Sunday, 15 December 2013

Skiing holidays, the costly to fake principle and online shopping

Travel agents have recently reported a new money making scam. The basic idea is to set up a bogus website selling chalet holidays in ski resorts, or to more simply sell a chalet holiday that does not exist. This scam particularly caught my attention because we often book online chalet holidays! And the emotions reading about it aroused were primarily ones of fear and mistrust - this could happen to us and so maybe we should not buy holidays online anymore. The costly-to-fake principle is a nice way to try and make sense of all this.
       In any economic transaction there is an element of uncertainty, because you cannot have perfect trust in the person you are trading with. When we book a ski holiday we have to put some faith in the travel agent to deliver what is being promised. Similarly the travel agent has to put faith that we will pay on time and not trash the chalet. Ideally we would like to reduce uncertainty as much as possible by trading with people we think we can trust. The extent that we will be able to do that depends on the costly to fake principle.
       To keep things simple suppose there are two types of trader - honest travel agents and fraudsters. Clearly the skier wants to book a chalet with an honest travel agent. If honest travel agents and fraudsters are indistinguishable then she will probably be too scared to book a holiday. This provides an incentive for honest travel agents to try and signal they are honest. Ways they can do this include: a registered address, shiny website, good reviews, official accreditation etc. The problem is that the fraudsters also have an incentive to signal they are honest. And what's more that is there sole objective. The honest travel agent is busy running a travel agency, and so signalling honesty is likely to come down the list of priorities. The fraudster, by contrast, has nothing else to do other than make it look as though they are honest. 
         The only way we can escape this problem is if honest travel agents can find a signal of honesty that it would be costly for a fraudster to fake. This way we get a separating equilibrium where the honest travel agents are distinguishable from the fraudsters. An office in a ski resort is very costly to fake and so is a strong signal. A bright shiny website, however, is not at all costly to fake. Online shopping, therefore, has a basic credibility problem: we should be sceptical of online shops and if we are sceptical then we may refrain from buying things. 
     This problem is not confined to ski holidays but a general problem with online shopping. And the consequences are interesting to explore. The first point to make is that this credibility problem with online shopping does not mean we will not use online shops. Amazon is a pretty blatant example of that. Amazon, however, has satisfied the costly-to-fake principle with its size and reputation. Big firms can succeed on line. The problem is likely to be for small firms. The more fraudsters there are, the more reluctant we will be to buy from small online retailers, and the more we will rely on the giants like Amazon. So, basically, competition is likely to suffer the more we rely on online shopping. 
       This conclusion of diminished competition may seem out of place when we think to EBay or online marketplaces. Surely these have empowered competition? The thing to keep in mind is that the advantages of online shopping are precisely what makes it easy-to-fake. Online retailing has such low fixed costs - you do not need a shop or to search hard for customers - that anyone can do it. But, because anyone can do it, anyone can claim to be doing it! So, beware of the fraudster.

Sunday, 17 November 2013

Two part tariffs: PlayStation4 versus XBox One

Depending on where you live the Sony PlayStation4 is either available or will be soon. Microsoft's Xbox One will follow shortly. Reviewers argue over which is best in terms of graphics, controller and the like, but the general consensus seems to be that they are pretty similar. They are not, however, similar in price! The PlayStation4 is around $100 cheaper than the Xbox. Of course, making like for like comparisons on price is difficult because Microsoft are offering things Sony are not and vice-versa. But, even so it is interesting to explore why Sony might want to come in with a lower price.
      Let's start by supposing Sony has a monopoly - they are the only games console maker. Sony has to set a price to sell the console and a price to sell games. In the parlance of micro theory this is a two part tariff where the console is a fixed cost and the games are a user cost. To make the most money Sony should set the price of games equal to marginal cost and set the price of the console as high as possible. To illustrate, consider the figure below that shows the demand curve of a typical consumer. If the marginal cost of a game is $20 then the games should be sold at $20. That means the consumer will buy 10 games and have a provisional surplus equal to area ABC. This area amounts to $500. Sony, therefore, could charge $499 and extract the entire (less $1) surplus from the consumer. This is the way to maximise profit.

       Now suppose that there are two companies producing an identical product. Selling the console at $499 is unlikely to make much sense any more because Sony's rival can undercut. Ultimately, we would expect the price of the console to be driven down to marginal cost. For example, if the marginal cost of a console is $350 then that's where the price will end up. The average consumer will be $150 better off. Sony and Microsoft only make normal profit (included in marginal cost).
       So, why would it make sense for Sony to charge less than $350? One possibility is to try and recoup money lost on the console by charging more for the games. For example, suppose Sony charges $300 for a console and $40 for games. At a price of $40 the consumer will buy 8 games and have a provisional surplus equal to area CDE. This area amounts to $320. So, if the PlayStation is priced at $300 the consumer is seemingly happy because he gets a $20 surplus. Moreover, Sony is happy because the $50 lost on the console is recouped by the 8x20 = $160 profit from selling the games. Sony is able to make a supernormal profit of $110 per customer.
        The flaw in this plan is whether consumers will go for it. If the PlayStation is priced at $300 and the games at $40 we have seen the consumer gets surplus worth $20. If the Xbox is priced at $350 and the games at $20 the consumer makes surplus $150. The savvy consumer is obviously going to buy the Xbox. Sony's pricing strategy no longer looks so good. Indeed Microsoft could increase the price of the Xbox to $400 and still be the best deal. The key thing to realise here is that: a consumer should value a PlayStation less than the Xbox, even though they are identical products, because it is going to be more expensive to use the PlayStation. The difference in value is equal to area ABDE which is a pretty huge $180.The PlayStation is worth $180 less but only costs (in our example) $50 less.
         But are consumers that savvy? Clearly, the PlayStation looks the better deal if you focus only on the price of the console. My prior, and possibly that of Sony, is that customers will focus on the console price and not pay sufficient attention to the price of games. Basically, the consumer is not going to realise that the high price of the games makes the PlayStation worth less money. If the consumer does not pay enough attention to the price of games then Sony looks a clear winner. They get more customers because of the cheaper console, and they make supernormal profit because of the high price of the games! Not a bad strategy, if it works. 

Saturday, 9 November 2013

Reducing food waste: Time for a rethink?

A report published last week by the Waste and Resources Action Programme (Wrap) showed that British families are throwing away around £60 worth a food a month. This report comes hot on the heels of figures from supermarket giant Tesco showing it generated almost 30,000 tonnes of food waste in the first six months of the year. Apparently 68% of bagged salad ends up in the bin, and 20% of bananas. Clearly, this does not look like an efficient outcome. Which raises questions about why it happens and how we can stop it.
      To most the answers seems obvious - consumers are making biased choices and need help to stop doing so. For example, food journalist Joanna Blytham is quoted as saying consumers are being 'ripped off' by supermarket promotions: "What we could say to consumers is 'wise up' ..... The minute you walk into the supermarket you may be able to get a few bargains but, more likely than not, you'll be nudged into buying stuff you didn't really want or need and it will go in the bin." Consumers, therefore, are buying things they simply do not want. But are consumers really so dumb?
      Consider this quote from Wrap Chief Executive Dr Liz Goodwin: "Consumers are seriously worried about the cost of food and how it has increased over recent years. Yet, as Wrap's research shows, we are still wasting millions of tonnes and billions of pounds." If consumers are seriously worried about the price of food then they have a big incentive to cut waste. Moreover, given that most of us shop at least once a week, we also have plenty of chance to learn from our mistakes (if they really are mistakes). Indeed, waste has been cut dramatically over the last few years. Given the incentives and opportunities to reduce waste, the fact that much waste still remains suggests to me that this is not just about consumers making bad choices.
      In elaborating on this point the crucial thing to recognise is that buying a food is a choice with uncertainty. The family goes out shopping on Monday without knowing whether they will eat out on Wednesday, or what they will feel like eating on Thursday, or how hungry they will be on Friday. The task, therefore, is to choose a bundle of goods that is expected to keep everyone happy. The optimal bundle of goods should almost certainly involve buying food that will be wasted. To give an illustration: suppose you are going for a picnic in the countryside where there are no shops. You estimate what the family will likely eat. How much food do you take? Pretty much everyone (especially those with children) would take more than the estimate. Then you have more food if you need it. You also can have a bit more variety to satisfy your tastes.
      The savvy consumer will, therefore, generate food waste. If they always want to have enough food in the cupboard and they like variety they will buy more food than they probably need. This is the optimal thing to do! Ex-post they end up wasting food, but this is a fair price to pay for having what they want when they want it. And, as a society we are now rich enough to pay for what we want when we want it.       
     Personally, therefore, I think food waste is much more a reflection on consumer preferences than consumer bias. I think consumers knowingly buy more food than they will probably need. If I'm right then we may need to rethink how to tackle the 'problem' of food waste. In particular, the real culprit is uncertainty and not supermarket offers. We need to think, therefore, of ways to reduce uncertainty. This probably means we need to encourage consumers to shop more often, and to make stores more accessible. The big, once a week shop in an out-of-town supermarket is most likely to lead to waste. Regularly picking stuff up to eat on the way back home from work is least likely to lead to waste.
      Interestingly, over the last decade Britain has seen a surge in the number of supermarkets opening small stores in town centres, rail stations etc. In other words, food shopping has become easier and more accessible. I wonder whether that has anything to do with the fall in food waste that we have seen in recent years?     

Saturday, 2 November 2013

Tea party and UKIP: What happened to the median voter theorem?

The median voter theorem is a workhorse of public choice and helps make sense of political manoeuvrings. Informally, the theorem says that if preferences are single peaked then the median voter will be on the winnings side of any majority vote. To say that preferences are single peaked essentially means that the vote is on a 'one dimensional issue' whereby that the closer is the outcome to a person's ideal then the happier they are. This naturally lends itself to talking of left wing, right wing and the centre ground. The median voter is then the person in the middle. And that is why the median voter will always be on the winning side: If the median voter prefers the 'left wing' option then the median voter and everyone to the left will vote for that option and it has a majority. Similarly, If the median voter prefers the 'right wing' option then the median voter and everyone to the right will vote for that option and it has a majority.
      If the median voter will always be on the winning side then political parties are naturally going to compete for the median voter. The median voter theorem is, therefore, very useful in making sense of the two party system that we have in countries like the US and UK. It tells us why the median voter is where the real action is always going to be: this is the vote politicians are competing for. And it also helps us understand why the 'centre ground' shifts over time as the preferences of the median voter evolve.
       Recent events, however, seem to cast doubt on the application of the median voter theorem. In the US we have the unyielding influence of the Tea Party wing of the Republican party. In the UK we have the emergence of the UK Independence Party as a political force. In both cases there is a clear pull towards the right wing: this is a battle far from the centre ground where we would expect to find the median voter. So what is going in? Interestingly, I think we can trace two slightly different explanations for this lurch to the right in the US compared to the UK.
        Looking to the US first: I see the Tea Party as essentially an attempt to move the centre ground to the right. The preferences of voters are clearly not fixed in stone and so an attempt to move the centre ground is not a completely dumb thing to do (if you are at the extremes of the political spectrum). But, it is political suicide from the perspective of the Republican Party because it leaves the centre ground wide open for the Democrats. And, herein lies the big flaw in the Tea Party's approach: the party in power has a lot more leverage to put their view across and move the centre ground. So, the Republicans are probably going to lose on both counts - no power and no shift to the right in the centre ground. The deal that concluded the recent government shutdown seems to illustrate the point nicely. The median voter theorem, therefore, is fine - it is just some in the Republican Party could do with being told about it!
       What about the UK. Here, I do not see much attempt to move the centre ground. Instead I just see general disillusionment in politics. The median voter theorem offers a good explanation for this. Basically, while political parties fight over the median voter everyone else can feel a little disenfranchised. Those to the more extreme right and left will feel most frustrated that 'no one gives them what they want'. This leaves the way open for protest votes such as those currently going to UKIP. I say protest vote on the basis that UKIP has no realistic chance of getting power. Note, however, that if a chunk of the electorate from the right wing of the political spectrum is going to vote for a party with no chance of winning then the 'electoral' centre ground moves to the left. Voters of UKIP, thus, face trading off a vote for something they believe in for an outcome even more removed from what they want. Come election day I have a feeling the UK public will ditch UKIP and the median voter theorem will prove its worth again. But, only time will tell.

Thursday, 3 October 2013

The anchoring effect and Harrods hampers

The anchoring effect recognizes that people's judgements (and choices) can be biased by things they come across before making the judgement. The most well known discussion of the anchoring effect is due to Ariely, Loewenstein and Prelec and their paper entitled 'Coherent arbitrariness: Stable demand curves without stable preferences'. Through six experiments they showed that valuations and experiences can be influenced by arbitrary anchors.
    The first experiment that they discussed is the one that typically grabs the headlines. Subjects were shown six different products - a computer mouse, keyboard, average wine, fine wine, Belgian chocolates and a book. Having been introduced to the products, subjects were asked if they would buy each product for a dollar amount equal to the last two digits of their social security number. So, if the last two digits of your social security number are 52 you would have needed to say whether you wanted to buy the box of Belgian chocolates for $52. Having done this subjects were then asked to write down how much they would be willing to pay for each of the products.
    The headline result was that those with a higher social security number put a significantly higher valuation on the products. There is clearly no reason why someone with a social security number ending in 79 should value Belgian chocolates more than someone with number 23. This shows how judgement - the valuation - can depend on an arbitrary anchor - the last two digits of a social security number.
     This result is a serious challenge to conventional economic modelling because it suggests that preferences are arbitrary and easily changed. It should come as no surprise, therefore, that some have challenged the result. For example, a recent paper by Fudenberg, Levine and Maniadis reports replications of the original experiment that show no anchoring effect at all. Such results leave a somewhat confused picture as to how important anchoring effects are.
     My personal take on the issue is that anchoring effects become influential when there is a lot of uncertainty. For example, if someone is asked to value a familiar box of chocolates that is freely available in local stores then anchors are not going to matter much; you know the box of chocolates is worth about $10. If that person is asked to value an unfamiliar, never before seen box of chocolates then anchors can matter; you have no idea if the box of chocolates is worth $5 or $35.
     If people are reluctant to buy things when they are uncertain about value then anchoring effects should ultimately not affect choice very much. But, that doesn't mean anchoring effects are completely irrelevant. Which brings me on to Harrods, the famous London department store.
    We just received the brochure advertising Harrods 2013 Christmas Hampers. For those of you unfamiliar with a Harrods Hamper it contains all you need for a jolly Christmas - alcohol, meat, cheese, mine pies, etc. How much do you think the most expensive hamper is? The Decadence Hamper will cost you £20,000 (approximately $30,000). The Opulence will cost you £10,000, the Ultimate £5,000.
      What has this got to do with anchoring effects? As you flick through the brochure the price drops. And once I had got over the shock of a £20,000 hamper and seen the price drop down to around £200 to £300 I found myself thinking - '£250 is not a bad price for a hamper, it looks a good deal'. Now, I am pretty certain that if you had asked me whether I was willing to pay £250 for a very sparse looking hamper before I had seen hampers priced at £20,000 and £10,000 I would have said 'no way'. My thinking that £250 is not a bad price was, thus, due to an anchoring effect. Exposure to high numbers made £250 look good value.
       My hunch would be that Harrods are aware how anchoring effects can work. Otherwise, why put the most expensive hamper first? Anchoring effects can, therefore, make a real difference. And because of that I have to convince myself that we do not want to buy a £250 hamper.

Saturday, 28 September 2013

Freezing energy prices will not work: what will?

Labour leader Ed Milliband hit the headlines this week with his plans to freeze energy prices if elected into power in the 2015 UK general election. The response was pretty fervent. But can a price cap work?
   The microeconomics textbook says that price caps are almost always a bad idea. To understand why it is interesting to see how labour defended the plan. Or, more properly, I should say how labour did not defend the plan. When questioned about the merits of the price freeze every shadow minister I heard reeled off a long list of reasons why the energy market is failing. What I never heard once was a minister argue that the price freeze will solve any of the market failures. And that's the problem, a price freeze will not solve any of the market failures! It will just make them worse.
   For example, I heard several spokespmen bemoan the fact the market is dominated by only six firms. Put aside for the moment that six firms is more than enough for competition to work, will an arbitrary price freeze encourage more firms to enter the industry? Of course not, it will scare away investment, in the short and long term. This illustrates the general point that a price freeze is arbitrary meddling in a market. Arbitrary meddling is never going to encourage competition. And if the government freezes prices at the wrong level then everyone, including consumers, are going to loose out. California's experience with a price freeze is a perfect example of how bad things can get. Freezing prices, therefore, is more political symbolism than economic sense.
    But what can fix the market failures? The main cause of market failure in the UK energy sector is consumer apathy. A market can only work if consumers go hunting for good deals. And UK consumers are not hunting for good deals. Instead, they are doggedly sticking with the supplier they have always used. This blunts competition. And the energy market is by no means the only market where we see this. A similar story can be told about many other services such as bank accounts, car and house insurance, telephone supplier etc.
    In order to fix consumer apathy we need to know what causes it. I would suggest three distinct causes: lack of information, procrastination and the endowment effect. If consumers do not have enough information to know where the best deals are then it is no surprise they do not go chasing them. Procrastination is where the consumer does want to change supplier but puts off changing until tomorrow, and then the day after, and so on. The endowment effect is where a consumer values something they have, like a long run relationship with the current supplier, more than something they do not have, like a relationship with a rival supplier; basically, it's better the devil you know. If these are the causes of consumer apathy then we can think of progressively more extreme measures that can try and improve matters:

(1) You could try and enthuse customers by making it easy to change supplier. The current UK government has done a lot to try and make this a reality. For example, a recent initiative makes it easier to switch bank accounts. They have also told energy companies to simplify their bills and tariffs. This solves the lack of information problem but does nothing about procrastination or the endowment effect. 

(2)  One way to directly tackle procrastination is to force energy contracts to be for a one year fixed term. Hence consumers would have to 'rejoin' a supplier at the end of every yearly contract. They cannot procrastinate any more. Surely this will force them to shop around? Well, what I'm proposing is very similar to what already happens in the insurance market, where car and house insurance come up for renewal once a year. This 'forced' renewal undoubtedly encourages some competition. But, we know that far too many consumers fail to search out good deals when renewing insurance. They simply stay with the existing supplier.

(3) That leaves us with the endowment effect. To get rid of this we can stick with the one year fixed term contracts but rule out a consumer staying with the same supplier two years running. We force customers to change supplier every year. Surely this will force them to shop around?

       This final measure might work, but looks well beyond what is acceptable. We are denying the consumer liberty to sign a long term contract or to stick with an existing supplier. It all looks a bit too draconian. But, if this is draconian then what is our overall objective from intervening in the market? If consumers cannot be bothered to shop around then is it right to force them too? Indeed, if the problem with the energy market is consumer apathy then is it a problem at all?
       Following this line of logic I come to the conclusion that the claims of market failure in the energy market are overblown. Consumers are not getting the best deal, but the that's because consumers are choosing to not get the best deal! Encouraging competition with a few nudges (measure 1) sounds good but anything more (measures 2 and 3) seems too much. And government's dictating prices is the most extreme measure of all.

Friday, 20 September 2013

Cottage holidays and social norms

For those unfamiliar with cottage holidays, the ideas is pretty simple: You rent a house, bungalow, or beach hut for a week or more, make yourself at home, relax and enjoy. What I want to explore is how different the experience feels in the UK and Denmark.
      When you arrive at a cottage in the UK you can expect ample supply of toilet rolls, kitchen towels and logs for the fire. There will almost certainly be a library of books, CDs, DVDs and local maps for you to enjoy. Bed linen is provided free of charge. At one cottage we recently went to there was a complimentary bottle of wine.
     Contrast this with Denmark. Here you have to pay for any electric, water and gas you use. Don't expect any toilet rolls or kitchen towels, let alone a complimentary bottle of wine. There's no library. Bed linen, or anything else, comes with an extra charge.
      Which system would you prefer? The economist in me says that I am supposed to prefer the Danish system. All the 'complimentary' things that are provided in a UK cottage are clearly added on to the overall bill. So you ultimately end up paying for them. Which means we are almost certainly better off in the Danish system because we use less than the average in terms of gas, electric and water, we're happy to bring our own bed linen, and we don't really like drinking cheap wine.
      There's something about the Danish system, however, that we don't like. To understand why it is necessary to think about social norms. The UK system makes you feel more at home. You feel like a welcome guest. You can relax. The Danish system puts more emphasis on money. These reminders of the fact you are paying money, e.g. reading the utility meters at the start and end of the holiday, crowd out the 'welcome' feeling. You are not a welcome guest, you are a paying customer. This makes it a bit less pleasant. I'm sure it also means guests will take a bit less care of the cottage during their stay.   
     The more general point this contrast illustrates is how social norms and money don't mix all that well. The cottage holiday system relies heavily on social norms. You are trusted to look after the cottage, to not steal anything, and to basically leave the place as you found it. The UK system with its complimentary bottle of wine lets social norms dictate. The Danish system with its itemized costs risks crowding out social norms. Which may explain why guests cannot be trusted with a library. 
      This kind of trade-off between social norms and money is very common. Consider, for example, effort in the workplace. In most jobs you inevitable have to put some trust in workers to do their best. You cannot constantly monitor performance. The more 'performance targets' and the like a worker is subjected to the more the social norms to do a good job are crowded out.
      Be careful, therefore, when mixing money with social norms. As Dan Ariely discusses in his book Predictably Irrational it is a not a good idea to mention how much the dinner cost on a first date. 

Friday, 13 September 2013

Apples and the sunk cost fallacy

   It is apple season for another year. The trees in the village where I live are packed full of tasty, fresh, organic apples. And, most of them are going to be left to fall to the ground and rot! Which I think is a great waste. I also think it is a great example of the sunk cost fallacy in action.
    Here's the issue: Consider someone called Mark who goes out to the supermarket and buys some apples. He will almost certainly eat those apples and go out of his way to not waste them. Mark, however, ignores the apples growing in his garden and does not think twice about letting them go to waste. Why does Mark save the apples he bought and not the apples  growing in his garden?
    You might say it is a difference in quality; but, the apples in my garden are easily as tasty as those in my local supermarket. You might say it is the difficulty of harvesting the apples; but, it takes seconds for me to harvest 20 apples from my garden. The difference, therefore, must be psychological. That is where the sunk cost fallacy comes in.
     A sunk cost is a cost that cannot be recovered. Given that it cannot be recovered it should not influence future choice. When Mark walks out of the supermarket (and throws away the receipt) the money he paid to buy the apples is a sunk cost. As such, the amount of money he paid for the apples should not influence whether or not he eats the apples.  We see, however, that it does: He is more likely to eat an apple he has bought than one growing in his garden. This looks like the sunk cost fallacy: Mark lets sunk costs influence his choice.
    Richard Thaler in his classic paper on mental accounting gives a slightly different example. In this case Mark has bought some expensive shoes that do not fit. The more expensive they are the more likely Mark will continue to try and wear them and the longer he will keep them in his cupboard. Note the subtle difference between these examples. In the shoe example the emphasis is on how Mark 'over-values' the shoes he has paid a large sunk cost for. In the apple example the emphasis is on how Mark 'under-values' the apples that he has got for free.
      The classic take on the sunk cost fallacy is that it is about mental accounting (see the paper by Richard Thaler). While buying this interpretation, I also think the fallacy is partly caused by people confusing the price they paid for something with the value it has for them. Mark, for instance, should focus on how much he values an apple and how much he values the shoes. For example, he might value a fresh apple at $2 and shoes that do not fit at $0. Instead, he will focus on how much he paid for the apple or shoes. If he got the apple for free he think it cannot be worth much, if he paid $1 for the apple it seems more valuable, and if he paid $300 for the shoes then they must be worth saving.
      The lesson, therefore, is to ignore how much something cost when deciding whether or not to use it. And, just because something is for free does not mean it is not valuable. So, let's get making some apple pie. 

Friday, 16 August 2013

Signalling games and giving to charity

In recent work with Amrish Patel we model giving to charity using a signalling game. With this approach a person is assumed to give to charity in order to signal some desirable trait about herself such as generosity or wealth. To many this approach seems quite a cynical one. It seemingly paints a picture of very strategic giving. Do people not give to charity because they want to make the world a better place?
      What I want to try and convince you of here is that a signalling game approach actually paints a nice picture of giving - strategic, but not overly cynical.
      Here is how a simple signalling game works: There are two types of people - generous and not-generous. The generous want to make the world a better place. The not-generous do not care. Society likes generous people. It likes them enough that it is willing to reward them in same way. This could be through esteem, status, or a greater willingness to help them when they need help, etc.
      Notice the 'nice' story being told here. There are generous people who want to give to make the world a better place. And society likes such people and wants to reward them.
      Now for the strategic bit. The not-generous do not deserve any esteem or status. The trouble is society cannot know a-priori who is a generous type and who is a not-generous type. There is, therefore, an incentive for the not-generous to appear generous and get some undeserved esteem. This is where signalling comes in. The generous type somehow needs to signal her generosity. How can she do that? She can give such a large amount to charity that no not-generous type would ever match her. This results in a separating equilibrium. Society can tell who the generous and not-generous types are. The only cynical part of this story is that some not-generous people exist. But, that's clearly true!
      A separating equilibrium is not the only possible outcome. Another possibility is a pooling equilibrium where the generous and not-generous are indistinguishable. In the work I did with Amrish Patel we argue that charities might want to set things up so as to get this outcome. The basic logic goes something like this: With a separating equilibrium the generous type gives more than she would like to signal her generosity and the not-generous types give nothing. In a pooling equilibrium the generous type gives what she wants and the not-generous types gives something. By forcing a pooling equilibrium the charity, therefore, loses out on the generous type but gains on the not-generous type. Overall, the gain will likely offset the loss. I also think there is something nice about the not-generous type being incentivized to give something! 

Friday, 2 August 2013

Jane Austen's ring and valuing the future

A ring that once belonged to Jane Austen came up for auction recently and was bought by US singer Kelly Clarkson for £150,000. The UK government has, however, subsequently put a ban on the singer taking the ring out of the country. The Culture Minister said 'I hope that a UK buyer comes forward so this simple but elegant ring can be saved for the nation.'
      This is clearly the kind of policy that will split opinion. Some are going to think its important to save our heritage, and some will think it stupid to stop the sale of a ring worn by an author who died nearly 200 years ago. What does amuse me, however, is that just about every spokesperson I have heard criticising the policy appeals to economic theory to back up their case. Listening to them talk you could easily get the impression that hard-headed economic logic leads to only one conclusion - sell the ring. This is wrong!
      The basic argument I heard more than once goes something like this. Kelly Clarkson paid £150,000 for the ring. If the UK populous really value the ring at more than £150,000 then they would do something to buy the ring, e.g. every member of the Jane Austen fan club could contribute £50 each. The fact that this has not happened shows the populous of the UK does not value the ring at £150,000. So it should be sold. This logic is flawed on at least three counts.
       First, keeping the ring in the UK is, in large part, a public good. Which means that individuals will try to free-ride on paying for it. Or equivalently individuals will wait and hope that someone else pays the money. The collective willingness to pay could easily exceed £150,000 and yet the money not be forthcoming because  everyone is waiting for everyone else. Indeed, measuring the willingness to pay for a public good is incredibly difficult - something called the preference revelation problem. Because of this, government intervention is justified in providing public goods.
       Second, there are large transaction costs in organizing lots of people to contribute towards the ring. That means raising the £150,000 needed to buy the ring is going to cost a lot more than £150,000. This will exasperate the public good problems. Again, government intervention is justified when transaction costs are high.
        Both the reasons above justify intervention on behalf of the current population of the UK. The ring, however, is to be saved for the nation. That presumably means future generations should count too. But we have a problem: future generations are not born yet and so cannot contribute towards keeping the ring! When valuing the ring we should estimate the value that future generations will put on it. This amount should be discounted a little, because, for instance, an asteroid might kill us all in 50 years time. But, the discount rate should be relatively small, because it is unlikely an asteroid will kill us all in 50 years time. Yet again, government intervention is justified to protect the interests of future generations.
       I'm not saying that the UK should keep the ring. But, I am saying that economic theory can go either way on this one. Hard-headed economic theory does not inevitably mean selling the ring. This is an important point to understand because the principle is very general. Many things are analogous to Jane Austen's ring. The natural environment probably being top of the list. For the same reasons economic theory may back saving Jane Austen's ring it also backs saving the environment (despite what many would have you believe).     

Sunday, 28 July 2013

Why is prospect theory ignored

I have finally got around to reading Daniel Kahneman's book Thinking Fast and Slow. It is a fantastic read. It brilliantly sets out how Kahneman and Tversky revolutionized the way we think about human judgement and decision making. But, here's the question I was left asking myself - why has the work of Kahneman and Tversky had so little impact in economics? That question might sound bizarre given that Kahneman won the Nobel Prize for Economics (Tversky had died). As far as I can see, however, the insights provided by Kahneman and Tversky have largely been ignored. So, what's gone wrong?
        In his book Kahneman points to prospect theory as one idea economists have endorsed. True enough, their paper on prospect theory is one of the most cited papers in economics. Cites, however, are different to real impact. And very, very little research in economics has properly applied prospect theory. Indeed, given that the original paper is a pretty tough read, I would be surprised if many of the people citing the paper have read it. Kahneman, therefore, seems a bit over-optimistic in saying economists have endorsed prospect theory. More apt is to ask why they have ignored it.
       Prospect theory puts together four basic ideas: (i) People judge outcomes relative to a reference point, so we get gains and losses. (ii) People are risk averse for gains and risk loving for losses. (iii) People overweight small probabilities and underweight large probabilities. (iv) The reference point will depend on context and the way the situation is framed. An example can help put things in context.
  • (Option A) gives £900 for sure and (option B) gives £1000 with probability 0.9 and £0 with probability 0.1. Would you choose option A or B?
Most people go for option A which shows risk aversion for gains. The 0.1 probability of getting £0 is also over-weighted. Consider a further example:
  • I'll give you £1000 to start off. Then (option C) you lose £100 for sure and (option D) you lose nothing with probability 0.9 and lose £1000 with probability 0.1.
Most people go for option D which shows risk loving for losses. Comparison of these two choices also shows the importance of framing. A versus B is exactly the same as C versus D. Yet many choose A and D!
       All four of the basic ideas in prospect theory are crucial to take account of when analyzing economic behavior. For instance, anytime that a person buys or sells something outcomes will be judged relative to a reference point. So, the decision made will depend on framing, mental accounting and how gains and losses are coded. For example, people buy a lot more stuff when they use a credit card than if they use cash. And people are far more reluctant to sell something into which they have put sunk costs. None of this could be predicted by the standard economic model. So why has prospect theory been ignored?
         The main reason is probably the marketing of the theory. Prospect theory was sold as a package for modelling risky choice. This was interpreted as meaning it only needs to be used if all the four basic ideas above appear relevant. Thus, prospect theory is relevant for explaining things like tax evasion, but not much else. This interpretation is wrong. It's enough that one of the basic ideas is relevant for prospect theory to be relevant. Wrong or not, the common interpretation gives economists a convenient excuse to ignore the theory. 
         While convenience is probably the main reason economists have ignored prospect theory, there are better reasons to question its usefulness. Any theory is judged by its ability to make testable predictions. And the problem with prospect theory is idea (iv). We now know that the reference point a person has in mind when making a decision can be just about anything. One person's loss can be another's gain. This is a big problem when it comes to making testable predictions. Recent work tries to tie down the reference point, such as a paper by Koszegi and Rabin, but the psychological heart of prospect theory starts to get ripped out. In its pure form prospect theory starts to become anything is possible.
         We also know that prospect theory is not good at explaining some of the things it was seemingly designed to explain. Consider, for example, the disposition effect bias whereby investors are more likely to sell stocks that have made a gain while holding on to stocks that have made a loss. Loss aversion seems a ready explanation for this - people do not want to cash in on a loss. Barberis and Xiong, however, showed that loss aversion can make the disposition effect even more of a puzzle. Basically, loss averse investors should buy more of the rising stock and sell some of the losing stock to best avoid realized losses.
         The fact that prospect theory is not perfect is not a reason to ditch it. The standard economic model is very far from perfect. Again, however, the foibles of prospect theory provide a convenient excuse to ignore it.
         I write all this as a firm believer that prospect theory should be used a lot more in economics. What it can do far exceeds what it cannot. So will things change? In his book Kahneman says that he can understand why prospect theory is not taught in undergrad econ classes. Well I cannot! I think its high time that prospect theory was brought into the classroom. This seems to me the only way to avoid another generation of economists who ignore the theory. And I think it is key that prospect theory, and behavioural economics more generally, makes its way into the core of principles classes, and not as some add on or option to be chosen. So, if you have not already done so, read Kahneman's book!

Saturday, 20 July 2013

What do NIMBYs, the British Open Golf, the battle of the sexes, and the availability heuristic have in common?

It is the weekend of the British Open Golf Championship. And yesterday there was a fair amount of discussion about slow play. Slow play is annoying in golf because one player taking their time holds up everybody else on the course. The referees have the power to counteract this by putting a player on the clock. Which basically means the player will be timed and penalized for taking too long. Yesterday, the referees put lots of players on the clock and penalized Japanese golfer Hideki Matsuyama. A similar thing happened at this years Masters Championship where 14 year old Chinese Golfer Guan Tianlang was penalized.  
    What interested me about the slow play discussion was the reaction of the players and commentators. All were in agreement that play had been to slow and that 'something needs to be done about it'. But mention a name, such as Matsuyama, and all were also in agreement that 'he was treated very harshly'. That sounds contradictory. There were only 40 or so players on the course at any one time. If there was slow play, they cannot all be innocent!
      This failure to see the aggregate as a sum of its parts is an example of NIMBYism. This acronym was coined to capture the common reaction of residents to a proposed new development. Everyone thinks we need more affordable houses, a road by-pass, a bigger airport, better train links. Everyone also says Not In My Back Yard. But, if it is in no one's back yard then it is clearly not going to happen.
       Why causes NIMBYism? Its partly about fairness and strategy. The NIMBY game is essentially a battle of the sexes game like that in the matrix below. In the standard version of the battle of the sexes husband and wife need to independently decide what to do at the weekend (think of them at their desk at work deciding whether or not to order the ticket). The options are ballet and football. They want to coordinate on the same option but the husband prefers ballet and the wife prefers football (this is not quite the standard version!). So, if they both choose ballet the husband gets payoff 2 and the wife a payoff of 1, etc.

        The battle of the sexes is an asymmetric coordination game with two pure strategy Nash equilibria - they both go to the ballet, or they both go to the football. The difficulty is how to coordinate - the husband would prefer the ballet and the wife would prefer football. Solving this coordination problem is by no means easy. (As an aside, an interesting study by Holm showed that the men are more likely to get what they want.)
           To relate the battle of the sexes to NIMBYism we need to re-frame the game to something like that below. There are two players out on the golf course, Adam and Barry. Play is slow and its only going to get quicker if one of them speeds up. The problem is coordinating on who should speed up. Now you might disagree that this game is a good representation of the slow play game - you might say they should both speed up, or that Adam would be at a bigger disadvantage if he speeds up and Barry does not. I could answer those concerns directly: for instance, Golf is a competition and so there are good reasons why they will not both speed up. The key point, however, is that even in this ideal world, where we only need one player to speed up for everyone to benefit, there are still good reasons why things are not going to work. Both players would rather the other speeds up.

          The battle of the sexes does, therefore, nicely capture the idea of  NIMBYism. Everyone would be better off if people coordinate - play speeds up and the new houses are built. But, no one wants it in their back yard. Adam doesn't want to be the one that speeds up, or has the new houses built next to his home. We can easily end up with zero.
          Another important component to NIMBYism is the availability heuristic. This heuristic says that things seem more important the more easily they are available in our memory. When we think of abstract concepts like a course full of golfers, or a city development, the availability heuristic is not switched on because it is not something we can easily relate to. When we think of a specific concept like a Japanese golfer or a person's back garden the heuristic is switched on. We think how frustrated the Japanese golfer must be to receive a penalty, or how angry the homeowner is to loose his peace and quiet. In the context of the battle of the sexes game this means that when we look at a good outcome we focus on the fact that one player gets less than the other. This seems unfair and we easily relate to it. We overlook the fact that both players are better off than they would have been otherwise. 
          Once we recognize the causes of NIMBYism it becomes much easier to solve. Crucial is the framing of the problem. Adam needs to be convinced that he can gain by speeding up. Sure, Barry gains more, but let's focus on the gain to Adam. We also need to overcome the availability heuristic. One way to do this is to personalize the more abstract concept by, for instance, focusing minds on the annoyance of those golfers held up by slow play. The prescription, therefore, as often in behavioral economics, is to focus minds on the gains realized and the losses avoided.

Friday, 12 July 2013

Reference points and Edgeworth Boxes: A tourist's gains from trade

We have just got back from the PET13 conference in Lisbon. On the day of our arrival in Lisbon we were tired and hungry and desperately seeking food. A stroll in the vicinity of the hotel finally revealed a local corner shop selling fruit and essentials, and we were saved. We were also pleasantly surprised by the price. Our expectation was to pay a lot, because we'd bought a lot and because the shop owner was presumably going to rip off the unknowing tourist. It was pleasant surprise, therefore, when the bill came in well below our expectations. 
      In all likelihood the shop owner did add a bit of 'unknowing tourist profit' to the price. But who cares? We, as customers, were very happy to pay the price we did. And the shop owner was presumably happy to charge the price he did. Everyone is a winner. Indeed, this is a textbook story of exchange - a buyer and seller exchange goods for mutual benefit. From a textbook point of view, the really curious thing about this exchange is why it felt so unusual. Any exchange is supposed to be about mutual benefit, but I rarely feel so happy about the price I have to pay in my local supermarket. So, what is the difference between buying goods as a tourist and buying from the local supermarket? 
       On reflection, the answer seems to be about expectations and reference points. To explain, let's start with a bit of textbook basics. The figure below shows an Edgeworth Box diagram. This is the classic way used to illustrate the gains from exchange. From the bottom left upwards we represent the outcome for myself and from the top right downwards we represent the outcome for the shop owner. The initial point is given by the red endowment point. I have no apples and some cash and have a utility of 1. The shop owner has lots of apples and some cash and also has a utility of 1. 
      Can we gain from trade? Yes. The purple 'Edward U = 1' line plots all the outcomes as good as the endowment point from my perspective. Anything above this is a gain for me. The brown 'Owner U = 1' line plots all the outcomes as good as the endowment point from the owner's perspective. Anything below this is a gain for him. If, therefore, I give up some cash for some apples both myself and the owner can gain. Ultimately we can trade to the point where we both have a utility of 2. This representation of exchange perfectly fits our experience in the shop in Lisbon. We bought some apples, and everyone gained.

       Why are things different when I go to the local supermarket? It's tempting to say that its because the price is different, the supermarket has monopoly power etc. But that cannot be the difference. The exchange that takes place at a supermarket is still supposed to fit the story above. I gain from buying apples, and the supermarket gains from selling the apples. My utility still goes from 1 to 2.
    The difference that I experience in the supermarket reflects my expectations. Given that I go to the supermarket every week I take it as given that my utility will be 2 and not 1. Put another way, my 'psychological endowment point' is to have already bought the apples. So, buying the apples doesn't make me feel all that happy. It's just that not buying the apples would make me feel unhappy. On holiday things are different. It's an unfamiliar city and expectations are much less refined. This means that my 'psychological endowment point' is the same as my actual endowment point. I do not take it for granted that I will be able to buy apples at a reasonable price. So, when we did find apples at a reasonable price it felt like a gain. I felt the gain in utility.
        This way of looking at things highlights the important of reference points and expectations. And, it yields a somewhat depressing conclusion: In our routine everyday life it is very difficult to feel pleasure because our expectations are too refined. Buying stuff from my local supermarket, for instance, does not feel as pleasurable as the textbook says it should because I psychologically take as given that it will be done. I can only get pleasure if something unexpected happens such as everything in the shop being half price. But, that doesn't usually happen! So, we are trapped in a world where pleasure is difficult to come by. This is possibly one big reason why buying experience goods (like going on holiday, going for a walk, or going to watch a football match) is known to give more lasting happiness than buying consumption goods (like a car, or the weekly shop). Experience goods are more likely to be surprising.


Sunday, 30 June 2013

Charging visitors to the UK, adverse selection, and moral hazard

A few months ago the Deputy Prime Minister Nick Clegg was expounding on the benefits of a security bond for visitors to the UK. The basic idea was that visitors to the UK would have to deposit some money with the government and they would get the money back when they left. I was hoping the plan would be quietly dropped, and it seemed to have been. But, unfortunately, the story is back and now looks worryingly likely to happen. Visitors from a select list of countries, including India and Nigeria, will be expected to deposit £3,000 with the UK government if they want to visit the UK. The government's policy on immigration has been a disaster for many years, but the idea of a security bond seems to be taking up a notch the level of stupidity. 
       To put this plan for a bond in context we need a bit of background. A large proportion of the UK electorate is anti-immigration. The current coalition government's answer is to bow to the electorate and promise a tough line on immigration. The message has gone out that Britain is closed to foreigners. Foreign students, for example, are no longer allowed to work in the UK for one year after their graduation. And universities find it ever tougher to hire foreign professors. The government's approach has catastrophically failed. It has not appeased the electorate, who have started voting for the UK Independence Party. And, more importantly, it has annoyed foreigners. Given that immigration is a good thing, this is not something to celebrate. Indeed, at the same time the government was closing the door to foreigners, the Prime Minister and others were trying to sell Britain's advantages in emerging markets, like India. Which doesn't make much sense! If the government would just get on with arguing the case for immigration rather than being trapped by public opinion we might see progress. Instead, we have the latest idea to annoy foreigners. 
       The logic behind the bond is simple enough: We have people who visit the UK and then illegally stay in the country longer than allowed. The bond is an incentive for people to leave when there supposed to. Unfortunately, this logic is fundamentally flawed. What we have here is a game of incomplete information. Suppose that there are two types of foreign visitors. Genuine visitors who want to visit friends and family. And illegal visitors who want to stay in the country indefinitely. The government wants to let in the genuine and block the illegal. But, it cannot tell which is which. That leads to the problems of adverse selection and moral hazard. 
        Adverse selection. Who do you think is going to be more willing to deposit £3000 to visit the UK, the genuine or the illegal? My money would be on the illegal. £3000 is a small price to pay to live in the UK and we know that many illegal immigrants pay a lot more than that to enter the country. Someone visiting friends, by contrast, may not have £3000 to hand. The government is, thus, likely to hand pick the very opposite of what it wants. This is a classic example of adverse selection: the least desirable are more likely to be willing to pay the bond.
      Moral hazard. Let's focus now on the people who paid the bond and have been let into the country. Will he £3000 bond change their behavior. My guess is that it will. We know that a financial payment can crowd out more pure incentives.* So, a genuine may decide to stay in the UK illegally. In other words, someone who may have returned home after they stay, because, say, they felt guilty at staying illegally, may now decide to stay. The bond removes their guilt. Again, this is the exact opposite of what the government wants to happen! 
         The security bond is a bad idea, even if the goal is to reduce immigration. So, hopefully, there is still time for the policy to be quietly dropped.

* Frey, B. S., & Oberholzer-Gee, F. (1997). The cost of price incentives: An empirical analysis of motivation crowding-out. The American economic review, 87(4), 746-755.

Saturday, 22 June 2013

Waiting times in A&E

The UK's National Health Service seems to have been constantly in the news in recent months for the wrong reasons. One issue has been waiting times at Accident and Emergency Departments. The government's target is to treat 95% of patients at A&E departments within 4 hours. Whether or not the target is met has become a general indicator of pressure within the NHS. Recently the government missed the target. But, how useful are such targets?
      Let us look at a hypothetical A&E department at 6pm on the 2nd July 2013. The waiting room is full of people. To be efficient we need to work out the benefit of treating each patient and compare that to the cost. The benefits and costs are shown in the diagram below. To illustrate how the benefit side works we can pick out two of the patients: David has had a heart attack and needs treatment or he will die, while Brian has sprained his ankle playing football. The benefit of treating David far exceeds that of treating Brian. On the cost side we recognize the capacity constraint in the department. The department can treat Q patients at any one time without much cost, but cannot realistically treat more than that. Who should the hospital treat? Clearly they should treat David and leave Brian waiting.
      Fast forward one hour. David is now in intensive care and Brian is still waiting. A new set of patients has arrived. Amongst these new patients is John who was in car accident and has serious injuries. Again, the benefit of treating John far exceeds that of treating Brian and so Brian is going to be left waiting a bit longer.
      Its now 10pm and Brian has been waiting four hours. The benefit and cost trade-off, however, has not changed. David and John have been treated but many new patients have arrived in more need of treatment than Brian. For example, Sarah has just arrived after a fall that caused serious head injuries. Who should the hospital treat? On any ethical and moral grounds they should treat Sarah. There are, however, 'strategic' or 'management' incentives to treat Brian in order to meet the target. Essentially, the benefit of treating Brian becomes artificially higher due to the target.
         One would hope that decisions are made on medical grounds. Unfortunately, however, we have evidence that sometimes they are not. Serious problems, for example, were uncovered at Stafford Hospital. An inquiry into the poor standard of care found a management culture that put targets ahead of patient care. Receptionists were left deciding who to treat in A&E. Brian might get treated ahead of Sarah. 
       Our hypothetical example illustrates the way that targets can distort incentives.They provide an incentive for the department to treat Brian ahead of more needy patients. And things work the other way too: why did Brian turn up at A&E with a sprained ankle? The promise of being treated in under four hours may have been a deciding factor. Which is why increasing the capacity of A&E is not necessarily the answer to the problem.
        This is not to say that targets are not a good thing. Performance measures and indicators are clearly essential to motivate performance. It is, however, necessary to be careful how targets are used. Setting a target that can be artificially met is not good - it is easy for a hospital to meet the waiting time target by sacrificing patient care. Setting a target that makes no sense is also not good - On neither efficiency or equity grounds do we want a hospital treating Brian ahead of Sarah. Undue focus on one target is also not a good thing - a mix of targets avoids distorting incentives in one particular way. Such nuances are, though, difficult to sell to a public audience that likes simple black and white tests of whether the NHS is performing up to standard.

Saturday, 8 June 2013

Why would you read an investment newsletter?

The latest issue of the Hargreaves Lansdown Investment Times arrived in the post last week. As always it was full of advice on which investment funds are good bets for your money. Adherents to the efficient market hypothesis would suggest that such investment newsletters are basically a waste of time. But, I always enjoying reading through my copy of the Investment Times. So, why can investment newsletters be useful?
       To answer that question let's start by explaining why investment newsletters are supposed to be useless. The efficient market hypothesis says that stock, commodity, bond, fund prices etc. should always reflect all the information available at that time. If, therefore, a freely available, published newsletter claims 'here's a great opportunity to invest' it shouldn't remain a great opportunity by the time you get the newsletter! The person writing the newsletter, for one, has an incentive to act on the advice. By the time you get the newsletter, prices should have adjusted, and the great opportunity will have disappeared.
      There's no denying that this argument has some truth in it. It is, for instance, unlikely a fund manager can outperform high profile indices, like the FTSE100, by 'good stock picking'. In such highly traded markets, prices will adjust immediately to new information and so 'good stock picking' equates to a heavy dose of  'good luck'. You would be better to invest in a tracker fund than pay extra for the services of a manager. An investment newsletter's claim to have found the best stock picker is likely to reflect past performance rather than future potential. They can tell you who was lucky, but are not so good at telling you who will be lucky!
     But, investment newsletters are not a complete waste of time. The 'textbook' benefit of a newsletter is that it can advise on the risk, return trade-off. Some investments are more risky than others and an investor would be well advised to take this into account. Someone close to retirement, for example, should have their money in relatively safe assets while someone far from retirement can play a more risky strategy. A good investment newsletter can explain this, and advise which investments are relatively safer or riskier.
      . To appreciate further benefits of a newsletter, we need to look at the limitations of the efficient market hypothesis. We know that in practice asset prices can be well above or below fundamental value. The issue then becomes one of time and patience. Suppose, for example, that shares in the FTSE100 companies are under-priced. Prices need not adjust immediately because speculators fear a further drop in prices. Indeed, for speculators eager to make money here and now, it is not particularly useful to know that companies are under-valued. For someone willing to take a longer term view, however, under-priced shares area a good opportunity to make money. Prices might go lower in the short run, but over time the price should readjust. Investment newsletters can advise on such opportunities. But, note, that you don't need a good stock picker to realize such gains. It is enough to invest in a tracker fund.
      The efficient market hypothesis also becomes less relevant when we come to markets with a smaller volume of information and investors. This puts attention on small companies and markets in developing countries. The lack of information creates the possibility for asymmetric information, and this can be exploited. Consider, for example, a small start-up company. Who knows whether this company will be a success or not? A good fund manager might be better than others at answering this question. Asymmetric information comes from the manager's efforts to study the firm, meet the CEO, ask the right questions etc. An investment newsletter can advise on who the good managers are. Such investments are likely to be quite risky, and so we can think if this as advice on the best risky investments.
     So, investment newsletters are not a complete waste of time. But, the advice needs to be treated with care. Claims on how to outperform highly traded markets are almost certainly overblown. Advice on which markets to invest in and who to trust with your money to in less traded markets is potentially more valuable.

Saturday, 1 June 2013

Last minute deals and price discrimination

I was flicking through a magazine yesterday when I saw an advert for the travel company Great Railway Journeys. The advert caught my eye because it guaranteed that 'you'll never pay more than last-minute bookers. If we reduce a holiday price for any reason, we'll give the same saving to anyone who has already booked'. To someone brought up on the microeconomics textbook this can sound a bit weird. The textbook tells us that price discrimination - charging different people a different price for the same good - is one of the main ways a company can increase profit. So, why would a company guarantee that it will not discriminate?
     Last minute deals are an example of second-degree price discrimination. This is where a company knows there are different types of buyer but cannot tell them apart. By offering a menu of packages the company can potentially get customers to reveal their type and charge them accordingly. To illustrate: Holiday makers may differ in their willingness to pay for comfort. Hotels with standard rooms, executive rooms, junior suites, and presidential suites are offering a menu of packages for holiday makers to choose amongst. And anyone staying in a presidential suite can expect to pay a lot more than someone staying in a standard room. The hotel can profit from discriminating in this way.
   The main hope of last minute deals is to discriminate between customers willing to pay a lot for a holiday - who will book early - and those willing to pay less for the holiday - who will book at the last minute. Many travel companies clearly use this strategy. But, there is a basic flaw - a time-inconsistency problem. If customers expect the price to drop at the last minute then why book early? Customers have an incentive to delay purchase and pick up the bargains. Unfortunately, this is the exact opposite of what the company wants: it creates uncertainty about the level of demand and means the company has failed to discriminate between customers.
     To understand why last minute deals can fail to work, its worth mentioning that most examples of second-degree price discrimination also come by the name of hurdle pricing. The idea being that to get a cheap price the customer has to overcome some hurdle. This will only work if the hurdle is high enough. For a traveler who values their comfort and has money to burn, staying in a standard room is a big hurdle; to get a cheap price, they have to sacrifice the comfort of the presidential suite for the cramped standard room. Booking late, however, is not much of a hurdle, particularly when there are lots of companies with holidays on offer. To get a cheap price, the customer merely has to wait a bit. And given people's present bias propensity to delay, waiting a bit is not a big hurdle!
    The time-inconsistency problem means that last minute deals can be more of a curse than opportunity for profit making companies. So, an ability to price discriminate is not always advantageous. Which explains why a company like Great Rail Journeys would want to 'tie their hands' and rule out last minute bargains. The guarantee 'if we reduce a holiday price for any reason, we'll give the same saving to anyone who has already booked' does this in a seemingly credible way. With a guarantee like that they have no incentive to drop the price. Moreover it should reassure customers that the list prices are not too high.    

Wednesday, 22 May 2013

Facebook: winners curse or irrational exuberance

It is a year since Facebook launched shares on the Nasdaq. They were launched at $38 per share and now stand at a lowly $26. Anyone who bought a share would have lost 30% of their money.
   At first sight this looks like a classic example of the winners curse. The winers curse captures the idea that the winner of an auction often loses money. IPOs (initial public offerings) are a textbook example of this. Here's the basic logic: If you ask 1000 investors to put a value on Facebook then the average valuation will probably be about right. But, shares are not sold to average investors. They are sold to the investors willing to pay the most. So, what really matters are the valuations of the most optimstic investors. And while the average investor will get the value about right, the most optimistic investors will not. They will overvalue the company and consequently pay too much. This is the winners curse: the investors who 'win the auction' to get Facebook shares would have been better to not bother.
    This is the textbook story, and it seems to fit the Facebook case pretty well. But, here are some things to add in to the mix. 
    One thing to consider is that the price of Facebook did increase in the first few minutes of trading up to $42, with a huge volume of orders. If you got a share at $38 and sold at $42 then that looks like good business. The stupid thing was to buy at $42! Its not clear whether buying the share after launch should be counted as the winners curse or a more general bubble effect that could be classified as irrational exuberance. I would call it the winners curse but others might not.
     Another thing to regonize is that many IPOs run without any winners curse. For example, the chart below compares the performance of Facebook with Google, Linkedin and Manchester United. We can see that investors who bought shares in Google or Linkedin would have done very well. Similar things were expected of Facebook. This still means its relevant to talk of the winners curse - investors in Facebook lost money - but it does suggest that the winners curse is less prevelant in IPOs than some might have us believe.
     A final thing to consider is the possibility of a 'winners bonus'. This is why I've put up the shares of Manchester United. The owners of United had originally planned to sell the shares for $16 to $20. They ultimately had to go for an underwhelming $14 (note that Google and Linkedin were launched at the top of their predicted range). Six months later the shares were up above $18. So, this is seemingly an example where easy money was there for the taking by buying the shares at a very low initial price. Clearly, the more that investors are caught by the winners curse the more cautious we might expect them to be in the future. With Manchester United they were seemingly very cautious. We essentially have the opposite of a winners curse.
    I think there's an interesting lesson in all this with regard to the efficient market hypothesis. According to this hypothesis the share price of a company always reflects the underlying value of the company. In that case an IPO is akin to any other auction because you are buying a good that has value in itself - a share is analogous to a painting, car, house or anything else you can get at auction. In reality, most think that the efficient market hypothesis is pretty dodgy. The share price of a company is more likely to reflect the game going on in the market rather than the fundamental value of the company. The price at any one time may, therefore, be well above or below fundamental value. That makes an IPO different to standard auctions because you are buying a ticket to a game and not something of value in itself. And so, while the winners curse is still relevant, its effects are likely to be overwhelmed by the game playing going on.

Thursday, 16 May 2013

Pregnancy, smoking, and principal agent problems

Earlier this week it the headlines that NICE (the National Institute for Health and Care Excellence) were recommending midwives use a carbon monoxide test to verify whether expectant mothers were smoking. Suitable fury from smokers followed. The proposal, however, is based on pretty sound economics.
    The relationship between a child and parent is a principal-agent relationship. The basic idea of any such relationship is that a principal 'employs' an agent to do a 'job' for her. Its fine to interpret 'employs' and 'job' very loosely. In this case we can think of the unborn child as employing the mother to protect her growth and development. Clearly it is in the best interests of the child that the mother quit smoking, eat healthily etc. The mother, however, has different incentives. And, there were lots of mothers I heard on the radio this week determined to carry on smoking regardless. This is an example of a moral hazard problem: The agent, in this case the expectant mother, takes on more risk than the principal, the unborn child, would like her too.
    Many people, at least many of the students I have taught, like to argue that the parent child relationship shouldn't be see as an example of a principal agent problem. Surely the mother acts in the best interests of her child? While, it would be nice to think so, the reality is often very different - count how many pregnant women smoke. So, moral hazard exists. And that's not the only problem.
     People can choose when and whether to have children. If quitting smoking is difficult, then a responsible smoker would quit before getting pregnant. Some people do quit smoking before getting pregnant but others do not. Simple logic says that the people who get pregnant irrespective are going to have more children than those who wait until 'everything is right'. The adage that you cannot choose your parents, therefore, understates the true problem. You are more likely to be born to an irresponsible parent than a responsible parent! This is an example of an adverse selection problem: Less desirable agents are more likely to be employed. Or in this case, unborn children and relatively likely to end up with irresponsible parents.
     We cannot, therefore, trust pregnant mothers (and fathers) to stop smoking. And a further thing to keep in mind is that the pregnant mother is employed by the taxpayer as well as the child. This is because the National Health Service will pick up the bill if anything goes wrong. That lessens the incentive for mothers to act responsibly. Indeed, one could argue that the benefits system positively encourages irresponsible behavior. So, I have no hesitation in saying that the carbon monoxide test is a good idea. The test, however, does not solve the problem of what to do with expectant mothers that want to continue smoking. For that the Health Service needs a credible threat to encourage non-smoking - and its hard to think how to do that.

Thursday, 9 May 2013

Obamacare and increasing insurance premiums

One of the big problems with US health care is the large number of uninsured people. A lack of insurance is costly for the state given that someone has to pick up the bill for all necessary treatment on uninsured patients. And its costly for society given that ill health can cause personal bankruptcy for anyone uninsured.
   To fix the problem you need to know what is causing it. There are three basic causes. In looking through these its useful to have the following figure to hand. On the horizontal axis we plot the publicly observable health of the person, which might include things like weight, age, illness in the family etc. These are things the insurance company will take into account when assessing risk. On the vertical axis we plot the privately known health of the person, which also takes into account things like diet and exercise. These are things the insurance company would like to know but cannot, only the person knows. Each dot in the figure is a particular person. Most people will be near the 45 degree line, but not all. For example, Fred is very healthy, exercises regularly etc, but looks very risky, because of say a genetic condition in his family. John, by contrast, is very unhealthy, eats fast food every day etc., but the observable characteristics make him look healthy.

   Now, to the causes of people being uninsured:

1. Some people look such a high risk that no insurance provider is willing to provide insurance. In the figure I have drawn a cut off point at N. No person beyond this will be given insurance. That's clearly harsh on Fred who is perfectly healthy. The problem is, the insurance cannot know that Fred is healthy because everyone can lie about taking exercise and eating healthy etc.

2. Adverse selection. Suppose the insurance company offers a standard price on insurance to anyone left of N. The price will be based on average health and so will look unfairly high to someone like Sarah who knows they are healthy. Sarah exercises regularly, eats healthy, and objects to paying a high price because others take less care of their health. As such, Sarah may choose to not buy insurance. This can push up the price of insurance even more given that those left buying it are the relatively unhealthy. In the figure anyone below H is assumed to not buy insurance because the premiums are too unfair. (This story assumes a standard price for everyone and the insurance company might charge according to risk. The basic logic, however, still follows through.)

3. Some people are risk loving. John, for example, might just risk that he can avoid ill health. Of course, a little bit of over optimism and present day bias is likely.

All three of these potential causes are surely at work in the US. So, how to fix them? Europe has a relatively simple answer - force everyone to get insurance. This can be done implicitly as in the UK through taxes or explicitly as in the Netherlands. Obamacare essentially tries to bring this philosophy to the US. How does this work? It solves problem 1 by guaranteeing everyone access to insurance. It solves problem 2 by forcing people to pay even if prices are unfair. It solves problem 3 by forcing people to buy insurance whether they want it or not. It is these last two sentences that capture a lot of the hostility towards Obamacare we see in the US. Why should people be forced to buy insurance against their will?
    Problem 3 is almost certainly due, in large part, to cognitive bias. Many people who risk no insurance may subsequently regret that decision. So, it is not unreasonable that the government forces people to make the right decision, particularly as the government picks up the bill. Problem 2 is a market failure. Forcing people to buy the insurance solves the problem. It has the advantage of lowering prices because healthy people are bought back into the market. Prices still remain unfair for people like Sarah, but they are less unfair than they would have been otherwise. And note that everyone benefits from the lower prices including those who were buying insurance previously.
    So far, so good. Fixing problem 1 is where the problems start. Morally, it seems easy to justify everyone having access to insurance. The drawback is that it brings the least healthy people into the market. Which can increase premiums for everyone, offsetting the gains from solving adverse selection. Recently, the Society of Actuaries predicted that insurers costs will jump by 32% by 2017. This increase is partly due to the increased risk for insurers of bringing less healthy people into the market. If that increase in costs is passed on in premiums in the private insurance market then there will be many unhappy people.
     Remember, however, that a lack of insurance has big costs. The savings the government makes, if everyone has insurance, should be enough to reduce insurance premiums through direct subsidy. In short, if the amount of treatment remains the same, there is no reason total health care costs should increase. All that's happening is a redistribution of the costs. The previously uninsured are paying where they did not before, and the government has savings that could be put back into the system. Compulsory insurance is not, therefore, as bad as the critics would suggest. And it is surely a fairer system? It forces people to buy insurance, but also means taxpayers are not forced to bail out the uninsured.    


Saturday, 23 March 2013

West Ham, the Olympic Stadium, and the puzzle of sunk costs

Yesterday West Ham United Football Club were essentially given the London 2012 Olympic Stadium for the bargain price of £15 million. True, they will not own the stadium, and will have to pay rent. But, this does nothing to alter the basic fact that West Ham has been handed a bargain.
   And its a bargain deal that has annoyed many. The Stadium cost around £500 million to build and converting it into a football stadium is going to cost at least another £100 million. Most of this funding has come from the taxpayer. So, on face value it looks like the UK taxpayer is giving a football club a very big gift - a £600 million stadium for £15 million. To make sense of this we need to think about sunk costs and bargaining. 
    Let's look at sunk costs first. The stadium was built for the London Olympics, and not the benefit of West Ham. Spending £500 million on the stadium was, therefore, arguably money well spent by the British taxpayer. But times move on: the London Olympics has long finished, the stadium still exists, and the question that matters now is what to do with the stadium. The money spent building the stadium is a sunk cost, it's gone, and should not be a factor in current decisions. So, London Mayor Boris Johnson was right to be relatively upbeat about the deal. The taxpayer is going to get a revenue from the stadium that is much better than could have been hoped for without West Ham. 
    West Ham, though, are getting a fantastic deal. They are getting a fantastic, iconic stadium that they could not possibly have afforded themselves. And this will dramatically increase the value of West Ham. Indeed, we already have the example of Manchester City to illustrate how a 'stadium for free' can transform a club - they got the stadium built for the Commonwealth Games and have not looked back. The owners of West Ham have got a very good deal. The supporters will also soon get over the nostalgia for their current ground.
    The deal struck is thus one that benefits the taxpayer a little and benefits West Ham a lot. Why did we end up with such a one-sided deal? Bargaining theory can help explain. The first thing to keep in mind is that while the stadium cost £500 million it is not worth £500 million anymore. Its a liability for the tax payer and worth, say, £200 million for West Ham. So, the parties are bargaining over £200 million. Note that a second potential user of the stadium might have changed this equation but that did not materialize. The taxpayer is in a relatively poor bargaining position because it wants to off-load the stadium and declare the Olympics a success. West Ham is in a much more strong bargaining position because it can carry on using its current ground and does not have cash lying around to pay for the stadium. Its no surprise, therefore, that West Ham gets the better deal.
     This situation can be viewed in terms of the ultimatum game. West Ham offered to give the taxpayer £15 million of the £200 million the stadium is worth to them. The taxpayer can either accept or reject the offer. It makes sense to accept, because £15 million is better than nothing. But, it's annoying to accept because West Ham do very, very well from the deal. So, it's a matter of interpretation whether you think the taxpayer got a good or bad deal.


Saturday, 9 March 2013

Free drink anyone

I was in a restaurant the other day, waiting for someone, and could not but help overhear a conversation between a restaurant manager and an elderly lady organizing a dinner party. They were discussing the arrangements for the party, and had just got onto the topic of drinks.
   The manager reminded her that drinks were not included in the package. 'Would she like to prepay for some wine and put it on the table?'
   She said 'no because not everyone drinks wine'.
   'OK, so, would she like to pre-book some wine under the proviso that it only has to be paid for if it gets drunk?'
   Displaying the characteristics of a true game theorist she replied 'well if you tell them they can drink it they are clearly going to drink it aren't they! No, I'm not doing that'.
  The next gambit of the manager was 'you could start a tab at the bar under the proviso that the tab will be split amongst all the guests at the end of the party'.
  To my horror she thought this was not such a bad idea. But, thankfully, she said she would have to think about it.
  How can a game theorist make sense of this exchange? The objective of the manager is to make profit - and that means selling as many drinks as possible. The dinner guests will drink according to the price of a drink. Suppose the 'face value' price of a drink is £2. If the drinks are 'free' - because they have been pre-booked and paid for - then the guests will drink the most. If the drinks have to be bought individually at £2 each they will drink the least. The interesting case is where the tab will be shared. Suppose there are 20 guests. Then the effective price of a drink is £2/20 = 10 pence. Which is as good as 'free'. So, from the manager's perspective splitting the tab is as good as the drinks being pre-booked.  The guests are going to drink a lot more than if they had to pay for it individually.
   From the guests perspective the tab is the worst outcome. They still have to pay for drinks but the incentive structure means they will drink a lot. Specifically, each drink costs every guest 10 pence each. So, if a guest has another drink that costs him 10 pence, but also costs the other guests £1.90. There is a negative externality. Indeed, the drinks tab is a common resource which will be over-exploited by the guests. The guests would be better off if they had to pay for their drinks individually. For example, suppose that at a cost of £2 each guest would have 3 drinks and at a price of 10 pence have 6 drinks. The total cost per guest is £6 if drinks are paid for individually and £12 if drinks are on the tab.
   From the perspective of the elderly lady organizing the party, there are mixed incentives. Clearly, if she doesn't pay for drinks then she's better off. Her main concern will thus likely be how much the guests enjoy the evening. While it may seem good that the guests drink and enjoy themselves, this is a misconception. The tab will almost certainly be antagonistic because of the negative externality problem it creates.