Controversial Rationality: 10 Microeconomic Principles and Testing Rationality

1. Lesson Overview Chapter 1 (continued) First Principles 10 Microeconomic Principles Testing Rationality Food Stamps to Alcoholics Social Security and Medicare Disaster Relief US Postal Service Child Tax Credits Crack Babies Controversy: Handicapped Parking Summary Review Questions BA 210 Lesson I.2 Controversial Rationality

2. 10 Microeconomic Principles Most microeconomic conclusions are summarized by 10 principles. Those principles help consumers make satisfying choices, help managers make profitable decisions, and help governments make effective public policies. BA 210 Lesson I.2 Controversial Rationality

3. 10 Microeconomic Principles • Principle 1: Everyone has to make choices about what to do and what not to do. • Yes, there are two paths you can go by But in the long run There's still time to change The road you're on • --- Stairway to Heaven, Led Zeppelin, voted best band ever. • Individual choice is the basis of economics --- if it doesn’t involve choice, it isn’t economics. BA 210 Lesson I.2 Controversial Rationality

4. 10 Microeconomic Principles Principle 2: The reason choices must be made is that resources --- anything that can be used to produce something else --- are scarce. BA 210 Lesson I.2 Controversial Rationality

5. 10 Microeconomic Principles Principle 3: Because you must choose among limited alternatives, the true cost of anything is what you must give up to get it --- the opportunity cost. BA 210 Lesson I.2 Controversial Rationality

6. 10 Microeconomic Principles Principle 4: Many economic decisions involve questions not of “whether” but of “how much” --- how many times to go to Medieval Times in one year and is the Museum of Torture worth the extra two dollars, how much time to spend on homework, … . Such decisions must be taken by performing a trade-off at that margin --- by comparing the costs and benefits of doing a bit more or a bit less. Decisions of this type are called marginal decisions, and the study of them, marginal analysis, plays a central role in economics. BA 210 Lesson I.2 Controversial Rationality

7. 10 Microeconomic Principles Principle 5: The study of how people should make decisions is also a good way to understand actual behavior. Individuals usually exploit opportunities to make themselves better off. If opportunities change, so does behavior: people respond to incentives. BA 210 Lesson I.2 Controversial Rationality

8. 10 Microeconomic Principles Principle 6: Interaction --- the success of my choices depend on your choices, and vice versa --- adds another level to economic understanding. When individuals interact, the end result may be different from what anyone intends. For example, an individual farmer may grow more corn to gain individual profit, but when every farmer grows more corn, prices fall and all profits may fall. (This is called a prisoners’ dilemma.) BA 210 Lesson I.2 Controversial Rationality

9. 10 Microeconomic Principles Principle 7: The reason for interaction is that there are gains from trade: by engaging in the trade of goods and services with one another, the members of an economy can all be made better off. Underlying gains from trade are the advantages of specialization, of having individuals specialize in the tasks they are relatively good at. (Being absolutely the best at something is not important to trade.) BA 210 Lesson I.2 Controversial Rationality

10. 10 Microeconomic Principles Principle 8: Economies normally move toward equilibrium --- a situation in which no individual can make himself better off by taking a different action. BA 210 Lesson I.2 Controversial Rationality

11. 10 Microeconomic Principles Principle 9: An economy is efficient if all opportunities to make some people better off without making other people worse off are taken. Resources should be used as efficiently as possible to achieve society’s goals. But efficiency is not the only way to evaluate an economy: equity, or fairness, is also desirable. And unless one is careful, there is a trade-off between equity and efficiency. For example, when you give food or shelter to a homeless person, you reduce their incentive to take care of themselves and, so, create inefficiency. BA 210 Lesson I.2 Controversial Rationality

12. 10 Microeconomic Principles Principle 10: Markets usually lead to efficiency, with some well-defined exceptions. And when markets fail and do not achieve efficiency, government intervention can improve society’s welfare. For example, governments can tax people that hurt others by their driving, noise, smoking, or drinking. BA 210 Lesson I.2 Controversial Rationality

13. Testing Rationality One reason economists disagree is over which assumptions are appropriate. Since all assumptions (commodities are all that matter, perfect selfishness, rationality) simplify reality, and are only approximately true, two economists can disagree about which assumptions are more accurate --- and therefore, they can arrive at different conclusions. BA 210 Lesson I.2 Controversial Rationality

14. Testing Rationality When determining effective public policy to help the poor, the most often debated assumption is consumer rationality. Consumers are assumed to be perfect calculators and flawless followers of those choices that are in their own best interests. BA 210 Lesson I.2 Controversial Rationality

15. Testing Rationality Extra Credit: Identify some irrational behavior, like maintaining unrealistic expectations, disorganization, or extravagance. And determine whether such irrationality is more common among the poor. Are the poor more likely to play the lottery? more likely to not plan expenses and maintain a bank account, and so require expensive check-cashing services? more likely to buy extravagant items they cannot afford, and so eventually sell them at a loss to a pawn shop? BA 210 Lesson I.2 Controversial Rationality

16. Food Stamps to Alcoholics What gift should you give to the needy? • A gift-in-kind is a gift of a good (like a bike). • Why do people give gifts in kind? • What gifts do kids want from relatives they do not know? • What gift should a policymaker give someone that fits the economic assumption of rationality and the assumption that commodities are all that matter? • How should a parent respond to a child asking for a coke in a restaurant? BA 210 Lesson I.2 Controversial Rationality

17. Food Stamps to Alcoholics Consider three public policies designed to help a group of needy people by giving them a gift in kind of a particular commodity (food, medical care, …). In each case, the central issue that defends or critiques the policy is whether people in that needy group are rational. If a needy person is rational, or as rational as the policymakers, then revealed preference theory concludes the most effective gift is cash, rather than a gift of a particular commodity. For example, giving a particular $20 item from Target (say, the Underworld Vampire Trilogy on DVD) can never make someone happier than a gift of $20 cash. And if the $20 cash were used for any other item, then that chosen item is preferred. BA 210 Lesson I.2 Controversial Rationality

18. Food Stamps to Alcoholics The United States Supplemental Nutrition Assistance Program (SNAP), historically and commonly known as the Food Stamp Program, is a federal-assistance program that provides assistance to low- and no-income people and families living in the U.S. Almost by definition, an alcoholic is not rational. And without the assumption of rationality, economists lose the revealed-preference conclusion that the most effective gift is cash, rather than a gift of food. The food stamp program can thus be defended if policymakers believe the target needy group of low- and no-income people and families living in the U.S. are irrational, like alcoholics. BA 210 Lesson I.2 Controversial Rationality

19. Social Security and Medicare Medicare is a social insurance program administered by the United States government, providing health insurance coverage to people who are aged 65 and over, or who meet other special criteria. Unless the United States government believes most seniors are not rational, revealed preference concludes a more effective gift is cash, rather than a gift of health care. Some senior would prefer trading some care, say by waiting in longer lines for medicine, in exchange for Social Security benefits or cash for a cell phone to call their kids. BA 210 Lesson I.2 Controversial Rationality

20. Social Security and Medicare Social Security is a social insurance program funded through dedicated payroll taxes called Federal Insurance Contributions Act (FICA). The main part of the program is abbreviated OASDI (Old Age, Survivors, and Disability Insurance). Benefits are paid for retirement, disability, survivorship, and death, which are the four main benefits provided by traditional private-sector pension plans. In 2004 the U.S. Social Security system paid out almost $500 billion in benefits. By dollars paid, the U.S. Social Security program is the largest government program in the world and the single greatest expenditure in the federal budget, with 20.8% for social security. BA 210 Lesson I.2 Controversial Rationality

21. Social Security and Medicare Although Social Security cash payments give more choices to seniors than the gift-in-kind of Medicare, Social Security is still a type of gift-in-kind because it only raises old-age consumption. Think of young-age and old-age consumption as two different commodities X and Y. Social Security cash payments are like a gift-in-kind of commodity Y, paid for by reduced good X. Unless the United States government believes most people are not rational in their choice between young-age and old-age consumption, revealed preference concludes a more effective gift is cash to young people, rather than to seniors. Some seniors alive today would have preferred trading some old-age consumption in exchange for cash payments or lower taxes when they were younger (and more vigorous). BA 210 Lesson I.2 Controversial Rationality

22. Disaster Relief Disaster Relief In 2008, New Orleans’ levee system is still being rebuilt after Katrina at a cost of $17.5 billion, and Hurricane Gustav will add to the financial strain of reconstructing a region still reeling from that devastation three years ago. Unless the United States government believes most people in New Orleans are not rational in their consumer choices, revealed preference concludes cash is a more effective gift than a levy. At a cost of less than $17.5 billion, every person in New Orleans could have been given suitcases and enough cash to happily relocate above sea level, either using some of the cash to live in safer areas of New Orleans or leaving the area altogether. And those that remain in New Orleans, could do so at their own risk. BA 210 Lesson I.2 Controversial Rationality

23. U.S. Postal Service What gift should you give to the needy? • A subsidy is a partial gift-in-kind. Rather than giving a good free (like a free bike), the purchase cost is reduced. • What gift should a policymaker give someone that fits the economic assumption of rationality and the assumption that commodities are all that matter? • Subsidies can be defended or critiqued just like gifts in kind. BA 210 Lesson I.2 Controversial Rationality

24. U.S. Postal Service Consider three public policies designed to help a group of needy people by giving them a subsidy of a particular commodity (food, medical care, …). In each case, the central issue that defends or critiques the policy is whether people in that needy group are rational. If a needy person is rational, or as rational as the people policymakers, then revealed preference theory concludes the most effective gift is cash, rather than a gift of a subsidy. For example, giving a $10 gift card at Target can never make someone happier than a gift of $10 cash. And if the $10 cash were used for any item not at Target, then that chosen item is preferred. BA 210 Lesson I.2 Controversial Rationality

25. U.S. Postal Service The United States Postal Service is obligated to serve all Americans, regardless of geography, at uniform price and quality. Is the United States Postal Service efficient? That is, are all opportunities taken to make some people better off without making other people worse off? BA 210 Lesson I.2 Controversial Rationality

26. U.S. Postal Service Question: Suppose you live in Los Angeles and have a relative in Fullerton (California) and a relative in Austin (Texas). Measure the value to you of writing them letters by the amount you would be willing to pay to send them each a letter. Suppose they do not value your letters but you value writing them letters as in the table above. And suppose the cost to the U.S. Postal Service of delivering a letter to Fullerton is 24 cents, and the cost to Austin is 64 cents. Would it be efficient to charge, as is the case, 44 cents for each letter to Fullerton and 44 cents for each letter to Austin? That is, do those prices lead to efficiency? BA 210 Lesson I.2 Controversial Rationality

27. U.S. Postal Service Answer: Step 1: Use the economic principle that markets, without taxes or subsidies or any other government intervention, lead to efficiency, meaning all opportunities to make some people better off without making other people worse off are taken. In the present case, competition in the marketplace for the delivery for each letter drives the price equal to the cost to the U.S. Postal Service of delivery. That is, the market price is 24 cents for each letter to Fullerton and 64 cents for each letter to Austin. At those market prices, you would choose to send Letters #1 and #2 to Fullerton, but zero letters to Austin. BA 210 Lesson I.2 Controversial Rationality

28. U.S. Postal Service Step 2: At the non-market prices of 44 cents for each letter to Fullerton and 44 cents for each letter to Austin, determine which letters you would choose to send. That is, Letter #1 to Fullerton and Letter #1 to Austin. Step 3: Conclude that since the non-market prices lead to different letters sent than at the efficient market prices, it would not be efficient to charge those non-market prices. BA 210 Lesson I.2 Controversial Rationality

29. U.S. Postal Service Comment 1: Going further than the original question, to demonstrate inefficiency at non-market prices, which makes you choose to sent only Letter #1 to Fullerton, show not all opportunities are taken to make some people better off without making other people worse off. Specifically, if you sent Letter #2 to Fullerton at a price between $0.24 and $0.30, then you would be better off and the Post Office (taxpayers) would be better off and no one else would care (or be worse off). Comment 2: There is a 20 cent tax to Fullerton and 20 cent subsidy to Austin, so the Post Office balances its budget when one letter is sent to each place. But the non-market prices are still inefficient. BA 210 Lesson I.2 Controversial Rationality

30. Child Tax Credits The United States Child Tax Credit reduces tax liability. For many families, the child tax credit will exceed their tax liability. It is available to taxpayers who have a “qualifying child.” A person is a “qualifying child” if he or she has not attained the age of 17 by the end of the taxable year and the taxpayer can claim a dependency exemption for the child and the child is the taxpayer’s son or daughter (or descendent of either), stepson or stepdaughter (or descendent of either), or eligible foster child. Are Child Tax Credits efficient? That is, are all opportunities taken to make some people better off without making other people worse off? BA 210 Lesson I.2 Controversial Rationality

31. Child Tax Credits Child tax credits are a subsidy if we consider children to be commodities. So unless the government believes most prospective parents are not rational in their consumer choices, including procreation, then cash is a more effective gift than a child tax credit. BA 210 Lesson I.2 Controversial Rationality

32. Child Tax Credits Question: Measure the value to you and your spouse of having kids by the amount you would be willing to pay each year to raise them. And suppose the cost or raising kids is $3,500 per kid each year. Would it be efficient if the government offered a child tax credit of $2,000 per kid each year? BA 210 Lesson I.2 Controversial Rationality

33. Child Tax Credits Answer: Step 1: Use the economic principle that markets, without taxes or subsidies or any other government intervention, lead to efficiency, meaning all opportunities to make some people better off without making other people worse off are taken. In the present case, competition in the marketplace for the goods needed to raise kids drives the price equal to the $3,500 cost of raising kids. At that market price, you would choose to have Kids #1 and #2. BA 210 Lesson I.2 Controversial Rationality

34. Child Tax Credits Step 2: With the child tax credit of $2,000 per kid, determine which letters you would choose to have. That is, the price of kids falls from $3,500 per kid to $1,500 per kid. So, you would choose to have Kids #1 and #2 and #3. Step 3: Conclude that since the child tax credit leads to different numbers of kids than at the efficient market prices, the child tax credit is not efficient. BA 210 Lesson I.2 Controversial Rationality

35. Child Tax Credits Comment: Going further than the original question, to demonstrate inefficiency with the child tax credit, which makes you choose Kids #1 and #2 and #3, show not all opportunities are taken to make some people better off without making other people worse off. Specifically, if after Kids #1 and #2, the government replaced the child tax credit with a gift of $2,000 per year, then you would have to pay the full $3,500 for Kid #3, so you decline. The net happiness of $2,000-$1,500 = $500 per year that you received from Kid #3 under the child tax credit has now been increased to a net happiness of $2,000 cash per year. Replacing the tax credit with cash thus makes your family better off (by $1,500 per year) without making other people worse off. BA 210 Lesson I.2 Controversial Rationality

36. Crack Babies In addition to the child tax credit, government subsidies for raising children include • Dependency exemptions. Each child or other dependent you claim on your 2009 tax return will knock $3,650 off your taxable income. • Dependent-care credits. Payments made to care for a child under the age of 13, or other qualifying dependent, while you work can earn you a tax credit from $600 (for one dependent) up to $2100 (for two or more dependents). BA 210 Lesson I.2 Controversial Rationality

37. Crack Babies What if prospective parents are considered irrational? What if they are on crack? • Project Prevention (founded and formerly known as Children Requiring a Caring Community or C.R.A.C.K.) is an American non-profit organization which pays drug addicts $200 for volunteering to receive long-term birth control or sterilization. As of January 2006, the amount offered has been increased to $300. • Barbara Harris founded the organization in 1997 after she and her husband adopted four children from a drug-addicted mother. After the experience of helping the children through withdrawal and other health problems, she attempted to have legislation passed in California which would have mandated long-term birth control for mothers who gave birth to drug-addicted babies. After this failed, she opted instead to start what is now called Project Prevention. • Despite the fact that all patients are volunteers, the organization has incited a large amount of controversy. Some claim that it is a human right to have children that should not be restricted. Critics also make comparisons to the eugenics (selective breeding) movement of the early 20th century. • As of July 16, 2006, Project Prevention has paid and treated 1854 women and 27 men. BA 210 Lesson I.2 Controversial Rationality

38. Crack Babies Project prevention is controversial precisely because crack addicts are considered irrational. • Offering money to a rational person cannot hurt them because they could just say no. • Debates about project prevention are sometimes obscured by euphemisms for irrationality, calling crack addicts “vulnerable” or “exploitable”. BA 210 Lesson I.2 Controversial Rationality

39. Controversy: Handicapped Parking Controversy: Handicapped Parking BA 210 Lesson I.2 Controversial Rationality

40. Controversy: Handicapped Parking In the United States, disabled parking permits generally take the form of either specially marked license plates or a placard that hangs from the rear-view mirror. Plates are generally used for disabled drivers on their personal vehicle, while the portable placard can be moved from one vehicle to another with the disabled person, both when driving or when being transported by another driver. The medical requirements to obtain a permit vary by state, but usually are confined to specific types disabilities or conditions. These as a general rule include the use of any assistive device such as a wheelchair, crutches, or cane, as well as a missing leg or foot. Many states also include certain cardiovascular conditions, respiratory problems, and conditions that cause pain while ambulating or otherwise require the person to rest after walking a very short distance. About half of US states (26) include blindness as a disability that can obtain a placard (for use as a passenger) and 14 states include a missing or maimed hand. Four states include deafness, and only 2 states (Virginia and New York) include mental illness or developmental disabilities. BA 210 Lesson I.2 Controversial Rationality

41. Controversy: Handicapped Parking Question: Is Handicapped Parking efficient? That is, are all opportunities taken to make some people better off without making other people worse off? BA 210 Lesson I.2 Controversial Rationality

42. Controversy: Handicapped Parking Answer: Handicapped Parking permits are a gift-in-kind. So unless the government believes most handicapped people are not rational in their consumer choices, then cash is a more effective gift than a handicapped parking space. What if the law were changed an handicapped people could sell or rent their special parking permits? Might some choose to sell to some rich Pepperdine students, and spend a few more minutes each day using their wheelchair, crutches, or canes to get to class. Those that choose to sell and those that choose to buy are made better off without making other people worse off. BA 210 Lesson I.2 Controversial Rationality

43. Summary Summary • When determining effective public policy to help the poor, the most often debated assumption is consumer rationality. • If a needy person is rational, or as rational as policymakers, then revealed preference theory concludes the most effective gift is cash, rather than a gift-in-kind or a subsidy of a particular commodity. • Food Stamps, Social Security, Medicare, disaster relief, U.S. Postal Service uniform pricing, child tax credits, aid to crack babies, and Handicapped Parking permits are examples of gifts-in-kind or subsidies. As such, their only defense is if the target needy group is irrational. BA 210 Lesson I.2 Controversial Rationality

44. Review Questions • Review Questions • You should try to answer some of the following questions before the next class. • You will not turn in your answers, but students may request to discuss their answers to begin the next class. • Your upcoming Exam 1 and cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exams. BA 210 Lesson I.2 Controversial Rationality

45. Review Questions Question 1: Suppose you live in Los Angeles and have a relative in Fullerton (California) and a relative in Austin (Texas). Measure the value to you of writing them letters by the amount you would be willing to pay to send them each letter. Considering just a simple possibility, suppose they do not value your letters but you value writing them letters as in the table above. Further, suppose the cost to the U.S. Postal Service of delivering a letter to Fullerton is 10 cents, and the cost to Austin is 90 cents. Would it be efficient to charge, as is the case, 44 cents for each letter to Fullerton and 44 cents for each letter to Austin? That is, do those prices lead to efficiency? BA 210 Lesson I.2 Controversial Rationality

46. Review Questions Answer 1: Step 1: Use the economic principle that markets, without taxes or subsidies or any other government intervention, lead to efficiency, meaning all opportunities to make some people better off without making other people worse off are taken. In the present case, the market for the delivery for each letter drives the price equal to the cost to the U.S. Postal Service of delivery. That is, the market price is 10 cents for each letter to Fullerton and 90 cents for each letter to Austin. At those market prices, you would choose to send Letters #1 and #2 to Fullerton, but zero letters to Austin. BA 210 Lesson I.2 Controversial Rationality

47. Review Questions Step 2: At the non-market prices of 44 cents for each letter to Fullerton and 44 cents for each letter to Austin, determine which letters you would choose to send. That is, Letter #1 to Fullerton, but zero letters to Austin. Step 3: Conclude that since the non-market prices lead to different letters sent than at the efficient market prices, it would not be efficient to charge those non-market prices. BA 210 Lesson I.2 Controversial Rationality

48. Review Questions Comment: Going further than the original question, to demonstrate inefficiency at non-market prices, which makes you choose to sent only Letter #1 to Fullerton, show not all opportunities are taken to make some people better off without making other people worse off. Specifically, if you sent Letter #2 to Fullerton at a price between $0.10 and $0.15, then you would be better off and the Post Office (taxpayers) would be better off and no one else would care (or be worse off). BA 210 Lesson I.2 Controversial Rationality

49. Review Questions Question 2: Suppose you live in Los Angeles and have a relative in Fullerton (California) and a relative in Austin (Texas). Measure the value to you of writing them letters by the amount you would be willing to pay to send them each letter. Considering just a simple possibility, suppose they do not value your letters but you value writing them letters as in the table above. Further, suppose the cost to the U.S. Postal Service of delivering a letter to Fullerton is 10 cents, and the cost to Austin is 90 cents. Would it be efficient to charge, as is the case, 7 cents for each letter to Fullerton and 50 cents for each letter to Austin? That is, do those prices lead to efficiency? BA 210 Lesson I.2 Controversial Rationality

50. Review Questions Answer 2: Step 1: Use the economic principle that markets, without taxes or subsidies or any other government intervention, lead to efficiency, meaning all opportunities to make some people better off without making other people worse off are taken. In the present case, the market for the delivery for each letter drives the price equal to the cost to the U.S. Postal Service of delivery. That is, the market price is 10 cents for each letter to Fullerton and 90 cents for each letter to Austin. At those market prices, you would choose to send Letters #1 and #2 to Fullerton, but zero letters to Austin. BA 210 Lesson I.2 Controversial Rationality