Daily Archives: September 22, 2005

The paper river experiment

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Lynne Kiesling

I am teaching environmental economics this fall, and Tuesday was our first day of class. As I have structured the class, it focuses on common-pool resource allocation decisions. So I typically start the class with the example of a river, which I draw on the board. I ask students to name the different ways that we use the river (transportation, recreation, fishing, swimming, electricity, natural beauty, drinking water, dump waste from paper mill, irrigation, runoff from farms, etc.). As I start to populate the drawing with all of these uses, it quickly becomes apparent that some of these uses conflict — power generation and transportation, for example, or swimming and waste dumping.

So the problem is one of conflicting uses of a scarce resource. For most goods, market processes help us solve those problems, but with common pool resources we either have real limitations to the extent to which we can define property rights, or we have made political choices to manage the common pool resource as a public good.

Then today we did an in-class experiment called Paper River, in which the common pool resource is small sheets of paper. Half of the room made profits by producing math problems, solving them by writing in pencil on sheets of paper. The other half made profits by making paper airplanes, but here’s the catch: the paper has to be clean before the plane can be “sold”. So the downstream plane firms bore a cost due to the production processes of the upstream math firms.

After doing one round of this, we discussed some policy options that could help to incorporate this uncompensated external effect (I am eschewing the increasingly meaningless word “externality”). Here’s the list that they came up with:

  • The plane firms should pay the math firms to use less paper
  • The math firms should pay the plane firms for the cost of their having to erase
  • The “government” (that would be me in this case) could subsidize clean paper or tax dirty paper
  • The math firms could invest in calculators, eliminating their use of paper (i.e., change their production technology)
  • The plane firms could adapt, and learn how to make planes with dirty paper (also a change in production technology, or maybe in customer acceptance)
  • The “government” could impose a paper use quota on the math firms

Because of the way I set up the experiment, the paper of one math firm went to one plane firm, so what they did after generating this list was bilaterally meet and negotiate how they were going to deal with this situation. Although we haven’t explicitly talked about the Coase Theorem in class yet, this is clearly an exercise in defining property rights and negotiating.

Most of the groups, interestingly, had the plane firms paying the math firms to use less paper. One group reached this interesting agreement: the math firm gets one free piece of paper, but then has to compensate the paper firm 1/2 point per additional piece of paper used (the profits in this experiment are class participation points). Two sets of firms merged, illustrating the other Coase point that some transactions are less costly to consummate through firms than through markets!

Then they did a second round. The combined math firm + plane firm profits in Round 2 exceeded those from Round 1; their negotiations produced a Pareto improvement.

I really like starting the class this way, because we build a big, diverse menu of policy alternatives, and then we can start comparing, contrasting, analyzing, looking at pros and cons.

[cross-posted at Environmental Economics]

Is it gouging for politicians to charge $1000 for a meal?

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Michael Giberson

The Associated Press carried the following news item on efforts to prohibit gasoline price gouging:

Northwest Senators Aim To Prohibit Gasoline Price Gouging
POSTED: 1:30 pm PDT
September 21, 2005

WASHINGTON — Two Northwest senators, Republican Gordon Smith of Oregon and Democrat Maria Cantwell of Washington, have introduced legislation to prohibit gasoline price gouging during national emergencies.

Cantwell is concerned oil companies are taking advantage of Hurricane Katrina to raise prices far beyond additional costs….

Of course, last year in her role as co-chairwoman of Kerry’s campaign in Washington, Cantwell had no problem charging $1000 for a meal at Seattle’s Westin Hotel. (See: The Seattle Times.) Either meals at the Westin in Seattle are very, very costly, or Cantwell was raising prices far beyond costs.

Let’s see, here is the menu at the Westin’s Coldwater Bar and Grill. If I order the single most expensive entree I can find — grilled venison loin with pinot noir sauce, wenatchee apple and lacinato kale — toss in the dungeness crab cake with shichimi celery root puree for a starter and add a bottle of wine — it would cost me no more than $100 per person not including tip.

Gouging?

Governors pile on the “price gouging” bandwagon

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Lynne Kiesling

Many thanks to jeffrey.d for alerting me to the letter signed by eight governors asking for a federal gasoline pricing probe, and possible refunds of “excess profits” (remind me to add that to the list of economic non-concepts, right behind “price gouging” and “windfall profits”).

The WaPo article mentions a study by Don Nichols at the University of Wisconsin, but because I could not find any such study online I cannot comment on it. I can comment on what the WaPo article says, though:

Historically, Nichols said, the markup between the price of a gallon of crude and a gallon of gasoline is about 85 to 90 cents a gallon, including refining, distribution and taxes.

The study estimated that for pump prices to reach $3 a gallon, the price of crude oil would have to be about $95 a barrel, but crude prices have been holding around $65 a barrel, and Katrina has not caused a surge in crude oil prices.

“The disconnect between gasoline and crude oil prices is quite remarkable,” Nichols said.

On its face I find this statement naive. People who study this industry have known for the past seven or so years that increasingly the refining capacity in the US is a bottleneck. If you are analyzing price effects along a vertical supply chain, and you have a capacity bottleneck in the middle of that chain, how can you expect historic relationships between the price of the initial input and the price of the final product to persist? That is incredibly naive and reflects a lack of understanding of how vertical supply chains work.

Of course the price of crude oil and the price of gasoline are going to become more disconnected as your refining capacity becomes the binding constraint. Furthermore, when a natural disaster exacerbates that bottleneck, you should expect a further deviation from that historic relationship.

More work for the FTC, which routinely investigates claims of “price gouging” when one politician or another raises the populist hue and cry. The FTC has studies stretching back for almost two decades that show no evidence of anti-competitive outcomes in gasoline markets.

Is there sufficient political will to just deal with the fact that energy scarcity is going to be more binding? Is there political will to let prices do their jobs?