Transcript UT Microeconomics of Domestic Security

Using All the Theory:
The Microeconomics of
Domestic Security
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
The Macroeconomics of Domestic
Security
• On September 11, 2001, United States suffered most serious terrorist
attack in history
• United States and world changed overnight
– Vital issues that had dominated U.S. political debates—such as expanding
health insurance coverage and bolstering social security—suddenly paled
in significance as domestic security rose to top of national agenda
• There were economic changes as well—some occurring with
astonishing speed
– Government responded almost immediately
• In weeks following attacks, Bush administration set aside $20 billion to help
rebuild lower Manhattan
• The private economy, too, responded
– Corporations were reviewing disaster plans, insurance coverage, and
travel policies
• In subsequent years, economy has continued to adjust to new concern
for domestic security
2
The Opportunity Cost Of Domestic
Security
• PPF curve in Figure 1 tells a simplified version of
economic response to September 11
• Economy began to move along its PPF
– Shifting resources out of the production of other things and toward
goods and services used to provide domestic security
• Over a longer period of time, PPF in left panel is not
realistic enough to describe ongoing process of
adjustment
– Ignores a central fact about the economy
• Economic growth
• What is impact of reallocation of resources in a growing
economy?
– Instead of moving along a fixed PPF, reallocation forces us to
choose a different point on our new PPF
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Figure 1: Production Possibilities Frontiers
For Security Goods and All Other Goods
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The Opportunity Cost Of Domestic
Security
• Assume that before September 11 economy would have
moved in a typical year from point A on its original PPF to
a point like B on its new PPF
• Although we produce more of other things, we don’t
produce as much more of them as we otherwise would
have
• Our standard of living depends on how much of these
other things we produce per person
• What effect will the ongoing reallocation of resources
toward domestic security have on our standard of living?
– Depends on three things
• How much total production grows each year
• How much the population grows each year
• How much spending and production for domestic security grows each
year
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The Ongoing Cost of Domestic Security: The
Narrow (Optimistic) Approach
• How much more are we spending for domestic security after
September 11?
• Figure 2 shows federal government’s part of this spending for three
years following attacks
• Figure tells us two important facts
– Annual domestic security spending by federal government has more than
tripled from $13 billion in fiscal year 2001 (ending in September, 2001) to
an average of about $40 billion in three following years
– Figure shows an upward trend for first two years—trend is likely to
continue through 2004
• Once we leave the federal government, picture turns a bit murky
– No centralized data source for this spending at state and local level
– Private sector spending for domestic security is even more difficult to
estimate
• Using an estimated GDP for 2004 of $11 trillion, increased spending
on domestic security in 2004 would amount to less than half of one
percent of GDP ($47.1 / $11,000 = .004 or 0.4%)
– What would this mean for average standard of living in U.S.?
• Living standards would grow more slowly, but not much more slowly
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Figure 2: Direct Federal Spending
For Domestic Security
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The Ongoing Cost of Domestic Security: The
Broad (Pessimistic) Approach
• If we consider domestic security costs more broadly we get a very
different picture
– Including all opportunity costs that result from our heightened concern for
domestic security after September 11
• By shifting priorities, government may be shifting resources away from
other valuable activities toward domestic security
– Even though explicit spending remains unchanged
• Another issue is whether to include all or part of security-related
military activities overseas
– Are not classified by government as part of homeland security spending
• By contrast, U.S. invasion of Iraq in early 2003 was highly
controversial precisely because of differing opinions about its
connection to U.S. domestic security
• Moreover, these and other U.S. actions overseas have led to ongoing
expenses
– Billions of dollars each year for reconstruction, development and
humanitarian assistance
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The Ongoing Cost of Domestic Security: The
Broad (Pessimistic) Approach
• Additionally, total spending on domestic security may be highly
unstable
• In broadest and most pessimistic view, annual cost of domestic
security would already have risen much more than $47.1 billion—
perhaps two or three times as much
• With so much uncertainty, the numbers must be considered highly
tenuous at best
– But qualitative conclusion remains certain
• Opportunity cost of increased production for security is a sacrifice in the growth
of our standard of living
• At worst, our living standard could fall
• At best, it will rise more slowly than it otherwise would
• Slower growth in living standards is an important (and unpleasant)
consequence of the need for more security
• Societies throughout history have replied primarily on three different
systems of resource allocation
– Command, tradition, and the market
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Using the Three Step Process
• Key Step #1
– Characterize the Market
• Key Step #2
– Find the Equilibrium
• Before we can analyze the economy’s response to an event, we must
characterize where the economy was before the event took place
• Key Step #3
– What Happens When Things Change
• In most economic analysis, this is the most useful step, and it’s why
we bother with the others
• We’ll use the three step process—along with other aspects
of the microeconomic theory you’ve learned in this text—in
order to answer a number of questions about the changes
our economy is undergoing
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Changes in Product Markets
• Virtually every product market in the country has
been affected in some way by shifting national
priorities after September 11
– First, we’ll focus on types of market affected most
directly
– Second, we’ll use the model of perfect competition
– Finally, it will be useful to categorize product markets
into two types
• Those experiencing a significant shift in demand
• Those experiencing a significant shift in supply
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Changes in Demand—An Example:
Bomb-Sniffing Dogs
•
Firms (and ideally, government agencies as well) will choose lowest cost
method of producing any given level of output
– Least-cost method of producing any given level of security often includes dogs
•
Why?
– At first glance, it seems that bomb-sniffing dogs could not compete with bombdetection machines
– Training each bomb-sniffing dog costs between $8,000 and $10,000
•
•
Moreover, once on the job, dogs require handlers who must also be trained,
and who generally earn higher salaries than machine operators
Why, then, are dogs so prevalent in the security market?
– Although dogs are expensive, bomb-detection machines are even more expensive
– Suspicious material containing explosives must be found and brought to a machine
• By contrast, a dog goes to the explosives
•
How are bomb-sniffing dogs “produced?”
– Many are trained by defense department at Lackland Air Force Base, or by Bureau
of Alcohol, Tobacco, and Firearms or by private companies
– Some are sold, while others are rented out by day or hour for emergencies
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Changes in Demand—An Example:
Bomb-Sniffing Dogs
• Use Figure 3 to analyze impact of increased
security production in this market
• After September 11, there was a dramatic change
in this market—significant increased demand by
– Large corporations
• Ford Motor Company and Johnson & Johnson
• Organizers of sporting events like the 2002 winter Olympics,
2002 Super Bowl, and 2003 Daytona 500 Nascar races
– Transportation companies
• Amtrak and Carnival Cruise Lines
– Schools, hospitals, and amusement parks around the
country
• How did the market respond?
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Figure 3: An Increase in Demand for
Bomb-Sniffing Dogs
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Changes in Demand—An Example:
Bomb-Sniffing Dogs
• Short-run response is shown in panel a of Figure 4
– Shows market demand curve for bomb-sniffing dogs shifting
rightward
• How does this increase come about?
– Because of a quirk in training, it was not possible to switch dogs
trained for other purposes to bomb duty
• However, as often happens in markets, an increase in
demand leads to surprising discoveries of new supply
• What about long-run?
– Dog handlers at many schools began increasing number of dogs
per “class,” and shortened duration of training
– Dog schools began scouring pounds for new recruits, further
increasing class size
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Changes in Demand—An Example:
Bomb-Sniffing Dogs
• Price of trained dogs ends up higher than
initially
• May not be the end of the story
– If research proves successful, supply curve
could shift far enough to actually decrease price
further down the road
• What we’ve seen in the market for bombsniffing dogs is also occurring in thousands
of markets for security-related products
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Changes in Demand—An Example:
Bomb-Sniffing Dogs
• After September 11, demand for security-related products
has increased
– In short-run, rise in price increases supply to some extent
– In long-run, higher price and associated profits increase productive
capacity in industry, leading to even greater increases in supply
• In other markets, the opposite has taken place
– After September 11, demand for air travel decreased by 20 - 30%,
and was still running 5% below normal through April 2003
• In short-run, drop in price decreased quantity supplied to
some extent
• In long-run, if decrease in demand persists, lower price
and associated losses will decrease productive capacity in
the industry
– Leading to even greater decreases in supply
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Changes in Supply—An Example:
Goods With High Transportation Costs
• Supply curve shifts in long-run in response to change in demand
• Need for increased security is like the opposite of technological
progress
• There are substitutes for increased security expenditures
– More insurance, relocation, a change in production methods that is less
vulnerable to attack, etc.
• U.S. freight carriers move about $10 trillion worth of products
– Some of this is from other countries, but most originating and delivered
within United States
– Many changes have been made in freight industry after September 11, all
of which raise costs
• Especially so for shipment of hazardous materials
• Shipping by truck has itself become more expensive, as hazardous
materials (hazmat) trucking companies have come under new scrutiny
– Also applies to not-so-hazardous materials such as
• Certain food additives, colorings, and flavorings
• Cleaning materials like ammonia and bleach
• Even cooking oils
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Changes in Supply—An Example:
Goods With High Transportation Costs
• This shifts supply curves leftward (or upward) for any goods that are
produced using hazardous materials
– Or for which transportation—especially hazmat transportation—is a major
part of the cost
• How do tools of microeconomics help us understand this?
• Figure 4 illustrates situation for gas stations in a market far removed
from sources of crude oil or refineries
– Therefore requires heavy use of hazmat transportation
– Notice what market accomplishes
• Using gasoline in this location now imposes a bigger opportunity cost on
society than it did before
– Because of all the additional resources that must be used if we want to limit the nowincreased risks of shipping it
• After September 11, it will take more resources to produce many
goods and services—such as those involving high-risk transportation
– Prices of these goods will rise
– Production will fall
• Consumers are forced to take account of higher opportunity cost of their
production
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Figure 4: A Shift in Supply in a
Distant Market for Retail Gasoline
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Air Travel: A Special Case
• Market for air travel stands out among those
directly affected by September 11, due to
nature of attack
• Even in 2003, air travel remained
significantly down from 2000 levels
• What has happened to airline industry?
– It was hit by several factors
• Demand curve has shifted leftward
• A further leftward shift in demand has been caused
by greater time cost of air travel
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Air Travel: A Special Case
• In Figure 5, shift in demand for air travel by itself would
move market from point A to point B along original supply
curve S1
• But diagram also shows a shift in supply curve to S2
– Effect of new tax on air travel to pay part of the costs of the new
Transportation Security Administration (TSA)
• Which now runs airport security nationwide
– Impact of a tax is to shift supply curve upward, moving market to
point C
• Point C is not the end of the story
– Reduction in demand has created losses at many airlines
– Process may have started in 2002, when two major airlines—U.S.
Air and United Airlines—filed for bankruptcy protection
– In 2003, American Airlines came close to bankruptcy
– If exit occurs, it will cause further leftward shifts of supply curve
• Rises in price
• Elimination of losses in industry
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Figure 5: Changes in the Market For
Air Travel
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Changes in Labor Markets—An Example:
Strategic Language Speakers
• Let’s examine a labor market for people who can speak, read, and
write what federal government has called strategic languages
– Arabic, Farsi (language of Iran), Hausa (spoken by 22 million people in
sub-Saharan Africa), Pashto and Dari (Afghanistan), Tajik, Turkmen or
Baluchi (Southwest Asia), and Malay
• Deterioration in U.S. language capabilities has been well-documented
for some time
• September 11 served as a long-delayed wake up call
• Need to monitor communications and infiltrate foreign organizations
would create a continuing need for strategic language speakers
• As Former Senator Paul Simon wrote in October, 2001
– “In every national crisis, our nation has lamented its foreign language
shortfalls
• But then the crisis goes away, and we return to business as usual
• One of the messages of Sept. 11 is that business as usual is no longer an
acceptable option”
• Might think that a country like United States—with millions of
immigrants—should have no such shortage
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Changes in Labor Markets—An Example:
Strategic Language Speakers
• U.S. Congress judged this to be a tragic mistake, one of 13 systemic
failures in intelligence-gathering that made the surprise attack possible
– Report released by Congress in July 2003 stated this clearly
• Our analysis of labor markets can help us understand the problem,
and the economy’s adjustment to it after September 11
– Figure 6 shows market for specialists in strategic languages who have
practical qualifications for government agency work at present, American
born speakers
• Notice initial demand curve for language experts (LD1) slopes
downward
– The higher the wage, the fewer will be demanded, all else equal
– Moreover, government must compete with other employers
• Universities, international organizations, media, research organizations, and
private firms who conduct business in the regions
• Short-run labor supply curve, LS1
– As wage rate rises, more people will seek jobs that require their language
expertise
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Figure 6: Changes In The Market
For Strategic Language Speakers
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Changes in Labor Markets—An Example:
Strategic Language Speakers
• Point A represents initial equilibrium in this market
– With Q1 qualified strategic language speakers working at a wage of W1
– After September 11, demand curve shifted dramatically rightward, to LD2 in
the future
• What about long-run?
– Two factors are working to shift labor supply curve rightward over the next
several years, as represented by shift to LS2
• Change in labor market tastes
– An increased interest among students to learn language and culture of a part of the
world suddenly very prominent in news
• Over long-run, rising salaries of strategic language speakers is a market signal
to people making career decisions
• Will take some time before any of these adjustments are seen in
market
• Similar adjustments are taking place in other labor markets as well
• Since September 11, demand for many types of labor has increased
– In short-run, wage rate has increased, with only limited increase in
quantity supplied
– In long-run, as people acquire needed skills, labor supply response will be
greater
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Financial and Capital Markets
• Financial markets play an important role in
resource allocation
– Enable business firms to obtain funds for capital
purchases
• After September 11, business firms that produced
security-related goods such as bomb-sniffing
dogs, access pass systems, hazmat suits, video
monitors and more wanted to purchase new
capital
• But there is a problem
– By increasing production of security goods, these firms
would increase their revenue and profits…in the future
28
Financial and Capital Markets
• After September 11, security-goods producers went to stock and bond
markets to obtain new funds
– At same time, people were even more willing than before to provide these
funds
– Why?
• With increase in demand for security equipment, probability that a
producer of, say, hazmat suits would go bankrupt and default on its
debt had suddenly decreased
• Something similar was happening in stock market
• After September 11, producers of security-related goods could
increase their profits by expanding their plant and equipment, which
required the purchase of new capital
– At the same time, potential suppliers of funds found stocks and bonds of
these firms more attractive than before
– Result has been an increased flow of loanable funds to firms and
industries that produce security goods
• Resulting in an increase in this sector’s productive capacity
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An Example: The Defense Industry
and The Stock Market
• Although national defense is provided by federal government, it
purchases the inputs in private economy
• Within days of terror attacks, it became clear that U.S. Defense
Department was poised for a major increase in orders from its
suppliers
– Both in short-run (next few months) and long-run (several years or more)
– In short-run, with a war in Afghanistan likely, American forces would be
dropping thousands of bombs
– Within weeks of attacks, it was clear that national defense spending would
increase sharply for at least a decade
• Additional defense production was sure to generate higher revenues
and higher profits for Lockheed Martin and other defense
contractors—in the future
– But government needed these contractors to expand production capacity
right away
– Firms obtain most of the funds they need for capital purchases in financial
markets
– And financial markets turn out to be a remarkably efficient mechanism for
providing them
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An Example: The Defense Industry
and The Stock Market
• Panels in Figure 7 illustrate this process
– Panel (a) shows behavior of Standard & Poors
500 index for two weeks before and after terror
attacks
– Panels (b) and (c) track share prices during the
same time period for two major defense
companies
• Lockheed Martin and Raytheon
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Figure 7(a): Share Prices for the S&P
500 and Two Defense Contractors
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Figure 7(b): Share Prices for the S&P
500 and Two Defense Contractors
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Figure 7(c): Share Prices for the S&P
500 and Two Defense Contractors
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An Example: The Defense Industry
and the Stock Market
• Let’s focus on market for Raytheon shares
• Expectations of Raytheon’s future profits were revised
upward after September 11
• But wait…all of this trading took place in the secondary
market—the market for previously issued shares of stock
• Recall that when a company issues new shares, it must
sell them at prevailing price in secondary market
– Dramatic rise in Raytheon’s stock meant that Raytheon could get
more funds than before for any new shares it issued
• Signal to Raytheon’s management that this was a good time to issue
them
• Raytheon’s managers—who are driven to maximize profits
for the firm’s owners—did not ignore this signal
• Like Raytheon, other established defense contractors
made public offerings in months after terror attacks
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Figure 8: Changes in the Market for
Raytheon Shares
36
Public Goods and Government
Involvement
• Markets are often an efficient engine for bringing about
resource allocation
– But they don’t always work
• Rivalry and excludability are characteristics of private
goods
– But some goods do not have these characteristics, and cannot be
efficiently provided by business firms
• On some issues, there is widespread agreement about
dividing domestic security among public and private goods
– National defense, for example, is both nonrivalrous and
nonexcludable
– But on issue of airline safety, while there has been some
agreement, there has also been strong disagreement
37
Public Goods and Government
Involvement
• In might seem that goods and services needed to provide
safe air travel are private goods
• Government could still establish regulations airlines would
have to follow, but it would require airlines to shell out all
funds to abide by the regulations
• A few economists have advocated this solution
• But is airline safety really a private good?
– Seems to be a consensus that airline safety is—at least in part—a
public good, and that safe air travel should be partially funded by
government
• Due to significant degrees of nonexcludability and nonrivalry for airline
safety, as well as substantial external benefits to the general
population from having low-cost air travel,
• Principle helped to shape federal government’s plan for
increasing airport security
38
Public Goods and Government
Involvement
•
Another aspect of airline security has proven controversial
– To say that government should provide some part of airline security doesn’t
necessarily mean government should produce it
•
•
Typically, questions about government or private production in United States
are controversial
Once it was decided government would provide a significant part of airline
safety, a heated debate arose over who should produce it
– Those who favored private production argued
• Government-imposed standards carried out by private contractors would lead to more
efficient, lower cost production of any given level of security
•
•
In late 2001, those who favored public production won an almost complete
victory
However, there were two compromises
– Special rules would make it easier to fire incompetent workers than was possible in
other government jobs
– Starting in 2005 airports would be permitted to return to private contracting if they
chose
• May lead to further controversy in 2005
•
While there is wide agreement that some aspects of airline safety should be
public goods (provided by government), an unresolved controversy persists
over the issue of public versus private production
39
International Trade and Domestic
Security
• International trade provides substantial benefits
• Some trade barriers may actually be reduced as a
result of September 11
• But these effects are likely to be dominated by
another, more pervasive impact of September 11
– Increased cost of delivering goods across international
boundaries due to heightened border security
• Consider, for example, 5,500-mile border between
United States and Canada
• Remember that each hour of delay uses up
resources
– Time of paid truck drivers, gasoline wasted while idling,
and damage to perishable cargo
40
International Trade and Domestic
Security
• Figure 9 illustrates impact of using more
resources for international trade
– Shows market for tomatoes in Mexico (panel (a)) and
United States (panel (b))
• Suppose an increase in concern for security has
led to more thorough vehicle inspections and
other significant time delays at Mexican border
– In new equilibrium after September 11, cost of tomatoes
will have to be 10¢ greater in United States than in
Mexico
• To account for new costs of bringing tomatoes into United
States
41
Figure 9: Increased Security
Concerns And International Trade
42
International Trade and Domestic
Security
• To find this new equilibrium, we must find a price in U.S.
and a price in Mexico that differ by exactly 10¢ (to reflect
new transportation costs) and at same time create an
excess supply in Mexico (exports) equal to excess
demand in U.S. (imports)
• What is the final impact of this increase in transportation
costs?
– Within each country, there are both gains and losses
– But with all these gains and losses, what is the total effect in each
country?
• Volume of trade has shrunk
– Effect of using more resources to transport goods is almost exactly
like effect of a tariff
• Ironically, United States—which suffered the direct
consequences of attack—is among the nations least
affected by increased costs of trade
43
International Trade and Domestic
Security
• Increased security at our borders will increase resource
requirements for a broad array of goods and services, and
contribute to slower growth in living standards
– By increasing costs of transporting internationally traded goods
and changing patterns of production at home
• Last 15 years have seen three major resource
reallocations
– First came about due to end of cold war
• Freeing up resources from military to domestic uses
– Second was rapid development and adoption of internet
• Resulted in huge investments in computers, software, fiber optic
cable, and more
– Third was when United States—and much of the world—began a
major reallocation of resources
• Toward global war on terrorism and provision of domestic security
44