This Document Contains Chapters 20 to 23 Chapter 20 Political Economy and Public Choice Learning Objectives After completing this chapter, students should: > understand what rational ignorance is and why the benefits of being an informed voter are small. > understand why the logic of political competition leads politicians to concentrate benefits and diffuse costs and the role that lobbyists play in this process. > know what political business cycles are and why they exist. > understand why democracies are less likely to kill or starve their own citizens than are other forms of government. Chapter Outline Voters and the Incentive to Be Ignorant Why Rational Ignorance Matters Special Interests and the Incentive to Be Informed A Formula for Political Success: Diffuse Costs, Concentrate Benefits Voter Myopia and Political Business Cycles Two Cheers for Democracy The Median Voter Theorem Democracy and Nondemocracy Democracy and Famine Democracy and Growth Takeaway Chapter Narrative This chapter explains a second reason that the world has so many policies this textbook has shown to be inefficient. The next chapter will give one possible explanation: that people value other moral considerations more than the logic of gains from trade. This chapter explains that one important reason we don’t have more efficient policies is because policymakers have bad incentives. The textbook began by emphasizing how good incentives lead to promoting the social interest. This chapter explains how the bad incentives faced by voters and policymakers often give economic actors bad incentives, and hence lead to inefficient policies. The chapter begins by exploring rational ignorance and the logic of politics. Most students will begin feeling very pessimistic about democracy while learning this material. The chapter ends on a relatively upbeat note: compared to other forms of government, at least democracies tend to kill or starve fewer of their own citizens! Teaching Tip: Students often have strong reactions to this material. It debunks much of what they might have learned in high school civics. Some students are enthralled by the material, others completely disheartened. Have fun with it. You might consider beginning your lecture with the in-class exercise at the end of this chapter. Voters and the Incentive to Be Ignorant More knowledge is a good thing, but relative to the benefit the knowledge will provide, sometimes the price of acquiring that knowledge is too high. You might illustrate this by asking the question that the textbook poses: how would their study habits change if you announced that you were going to average all of the students’ exams together and every student would receive the class average grade? Most students will admit that they’d study a lot less. It’s obvious that the marginal impact of their individual studying will do little to raise the class average and thus their own grade. The cost of acquiring knowledge (studying) doesn’t provide much of a benefit, so less knowledge will be acquired. Using the average grading example helps students understand the logic of rational ignorance in a nonthreatening way. The parallel to voting should be obvious. It is costly for an individual to acquire detailed information about policies and candidates. The only way that the information provides a benefit in terms of changing policy is if the individual voter turns out to be the marginal voter who changes the outcome of the election. Otherwise, the same candidate and policies would have been chosen even if the individual had remained uninformed. Since the likelihood of an individual vote being the one that makes the difference in a major election is near zero, so are the benefits of being informed. Because the information is costly to acquire and the benefits are nearly nonexistent, voters remain uninformed or rationally ignorant. It’s rational to be ignorant because the costs of eliminating the ignorance are greater than the benefits. Teaching Tip: You might ask the students how often they share stories or claims on social media. Then ask them what percentage of those “shares” they read and investigated (i.e., made sure there is some truth to them) before they shared the link. The percentage is likely quite low (published research shows about 6 in 10 will not read the link before sharing it), especially if the story or claim already supports something the student supports. You can use this to explain rational ignorance by asking them what the cost of investigating the link would be and compare that to what “cost” they face if the link is wrong. You can also tie this to the ideas of media bias and why media outlets might be willing to run stories before fully vetting the sources. There is massive evidence showing that citizens are rationally ignorant about political matters. When given six choices in a survey (welfare, interest on federal debt, defense, foreign aid, Social Security, health care) and asked to name the two largest sources of government spending among them, 41 percent chose foreign aid as one of the two despite the fact that it is by far the smallest program of the six. The second most popular choice was welfare. (Correct answers are defense and Social Security.) When it comes to specific legislation, people are similarly ignorant. Most Americans who were asked admitted to knowing “not much” or “nothing” about the Patriot Act. Hundreds of surveys over the years have demonstrated that Americans know little about political issues. Why Rational Ignorance Matters Rational ignorance matters for at least three important reasons: 1. If voters don’t know what legislation says or what economic conditions are, it is hard to make informed choices. This problem is compounded when voters don’t know the politicians’ position on the issues and is even worse when they don’t understand the possible solutions to problems. 2. Rationally ignorant voters will make decisions for irrational reasons. For example, better-looking candidates get more votes, although looks have nothing to do with policy. 3. Not everyone is rationally ignorant. For some groups or individuals, the benefits of a policy are high enough to outweigh the costs of being informed. Teaching Tip: Some students might be questioning just how misinformed voters can be, since so much information is provided in the news. It’s important to point out that much of the political news they receive is really entertainment. Politicians’ extramarital affairs make for more entertaining news than the details of the last farm bill. One survey showed that the best-informed voters were people who regularly watched The Daily Show and The Colbert Report (comedies) rather than those who read the daily paper. Special Interests and the Incentive to Be Informed Although voters have an incentive to be rationally ignorant, special interest groups do not. The textbook uses the example of the sugar quota, which raises the price of sugar in the United States to three to four times the world market price. Although sugar consumers are harmed by the quota, few of them know the quota exists, let alone its effects. The quota costs consumers over $1 billion per year, but because this cost is diffused over millions of sugar consumers, it costs each consumer only $5 to $6. Even consumers who do know of the quota’s existence aren’t likely to do anything about it. It takes more than $5 worth of effort to write or call their congressman, and there is little probability that that call would get the policy changed anyway. Although there are millions of sugar consumers, sugar production in the United States is concentrated among a handful of producers. For each producer, sugar quotas mean millions of dollars, so they are rationally informed about sugar quota policy. The House and Senate agricultural committees decide the sugar quotas. Sugar producers know who’s on the committee and contribute to their campaigns. Table 20.1 in the textbook lists how much each person on the Senate committee received from the American Crystal Sugar PAC. Many senators also received money from the American Sugar Cane League, the Florida Sugar Cane League, the American Sugarbeet Growers Association, and the U.S. Beet Sugar Association. Sugar planters and executives also make campaign contributions as individuals. José and Alfonso Fanjul run one of the largest sugar cane growing companies in the United States. Each donates individually—one to Democrats and one to Republicans—and other Fanjul brothers, wives, daughters, sons, and sisters-in-law make campaign contributions as well. A Formula for Political Success: Diffuse Costs, Concentrate Benefits Politicians can get ahead by establishing programs that have diffuse costs and concentrated benefits even when the total net benefit of a program is negative. The people who are harmed are rationally ignorant, so they will not oppose the program or punish the politicians who support it. Meanwhile, those who benefit from the program are rationally informed and will support the politicians who promote it. The politicians’ self-interest doesn’t align with the social interest. The textbook gives a number of examples of programs fitting this description; agricultural subsidies and price supports are one example. The political power of farmers has increased as the share of the farmers in the population has decreased, because the benefits of these programs have become more concentrated among the fewer remaining farmers and the costs more diffused over a larger population. Government spending on roads, bridges, dams, and parks concentrates benefits on local residents while diffusing costs across federal taxpayers. Alaska’s Bridge to Nowhere is an extreme example. It would have connected an island with a population of 50 to a town with a population of 8,900 at a cost to federal taxpayers of $320 million. Special tax credits and deductions rather than lower tax rates across the board are another way to concentrate benefits and diffuse costs. The federal tax code is more than 60,000 pages long and gets longer every year as politicians add new special interest provisions. A multibillion-dollar lobbying industry has sprung up to take advantage of the system and secure special programs for their clients. The influence of lobbies should not be underestimated. It is not uncommon for lobbies to propose and even write up the details of forthcoming legislation. Potential Pitfall: Students will be tempted to think that campaign finance reform is a solution to the problem. It is important to point out that campaign finance reform generally helps to protect incumbents from challengers because challengers need to raise more money to compete. Also, remind them that it is incumbents who will write campaign finance reform laws. Their incentive is obviously to protect themselves. For this reason, campaign finance reform laws generally tend to be very complicated, which makes it hard for “outsiders” to comply with them. The same is true for rules which limit the ability of government officials to become lobbyists (revolving door policies). While these are likely very popular with the general population, why is it so hard to get such laws though the legislatures? Although each special interest policy may harm the economy by only a few million or billion dollars, when they are all totaled up, they can cost the economy a great deal and slow down economic growth. Voter Myopia and Political Business Cycles Voters reward incumbents when the economy is doing well and punish them when it’s doing poorly. Figure 20.1 in the text shows the share of the two-party vote won by the party of the incumbent since 1948; 50% or greater means the incumbent’s party stayed in office. The darker line shows the share of the vote predicted for the incumbent’s party based on growth in personal disposable income per capita in the year of the election, the inflation rate the year of the election, and a measure of how long the incumbent’s party had been in office. The incumbent party wins when personal disposable income is growing, when the inflation rate is low, and when the incumbent’s party hasn’t been in office for too many terms in a row. Figure 20.1 Economic conditions in an election year predict presidential votes Voters are myopic. They don’t evaluate economic conditions over an incumbent’s entire term. They instead focus on the immediate conditions. This gives politicians the incentive to try to increase personal income and decrease inflation in election years even if that means decreased income and higher inflation at other times. President Nixon sent a letter to 24 million Social Security recipients two weeks before the 1972 election announcing that their benefits were going up 20% immediately and that future benefits would include cost of living adjustments. He timed it so the higher Social Security payroll taxes wouldn’t take effect until after the election. His example is not unique. Government benefits of all types typically increase before elections, but tax increases usually come after elections. In election years personal disposable income grows on average 3.01%, but in nonelection years it grows by 1.79% on average. The same isn’t true of GDP growth. Presidents can do more to affect personal income than they can to affect pure economic growth. Inflation tends to decrease during election years and increase after an election. At the state and local level, mayors and governors try to increase the number of police on the street in election years to make people feel safer. Two Cheers for Democracy At this point in your lecture, students are probably pretty pessimistic about democracy. Much of the remainder of the chapter explains why other forms of government are often much worse. First, though, the chapter considers how voter opinion translates into policy on issues that are highly visible, that affect millions of people, and that voters are likely to have an opinion on. The Median Voter Theorem If voters care about a single issue, such as spending more or less on Social Security, and each will vote for the candidate who has a position closest to his or her own ideal point, then the median voter theorem can predict the outcome of political competition. The median voter on this issue is the one who wants more spending than half of the voters and less than the other half. In such a situation, the median voter theorem says that the ideal point of the median voter will beat any other policy in a majority rule election, so the candidate closest to that position will win. You might want to draw a figure like Figure 20.3 in the text and explain how candidates will be driven by competition to Inez’s (the median voter in the figure) ideal point. Figure 20.3 The Median Voter Theorem Teaching Tip: To further help students understand this idea, there is a nice animation that uses popcorn stands to help explain the basic idea behind the median voter theorem on YouTube. The link is https://www.youtube.com/watch?v=cFt0k6n_HKc The median voter theorem doesn’t always apply. Voters will not always vote for the candidate with the policy closest to their own ideal point. If no candidate is close to a voter’s ideal point, then the voter might choose to vote for no one. In this case a candidate that moves too close to the median would risk losing votes from the extremes, and as a result, competition wouldn’t converge to the median voter’s ideal point. Also, if voters care about more than one issue, like taxes and war, and the issues don’t both fit neatly into a left–right spectrum, then the median voter theorem doesn’t hold. With two voting dimensions, it is likely that no policy would beat every other policy, so politics might not converge on a stable policy. The median voter theorem is applicable in some but not all circumstances. The main reason to introduce the median voter theorem at this point is to remind students that politicians in a democracy will have a strong incentive to listen to what voters want with regard to some issues. Of course, even if politicians do what voters want when the median voter theorem applies, they will not necessarily adopt efficient policies. The quality of the policy will be only as good as the wisdom of the median voter. Democracy and Nondemocracy Most wealthy countries tend to be democracies. This is in part because as wealth increases, so does demand for democracy. But the favorable institutions for economic growth also are more likely in a democracy than a dictatorship. Figure 20.4 in the text illustrates the relationship between economic freedom and standards of living. Economic freedom promotes higher standards of living. The countries with darker dots are full democracies. All of the countries with the highest economic freedom except two, Hong Kong and Singapore, are also full democracies. Figure 20.4 Economic Freedom, Democracy, and Living Standards Although voters in democracies are often rationally ignorant, citizen ignorance is often much worse in nondemocratic countries. One reason people in other political systems are so ignorant of political issues is that the government controls or censors the media. In Africa, most countries have outlawed private television stations. Governments have a state monopoly on television broadcasting in 71 percent of African countries, and most African governments control the largest newspaper in their country. Control over the media allows special interests to control the government for their own ends to the detriment of the society. Government ownership of the press is associated with lower levels of political rights and civil liberties, worse regulations, higher levels of corruption, and a greater risk of property confiscation. It’s important to point out to your students that all comparisons are relative. Democracies do have inefficient policies because of rational ignorance and the logic of collective action. However, compared to citizens in the current nondemocratic and quasi-democratic countries, democratic citizens are better informed and better able to influence policy. Democracy and Famine Mass starvations have occurred when plenty of food could have been made available. Many of the worst famines in history have been intentional. The Ukrainian famine is one such example. When Stalin came to power in 1924, he saw the relatively wealthy Ukrainian farmers as a threat. He collectivized their farms and expropriated their land. Agricultural production plummeted, and the Ukrainians began starving. Despite their starvation, Stalin continued to ship food out of the Ukraine. Millions of people starved to death. Stalin did not need the votes of the Ukrainians. Democratically elected politicians cannot similarly ignore a starving region that has millions of votes. The 1974 famine in Bangladesh killed 26,000 to 100,000 people. Floods destroyed rice farming land, pushing up rice prices and forcing harvest workers into unemployment. The lower income and higher prices led to starvation. Yet total food per capita in Bangladesh was at an all-time high in 1974. The starving people lacked both the economic and political power to get more food. Government regulations made it difficult to purchase foreign exchange, so it was also difficult for capitalists to import rice from Thailand or India. Amartya Sen has claimed that no famine has ever taken place in a functioning democracy. He claims that access to newspapers and adversarial politics are the best improvements that can be made to avoid famines. Using newspapers so citizens have information is important, but without political competition, informing people alone will not necessarily give policy makers incentives to avoid famines. India has a federal democracy with 16 major states. Two economists studied the states and found that more political competition is associated with higher levels of public food distribution and that government is more responsive to a food crisis when newspaper circulation is higher. Democracy and Growth Students may feel that being unlikely to kill their own citizens or let them starve to death is a pretty low bar for any form of government. It’s important to point out to them that many governments have failed to achieve this standard. Democracies also tend to support markets, property rights, the rule of law, and other institutions that support economic growth better than nondemocratic governments. The only way the public as a whole can become richer is by supporting efficient policies that promote growth. Oligarchies and quasi-democracies are ruled by small groups. The ruling elite can enrich themselves and ignore the larger costs borne by the rest of society. Sometimes the ruling elite even desire policies that keep their citizens poor because it makes their own control over the country more secure. Smaller groups can make decisions that benefit themselves at large costs to others. As the ruling group grows larger, it has to be more concerned about overall costs to society for the simple reason that the rulers themselves make up a large fraction of society. Also, as the group in charge grows larger, transfers become less lucrative. So the greater the fraction of the population that has power, the more likely it is that they will favor policies that are more efficient and benefit everyone rather than just a few ruling elite. Compared to oligarchy, democracy is a step in this direction. Takeaway Students should appreciate that incentives matter just as much in politics as they do in markets. The incentives under democracy do not lead to the self-interest of the politicians to promote the most efficient policies, and that is an important reason the world around them doesn’t adopt the efficient policies they learned throughout the course. Voters are rationally ignorant, so special interests are able to direct the political process for their own benefit. Politicians have an incentive to establish policies that concentrate benefits and diffuse costs. Politicians also manipulate spending, taxes, and inflation to take advantage of voter myopia. Despite its major drawbacks, democracy still compares favorably to oligarchy and other nondemocratic forms of government in the world today. Democracies have been less likely to intentionally kill or starve their own citizens than other forms of government. In- and Out-of-Class Activities You can illustrate massive voter ignorance with a simple in-class exercise. Ask students to rip out a single page of notebook paper that they can turn in to you. Then ask them to write the president’s name on the top line. Ask them to write the vice president’s name below that. Tell them that it’s okay if they don’t know and to just put a question mark for any question they don’t know the answer to. Give them 10 seconds or so for each question you ask. Go on asking for names: their governor, their two U.S. senators, their representative to the U.S. House, their state senator, and their representative in the state house. Have them all pass the papers forward. Quickly read each of their answers out loud. In a 30-person class this only takes a few minutes (for a larger class just use a sample of answers or this would be a good time to employ student response devices). You’ll likely find massive ignorance of who their elected officials are. I usually find that in a class of 30, only two or three will be able to name them all. While you are reading their answers aloud, some students will start giggling. Others will drop their heads in shame. When you finish reading their answers, you can say something like, “Wow. You are all in college and are probably an elite group of voters. But look how ignorant you are of even the politicians’ names. If we want to give politicians the incentive to set the right policy, we have to know what the right policy is and what policies the politician favors. You also have to know who they are, but most of you didn’t even know that.” Point out that while most pundits would be dismayed at their lack of knowledge, many economists would not be. Your students are ignorant, but it is rational for them to be. This can lead nicely into your lecture on this chapter, starting with rational ignorance. If you do have a few students who are able to answer all the questions, you might ask them a little about themselves such as their major or how politically active they or their family are (or just why they know the answers). The students will likely have something about them (i.e., major in political science, have politically active families) that makes it less beneficial for them to be rationally ignorant. This will help explain why rational ignorance matters. Chapter 21 Economics, Ethics, and Public Policy Learning Objectives After completing this chapter, students should: > understand the difference between positive and normative economics. > know some of the reasons some people don’t think that maximizing gains from trade is necessarily good. > be familiar with three of the major competing theories of the just distribution of income: Rawls’s maximin. utilitarianism. Nozick’s entitlement theory. Chapter Outline The Case for Exporting Pollution and Importing Kidneys Exploitation Meddlesome Preferences Fair and Equal Treatment Cultural Goods and Paternalism Poverty, Inequality, and the Distribution of Income Rawls’s Maximin Principle Utilitarianism Robert Nozick’s Entitlement Theory Who Counts? Immigration Economic Ethics Takeaway Chapter Narrative The chapter opens by shocking students with a passage from economist Larry Summers: “[the] economic logic behind dumping a load of toxic waste in the lowest wage country is impeccable.” His reasoning is simple. Costs of pollution are measured in forgone earnings from increased mortality. If the pollution is shipped to a country with lower wages, the costs of any given amount of pollution will be lower. There could be gains from trade between poor and rich countries. Next, students are introduced to an idea that Gary Becker and many other economists support: the government should legalize a market in kidneys. More than 75,000 people in the United States are on a waiting list for a transplant because we have a shortage at the legal price of zero. Many people in poorer parts of the world would be willing to trade one of their kidneys for cash, but they are not allowed to. As with pollution, there are potential gains from trade, but many people don’t believe they should be captured. The chapter distinguishes between positive economics and normative economics. Positive economics describes, explains, or predicts economic events, and normative economics recommends policies. This chapter explores reasons that some people are not persuaded by the logic of gains from trade. Much of the chapter deals with ethics and morals. It examines some of the limitations of economics and which ethical values are left out of economic theory. It also explores some misleading arguments against economics and where those arguments fall short. Teaching Tip: This chapter is significantly different from most of the rest of the book. Its primary goal is to raise questions for the students to consider rather than to provide answers to problems. Many topics in the chapter can be used in class discussions to encourage students to ask themselves what value systems they are using. The material also lends itself to open-ended essay questions on exams. The Case for Exporting Pollution and Importing Kidneys The logic in this section is straightforward: trade makes people better off. If wealthy people value their health more than poor people, both groups can be better off if they trade with each other. The same is true for kidney sales. Teaching Tip: At this point in the course, good students who are convinced by the logic of economics are probably asking why our world has so many inefficient policies. One answer is, of course, politics (which was covered in the previous chapter). Another is that people value things outside of economic theory. Now is a chance for them to consider how persuasive these other things are to them. The textbook considers six common objections to standard economic reasoning: The problem of exploitation Meddlesome preferences Fair and equal treatment Cultural goods and paternalism Poverty, inequality, and the distribution of income Who counts? Should some count for more? Exploitation Transplant surgeon Francis Delmonico claims that kidney sales are exploitative because it is poor people who sell. It is true that poor people are more likely to sell, but what does exploitative mean in this context? The text considers three cases: Alex buys a kidney from Ajay. Alex pays Ajay to clean his house. George Mason University pays Alex to grade exams. In each case, the trade wouldn’t occur if the seller were wealthier. Where is the dividing line between exchange and exploitation? Is it just health risk? Many people take dangerous jobs to earn compensating differentials. The yearly mortality rate of fishermen in Alaska is seven times higher than the mortality rate for donating a kidney. What makes one trade more exploitative than another? The textbook considers three cases of kidney donation that you might use for class discussion: Someone asks you to donate a kidney but offers you nothing in return. Someone offers you $5,000 to donate a kidney. Someone offers you $500,000 to donate a kidney. Try asking the students which of these is exploitative. Some may think that the first option is not exploitative. So ask why it becomes exploitation when money is added to the equation. Ask how many would be willing to sell their kidney for $500,000 and then ask them if they would be exploited if they did. Now ask what the difference is if a poor person in another country would be willing to do it for $5,000. Meddlesome Preferences Meddlesome preferences manifest when people have preferences over what other people do, even though they are not directly involved themselves. For example, some people just have a gut feeling that selling kidneys is wrong, so they don’t want other people to be able to do it. The text considers another example of meddlesome preferences: eating horsemeat. The state of California prohibits human consumption of horsemeat, yet you can order horsemeat on menus in Japan and Europe. The National Horse Protection League often lobbies to prevent horses from being exported to markets where they can be eaten. Meddlesome preferences are hard to reconcile with other values that many people consider important, such as liberty, rights, and religious freedom. What about meddlesome preferences against homosexuality, interracial dating, or some religious practices? Should those be counted? Why should some meddlesome preferences be counted and not others? Fair and Equal Treatment Some people believe that trade and efficiency should be sacrificed in favor of fair and equal treatment (although it can be problematic to define fair and equal). The text uses the example of New York City converting its buses so they could “kneel down,” making them accessible to people in wheelchairs. A study found that it would have been cheaper to give each person in a wheelchair free lifetime taxi trips, which would have also been more convenient for them. Defenders of the investment in buses claimed each handicapped person should have the same transport options as everyone else and that “equal treatment” was more valuable than savings for the city or convenience for the handicapped. Economics cannot answer questions about the trade-off between “equal treatment” and efficiency. Cultural Goods and Paternalism Should governments fund goods even when the public isn’t willing to pay for them? The argument in favor of this is that culture is more valuable than what people will otherwise spend their money on and that the government is better able to judge what is best. The French government spends 1.5 percent of its GDP subsidizing culture. The government requires 40 percent of movies on TV be in French, and there is a French Ministry of Rock and Roll to promote French-language music. Supporters of such policies argue that subsidizing the French culture is valuable and that the aesthetic judgments of the marketplace should not be final. One counterargument to this position is that government’s subsidies might undermine culture. Perhaps French movies would be more successful—more worth watching—if they faced open competition. A more philosophical objection is that people should be allowed to spend their money as they choose, because freely chosen values have a moral worth of their own that should be respected. The U.S. federal government also subsidizes the arts, though to a lesser degree than France, partly because some people want to encourage the production of a higher quality and diversity of art than they think will arise through the marketplace or through charity. Teaching Tip: You can also define product egalitarianism here. This is the case where members of a society believe that a product is so important it should be available to all individuals. In several cases of government funding culture, it is based on this idea that cultural experiences should be available to all. Poverty, Inequality, and the Distribution of Income Some of the objections to kidney sales and pollution export might not be objections to the trade per se but objections to the poverty and inequality that make the trade happen. This raises the question of what is a just distribution of wealth. The textbook considers three competing views: Rawls’s maximin, utilitarianism, and Nozick’s entitlement theory. Rawls’s Maximin Principle In A Theory of Justice (1971), John Rawls advocated the maximin principle: a government should, without violating basic rights, maximize the benefits accruing to the most disadvantaged group in society. This means maximizing the welfare of the worst-off group is more important than overall improvements in welfare and efficiency for the entire group. It is different from, although sometimes mistaken for, maximizing equality. The following table, which appears in the text, can be useful for generating class discussion:
Society Red Blue Green Average Income
A 100 100 100 100
B 150 100 50 100
C 600 600 99 433
D 1,096 102 101 433
Three individuals, Red, Blue, and Green, have the income listed below them. Try asking your students which society they would prefer to live in. (If you want to be more Rawlsian, ask them if they didn’t know what color they’d be, which society they would choose to live in behind a veil of ignorance.) D satisfies the maximin criteria among these four choices (even though it’s considerably further from equal than A). Try asking about society A versus society C. A is equal, and the least well-off is better in A than C, but C is much wealthier. A Rawlsian would prefer A to C. Maximin is more influential among philosophers than economists. Utilitarianism Utilitarianism tries to implement the outcome that brings the greatest sum of utility or happiness to society. Utilitarians assume that an extra dollar of wealth generates more utility for a person with only a few dollars than for someone with millions: an extra dollar for the poor person may go toward a visit to the doctor, while an extra dollar for the rich person may just go toward another silk tie. For questions of income redistribution, utilitarians ask who will get the greatest happiness from a little more income. Utilitarians, however, are not trying to maximize the utility of the least well-off. They are trying to maximize total utility in society, so they advocate redistributing income only when the gains in utility to the person who receives the income are greater than the utility losses to the people who give it up. Incentives limit utilitarian redistribution. Taking money from rich people limits their incentive to create wealth in the first place. Also, giving money to poor people might not be the best way to improve their utility. Throughout the textbook all dollar gains (efficiency) have been treated equally no matter who received the dollars. Utilitarianism goes beyond standard economic theory and makes assumptions about the amount of utility gains those dollars provide for different people. However, standard economic tools do not give us any way to measure utility or happiness. Most economists believe that comparing happiness or utility between two people is unscientific and illegitimate. In-Class Exercise: You might consider asking your students why we should care about wealth maximization (efficiency) as they’ve studied it in the text. Are they implicitly assuming that wealth maps into happiness equally for all people, or are there other reasons they value wealth maximization? Are there differences in what we can say about happiness from voluntary trades compared to provision of public goods or externalities? Robert Nozick’s Entitlement Theory Most theories of just distribution require taxation. Nozick’s entitlement theory of justice is one of the few that can be achieved by market forces. In Anarchy, State, and Utopia (1974), Nozick argued that the distribution of income was irrelevant; what mattered was whether the income differences were justly acquired. Nozick argued that if two people wanted to trade, then provided that they do not violate anyone else’s rights, the decision should be left up to them. In short, all capitalist acts between consenting adults should be allowed; whatever distribution of income was achieved by the process of trades would be just. Nozick offered his famous Wilt Chamberlin example to support his argument. The textbook updates the example with J. K. Rowling, who wrote the Harry Potter books. Nozick says to imagine one day the distribution of income is exactly what your theory of justice requires. Then imagine that J. K. Rowling writes a Harry Potter book and offers a copy to anyone who is willing to buy it. Because many people want the book, a lot of money is transferred from readers to Rowling. In the end, the distribution of wealth is very different from what your ideal theory dictated. Yet how can the new distribution be unjust? No one’s rights were violated, and everyone involved in the trade was made better off every time Rowling sold a book. Why should any outsider disapprove of the resulting pattern of wealth? Nozick’s argument emphasizes that the equality of outcome is not important but instead that we should care about the justness of the process that leads to differences in wealth. Who Counts? Immigration When economists evaluate economic policy, they typically count everyone affected, regardless of where they live. National governments usually weigh the preferences of their own citizens much more heavily than they do the preferences of foreigners. Immigration is one issue that raises the question of who should be counted. The overall impact of immigration on the U.S. economy is relatively small. However, the economic impact of immigration matters a great deal to the approximately 400,000 Mexicans who try to cross the border each year. They may earn only a dollar or two per day in Mexico but could earn $10 an hour or more in the United States. Should United States immigration policy count their welfare and the welfare of their family members who would remain at home and receive remittances? Economic Ethics The predictions of economics are independent of any ethical theory, but there are ethical ideas behind all normative economic reasoning. One main ethical idea held by many economists is that people’s choices should be treated with respect no matter who the person is or what that person chooses. When economists reject the idea of exploitation in kidney purchases, they are respecting the choice of kidney sellers. Respect for peoples’ preferences leads economists to respect voluntary trade. You might want to mention to students that economics got the name the “dismal science” because of economists’ ethical views. Thomas Carlyle, the Victorian-era writer, called economics the dismal science because economists like John Stuart Mill thought all people were capable of rational choices and that everyone’s happiness should be counted equally regardless of race. Because of these ethical views, Mill and other laissez-faire economists of the nineteenth century opposed slavery. Carlyle was a supporter of slavery, and it was the ethical views of the economists that he found dismal. Takeaway The core idea from economics that students should understand at this point is gains from trade, and they should have been wondering why not everyone accepts the importance of all gains from trade. This chapter should open their eyes to some of the ethical reasons not everyone approves of gains from trade and to some of the limitations of economic science. They should understand the difference between positive and normative economics and know that when advocating policy, they are engaged in normative economics and are implicitly making ethical judgments. This chapter should have given them a feel for what some of the ethical debates are so that they can consider them more on their own or in class discussions. The chapter doesn’t attempt to argue in favor of one ethical system over another. In- and Out-of-Class Activities This chapter mentions that some economists favor legalizing a market for kidneys. You can get current data on the number of people waiting for organ transplants at http://www.infoplease.com/ipa/A0778977.html The number of transplants done each year is available at http://www.infoplease.com/science/health/us-transplants-year-1988-2007.html Share the data with your students and point out how long people can expect to be on the waiting list given the length of the list and recent number of transplants annually. Use this information to begin a class discussion on setting up markets for kidneys. Try asking the students to tell you all the reasons kidney sales should be illegal. Write the list on the board. Then use economics to address as many of them as possible. Point out the objections they gave that economics doesn’t have an answer to and discuss the ethical questions. Draw a supply and demand diagram to illustrate the shortage based on the numbers on the Web site. (Roughly speaking, we’d have an upward-sloping supply curve that intersects the quantity axis at around 14,000 organs and a demand curve that intersects the quantity axis at about 83,000 for kidneys.) Discuss what elasticity of supply might be like. How would it differ for living and for dead donors? Point out that there are about 2.4 million deaths in the United States each year. Finally, ask the students about an alternative: trading organs for organs rather than money for organs. What do they think about giving first priority for organs to people who themselves are registered organ donors? One private group, Lifesharers, is already running such a system. Show them the Web site http://www.lifesharers.org and ask them what they think about that as an alternative to the current system or a market in organs. Chapter 22 Managing Incentives Learning Objectives After completing this chapter, students should: > understand that when incentives are aligned with the social interest, the incentives can be a powerful force for good, but misaligned incentives can be a powerful force for bad. > know the chapter’s four main lessons: You get what you pay for, but what you pay for isn’t always what you want. Strong incentives put more risk on agents, and as a result the agents will demand more compensation. Money isn’t everything. People also want to enjoy their work, identify with a team, and be respected, among other things. All of these provide incentives. Nudges can work. Sometimes the decisions people make are affected by the way the choice is presented. Chapter Outline Lesson One: You Get What You Pay For Prisons for Profit? Piece Rates versus Hourly Wages Lesson Two: Tie Pay to Performance to Reduce Risk Tournament Theory Improving Executive Compensation with Pay for Relative Performance Environment Risk and Ability Risk Tournaments and Grades Lesson Three: Money Isn’t Everything Lesson Four: Nudges Can Work Takeaway Chapter Narrative This chapter focuses on how to structure incentives so that people help you achieve your goals better. Numerous examples are drawn from business, public policy, and everyday life. If you’ve taught principles before, it’s unlikely that your prior text had a chapter like this one. No new technical material or graphs are introduced in this chapter. The chapter instead gives numerous examples to help students think like economists in business and their everyday lives. Teaching Tip: Much of the material in the chapter is fairly straightforward. The main examples are summarized here. You may find it beneficial to have the students read this chapter on their own and only briefly cover the four main lessons in class. Alternatively, you might find it beneficial to draw on some of these examples early in your course, when you’re explaining the importance of incentives while lecturing on Chapter 1. The material is fairly flexible and can support either of these approaches but could, of course, be covered in a more traditional manner. Lesson One: You Get What You Pay For When people are given monetary incentives for their performance, they are often motivated to achieve the goals that will get them paid. It’s often the case, however, that what is desired is hard to measure. In those cases, monetary incentives are often given for some proxy that is more easily observable. But using strong incentives sometimes leads to worse outcomes. The closer what you pay for is to what you want, the more you can rely on strong incentives. The textbook goes through a few examples. Students in the Chicago public school system take a standardized test, and in 1996 they changed the rules so that in schools that had low scores, teachers would be reassigned, principals fired, and schools closed. Presumably the city of Chicago wanted more knowledgeable students. They used better test scores as a proxy. Unfortunately, this gave teachers an incentive to improve test scores rather than students’ knowledge. Teachers cheated. Economists Brian Jacob and Steve Levitt found troubling patterns in the test score data. There were students who got easy questions wrong and hard questions right, groups of students with exactly the same right and wrong answers, and students who had high grades on the test but low grades the year after. All of these things became more pronounced once there was a strong penalty for low-performing schools. Overall, Levitt and Jacob estimated that cheating occurred in 4 to 5 percent of the classes. In the 1980s, many CEOs began getting stock options as a form of compensation. These options had value only if the firm’s stock price reached a certain height. Stock options do give CEOs an incentive to work harder even now, but they also give them an incentive to cheat by manipulating earnings reports to make their firms appear more profitable than they really are. As a result, we have better monitoring now. Despite the incentive to cheat, most of the stock option incentives have stayed in place, indicating that the stronger incentives do more, on balance, to encourage hard work than cheating. Prisons for Profit? Private prisons have more of an incentive to cut costs than public prisons because private firms earn extra profits when they have lower costs. Government-run prisons do not have as strong an incentive because cost savings just result in more money in the public treasury. Kentucky became the first state to contract prisons out to private firms in 1985. Today about 8% of prisoners held in the United States are in privately run prisons. Some economists claim that privately run prisons create too strong an incentive to cut costs. They claim that, although policymakers care about low costs, they also care about prisoner rehabilitation, civil rights, and low levels of inmate and guard violence. These economists worry that these other goals will be sublimated to private firms’ incentives to cut costs and maximize profit. Other economists point out that cutting quality doesn’t necessarily decrease costs. Low levels of inmate and guard violence are also likely to reduce cost, and not violating prisoners’ civil rights will result in fewer costly legal battles. When increased quality and cost cutting move together, private incentives improve performance. Economists also point out that although low-powered incentives involved with public operation of prisons may reduce the incentive to cut costs, it doesn’t necessarily increase the incentive to improve quality. Extra slack in the budget may be used to benefit prison employees rather than improve inmate rehabilitation. Piece Rates versus Hourly Wages Piece rates, when employees are paid according to their output, work well when quality is either unimportant or easy to measure. In these cases what you pay for is close to what you get. Piece rates are common in agriculture when workers pick fruit. Output and its quality are easy to measure, and the piece rate provides incentives for workers to pick faster. Piece rates do not work as well when quality is important but difficult to monitor. At one point IBM paid its programmers per line of code written. As a result IBM employees produced lots of lines of poor-quality code instead of taking the time to make each line work best. IBM quickly switched away from piece rates and back to the low-powered incentive of hourly wages. Piece-rate pay can also attract more productive workers. The Safelite auto glass installing company switched to a piece-rate payment system in 1994. It also tracked who installed what glass, and if a quality problem arose with an installation, the same worker had to fix it on his or her own time. Productivity shot up by 44%. Half of that increase came from current employees working harder; the other half resulted from the firm attracting new employees who were more productive. As information technology improves, it becomes easier to measure the output of many types of workers, so performance pay (piece rates, commissions, bonuses, and so on) is becoming increasingly common. Trust can be one barrier to implementing piece rates. Workers may be reluctant to work harder and produce more when a company switches to a piece-rate system if they fear that the firm will respond by reducing the piece rate in the next period. Lesson Two: Tie Pay to Performance to Reduce Risk Paying employees by commission can induce them to work harder, but it also increases the risk employees face because their hard work is not the only factor that influences sales. The textbook uses the example of the auto salesman. Sales depend on their hard work, but also on things they don’t control, like the price and quality of the car, the price of gas, and how well the economy is performing. Because these other factors influence sales, they increase the risk of an employee’s earnings dropping through no fault of his or her own. Most people don’t like risk. As a result, when employees are paid on commission, they have to be paid more, on average, than they would if they were paid a wage. If the owner of a firm is better able to bear the risk of a recession, weak incentives from wages might be in everyone’s best interest. The owner essentially sells “recession insurance” by paying workers a fixed salary or wage lower than they would earn from a commission, and the employee buys the insurance by accepting the lower wages with less variation in earnings. The more that sales are influenced by important factors beyond the employees’ control, the less sense commission-based pay usually makes. There is another high-powered incentive, though. Tournament Theory Teaching Tip: You might want to cover the section on tournaments and grades with students before covering this section, since you can provoke discussion more easily and they have more direct experience with it. You can then use that discussion to relate to behavior observed in this section. Tournaments are one way to provide high-powered incentives without increasing the risk to employees from the general economic environment. Tournaments, like their sports equivalents, pay bonuses to employees not on their absolute number of sales but by their sales relative to those of the other agents. Tournaments mean each sales agent competes against the others rather than against an external standard. When the economy is bad, all sales will suffer, so the employees who perform best can still achieve high earnings. When outcomes are no longer influenced by factors outside an agent’s control, factors within their control become all the more important, so tournaments can induce even harder work. Improving Executive Compensation with Pay for Relative Performance Many CEOs are paid with stock options. When their company’s stock prices do well, these executives earn large salaries. However, a company’s stock price is influenced by many factors that are beyond the CEO’s control, such as the state of the economy in general, so that much of a CEO’s pay is based on luck. The textbook suggests tying executive compensation packages to the company’s stock performance relative to the performance of other stocks in the same industry. That way, more of their compensation would be tied to factors CEOs can control and less to factors outside their control, such as the economy or general market conditions. Such a compensation package should induce harder work from CEOs. Environment Risk and Ability Risk Tournaments remove the risks from outside factors that are common to all players (called environmental risk), but they introduce ability risk. When some employees are much more talented than others, even hard work (or lack of hard work) may not change relative performance much. The textbook uses the example of Tiger Woods playing against the reader in a golf tournament as an example of ability risk. However, like golf, business tournament pay can be structured with divisions or handicapped to improve incentives. Tournaments help explain some CEOs’ high wages. Many people understand that junior lawyers compete hard against each other to make partner. The same is often true in corporations. Paying CEOs a high salary with lots of benefits may not be to induce the CEO to work harder but to induce all of the vice presidents to work harder. If there are eight VPs competing to become CEO, then the CEO pay and perks become a tournament reward that induces all of them to work harder. Tournaments can, however, induce too much competition in a business. Because employees are competing against each other, they don’t have an incentive to help each other and may even undermine each other even though it’s bad for the company. Tournaments do not produce good incentives when teamwork is important. Tournaments and Grades Students who have been graded on a curve will be familiar with tournaments. When there is a fixed number of each grade, the students compete against each other for the best grades. Teaching Tip: Try asking them how they like this system and what type of behavior it induces. Ask what type of students perform well in this system or in what type of classes they’d like it. Grading on a curve reduces environmental risk but increases ability risk. If the teacher or book is bad or the subject hard, a curve reduces the environmental risk, since everyone faces the same handicaps. However, grading on a curve increases ability risk. If some students are geniuses while others are below average, the differences in ability may not lead to any harder competition between them, since the smarter students will come out on top even without much effort. Students are less likely to cheat, but they’re also less likely to have study groups and help each other learn the material. They may even sabotage others by ruining library books with the answers to problems in them. Students may also collude and not put forth much effort, but this is unlikely in any but a very small class because of the incentive to cheat on the agreement. Lesson Three: Money Isn’t Everything Money is an important incentive, but it’s not the only one. Feelings of belonging that come from being part of a team, joy of having done a job well, and status that comes from success are all powerful intrinsic motivators. Sometimes money complements these intrinsic incentives; other times it can hinder them. Many companies give their employees shares of stock in the company. Since most employees don’t have much of a marginal impact on the company’s stock price, options aren’t given to provide monetary incentives. Instead, making employees part owners helps them identify personally with the company so that they feel the company’s success as part of their own, much in the same way baseball fans celebrate the victory of their favorite team. Firms try to create a good corporate culture by giving stock shares or using bonding activities like retreats, parties, and softball teams. Good corporate culture helps to encourage hard work for its own sake, so it is particularly helpful at building incentives for activities that are difficult to measure. The textbook discusses how Sam Walton developed a corporate culture at Walmart. He spent several days each week visiting his stores and talking directly with employees. He led them in corporate cheers. Management was encouraged to find out what was on the minds of workers. The corporate culture of Walmart provided valuable information from low-level employees to management. Monetary incentives can sometimes conflict with intrinsic motivation. A child might feel a sense of obligation, as a member of the family, to do the dishes. But a child who is paid for the task may view doing the dishes as less of a familial obligation. In fact, getting an allowance from their parents for doing the dishes might make teenagers feel like little children dependent on their parents. Yet a monetary payment from the local restaurant for the same task may make the child feel like more of an adult and take more pride in doing dishes. Monetary rewards are most effective when they are supported by intrinsic motivation and measures of social status. Lesson Four: Nudges Can Work Economists refer to planning where, when, and how individuals make choices as “choice architecture.” Changes in choice architecture—or nudges—can be used to influence the decisions made by individuals. Retail stores are notorious for using choice architecture as a means of increasing sales. Nudges generally relate to how choices are framed or presented. And while economists generally focus on incentives such as prices and income in determining behavior, sometimes nudges also affect behavior. Some examples of nudges given in the text: > Placing items usually purchased on impulse at the checkout lane in stores > Placing essential items in the back of the store, so shoppers must walk past flashier but less important items on the way > Advertising meat as 80 percent lean rather than 20 percent fat > Noting when energy use is above average on electric bills to encourage conservation > Using emoticons with frowning or smiling faces in response to above- or below-average energy use > Putting healthy food choices in visible locations in workplace cafeterias to encourage healthy eating habits by employees Takeaway Students should come away from this chapter more able to think like economists. They should better understand how to align incentives to promote social (or their own) interests. They should understand the trade-offs between using strong and weak incentives and that strong incentives may impel employees to demand higher average compensation, since they are at greater risk. Finally, they should understand that there are powerful incentives besides money and that monetary incentives can sometimes undermine these other intrinsic motivators. Chapter 23 Stock Markets and Personal Finance Learning Objectives After completing this chapter, students should: > understand passive versus active investing and why it’s hard to beat the market. > understand some principles of investing in the stock market. > be able to identify some other benefits and costs of the stock market. Chapter Outline Passive versus Active Investing Why Is It Hard to Beat the Market? How to Really Pick Stocks, Seriously Diversify Avoid High Fees Compound Returns Build Wealth The No-Free-Lunch Principle, or No Return without Risk Other Benefits and Costs of Stock Markets Bubble, Bubble, Toil, and Trouble Takeaway Chapter Narrative This is a relatively short and straightforward chapter that deals mainly with basic personal finance issues, which relate specifically to stock market investing. These topics are generally tangential to the overall micro model developed through most of the rest of the text. Passive versus Active Investing Everyone wants to know the secret of getting rich on Wall Street. The truth, however, is that the secret may be more about luck than skill. This section explains why. Active investing refers to picking stocks individually for a portfolio in an attempt to choose stocks that will outperform the market as a whole. This is as opposed to passive investing, or picking a broad group of stocks that is generally representative of the overall stock market or some subset of the market. Teaching Tip: Emphasize to students that in this chapter, the word investing is not used in the traditional macroeconomic sense (meaning business spending on new physical capital) but rather to mean the way savers allocate their savings across various financial assets. The key point is that actively managed mutual funds (collections of stocks in which investors can buy shares) generally do not consistently outperform passively managed mutual funds, which simply mimic the composition of the overall market. And as actively managed funds charge higher fees, the question is whether you’re getting your money’s worth. In general, the answer is no. Teaching Tip: The text brings up Warren Buffet, who can be used as an example of passive versus active investment and to motivate the next section. In 2007, Warren Buffet and an investor by the name of Ted Seides entered a 10-year charitable bet. Buffet claimed, and was willing to bet $1 million, that the S&P 500 Index Fund (a passive investment) would outperform any hedge fund (an active investment). Mr. Seides, a hedge fund manager, disagreed and took the bet. The bet ends in 2017, but it is already clear that Buffet has won the bet. Why Is It Hard to Beat the Market? Why is it so hard to consistently pick stocks that outperform the overall market? The answer is what economists call the efficient markets hypothesis. The efficient markets hypothesis says that stock prices already reflect all publicly available information. The textbook uses the following example: The advice goes that as the baby boom generation ages, the number of senior citizens will increase. Therefore, it might seem like a good idea to invest in the companies that provide goods or services for seniors. However, everybody in the market already knows this—and can already anticipate the growing number of seniors—so the stock prices for companies that provide these goods or services already reflect this information. Remember that for every buyer, there must be a seller. Why would a person sell stock in these companies for a low price that did not reflect the future increase in demand? Publicly available information cannot be used to consistently pick winning stocks. Likewise, beating the market consistently can occur only with the use of insider information or mere luck. How to Really Pick Stocks, Seriously Without depending on mere luck, what strategy will produce the best results from investing in the stock market? The authors provide four tips. Diversify Diversification is the principle of not putting all your eggs in one basket. Buying a wide variety of stocks insulates you from the vulnerability of fluctuations in any single stock or industry. The text gives a brief explanation of the three most common stock indexes: the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite Index. The Dow is the least diversified of the three. The helpfulness of diversification goes beyond stock market investing. If you’re an aerospace engineer, don’t invest in aerospace companies, because your human capital is already tied up in that industry. Should that industry shrink, you don’t want both your degree and your stock portfolio to lose value. If you’re a dentist, don’t marry another dentist for the same reason. Teaching Tip: Students might think this is a fun application of the idea of diversification, so you may want to engage them in a classroom discussion using these principles. Find out what majors students have or what fields they plan to go into, and then ask them where they might invest money (or whom they should marry) to diversify. You may be able to take it a step further: if a student really enjoys tennis, maybe it’s a good idea to invest in a company that makes tennis equipment. If the company does well and the industry is profitable, prices will rise (making tennis as a hobby more expensive) but so will stock prices (raising the value of the portfolio). Avoid High Fees Avoiding high fees on investments and mutual funds is another recommendation for success in the stock market, since high fees—even in exchange for actively managed funds—are generally not worth the extra expense. For example, investing $10,000 over 30 years with a real rate of return of 7% will yield $74,016 if the investment firm charges 0.10% per year in fees but only $57,434 if the fees are 1% per year. The higher fees are very costly but likely provide no benefits. Compound Returns Build Wealth Compound returns build wealth, meaning that small differences in returns can result in big differences in the amount of wealth built over long periods. Investing in stocks over the long haul is likely to be a better strategy than investing in bonds, because stocks average a higher rate of return, which, over long periods, will generate considerably more wealth than bonds. The rule of 70 is a helpful way to approximate investment growth and to demonstrate the importance of compounding interest. If the rate of return is x, then the approximate number of years required for an investment to double in value is 70/x. An investment that grows at 2% per year will double in 35 years, but an investment that grows at 7% will double every 10 years. The No Free Lunch Principle, or No Return without Risk No return without risk describes the systematic relationship between risk and return. This relationship is often referred to as the risk-return trade-off, which implies investors should not expect returns without a willingness to take on risk, and the more risk you are willing to take, the higher the expected return. Relatively safe assets such as Treasury bonds generally pay a lower return than riskier stocks. Even among stocks, the riskier classes of stock will generally pay higher returns. Along the same lines, assets that pay a return in fun—such as the pleasures associated with owning a house or a piece of fine art—will generally pay a lower return than equally risky assets without the fun factor. Other Benefits and Costs of Stock Markets In addition to providing investment vehicles, stock markets provide the following benefits: > Stock markets are an important means for raising capital for new business investment. > Stock prices provide a signal about the value of a firm. > Stock markets provide a way to transfer control of a firm from less competent to more competent people. Bubble, Bubble, Toil, and Trouble A potential downside risk of investing in stock and other asset markets is the possibility of speculative bubbles. A bubble is a run-up in the value of an asset that is not justified by the fundamental determinants of value in that market. Speculative bubbles are problematic because: > large amounts of capital are invested in areas where it is not justified during the formation of a bubble. > the loss of wealth associated with the bursting of the bubble causes a negative shock to aggregate demand that can have enormous adverse effects on the entire economy. The recession of late 2007–2009 began with the bursting of a housing bubble. Housing prices were rising very rapidly (as can be seen in Figure 23.4 in the textbook), and banks became too lax about the value of the assets backed by mortgages. When housing prices fell, people began to default on their mortgages, and the value of these assets fell dramatically. To stave off bankruptcy, banks cut back on lending. That is how the problem spread quickly to the rest of the economy. The problem is exacerbated when low housing prices make people poorer, so they spend less, which also slows the economy. Takeaway Students should leave this chapter with an understanding of the difference between active and passive investing—and they should understand why it is hard to beat the market with active investing. They should also understand the principles of sound investing: diversification, avoiding high fees, building wealth with compound returns, and having no expectation of return without risk. They should appreciate some basic benefits of the stock market, such as raising capital for firms and providing a valuation of the firm, as well as some basic costs, such as speculative bubbles. In- and Out-of-Class Activities Often, financial analysts anxiously wait for announcements on policy (especially monetary policy) before they forecast where markets are heading. But based on what you’ve taught your students in this chapter, policy announcements shouldn’t be expected to have huge impacts on markets. Set up the following scenario for your students: A financial network news reporter comments that the stock market is anxiously waiting for the Fed to announce whether it will cut interest rates—in hopes that rates will be lowered. Yet when the announcement comes that rates have indeed been cut, the market responds with little or no change. Ask your students to use their understanding of the efficient markets hypothesis to explain. Your students should be able to explain that the lack of a noticeable response by the market most likely means it had already factored in the expectation that rates would be cut, so when the news came, there was no additional change. Had rates been cut less than expected, the market likely would have responded adversely to the news, and if the rates had been cut more than expected, the market would have reacted favorably. The lack of reaction suggests that the market had correctly anticipated the level of the cut. Instructor Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766
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