How “Free” is Free-Trade Coffee?

Filed Under (Other Topics) by Dan Karney on Nov 11, 2011

I drank a cup of coffee this morning.  Chances are you probably did too.  It seems a coffee shop is located on every corner.  In fact, coffee is the second most traded commodity by market value, behind only petroleum.  Last week, when I was in the grocery store buying whole bean coffee, I became intrigued by what exactly the “Free-Trade” label means and what economics can tell us about the market impact of free-trade coffee.

To begin, many different “Free-Trade” certifications programs exist, including certification efforts by big companies such as Starbucks and Nestle.  However, the Fair-Trade Labeling Organizations International (FLO) is the largest and most widely recognized certification system, and thus will be the focus of my discussion (source: The Market for Organic and Free-Trade Coffee).  The FLO’s “mission is to connect disadvantaged producers and consumers, promote fairer trading conditions and empower producers to combat poverty, strengthen their position and take more control over their lives [link].”  Those are laudable goals, but how does the FLO attempt to achieve those goals?

The FLO’s certification has three central criteria that must be met for a coffee to be labeled as free-trade (source):

1) The producer is guaranteed a minimum price depending on coffee grade (e.g. $1.26 per pound for washed Arabica).  If the market price exceeds the price floor, then a price premium of $0.05-$0.10 per pounds is added to the market price.

2) The buyer provides credit to producers for up to 60% of the expected harvest value at the beginning of the growing season.

3) Buyers enter long-term (1-10 year) contracts with producers.

It is clear that these criteria help small, credit constrained coffee producers.  Essentially, the long-term contracts and price floor give income stability by guaranteeing sales.  In contrast, large coffee producers with access to credit can more easily withstand the coffee price fluctuations that occur frequently.  By providing income stability to small coffee farmers, fair-trade advocates hope to eliminate speculative export middle-men and provide an equal playing field between small and large producers.

However, I pause to consider market impact of the price floor and market premium for fair-trade coffee.  As an economist, the FLO’s fair-trade pricing criteria act as a subsidy, and recalling basic Econ 101, subsidies lead to over-production.  That is, in terms of economic efficiency, should there be as many coffee farmers as exist today?  The basic analysis says no.  However, the real world is more complicated than Econ 101, and economics has little to say about equity and ethics.  Today, this blog cannot answer the question “Is fair-trade coffee ‘good’ or ‘bad’?”; rather, I can tell you what fair-trade coffee is.  Enjoy your cup of joe!

A brief update on Netflix

Filed Under (Other Topics) by Tatyana Deryugina on Oct 26, 2011

As you may have heard, Netflix nixed its plan to split its services into two – a mail DVD delivery service and an online streaming service, each with its own website. It now appears that, even though the plan was never realized, this was a very costly experiment. Netflix stock is down, 800,000 subscribers left, and the split wasn’t even implemented. Of course, this may have been the result of the earlier price hike. But judging by the outrage at the split plan, I don’t think that’s the whole story.

Economists often wonder why companies don’t experiment more. It’s well-known that prices are “sticky” and many economists think that firms should to change them more often to figure out the profit-maximizing price. I think the Netflix example suggests one explanation for why companies are reluctant to experiment – consumers appear to really not like it.

A Look at Herman Cain’s 999 Tax Plan

Filed Under (Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Oct 21, 2011

The point of this blog is to inject some substance into discussion of Presidential candidates. To see the problem, consider what I wrote on my facebook page: “In an airport for an hour yesterday, we could not avoid hearing CNN talk about the upcoming presidential debate. For the entire hour, we heard only comments like: Perry needs to come out swinging; or, ‘Is Cain a viable candidate?’; or, Bachmann has really fallen in the polls; or, ‘This now boils down to a two-man race’, followed immediately by the wisdom that ‘Yes, but we don’t know yet who the two men are.’  What inanity! It is JUST a horse race! Not a single comment during the entire hour had anything whatever to do with any substantial issue of policy. Is this all we get?”

There must be more to consider, in this important decision.  So, I started by looking at Herman Cain’s 999 tax reform plan.  See more at his website, with the key bullets in the insert below. 

Bear in mind that I’m a former Deputy Assistant Secretary of the U.S. Treasury (1985-87), so I worked hard on President Reagan’s successful “Tax Reform Act of 1986” to lower the rates and broaden the base.  Since 1986, however, Congress has managed to reintroduce plenty of new deductions and tax breaks, while raising the rate.  Maybe it’s time to do something again!

Cain’s proposal has a lot of similarities to the 1986 reform, if perhaps more extreme.  It is meant to be revenue neutral, raising the same total tax.  It would eliminate virtually ALL deductions, like mortgage interest paid, and it would cut rates drastically.  It would eliminate the income tax as we know it, and introduce a national sales tax (or value added tax).   What about the accuracy of Cain’s claims below?  By reducing rates drastically, this proposal probably WOULD reduce the distorting effects of taxation by reducing the interference of taxes in the productive activities of workers and business – what economists call “deadweight loss”.  For similar reasons, it probably would provide greater incentive for work and investment, and therefore probably provide some stimulus to growth.  That’s all for the good.

However, ANY tax reform plan of ANY politician EVER, no matter what motivation, will always have two effects to watch out for.  First, any tax reform will always raise taxes on some taxpayers and reduce taxes for others.  It will have distributional effects worth analyzing.  Second, it will therefore create disruptions and reallocations.  Activities to pay additional tax may shrink – laying off workers who may remain unemployed for some time until they can re-train and find work in other activities that now face lower tax rates and hope to expand.  That is, for only one example, the Cain plan might hurt homeowners and homeownership by eliminating the mortgage interest deduction.  With such pervasive changes, however, the disruptions will be widespread and costly in themselves.

Finally, for now, note the point about distributional effects.  Nothing in any of Cain’s bullets says anything whatever about distributional effects.   I’m afraid this point is the Achilles heel of Cain’s 999 plan.  According to the non-partisan Tax Policy Center, Cain’s plan will greatly reduce taxes of those with the highest incomes and raise total taxes on those with low incomes.  It is ‘regressive’.  And you don’t even need to read the TPC analysis to know this is true.  Cain’s plan cuts the top personal rate from 35% to 9%.  There is no amount of tax-base broadening for those high income taxpayers that can get back the same tax revenue from them.  And currently those with the least income pay no Federal tax at all.   Under Cain’s plan, everybody will pay the 9% sales tax, on everything they buy.  Moreover, if those low-income individuals are working, they will probably bear some additional burden of the 9% business tax that applies to all profits AND wages paid: it applies to all sales revenue minus purchases and capital investment, not subtracting wages paid to workers.

I’d personally favor another revenue-neutral reform like the TRA of 1986, one that lowers the rates and broadens the base.  Such a reform would undoubtedly cause some disruptions and adjustments costs.  And it would help some while hurting others.  But perhaps it could be designed in a way that also tries to be distributionally neutral, not adding tax burdens on those least fortunate while cutting taxes on those already doing well.

Performance Incentives for Higher Education: You Get What You Pay For

Filed Under (Other Topics) by Nolan Miller on Oct 12, 2011

The Daily Illini ran a story today about a change to the way public universities will be funded in the future.  This year’s higher education bill, HB 1503, contains provisions instructing the Illinois Board of Higher Education to come up with performance measures that will be used, in part, as a basis for funding public colleges and universities in the state.  Let me begin by saying that, in general, holding government bodies accountable for their performance is a good idea.  The people of the state have a right to know that their money is being well spent.  I encourage the adoption of performance measures in all areas of public expenditure.

Having said that, I encourage (e.g., warn) the Illinois Board of Higher Education to keep in mind that when you pay someone to do something, they’re going to do exactly that.  So, you need to be careful what wish for.  If you increase a school’s funding when they increase their graduation rate, you should expect them to increase their graduation rate, and in many cases they’ll adopt the lowest-cost approach to doing so.  Sure, they may increase advising and keep closer tabs on students as they work their way through their educational careers.  That would be great.  But, they might also be more lenient in counting credits toward graduation, lowering their standards, or they might be more reluctant to admit students who seem unlikely to graduate on time, decreasing access.  While increasing advising effort costs money, relaxing standards and not admitting students who are unlikely to graduate (assuming there is another student waiting to take his place) are relatively costless.  We should not be surprised if, in the face of increased incentive, public universities make use of the latter two tools to increase graduation rates, because we paid them to do it.

To be sure, legislators and the IBHE are aware of these possibilities.  In fact, the bill suggests that there should be both overall performance measures (e.g., graduation rates) as well as measures that look at how well the school serves at-risk students.  However, incentives are complicated, so-much-so that social scientists have a name for what happens when they go awry.  We call it the “Law of Unintended Consequences.”  Further, there is increasing evidence that when you create explicit, monetary incentives to do a thing, you crowd out intrinsic incentives.  So, while you may have student advisors who today go the extra mile to get a student through to graduation out of a sense of altruism or duty, once you put a price on performance, this sense of duty seems to take a back seat.  People start to say “if I go the extra mile to help this student, it isn’t going to affect our overall graduation rate, which is what the state really cares about, so why bother.”  In an environment where people generally do their jobs, and do them well, because it is the right thing to do, putting a price tag on things can significantly reduce their intrinsic motivation.

The next point of concern comes from the funding structure.  It is unclear whether the incentive payments will be “new” money in addition to that already allocated to public colleges and universities, or whether it will be a reallocation of current money.  Much ado is made regarding government funding from the idea that people can do more with less.  We often hear cries to reduce “waste, fraud and abuse.”  But we need to keep in mind that public colleges and universities in Illinois have just been through a years-long belt-tightening process.  The easy cuts have already been cut.  Trying to squeeze the incentive payments within current budgetary allocations encourages “robbing Peter to pay Paul,” pulling resources away from other functions in order to meet performance goals, and the tighter the budget gets the more schools will be tempted to increase their performance scores through the cheapest way possible (i.e., lowering standards) rather than through the “right” way (i.e., increasing learning).

Finally, in setting up the pool of money available for performance bonuses, the IBHE needs to be careful not to exacerbate competition between public schools.  If the bonus pool is fixed and awarded to schools based on how well they meet performance goals, this may increase incentives to compete with other public schools.  Perhaps they will increase marketing expenditures in order to attract better students.  However, if all public schools do this, in the end you might have a lot of money going to marketing firms that would otherwise go to student services, and students more-or-less ending up in the same places they would have gone before.  Or, schools may spend money on improving student services such as the quality of the gym and/or the dorms, which make students happy but do not contribute to educational attainment.  The stronger the incentives offered by the new system, the more temptation there will be to engage in expenditures of this sort.  If competitive incentives are strong enough, forcing public schools in Illinois to compete more intensively over students may actually leave less money available for education and reduce overall attainment.  More unintended consequences.

Let me finish by saying that I’m not necessarily against performance incentives. But, incentives are complicated things, and the unintended consequences of incentive payments are often as important, if not more so, than the intended ones.  Designing incentive schemes that induce the behavior you want without encouraging the behavior you don’t want is a very difficult task.  I hope the IBHE is up to it.

The Netflix split

Filed Under (Other Topics) by Tatyana Deryugina on Sep 20, 2011

Netflix has been in the news quite a bit in the last couple of months, in a way that should provide a good case study for the question “Is any publicity good publicity?” In July, Netflix announced a significant change in its prices, which left some subscribers facing a 60% price increase. Then, late this Sunday, Netflix announced that it is splitting into two companies. One will be focusing on streaming content and will keep the name Netflix. The other will be for mailing DVDs and will get the new name “Qwikster”. In the announcement, the CEO of Netflix, Reed Hastings, said that the company felt that splitting up the streaming content from the physical DVDs was going to help them become better at both. The reaction of consumers is illustrated quite amusingly in this comic.

How can this possibly be a good move for Netflix? In general, it may be true that by specializing, companies can perform better in each area. But is there no economies of scope from combining online streaming with mailing DVDs? For example, Netflix spent a non-trivial amount of money (and probably effort) on creating its system of recommendations. Once Netflix splits into two websites, one of two things will happen to the recommendation system. Assuming Netflix still has subscribers that get both streaming and DVDs, one possibility is that the quality of recommendations will be lower (unless the websites will share information with each other, which doesn’t seem to be the case). Alternatively, the cost of getting quality recommendations to customers will be higher because those that subscribe to both services will have to rate movies on both websites.

The set of customers who subscribe to the online content and get the DVDs is large as a fraction of total subscribers. According to one website I found, Netflix expects to have 9.8 million streaming only subscribers by the end of the third quarter, 2.2 million DVD only subscribers, and 12 million users who subscribe to both services. Thus, a lot of people seem to treat streaming and DVD as complements, not substitutes, even AFTER the price increase that made it more expensive to have both services.

However, this move may make more consumers rethink their Netflix subscriptions; I would bet there are many subscribers out there who pay for the service but almost never use it. By making the cost of having the subscription more salient, the firm might cause people who otherwise would have gone on paying for a service they don’t use to cancel or downgrade.

Even assuming that the number who cancel or downgrade is small, it’s not clear that the split is worth it unless it helps Netflix improve its streaming content. It seems to be at the forefront of the pack in its streaming technology. I can vouch for that as someone who’s compared Netflix to other streaming websites on devices ranging from laptops, iPads, and Blu-Ray players to Wiis, Rokus and Apple TV’s (yes, I have access to lots of technology). The image quality and continuity of streaming is better than any other website. Its physical delivery system also seems to work well. I would be surprised if splitting the two services can help Netflix improve along these dimensions.

To summarize my two cents, the only way this move makes sense to me is if Netflix is planning on selling off its mail-in DVD business completely, in which case this is a reasonable transition step.

The Economic Costs of September 11, 2001

Filed Under (Other Topics, U.S. Fiscal Policy) by Jeffrey Brown on Sep 11, 2011

Today, September 11, 2011, we remember the terrible human tragedy that occurred 10 years ago.  What started out as just another beautiful Tuesday morning was devastatingly interrupted by the sights and sounds of four commercial aircraft being intentionally flown by terrorists into the World Trade Center, the Pentagon, and a field in Shanksville, Pennsylvania.  In the hours and days following, we learned of countless acts of courage and selflessness, such as the stories of first responders who were on their way up when the Twin Towers came down.  Or the brave passengers on United 93 who fought back and most likely prevented their plane from crashing into the White House or the Capitol.

A lot was lost that day.  Thousands of innocent lives.  Our nation’s sense of security.  Clearly, relative to those human costs, the economic costs seem almost inconsequential.  Indeed, as someone who feels personally indebted to the heroes of United 93 for quite possibly saving my life (if their flight had hit the White House, I would have been among the victims that day), I will be among those who spend this day remembering their heroism.

Nonetheless, a decade out, it is indeed appropriate that we consider the broader implications of these terrorist attacks.  There are few aspects of our lives, culture and economy that have been left unchanged.  As an economist, I feel most qualified to speak to the economic issues, so this post is about the economic impact of 9/11.

This is a far more difficult exercise than it may seem.  Any numbers I cite here should be taken with a grain of salt, but I felt it useful to at least give a sense of the order of magnitude of the economic implications.

Let’s begin with the easiest part – the direct financial costs of that day.  This includes the loss of buildings and properties, such as the World Trade Center and surrounding buildings and the cost of the four aircraft.  According to an estimate in the Insurance Journal, the direct insured costs from 9/11 were approximately $40 billion in today’s dollars.  But this number includes things like business interruption insurance, which is a real cost to the insurers, but may double count some of my other numbers below.   So if we limit the numbers to property (WTC, other property, worker’s compensation claims, and the like), we are looking at something on the order of $20-25 billion.  A big number, but small in comparison to the indirect costs.

Second, the loss of life.  Economists are often accused of being insensitive, or worse, by trying to place a dollar value on human life.  Without getting into the debate here, suffice it to say that we feel that we can at least measure the value of a  “statistical” life.  Individuals, families, businesses and governments implicitly do this all the time (such as when a worker accepts higher pay in return for taking more risk to his or her life.)  There is a large literature on the “Value of a Statistical Life,” and it is clear that the measure varies by context and by how one models the analysis (if you are interested, you can read more about the difficulties in this nice article by economist Orley Ashenfelter.)  Just for the sake of conversation, let’s use a $5 million per life.  Then we are talking about a $15 billion “economic cost” associated with the lives lost.  Note this is much higher than the $1.2 billion of losses as measured by the value of life insurance payouts.


Third, and much more difficult to measure, there are the ongoing costs of slower economic growth as a result of these events.  In the short-run, the 9/11 attacks exacerbated the weakness of an already weak economy (recall that we were already in a recession).   But figuring out how much of the economic slowdown in the period was due to the attacks is notoriously difficult.  A paper put out about a year after the attacks by the Congressional Research Service discusses the many reasons it is so hard to measure, include the fact that we were already in recession, and that there were policy responses to the attacks (both in terms of monetary and fiscal policy) that helped mitigate the short-term impacts (but in some cases at longer term costs).  Even so, it is worth noting that, given the size of U.S. GDP at the time, even a 0.5% reduction in economic growth over the subsequent year would have resulted in output losses on the order of $50 billion, a number larger than the prior to estimates of the direct effects combined.  If the effects persisted more than one year, or if the effect was larger, then the estimates would go up even more.

Fourth, there are the ongoing costs of our investment in additional security measures.  Think about the extra time spent each traveler spends in airport security lines taking off their belts, shoes, removing liquids and gels, getting full body scans, etc.  Now multiply that by the millions of travelers.  And then think about the value of that time.  I have not seen reliable estimates of this, so I won’t attempt to quantify it, but it is a big number.

Finally, perhaps the largest cost of all – our wars in Afghanistan and Iraq.  Without getting into the debate over whether the war in Iraq was really justified based on a terrorist attack by a non-Iraqi terrorist group, I think it is plausible that if the 9/11 attacks had never occurred, the Iraq war would not have occurred either.  In 2007, the Congressional Budget Office made news with an estimate that the cost of these wars could total $2.4 trillion (projected through about 2016 or so).  And, yes, that is trillion, with a t.  That is just the direct costs of these wars – if one includes indirect costs, such as the value of the military lives lost, the numbers would be much higher.

Some of these costs – indeed the most tragic ones, such as the loss of human life, the permanent destruction of the Twin Towers, and so forth – are costs with no corresponding benefit.  Other costs – such as those associated with ridding the world of a horrible dictator (Hussein) and the head (bin Laden) of the world’s leading terrorist organization – also bring enormous direct and indirect benefits.

But no matter how you look at it, the true economic cost of 9/11 was orders of magnitude greater than the direct costs incurred on that day.


Who Should Pay for Disaster Aid?

Filed Under (Environmental Policy, Other Topics) by Tatyana Deryugina on Sep 7, 2011

Last week, Republican House Majority Leader Eric Cantor insisted that disaster relief money for victims of Hurricane Irene has to be offset by spending cuts in other areas. responded promptly with an ad accusing Cantor of ”abandoning families who have lost everything”. President Obama quickly promised that the government would provide “all the resources that are necessary” thus meeting its “federal obligations”.

Should disaster aid be a government “obligation”? If your home burns down in an electric fire or you get into a car accident, there is no federal program you can apply to for aid. If a tornado destroys your house and leaves everyone else’s untouched, chances are that the government doesn’t declare your area a disaster area, which in turn means that you cannot get any cash from the government (except a tax write-off). Is it reasonable that you should get more money when you lose your house if someone else also lost theirs?

According to the Consolidated Federal Funds Report (CFFR), which tracks federal spending, the US has spent $90.7 billion on disaster aid between 1983 and 2008 for an average of $3.5 billion per year. While this number pales in magnitude to some other spending, such as Medicare, disaster aid is notable in that states pay nothing whatsoever for it. At the very least, disaster aid is redistributive: according to the CFFR, the total amount of disaster aid received between 1983 and 2008 ranged from a low of $74 per person in Washington DC to a high of $41,977 per person in Florida (in 2008 dollars). Not only is this a large difference in funding; it is also not clear whether this redistribution is progressive or regressive (last I checked, people living on Florida coasts weren’t exactly struggling). At worst, the implicit promise of federal aid may encourage more people to live in disaster-prone areas and discourage individuals and cities from implementing protective measures that can reduce damage if nature does strike.

Of course, there is no credible way for the government to commit to not bailing victims of disasters out (as demonstrated by the links above). In addition, we might think it’s unethical to leave victims to fend for themselves, especially if whole towns are left devastated and local employment is affected, making it hard for people to earn money to rebuild their homes. However, why not make people pay disaster aid premiums before they’re affected?

One way I can think of to implement real disaster “insurance” is to mandate that every county or city pay a premium to the federal government based on its risk level and number of people. The city is then free to decide how to raise that money. Presumably, cities are better at setting up proper incentives for their residents than the federal government.

Particularly poor areas could receive premium subsidies based on their population and risk characteristics in the year before the scheme is implemented. This is similar to “grandfathering”, which is implemented in many government regulations. However, in this case “grandfathering” ensures that cities still pay the marginal cost of having extra residents in disaster-prone neighborhoods.

Why not mandate insurance on an individual level? Contrary to what you might think, a large fraction of the aid does not flow into individuals’ pockets. According to FEMA, $5.8 billion was given to individual victims of Katrina. An additional $8.9 billion was given in Public Assistance, of which $5.2 billion was for repairing and rebuilding affected areas. Of course, $5.8 billion is not a small chunk of change, but it makes up only 39% of the total.

One could then do what insurance companies do with individuals – lower premiums for cities that implement measures that reduce their risk. This kind of scheme would largely eliminate concerns about moral hazard, at least on the city level. Of course, it would first have to pass Congress, and I’m guessing the residents of Florida and California will not be thrilled about having to pay for the risks they’re facing.

Closing the Barn Door after the Horses Escape

Filed Under (Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Sep 2, 2011

The New York Times today says that the Federal Housing Finance Agency is set to sue major U.S. banks such as Bank of America, JPMorgan Chase, Goldman Sachs, and Deutsche Bank, among others.  The U.S. government argues that the banks sold packaged mortgages as securities to investors while ignoring evidence that the homeowners’ incomes were inflated or falsified.  That is, the banks failed to perform the due diligence required under securities law.  When many of those homeowners were unable to pay their mortgages, the securities backed by the mortgages tanked.  Housing and financial crises ensued.

Kinda late, isn’t it?  Well, certainly it’s too late this time, to prevent the housing and financial crises of the past few years.  What is the point of the suit, then?  Does the U.S. Federal government really need the money that they can get from these banks, as damages, and will they give it back to all of us who lost money during those years?  The U.S. might sue for around a billion dollars, which is peanuts these days.  Divided by 333 million Americans, that would be about three dollars each.  Why bother?

An important conceptual point here is the difference between ex post liability (after the fact) and ex ante incentives (beforehand).   The point of this suit is not to collect a billion dollars after the fact, although arguments are made about the fairness of those liable to pay for damages.  Rather, the point is to provide the proper incentives to private companies before the next time.  To a private company, a billion dollars really is a lot of money.  If they have to worry about the loss of a billion dollars, for ignoring their legal responsibilities, then maybe next time they’ll be more careful to follow the law.

Government regulation can take alternative forms.  One alternative is to send auditors and inspectors into every bank, every day, to check what they are doing.  That would be very expensive.  A cheaper alternative is to let the banks decide for themselves if they are exercising due diligence, but with the “threat” hanging over their head that they might get sued if they don’t.

Around the Web in Public Policy

Filed Under (Finance, Other Topics, U.S. Fiscal Policy) by CBPP Staff on Jul 19, 2011

Charter School in the Suburbs?

Charter schools, a concept originating from the United Kingdom and first popularized in the United States in Minnesota, have typically been viewed as the answer to failing schools in poor communities.  However, as this article examines, more and more charters are attempting to expand into suburban areas where stereotypically, people are content with the offerings and success of the local public schools.  As the article points out, suburban districts have felt the pinch in many ways as a result of the housing bubble bursting and charter schools will continue to compete for the public schools already tight resources by opening in these areas.  How suburban public schools respond to this competition will be both telling and eye-opening for the future of charter schools as they continue efforts to expand into restricted areas.

Will They or Won’t They?

With the countdown of August 2nd nearing when the United States will exceed the Congressionally approved debt limit, the question of how agencies such as Fitch Ratings will respond and rate the nation is quickly becoming more and more important.   Officials at Fitch have said that the downgrade could be temporary and will depend on their “assessment of the credit-worthiness of the U.S. government”.  The article goes on to discuss the impact such a downgrade could have on the economies of nations that that tie their currency to the American dollar.  Corporate ratings in the United States would likely be untouched, however.

Cordray Nominated to Head Consumer Financial Protection Bureau

President Obama has announced that Richard Cordray, the former Attorney General for the state of Ohio will be his nomination to lead the agency that came into being with the signing of the Dodd-Frank Act and was initially led by Elizabeth Warren.  Many consumer groups had their hopes on the President appointing Warren to the post for a full appointment, a proposition it was never clear she would even choose to accept.  Regardless, the politicking has already begun with many Senate Republicans refusing to vote for any nominee “without changes in the bureau’s structure.”



Should Students Pay for the Creation of Knowledge?

Filed Under (Other Topics, U.S. Fiscal Policy) by Jeffrey Brown on Jun 20, 2011

To briefly summarize this long post: the creation of knowledge through fundamental research is a public good.  Economic theory is clear that public goods will be under-provided without government funding.  And as government funding for higher education continues to shrink, it is increasingly the students and their families who are paying for the provision of a good that benefits everyone.  Is that really what we want? 

First, some background.  When economists speak of “public goods,” we have something specific in mind: goods that, once produced, are “non-rival” and “non-excludable.”  In plain English, “non-rival” simply means that one person’s consumption of the good does not diminish other people’s ability to use the good.  For example, the fact that I get to enjoy a fireworks show or the protection of a missile defense system does not prohibit my neighbor from also enjoying benefits from these goods.  This is in contrast to most usual consumption goods – for example, if eat a candy bar, it is impossible for someone else to then eat the same candy bar.  “Non-excludable” means, roughly, that once the good is made available, it is available to everyone.  A classic example of a public good is clean air in a city: my breathing the clean air does not prevent you from also enjoying it, and it is also difficult to exclude people from breathing the clean air when they are in the city.

A many-decades old and quite famous result in economic theory is that public goods are under-provided in a private market.  In essence, I might be able to contribute a little bit to the creation of clean air insofar as the net benefits to me of my efforts are positive.  But in making that calculation, I will fail to take into account the benefits on everyone else.  They will do the same.  So we will effectively end up with too little clean air.  It is a special case of market failure where – (tea partiers should cover your ears) – government intervention can actually do a better job of approximating the efficient market solution than free markets.     

Universities are in the business of creating several goods that are, at least partially, public goods.  The most obvious of these is the creation of knowledge.  Indeed, the mission statement here at the University of Illinois lists “creating knowledge” as one of the three central tenants for our existence.  In contrast to applied research – such as pharmaceutical company investing in R&D for a new drug – most of the knowledge created in our universities is “fundamental research” – sometimes called “basic research” (although basic is meant to mean fundamental, not easy!)  What distinguishes this type of research is that the ultimate goal is not a marketable product, but rather the advancement of knowledge itself.  While this knowledge often leads to tangible benefits that can be commercially viable down the line (e.g., two famous Illinois examples include the MRI and web-browser technology), much of the cutting edge research does not have commercial applications.  But it is extremely valuable nonetheless.    

A great competitive advantage of the U.S. over the past century has been its system of public and private research universities.  Indeed, this is one of the “secret sauces” that launched the United States into a world economic powerhouse over the past century.  Universities have been responsible for much of the technological and intellectual innovation that has shaped the world in which we live.  The fact that our standard-of-living is many times higher today than it was a century ago is due – in part – to our outstanding research universities.

Historically, much of this research has been supported by public dollars.  At public and private research institutions, much direct research funding has come from federal agencies such as the National Science Foundation, the National Institute of Health, as well as research funding from other cabinet agencies (e.g., Department of Energy, Department of Defense).  At public institutions, support has also traditionally come from state appropriations to support both the teaching and research missions of public universities.  For example, state funding has long been an important source of funds to pay faculty salaries, and it is those faculty who are, in turn, creating knowledge.

That model, however, is coming under increasing strain.  Thanks to enormous fiscal imbalances at the federal and state levels, many traditional sources of public support for higher education are declining.  Perhaps the most notable of these is the decline in state appropriations that support public research institutions.  Here at Illinois, our Chief Financial Officer, Walter Knorr, remarked in March that the,  “the state’s direct appropriation to the university is 26 percent below what it was 40 years ago, when adjusted for inflation.”

One of the leading experts on the economics of higher education, Ron Ehrenberg of Cornell University, has written extensively on changing nature of higher ed funding over the decades.  In a 2003 paper titled, “Who Bears the Growing Cost of Science at Universities,” he notes that ”while undergraduate students may benefit from being in close proximity to great researchers, they also bear part of the growing costs of research in the form of larger class sizes, fewer full-time professorial rank faculty members and higher tuition levels.”

 Since his paper was written, tuition rates have continued to climb, largely in an attempt to offset declining public sector support. In essence, students and their families are footing a larger share of the bill for the creation of knowledge. 

To be clear, I am not saying that students are getting a bad deal for their tuition dollars.  Indeed, every study of the returns to a college education reinforce that – at least on average – a college degree continues to be one of the best investments an individual can ever make.  This remains true even as tuition rates climb.  And it is also the case that students enrolled at research institutions benefit from interacting with faculty who excel at knowledge creation.  Clearly, students and their families agree that an Illinois degree is still a phenomenal investment, as indicated by the fact that applications to the University continue to jump, even in the face of tuition hikes.

Nonetheless, these are troubling trends.  If knowledge creation is central to our national well-being and economic growth, then we need to ensure it is supplied at the optimal level.  It should not be limited by the willingness and ability of students and their families to pay to for a university education.