CH-20-22 Political Economy and Public Choice – Modern Principles: Microeconomics : Book Guide

This Document Contains Chapters 20 to 22 CHAPTER 20 Modern Principles of Economics: Political Economy and Public Choice Facts and Tools 1. Which of the following is the smallest fraction of the U.S. federal budget? Which are the two largest categories of federal spending? Welfare Interest on the federal debt Defense Foreign aid Social Security Health care Solution 1. Foreign aid is the smallest, while Social Security and defense are the two biggest. 2. a. How many famines have occurred in functioning democracies? b. What percentage of famines occurred in countries without functioning democracies? Solution 2. a. Zero. b. 100%. The answers are according to Nobel Prize̵–winner Amartya Sen. The precise numbers are a bit debatable, but in the social sciences it’s rare to find relationships that are this strong: a point worth emphasizing. 3. Around 138 million voters participated in the 2016 U.S. presidential election. Imagine that you are deciding whether to vote in the next presidential election. What do you think is the probability that your vote will determine the outcome of the election? Is it greater than 1%, between 0.1% and 1%, between 0.01% and 1%, or less than 0.01% (i.e., less than 1 in 10,000)? Solution 3. The right answer is much less than 1 in 10,000. Andrew Gelman, Nate Silver, and Aaron Edlin calculate that in 2008 the probability of an average voter affecting the outcome of the presidential election was 1 in 60 million. For a voter in a key state, it was 1 in 10 million. (Gelman, A., Silver, N. and Edlin, A. (2012). “What Is the Probability Your Vote Will Make a Difference?” Economic Inquiry, 50(2), 321–326.) In 2000, the election in Florida was decided by around only 200 votes, a very rare event, that was only true in Florida, one state out of 50. Further, on those rare occasions when elections are close, a single vote doesn’t make a difference (one vote is still far less than 200 votes). 4. If a particular government policy—like a decision to go to war or to raise taxes—works only when citizens are informed, is that an argument for that policy or against that policy? Solution 4. That’s an argument against the policy. If a policy really needs careful citizen monitoring to work, and if there is little citizen monitoring, then the policy probably won’t work. Individual voters should recognize that most of their neighbors just won’t try very hard to keep informed, and take that into account when choosing which policies to support. 5. True or false? a. During Bangladesh’s worst famine, average food per person was much lower than usual. b. Democracies are less likely to kill their own citizens than other kinds of governments. c. Surprisingly, newspapers aren’t that important for informing voters about hungry citizens. d. Compared with a dictatorship or oligarchy, democracies have a stronger incentive to make the economic pie bigger. e. Compared with most other countries, full democracies tend to put a lot of restrictions on markets and property rights. f. When it comes to disposable income, American presidents seem to prefer “making a good first impression” rather than “going out with a bang.” g. When the government owns most of the TV and radio stations, they’re motivated to serve the public interest, so voters tend to get better, less biased information. Solution 5. a. False; b. True; c. False; d. True; e. False; f. False; g. False 6. The median voter theorem is sometimes called the “pivotal voter theorem.” This is actually a pretty good way to think of the theorem. Why? Solution 6. The median voter is the pivotal voter. If all other voters are far apart on the spectrum, and the median voter changes her views slightly, then politicians will change their policies so that they shift along with the median voter. If today’s median voter chang¬es her views so much that she’s no longer the median voter, then there will be a new median voter: And politicians again will do what she now wants. Either way, whatever today’s median voter wants is pivotal for deciding what the politicians will do. 7. Perhaps it was in elementary school that you first realized that if everyone in the world gave you a penny, you’d become fantastically rich. This insight is at the core of modern politics. Sort the following government policies into “concentrated benefits” and “diffuse benefits.” a. Social Security b. Tax cuts for families c. Social Security Disability Insurance for the severely disabled d. National Park Service spending for remote trails e. National Park Service spending on the National Mall in Washington, D.C. f. Tax cuts for people making more than $250,000 per year g. Sugar quotas Solution 7. Options a, b, and e have relatively diffuse benefits. Those who benefit from the con¬centrated benefits of policies c, d, f, and g probably stay better-informed than those who benefit from the other three policies. Thinking and Problem Solving 8. David Mayhew’s classic book Congress: The Electoral Connection argued that members of Congress face strong incentives to put most of their efforts into highly visible activities like foreign travel and ribbon-cutting ceremonies, instead of actually running the government. How does the rational ignorance of voters explain why politicians put so much effort into these highly visible activities? Solution 8. Politicians put effort into visible activities because voters aren’t paying much attention to politics most of the time. “Rationally ignorant” implies “not trying too hard to get information.” Politicians have to break through the voters’ apathy by being flashy: meeting with foreign leaders, riding in helicopters over a wildfire, conducting pithy speeches, and things like that. Voters will see those fleeting images on the news, so even a voter who isn’t trying that hard to learn about politics will pick up a little something just by glancing at the TV now and then. 9. An initiative on Arizona’s 2006 ballot would have handed out a $1 million lottery prize every election: The only way to enter the lottery would be to vote in a prima¬ry or general election. How do you think a lottery like this would influence voter ignorance? Solution 9. As the chapter explained, voters are often rationally ignorant but nonvoters are even more ignorant. That is, in the United States, better-educated and better-informed citizens are more likely to vote—after all, why bother going to the polls if you don’t know much about the election? If there were a lottery, this would encourage more people to go to the polls but relatively speaking it would encourage less-informed people to go the polls (because the better informed are already voting); thus, overall it would tend to increase voter ignorance. By the way, the voters rejected the initiative by a 2–1 margin. Perhaps the outcome would have been different if the nonvoters had voted! 10. We mentioned that voters are myopic, mostly paying attention to how the economy is doing in the few months before a presidential election. If they want to be ra¬tional, what should they do instead? In particular, should they pay attention to all four years of the economy, just the first year, just the last two years, or some other combination? Solution 10. At the least, they should pay attention to the last two years, perhaps the last three years. Paying attention to the first year is probably unwise, since as most students will intuitively understand, a president (in his or her first term) can’t do much about an economy in his or her first year: He influences the economy with a lag of perhaps a year or more. By the way, it’s possible that presidents deserve almost no credit for economic performance—a topic beyond the scope of this textbook—but certainly the last two or three years should get more attention than the last 12 months before an election. Perfectly rational voters would combine information from the past to make forecasts of future performance. 11. In his book, The Myth of the Rational Voter, our GMU colleague Bryan Caplan argues that not only can voters be rationally ignorant, they can even be rationally irrational. People in general seem to enjoy believing in some types of false ideas. If this is true, then they won’t challenge their own beliefs unless the cost of holding these beliefs is high. Instead, they’ll enjoy their delusion. Let’s consider two examples: a. John has watched a lot of Bruce Lee movies and likes to think that he is a champion of the martial arts who can whip any other man in a fight. One night, John is in a bar and he gets into a dispute with another man. Will John act on his beliefs and act aggressively or do you think he is more likely to rationally calculate the probability of injury and seek to avoid confrontation? b. John has watched a lot of war movies and likes to think that his country is a champion of the military arts that can whip any other country in a fight. John’s country gets into a dispute with another country. John and everyone else in his country go the polls to vote on war. Will John act on his beliefs and vote for ag-gression or do you think he is more likely to rationally calculate the probability of defeat and seek to avoid confrontation? Solution 11. a. Of course, it could go either way, but in the bar, John’s choice has a big effect on the outcome. If John chooses aggression, there will be aggression and John will have to face the costs of his choice. If John chooses peace, there will be peace. John’s choice matters and so he has an incentive to think carefully about whether he really is or isn’t a champion of the martial arts. If John backs down he may have to change his beliefs, which could be uncomfortable, but he will also be able to walk away. b. Once again, it could go either way, but in the voting booth, John’s choice has almost no effect on the outcome. No matter what John does, if most people vote for war, there will be war, and if most people vote for peace, there will be peace. So the outcome is out of John’s hands. In this case, why would John give up his enjoyable belief that his country is a champion of the military arts? John’s choice in the war scenario doesn’t affect the outcome, as opposed to in the bar scenario where his actions drastically impact the outcome, so he is more likely to vote for war than to work for peace. Most generally, Caplan’s point is that democracy insulates an individual’s beliefs about public policy from consequences and thus makes people more likely to hold irrational beliefs. 12. In the television show Scrubs, the main character, J. D., is a competent and knowledgeable doctor. He also has very little information outside the field of medicine, admitting he doesn’t know the difference between a senator and a representative and believes New Zealand is near “Old Zealand.” a. Suppose J. D. spends some time learning some of these common facts. What benefits would he receive as a result? (Assume there are no benefits for the sake of knowledge itself.) b. Suppose instead J. D. spends that time learning how to diagnose a rare disease that has a slight possibility of showing up in one of his patients. What benefits would he receive as a result? (Again, assume there are no benefits for the sake of knowledge itself.) c. Make an economic argument that even given your answer to part b, voters have too little incentive to be informed about political matters. Solution 12. a. There would be virtually no benefit to J. D. from learning these facts, although he might avoid some embarrassing social situations. b. If J. D. spends time learning how to diagnose a rare disease, he would be able to save additional lives and do his job much better, earning the respect of his peers and bosses. He could also make more money. c. J. D. wants to learn things that help him to raise his wage so he invests in learning information with a large private benefit. J. D. has very little incentive to invest in learning information that helps him to vote intelligently because his vote is unlikely to make a difference to the election outcome. Nevertheless, when J. D. votes intelli¬gently he benefits every voter by a small amount, a positive externality. Learning to vote intelligently is like getting a flu shot: The life you save may not be your own! As we learned in Chapter 9, goods with positive externalities are underprovided. Thus, rational ignorance is rational for the individual but not good for society. 13. Driving along America’s interstates, you’ll notice that few rest areas have com¬mercial businesses. Vending machines are the only reliable source of food or drink, much to the annoyance of the weary traveler looking for a hot meal. Thank the National Association of Truck Stop Operators (NATSO), who consistently lobby the U.S. government to deny commercialization. They argue: Interchange businesses cannot compete with commercialized rest areas, which are conveniently located on the highway right-of-way . . . rest area commercialization results in an unfair competitive environment for privately-operated interchange businesses and will ultimately destroy a successful economic business model that has proven beneficial for both consumers and businesses. a. How does NATSO make travel more expensive for consumers? b. Do you think most Americans have heard of NATSO and the legislation to commercialize rest stops? How does your answer illustrate rational ignorance? Do you think that the owners of interchange businesses (i.e., restaurants, gas stations, and other businesses located near but not on highways) have heard of NATSO? c. Why does NATSO often succeed in its lobbying efforts despite your answer to part a? (Hint: What is the concentrated benefit in this story? What is the dispersed cost?) Solution 13. a. NATSO lobbies to prevent rest stops from offering commercial services; thus, it adds additional inconvenience to travelers because the travelers have to go farther from the interstate to get food and gas. b. Most Americans have probably never heard of NATSO or connected the lack of food at rest stops to NATSO’s lobbying. Americans are rationally ignorant about NATSO because the cost that comes from not having commercialization of rest stops is small—too small to be worth investigating the issue. Owners of interchange businesses, however, not only know of NATSO, they support the organization in enough numbers to fund its lobbying. Owners of interchange businesses have a strong financial incentive to have heard about an organization that seeks to restrain their competition. c. NATSO succeeds because the benefits to interchange businesses from preventing rest stop commercialization (in the form of higher prices or increased customer volume that come with reduced competition) are fairly concentrated; concen¬trated enough to fund a lobbying organization. The costs of preventing rest stop commercialization, however, are dispersed so that people harmed by this legisla-tion do not even know about it, let alone oppose it. 14. The following figure shows the political leanings of 101 voters. Voters will vote for the candidate who is closest to them on the spectrum, as in the typical median voter story. Again as usual, politicians compete against each other, entering the “political market” just as freely as firms enter the economic market back in Chapter 11. a. Which group of voters will get their exact wish: the group on the left, the center-left, the center-right, or the right? b. Now, four years later, it’s time for a new election. Suppose that in the meantime, the two right-leaning groups of voters have merged: The 25 center-right voters move to the far right, forming a far-right coalition. In the new election, whose position will win now? c. As you’ve just seen, there’s a “pivotal voter” in this model. Who is it? Solution 14. a. The median voter will win: The single voter by herself on the center-left. b. The same voter will win: The single center-left voter. c. The center-left voter is pivotal here: She is the median voter so shifts in the views of nonmedian voters don’t matter (as long as those nonmedian voters stay nonmedian). 15. Let’s rewrite a sentence from the chapter concerning the Roman Empire: “As the American Empire grew, courting politicians in Washington became a more secure path to riches than starting a new business.” Does this seem true today? If it started happening, how would you be able to tell? In your answer, put some emphasis on market signals that could point in favor of or against the “decadent empire” theory. (Hint: By some measures, Moscow has the highest real estate prices in the world, and it’s probably not due to low housing supply.) Solution 15. You probably have to be near power to influence it, so lobbyists (in banking, military, manufacturing, state government, and other sectors) have to live in Washington, D.C. Thus, if the payoffs to being near power rise, then the demand for Washington, D.C.–area housing will rise, and this will push up real estate prices. House prices in Washington, D.C., and the surrounding area are among the highest in the nation. On the other hand, real estate prices there are currently lower than in Manhattan or in the Silicon Valley area and that is a good sign. Other examples: If the shopping malls in the Washington, D.C., area become the best in the country, with the fanciest high-end products, that would be another Late Roman Empire sign. Or if there were more Bentleys and Rolls-Royces and Maseratis in Washington, D.C., than in Manhattan, that would be another troubling sign. We, the authors, live in the Washington, D.C., area and as of yet there aren’t a lot of Maseratis, but it may be troubling that Tyson’s Corner in the Washington, D.C., area is one of the nicest malls in the United States and the three richest coun¬ties in the United States are all suburbs of Washington, D.C. Challenges 16. Is rational ignorance the whole explanation for why voters allow programs like the sugar quota to persist? Perhaps not. In the early 1900s, the government of New York City was controlled by a Democratic Party organization known as Tammany Hall. In a delightful essay entitled “Honest Graft and Dishonest Graft” by George Plunkitt, one of the most successful politicians from the Tammany machine, he argued that voters actually approve of these kinds of government-granted favors. (The essay and the entire book Plunkitt of Tammany Hall: A Series of Very Plain Talks on Very Practical Politics, are available for free online.) For example, Plunkitt said that ordinary voters like it when government workers get paid more than the market wage: “The Wall Street banker thinks it is shameful to raise a [government] clerk’s salary from $1500 to $1800, but every man who draws a salary himself says, ‘That’s all right. I wish it was me.’ And he feels very much like votin’ the Tammany ticket on election day, just out of sympathy.” a. Plunkitt said this in the early 1900s. Do you think this is more true today than it was back then, or less true? Why? b. If more Americans knew about the sugar quota, do you think they would be out¬raged? Or would they approve, saying “That’s all right, I wish it was me?” Why? c. Overall, do you think that real-world voters prefer a party that gives special fa¬vors to narrow groups, even if those voters aren’t in the favored group? Why? Solution 16. a. Since there’s no real research on the subject, it’s mostly a matter of speculation. But there’s probably not much change in this view since Plunkitt’s day. Example: The Davis-Bacon “prevailing wage” law seems quite popular and robust. It re¬quires that government-contracted construction jobs have to pay above-market union-level wages. Davis-Bacon is pretty close to Tammany’s story—high wages for govern-ment-paid jobs—and it’s going on right now. Modern voters generally suspect that most government jobs involve little work, great benefits, and decent wages, so “rational ignorance” probably isn’t a big factor: It seems that Plunkitt’s “sym¬pathy channel” is important. b. Again, this is a matter of speculation, but surely many voters like the idea that somebody is getting a good deal from the government. Today, many voters will use folk-Keynesian ideas to argue that if the government pays some workers a little extra, society will stay richer on the whole—so there could be a rational argument in addition to an emotional, sympathetic argument. c. Again, speculation, but voters seem to value at least some visible redistribution—and not just redistribution to obviously sympathetic groups like the ill and the handi¬capped. Perhaps they see it as a signal that the government is competent enough to actually accomplish something, even if it’s against the common interest. Perhaps they like to identify with the lucky recipients, Plunkitt-style. Or perhaps they believe in economic models in which selective government aid indirectly helps everyone. 17. a. When a drought hits a country and a famine is possible, what probably falls more: The demand for food or the demand for haircuts? Why? b. Who probably suffers more from a deep drought: People who own farms or people who own barbershops? (Note: The answer is on page 164 of economist Amartya Sen’s sum¬mary of his life’s work, Development as Freedom, 1999.) c. Sen emphasizes that “lack of buying power” is more important during a famine than “lack of food.” How does the Sen’s barber story illustrate this? Solution 17. a. The demand for haircuts falls more. It is more of a luxury, and it is something you can always get next month. You can’t wait a month for food. b. People who own barbershops. c. There might be enough food in the drought area for everyone to survive, but if people panic during a famine and stop buying nonessentials, then people who make those nonessentials could starve to death. Anyone making nonessentials could find their buying power just vanish. Sen uses this anecdote to illustrate that falling buying power for certain kinds of labor is central to famines, more important than falling supplies of food. As Sen notes, it may be falling demand for day laborers because of a flood, as in Bangladesh, or falling supply of food in rural areas because all of the food is being drawn into temporarily rich cities, as in Bengal during World War II. Either way, rural workers, politically less powerful than urban workers (who can more easily riot and get the government’s attention), are vulnerable to temporary declines in labor demand. 18. Political scientist Jeffrey Friedman and law professor Ilya Somin say that since voters are largely ignorant, that is an argument for keeping government simple. Govern¬ment, they say, should stick to a few basic tasks. That way, rationally ignorant vot¬ers can keep track of their government by simply catching a few bits of the news between reruns of Modern Family. a. What might such a government look like? In particular, what policies and pro¬grams are too complicated for today’s voters to easily monitor? Just consider the U.S. federal government in your answer. b. Which current government programs and policies are fairly easy for modern voters to monitor? What programs do you think that you and your family have a good handle on? c. Can you think of easy replacements for the too-complex programs in part a? For instance, cutting one check per farmer and posting the amount on a website might be easier to monitor than the hundreds of farm subsidies and low-interest farm loans that exist today. Solution 18. a. Answers will vary, of course. But any secretive government agencies appear too hard to monitor: Voters can rarely find out if those agencies are doing a good job or not. Many regulatory agencies are also difficult to monitor. Can voters tell whether job safety regulations, product safety regulations, or antitrust laws are too tough or too lax? Voters will have opinions on these issues, of course, but a moment’s reflection should convince most students that voters won’t know enough to make an informed decision. b. Voters can tell that Social Security checks actually get paid or that federal prisons actually hold some criminals they’ve seen on TV. Many other examples are possible. c. For many of the regulatory agencies, it may be possible to use highly visible tax¬es and fines to get the same kinds of results. If a worker gets injured, and voters think that compensating differentials and the threat of lawsuits aren’t enough of a deterrent, they can demand that the government impose fines on the worker’s firm. Highly visible, permanent fines might accomplish the task in a way that voters can easily monitor: Worker gets hurt, fine gets imposed. It’s difficult to come up with good substitutes for intelligence agencies, unless you’re convinced that these agencies actually know little about threats to Americans. That question is beyond the scope of this textbook. 19. We mentioned that the median voter theorem doesn’t always work, and some¬times a winning policy doesn’t exist. This fact has driven economists and politi¬cal scientists to write thousands of papers and books both proving that fact, and trying to find good workarounds. The most famous theoretical example of how voting doesn’t work is the Condorcet paradox. The Marquis de Condorcet, a French nobleman in the 1700s, wondered what would happen if three voters had the preferences like the ones in the following table. Three friends are hold¬ing a vote to see which French economist they should read in their study group. Here are their preferences: a. They vote by majority rule. If the vote is Walras vs. Say, who will win? Say vs. Bastiat? Bastiat v. Walras? b. They decide to vote in a single-elimination tournament: Two votes and the winner of the first round proceeds on to the final round. This is the way many sporting events and legislatures work. Now, suppose that Jean is in charge of deciding in which order to hold the votes. He wants to make sure that his favorite, Walras, wins the final vote. How should he stack the order of voting to make sure Walras wins? c. Now, suppose that Claude is in charge instead: How would Claude stack the votes? d. And Marie? Comment on the importance of being the agenda setter. (In case you think these examples are unusual, they’re not. Any kind of voting that involves dividing a fixed number of dollars can easily wind up the same way—check for yourself! Condorcet himself experienced another form of democratic failure: He died in prison, a victim of the French Revolution that he supported.) Solution 19. a. W vs. S: Say wins. S vs. B: Bastiat wins. B vs. W: Walras wins. b. Jean will set the first vote to be Say vs. Bastiat. Bastiat will win that round and then will lose to Walras in the final round. c. Claude wants Say to win in the last round: So it’s Bastiat vs. Walras in the first round, and then Walras will lose to Say in the final round. d. For Bastiat to win the final round, it should be Say vs. Walras in the first round, and then Say vs. Bastiat in the last round. Since the order in which items are voted on can often (not always) determine the outcome, a clever agenda setter has an advantage in achieving his preferred outcome. 20. In the previous question you showed that sometimes there may be no policy that beats every other policy in a majority rule election and, as a result, the agenda can determine the outcome. In the previous question, all of the policy choices on the agenda were as good as any other, but this is not always the case. Imagine that three voters, L, M, and R, are choosing among seven candidates. The preferences of the voters are given in the following table. Voter M, for example, likes Grumpy the best and Doc the least. a. Imagine that we vote according to a given agenda starting with Happy vs. Dopey. Who wins? We will help you with this one. Voter L ranks Happy above Dopey, so voter L will vote for Happy. Voter M prefers Dopey to Happy, so voter M will vote for Dopey. Voter R ranks Dopey above Happy so voter R will vote for Dopey. So _____ wins. b. Now take the winner from part a and match him against Grumpy. Who wins? c. Now take the winner from part b and match him against Sneezy. Who wins? d. Now take the winner from part c and match him against Sleepy. Who wins? e. Now take the winner from part d and match him against Bashful. Who wins? f. Finally take the winner from part e and match him against Doc. Who wins? g. We have now run through the entire agenda so the winner from part f is the final winner. Here is the point. Look carefully at the preferences of the three voters. Compare the preferences of each voter for Happy (or Grumpy or Dopey) with the final winner. Fill in the blank: Majority rule has led to an outcome that _____ voter regards as worse than some other possible outcome. The answer to this question should shock you. This question is drawn from the classic and highly recommended intro¬duction to game theory, Thinking Strategically by Avinash K. Dixit and Barry J. Nalebuff (New York: W.W. Norton, 1993). Solution 20. a. Dopey wins. b. Grumpy wins. c. Sneezy wins. d. Sleepy wins. e. Bashful wins. f. Doc wins. g. Amazingly, voters L, M, and R all prefer Happy, Grumpy, or Dopey to Doc. Thus, majority rule has led to an outcome that everyone regards as worse than some other possible outcome. It’s not surprising that democracy can lead to outcomes that some people think are worse than other possible choices. It’s shocking that democracy can lead to outcomes that everyone thinks are worse than other possible choices. Nevertheless, this is an implication of voting theory. 21. In the 1998 Minnesota gubernatorial election, there were three main candidates: Norm Coleman (the Republican), Jesse “The Body” Ventura (an Independent), and Hubert Humphrey III (the Democrat). Although we can’t know for certain, the vot¬ers probably ranked the candidates in a way similar to that found in the following table. The table tells us, for example, that 35% of the voters ranked Coleman first, Humphrey second, and Ventura third; and 20% of the voters ranked Ventura first, Coleman second, and Humphrey third; and so forth. a. Suppose the election is by plurality rule, which means that the candidate with the most first-place votes wins the election. Who wins in this case? b. In Challenges question 19, you were introduced to the Marquis de Condorcet. Today, voting theorists call a candidate a Condorcet winner if he or she can beat every other candidate in a series of 1:1 or “face-off” elections. Question 19 showed you that in some cases, there is no Condorcet winner. What about in the Minnesota guber¬natorial election of 1998? c. A Condorcet winner beats every other candidate in a face-off. A Condorcet loser loses to every other candidate in a face-off. Was there a Condorcet loser in the 1998 Minnesota gubernatorial election (given the preferences we have estimated)? Solution 21. a. Jesse “The Body” Ventura wins with 37% of the vote, followed by Coleman with 35%, and Humphrey with 28% of the vote. This, in fact, is what happened in the actual election. b. Coleman was the Condorcet winner. In a face-off with Ventura, Coleman would have won in a landslide, with 63% of the vote to Ventura’s 37%. Coleman would also have beat Humphrey in a face-off, with 55% of the vote to Humphrey’s 45%. Do you see where Humphrey’s 45% of the vote came from? Count up all the vot¬ers who rank Humphrey above Coleman (28% + 17% = 45%). c. Yes. We know from answer b that Ventura would have lost to Coleman in a face-off, so the only question is what would happen in a face-off between Humphrey and Ventura? In this case, Humphrey would have won in a landslide, with 63% of the vote to Ventura’s 37%. In other words, Jesse Ventura was a Condorcet loser, but don’t tell him that to his face! What this question shows us is that plurality rule, the standard voting system used in the United States, can elect Condorcet losers and fail to elect Condorcet winners. As a result, many people who study voting consider plurality rule to be one of the worst ways to elect people to office. CHAPTER 21 Modern Principles of Economics: Economics, Ethics, and Public Policy Facts and Tools 1. a. In this chapter, we never actually defined “exploitation.” What is one dictionary definition of the word? b. Decide whether the six cases of alleged exploitation we discussed earlier in the chapter fit your dictionary’s definition. Yes, this will involve quite a bit of personal judgment, as will most of this chapter’s questions. c. In your opinion, does the dictionary definition go too far or not far enough when it comes to labeling some voluntary exchanges as exploitation? Solution 1. a. Students will use many dictionaries, of course. The Oxford English Dictionary’s definition 1b is the closest to the usual American usage, but it’s quite different from what most economists would consider exploitation: “The action of turn¬ing to account for selfish purposes, using for one’s own profit.” This is too broad from the economist’s point of view since almost all production and trade would then be considered exploitation. MSN Encarta’s definition gets closer to the typical American usage: “unfair treatment or use: the practice of taking selfish or unfair advantage of a person or situation, usually for personal gain.” The unfairness seems to be the key element of the United States use of the term. b. This will vary, of course. To decide if the six cases of alleged exploitation fit the dictionary definition, assess whether there’s a significant power imbalance and unfair advantage. Use personal judgment to determine if the actions taken by one party excessively benefit at the expense of another. If the terms of engagement were voluntary and mutually beneficial, it may not be exploitation. Otherwise, it likely is exploitation if unfairness dominates. Each case will vary based on these factors. c. Most students will realize that “unfair” has a very loose meaning. A key goal of this chapter is to introduce the students to three kinds of “fairness”: Rawlsian, utilitarian, and Nozickian. 2. Of the three ethical theories we discuss (Rawlsian, utilitarian, and Nozickian), which two are most different from the third? In what way are the two different from the third? Solution 2. Rawls’s perspective and utilitarianism are quite different from Nozick’s view. The first two look directly at the well-being of people, while Nozick looks only at whether the transactions involved were individually just, with no regard for the effect on individual or aggregate well-being. 3. One of Nozick’s arguments against utilitarianism was the “utility monster”: A person who always gets enormous happiness from every extra dollar, more happiness than anyone else in society. If such a person existed, the utilitarian solution would be to give all the wealth in society to Nozick’s utility monster: Any other income distribution would needlessly waste resources. This possibility was appalling to Nozick. Nozick’s argument is intentionally extreme, but we can use it as a metaphor to think about the ethics of real-world income redistribution. a. Do you know any utility monsters in your own life: people who get absurdly large amounts of happiness from buying things, owning things, going places? Perhaps a family member or someone from high school? b. Do you know any utility misers? That would be people who don’t get much pleasure from anything they do or anything they own, even though they probably have enough money to buy what they want. c. In your view, would it be ethical for the government to distribute income from real-world utility misers to real-world utility monsters? Why or why not? Solution 3. a. and b. Most students will be able to think of someone for each case. c. If students are utilitarian, they will say yes, and if they are Rawlsian or Nozickian they will likely say no. (There’s some chance a student will think that the “utility monster” is the worst-off person in society, in which case she’ll defend redistribution on Rawlsian grounds.) 4. a. Just thinking about yourself, if you did not know in advance whether you were a Red, Blue, or Green person, would you rather live in Society A, B, C, or D, discussed in the Rawls’s section of the chapter? Why? b. Which society would you like least? Why? Solution 4. a. This will give students a chance to think about their own willingness to take risks. Students who choose A are strong egalitarians or, in other words, have strong “inequality aversion” (a trait that many humans share with many capuchin monkeys, according to Brosnan and de Waal [Nature, 2003]). Few will love risk enough to choose B, which is just a mean-preserving spread of A. Most will probably choose C: Things are only a little worse off at the low end compared with A, yet they’ll probably wind up quite rich. More risk-loving students will choose D. b. Option B—high risk, low return—will probably get the fewest votes. 5. Rawlsians support government income redistribution to the worst-off members of society. If “society” means the whole world, how much redistribution might be involved? In other words, what fraction of people in the rich countries might have to give most of their income to people in the poorest countries? Keep in mind that the poorest Americans have clean water, guaranteed food stamps, and free health care, while billions of people around the world lack such guarantees. Solution 5. Under a global Rawlsianism, it seems that most people in the rich countries would have to give the overwhelming majority of their income to the poorest people in the world, unless the prosperity of the rich could be justified as a way to help the world’s poorest. Perhaps the inventors in the rich countries need to be rewarded in order to invent new drugs or new food sources or new economic models to help the world’s poorest people: That would justify their keeping some of their earnings. But since few of the poorest Americans are making such contributions to the poorest Asians, Africans, and Latin Americans, poor Americans would likely end up contributing a lot to the poor of the rest of the world. This is another reminder that the poor in the rich countries are largely poor by local standards, not by global standards. 6. Would a “global utilitarian” (someone who values the utility of everyone in the world equally, without giving more weight to people in their own country) who lives in America want more immigrants from poor countries or more immigrants from rich countries? Why? Solution 6. A global utilitarian would want more immigrants from poor countries, because immigration massively improves the lives of immigrants from poor countries, but only has a modest effect on the lives of immigrants from rich countries. Thinking and Problem Solving 7. To a Rawlsian, would the world be better off without the Harry Potter novels and one additional billionaire? Solution 7. Under the Rawlsian view, it’s possible, perhaps even likely, to be pro-Potter. A Rawlsian supports inequality when it helps the worst-off members of society. And if “society” only refers to people in the rich countries (a strange but common formulation of the Rawlsian view), then we should notice that a lot of low-income Americans love the Harry Potter books. They read them secondhand, they borrow them at libraries, they save up and buy paperbacks. Since the books make their lives better off, Rowling’s wealth is justified. Of course, for the Rawlsian, it could be even better if Rowling’s wealth were taxed and distributed to the poor—so long as she wasn’t taxed at such a high rate that she didn’t write the books. 8. Some people say that the right to equal treatment has no price. But it seems that most people don’t really believe that: Those are just polite words that we tell one another. Consider the following cases: a. What if it cost $10 million per kneeling bus? b. What if it costs $10,000 to hire translators to translate ballots into a rare language spoken by less than 10 voters? c. What if it costs the lives of dozens of police officers to ensure the right of a persecuted minority to vote? d. At these prices, is the right to equal treatment too expensive for society to buy it? In each case, describe what you think the exact price cutoff should be (in dollars or lives), and briefly explain how you came to that decision. Why not twice the price? Why not half? Solution 8. a. Most students would pick a price of well under $1 million per bus, perhaps as low as $10,000. b. This might be the one that students think is a reasonable price. But few students will choose a price greater than $100,000. c and d. When a determined violent insurgency fights against minority rights they often win, so there will be a number of probably no more than 100 police officers for most students. The question of time frame will matter: If 50 officers die for a “permanent” right to vote, that might be worth it in a way that a 20-year victory would not. 9. The line between “having a meddlesome preference” and “recognizing an externality” is not always clear. Both are ways of saying, “What you’re doing bothers me.” As we used it in this chapter, a “meddlesome preference” is some¬thing that reasonable people should just not worry about so much. By contrast, “recognizing an externality” is a way of putting up the subject for public discus¬sion and perhaps even for a vote. In the town you grew up in, which of the fol¬lowing issues were considered things that should be left to individuals and which were things that should be put up for a vote? Is there a good way of distinguish¬ing between the two? a. The amount of pollution emitted by a local factory b. How much noise would be allowed after 11 P.M. c. Whether siblings should be allowed to marry, even if it is consensual d. Where liquor stores could be located e. How people should dress in public f. How many children someone should have Solution 9. Students will have different answers, but it’s important to note that the distinction between negative externality and “meddlesome preference” is in part culturally determined. A good case can be made, for example, that how many children someone has does have a big externality effect (which could be positive or negative) while whether siblings marry does not. Yet in the United States, the former is considered something that should be unregulated while the latter is illegal. In other times and places, how many children someone should have has been regulated and the argument for regulation was supported using externality arguments. In the United States, the state of Virginia passed a compulsory sterilization law for the mentally retarded “for the protection and health of the state.” Oliver Wendell Holmes, the highly respected Supreme Court justice, declared the policy constitutional and wrote “The principle that sustains compulsory vaccination is broad enough to cover cutting the Fallopian tubes” (Buck v. Bell, 274 U.S. 200, 1927), a very direct connection between two types of negative externality arguments, one of which almost everyone supports today and the other of which is denounced. The ethical component of negative externality arguments is often ignored by economists. 10. Let’s see how a utilitarian dictator would arrange things for Adam, Eve, and Lilith. One heroic assumption that utilitarians make is that you can actually compare happiness and misery across different people: In reality, brain scans are making this easier to do but it’s still a lot of guesswork. Let’s suppose that this utilitarian dictator has eight apples to distribute: The table below shows the utility that each person receives from their first apple (a lot) but extra apples give less extra happiness (apples give diminishing marginal utility, in economic jargon). a. So, if the dictator wants to maximize the sum of Adam, Eve, and Lilith’s utility, how many apples does each person get? b. If, instead, Lilith received 2,000 units of utility from the first apple, how would this change the optimal utilitarian distribution? Solution 10. a. Just start off giving the first apple to the person with the highest utility in the first row, and then proceed from there, looking for the next smallest number. Lilith first, then Adam, then Eve (equal distribution for each person’s first apple), then Eve again and again and again (she’s the utility monster here), then Lilith, and the last one for Adam. So, two each for Adam and Lilith, and four for Eve. b. It would not change at all. It’s just good news for Lilith. 11. a. The “trolley problem” is a famous ethical puzzle created by Phillipa Foote: You are the conductor of a trolley (or subway or streetcar or train) that is heading out of control down a track. Five innocent people are tied to the track ahead of you: If you run over them, they will surely die. If you push a lever on your trolley, it will shift onto another track, where one unfortunate person is tied up. Either you let five people die or you choose to kill one person: Those are your only choices. Which will you choose and why? Which ethical view from this chapter best fits your reasoning? (If you Google “trolley problem,” you will find many other interesting ethical dilemmas to debate with your friends.) b. Another ethical dilemma sounds quite different: You are a medical doctor trying to find five organ donors to save the lives of five innocent people. A new patient comes in for a checkup, and you find that this patient has five organs exactly compatible with the five innocent people. Do you kill the one innocent patient to save the lives of five innocents? Suppose you will never get caught: Perhaps you live in a country where people don’t care about such things. Is this the same dilemma? Is it the same dilemma from a utilitarian perspective? Solution 11. a. Probably most students will be okay with switching the trolley to the other track. This sounds utilitarian. b. The numbers are the same but the answer will be quite different—it’s hard to pin down what essential difference exists between these two stories. From a strict utilitarian perspective, there is no difference. 12. What do you think best describes the reason that trade in recreational drugs is illegal: fear of exploitation, meddlesome preferences, notions of fairness, paternalism, concerns about equality, or some other factor? Solution 12. Students will differ in their answers, of course, but meddlesome preferences and paternalism/exploitation will be at the top of the list. Negative externalities (crime) might be mentioned, as will the power of government to help people to solve self-control problems. 13. Based on the tools from this chapter, how could a person reasonably justify a ban on gambling? Solution 13. Gambling may be considered exploitive since it appeals to those who are the worst off and its effect is only to make them even more worse off. It may also run afoul of certain religious or personal doctrines—these would be more like externalities or meddlesome preferences. If it’s mostly poor people who are gambling and gambling redistributes to the richer citizens, then utilitarians or Rawlsians would object to gambling. 14. Compare a Rawlsian view against a utilitarian view on the question of whether it should be legal to copy movies and music freely. Solution 14. Under Rawls’s maximin criterion, the free copying of music by those who are the worst off will create a welfare improvement, but broad copying of music by all people could not be welfare-improving. It may in fact limit the quality of music that could be freely given to the worst off in the future, leading to decreases in their potential future welfare. So, a Rawlsian would look for a way for the poor to copy music for free. Currently, by contrast, it is the technologically literate who can copy music for free. Utilitarian analysis would hold that limited amounts of music copy¬ing could increase welfare, though only a small amount, by people who would not have paid full price and thus would not have enjoyed the music but for the copying. The primary utilitarian argument against legalizing music copying is that it could reduce the incentive to produce good music, leading to a reduction in social welfare. The primary Nozickian or rights-based argument is that if the producer has not agreed to allow copying, then copying music is very similar to stealing. Challenges 15. Should responsible adults be allowed to sell a kidney? Why or why not? If so, what restrictions would you place on such sales, if any? (For more on this issue, link to the Kidney for Sale video on page 411.) Solution 15. They’re on their own for this one, though one can imagine restricting donors if they have certain diseases (HIV/AIDS) or are under duress from the recipient. 16. a. In your view, when should governments enforce a “live and let live” rule: on issues that matter most to people (e.g., matters of life and death, matters of how much income to give to the government, matters of religion, matters of sexuality) or on the issues that matter least to people (e.g., what flavors of spices are permitted at the dinner table, what kind of clothing is acceptable in public)? b. Europeans fought a lot of wars in the 1500s over the right to meddlesome preferences. Thinking back on your history courses, what preferences did Europeans want to meddle with? c. What was the usual argument given in the 1500s for why it was right to meddle with other people’s preferences? Solution 16. a. This is intentionally ambiguous: In our society we have a strong tolerance norm on religion but less so regarding the other three. Most will oppose “live and let live” when it comes to taxation, in particular. b. Religious preferences. c. Interfering with someone’s religion strikes us today as meddlesome but in earlier eras this was considered good public policy on negative externality and paternalistic grounds. After all, religious decisions have eternal consequences, so it’s reasonable to meddle with other people’s decisions if they are about to make a huge mistake. It’s an extreme version of product safety regulation: Firms have no right to sell danger¬ous products, so similarly false religions (whose effects last eternally) should have no right to sell dangerous products. See also Thinking and Problem Solving question 9. 17. Philosopher Alastair Norcross poses the following question. Suppose that 1 billion people are suffering from a moderately severe headache that will last a few hours. The only way to alleviate their headache is for one person to die a horrible death. Can the death of this one person ever be justified in a cost-benefit sense? Solution 17. Utilitarianism would seem to suggest that there is some particular number of people such that relieving their small pains is worth the death of a single person. Does this sound inhuman? Coal miners risk their lives to heat our homes—why is this different? Note that we, Tyler and Alex, disagree about the correct answer to this question. See here (and follow the links for more). http://www.marginalrevolution.com/marginalrevolution/2006/11/headaches/comments Norcross’s argument can be found here: Norcross, Alastair. 2003. Great Harms from Small Benefits Grow: How Death Can Be Outweighed by Headaches. Analysis 58 (2): 152–158. 18. If the rich countries were able to send individual cash payments to people in poor countries, bypassing possibly corrupt governments, would you let rich countries pay people in poor countries to take their high-polluting factories? If so, how high would the annual payment have to be per family? If not, why not? Solution 18. Again, they’re on their own. If rich countries could bypass corrupt governments and directly pay families in poor countries to host high-polluting factories, ethical and economic considerations come into play. Accepting such payments could be viewed as enabling environmental harm to marginalized communities. However, if the payment were to be justified, it would need to be substantial enough to cover long-term health care, environmental cleanup, and opportunities for sustainable development. A potential figure should reflect not just immediate needs but also compensation for future risks. Refusing this offer may prioritize environmental justice and the right to a clean and safe living environment. 19. You would probably sacrifice yourself to save all of humanity, but you probably wouldn’t sacrifice yourself to save the life of one random stranger. What number is your cutoff: How many lives would you have to save for you to voluntarily face sure death? Solution 19. You’ll have a massive standard deviation on this answer. Determining a personal "cutoff number" for the amount of lives one would save at the cost of their own is complex and depends on one's values, sense of duty, and emotional attachments. People might make different choices based on a mixture of altruism, the perceived impact of their sacrifice, or the people involved. 20. Some people feel inequality is justified if the people with unequal outcomes accepted risks voluntarily; it was simply the case that some won and some lost. Imagine two people, each spending $10,000 on lottery tickets, but only one of them wins. We end up with one poor person and one multimillionaire. Is this inequality better or worse than if one person is born into a rich family and the other is born into a poor family? What exactly is the difference and why? Solution 20. There is a lot of room for different opinions here. 21. Sometimes poor countries have a lot of people; India has more than 1 billion people. Indians are relatively poor and we know that as families become wealthy, they tend to limit their number of children. So, a much wealthier India, over time, would probably have many fewer than 1 billion inhabitants. Would this make for a better India or a worse India? Although each Indian would have much more, there would be fewer Indians. As a result, is there any argument for keeping India poor, so as to have a higher number of people? If not, why not? In general, what can economics tell us about the ideal number of people in a society? Anything at all? Solution 21. Utilitarianism has traditionally assumed that the number of people is fixed and the goal is to raise their utility. But once we allow population to vary, the goal is not obvious. Is the goal to maximize total utility, for example, or utility per capita? Maximizing total utility could lead to a large population with each person quite miserable (but still glad to be alive). Maximizing average utility could lead to very few people, each with lots of utility. Economics offers no answer to these questions, but economic concepts of total, average, and marginal are useful for thinking through these questions. 22. Let’s say that Tom, who is 25 years old, wants to smoke a cigarette. Consider the following two situations. a. Tom is smoking. Suddenly the government comes along and tells Tom that he cannot do this. The government claims that Tom is inflicting an “external cost” on other human beings. Is this a good policy or bad policy? b. Tom is smoking a cigarette at home with no one else around. Suddenly the government comes along and tells Tom that he cannot do this. The govern¬ment claims that Tom is inflicting an “external cost” on another human be¬ing. Tom asks who this might be. The government says that the 65-year-old-Tom will be harmed by the smoking-today-Tom. The government claims that today-Tom isn’t doing enough to look out for the well-being of future-Tom. Does this argument make any sense? Is it ethically correct? If so, can and should we trust our government to make these decisions for our future selves? Solution 22. a. The standard negative externality argument would seem to apply here, at least to the extent that secondhand smoke is dangerous. Note that an econo¬mist would suggest taxing smoking but probably not so much as to reduce smoking entirely. Given particular circumstances, there may also be variations on the argument. A ban on smoking in bars, for example, is difficult to justify in standard economics because the bar can internalize the externality—that is, the bar can allow or not allow smoking so as to maximize the net benefits of those who come to the bar. Note that in terms of ethics, those people in favor of a smoking ban will argue that the smoking is a rights violation—we don’t allow people to trespass on other people’s property so why should we allow smoke to trespass? Those against the ban will argue that there ought to be some scope for freedom of choice and in the case of the bar, people can choose to associate with smokers or not. b. There is also a lot of room for opinion here! The question goes beyond economics and even beyond ethics to consider the nature of the self. Many people have conflicting goals and desires —whether to eat chocolate or lose weight—which suggest that today-Tom and future-Tom may be quite different people. Today-Tom certainly has some incentive to look out for future-Tom but perhaps not enough. Interestingly, some smokers don’t want to stop smoking but will support a tax on cigarettes, suggesting that they seek ways to govern themselves. There is also a lot of room here for disagreement on the role of government. CHAPTER 22 Modern Principles of Economics: Managing Incentives Facts and Tools 1. This chapter had four big lessons. Each of the following situations illustrates one and (we think) only one of those lessons. Which one? a. Militaries throughout the world give medals, citations, and other public honors to members of the military who excel in their duties. b. People tip for good service after their meal is concluded. c. Real estate agents work on commission, but office managers at a real estate office are paid a straight salary. d. In Pennsylvania in 2009, two judges received $2.6 million in bribes from a juvenile prison. The more people they sent to jail, the more they received from the prison owners. What tipped off prosecutors was that the judges were sentencing teens to such harsh sentences for relatively minor crimes. One teenager was sent to prison for putting up a Facebook page that said mean things about her school principal; another accidentally bought a stolen bicycle. (Both judges pled guilty.) e. Studies have shown that when employers initially enroll all workers in a retirement plan, the workers save more than when they must ask to join the retirement plan, even when in both cases workers can quit or join the plan at any time. Solution 1. a. Lesson Three: Money isn’t everything. b. Lesson Two: Tie pay to performance. c. Lesson Two: Tie pay to performance. d. Lesson One: You get what you pay for. e. This demonstrates that nudges can work. Initially enrolling all workers in the plan leads more workers to stay in the plan, a default option bias that is similar to the organ donor example used in the chapter. 2. An American church sends 10 missionaries to Panama for three years to try to find new converts. Every six months, the missionary with the most new converts gets to be the supervising missionary for the next six months. This basically means that he or she gets to drive a car, while the other 9 have to walk or ride bicycles. Clearly, this is a tournament. Now consider the following two cases. For which case will the church’s incentive plan work better? (Hint: Think about ability risk vs. environment risk.) Case I: Missionaries specialize in different regions: Some stay in rich neighborhoods for the whole six months, others stay in the poor neighborhoods for the whole six months. Case II: Missionaries move from region to region every few weeks, so that all missionaries spend a little time in every kind of Panamanian neighborhood. Solution 2. Case II is probably better. In Case I, the tournament-winning missionary might just be in a district where people want to join a religion. In Case II, everyone has a fair chance at spending a little time in the most promising neighborhoods. In Case I, you may be rewarding luck. In Case II, the best missionary is more likely to win the tournament. 3. Clever marketers understand choice architecture. Why are clearance racks in clothing stores usually located in the back of the store rather than in the front? Solution 3. The clothing at the clearance racks are sold at lower profit margins. Therefore, locating the clearance racks at the back ensures that people in a hurry and having less patience will choose clothes from the fresh stock, which have higher profit margins. 4. The basketball player Tim Hardaway was once promised a big bonus if he made a lot of assists. Can you think of any problems that such an incentive scheme might cause? Many professional athletes get a bonus if they win a championship. Is this kind of incentive better or worse than a basketball player’s bonus for assists? Why? Solution 4. It is probably better because it is more closely tied to what the team’s owners might actually want—a championship. In addition, if everyone gets a bonus when the team wins a championship, this encourages team behavior, such as passing. 5. Let’s return to Big Idea Four (thinking on the margin) back in Chapter 1. Why are calls to give harsher penalties to drug dealers and kidnappers often met with warnings by economists? Solution 5. Economists worry about reducing the incentives for an attacker not to kill his or her victim. For instance, when penalties for crimes less than murder are the same as the penalty for murder, the marginal cost of murdering a victim is reduced. Once the criminal kidnaps you or sells a lot of drugs, that person might as well kill everyone in his or her way. Economists thus are attempting to protect possible victims when they speak out against increasing penalties. 6. Why are salespeople so much more likely than other kinds of workers to be paid on a “piece rate” (i.e., on commission)? What is it about the kind of work they do that makes the high-commission + low-base-salary combination the equilibrium outcome? Solution 6. The key reason is because sales are close to what a manager wants and they are easy to observe: Either the person moves a lot of product or not. In many examples from the chapter, piece rates are risky when the quality of output is more difficult to observe. But that’s not a real problem with sales. It is possible that strong incentives cause salespeople to be overly aggressive, as we discussed in the chapter, but if the salespeople stick around for a long time, they have an incentive to build long-term relationships with customers, which is usually in line with the owner’s long-term interest. There is another reason why salespeople are often paid on commission: It’s very easy for a salesperson not to work hard. If the boss paid low or zero commissions, then the worker could always tell the boss that “the fish just aren’t biting today” or “times are tough out there, nobody wants to buy.” So the boss would pay workers a high salary but get few sales. That’s not an equilibrium. Putting it all together, from the owner’s perspective, paying based on sales means that “what the owner pays for” is very close to “what the owner wants.” 7. Unlike in the previous question, sometimes piece rates don’t work so well. Why might the following incentive mechanisms turn out to be more trouble than they’re worth? a. An industrial materials company pays welders by the number of welds per hour. Of course, the company pays only for necessary welds. b. A magazine publisher pays its authors to write “serial novels” one chapter at a time. The authors are paid by the word (common in the nineteenth century and how Dickens and Dostoyevsky made their livings). Solution 7. a. It takes time to heat the metal enough to make a good weld. If the welder is paid by the piece, the welder won’t worry about quality, just quantity, and it’s not easy to judge a quality weld after the fact. Finally, if the welder is putting together a bridge, quality matters. b. You’ll get very long novels, just as in real life. Quality will usually suffer, although the novels by Dickens and Dostoyevsky turned out okay. 8. The typical corporate executive’s incentive package offers higher pay when the company’s stock does well. One proposal for such executive merit pay is to instead pay executives based on whether their firm’s stock price does better or worse than the stock price of the average firm in their own industry. Does this proposal solve an environment risk problem or an ability risk problem? How can you tell? Solution 8. This solves an environment risk problem: Some years are just good for an entire industry. So if you pay the executive more when the stock price goes up, you might just be rewarding her for showing up. If you pay her based on how her firm does compared with the competition, it’s more like a “tournament” (though it’s a tournament where each player gets paid from a different pot of money). Tournaments are good for solving environment risk problems. Thinking and Problem Solving 9. In 1975, economist Sam Peltzman published a study of the effects of recent safety regulations for automobiles. His results were surprising: Increased safety standards for automobiles had no measurable effect on passenger fatalities. Pedestrian fatalities in automobile accidents, however, increased. (This is now known as the Peltzman effect and has been tested repeatedly over the decades.) a. Why might more pedestrians be killed when a car has more safety features? b. Economists have looked for ways out of Peltzman’s dilemma. Here’s one possible solution: Gordon Tullock, our colleague at George Mason, has argued that cars could have long spikes jutting out of the steering column pointed directly at the driver’s heart. Keeping Peltzman’s paper and the role of incentives in mind, would you expect this safety mechanism to result in an increase, decrease, or no change in automobile accident fatalities? Why? c. Would a pedestrian who never drives or rides in cars tend to favor Tullock’s solution? Why or why not? Solution 9. a. The incentive to drive faster or in a riskier way is higher if the car is safer, because in a safer car an accident is less of a problem. Less of a problem for the passengers, but not for pedestrians! (The regulations Peltzman was studying only improved safety for those inside the car.) b. Tullock’s solution would almost surely create a wave of safe driving across the country. Drivers would never want to get in even the smallest fender bender, since it could be fatal. Indeed, people would probably drive much less. Tullock’s solution might make drivers too careful. c. Pedestrians would probably favor Tullock’s solution, because they want drivers to be very careful on the road, and current highly safe cars encourage careless (or more politely, “carefree”) driving. 10. One reason it’s hard for a manager to set up good incentives is because it’s easy for employees to lie about how they’ll respond to incentives. For example, Simple Books pays Mary Sue to proofread chapters of new books. After an author writes a draft of a book, Simple sends chapters out to proofreaders like Mary Sue to make sure that spelling, punctuation, and basic facts are correct. As you can imagine, some books are easy to proofread (perhaps Westerns and romances), while others are hard to proofread (perhaps engineering textbooks). But what’s hard or easy is often in the eye of the beholder: Simple can’t tell which books are particularly easy for Mary Sue to proof, so they have to take her word for it. Let’s see how this fact influences the publishing industry. In the following figure, Q is the number of chapters in the new book, Burned: The Secret History of Toast. It’s a strange mix of chemistry and history, so Simple isn’t sure how Mary Sue will feel about proofing it. The marginal cost curve shows Mary Sue’s true willingness to work: The more chapters she has to read, the more you have to pay her. If Simple offers to pay her $50 per chapter, as shown, she’ll actually finish the job. a. If Mary Sue wants to bluff, claiming that the book is actually painful to read, what is that equivalent to? Supply curve shifting left Supply curve shifting right Demand curve shifting down Demand curve shifting up Once you decide, make the appropriate shift in the figure. b. The publisher just has to have Mary Sue proof all Q chapters of Burned,: All its other proofreaders are busy. The publisher will pay what it needs to for her to finish the book. This is the same as another curve shift in a certain direction: Draw in this shift in the figure. c. What did Mary Sue’s complaining do to her price per chapter? What did it do to her workload? d. (Bonus) You’ve seen how Mary Sue’s bluffing influenced the outcome. What are some things that Simple might do to keep this from happening? Solution 10. a . b. This is the same as the demand curve shifting up. c. Her complaining raised her price per chapter, while keeping her workload unchanged. d. One way is to have a lot of proofreaders available: That way, Simple can always shop around, asking another proofreader if he wants to take the job. It might also have higher-level editors with enough experience in the industry to know what’s really difficult and what’s not that difficult; experienced managers might help solve these bluffing problems. 11. Who do you think is in favor of forbidding baseball player contracts from including bonuses based on playing skill? Owners or players? Why? Solution 11. Although teams would certainly benefit from paying based on performance, players could stand to lose millions of dollars a year if they are injured or underperform, quite a substantial amount, especially given the short careers of professional athletes. While these types of bonuses may give athletes incentives to increase their skills, the downside risk is severe enough that they would choose to ban these types of contracts. Thus, it is most likely the players (through their union) would vote to forbid these types of contracts. Because the biggest environmental risk is on the player’s side, they’re probably the most worried about the downside of incentive contracts. 12. In the short, readable classic Congress: The Electoral Connection, David Mayhew uses the basic ideas of incentives and information as a pair of lenses through which to view members of Congress. What he saw was quite simple: The urge for reelection drives everything. Thus, members are driven by self-interest to give the voters in their home district as much as possible. Of course, voters face the same problem in judging members of Congress that any manager faces when evaluating an employee: Some outputs are harder to measure than others, so voters focus on measurable outputs. With that in mind, what will voters be most likely to care about? Choose one from each pair and briefly explain why you made that choice. a. How many dollars come to the district for new hospitals and highways vs. how many dollars are spent on top-secret military research. b. How well the member behaved in private meetings with Chinese leaders vs. how the member sounded on Meet the Press. c. How well the member did in reforming the Justice Department vs. how well the member did at the Turkey Toss back in the district last Thanksgiving. (As you’ve seen, voters’ focus on the visible can easily drive the member’s entire career. Mayhew’s book was an important early work in “public choice,” the use of basic microeconomic ideas like self-interest and strategy to study political behavior. For more on the topic, Kenneth Shepsle and Mark Bonchek’s short textbook Analyzing Politics is highly recommended. See also Chapter 20 of this textbook.) Solution 12. a. The former: Hospitals are easy to see (and visit), while secret military projects are tough if not impossible for voters to evaluate. b. The latter: Voters can watch TV but not look in on private meetings. c. The latter: Government reform is tough to evaluate, but judging public appearances and handshakes is easy. 13. In the movie business, character actors are typically paid a fixed fee while movie “stars” are typically paid a share of the box office revenues. Why the difference? Try to give two explanations based on the ideas in this chapter. Solution 13. The first reason is that the success of the movie depends more on the stars than on the character actors—remember that the success of the movie depends not just on the acting ability of the stars but on how much effort they put into publicity after the movie opens—so paying the stars a share of the box office revenues is tying pay to performance. The second reason is a bit less obvious. Usually, firms have more wealth than workers and thus are more willing to bear risk. As a result, firms typically pay workers a salary that doesn’t vary much with firm profits. In the movie business, however, some of the stars are wealthier than the producers. It makes sense, therefore, for the stars and the producers to share some of the risk, which they can do by having the stars paid based on box office revenues. Reducing the risk to producers makes them more willing to produce risky movies. 14. Let’s return to the question we posed in the chapter: Suppose that the big environmental risk is not bad professors but rather hard material. Imagine, for example, that some classes are more difficult than other classes (quantum physics 101 vs. handball 101). If you really wanted to learn a little about quantum physics but you were afraid of reducing your GPA, you’d face a tough choice. A curve is better for you than an absolute scale, but even if your professor grades on a curve, you’re probably still sitting in a class with other well-trained physics majors. Let’s see if we can find a work-around. a. At your school, are there certain times of the day when the less serious, more fun-loving tend to take their classes? If so, when is it? If you sign up for a section scheduled then, you might look better on the curve. b. Some schools offer simplified (we won’t say “dumbed down”) versions of some hard courses. Does your school offer anything like this? If so, does it allow majors to take the same sections as the nonmajors? How is this sorting related to tournament theory? c. If you were a professor, which teaching schedule would you rather have: Two sections where the majors and nonmajors are mixed together, or one section with the majors and one with the nonmajors? Solution 14. a. At most schools, the afternoon classes bring in more casual students; they like sleeping in. At some schools, it could be night classes, but the morning classes tend to have the more serious students. b. Offering simplified courses is common and the simpler classes are usually for nonmajors only. This is a lot like sports tournaments in which the players compete in classes or levels. In the chapter, we emphasized that competing against people who are your peers provides better incentives. Here, we emphasize that it’s more fun. c. Professors would probably rather have the serious students in one section and the casual students in another. It’s also more fun for the professors to teach at a level that most of their students can understand rather than to confuse some and bore others. 15. When an accused defendant is brought before a judge to schedule a trial, the judge may release the defendant on his or her “own recognizance” or the judge may demand that the defendant post bail, an amount of cash that the defendant must give to the court and that will be forfeited if the defendant fails to appear. Many defendants don’t have the cash so they borrow the money from a bail bondsperson. So if the defendant fails to appear, the bail bondsperson is out the money, unless the defendant is recaptured within 90–180 days. To recover their money, a bail bondsperson will hire bail enforcement agents, also known as bounty hunters, to track down the missing defendant. If the bounty hunters don’t find the defendant, they don’t get paid. a. If defendants released on their own recognizance fail to appear, they are pursued by the police, but if they are released on bail borrowed from a bondsperson and they fail to appear, they will be pursued by bounty hunters. Which type of defendant do you think is more likely to fail to appear and which type is more likely to be recaptured if they do fail to appear? Why? b. Perhaps surprisingly, bounty hunters tend to be quite courteous and respectful even to defendants who have tried to skip town. Can you think of one reason why? Solution 15. a. Defendants who fail to appear are more likely to be recaptured and they are recaptured more quickly when they are pursued by bounty hunters than when they are pursued by the police. It takes a lot of boring legwork to recapture defendants. Bail bondspersons and bounty hunters have the strongest incentive to recapture defendants because if they don’t, they are out of business. Perhaps for this reason, defendants released on bail borrowed from a bondsperson are more likely to show up for trial than similar defendants released on their own recognizance. Source: Helland, E., and A. Tabarrok. 2004. The fugitive: Evidence on public versus private law enforcement from bail jumping. Journal of Law and Economics XLVII(1): 83–122. b. On his television show Dog the Bounty Hunter, Dog is courteous to the people he captures but that’s TV. One of the authors of this textbook (Tabarrok), however, found that bail enforcement agents in Baltimore were also very courteous to defendants. One of the bail enforcement agents explained why: “We rely a lot on repeat business.” 16. a. Why do so many charitable activities like marathons, walks, and 5K runs give the participants “free” T-shirts, wristbands, hats, bumper stickers, and so forth? b. Charitable organizations could probably make a lot of money for their cause by selling these items on their websites, but you usually have to actually attend the “2018 Cancer Run” to get the “2018 Cancer Run” T-shirt. Why? Solution 16. a. These goodies are an incentive to participate: not because people want the hat but because people want to advertise their virtue to others, so they join the activity. These goodies are, of course, an important nonmonetary incentive. b. If you could buy the T-shirt on the Internet, it would cheapen the social signaling value of the shirt. Right now, the T-shirt is a signal that you cared enough about cancer to actually get out there and run early in the morning. If you can just get the shirt on the Internet, then it doesn’t stand for as much. 17. Waiters and waitresses are generally paid very low hourly wages and receive most of their compensation from customer tips. a. As the owner of a restaurant, what do you want from your waitstaff? b. Which element of a waiter’s or waitress’s compensation—the hourly wage or the tips—represents a method of “tying pay to performance”? c. Which element of a waiter’s or waitress’s compensation—the hourly wage or the tips—plays the role of “insurance” that the restaurant owner provides for the waitstaff? Against what are the waiters and waitresses being insured? d. Theoretically, a restaurant owner could pay workers a higher wage, raise menu prices, and make the restaurant strictly tip-free. Or, the owner could eliminate the wage, reduce menu prices, and encourage greater tipping by alerting customers to the fact that the waitstaff do not earn an hourly wage. What are the potential pros and cons (from the point of view of the restaurant owner) of each system? Solution 17. a. The owner wants the waitstaff to be polite and act professionally, to accurately communicate customer orders to the kitchen, and to be attentive to customer needs. (Some restaurants may have other wants as well, like doing side work or maintaining the restaurant’s image.) b. Tips tie a waiter’s or waitress’ pay to their performance with respect to how well they deal with customers. Neither tips nor wages are tied to the performance of other tasks, like rolling silverware or refilling salt and pepper shakers. c. The wages act as insurance. Servers face uncertainty that they do not control, “environmental risk” from cooks, competitors, and other factors. If the cook is having an off night, for example, tips will decrease even when servers do their jobs well. If a new restaurant opens nearby or the economy goes into a recession, tips may fall regardless of how well servers do their jobs. Wages guarantee servers a certain minimum amount of compensation to make up for those times when tips fall independent of the performance of the waiter or waitress. d. Paying higher wages and discouraging tipping would protect servers from the environment risk and make their wages more predictable. This could increase productivity with respect to certain tasks, like side work, for which servers typically get paid very little. However, servers would have less incentive to be polite to customers or to respond quickly and appropriately to their needs. Such actions might reduce profits if customers decided the service was unacceptable. The other method (eliminating the wage and reducing menu prices to make tips a larger share of compensation) would give the workers a very strong incentive to be kind and attentive to customers, but it would eliminate the incentive to do any work for only the owner, like the side work already mentioned. If the environmental risk of bad tipping still existed, and was strong enough, some servers would not respond to the tip incentive, because they would feel like luck plays too great a role in the determination of tips. As the book points out, where luck plays a major role, there is less incentive to work hard. 18. In early 2004, Donald Trump took the idea of using a tournament for hiring executives to a whole new level with the premiere of the TV show The Apprentice. On the show, a group of contestants compete for position running one of Trump’s many companies for a starting annual salary of $250,000. Generally speaking, each episode, the contestants are divided up into teams and compete to most successfully complete some business-related task, and a member of the losing team is eliminated. a. Contestants for The Apprentice are carefully auditioned and screened to make sure that each contestant has the skills necessary to do well on the show. Why do you think this screening is done? What kind of risk is being eliminated by this audition process? What would happen if there was one contestant who, right from the beginning, demonstrated more potential and greater capabilities than the other contestants? b. Though only one contestant will end up with the job at the end of the show, each must try to prove his or her worth to Trump by performing well in the team challenges. What impact do you think the tournament structure of this “ultimate job interview” has on these team challenges? c. Some of the challenges can be quite demanding, and the contestants often work very hard. Wouldn’t it be easier if they all shirked rather than working hard? Trump would still (presumably) have to choose one of them as the winner—and chances are it would be the same person whether everybody worked hard or not. Why are the contestants not likely to all agree to stop trying so hard? Solution 18. a. The screening process is a way of eliminating ability risk. If one contestant were obviously much more talented than the others, no one would have an incentive to try very hard. The other contestants would realize that they don’t have a chance, and the contestant with the advantage would also realize that to win, he or she doesn’t need to exert maximum effort. This would make the show very boring, since all contestants would just wait for the inevitable outcome. b. Because each person is essentially competing with all the other contestants, cooperation in team challenges is likely to be strained. No contestant wants to lose the challenge and risk being fired, but also no contestant wants to cooperate with others so much that their efforts improve the performance or standing of another contestant. Indeed, watching the contestants navigate these mixed incentives is what makes this show (and others like it, like Survivor or Hell’s Kitchen) interesting. c. It would be easier if no one worked hard, and the outcome would probably be the same. It would also be very boring television. Fortunately for Trump, for the producers, and for the viewers, this is unlikely to occur because each individual contestant has an incentive to work hard, especially if all the other contestants agree to shirk. (Remember, cartel members like to cheat!) It is basically a prisoner’s dilemma. If all the contestants work hard, then an individual contestant must also work hard to try to win. If none of the contestants work hard, then working hard will make any individual contestant stand out. Working hard is a dominant strategy, so they will all work as hard as they can. 19. Suppose a CEO wanted more of her employees to get flu shots. How many of the four big lessons in this chapter can you employ to come up with different solutions? (Don’t worry if they’re not all feasible or practical—that’s the reason there are four big lessons in this chapter, not just one.) Solution 19. Student answers may vary, but here are some examples that use both money incentives, nonmoney incentives, and nudges: She could pay her employees to get flu shots or charge them if they get the flu! She could send a personal thank you note to each employee who gets a flu shot, or stop by their offices to say thanks, or publish a list of people at the company who haven’t had flu shots with the warning: “Stay away from these unvaccinated people.” The CEO could also publicly get a flu shot to indicate that the corporate culture supports keeping everyone healthy. Paying a nurse to come by the office to make getting the shot very easy and convenient could also work even better than paying employees to get flu shots. 20. A growing anticorruption campaign in India has a clever new tool: a zero-rupee note. The impressive note looks just like a 50-rupee note, but it is clearly marked as being worthless and contains anticorruption messages. Indians are encouraged to give these notes to public officials who demand or expect bribes. Over 3 million of the notes have been distributed since 2007. A Twitter user tweeted economist Richard Thaler (of Nudge fame) to ask whether this counted as a nudge. What do you think his answer was, and why? Solution 20. Thaler agreed it was a good nudge. It is a nudge because the purpose of it is to weed out corruption and eliminate the culture of bribery. It does not do this by coercion—by strictly enforcing punishments, and so on—but rather by reminding the government official that bribery is not acceptable and that law-abiding citizens should not have to participate in it to receive services from government officials. In one sense, it works like an information nudge: The fact that the notes are so popular reveals that many people are part of this movement and that public opinion against bribery is strong. 21. Researchers seem to have a lot of fun testing different nudges to see how well they work. In one experiment, they placed mirrors in shopping carts so customers at a grocery store were forced to look at themselves while they shopped. How would you expect this kind of nudge would impact shoppers’ behavior? (PS: It worked!) Solution 21. This kind of nudge would probably lead more people to the produce aisle to buy healthier, fresher foods. The mirror forces the shopper to look at themselves, and it could be that shoppers begin to recognize the relationship between the foods they eat and their own self-image. Challenges 22. Let’s tie together this chapter’s story on incentives with Chapter 15’s story about cartels. Suppose your economics professor grades on a curve: The average score on each test becomes a B–. If all the students in your class form a conspiracy to cut back on studying, point out how this cartel might break down just like OPEC’s cartel breaks down during some decades. Solution 22. Students will promise to cut back on studying but many will cheat on the promise. As a result, the deal will unravel, and it will be as if there was no deal at all. We’ll get the competitive solution, not the cartel solution. Grading curve cartels could work in very small classes in which students all know one another and see one another often—that could create a kind of honor among thieves—but that’s quite unlikely at most colleges. 23. What type of systems in the United States help overcome the incentive of physicians to order medically unnecessary tests? Solution 23. Insurance companies in the United States pay for most tests. In order to control their costs, insurance companies will not pay for tests that are unrelated to a patient’s condition. Insurance companies may also insist on third-party laboratories to conduct tests to remove the incentive for doctors to misdiagnose a patient to justify the tests. 24. In his path-breaking book Managerial Dilemmas, political scientist Gary Miller says that a good corporate culture is one that gets workers to work together when they face prisoner’s dilemmas (discussed in detail in Chapter 15). In a healthy corporate culture, you feel guilty if you’re being lazy while your buddy is working. Let’s sum up “guilt” as simply as possible: It’s some number “X” that represents how you feel. These figures are adapted from Figure 15.4. a. What does X have to be in order to keep this from being a prisoner’s dilemma? Answer with a range (e.g., greater than 12.5, less than –2). b. Now, there are two Nash equilibria in this problem. What are they? Using the language of Chapters 15 and 16, what kind of game has this just become? c. There’s an idea buried in the questions from Chapter 16 that will “point” Stan and Kyle toward the best possible outcome. What is it? (Keep in mind that a good corporate culture can help with this part, too.) Solution 24. a. Since X must be strictly less than 4, 3.9 or below would be a good answer—if students aren’t comfortable with the difference between “less than” vs. “less than or equal to.” b. The two equilibria are (Work/Work) and (Shirk/Shirk). This is a coordination game, even after the guilt is laid on. c. Focal points: The better, “payoff-dominant” equilibrium will seem natural to most people. 25. a. Many HMOs pay their doctors based, in part, on how many patients the doctor sees in a day. What problems does this incentive system create? b. If HMOs pay their doctors a fixed salary, what problems does this incentive system create? c. Ideally, we would like to pay doctors based on how long their patients live! What problems exist in implementing this type of system? Solution 25. a. The problem with paying doctors based on the number of patients they see is clearly the incentive to rush visits and not do a thorough job. This incentive is balanced by the doctors’ desire for a good reputation but it’s still a problem. b. A fixed salary has the opposite problem—doctors would have little incentive to be efficient. Of course, doctors would still have to show up for work, but they might spend too much time with the attractive patients with ankle sprains and not enough time with patients in greater need. c. The key to implementing this type of strategy is to accurately measure a patient’s life expectancy with and without the doctor’s treatment. We would like heart surgeons to be paid more, for example, the greater the survival rate of their patients, but if we do this in a naïve way, doctors might choose to do surgery only on their healthiest patients. We would like to reward doctors who take on risky cases and succeed, but that means we need to measure the health of patients going into surgery as well as the health of patients coming out of surgery. Getting incentives right is hard, and, as this chapter suggests, there are many important factors to consider that make finding the right incentives very complicated. 26. In most big cities, taxicab fares are fairly standardized, and they are regulated by local governments. For the sake of simplicity, assume that a cab driver works for a licensed taxicab company, and he or she pays a fixed daily fee for the use of the taxi; all fares and tips go to the driver. a. In Atlanta, Georgia, meter rates are $2.50 for the first 1/8 mile and $0.25 for each additional 1/8 mile. What are the benefits of allowing cab drivers to charge fares based on the number of miles driven? In other words, what good behavior is encouraged—or what bad behavior is discouraged—by this? What are the possible drawbacks? b. In addition to the meter rates, there is a $21 per hour waiting fee. Why do you think there is a waiting fee? If cab drivers could not charge a waiting fee, how might that change their behavior? What if cab drivers were always just paid an hourly wage of $21 per hour? What would be the benefits and drawbacks of this payment scheme? c. For some fairly standard trips in Atlanta, there are flat fees. A trip from the airport to anywhere downtown, for example, is always $30 (plus $2 for each additional person). What are the potential benefits and drawbacks of this kind of compensation scheme? Why might a city require this payment scheme for trips from the airport? d. In the chapter, we talked about the importance of the gap between what you pay for and what you want. What is it that Atlanta’s City Council and taxi customers want from the cab drivers in Atlanta? Which basis for cab fares (miles, hours, trips) comes closest to closing the gap between what is wanted and what is paid for? Solution 26. a. If cab drivers are compensated on the basis of miles driven, they have an incentive to drive as many miles as possible in a shift, which means they will pick up fares whenever they can and will get the customer to his or her destination as quickly as possible. Driving slowly and avoiding picking up customers are two behaviors that are discouraged by this incentive. Among the possible drawbacks are the possibility that driving very fast may become unsafe and that drivers may have an incentive to take “the long way” to a customer’s destination in order to rack up miles. (This second drawback is even more likely if the driver feels unsure that he or she will be able to pick up another fare right away.) b. If cab drivers could not charge a waiting fee, then they would never wait. Often customers need a taxi to take them to multiple locations to, say, run errands. No driver would allow this behavior if the meter could not run even if the car was not moving. However, if cab drivers were paid by the hour all of the time, they would drive very slowly. In this case, they would take “the long way” with respect to time, not miles as in part a above. If the $21 per hour wage applies only when there is a fare, then this payment scheme encourages the driver to pick up passengers. Also, since they drive slower, there may be some gains with respect to safety. If the $21 wage is paid by the owner of the taxi, then the driver would have no incentive to take any customers anywhere (if it can be avoided). Also, this behavior would be difficult to monitor. c. As with payment per mile, drivers compensated by a fixed fee will want to drive quickly, which has both benefits and costs. Note, however, that taxi drivers paid a fixed fee will want to take the fastest/shortest, route, i.e., a fixed fee discourages driving slowly or taking indirect routes. This may be particularly important for airport trips because, since visitors are less likely to know the quickest route to town, they are more vulnerable to exploitation by shady taxi drivers. A fixed fee means the passenger can rely on the taxi driver to take the shortest trip route without the passenger having to worry or check a map. d. What we generally want is for taxis to be available and for taxi rides to be as short (with respect to time) as possible and as safe as possible. (Students may have other additional criteria, too.) Paying by miles gives us available, but not necessarily safe (drivers will drive fast) or short (drivers may take the scenic route). Paying by time gives us available (if the wage is only paid when there is a fare) and possibly safe, but not necessarily short. The flat per-trip fee gives us available and short, but not necessarily safe. Students may have additional insights, as well. No scheme is perfect, which is why different cities have different schemes, and those scheme can even change within a city for trips from different locations. The general conclusion is that no scheme completely closes the gap between what you want and what you pay for. Solution Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766