When Rivalry and Competition Isn't Synonymous

For the past eight years the antitrust division of the Department of Justice (DOJ) has been in hiding. Virtually no antitrust claims occurred during the Bush administration. But in only the few months Obama has been in office, antitrust claims have abounded. There are currently claims on large pharmaceutical companies, Google, telecom providers, and various airlines.

With this rebound of antitrust law, it is important that the DOJ remembers the matter in which they are defending; consumer welfare. Too often, especially in the past, the DOJ has brought to trial cases in which consumer welfare was actually increased by a so-called anticompetitive agreement.

Up until the 1980’s, lawmakers had a vague and broad idea of what competition was, which turned out to be thoroughly wrong. They viewed firm competition akin to competition seen in sports: the more players, the more competition (i.e. rivalry). So for over half a century antitrust law was mistakenly used to simply increase the number of firms in a given market. This turns out to actually decrease market efficiency and consumer welfare.

The new, and correct, definition of firm competition is whatever means create the highest consumer welfare.

Example: An industry contains 3 firms, all with equal market share. Another industry contains 20 firms, 1 firm with 90% of the market and the remaining 19 firms share the last 10% of the market. Clearly there is more “rivalry” in the latter example but the former example is more competitive.

When looking at competition, we must take into consideration market share - the larger the market share of a firm relative to other firms, the more monopoly tendencies that firm will exhibit. The former industry will create higher consumer welfare and therefore is deemed more competitive by modern standards.

Question: Is bigger always badder?

Answer: No. If a firm is able to increase market power and size by increasing efficiency while still making high quality products, then this is not bad. What’s more, this is actually better for consumers.

Example: Costco. Costco is able to offer high quality products at lower prices than competitors because they have been able to increase efficiency by selling items in bulk in warehouse-like retail stores. They save money by eliminating flashy displays and store decorations and then pass those savings on to consumers.

So the next time you snub Wal-Mart, relish the increases in consumer surplus they allow consumers to enjoy!

Trading Pollution: Are Trade Barriers Ever Appropriate?

There seems to be no lack of subjects to write on with the passage of the climate bill through the House. Yet another provision in the bill is to impose import tariffs on goods from countries not meeting U.S. carbon-emitting requirements. As an economist, I would tote our party line that any barriers to free trade are inefficient – but I have to wonder, “Is that true in every case?”

Political reasoning for imposing import tariffs is simply protectionist. Politicians must support, or appear to support, domestic industry and are no doubt being lobbied by many such industries not wanting to conform to the new emission requirements.

But behind the politics there is another reason for why import tariffs might not be considered inefficient. The objective of the climate bill is not, or should not, be to make American industry more or less competitive, nor to make the American people better or worse off financially; the objective is to reduce greenhouse gas emissions through a system of cleaner technology and domestic and international offsets. The climate bill is not for political or economic gain – it is to delay adverse effects of our carbon-excessive lifestyles.

If this is the case, then imagine the effects the bill would have if this provision were not included. Suddenly, it would get more expensive to produce virtually all goods and firms would choose to either trade carbon credits or invest in offsets. These offset opportunities are much more plentiful outside the U.S. and are much less expensive as well, which would entice firms’ offset activities abroad. As domestic prices rise, importing will become more attractive. It should be noted that this does not necessarily imply that goods will be imported from countries allowing total environmental degradation for the purpose of manufacture, but demand for goods will increase in these areas. Consumers would essentially be substituting goods to non-environmentally-regulated countries from regulated-countries; thereby undermining the objective of the bill since the same amount of global carbon will be emitted.


By imposing import restrictions, the government is essentially taxing countries for not upholding certain environmental standards. Unfortunately, there are so many wrongs that go with these sorts of trade barriers that the above argument could not even begin to neutralize.

First, this is the classic case of the U.S. trying to impose American mores on other countries. The U.S. did not sign the Kyoto treaty because we did not want to be held to internationally agreed upon standards; essentially, the U.S. was not ready. Now that the U.S. has decided to take on some environmental responsibility, it assumes every other nation is ready. While many might argue that the U.S. has had the capability of environmental responsibility for years and has recoiled, there are truly many countries that are simply not ready. Who is the U.S. to demand the path in which other countries take?

Further, the provision says that barriers will be imposed on those countries lacking “similar” programs – but what constitutes as similar. Our program focuses on carbon emissions, but there are many other foci a program would take to promote environmental health. China might implement a clean water program which would drastically increase their production costs in just about every industry; and while the objective of the program is the same, to promote a healthier planet, it is quite different and is likely to not be counted as a similar program.

Finally, there is a question of magnitude; will countries be fined a flat tax for not having similar programs? Or will it be based upon a variable element, such as emissions per capita of that country or average emissions of producing a good? Surely, this would create the correct incentives for countries and firms who would adjust production methods until the marginal cost of decreasing emissions equals the increase in marginal revenue from decreasing emissions.

There is always the inevitable trade war that occurs when unilateral trade barriers are imposed – but that is only one of the adverse reactions that will result from import tariffs.

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.