Projecting Rates of Return

My introduction to agricultural economics students must write a paper calculating the percentage of income they need to save during their working years to adequately save for retirement. Additionally, they must articulate how they manage these savings through investment. Do they invest it all in stocks, bonds, or create a portfolio of stocks and bonds?

To perform this calculation, they must state the rate-of-return they expect to achieve using bonds, stocks, or savngs accounts. This requires an understanding of the historical rate of return of various investments, and an idea of the volatility of stocks. Below are some suggestions.

(1) This website provides great information about the historical rate-of-return of stocks, bonds, and cash investments (savings, CD's, and money market accounts). The user can even create a portfolio of stocks, bonds, and cash, and the calculator will show the average rate-of-return for that portfolio. What I like best is that the user can check "Adjust For Inflation" and it shows the real rate-of-return. Students should adjust the time period over which they wish investments to be evaluated, and since all we desire is a rate-of-return for stocks, bonds, and money market accounts, the amount of money invested doesn't matter. I encourage students to also check "Adjust growth for MER's", as that accounts for the fees you must pay financial advisors to purchase the investments for you.

(2) Students who are not familiar with certain financial terms can utilize the Forbes Financial Glossary.

(3) For an understanding of the riskiness of stocks, students can study this article by The Economist magazine. I particularly like the statement, "As a result, saving seems like pouring money into a black hole (see article). Any American who has diligently put $100 a month into a domestic equity mutual fund for the past ten years will find his pot worth less than he put into it; a European who did the same has lost a quarter of his money."

(4) The Wall Street Journal published an interesting article regarding the performance of stocks during the last 200 years. Within this discussion is information on the performance of stocks relative to safer investments, like bonds. Highlighs are: "As of June 30, U.S. stocks have underperformed long-term Treasury bonds for the past five, 10, 15, 20 and 25 years," and "Ever since Thomas Jefferson was in the White House, stocks have generated a "remarkably constant" average return of nearly 7% a year after inflation."

(5) The last table of the paper at this link provides an informative description of how the real rate-of-return for stocks can vary across different time periods in recent U.S. history.

Opportunity Costs, Livestock, and Colonial America

Economists enjoy explaining behavior as being dictated largely by opportunity costs (the value of the next best alternative).

Consider the level of care afforded to livestock in Colonial America in the Chesapeake (modern-day Maryland, Virginia) and New England. Both would realize rewards from giving their animals diligent care. New England did so, keeping a careful watch on their animals and providing their animals' needs in abundance. Chesapeake settlers, however, allowed their animals to roam the woods in a state resembling a wild animal. Each spring, it became a tradition to treck into the woods to look for their animals.

The difference? Opportunity costs. Chesapeake settlers had the cash crop called tobacco, which was too valuable to divert their own labor and that of their servants towards livestock. New England settlers could not grow tobacco well, so without this high opportunity costs, they choose wisely to exert much effort in animal husbandry.

Reality of Politics

Many of my students enter college with a dangerously naive view of politicians. They think politicians should be revered, and often want to be a politician. Besides teaching them about the rent-seeking aspect of politics, which destroys their naive view of politicians performing the vital role of government efficiencyc, we need to clearly demonstrate their persistent hypocracy. Politicians should not be thought of as role-models.

See this entry for a good overview of the latest scandel involving John Ensign.

Death To America

Regardless of what you think of Bill Haher, you can learn something from Real Time. I recently learned that Death To America doesn't really mean they want to kill us. It is more of a "cute" statement. Muslims may say death to potatoes if they don't like potato salad.

Source: Real Time With Bill Maher, June 20, 2009

The Rational Man

Is anyone else sick of the generic behavioral economics journal article providing an experiment showing that humans are not perfectly rational in the specific context of the experiment?

Finally, some researchers are illustrating human's ability to reason.

Reason-Based Judgments: Using Reasons to Decouple Perceived Price-Quality Correlation

Ivo Vlaev^{a, ,} , Nick Chater^a, Rich Lewis^b and Greg Davies^a

^aDepartment of Psychology, University College London, London, WC1H 0AP, UK

^bDepartment of Psychology, University of Warwick, Coventry, CV4 7AL, UK

Received 23 October 2007;

revised 18 May 2009;

accepted 10 June 2009.

Available online 13 June 2009.

Abstract

Many models of consumer behaviour assume that people evaluate price and quality independently. However, evidence shows that consumers perceive price and quality as positively related even when they are weakly correlated in the real markets. This paper explores whether this perceived relationship can be cognitively de-coupled by providing explicit reasons why low price and high quality may be compatible. The participants were asked to rate existing stores and fictitious stores in a two-dimensional price-quality space. When the participants were given plausible reasons why the seemingly high quality fictitious stores could have lower than average prices, their judgement of the price-quality relationship was significantly less correlated than when these stores were judged without such reasons. Therefore, the demonstrated phenomenon of reason-based judgments can be used to attenuate the typical price-quality overestimation, or heuristic, which has important implications for decision making research and marketing practice.

Keywords: judgment; reasons; price-quality correlation; consumer behaviour; decision making

Journal of Economic Psychology

Passive Values and Policy

The concept of valuation and willingness-to-pay is receiving greater attention in the classroom. I recently ran across a paper discussing the importance of passive or existence values, where people value things even though they will not directly use them. We may receive pleasure knowing salmon can breed naturally as they have been doing for thousands of years, even if we will never visit those areas.

This paper, Importance of Including Use and Passive Use Values of River and Lake Restoration, by John Loomis, also illustated political meddling in economic valuation.

Great for teaching!

The COE originally planned to include a nonuse

value question in its economic analysis, but

intervention by then Washington Senator Slade

Gorton (who supported dam retention) resulted

in the question being removed from the survey.

Calculation of the non-use value for salmon and

free flowing rivers was done using benefit transfer

from existing non-use valuation studies. Using a

variety of benefit transfer protocols, the passive use

value of salmon was estimated for the dam removal

alternative at between $22.8 and $310.5 million

(U.S. Army Corps of Engineers 2002: 42). The

passive use value of restoring the free flowing river

was estimated at $420 million (U.S. Army Corps of

Engineers 2002: 42).

As shown by including the passive use values

of the free-flowing river and salmon restoration,

this would make dam removal economically

efficient, which yields the highest net benefits.

The omission of the passive use values may have

contributed to the Corps of Engineers decision to

keep the dams in place.

Incentives and Unintended Consequences

When introducing the economic way of thinking, economists stress the importance of incentives and why incentives are important through the law of unintended consequences. During these lectures, the more interesting examples you use, the more effective the lecture.

The CATO Institute on June 12, 2009 released a podcast about smoking that provides some good examples. The examples are especially relevant for OK State University, who recently banned smoking on campus.

Importance of Incentives - Cigarette taxes are intended to curb smoking and thus positively influence the smokers' health. Yet, if each cigarette costs more, smokers have the incentives to smoke each cigarette more intensely. Scientific studies have shown that this greater intensity in smoking outweighs the reduction in the number of cigarettes smoked, such that the cigarette tax negatively impacts the smokers' health.

Law of Unintended Consequences - Regulation of tobacco is often justified on the grounds that the health care of smokers is paid for in part by society at large. Thus, improving the health of smokers reduces the cost society pays in taxes and such. However, studies have shown that if all smokers ceased smoking, they would indeed live longer. More importantly, they live longer in their elderly years, drawing more money in social security, medicare, and medicaid. As a result, smokers who quit actually increase government costs by living longer, an unintended consequence.

Minimum Wages - Good For Some, Bad For Many

In an earlier post, I stated that one of the most important concepts to articulate in an introductory economics course is the fact that policies which are good for some are not necessarily good for society as a whole. As this Wall Street Journal editorial describes, minimum wages are an excellent example. Though the higher minimum wages currently being considered will benefit those who already have and do not lose their jobs, the author states...

The best estimates from studies since the early 1990s suggest that the 11% minimum wage increase scheduled for this summer will lead to the loss of an additional 300,000 jobs among teens and young adults. This is on top of the continuing job losses the recession is likely to throw our way.

Incentives and Economics

In my textbook, I describe the economic way of thinking as the 3 I's: incentives, interactions, and indifference. Saying "incentives matter" is no profound statement, but the difference between economists and non-economists is that economists (as Steven Landsburg puts it) insists on taking incentives seriously at all times.

Thus, when designing health insurance plans a good economist is likely to focus on designing incentives that lead to good health and, correspondingly, lower health care costs. This is exactly what Safeway has done, as described in the Wall Street Journal here. The author argues that with the proper incentives, insurance policies with better incentives can reduce health care costs by 40%.

This article is a good tool for articulating to students the rewards associated with smart incentives.

Perils of Inflation

Fighting the economic downturn, the Federal Reserve has printed more money--much, much more money--than it ever has. Once the economy begins to heal the Federal Reserve may be able to take this new money back out of the economy, but that will be difficult, and to the extent that it does not, inflation will ensue. Most of us are accustomed to low inflation rates and do not possess the experience to plan for a future with high rates.

Consequently, should high inflation rates take hold many will be adversely affected. The Notable and Quotable section of the Wall Street Journal contained a description of the harms inflation inflicted on one particular person in the 1970's. Students identify better with stories of real people than abstract concepts, so relaying this little story may help them understand how inflation harms innocent people as they try to plan for the future.

From June 12, 2009 - "He was the epitome of the Protestant Ethic. He had inherited money, he had saved, he was very frugal, had a very modest house, had part of his investment money in bonds and short-term securities, had always maintained liquidity. And he came out of the Seventies looking like a fool."

The Indifference Principle

In a previous post, I stated how I disagree with my peers over what constitutes the core principles of economics.  Arguing indifference curves and production stages are not core principles, I argued the Indifference Principle (IP) is a core principle.

The IP was articulated in Steven Landsburg's The Armchair Economist, but is not a discovery. It is a succinct description for how economists think about market behavior.  The principle states that unless there are unusual talents or tastes, all actions must be equally desirable.  To illustrate how the IP is a core principle, consider how many economic questions it explains with parsimony.

The IP explains

• Why landownders benefit from farm subsidies when land is fixed
• Why consumers benefit from farm subsidies when land is not fixed
• Why the price of corn and sorghum move in tandem
• Why the prices of commodities between regions do not exceed transportation costs
• Why stock prices and commodity prices are efficient
• Why sunny days are not necessarily the best time to go to the zoo
• Why crop prices increase between harvests
• Why compensating people for building in areas where floods will predictably occur make everyone worse off.
• Why rent-seeking often eliminates any potential benefit from government subsidies.
• Why rent-seeking limits the ability of government to correct for market failures.

These are economic questions students in introductory economics courses should be able to address.  The IP allows one to address them, but indifference curves and isoquants do not.

Principles of Economics

This semester I will be teaching the intro to ag econ class for the first time in many years.  It is in this class where the instructor is expected to cover the "core principles", yet the more I have thought about this class the more I believe I disagree with my peers over what these "core principles" are.

In my department, the core principles are described as follows.  Consumer preferences are derived from indifference curves, and from theese curves the consumer demand curves are formed.  Supply stems from production isoquants and the three stages of production, which yields supply curves.  Putting the two together, you have supply and demand, from which the instructor should spend considerable time covers substitutes, complements, normal goods, inferior goods, and elasticities.

I don't like this view.  You could learn all this and really know nothing about economics. Consumer indifference curves are useful for some problems, but are not the foundation of consumer demand.  To get demand curves from these indifference curves, one must make assumptions about their shape to avoid giffin goods, which implies they are not the foundation of demand curves--demand curves are entirely an empirical construction.  Now for production.  One of my colleagues once stated that the stages of production are of paramount importance, because a falling marginal product curve drives everything.  Yet what does it "drive?"  All it does is imply that prices are positive but not infinite, and that we consume a finite amount of any good.  If that is all the production stages can do, that is not impressive.  Topics like substitutes and normal goods and elasticities are good for writing exam questions, but alone do not answer any economic questions.

So what are the "core principles" of economics?  Frankly, I don't believe there is a general model of economics that encompasses everything.  To me, the most important concept is the indifference principle. Which does not turn up in a Google search, nor is any any textbook except my own.  More on the indifference principle later.

Good for the Group, Not for Society

The goals of an introductory economics course should be succinct.  They should seek to instill an understanding of a few basic economic principles.  Seeking to cover a large amount of material is like pouring water onto concrete; the water spreads over a large area but no one gets a sip.

This is one principle I feel is important: what is good for a group is not necessarily good for society.  Most of the policies of the great depression (price controls, plowing under cotton, killing baby pigs) were based on the idea that this principle is false, and that if one group is made more profitable, society is made better off.

How can one instill this principle?  One way is the traditional supply and demand diagram with consumer and producer surplus contrasted with the same diagram under a monopoly case.  Yet, students often memorize the graphs without actually understanding the concepts.  It is perhaps better simply to discuss what happens when we force farmers to plow under their cotton, which raises their prices and profits (if done right).  Yet the impact for society is obvious--less cotton. More importantly, there was some cotton that individuals wanted to voluntarily trade, but now cannnot.  Some students may then ask: perhaps farmers spend their higher profits on other goods, so there may be less cotton but more other stuff?  Fair question, which demonstrates why those diagrams are important; those diagrams show that after the reduction in cotton there is, physically, less money to spend on other stuff.  Society is made poorer.

What Is An Economist?

Over at EconLog Bryan Caplan wonders exactly what "economics" means.  I will be teaching Introduction to Agricultural Economics for the first time this fall, and necessarily must address this question.  Caplan points to the fact that in many facets the term "sociologist" is more appropriate for the research we conduct than "economist."  In ag econ, I would argue that "management" might be an appropriate substitute also. Many ag econ departments in fact call themselves agribusiness departments, and most of our students obtain agribusiness degrees.

In my textbook I gave the standard definition "study of the allocation of scarce resources" but quickly told the reader that this definition should not mean much to them.  Instead, I informed the reader about the questions we address.  In my field, these questions are questions of management and sociology.

Fortunately, we do not need to provide students with a good definition. Frankly, they don't care.

Stumbling Upon Adam Smith

In his best-selling book, Stumbling Upon Happiness, author Daniel Gilbert argues that we know little about how to make ourselves happy.  We suffer the delusion that the pursuit of wealth will make us happy, but why should such an intelligent species be so naive?  Gilbert argues that this type of delusion tends to persist in cultures because that type of delusion is helps fortify the resilence of that society and its propensity to conquer others.  Wealth may not make us happy, but it overwhelms those who do not chase after wealth, until all that is left are those who suffer the delusion.

In my recent readings of Adam Smith's The Theory of Moral Sentiments, I found that Smith "stumbled" upon this same idea long ago.  In describing man's pursuit of wealth, he states, "They keep off the summer shower, not the winter storm, but leave him always as much, and sometimes more exposed than before, to anxiety, to fear, and to sorrow; to diseases, to danger, and to death."

But shortly after Smith asserts, "And it is well that nature imposes upon us in this manner.  It is this deception which rouses and keeps in continual motion the industry of manking."

Benefits of Education

HT: Carpe Diem

Teaching Tips by Eric Devuyst

Eric is a new professor to our department, and the more I get to know him the more I think it a shame he is not teaching our undergraduates.  Here are some ideas he gave me that I plan to steal, and offer to you to steal as well.

Teaching the Art of Economic Modeling - Eric asks for volunteers to approach a flat map of the world.  Giving them a piece of string, he asks them to find the shortest distance between their university and Tokyo Japan (there will be many laughs as they struggle to find Japan, so don't call on volunteers who you think are smart).  Then, ask the students to perform the same activity on a realistic model of the world: a globe.  As they find their more direct route they quickly see that it differs from the route selecting using the flat map.  This illustrates the importance of using a good model for the problem at hand--in economics and everything.  During the Great Depression people thought that whatever was good for a cartel was good for everyone.  This is why they promoted price-fixing, plowed under acres of cotton, and killed baby pigs.  This model of how the welfare of cartels affected the welfare of everyone proved to be a bad model - with terrible consequences.

Teaching the Three Stages of Production - Most introduction to economics professors have an activity they use to teach the three stages of production.  I once had them build structures out of empty beer cans (guess where the empty cans came from!).  Andrew Barkley has them build paper airplanes.  My intro teacher had us build "products" where were five sheets of paper stapled together.  In all cases, there is a fixed amount of capital (beer cans, paper, stapler) and a variable amount of labor.  Start with one person, measure output, then do the same for two, three, ..., twenty people and plot how production changes with labor.  Eric uses a method that might not be as fun as building a beer can structure, but I think illustrate the concept better.  he draws a rectangle on the chalk board and has them write something like "Bailey Rocks" as many times as they can in a limited time period. The fixed capital is the area within the chalkboad and the time limitation, and the variable labor is the number of people drawing.  You can imagine the fun and laughter as they get in each others way when the number of participants becomes large.