FREC 424 Intro

The course syllabus is at http://www.udel.edu/johnmack/frec424/. Course assignments are all linked from there.

The field of economics has broadened dramatically in the past 25 years, and the textbooks are struggling to catch up. Economics was traditionally defined as “the study of the allocation of scarce resources among alternative uses.” This definition is already pretty broad, since it does not include the words “money,” “prices” or “markets” (but it does include the word “resources”).

Steven Leavitt’s recent best-seller Freakonomics illustrates the further broadening of economics. A more up-to-date definition might be “the study of human incentives and their consequences.”

In many respects the discipline of economics is returning to its 19th century roots in political economy. This course will explain the behavior of resource markets, and present a finite taxonomy of market failures that impose quantifiable economic losses on society. It will also explain the processes of contemporary democracy as they relate to markets, and explain some important political failures that also generate significant social costs.

Lay people are typically quick to doubt the efficiency of markets, and slow to recognize the unintended consequences of government intervention in markets. My hope in this course is that you will develop more confidence in the generally efficient way free markets allocate resources, and a well-informed skepticism about government policies that distort market incentives, allocate resources inefficiently, and reduce overall social welfare.


Economics uses simple little models to illustrate, test and prove important principles. Their logical rigor is what’s important, not their realism. Most economic models are predicated on the expectation that economic actors are rational and pursue their own self-interest. Economic behavior is generally predictable.

The predictions derived from simple, highly-formalized economic models can be tested empirically. For example, demand theory is based on mathematic models in which each consumer purchases a specific combination of goods in order to maximize some utility function, subject to his or her budget constraint and the prices of the goods. The fact that consumers aren’t really doing the math here is irrelevant. The question is: are they behaving as the model predicts? A good economic model provides testable predictions, not realism.

So the most fundamental methodology of economics is look at the incentives! You can usually predict how rational, self-interested people will respond to incentives. People engage in voluntary market exchange because they both expect net benefit, and both usually get it.


Let’s begin with a little bed-time story that happens to be true:

The Story of Nauru

Chapter 1: The little island of Nauru far out in the Pacific Ocean was built up over millions of years from guano (bird shit). Pretty much the entire island is marketable phosphate, a valuable fertilizer. So a few decades ago the islanders literally started exporting the island they were standing on. For a while little Nauru had the highest per-capita income in the world! But gosh, kids, this resource-based economy certainly isn’t sustainable in the long run! How long would this little island nation survive? (Isn’t this kind of like little Spaceship Earth, our precious lifeboat with its finite resources, floating alone in the darkness of space?)

Chapter 2: Happily, the Nauruans didn’t just blow their incomes on beer and silly hats. The government created a huge trust fund for them, and socked millions of dollars away in Swiss bank accounts. They converted a chunk of their island into a big trust fund and lived very comfortably off the earnings from that—no need to keep selling off their island! So what looked like an unsustainable system turned out to be perfectly sustainable after all!

Chapter 3: Unfortunately, crooks in the Nauruan government blew most of the trust fund on lousy investments. Now the islanders are poor again, and many are emigrating. The market did not betray these people; their political leaders did.

You probably thought of Nauru as a closed system, and maybe the Swiss bank accounts seemed like cheating, but Nauru is not a closed system. The Earth is not a closed system either; we get steady, reliable energy from the Sun that drives all life on the planet.


Here’s another true story that illustrates the unintended consequences of a market-distorting government policy:

Rent Control

In cities that have many more renters than landlords, politicians may get elected to city council by promising to impose rent controls. In the short run the tenants benefit and the landlords lose, but in the long run pretty much everybody loses. Suppose you’re the tenant of record in an apartment in New York that would rent for $4,000/month in a free market, but your rent is capped at $400/month. Now suppose your job transfers you to San Francisco--another expensive place to live. Your options are: (A) simply give up your New York apartment, or (B) sub-let it for $4,000 a month to someone who will maintain the fiction that you still live there too; you keep paying the landlord his pitiful $400/month rent, and pocket the extra $3,600/month, which makes San Francisco more affordable for you. Although rent-control ordinances prohibit sub-letting it is widespread. For anyone moving to New York, finding an apartment at a controlled rent is virtually impossible because nobody ever gives them up; you have to sublet and pay the tenant of record the equivalent of a free-market rent. As time goes on, fewer and fewer actual city residents benefit from rent control.

Over the very long term, rent control is truly destructive. The controlled rent gives landlords no incentive to maintain their buildings, or build new apartments, so the housing stock gradually turns into slums. (Illegal sub-lettors won't call city inspectors about code violations.) Eventually the market rents decline, the tax base shrinks, crime rates increase, etc. Over a few decades the city spirals into poverty and ends up looking as if it was subjected to an aerial bombing campaign.

Under the federal Emergency Price Control Act (1942), New York City instituted rent controls in 1943 and experienced these unintended consequences over the ensuing decades. More recently, state law has phased out strict rent controls in favor of rent stabilization programs that permit reasonable rent increases.


Economists have recently turned their attention to many interesting problems that are outside the traditional purview of economics, e.g., quantifying the frequency of point-shaving in NCAA basketball tournament games, identifying public school teachers who altered students’ standardized test sheets, etc.

One of the more interesting chapters in Leavitt’s Freakonomics addresses the question “If illegal drug-dealers make so much money, why do they mostly live with their mothers?” An Indian grad student at the University of Chicago was trying to conduct a survey in the projects and got kidnapped by a drug gang. The gang members eventually learned to trust him, and when the gang leader got sent to prison, he gave the grad student the financial records of the gang’s drug-dealing. The records showed how the profits are retained by the top-ranking gang members; the street-level dealers get almost nothing. Street dealers are economically desperate. They face high risks of getting shot by a competing gang, but they simply have no better alternative to dealing, and the gang provides a better social support system than their dysfunctional families. They may have to kill competitors to retain their turf. Is capital punishment an effective deterrent to murder for these kids? Not when the mortality rate is lower on “death row” in prison than on the street.

There is an economic context to most social issues. Public policies that operate within this context, and account for the economic incentives that drive human behavior, can be efficient and effective. Policies that ignore these factors typically generate unintended consequences and high social costs.