Economics is as much a communicable disease as it is a discipline. Economics is a way of thinking about everything and coming to a better understanding of life. When you catch it, the way of thinking (by way of learning a few basic but powerful economic principles), it is hard not to see most of life’s large and small events as economic puzzles worthy of reflection and solution.

We admit it; we are economists with this affliction: We are constantly puzzling over everything we read in the newspapers, watch on television, and hear others say, especially when the comments are about why prices are what they are (and not something else). But then we puzzle over observed prices when many others seem to miss their importance. We understand all too well that prices are the products of so-called market forces, but leaving the explanation at that superficial level of analysis is hardly satisfying, especially since our affliction is terminal. We feel a compulsion to understand exactly what market forces are at work on the prices we see. And when we see prices that do not make sense, our compulsion goes into overdrive. We must understand why prices are what they are.

Chalking supposedly ill-conceived prices up to people’s stupidity (or to their unthinking or irrational behavior) is hardly satisfying, not that we do not recognize that people—both buyers and sellers—do a lot of stupid things as they go about their daily business. Most ill-conceived prices are quickly corrected, mainly because ill-conceived prices imply that someone can make them better—and profit by doing so. The ill-conceived prices we often notice are ones that are systemic and have staying power, or else we would not have time to pay much attention to them, or need to explain them. We cannot help but search for explanations for persistent “ill-conceived prices”—that, to us, by their very persistence suggests that they are not nearly so ill-conceived as thought. Indeed, “ill-conceived prices” often do have rational, albeit counterintuitive, explanations, with “rational” explanations being grounded in the costs and benefits market participants face. Finding explanations for observed prices is a form of economic detective work, which can be fun, especially when the sources of observed prices and their consequences are as unintended as they are unexpected.

Prices have been at the heart of economic inquiries for a very long time, but prices can still be mysterious. Satisfying explanations for the many prices we see all around us can be as surprising as they are elementary. Pricing strategies can also have consequences that are … well, perverse—again, as will be shown time and again throughout this book. For a start, consider a puzzle embedded in Apple’s price for the iPhone on its release in mid-2007 (and its one-third reduction in the price of the top model two months later), Audible.com’s announced clearance sale, and the proposed price control for brothel prostitution in postwar Japan.

Early in 2007, Steve Jobs, the now late founder and CEO of Apple, announced that his company would enter the mobile phone business with the introduction of the iPhone by mid-2007. The iPhone would be a multipurpose device, one that could be used to make calls, to listen to music, to store pictures and videos, and to surf the Web, all with the typically sleek Apple design touch.

In making his announcement, Jobs set off a worldwide media feeding frenzy about the iPhone that reached a crescendo in late June 2007. And sure enough, as the June 29 released date approached, Apple devotees around the world began forming lines outside of Apple stores and AT&T stores (which, at the time, had exclusive service rights). To hold their places in line, many slept for several nights on the sidewalks, even in the rain.

Just before midnight on June 28, the queues outside of many Apple stores wound around several blocks—in spite of some technology reviewers’ warnings that the iPhone had problems (a not-so-user-friendly virtual keyboard and connection incompatibilities, for example) and in spite of iPhone’s high initial prices, $499 for the model with 4 GB of memory and $599 with 8 GB. Notwithstanding the iPhone’s early less-than-stellar reviews, people in the long queues were convinced that the device would be as cool as the phenomenally successful iPod, and would set the standard for the next generation of cell phones just as the iPod had set the standard for MP3 players a half-dozen years earlier.

When the doors of the Apple (and AT&T) stores swung open one minute after midnight on June 29, the throngs of “Appleholics” poured in to snatch up their iPhones. During the first weekend, Apple reportedly sold at least a half of a million, and maybe three quarters of a million, iPhones, several times Apple’s and everyone else’s aggressive sales projections based on market research, but the company could have sold more.1 Any number of Apple (and AT&T) stores quickly ran out of both iPhones models before 1:00 a.m., and surely before the sun came up.2

The iPhone’s introduction, and its immediate market mega-success, is surely puzzling to many economists, if not everyone else, for several reasons. Aren’t markets supposed to clear? If they are, then the long queues at the Apple stores for the iPhone’s release must have been an unintended consequence, or was it? When Jobs saw the media feeding frenzy build early in 2007, why did not he order an even higher price in anticipation of long queues on the release date to ensure that many people would not waste time camping out for days—and, not immaterially—that Apple’s profits would rise? Immediately after that last weekend of June, reports surfaced that the 8-gig model, which was in especially short supply, began showing up on eBay at prices a third higher than the posted retail price at Apple stores. EBay reported that the highest bid for an iPhone that first weekend was a remarkable $12,500.3 Why did Jobs leave money literally on the sidewalks for “technoscalpers” to pick up, or did he? Did Jobs know something that is not apparent to microeconomic textbook authors (who write glowingly about how price hikes can, and will, relieve market shortages)?

Then, we cannot help but wonder why Apple charged only 20 percent (or $100) more for the iPhone with 8 GB of memory than the 4-GB model? Why not more, especially since the excess demand of the 8-gig model was greater? Does anyone really think that the price difference is attributable to the cost difference in memory? If cost does not explain the price difference, then what was behind Apple’s pricing strategy?

During the first week of September after the iPhone’s release, Jobs did what he had never done before: he lowered the price of the 8-gig iPhone by $200, causing the price of Apple stock to fall immediately by 5 percent, because, according to media reports, the price reduction indicated that the iPhone was not selling as well as anticipated, as reported by the Wall Street Journal.4 Might it not be the case that the market got it wrong? Perhaps Apple hiked the price of the iPhone on its release in anticipation of the initial surge in demand—and in anticipation of the price reduction two months later and the encouragement of a “tipping” of the media player market even more in Apple’s favor.5

Even more perplexing, why did the prices for all iPhones end with “9”? For that matter, why have the prices of almost all Apple products, from iPods to iTune songs, ended with “9”? Do Jobs and the obviously very smart marketing people at Apple really think that their buyers are so dumb that they cannot see that prices of $499, $599, or $399 are just a dollar short of $500, $600, and $400, especially since they were obviously smart enough to earn enough to pay the considerable purchase prices of their iPhones? If the $1-off prices were intended to fool people, then it is hard to see how, since so many print and online news reports of the iPhone’s release dispensed with the 9s, giving the prices of the two models at $500 and $600.

Shortly after the iPhone was released in the summer of 2007, we went to Audible.com to download additional audiobooks and were struck by the Web site’s banner announcement: “SUMMER CLEARANCE SALE … 25% Extra Off … Selections from Thousands of Titles.” We could not help but wonder, Audible is clearing out its inventory? How can that be? It does not have an inventory, other than the master copies of audiobooks from which it duplicates the copies its subscribers download (at a close to zero cost to Audible, we might add, since its “inventories” are nonmaterial, or are nothing more than electrons in a server’s hard drives). Surely Audible is not giving up its masters. There would be no need. Why would Audible announce a “summer clearance sale”?

Only a marketing gimmick, you might be thinking? Maybe so, but maybe Audible’s clearance sale suggests that similar sales conducted by brick-and-mortar retail stores may be motivated by some economic motive that is independent of the stores’ interest in clearing out inventories that are, supposedly, unwanted because they represent mistakes in ordering. If inventory clearance does not explain many seasonal (winter, summer, or after-Christmas) inventory clearance sales, then what does? Might not after-Christmas sales be as planned as carefully as the before-Christmas non-sales, suggesting that “sales” may have a hidden logic beyond the obvious that stores use them to move unwanted goods?

If you find such questions uninteresting, you probably bought the wrong book. If you find them intriguing and enticing, then read on, because addressing those kinds of questions is what this book is about—but also much more, as another puzzle dealing with … (oh no!) sex reveals. By the time you finish this book, you should have a far deeper understanding of why Jobs and Apple chose the pricing strategy they did, without our ever providing an explanation—not directly, at least.

Hybridnomics: HOV-Lane Economics, California Style

To encourage sales of fuel-efficient, environmentally friendly hybrid cars, Congress authorized a tax credit for hybrid automobiles (which use a combination of gas and electric powered motors) of up to $3,150, with the credit varying with the hybrid’s EPA fuel efficiency and the year of production.6 The California legislature upped the ante for owning hybrids, authorizing the state’s Department of Motor Vehicles to distribute 85,000 stickers to hybrid owners entitling them to drive alone in any of the state’s High Occupancy Vehicle (HOV) lanes formerly restricted to cars with two or more passengers. But only owners of cars that had an EPA fuel efficiency rating (given the rating methods in place at the time) of at least forty-five miles per gallon received HOV-lane stickers.

The tax credit and HOV-lane sticker privilege did what they were supposed to do. They drove up the demand for the Toyota Prius and Honda Civic hybrids (the only cars that qualified for stickers at the time), but the sticker privilege surely had market consequences that were unexpected and unintended. For example, because of the stickers, the small Prius in 2006 was selling for over $30,000, and had waiting lists until early 2007. The Civic hybrid carried a dealer “added premium” to the manufacturer’s suggested list price of as much as $4,000 (with the hybrid Civic total price more than $7,500 higher than the quoted price of a nonhybrid Civic).

No doubt, there were many hybrid buyers who did not have warm and fuzzy feelings for the environment. They recognized that the tax credit plus the HOV-lane privilege amounted to a reduction in the effective price (dealer price minus tax and commute savings) of the hybrid. The tax credit that accompanied the hybrid purchase lowered the after-tax purchase price of the hybrid. The reduction in buyers’ time cost of their commutes to and from work also lowered the effective price commuters had to pay for their cars. Commuters’ demand for hybrids, inflated by the tax credit and the lower commute times, drove up the dealer prices for hybrids and drove out of the hybrid market many dedicated environmentalists who were not sufficiently dedicated or wealthy to pay the hybrid premiums commuters were willing to pay.

At the end of January 2007, the DMV ran out of stickers, leaving more than 800 new Prius and Civic hybrid owners, who had bought their hybrids at premium prices and who had applied for the stickers, with the tax credit but without the right to drive alone in the state’s HOV lanes.7 They gambled and lost on the stickers, and we can feel their pain.

Now with no more stickers to distribute, what can be expected to happen in the California market for hybrids? No doubt some of the effects we can list were unanticipated and unintended.

First, we should expect a drop in the demand for new hybrids at dealers, along with a drop in their negotiated sale prices. Buying a new hybrid Civic instead of a nonhybrid Civic has been difficult for even warm-hearted environmentalists to justify, since the hybrid would very likely have to be driven over 500,000 miles (or driving the car for more than forty-two years at 12,000 miles a year!) before the savings in gas could offset the added purchase price plus the cost of replacing the hybrid battery (most likely every ten years) and the added interest and sales taxes on the added purchase price.8,9 However, those added car costs can be easily justified by a commuter who earns $40 an hour and who, with the stickers, can save an hour a day commuting to and from work. Such drivers can cover the added hybrid costs through lower commute costs within a year.

Since the HOV-lane stickers stay with the hybrids, the demand for used hybrids with stickers can be expected to rise, along with their prices, perhaps dramatically. Used hybrids with stickers can be expected to sell for more than hybrids comparably equipped with approximately the same miles on them but without the HOV-lane stickers. Hardly surprisingly, by spring 2007, USA Today reported that Kelly Blue Book had found a $4,000 difference in used Priuses with and without stickers.10 No doubt the hybrid/nonhybrid price differential will rise with the growth in California’s population and the count of cars on the state’s freeways and will fall as the expiration date for the HOV-lane stickers draws closer (now set for 2011), and, of course, will rise with any extension in the expiration date for the stickers.

The growing number of drivers with long commutes and high opportunity costs, meaning high hourly earnings, can be expected to spur the demand for used hybrids. They can be expected to buy hybrids from owners who bought their hybrids for environmental reasons and from owners who have lower cost savings from using the HOV lanes, because they have lower wage rates and/or shorter commutes.

As a consequence of the used hybrid sales, we should expect the HOV lanes to become more crowded because the lanes will be dominated to a greater extent by people with longer commutes (while all other lanes will become marginally less crowded), which will, of course, undercut (albeit marginally) the value of the stickers and the price of used hybrids. Given the market value of stickers (equal at least to the $4,000 price differential between hybrids with and without stickers) and the fact that the DMV appears to have distributed stickers that are far from counterfeit proof (even though the stickers are designed, supposedly, to crumble if tampered with), no one should be surprised if a healthy black market for stickers emerges, with the counterfeit stickers dampening the rise in the prices of used hybrids. And not surprisingly, the theft rate for hybrids with stickers exceeds by a healthy margin the theft rate for hybrids without stickers. Indeed, by mid-2007, reports had surfaced that 2–3 dozen sets of California HOV-lane stickers were being stolen from hybrids each month.11

The impact of used hybrid sales on automobile pollution is more difficult to assess. On the one hand, the people who buy used hybrids to speed up their commutes will reduce pollution, since they will be driving the less-polluting hybrids and will spend less time on their commutes with their engines running. On the other hand, the more crowded HOV lanes will mean that other nonhybrid HOV-lane users will, because of the greater crowding, have longer commutes with their nonhybrid engines running all the while. The slowing of traffic in the HOV lanes can also lead to less carpooling (again, albeit marginally).

Should hybrid owners with stickers have been allowed to sell their stickers as separate items, that is, without selling their cars? Of course so, if the goal of government is to make sure that those who use the scarce HOV-lane slots are drivers with the most urgent need to travel faster, but pollution control might be the more important government goal.

On first thought, it might seem that pollution would remain unchanged, since the stock of stickers and hybrids will remain at 85,000; however, you can bet that current hybrid owners with stickers would love to be able to sell their stickers separate from their cars. Doing so would save them the hassle of buying another car, and the added value commuters with Hummers (and all other large and small cars) would put on the stickers would drive up the demand for and price of the HOV-lane sticker advantage. Hummer dealers, before the line folded in 2009, could also see an advantage in independent sticker sales since people could buy Hummers with the intent of going into the “used sticker” market to reduce their commute times. If stickers could be sold independently of the hybrids, we might see another marginal increase in the crowding of the HOV lanes because of the likelihood that some of the used sticker buyers would have cars larger than the relatively small Prius and Civic that would be replaced in the HOV lanes.

The impact of shifting to independent HOV-lane sticker sales on pollution is, again, problematic. If current Hummer owners move into the HOV lanes, they might pollute less, since they would have lower commute times, but, again, the added crowding could add to the pollution coming from all the nonhybrid cars using the HOV lanes for daily commutes. However, independent sticker sales could spur sales of cars and trucks larger than the current crop of hybrids. Such sticker sales could also cause large car buyers to move farther from work.

Hybrid owners needed to be aware that their cars’ resale prices would wane with time because the stickers expired at the start of 2011. Hence, the stickers’ value to both commuters and environmentalists could have been predicted to decrease as the expiration date approached, which indeed happened. The use value of the stickers simply diminished as the deadline drew nearer.

Air Travel Safety for Infants and Toddlers

Historically, parents have been able to buy airline tickets for themselves and hold their infants and toddlers under two years of age on their laps during flights. But in the late 1980s, under the banner of saving children’s lives, the National Transportation Safety Board and Los Angeles Area Child Passenger Safety Association petitioned the Federal Aviation Administration to end the free ride for young children by requiring the use of child-restraint systems in paid seats for infants.12 James Kolstad, chairman of the NTSB, said, “The economic cost of the extra passenger seat … [is] a very small price for preventing injuries and saving lives.”13

To ensure the FAA did not resist changing its child-seating rules, then Representative Jim Lightfoot (R-Iowa) and Senator Kit Bond (R-Missouri) introduced legislation to mandate the use of safety seats for infants and toddlers on airplanes.14 Congressmen Lightfoot was spurred to introduce his bill after the death of two infants in the crash of United Airlines flight 232 in Sioux City, Iowa, in July 1989. (Video of the crash, in which the plane somersaulted down the runway, has been aired repeatedly around the world because of how fiery it was.) Lightfoot spoke for his supporters within policy circles and the general public when he reasoned that rules requiring the use of safety seats in automobiles should be extended to airplanes because “the potential for injury in an aircraft flying at 550 miles per hour is much greater than the potential for injury in an automobile traveling at fifty miles per hour.”15

The FAA, the fifty or so members of Congress, the National Transportation Safety Board, and everyone else who at the time supported the rule change were rightfully concerned with the safety of traveling children. However, what proponents of child seat rules, both back then and since, have not considered is beyond the obvious effects from the rule change, there might also be some unanticipated, unintended, and even perverse results.

The more notable unanticipated and unintended effect was that the infant seat requirement would increase the total price of air travel for families, encouraging families to travel by automobile instead, and auto travel is far more dangerous than flying. At the time Lightfoot and Bond introduced their bill to regulate infant safety in the air, automobile transportation was at least 30–40 times as hazardous in terms of the death rate per mile traveled.16 In a study prepared for the FAA, Department of Transportation researchers concluded that mandatory infant safety seats on airplanes could have prevented at most only one infant death since 1978. All other infant fatalities in airline crashes occurred in sections of planes where no one survived.17 On the other hand, nearly 1,200 children under age 5 were killed in automobile accidents in 1988.18,19 That means that there were approximately one-quarter more automobile deaths of very young children in 1988 alone than there were total deaths of children and adults on scheduled airlines during the entire 1980–1988 period.20,21

According to the FAA’s own (admittedly rough) calculations at the time of the congressional debate, mandated safety seats for infants could increase the average air travel cost of a family of four (two parents with one child over age 3 and one infant) by at least 21 percent—assuming that airlines charged half fares for infants and did not raise their fares across the board because of rule-induced increased demand.22,23 That cost increase could reduce the number of infants on board by about 18 percent, or 700,000, again according to FAA estimates. Nevertheless, the FAA figured that airlines would be able to sell 3.3 million additional seats each year to infants’ parents at a cost of $205 million (equal to about $325 million in 2007 dollars), a handsome sum that explains the airlines’ interest in the proposed rule.24

The precise effect on air travel safety of requiring seats for infants and toddlers has been debated ever since Congressman Lightfoot and Senator Bond introduced their legislation in 1990, and will probably be debated again. One of the authors’ (McKenzie’s) own econometric research (undertaken with colleagues at the University of Mississippi and Clemson University) on the impact of airline deregulation documents a point that the FAA and Congress must keep in mind: air and highway travel are interchangeable modes of transportation for many families. Changes in airline fares significantly alter the amount of highway traffic, and highway accidents, injuries, and deaths are highly correlated with the amount of highway travel and congestion.25 Our research suggests that there is every reason to believe that increases in air travel costs for families, as a result of the proposed safety seat requirement, should have the opposite effect of the one intended: the infant safety seat proposal would have, on balance, increased infant travel deaths.26

The FAA subsequently drew the same general conclusion: an infant seat requirement would cause more infant travel deaths than it would save, although its estimates of the infant lives lost were much more conservative than the estimates our research indicated.27 In essence, the infant seat proposal to save infant lives is probably a proposal to sacrifice lives of relatively less wealthy people who make their trips by car to save fewer lives of relatively more wealthy people who continue to fly, in spite of the added expense.

From time to time, a Lightfoot/Bond-type proposal has been tendered in the media, prompting the FAA to make additional pronouncements against an infant seat requirement as late as 2005.28 If such a proposal were ever adopted, an unknown number of the travel victims would surely be infants who would have traveled quite safely on their parents’ laps in airplanes. Many of the automobile victims will also be the infants’ parents, brothers, and sisters, but many will also be road travelers who may have never contemplated air travel as an alternative means of transportation. They just happened to be in the wrong place at the wrong time on the nation’s roads, made marginally more congested by an airline infant safety seat requirement.

There is one good rule that comes out of this analysis that Congress and all government agencies should heed: do not create a travel-injury problem that is bigger than the one being addressed. Changes in policies that make for changes in prices, whether explicit or hidden, can prove deadly, which is a point fortified in the following discussion of antiterrorism measures.

/11 Terrorists and American Deaths Since 9/11

The overarching lesson of the last section should never be forgotten when assessing the consequences of one of the most appalling acts of terrorism in human history committed on September 11, 2001. The nineteen 9/11 terrorists killed more than 2,700 Americans when they commandeered four planes and flew them into buildings and the ground on that surreal day. Such a loss of innocent lives is tragic enough. However, those terrorists have very likely killed (albeit indirectly) more Americans since that fateful day than they killed on that day.

How can that be? The explanation is remarkably straightforward. On 9/11, the terrorists immediately increased the overall price of flying by increasing many potential air passengers’ perceived risk of flying. After all, before 9/11, few Americans considered the prospects that a bunch of religious zealots would harbor so much hatred for Americans that they would be willing and able to take over planes only to use them as guided missiles. Since 9/11, most air travelers have understandably feared that copycat terrorists would strike again.

The terrorists, of course, forced the U.S. government to dramatically beef up security checks at airports, the result of which has been an increase in travel time for all passengers. The time spent in security lines at airports has translated into a greater overall cost—and effective price—of air travel relative to ground travel.

Hence, since 9/11, more Americans than otherwise have been more inclined to choose automobile travel, leading to more miles driven and greater highway congestion. Since travel by car is far more deadly per mile than air travel, it should surprise no one that automobile accidents, injuries, and deaths have increased as a consequence of the greater cost of air travel imposed by the 9/11 terrorists (independent of other changes—for example, road conditions—that can be expected to affect car-travel deaths).

Cornell University economists Garrick Blalock, Vrinda Kadiyali, and Daniel Simon have reported in two working papers the econometric findings of the price tie-in between the 9/11 terrorists’ actions and car-travel deaths.29 They found that the 9/11 events and resulting security measures reduced air travel volume, independent of other forces, by about 5 percent across all of the nation’s airports and 8 percent from the nation’s major airports. The resulting increase in car travel following 9/11 led to approximately 242 more automobile deaths per month than would otherwise have been predicted for the last quarter of 2001.

As Americans adjusted their travel behavior in subsequent months to accommodate the greater cost of air travel, the increase in the number of car deaths per month attributable to the 9/11 attacks began to taper off. Still, the Cornell researchers were able to surmise that at least 1,200 more Americans lost their lives on the nation’s roadways in the 12 months following 9/11 than would have otherwise been predicted.30 It is no stretch to think that the greater count of American road deaths over the past 6-plus years attributable to greater flying risks and 9/11 security measures have surpassed the 9/11 deaths.

The economic tie between air and car travel means that the Transportation Security Administration (TSA) should be ever mindful of the prospects of unintended consequences, the most notable of which is that raising the security alert from, say, yellow to orange can spell greater road deaths, because the security measures can lengthen check-in lines and thus increase the total cost of flying and drive many would-be air travelers to the much deadlier highways. Indeed, the Cornell economists cited above have found that the tighter airport security measures instituted by the TSA after 9/11 also decreased air travel, increased road travel, and led to about 1,250 more American road deaths in the 12 months following 9/11 than would have been projected.31

The price tie between tighter airport security measures and road deaths means that the TSA has a life-and-death management issue on its hands that has no easy solution. Suppose the TSA has heard of a potential terrorist plot to take over a plane. The TSA considers the source reliable, but not perfectly reliable. Should it raise the alert status from, say, yellow to orange? Without the potential for its security measures affecting road deaths, the TSA’s decision is perhaps clear—raise the alert status because the only effect will be to inconvenience travelers who will have to stand in longer lines and to suffer more frequent searches. With the price tie of its alert pronouncements to road deaths, the TSA’s decision is far more serious, because its decision can lead to more highway deaths, perhaps more deaths than would be suffered if the alert status were not raised and the terrorist plot became a terrorist act, with deaths in the air.

Needless to say, the TSA might at times refuse to raise its alert status because by not doing so, it can save more American lives on the nation’s highways than might be lost from terrorists in the nation’s airways. But then, the TSA must also be ever mindful that not raising the alert status can result in additional deadly terrorists’ acts on planes, which, again, can drive hordes of Americans to the nation’s roadways. Indeed, without an occasional elevation of the alert status, many Americans might drive with greater frequency to their destinations because they fear that the TSA is not doing its job, which is catching wind of terrorists’ plots to use planes as missiles.

Clearly, the line of argument developed here speaks to one policy issue: Any waste of scarce TSA manpower on screening everyone—even infants and aging grandmothers—because of a prohibition on profiling can be deadly. This is because the tighter security measures and waste of security resources can increase the time cost of air travel and result in more car travel, and subsequently, more road accidents, injuries, and deaths.

Of course, terrorists may figure that they can effectively cause greater deaths of Americans even when they get caught trying to breach airport security defenses. Their failed efforts can keep the terrorist threat alive, and can cause more Americans than otherwise to take to the roads.

By the same token, efficiency improvements in screening passengers, which reduce the time spent in security lines, can save American lives. The price effect of shorter lines can lead to a reverse substitution of air travel for car travel—and fewer accidents, injuries, and deaths on American roads.

In short, the interplay between the full cost of air and road travel cannot—and should not—be overlooked, by homeland security agents or terrorists as they develop their respective defensive and offensive strategies. Regrettably, TSA officials understand all too well that they will catch hell from the media and policymakers if they allow terrorists to slip through and pull off another massacre on board a plane. Those same officials will not likely ever be held responsible for how their airport policies affect highway accidents and deaths. Accordingly, we should not be surprised if TSA officials will want to err on the side of being too cautious, which can translate into more deaths on the nation’s roads than will likely be saved in the air.

Water Crises in Southern California

University of California, Irvine, executive MBA students enrolled in microeconomics are frequently asked during the first class lecture: “Why are there water crises in Southern California?” Students seem to draw back, somewhat puzzled, because on the surface the question seems silly. Of course, in spite of their puzzlement, they think they know the answer, and more than one student will offer the “obvious” answer, “It does not rain much in Southern California!”

Granted, the prompt answer contains an element of truth. Rainfall in Southern California averages 13 or fewer inches a year, making the area close to desert conditions.32 The obvious answer to the question of why there are water crises may be a good one for a course in atmospheric physics. But an economics class challenges students to think beyond the typically low rainfall when considering the problem of water shortages.

We like to remind students, “True, it does not rain water in Southern California, but it also does not rain Mercedes Benzes in the area either, and neither does it rain Snickers candy bars, or any other good of value! But have we ever had a Mercedes Benz crisis in Southern California?”

The question answers itself and directs student’s attention (eventually) to a good old-fashioned reason why Southern California sometimes has water shortages (that, in the media, easily get elevated to dire “crises”) but never Mercedes Benz shortages. The streets are full of Mercedes Benzes, as are the lots of dealerships—all for a very good reason: the price of Mercedes Benzes is left to move with the forces of supply and demand. If the demand for Mercedes rises or if their supply contracts, the price of the cars rises, cutting out any would-be shortage by curbing the number of Mercedes bought and averting anything approaching a shortage, much less a crisis.

On the other hand, the price of water is stuck at some subsidized level, determined by government officials who are reluctant to change the price of water to accommodate transient changes in the demand for and/or availability of water. If rainfall drops way below average, as it is bound to do from time to time, and the price is not hiked, people can be expected to continue using water as if nothing has happened. After all, the low price of water tells many consumers (especially a large percentage of the population that never pays attention to the news) that water is as abundant as ever. The continuing flow of water out of home faucets can convince uninformed and informed consumers that any shortfall in rainfall in Southern California could be offset by a greater snow pack in the mountains of Northern California where Southern California gets a third of its water.

Southern California water consumers can also reason (if they are aware of the drought) that if they alone curb their consumption, the water tables in the area’s reservoirs will not be noticeably affected. Even if a sizable bunch of consumers curb their water use, consumption would not likely be materially affected because other consumers can expand their use of water. And do understand that Southern Californians use water with little thought of how scarce water really is, mainly because its low price—0.25 cents per gallon for residential use,33 which is one third the price of water in Mississippi where the rainfall is over fifty inches a year—makes it seem abundant (which is the case, given the considerable federal, state, and local government subsidies to draw water from other parts of the state through aqueducts and from other parts of the country through tapping into aquifers that extend into the upper Midwest). Accordingly, many Southern Californians enjoy backyards that look for like the tropics (without the heat and humidity). The water subsidies have actually increased the price of Southern California housing because they have made living in a semidesert more affordable than it otherwise would be.

So, when rainfall falls off and people continue to use water without restraint, a “crisis” eventually raises its ugly head in public discussions, with public officials first appealing for voluntary cutbacks in water consumption, which typically have meager impacts.

Indeed, during a recent water crisis, the Orange County, California water authorities told everyone that the situation was “dire” (given the combination of little rainfall and the reconstruction of a major water main), and pleaded with everyone to conserve. What happened? Water consumption rose markedly, as many people hurried to wash their cars and water their lawns, fearing that their faucets would soon run dry or prohibitions would be imposed on outdoor water usage.34 All the while, the waterlines around the area’s reservoirs were sinking deeper and deeper. Understandably, appeals for voluntary curbs are usually followed by threats of “water police” prowling neighborhoods looking to give tickets to violators of water-use ordinances.

Of course, some state institutions pay lip service to water conservation, with some effect. In the midst of the recent growing water crisis, the University of California announced reductions in its sprinkling of the campus lawns. At the same time, it continued landscaping newly opened areas of the campus with thousands of water-thirsty shrubs, trees, and flowers.

The more general lesson to be learned from the water crisis puzzle posed to MBA students is as simple as it is unheralded: where shortages are evident, it is a good bet that prices have been held in check someway, somehow. Water crises would evaporate if the water authorities had the fortitude to do what businesses—Chevron, as well as Mercedes—do naturally: raise the price! And make no mistake about it: at the same time that a water crisis in Southern California was emerging, the price of gasoline was well above $3 per gallon and rising rapidly (because of ongoing political/military problems in the Middle East and because refineries were being taken offline for repairs). But the price increase (even though it might be temporary) did its job. Even though both the number of licensed drivers and the number of vehicles on California roads had risen by more than 10 percent during the 2000–2006 period, gasoline consumption had risen far less and showed signs of falling, according to reports in the Los Angeles Times.35

Ethanol Subsidies and World Hunger

Following the OPEC oil embargo of 1973, which led to a spike in gasoline prices, price controls on gasoline, and long lines at service stations, Congress legislated the use of ethanol, which is produced from corn, as a gasoline substitute. In 1977, then President Jimmy Carter made energy independence the “moral equivalent of war,” a position that during the intervening decades led to the passage of a variety of federal and state subsidies for the production of corn and ethanol.36 In 2005, U.S. corn farmers received nearly $9 billion in subsidies from the U.S. Department of Agriculture intended to stimulate corn production, a growing portion of which has been used in ethanol production. Ethanol producers receive slightly more than a half dollar in subsidies (in the form of tax credits) for every gallon produced. The wars and political instability in oil-producing countries of the Middle East and the rapidly modernizing and expanding economies of India and China caused a run-up in the price of oil on world markets in the early 2000s that further increased the demand for oil substitutes, with ethanol being one of them.

Not surprisingly, by the end of 2006, 110 ethanol refineries were in operation in the U.S.A., many of which were expanding their production capacities. Seventy-three more refineries were being built.37 In 2006, U.S. biofuel firms produced five billion barrels of ethanol. In 2007, production was expected to rise 40 percent to seven billion barrels.38 Also not surprisingly, the growing demand for ethanol has hiked the demand for corn, which has driven up the price of corn by a third in less than a year, from $3 a bushel in the summer of 2006 to $4 a bushel in the spring of 2007, a price level not seen in a decade.40 Moreover, the prices of other food crops—for example, wheat, peas, sweet corn, and rice—have jumped upward as farmers have moved land into the production of corn, contracting the supplies of other food crops and causing their prices to rise. The growing prices for grains have (literally) fed into upward pressures on chicken and beef prices—and to price increases on (among other products made from grains crucially important in the diets of many poor and rich people alike) tortillas!39

What is the basic problem with the corn and ethanol subsidies? To fill up an SUV with ethanol, it takes 450 pounds of corn, which contains enough calories to feed a poor person for a year.40 There are at least a half billion and maybe a billion people in the world who are chronically hungry, which means that they do not get enough calories on a daily basis to remain healthy, many of whom continually face starvation. For every 1 percent increase in the prices of basic foods, the poor’s consumption of calories declines by 0.5 percent, according to the World Bank.41 Moreover, the world’s count of “food insecure” people rises by sixteen million for every 1 percent increase in the prices of staple foods.42 And the various policies designed to encourage use of ethanol could have increased the world price of corn and other grain crops by several percentage points.

No doubt, Jimmy Carter and other political leaders who have pressed for the development of an ethanol industry may have had their hearts in the right place, but they may have overlooked the power of the law of unintended consequences, which in this case can be bleak for many poor people around the world. As applied economists C. Ford Runge and Benjamin Senauer have observed, “The world’s poorest people already spend 50 percent to 80 percent of their total household income on food. For many among them who are landless laborers and rural subsistence farmers, large increases in the prices of staple will mean malnutrition and hunger. Some of them will tumble over the edge of subsistence into outright starvation, and many more will die from a multitude of hunger-related diseases.”43

Perhaps the bad things the world’s poor will suffer because of the indirect effects of corn and ethanol subsidies could be offset by a couple of potentially positive effects. The rise in the world price of corn, along with the drop in the price of blue agave, a cactus-like plant used in Mexico and elsewhere to make tequila, has caused Mexican farmers to contract their planting of agave to make room for corn. The reduction in the supply of agave (from what it would otherwise have been) can be expected to lead to a rise in the price of tequila, and a reduction in its consumption.44 That price change can be expected to lead to less drunk driving and, very likely, fewer road accidents, injuries, and deaths among Mexicans. Through a change in the world price of tequila, such a positive effect of the hike in the price of corn can be expected to spread across the globe (although the effect might be hard to detect).

The corn and ethanol subsidies harbor the potential for positive environmental—or “green”—effects from ethanol use. A cleaner environment could mean a healthier world population and, hence, more income, and a better life, on balance, for the world’s poor. However, Runge and Senauer report that “using gasoline blends with 10 percent corn-based ethanol instead of pure gasoline lowers emissions by 2 percent.”45 Then, the crops used to make ethanol require the use of fertilizers and pesticides, and farm machinery that consumes oil-based products as they are used on farms. In short, the environmental effects could be meager and difficult for the poor of the world to detect.

Then again, the green effects could be significant—and negative. According to reports by the Friends of the Earth, Europe’s encouragement of use biodiesel fuels has led to the destruction of rainforests in Indonesia and Malaysia because of the creation and expansion in those countries of oil-palm farms to satisfy the increased demand for oils that come mainly from palms and rapeseeds used in the production of biodiesel fuels.46

Granted, biodiesel fuel can be made, and is being made, by firms such as Metro Fuel Oil Corporation, which in 2007 was awaiting approval to open its plant that would produce 110 million gallons of biodiesel fuel from recycled raw vegetable oil collected from restaurants in the New York City area.47 The use of such oil could have beneficial green effects since some of the used oil would have been thrown away, but some of the oil could have been recycled for use again in restaurants’ deep fryers. That means that the production of biodiesel fuels from used vegetable oil would require the production of more new vegetable oil used in restaurants that, again, could cause some food prices to rise and impose problems for the world’s poor.

In short, subsidizing the use of renewable plants to satisfy a portion of the world’s energy needs sounds like a nice idea on all fronts, until you consider the price implications and how the world’s resources will be shifted, often in unanticipated and unintended ways, in response to price shifts. Those who would like to think biofuels provide the proverbial “free lunch” either for the economy or the environment will be sadly disappointed.48

If (or to the extent that) carbon dioxide is a significant culprit in global warming (or any other environmental problem), a more promising solution is the one that economists have been touting for decades: tax the carbon dioxide that is emitted from cars (or any other plant and equipment). The greater the carbon dioxide emitted, the greater the tax. The expectation is that the tax will feed into the price of the offending products, and fewer of those products will be bought and used. Greenhouses gases will be reduced. Global warming will be setback into the future, if not eliminated altogether. Okay, the higher prices will affect the poor, and no one wants to hurt the poor. But there is an easy solution on that front: return the carbon taxes paid by everyone to the taxpayers who paid the carbon taxes in the form of tax refunds. People will have more or less the same spendable money incomes, plus a cleaner environment. But because of the carbon tax and the higher prices on the taxed products, people will move their consumption from less environmentally damaging products.49

But then, relief for the poor and the environment can come through price adjustments. By late 2007, it was becoming apparent that an overcapacity in ethanol production had emerged since early 2007, with the price of ethanol falling 30 percent between March and September.52 That price reduction can dampen the demand for corn and other crops, which can reduce upward pressures on food prices paid by the poor. Nevertheless, the subsidies for ethanol should still leave corn and other grain prices higher than what they would have been.

Concluding Comments

The discussions of various topics in this chapter have helped to spotlight an important economic lesson: unless business people and policymakers understand how prices are affected by market and nonmarket forces, the “law of unintended consequences” will bedevil people’s best intentions when setting prices—and especially when they try to subvert market forces.

The discussion of infant and toddler seat requirements on airlines explains why policymakers need more than good intentions to save lives; they need to understand the interplay between the prices of various modes of travel. Similarly, the discussion of the 9/11 tragedy exposes how the TSA’s changes in the security alert status at airports should be taken with deadly seriousness because the consequences can indeed be a matter of life and death in ways not widely recognized. Security alerts can change the relative price of air travel vis-à-vis car travel, all without anyone noticing the change or its consequence. The “law of unintended consequences” rules, often with deadly silence. That theme will continue to form the foundation of the discussions of additional pricing puzzles considered in following chapters, especially the next one.

An important purpose of this chapter has been to reassert a point too easily overlooked: a well-functioning market system depends crucially on prices. Prices do far more than alert people to how much they must pay for the things they buy. They are themselves productive by providing incentives for people to choose and buy wisely, by containing a great deal of information that permits people to economize on the amount of information they must gather and absorb, and by helping coordinate close-at-hand exchanges and also complex economic activity of people spread throughout the world. Without prices to “grease the skids” of the economy, we all would be less productive than we are and worse off.

Another, equally important purpose of the discussions in this chapter has been to convince you that a study of prices can help us understand better (not perfectly) why people behave the way they do. An understanding of how prices are determined and changed can help us unravel a host of seemingly obtuse economic puzzles.

Much of the discussion in this chapter has been founded on one economic principle, the “law of demand,” that price and quantity are inversely related. If the price of a good is raised, people will consume less of it. If the price is lowered, people will consume more of it. That principle will remain in heavy use throughout this book and will play a key role in our unraveling many pricing puzzles.