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Thursday, September 24, 2009

Bad quote of the week

Many people, professional economists included, often lapse into the fallacy of the "broken windows" source of growth. The idea is that if all windows were broken there would be a lot of economic activity focusing on replacing the windows. This would look like a positive impact on economic growth when, in reality, such activity would incur large opportunity costs and would likely not be a net gain to the economy.

The "cash for clunkers" program was the most egregious example of the "broken windows" fallacy in recent memory. Yes, car sales were up 10.6% last month but they are tanking now and will continue to be low for the foreseeable future as individuals who were going to buy a car sometime in the near future simply shifted their purchase to last month.

Another fallacy is that government regulation creates markets and therefore some, if not all, government regulation can create net economic activity. This is a mistake because there is no reason, a priori, to assume that the government, comprised of rent seekers and those who respond to pressure groups, would necessarily choose a good regulation which would create a market that would improve efficiency. In fact, there is every reason to suspect that markets "created" through government regulation/intervention reduce efficiency and also come with a whole host of unintended consequences.

For example, CAFE standards sound like a good thing. The government regulates the minimum gas mileage that a fleet of new vehicles must obtain. However, the government realizes that not all cars are created equal and therefore the CAFE standards actually allow for different mileage targets for different size vehicles. What is one unintended consequence of this policy? Car manufacturers face two competing demands on their ingenuity: the government's mandate and the public's demand for certain features, above and beyond the mileage of the vehicle.

Ever notice how a Honda Oddysey has been increasing in size over time? How the Ford Explorer of 1992 is considerably smaller than the Ford Explorer of 2008? Why do vehicles increase in size over time? One reason is that engine performance and overall efficiency of the vehicle improves somewhat over time, allowing the manufacturer to increase the size of the vehicle while maintaining performance standards. Another more practical reason is that the consumer might demand a bigger vehicle. However another, more subtle, argument also pertains. As the manufacturers try to satisfy the demands of their customers they find that their ability to make the vehicle ever more efficient declines. Indeed, at some point the engineers will throw up their hands in frustration because they simply cannot meet the twin demands of government regulation and consumer preferences. At that point, the engineers have two options. First, they could reduce the amenities and other consumer-driven aspects of the vehicle. Second, they can increase the size of the vehicle so that it qualifies as a "bigger car" and therefore has a lower CAFE standard to meet.

In the end, the vehicles get bigger, the manufacturer actually claims that their fleet is "more efficient," by government if not reality's standards, and the overall efficiency of the fleet stays the same or might actually decline over what it might have been without the government intervention.

Unintended consequences of government regulation/intervention are legion in economics. It is a shame that the rest of the world often fails to recognize this problem.

Case in point, page 8 of this weeks "Business Week" has the following quote:
One of California's big lessons, says Brownstein, is that regulation can create markets. The state captured nearly three-fifths of the $3.3 billion in venture capital that flowed into clean-tech startups last year...
I am sure that the number is correct, but that is not the point. What was the opportunity cost of throwing $3.3 billion towards clean-tech if the only reason such money was there was because of the actual or anticipated subsidy/protection of the state government?

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