Posts Tagged ‘economics’

This week, it was announced that Richard Thaler had been awarded the Nobel prize for economics. It is long overdue. Here is why.

Thaler is best known for his 2008 book Nudge: Improving Decisions About Health, Wealth and Happiness which he co-authored with Cass Sunstein. He was a summation of his many years of work on behavioural economics. You can read my review here.

This understates his contribution though: Thaler is considered by many to be the father of behavioural economics.

To understand why that is important, we need to look at what behavioural economics is. Economics, as a subject, has been around for thousands of years. Except that in many ways it really hasn’t. Traditionally, at least in recent tradition, it has focused on building financial models based on people making perfectly rational decisions.

Take the free market, for example. If you put prices up, you decrease demand. It’s nice and simple.

But then Thaler came along and said: “hang on, do people act like rational beings all of the time?” The answer, of course, was no. And a new field of economics was born: behavioural economics. The study of what people actually do.

But what exactly is non-behavioural economics? The more you think about it, the more you realise that we can basically can anything we thought we knew about economics beforehand, because all economics should be behavioural economics. Models that use “econs” rather than “humans” do not work in the real world. Which is where all research should eventually have some kind of relevance.

So, well done to the Nobel prize selection committee for making such an excellent choice. In a perfect world, it would have happened much sooner. But the selection committee, like the rest of us, are humans, not econs.

Selfish Reasons to Have More Kids is a book by economics professor Bryan Caplan and has quickly become my favourite book on parenting. In it he argues that regardless of the number of kids you were going to have, a few more might be better. So if you were planning on zero, maybe you should have one. Or if you are planning on having four, maybe you should have six.

His thesis is that having children is actually less work than most parents put themselves through. People spend hours and hours ferrying their children round activities and after-school clubs, playing them Mozart and generally doing things they hate doing, and often the child hates doing, because they want the child to be more successful.

However, all the research shows that this has basically no effect. Whether it is IQ, happiness, success, character or honesty, most of it is set by genes and the rest is set by the environment, only of which a small fraction is parenting. Therefore parents are simply making themselves totally unhappy for basically no gain.

Let’s say you have a child, and the chance of them growing up to be a lovely person is 80%. You could work really hard and sacrifice your life to budge that to 82%. That gives you an 82% chance of having a lovely child when they’re grown up. Or, you could do nothing, have two kids, and give yourself a 96% of having at least one lovely grown-up child.

Even religion is not determined that much by parenting. What parenting does affect is the labels that people use. But actually turning up to the place of worship as an adult is a whole different ball game.

They are drawbacks to having more children. However, Caplin tackles these too. For example, people without children are slightly happier than people with children. Repeated studies find this. However, when you take out all the stuff the parents hate doing, this gap is incredibly small. Also almost no parent says they regret having kids, whereas the majority of childless people do say they regret it. Finally, most of the happiness hit is with the first child, so once you have had one, you might as well keep going.

There is also the time, money and sleep loss. Caplin tackles this too. This is a short term perspective. Sure, four kids is a huge amount of kids if they are all three years old. But, by the time they are teenagers you will probably have to ask them to spend time with you. And by the time they are adults it is a pleasure to have four adult kids that you can go see. Not to mention that the only reliable way of improving your odds of grandchildren is to have more children yourself.

Is it a message of doom and gloom that parenting doesn’t matter? Not at all. You can change your child in the short term. Discipline, for example, is necessary to have any kind of sane household. Just don’t expect those lessons to last forever. More importantly, the one thing you do have a long-lasting impact on is how your child remembers and perceives you. So shower them with love and kindness. Don’t bother doing stuff you both hate, or culture-cramming. Instead, use your time together to just have fun. It does no harm and makes both of your lives more enjoyable.

SuperFreakonomics is a non-fiction book published in 2009. It is written by Stephen Dubner and Steve Levitt as a follow-up to their 2005 book Freakonomics.

I had this book vaguely on the back-burner of things I wanted to read. However, while holidaying in Wales I found, to my surprise, a copy lying around in the cottage we had rented. So I sat down and had a read.

It is a short book, weighing in at just over 200 pages plus an extensive notes section. It is also a fun book. I read through it in about 24 hours. While enjoyable, I find it less enlightening or informing than their first book. I enjoy their writing style. There is a short rant about how people say things were better in the old days, even though on almost every metric things are better today. I often have this exact same rant.

The most interesting statistic they produce is arguably in the introduction. They discuss the risk of fatal accidents while driving drunk. It turns out that you are actually more likely to die if you walk home than if you drive. Walking home is dangerous: you might wander out into the road for example, or, if you’re in Leeds, into the river (sadly people frequently have).

It makes sense that drunk driving is illegal, because you are more likely to take an innocent victim with you, but actually it would be safer to let people drive home. Or, if you are the drunk trying to work out what method of transport to take, the best option would be to take a cab.

While the book is on the subject of vice, it next moves onto prostitution. Prostitution pays comparably well compared to many other professions but used to be far better paid. The problem: increased competition. These days, pre-martial sex is acceptable, and so you don’t need to pay a woman to have sex with you, you can just go dating instead.

They suggest this has implications for fighting drugs. If you go after the dealers, more will pop up, because the demand exists. Prostitution reduced because demand reduced, and so perhaps the way to deal with drug dealers is to go after the users and reduce the demand. This ignores the complexities of addiction but could be a good way to think about many other problems society faces.

They also discuss whether child car seats save lives. I blogged about this last month after watching Steve Levitt’s talk at TED.

While on children, they talk about how increased access to television correlates with criminal convictions later in life. This is something I am also reading about in The Village Effect, a book that stresses the importance of face-to-face communication over raising a child in front of the TV.

The book ends with a discussion on climate change. They note that food transport makes up only 11% of carbon emissions. Therefore, buying locally can actually be bad for the environment because large farms are typically more efficient. Rob Lyons talks about the same thing in Panic on a Plate: local farms might be closer, but in third world farms far more is done by hand, as opposed to carbon-polluting machinery.

I am less convinced about their solution to climate change though. They suggest that a technique called Budyko’s blanket could solve the problem. It would be nice if there was a simple solution that we had overlooked. However, a quick check on Wikipedia seems to rule this one out.

Who Gets What – And Why: The Hidden World of Matchmaking and Market Design is a book by Nobel laureate Alvin E. Roth on market design.

He begins by pointing out that not all markets are money driven. Community markets commonly are. Food for example will typically rise and fall in price depending on supply and demand. It’s relatively simple. Many markets are matching markets however. These involve much more complicated transactions.

Take the job market for example. This is not simply supply and demand. You have to both want to go work for a company, and the company has got to want you. I cannot simply turn up at Google’s offices and announce I am starting work. Nor can they demand I come work for them. We have to be matched by agreement. This is common – university applications and martial partners are good examples. These are major issues in our lives.

He then states that a free market is one that works well because of strict rules. The free market is not one where people can do whatever they want but one were the players find a safe environment in which to transact.

This is often not the case in matching markets. Take school applications for example. When I was a kid we lived next to an okay school. However, I wanted to go a better school down the road. The risk was that if I put the good school as first preference and the close school as second preference, I would fail to get into the top school because they had other priority students and fail to get into the okay school because it was over-subscribed from people who had put it as their first preference.

Typically people will instead put the okay school as their first preference to play it safe. This is bad market design because it does not allow participants to express their true preference and often not to get what they actually wanted.

Can you fix this by implementing a market that allows people to express their true preference without the risk? It turns out you can!

Roth describes a multi-round matching algorithm that makes this possible. Here is how it could work for a school system:

• Parents list their true preferences for the schools they want
• Round one starts and each school makes offers based on the students that each school wants (typically based on proximity, or perhaps test results)
• Each student tentatively accepts the the best offer according to their preference
• In round two, the school makes new offers based on the places freed up from rejected offers in the previous round
• Students can then switch their offers if they get a better one, or hold on to their existing offer
• Rounds repeat until there is a stable match for as many people as possible

I am unlikely to have done the algorithm justice. I’m not a Nobel laureate – buy the book if you want to understand it. However, the outcome is that people can list their true preferences without the risk of losing out and everyone gets the best match possible.

Let us take continue with my school problem. I list the good school first and the okay school second. Under a traditional system I could miss out on both. Under this system, it does not matter that I listed my true preferences because the okay school would make me an offer in round one, which even if I didn’t get an offer from the good school, I could still accept. In addition it works better for the schools because the multi-round system means they get the students they most desire who also want to go attend them. Everyone comes out on top so it is in both parties interest to take part.

He also discusses unravelling. This is where a market moves further and further forward. Graduate recruitment is a good example of this. If you wait until people have finished their degree to make a job offer, they have often taken another offer. So you begin making offers earlier, and then everyone does it earlier, so you move even earlier. In the end you are making offers after their first year, without any guarantee they are going to get a good degree at the end!

The university American football bowls were a good example of this. They would often make deals with teams before the year had finished. These teams would then go on to lose a few games and thus the bowls would end up with mediocre teams in the “play-offs”. Exposing limits typically does not work. That is to say “nobody makes offers until this date” participants typically ignore it or make informal deals.

A better solution is to redesign the market so that it is not in their advantage to go early and begin the process of unravelling. In the case of the bowl series, the five major bowls combined to rotate who gets the biggest championship game each year. Getting the top teams and thus far higher viewing figures makes it well worth them only getting it one in five times.

Controls on markets rarely work as well as a well designed market. Take prohibition in the US for example. It didn’t stop people drinking, it just created a black market. Organised crime got involved. This is a big problem because when prohibition ended, the criminals didn’t stop being criminals, they just did something else.

This might be a good lesson for the war on drugs. Not only it is obviously failing to control drug use and supporting organised criminal activity, but even if we decriminalised drugs, which the evidence shows is clearly a good thing, we would also have the legacy of organised crime to mop up.

A better market is also a thicker market. One where there are plenty of buyers and sellers that can be matched. There are a number of ways to do this.

Commoditisation is one. Take coffee for example. If everyone sells individual coffee you need to build up a relationship with each coffee grower to ensure their quality is high. But if you implement national standards and grading, people can buy a specific grade coffee without this information. You can even have a futures market.

Money can be a useful tool for easing congestion in a crowded market. Ticket reselling sites are a good example of this. The ticket market is broken. Gig tickets are typically sold all at one price, even though some people want to attend an event so much that they would be willing to pay a premium. Ideally this would be done at the original point-of-sale, but it isn’t, so the ticket resale market has sprung up to fix this.

Speed is also important. eBay is a good example of this. They have transitioned from an auction format which takes time and there is no guarantee you will win. Now, most transactions are Buy It Now, matching buyers and sellers instantly. Their feedback system is also an example of an evolving market. Initially people would always leave positive feedback for sellers, because otherwise the seller would retaliate. Now, only buyers can leave feedback, so they are free to be honest about bad experiences.

Filtering can also be an issue in over-crowded markets. If you are an attractive woman in online dating, you may receive more messages than you can respond to. Or for popular jobs, a company will receive more applicants than it can sort through. Roth suggests that one way in which a degree can be valuable is almost like a peacock’s tail. If you can show you can deliver on a three year project, it doesn’t matter that it might not be relevant to the job you apply for.

In summary, many markets are not just simple money-driven commodity markets. matching markets are complex and often do not work well or safely. This is a major problem because matching markets affect huge areas of our lives – education, jobs and love! Therefore it is important that we design these markets in such a way as to make them work as well as possible for all participants. Importantly, it is possible to do this with good market design.

How has wealth inequality changed over the previous few centuries and what does that tell us about the present? That is the rather large question that French economist Thomas Piketty attempts to answer in this book.

No doubt his writing is in a far more coherant and structured format than my description of it, but here goes.

H begins with a global outlook. Poor countries are gradually catching up with rich countries, and he notes that wealth inequality is primarily within a country. China is making rapid progress in catching up with Europe for example, while the working class of Europe are not making the same gains on the upper class.

Nevertheless, it is a long and hard struggle. Once one country has an advantage, it can essentially own another. This is how European nations managed to maintain colonial domination while running a trade deficit. We could simply put our colonies into debt and then force them to work for us to pay it off.

Once they do grow, they are unlikely to overtake us because as they become a first world country the growth levels off. They are also a long way behind. Europe has 2000% the wealth of China for example, so even growing at 8% a year, once you factor in that Europe is also growing, that is a long way to catch up.

The oil countries could see huge growth though because of their sovereign wealth funds.

Europe itself remains incredibly rich. Richer than anyone else in the world. Though admittedly the United States are the only real competition. However this wealth is all in private hands. European governments themselves are heavily in debt, mostly to their own citizens, and typically have a capital of 0, because their public assets only just cover said debts.

It is traditionally highly unequal wealth. Far from being the land of the financially free, it was the United States that pioneered high tax of the wealthiest and it is only in recent decades that America’s wealth inequality has become greater than Europe’s.

This wealth is very concentrated. One way is labour inequality. Some people are paid far more than others. Though this is not always the close. In 1970s Scandinavia the top 10% of earners claimed 20% of the earnings. This seems a reasonable level of inequality to me.

A much more pressing issue though is capital inequality. Even in the most equal societies the bottom 50% will typically own nothing. Before the World Wars 1% typically owned 50% and 10% owned another 40%. The Wars changed this, but only as far as to allow the next 40% to buy their own home, which is not much by comparison, and still leaving 50% without assets.

Capital inequality is typically inherited. Thus it is not a useful form of inequality because it does not provide motivation for people to earn money. The point of inequality is to motivate people to work hard and earn money, but there is no utility in allowing people to merely inherit large amounts of capital – in fact this encourages them to do nothing.

It is also worth noting that labour inequality does not necessarily provide this motivation either. This is because the differences in “super manager” compensation cannot be directly related to a persons output but rather by industry and non-talent based conditions (luck).

Once people are rich the problem of wealth inequality perpetuates itself. Inflation, which many assume would reduce wealth, actually makes the situation worse. This is because poor people see their savings eroded by inflation while large amounts of capital is able to better protect itself.

It does this in a number of ways. By being larger, the capital of American university endowments when compared to individual savers for example, can afford to spend far more on management. Harvard has around $30 billion, so can spend $100 million a year on management with that only being 0.3% of their capital, which will be more than made up for in growth.

Secondly, with a bigger fund you can diversity into more risky assets. This produces a less predictable short term but a more profitable long term. Thirdly, many options that Harvard invest in may simply be entirely unavailable to small amounts of capital, such as products which require a large minimum investment.

Thus the rich get richer and the poor get poorer with no relation to the work, productivity or utility of the individual. There is no self-correcting mechanism for this.

What can we do about this?

Free university could be one way. It seems to have reduced inequality in the Nordics, though this has not been entirely proven. Picketty also suggests minimum wage will not help in the long run.

He suggests a global tax on capital. This would be low, initially at 0.1% of total capital, progressively rising to 0.5% for the largest fortunes.

This would have to be done in a global level, or at least a European level and require cooperation from banks. Otherwise people would just hide their assets. Indeed, it should be noted that the balance of payments for Earth is currently negative! More wealth flows out that comes in. This is of course theoretically impossible, but could be accounted for by tax heavens not being transparent.

A global tax on capital would encourage people to generate money and become rich, which ensuring that these fortunes cannot be used by future generations to unfairly dominate the economic landscape.

In summary, the following points:

• Capital inequality is the biggest form of inequality
• The twentieth century saw some reduction in the importance of inheritance, but this is now returning
• Large inherited fortunes serve no utility to society
• Large fortunes are able to perpetuate themselves and thus the rich get richer and the poor get poorer
• There is no natural self-correcting mechanism for this
• The best way to tackle this would be with a global tax on capital

The Laffer Curve is a representation of the relationship between taxation rates and income. That is to say that it shows how much tax revenue you generate at varying levels of tax rates.

Wikipedia has a good article on it. It discusses some of the theoretical and empirical issues with the curve.

RationalWiki has a far lower quality article on it. It reads like a character assassination. For example, it claims that the Laffer Curve shows we should slash income tax and thus it must be wrong. This is nonsense. The Laffer Curve is a theoretical curve and does not have a concentre plot, so we cannot tell what it suggests.

Even when empirical data is used to actually plot the curve, most of the datasets suggest it should peak somewhere between 65-70%, which would suggest a rise in income tax.

RationalWiki can often be a good source for rubbishing some nonsense that you need to rebut. However, it is not without its own biases and political leanings.

Daniel Kahneman is a psychologist who won the 2002 Nobel Prize in Economics. His book “Thinking, Fast and Slow” summarises a lot of the research he has done and proves to be a fascinating reading.

As someone who isn’t a psychologist I found some of it heavy going, but very interesting. The book is arranged into sections and these are then broken down into short chapters, which made it more readable.

Some of it was shocking too. For example, when it comes to making parol decisions, one of the biggest factors is how recently the parol office has eaten! Just after a meal they are far likely to grand you parol than just before a meal.

His discussion on priming reminded me a lot of what Richard Wiseman talks about in his book Rip It Up. Behaviour can drive emotion, even though we always think of it as emotion that drives behaviour.

The question of how effective pure branding advertising is gains some support. “Familiarity is not easy to distinguish from truth”. The more you show something to people the more confident they feel about it. Other times a lack of clarity is helpful. For example, using a bad font makes exam scores go up, because people have to concentrate more than they normally would and so make less mistakes.

Much of the book discusses the differences between System 1 (that does the fast thinking) and System 2 (that does the slower, more considered thinking). Elina often reproaches me for not noticing snails on the path, suggesting that I need to notice things or one day I will be eaten by a lion (metaphorically, these days). I now maintain that my System 1 is keeping an eye on things and simply not bothering to engage my System 2 because there is no danger.

Kahneman also adds weight o Burton Malkiel’s book A Random Walk Down Wall Street, which both discuss how the stock market is almost entirely unpredictable and therefore stock market traders actually add no value to what they do. Indeed, as 60% of mutual funds do worse-than-guessing, they actually subtract value.

Ultimately, people are just really bad at making judgements. 90% of drivers rate themselves as above average. Similarly, the majority of new businesses fail, yet the people who start them almost always believe they are exempt from such rules.

The answer to many of these issues is to replace judgement with a formula. This is essentially the entire point of Michael Lewis’s book Moneyball. Even a simple formula will do, according to Kahneman multiple regression does not even make it much more accurate.

One of the most useful points I took away from the book (almost certainly not the objectively most useful) is the idea of taking small gambles. In one chapter, Kahneman describes how people are unwilling to take profitable one-off gambles, such as a 50/50 chance of winning £20 or losing £10, but would be willing to take it if they knew they could take it 100 times in a row. The larger sample size means they are very likely to come out on top. However, they fear doing it once because there is a 50% chance they will lose and that will go down in their mental accounting.

Kahneman makes the point that we are “not on our death bed” and thus we will get chance to get even with the universe over time. Extended warranties are a great example of this. You pay a premium to insure your products, so it costs you money in the long term. A better strategy is not to buy the warranty and accept that sometimes you are going to have to replace a product – but over your lifetime you will almost certainly be up.

Freakonomics: A Rogue Economist Explores the Hidden Side of Everything is a book co-written by Steve Levitt and Stephen Dubner. It explores quirks of society and challenge some commonly held ideas about how the world works, providing better explanations.

For example, why do drug dealers most drug dealers live with their mothers? The answer is that they are earning less than they could make at McDonald’s. Drug dealing is a pyramid scheme at the people at the bottom are on less than minimum wage.

The most controversial chapter of the book looks at falling crime rates in New York. This is the shining example of broken window theory, as Malcolm Gladwell discusses in The Tipping Point. Dubner and Levitt show this is nonsense. Other cities in America that did not implement zero-tolerance also experienced this drop in crime. What fits the actual data far better is that it was a result of legalising abortion, which leads to would-be-criminals simply never being born.