The New Economics of Online Education

Let’s stipulate up front that there is an old model of online for-profit education that has completely failed. The old model is this: take everything that used to be done in person, put it online, charge for it. There are some programs along these lines that are still kicking, and some traditional universities have online programs, but it seems clear now that the future of online education does not lie here.

A large problem with this model is incentive-compatibility. The incentives of the online provider are to enroll as many students as possible, especially since students are often subsidized, and then to let standards slip so that the students pass. If most students fail, they will be angry, and the commitment to keeping standards high is not credible. High standards are not a subgame perfect equilibrium.

The reason most universities are not for profit is that the profit motive strengthens the incentive to let standards slip, although it should be noted that standard-slippage has happened, albeit more slowly, even at non-profit universities. The great success stories in for-profit education are those that generate easily verifiable skills. For instance, if you want to learn German, you are probably better off going to Berlitz than to Harvard. When you finish at Berlitz, you know whether you got your money’s worth because you know whether you know German; this solves much of the incentive-compatibility problem. If Berlitz taught English literature (to English speakers), I don’t think it would be as successful as Harvard.

Enter Udacity. Unlike many other online education providers, Udacity has not tried to simply replicate the old in-person education experience online. Rather, they are adopting an entirely new business model. First, they have a radically different cost structure than traditional providers. Udacity does its grading by AI, so the marginal cost of another student is basically zero. It has a much higher fixed cost per course, because it needs to train the AI to grade homework and exams.

Since Udacity’s marginal cost of a student is zero, it can give away the courses for free if it can find another way to cover its fixed cost. I perked up when I read this:

All classes are currently free, and the goal is to keep it that way. When asked how it will make money, [Udacity co-founder] Sebastian [Thrun] pointed out that recruiting good technical talent is something that companies pay for. Udacity knows who the best students are and could pass them along to companies looking for new hires.

In Silicon Valley, finding talent is so difficult that recruitment bounties are often as high as 20 percent of the new hire’s first-year salary. This provides an opportunity for a new revenue structure for online education: vertical integration into job placement.

Udacity can sell its database of high-performing students to recruiters from tech firms. They can survey these students to see if they are interested in a job before they do so to ensure that the database is high quality in the interest dimension as well. This database is a very valuable asset, one that seems likely to cover Udacity’s fixed costs.

I think the Udacity model can succeed in subject areas where:

  1. Skills command a large premium in the labor market.
  2. Employers can verify skills in the medium run, so that they can decide whether to continue to pay for Udacity-educated recruits.
  3. It is possible to evaluate coursework using artificial intelligence (we’re not there for writing yet).

Udacity has started out with classes on computer programming, because that is what its founders know, but they seem eager to expand to new subject areas. I wonder if economics will be one of them.

Socially, there are some advantages to the Udacity model versus the traditional university system. Perhaps most obviously, we can avoid a lot of the student debt crisis. Since classes are free, there is no tuition expense, and since revenue is constrained by the labor market, the skills taught will need to correspond to those that are valuable. We can also save a lot of money on government subsidies for higher education; indeed, cutting off these funds now would hasten the adoption of new education business models.

Speaking generally, new contexts allow for new business models. People are often slow to recognize these new opportunities. We need to make sure as a society that we are not locking in old business models and preventing change. This means giving up control and being willing to be surprised by the outcome.

Would You Use a Brain-Computer Interface While Having Sex?

Adam Ozimek reminded me of his old post on brain-computer interfaces, in which he argues that in the future virtually everyone will have one. Adam reasons that such interfaces will augment our intellectual capabilities so much that only a few extreme luddites will turn them down. If I were in a different mood, I would probably agree with him; it is a good post. However, I’m not in that mood (go ahead, psychoanalyze me), so I will make the opposing argument.

It is a basic trope of science fiction that as human technology advances, humans will begin to meld with their machines. Maybe we won’t be RoboCop exactly, but we’ll have significant physical modification to extend our capabilities. Transhumanists say that at some point in the not-too-distant future we might even be posthuman.

I’m not a luddite; I am a relative optimist, for instance, about radical life extension, and I am certain that brain-computer interfaces will be widely used to help the disabled, if we don’t have the technology to fix their disabilities directly. But when I think about a world of increasing wealth, I don’t think of one where everyone is part computer. I basically think about vacations. What do I like to do when I’m on vacation? I like to eat good food, see and try new things, lay in the sun, be creative, have good conversations with friends, have plenty of sex, read books, and generally unwind.

What do these things have in common? With the exception of reading books, which to me is an awful lot like conversation, they are all things our distant ancestors enjoyed as well. Is this so surprising? We are all paleolithic animals; 12,000 years ago our ancestors invented farming, but humans have barely evolved since then. Human evolution is happening at a rapid rate, but 12,000 years just isn’t very long in evolutionary time.

Jared Diamond has famously argued that farming was “the worst mistake in the history of the human race.” There is good evidence from modern forager societies that our forager ancestors had much more time to engage in these primal vacation activities than our early farmer ancestors did. As much as we want to be productive and get wealthy, and maybe this is me projecting a little, we also want to use our wealth to be more paleolithic in a sense. We don’t want to totally revert to a forager lifestyle—which we could do! Rather, we want to take the advantages of modern civilization, technologies that make us healthier, more productive, and more comfortable, and combine them with the things that make us feel more primally human.

What do I not like to do when I am on vacation? Near the top of my list, at least if I am doing it right, is “be notified that I have email.” This is why I am skeptical of widespread adoption of permanent brain-computer interfaces with augmented reality capabilities. As we get wealthier, we will accept fewer interruptions in our lives. It’s also part of why I think Google’s Project Glass will be a failure.

The kinds of technologies that will make the biggest difference in our lives in the future will be the ones we don’t notice directly. Energy breakthroughs will be important, as will advances in materials science. As I wrote above, I am somewhat bullish on curing aging, but we won’t think about how we feel 25 unless we stop and reflect on it; we’ll just keep living and feel great. Many current technologies will evolve in more ambient directions. Our houses will just know what temperature they should be; the user interface will gradually disappear and the technology will get out of the way.

The bottom line is that a simple heuristic to think about technology in a wealthier world is just to ask, “would I want to use this if I were on a great vacation?” I don’t think that the kind of direct-to-brain augmented reality technology that Adam envisions passes that test.

Bleeding-Heart Social Moral Anti-Realism?

Like many of you, I have been enjoying recent posts on Cato Unbound about “bleeding-heart libertarianism,” as well as on the similarly-named blog. What follows are some half-formed thoughts they prompted. This post is not meant as an explicit critique of anybody; everyone involved knows way more about philosophy than I do.

Most philosophers (and virtually all ordinary people) accept or lean toward moral realism, the idea that moral claims purport to report facts, and that these facts are sometimes true. But it seems to me that we can distinguish between “individual moral realism” and “social moral realism” (my terms; real philosophers might have other ones). For the purposes of this post, let me accept individual moral realism; there is such a thing as the good life, and moral claims about individuals sometimes correctly report facts about it.

The acceptance of individual moral realism does not necessarily obligate me to accept social moral realism. There is at least one possible reason to think that social moral realism is unnecessary, and one for rejecting it. First, social moral realism is unnecessary if all true claims about the good society follow directly from facts about the good life. If this were true, then there would be no independently true claims about the good society. True claims about social justice, for instance, would be mere restatements of true claims about ordinary justice.

Second, we should reject social moral realism if insofar as the good life for some people is in tension with the good life for others, it is impossible to coherently rank different conceptions of the good society. Think of it like Arrow’s impossibility theorem. Arrow proves that even if there are such things as facts about individual rationality, there are not necessarily facts about collective rationality (under particular assumptions). Why would something similar not hold for morality?

I read both Rawlsians and utilitarians as attempting to assert facts about the correct way to adjudicate tensions between individual pursuits of the good life. These assertions are similar to those about different methods of collective decision-making: “Simple majority voting is the best decision-making system!” “No, instant run-off voting is the best!” “Have you forgotten about the Borda count?” If something like Arrow’s theorem holds for morality, we should reject Rawlsian and utilitarian claims. Further, we might be suspicious of them as attempts to wield power over people (not very libertarian, huh?).

What does this mean for bleeding-heart libertarianism? To my mind, it means that the strongest grounds for BHL is simply individual morality. It is wrong, inconsistent with the good life, to seek to dominate other people for the sake of domination; this plus some reasonable positive claims about the world implies quite a bit of libertarianism, does it not? It is good for people—it cultivates gratitude and compassion, which are good—to be concerned about those who are marginalized. These, to me, are far more persuasive than top-down approaches to BHL.

I know the above is sloppy. I’m happy to be corrected or constructively criticized, so go ahead, real philosophers: shoot holes in my argument.

Marketizing Democracy

The Boston Review published a symposium on inequality. It features a lead essay by David Grusky and responses by several commentators. The Internet has assigned me to reply to Mike Konczal’s response, which I am happy to do.

Mike agrees with David’s point that there is an awful lot of “corruption, bottlenecks, and sweetheart deals” in our highly politicized economy, and that these generate inequality. However, he disagrees with David’s prescription:

But Grusky also thinks that a program to reduce inequality should embrace an authentic commitment to a competitive market economy, as if there were such a thing as a pure, competitive market economy, apart from law and regulation. Instead, we need to acknowledge that markets always depend on legal and regulatory choices, that different choices of laws and regulations lead to different outcomes, and that part of the point of democracy is to make those legal and regulatory choices well. We cannot take refuge in the abstraction of a competitive market economy. (emphasis mine)

Mike’s solution is “democratizing markets.” He wants us to make different legal and regulatory choices, especially about corporate personhood, debt and foreclosure, basic services, and labor policies. I don’t agree with his policy recommendations, but given our respective ideological commitments that is not much of a surprise. Instead of rehearsing familiar (and boring) arguments against these, I want to try to challenge Mike at a more fundamental level.

On Mike’s view, (part of) “the point of democracy” is to make good collective choices. If the same collective choices are made by plutocrats instead of by the median voter, they will not turn out as well for everyone. This is a common view.

To me, it is not an attractive one. This is not because I think that plutocrats should be making our collective choices for us (I don’t), or even because the median voter does such a terrible job (she does). It is because the point both of democracy and of reducing inequality should be to foster self-governance.

Let’s take the latter point first. A number of conservatives and right-leaning libertarians have argued that inequality per se does not matter; what matters is absolute poverty. This is not my view. Relative inequality matters to me insofar as it leads to some people being socially marginalized, even if material conditions are quite good. It seems to me that it is difficult to flourish if you are isolated; there is little for your autonomy to be about. Therefore, to whatever extent inequality causes social marginalization, I am against it. On the other hand, we can in principle imagine a social change which creates more material inequality but nevertheless decreases social marginalization; I would be in favor of this change. For instance, the increase in professional opportunities for women since the 1970s has dramatically reduced their social marginalization even as it increased material inequality through assortative mating, and on the whole this was a good change.

Our political institutions should also foster self-governance, and democracy as it is popularly conceived—majority rule—does not do this. It is a system in which we are all subject to an anonymous deciding vote, the median voter. If the median voter says I must give $1000 to Bill, it does not matter whether Bill is homeless or married to Melinda Gates: Bill and I are not relating to each other as free persons, and our relationship is not self-governing. Nor is our relationship truly self-governing if the median voter merely declines to intervene in it; she always hangs around like the sword of Damocles.

What would political institutions that foster self-governance—true democracy—look like? For one, the median voter would have no more power than anybody else merely in virtue of being at the center of an ideological spectrum. Instead of dealing with value pluralism through voting, true democracy would accommodate it by allowing people to self-select into one or more like-minded communities. These communities could develop their own collective decision-making methods, but they would at every moment be subject to each person’s willingness to remain in the community. Collective decisions, therefore, would be undertaken not for a fixed polity, but for a coalition of the willing. Communities, too, could relate to each other on whatever terms they both agree on, or they could choose to ignore each other entirely.

In its better moments, the Occupy movement thinks in terms similar to these. At less clearheaded times, it contradicts these ideas by making demands of people outside its coalition of the willing. Despite these contradictions, there is much to admire about Occupy’s voluntary efforts to supply basic services to the poor and marginalized. Mike points out that these services were made “universally and unconditionally available, rather than distributed through market logic.” The ironic punchline of this story is that at a deeper level, it is precisely market logic that distributed these resources. The logic of the market is like the logic of true democracy as I’ve described it above. At its core is accommodating value pluralism through freedom of association, rather than by forcing dissenters to submit. And as the Occupiers have shown, to whatever extent meeting the needs of the marginalized is an important part of our values, we can do it through voluntary association rather than through the conscription of unwilling participants.

So whereas Mike wants to democratize markets, I want to marketize democracy. I want to find ways for us to live together that create rather than restrict autonomy for each of us, and for our communities. I don’t think that such an arrangement would result in a utopia, and I can’t promise a particular outcome, such as a massive reduction in inequality, with certainty; when we relate to each other as free persons, by definition the outcome is open to surprise. But when I think about the litany of outrages that majority-rule democracy has wrought—the prison-industrial complex, immigration restrictions, the war on drugs, urban public schools, agricultural subsidies, and corporate bailouts to start—I am grateful that we have more markets and less democracy than Mike desires.

Could the US Default?

One claim that I often hear around the blogs and tweets is that the US could never default because it borrows in its own currency. Greece defaulted because it borrows in Euros, and other EU countries have strong objections to the ECB printing money to pay off Greece’s debts. However, when the US debt comes due, the worst case scenario is that the Fed prints up the funds to pay off the debt. Problem solved.

I don’t think the US monetary-political system works that way at all. Let’s run through some back-of-the-envelope calculations. According to Wikipedia, before Greece’s default, it owed around €350 billion; the default constituted a €107 billion reduction in debt. Let’s call that ratio 30%.

Let’s suppose that the US had to print enough money to weather a Greek-style crisis. Could it cover 30% of its outstanding debt simply by printing the funds? According to the Treasury, as of last Friday, the US owes $10,820,230,118,370.38 to the public. To do so, it would have to print and introduce into circulation $3.25 trillion.

What would that do to the economy? According to FRED, as of last Wednesday, there are currently less than $1.1 trillion in circulation at the moment. So printing enough money to weather a Greek-style crisis would result in almost a quadrupling of the number of dollars in circulation. In the long run, if velocity is determined basically by technological factors, that means that we would expect prices to almost quadruple. This would represent a seizure of assets from holders of future nominal claims, which would be damaging to the economy. However, in the short run, the story is even worse. If I were concerned that the government was going to print $3 trillion, I would try to get rid of all my cash holdings and hoard real resources. So would everyone else. This could cause a hyperinflation even before the Fed starts printing money. Banks, too, would want to convert their nominal assets into real ones. And since real resources would be hoarded, they would not be available for use in investment projects. It would be an economic disaster.

If you want to salvage the hypothesis that the US could never default, you would make two points. First, the government need only credibly commit to printing money to pay off its debts if necessary. The fact that markets believe it would do so means that interest rates on Treasurys never get high and the fiscal burden of interest payments are bearable. Second, the economic effects of a default would also be pretty bad. Since an economic collapse is unavoidable either way, it is better if politicians credibly commit to printing the money if necessary.

However, I’m not sure that the government can credibly commit to printing instead of defaulting. Almost half of the US debt is held by foreigners. If you were a politician seeking reelection, would you not counter a proposal to inflate away $3.25 trillion of debt with a suggestion to default on debts held by foreigners? This would wreak economic havoc, but the worst damage would be borne by China and Japan, not by your own beloved constituents. I’m not saying this is a good idea, but to my mind the US political system, defective as it is, cannot credibly commit to not doing this.

The other factor that makes the situation worse for the US than for Greece is that Greece has an international consortium as a backstop to make credible loan guarantees. These guarantees are worth hundreds of billions of dollars. By no one can credibly guarantee the US’s trillions of dollars of loans. This means that while Greece’s crisis has played out as a slow and steady collapse, a US crisis would be more severe because it would happen much more suddenly.

My claim is not that the US is likely to default. Rather, my point is a narrow one: people who say that the US could never default because it borrows in its own currency are mistaken. They should either stop saying that or tell me why I’m wrong, which I would be happy to be.

Etsy and the Business Cycle

Reihan Salam offers some very good thoughts on self-employment via Etsy and Kickstarter as a possible driver of economic recovery, in which he kindly quotes yours truly on technologies of control and resistance. What follows are just a few additional ideas on self-employment prompted by his post.

In response to Reihan, Justin Wolfers tweets that, in fact, self-employment is falling, citing BLS data. I’m not totally persuaded that the metric Wolfers points to, “Self-employed workers, unincorporated,” actually captures all the movement we are observing. To the extent that more people are interested in self-employment, thicker markets in incorporation services develop, so it’s possible that unincorporated self-employment could fall even as total self-employment increased. More importantly, a lot of people have several income streams, only one of which is a full- or  part-time job. Unless I am mistaken, these people show up in the household survey as employed either full-time or part-time, even though their Etsy/Kickstarter/App Store/Kindle Single incomes are economically or otherwise important.

I was in that category last year. I had a part-time job, but I earned more money through the Mac App Store and various freelance economist gigs than I did from my job. I have a good friend who works part time so that she can pursue her passion for felting through Etsy (and increasingly, other avenues). I have no idea how substantial her Etsy income is, but I know that Etsy is an important part of her life.

Putting aside whether self-employment is rising, I am convinced that self-employment is desirable, other things equal, from a business cycle perspective. This is true whether you are a Keynesian or a ZMP theorist. A popular Keynesian story is that when demand falls, workers refuse to accept nominal wage cuts without a corresponding decline in morale, making them less productive. Consequently, firms prefer to fire a fraction of the workforce and then announce “no more layoffs” rather than cut wages for everyone. Promises from laid-off workers to work at half their former salary with no decline in morale are not credible. Self-employment maybe doesn’t solve the problem of low morale during a recession, but it at least obviates the need to make promises about future work at low salaries. When demand falls, self-employed workers accept lower wages, at least until they find other employment, because what choice do they have? And there is no one they need to convince to keep them on staff.

There is something to the morale story, although I have a hard time believing it can explain a protracted recession. I’ve been pushing a version of ZMP theory that considers the agency costs associated with overseeing employees as roughly a fixed cost (I consider this version a complement to, not a substitute for, other versions of ZMP that are based more on coordination and recalculation). Although we teach in freshman econ that the wage equals the marginal product of workers, workers also have to cover the overhead associated with hiring them, which is often substantial. A major part of the cost of employing workers is the cost of supervising them, and this cost is fixed with respect to demand. If we suppose that a worker can produce $30/hour and costs $15/hour to employ, the worker will take home $15/hour in wages, his net marginal product. If demand falls so that the worker’s output is valued at $20/hour, and the cost of employing him remains $15/hour, his net marginal product falls to $5/hour, which is below the minimum wage. The employee is therefore unemployable, even if his wage demands are totally flexible, and he will be fired.

In this example, a 33% decline in the value of output resulted in a 67% decrease in net marginal product and a 100% decline in employment. Fixed management costs, therefore, tend to amplify the effect on workers’ employment prospects of shocks to demand (or supply). Because there are no agency costs associated with self-employment, demand and supply shocks are not amplified among the self-employed. Employment is fragile; self-employment is robust. We should expect that a self-employed economy would not be as susceptible to long recessions as an employed one.

It is worth exploiting an analogy with another fragile market, the market for bonds (and for other financial claims with priority). It is well understood among economists that debt instruments are more fragile than equity instruments. The value of a bond is relatively insensitive to changes in the underlying income stream when profits are high, but becomes extremely volatile when the underlying income stream approaches the margin at which repayment comes into question. The volatility is compressed into a narrow range of profit space. In contrast, if an income stream is divided only among a single tier of equity, the value of the equity instrument will vary smoothly with the income stream.

The net marginal product of an employee with substantial management costs is like the value of a bond. It varies relatively slowly when business conditions are good and becomes extremely volatile at the low end of the business conditions spectrum. The volatility is concentrated, if not fully compressed, into a relatively small range of outcome space. And concentrated volatility means fragility. Many economists recognize that it is desirable for an economy to limit its use of debt finance in favor of equity finance. Financial systems that are heavily reliant upon debt are prone to crisis when times get bad. Similarly, when employee management costs are high, it is desirable for an economy to limit its use of employment in favor of self-employment.

In paragraph 4, I added an important caveat: “other things equal.” People generally work for firms because firms are productive intermediaries. But to the extent that Etsy, Kickstarter, and other platforms can disintermediate the labor economy, we should be very grateful. Not only are these platforms beneficial technologies of resistance as Reihan emphasizes, they might be generators of macroeconomic robustness.

A Straussian Reading of *Launching the Innovation Renaissance*

This is a post that I promised to write several months ago; I hope that in spite of its tardiness, you will find that it contributes much to the issues of the day.

You may recall that Tyler Cowen included hidden meanings in his short ebook, The Great Stagnation. It turns out that he is not alone. Tyler’s Marginal Revolution co-blogger, Alex Tabarrok, also has an esoteric style. Whereas Cowen points us to the future by looking at the recent past, in Launching the Innovation Renaissance, Tabarrok points us to the more distant past by ostensibly talking about innovation in the future. Underneath all the sensible-sounding evidence-based arguments for reform is a hidden, retrograde manifesto that establishes Alex as one of today’s leading reactionary thinkers.

In case you think I am making this up, let me start by noting that the book literally begins over 700 years ago, in 1296. “From father to son, to son again, the architects, stonemasons and artists of Florence labored with love and devotion to produce the greatest cathedral the world had ever known” (26). Since that time, things have gone mostly downhill, as the institutions that made medieval Florence great have foundered. The questions that Tabarrok wants you to ask yourself are these: “When I go to work, do I labor with love and devotion? Am I producing something of transcendent value, like a cathedral, or am I just doing a mundane job? How can we go back to a simpler time of less turbulent change and greater personal meaning?”

Of course, Tabarrok cannot dwell on the medieval period throughout the book without giving away his occult hypothesis to even his slower readers. Consequently, he discusses several different eras of the past and how they are superior to the present. For instance, lamenting the modern patent system, he writes, “As early as 2,500 years ago the Chinese were breeding new roses, and Confucius tells us that the emperor had hundreds of books about roses and rose breeding in his library. The world did not appear to lack new roses even though, until 1930, no roses were ever patented” (83). This is a telling metaphor. The “old roses,” the old books, the old ways—they are just as good as, if not better than, the new roses.

Not only was the past a simpler and more satisfying time, the excesses of the modern world are deeply disturbing. One can almost feel Tabarrok recoil in horror as he relays the story of the OncoMouse, a genetically engineered monster. To the modern mind, this is a great advance; but a careful reader can discern Tabarrok’s deep reservations about this kind of coarsening of the value of life. He notes that mice “share 95 percent of their genes with humans” (205). It is bad enough that people might conduct experiments on creatures that are 95 percent human; must we also play God with these close cousins of ours by modifying their genes? And must we, of all things, patent them?!

Tabarrok is perhaps at his most persuasive when he points out that the deterioration in American education is caused by ill-advised “advances” in the rights of women:

One of the reasons for the poor performance of U.S. education is that teacher quality has declined significantly over the past four to five decades.

In the 1970s smart women became teachers. In fact, in 1970 about half of all college-educated women were teachers…Many smart women have exited teaching and entered the professions because of declining discrimination in the professions… (454)

It seems obvious—is it even worth pointing out?—that the simplest way to improve teacher quality is to bar women from entering professions like law, medicine, and business. This bit of subtext, needless to say, is completely lost on Alex’s less attentive readers.

Another problem with the modern world, according to the esoteric Tabarrok, is that people no longer have respect for the station in life in which Nature has put them. In a word, people are uppity. This causes countless problems, not least of which is higher education. “College has been oversold, and in the process the amount of education actually going on in college has declined as colleges have dumbed down classes and inflated grades to accommodate students who would be better off in apprentice and on-the-job training programs” (525). If only we could return, says Tabarrok, to a time when people knew their place.

Launching the Innovation Renaissance represents Alex Tabarrok standing athwart history, yelling “Back up 700 years!” You may think that these ideas are unlikely to gain much traction. Nevertheless, I think they have great relevance in today’s political debate. In fact, although Alex has not yet publicly endorsed a presidential candidate, I bet I can predict who he will be supporting.

Triangles versus Trapezoids, Spectrum Auction Edition

Good news! The FCC is going to auction off more radio spectrum! This is a huge win for sensible policy no matter what your ideology; let us all rejoice.

Nevertheless, there is still some ideological and self-interested debate over the auction itself. Harold Feld reports that AT&T and T-Mobile, among others, are fighting over the FCC’s ability to impose eligibility restrictions on the auction. Effectively, the question is whether AT&T and Verizon should be allowed to participate in the auction since they are such dominant incumbents in the wireless industry.

Under some circumstances, it makes sense to keep dominant incumbents out of auctions. Klemperer shows how the presence of dominant incumbents, combined with poor auction design, can reduce entry and facilitate collusion in spectrum auctions. The important point, however, is that good auction design can virtually eliminate these problems. We’ve learned a lot about spectrum auctions in the last 10 years, much from Klemperer himself, so I really don’t think this is a very good reason to impose eligibility restrictions on spectrum auctions any more.

Feld advances a different possible rationale for eligibility restrictions. He argues that there is a tradeoff between auction efficiency and competition policy. Since AT&T and Verizon have deeper pockets and economies of scale, they can win any auction they want to win, which further entrenches their duopoly. So either we accept some inefficiency in terms of spectrum allocation from eligibility restrictions in the auction or we accept some inefficiency in terms of mobile service allocation from reduced competition in the wireless industry.

I don’t quite agree with Feld that this is much of a tradeoff. I’m not terribly worried about competition in the wireless industry, which strikes me as much more Bertrand than Cournot. I also think that modern finance can pretty much handle funding for smaller players or new entrants, and that at some point, there must be diminishing marginal utility to spectrum even for AT&T and Verizon; if the wireless industry is not competitive enough, it should be dealt with by auctioning off even more spectrum.

But putting these issues to one side, my intuition is that it’s still much more important that the spectrum be allocated efficiently than that competition in the wireless industry be maintained. Consider the graph below, which shows the market for wireless services.

If the market is imperfectly competitive and the price and quantity are given by the dashed lines, then the shaded triangle represents the deadweight loss from diminished competitiveness.

Now consider a different graph for the wireless services market:

This graph shows the situation when the most efficient producer is kept out of the market. The marginal cost rises from MC1 to MC2, and the deadweight loss is represented by the shaded trapezoid.

Now I will say something that is obviously absurd to a geometrician, but is nevertheless true in economics: most of the time, trapezoids are much bigger than triangles. Is it a totally rigorous statement? No. But when you are talking about changes on the same order of magnitude, you are almost always better off if you accept the deadweight loss triangle to avoid the deadweight loss trapezoid.

My intuition, therefore, is that we should not restrict participation in spectrum auctions. To turn that intuition into rigorous analysis, obviously we would need to estimate some parameters and bring back in those issues we put to the side earlier. Nevertheless, I think some of these intuitive concepts can take us a long way to better economic policy.

Is There a Cybersecurity Market Failure?

That is the title of my Mercatus working paper (PDF), released yesterday. Basically, it aims to be a short course in public economics for tech policy analysts. Almost all policy wonks have taken Econ 101, perhaps even a graduate version, in which they learn that externalities can cause markets to get prices wrong, and that this can result in market failure. What my paper stresses is that this link, from externality to market failure, is not automatic.

The paper is heavy on “what Coase really meant” (lots of smart people get this wrong), on non-property institutions and norms à la Ostrom, and on the often-ignored inframarginal externality as discussed by Buchanan and Stubblebine. By applying these ideas to cybersecurity policy, I try to show that it is not at all as obvious as many analysts think that there is significant scope for welfare-enhancing regulatory intervention. The point is not that there is literally zero market failure, but that proponents of cybersecurity regulation have not done the work they need to to show that market failure exists, if it exists. Indeed, many policy analysts may not even realize they are missing something. I hope that this paper will correct that and lead to a more humble and cautious approach to market failure among its readers.

I have plans for more work on tech policy in the future. Internet security and governance is a great research topic for young, tech-savvy economists interested in polycentric governance and institutions. If you’re interested in doing research in this area, let me know, I may be able to help.

Copyright Theory versus Copyright Law

In honor of the SOPA blackout, here are some thoughts on copyright law. But first, a brief detour into murder law.

There are a positive number of murders each year. If we put more resources into investigating and prosecuting murders, there would be fewer murders. Nevertheless, it is not at all clear that we are spending too little on murder. The optimal number of murders is positive, not zero. The best policy with respect to murder is to try to maximize the net benefits of the policy, not to minimize murders.

Suppose a new technology were introduced that made it easy to get away with murder (e.g., David Friedman’s plan for Murder Incorporated). This technology makes it extremely costly, though, say, not impossible, to stop murders from occurring. What happens to the optimal amount of murder enforcement? The amount that must be spent to deter each murder has gone up, so the price of deterrence has gone up. Consequently, society should aim to deter fewer murders. Under some extreme circumstances, we might even be better off if murder were legalized (and if people were advised to just be more polite to each other).

Similarly, whatever your prior belief about copyright enforcement, the Internet has made it easier to get away with copyright infringement. The amount that must be spent to deter each instance of copyright infringement has increased. Consequently, society should aim to deter fewer instances of copyright infringement, not more instances as SOPA supporters advocate.

In fact, the cost of deterrence has increased so much that we should begin to rethink copyright law. We could increase the benefits of deterrence if we targeted only high-value infringements. This means that we should shorten the term of copyright, since high-value IP tends to be newer IP (in fact, copyright terms have increased in recent decades, a move in the wrong direction). We might consider expanding “fair use” copyright exemptions to include more non-commercial uses, since commercial infringements are more likely to diminish the value of a copyright. Most importantly, we should withdraw public resources from the enforcement of IP violations. Private enforcement through the tort system has a built-in safety valve: when the cost of enforcement rises, people will do less of it. But the criminal system is essentially a public subsidy for enforcement; no wonder that pro-copyright factions are attempting to criminalize copyright infringement through SOPA and other legislation.

The bottom line is that recent expansions of copyright terms and enforcement powers get the comparative statics exactly backwards. In an age of costly enforcement, it’s time to give up, at least at the margin, on copyright. And at the margin, content creators should just be more polite to content consumers.