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Brooks Wilson's Economics Blog: March 2012

Friday, March 30, 2012

Unemployment During the Great Recession

If a picture is worth a thousand words, this is a long post.  The plots of the United States measure the biannual changes in the unemployment rate by state beginning in January 2008.  Low rates of unemployment are yellow and high rates, dark red.

January 2008.
July 2008
January 2009
July 2009
January 2010
July 2010
January 2011
July 2011
January 2012

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Tuesday, March 20, 2012

Using Supply and Demand to Illustrate How Policy Impacts the Gasoline Market

Voters’ blood pressure has soared as rising gasoline prices have hammered their budgets. Many heap blame on President Obama as they have on past presidents for events that occur under their administrations, perhaps because politicians running for office claim they can fix all problems. Seizing an opportunity to win votes, Republican politicians blame President Obama’s policy for rising gasoline prices and promise to dramatically lower prices just as Democratic claimed power to solve pertinent economic problems four years ago. Politicians are not omnipotent and even when policies affect outcomes; their policies can be overwhelmed by market forces.

The graph “EIA U.S. All Grades Formulations Retail Gasoline Prices” plots the price of gasoline over the past eleven years beginning with President Bush’s first term. As President Obama’s Republican critics state, the price of gas has nearly doubled since he took office. Picking a starting point is a good way to trick unwary readers. By using a longer time frame, it is clear that rising prices preceded the Obama administration and that the trend was only interrupted by the Great Recession. In March 2001, the price of gasoline was $1.45 per gallon compared to $3.64 per gallon last week.

In this post, I use tools presented to principles of economics students to describe the markets for gas and related products and the possible influence events and policy have on them. Skip the remainder of this paragraph if you are not interested in the pedagogical background of supply and demand. The demand for gas can be described using an equation without functional form, Qg=D(Pg, I, Ps, Pc, N, Txd), where Qg is the quantity of gas demanded, Pg is the price of gas, I is the income level of consumers, Ps is the price of substitutes for gasoline, Pc is the price of complementary goods, goods used with gasoline, N is the number of consumers, and Txd is taxes on consumers. The supply for gas can be similarly described, Qg=S(Pg, Pi, Tc, Txs, E), where Qg is the quantity of gas supplied, Pg is the price of gas, Pi, the price of inputs, Tc, technology, Txs, taxes on suppliers, and E, suppliers’ expectations.

The Law of Demand states that holding all variables but price and quantity constant, as price rises, the quantity demand of a good or service falls. The Law of Supply states that holding all variables but price and quantity constant, as price rises the quantity supplied increases. The graph “U.S. Gasoline Market: 2001-2012” is a simplification of the market at the beginning and end of the eleven years. It depicts supply and unchanging and contains two demand curves, the first for March 2001 and second, March 2012; the equilibrium prices are taken from the trend line in the first graph.

In the remainder of post, I change one supply or demand variable at a time to explain the trend; this technique is called comparative statics. The first variable of note is income (I). Over the last two decades, world income has grown rapidly, leading to increased demand for gasoline with much of that demand coming from China and India. While income has grown, the increase in gasoline prices has had a subtle negative impact on income. The increase in gasoline prices reduces remaining purchasing power producing the same result as a decrease in income. Because consumers can substitute away from gasoline, the increase in income will not be completely offset by the increase in gasoline prices. The increase in world income is probably the most important variable causing demand to increase (shift to the right from D01 to D12) between 2001 and 2012.

To understand the market for gasoline, it is necessary to understand the market for its most important input, oil. The cost of producing gasoline largely reflects the price of its major input (Pi), oil. The supply equation for oil is slightly different than that of gasoline, Qo=S(Po, Tco, Txo, R) where the variables, where Qo is the quantity of oil produced, Po is the price of oil, Tco is oil technology, Txo is taxes on oil and R is oil reserves.

I believe that it is the reserve of oil (R) that explains the lack of a supply response to the upward march of prices. As demand has increased, increasing prices, gasoline manufacturers have a profit incentive to produce more, requiring more oil. The oilfields that are cheapest to exploit are producing. New oil must be produced from fields that are more costly and time consuming to exploit. New technology, (Tco), such as the conversion of tar sands to oil in Canada and hydraulic fracturing will allow supply to expand more rapidly (a movement from S to SI), slowing the pace of oil price increases directly and gasoline prices through its major input, oil, but when all is said and done, oil is a finite resource and its reserves will eventually be depleted.

In 2008, candidate Obama ran in part as an environmental warrior ready, willing and able to use the resources of United States government to combat carbon emissions primarily from the consumption of oil and coal. In office, President Obama has introduced programs that affect the price of substitute goods to gasoline. He promoted the electric car with $7,500 per vehicle tax credits (a subsidy is a negative tax, Tx), and invested directly in alternative fuel companies lowering the price of substitutes, a type of related good. The graph “U.S. Gasoline Market: Shifts in Demand” illustrate the impact of these policies. Because they make alternatives to gasoline less expense, they decrease the demand for gasoline (shifting demand to the left, D to DD where DD is a decrease in demand). He has also increased EPA standards for all vehicles (a constraint on the technology of complements (Tc). This technology variable is part of the supply of vehicles. On the demand side, higher EPA standards increase the fixed price of a compliment to gasoline while lowering the operating price making the overall impact on the demand for gasoline is ambiguous.

The graph “U.S. Gasoline Market: Shifts in Supply” depicts possible supply responses. On the supply side, the administration quietly followed a policy to slow down the domestic production of oil which again, other things equal, decreases supply (a shift from S12 to SD where SD is a decrease in supply) and increases the price of gasoline. In a 2008 interview with the Wall Street Journal, Steven Chu who is now the energy secretary, said, “Somehow we have to figure out how to boost the price of gasoline to the levels in Europe.” The price of a gallon in Europe is above $8.00 per gallon. This policy might makes sense if you believe that carbon emission will cause extensive and costly damage to the economy and if unilateral action of the part of the United States will significantly slow global carbon emissions.

The president claims an “all of the above approach” to energy production but policy seems aimed at slowing production without saying no. In Alaska, the administration has slow walked approval of infrastructure projects necessary to extract oil. In the Caribbean, the time it takes to get a permit to drill has nearly doubled. Leases to drill on federal land in the West are down 40%. The administration killed the Keystone XL pipeline that would bring tar sands oil to the United States. Each project has a legitimate environmental concern, but when all are summed, they total a policy aimed at maintaining high gasoline prices by slowing exploration and extraction that would lead to increasing the supply of gasoline.

These policies reduce the purchasing power of U.S. consumers. They can only be welfare improving if the environmental benefits exceed the loss in purchasing power. They are unlikely to bring technological breakthroughs. European countries maintain policies that have kept gasoline prices high for a very high for a very long time and they have not resulted in technological breakthroughs. It seems unlikely that policies designed to do the same here will have any more success.

Candidate Gingrich has claimed that if elected, his policies would lead to $2.50 per gallon gasoline. If elected, he would control U.S. policy, not markets and market forces are likely to overwhelm policy. Like candidate Obama, he promises too much.

If you believe that carbon emissions are costly to future generations and that unilateral U.S. action can reduce emission, policies to restrict gasoline supply make sense. If you do not, they do not. If you believe that the government is better at venture capital, investing in startup companies, than markets, then the president’s policies make sense. If you do not, they do not.
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Friday, March 9, 2012

Can Romney Recapture the Center on Immigration?

Pete Dominick, a radio talk show host for POTUS, recently asked how Mitt Romney, a politician often viewed as a centrist who veered right in running for president in the Republican primaries could move toward the center if he the nomination. I will describe how Romney can move to the center and increase his appeal to Hispanic voters by further describing rather than changing his immigration policy.

Romney described his plan before the Hispanic Leadership Network (“Mitt Romney & Newt Gingrich Attend Hispanic Conservatives Conference”) He would establish a low cost method for employers to verify that an employee was qualified to work in the United States. Deprived of employment, many illegal immigrants would return to their countries of origin. Workers that are here illegally would be given a temporary work permit to an orderly exit. He would also expand the visa program for hospitality and agriculture.

Before proceeding, I have a small confession. Mitt Romney and I share the same religion and we both served missions for the Church of Jesus Christ of Latter-day Saints, Romney in France and I in Argentina. Because of that shared experience, I looked for candidates that were not LDS (Mormons) that I could support but they did not run or dropped out of the race. I now grudgingly and reluctantly support his run for the Republican nomination despite my mission experience. The dynamic nature of our economy and foreign policy distracted potential proselytes from our gospel message. People often approached us, and yes we travel in twos, asking questions like why President Ford or Carter took some action or why the United States spent so much on the NASA rather than giving more international aid. These distractions would explode under a Romney presidency.

I also find Romney’s position on illegal immigration, which I will describe latter, harsh. My opinion is three parts normative and one part positive. First, having lived in Argentina, a relatively prosperous country that was mired in a low grade civil war known as the Dirty War, I understand completely why many wish the peace and security of the United States. Like virtually every other religion, mine teaches that parents have a God given duty to care for their families. For many, illegal immigration not only helps fulfill that mandate, it is the only chance they have to do so successfully. Second, Romney’s policy also fails to explicitly address the problem of families with split nationalities. Mexican parents may have four kids under ten, two who are Mexican citizens and two who are United States citizens. Under Romney’s plan, parents without legal status would return to Mexico and apply for legal status. In the meantime, two of their children would remain in Mexico, receive a bad education for the U.S. workforce and have the legal right to enter the United States and earn welfare benefits when the turn eighteen. The plan to end illegal immigration could slow the growth of the LDS church in Hispanic communities, a very high price to pay for having and LDS president (“Romney's tough line on immigration jars with some Mormons”). Finally, the economic literature does not support the contention that illegal immigration is costly to our country. The opposite is probably correct (“Economists’ on Immigration”).

Romney’s plan could easily become generous to current illegal immigrants while slowing future entrants. The Unites States has a quota of 700,000 for those seeking to immigrate. That number could be raised to two million per year. Grant work visas for five years for the parents of U.S. citizens born prior to January 1, 2012 and give them priority when filing for citizenship from their countries of origin. He already plans to expand work visas; granting a generous number of visas makes economic sense. Vigorously enforce the law. These changes are within the bounds of the policy that Romney has described and would be generous to current illegal workers, clarify their legal status without attracting people to enter illegally to work in the future.

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Monday, March 5, 2012

Comparative Advantage and Manufacturing Subsidies

President Obama, Republican presidential candidate Rick Santorum and many other politicians have proposed granting tax cuts for domestic manufacturers to recapture markets lost in competition with foreign producers. Beginning with Adam Smith, economists have favored free trade domestically and internationally including freedom from tax distortions. This post uses the first trade model presented in introductory classes that was first developed by Adam Smith and improved by David Ricardo to demonstrate that, given a set of assumptions, trade results in higher national well-being than a policy of no international trade or autarky. The model will be exploited to show that tax distortions that promote domestic production lower a country’s well-being.
The model assumes two countries, the United States and China. Both produce two goods, cars—a manufactured good, and fruit—an agricultural good. The models are depicted in two graphs and a table. The first graph depicts the movement from autarky to free trade, and the second, from free trade to trade distorted by taxes and subsidies. The red lines are the production possibilities frontiers (PPF) and show the output combinations of the two goods that maximize the output that can be achieved with the country’s resources. Resources move costlessly from the production of one good to the other. The slope of the PPF gives the physical tradeoff between the two goods; the tradeoff is the opportunity cost of cars in terms of fruit. The slope in the United States is 3 implying that the country gives up three tons of fruit to produce 1 car. The slope in China is 1, implying that China gives up 1 ton of fruit to produce 1 car.


Cars Fruit Cars Fruit

Production=Consumption 8 24 8 8
With Trade

Production 4 36 16 0
Trade 5 -10 -5 10
Consumption 9 26 11 10
Gains from Trade 1 2 3 2
With Tax Distortions

Production 12 12 0 16
Trade -9 6 9 -6
Consumption 3 18 9 10
Grains from Trade

Compared to Autarky -5 -6 1 2
Compared to Free Trade -6 -8 -2 0
Without international trade, a country consumes what it produces. The model does not set production levels or trade prices for each good making a little story telling necessary. The story does not detract from the outcome. Through the interaction of economic agents in markets, the United States produces and consumes 8 cars and 24 tons of fruit (P1=C1(8, 24)). China produces and consumes 8 cars and 8 tons of fruit (P1=C1(8, 8)). 

Trade increases the well-being of a country because it promotes specialization. The United States and China decide to trade. Because the United States gives up 3 tons of fruit to make a car, it specializes in the production of fruit. Because the China gives up only one ton of fruit to make a car, it specializes in the manufacture of cars. China has the comparative advantage in the manufacture of cars and the United States, in the production of fruit. 

Through the interaction of economic agents in international markets, the price settles at two tons of fruit per car. The United States increases its production to 36 tons of fruit while cutting car manufacture to 4. China specializes completely in the manufacture of cars producing 16 cars and no fruit (P2(16, 0)). Economic agents in the United States trade 10 tons of fruit for 5 cars and Chinese economic agents make the opposite trade, getting 10 tons of fruit for 5 cars. The blue arrows are the trade paths; both have a slope of -2 but the arrows point in different directions. They connect the second production points to the second consumptions points. After trade, both countries consume more than they did prior to trade as summarized in the graph and table. The United States consumes 9 cars and 24 tons of fruit (C2(9, 264)) and China, 11 cars and 10 tons of fruit (C2(11,10)). The United States gains 1 car and 2 tons of fruit. China gains 3 cars and 2 tons of fruit. 

The United States government decides that more economic agents should specialize in the production of the manufactured good, cars.  To accomplish its goal, it taxes production of fruit and subsidizes the manufacture of cars.  The international price changes to 2 tons of fruit for 3 cars.  In response to the incentives, production in the United States shifts to 12 cars and 12 tons of fruit (P3(12, 12)).  In response to the change in the international price, China specializes completely in the production of fruit (P3(0, 16).  When the Unites States subsidizes the manufacture of cars it changes the allocation of resources and the international price in both countries. 

The new trade path is represented by the green arrows in the graphs of each country.  It demonstrates how the tax distortion harms the United States but allows China to consume above its PPF.  Rather than set the international price between the countries by the slopes of the two country’s production possibilities frontiers, their trade is determined by the tax distorted price in international markets and the opportunity cost in China.  The distortions move specialization in the wrong direction in the United States.  Because the slope of the trade path is greater than slope of the PPF (-2/3 > -3) in the United States and because the United States is specializing in cars, trade moves to the interior of the PPF.  It consumes 3 cars and 18 tons of fruit (C3(3, 18)). 

The United States would be better off not trading than subsidizing the manufacture of cars.  It loses 5 cars and 6 tons of fruit compared to autarky and losses 6 cars and 8 tons of fruit compared to free trade.  Because China has not distorted its markets and shifts market production according to the relationship of the slope of its PPF, its opportunity cost and the international price, it again consumes above its PPF but its net gain is 1 car and 2 tons of fruit compared to autarky and -2 cars and 0 tons of fruit when compared to free trade.  Although China is better off even with distortions in the international markets caused by tax policy, it is worse off than under a free trade.  Compared to autarky, it gained 1 car and 2 tons of fruit but compared to free trade it lost 2 cars.
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