficient use of money.

The government has implemented some measures to deter drug use such as increasing penalties for persons caught with drugs but it is hard to say if these penalties are working. Since people are risk-averse (even those that use drugs), an increase in the penalty will not deter drug use as effectively as an increase in the probability of getting caught. To increase the probability, the government must hire many more law enforcement agents, which is an expensive process. Though, putting stoners in jail or prison can't be too cost effective either.

The Issue of Property Rights

Development economics is a hot topic right now. It seems to baffle everyone, even economist, why some countries fail and some succeed, and why some countries can do either quicker than some. There are many theories out there, all credible in some respect, that try to ascertain one common solution to the problem. It's hard to believe that one solution could fix all developing countries but there is a theory of property rights which goes a long way to identify and solve the problem of development.

Hernando De Soto, a Peruvian economist, tries to explain why poor countries are poor and rich countries rich. His theory centers around the legal system employed in those countries and more specifically, property rights.

A major assumption of economics, which is never discussed in economics classes, is that proper legal institutions must exist. For instance, if I wanted an apple from the store I might just take it without paying for it. If there were no legal institutions that provide incentives against theft, what is stopping me from stealing? It is basically impossible to have a functioning market without the correct legal incentives. De Soto brings this to the forefront in The Mystery of Capital in which he discusses the abominable state of legal rights in developing countries versus those in countries that are considered developed.

In developing countries it is not unusual for people to have houses and land. They build houses and cultivate crops on this land, just like in developed countries. But when it comes time to use that land for collateral for a loan, no matter the size, it is nearly impossible. Though many people occupy land in developing countries, very few have the legal paperwork showing that they own the land. It has been passed down through family generation after generation before deeds were issued or it was given to them during a land-reallocation project but the government was too busy to issue deeds. De Soto calls this "dead capital."

Dead capital is "stuff" that can't be used to generate surplus value. This stuff is normally land, houses, tractors, anything of value that is not legally beholden to anybody; in the legal framework, it is essentially community property. One of the big failures of communism is that there are no property rights and therefore, every thing is community property. When things are not owned, you cannot use them for personal gain; in this case, you cannot put them up as collateral.

The solution to this dead capital is to create a system of property rights that allow people in developing countries to use their things for more than just production. But creating a legal framework is difficult and has taken thousands and thousands of years in developing countries. Europe tested legal and political systems for years before settling on one and then refining it. The US lucked out in the our legal system was implanted by European powers but during early American history, property rights were rare the further west one moved.

The moral is, there may not be one cure for developing countries but before any economic solution can be tried and implemented, these countries must first create the correct framework for a market to function on. Without the correct legal foundations no amount of money, aid, or miracle cures can work.

"Irrational Everything"

A great piece was done by Guy Rolnik, the highly educated editor of Haaretz, on why economists use models if they don't work. As I've pursued my undergrad and graduate education in economics, I have been harassed, or at the very least agressively questioned, on why economists forecast the economy with models that can't even match the current trends. My default reply is simply that our job is not to change the economy, but simply understand it in its most basic form.

Today when I read Rolnik's interview of Professor Kahneman, the logic of modeling finally came to me. Kahneman relates the economy to the weather system - it's irratic, hard to forecast, but people still put their faith in the weather report.

I liken what is happening now to a system that forecasts the weather, and does so very well. People know when to take an umbrella when they leave the house, or when it will snow. Except what? The system can't predict hurricanes. Do we use the system anyway, or throw it out? It turns out they'll use it."

Okay, so they use it. But why don't they buy hurricane insurance?

"The question is, how much will the hurricane insurance cost? Since you can't predict these events, you would have to take out insurance against many things.

This brings us back to Law and Economics. The cost of precaution to guard against any possible negative outcome is prohibitively high and so we don't. It's like instead of carrying an umbrella on a 100 degree day, we take a chance that the weather report was right since the inconvenience of carrying the umbrella outweighs any expected benefits.

I'm glad I spotted this peice because even in a time where macroeconomics is falling apart, I need to have some assurance that what I'm studying is worthwhile.

Read the full article here!

Are Statutory Rape Laws Economically Efficient?

This post has been very difficult for me to write as I have very strong feelings against Statutory Rape laws and after a lot of research and careful consideration, I am still not sold on the efficiency of this law.

The Statutory Rape law basically makes it illegal for any person over 18 to have consensual sex with a person under 18. The laws very from state to state but let's use this definition to keep analysis simple.

This statutory rape law basically employs the idea of strict liability which says that by committing the act, the wrongdoer accepts absolute legal responsibility for the act despite any intentions and/or negligence on behalf of the victim. The penalty for statutory rape is a felony conviction, prison sentence, and sex offender registration (in some states).

Let's first look at the justification for such sever penalties. Statutory rape is not frequently enforced in that police officers are not busting down the doors of 19 years olds to see if they are having sex with a minor. There is very little evidence of the crime that is in the public domain. Therefore, we can say that the enforcement of the law is very low, normally occuring if a complaint is made. If the parties know this, the low probability of being caught will not deter the parties. The law must then enact a harsh penalty to create a deterrence effect. This is economically efficient because it reduces transaction costs.

The rule of strict liability limits the degree of evidence needed for a conviction. Since there is no defense, the prosecutor must only show that the act happened without showing intent of the wrongdoer or negligence of the victim. This greatly reduces the administrative costs of justice which are considered when making laws. The costs to prosecute must be proportionate to the benefit society will gain from the prosecution.

The statutory rape law is partly justified by true paternalism and externalities. True paternalism is the notion that, in this case, the government knows better what you need than yourself. The district attorney will pursue a statutory rape case based on the assumption that the minor is an irrational agent. But is this assumption wholly ill-based?

Criminal law does not stand solely to bring justice to minor in question but to increase social welfare; this is where externalities come in. It may be that the relationship between the wrongdoer and victim was completely consensual and further, let's assume the victim was a rational agent; why can this case still be pursued by the DA? It's the externality argument. The US government does not want sex between minors and people over 18 to occur regularly in fear of creating an atmosphere where this act was commonplace. An atmosphere such as that could have negative effects on society, including parents and general distaste among ordinary people. Therefore, it is more efficient to have a strict liability law forbidding it.

But why might the law not be efficient? Anyone labeled as a 'sex offender' must register as one and are then subject to certain proximity laws, which are economically inefficient since you are regulating voluntary transactions. A registered sex offender is also limited in the job market and as such, creates inefficiencies since a possible comparative advantage cannot be utilized.

Taking from contract law we use the concept of default rules. One of the many purposes of default rules is to encourage full disclosure of information; therefore, the default rule holds the party with more information at fault. In our discussion, would this not be the minor? Suppose that the minor misled or simply did not offer the information to the person over 18, should the minor not be held liable? Because the statutory rape law goes against this principle, it can be said that it is not the most efficient law.

On the same subject of misrepresentation, could we not charge the minor with intentional fraud or unitentional misrepresentation? The minor chose to withold information that led to the crime; why is the minor not liable? Once again, this seems to be an inefficient result.

Further, let's look at the incentives the law creates. I would have to say that when it comes to sex, disincentives are left at the doorstep. Instead of reducing the occurrence of relationships where one party is a minor, it increases the probability that these relationships are going to be kept secret. When and if someone discovers the relationship, there is no evidence to suggest that a relationship existed and the mere testimony from the minor would be seen as mere coercion, and therefore, an acquittal would be highly unlikely.

The conclusion to this piece is not definitive and I am still unsure about where I stand since there are good arguments for and against the efficiency of this law.

Stimulus 101

Two of my former professors from the University of Oregon, Mark Thoma and Tim Duy, were on KLCC the other day talking about the recession. You can listen to it here. They cover topics such as shadow banking, the great moderation, and a great explanation of what a toxic asset really is. They explain just why economists didn't see this coming and why government spending is better than tax cuts during a recession. There's even a diplomatic answer to a livid Eugene commie that calls up. Very entertaining!

Today I have posted my opinion on the Stimulus Package, the goods and the bads. As a Libertarian I have to say I don't like the government mucking around in markets but it seems to be necessary at this point.

I feel that the Stimulus Package is necessary, though the restrictions that have recently been added and the allocation of funds is incorrect. The Great Depression era was the time of little government intervention and a strong reliance on the market. The thought then was that the market always works and that government was superfluous. The solution then, to the Great Depression, was to do nothing. While banks failed, the FED sat idly by and allowed deflation and illiquidity to spiral out of control. The government waited 4 years before finally enacting large amounts of government spending in 1933. By this time, the economy had collapsed and getting out of the hole it dug for itself was near impossible. It was not until 1940 that the economy started to pick up again, 11 years later. Since then, many economists have changed their theories on how the market works through thorough theoretical and empirical research. The stimulus bill has very little theoretical backing other than we know what didn't work before. It is thought that government spending can stimulate the economy, but as to how those funds should be spent, when, and for how long, is all a mystery. I will try to explain why it is so hard to predict: Assume you put 1 million dollars into a small economy for stimulation purposes. Not only do you have to track each dollar of those million, but also the social welfare and surplus value (ie. does that money help individuals or businesses to get loans, does it create public goods, etc) created by each dollar. Then you must quantify this effect. What monetary value does a public good have to each person able to use it.

ex. A bridge is built from a San Francisco peninsula to Oakland (i.e. Bay Bridge). Assume that a combined 2 million people live in Oakland and San Francisco that might regularly use the bridge. Then you must ask, how much time does this save each person, what does each person value their time as (obviously, the wage they work for), and you can get the net benefit by multiplying each person's wage by the time they save using the bridge (instead of going around the mainland) less cost of constructing the bridge. But then there are also other things to consider. The cost of constructing the bridge is money that went to pay for wages and materials (supplied by people and companies) that stimulate the economy. So is this a cost or a benefit? Also, maybe the bridge increases traffic between San Francisco and Oakland from people that don't live in either area. It also might increase tourism. How do you quantify all of these factors? You cannot - and this is why it is so difficult to know exactly how government spending affects the economy.

The stimulus bill is going to put funds into banks, mortgage assistance, infrastructure programs, and energy conservation and alternative fuel research, among many other things. This is where I theoretically disagree with the stimulus package. I feel that infrastructure programs are the best way to stimulate the economy while creating the greatest net benefit. One of the largest negatively affected industry segments of the economy is contractors, construction companies, architectural firms, etc; infrastructure programs would target this labor market while also creating the largest social welfare by building public goods that could last the next 100+ years.

Allocating money to banks and mortgage assistance is a great idea. Many feel that banks should be punished for their belligerent loaning that has characterized the industry for the past 7 years; I am among those people. Unfortunately, it is economically inefficient and dangerous to let the banking sector fail.

ex. Let's take the case of Bank A who has lent long term the money that it has borrowed in the short term. Assume that something happens in the market to dramatically reduce consumer confidence (in this case, excessive consumer debt) and all of the bank's short term lenders (those with savings accounts, etc) come asking for their money back simultaneously. If the bank were inside the capitalist system, Bank A would not be able to pay everyone and it would fail. As soon as other short term lenders (consumers) to Bank B, C, D, etc saw the failing of this Bank A, they would quickly try to pull their money out as well - leading to a complete and devastating collapse of the entire financial sector.

This is why banks are government backed (FDIC) and outside the capitalist system. Since banks can only successfully operate with consumer confidence and trust, it is the government's job to maintain bank stability through regulation so that a troubled bank does not bring down the entire system. The argument for allocating funds to banks is to increase liquidity and therefore increase lending.

ex. To better understand liquidities role in the economy, think of liquidity as a faucet and money is the water that flows from that faucet. In good times, the water runs freely to individuals and firms. But when there is a shock to the system the water pressure supplied to the faucet drops and water cannot flow.

This is essentially what has happened. The shock that dropped the water pressure was the mass number of mortgage defaults and the short period in which they occurred. At the same time, the demand for water has increased and it cannot be supplied quickly enough. The increase in demand has been caused by a collapse of the commercial paper system in which individual investors in money market funds have simply stopped lending. This has put additional strain on banks. The hope is that by injecting money into failing banks, we can increase liquidity in the market and therefore, banks will feel freer to lend to reputable borrowers. Furthermore, the government has started to step in and lend money to firms directly as a stand in for the crippled commercial paper market, another favorable stimulus objective.

Unfortunately, Senator Dodd has added some last-minute restrictions to the stimulus package that disrupts certain economic theories. The restriction most pertinent is the bonus-cap for firms receiving aid. As was signed into the bill, bonuses awarded may not be greater than 1/2 of that person's salary. At first look, I completely agreed with this restriction and was appalled that Summers and Geithner could be against this. But this restriction goes against the theory of economic efficiency.

ex. When speaking of efficiency, past costs must be disregarded for they have already happened and this cannot be undone; we call this the 'sunk cost.' Therefore, since this cost is in the past, it should not effect future decisions. In our case, this 'sunk cost' is the money lost from irresponsible lending and mortgage defaults.

By trying to punish firms for their past behavior by creating a bonus-cap is inefficient and counter productive. Bonuses are incentives; do a good job, you will be rewarded. Unfortunately, in the last 20 years, bonuses have become more of an expectation than a measure of productivity. By interfering with incentive-based pay, the government is essentially creating an atmosphere where top executives will have no motivation to work harder to fix the firm's current economic problems. (It should be noted that an average Wall Street salary before bonuses is around 300-500 thousand dollars, with a handful making around 1 million dollars; average bonuses are upward of 10 million dollars). Further, Summers and Geithner argue that by creating bonus-caps, you are effectively funneling money from the middle class to the upper class.

ex. Let me explain this argument. The pay structure in firms has a very large lower/middle tier where you will find workers that make up the middle class. At the top tier you have relatively less people making about the same in non-bonus salary and receiving excessively large bonuses; this is where you will find upper class workers. If a bonus-cap is imposed then the thinking is that the firm will take money formerly given as salaries to the lower/middle tier workers and funnel it up to the top tier workers to increase base salaries for two purposes, to compensate for drastically reduced salaries due to bonus-cap and to allow larger bonuses to be given (since the bonus must be under 1/2 of non-perk salary).

As a taxpayer, it irks me to think that these people have been rewarded in the past for belligerent behavior but as an economist I feel that efficiency is the best policy. The only way that I could feel perfectly fine with large bonus structures is if there was a disincentive for bad and irresponsible behavior, something like shift in bonus curve so that a bonus at every level would be lower until they proved that they deserved a higher bonus curve.

The largest problem that I find with the stimulus package is the money being allocated to research and development of alternative fuel sources and energy conservation. My sentiments are completely independent of any political affiliation I might have and any feelings I have on energy and the environment. Instead, they rest on an analysis of the targeting and social benefit that can be supplied by R&D. First, R&D in general should never have to be financed by the government. R&D is the outcome of competition between firms in the search to supply a better, cheaper, and more innovative product to consumers. Additionally, government funded R&D projects go straight into the public domain for access by any company - what incentive is there for government funded scientists to produce a result since they will have no chance of obtaining a patent or copyright.

ex. Say the government wants to create a domestic market for hybrid technology. This is pointless because if GM and other US automakers had been forced to be competitive firms instead of relying on government assistance, this technology would already be in use. But because the government has subsidized US automakers with pension loans and through military expenditures, they have not needed to respond to market forces demanding hybrid cars.

Further, how many energy research scientists have become unemployed in the past year. I don't know this number but I have a hunch that this labor market segment has not been so readily affected by the economic downturn. Considering the mass amount of factory, construction, and real estate workers out in the labor market, energy research scientists are a small group comparatively. In the economy, there will always be winners and losers, but the hope is to maximize the net benefit of government action. Creating jobs for research scientists is not a way to maximize the net benefit of this stimulus package. Furthermore, to assume any benefit other than job creation for scientists would require the R&D funding to guarantee an outcome. What I mean by this is that R&D is a game of uncertainty, there is no guarantee that anything will come of it. So the government spends however many billions in R&D and in the end there is a good chance that no alternative energy will be found. It is essentially paying men to dig holes and fill them up, there is no assured social benefit from this.

The Largest Ponzi Scheme of All Time

I'm not going to waste my time talking about Madoff - that is not what this post is about. Rather, I'd like to clue everyone in to the largest Ponzi Scheme of all time and that is Social Security. When I sat down to write this post I was hoping to answer the following questions: what is the economic justification for Social Security and does it make economic sense to have Social Security in its current form?

A Ponzi scheme is basically an investment that pays returns from subsequent investor's money rather than profit stemming from your own investment. Ponzi schemes are not sustainable, i.e. at one point there will be losers as new investors are harder to come by.

Is this not the definition of Social Security? Instead of giving our money to the government for safe keeping and eventual return, we are financing people who have already paid into the scheme whose money has been given to someone else.

In creating Social Security, the government wasn't trying to defraud Americans. Theoretically, Social Security is a great idea given certain assumptions. One the of largest assumptions a government must make is to have a population growth greater than or equal to the baseline year when the system starts and further, to maintain the same age structure in the economy. If this were true then there would be a never ending, ever increasing base from which to extract payouts to elders. Unfortunatley this is an assumption which we know to be false and this has caused the deterioation of the Social Security system in recent years.

The first hurdle is why have Social Security at all? For this I'm going to reference my Law and Economics background and argue self paternalism. Self paternalism is basically the idea of saving ourselves from ourselves. It is creating institutions to prevent individuals from "yeilding to momentary temptations which they deem harmful to themselves." In the case of Social Security, government creates an institution in which individuals are forced to pay into so that they do not yeild to excessive consumption and leave themselves destitute in their later years.

There definitely are many economic arguments against Social Security, the one that comes first to mind is the deadweight loss that occurs when a tax is administered due to lost and delayed transactions. This means that there is a net social loss from having a Social Security Tax.

The next question which I feel will be more difficult to answer is why Social Security has taken the form of a public retirement fund rather than a system of privatized accounts. I believe that the current system was based on very little economic logic and moreso on a social objective which was to insure people against a defined risk. Due to excessive need during the depression era, a system of private accounts would not have satisfied the objective of the day which was to provide to elders what they could no longer provide to themselves.

The economics behind Social Security was risk pooling to minimize the individual cost of elderly unemployment by spreading that cost over a large tax base. We see this same concept applied frequently in insurance, joint land ownership, joint-ventures, etc. The idea is simply to spread a fixed risk over many people to reduce the risk, and therefore cost, to any one person.

But today the objective of Social Security has changed. It is no longer for those in need but those who are 65 years old. It is now a retirement plan and as so, should be treated like one. We are no longer providing social insurance but we are still using the same system from which stems inefficiencies. Though the issue of this post was not to argue the fate of Social Security, I do believe that establishing an Employees Provident Fund, such as exists in Malaysia, is the best alternative.



*The above quote is taken from Guido Calabresi's Law and Economics Anthology, page 197.

Human Trafficking: Is There a Way to Stop It?

A friend of mine recently asked my opinion on human trafficking the other day and if there was any economic justification behind it.

Human trafficking isn't just a Third World phenomenon. It happens in the US and Europe all the time. Ever take the bus down Geary and see all the massage parlours with bars on the doors? That's a sign of human trafficking. In the US, foreign women will be promised a job as a nanny and will be charged a fee for finding them a job. When they arrive they are told that the fee has increased to a ridiculous sum. They are given two choices, work as the nanny and it will take 4 years to pay the fee, or work for a "massage parlour" and pay off the fee quicker. There's a great Frontline interview on it here.

The quick simple reason it exists: profit margins. Enough said.

So what are the economics behind it? Let's talk about incentives, rationality, and contract law. The women being trafficked are generally in a bad economic and social position. One cannot argue that they need the money and therefore it's a Pareto improvement since they get compensated for their time doing unmentionable things and the trafficker gets a large payoff. Unfortunately, the trafficker is only compensating for time, not for disutility and risk of prostitution. This goes to the theory of Compensating Wage Differentials which states that jobs tend to compensate more as risk of the job increases. This is not happening here. Further, if they needed the money they would be a prostitute in their own country; why move to another country where you are at the complete mercy of another, possibly brutal, person?

There are arguments for this but they are not based in economics so I will skip them.

So if they could be a prostitute in their own country, why do they come to the US to do it. The simple answer is that they have no intention of being a prostitute when they come here. They enter into a fraudulent contract where the trafficker promises them a job and doesn't perform. Due to the unenforcable nature of these contracts (most are probably verbal) and the host country's high opportunity cost for seeking these people out, human trafficking is basically allowed.

It was suggested to me that human trafficking occurs as a result of Third World economic misfortunes. We already know that aid doesn't work miracles so how could we target the economic misfortunes of the women being trafficked. In many third world nations opportunities for women are not adundant. By increasing women's access to education and jobs, a nation can increase the economic wellbeing of women; which is also shown to increase economic activity in the whole economy.

As far as trying to internalize the externality that is human trafficking, I don't think there is a way. One way to internalize is to privatize; I'm not sure what could be privatized except legalization of prostitution in which a nation could assign a right to sell one's body. Another way to internalize is to raise prices. Well, to do this there must a a market that can be regulated - either way the answer is legalization. There must be other methods of internalizing the cost of an externality but none of them come to mind.

The only way to stop this is to create high disincentives to traffick women. I believe there are two ways, the first is to create high penalties for human trafficking. This would only be effective if the probability of being arrested and convicted was increased. As it stands, the probability of being caught is too low given the payoff matrix. The other solution is to legalize prostitution. With that would come extremely high workplace standards, licences for all owners and workers, enforceable contracts, etc. But once again, policing and enforcing regulations would be key to keep the traffickers away. Obviously this wouldn't eliminate black market prostitution since there's always someone destitute enough to sell themself for a less-than-market price but I believe it would create effectively high enough disincentives to discourage human trafficking. Of course, these traffickers will just choose another country to set up trade.

The baseline: sex is a commodity, however much we don't like to admit it, and there is a price on that commodity. As long as people are willing to pay for sex, human trafficking and prostitution will exist. The only way to create higher standards for these activities is regulation; which can't happen unless prostitution is legalized.

Thanks Helena for the interesting topic. I really enjoyed writing on this one!

Fighting Pirates with Economics

Part of what I love about economics is to apply economic reasoning to unconventional situations (the whole Freakonomics trend). So today as I was reading yet another article on BBC News about Somali pirates hijacking yet more boats around the Horn of Africa and tried to come up with a simple economic (versus political) solution. My solution is as follows:

Basically, my idea is that you assign a property right to Somalia for an area of ocean and they can create a taxable shipping lane that is protected by either Somalia, or by a group of countries that are willing to take on the task. According to the Law and Economics movement, privatizing allows for externalities (pirates) to be internalized through higher prices (fee of passage). Though this would be increasing the price, the expected price should be the same.

Economic Analysis
Assume a probablility of being hijacked, 0.1%, and a cost associated if hijacking occurs, $5 million (includes loss of life, cargo, and naval costs incurred by supporting hijacked crews). Assume if hijacked, the shipper makes no profit. Therefore, the expected benefits are profits, $1 million. Further, assume shipping companies are risk averse.

Expected Utility = 0.99ln(1m) - 0.01ln(10m) = $13.52

Now assume the shippers have a choice, they can pass with uncertainty (above) or pass with certainty and pay a fee. Assume the fee is $110,000.

Expected Utility = ln(890,000) = $13.70

So we see that 13.70>13.52 and therefore it would raise the shipping company's utility to pay a fee.

*I use a utility function of natural log simply because we know this is a concave function which implies risk aversion. *

Essentially this is Adam Smith at work: division of labour. To enter the lane you pay a fee and for that fee you are guaranteed safe passage.

Right now the US government is saying that it is the responsibility of the shipping companies to protect their boats. This results in the shipping company having to take extra precautions to ensure that their cargo is safe through that area of the ocean. Why not divide the labour? Let an organization worry about protection, and let the shippers ship their cargo. I have no doubt that this could be a great commercial venture for Somalia - I'm sure they could use the money.

Unfortunately, to construct something such as this requires a stable, working government; something Somalia has been lacking since the early 90's. But Somalia does not have to be the acting force here; as I said above, it could be established by a group of nations that value safe waters. The prices could be set a break even so that shippers are not being excessively burdened and the revenue would be used to fight off those pesky pirates: problem solved.

TGR: Efficient Allocation System?

What's a TGR? Read Martin Feldstein's article in the WSJ.

Tradable Gasoline Rights are a great idea because they essentially solve the Tragedy of the Commons that is our ozone layer. By assigning the right to pollute we can internalize the marginal cost of CO2 emissions. The government would effectively set a cap (just like cap and trade) so that our consumption would be limited. This would be the mechanism for setting a market price that internalizes the societal harm of excessive gas consumption. Instead, if we were to implement a gas tax, we could to get to the same consumption but calculating the correct tax would be difficult or near impossible. TGR offers a simple solution to this difficult calculation. Further, many say a gas tax would be easier but a tax doesn’t limit quantity which is the objective of TGR. A tax would be effective if the sole objective were collecting higher government revenues and inflating the price of gas as to justify research and development on alternative energy technologies.

The best part about TGR versus tax is that TGR would be a progressive policy, i.e. it would tax those that use higher quantities more whereas a gas tax is regressive (all sales taxes are) and would essentially tax the poor proportionally more than the rich.

With a system of TGR there is an externality that arises which could be detrimental to society; that is the urban migration externality. If people are given the choice to sell or use their TGR, many would chose to sell and use less gas which might mean moving to more urban residences. China and many upcoming third world nations have major problems due to urban overcrowding where the city grew faster than the planners could keep up with which leaves poor sewage, water, and electricity structures.

Another problem with this system would be the rationing. I feel that getting the rationing correct isn’t necessarily the problem because the market will naturally reallocate the TGR to the people who value them the most but rather the share that are for businesses versus individuals. I have heard the suggestion that TGR should only be given to individuals where businesses would have to buy TGR which would create high incentives for businesses to invest in energy efficient technologies. This would also eliminate any political lobbying for higher allocations of TGR to certain industries.

I am not sure if my assumption that the market will allocate responsibly is valid and therefore, I feel that either the market will prevail or rationing correctly will be an integral part of a TGR system working. And this all goes back to Hobbes who said that if transaction costs are high (i.e. calculating allocations to each individual or household) then you have to get it right the first time. This is the major hurdle with a system of TGR.

The good thing with a TGR system there is little opportunity for a black market to start simply because a TGR would not be a tangible asset and the ability to transfer a TGR between individuals would be only possible within the electronic system – although we must give credit to all those hackers that find a way around most cyber-barriers.

Then the next hurdle is: how do you deal with mass transit? Would a part of a TGR be taken for every bus ride you take? Would it matter on the length of the ride? Would the price of the TGR just be passed onto the consumer via a bus ticket and the transit authority would get rationed TGR? This might make for a very volatile bus fare.

The Economics of Legalization: An Argument Against

There have been many a debate on the legalization of marijuana and other such drugs. More often than not the person in favor of legalization feels entitled to the free use of the drug and hides behind weak economic pretenses for the benefits of legalization. I'm here to present an economic argument against the legalization of now-illegal drugs that centers not on increased tax revenues but on decreased societal value.

Let's assume (the famous first words of any economist) that there are two types of people; those that use drugs illegally and those that do not. Let's also assume that drug users tend to congregate in blue collar industries where non drug users collect in white collar industries.

This might seem like an unfair assumption but it has been shown my multiple studies and surveys that drug use is more prevalent in blue collar jobs (Drug use at work). Further, you must remember I am an economist and therefore assumption are all I got - so go with the flow!

Now, as the world stands, drug use is illegal and those that use drugs illegally are blue collar workers. If drug legalization were to occur, I argue that marijuana use would shift towards the white collar population which would be more detrimental than the current situation.The mass argument is that if you legalize marijuana then the product will be cheaper by default since risk has been eliminated and transaction costs are considerably lower. Then it is thought that the government impose a tax on the drug up to, but not exceeding, the black market price (or else black market operations would still exist).

I argue that the cost of marijuana would increase from the current black market price. The price of marijuana could be set higher since black market sellers would be subject to even greater punishment (conceivably) after legalization and therefore the risk premium of black market operations would outweigh the expected benefits.

If the price of marijuana was to increase after legalization, then two things would happen. White collar workers would be more readily able to purchase the more expensive product than blue collar workers. This would shift drug use towards more white collar workers.

You might ask why this matters. Well to be blunt and terse, the social value of a white collar worker is higher than that of a blue collar worker. If a higher proportion of our white collar workers are engaging in marijuana usage we are limiting the value society can reap from these people. I do not care to go into evidences and anecdotes about how marijuana does or does not effect brain function or if it is or is not addictive. I will just state that externalities would more than likely result from increased usage among white collar workers and therefore a higher social cost will be observed.

Here I don't touch on the cost of overcrowding in jails and prisons due to drug possession crimes. I feel that this cost is not explicit to the illegal status of drugs but rather the criminalization of drugs. Those costs could simply be reduced by decriminalizing some or all drugs. This is just another example of false evidence used by pot activists to convince the masses of the economic benefits of legalization.

The Incentive Effect

In Switzerland, the law of crossing the street goes as follows:

If the pedestrian is jaywalking and gets hit, then all costs to self, driver, and car are borne by the pedestrian

If the pedestrian is using a crosswalk and gets hit, then all costs resulting from that accidents are legally borne by the driver.

Now, unlike in the US, crosswalks do not just appear at stop signs and stoplights; rather, they appear randomly in the middle of a 45 mph road, as pictured above. Because of the random nature in which crosswalks are placed, I feel that this law creates some interesting incentive effects and behavior to result.

On the positive side: this law creates very strong incentives for pedestrians to not jaywalk. For drivers, it creates incentives to be more cautious when a crosswalk is nearing. These are both

But suppose a pedestrian is approaching a crosswalk. To this pedestrian is attached a numerical value for how much disutility he would incur if hit (above any medical expenses). The pedestrian now has a choice, he can asses the situation and decide rationally whether to cross the street at that time (read: is a car coming at a speed which would be prohibitive to him crossing the street safely), or he can simply walk out on the crosswalk knowing that there is a chance he might be hit by a car. If the expected compensation above medical bills (i.e. what he would be awarded for 'pain and suffering') is greater than the disutility he incurs from getting hit, the pedestrian will take a chance and step unknowingly onto the crosswalk.

But not only this, if the expected compensation is excessively high then this creates incentives opportunistic behavior. A pedestrian might jump onto the crosswalk moments before a car approaches the it in hopes of gaining large monetary rewards from a potential, and almost certain, accident.

Now, this law is there for a reason and I'm going to venture to say that opportunistic behavior does not run as rampant in Europe as in the US. If that's the case, then this law would produce the correct incentive effects.


Disclaimer: I have not read the Swiss legal code; this is just the rule that was imparted on me by locals while living in the south of Switzerland.