Harvard University Spring 2014

Harvard Kennedy School Graduate School of Design

Markets and Market Failure with Cases HKS API-105B & GSD 5203B

Class Meetings:

Mondays and Wednesdays, 8:40-10 AM, GSD Gund 111

Review Sessions:

Fridays, 12 – 1:30 PM, GSD Gund 124

Faculty:

Prof. Jose A. Gomez-Ibanez (GSD and HKS) Taubman 316 (HKS) and Gund 326 (GSD) 617-495-1341, [email protected]

Office Hours:

Mondays, 4:00-6:00 PM at GSD Gund 326 (Use this link to sign up for a time slot.) Thursdays, 4:00-6:00 PM at HKS Taubman 316 (Use this link to sign up for a time slot.)

Faculty Assistant:

Jeanne Burke HKS Taubman 321 617-495-5140, [email protected]

Teaching Assistants:

TF: Nathan Fleming, ([email protected]) Office hours and location: Fridays, 1:30-2pm, GSD Gund 124 CAs: Raven Anderson ([email protected]) Office hours and location: Fridays, 10am-12pm, GSD Chauhaus Ted Conrad ([email protected]) Office hours and location: Thursdays, 24pm, GSD Chauhaus

OVERVIEW This course provides an introduction to how markets operate, criteria for assessing their performance, and the circumstances under which they perform well or poorly. o The first half of the course covers market behavior including supply, demand, and market prices; the strategies of consumers and firms; and the effects of taxes, subsidies, price controls and other kinds of government interventions. o The second half covers the assessment of market performance, the problems caused by monopoly, externalities, public goods, and asymmetric information, and the types of policy solutions that might be applied to correct such market failures. The course presumes no prior economics although prior exposure is useful This course is offered in two sections that utilize most of the same cases and employ the same problem sets and similar exams. This section (HKS API-105B and GSD 5203) is taught at the GSD in the spring semester by Jose Gomez-Ibanez and places slightly more emphasis on Markets and Market Failure with Cases HKS API-105B & GSD 5203

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urban issues. The other section (HKS API-105A and GSD 5222) is taught at the HKS in the fall semester by Albert Nichols and places slightly more emphasis on government policy toward business. Both sections of the course are jointly listed by both the HKS and the GSD and open to students from either school. Students cannot take more than one section of the course for credit. At the GSD the course is open to all but is strongly recommended for MUP and MDES real estate students. At the HKS, this course covers the same topics as API-101 but is taught with extensive use of case discussions. MC/MPA and MPA2 students can use this course to satisfy their quantitative methods requirement. MPP students can use this course to fulfill their API-101 requirement only with the permission of both the API-105 instructor and the course head of API101 (Professor Chris Avery). Students can not take both this course and API-101 for credit. Enrollment in both sections is limited by the capacity of the classrooms. If this constraint is binding GSD seats will be assigned with preference to students who are required to take the course and HKS seats through the HKS lottery. REQUIREMENTS Class: Students are expected to come to class having done the assigned reading and prepared to participate in case discussions. No mobile phones, PDAs or laptops may be used in class without prior permission. Review sessions: These Friday sessions are entirely optional and generally will focus on the issues relevant to the problem set due that day. Problem sets: There is a short problem set due (almost) every Friday at 5 PM in either of Gomez-Ibanez’ offices (Gund 326 or Taubman 316). Problem sets are graded on an advisory basis but students should be sure complete them as practice is essential to learning economics. Exams: There will be an in-class mid-term exam on October 10. The in-class final exam will be on either May 12 or 13, the exact day, time and place to be announced.. Grade weights The final course grade in this section will be based on the mid-term exam (20 percent), class participation (30 percent) and the final exam (50 percent). Text: The text is Microeconomics, 8th Edition, by R. Pindyck and D. Rubinfeld and it is for sale at the Coop under HKS API-105 and on reserve at GSD and HKS libraries. Used copies are generally available and you can use an earlier edition if you like—the 7th edition is nearly identical to the 8th. Case package: Electronic copies of the cases will be distributed to the students using the HKS electronic course materials distribution system. GSD students should contact Jeanne Burke ([email protected]) to be given free access to the HKS system.

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COURSE CALENDAR MONDAY JANUARY

FEBRUARY

MARCH

APRIL

WEDNESDAY

FRIDAY

Jan. 23-24: No shopping Jan. 26 No assignment class at HKS C2 – Jan. 29: Lecture: Jan. 31: Problem set 1: I. Markets C1 – Jan. 27: supply, demand and supply and demand Introduction equilibrium; elasticities C3- Feb. 3: Case: C4 – Feb. 5: Lecture: Feb. 7: Problem set 2: Coffee Crisis surpluses; price and elasticities and price quantity controls controls C5—Feb. 10: Case: C6 – Feb. 12: Lecture: Feb. 14: Problem set 3: Portland’s Urban subsidies and taxes; subsidies and taxes Growth Boundary incidence C7 – Feb. 17: Case: C8 – Feb. 19: Lecture: Feb. 21: Problem set 4: Liconsa Milk Assistance costs, technology, and isoquants and isocost, cost firm size curves C9 – Feb. 24: Case: C10 – Feb. 26: Lecture: Feb. 28: Problem set 5: Nicaragua Electricity profit maximizing P and profit maximizing P and Q Q C11 – Mar. 3: Case: C12 – Mar. 5: Lecture: Mar. 7: Problem set 6: Sullivan Gray Rait Supply in a competitive derivation of supply market C13 – Mar. 10: Mar. 14: No assignment II. Market Failure C14 – Mar. 12: Lecture: Midterm Exam Pareto efficiency; trade SPRING BREAK MARCH 15 TO 23 C15 – Mar. 24: Case: C16 – Mar. 26: Lecture: Mar. 28: Problem set 7: Parking in San Francisco monopoly and oligopoly trade and monopoly C17 – Mar. 31: Case: C18 – Apr. 2: Lecture: Apr. 4: Problem set 8: Regulating Broadband in Information asymmetry price discrimination, Chile and limited rationality information asymmetry C19 – Apr. 7: Case: C20– Apr. 9: Lecture: Apr. 11: Problem set 9: CAFÉ standards externalities and public externalities, public goods goods C21 – Apr. 14: Case: C22 – Apr. 16: Lecture: Apr. 18: Problem set 10: Arsenic in Drinking alternative remedies to externalities, public goods Water externalities C23 – Apr. 21: Case: C24 – Apr. 23: Lecture: Apr. 25 Problem set 11: California Global agglomeration economies agglomeration economies Warming Solutions C25 – Apr. 28: Case: C26 – Apr. 30: Case: Far West Midtown Vancouver Regional Plan (Last class)

Final Exam: To be scheduled either May 12 or 13 * Note: • • •

The GSD and the HKS have slightly different academic calendars and this course compromises in several respects: The course starts on Monday, January 27—there is no “shopping class” on January 23-24. The course meets on President’s Day, February 17 (as per the GSD calendar), and The last class is April 30 rather than April 28 (as per the HKS calendar)

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CLASS MEETINGS, READINGS AND ASSIGNMENTS I. MARKETS A. Supply, Demand, and Market Equilibrium (Note there is no optional shopping session for this course at HKS) Class 1 – Mon. Jan. 27: Introduction Read: Pindyck and Rubinfeld, Ch. 1 skim all Class 2 – Wed., Jan. 29: Supply, demand, and market equilibrium Read: Pindyck and Rubinfeld, Ch 2 read sec. 2.0-2.6 only (PS 1) Fri., Jan. 31: Problem Set 1 due Class 3 – Mon., Feb. 3 : Predicting prices: The Coffee Crisis case Read: The Coffee Crisis*, HKS case 1776.0 and Learning by the Case Method, HKS note N15-86-1136.00 Assignment: Imagine that you are the Minister of Agriculture for some relatively high-cost arabica producer, such as El Salvador or Costa Rica. Would you advise your farmers to get out of coffee or not? In formulating your answer, please consider: 1. What influences the demand for coffee on the part of consumers in the short run (in the next year or two)? In the long run (in five or more years)? How sensitive is consumption to wholesale coffee prices? 2. What are the determinants of the supply of coffee in the short run? In the long run? How sensitive is supply to prices? 3. Do you think Arabica prices are likely to rise or fall in the next five years? By how much? B. Predicting the Effects of Market Interventions Class 4 – Wed., Feb. 5: Consumer and producer surpluses and the analysis of price and quantity controls. Read: Pindyck and Rubinfeld Ch. 2 review 2.4 and 2.5 (on elasticities) and read section 2.7 and in Ch. 9 read sections 9.1, 9.3 and 9.4 skip 9.5 (PS 2) Fri., Feb. 7: Problem Set 2 due Class 5 – Mon., Feb. 10: Zoning: Portland’s Urban Growth Boundary case Read: Portland’s Urban Growth Boundary and Housing Prices (A): The Debate, HKS case 1703.0, Portland’s Urban Growth Boundary [UGB] and Housing Prices (B): Note on Measuring Housing Prices, HKS case 1704.0, and Ed Glaeser and Joseph Gyourko, “The Steep Price of Zoning,” pp. 2-3 in Taubman Center for State and Local Government, Annual Report, 2003.

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Assignment: Please come to class prepared to explain whether or not you would support the proposed expansion of the UGB boundary by 17,000 acres, mostly in southeast Clackamas County. In thinking about your decision, please consider: 1. What benefits supporters claim for the UGB? What are the costs detractors attribute to the UGB? 2. In theory, how would a UGB affect housing prices? How would exclusionary zoning affect housing prices? 3. What are the other factors that might account for differences in average housing prices among metropolitan areas? Please distinguish between factors that might cause price differences in the short run from those that might cause price differences in the long run. 4. Do you think that the UGB has caused long-run pressure on housing prices in Portland? Class 6 – Wed., Feb. 12: Taxes, subsidies and their incidence Read: Pindyck and Rubinfeld, Chapter 9 read section 9.6. (PS 3) Fri., Feb. 14: Problem Set 3 due Class 7 – Mon., Feb. 17: Assisting the poor: Liconsa and the Program of Social Assistance for Milk case Read: Liconsa and the Program of Social Assistance for Milk, HKS case 1766.0 Assignment: Please come prepared to explain whether you think Liconsa's milk program should be replaced by Oportunidades/Progressa program or not. Note that the Liconsa subsidy is only for the first four liters of milk per beneficiary per week. In formulating your position please consider: 1. What are the advantages and disadvantages of Liconsa's milk program as a means of helping the poor? 2. Would giving the poor money be better or not? 3. Is the Oportunidades/Progressa program better? C. The Firm: Technology, Costs and Prices Class 8 – Wed., Feb. 19: Costs, technology, and firm size Read: Pindyck and Rubinfeld, Ch. 6 read all, in Ch. 7 read sections 7.0 to 7.4 and skim sections 7.5 and 7.6 if interested (PS 4) Fri., Feb. 21: Problem Set 4 due Class 9 – Mon., Feb. 24: The structure of costs: Rural Electrification in Nicaragua case Read: Rural Electrification in Nicaragua, (abridged) HKS case 1705.3 Assignment: Come to class prepared to advise the National Commission on Energy on whether its consultants have chosen the appropriate technologies for the El Ayote pilot communities. In fashioning your advice, please consider: 1. How much do you think residents might be willing to pay for electricity service from a diesel- or hydro-powered mini-grid or from a PV system? 2. How do the costs of solar, diesel, and hydro compare? What are the marginal costs of each technology? What are the fixed costs? Markets and Market Failure with Cases HKS API-105B & GSD 5203

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3. How does electricity demand vary during the day in these communities? What problems does this create for the design of the electricity system? Class 10 – Wed., Feb. 26: Profit maximization and the firm’s choice of price and quantity Read: Pindyck and Rubinfeld, Ch. 8 sec. 8.0-8.4 only and Ch. 10 sec. 10.0-10.1 (but only through figure 10.3 in sec. 10.1) (PS 5) Fri., Feb. 28: Problem Set 5 due Class 11 – Mon., Mar. 3: Pricing and competitive strategy: Sullivan, Gray, Rait case Read: Sullivan Gray Rait, GSD case. Assignment: Come to class prepared to explain the price you would quote to Max Reptan for the Gahanna job if you were Gary Gray or Mike Whaley. In formulating your position please consider: 1. How did Gary Gray and Mike Whaley justify their original $56,000 bid? On what basis are they now considering dropping the bid to $41,000? 2. What role should costs play in their calculation? What is the relevant cost? 3. What other considerations besides costs are important in formulating the bid? D. Supply in Competitive Markets Class 12 – Wed., Mar. 5: Perfect competition, long run equilibrium, and the supply curve Read: Pindyck and Rubinfeld, Ch. 8: review sec. 8.0 to 8.4 (assigned for class 10) and read sec 8.5 to 8.8. Class 13 – Mon., Mar. 10: In-class Midterm Exam

II. MARKET FAILURE A. Efficiency and Competitive Markets Class 14 – Wed., Mar. 12: Efficiency, equity and the example of trade Read: Pindyck and Rubinfeld, Ch. 9 sec. 9.5 only and Ch. 16 sec. 16.6-16.7 only. Read the rest of chapter 16 if you are interested (Spring Break: March 15 – 23) Class 15 – Mon., Mar. 24: Efficiency and equity: Parking in San Francisco case Read: Parking in San Francisco, HKS case no. 1877.0 Assignment: Come prepared to explain whether you support the proposals for more marketbased parking policies. In formulating your position please consider: 1. If the prices for on-street spaces were set by the market, how much would they be? 2. In what respects is the current system of free on-street parking inefficient? 3. Would a shift to market prices for on-street spaces be Pareto-improving? 4. Is there an economic rational for either minimum or maximum off-street parking standards? Markets and Market Failure with Cases HKS API-105B & GSD 5203

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B. Monopoly and Oligopoly Class 16 – Wed., Mar, 26: Monopoly and its remedies Read: Pindyck and Rubinfeld, Ch. 10 review sec. 10.0-10.1, read 10.2-10.5, 10.7 (PS 8) Fri., Apr. 4: Problem Set 8 due Class 17 – Mon., Mar. 31: Assessing market power: Broadband in Chile case Read: Regulating Broadband in Chile, HKS case no. 1955.0 Assignment: Come to class prepared to discuss the following questions: 1. In what ways has the government regulated voice telephone companies since the privatization of Telefónica in 1990? In what respects have these regulations improved the performance of the industry? In what ways might they have caused problems? 2. How has the regulation of Internet providers differed from the regulation of voice telephony companies? On balance, do you think requiring Internet providers to grant access would be desirable or not? C. Information Asymmetries and Behavioral Economics Class 18 – Wed., Apr. 2: Information asymmetry Read: Pindyck and Rubinfeld, Ch. 17 sec. 17.0-17.4 only The Subprime Mortgage Crisis, HKS draft case (PS 9) Fri., Apr. 11: Problem Set 9 due Class 19 – Mon., Apr. 7: Information asymmetries: The CAFE case Read: Corporate Average Fuel Economy Standards 2017-2025, HKS case 1973 Assignment: Do the proposed standards make sense? In formulating your answer consider: 1. What is the rationale for regulating motor vehicle fuel economy? 2. What would happen if the fuel economy standards were not tightened? 3. Which of he six reasons that NHTSA offers for consumer’s’ mistakes do you find convincing? D. Externalities and Public Goods Class 20 – Wed., Apr. 9: Externalities and public goods Read: Pindyck and Rubinfeld, Ch. 18 sec. 18.0-18.1 only (PS 9) Fri., Apr. 11: Problem Set 9 due Class 21 – Mon., Apr. 14: How much to clean up: Arsenic in Drinking Water case Read: Arsenic in Drinking Water, HKS 1680.0 Assignment: What standard should Administrator Whitman set for arsenic in drinking water? In formulating your recommendation, please consider: 1. What principles would you use in setting the rule? Markets and Market Failure with Cases HKS API-105B & GSD 5203

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2. What are the major costs and benefits of the proposed rules? How uncertain are they? 3. How should non-quantifiable benefits be incorporated into EPA’s analysis? 4. What should EPA do about small drinking water systems? Class 22 – Wed., Apr. 16: Alternative remedies to externalities Read: Pindyck and Rubinfeld, Ch. 18 sec. 18.2-18.7 (PS 10) Fri., Apr. 18: Problem Set 10 due Class 23 – Mon., Apr. 21: Public goods: The California Global Warming Solutions Act case Read: The California Global Warming Solutions Act (AB 32), HKS 1944.0 Assignment: Come to class prepared to explain: 1. Was California’s decision to commit to reducing its Green House Gas (GHG) emissions to 1990 levels by 2020 sensible or not? 2. Assuming the goal is sensible, has CARB chosen the best instruments to achieve that goal? E. Economic Geography and Urban Planning Class 24 – Wed., Apr. 23: Agglomeration economies Read: Edward Glaeser and Abha Joshi-Ghani, “Rethinking Cities: Toward Shared Prosperity, World Bank, Economic Premise no. 126, October 2013 available at http://siteresources.worldbank.org/EXTPREMNET/Resources/EP126.pdf Optional: World Bank, Reshaping Economic Geography, 2009 World Development Report (Washington, DC: World Bank, 2009) pp. 126-140. Edward L. Glaeser and Janet E. Kohlhase, “Cities, Regions and the Decline of Transport Costs,” Harvard Institute of Economic Research, Discussion Paper number 2014, July 2003. (PS 11) Fri., Apr. 25: Problem Set 11 due Class 25 – Mon., Apr. 28: The Far West Midtown case Read: Far West Midtown, GSD case. Assignment: To be announced Class 26 – Wed., Apr. 30: Metropolitan planning: Vancouver’s Livable Region Plan case Read: Vancouver’s Livable Region Plan, HKS case no. 1361. Assignment: Come to class prepared to explain whether you would support Vancouver’s regional plan if you were a concerned citizen of the region. In formulating your answer, please consider: 1. To what extent are you sympathetic with the plan’s goal? 2. What are the benefits and costs of the plan? 3. Do you think the plan is practical or realistic? Final Exam: May 12 or 13, exact day, time and place TBA.

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