API-102C Section 2 Notes Chris Carrigan Agenda • Conceptual discussion of vertical integration (Carlton & Perloff 2000) • Merger of Ticketmaster and Live Nation (DOJ case documents) • Vertical restrictions as alternative Topic 1: Conceptual discussion of vertical integration When is firm vertically integrated? Firm participates in more than one successive stage of production or distribution. Why might vertical mergers be challenged by antitrust authorities? 1. Eliminate potential competitor • Acquiring firm could be viable potential competitor in affected market absent merger. With

potential competitor, must engage in limit pricing where commit to quantity such that not profitable for viable competitor to enter. Without, reduce quantity and raise price.

• DOJ mainly interested when Herfindahl-Hirschman Index (HHI) > 1800. 2. Monopolize second market • Integrates and impedes access to inputs or customers for firms in competitive market. • DOJ asks whether alternative sources support two firms. • Helps with variable proportions production where don’t need exact proportion of inputs to

production. Why? Assume competitive product has 2 inputs where perfect substitutes for each other. Input 1 is provided by monopolist. Input 2 provided competitively. If monopolist tries to raise price of input 1, downstream purchasers use input 2. Thus, monopolist has no pricing power. However, if monopolist integrates forward, now can price where MR = sum of input costs. Has market power. If fixed proportion production, monopolist indifferent between integrating and not.

3. Facilitates collusion • Substantial integration may enable resulting firms to monitor prices easier which facilitates

price fixing. Since prices easier to observe at retail level relative to intermediate level, deters secret price cutting.

• DOJ mainly interested when HHI > 1800. 4. Avoid regulations • Buy input manufacturer so can inflate input prices to increase regulated price. • May try to shift profits away from regulated division. In 1982 AT&T breakup, concern that

difficult to monitor shifting of costs between regulated (phone service) and unregulated (phone manufacturing).

What are some reasons vertical integration facilitates competition? 1. Can reduce transaction costs (Williamson) What are examples of substantial transaction costs? • Uncertainty – Fisher Body made car shells and refused to locate near GM when demand

increased unexpectedly in late 1920s. GM bought Fisher. • Coordination with suppliers – inefficient to let pig iron cool before sending it to steel

furnace. If uncertainty over future, what does contract look like between supplier and buyer? • Specify actions in all states of world. Costly to design. Might also be impossible for third

party (e.g. court) to determine afterward if contract fulfilled. • Write open-ended or incomplete contract. Costs are:

1) ex-post haggling = costly determination of how to divide surplus after investments made. 2) ex-ante hold up = recognition that will have to divide surplus ex-post reduces investment ex-ante. Remember that requires relationship specific investment (cannot take investment to another party).

What is solution? Integrate production if transaction costs inside firm (reduced worker effort) < transaction costs outside firm (hold up and haggling). Example from drug industry (Grossman & Hart 1986; Aghion & Tirole 1994) • Large pharmaceutical company wants to contract with small biotech to develop new drug. • Both companies must invest to make project profitable. • Cannot specify what innovation will be so contract incomplete. Should pharmaceutical giant (P) backward integrate biotech (B)? Non-integration: Both P and B reduce investment since must share surplus generated from new drug after developed. Backward integration: P makes optimal investment but B makes no investment because now employed by P. How to decide? Integrate if marginal product (MP) of P effort sufficiently large relative to MP of B effort. Is this likely? If B better at inventing and P better at marketing, then should not integrate B early in process when MP of B effort more important. Integration decision rests on effect it has on willingness to invest. 2. Ensure supply How do suppliers allocate goods when prices do not adjust to demand?

Rationing where might be that best customers get access. To increase probability of obtaining input, integrate.

3. Internalize externalities What is externality associated with distributor? • If have one bad outlet, affects view of whole distributor as well as manufacturer. Outlet

does not internalize effects of actions. Manufacturer may integrate to control this. • Related to decision of retailer whether to franchise or own outlet. When hard to monitor,

franchisee keeps bulk of profits to encourage effort. When not, could own.

4. Eliminate market power • Could be only one firm sells particular input so is monopoly. Integrate to reduce market

power. However, only works if variable proportions production since pay discounted value of future monopoly profits to acquire monopolist.

• When manufacturer and distributor both monopolies, double markup is loss to both firms and consumers. Price above and quantity less than integrated monopoly. From below, PM > PI and QI > QM. If maxed π, integrated firm would choose PI.

Topic 2: Merger of Ticketmaster and Live Nation What are market facts? • Distribution channel for live music entertainment:

Performer → Manager → Promoter → Venue → Ticketing → Merchandise • Shares in primary ticketing prior to Live Nation’s entry:

Ticketmaster = 83% Tickets.com = 4% New Era = 2% Front Gate = 3% Other = 8% High barriers to entry to ticketing. Ticketing platform technologically complicated, expensive to develop, and must withstand heavy transaction volume. Also, Ticketmaster uses long-term exclusive contracts.

• Ticketmaster purchased manager (Front Line) in October 2008. • Live Nation largest promoter representing 33% of concert revenues. Long-term deals with

popular artists to promote, sell recordings, and market merchandise. Also, owns or operates 75 venues (15% of market). Ticketmaster’s largest customer.

• Live Nation entered ticketing December 2008 by licensing ticketing technology from CTS, leading German provider.

• By ticketing to own venues and winning contracts from Ticketmaster, shares in primary ticketing after Live Nation’s entry now: Ticketmaster = 66% Live Nation = 17%

• Proposed merger of Ticketmaster and Live Nation in February 2009. How would you calculate Herfindahl-Hirschman Index in ticketing here? Before Live Nation entry and post merger (assuming Others have minimal shares): HHI = ∑s2 (in percentages) = 832 + 42 + 22 + 32 = 6918 After Live Nation entry: HHI = 662 + 172 + 42 + 22 + 32 = 4674 What affects HHI? Number and relative sizes of firms. When 5 equal sized firms, HHI = 2000 (202 + 202 + 202 + 202 + 202) When 1 large firm (60%) and 4 equal sized firms, HHI = 4000 (602 + 102 + 102 + 102 + 102) Why did DOJ challenge merger (and why did US and states’ Attorney Generals file complaint)? 1. Political statement – “The deal…had been closely watched by business as a barometer of just

how tough the Obama administrator planned to be on proposed mergers.” WSJ 1/26/10. Zero vertical mergers challenged during Bush administration.

2. Eliminates potential competitor – Live Nation viable ticketing competitor without Ticketmaster. Could generate scale by ticketing own venues and bundling access to concerts with new ticketing service. Merger reduces incentives to innovate.

3. Monopolizes other markets – merged firm’s ability to bundle ticketing with access to artists through Front Line management and Live Nation promotions might enable it to extend ticket monopoly into content. At minimum, increases barriers to entry since competitors must

provide all services to compete. Might think promotion and management substitutes so variable proportions.

How might Ticketmaster and Live Nation argue merger is pro-competitive? 1. Eliminates market power – Ticketmaster and Live Nation combined have presence at every

stage of production. Removes multiple markup inefficiencies to lower ticket prices. 2. Reduce transaction costs – By merging with Ticketmaster, can Live Nation avoid holdup?

However, long-term contracts may eliminate this issue anyway. What was remedy in case? Merger allowed which creates Live Nation Entertainment. Resulting company presence at all stages of production. However, conditions imposed on merged company include: 1. Must provide AEG (second largest promoter with 14% of market and owner or operator of

30 venues) with access to Ticketmaster’s ticketing platform. Includes providing AEG: • Ticketing website based on Ticketmaster’s platform. Royalty rate lower than current

market rate. • Opportunity to acquire perpetual paid-up license to most current version of

Ticketmaster’s platform. 2. Must divest Paciolan to Comcast or another company with potential to compete with

merged company. Paciolan, division of Ticketmaster, performs ticketing for college sporting events.

3. Cannot tie ticketing to promotion and management. Thus, venues must be able to acquire acts from merged company while using alternative ticketing company.

Topic 3: Vertical restrictions as alternative How do vertical restraints differ from vertical integration? Firm dictates terms to distributors through contracts but does not purchase distributors. May have many so cannot buy all. What are examples of vertical restraints? 1. Resale price maintenance – sets minimum price that retailers may charge. 2. Exclusive territories – distributor assigned specific territory. 3. Exclusive dealing – cannot sell products of competing manufacturer. When can vertical restraints improve outcomes? In addition to sharing some pro-competitive effects of vertical mergers, helpful when free riding among distributors or manufacturers. Distributor free riding • Car dealership has showroom, employs salespeople, and facilitates test drives. If provide

costly services, must charge higher price. However, incentive for another dealership to not provide services and sell at lower price. Buyer goes to full service for information and buys at discounter. Effect is less than optimal level of sales support.

• Resale price maintenance and exclusive territories may solve problem.

Manufacturer free riding • If car manufacturer advertises to encourage consumers to visit distributor, price of car

increases. However, if distributor sells more than one type of car, may recommend another similar car since cheaper. Effect is less than optimal level of advertisement. Can also occur with distributor training.

• Exclusive dealing may solve problem. What are antitrust authorities concerned about with regard to vertical restrictions? Facilitate collusion Resale price maintenance and exclusive territory arrangements make collusion easier among distributors and manufacturers. Raising rivals cost As discussed in Microsoft case, exclusive dealing contracts can eliminate sources of inputs or customers for other competitors. Resale price maintenance, exclusive territories, and exclusive dealing all governed by rule of reason in US.

API-102C Section 3 Notes Chris Carrigan Agenda • Voting and public goods (Perloff 2001) • Electoral rules and government spending Topic 1: Voting and public goods From class, why does private sector typically under provide public goods? If non-excludable, have free rider problem. Individuals have incentive not to be truthful about their valuation of good in hopes that someone else will purchase it. Even if can exclude, costs associated are social waste. What impediments do governments face in providing public goods optimally? 1. Can crowd out private sector provision. 2. Determining benefits of public good difficult. Includes getting people to recognize and

reveal preferences and knowing how to aggregate these preferences. Does voting lead to optimal provision? Could but does not necessarily follow that will. Why does voting not lead to optimal provision? Typically voting does not consider preference intensity. Example: Cambridge public hearing on shade tree removal Are shade trees along sidewalks a public good? Since one cannot exclude another from enjoying tree (non-excludable), and my consumption does not restrict another from enjoying tree (non-rival) except possibly when sitting under it, reasonably characterized as public good. On February 17, Cambridge held public hearing to remove and replant various trees along sidewalks in city. By law, if anyone objects in writing at meeting, tree warden cannot cut down tree unless approved by mayor. Further, shade trees can only be removed by tree warden except with his or her approval. Will anyone object to removing and replanting dead shade trees? Ignoring costs associated with attending meeting, citizen will object if marginal benefit associated with removing dead trees and replanting them is less than increased tax liability associated with activity. If Cambridge introduced majority vote on tree removal and replanting, would that lead to optimal outcome? To illustrate, say voting separately on removal at three places where each costs $30,000: 1. Broadway is busy street. 2. Irving St. is somewhat busy. 3. Fayerweather St. is not busy.

Three equal sized groups of voters who share cost equally through Cambridge tax: 1. Cost conscious – tree removal is waste of money. 2. Conservationist – willing to pay somewhat more if trees more likely to survive. 3. Practical – willing to pay more if more likely to see trees. Which projects are approved? Voter group approves if aggregate dollar value to group ≥ share of cost they pay. Voter Type Broadway Irving FayerweatherCost Conscious $4,000 $4,000 $4,000Conservationist $9,000 $10,000 $11,000Practical $20,000 $16,000 $12,000

Total Benefit $33,000 $30,000 $27,000Approved? No Yes YesNet Benefit $3,000 $0 -$3,000 Is this optimal? No. Broadway project that provides most total benefit is not approved whereas Fayerweather which provides least is approved. Why doesn’t voting generate efficient outcome? Only measures whether majority of groups value tree project above certain amount. Does not allow those who strongly desire or oppose public good to have greater influence. Further, does not allocate cost based on willingness to pay. Topic 2: Electoral rules and government spending1

So how are spending decisions for public goods made?

Whole literature in political economy that attempts to answer this question. However, as above example shows, voting systems important so focus on that here. What is Median Voter Theorem? Somewhat technical definition provided. When have set of conditions including single policy dimension, sincere voting, and single-peaked policy preferences (smooth preferences), then have Condorcet winner (policy that beats any other feasible policy in pairwise voting) which coincides with median-ranked ideal point. With two parties who only care about winning and can commit to policy, both propose median voter’s ideal point. Standard model of government redistribution or spending is Meltzer & Richard model (1981). Predicts that as inequality increases so should spending on redistribution. Why? Median voter’s income relative to mean income falls with more inequality so wants more redistribution. Since median voter controls election, parties seek to please median voter.

1 Much of this discussion is adapted from Torben Iversen’s course on comparative political economy as well as my section notes for that class.

Ymedian = Ymean = Y’mean

Right-Skewed Income Distribution

Y’median

As a result, M-R model predicts that countries with more economic inequality should also have more redistribution. Is this true in reality? No. Among advanced democracies, those with more pre-tax equality also spend more on redistribution as graph below suggests (Robin-Hood Paradox).

How do we reconcile this puzzle? One possibility is to look at electoral rules. What is the difference between proportional and majoritarian voting systems? Proportional voting systems allocate seats based on votes (e.g. 30% of vote garners 30% of legislative seats). Majoritarian or plurality voting based on “winner takes all” principle.

Single Member One District

PR (Proportional)Pure Proportional

RepresentationPlurality

(Majoritarian)Single Member

MajorityPresidentialism

Voting Method

District Size

What mechanisms affect spending in proportional relative to majoritarian systems?

Electoralsystem

Incentives to target

Number ofparties

SpendingCommonpool problem

Partisanship 1. Spending more targeted in majoritarian systems (Persson & Tabellini 2004; Milesi-Ferretti et

al. 2002). a. Candidates have incentive to target spending to swing (closely contested) districts in

majoritarian systems. Same incentive does not exist in proportional systems, particularly if one district.

b. Voters elect extreme candidates to avoid sharing spending in majoritarian systems. Imagine that have three geographical regions, three groups that care about particular types of transfers (elderly, poor, young – education) and are interspersed evenly among regions, and electing three candidates. • Proportional – elect three candidates where regions considered one district. • Majoritarian – elect one candidate from each region. What is result? With proportional system, voters from each group elect candidate that promises to focus spending on their group. True because if focus spending on particular region, will share it with other groups and receive less overall benefit. With majoritarian, voters from each region elect candidate that promises to focus spending on their region for same reason.

East Central West East Central WestElderly Elderly

Poor PoorYoung Young

Proportional Result

Group

Region

Candidate ACandidate BCandidate C

Majoritarian ResultRegion

Group A B C

2. Spending greater in proportional systems (Persson & Tabellini 2004; Iversen & Soskice 2006).

Why? Number of parties – due to Duverger’s Law, majoritarian systems typically support two parties. If preferred party no possibility of winning, will change vote in majoritarian. Since greater chance of participation, proportional systems support more parties.

What is effect of this? a. Common pool problem – spending is focused on particular group but share tax burden

with everyone so common pool good (rival but not excludable). Result is that where more parties represented, don’t internalize costs of spending so overspend. If one party, fully feel impact of spending decisions.

b. Partisanship – proportional systems allow left to influence decisions. Why? Imagine that have three equally sized groups: low-income (L), middle-income (M), and high-income (H). L would like to tax M and H and redistribute to L, M would like to tax H and redistribute to M and L, and H would like no tax (assumes tax cannot be regressive). • Majoritarian – have two parties (ML and MH) where both battle to gain vote of M so

propose moderate candidates. M can choose to side with L so can tax H and share revenue between M and L. Alternatively, M can choose to side with H. Problem is commitment. If ML leader really favors L and cannot commit to not taxing M as well as H when wins, M will side with H. True because even if MH leader if really favors H and so cannot commit to taxing own group, will choose no tax because taxes cannot be regressive. Result is that M at least keeps income when sides with H. Thus, more center right governments (MH) in majoritarian systems.

• Proportional – have three parties (L, M, and H) and government created through coalition of two. M always included in coalition, and outcome results from bargaining. No possibility of reneging because government made up of two equally powerful groups. If side with L, can tax H and share with L. If side with H, can tax but must share with L. Better to side with L. Thus, more center left governments in proportional systems.

• More spending with left included in government so proportional systems have more redistribution and spending.

What do data show? Generally support both notions. Spending greater in proportional relative to majoritarian

More left governments in proportional (among 17 advanced democracies) More broadly focused spending as increase district size

Spending less targeted in proportional systems (Funk & Gathman WP 2009) Data on 25 Swiss cantons: 1890 → all plurality voting systems 1992 → 23 had proportional voting systems Find that proportional voting associated with increase in spending on education and welfare (social security and poor assistance) but decrease in spending on roads and agricultural subsidies. Regression results:

Education Welfare Roads AgriculturePresence of

Proportional Voting+10% +33% -53% -28%

% Change in Spending Per Capita

Conclude that because education and welfare relatively less targeted than roads and agriculture, proportionality associated with non-targeted spending.

Electoral system and the number of years with left and right governments(1945-98)

Governmentpartisanship

Proportion of rightgovernments

Left Right

Electoralsystem

Proportional 342 120 0.26(8) (1)

Majoritarian 86 256 0.75(0) (8)

Electoral system and the number of years with left and right governments(1945-98)

Governmentpartisanship

Proportion of rightgovernments

Left Right

Electoralsystem

Proportional 342 120 0.26(8) (1)

Majoritarian 86 256 0.75(0) (8)

Which of these are public goods? Possibly education and roads (if uncongested and non-toll). Ultimately, extent to which electoral rules influence government supply of public goods determined by how targeted they are. If public goods generally not targeted, then supply increases with proportionality of electoral system. Overall spending increases with proportionality as well.

API-102C Section 4 Notes Chris Carrigan Agenda Climate Change and Innovation (Gruber 2007; Stern 2007; Bauman et al. 2008; Johnstone et al. 2009; Metcalf 2009; Popp 2010) What are some facts about climate change? • Greenhouse gases like carbon dioxide and methane keep heat in earth’s atmosphere and

reflect heat back to earth (greenhouse effect). • Using fossil fuels which produce carbon dioxide accounts for 80% of greenhouse gases. • China (21%), U.S. (20%), Russia (6%), India (4%), and Japan (4%) top five CO2 emitters in

2006. Non-OECD CO2 emissions expected to exceed those of OECD by 77% in 2030. • Current concentration around 430 parts per million carbon dioxide equivalent. Rising at

2.5ppm per year. • Stock, not flow, of CO2e important for global warming. Need stabilization below 550ppm

CO2e which corresponds to 30% cut in emissions by 2030 and 50% by 2050. • China emissions to double by 2030 which would cause increase to accelerate to 4ppm per

year. By 2100, would be at 750ppm where 50% chance of 5°C temperature increase. Last time that high 35 million years ago and alligators lived at North Pole.

• CO2e emissions from variety of sources.

• Estimated cost to stabilize at 550ppm varies widely. Ranges from 4% of projected world GDP in 2050 to no cost at all.

• U.S., Japan, and Germany accounted for two-thirds of patents for renewable energy, energy efficiency, and carbon capture technologies over period 1978 to 2003.

To review, with climate change, what is externality? Definition of externality from class is action taken that affects another for which latter does not pay or is not paid. Consumption of and production using fossil fuels generates CO2e. Climate effects of CO2e shared globally. Do not internalize impact on climate when using fossil fuels. Could assigning property rights work in this case? Problems are: • Assignment – how to determine who is causing what. • Holdout – amplified when many potentially damaged. • Free riding – incentive to not contribute to reduction. • Transaction costs – how to negotiate with this many parties. Assigning property rights most effective when small, localized externality. Not large scale global one like global warming. What are resulting instrument choices? • Command and control – quantity regulation. • Cap-and-trade system – quantity regulation plus opportunity to trade. • Taxes – tax to point where quantity is reduced to optimal level. With substantial uncertainty in estimated impact of increases in CO2e, what is effect on choice of optimal instrument? If know marginal cost (MC) of abatement, no effect when comparing quantity regulation with taxes because uncertainty of marginal benefit (MB) affects DWL associated with either in same way.

Carbon Reduction

Price of Carbon Reduction

0

MC

P*

R*

MBActual

MBEstimated

RReg

PTax

DWL Same

What is source of uncertainty associated with cost of stabilizing CO2e? Impact of research and development. Innovations would include technologies for using alternative energy sources (water, wind, solar, nuclear) and those that limit impact of fossil fuels (carbon capture). How do innovations affect MC curve? Shift down and flatten curve. What is shape of MB curve with carbon dioxide emissions? Relatively flat since stock of CO2e matters most. Metcalf – “With a stock pollutant that persists in the atmosphere for a very long time, marginal damages from emissions in any given year are essentially constant.” How does shape of MB curve affect optimal instrument choice when MC uncertain? As graph shows, DWL less with tax when MB flat. Intuition is that when MB steep, really important to get quantity right since damage really high past some threshold. If no real threshold, better to use taxes.

Flat Social Marginal Benefit

Carbon Reduction

Price of Carbon Reduction

0

MBSocial

MCActual

RReg

PTax

DWLReg

MCEstimated

RTax

DWLTax

Steep Social Marginal Benefit

Carbon Reduction

Price of Carbon Reduction

0

MBSocial

MCActual

RReg

PTax

DWLReg

MCEstimated

RTax

DWLTax

What then is optimal choice of instrument for climate change? Taxes preferred to quantity regulation. What is problem with this analysis? Considers static policy choice. With frequent updating, instruments have same consequences. What is public good associated with climate change? Research and development. How do we deal with public goods? Because social marginal benefit > private marginal benefit, subsidize creation or use patents. Here, could fund energy research, provide subsidies for adoption of alternative energy, or allow R&D tax credits. Why are these types of technology policies not likely to encourage sufficient R&D? Without emissions controls (environmental policies), firms will not adopt new technologies if increase cost of production. Absent need to engage in abatement, MC of production determines whether will use alternative energy sources.

Carbon Reduction

Price of Carbon Reduction

0 = RPrivate

MBSocial

MCActual

MBPrivate

Can environmental policies encourage R&D by themselves? Yes. As below graph shows, alternative energy patent applications increased in Europe with 1997 Kyoto agreement.

Do quantity controls or taxes provide greater incentives for R&D? Traditional view is that taxes and other market-based policies such as permits superior because provide incentives for continuous improvement rather than achieving particular standard. Empirical evidence to support this. However, if innovation does not everywhere reduce marginal cost of abatement, command and control could be superior to force innovation. Might happen when have to shut down plant to install efficient equipment. In below graph, with tax, firm will choose to keep old technology and reduce emissions by RTax. With regulation, firm will choose to adopt new innovation since cost is less to reduce emissions by RReg.

Carbon Reduction

Price of Carbon Reduction

0

MCInnovation

RTax

PTax

MCOriginal

RReg

MBSocial

Are environmental policies sufficient to encourage R&D? No because R&D still a public good. Encourages firms to focus on technologies closest to market and neglect those with long-term potential. What is role for government? Support basic research which is more like public good: • Tends to be long-term so more subject to appropriation by others (non-excludable). • Less likely to crowd out private research since less likely to have immediate applications.

One example is improved energy transmission system which benefits all technologies. If subsidize research firm doing anyway, may use funds spending on research for something else. This is crowd out. However, if would not conduct research otherwise, no crowd out.

• With uncertainty over R&D results, government can pool successes and failures more easily. China and other developing countries expected to emit substantially more in future, but OECD countries generate vast majority of innovations. How does innovation diffuse to developing countries? Adoption thought to follow S-shaped curve so slow initially. How can speed process up? One example – Clean Development Mechanism (CDM) as part of Kyoto allows emission credits for financing emission reducing projects in developing countries. Helps developed countries reach targets at lower cost since targeting “low-hanging fruit.” What is argument against this instrument? Makes developing country later efforts at emissions control more costly. Will be less likely to enter into emissions reduction agreements later. What is potential shortcoming in this argument? Assumes shape of MC curve stays constant. If technology transfers to developing country, flattens MC curve so future reductions could still be cheaper. In below figure, small technology transfer partially offsets movement up MC curve that results from targeting “low-hanging fruit” initially. With large technology transfer, new technologies completely offset effect.

Carbon Reduction

Price of Carbon Reduction

0

CDM

MCSmall Transfer

RInitial

PInitial

PProgram

MCOriginal

RProgram

MCLarge Transfer

API-102C Section 6 Notes Chris Carrigan Agenda • Applying cost benefit analysis under various choice scenarios (Stokey & Zeckhauser 1978) • Cost benefit analysis applied to stadium funding (Rappaport & Wilkerson 2001) Topic 1: Applying cost benefit analysis under various choice scenarios One can use cost benefit analysis to evaluate whether to engage in single project. However, what are some other conditions under which analyst may make recommendations to policy maker? • Choosing one project among number of alternatives. • Deciding on appropriate scale of one project. • Accepting multiple projects subject to resource constraint. • Accepting multiple projects where scale is variable subject to resource constraint. Consider following alternative ideas for developing public parks in city. In each case, government owns parcel of land. • Plot A is close to city center. • Plot B is in residential area. • Plot C is in less populated place.

Benefits and Costs of Three Park Projects (in $1,000) Land Plot

Total Benefit

Construction Cost

Net Benefit of Parking Lot

A $410 $150 $100 B $300 $100 $50 C $190 $50 $0

What is relevant concept in computing cost of park? Opportunity cost. What is opportunity cost? Value of resource in next best use. If alternative use of land is to build parking lot, cost is net benefit of parking lot. It is not selling price of land unless that is next best alternative (i.e. no other use for land). How do construction costs associated with converting land to park enter computation? They are considered in addition to land cost. If competitive market for construction inputs, can be valued at market price. However, remember case from class where government pays $20/hour for labor, but unemployed construction worker willing to work for $5/hour. Opportunity cost is $5/hour and additional $15 is transfer to worker.

Which should choose if can only pick one? A generates $160K ($410 – $150 – $100) in net benefit. B generates $150K in net benefit. C generates $140K. Pick A since yields highest benefit if can afford it. Say have line item budget. If have $150K to spend on parks, which option or options should you pick? Since net benefit of building parking lot is not expenditure, consider it negative benefit. Can then compute critical ratios (net benefit / cost) to determine which projects to take. Ratios are 3.8 for C, 2.5 for B, and 2.1 for A. Select C and B since have highest critical ratios. Net benefit from doing so is $290K which is greater than $160K if A chosen. However, beware of using critical ratio analysis if budget constraint not issue. In case above, where picking one project with no constraint, would have picked wrong project using this technique! Implicitly assumed projects indivisible. If divisible, under what assumption would analysis still hold? Marginal benefit of each project constant. In other words, net marginal benefit of first $1 spent on project = net marginal benefit of last $1 spent on project. Assume instead marginal benefits not constant and projects divisible. What is decision rule? If benefits determined by smooth function, invest in each up to point where net marginal benefit per dollar spent same across projects at point where budget exhausted. Here are revised estimates of costs and benefits of potential public parks where net benefits change after $50K invested in project. Would happen if initial dollars spent generate most benefit. In other words, adding second playground to park much less beneficial than first.

Benefits and Costs of Three Divisible Park Projects (in $1,000)

Land Plot Benefit (First $50 Spent)

Add'l Potential Spend

Benefit (Add'l Spending) Total Benefit Total

Construction Cost A $200 $100 $110 $310 $150 B $150 $50 $100 $250 $100 C $190 $0 N/A $190 $50

How much should spend on each option? $50K on each. True because critical ratio on first $50K spent is 4.0 for A, 3.8 for C, and 3.0 for B. This exhausts budget. However, to make sure should spend on all three, check ratios for additional money spent on A or B. Ratio for A is 1.1 and B is 2 so best option is to spend $50K on each. Topic 2: Cost benefit analysis applied to stadium funding What are approaches to measuring benefits of having professional sports franchise? • Analyze economic growth rates of cities: o Compare cities with and without pro sports.

o Compare before and after in cities that acquire teams. • Measure specific economic activity (economic impact analysis). Focus on specific economic activity. What are some potential benefits of having franchise? • Job creation. Could miss wage increases but evidence suggests of minor importance. • Increased sales and income tax revenue. Study commissioned by Greater Boston Convention & Visitors Bureau and Greater Boston Chamber of Commerce in 1999 estimated following effects of new baseball stadium to replace Boston’s Fenway Park.

Annual Spending and Employment Attributed to Red Sox ($ in millions)

Fenway New Ballpark Incremental

Increase Total Spending $298.2 $502.5 $204.3 Total Employment 4,132 7,217 3,085

If estimates of impact correct, and park expected to cost $600M of which state and local taxpayers expected to fund $250M, should move forward with project? Depends on how increased spending and/or jobs translate to net benefits to taxpayers. However, given size of annual increase in spending and job creation, may be inclined to say yes. To see this, compute NPV of increased economic activity. If useful life of stadium is 30 years and 6% is relevant discount rate, computation is: NPV = $204.3/(1.06)1 + $204.3/(1.06)2 + … + $204.3/(1.06)30 = $2,812.2M If want to determine value of franchise like Rappaport and Wilkerson (2001), which column is relevant? Either Fenway or new ballpark column depending on whether stadium is built. NPV of yearly spending associated with new ballpark is even larger: NPV = $502.5/(1.06)1 + $502.5/(1.06)2 + … + $502.5/(1.06)30 = $6,918.8M This figure is very different from findings in Rappaport and Wilkerson article (2001) on reading list which estimates NPV of franchise between $26.7M to $40M. While their estimates focus on net benefits and not simply increased economic activity, would have to believe incremental spending brought very little benefit to reconcile these. To see why so different, let’s look at analysis in more detail. Spending projections are categorized as:

Annual Spending Attributed to Red Sox ($ in millions)

Fenway New

Ballpark Incremental

Increase

In State Spending

Direct (fans, players, etc.)

Inside park $45.8 $76.7 $30.9 Outside park $45.9 $81.2 $35.3 Other $9.3 $21.9 $12.6

Indirect $77.1 $137.1 $60.0

Out of State Spending

Direct (fans, players, etc.)

Inside park $24.6 $41.3 $16.7 Outside park $26.9 $46.8 $19.9 Other $16.3 $17.0 $0.7

Indirect $52.3 $80.5 $28.2 If want to determine whether should build new stadium, which column is relevant? Column labeled incremental increase since this measures change in consumer spending associated with new ballpark. Would be case unless Red Sox planned to leave Boston if new stadium not built. In that case, would consider new ballpark column since alternative is no team at all. What is indirect spending? Spending because, for example, restaurant needs to buy more food to support increased spending by fans and players. Further, waiter or waitress spends additional tips. Same as local multiplier in Rappaport and Wilkerson (2001). What is difference between partial and general equilibrium analysis? Partial equilibrium – considers impact in markets directly affected. General equilibrium – extends analysis to consider effects on other markets. How does concept of general equilibrium affect which figures are relevant? Analysis should consider idea that some increased spending accompanied by drop in spending elsewhere. To extent increased spending at sports events reduces ability to go to movies, museums, theater, etc., get crowd out. Might think effect large because income determines spending – can’t just increase spending without accompanying increase in income. Rappaport & Wilkerson (2001) completely ignore incremental spending in state in reporting results of this study. Considering only out of state spending, NPV of incremental spending now: NPV = $65.5/(1.06)1 + $65.5/(1.06)2 + … + $65.5/(1.06)30 = $901.6M Is out of state incremental spending also subject to same critique? Not necessarily since potentially represents spending that would have occurred in Rhode Island, New Hampshire, and elsewhere.

Will all out of state spending associated with ballpark attendance be attributable to Red Sox? No. If primary purpose for coming is not to see Red Sox, watching game likely substitutes for alternative form of entertainment. Say 50% of out of state Fenway attendees visiting for other reasons like a convention, for business, or to view historical sites. Now NPV of incremental spending is: NPV = $32.75/(1.06)1 + $32.75/(1.06)2 + … + $32.75/(1.06)30 = $450.1M Analysis projects 45% increase in Red Sox attendance (27.2K → 39.5K per game). What are some general equilibrium effects of this? Externalities include congestion and displaced businesses which generate job losses. Without infrastructure investment which is costly, no ability to manage increase. Even without valuing externality directly, might expect that projected attendance increase unlikely given that already congested in Fenway neighborhood. If, without investment, can only accommodate half of expected increase, NPV of new stadium now: NPV = $16.375/(1.06)1 + $16.375/(1.06)2 + … + $16.375/(1.06)30 = $225.4M Point is that reasonably careful consideration of general equilibrium effects produces much different picture of new ballpark project. NPV of incremental spending is $225.4M (v. $2,802.2M) which is less than taxpayer cost to build stadium ($250M). And this is before considering whether assumptions on attendance and spending make sense: • Is attendance likely to increase substantially given that Fenway Park is a landmark? • If increase in capacity is mainly premium seating which is purchased for season, will 35% of

additional attendance be out of state? • Is it reasonable to assume spending by out of state fans will increase by over 35% just

because Red Sox have new stadium? How can one rescue proponents of using taxpayers’ money to build new stadium for Red Sox? Possibly by appealing to quality-of-life benefits. What are quality-of-life benefits? Satisfaction or happiness residents derive from shared area attributes which can be pleasant weather or recreational opportunities. What quality-of-life benefits are associated with professional sports team? • Fan happiness associated with attending games above ticket price (willingness to pay). • Fan happiness associated with watching, reading about, or discussing games. • Shared community experience of rooting for team. • Civic pride since contributes to idea that “world class” city.

How would one use hedonic regression to compute quality-of-life benefits? Like in class, regress house price on city characteristics and house characteristics or wage on city characteristics and individual characteristics. Positive quality-of-life benefits should increase house price and decrease wage. You pay through lower wage to gain quality-of-life benefits. What are limitations associated with hedonic measures? • Omitted variable bias. • Self selection bias. • Out-of-sample extrapolation. Why is it difficult in practice to apply hedonic regression to computing benefits associated with sports team? Sports teams select areas with large populations and employment. Thus, cannot distinguish between effect of sports team and population size because highly correlated. However, can use hedonic regression to value other quality-of-life benefits to compare to pro sports team. What is value to Boston of extra sunny day every year for thirty years? If Boston has metro population of 4.5M, and hedonic regression shows extra sunny day worth at least $4, NPV computation is (4.5M * $4 = 18M): NPV = $18/(1.06)1 + $18/(1.06)2 + … + $18/(1.06)30 ≈ $250M If having Red Sox in new stadium more valuable than one extra sunny day each year, project may make sense since public cost is $250M!

API-102C Section 7 Notes Chris Carrigan Agenda • Prohibited markets and economic theory. • Application to illegal drugs (Miron 1995, 2005). • Application to human organs (Blair & Kaserman 1991, Becker & Elias 2007). Topic 1: Prohibited markets and economic theory What are examples of prohibited markets? • Murder for hire (e.g. hitmen). • Prostitution. • Gambling. • Illicit drugs. • Body organs. What are some reasons for prohibiting markets for certain goods? • Repugnance associated with monetizing some transactions. This aversion associated with

objectification, coercion, or fear that leads to slippery slope (Roth 2007). • Negative externalities – actions taken that affect another for which latter does not pay or is

not paid. What is economic rationale for having government prohibit markets? Negative externalities. What are relevant types of externalities present in goods which are prohibited? • Negative consumption → social marginal benefit < private marginal benefit. With drugs,

may have loss of productivity among users. • Negative production → social marginal cost > private marginal cost. With drugs, may have

gang violence associated with suppliers. How does graph look? Negative externalities must be large so that Q* ≤ 0.

S = PMC

D= PMB

Q1

P1

SMC = PMC + MD

SMB = PMB + MD

Does market go away when outlawed? No. Have black market but might expect that demand and supply will both shift in (demand ↓ and supply ↓ at any given price). What are alternatives available to government? • Government provision – alcohol sold through state liquor stores. • Private provision with government regulation – FDA oversees distribution of prescription

drugs. • Private provision with minimal regulation – use courts to prosecute offenses. Topic 2: Application to illegal drugs What is effect on market equilibrium of making drugs illegal? As discussed above, expect that both supply and demand fall. • Enforcement and potential legal punishment → costs of supplying drugs increase. Also,

cannot rely on legal system to enforce contracts. • Penalties for possession → individuals abstain from illegal acts. Also, danger associated with

transactions in illegal market. What is impact on quantity? Decreases. What is impact on price? Depends on relative shifts of supply and demand as well as elasticities.

SL

DL

QL

PL

SI

PI

DI

QI

Inelastic Demand v. Elastic Demand

SL

DL

QL

PL

SI

PI

DI

QI

Might think supply will shift more than demand because punishments for suppliers more severe than consumers (price ↑ which matches evidence where, for example, cocaine estimated to sell at 20 times market price). Why make drugs illegal? Negative externalities associated with drugs such as:

• Associated violence. If drug consumption drives violence, reducing consumption decreases violence.

• Increased property crime. People steal to finance habit. • Addiction. People underestimate how likely are to become addicted leading to abuse. May

differ in that regard from alcohol and tobacco. • Lower productivity among users. • Moral imperative. What are reasons to legalize drugs? Negative externalities associated with making illegal: • Associated violence. If drug production drives violence, prohibition increases violence.

Marginal benefit to violence ↑ since cannot use legal system and marginal cost ↓ if evading apprehension complementary across crimes and if extra charges generate less than proportional penalty increases.

• Increased property crime. If prices increase through prohibition, might induce more crime. Also, prohibition diverts police from other crime.

• Reduced quality control since government no ability to regulate. Increased poisonings. Unclean needles promote spread of disease.

• Enforcement costs. Federal, state, local governments spend roughly $44B to enforce prohibition. Approximately 1.8M arrests made each year.

• Foregone tax revenue. • Substitute to similar legal substances. Alcohol impairs driving ability as well. If heavy users generate most negative consumption externalities, what is likely effect of prohibition? Little reduction in externalities. True b/c if heavy user, also inelastic demand. If casual user, elastic demand. Prohibition greater impact if elastic demand (see graph above). Reduction disproportionately among casual users who generate few negative externalities. One alternative policy option is to continue to make sale of drugs illegal while eliminating penalties for consumption and use (decriminalization). Will this likely have positive effect? Would reduce demand side enforcement costs. Further, while quantity consumed ↑, unlikely to generate additional negative externalities since increase likely concentrated among casual users. However, since supply still prohibited, negative externalities associated with illegality on supply side such as violence and lack of quality control remain. Also, property crime ↑ b/c price ↑. Scheduled November vote in California to make marijuana legal. Would tax and regulate its cultivation, processing, and distribution. Similar bill in Massachusetts Legislature (S1801 – An Act to Regulate and Tax the Cannabis Industry). What would be budget impact of making marijuana legal? Combining effects on federal and state governments, yearly impacts estimated at: • Enforcement cost reduction (police, legal, and corrections) = $7.7B. • Tax revenue = $2.4B (taxed liked other goods) to $6.2B (taxed liked alcohol and tobacco).

Topic 3: Application to human organs What federal law governs organ donation? National Organ Transplant Act (1984). “It shall be unlawful for any person to knowingly acquire, receive or otherwise transfer any human organ for valuable consideration for use in human transplantation…” What do data suggest about organ transplants in U.S. (source is Organ Procurement and Transplantation Network)? • Waiting list as of 4/1/10: 106,729. • Transplants in 2009: 28,464. • Waiting list and deaths while on waiting list substantial and growing. What would economist suggest? Compensate for live and cadaveric organs. What are some arguments against introducing price mechanism? • Asymmetric information. Those with poor health histories will try to pool with those with

good histories. Similar issue with blood supply. • Moral hazard. Less care provided for ill by physicians to obtain organs. • Crowd out. Might reduce supply of organs donated for altruistic reasons. • Behavioral issues. People may provide organs impulsively. • Ethical arguments.

o Unfair to allocate based on ability to pay. However, artificial limbs and heart valves are sold.

o Involves “commodification” of body parts. However, similar markets exist such as for surrogate mothers. Workplace allows for compensating differentials.

o Donors likely to be disproportionately concentrated among poor. Move from voluntary army exhibits many similar characteristics – “commodification” of body; fear that only poor would enlist and would crowd out patriots. Are organ transplant centers likely to support creation of market? Might think lifting ban on selling organs would increase supply which would be better for centers performing operations. However, political economy explanation suggests if ban artificially restricts quantity, makes collusion easier. Typically, collusion fails b/c εFirm > εIndustry. Intuitively, this is true because if only one firm decreases price by 10%, current customers will buy .1εIndustry more. However, some customers of other colluding firms will also begin to buy from cheating firm. Thus, firms have incentive to cheat since agreement forces them to produce where MRFirm > MC. By restricting supply of input (organs), ability to increase surgeries by cheating on agreement restricted. Thus, collusive agreement easier to enforce and resulting prices higher for consumers.

What are alternatives to current system? • Presumed consent instead of informed consent. Individual classified as donor unless family

objects. Would raise donations by 25-30% (Abadie & Gay 2005). • Transfer property rights for organs from supplier upon death. If transplant recipient allowed

to obtain organs at no cost, will eliminate shortage. However, potentially socially inefficient since results in too many surgeries.

• Use price mechanism. Provide compensation to families of deceased or directly to live donor.

Let’s focus on kidneys and estimate price at which U.S. market for kidney transplants would clear. Given current ban on selling kidneys, what does market look like? • Assume cost of performing operation = $160K currently. • Paid by insurance companies or government.

Market for Kidney Transplants (No Donor Compensation)

D

QD

CNC = $160K

SNC

QNC

Cost

Quantity

Shortage

Since donor does not receive direct compensation for organ, donations determined by altruism. Past QNC, potential donors not willing to donate organs without compensation. Since compensation not available, supply not dependent on price above cost of surgery. What would equilibrium price of kidneys be? Here is back-of-the-envelope calculation considering only living donors (data and calculations from Becker & Elias 2007). Costs to individual include: • Compensation for risk of death = value of life * probability of dying.

$5 million * .1% = $5,000. • Foregone earnings = recovery time * lost earnings.

4 weeks * $35,000 / 52 weeks = $2,700. • Potential for reduced quality of life.

~ $7,500. • Total kidney price.

$15,200. Sensitivity analysis yields prices ranging from $7,700 to $27,700.

How would consumer and producer surplus be reallocated by lifting prohibition on market for kidneys?

Market for Kidney Transplants (Donor Compensation)

D

QC

CNC = $160K

SNC

QNC

SCCC = $175K

Cost

Quantity

a

b

dc

SNC is supply curve when kidneys cannot be bought and sold. SC reflects supply curve when kidneys can be bought and sold. Diagonal portion is supply of kidney transplants using kidneys from cadaveric donors. Since kidneys likely to be cheaper when they are from cadavers, one might expect supply curve to be below that for kidneys from live donors. However, if cadaveric donors cannot supply entire market clearing quantity, kidneys from live donors will be used. Because there exists a potentially massive supply of kidneys from live donors, assume perfectly elastic supply at $160K + $15K where $15K is price computed above. With regard to surplus: a = remains consumer surplus. b = shifted from consumers to suppliers. c = additional surplus accrued to consumers (was deadweight loss). d = additional surplus accrued to suppliers (was deadweight loss). Caveat: this is likely to understate gains in surplus since under old regime, no way to ensure that those who value kidneys most receive them. For example, those with willingness to pay below CC might receive kidneys instead of those at very top of demand curve. Not so when market for kidneys created. Further issue involves valuing reduction of wait time including reduced discomfort and possibly death associated with wait.

API-102C Section 8 Notes Chris Carrigan Agenda • Political economy of regulation – an example. • Agency motivation. • Political control. Topic 1: Political economy of regulation – an example During last week’s section, we discussed the possibility of markets for live and cadaveric organs. Are organ transplant centers likely to support creation of market for organs? As suggested in last week’s notes, maybe not. Since supply of organs would increase, might think would be better for centers performing operations as more operations possible. However, consideration of barriers to entry might suggest otherwise. What is barrier to entry here? Generally refers to explicit restriction or cost that potential entrants have to pay that is not also borne by incumbent firms. Access to input which is organ might be barrier to entry since cannot perform operation without organ. Would be particularly pertinent if centers contract with existing suppliers. How can limited access to organs help organ transplant centers? In addition to increasing existing centers’ market power, may also facilitate creation of cartel. Two related reasons: • Fewer centers can operate in market so monitoring each other’s actions easier. Makes

detecting cheating on agreement easier so centers less likely to engage in cheating. • By restricting supply of organs, ability to increase surgeries by cheating restricted. As

discussed in section 7 notes, elasticity of demand of individual firms typically greater than industry (εFirm > εIndustry). True because if one firm drops price by 10%, its customers will buy .1εIndustry more. In addition, customers of other firms switch to cheating firm. As graph below shows, agreement forces firms to produce where MRFirm > MC:

Individual centers want to lower price to increase sales beyond agreed upon level (QMonopoly/N) to qFirm to maximize πFirm. However, limited access to organs makes gains from doing so small → εFirm ≈ εIndustry.

What determines whether politicians will write legislation to create market? In world of public choice theory where politicians not primarily interested in social welfare, relative ability of interest groups to both provide favors and affect chances for re-election determines whether politicians will work to create market. Assume organ issue involves two groups. First is organ transplant centers (and their surgeons) who support prohibition on buying and selling organs. Second is transplant recipients and donors who desire market since benefit from it. Will market for organs be created? Depends on ability of either group to act collectively. Theory of collection action suggests that small groups more likely to organize to influence politicians. Since benefits accrue to whole group, incentive to free ride within group. However, with smaller groups, easier to overcome problem. If surgeons have easier time than potential recipients and donors acting collectively (which is likely), would expect them to have more influence over politicians entrusted with lawmaking. Logic here similar to that used to explain why public goods underprovided earlier in semester. Topic 2: Agency motivation Distinction between regulators and politicians not explored in above discussion. However, in this and next section, recognize that two different groups. What are potential factors that motivate bureaucrat behavior in regulatory (or other) agencies? • Laziness. • Job security. • Organizational mission. • Professional status. • Money and/or other perks. • Political power. Let’s explore implications of three of these possible motivations: money or other perks, job security, and political power. What is capture theory? Idea that agency created to regulate some business activity for benefit of public may instead act for benefit of those supposed to regulate. Agency is then “captured” by industry. While cited cases of capture are numerous, one prominent example is now defunct Interstate Commerce Commission (Huntington 1952). Although ICC created to protect farmers from being charged discriminatory prices by giving ICC authority to set rates, over time railroads and ICC developed partnership. Why would ICC choose to act in interest of railroads and not farmers? Possible reasons include:

• Potential for bribes and offers of future employment after leaving agency may have caused ICC to be more sympathetic to railroads. Those motivated by money and perks particularly likely to be influenced by these opportunities. Of 142 commissioners of the Civil Aeronautics Board, Federal Communications Commission, or ICC through 1977 whose post-agency employment known, 51% went to work for regulated industry (Eckert 1981).

• Limited resources may cause ICC to trade funding by railroad companies for higher rates. • Agency survival may depend on developing constituency to back it. If job security important

to ICC employees, gaining support of railroads ensures politicians interested in transferring or abolishing ICC have to overcome railroad lobby.

What is assumption in above analysis of decision of ICC to support railroads? As in case of organ transplant providers relative to consumers, assumes ability of railroads to act collectively to provide favors and influence politicians greater than that for farmers. What was benefit to railroads? Beyond simply receiving higher rates, created barrier to entry since ICC consistently acted to protect railroads against alternative methods of transporting goods including trucking. What broad implication does this have for firm behavior? Firms in particular industry may actually pursue regulation as means to create barriers to entry to facilitate exercise of market power and collusive practices. Let’s take four regulatory agencies and determine where capture most likely: • Department of Justice Antitrust Division (Antitrust Division) – enforces antitrust laws. • Federal Maritime Commission (FMC) – monitors collusive agreements among ocean carriers. • Food and Drug Administration (FDA) – protects human health by supervising food safety,

drugs, etc. • Occupational Safety and Health Administration (OSHA) – issues and enforces standards for

workplace safety. How can we think about where capture may reflect agency behavior? One way is to consider interest groups involved and ability of groups to act collectively. Wilson (1989) characterizes regulatory interest group environment as follows:

Regulatory Benefits

Concentrated Dispersed

Regulatory Costs

Concentrated Interest-group politics (OSHA)

Entrepreneurial politics (FDA)

Dispersed Client politics (FMC)

Majoritarian politics (Antitrust Division)

Chart suggests that political environment defined by extent to which costs and benefits of regulation borne or enjoyed by well organized or unorganized groups. For example, with entrepreneurial politics, costs are focused on organized group whereas benefits are dispersed

more widely. Would appear to characterize FDA since pharmaceutical and food industries better organized than public. So which agencies most likely to be captured? Those where concentrated group pitted against dispersed group. With interest-group politics, environment likely hostile but unlikely that one group capable of capturing agency. With majoritarian politics, no group likely to exercise substantial influence. Thus, client and entrepreneurial politics are most likely candidates. Particularly true when benefits concentrated and costs dispersed. Say observe that FDA drug approval times of incumbent drug manufacturers substantially shorter than those for new entrants. Is this capture? Might think yes if FDA favoring incumbents in exchange for favors from these firms. From entrant’s perspective, slow approval rate acts as barrier to entry. If approval viewed as input to production, entrant faces higher costs. What might be alternative explanation if FDA bureaucrats place high value on job security? If regulators risk averse, may be more comfortable approving drugs of incumbents. Could be case if have had good experiences with these firms in past. In other words, less uncertainty associated with approving new drugs of incumbents. Takeaway is that regulatory motivation important to correctly characterizing behavior (Carpenter 2004). What broad evidence exists for presence of capture? ICC is one of many examples at agency level. Evidence also exists that capture varies across countries. One study compiles data on time and costs associated with starting new business in countries around world (Djankov et al.). Authors find that varies greatly even among advanced democracies as shown by following sample:

Country Procedures (#) Time (days) Cost (% per capita GDP) Canada 2 2 1.45 USA 4 4 0.49 Switzerland 7 16 17.24 Italy 16 62 20.02 Madagascar 17 152 42.63 Dominican Republic 21 80 463.09

Why might one suggest difficulty in starting new business is evidence of capture? If more onerous regulation benefits existing firms and bureaucrats and hurts those aspiring to create businesses, might think this is capture. However, if more regulation associated with fewer damaging externalities and more competition, might think government operating in public interest. What explains variation in country’s procedures in starting new business? Number of procedures positively associated with: • Amount of pollution.

• Poorer health outcomes. • Employment outside of official economy. • Less product market competition. However, could be that regulation necessary because externalities worse in these countries, but graph shows that corruption greater where more procedures. Suggests capture likely:

Topic 3: Political control What does focusing solely on agency motivation suggest about extent to which politicians control bureaucracy? Limited ability to do so. What is principal-agent problem? Situation where one individual (principal) delegates authority over some activity to another (agent). Problem is that agent’s incentives might not be in perfect harmony with principal’s incentives. Classic example is where firm owner hires employee but cannot perfectly observe effort of that individual. Owner must structure employment contract to elicit costly effort from employee. In our case, principal is politician and agent is regulator. Politician delegates implementation of law to regulator but must ensure acts according to desires of politician. In U.S., who are political actors with ability to control bureaucracy? Three branches of government: • Executive (President) • Legislative (Congress) • Judicial (Courts) What methods are at their disposal? Range of methods used differ primarily by extent to which demands direct action on part of principal. Some include:

• Appointments and appropriations. • Oversight hearings. • Rulemaking oversight (including judicial and OMB review). • Procedures such as notice-and-comment and mandated cost-benefit analyses. Why is measurement of bureaucratic performance difficult? At least two reasons: 1. Difficult to measure ultimate output. For example, how to determine whether Department

of Homeland Security deterring terrorism? 2. Typically agencies have monopoly over policy area so no benchmark to compare against. Let’s take one of these, appropriations, and see when this might be effective method of control. How would bureaucrats interested in accumulating power behave? Might seek to maximize agency size. Can do this through budget. What implication does measurement problem have for agencies interested in power? Agency will be too large. Particularly acute if salary tied to responsibility and not efficiency, which is likely case. Say agency is sole producer of regulatory function such as enforcing antitrust law, only it knows its cost schedule, and agency seeks to maximize budget. How can we determine when appropriations effective in controlling behavior? To answer question, assume committee in Congress has demand curve for enforcement actions, which agency knows. In deciding on budget, committee will ask for cost associated with prosecuting an enforcement action to decide how much to fund agency. So pick budget based on quantity demanded at particular price. As shown in graph below, whether agency’s budget too large depends on level of marginal cost of prosecuting cases (MCH or MCL) compared to point at which agency budget size maximized (Mueller 2003).

MCH

MCL

QL

PL ε = 1

ε > 1

ε < 1

PH

QH Antitrust enforcement agency would like to assert that costs PL to prosecute case which is associated with committee demand for prosecutions equal to QL. Results in total budget = PL * QL. This is point where budget maximized b/c any move away entails larger decrease in price or quantity associated with corresponding increase in other variable. For example, move down

demand curve implies % increase in cases prosecuted not sufficient to offset % decline in allocated resources per case (P). When will budget exceed optimal level? For budget maximizing antitrust regulator, when marginal cost is really MCL, says cost is PL to increase total size of budget. When marginal cost is MCH, would like to say cost is PL. However, if does, will not be able to prosecute QL cases with budget = PL * QL. True b/c actual cost greater than budgeted cost (MCH > PL). To garner largest budget under this constraint, tells truth that cost is MCH. Budget size now optimal at QH * MCH. Thus, only when MC < PL will agency be able to use information advantage to undermine oversight. Of course, if can ask for additional money later to fulfill QL, may still be able to increase budget beyond optimal level. However, negatively impacts agency credibility and may not be procedurally possible to request additional funds later. Thus, have shown that direct oversight through appropriations can be effective in controlling agency behavior. However, if see little direct oversight by Congress, does this suggest regulators operating autonomously? Not necessarily. List above includes procedural controls such as mandated cost-benefit analysis and notice-and-comment that might effectively control regulatory actions as well. Broadly described as “fire-alarm” v. “police-patrol” oversight. Making information available allows interest groups and citizens to alert politicians when problems arise (McCubbins & Schwartz 1984). Why might politicians want to use procedures instead of direct methods to control regulators? • Less costly to politician. Interest groups bear cost of notifying politicians when bureaucrats

behaving inappropriately. • Focuses attention on issues most salient to voters. Politicians do not waste resources

investigating unimportant bureaucratic failures. • Allows politicians to “stack the deck.” For example, by forcing all agencies to assess

environmental impact of activities through National Environmental Policy Act of 1969, establishes environmentalists as important voice today and in future. Once law enacted, difficult to reverse since those benefiting unwilling to relinquish gains (McCubbins et al. 1987).

Should regulators be controlled by politicians? Complicated and involved question. Might think that depends on which arrangement likely to yield results most consistent with public interest. For example, when policy tasks subject to short-sightedness, bureaucrat independence likely better (Alesina & Tabellini 2007, 2008).