The Visible Hand Spring 2005 - [email protected]

2 | The Visible Hand | Spring 2005

THE VISIBLE HANDSPRING 2005

Investigating the issues

Economic Trends

5 The Recent Surge in Mergers and Aquisitions Linda Pedersen

8 New Luxury: Like It or Spike It? Olivia Liang

12 The Common Agricultural Policy and Struggling Katherine DeWitt International Agricultural Economies

14 Financial Integration: A Road Towards Growth or to Madhurima Bhattacharyay Increased Vulnerability and Poverty?

16 The Role of Economics in the Origins of the Civil War Adam Sasiadek

Economic Policy

18 Economic Interstate Conflict: The World Trade Organization Neelu Toor and Dispute Settlement – Evaluating Schools of Thought

22 Privitization of Social Security Jerry Shih

26 Capital Punishment as a Deterent to Murder Ali John Ghassabeh

30 The Good Samaritan Law and the Duty to Rescue: Vincent Wong A Cost-Benefit Analysis

36 NO! to Internet Taxes Jarett Goldman

FREE TRADE Scholars andinternational politicaleconomy experts have offereda variety of explanations forwhy trade disputes havecontinued and even increaseddespite the World TradeOrganization’s best efforts todeter and resolve them. Page18

CONSUMER BEHAVIORConsumers are turning toproducts that possesspremium quality yet arerelatively more accessible tothe masses than traditionalluxury goods. These so-called “new luxury goods”are refreshing the marketwith their distinct characterthat makes them soemotionally attractive to theconsumer. Page 8

Spring 2005 | The Visible Hand | 3

Asia

38 Exchange Rate and Current Account Imbalances in Ray Wang China and ASEAN: Are They A Problem?

41 The Development of the Chinese Auto Industry Samson Cheng

44 The Investment Landscape for Foreign Acquisition in the Rosy Ko Chinese Banking Industry

47 The Future of ASEAN’s Economy: Growth through Thummim Cho Foreign Direct Investment

Cornell

50 Online Auctions: Changing the Face of Game Theory Dan Tevet

52 Behavioral Economics: A Look into this New Course and Tulika Kumar Professor O’Donoghue

THE VISIBLE HANDSPRING 2005

Investigating the issues

DEVELOPMENT Auto-makers from Detroit andStuttgart continue to pour inbillions of dollars intobuilding new plants andtraining staff in China. Theautomobile market has seenimpressive growth in recentyears and the potential seemsto be enormous. But is thegrowth sustainable? Are theinternational auto giants’moves into the market tooabrupt? Page 41

M A C R O E C O N O M I CPOLICY Several years ofrapid growth caused by tradeimbalances have absorbedthe initial slack that existedin many Asian countries.However, if left unchecked,large external deficitscombined with overheatingof an unsustainable economywill expose these countriesto external shocks andpolitical unrest. Page 38


The Visible HandVolume XII: Number II

Editor-in-ChiefMichael Tang

Managing EditorsLiza Lee

Linda R. Pedersen

Associate EditorsSeraphina Kuah

Tal ManorJerry Shih

Design EditorMeredith Shull

Marketing DirectorOlivia Liang

Contributing EditorsSamson Cheng, Gregory Clother,

Katherine DeWitt, Hanoch Feit, AllenLi, Liza Lee, Tianai Lin, Neal Miniyar,Marie Schell, Ariel Tan, Thomas Wei

Contributing WritersRima Bhattacharyay, Samson Cheng,

Thummim Cho, Katherine DeWitt, AliJohn Ghassabeh, Jarett Goldman, RosyKo, Tulika Kumar, Olivia Liang, Wee

Lee Loh, Linda Pedersen, AdamSasiadek, Jerry Shih, Dan Tevet, Neelu

Toor, Ray Wang, Vincent Wong

Cornell Economics Society PresidentJason Roth

Faculty LiasonProf. Jennifer Wissink

Our Mission

1. To raise economic, political, and social awareness amongst Cornellians of ourroles as citizens of the global community.

2. To address and analyze current news-worthy events while promoting further inquiryinto how they fit within a historical context, as a link between our past and the possiblerealities of our future.

From the Editor:“I would found an institution where any person can findinstruction in any study.”

- Ezra Cornell, 1865

Now, while our benefactor and namesake’s goalwas laudable, it’s kind of like saying that Abercrombie andFitch is an equal opportunity employer. Any study? Really?Ok, so we all know and love Economics, but let’s see, does Cornell offer Animal Science?Check. Science of Earth Systems? Yep, we’ve got that too. How about Textiles and Apparel?Amazingly enough, future Ralph Laurens and Donna Karans can find what they’re lookingfor in the College of Human Ecology. We even have a curiously named “Special Programs”major, as well as the best school of hotel management in the country. It seems that “anystudy” isn’t all that far from the truth!

But, can “any person” truly find instruction at Cornell? Not exactly. Unlike “openuniversities” like the University of Phoenix and Podunk U, the gates of Cornell are controlledby the fine people at the admissions office. Of course, if you’d like a building named afteryou, I’m sure that an exception could be made. However, there is an additional financialbarrier to cross as well. With tuition alone in the “endowed” colleges currently running atthirty-thousand dollars a year, by the time we graduate some of us will be paying down theequivalent of a small mortgage for our Cornell education.

And herein lies my point. Not just Cornellians, but Americans as a whole aresliding into dangerous levels of debt. According to a recent article in Forbes by A. GarySchilling, the national savings rate has dropped from 12% in the early 1980’s to virtuallynothing today. And our penchant for spending extends to our government too, with thenational debt approaching almost 8 trillion dollars! To put that in perspective, every man,woman, and child would have to pay the government more than $26,000 dollars each tocover the debt.

However, Joe Average hasn’t been the one footing the bill for our national debt…yet. Instead, enormous consumer demand for imported goods has led to a massive tradedeficit. In exchange for the inventory of a typical Wal-Mart, countries such as China havecollected vast reserves of US dollars, which are then reinvested into the United States astreasury bonds. Effectively, our foreign trading partners buy our national debt. The bigquestion is whether the current situation is sustainable, which is not a question easilyanswered.

And on that inconclusive note, I’d like to take this time to thank all the writers,editors, and sponsors who make The Visible Hand possible! I would also like to encourageanyone interested in writing about economics or working with an enthusiastic editorial teamto join us next semester as we begin work on the Fall 2005 issue. For more information,check out our website at [groups.yahoo.com/group/visiblehand] or subscribe to our listservby sending an email to [[email protected]]. With that, I would liketo welcome you to the Spring 2005 issue of The Visible Hand!

Best,Michael Tang

©2005 Cornell Economics Society. AllRights Reserved. The Visible Hand ispublished once a semester and availablefree of charge at all major distributionlocations on the Cornell Campus,including all seven undergraduatelibraries.

The Visible Hand welcomes youreconomic-related submissions andcomments. Please contact the editor-in-chief or send mail to: Cornell EconomicsSociety, Uris Hall, 4th Floor, CornellUniversity, Ithaca, NY 14853.


The Recent Surge in Mergersand Acquisitions

By: Linda R. Pedersen

Linda Pedersen ‘06 is anEconomics Major in the

College of Arts and Sciences

There seems to have been aconsolidation surge in manydifferent industries recently,

involving widely discussed merger andacquisition deals ranging from marketsectors such as telecommunications tothe personal care industry. Why dofirms choose to merge, and who are thestakeholders in these M&A deals? Dothe interests of the firms’ managementand their shareholders conflict, or isconsolidation to the benefit ofeveryone? How does consolidationaffect the performance of the firmsinvolved and the competitors in thefirms’ industry? These are all questionsthat need to be answered in order toreveal the true benefits and costs ofmergers and acquisitions.

The Mechanics of M&A

Consulting a Financial Economicstextbook (Brealey, Myers & Marcus,2004), I was able to acquire a generaloverview of the mechanics of mergersand acquisitions. This textbook on

Corporate Finance identifies three waysfor a company to acquire anothercompany:

1. Merge the two companies into one.The acquirer will take over all of theassets and liabilities of the acquiredcompany, and the acquired firm will ineffect disappear, with its shareholdersreceiving stock from the acquirer orcashing out.

2. A tender offer in which an outsidecompany attempts to buy anothercompany’s stock through its shareholdersrather than its management, and canthereby take control over the firms’management.

3. Acquiring the other company bypurchasing the firm’s assets directlyrather than through the shareholders.


Despite these three major waysof acquiring another company, theoverwhelming trend in the recent high-profile mergers and acquisitions such asthe P&G and Gillette merger seem tohave favored option #1 above. As longas the potential merger is thought toimprove the firm’s standing in the marketand thereby increase shareholder value,it should be in the shareholders’ bestinterest to encourage the merger.

Merger Types

With such a distinctive trend ofconsolidation invarious differentindustries, there mustbe some clear benefitsto derive from M&A.Mergers can beclassified as threedistinctive types, each with presumablydifferent motives and benefits:

1. Horizontal mergers, involving twoformer competitors in the same industry.

2. Vertical mergers, involving companieswho operate at different stages of theproduction process.

3. Conglomerate mergers, involvingcompanies in completely differentindustries.

The P&G and Gillette merger isclearly of type #1, with the two formercompetitors now usurping a considerableshare of the personal care market withtheir combined operations. This type ofmerger does seem to be the most commonin recent high-profile M&A deals rangingfrom the SBC Communications andAT&T merger, to the currentlyprospective MCI and Verizon or MCI andQuest Communications merger. The restof this article will therefore be devotedto investigating the ins and outs ofhorizontal mergers.

Why Merge?

Why do firms find it profitable to mergewith former competitors? The mostobvious explanation for this is thepotential for economies of scale. Thefixed costs of the company can bedecreased by spreading them over a largevolume of output, especially in suchaspects as back-office operations andcomputer systems (Brealey et al., 2004).However, large companies engaging inhorizontal mergers do need to be awareof the potential for anti-trust legislation

due to the decreased competitiveness ofthe market in their industry as a result oftheir consolidation. Companies may alsoincur wrath from consumers, who maybe forced to pay more and have lesschoices due to the decreased marketcompetitiveness. For example, theConsumers Union is currently criticizingthe potential MCI and Verizon merger ashurting telecommunications customers.According to a policy advocate for theConsumers Union, Kenneth DeGraff,"The mergers might satisfy Wall Street,but they'll hurt Main Street” (Cheng,2005).

Additionally, there are severalproblems that may arise as a result of twocompanies merging together which needto be taken into account when analyzingthe potential costs and benefits of anM&A deal, such as different corporatecultures perhaps not being compatible.The recent dismissal of former Hewlett-Packard CEO Carly Fiorina demonstratesthe potential for unsatisfactory resultsfrom merging two giant companies, inher case Hewlett-Packard and Compaqback in 2002 (Berman & Latour, 2005).However, horizontal mergers in generaldo have a greater success-rate than othertypes of mergers, and for example theP&G and Gillette merger does stand toreap from the benefits of cost-rationalization (The Economist, 2005).

Who Benefits from a Merger?

From a shareholder’s perspective, it maybe desirable to be a shareholder of thecompany that is being taken over. To usethe P&G and Gillette merger as a recentexample, Gillette shares increased by13% when it was confirmed that P&Gwas willing to offer $52.4 billion forGillette (Zuckerman, 2005). However,there has been recent speculation aboutwho really benefits from a companymerger. Calpers, the largest publicpension fund in the country, has releaseda statement questioning whether adviceto shareholders from investment banksinvolved in the merger may be biased,and in that way push through M&A dealsthat may not be beneficial for shareholdervalue and may result in a large numberof layoffs, while benefiting top

"The mergers might satisfy WallStreet, but they'll hurt Main Street”

Economic Trends


management and the investment banks(Davis, 2005).

An article in the The Wall StreetJournal, “No Razor Here: Gillette Chiefto get Giant Payday,” similarly questionswho stands to lose and who will

inevitably benefit from company mergers(Maremont, 2005). According to thearticle, Mr. Kilts, Gillette's chairman andchief executive, may earn more than $153million from the deal, while more than6,000 P&G and Gillette employees areestimated to get laid off as a result of themerger. As an article in The Wall StreetJournal claims “One of the best ways totake advantage of the return of the bigdeals is to buy shares of the onlycompanies sure to see a payoff from itall -- the investment banks that get paidbig sums to negotiate the deals ”(Zuckerman, 2005). Regardless of themotives behind M&A deals and how theywill affect stakeholders, it is apparent thatfurther consolidation is the wave of thefuture in a wide variety of industries.

Who Will Be Next?

As a result of the recent P&G and Gillettemerger, it is likely that we will experiencemore consolidation in the personal careindustry. Similarly, the SBC and AT&Tdeal clearly triggered further

consolidation in telecommunications, asthe current merger discussions betweenMCI and Verizon, and MCI and Questdemonstrate. It is a general trend thatonce an industry experiences a mergerof that size, the competitiveness of themarket will be changed in such a way that

competitors will find it in their bestinterest to merge as well (Zuckerman,2005).

Other industries that are thoughtto be consolidating further in the futureinclude the financial services industry,due to the large number of Americanbanks and the competitiveness of theindustry, and the pharmaceutical industry,which has a number of companieslooking to spend their money(Zuckerman, 2005). Additionally,another major trend for the future maybe an increase in cross-border deals. Thecloser integration of the European marketas a result of the recent EU expansionand other legislation specificallytargeting cross-border deals shouldprovide such a trend in the future.American companies with operationsabroad also stand to benefit from cross-border mergers, as acquiring a localcompany will enhance their localknowledge and presence in that region(Cauchi, 2005).

Although it is clearly too earlyto say whether the recent giant P&G andGillette, and SBC Communications andAT&T deals were successful andbeneficial to the various stakeholders ofthe firms, these deals are representativeof what we should expect to see in thefuture. Mergers will continue to behighly debated phenomena, with interestgroups representing consumers arguingthat consumers are being hurt in theprocess, while firms and theirmanagement argue that they will be betterable to serve the needs of the market.Regardless, further consolidation is theclear trend in virtually all industries ofthe economy, and it is therefore a questionof how soon, not if, the next giant mergerdeal will occur.

References:

Berman, D. K. & Latour, A. (2005,February 10). “Too big: Learning frommistakes: Fiorina's departure from H-Preminds companies about risks during thecurrent merger boom.” The Wall StreetJournal, p. C1.

Brealey, R.A., Myers, S.C., & Marcus,A.J. (2004). Fundamentals of CorporateFinance. New York, NY: McGraw-Hill/Irwin.

Cauchi, M. (2005, January 31). “M&Aactivity to spur more consolidation inbanking.” Dow Jones Newswires.

Cheng, R. (2005, March 29). “Verizon-MCI Merger Faces Scrutiny FromConsumer Groups.” Dow JonesNewswires.

“Company mergers, Love is in the air.”(2005, February 3). The Economist.

Davis, A. (2005, February 8). “WallStreet's 'fairness opinions' draw fire fromCalpers.” The Wall Street Journal, p. C1.

Maremont, M. (2005, January 31). “Norazor here: Gillette chief to get a giantpayday.” The Wall Street Journal, p. A1.

Zuckerman, G. (2005, February 8).“Seeking profit from merger fever hasrisks for holders on all sides.” The WallStreet Journal, p. D2.

The Recent Surge in Mergers and Aquisitions


New Luxury:Like It or Spike It?

By: Olivia Liang

Olivia Liang ‘07 is anEconomics and PsychologyMajor in the College of Arts

and Sciences

Being spun off by its parentcompany, Sara Lee, marked thebeginning of robust growth for

Coach Inc. The New York-based leathergoods and accessories retailer has morethan doubled its net sales and increasedits net income by more than six-folds inthe four years following its initial publicoffering in 2000 (Coach, 2004). With itsunique market positioning that targets themiddle-income consumers (especiallyfemales), Coach is aggressively grabbingthe market share from traditional luxuryretailers such as Louis Vuitton andBurberry. The phenomenal growth ofCoach is a reflection of the rapidlychanging taste among Americanconsumers nowadays. As more and moreAmerican consumers are capable ofaffording a higher premium for all kindsof products, they are not only focusingon the functionality and reliability of theproducts but also the experiential andemotional components. In particular, theconsumers are turning to products thatpossess premium quality yet are relativelymore accessible for the mass consumers

that traditional luxury goods. These so-called “new luxury goods” are refreshingthe market with their distinct characterthat is so emotionally attractive to itstarget consumer segment. In this article,I will take a look at who these consumersare, what they look for in a luxuryproduct, and what it takes for a brand towin in this competition.

Who are demanding new luxurygoods?

The emergence of new luxury goods hasbeen no accident. Multiple factors havecontributed to consumers’ changing needand taste, germinating a series ofproducts that combines the premiumquality of a traditional luxury with arefreshing consumption experience.Several of the more important factors arethe constant income growth throughoutthe past decades, the increasing activerole that females play in the householdand the workplace, and the dramaticchanges in lifestyle among the babyboomer generation and the youngergeneration.

The steady growth in realincome level, particularly in the 1990s,has boosted the growth in consumptionamong American households. According

to the household income report releasedby U.S. Census Bureau in 2004, 73.2%of American households had an annualincome of $54,500 or above in 2003(Current Population Survey 2003 and2004, Annual Social and EconomicSupplements 2004). The real medianincome has climbed from $33,000 in1967 to $43,400 in 2003 (in 2003 dollar).As a greater proportion of the populationenters the middle income market, thesepeople are dominating society’s

Economic Trends


aggregate purchasing power. Moreover,these middle-income households’ wealthis growing at a much faster rate than theirconsumption, leaving these householdsapproximately $3.5 trillion disposableincome sitting in their bank accountwaiting to be spent. The implication forbusiness owners is enormous: most of theproducts available in the existing marketmerely fulfill consumers’ basic needs andfail to address new needs of theincreasingly demanding consumers orcreate needs for them. An under-addressed purchasing potential passes bythe market without inspiring muchinnovation or creativity in companies.

The second factor—theincreasingly active role that females playin the household and the workplace—isvisible through the comparison betweenfemale’s historical and current income.If one decomposes the aggregate realincome growth by ethnicity or gender,one would find that the increase infemale’s income becomes progressivelysignificant. Female workers, especiallyfull-time workers, whose real incomealmost doubled in the past four decades,have boosted the female-male earningratio up to 76:100 from 61:100 in 1960(Current Population Survey 1961 to2003, Annual Social and EconomicSupplements 2003). Accompanyingfemales’ higher participation rate in the

work force is the postponement ofmarriage by an average of four years anda higher divorce rate (U.S. AdultsPostponing Marriage2001). Thepostponement of marriage results in alarge population of young singles whoare more likely to spend money onthemselves and to polish their self-imagewith affordable premium products. Thesame story applies to a higher divorcerate as well. In a new single state, peopletend to increase consumption to alleviatethe negative emotional impact that thedivorce has on them and perhaps, to seeknew partners (Fiske and Silverstein2003). This changing consumptionpattern is particularly typical of women,who tend to express their emotions moreopenly than men. This indicates that themiddle-income women are searching fornot only premium products that breaksout of the box of traditional luxurygoods, but also goods that they canemotionally relate to.

In addition, the middle-incomebaby boomers, who have the strongestpurchasing power in the society now, arecraving for ideas and products that revealmore undiscovered needs on which theycan spend their no-where-to-spend sparecash. Data shows that the 75 million babyboomers are controlling $1 trilliondisposable income every year yet aredirectly targeted by only 10% ofadvertisements (Davis 2005). Not onlydo baby boomers have a large store ofdisposable income, they also activelyexplore products that can add more spiceto their lifestyle as they are free of a child-rearing burden and are mostly headingtoward retirement. According to aconsumer confidence survey reportreleased by the market research firm ACNielsen in 2004, American consumers

spend 23% of their spare income (definedas the income left after consumers coveressential living expenses ) on out-of-home entertainment, 21% on newclothes, and 20% on homeimprovements, making almost half oftheir spare income (ConsumerConfidence Survey 2nd Half 2004). Withbaby boomers’ unique needs and strongpurchasing power, this particular under-targeted consumer segment is anothercritical factor that catalyzes the surge ofnew luxury goods.

Why new luxury goods?

By now I have discussed who isdemanding new luxury goods and why,but this is still not sufficient to explainwhy middle-income consumers arestreaming into Crate&Barrel or PotteryBarn instead of Wal-Mart for homenecessities, or why women are carryinga Coach handbag instead of the latest LVlogo bag. What is so attractive about thenew luxury goods? This is the questionthat I will try to answer in this section.Although virtually every new luxurybrand/product carries a unique messageand targets different consumer segmentswithin the middle-income consumers,their marketing strategies are not muchdifferent from each other. The first stepin understanding the secret of these newluxury goods is to understand theirmarket positioning, in another word, themessage that they want the consumersto receive.

Create or emphasize anunfulfilled need for customers and helpthem satisfy this need—this is theessential component in every successfulmarketing recipe. Marketers for new

...virtually every newluxury brand/productcarries a unique messageand targets differentconsumer segments...

...the 75 million babyboomers are controlling$1 trillion disposableincome every year yet aredirectly targeted by only10% of advertisements.

New Luxury: Like It or Spike It?


luxury goods follow the same golden rulewith no exception. The previous sectionof this article suggests that the emotionaland personal element in a product isbecoming an increasingly crucial factorthat influences purchasing decisions.Consumers start to recognize theimportance of the consumptionexperience surrounding a certain product,and thus, are willing to pay more for aproduct that provides them with such anexperience than for a product that merelysatisfies daily necessity. This particularconsumption experience was once quiteexclusive to the super-premium products,which in fact charge the consumers ahuge premium for the excellent service.Recognizing this desire for a personalizedshopping and consumption experience,the marketers for new luxury productsequip their products with a series of pre-and post-purchase services thatcorresponds with the value positioningof the product. For example, Crate &Barrel always conducts extensive siteselection before the opening of eachbranch store. The design of each store hasto match with the community that thestore situates. The lighting and the musicwithin each store are specifically chosento create a soothing shoppingenvironment that makes the customerswant to linger. Each product conveys notonly its functional value but also a uniquelifestyle and a pleasurable shoppingexperience. And this experientialcomponent of the products is preciselywhat the consumers are willing to pay apremium for. By targeting this unfulfilledneed in the middle-income market, thenew luxury goods successfully dominatethis consumer segment with highpurchasing potential.

Providing a distinctiveshopping experience, however, is not atall a new idea to the market. This is infact what most of the super-premiumbrands have relied on for their survival.The marketers for new luxury goodsneed to differentiate their products fromthe traditional luxury goods byresponding to the consumption patternof this particular consumer segment. Thetarget consumers of new luxury goods—the middle-income consumers—occupythe gap between the mass market and the“class” market. Although theseconsumers may not be financiallycapable of being a frequent customer atPrada, they do have the preference foran affordable premium product overconventional products. As long as theirfinancial ability permits, these middle-income consumers are perfectly willingto pay a 20% to 200% premium for near-the-top products—in another word, totrade up in acertain productc a t e g o r y .Knowing thisconsumpt ionpattern, themarketers fornew luxurygoods positiontheir productswith the “classto mass”philosophy inmind. On onehand, sincec o n s u m e r soften use pricesas an indicatorof quality, themarketers pricetheir products ator near the topof the productcategory todistinguish thep r o d u c t ’ sp r e m i u mquality fromconvent ionalproducts in themarket. On theother hand,m a r k e t e r sensure the

quality and reliability of their productsare consistent and comparable to thoseof the super-premium products. Byproviding an equally high-qualityproduct at a slightly lower price, themarketers prove their products to be a“better deal” for consumers. For example,Urban Outfitters, Inc., a retail companythat specializes in merchandising lifestyleproducts ranging from clothing to homeaccessories, has been growing robustlyin recent years by catering “culturallysophisticated and self-expressive” imageto the younger generation (UrbanOutfitters, Inc. Form 10K 2003). One ofits brands, Anthropologie, which targetsupscale urban females in their thirties andforties, started off its business with 7stores in 1993 and has now expanded to40 retail stores covering North America(Ibid). It provides a full line of lifestyleproducts that are relatively high-pricedyet are more affordable than some of the

...the emotional andpersonal element in aproduct is becoming anincreasingly crucialfactor that influencespurchasing decisions.benefits.

Economic Trends


other more upscale luxury brands. Thebrand consistently puts a huge amountof effort into crafting a visually andemotionally pleasing and eye-catchingcatalog, which helped boosting both itsin-store and online sales as well asunambiguously conveying its brandimage. By differentiating itself with astylish yet urbane lifestyle it promotes,Anthropologie now accounts for 44% ofUrban Outffiters’ net sales (Ibid).Anthropologie’s rapid growth capturesthe increasingly challenging demandfrom modern consumers, especiallyfemale consumers. The affordablepremium price of the new luxury goodsrepresents a better deal for middle-income consumers; while the highquality of the products corresponds withthese consumers’ desire to “trade up” inthe product category.

In summary, providing aconsumption experience that waspreviously inaccessible to most middle-income consumers are what is mostappealing about new luxury goods.Brands that are traditionallycharacterized as middle-market players,such as Coach, are capitalizing on thiscraving for a compromise of quality andprice. Moreover, many traditional luxurybrands, such as BMW, are extending theirproduct line to embrace this emergingmarket. And other relatively moreconventional products, such as Oil ofOlay, are moving up the category in aneffort to scoop a share of this hugemarket.

The Future of New Luxury Goods

One may tend to think of the existing newluxury goods as a temporary alternativefor the middle-income consumers whocannot afford the super-premium brandsyet. It may seem that they will eventuallytrade up to the top of the category as theirincome accumulates. Thus, the ultimatewinner of the competition is still thetraditional luxury goods. This could verywell be true, and it is certainly one of thechallenges facing the entire new luxurygoods market. But here is the good newsfor the marketers for new luxury goods:

Consumers’ taste is plastic and constantlychanging. Just as the new luxury productsare differentiating themselves from thetraditional luxury products by prices, theycould very well achieve this goal bychanging the consumers’ taste. The secretrecipe to success is the same for both newand traditional luxury products—tocapture the unfulfilled needs amongconsumers and address them withinnovative product features. A newluxury brand could very well be themarket leader once it controls the rule ofa particular product category. Coach isalready turning this possibility into realityin Japan by rapidly catching up with the

No. 1 seller in Japan, Louis Vuitton.Perhaps we are not far away from the daywhere every woman is tugging a handbagwith symmetric C’s under her arm.

References:

Coach, Inc. Financial Reports 2000-2004. (2004). Retrieved on March 11,2005, retrieved from Mergent OnlineDatabase.

Current Population Survey, 2003 and2004 Annual Social and EconomicSupplements. (2004). Retrieved from USCensus Bureau website.

Current Population Survey, 1961 to 2003Annual Social and EconomicSupplements. (2003). Retrieved from USCensus Bureau website.

U.S. Adults Postponing Marriage,Census Bureau Reports. (2001).Retrieved from U.S. Census BureauNews on U.S. Census Bureau website.

Michael J. Silverstein & Neil Fiske(2003). Luxury for the masses. HarvardBusiness Review, April.

Kristin Davis. (2005). Oldies but goodies.U.S. News & World Report. Vol 138,No.9.

Consumer Confidence Survey 2nd Half2004. (2004). AC Nielsen. Retrieved onMarch 11, 2005, retrieved from http://acnielsen.com/reports/documents/2004_eu_confidence2.pdf.

Urban Outfitters, Inc. Form 10K. (2003).Retrieved on April 1, 2005, retrievedfrom Mergent Online Database.

New Luxury: Like It or Spike It?


The Common Agricultural Policyand Struggling International

Agricultural EconomiesBy: Katherine DeWitt

Katherine Dewitt ‘06 is anEconomics Major concentrating

in Law and Society in theCollege of Arts and Sciences

The Common Agricultural Policy in the European Union has many internationalconsequences. Many of these are detrimental, such as the consequences of its variabletariffs on imports, as well as the change in EU position in agricultural markets due to

increased green technology.

The business of farming is treatedwith specific economic analysisin most countries. Rural

communities are seen as refreshing escapesfrom the city professionalismof starch black suits andcrunching numbers. A farmbrings to mind the picturesquescene of expansive fields andthe preservation of traditionalvalues. It was with thismindset that the CommonAgricultural Policy (CAP)was established in 1962(Baldwin & Wyplosz, 2004).The CAP allows EuropeanUnion (EU) countries toguarantee EU farmers high,stable prices for their goods throughdomestic price support and import tariffs.However, prosperity at home for the EUoccurs with the cost of depressing theeconomies of agricultural countries inSouth and Central America. Bysimultaneously decreasing quantities of EUimports and increasing quantities of EUexports into the world market, the CAPdepresses the world price of agricultural

products. This leaves the major agricultureproducers, the Cairns countries, to absorbthe negative shocks of the CAP.

The objective of the CAP in the

1960s was to protect EU farmers byproviding high and stable prices foragricultural goods which, in turn, wouldmaterialize into a stable income forfarmers. The Treaty of Rome (article 39)states one objective of the CAP is “toensure a fair standard of living for theagricultural community, in particular byincreasing the individual earning of personsengaged in agriculture; to stabilizemarkets.” By making farming moreprofitable, the EU strived to maintain theexistence of rural communities andtraditional values while easing urbancongestion. The CAP also set forth toaddress environmental concerns as well astechnical efficiency in hopes of the EUbecoming competitive in the international

agricultural market. The CAP garneredsupport because after WWII, policieswhich offered price and income securitywere a welcomed intervention from thevolatile times of the past.

The two primary mechanismscreated and utilized by the CAP aredomestic price support through a pricefloor and the imposition of tariffs onimports. In practice, this means aminimum price floor of 50%-100% aboveworld prices is set in the EU with theguarantee that any products not sold at thisprice will be bought by the EU (Baldwin& Wyplosz, 2004). In addition, as one ofthe largest agricultural importers, the EUalso levies tariffs on imports to ensure that

lower world prices will not negativelyaffect local producers by running theirhigher priced goods out of the market. Intheory, this special treatment of agriculturalproducts will bring an “even closer unionamong the peoples of Europe,” (Baldwin& Wyplosz, 2004). In the 1950s theagricultural sector constituted a significantfraction of those people, about one in fiveliving on farms at the time (Baldwin &Wyplosz, 2004).

Unfortunately, the largestagricultural economies outside the EU,called the Cairns group, are also the poorestcountries (Baldwin & Wyplosz, 2004).These countries include Argentina, Bolivia,

By simultaneously decreasingquantities of EU imports andincreasing quantities of EU exportsinto the world market, the CAPdepresses the world price ofagricultural products.

Economic Trends


Brazil, Chile, Colombia, and Costa Ricaamong others. The CAP greatly affectedtheir economies with regard to both importsand exports. First, the EU regulates tradeby charging these countries variable tariffsto import their goods into the EU. Thesevariable tariffs precipitate the depressionof the world price and instability of theeconomies of poor countries.

In order to maintain a fixed pricefor agricultural goods imported into theEU, the CAP established variable tariffs onexporting-non EU countries. Theimposition of an import tariff translates toreduced exports out of poor countries, sincethey now have to pay a fee for each goodimported into the EU in order to ensure aconstant, high EU price. However, thistariff cannot itself be constant because cropoutput depends on many environmentaland economic factors. For example, in ayear with plenty of sun, poor countryfarmers may have a better crop than theprevious year, therefore naturallyincreasing supply. However, in order tomaintain a constant EU price an increasein natural supply simply means thatbecause more goods are available, pricedecreases and the tariff representing thedifference between the world price and EUprice increases.

This variable tariff has multipleeffects. First, it makes the economy of theCairns countries very volatile, whichnegatively affects their financial planningand investments. In addition, the real pricethe country receives for exports during anincreased output season is reduced, as alarger portion of it merely pays the importtariff. Also, with a fixed price for importsthe quantity of exports out of the South andCentral American countries falls.Therefore less quantity is sold at a lowerreal price, reducing revenue.

Decreasing exports leads to adepression of the world price. The resultof decreased exports bought by the EU isan increased supply of agricultural goodswithin Cairns countries. However, thedemand for food is fairly inelastic becausethere is an upper limit on the amount oneperson can consume. Basic economicanalysis explains that as supply increasesand demand remains fairly constant, theprice of goods must decrease in the Cairnscountries. Therefore, the world price of

goods produced is depressed, leaving poorcountries with less revenue from theirproducts.

The depression of world pricesonly worsened once the CAP continued andthe importing position of the EU radicallychanged. During the 1960s post-warperiod, just as the CAP was instated, a rapidgrowth in the EU technology of pesticides,fertilizers, and farm machinery occurred,called the “Green Revolution” (Baldwin &Wyplosz, 2004). This greatly increased thesuccess and productivity of EU farmers.This production growth led to drasticallyincreased domestic supply of agriculturalproducts.

Prior to the Green Revolution, thesupply of EU farm goods at the CAPguaranteed price floor was less than thedemand, meaning the EU imported goodsfrom Cairns countries. However, after theGreen Revolution, and due to increasedproduction capacity, supply of EU farmgood increased, while demand and priceremained constant. Therefore, at the pricefloor, supply was greater than demand andthe EU became an exporter. However,since the CAP price was necessarily higherthan the world price, in order to exportgoods the EU had to sell excess goods atthe world price and pay EU traderssubsidies equal to the world price minusthe CAP price guarantee. This “exportingof goods at a price that is below cost,” iscalled dumping (Baldwin & Wyplosz,2004). Dumping EU goods back into theworld market created a greater supply ofagricultural products in the world market,including poor countries. Therefore,economics dictates that increased supplywith constant or decreased demand resultsin decreased world prices.

The Green Revolution and pricestability of CAP reduced the EU demandfor imports from Cairns Group countriesbecause home production increased.Eventually, as the EU farm industrythrived, it became a net exporter and thesupply of exports onto the world marketincreased. These changes erode both theprice Cairns countries receive for theirexports, as well as the quantity they are ableto export into the EU. World price andexport quantity have been depressed by theCAP, leading to lost profits for pooragricultural economies.

In addition to the economicdepression of poor countries, the CAPinfluences the United States, which alsosubsidizes exports. EU exports under CAPpolicies create excess supply in the worldand depress world price. Therefore, theU.S. then has to pay more in order tosubsidize the increased difference betweenthe lower world price and its exportingthreshold.

Clearly, the CAP has encounteredits share of problems. In the 1980s, theproblems forced new EU members Spainand Portugal to ally with existing members,Greece and Ireland. They advocated theallocation of structural funds to countrieslike themselves that contributed to the EUbudget but did not have suitable farmlandand therefore saw no returns. In addition,in 1990 the Cairns group threatened towalk-out of all trade agreements when theEU refused to liberalize agriculturaltrading. These actions finally resulted inreforms in 1994 in the Uruguay Roundwhich made tariffs fixed as well asmandated that the EU allow 5% ofdomestic demand be fulfilled by imports(Baldwin & Wyplosz, 2004). Thesereforms affected the internationalcommunity by reducing dumping, resultingin a slight increase in world price andtherefore increased revenue for agriculturalcountries.

The CAP intended to stabilizeprices and incomes within the EU farmingsector. It resulted in exactly the oppositein poor agricultural economies. Variabletariffs reduced the amount and price atwhich countries could afford to export,which decreased revenue. This increasedsupply in poor countries, lowered worldprice and further depressed revenue. Asthe EU agricultural sector flourished duringthe Green Revolution, the dumping ofexcess exports into the world economyfurther increased supply. This againdecreased world price and revenue in poorcountries. Overall, the CAP set out toprotect farmers at home, yet in practice itdepressed world price and revenue for pooragricultural countries in the world market.

References:

Baldwin, R., & Wyplosz, C (2004). TheEconomics of European Integration.London: McGraw Hill.

The Common Agricultural Policy


Financial Integration: A RoadTowards Growth or to Increased

Vulnerability and Poverty?by: Madhurima Bhattacharyay

The devastating impact of the 1997 financial crisis on several East Asiancountries raised the important question: should developing nations open their

financial systems to global capital flows?

Madhurima Bhattacharyay ‘06is an Economics Major in theCollege of Arts and Sciences

Over the last decade, manydeveloping countries havebecome increasingly integrated

into global financial markets. Financialintegration usually refers to financialopenness or a country’s linkages tointernational financial markets and isassociated with policies on capitalaccount liberalization (the extent ofgovernment restriction on capital flowsacross the border) and actual capitalflows. It is a process by which separatedfinancial markets become connected,open, and unified so that all the marketplayers have full and free access of theintegrated markets. It can be achievedthrough deregulation, liberalization, andprivatization of the market. Liberalizationof the capital account is a key steptowards openness. This allows the marketplayers, consumers, and investors freeand full access to all markets to acquiredifferent kind of financial products, riskmanagement methods, and investmentand portfolio diversification facilities.

In theory, financial integrationor financial globalization assists in

supplying and allocating capital,fostering economic growth and inreducing macroeconomic volatility, andin increasing standard of living or welfareoverall. It does this by developing (i) aneffective financial sector- throughincreased international portfolio flowsresulting in improved liquidity ofdomestic stock markets and increasedforeign bank participation that facilitatesaccess to international financial markets,introduces new financial products andtechniques and assist in strengthening theregulation and supervision of domesticbanks, (ii) enlarging the supply of savingsthrough foreign direct investment, (iii)lowering the cost of capital through betterallocation of risk, increasing riskmanagement systems through improvedrisk-sharing and (iv) helping to transfermodern technology and skills(managerial know-how) from outside ofthe country as a result of foreign directinvestment in domestic firms.

Financial integration usually isachieved by reducing restrictions oncapital flows and allowing markets to setprices of currencies and securities. Theresultant increase in international capitalflows to developing countries is theresults of both “pull” and “push” factors.Liberalization of capital accounts anddomestic stock markets and privatizationof state-owned banks and firms are the“pull” factors. On the other hand,business cycle conditions andmacroeconomic policy changes indeveloped countries are the “pushfactors”. The benefit of integrationincludes rise in capital flows acrossmarkets and in the long run returns andprices of the traded financial productsconverge in common currency terms.

The devastating impact of the1997 financial crisis on several EastAsian countries and 1994-95 Mexicancrisis raised the important question:should developing nations open theirfinancial systems to global capital flows?To answer this question, one needs toexamine empirical data to assess whetherfinancial integration fosters economicgrowth for developing countries or leadsto increased vulnerability and poverty.

In 1997 and 1998, suddenoutflows of capital from several East

Liberalization of thecapital account is a keystep towards openness.

Economic Trends


Asian countries with open financialmarkets sparked a plunge in theircurrencies, stocks and other assets andseverely damaged some of their financialinstitutions. Economies contracted andthe standards of living of millions ofpeople worsened. Economicdevelopment was set back for years insome areas. The Asian financial crisis hasdemonstrated how financial integrationcould expose developing counties toexternal shock. These shocks reversed thesuccess in poverty reduction in somecountries from openness of the financialmarkets and caused a significant increasein poverty in the short to medium term.

A recent IMF study by Prasadet. al (2003) concludes that countriesneed to build effective financialinstitutions and put in place soundeconomic and regulatory policies beforethey integrate their financial systems andliberalize their capital accounts. Theempirical analysis does not show thatfinancial integration enhanced economicgrowth for developing countries.Countries with pegged exchange rates,poorly supervised financial markets andweak macroeconomic policies will facemore frequent and deeper crises if theylink into global markets without firstmaking radical changes, the study says.Prasad indicates that though it mayappear that better financially integrateddeveloping countries have attained ahigher per capita income than others, asystematic examination of the evidencedoes not appear to show a strong causalrelationship between the degree offinancial integration and output growthperformance. On the contrary, evidencesuggests that the process of capitalaccount liberalization, in some cases,

appears to have been accompanied byincreased vulnerability to crises. As aresponse to the cause behind thisincreased susceptibility, Prasad reasonsthat “Globalization has heightened theserisks since cross-country financiallinkages amplify the effects of variousshocks and transmit them more quicklyacross national borders."

With respect to benefits ofincreasing growth and reducingmacroeconomic volatility, the IMF studyconcludes that "Development of aneffective financial sector and institutionsis a crucial prerequisite for delivering thebenefits or preventing a country’svulnerability to crisis. Developingcountries can benefit significantly fromfinancial integration with the worldeconomy [only if] their economic policesare good. Countries with a peggedexchange rate regime, unsound domesticmacroeconomic policies and poorlysupervised financial markets will facemore frequent crises and deeperdepressions”.

What is the impact of financialintegration on poverty? A separate studyby Agenor (World Bank, 2002 and 2003)says countries become more vulnerableto financial crises and accompanyingincreases in poverty in the early stagesof financial integration. They achieve the

greatest benefits after integration reachesa certain stage. Beyond a certainthreshold, integration brings with it, orinduces governments to implement far-reaching domestic institutional reformsthat improve savings and investment,strengthen the financial system andimprove the social and legalinfrastructure to encourage greater risktaking.

According to Agenor,international financial integration leadsto several benefits such as risk sharingfor consumption smoothing, increasedinvestment through capital flows, andgrowth through greater efficiency andstability of financial systems; however,he acknowledges that there are severalrisks associated with it as well. Theserisks include a high degree ofconcentration of capital flows/lack ofaccess to capital for small countries,inadequate domestic allocation of capitalflows, loss of macro stability; volatilityof capital flows, risks with foreign bankpenetration, and procyclical movementsin short term capital flows. The foreignbanks may cause credit rationing to smalland medium size firms, particularly innontradabale sector, and increasedconcentration of allocation of credit thatmay increase income inequality.

In the case of small open

Countries becomemore vulnerable tofinancial crises anda c c o m p a n y i n gincreases in poverty inthe early stages offinancial integration.

Financial Integration: A Road Towards Growth or to Poverty?


developing countries, the benefits offinancial integration are mostly long termin nature; whereas the risks associatedwith it can be significant in the short term.For instance, poverty at first tends toincrease when financial globalizationrises from low to moderate levels;however, it declines once globalizationincreases beyond a certain point.Therefore, Aegnor concludes that“Globalization may hurt the poor in somecountries not because it went too far butrather because it did not go far enough.Beyond a certain threshold, a greaterdegree of real and financial integrationbrings with it (or induces governmentsto implement) far-reaching domesticinstitutional reforms that improve savingsand investment, strengthen the financialsystem, and improve the social and legalinfrastructure conducive to greater risktaking”.

According to a study byBaldaccci et. al. (2002), the 1994-95Mexican financial crisis gave rise to anincrease in poverty and some cases,income inequality. The incidence ofpoverty as defined poverty head countratio increased by around 6% to reach17% in 1996 from 10.6% in 1994,reversing the reduction in poverty made

between 1992 and 1994. Adequate socialsafety nets for households should be inplace prior to the integration of domesticfinancial markets.

These studies suggest thatsudden financial integration withoutsound economic policies and adequateabsorptive capacity, flexible exchangerate, effective institutions and goodgovernance, particularly well supervisedfinancial markets can increasevulnerability to crises, recession andincreased poverty. On the other hand, ifthe financial sector is well developed andsupervised, a proper exchange rate policyis in place and institutions arestrengthened prior to financial openness,it can minimize the adverse effects ofincreased vulnerability to crisis andmaximize its benefits in terms of growthand welfare. To have a positive impacton poverty through higher economicgrowth and lower instability, countriesshould continue with the process offinancial integration until substantialprogress is achieved and a certainthreshold, with respect to the soundnessof their domestic monetary and fiscalpolicies and the quality of their social andeconomic institutions, has beensurpassed.

References:

Agenor. P. Does Globalization Hurt thePoor? World Bank WP 2922, WB, 24October 2002.

Agenor Pierre-Richard, Benefits andCosts of International FinancialIntegration: Theory and Facts, WorldBank, 25 February 2003.

Baldacci. E., Mello, L. D., Inchauste, G,Financial Crisis, Poverty and IncomeDistribution, IMF Working Paper, WP/02/4, IMF, January 2002

Prasad E., Rogoff K., Wei S.J., and KoseM.A., Effects of Financial Globalizationon Developing Countries: SomeEmpirical Evidence, IMF, 17 March2003.

Economic Trends


The Role of Economics in theOrigins of the Civil War

By: Adam Sasiadek

In contemporary academicdiscussions of the causes of theCivil War, American students will

very likely hear about the role of slavery(and the need to end it), the necessity ofpreserving the Union, and othersociological and political factors. Thoseare undoubtedly valid and importantreasons and are thus appropriate toclassroom discourse on this topic.Unfortunately, however, very little focusis ever given to the role of the economicforces that contributed to the climate thatled to the conflict. Understanding theeconomic underpinnings behind thesedevelopments will allow us, asAmericans, to delve deeper into theorigin and impact of a historical eventthat still greatly interests us and thatremains the focus of much discussionand debate.

Economics played atremendous role in fomenting anatmosphere of deep animosity betweenthe North and South during theantebellum period, and the central

economic issue driving this ongoingdisagreement was the protective tariff.The Constitution had originally prohibitedany form of direct taxation, such as theincome tax, but it did allow for the federalgovernment to generate revenue through“duties, imposts, and excises,” as statedin Article I, Section 8, a provision whichthe Founding Fathers applied through thetariff. Even at that time, however, theideological division that would reach itsdestructive fruition in the Civil War wasalready apparent—that between theHamiltonians and the Jeffersonians.

Alexander Hamilton supportedan economic system of centralized,Federal government intervention (albeitinterventions on a diminutive scale,relative to today’s economic situation),which involved the use of policies suchas the protective tariff, monetary inflationthrough a centralized banking system, aFederal land policy, and corporatesubsidies, policies that were laterchampioned by the Whig Party (the partythat Abraham Lincoln, coincidentally,belonged to). Thomas Jefferson, on theother hand, and those who would continuehis intellectual/political tradition(primarily the Democratic Party), opposedthese initiatives of economic intervention,favoring instead a much smaller role forthe state, a free banking system, and freetrade (or at least revenue tariff as opposed

to the protectionist tariff), all operatingwithin a decentralized economic/politicalframework. It should be remembered,however, as economists Mark Thorntonand Robert Ekelund (2004) point out intheir book, Tariffs, Blockades, andInflation: The Economics of the Civil War,there were some northern free traders andsouthern protectionists, but it can be safelygeneralized that by the 1850s, the Northwas mostly protectionist/Hamiltonian,while the South was pro-free trade andJeffersonian in outlook.

The economic development ofeach region played a role in thesedisagreements over policy, with theindustrialized northern states supportingthe protective tariffs for industries such assteel, and the dominantly agrarian Southdepending upon access to internationalmarkets to sell its cash crops like tobaccoand cotton, and therefore favoring freetrade (DiLorenzo, 2003). Throughoutmost of the 19th century, starting with theClay Tariff of 1824, a protectionist tariffpolicy was in place to some extent, andthis situation clearly benefited the Northat the expense of the South. As economistThomas DiLorenzo has pointed out(2004), “Since Southern farmers soldsome three-fourths of what they producedon world markets, they simply had to eatthe costs of tariffs, and were unable to raisetheir prices to any significant extent in

Adam Sasiadek is a Junior inthe School of Industrial and

Labor Relations


response to the higher tariff rates that madeclothing, farm tools, and machinery, andmany other manufactured items moreexpensive.” The tariffs therefore inflictedeconomic damage not only on consumers,but on exporters as well, who were unableto pass on the costs of the tariff due to thecompetitive pressures of the world market.To view the tax situation another way, theSouth was paying 75% of the nation’sfederal taxes, while most of the federalgovernment’s expenditures were in theNorthern states. This clearly unjustsituation was a major factor in the South’sanimosity toward the North (Adams,2001). The North, meanwhile, becomingever more dependent upon manufacturing,would become ever-more supportive of aprotective tariff and thus be placed ingreater ideological opposition to theSouth.

This economic situation came toa political boiling point by 1860. Theaverage tariff rate during the 1850s hadbeen at a historical low for the 19thcentury, 15%, but then the Morrill Tariffwas passed in March, 1861, shortly beforeAbraham Lincoln entered office, whichraised the average rate to 47%, andexpanded the range of good to which itapplied. It was named after CongressmanJustin Morrill, a steel manufacturer fromVermont, the same person who alsosponsored the Morrill Land-Grant CollegeAct of 1862, and in whose honor Cornell’sMorrill Hall is named (being that Cornellbenefited from the Act). While the Southhad been able to exert its influence againstthe tariff earlier in the century, when SouthCarolina nullified the Tariff of 1828 (the“Tariff of Abominations”), forcingPresident Andrew Jackson to back downfrom his support of the bill and allowingfor the rates to be gradually reduced, it wasunable to do so in 1861, and the MorrillTariff was passed with overwhelmingNorthern support and equally strongSouthern opposition (DiLorenzo, 2003).

Abraham Lincoln, a supporter ofthe tariff, centralized banking, and theother aspects of the Whig economicplatform, was essentially the “politicalheir” of Alexander Hamilton (DiLorenzo,2002), and in his March 4, 1861 inauguraladdress declared that “The power confidedin me will be used to hold, occupy, and

possess the property, and places belongingto the government, and to collect the dutiesand imposts; but beyond what may benecessary for these objects, there will beno invasion – no using force against, oramong the people anywhere” (DiLorenzo,2002). He was not going to back downon the tariff issue the way Jackson did—either the duties would be collected, orthere would be an “invasion”—war. TheSouth had long felt cheated by the tariffsystem, and wanted only furtherreductions in the rates. For theRepublicans to triple the average taxationrate for Southerners through the MorrillTariff and to then vigorously enforce thenew law without compromise gave theSouth few options for a just remedy (or atleast that is how they probably perceivedthe situation). As DiLorenzo notes,“Several Southern states had alreadyseceded, including South Carolina, thatpast December, when it was apparent thatthe tariff would probably pass the Senateand would be enforced by Lincoln, thecareer-long protectionist. Again, this isnot to say that the tariff was the sole causeof the war, but it was certainly relevant(2002). The South soon acted upon oneof those options. On April 12, 1861, thetariff collection center of CharlestonHarbor, Fort Sumter, was attacked by theConfederates. Indeed, economicconsiderations, particularly the tariff,played an important role in dividing theNorth and the South and in the events thatlead to the South’s secession.

The Civil War took the lives of600,000 American men (the equivalent fortoday’s population would be five million)and had a tremendous impact on thepolitical and social course that our nationwould take, its repercussions lasting to thisday. Understanding the economic causesbehind this event will give us a morecomplete historical picture of how andwhy it was fought at all. Economicanalysis is vitally important in ourinterpretation and understanding ofpolitical events, yet its power is oftenignored or given little emphasis,unfortunately. Hopefully this article willallow its readers to keep this in mind, sothat they will always remember to examinethe economic aspect behind historical andcontemporary political issues.

References

Adams, C. (2001). For Good and Evil:The Impact of Taxes on the Course ofCivilization. Lanham: Madison Books.

Denson, J. (1998). The Costs of War:America’s Pyrrhic Victories. NewBrunswick: Transaction Publishers.

DiLorenzo, Thomas J. (2002). RewritingEconomic History. Retrieved March 12,2005, from the World Wide Web: http://www.lewrockwell .com/dilorenzo/dilorenzo17.html

DiLorenzo, Thomas J. (2002). Lincoln’sTariff War. Retrieved March 12, 2005,from the World Wide Web: http://w w w . m i s e s . o r g /fullstory.aspx?control=952&fs=lincoln%27s%2btariff%2bwar

DiLorenzo, Thomas J. (2002). When YouKnow You’re Doing Something Right.Retrieved March 12, 2005 from the WorldWide Web: http://www.lewrockwell.com/dilorenzo/dilorenzo19.html

DiLorenzo, Thomas J. (2003). Gods,Generals, and Tariffs. Retrieved March12, 2005, from the World Wide Web: http:// w w w . m i s e s . o r g /fullstory.aspx?control=1168

DiLorenzo, Thomas J. (2003). The BuyAmerican Myth. Retrieved March 12,2005, from the World Wide Web: http://www.lewrockwell .com/dilorenzo/dilorenzo43.html

DiLorenzo, Thomas J. (2004). TheUnconstitutional Tax on AmericanExports. Retrieved March 12, 2005 fromthe World Wide Web: http://www.lewrockwell .com/dilorenzo/dilorenzo58.html

DiLorenzo, Thomas J. (2004). BookReview: Tariffs, Blockades, and Inflation:The Economics of the Civil War. Journalof Libertarian Studies, 18(4), 95-101.

Thornton, M. & Ekelund, Robert (2004).Tariffs, Blockades, and Inflation: TheEconomics of the Civil War. Wilmington:Scholarly Resources.

Economic Trends


Economic Interstate Conflict:The World Trade Organization and

Dispute Settlement –Evaluating Schools of Thought

Neelu Toor ’06 is aGovernment Major in the


By: Neelu Toor

Carl von Clausewitz, therenowned theorist of war, wrotethat war is politics conducted by

other means; today, the same could besaid for law (Esserman & Howse, 2003).Disputes that previously were settled bynegotiation or force of arms are nowtaken to international courts, tribunals,and arbitral panels - legal briefs areproliferating to replace diplomatic notes(Esserman & Howse, 2003). Since1995, trade disputes, in particular, haveexploded in number, compared to thepre-World Trade Organization era underthe General Agreement on Tariffs andTrade (GATT). Under the 48 years ofthe GATT, there were 101 disputesbrought to trial; contrastingly, in the 10years of the WTO, 328 disputes havebeen brought to the WTO’s DisputeSettlement Board (DSB) (WTO, 2005).

Scholars and internationalpolitical economy experts have offereda variety of explanations for why tradedisputes have continued and evenincreased despite the World Trade

Organization’s best efforts to deter andresolve them. The literature on exactlywhy disputes increase and continue isunderdeveloped and limited, but there isinformation available on why countrieschoose to violate agreed upon rules, andwhat causes trade disputes to arise. Byexamining this literature it is possible toextrapolate the causes of trade disputesto address the question of why thedisputes have continued and evenincreased.

Changes in the International Economy:Globalization School of Thought

Since the advent of the WTO in 1995, vastchanges in the international tradingregime have occurred as the world hasglobalized: international financialinstitutions play an increasingly importantrole in interstate relations, the demand forservices and products from around theworld have gone up, and new bordershave opened. With globalization, thejurisdiction of the WTO has expanded tocover sectors that were not included inthe GATT. In addition, global trade hasincreased, and new markets anddeveloping countries have liberalized andgrown. At first glance, scholars oftenoffer up these three changes asexplanations for why trade disputes haveincreased.

Expansion of WTO Jurisdiction

Before the WTO, the GATT was seen asthe main authority governinginternational trade laws and relations.From 1947 to 1995, there were 101disputes brought to the GATT forresolution, averaging approximately twodisputes per year and including onlydeveloped countries (WTO, 2005). TheWTO has recently witnessed a majorjump in disputes: between 1995 and 2005,there have been 328 disputes brought tothe DSB, averaging 32.8 disputes per year(WTO, 2005).

To explain this dramaticincrease in disputes, scholars first pointto the fact that the governance of theWTO has expanded to areas not coveredby the GATT, such as agricultural policiesand intellectual property rights (WTO,2005). Others claim that the expandedrules that arose during the creation of theWTO have led to the increase in disputesbecause the rules are now stricter (Yin &Doowon, 2001).

However, with the expansion ofauthority over certain sectors, the WTOalso expanded its ability to deterviolations of rules. The DisputeSettlement Procedure (DSP) granted theWTO the ability to allow nations to seekcompensation and retaliation if they ruled


that agreements were violated. Therefore,one would assume that despite theincrease over areas that could be ruled,the number of disputes would decrease,or that it would at lease offset the numberof disputes because of the deterrence fromthe system. Yet, this has not been the case.Empirically, the number of disputes hasincreased, countries continue to chooseto violate rules, and other countriescontinue to question and demand justicewhen those violations aredeemed to have occurred.

Increase in Global Trade

Certain scholars point to thegrowing levels of internationalcommerce as the basis for therise in trade disputes (Stein,2001). Therefore, they claim that theincreasing number of disputes is simplythe result of expanding world trade (Yin& Doowon, 2001). This makes senseinsofar as trade disputes presuppose trade;that is, trade disputes do not arise betweennations that do not trade with one another(Yin & Doowon, 2001). For the purposesof this analysis, the trade that is of concernis that between members of the WTO whohave the ability to bring conflicts to theDSB. Therefore, in order for this sub-school of thought to be accurate, tradewould have to first increase amongmember nations for trade disputes to alsoincrease.

However, when examining theten-year history of the WTO, peculiaritiesarise regarding the proportion of trade andthe number of disputes. Although totaldisputes have increased since 1995, thefirst five years of the WTO saw moredisputes taken to arbitration than the lastfive years (Yin & Doowon, 2001). Eventhough trade has increased, within thefirst five years of the WTO, when 180 ofthe 328 disputes were brought to the DSB,the major complainants and defendantswere developed countries, nations thathad already actively been engaged inworld trade and in various sectors forsome time (Yin & Doowon, 2001). It isin the last five years that new membershave been admitted to the WTO, and sincethen, the number of disputes has not beenas high (Yin & Doowon, 2001).

Thus, the critical implication isthat trade disputes presuppose trade, andif the argument is that increases in tradecause increases in disputes, then based onmembership, the last five years shouldhave seen more disputes than between1995-2000, which, empirically, is not thecase (Stein, 2001). Also, it might seemself-evident that the more trade a countryconducts, the more conflicts and frictionit is likely to encounter, but there are

exceptions. For example, India was the22nd largest county in terms of tradevolume, but it was ranked the 4th largestcountry in terms of the number of disputesin which it was involved (Yin & Doowon,2001).

Emerging Markets and DevelopingCountries’ Involvement

As aforementioned, trade disputes do notarise between countries that do not trade,and despite the fact that the overallnumber of disputes have decreasedslightly since new members have joinedthe WTO, the number of disputes broughtforth by developing countries withemerging markets has actually increased(WTO, 2005).

Developing markets arebecoming key players in the worldeconomy as their trade activity hasincreased (Stein, 2001). Increased tradeactivity has led to simultaneous increasesin trade disputes. Under the old GATTsystem, most of the complaints weredirected at developed countries, whilemany developing countries enjoyeddifferential treatment (Yin & Doowon,2001). Under the WTO, however,developing countries have beenincreasingly involved in more tradedisputes as competition has intensified inthe global market and as the developingcountries have begun to lose their tradeprivileges (Yin & Doowon, 2001).

This year alone, the threedisputes brought forth have been fromdeveloping countries – Mexico, Chile andPakistan (WTO, 2005). Under the WTO,about half of all disputes includedeveloping countries as either thecomplaining party or respondent,compared to only one quarter beinginvolved under the GATT (WTO, 2005).Previously, smaller countries may haveworried that the support/benefit of

maintaining an amicablerelationship with a powerfulcountry would be compromisedby litigating against them. As aresult, developing nations wereless likely to make use of theDSP, but since the beginning ofthe Doha round of trade talks,developing countries have

started taking a stand for themselves(Chang, 2002). Instead of making theusual concessions to developed nationslike the United States and the EuropeanUnion, developing countries have beenrefusing to accept trade barriers and havebeen demanding changes be made to tradeimbalances.

Therefore, even though disputeshave declined since 2000, the number ofdisputes concerning developing countrieshas risen, and this is commonly given asan explanation for the increase and forthe continued rates of trade disputes.While this explanation is adequate forexplaining the trend in the last five years,it still does not describe why levels havebeen so high over the last ten years. Evenwithin the last five years, this sub-schoolonly accounts for half of the tradedisputes. Moreover, as much asdeveloping countries might increasinglybe the defendants in trials, many countriesstill lack the resources and capacity tobring trade conflicts against developedcountries to the DSB.

Conflicting Norms and Conflicts ofLaw: Trade Barriers School of Thought

As history has shown, trade relationshipsembody and generate conflict. Initially,political conflicts over trade emergedwhen countries had to renegotiate tariffreduction agreements and other barriersto trade (Stein, 2001). Since the GATT,

Developing markets are becomingkey players in the world economyas their trade activity has increased

Economic Policy


many tariff barriers have been lowered,and under the WTO, non-tariff barriers(NTB) have proliferated.

Conflicts emerge over issuessuch as standards barriers, subsidies,intellectual property rights violations,dumping, discriminatory domestic taxes,government procurement, and measuresrelated to investment (Yin & Doowon,2001). The conflicts over the array ofincongruent domestic practices, whichresult in trade disputes, can be dividedinto two categories: trade barriers causedby influences from national sectors(certain industries and lobbyists) andtrade barriers that arise from nationalideals and principles (attitudes towardscertain products) (Yin & Doowon, 2001).

NTB and other modes ofunwillingness to adhere to WTO rulespose barriers for trade since they preventother countries from exporting and alsolimit imports (Yin & Doowon, 2001).These barriers to trade are a result ofconflicting norms and the desire to protectdomestic industries and interests.According to this school of thought, thepolitical inability to comply is basicallythe prime reason why states do notcomply with rules they initially agreed to(Esserman & Howse, 2003). Therefore,nations choose to violate rules and seekretribution for those violations due toconflicts between legal systems and slowinternalization of the relevantinternational norms (Esserman & Howse,2003).

Sectoral Influences

Countries want to protect their domesticinterests, and leaders of countries wantto appease their constituents. As a result,the roles of certain powerful domesticsectors with self-interested economicmotives influence a country’sinternational trade policy. These interestsare reflected both in the violation ofagreed-upon rules and the desire ofcountries to take certain issues tolitigation.

Countries are influenced in avariety of ways by representatives ofvarious sectors, but the size and theimportance of an industry to a certain

demographic of the population forms thegroup of representatives. The EuropeanUnion and the United States are arguablythe WTO Members who are mostinfluenced by domestic NGOs, lobbying,civil society and public opinion throughchannels like television, the internet anddemocratic politics (Esserman & Howse,2003). In terms of traditional powerpolitics, these groups are, in a sense, thenegotiating "weaknesses" of these twopowerful players (Esserman & Howse,2003). It is these sectoral influences thatsometimes force states to engage inactivities that will most undoubtedlyprovoke retribution or incite states topursue retribution against another state.

The content of clashes oversectoral interests often concerns conflictsof national laws. Each country has itsown tax code, and some provisions ofthose tax codes tend to favor certainindustries or certain companies thatengage in international trade. Low-interest loans, government guarantees,export assistance, tax credits or specialtax treatment for engaging in certainexport activities are prevalent in certaincountries. Such actions tend to provokeconflicts (Yin & Doowon, 2001).

Most trade conflicts occur incommodities where regulation supportprograms and quality and health standardsare significant aspects of the marketstructure (Yin & Doowon, 2001). Thepersistence of national subsidies alsocomprises a large portion of tradedisputes; in fact, ongoing disputes oversubsidies that violate existing WTO ruleshave led to the largest amount ofauthorized retaliation in WTO history(Bagwell & Staiger, 2004). The specificindustries that have the greatest influenceon pressuring their governments to violaterules or go after other countries forviolating rules are agriculture, electronics,steel and businesses dealing withintellectual property rights (Bagwell &Staiger, 2004).

This sub-school does a good jobof explaining why a country may chooseto violate WTO rules despite thedisincentives. An actual study of casesbrought to trial also supports the claims

that certain domestic rules are the causeof conflict and that it is the conflict overnational laws that cause trade barriers,which in turn result in trade disputes.Nevertheless, the desire to protectdomestic industries is not a new one ininternational trade; indeed, manycountries have a legacy of protectionism.Therefore, this is not a unique explanationof why trade disputes have increased inthe post-GATT era. Of course, it is truethat the GATT did not have jurisdictionover agriculture and intellectual propertyrights over which the WTO does. Despitethis, the majority of trade disputes, whenexamined by issue, have been over anti-dumping measures that cover a greatervariety of industries than thosetraditionally protected by sectoralinfluences (WTO, 2005).

National Ideals

As with sectoral influences, which arebased on clear-cut economic interests,national ideals and principles alsoinfluence a country’s international tradepolicies but are instead based on sharednational norms and mores. Health, laborand environmental policy concerns, incombination with perceptions of what thelaw is or should be, play an important rolein creating the type of political pressurethat constrains a country’s policy choices(Esserman & Howse, 2003).

There are a growing number oftrade disputes over product standards(Strum, 2001). When importing itemsfrom certain nations, human rights issuesare a concern; when accepting certainplants or animals into a country,regulations are a consideration; and whentrading drugs, health standards arequestioned. Every country has its ownsets of norms and beliefs, and these arereflected in their trade policies, both inthe items they are willing to export andimport. When a country refuses to acceptan item, trade disputes often arise.

In most cases, the disputedpolicy regulates a product, theconsumption of which causes localdamages and infringes upon nationalnorms of what are acceptable products.For example, consider the case ofhormones: both political and societal

Economic Interstate Conflict: The WTO and Dispute Settlement


pressure within the European Union toretain some form of ban on meat producedwith growth hormones seem to stem, atleast partly, from the European Union’sideological opposition to the trade item(Strum, 2001).

These trade disputes overnational product standards are a growingsource of tension in the internationaltrading system and are cited as one of themain reasons for the increase in thenumber of disputes (Strum, 2001). Whathappens in certain cases is that a countryintroduces a new product standard for allsales of a good in its local market, whichis justified as necessary for consumer orenvironmental protection. Importers intothe local market, however, challenge thestandard as a “disguised barrier to trade”or “green protectionism” (Strum, 2001).

As with the “sectoralinfluences” sub-school of thought, thisone also explains the reason behind tradedisputes as a result of countries’ violatingWTO rules or seeking retribution becauseof domestic influences. The politicalinability to comply is the primary reasonwhy states do not comply with rules theyinitially agreed to. Also, the sources of

the disputes are conflicts over norms andlaws, which result in barriers to trade.While the authors suggest that thesenational ideals influence policy, they citeonly anecdotal evidence that politiciansmake decisions based on principles. Theproduct standards that they choose mayindirectly influence the terms of trade andserve political interests, but there is noconcrete evidence in support of this(Strum, 2001). Even if certain cases arecategorized as possibly arising becauseof barriers stemming from national idealsand principles, the number of suchdisputes is limited (WTO, 2005).Therefore, in the absence of more

empirical evidence, this sub-schoolcannot adequately be relied upon toexplain the increase in trade disputes.

Why Have Trade Disputes Increased?

On the whole, these schools of thoughtseem implausible as adequately beingable to explain the increase in tradedisputes. However, two schools stand outas being interrelated and important inanalyzing the cause of and increase intrade disputes: the emergence of newmarkets and conflicting norms and laws.

As mentioned, the conflicts overnorms and laws are not new barriers totrade. The difference now compared tobefore is that there were fewer mainplayers in the pre-WTO internationaltrading world. However, within the lastten years, emerging markets anddeveloping countries are starting to playa greater role in international trade. Theyare starting to retaliate, and the older andmore powerful players, like the UnitedStates and the European Union, are facingthe consequences. Therefore, despite thefact that within the last five years tradedisputes have fallen slightly overall,developing nations are becoming more

active in bringingconflicts forward.Even though trade isincreasing andborders are opening,certain countries areclinging to their oldtrading norms in theinterest of domesticpolitics, and as a

result, are facing conflicts of law as thebarriers to trade are no longer being leftunquestioned.

Therefore, the increase in tradedisputes may be partially explained by theincrease in developing markets having thecapacity and initiative to respond toviolations against them, and partially bythe persistence of trade barriersattributable to conflicting cross-bordernorms and laws. A closer look at therecent WTO ruling on the Brazil cottoncase could show exactly how adeveloping market had the capacity to winagainst the US over a prominent tradebarrier. Thus, while this paper presents a

review of current ideas about the causeof trade disputes, further research mayhelp shed new light on the mechanismsthat are at work.

References:

Bagwell, K., & Staiger, R.W. (2004).Subsidy Agreements. NBER WorkingPaper No. W10292. Retrieved March 15,2005, from http://ssrn.com/abstract=499317

Chang, P.L. (2002). The Evolution andUtilization of the GATT/WTO DisputeSettlement Mechanism. Retrieved March15, 2005, from University of Michigan,Working Papers Web site: http://www.fordschool .umich.edu/ rs ie /workingpapers/Papers451-475/r475.pdf

Esserman, S., & Howse, R. (2003).Global Law, Global Politics. ForeignAffairs.

Stein, A.A. (2001). Trade and Conflict:Uncertainty, Strategic Signaling, andInterstate Disputes. Retrieved March 15,2005, from UCLA Web site: http://psweb.sbs.ohio-state.edu/faculty/bpollins/book/stein.pdf

Strum, D. (2001). Product Standards,Trade Disputes and Protectionism.London, England: London School ofEconomics and Political Science, Centerfor Economic Performance.

Yin, J.Z., & Lee, D. (2001). Explosion ofTrade Disputes?. Retrieved March 15,2005, from http://pirate.shu.edu/~ y i n j a s o n / p a p e r s /Ch%2014%20Trade%20Dispute%20Wars%20(Final%20US).pdf

World Trade Organization. (2005).Dispute Settlement. Retrieved March 15,2005, from http://www.wto.org/english/tratop_e/dispu_e/dispu_e.htm#disputes

...trade disputes over nationalproduct standards are a growingsource of tension in theinternational trading system

Economic Policy


Privatization of SocialSecurity

By: Jerry Shih

Jerry Shih ‘08 is anEconomics and Mathematics

Major in the Internal TransferDivision

Privatization of Social Security hasbeen a heated topic of discussionin America. With the impending

retirement of the so-called Baby Boomergeneration (born between the mid-1940sand the mid-1960s) in 2008, the publichas begun to worry about the ability ofthe current Social Security system tosustain such a great demand of retirementbenefits. Despite a positive balance in theSocial Security Trust Fund, by 2015Social Security will be paying more inbenefits than it collects in taxes, and by2039 the Trust Fund will be depleted(Figure 1-1, Board of Trustees, 2000).

The aims of this article are (1)to examine the problems within thecurrent Social Security system, (2) toanalyze the claims by the proponents ofa Social Security under privatization, andfinally (3) to determine whetherprivatization will solve the imminentfiscal imbalance.

We first examine the basicstructure and components of the current

Social Security system. The SocialSecurity program was created in 1935 inresponse to the Great Depression. Itsmain purpose was to ensure a securesource of income for the elderly who hadbeen impoverished by the depression.Several modifications were subsequentlymade to the program. In 1939, SocialSecurity included survivor benefits to thespouses and children of covered workers.In 1956, it provided disability insurance

to disadvantaged workers under thesystem. Therefore, the Social Securityprogram is also known as OASDI (Old,Age, Survivor, and Disability Insurance).

The extension of coverage tothose over age sixty-five in 1939established the system in a PAYGO (Pay-As-You-GO) framework, where retireeslive on the income of current workers.Instead of an accumulated fund,


payments for each generation of retireesare made by the current generation ofworkers. The PAYGO element in thesystem not only enables risks to be sharedacross different generations, but alsotransfers income among individuals,leading to the enactment of SupplementalSecurity Income in 1972. SSI provides anationwide minimum income guaranteefor the aged, blind, and disabled. Suchdistributive features of Social Securityraised much controversy, which we willdiscuss in a later part of the article.

The system is financed by thepayroll tax. As benefits have grown, sohave payroll tax rates (Office of the ChiefActuary, Social Security Administration).The Social Security Amendment in 1983arranged surpluses from Social Securityto be accumulated in Social SecurityTrust Fund. Any surplus—resulting frompayroll tax revenue exceeding paymentsto beneficiaries—is transferred to theSocial Security Trust Fund and isstatutorily required to be invested inTreasury securities.

The main problems faced by thecurrent Social Security system are thelong-term fiscal stresses on it. Projectionsof Social Security finances under currentrules suggest that the system will bepaying out more benefits than collectingcontributions by 2012, and will enterfinancial insolvency by the year 2012(Table IV.B1, 2001 OASDI Trustees’

Report).

If tax rates and benefit structureremain constant, Social Security will beunable to pay promised benefits.Different options have been suggested tosolve the imminent fiscal imbalance. Areduction in benefits and an increase incontribution will solve the problem in theshort-term. One proposal is to reduce thebenefits by indexing the NormalRetirement Age (NRA), the age at whichan individual qualifies for full SocialSecurity retirement benefits, to lifeexpectancy. With the advance of medicaltreatments, life expectancy has increaseddramatically; and an increase in lifeexpectancy raises the cost of SocialSecurity. The government can solve thefiscal imbalance in a short run by raisingthe NRA. The NRA is 66 for individualsborn between 1944 and 1954. It thenincreases by two months per year,reaching 67 for workers born in 1960sor later. Yet, the legislation did not changethe minimum age of 62 for claimingretired worker benefits. Thus, changes inthe NRA in turn change the bases usedto calculate the retirement benefits indifferent benefit formulas for people whodelay their retirement (after the NRA) andfor people who retire early (before theNRA). There will be a permanentreduction in the benefits for peopleretiring at 62- the benefit they receive willbe 70% of the Primary Insurance Amountinstead of 80% (Diamond, 1996).

However, as suggested by Altigand Gokhale, such a policy will likelyface several obstacles. A significantbenefit cut will alleviate the situationtemporarily at the cost of people in ornear their retirement. People approachingtheir retirement expect a major part oftheir income after retirement comingfrom Social Security benefit. With a cutin their benefit, their living standards willbe jeopardized (Altig, 1997).

Privatization brings light tosuch a time of turbulences. Two mainarguments made by the proponents ofprivatization are that a privatized SocialSecurity will increase national saving,and by investing the Trust Fund in private

If tax rates and benefitstructure remain constant,Social Security will beunable to pay promisedbenefits.

Economic Policy


equities, the higher rate of return mightalleviate the fiscal pressure on the system.

As stated earlier, the expansionof PAYGO enables risks to be sharedacross generations and transfers incomeamong individuals. Retirees who live onSocial Security do not receive theirincome from their contribution to thesystem. Instead, they are supported by theincome of current working generation.Thus, the current working force is notpaying for their benefits in the future butfor others in retirement. It is known as adefined-benefit system where you workfor a certain amount of time and devoteyour labor to the economy, and youobtain pensions when you retire.Furthermore, the system also distributesincome within set age groups, fromhigher earnings to lower earnings. Thehigher the individual’s income, thesmaller the individual’s gain from SocialSecurity (Table 9.3, Rosen, 199).

Such intergenerational andintra-generational resource transfer isconsidered a major cause of the declinein the United States’ national savings,because it discourages the currentworking class’s incentive to save(Gokhale, 1996).

Privatizing Social Security willchange the system from defined-benefitto defined-contribution, where youcontribute your earnings to an actual

account—Personal RetirementAccount—from which you will obtainyour income during retirement. Defined-contribution will increase people’sincentive to save because how much yousave determines how much you will getafter you retire. Saving accounts such asthe IRA and the Roth IRA in the UnitedStates are set up similarly in order toencourage people’s incentive to save.

Moreover, privatization willincrease people’s incentive to work. Thecloser the link between contribution andbenefits, the smaller the labor-supplydistortion and the efficiency losses(Diamond, 1977; Kotlikoff, 1995).Privatization can increase these linkagesby different means, such as removing theadjustment of the NRA (Mitchell, 1996).

However, privatization does notguarantee higher national saving, andmight even discourage people’s incentiveto save. Whether national savingincreases depends on the income andsubstitution effect. Privatizationincreases the reward on saving, therebymaking saving more attractive to people.However, privatization also creates anincome effect, where one needs to saveless to achieve any level of futureconsumption (Mariger, 1997). Which isthe stronger effect depends on individualpreferences. The result is thusambiguous.

Another argument made by theproponents of privatization is that byinvesting the Trust Fund in equitymarkets, the government will receive ahigher return and thereby solve theimpending fiscal imbalance. Instead ofpurchasing Treasury securities, funds inthe Trust Fund will be used to purchaseprivate assets. The returns obtained fromprivate assets will be paid out as benefits.Historically, the return on stocks exceedsthe return on Treasury bonds (Miron,2001). Thus, it appears that investing inprivate assets will improve the TrustFund’s solvency without anyunnecessary reforms such as raisingpayroll taxes or extending the NRA. Ifthe government can successfully exploitthe disparity in the rates of returnbetween Treasury bonds and equitymarkets, insolvency should supposedlybe eliminated.

Yet, it has to be noted that ahigher return from private assets comeswith a higher risk. It is possible thatstocks, instead of increasing returns, willput individuals into financial risk.Furthermore, privatization willencourage individuals to borrow to investin equities, thereby increasing thedemand of assets. With an ambiguousresult in the amount of national saving,such an increase in asset demand merely“reshuffles” the claims to capital incomewithout increasing the funds forretirement consumption (Mariger, 1997).Thus, it does not solve the fiscal problemthat Social Security faces.

In addition, there are also somedownfalls to a privatized Social Security.The current Social Security forces peopleto save. Without a Social Security run bythe government, saving might decline.People might not save enough to supporttheir retirement consumption needs.

Furthermore, administrativecosts of the current Social Securitysystem are only one-fourth of those undera private pension system (Reid, 1995).Transition from the current SocialSecurity to a privatized one necessitatesadditional costs, increasing the national

Privitization of Social Security


debt. If the system is privatized, oldergenerations still need to be included inthe current Social Security while youngergenerations are under a privatized SocialSecurity. There will be a gap betweenbenefits payouts and revenues collected,which will probably be closed by creatingadditional public debt. Thus, there willbe a sizable increase in fiscal deficits tofinance benefits payments to oldergenerations (Kotlikoff, 1996).

More importantly, SocialSecurity is not just a retirement system.It is also a social insurance for individualswho experience unexpected trauma.Incorporating disable individuals inSocial Security enables them to receivefull benefits until their retirement age, atwhich point they become covered by theretirement plan. Privatizing SocialSecurity eliminates such benefits for thedisabled and thereby makes them worseoff. Furthermore, Social Securitydrastically reduces the poverty rateamong the elderly. Compared to theoverall poverty rate of 12 percent in theUnited States, the poverty rate for theelderly is 10 percent. Without SocialSecurity, the poverty rate for the elderlywould be about 50 percent (Apfel, 1998).Thus, Social Security plays a crucial rolein reducing poverty among the elderly.

Unfortunately, the privatizationof Social Security is not as ideal as itsproponents claim to be. Whether it willincrease national saving depends on theincome and substitution effect’s impacton individual saving behavior, whichvaries due to different individualpreferences. In addition, because of theambiguous outcome in national savings,it is difficult to determine whether therewill be a higher return from investing inprivate assets. Instead of exposingretirement incomes to risks in stocks, thegovernment could achieve the sameresult in a safer way- raising payroll taxesor cutting benefits. In addition,privatizing Social Security will eliminatethe redistributive property and willthereby increase the poverty rate amongthe elderly and deprive the disabled of asignificant source of support.

The future of Social Security

will depend on what the governmentexpects the system to achieve. However,there is a need for a change in the currentSocial Security system. Privatization maynot fulfill its promises, but it offers anopportunity to fix a system that isinequitable between generations and isfilled with economic distortions. Thetransition to a privatized Social Securitymay not be as “painless” as its proponentsclaim, but it is a necessary step to take toremove today’s dysfunctional SocialSecurity system.

References:

Altig, David., & Gokhale, Jagadeesh(1997). “Social Security Privatization: ASimple Proposal,” EconomicCommentary Federal Reserve Bank ofCleveland, January 1996.

Apfel, Kenneth S. “Income of the AgedChartbook,” Social SecurityAdministration, Office of Research,Evaluation, and Statistics. (May, 1998)

Diamond, Peter A., “Proposals toRestructure Social Security,” The Journalof Economic Perspectives, Vol. 10, No.3 (Summer, 1996), 67-88.

Diamond, Peter. “A Framework forSocial Security Analysis,” Journal ofPublic Economics, December 1977, 8(3),p 275-98.

Gokhale, Jagadeesh, Laurence J.Kotlikoff, and John Sabelhaus,“Understanding the Postwar Decline inU.S. Saving: A Cohort Analysis,”Brookings Papers on Economic Activity,1:1996.

Kotlikoff, Laurence J., “Simulating thePrivatization of Social Security inGeneral Equilibrium,” NBER workingpaper 5576, September 1996.

Kotlikoff, Laurence J., “Privatization ofSocial Security: How it Works and Whyit Matters,” NBER working paper 5330,October.

Mitchell, Olivia S., & Stephen P. Zeldes(1996), “Social Security Privatization: AStructure for Analysis,” NBER workingpaper 5512, March.

Mariger, Randall P. “Social SecurityPrivatization: What It Can and CannotAccomplish,” Board of Governors of theFederal Reserve, Washington, 1997.

Miron, Jeffrey A. & Murphy, Kevin M.“The False Promise of Social SecurityPrivatization”, Wellesley, MA: BastiatInstitute, May, 2001.

Reid, Gary and Mitchell, Olivia S.“Social Security Administration in LatinAmerica and the Caribbean,” World BankReport 14066, Washington, DC, March1995.

Rosen, Harvey S. “Public Finance,” TheMcGraw-Hill Companies, Inc., NewYork, NY, 2002.

The Board of Trustees, Federal Old Ageand Survivors Insurance and DisabilityInsurance Trust Funds, the 2000 AnnualReport, U.S. Government PrintingOffice, Washington, 2000.

The Board of Trustees, Federal Old Ageand Survivors Insurance and DisabilityInsurance Trust Funds, the 2001 AnnualReport, U.S. Government PrintingOffice, Washington, 2001.

Economic Policy


By: Ali John Ghassabeh

Ali John Ghassabeh ‘05 is anEconomics Major in the College

of Arts and Sciences

The controversy over capitalpunishment has been debated formany years, and continues to be

a hot button political issue around theworld today. Most arguments over itrevolve around morality and justice.Many industrialized nations today, theUnited States being the most notableexception, have banned the death penaltybecause they describe the punishment asbarbaric, cruel, or inhumane. Even in theU.S. only a handful of states use capitalpunishment. Although it is customary touse terms like justice, vengeance, andmorality, the economic debate overcapital punishment hinges on deterrence.

Much of the early so-calledeconomic work on crime was simple,crude, and contained flawedgeneralizations. In 1968, Gary S. Beckerapplied basic microeconomic principles,specifically the Subjective ExpectedUtility model to crime, marking thebeginning of comprehensive economicstudy in the field of crime (Cameron,2002). His studies stated that

imprisonment for crimes not only punish,but also prevent crime through the threatof punishment. Isaac Ehrlich’s “TheDeterrent Effect of Capital Punishment:A Question of Life and Death”introduced the idea of a possible deterrenteffect of capital punishment. The U.S.Supreme Court referred to this articlewhen it decided to re-institute capitalpunishment in 1976 (Cameron, 1993).Although the conclusions of his 1975article have been criticized often,Ehrlich’s model has yet to beconclusively disproved. Most othereconomists that work in the field ofcrime, including Dale Cloninger andStephen Layson, have come to similarconclusions using totally separate andslight variations of Ehrlich’smethodologies in approaching a possibledeterrent effect of law enforcement andcapital punishment (Cameron, 2002).

The deterrent effect of capitalpunishment is its ability to preventwould-be murders by executing somecriminals convicted of capital crimes.Most economists that believe in thistradeoff agree that capital punishment isjustified only because of its ability todeter. Capital punishment cases usuallyhave higher costs with increased lawyerfees and a longer appeals process. Therest of society often pays for these fees.

There is also an incredibly high amountof disutility to society and an individualif an innocent person is mistakenlyexecuted. None of this would beeconomically reasonable if not fordeterrence.

Crime and Society

One of the basic assumptions of mosteconomic models is that of the rationalconsumer. Some criminals may havederanged, illogical minds that cannotcomprehend their actions or the possiblepunishments that may result. Theseirrational criminals are largely ignored inthe economic approach to crime. Thefollowing economic approaches assumethat most criminals are rational, self-interested human beings. Every analysisassumes that potential criminals canrespond to (dis)incentives to commitcrime, and so, crime can in some waysbe deterred. A criminal’s choice tocommit crime is simple utility-maximization.

A person can choose betweendoing legal activities and committingcrimes. This choice is influenced by thebenefits and costs of performing thecrime. The benefits are clear-cut; it is theutility gained from the crime. The costsof the crime depend on a number of

Capital Punishment as aDeterrent to Murder


issues. First, the probabilities of beingarrested, convicted, punished, andexecuted must be taken into account. Theopportunity cost of the crime, especiallythe substitute of legal activities also isconsidered. Hence, people with highopportunity costs to crime, such as a high-paying job, would be less likely tocommit a crime than those with smalleropportunity costs to crime. Then, if weassume people have similar tastes,everyone technically is a potentialcriminal. Those that perform crimes havedifferent benefits and costs (Cameron,1994).

Crime can be simply defined asany act that violates the law, which ispunishable by the state. A crime almostalways provides a disutility to society asa whole. In turn, society responds to thisexternality by paying for lawenforcement, courts, and a prison system.The society is trying to minimize its costsby reducing crimes through this system,and arguably gaining some sort of utilitywith the acknowledgement that criminalsare being punished.

We can assume that the deathpenalty is a worse punishment than lifeimprisonment for any rational prisoner.The main evidence proving this is thatindividuals sentenced to death havealmost always tried to get the sentencecommuted to life imprisonment.However, there have been practically noinstances of someone receiving lifeimprisonment and then attempting to getthe sentence changed to death (Ehrlich,1975). This leads to the conclusion thatthe death penalty is the worst punishmentpossible in the United States.

Ehrlich and Capital Punishment

Isaac Ehrlich wrote the mostrevolutionary and influential work on thedeterrent effect of capital punishment.Becker’s supply of crime model showedthat increasing police force, higherconviction rates, and harsher prisonsentences could deter crime. Byincreasing the likeliness of gettingarrested and issuing longer sentences, thecost of committing the crime in the firstplace is higher. Hence, some crimes

would be prevented. Ehrlich applies thisconcept to capital punishment.

As stated previously, crime canbe seen as a utility maximizing function.If the expected utility of performing acrime were greater than the expectedutility of legitimate activities, a personwould logically commit the crime.Similarly, if the expected utility oflegitimate activities is higher than theexpected utility of committing a crime,the potential criminal is just another law-abiding citizen. Ehrlich’s utility functionof committing a capital crime can besummarized as follows (Cameron, 2002):

EU = (1 – PCON) U (C0) + PCON (1 –PE) U (C1) + PCON x PE U (C2)

EU: Expected Utility

PCON: Probability of a murderconviction

PE: Conditional probability of anexecution

U (C0): utility if not convicted

U (C1): utility if convicted, but notexecuted

U (C2): utility if executed

The first part of the equation yields theprospective criminal positive utility. Itmeasures the utility of the murdermultiplied by the probability of not beingconvicted. The second part of theequation brings disutility. The utilitymultiplies the probability of a conviction,the likeliness of no execution, and thenegative utility of the prison term. Thefinal part multiplies the probability ofconviction, the conditional probability ofan execution, and the enormous disutilityof being executed. The enormousdisutility of an execution to the prisonerbrings the overall expected utility lowerthan if there was no possibility ofexecution (PE=0). A decrease in theexpected utility makes murder less likely.Hence, anything that causes such adecrease, including the existence ofcapital punishment, can be a deterrent tomurder. This is the basis for the Ehrlich’smurder supply theory and ultimately

leads to his conclusion that capitalpunishment deters potential murdersfrom ever happening.

The above model shows thatincreasing the probability ofapprehension by a certain percentagedecreases the expected utility of murderby an even greater percentage (Ehrlich,1975). By increasing the probability ofbeing arrested, there is also an increasein the probability of being convicted (andimprisoned). An increase in theprobability of a conviction then increasesthe probability of an execution. Anincrease in the probability of executions,however, increases neither theprobabilities of arrests nor convictions.Because of the rebounding effects, wecan conclude that an increase in theprobability of arrests has a greaterdeterrent effect than an increase in theprobability of conviction, which has agreater deterrent effect than an increasein the probability of executions (Ehrlich,1975).

To combat the disutility thatcrime, especially murder, causes tosociety, the public pays the governmentto provide a system to catch and punishcriminals. All else being equal, theresources put into this system arepositively correlated with the probabilityof apprehension. However, there can alsobe too much enforcement. The marginalrevenues from law enforcement andpunishment must equal the marginal coststo society. The reasoning behind this isthat law enforcement, lawyer fees,imprisonment, and executions all costmoney. It is inefficient to increasespending when the costs of an additionalunit of utility (protection and justice) aregreater than the costs of crime beingdeterred.

Ehrlich recognizes that the marginalrevenue from execution must beequalized with the marginal cost of crime.Similar to an equilibrium amount of lawenforcement, there also exists anequilibrium number of executions. Hedefines the marginal revenue of executionas the value of the potential lives savedand the lower costs of law enforcement(because of the fewer murders being

Economic Policy


committed from the deterrent effect). Themarginal cost of execution is theadditional costs required for theexecution as opposed to lifeimprisonment and the cost to society ofexecuting a person given the probabilityof legal error (Ehrlich, 1975). Even whenfactoring in the possibility of anexecution of an innocent person, theoverall utility (and marginal utility) ofsociety is still higher with capitalpunishment because of the ability todeter. He concludes that there is anoptimal number of executions, at whichthe marginal revenue and marginal costequations are equal. So, there will beinstances when the death penalty couldlegally be carried out, but it would beinefficient to do so.

Portfolio Approach

Dale E. Cloninger is another majoreconomic writer on the issue of thedeterrence effect of capital punishment.In his article, “Capital Punishment andDeterrence: A Portfolio Approach,”Cloninger uses a different methodologywith new data and conclusions thatsupport the existence of a deterrent effect.It compares “models of changes inhomicide rates in executing and innonexecuting states relative to changesin crime rates generally” (Cloninger,1992). Cloninger uses most of the sameassumptions and conclusions of Beckerand Ehrlich. Each potential criminal isrational, having a choice betweenlegitimate activities (the risk-less asset)and crime (the risky asset). The potentialcriminal’s choice depends on his riskaversion and the expected utility of crime(Cloninger, 1992).

Cloninger puts all crimes into aportfolio, which together brings disutilityto the victims and society as a whole.

Individual crimerates are the crimerates of specificcrimes, such ashomicide orrobbery. Theseindividual crimerates can “varymore than, thesame as, or lessthan the rate ofportfolio crime”(Cloninger, 1992).The changes of aspecific crime raterelative to changesin the portfoliocrime rate arecalled “crimebetas” (Cloninger,1992). Crimeswith betas greaterthan 1 vary morethan the portfoliocrime rate, andimply a greaterrisk to society ofthat particular crime. Similarly, crimeswith betas equal to 1 vary proportionallyto the overall, portfolio crime rate.Crimes with betas lower than 1 vary lessthan the portfolio crime rate, and implya relatively smaller risk to society of thatcrime when the portfolio crime rate goesup.

The existence of a deterrenteffect of capital punishment requires asmaller beta for homicide whenexecutions do occur than the beta whenexecutions do not occur (Cloninger,1992). In other words, when executionstake place, increases in the homicide raterelative to the overall crime rate are lowerthan the increases when there are noexecutions. Cloninger found that thehomicide beta was 1.28 with the presenceof executions. This means a 10% increasein the crime rate corresponds with a 13%increase in the homicide rate (Cloninger,1992). The homicide beta in the absenceof execution was 1.56, meaning a 10%increase in the crime rate wouldcorrespond with an increase in thehomicide rate much larger than 13%(Cloninger, 1992). Ultimately, theseresults simply mean that in the presence

of capital punishment there would befewer homicides than if there was nocapital punishment. Clearly, it complieswith the deterrence theory.

Capital punishment could onlydeter murder because there is no threatof execution on other street crimes.Having shown that the homicide betais less in the presence of execution thanin its absence, the data shows that noother individual crime beta changes insuch a way. Hence, if the overall crimerate is unchanged and the death penaltyis put into effect (at least 1 execution),the homicide rate will fall. Cloningerconcludes that the possibility of capitalpunishment (performing at least 1execution) on average lowers thehomicide rate by 8.7%. An increase inthe overall crime rate of 6.6% wouldbe needed to offset the potentialmurders deterred (Cloninger, 1992).Cloninger’s portfolio approachreaffirms the deterrent effect of capitalpunishment that Ehrlich first showed.

...when there areexecutions in a society,the overall utility ofsociety is higher than ifthere were none.

Capital Punishment as a Deterrent to Murder


Conclusion

Ehrlich himself recognizes a problem inhis theory because of marginaldeterrence. In the U.S. the use of tortureis outlawed. This limits the number ofcrimes that can be punishable by deathbecause severe punishments cannotalways easily be handed out for moresevere crimes. If the death penalty canbe utilized in cases of a single murder, itcannot deter that criminal from

committing more murders in an attemptavoid arrest. Therefore, the suspect hasan added incentive to kill off any one thatgets in his way, including witnesses andpolice officers (Ehrlich, 1975). Thisseemingly is a flaw in a legal system thathas the death penalty for only a singlemurder. However, a person who commitsmultiple murders is still more likely toreceive a worse punishment (i.e. deathpenalty) than a person who murders onlya single person. Also, if there were nodeath penalty, prisoners serving a lifeterm would have no deterrence to killingother prisoners or guards (Posner, 2003).

The final issue emphasized bymany people who oppose capitalpunishment is the possibility of aninnocent man being executed for a crimethat he did not commit. This is thestrongest argument, and often acts as atrump card against capital punishment.Indeed, the disutility to that innocentindividual and his family and friendswould be extremely high. And, of course,the disutility of that individual would beindisputably taken into account (unlikea true murderer). He never lost his rightsas a member of society because he neveractually broke the laws and limits set by

society. Some proponents claim thatcases involving the possibility of anexecution require so much more evidenceand confidence that the person is guilty.A better argument against this is that theexistence of capital punishment detersmany murders. Since many moreinnocent people die in the absence ofcapital punishment, the utility loss ofmany innocent people being murdered isstill greater than the loss of few innocentpeople that are executed.

Capital punishment is a fairlyeffective deterrent to murder. Noeconomist has been able to sufficientlydisprove Ehrlich’s conclusions, andwriters, like Cloninger have onlyreaffirmed the existence of a deterrenteffect. Because of this deterrent effect,when there are executions in a society,the overall utility of society is higher thanif there were none. On these economicgrounds, capital punishment is anappropriate form of punishment.

References:

Cameron, Samuel. The Economics ofSin: Rational Choice or No Choice AtAll? Cheltenham: Edward ElgarPublishing, 2002.

- - - . “A Review of the EconometricEvidence on the Effects of CapitalPunishment.” Journal of Socio-Economics, v23, n1-2, (Spring/Summer1994): 197-214. http://ezproxy.library.cornell.edu:2055/direct.asp?an=9407291304&db=buh

- - - . “The Demand for CapitalPunishment.” International Review ofLaw and Economics, v13, n1, (March1993): 47-59.

Cloninger, Dale O. “Capital Punishmentand Deterrence: A Portfolio Approach.”Applied Economics, v24, n6, (June1992): 635-645.

Ehrlich, Isaac. “The Deterrent Effect ofCapital Punishment: A Question of Lifeand Death.” American EconomicReview, v65, n3, (June 1975): 397-417.

Posner, Richard A. Economic Analysisof the Law. 6th Ed. New York: AspenPublishers, 2003.

Reynolds, Morgan O. “On WelfareEconomics Aspects of CapitalPunishment.” American Journal ofEconomics and Sociology, v36, n1, (Jan1977): 105-109.

...the possibility ofcapital punishment(performing at least 1execution) on averagelowers the homiciderate by 8.7%.

Economic Policy


Consider the following scenario. I amwalking down the street when I observea flowerpot falling off a windowsill. I cando one of two things – shout to alert theperson standing under the falling pot, orlook the other way. If I choose the firstoption, I would be offering my time andservices to another without seeking anypayment or restitution. The cost to mewould be minimal, while the benefit tothe rescued is large, if not life-saving.Interestingly, in spite of the blatant lowcosts and potentially high gains, only ahandful of the 52 United States ofAmerica impose a duty to rescue.

In order to encourage anincrease in the amount of altruistic acts,legal scholars have suggested legallybinding bystanders to strangers inaccident situations. In other words, in asituation with possibility for rescue, abystander who chooses not to rescue thevictim is liable to criminal prosecutionand civil action from the victim. For thepurposes of this article, I will not go intothe technical details but will refer to the

general law that upholds this spirit as theGood Samaritan Law.

Surely such a law that mandatesits citizens to help one another can bringabout no harm. Yet despite the seeminglylarge benefits, as mentioned earlier, manystates have been reluctant to pass such aGood Samaritan Law. Previously, muchof the reasoning driving both sides of theargument for such a law was based onmorals and ethics. However, as thescholarship of economics in lawcontinues to gain popularity, there hasbeen an increasing amount of literatureanalyzing the economic problems andconnotations that the duty to rescue anda possible Good Samaritan Law mightbring about. These analyses quantify thecosts and benefits of such a law on societyand weigh them against each other.

In this article I try to present theeconomics of both sides of the argumentand examine the validity of theirrespective claims. I will first present thecase for a Good Samaritan Law, followedby the case against a Good SamaritanLaw. I will then take stock of botharguments and weigh their strengthsagainst each other and see if analternative solution or possible consensusof improvement can be reached thatwould satisfy complaints from both sides

of the argument. What kinds of problemsmight or might not be solved by such alaw, and more importantly, what kinds ofnew problems could foreseeably arise?Will the passing of a Good SamaritanLaw ultimately create more positive thannegative effects on society? These aresome of the questions I seek to answer inthis article.

The Case for the Good Samaritan

The flowerpot example

Advocates of the Good Samaritan Lawoften argue that often the act of rescuemay only involve calling the appropriateauthorities or shouting a verbal warning,and “if one considers the low costs ofprevention to B of rescuing A, and theserious, if not deadly, harm that A willsuffer if B chooses not to rescue him,there is no reason…the general rules ofnegligence should not require under painof liability, the defendant to come to theaid of the plaintiff.” (Hasen, 1995)

We can illustrate this hypothesisin the earlier flowerpot example with 2characters, Mr. Bad-luck and Mr.Stranger, and a flowerpot falling from awindow. If Mr. Stranger does nothing, thefalling flower pot will hit Mr. Bad-luckand cause substantial head injury. We can

The Good Samaritan Law and theDuty to Rescue: A Cost-Benefit

Analysis

By: Vincent Wong

Vincent Wong ‘07 is anEconomics Major in the



represent the expected utility function ofMr. Bad-luck and Mr. Stranger with thefollowing equations:

EUBL = U - CI

EUS = U

Whereby, EUBL is the expected utility ofMr. Bad-luck, EUS is the expected utilityof Mr. Stranger, U is the original utilityand CI is the cost of the head injury toMr. Bad-luck. If however, Mr. Strangershouts a verbal warning, Mr. Bad-luckwill move from the spot he is standingand incur no injury, thus transformingtheir expected utilities to:

EUBL = U

EUS = U – CA

In such a case, CA, the cost of the altruisticaction to Mr. Stranger, is trivial andrepresents a value so small we canassume it ultimately goes to zero. Itbecomes immediately obvious that in thesecond case, the combined utility of thetwo individuals is greater than that of thefirst case (2U > 2U – CI).

Market failure

Part of the problem arises exactly becausethe cost of his shouting, CA, is trivial; thushe is indifferent between shouting and notshouting a warning (his expected utilityregardless of shouting the warning staysat U because we assume CA to be zero).If we treat the altruistic act as a good,GA, then the market will decide on anequilibrium price; Mr. Stranger will shoutthe warning and Mr. Badluck will avoidthe head injury. We should note however,that any offer from Mr. Stranger to ‘sell’the warning at a price, CI – å, as long asit is lower than CI, will be accepted byMr. Bad-luck. Even if å is extremelysmall, for example $1, this still holds true.Thus Mr. Stranger would extract a pricealmost as large as CI from Mr. Bad-luck,and although the accident is averted, as asociety we are being virtually no moreefficient than we were earlier.Furthermore, problems of ‘setupaccidents’ and ‘false saves’ might alsoarise.

Liability as a behavioral incentive

If we cannot trust the market to help usallocate resources efficiently in such acase, then perhaps a Good Samaritan Lawis necessary. But how would a lawprovide such desired behavioralincentives? Legal scholars have suggeststhat the law “does so by treating all theregimes as pricing mechanisms, addingto the cost of an activity and therebyreducing the demand for it.” (Ogus, 2004)Going back to the example of the fallingflower pot, if Mr. Stranger fails to shouta warning, he incurs a cost of CLI thatcould include fines, mandatorycommunity service or a combination ofboth. If he compares the expected utilitiesof the two choices, U against U - CLI, fromwarning and not warning respectively, heis now swayed to choose the secondoption.

In the simplified analysis justoutlined, it is clear that such a law wouldprove to be beneficial. But assuming thatall parties are rational players, we musttake into further account their expectationof being caught and the degree to whichthey will be punished if convicted. Wecan illustrate his expected utility if hedoes not perform a rescue under theSamaritan law below:

EUS = U- CCP(C) - CPP(P) P(C) > 0

Whereby CCP(C) represents the cost ofbeing caught by law enforcementsmultiplied by the probability of beingcaught, and CPP(P) represents the cost ofthe punishment multiplied by theprobability of being formally convicted.If however, Mr. Stranger believes that hispossibility of being caught, P(C), is equalto zero, he does not consider the costs orthe probabilities that are associated withCPP(P). Thus the law is able to ‘sway’Mr. Stranger into committing more moralacts and achieve Pareto efficiency in thetwo players involved.

Self interest

In the flowerpot example, clearly Mr.Stranger would prefer not to have a GoodSamaritan law; legal prosecution andcivil action effectively forces his hand to

choose rescue. However, it is importantto remember that it is only in this instancethat Mr. Stranger is the rescuer. It wouldbe rational to think that it is equally likelyfor Mr. Stranger to be standing under thefalling flowerpot and for Mr. Bad-luck,who we might now call Mr. Good-luck,to be the player who is faced withchoosing between shouting and notshouting a warning.

If this is true, then we can usethe following model (Hasen 1995) toshow that a Good Samaritan law iseconomically efficient. Under the GoodSamaritan Law, Mr. Stranger’s expectedutility is given as:

EUS = U – P(1 – p)CA

If there is no such law, his expected utilityis given as:

EUS = U – P(p)VLS

Whereby P represents the probability thatMr. Stranger is involved in a rescuesituation, p represents the probability thatMr. Stranger expects to be the victim insuch a situation, and VLA represents thevalue of Mr. Stranger’s life. If wecompare the two equations, Mr. Strangerwill prefer a Good Samaritan Law if:

U – P(1 – p)CA > U – P(p)VLS

Or by reducing the equation, if:

(p)VLS > (1 – p)CA

Assuming that Mr. Stranger believes thepossibility of him being a victim or arescuer to be equally likely,6 then he willprefer the rule if:

0.5VLS > 0.5CA

If we take the rational assumption thatVLS is far greater than CA, then it followsthat Mr. Stranger or any other individualwould surely be in favor of a GoodSamaritan Law.

The Case against the Good Samaritan

The beach example

The Beach example is a common

Economic Policy


scenario used in argument against thelegislation of a Good Samaritan Law. Inthe beach example, Mr. Stranger isholidaying on the beach and Mr. Bad-luck has a muscle cramp while outswimming. Mr. Stranger is now facedwith a number of options; he can donothing, he can call the lifeguard, or hecan attempt to rescue Mr. Bad-luck byhimself. Under the Good Samaritan Law,he must choose either of the latter twochoices or face legal consequences. Inthis section of the paper I will outlinesome problems that might arise from aGood Samaritan Law

Negative activity-level effect

If Mr. Stranger knows that by going tothe Beach, he is subjecting himself to thepossibility of being forced to participatein a save, we might expect that he nowhas a “disincentive…to be a in a placewhere one might be liable for failing torescue a person.” (Posner, 2003) Wemight explain his expected utility fromvisiting a ‘hazardous’ place as:

EUS-H = U – pHCA

In the same way we could describe hisexpected utility from visiting a ‘safe’place as:

EUS-S = U – pSCA

Thus, if EUS-S > EUS-H, he will avoid‘hazardous’ places, and instead frequent‘safe’ places where there is a lesserlikelihood of him being involved in arescue situation.

It might seem that only non-altruistic individuals such as Mr. Strangerare affected, but we should also expectthe negative activity-level effect to affectpotential rescuers such as Mr. Goodguy.The first reason is that even altruists, suchas Mr. Goodguy, like to be given a choicebefore attempting the save. The secondreason is that a legal duty to rescue wouldtake away much of the positive utility,primarily public recognition, that Mr.Goodguy would otherwise have gained.The rescue is no longer an altruistic actbut rather a duty that if disregarded wouldhave resulted in legal consequences.

Anti-cooperative effect

So far we have only discussed examplesof rescue from external elements such asfalling objects and natural misfortune.But what of instances in which Mr.Stranger witnesses a crime beingcommitted? For the purposes of thispaper, I will take the Good SamaritanLaw to include not only the duty torescue, but more specifically at a crimescene, a duty to report.

Volokh warns that GoodSamaritan laws create an anti-cooperativeeffect. He claims that there are 5 varietiesof Samaritans – the Good Samaritan, whowill help regardless of the law; the“Hopelessly Bad Samaritan”, who willnot help regardless of the law; the“Legally Swayable Samaritan”, who willhelp if there is a law, the “DelayedSamaritan”, who does nothing initiallybut sometime after the incident decidesto come forward and report what he saw;and the “Passive Samaritan”, who doesnothing but if asked by the police willcooperate fully. We are familiar with thefirst two types which, for our purposes,are irrelevant because they are indifferentto a Good Samaritan Law. The LegallySwayable Samaritan is also someone weare familiar with; he is the champion ofthose advocating for a Good SamaritanLaw and if not for the law’s incentives(legal consequences otherwise) wouldnot have performed the rescue. In ouranalysis it is the Delayed Samaritan andthe Passive Samaritan who are moststrongly affected by the anti-cooperativeeffect and thus are whom we are mostinterested in.

If there is no duty to rescue, theDelayed Samaritan and the PassiveSamaritan will cooperate fully with lawenforcement authorities and the DelayedSamaritan will even take the initiative toprovide testimony. If however there is alegal duty to rescue, we would be led tobelieve that the Delayed Samaritan andthe Passive Samaritan would now bemuch more reluctant to help theauthorities in investigating the crime. Bycooperating with the police, they are ineffect putting themselves at risk of being

convicted of neglecting their duty torescue or report; Volokh calls thisphenomenon the anti-cooperative effect.This effect is likely to be even greater onthose with questionable criminalbackgrounds such as prostitutes or drugabusers because they risk greaterpenalties. We can take stock of the anti-cooperative effect on expected rescues inthe following equation:

ER = RG + RL – RLT - RP

Whereby RG, RL, RLT, RP, are representedby the number of rescues performed bythe Good Samaritan, the LegallySwayable Samaritan, the DelayedSamaritan, and the Passive Samaritanrespectively. Thus if RL exceeds thesummation of RLT and RP, we would bein favor of a Good Samaritan Law.However, it is unlikely that that wouldbe the case; when a bystander witnessesa crime and does not report it, it is usuallybecause of some irrational fear or perhapsof allegiance to the committer of thecrime. Thus it is unlikely that knowledgeof a duty to rescue will sway them. andwe can assume RL, the number of LegallySwayable Samaritans, to be relativelysmall. On the other hand, we can imaginethe number of Delayed Samaritans to besubstantial; during the time of the crimehe may have been seized by an irrationalfear and thus not reported or helped,however, as time passed, this feardissipated and he is willing to report thecrime and provide assistance to thepolice. It would appear that a GoodSamaritan Law, whose purpose was toincrease the expected number of rescues,ER, may in effect lower the number ofrescues because we would expect thesummation of RLT and RP to exceed RL.

High enforcement costs, loss of libertycosts, and level of care

Another primary argument against aGood Samaritan Law is the difficultiesand high costs associated with theenforcement of such a law. How wouldlaw enforcement agencies prove that Mr.Stranger or any other individual whoallegedly neglects his duty to rescue trulywitnessed the accident? And if this isproved, how then would they prove that

The Good Samaritan Law and the Duty to Rescue


his failure to rescue was not simply theresult of a misjudgment or anoverestimation of the level of dangerinvolved in the rescue? Furthermore, anywitness who is willing to identify Mr.Stranger as having witnessed the crimeis effectively admitting his own failureto rescue or report, and thus would beequally reluctant to come forward. Apossible solution could be to increase thenumber of law enforcers, but the financialcosts of doing so would most likelyoutweigh the benefits of the fewadditional rescues.

The Good Samaritan Lawessentially limits the choices anindividual can make when faced with arescue situation. Mr. Stranger technicallyhas a choice of not rescuing an individual,just as a person being mugged has thechoice to not hand over his wallet, butfor the former his doing so would resultin legal consequences and for the latterpossible loss of life. This loss of civilliberty to each individual may not be alarge value, but the summation of thiscost to each individual in society,particularly one with a large population,would no doubt be substantial, and wouldmost likely outweigh the social benefitsthat such a law would provide.

Furthermore, there is a dangerthat a duty to rescue will see moreindividuals who are not in a position torescue, participate in an accident situationas a rescuer. For example, a weakswimmer attempting to rescue adrowning victim would do more harmthan good. Also, there is a concern that ifthe duty to rescue is a legal one, therescuer is less likely to be careful becausehe is essentially being coerced by the lawto engage in the rescue. An unwillingrescuer might again cause more harm tothe victim than good and aggravate anyinjuries that the victim already has bybeing rough.

The Good Samaritan Law: A Cost andBenefit Analysis

Taking stock

The arguments both for and against aGood Samaritan Law establish valideconomic points. We have seen throughmodels proposed by both sides thatindeed their arguments contribute to agreater efficiency in the allocation ofresources. But how can this be? Eitherthe law increases efficiency or it doesn’t;the two are mutually exclusive and bothcannot allocate resources more efficientlythan the other. Thus we compute a costand benefit analysis of the law, but indoing so we must first examine thearguments’ underlying assumptions inorder to balance the validity of theirclaims.

A small value P and the large cumulativevalue of CL

The economic reasoning behind themodel for the efficiency in duty to rescue,[U – P(1 – p)CA > U – P(p)VLS], iscompelling. It would be fair to say that“individuals assess the probability ofbeing a victim or potential rescuer asequal” and even for individuals who seetheir probability as being biased towardsalways being a rescuer (a large value p),it is likely that the reasoning holds truesimply because the value we place on ourown lives is far greater than the cost ofour altruistic actions. However, his modelhinges on the probability, P, that theindividual believes he will be involvedin a rescue situation. If the value of P isextremely small, the expected utilitieswith and without a Good Samaritan Lawbecome closer and closer, and indeed ifthe value of P is zero, then we are onceagain indifferent between having a GoodSamaritan Law. It is highly likely for usto place a small value to probability P;few rational people go through their daysbelieving that they will witness a crime,warn a person of a falling flower pot, orrescue a drowning swimmer – even ifthey are at a beach or pool. On the otherhand, the loss of civil liberties is a cost,CL, independent of probabilities. This lossunder the law is illustrated by:

EU = U – P(1 – p)CA – CL

As mentioned earlier, the individual costof CL may not be great, but if we take thesummation cost it

has on society, we see that it willsignificantly decrease the overall utilityin society.

High enforcement costs and difficultiesof behavioral incentives

In order for the law to act as abehavioral incentive, individuals mustbelieve that they are likely to beprosecuted. For example, it would be fairto assume that more students are willingto cheat on their homework than they areon their exams or tests; the likelihood ofa student ‘rephrasing’ his classmate’shomework being caught is much lowerthan the likelihood of a student beingcaught cheating in an exam, and thus theformer happens more often. As outlinedearlier, enforcement is not only extremelycostly but also exceedingly difficult. Itfollows that any individual who neglectshis duty to rescue believes his likelihoodof being caught to be relatively small.Thus the argument that a Good SamaritanLaw serves as a significant behavioralincentive is unlikely to be valid.

The negative-activity level effect

In order for the negative-activity leveleffect to influence an individual, we mustassume that he is able to determine thedifference between a ‘hazardous’ and a‘safe’ place. I believe, and advocates ofthe Good Samaritan Law argue, that theassumption that an individual can easilydistinguish between a ‘hazardous’ and a‘safe’ place is an erroneous one. Part ofthis is tied to the low probability, P, thatan individual believes himself to beinvolved in a rescue situation; if P is low,then the distinction between a‘hazardous’ and a ‘safe’ place is no longerclear.

Moreover, the negative-activityeffect assumes that the utility we receivefrom going to a ‘hazardous’ place is equalto the utility we receive from going to a‘safe’ place. Is the utility generated fromseeing a movie or going to the library,both ‘safe’ activity, equal to thatgenerated from ‘hazardous’ activitiessuch as camping and going to the beach?It is difficult to compare the two and thusI find the negative-activity argument

Economic Policy


unconvincing.

The anti-cooperative effect and the dutyto cooperate

A far more convincing andserious objection to a Good SamaritanLaw is the anti-cooperative effect. If byhelping law enforcers with theirtestimony an individual is admitting hefailed his duty to rescue, it is unlikely thatthe Delayed Samaritan or the PassiveSamaritan will cooperate with authorities.We might suggest that prosecutors havethe power to drop charges for specificwitnesses who are willing cooperate, butdoing so would render the witness lesscredible in front of a jury; he is providingtestimony in exchange for his freedom.We might then suggest a change in thelaw that allows individuals such as theDelayed Samaritan and the PassiveSamaritan immunity once they cooperate.But in doing so we would be changingthe law from a duty to rescue to a ‘dutyto cooperate’, and we lose exactly thebenefits that society hopes to gain froma duty to rescue. Furthermore, such a lawwould be redundant as there are existinglegal tools, subpoenas for example, thatforce witnesses to cooperate.

Conclusion: Going beyond the GoodSamaritan Law

A cost benefit analysis from an economicstandpoint shows that, because of thedifficulties and the high costs involvedin enforcement, the overwhelming anti-cooperative effect, and the cost of the lossof legal liberties on society, a GoodSamaritan Law would ultimatelydecrease efficiency in the allocation ofresources in society.

If the Good Samaritan Lawcannot help us efficiently allocateresources in society, is there anothersolution that can help us achieve thedesired behavioral incentive to actaltruistically? I believe that the majorityof individuals do not need to be coercedinto behaving altruistically; there aresocial norms that guide the way in whichwe make choices and informal costs thatwe have to take into consideration. If anindividual sees a drowning person at a

beach, I postulate that his first instinct isto call for a life guard. If we are optimisticwe might say that he is actingaltruistically. If we are cynical we mightsay that he is acting out of personalbenefit; the cost of a guilty conscienceand possible stigma from the public maybe too high. But regardless, I am led tobelieve that a duty to rescue is so intrinsicin the moral fabric of the most of us thatchoosing rescue is an act out of oursubconscious, and thus attaching a legalduty does little good in helping us makethis decision.

However, altruistic acts arebeneficial to society, and accordingly,altruists should be rewarded or at leastencouraged. I am not suggesting victimslegally owe their rescuers restitution, butrather that the government should stepin. Gold stars and war stripes are hardlya fair compensation for the risks warheroes take in fighting for their country,but either through education orpropaganda, governments have swayedtheir citizens into risking their lives, oftenrepeatedly, for their country. Legalincentives may not be the best solutionfor allocating resources efficiently, butwhere the Good Samaritan Law fails thegovernments must pick up.

References

Dagan, Hanoch. In Defense of the GoodSamaritan. Michigan Law Review [Vol.97:1152], 1999

Hasen, Richard. The Efficient Duty toRescue. International Review of Law andEconomics [15:141-150], 1995

Murphy, Liam. Beneficence, Law, andLiberty: The Case of Required Rescue.Georgetown Law Journal, 89 Geo. L.J.605, 2001

Ogus, Anthony. What Legal ScholarsCan Learn From Law And Economics.Chicago-Kent Law Review [Vol 79:383],2004

Posner, Richard. Economic Analysis ofLaw. New York: Aspen Publishers, 2003

Volokh, Eugene. Duties to Rescue andthe Anticooperative Effects of Law.Georgetown Law Journal, 88 Geo. L.J.105, 1999

Wein, Sheldon. Rescuing charitableduties. International Journal of SocialEconomics, Vol. 29 Bo. 1/2, 2002, pp.45-53

“Duty of Care” Economica Ltd, Vol. 3,No. 4, 1998 http://www.economica.ca/ew34p2.htm. 22 Sept, 2004

“Good Samaritan Law” Law.com http://d i c t i o n a r y . l a w . c o m /default2.asp?typed=samaritan&type=1.22 Sept, 2004

The Good Samaritan Law and the Duty to Rescue


By: Jarett Goldman

Jarett Goldman ‘08 is a PolicyAnalysis and Management

Major in the College of HumanEcology

If you can show me an untaxed cornerof the economy, I will show you apolitician eager to tap a new source

of revenue. So it is with the Internet,which has America's 30,000 state andlocal taxing jurisdictions jumping at thethought of gaining extra revenue fromthis promising new industry.

Absent from their thinking is thefact that subjecting digital commerce to30,000 different sets of tax collectorswould hamper one of the fastest-growingsegments of the U.S. economy. Supply-siders have long argued that economicincentives, especially after-tax returns,influence individual and businessbehavior. When you tax something, youget less out of it and when you taxsomething less, you get more out of it.This is why sales taxes matter as muchas other taxes. When former New YorkMayor Rudolph Giuliani declared a sales-tax holiday, sales volume soared. Bycontrast, it was the threat of a new taxthat helped lead to the October 1987 stockmarket crash.

This logic suggeststhe harm that a sales taxwould inflict on Internetcommerce. Imposing anInternet sales tax wouldcreate an unnecessary taxburden that both raisesproducer costs and leads to adecrease in consumervolume.

For the time being,however, e-commerce isbooming. It is attracting new customerswho will increase overall retail sales.Quick and convenient Internet shoppingis very appealing to the growing elderlypopulation, as well as to busy executives,stay-at-home moms, bargain hunters, thesick, the handicapped and others.

More impressive yet iselectronic commerce's growth potential.Think of the mass-production oftelephones and automobiles in the 1920s,

or the jump in purchases of washingmachines and television sets followingWorld War II. In both periods, newtechnologies spurred long-termprosperity and stock market surges. It isonly fitting to put the Internet and e-commerce in that category (Bettelheim,1999).

But for those who are intent upon instituting some type of Internet tax,there is another barrier: the U.S.Constitution. The Founding Fathers(wisely may I say) included a section inthe Constitution that prevents states andlocalities from taxing interstatecommerce, which is exactly whatelectronically transmitted information is.When any good enters the realm ofinterstate commerce, the “CommerceClause” gives Congress the sole power

NO! to Internet Taxes

Imposing an Internet sales taxwould create an unnecessary taxburden that both raises producercosts and leads to a decrease inconsumer volume.

Economic Policy


to regulate its transactions.

While the founders could nothave envisioned the development of theInternet, the Constitutional frameworkthey outlined for basic commercialactivities still applies. State and localofficials may not like it, but their taxingauthority ends at their borders.

Moreover, even if states andlocalities had the proper authority to taxthe Internet, they would run into anumber of problems. Electronically

transferred information travels across theInternet far too quickly for regulators tomonitor and, more importantly, does soin a way that respects no geographicboundaries (Bettelheim, 1999). It isvirtually impossible to know the pointsat which the billions of daily Internettransactions begin and end.Consequently, state and local attempts totax such intangible electronic commercewould result in a confusing andoverlapping set of tax laws.

The growth of satellite-based

technologies and the wirelesstransmission of information will only addto the confusion. As an increasingamount of Internet traffic is transmittedwirelessly across the United States andaround the world, the jurisdictionalclaims of states and localities willcertainly be blurry at best. States andlocalities will have to be content withtaxing firms that provide Internet serviceswithin their jurisdictions. Anything morethan that will become legally andlogistically impossible (Bettelheim,1999).

The boom in electroniccommerce demonstrates once again theenormous benefits of the Internet. But,it must be realized that tax freedom leadsto cheaper products, easier access,stronger growth and happier consumers.Politicians in Washington should thinktwice before contemplating theimposition of tax or regulatory obstaclesthat would cripple the technologicalrevolution that has become the spine ofour dynamic new economy.

References:

Bettelheim, A. (1999, February 5).Digital commerce. The CQ Researcher,9. Retrieved March 14, 2005, from http:// l i b r a r y . c q p r e s s . c o m / c q p a c /cqresrre1999020500. Document ID:cqresrre1999020500.

Politicians in Washington should think twice beforecontemplating the imposition of tax or regulatoryobstacles that would cripple the technologicalrevolution that has become the spine of our dynamicnew economy.

NO! to Internet Taxes


Exchange Rate and Current AccountImbalances in China and ASEAN:

Are They A Problem?

By: Ray Wang

Ray Wang ’07 is an EconomicsMajor in the College of Arts

and Sciences

The undervaluation of China’scurrency and current accountimbalances in a number of

ASEAN (Association of SoutheastAsian Nations) countries have widenedsince the early 1990s. ASEAN wasestablished on August 8, 1967 inBangkok by the five original membercountries: Indonesia, Malaysia,Philippines, Singapore, and Thailand.The currency and trade imbalances inthis region have generated concern thatpolicy measures may be required inorder to avoid costly and destabilizingshifts in the world market, such as thosewitnessed during the East Asian Crisis.During this 1997-1998 crisis, exportrevenues of many East Asian countriesdid not increase despite massivecurrency depreciation by the afflictedeconomies. Concern over currentaccount imbalance has been expressedwith respect to China and five majorASEAN countries. Both Malaysia andThailand’s current account deficitswidened to over eight percent of GNPby the mid-1990s. Concerns have been

raised about the widening deficit of thesecountry’s external debt and service debtlevels, which are significantly higher thananywhere else in the world. Several yearsof rapid growth caused by the imbalancehave absorbed the initial slack thatexisted in these countries, but now,overheating may instead become aproblem. If left unchecked, large externaldeficits combined with overheating of anunsustainable economy will expose theseAsian countries to external shocks andpolitical unrest.

Countries should be concernedabout large current account deficits andsurpluses because they are simplyunsustainable in the long-run. There areinstances when a deficit may bewarranted, for example borrowing todayto improve productivity in order to havea higher national income tomorrow. But,for any period of current account deficit,there must be a corresponding period inwhich spending falls short of income (i.e.,

current account surplus) in order to paythe debts incurred to foreigners. In theabsence of extraordinary investmentopportunities, the best course for a stableeconomy is to follow a path ofconsumption smoothing. A currentaccount surplus means that a country isa lender on the world scene and mayexperience an imbalance of payments.The official settlements balance (balanceof payments) is crucial to every country.The reserves of foreign currency held bya country’s central bank change its

official settlements of balance. Thus,central banks can readily use their foreigncurrency reserves to influence exchangerates. A depletion of foreign reserves,due to lending or trade imbalance, willthen limit the central bank’s ability toinfluence or peg these rates. It isextremely important for any country tohave control over its exchange rate inorder to prevent speculators and otherexternal factors from depreciating or

...policy measures may be required in order toavoid costly and destabilizing shifts in the worldmarket, such as those witnessed during the EastAsian Crisis.

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inflating its currency value. For somecountries, particularly developing Asiannations, central bank reserves areimportant as a way of allowing theeconomy to maintain consumption orinvestment when foreign borrowing isdifficult. A high level of reserves willalso perform a signaling role byconvincing potential foreign lenders thatthe country is credit-worthy. Thus, it isoptimal to have a balanced currentaccount and not fall into the trap of beinga huge borrower or lender in theinternational arena.

The current account representsthe rate at which a country accumulatesor decumulates foreign assets. Oneapproach in determining whether anexternal imbalance is a problem is toanalyze the assumption that all externaldebts will ultimately be paid. This is thenotion of “intertemporal solvency.”However, intertemporal solvency is arelatively weak indication of emergingproblems because solvency requires thatall debts are repaid, but only in the verylong run. This parallels current UnitedStates taxation and Social Securitypolicies, where massive debts areaccumulated and justified through long-term policy adjustments that will notoccur until the distant future. This allowsa country to remain technically solvent,

even while running large externaldeficits, as long as policies are adjustedin the distant future to bring about therequired surpluses. The alternate, andmore effective, indicator of whethercurrent account deficits are a problem isbased on a model of optimal borrowingand lending posited by economist PaulR. Krugman (2003). The modelincorporates intertemporal solvency withprivate expectations about future incomegrowth, investment, and fiscal policy.

These include the underlying decisionsof how much to save or consume in agiven period. By utilizing theseexpectations, the model is able to providean optimal consumption-smoothingcurrent account. This optimal currentaccount balance can serve as abenchmark to judge the evolution of thecurrent account. If the deficit of a nationexceeds the optimal deficit generated bythis model, this provides an indication of“over-borrowing.” Such indications ofexcessive borrowing are especiallyprevalent in Thailand and most otherASEAN countries.

The industrialization of Chinaand undervaluation of the renminbi is thepremier example of current account andexchange rate imbalance. Recentevidence would seem to indicate that theChinese economy is overheating. Bankloans are expanding at a frenetic rate, andthe pace of investment recalls whathappened in other Asian countries in thedays before the East Asian Crisis. Thestatistics tell us that China has been incurrent account surplus for a long time.

Not only that, but China has been a netcapital importer. It is a country that isstill underdeveloped but has thefundamentals in place to permit rapidgrowth if it invests heavily. Because ofthese two factors, Chinese reserves havegrown to a point where they are now thesecond highest in the world (after Japan).The growth of China’s economy, bothfrom internal and external factors, pointsto the desirability and necessity for acurrency revaluation. This would relievetensions in the domestic economy, as wellas diminish the external surplus andreserve accumulation.

How large a revaluation wouldbe desirable? That depends on how largean adjustment is deemed to beappropriate. In 1996, Molly Maharpostulated a current account deficit of 2.8percent of GDP as a reasonable objectivefor China over the following years, onthe grounds that China is a developingcountry that can expect investments inexcess of savings generated at home.China would have no difficulty inimporting enough capital to finance sucha deficit. In fact, China has importedcapital, but on a somewhat smaller scalethan this, at an average rate of one percentof GDP per year.

World leaders have been criticalof Chinese resistance to a revaluation ofthe renminbi, but Chinese authoritieswere absolutely right to resist USTreasury Secretary John Snow’s call for

Recent evidence would seem to indicate thatthe Chinese economy is overheating.

Exchange Rate and Current Account Imbalances in China and ASEAN


a liberalization of the capital account andfor a float of the currency. The dangerof Snow’s proposal lies in the fact thatliberalization of the capital accountwould cause many Chinese savers toswitch a part of their portfolio to foreigncountries, in order to avoid holdingmoney in Chinese banks if and when afinancial crisis finally hits. The attemptof many savers to safeguard their positionin this way is likely to bring about thevery calamity they were trying to avoidin the first place, as is normally true in abank run. The obvious policy responsefor the Chinese government is to delaycapital account liberalization until afterthe banks have been cleaned up. Thiswould be in accordance with theconventional wisdom of the sequence ofliberalizing a financial system, which isto liberalize the capital account at the endof the restructuring process, not at thebeginning.

If capital account liberalizationdid in fact cause a substantial capitaloutflow, then it would cause adepreciation of the renminbi rather thanan appreciation. While marketfundamentalists may shrug theirshoulders and say “so be it,” morepragmatic economists would regard suchan outcome as counter productive, as itwould further strengthen China’s currentaccount imbalance. It would do little tohelp China overcome the financial crisisthat has been thrust upon it, and it would

do nothing at all to resolve world tradeimbalances, especially the US paymentsdeficit.

John Williamson was the WorldBank's Chief Economist for South Asiaduring the East Asian Crisis: “just afterthe crisis had broken, there was still somepressure to implement therecommendations of the TaraporeCommittee that had reported to the Indiangovernment shortly before the crisis, andwhich recommended a "gradual" processof capital account liberalization lastingthree years. I told an Indian newspaperthat I thought thirty years would be morerealistic” (as qtd. in Williamson, 2003).It seems that China should be thinkingof a similar timescale to complete theliberalization process. That would thenput Asian countries on the same sort oftimescale that Europe followed whenmoving back to a liberal economy afterWorld War II. While the process wasslow, it was also thorough, which resultedin few worries that Europe may revert toa repressed economy. According toWilliamson, “that is vastly better than arush to liberalize followed bybacktracking, as has often occurred inLatin America (with Argentina being adramatic recent example)” (as qtd. inWilliamson, 2003).

The currency and tradeimbalances in China and the ASEAN willeventually cause economic problems in

the future. However, China shouldcontinue to resist external politicalpressures from the United States andEurope for the immediate restructuringof its currency and liberalization of thecapital account. It would beeconomically devastating to liberalize thecapital account and float the exchangerate in an untimely manner. Rapidappreciation of the renminbi will causeChina to dive into an economic crisis.Bank runs, combined with a lowercurrent account and GDP, willoverwhelm the economy. The confidencelevel of foreign investors and domesticcitizens in the stability of a nation’scurrency is the foundation of a stableeconomy. Any economically stablenation has to have control over the abilityto peg the exchange rate. On the otherhand, the ASEAN countries are not asindustrialized as China, and the correctpolicy for the ASEAN would be to scaleback borrowing from the richer countriesand not overheat the economy. In orderfor this to work, such economic policiesmust be initiated and carefully followedwithout political interference fromexternal factors.

References

Bullock, M., & Grenville, S. Theexchange rate and current account.Retrieved March 11, 2005, from http://w w w . r b a . g o v . a u /PublicationsAndResearch/Conferences/1993/BullockGrenvilleHeenan.pdf

Croke, H. (2005, February). InternationalFinance Discussion Papers. RetrievedMarch 11, 2005, from http://www.federalreserve.gov/pubs/ifdp/2005/827/default.htm

Krugman, P.R. (2003). InternationalEconomics: Theory and Policy. NewYork: Addison Wesley.

Williamson, J., & Mahar, M. (2003,October 29). Institute for InternationalEconomics. Retrieved March 10, 2005,from http://www.iie.com/publications/papers/williamson1103.htm

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The Development of theChinese Automobile Industry

By: Samson Cheng

Samson Cheng ‘07 is anEconomics and GovernmentMajor in the College of Arts

and Sciences

Since the turn of the century,businesses around the globe areputting most of their attention on

the world’s fastest growing market –China. As conditions for entry into theWorld Trade Organization in 2001,China has been gradually opening up itseconomy to foreign investors.Multinational corporations in everysector have set up ambitious plans to geta share of profits in the fastest growingmarket. In the automobile industry, thereduction in duties and tariffs in recentyears have attracted automakers fromDetroit and Stuttgart to pour in billionsof dollars into building new plants andtraining staff in the world’s mostpopulated country. The automobilemarket has seen impressive growth inrecent years. The potential seems to beenormous. But is the growthsustainable? Are the international autogiants’ moves into the market tooabrupt?

Potential in the Chinese AutomobileMarket

The Chinese automobile market haslong madec a r m a k e r saround the worlds a l i v a t e .According toJ.D. Power andAssociates Inc.,there are 8vehicles per 1000residents inChina, compared to 940 in the UnitedStates and 584 in Western Europe(Roberts & Welch, 2004). With apopulation of 1.3 billion (four times ofthe U.S.), China has just surpassedGermany, where half the populationowns a car (Tierney, 2003), as theworld’s third largest auto market interms of car sales, behind the U.S. andJapan. It is expected that this mostsought-after market could leapfrogJapan by 2007 and even the U.S. by2020 to become the largest auto marketin the world.

With around 10% annual GDPgrowth in consecutive years, China hasenjoyed economic prosperity over thepast decade. Now the country has seenthe emergence of a middle class with

enormous purchasing power. As thecommunist state transforms its economyinto a capitalist one, individual buyershave become the new driving force for

the auto market.Sales ofVolkswagen inChina are nowhigher than that inits home market ofGermany. Chinahas also becomeBMW’s biggestmarket for the most

expensive 7-series sedan, even though theChinese are paying double whatAmericans pay (Roberts & Welch, 2004).

The growth sprint began in 2001as China became a member of the WTO.As required, the Chinese governmentlowered the tariffs and allowed foreigncompetition in the domestic auto market.This move has made cars produced byprotected local carmakers (with inferiorquality and old-fashioned design) nolonger saleable. With strugglingperformance in Europe and the U.S. as aresult of a global price war, automakersaround the globe could not wait to seizethe opportunity as a relief. Automakerssuch as Volkswagen and General Motorsbegan to build plants with their Chinesepartners. At the early stage, they found

The country has attracted60-80% of the foreignautomakers’ internationalinvestment.


that their production capacity could notkeep up with demand and had tocomplement the sales with imported carsbefore further expansion of itsmanufacturing plants were completed.Not able to wait any longer for a share ofthe cake, automakers have announcedambitious plans to increase production inChina. GM is planning to spend $3billion to double its production capacityto 1.3 million vehicles by 2007.Volkswagen is pouring in $6.3 billion todouble capacity to 1.6 million units by2008. Ford Motor Co. wants to spend $1billion on expansion in China, whileToyota will invest $730 million to expandcapacity in its plants in Guangzhou andTianjin. According to consultancy A.T.Kearney Inc., nine multinationalcarmakers are planning to spend $9.7billion in total between 2003 and 2007,boosting the country’s annual productionto 5 million passenger cars (Balfour &Wu, 2004).

All these have reflected China’semergence as the most sought-aftermarket. The country has attracted 60-80% of the foreign automakers’international investment (Xinhua NewsAgency, 2005). Annual growth rates insales have been impressive at 60% to 70%in recent years (Standard & Poor’s RatingServices, 2005). In 2003, General Motorsmade $437 million in China, almost halfof its global profits (“Rick Wagoner onGM’s Chinese future,” 2004).

Dramatic Slowdown in Growth

Prospects have been very promising toforeign automakers. However, whileplants are being constructed across thecountry to prepare for future waves ofmarket boom, auto sales have indeedbegun to slow down. In 2004, 2.33million passenger cars were sold in China,representing a growth of 15% (Standard& Poor’s Rating Services, 2005) afternearly doubling in 2003.

The Chinese economy hassustained high growth for over a decade,but economists today argue that there aresigns of overheat in the economy. Overlyrapid growth in industries such as steel,cement, and real estate has been fueled

by financial institutions’ loose lendingpractices. Standard & Poor’s estimatesthat 40% of business loans in China arenonperforming (Roberts & Welch, 2004).Fear of a bubble burst has prompted thegovernment to slow down investment andcool down the economy. The People’sBank of China, the Chinese central bank,has ordered the nation’s financialinstitutions to impose tougherrequirements for giving car loans. Themiddle class, estimated to be 60 million,are largely put off by the state’s effort torein in its overheated economy. At theauto dealerships in cities along thewealthier coastal regions, more customersare looking instead of buying. As a resultof the credit restriction, 10% of carpurchases were financed with loans in2004, down from 35% in 2003 (Balfour& Wu, 2004).

As more automakers havejumped into the Chinese market, stiffcompetition has led to price wars. Whileauto dealers believe the price cut will helpboost the car sales, there comes theunintended effect: people now are putting

off their plans to buy a car, waiting foreven deeper discounts. Automakers nowbegin to feel the effect of intensifiedpricing pressures and weakenedprofitability. According to 2004 statisticsfrom the China Association ofAutomobile Manufacturers, among thenation’s 15 large-scale automakers, onlynine reported sales growth over theprevious year, and only five achievedprofit growth (“China’s auto sector enters

restructuring stage,” 2005).

Automakers that reached out tothe new middle class were the ones thathave suffered the most in the slowdown.Now they realize the middle class is notquite there. Indeed things are not asglamorous as they appear to be, seen incities such as Shanghai and Beijing.Unemployment rate remains high at 10%in 2004 (Economist Intelligence Unit,2004), leaving approximately 78 millionpeople jobless (more than half theworkforce of the U.S.). As furtherrestructuring takes place in state-runcompanies, unemployment rate isexpected to rise further.

With estimated annualproduction of 5 million vehicles by 2007and the sudden slowdown in sales growth,concerns over a bubble burst in the automarket have recently arisen. Car salesin February 2005 were already down by24% year-on-year. If sales do not catchup with production output, it would meana disaster in the industry with inventorybeginning to pile up. Did the foreign

automakers make amistake in extrapolatingthe initial trend of highgrowth into the 1.3billion population?(Xinhua News Agency,2004)

Future Prospects

Will China run into anauto market overheatlike the Brazilianeconomy did in the early1990s, when plantcapacity was twice thedemand? Such worry isnot apparent among the

executives in Detroit. Despiteeconomists’ warnings against excesscapacity, automakers believe the Chineseadministration can do a better job thanBrazil in handling the market overheat,based on past record of management ofthe economy since the 1980s. The factthat China has the world’s second largestforeign currency reserve has givenforeign investors further assurance.

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Currently, almost all the vehiclesproduced in China are intended forinternal sales. If serious overcapacitydoes exist in the near future, there needs

to be a way out for the automakers. Withsluggish sales in their home countries ofEurope and the U.S., foreign automakerssee moving production bases to China asa possibility in the future, when workersand manufacturing method meetinternational standards. The automakershope to sop up excess production byexporting Chinese-made cars.

People now have been talkingabout the same things that were being saidabout Chinese-made electrical appliancesa decade ago. In the early 1990s, whenChinese firms began exporting electricalappliances, Japanese and American firmsdid not even consider them ascompetitors. Today you can walk intoBest Buys and easily find a Lenovocomputer or a Haier refrigerator. Adecade ago people might think it was ajoke. The “China price” has led to theemergence of Chinese brands as globalplayers. Haier now has 40% market sharein the U.S. for small refrigerators andwine coolers (Deloitte Research, 2005),and Lenovo has recently acquired IBM’spersonal computer business. Economistsexpect that something similar will likelyto happen in the automobile market. AsChinese automakers achieve internationalcompetitiveness, they will be able toprovoke a massive price war and undercutEuropean, American, and Japanese

brands.

No matter what the result of thestiff competition will be in the future –

the ultimate winner ofthe auto boom will beChina itself. CurrentChinese regulationsforbid foreigninvestors to own morethen 50% of aChinese carmanufacturer andrequire that theypartner with Chinesecompanies to enterthe market. With thehelp from the west,Chinese automakersin the future willbenefit fromt e c h n o l o g i c a l

spillover. The ownership restrictions onforeign carmakers will allow local firmsto develop their own brands without muchreliance on the foreign partners in thefuture. It may not be surprising that by2020, Chinese automakers, like Hyundaiin Korea, will be exporting cars undertheir own brand names to the U.S., Japan,and Europe..

References:

(2004). Automotive Resources AsiaLimited. Retrieved April 4, 2005, fromhttp://www.auto-resources-asia.com

Balfour, F., & Wu, C. (2004, September20). China: Letting up on the gas.BusinessWeek Online. Retrieved April 4,2005, from http://www.businessweek.com/print/magazine/content/04_38/b3900074.htm

Bremmer, B., & Roberts, D. (2005, March14). Asia: Audi needs to burn rubber.BusinessWeek Online. Retrieved April 4,2005, from http://www.businessweek.com/print/magazine/content/05_11/b3924009.htm

(2005, March 4). China’s auto sectorenters restructuring stage. ChinaEconomic Net. Retrieved April 4, 2005,from http://en.ce.cn./Industries/Auto/

200503/04/t20050304_3234615.html

Deloitte Research. (2005, April 1). Overto Chinese MNCs. Asia Times Online.Retrieved April 4, 2005, from http://w w w. a t i m e s . c o m / a t i m e s / C h i n a /GD01Ad07.html

Economist Intelligence Unit. (2004, May13). Country briefings: China.Economist.com. Retrieved April 4, 2005,from http://www.economist.com/c o u n t r i e s / C h i n a /profile.cfm?folder=Profile%2DEconomic%20Data

(2004, June 21). Rick Wagoner on GM’sChinese future. BusinessWeek Online.Retrieved April 4, 2005, from http://www.businessweek.com/print/magazine/content/04_25/b3888097_mz017.htm

Roberts, D., & Welch, D. (2004, June 21).GM: Gunning it in China. BusinessWeekOnline. Retrieved April 4, 2005, fromhttp://www.businessweek.com/print/m a g a z i n e / c o n t e n t / 0 4 _ 2 5 /b3888092_mz017.htm

Standard & Poor’s Rating Services.(2005, March 30). Global carmakers arestuck in park. BusinessWeek Online.Retrieved April 4, 2005, from http://www.businessweek.com/print/investor/c o n t e n t / m a r 2 0 0 5 /pi20050330_1634_pi036.htm

Tierney, C. (2003, December 7). Big 3gamble on China as market comes of age.The Detroit News. Retrieved April 4,2005, from: http://www.detnews.com/2003/specia l repor t /0312/08/a01-343414.htm

Xinhua News Agency. (2005, March 20).China to become world biggest automaking center. People’s Daily Online.Retrieved April 4, 2005, from http://english.people.com.cn/200503/20/eng20050320_177545.html

Xinhua News Agency. (2004, December7). Hot China auto sales slow down.China Daily. Retrieved April 4, 2005,from http://www.chinadaily.com.cn/e n g l i s h / d o c / 2 0 0 4 - 1 2 / 0 2 /content_396748.htm

The Development of the Chinese Automobile Industry


The Investment Landscape forForeign Acquisition in

the Chinese Banking Industry

By: Rosy Ko

Rosy Ko ‘07 is anEconomics and GovernmentMajor in the College of Arts

and Sciences

The wave of foreign acquisition ofChinese banks reached a recordhigh with London-based HSBC

buying 19.9% stake in the Shanghai-based Bank of Communications for 1.75billion, an investment eight times largerthan any previous foreign investment ina Chinese bank. As one of the leadingforeign banking institutions in China,along with Citigroup and StandardChartered, HSBC’s strategy in Chinareflects a growing trend among foreignbanks. Specifically, that of increasingbanking market penetration throughgaining minority stakes in small- andmedium-sized commercial banks, insteadof investing in the traditional Green-fieldjoint-venture projects. Current restrictionlimits foreign ownership to a maximum25% in any single banking entity. Thisstrategy surely allows the foreigninvestors to extract the most profits fromChinese consumers’ rising financialneeds. Yet, forces that motivate theperformance of this strategy also indicatethat foreign firms are betting on theuncertain prospect of fundamental

banking-sector restructuring in China.

Factor & Demand conditions

One of the first incentives for acquisitionof minority stake is expanding marketdemand conditions: foreign minoritystake in China often expands operationsin wealth-management, dual-currencycredit cards, insurance, and renminbi(RMB) businesses. However, successalong the dimension of demandconditions would not be realistic withoutcomplementary factor conditions,namely, a broad consumer base. Althoughthe geographical restrictions on renminbibusiness by foreign banks will beremoved completely by December 11,2006, RMB business cannot beconducted without branch networks. Thisrequirement of developing extensivenetwork access for resource and strategicassets seeking has significant limitationsin the traditional green-field joint-ventureprojects. If foreign banks were to set uptheir own distribution channels, thecapital requirement for new branch is 500million, which automatically eliminatesoperations in second- and third-tier cities(Dolven, Winn & Murphy, 2004), whichcarry greater potential for future growthand opportunity for expansion in RMBdeposit businesses. Therefore, the burdenof restrictions and regulations on branch

establishment has prompted foreignbanks to divert from the traditionalGreenfield joint-venture projects, andinstead, invest minority stakes in Chinesebanks organized as companies limited byshares (CLSs), which are not subject tothe same stringent requirements (Howson& Ross, 2003). When the foreign firmsgain a broader customer base, moreforeign funds, sophisticated westernassistance and services are alsosimultaneously infused into the localbanks. As China plans the gradualopening of its capital account, therewould be more competition amongforeign banks for RMB businesses.Gaining access to distribution channelsalready implanted by a local commercialbank becomes the preferred mechanismto broaden the reach to China’s vastpopulation.

Yet the ability to impose a moreadvanced banking standard, which ismuch needed for the branches to besuccessful in gathering RMB business,may not be automatic if foreign bankscan only impose minority influence onthe board. China’s corporate law is moreadverse to the protection of minorityrights, whether in participation or vetopower. China’s Company Law requires2/3 approvals for resolutions at the CLSs,stripping the veto power even of holders

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of 33% of equity (Dong, 2005). Inaddition, shareholders in many small- andmedium-sized state banks are often otherstate-controlled or related agencies. Asimple juxtaposition between HSBC andBank of Communication can reflect thelatter’s more primitive level inmanagement of branch efficiency andcustomer service. Unless there isfundamental change among the Chinesebanking professionals towards a moreprofit-oriented mindset, they may be stillreluctant to overhaul the status-quo.

However, it is important to notemuch recent development in the regionwould help foreign firms to generatemore success along the factor anddemand conditions. In a policy statementreleased in February 2005, the Chinesegovernment has claimed to allow moreprivate-sector competition in the bankingindustry. The government also has theimpending goal of removing restrictionson customers of foreign banks inconducting local currency business, andgranting “National Treatment” to foreignbanks according to its WTOcommitments (Dolven et. al., 2005). TheChina Unionpay company has also beenestablished to facilitate the inter-changeand transaction for bank’s cardbusinesses (Dolven et. al., 2005).

Synergy

In early 2004, Citibank partnered withShanghai Pudong Development Bank tolaunch dual-currency credit card servicesfor the Chinese. Though foreign firmsmay not issue their own local credit cardsuntil 2007 at the earliest, the combinationrepresents the unique investmentopportunity for the foreign firm to gainstrategic familiarity with the Chinesemarket before developing their ownbusiness establishments. Such acombination allows for synergy linkagebetween Chinese customers with higherlevels of western services. By launchingan innovative service in a foreign locale,establishments such as Citibank have alsoachieved overall risk reduction.

In “A Review of Cross-borderMergers and Acquisitions in APECEconomies,” Chen and Finlay claim that

the synergies in cross-border M&A oftencome in two forms: static and dynamic.Static synergy emphasizes pooling ofmanagement resources and using eachother’s market base and distributionchannels to enhance revenue. It isparticularly important “in industries withincreased competitive pressure, fallingprices and excess capacity.” At the sametime, the authors pointed out thatdynamic synergy exists through thematching of resources and skills toimprove innovatory capabilities inindustries of “increased competitivepressure, falling prices and excesscapacity” and is beneficial to sectors offast technological growth. The singlemost important synergy that must takeplace between foreign and Chinese banksis the improvement of credit ratingsmechanisms aimed at reducing non-performing loans (NPLs) and infusingmore transparency in banking practices.Due to an underdeveloped capital market,bank assets comprise 77% of all financialassets in China compared with 26% inAmerica (Bowers). Local managers’ lackof training in credit assessment largelylies in the fact that they are being awardedon basis of asset growth. Although from2007 all commercial banks must attainthe international benchmark in having acapital requirement of 8% of risk-weighted assets, banks are still onlysubjected to a maximum loan-to-depositratio of 75% (Dong, 2005). Withoutinstitutionalized mechanisms to deal witha NPL issue that is as high as 50% of totaloutstanding loans, the core of assetbusinesses in the Chinese banking sectorwould certainly deter the synergisticgrowth between the local resourcesoffered by host economy and operationalexpertise brought by foreign banks. Thelocal banks are in desperate need ofacquiring a profit-oriented managementthat can properly control credit risk.

The ease of minority stakeacquisition is also not as flexible as onemight imagine given the recentacquisition successes. There areregulations governing foreign investmentin commercial banks and foreignpurchases of equity in Chinesecompanies in private transactions.However, no law or regulation provides

a legal basis for foreign or foreign-invested entities to purchase stocks inChinese commercial banks organized bycompanies limited by shares (CLSs) inprivate transactions. Past equityinvestments in commercial banks areapproved by the State Council on a case-by-case basis. After Bank of China hasceded supervisory responsibility overcommercial banks to the China BankingRegulatory Commission (CBRC), thenewly established agency will likelycontinue to limit aggregate foreignownership to 25% in one entity, and a15% limit on individual investor(Howson & Ross, 2003). In addition,PRC authorities might be more willingto cede minority participation to non-strategic partners who are less likely todominate the smaller Chinese financialinstitutions.

Strategy, Structure and Rivalry

In contrast to the increasing incidents ofalliances between foreign banks andsmall- or medium-sized commercialbanks, nothing is yet to be done with thefour biggest state-owned banks: Bank ofChina, China Construction Bank,Industrial and Commercial Bank ofChina and Agricultural Bank of China.Even though Bank of China can beacquired for a 5-10% stake at a likely 1-2 billion, no foreign investor has showninterest. The deterring forces are bothpolitical and financial. Given the politicalsignificance of the above-mentioned fourstate banks to the Chinese government,foreign banks often believe that there isno prospect of ever gaining board controleven after the removal of limitations onforeign majority ownership in state banks(Howson & Ross, 2003). In addition, the“Big Four” banks had outstanding non-performing loans (NPL) amounting to1.99 trillion yuan (US$239.76 billion) inthe end of September 2003, a NPL ratioof 21.4% that is beyond the acceptablestandard of foreign banks (Dong, 2005).However, a majority of corporate anddeposit accounts still lie in the hand ofthese “Big Four” banks. Even if theforeign banks want to shift away fromcorporate-banking to credit cards andwealth management businesses, theycould demonstrate far more growth with

The Investment Landscape for M&A in the Chinese Banking Industry


the extensive consumer base and wealthydepositors from the top four bankinginstitutions. Despite the difficulty ofacquiring minority stake in these fourbanks, much is to be anticipated on thepossibility of a business or strategicalliance between a foreign bank and oneof the leading state banks.

In pursuing success in thestrategic fit of the acquisition, thecombining firms ought to examine thecommonality in their performance andstrategic attributes. The combinedbusinesses should also strive to havecompatible culture, management styles,ability to implement changes and goodquality of corporate governance (Chen& Findlay, 2003). As foreign firms striveto outperform their rivals in the Chinesecurrency market, the potential for successlies in how each foreign firm cansuccessfully integrate its own standardsinto the domestic system, so that the localbanks can dramatically improve theefficiency of distribution channels,quality of customer service and standardsof risk assessments. The Chinesegovernment’s dedicated reforms in thebanking sector would also facilitate thelikelihood of strategic and organizationalfit, with the introduction of systems forbank loan classification, recapitalizationof the four state commercial banks andrestrictions aimed at getting banks out ofstock market speculations.

Conclusion

Given current restrictions on foreignmajority ownership in local bankingindustry, acquiring minority stakes invarious Chinese local banks has placedmany foreign banks at a strategicadvantage in exploring the regionalpotentials in the currency business, assetand insurance management, consumerbanking, and credit card businesses.Despite the obvious attractions of theChinese market, it remains largelyuncertain to what extent China’sweakness in corporate governanceregulation and long-standing problem inNPL will compromise the prospectivegains of the foreign acquisitions. On theother hand, scholars and foreign investorsremain hopeful that cross-border M&A

in China can play a positive role inpromoting the economic restructuring ofthe host economy (Chen & Findlay,2003).

Therefore, acquisitions inChinese banks should not be made withthe short-term goal of making capitalgains from buying an undervaluedChinese asset. An under-developedcapital market means that stock pricestend not to fully reflect the market valueof the firms. Chinese appraisers tend tobase their valuation on replacement valueless depreciation, leading to gross over-valuation of the firms. Other than over-valued assets, the benefits of foreignstake in the Chinese banking businesscould only translate into reality if thecountry can cash in on its promises oneconomic restructuring in corporategovernance and credit assessment. Theforeign investors are in for the long term,a very long term. As one observerremarks on the strategy of HSBC, theLondon-based banking institution is oneof the few banks that can make“piecemeal-type of minorityshareholdings, and wait a generation forit to turn into real money.” (Dolven et.al., 2004)

References:

Adams, C., Mathieson, D.J., Schinasi, G.,& Chadha, B. (1998, September)International Capital Markets-Developments, Prospects and Key PolicyIssues. [Electronic version]. WorldEconomics and Financial SurveysInternational Monetary Fund Publication.

Bowers, T., Gibb, G., & Wong, J. (2003).Banking in Asia: Acquiring a ProfitMindset. Singapore: John Wiley & Sons(Asia) Pte Ltd.

Chen,C., & Findlay,C. (2003). A Reviewof Cross-border Mergers andAcquisitions in APEC Economies. Asian- Pacific Economic Literature, Vol. 17(2),14-38.

Dolven, B., Winn, H., & Murphy, D.

(Aug 2004) HSBC bets big on China. FarEastern Economic Review Hong Kong,Vol. 167, Iss.33, 42-47.

Dong, T. (Jan/Feb 2005). Five Points toWatch. Far Eastern Economic ReviewHong Kong, Vol. 168, Iss. 2, 55-57.Finance And Economics: Root andbranch; China’s banks. (Nov 6, 2004)

[Electronic version] The Economist,London, Vol. 373, Iss.8400, 73-74.

Howson, N.C., & Ross, L. (July/August2003). Foreign minority equityinvestments in Chinese commercialbanks. The China Business ReviewWashington, Vol.30, Iss. 4, 18-23.

Moon, H.C., Kim, H.K., & Lee, D.H.(2003) Cross-border merges andacquisitions: Case Study of Korea; China;And Hong Kong, China. APECPublication.

Asia


The Future of ASEAN’sEconomy: Growth throughForeign Direct Investment

By: Thummim Cho

Thummim Cho ‘08 is aPolicy Analysis and

Management Major in theCollege of Human Ecology

The difference between ForeignDirect Investment (FDI) andother types of cross-national

investment exists in that FDI grants theinvestor control over the acquired asset[those investors are often referred to as‘multinational enterprises’ (MNEs)]. FDIis useful because it not only overcomesthe limitation of domestic funds, but alsoincreases the country’s productivity byintroducing new technologies,management strategies, and laborpractices. For those reasons, FDI oftenworks to drive high GDP growth indeveloping countries such as those whoare members of Association of SoutheastAsian Nations (ASEAN). This article willexamine the relationship between FDIand economic growth, the role ofeconomic integration in attracting FDI,and the development of integrationwithin ASEAN to draw a conditionalconclusion about the future of ASEAN’seconomy.

FDI and economic growth

More evidence suggests that FDIcontributes to high economic growth indeveloping countries. In the neoclassicalperspective, FDI increases capital stockper efficient labor unit in an economy notin steady state, inducing short runeconomic growth. The effect is moresignificant in less developed economiessince it tends to yield higher marginalproduct of capital. A recent study (Alfaro,2001) empirically examined the directeffect of FDI on economic growth usingthe Ordinary Least Squares method toestimate the following cross-sectionregression model:

Growthi = ß0 + ß1FDIi + ß2(FDI *FINANCEi) + ß3FINANCEi +ß4CONTROLSi + vi

Based on a sample of 39countries from 1981-1997 with a fairrepresentation of various economies interms of GDP per capita and FDI level,the coefficients on FDI ranged from 1.12to 1.42 depending on the different setsof control variables. The result supportsthe hypothesis because positivecoefficient denotes positive relationshipbetween FDI and economic growth.

The contribution of FDI to

economic growth is greater for ASEANthan other economies because a large partof ASEAN’s international trade has beenconducted through multi-nationalcompanies (Mahani, 2004). According toFan and Dickie (2000), FDI’scontribution to ASEAN GDP growthincreased from 4 percent in 1987 to morethan 20 percent in 1997, suggesting thatFDI is an important determinant of GDPgrowth especially for ASEAN.

Indeed, both GDP and FDI ofASEAN5 (the five original membercountries: Indonesia, Malaysia,Philippines, Singapore, and Thailand)had risen dramatically during the late 80sto mid 90s. The 1997-98 Asian crisis ledto stagnation of both FDI and GDPgrowth.

To extrapolate what stimulatedrapid growth of FDI between the late 80sand mid 90s, it is necessary to examinewhat major changes took place inASEAN during the time period. Anoteworthy movement during the intervalis that ASEAN launched and began tocarry out the plans for economicintegration.


Integration as a driving force of FDI

An ideal economy for FDI should offerthe package of big market, lowproduction cost, high productivity, andmore flexible legal system regardingforeign investment. ASEAN economicintegration is an important determinantof FDI for that reason. It cuts costs acrossthe production value chain so that MNEscan do business with lower cost acrossthe borders within ASEAN, allowing theMNEs to use the cheapest inputs and thebest workers in production. A case studyin the electronics sector done by Schwarzand Villinger (2004) suggests thatincreased regional integration could cutthe costs of companies by 10 to 20percent. Therefore, it seems logical toexamine the development and future ofASEAN integration to predict the futureof FDI in the ASEAN’s economy.

ASEAN has clearly pursuedintegration. Established in 1967 with fivefounding members—Indonesia,Malaysia, Philippines, Singapore, andThailand—and joined later by Brunei,Laos, Cambodia, Myanmar, andVietnam, ASEAN has regarded economiccooperation and liberalization as one ofits important goals. Recognizing that littleeconomic interactions were taking placeamong the member countries, ASEAN inthe 70s began to address the situationthrough economic cooperation schemessuch as the Preferential Trading

Arrangement of 1977, aimed at tariffpreferences for intra-ASEAN trade.

ASEAN geared up itsintegration effort at the Third ASEANSummit in Manila in 1987 by adoptingan Enhanced PTA Programme. In 1992,it launched a scheme toward an ASEANFree Trade Area Agreement (AFTA) aswell as some other measures through theFramework Agreement on EnhancingEconomic Cooperation adopted at theFourth ASEAN Summit in Singapore.Five year later, the ASEAN leadersimplemented the ASEAN Vision 2020 tostimulate economic integration within theregion. The purpose of AFTA is to“increase the ASEAN region’scompetitive advantage as a singleproduction unit” (ASEAN Secretariat,2004) by removing tariff and otherbarriers among the ASEAN countries toachieve greater economic efficiency,productivity, and competitiveness. TheCommon Effective Preferential Tariff(CEPT) schedule has worked as theimplementing mechanism for the AFTA.(The ASEAN Secretariat, 2004). Tradeand investment liberalization is not theonly way of pursuing economicintegration. According to The ASEANSecretariat (2004), ASEAN is alsopromoting trans-ASEAN transportationnetwork, the interoperability andinterconnectivity of the nationaltelecommunications equipment andservices, and trans-ASEAN energy

networks.

Two simple measures ofeconomic integration show thatASEAN’s economy has been integrating.According to catching hypothesis, aseconomies integrate, the countries withlower initial income and productivitylevels benefit as information andtechnology transfer from the developedcountries, thereby raising theproductivity without paying the cost ofresearch and development. That way, theless developed economies catch up withthe more developed countries, a tendencymanifested through higher GDP growthof the latter. The graph suggests that likethe other cases of integration, the lessdeveloped economies in ASEAN(Cambodia, Laos, Myanmar, andVietnam) have experienced much higherGDP per capita growth than ASEAN6(Brunei, Indonesia, Malaysia,Philippines, Singapore, and Thailand),which in contrast experienced negativegrowth due to the 1997 crisis and the2001 economic slowdown.

Growth in percent of intra-regional trade as a percentage of theregion’s total trade is also a good measureof regional integration because economicintegration tends to raise trade within theregion compared to total trade. From1993 to 2003, trade within the 10 ASEANeconomies as a percentage of theeconomies’ total trade had risen by 3%.Although data was only available from1993, The ASEAN Secretariat (2004)indicates that the figure in the early 70’swas 12-5%. This suggests that for thethirty years, the figure has risen by 7-10%, implying that the average rate ofgrowth from 1993 to 2003 is likely to belower than the rate of integration duringthe 80s since the rate must have startedto significantly rise at least after the firstmovement towards integration in 1977.

Lagging integration

Although it is clear that integration hasbeen taking place, the rate of integrationhas been decreasing. The fitted line basedon logarithm has a greater R-Squared

Foreign Direct Investment and Economic growth

0

5000

10000

15000

20000

25000

30000

35000

1,981 1,983 1,985 1,987 1,989 1,991 1,993 1,995 1,997 1,999 2,001 2,003

Year

Am

ount

of F

DI i

n U

SD(m

illio

n)bl

ack

-15

-10

-5

0

5

10

GD

P pe

r ca

pita

gro

wth

rat

e (%

) gr

ay

Sources: Economist Intellectual Unit DataServices and Penn World Table

Asia


value (or the goodness of fit), meaningthat it might explain the time-seriesvariation in the intra-ASEAN trade ratebetter than the line based on linearitydoes. This implies that there are someobstacles to deeper economiccooperation.

One of the biggest problems isthat the member nations are politicallyunwilling to pursue full integration,putting off liberalization plans to protectdomestic industries. Since 2000, somecountries have deferred their tariffreduction commitment under the CEPTscheme to protect its industries. Forinstance, fearing that its automotiveindustry would not survive liberalizationof the industry, Malaysia has asked todelay tariff reduction for the ‘sensitivesector.’ Also, in response to the globalabundance of steel production in 2002,Malaysia increased its tariff rates for steelfrom 25 to 50 (Mahani, 2002).

Consumer prices of ASEANcountries are also not diverging when itis natural for prices among the integratingeconomies to diverge and fall, for thelowest price supplier of certain goodexports to the other member countries.Analyzing the cost of 70 commonhousehold products, Schwarz andVillinger (2004) concluded that the pricesstill varied significantly among theASEAN economies, suggesting that thecreation of a large, unified consumermarket is not taking place in the region.The tendency must have discouraged FDIbecause companies cannot market goodsfor the whole consumer market.

The future of FDI and economicgrowth of ASEAN

The CEPT plan was to reduce the IncludeList (IL) products’ tariff rates to below 5percent by 2002. From the comparisonbetween 2000 and 2003 average tariffrates of 7 ASEAN countries, it seems thatASEAN has well adhered to the CEPTplan.

Now the issue is the reductionof both tariff lines of the new members(Cambodia, Laos, and Vietnam),

classified as Temporary Exclusion List(TEL), and the number of sectors in theSensitive List (SL). In 1998, the ASEANInvestment Area (AIA) was establishedto simplify investment procures as wellas approval processes and to make thelaws and regulations regarding FDI moretransparent. It also periodically reviewsSL. Also, TEL for the three newmembers phase out by 2010. In otherwords, given that the three economiesabide by the plan of phasing out and theAIA agreement develops towards a fullmultilateral investment rules agreementas put forward at the WTO, the rate ofeconomic integration of ASEAN will rise(Mahani, 2004). It will take some time,but price differences will decrease as theother economic indicators of thecountries converge.

The other factors of FDI areshowing positive signs. According to thedata of Economist Intelligence Unit, therate of labor productivity increase ofASEAN has been greater than theaverage. For example, that of Vietnamhas grown by approximately 10% everyyear. The major export industries ofASEAN are global high-growth sectors(Schwarz and Vilinger, 2004). ASEANalso has established a number of FreeTrade Areas (FTAs) with non-ASEANcountries, such as the ASEAN-ChinaFTA, to pursue external liberalization.Some countries, notably Singapore, arepursuing bilateral arrangements as well(Mahani, 2002). These efforts will makeASEAN more accessible for foreign

investors, thereby attracting more FDI.Therefore, there seems to be enoughevidence to draw this conditionalconclusion: given that the membercountries carry out the project as planned,inward FDI rate of ASEAN will be backon track, resulting in higher economicgrowth of ASEAN in a number of years.

References:

Alfaro, L., Chanda, A., Kalemli-Ozcan,S., & Sayek, S. (2001). “FDI andEconomic Growth: The Role of LocalFinancial Markets.” Journal ofInternational Economics, Supplement,64, no. 1, (2004): 89.

Fan, X. and Dickie, P. M. (2000). “TheContribution of Foreign DirectInvestment to Growth and Stability: APost-Crisis ASEAN-5 Review.” ASEANEconomic Bulletin, 17, 3, 312-24.

Mahami, Z. (2004). “ASEANIntegration: At Risk of Going in DifferentDirections,” The World Economy, 25, 9,1263-77.

Schwarz, A. and Villinger, R. (2004).“Integrating Southeast Asia’seconomies.” The McKinsey Quarterly,2004-1.

The ASEAN Secretariat (2004).Economic and Functional Cooperation.Retrieved March 11, 2004 from theWorld Wide Web: http://www.aseansec.org/64.html.

Evidence of Catching UpAverage Growth Rate of GDP

-2 -1 0 1 2 3 4 5 6 7 8

ASEAN (1997-2003) 4 Less developed

ASEAN6

EU (1993-2001)Ireland, Portugal, &

SpainFrance, Germany, &

UK

NAFTA (1995-2001)Mexico

Canada & US

Sources: Mckinsey Quarterly; ASEAN Finance and Macroeconomic Surveillance Unit

The Future of ASEAN’s Economy: Growth through FDI


Online Auctions:Changing the Face of Game Theory

By: Dan Tevet

Dan Tevet ‘06 is an OperationsResearch and Engineering

Major in the College ofEngineering

With the advent of the Internet in the past decade, the popularity of online auctions hasexploded. These auctions differ quite a bit from traditional English auctions, requiring

the creation of new game-theoretic models.

Until about ten years ago, theaverage person seldom, if ever,participated in serious auctions.

Though casual charity auctions werealways common, these noncompetitiveauctions needed no game theory analysis.The logic of an auction seemed simple tomost – to keep bidding on the mostcoveted item until the price exceeded whathe is willing to pay. The only truecompetitive public auctions occurred inSotheby’s-style houses, where rich patronswould gather to hear a fast-speakingBritish auctioneer attempting to sellpretentious artwork. These “Going,Going, Gone” auctions were believed bymany to be the only type.

How the times have changed.The advent of the Internet in the pastdecade seems to have drastically changedthe perception of an auction. With theplethora of online auctions currentlyavailable, anyone can become an avidbidder. This explosion in auctionparticipation, coupled with the fact thatonline auctions differ greatly in form fromlive auctions, has led to great demand for

game theory models. Though there aremany interesting topics to address, I willfocus on two: second-price auctions andsniping in online auctions.

The vast majority of auctionsprior to the era of the Internet were simplefirst-price auctions. In this plain andsimple style, the item is given the highestbidder at his or her winning bid. Bycontrast, in a second-price auction (alsoknown as a Vickrey auction), the item isgiven to the highest bidder at the amountof the second highest bid. Though thismethod may seem strange and pointless,it incorporates the major principle of thegame theoretic dominant strategy, whereeach participant bids his or her value ofthe item.

To show why second-priceauctions are so theoretically attractive,consider the simple case of two bidders.Let v1 be the value of the item to Bidder1, v2 be the value of the item to Bidder 2,b1 be Bidder 1’s bid, and b2 be Bidder 2’sbid. Assume that each player knows howhe values the item, but does not know howthe participant values it. First, take thecase where v1 > v2, assuming the item ismore valuable to the first bidder than it isto the second bidder. If Player 1 bids hisvalue (that is, b1 = v1), then consider thepossibilities for Player 2. If she bids morethan v1, she would get the item, but she

would have to pay v1 for it, giving her anegative payoff of v2 – v1, since v1 > v2. Ifshe bids less than v1, she would not getthe item and her payoff would be zero.Thus, if v1 > v2, Player 2 cannot do anybetter than to bid her value, assumingPlayer 1 bids his value.

Now take the case where v2 > v1.Assume Player 1 bids v1 (b1 = v1). If Player2 bids b2 < b1, she does not get the itemand has a payoff of zero. If she bids b2 >b1, she gets the item and has positivepayoff of v2 – v1. Thus, if v2 > v1, Player 2can do no better than to bid her value,assuming Player 1 bids his value.

To examine the case where v1 =v2, assume that the two players bid thesame amount (b1 = b2). In that situation,the item will either go to Player 1 or Player2, each with an equal probability ofwinning the bid at 1/2. Again, assume thatPlayer 1 bids his value (b1 = v1). If Player2 bids b2 < b1, she does not get the itemand has zero payoff. If b2 > b1, Player 2gets the item and pays v1 – v2 = 0, for it. Ifshe bids b2 = b1, she would get the itemwith probability 1/2 and not get the itemwith probability 1/2. Thus, her payoff ineither case is zero. In conclusion, if Player1 always bids his value, Player 2 can dono better than to bid her value and theopposite argument clearly holds bysymmetry. Thus, in a second-price

Cornell


auction, the dominant strategy is to alwaysbid your value.

Though second-price auctionsare more theoretically attractive than first-price auctions for the reasonsaforementioned, second-price auctionshave significant limitations. Mainly, in anopen auction, there are no barriers toprevent someone from initially bidding anobscenely high price (say $20 milliondollars for an iPod). Since the secondhighest bid would be zero, the quickestbidder would get the item for free. Thoughsecond-price auctions succeed in a closed-bid system due to the possibility ofsomeone else having the same strategy,they do not work in open-auctions, or atleast, not in pure form. However, a closederivative of second-price auctions is usedby many auction websites such aswww.ebay.com andwww.bigredexchange.com.

The key aspect of many onlineauction websites, which makes their stylesimilar to that of a second-price auction,is the use of software bidding agents. Auser simply tells the bidding agent howmuch he is willing to pay for the item andthe agent keeps increasing the bids by theminimum bidding increment until eitherno one else is bidding or the user’smaximum price has been met. Thus, theitem goes to the highest bidder at the valueof the second-highest bid plus theminimum bidding increment, at least intheory. As a result of this system, second-price auctions, once rarely used, are nowprofusely utilized millions of times eachday, though the users seldom realize it.

While the use of second-priceauctions is a significant change in auctiontheory brought about by the explosion ofInternet auction sites, the biggestdifference between online auctions andlive auctions is the possibility of “sniping.”Almost all live English auctions (real-timeascending-price auctions) are soft-close,meaning that the human auctioneer closesbidding once no one else is willing to bid.In comparison, a hard-close auction has afixed stopping time, in which only bidssubmitted before the close are counted.Most online actions are hard-close, leadingto the possibility of what has been termedsniping. Sniping involves posting a

relatively high bid at the very last secondsbefore the auction closes. Since the otherparticipants wouldn’t have time to react,the sniper could win the item at a non-competitive bid.

In theory, the use of softwarebidding agents should nullify any threatof sniping, but the situation is not as simplein practice. In a recent analysis of 1000completed eBay auctions, 28% had zerobidders and 16% had exactly one bidder.Of the remaining 56% with multiplebidders, 74% showed multiple bidding(meaning that a bidder raised his reserveprice at least once amid the auction) and18% showed bidding in the last 60 secondsbefore the auction closed. These resultssuggest that sniping, in practice, is not astrivial as theory would suggest.

The main reason for the successof sniping is probably asymmetricinformation. As is common in economics,auctions have an equilibrium if we assumeperfect information, but the introductionof asymmetric information quickly leadstoward disequilibria. People bidding onan item may not know its value or befooled by lower bids. Take, for example,a ticket to a sporting event that I initiallyam willing to pay $40. However, severalhours before the auction closes, themaximum bid is only $10. I then believethat I may have overestimated the valueof the ticket, so I only authorize mybidding agent to bid up to $30. Then, lastminute, a sniper bids $35 and wins. Thus,fear of the winner’s curse (the possibilitythat the winner wonbecause he overvalued theitem), may be the primaryimpetus for sniping.

Though auctionsites have taken muchcriticism for allowingsniping, eBay, as well asCornell’s ownb ig redexchange .com,maintain that sniping is allpart of the game. In fact,one can argue that thepossibility of sniping ismore likely to push anauction toward equilibrium.If everyone were to initiallyenter his true value into the

software-bidding agent, sniping would notbe a problem at all. Hence, the threat ofbeing sniped forces bidders to think hardabout how they value the item. Still, thisanalysis assumes perfect informationamong bidders.

One major auction site, AmazonAuction, has taken steps to preventsniping. If a bid is entered on an AmazonAuction within the last minute beforeclose, the auction is automaticallyextended by ten minutes to allow the otherbidders to rethink their valuation. Therehas been pressure on eBay to follow suit,but only time will tell whether or not thispractice will be followed.

In summary, competitiveauctions, once inclusive only to richpatrons and business executives, are nowaccessible to anyone with Internetconnection. Since the old generation gametheory models, employed to analyzeauctions, mostly apply only to first-priceEnglish auctions, they must be revampedto apply to current online auctions. Also,new models must be created to analyzesuch phenomena as sniping, which waslargely unheard of before the Internetauction explosion. However, the best wayto understand an online auction is simplyto participate in one. For more informationabout participation in the Internet auctioncraze, I encourage you to visitwww.ebay.com. Even better, if you’re aCornell student, visit Cornell’s ownauction at www.bigredexchange.com.

Online Auctions: Changing the Face of Game Theory


Behavioral Economics: ALook into this New Courseand Professor O’Donoghue

By: Tulika Kumar

Tulika Kumar ‘05 is anEconomics and Math

Major in the College ofArts and Sciences

Behavioral economics, an up-and-coming field of economics thatintegrates aspects of psychology

and other social sciences, is finally beingtaught at the undergraduate level byProfessor Ted O’Donoghue. The course,Economics 358, specifically aims toquestion the standard models andassumptions made in economics byshowing that human behavior does notalways fit such traditional ideas. With agoal to modify these standard models andlearn about newer ones that incorporatemore realistic assumptions about humanbehavior, this course assesses whetherthese modifications and interpretationsimprove economic analyses.

Professor O’Donoghue plans tocover four main topics in Economics 358:prospect theory and its applications,hyperbolic discounting and self-controlproblems, altruism and socialpreferences, and errors in informationprocessing and biased perceptions. Real-world applications including 401Kretirement decisions and questions about

full versus partial insurance will bediscussed with respect to behavioraleconomics.

In a previous lecture, ProfessorO’Donoghue addressed a classic timepreference experiment. He askedstudents if they would prefer $10 nowversus $10 next week, $10 now versus$11 next week, $10 now versus $12 nextweek, and so on. The same question wasposed for a one-week delay so that hewas asking $10 now versus $10 twoweeks away, $10 now versus $11 twoweeks away, and so on. The standardresult shows that people tend to be moreimpatient when thinking about nowversus next week than when thinkingabout a one-week delay in the future.Data from the class supports thisconclusion, although very weakly. Thenotion of impatience, as well asanticipation, anxiety, self-interest, andloss aversion, are just a few of the manyexamples of human behavior that affectstandard models.

As an undergraduate atDartmouth College, ProfessorO’Donoghue found a strong liking forpsychology and economics. When heapplied to graduate school, he wanted tocombine the two fields. He went on tocomplete his dissertation at the

University of California, Berkeley, wherehe researched patent design. Towards theend of his graduate career, he was ableto pursue the mix of psychology andeconomics with Matthew Rabin, withwhom he wrote many papers. ProfessorO’Donoghue says that going intoacademics has allowed for his “love forthe twin components of teaching andresearch.” Currently, ProfessorO’Donoghue is co-authoring a paperabout projection bias, when individualsproject current feelings to the future.Specifically, he, along with ProfessorVogelsang and Professor Michael Conlinat Syracuse University, will examineorders of winter clothing items in catalogcompanies. They will explore how thepropensity to return an item depends on

Economics 358,specifically aims toquestion the standardmodels and assumptionsmade in economics byshowing that humanbehavior does not alwaysfit such traditional ideas.

Cornell


the outdoor temperature.

While behavioral economicshas been taught at the graduate level byProfessor O’Donoghue (Economics758), the economics department neverincluded a course for undergraduatesuntil this semester. Economics 358 is notonly a brand new course for Cornell, butit is also new for Professor O’Donoghue.When asked about the challenges hefaced while designing the course, henoted that it was difficult “trying to puttogether a course that is coherent,”especially without a textbook. Thecourse is designed so that students learneverything they need to from lectures andsome supplementary articles. ProfessorO’Donoghue also realized in order toshow how behavioral economicsquestions standard assumptions andmodels, he would actually have to firstteach these standard notions. As a result,he usually devotes some time tounderstanding standard economicmodels, throws some twists and turns intothem, and shows how a newer model thatincorporates human behavior mayexplain real-world settings in a betterfashion.

An interesting feature of thecourse is that it is designed in a veryflexible manner. No matter what,homework will count for 30% and examsfor 70%. How the 70% is allocated iswhat is unique to this course. Dependingon each student’s individual performanceon the exams, he weighs the examsdifferently for each student. The twoprelims can be 15% each with a 40%final, or 25% each with a 20% final.

For students who are interestedin taking Behavioral Economics, hesuggests a good way to get a generaloverview of the course matter is to takea look at a book written by Richard Thalercalled “The Winner’s Curse: Paradoxesand Anomalies of Economic Life.” Thebook documents anomalies inconsistentwith standard economic models.According to Professor O’Donoghue, itis very accessible at the undergraduatelevel. The prerequisites for the courseinclude Intermediate MicroeconomicTheory (as taught in Economics 313 or

301) and some knowledge of calculus.

For his current students, when asked fortips on how to do well on the final examfor Economics 358, ProfessorO’Donoghue advises, “Be calm. Thinkfirst, then write.”

Overall, the course seems to bevery different from other upper-leveleconomics classes. It has numerous real-world applications and ProfessorO’Donoghue has a unique and funapproach to the class. As for his personalgoals for the course, he says, “what I hopeto get across most is to illustrate thebeauty of the economic way of thinking”since specifically behavioral economicsshows “economics at work.”

References:

Interview with Professor TedO’Donoghue – Thursday, March 3, 2005

Class website – http://instruct1.cit .cornell .edu/courses/econ358/

Research: search articles sinceFall 2003 on DSpace at theCornell University Librarywww.dspace.library.cornell.edu

Print edition: available onlineby study week atwww.rso.cornell.edu/ces/publications.htmlJoin our Fall 2005 issue! Visit ourwebsite at [groups.yahoo.com/group/visiblehand] or subscribe toour listserv by sending a messageto [[email protected]]

Acknowledgements

The Visible Hand would like toprofusely thank:

Dr. Isaac Kramnick, Vice Provostof Undergraduate Education forhis continued dedication toexcellence in undergraduateorganizations and for providingmost welcome financial support.

Dr. Robert J. Cooke, Director,Internet First Press, Dean ofFaculty Emeritus for his supportin archiving the journal online fordecades to come.

The Economics Department forproviding us with the resources toraise economic, social, andpolitical awareness.

The Student Assembly FinanceCommission for their generouscontinuous financial support,without which none of this wouldbe possible.

Daryl Andersen of ICS Press forhelping us to create a great lookingpublication time after time.

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