In this lesson, we will begin our look at why using government to attempt to correct market failures may not always be a good idea. There are times when using government does not improve aggregate welfare over a market outcome, and there are some cases when using government to do this actually makes things worse. We will talk in this lesson about some of the main underlying causes for this.
By the end of this lesson, you should be able to:
This lesson will take us one week to complete. Please refer to Canvas for specific time frames and due dates. There are a number of required activities in this lesson. The chart below provides an overview of those activities that must be submitted for this lesson. For assignment details, refer to the lesson page noted.
Requirements | Submitting Your Work |
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Please read Chapter 6 in Gwartney et al. OR Chapter 13 in Greenlaw et al. And links to other reading contained in the lesson text. |
Not submitted |
At this point in the course, I have to introduce a couple of properties of economic goods that we have not talked about. These two properties can be called "rivality" and "excludability."
"Rivality" refers to how many people can use a good. A good is called a "rival" good if it can only be used by one person, or one group of persons at a time, and the use of the good by that person makes use by another person impossible. So, a Big Mac is clearly a rival good - if I eat it, you cannot. On the other, cable television is a non-rival good. One person using cable TV does not stop another person from using it. A movie ticket could be a rival or non-rival good. If there have been 100 tickets sold to see a movie in a 500-seat theater, then the 101st ticket is not a rival good, because the consumption of that ticket does not stop anybody else from seeing the movie. On the other hand, if the theater owner has sold 499 tickets, the 500th and last ticket will be a rival good.
"Excludability" refers to the ability to stop somebody from consuming a good if they have not paid for it. If we assume for a minute that theft is not occurring, it is easy to see that excluding people from consuming Big Macs if they have not paid for them is easy. However, it can be difficult for other things. Every year on July 4th, I used to sit in the parking lot of the local Wal-Mart and watch the spectacular fireworks display put on at Longwood gardens in Kennett Square, PA. If I wanted to go into Longwood Gardens to watch, I would have to pay \$30 or more, but by sitting outside the grounds, I get to see the fireworks for free.
So we have two variables: rivality and excludability. We can draw a little 2 by 2 table, and see what we get when these properties intersect:
Rival good | Non-rival good | |
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Excludable good | Private goods | Club goods |
Non-excludable good | Common pools | Public goods |
So, given that we have two variables and each of these two variables has two states, we end up with 2 x 2 = 4 possible outcomes, which are defined in Table 8.1 above.
The quadrant labeled "private goods" refers to goods that are rival and excludable. This quadrant includes the vast majority of economic goods, and does not present us with any serious problems. Because they are excludable, we can assume that property rights are well-defined and are operable.
The other type of excludable good, the club good, refers to the other case where property rights enable the exclusion of non-payers. This includes things like movie theaters, golf and country clubs, cable TV, and so on. Once again, these do not present us with any serious economic issues.
Moving on to the second row of the table is where we run into some interesting issues. If a good is both non-rival and non-excludable, it is what we refer to as a public good. This is a good where it is difficult to exclude people who do not pay, but whose use of the good does not impede others from using it. The city streets are typically public goods: when I was in State College, I could drive from my apartment to campus without having to pay to use the roads, at least directly. Of course, parking is another issue, but let's not talk about that here...:-)
Public goods can be thought of as a type of market failure. Individual economic actors have incentives to under-pay - this is what is referred to as the "free-rider" problem. The price paid is usually lower than the costs of supply - quite often there is no price, as people are not forced to pay the market-clearing price which would be defined by "marginal cost = marginal benefit".
Subsequently, there is a shortage of supply. Users derive great utility from consuming the public good, but nobody can profit from operating a public good, so there is no market-based, self-interested incentive in a person or group of persons providing the good.
Let’s use National Defense to illustrate: suppose Americans are expected to pay for national defense through voluntary donations to the Department of Defense. Since I cannot be excluded from the benefits of national defense, I have incentives to not “donate” any money while still being protected. You (and everybody else) face the same incentives, so no one will voluntarily pay. So, left to this state of affairs, the Pentagon would have to defend us with imaginary weapons (and imaginary soldiers, too)!
This is why taxes are not voluntary.
The above scenario is true for all public goods; there will be less supply than the socially optimal quantity because people will pay less than what the good is actually worth to them, due to the free rider problem. To correct the situation, a central agency which can mandate payment (i.e., the government) provides the good. This is generally held to be a desirable outcome because, this way, the right amount of a public good is supplied - if we assume that government is able to define the optimal quantity of a public good. We will talk about this more in the next lesson when we introduce the concept of government failure.
Of course, with an election approaching, a large debate has arisen as to "how much" of a large number of public goods should be provided, but that is a political issue that is beyond the scope of this course.
In the above case, the government has assumed the property right for the public goods.
Now, we will look at the last of the four quadrants in the table above, the common pool, sometimes referred to as "common property resources."
Common property resources are defined by 3 characteristics:
As a result of these characteristics, exploitation - overuse - usually results. A common pool presents a problem, in that nobody who uses a common pool has an incentive to consume less today and save some for tomorrow. If you chose to defer consumption of a good to tomorrow, then somebody else will come in and consume it today. Therefore, it is in your best interest to consume extra today. When many people behave like this, the common pool will be exhausted very quickly. Some common examples:
Let us focus on a particular issue which has aroused a lot of concern lately, that being the notion of overfishing. The basic problem is that fish in the wild are not owned (non-exclusive property rights) until they are captured, at which point they are dead and, hence, unable to reproduce. A lot of fishing is complicated by the fact that a lot of fish exist and are caught in what are called "international waters," which are typically any oceans more than 12 miles from the coast of any nation.
Given a certain population of fish, it is possible for humans to consume a certain amount of fish in a given year, and the fish in the ocean will breed and reproduce, allowing the quantity of fish in the ocean to stay more or less constant. However, if we catch too many fish today, then the population remaining in the sea will not be able to generate enough offspring to replenish the stock, and the quantity of fish in the sea will shrink over time. Eventually, it will become extinct. Clearly, mankind as a collective entity has an incentive to not over-fish today, to ensure that enough fish in the sea will remain to allow us to consume fish for the rest of time. Unfortunately, very few individuals face the same incentive privately. Catching more fish today means more profit today, and if I were to catch fewer fish, it is likely that someone from another ship will come and catch any fish that I am trying to "conserve," because I do not have any property rights to fish in the wild.
How do we solve this problem? The common answer to this is to grant property rights to the pool. Then, when somebody owns the pool, they have an incentive to preserve some of it for tomorrow. This is why cows are not in danger of becoming extinct – all cows are owned by somebody. African elephants were in danger of going extinct because nobody owned elephants, and people would kill them for ivory. In southern Africa, elephants have been converted to private property, and the population is growing. Note that the Indian elephant has never been at risk of extinction, because in India elephants are working animals that are owned by people.
Returning to the example of fish, there was a great source of fish in the North Atlantic known as the "Grand Banks," a warm shallow area off the coast of Newfoundland in Canada. The history of the Grand Banks is described at the following link in more detail than I can cover here, so I urge you to read it. Although it is an "environmentalist' magazine, and is thus written from a certain point of view, it is generally a good rundown of the facts.
Thompson, Tim. (1987). A Run on the Banks, How "Factory Fishing" Decimated Newfoundland Cod [1], Emagazine.com
The bottom line is, a common-pool problem existed, which the government of Canada solved by extending their territorial waters from 12 miles to 200, and then by requiring licenses to fish at a level that was felt to be sustainable. Perhaps it was too late in this case, and many people believe that the North Atlantic cod stocks are gone forever. Nonetheless, this is a good illustration of how other countries have striven to address the common pool issue - a number of countries have extended their stewardship over marine life and limited harvests in order to ensure sustainability and an adequate supply for future generations.
Read Chapter 6 in the textbook to accompany this lesson.
In the first section of the course, we found that the best way to allocate resources was through a competitive market. More specifically, we said that perfectly competitive markets produce the best outcome, and by "best" we mean the wealth maximizing outcome. We also talked about how deviations from, or interferences with, the functioning of the perfectly competitive market decreased total wealth accruing to society. We talked about ways in which markets can fail to provide the optimal, social-wealth maximizing outcome, which we called market failures.
Some of the market failure mechanisms we described:
We also examined some of the solutions to market failure:
Most of the solutions require government intervention or permanent government control of the failed market. In each case, the government enters into a market in order to solve a problem of wealth not being maximized. When governments intervene in markets, they are exercising power, and exercises of power tend to have a lot of results and consequences that are neither expected nor optimal.
This is a point in the class where we veer dangerously close to politics, as government choices to intervene in market processes are typically "policy" decisions that are outcomes of election processes. I wish to avoid discussion of politics and talking about which policies might be "good" or "bad." Those are normative and not positive questions.
What we are striving to look at here is the actual results of certain policy decisions, and whether those end results are what the policy-makers intended, and whether the policy in question tends to help or hurt the economic "size of the pie."
Not all regulation is "bad" in this sense. It is broadly, if not universally, held that workplace safety rules or bans on child labor or food safety laws are net beneficial to a society, even if they represent impingements on the behavior of either private firms or individuals.
The problem of regulation is that, like all other economic processes, it suffers from diminishing returns. The first bit of regulation, which corrects major distortions or market power exercises, is generally very beneficial. We then move on to addressing the next worst distortion, which gives us a smaller benefit. And so on. We are now at a point in our history where we begin regulating smaller and smaller distortions, and we often find ourselves causing more harm to the economy than benefit by our government action. These are the types of issues we are talking about here - not fundamental discussions about the appropriate role and size of government, but whether, "at the margin," some set of government actions actually solves the problems they strive to address, and whether, in the process, they end up hurting the size of the economy more than if the government did nothing.
Reiterating, we are talking about diminishing marginal return to regulation, not whether some regulation is "good " or "bad" policy.
We will now examine some of the ways in which governmental entities behave in these situations.
Before we move on, I wish to introduce a new term, or a new paradigm. Remember that the word "paradigm", which has been greatly ridiculed as a horrible piece of biz-speak jargon, has an actual meaning: a paradigm is a "way of thinking" or a way of looking at the world. So now, I wish to introduce the concept of "methodological individualism." A good description of this concept can be found at the Wikipedia page: Methodological individualism [2].
However, I will briefly sum things up this way: methodological individualism is a way of looking at the world and a way of explaining outcomes that views institutions not as "things" in their entirety, but merely as collections of individuals. Thus, a government, a firm, a university, or some other grouping of people is merely a large collection of individuals and individual decisions. It boils down to this: only people can make decisions, and only people can perform actions. A firm does not make decisions; the managers inside it make decisions. Governments do not make decisions or take actions; the people who constitute the government, such as politicians and bureaucrats decide things and do things. Societies do not do things; people do things.
Thus, every action taken by some collective entity, be it a government, a company, a school, a team, a society, or a family, is actually an action undertaken by a person, or multiple persons.
I have found this to be a useful way of thinking when examining actions taken by such collective entities. It is helpful because, in a microeconomics framework, we like to look at the aggregate results of millions of separate, independent decisions and actions performed by consumers. Thinking of markets as aggregates of all of the decisions and actions of the individual economic actors is the accepted and well-practiced framework of microeconomics - it works well to explain and predict market outcomes. We look at these individuals as rational, self-interested, utility maximizers operating in an environment of imperfect information and scarce resources.
It turns out that examining and predicting the actions of non-market aggregations, such as government bodies or companies by looking at the incentives faced by the individuals that make up those entities works well. Note that when I say a company is a non-market entity, I don't mean that it does not participate in markets, but that, internally, a firm is not a market, but an authority based hierarchical structure.
So, putting this as simply as I can, if we want to figure out why governments and schools and companies do what they do, we should look at the incentives faced by the people who make decisions inside those structures, and how those individuals would act if they were rational utility maximizers, which, of course, they are.
We spoke earlier in the course of the notion of "normative" and "positive' questions. Normative analyses examine what outcome "should" occur (what happens in the best of all possible worlds), assuming that we have some notion of what "should" and "best" mean. Positive analyses determine what actually is happening, and why. We have already determined how the government "should" act when it intervenes in a market place to correct market failure: it "should" strive to correct the market failure in a way that maximizes wealth in the society that is being affected by the market failure. Unfortunately, that seldom, if ever, is what happens. Now, we want to examine how the government actually acts - thus the usage of the term “The Positive Theory of Government." This is a study of what government does in real life, and why.
We assume that greed motivates consumers and firms, and it is logical to assume this, since we all prefer more to less, and this assumption has been shown over time to be a reliable predictor of market actions and outcomes. We now know how government should behave (as summarized above), but we want to know how governments operate, i.e., we want a positive (rather than normative) answer.
Within economics, this field of study is known as "Public Choice." It attempts to explain what factors determine how governments make decisions. Government is composed of government officials - elected politicians and civil servants. Remembering the framework of methodological individualism, we need to ask: What do government officials want? What motivates government officials? What incentives do they face?
Politicians have one great goal, the one thing that defines them as successful politicians, which is the ability to get elected and then re-elected. A politician who cannot win an election is a poor politician indeed. Civil servants, on the other hand, are motivated by their desire to get promoted to positions of higher pay and higher authority.
Using the simplest terms and most convenient definitions, GREED motivates both politicians and civil servants.
Since government agencies are controlled by individuals motivated by greed, it is easy to imagine that these agencies are not always run in a manner consistent with society’s best interest. Let us take a look at a basic civics lesson, from an economist's point of view.
How does a politician get/keep her job? He or she gets elected by the voting public. Thus, we can say that voting is the first input to the political process (i.e., all power comes from the majority’s mandate). Generally, in a representative democracy, we vote for a candidate who will represent us on all issues. However, it is unlikely that one candidate will mirror our desires completely. As a result, we must make compromises when we cast our votes. Most people tend to choose the candidate with a platform that, on average, matches ours better than any other candidate. However, there are a couple of other selection criteria that are also commonly employed by large shares of the electorate: choosing the candidate with the position closest to ours on the most important issue, and choosing the candidate who will do the least damage.
Representative democracy has the advantage of allowing someone to specialize in making decisions. It is far better to have someone thoroughly trained in making decisions, someone who has the best information on the issues actually making the decisions. For example, it would make little sense to have national referendums on how to design military aircraft. Representative democracy also gives substantial powers to elected officials who can then use it, often for a period of several years (for example, the term of office for a US Senator is 6 years), without going back to the voters. It is possible to have direct votes (referenda) on various issues; this is an alternative to electing people for extended terms. They are commonly employed in some countries, Switzerland being the most frequently cited example. However, the frequent use of direct referenda has its problems. In California, voters typically vote on over 100 items on a ballot, and one has to wonder if they really know what they are voting for. Also, when voting on a single issue, it is often being examined without any sort of context.
So, when we vote, economic theory suggests we pick the candidate who will improve our welfare. But in some sense, it can be very difficult to tell just who is the best candidate. Individuals have little incentive to seek the necessary and costly information on politicians and policy to determine which candidate will most likely improve our welfare. Thus, voters are rationally ignorant; they are not properly informed on all the issues and candidates. We say rationally ignorant because your equilibrium behavior is to be uninformed. The cost of discovering all you need to know about all of your electoral options is greater than the benefit of doing so - it is actually rational to be ignorant! (by ignorant, we mean "not in possession of all possible information").
A short (one-page) paper from Clemson University explains rational ignorance in a little more depth. You can find this paper on Canvas.
The vote of one person is seldom decisive in a democracy - it is extremely rare for an election to be decided by one vote, outside of a very small society. The lack of impact of one vote ultimately means that your vote does not count. Since you cannot directly affect the outcome, you have no incentives to acquire all the necessary information for you to act rationally (as opposed to acting ignorantly). To illustrate, compare the incentives of a consumer buying a house and a voter "buying" a politician (spending valuable, and limited, resources to choose the “right” politician). A typical consumer will generally will take great care in acquiring information about which house he buys, because if he makes a bad choice, he’ll suffer. However, voting generates a public good, in the sense that a vote for the "best" candidate benefits others. Therefore, we can say that “correct” votes will be under-supplied, and there are thus no incentives for voting efficiently.
So, as a consequence, we look for shortcuts when it comes to ways of educating ourselves about how we should vote. This is where labels, such as "Republican," "Democrat," “liberal,” or “conservative” come into play. These are ways of conveying a large bundle of information in a shorthand way. They are attempts by politicians to overcome rational ignorance. Since we expect that politicians will seek to retain office, just like car manufacturers will seek to stay in business, and since politicians are driven by rationally ignorant voters, we see a lot of image advertising which costs a lot of money – and may not properly represent the politician.
The phenomena, taken together, are part of what we call the theory of public choice, which is a study of how the public makes collective decisions with respect to choosing government. One of the founders of this field, a Nobel Prize winner called James Buchanan, referred to this as the study of "politics without romance", by which he meant that it is a study of political behavior devoid of the romantic notions of "doing the right thing for society." For a little more background in this area, please read the below article from the Concise Encyclopedia of Economics, which is a document put together by a libertarian organization called Liberty Fund.
Shughart II, William. "Public Choice [3]". The Concise Encyclopedia of Economics.
We spoke in the previous section of public choice theory, which relates to the choosing of politicians. In this section, we will look at how the other, larger part of government functions, from a "positive" point of view. A bureaucracy is an agency the government charges with a specific obligation for which the government is ultimately responsible. The word "bureaucracy" has become negative in modern society, with connotations of red tape, confusing instructions and poor service. However, this is an improvement on the system it replaced. The word "bureau" is French for "desk," and the word "bureaucracy" comes from the government structure that was developed after the French Revolution. Before the Revolution, if a person wanted anything from the government in France, they had to make a personal appeal to the king or one of his regional representatives. The decisions of these people could be completely arbitrary, or would depend on the paying of bribes or kickbacks. After the Revolution, a system of written rules, standards and practices was established, with these rules being managed by supposedly disinterested civil servants, who would decide whether somebody received a government favor based on merit and adherence to a rule or regulation, and not as a personal favor. This was largely seen as a great improvement on the previous system, and systems like this are used in most parts of the world - at least in theory.
Some examples relevant to the United States:
In each of the above examples, the government (either Congress or the President) is assigned (or assumes) the property rights for the said resources and programs, and then chooses to "contract out" the work to an agency working, nominally, for the politicians. This is like hiring a maid to clean your house, or a gardener to mow your lawn, except the government hires large numbers of economists, accountants, engineers, scientists, lawyers, and administrators to perform the management, execution and enforcement of the rules that the politicians put into place. So, for example, the politicians will pass a law like the Clean Air Act, with a bunch of goals and targets for cleaning up the environment, and will then delegate to an agency (in this case, the EPA) the job of making sure that the law is put into effect.
Quite a bit of academic work has been done studying how bureaucracies work. American economist William Niskanen came up with a theory of bureaucracy that can be briefly summarized as follows.
A bureaucracy is a response to a market failure, but is a form of government failure with 3 main elements:
The third point can be summarized in the context of the first two: the bureaucrats know that the public places some value on the services they provide, for example, they want national defense, they want a clean environment. Since the bureaucrats are the people who provide the service, they have the best knowledge about their costs, much like a firm providing a good or service in society knows its costs better than its customer. However, the bureaucrats also have a good understanding of what the public (via their selection of politicians) is willing to pay for the services. So, we have a difference between a cost and a willingness to pay. In a market, this is known as the "total wealth" derived from trade, which can be divided into producer surplus and consumer surplus. A market will establish the equilibrium price, which divides the wealth up between the producers and consumers. In this case, we have a type of market, but the sellers (the bureaucrats) have market power - they are typically a monopoly, and they have information asymmetries working in their favor, and they are striving to maximize the "producer surplus" while minimizing the "consumer surplus." That is, the bureaucrats would like to be "paid" the highest amount possible, which is the total willingness to pay by society.
Furthermore, it is difficult for the government to detect or control for this behavior, as the disparity will always exist by nature of the system.
This theory is a bit extreme, however: bureaucracies do have controls - politicians, who have to be elected. Occasionally, the public grows unhappy with the capture of wealth by bureaucrats and elects politicians who campaign on the promise of reducing the size, power, and cost of the bureaucracy. Unfortunately, politicians often have less power than the bureaucrats, who have often been in their positions for many decades and know how to play the system and public sentiment. Bureaucracies are greedy and do have power, and are generally unwilling to give up that power. What incentives do agencies have to be efficient? Few, because being efficient means more work for less budget — we often hear the phrases “close enough for government work,” and “in government, 10% of the people do 90% of the work.” However, fear of losing the position provides some incentive for efficiency.
In business, many of the processes can be measured, and their "contribution" to the bottom line (profit or loss) can be assessed. How can the output of bureaucracies be measured? In many situations, it is very difficult. If there is no attack from Canada, can we really say the DoD succeeded in defending us? The next question is, how can legislators monitor bureaus? Who is more likely to show up on a bureau’s oversight committee? Congress-people, who often have vested interests in the bureaucracy. Because they are basically the people who perform the day-to-day operational functions of government, the agencies can make life very difficult for politicians if they want to. Thus, the politicians, who want re-election, will often strive to keep the bureaucracy happy because actions of the bureaucracy can make a politician look very bad in the eyes of the public. Only when a politician has strong support to act against bureaucracies will they try hard to crack down on agencies, but this can often backfire on the politicians, when the public sees that something that they value is being taken away. The public is notoriously fickle - they may elect politicians who promise to crack down on public spending, but become very unhappy when that "cracking down" means less service from government agencies.
What do bureaucracies want? Maybe the same thing as everyone else - money. However, government officials generally cannot profit from their actions - we hope - at least not in the same way that private parties can. So what do government officials maximize? Power in various forms (either budgets or power over private authorities). Often, this power manifests itself in large budgets, which means large staffs. A bureaucrat who has 5,000 people is a lot more powerful than one who has 150 people working for him.
An example, let's say we went to the EPA and gave them two choices for regulating pollution:
Under (1) EPA has a lot more authority and power, so we might think they would choose this method.
Looking a little deeper into this example: the government basically “hires” the EPA to provide a clean environment. The means for accomplishing this come from a budget for which the EPA asks (since the EPA knows better than Congress how much it will cost – see the inherent flaw?) The EPA asks for as much as it can get without being rejected. This is the point at which we are indifferent between spending one more dollar on cleaning the environment and letting pollution flow freely from factories. Notice that it may only take a clever ad campaign threatening dire consequences to protect the environment to scare the public. Congress accepts the budget request because the EPA knows better how much it costs, and the bureaucrats are better off at society’s expense. The difference between the true costs and the budget are at the disposal of the bureaucrats
We expect that firms will maximize their stream of profits discounted by the interest rate. This means that firms discount the future ("discount" means "count as less valuable"). Investments that pay off in the future are less valued than ones that pay off in the present. What would you prefer, a dollar today, or a dollar tomorrow? What would you require in order to accept payment tomorrow instead of today? This is a complaint that many make about businesses - that they are focused on "short-term" profits, but do not take the long-term benefits of society into consideration when making investment or production decisions. It is a commonly held belief that governments do a better job of considering long-term effects of policies, because government does not have short-term, profit-maximizing objectives. Put in a more technical way, we would expect government to have lower "discount rates" than business - because they will place a higher value on future events, they do not "discount" them as much. So, is this true? How much do politicians discount the future?
Politicians care about getting votes. But we know that voters are rationally ignorant and are going to have a hard time predicting the impact of policy on future events. Thus, we might expect that voters would focus on how well things are going on election day. As a result, politicians have little incentive to engage in policies that will have benefits past the next election day. You see this in states with surpluses from oil revenues (Arkansas, Louisiana, Alberta), where the surpluses are generally spent immediately. Thus, while the private market has positive discount (interest) rates, we might expect government to have even higher rates. A firm, and its shareholders, might focus on short-term profits, but the firm does want to be in existence 5, or 10 or 25 years from now, and thus they are unlikely to perform actions that will hurt the company in the long term. Any firm that does something in the short-term that can be seen to hurt it in the long-term will likely be punished in the stock market. However, in the market for votes, people generally care little about the next election, and focus on the present one.
In this lesson, we began to take a look at the way government functions in the real world - that is, we looked at government from a "positive" perspective, as opposed to a "normative" perspective. We looked at the public choice theory of government, which describes the flaws in the methods we use to elect politicians, and we looked at the theory of the bureaucracy, which explains why using government agencies to perform actions that are not supplied in the marketplace can be expensive, and why the bureaucracy has incentives and abilities to maximize its own utility, even in the face of opposition from politicians seeking to get elected.
In the next lesson, we will look at a couple more facets of government failure, and we will look at some of the actions that governments can take to intervene in a marketplace and what some of the concrete results are.
You have reached the end of Lesson 8! Double check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there.
If you have anything you'd like to comment on or add to the lesson materials, feel free to post your thoughts in the discussion forum in Canvas. For example, if there was a point that you had trouble understanding, ask about it.