Friday, 19 December 2014

The russian economic crisis and comparative advantage

As the Russian economy heads towards tough times Putin seems to be pulling up the drawbridge. If Russia is going to prosper then, so the logic goes, it needs to rely less on foreigners and more on itself. This is a familiar nationalist argument that long pre-dates Putin. But it is one that economists have long tried to counter with the logic of comparative advantage.
        Simply put comparative advantage says that a country should produce what it is relatively good at. To give an example suppose that both a barrel of oil and a tablet computer sell for $100 on international markets. If it costs Russia $40 to produce a barrel of oil and $100 to produce a tablet then Russia should produce oil because this is where it has a comparative advantage. Crucially this logic holds even if Russians only want tablets. For instance, with $400 of cash they can produce 10 barrels of oil and trade these on the market for 10 tablets. Or, they can produce 4 tablets themselves. Clearly 10 tablets is better than 4. And pulling up the drawbridge is a bad idea.
        Analysts have also been quick, however, to criticise Russia for becoming too reliant on oil. And this does seem to make for an inconsistent argument. Comparative advantage says that a country should specialize, but then we criticize Russia for becoming over specialized! So, is there a flaw in the logic of comparative advantage?
        Comparative advantage says what a country should produce, not how well it will do producing it. The recent dramatic fall in the price of oil is clearly bad news for any country that specialized in oil. But the logic of comparative advantage still holds firm. To illustrate, let us return to the example above and say the oil price is $60 per barrel. With $400 Russia still produces 10 barrels of oil, which sells for $600 and buys 6 tablets. The purchasing power of Russians has dropped from 10 to 6 tablets but this is still better than the 4 tablets they can make on their own. There is no flaw in the logic of comparative advantage.
         So, where does the call for diversification come from? As far as I know there is no strong economic argument for diversification. The popular argument essentially seems to be specializing is 'too risky' because a country becomes vulnerable to shock. Many, for instance, worry that the UK is over-reliant on the financial services sector. But, risk is something that could be insured against, as evidenced by Norway's wealth fund. 
         I'm not convinced, therefore, that Russia's 'over-reliance' on oil deserves the criticism it gets. Specialising in oil is fine if that is where Russia has comparative advantage. For comparative advantage to really benefit Russians, though, the Russian economy needs a big scale market liberalization and associated reduction in corruption. There is not much sign of that happening any time soon! 

Wednesday, 10 December 2014

Reform of stamp duty should raise revenue

Stamp duty is a tax on house purchases. And it will surely go down in history as one of the most badly designed taxes ever. Why? Because, until last week, the tax operated in bands that applied to the full purchase price. For example, if a house sold for £249,999.99 then it was taxed at a rate of 1% meaning a tax of £2,500. If the price increased by two pence to £250,000.01 then it was taxed at a rate of 3% meaning a tax of £7,500. So, a two pence rise in purchase price meant a £5,000 increase in tax!
         Clearly such a tax is highly distortionary. No one was going to buy a house for £251,000. House prices, therefore, inevitably clustered at the bands of £125,000, £250,000 and £500,000. There was also the clear incentive to circumvent the tax. For instance, to buy a house for £249,999 but then agree to pay £10,000 for the living room curtains.
         In the Chancellor's Autumn Statement stamp duty was finally reformed. The current slab system was replaced with a system of incremental taxation. Paying two pounds more will now cost at most two pence in extra tax. Common sense can breathe a sigh of relief. I found it particularly interesting, though, the way that the Chancellor spun this good news.
         The headline claim was that 98% of home buyers would pay less under the new system than the old. And if you look at some raw numbers like those in the table below it is easy to see why this claim seems justified. Across the board there are seemingly significant gains for home buyers.

       Why may these gains be illusory? House prices are unlikely to stay the same. Houses that were selling for just under £125,000, £250,000 and £500,000 will clearly go up in price. This, in itself, is enough to mean that some will pay more. For instance, someone who would have bought a house for £125,000 but now has to pay £130,000 sees a £100 rise in tax. Similarly, someone who would have a bought a house for £250,000 but now has to pay £260,000 sees a £200 rise in tax.
        These are modest rises but given that a large proportion of transactions take place around the £125,000 and £250,000 mark they are not innocuous. And things may be worse. Because pushing up some prices is inevitably going to push up others. The gains, particularly in the £125,000 to £250,000 bracket, may not, therefore, be as large as the table suggests. The Chancellor may well have pulled off the political magic trick of a popular tax rise.  

Wednesday, 3 December 2014

Phillip Hughes and safety at work

The death of Australian cricketer Phillip Hughes shocked everyone. It serves as a powerful reminder that safety at work, whether it be the sport's field or a gold mine, is not something that should be left to the discretion of individual workers. This point has been most powerful made in recent years by Robert Frank whose argument rests on the notion of positional externalities.
             To illustrate the point consider the game below where two cricketers have to independently decide whether to wear a helmet. The best joint outcome is for them to both wear a helmet (and get a payoff of 10 each). There is, however, an advantage - this is the positional externality - from not wearing a helmet when the other cricketer does (and get 12 to his 0). The advantage comes from increased performance or, in economic speak, from increased productivity and the consequent higher wage. This incentivizes neither player to wear a helmet. Which is a bad outcome for everyone.
            Instead of 'wear helmet' we could write 'use a safety rope when tree cutting', 'wear a respirator in the gold mine', 'work in a dangerous factory', 'drive the lorry when tired' etc. The crucial point is we end up with a race to the bottom, a race to minimal safety. That gold miners choose to work without a respirator is not evidence that this is what they want. It merely shows that in a competitive world where 'someone else will do the job' incentives drive miners to accept low safety. Individual workers are not able to stop such a race to minimal safety, only rules and regulations can do so.
           Phillip Hughes was wearing a helmet. The simple story above still, though, applies. We could surely produce helmets that would virtually eliminate the risk of death. It is just that without regulation no cricketer would ever choose to wear such a helmet. There will always be an incentive to wear a lighter, more agile, and less safe helmet. Over time, cricket has increased regulations, requiring the use of helmets for under 18s and restricting use of bouncers, but it still takes a relatively hands off approach to safety. Could it do more?
          This is a difficult question. Whenever there is tragedy there is a call for action and this brings with it the possibility of overreacting because of things like hindsight bias. It would, for example, be a false legacy if rules and regulations are put in place that primarily result in less children playing cricket. It is a case of weighing up costs and benefits. I do not think, however, this is as difficult as some suggest. The insight we get from positional externalities is of a general bias towards less than optimal safety. The insight we get from hindsight bias is of a bias towards ad-hoc regulation that does nothing to improve safety. The important thing, therefore, is to keep in mind what the rules and regulations are supposed to achieve. And that requires an understanding of positional externalities.    

Wednesday, 19 November 2014

The ignorance epidemic and bounded rationality

This week's edition of the economist had an interesting article on the knock-on effect the Ebola outbreak is having across Africa. Safari bookings, for instance, are dramatically down on previous years. This seemingly makes no sense: the traditional safari hotspots are further away from and less connected with the effected areas than most European capitals. Through the lens of bounded rationality, however, such an 'ignorance epidemic' is much easier to explain.
       To explain, consider the Jackson family deciding where to go on holiday this year. Suppose that a safari in Tanzania is the best. Then, in the world of the economic textbook, a safari maximizes utility and the Jacksons would set off for Africa. And reality?
        Deciding where to go on holiday is undoubtedly going to be a difficult choice because of the almost limitless possibilities to choose from. So, the Jacksons are not going to maximize utility. The best they can realistically aim for is satisficing. This is the term introduced by Herbert Simon to capture the idea people search until they find a 'good enough' option. The Jacksons may decide that a holiday in Australia is good enough for them.
        Where does Ebola fit into this story? Without Ebola maybe the Jacksons would go to Africa. With Ebola they go to Australia. The crucial point to recognize is that the Jacksons don't lose much either way: in a world of satisficing Africa and Australia are pretty much as good as each other. In other words, the Jacksons don't pay for their 'ignorance'. Africans, however, will pay for the collective ignorance of families like the Jacksons. This is inefficient.
         In a recent paper with Myrna Wooders we show that such inefficiency often comes with stereotyping. Basically, the people doing the stereotyping (the Jacksons in the example) don't lose much by stereotyping. But the people who are stereotyped (Africans in the example) may lose a lot.  The standard economic model is poorly suited to picking up and analysing such things. In particular, the standard model assumes the Jacksons will eliminate bias over time. From a satisficing perspective, however, there is no incentive to do this. The bias will likely persist. 
         Such persistence of bias means that framing effects, which drive things like stereotyping, can have big consequences. It also means the general tendency within economics of wishing away framing effects and coherent arbitrariness is not good enough. Trying telling Africans whose livelihood relies on safari tourists that the 'Ebola framing' is not that important. 

Saturday, 1 November 2014

Social welfare and social preferences: Let the altruists be altruistic

I recently attended a conference session that ended with a debate on whether social preferences should be taken into account when measuring social welfare. That might not sound like a particular exciting issue but I think it's an interesting and important one. So, lets look at the issues.
         We can all agree on the idea that social welfare should guide policy. A policy can be considered good if and only if it improves social welfare. The difficulty is measuring social welfare. How can we reconcile the differing desires and preferences within a population? How can we take into account the desires and preferences of future generations who will be influenced by a policy? And so on. 
          The presence of social preferences, such as envy and altruism, muddies the waters even more as the following example illustrates. Robinson and Friday are the only people living on a desert island. Robinson is selfish and envious. Friday is altruistic and generous. You arrive with a boat full of goodies and have to decide how to distribute your cargo. What should you do?
          If your measure of social welfare takes account of social preferences then you should give all your cargo to Robinson. This keeps Robinson happy because he has no reason to be envious and it keeps Friday happy because he likes to see Robinson happy. The selfish guy gets everything! This outcome strikes many as worrying. Worrying enough that they argue social welfare should not take account of social preferences. But, I find this argument unconvincing. Here are three reasons why.
1. The Robinson, Friday example is just an example. We know that the social preferences of real people are far more subtle. For instance, overwhelming evidence  suggests that generosity is always given conditionally. In short, Friday's simply don't exist. And if Friday's don't exist then we have much less of a problem incorporating social preferences into social welfare. We can rule out the extreme kinds of preferences that people don't like and not miss anything important. 
2. The Robinson, Friday example gives a negative picture of social preferences, which is at odds with the positive view given elsewhere. Social preferences are about sharing things, rewarding those who work hard, punishing those who free-ride, cooperating for mutual benefit etc. Social preferences are almost always a good thing! So, to not take account of them seems strange. If for example, 'rich' people want 'poor' people to have a reasonable standard of living it seems strange to not take account of that when measuring the welfare benefits of a redistributive policy.
3. Social welfare is essentially about judging fairness. This means that social preferences naturally underpin any measure of social welfare. So, we allow the policy maker to have social preferences. And, we allow the economist who comes up with measures of social welfare to have social preferences. But, we don't take account the social preferences of others? That seems way too egocentric. For instance, you might consider it fair to split equally the cargo between Robinson and Friday. The problem is, neither Robinson nor Friday consider it fair! And why should your definition of fairness trump theirs?    
I think, therefore, measures of social welfare should take account of social preferences, and should take account the diversity of social preferences. But, that challenges us to improve our understanding of what fairness means to people.

Friday, 10 October 2014

The prisoners dilemma and a fair justice system

The prisoners dilemma is probably the most well known product of game theory. Typically, the game is used to illustrate the difficulty of sustaining mutual cooperation. But, as the name may suggest, it also raises questions about justice and the legal system. A recent article in the economist suggested that power has swung too much in favour of the prosecution in the US justice system. The prisoners dilemma can help us understand how easily this can happen.
       Suppose that Fred and William are arrested by the police in regard to a serious crime. The two are put in separate rooms and questioned. There is clear evidence that they committed a minor crime but the evidence regarding the serious crime is weak. The basic options open to the two suspects are to deny the serious crime or confess but blame the other suspect. If they both deny then they will receive one year in jail for the minor crime. If both confess then they will receive ten years in jail for the serious crime.
      The crucial thing is what happens if one confesses and the other denies. The police offer a deal: If Fred confesses and William does not then Fred walks away without a jail term. A similar deal is offered to William. Putting this together we end up with the game depicted below. We see that, no matter what William does, Fred is better off confessing. Same goes for William. The prediction, therefore, is that both Fred and William will confess. 
        For the police and society this looks like a good outcome - we get a conviction. Note, however, that the story above says absolutely nothing about whether Fred and William are actually guilty of the serious crime. They may not be guilty! The crime may have been committed by someone else! In this case confession does not look such a good outcome.
        At this point you might argue that an innocent person would never confess, because of psychological costs not captured in the simple game above. We know, however, that may innocent people do confess. You might also argue that the police should only resort to plea bargaining when they are sure Fred and William are guilty. But then trial by jury just becomes a façade under which the police really decide who gets convicted and who does not. That is not justice.
         So, why not ban plea bargaining? Plea bargaining has at least two clear merits: (i) A guilty plea negates the need for a trial with the misery that this can impose on victims. (ii) Society may want to be more lenient on wrongdoers who show genuine remorse for their wrong. Plea bargaining, therefore, is not the problem. Problems only arise if the incentives of the police or prosecution become misaligned with the desires of victims and society. That is almost certainly going to be the case in a system like the US or UK that rewards the police and prosecution for 'successful' convictions.
        So, how we can realign the incentives of the prosecution and society? This a tough question with no simple answers. It is, though, important to recognise the question exists! At the moment there does not seem an enough awareness of the issues and that is a problem for justice.  

Saturday, 20 September 2014

Scotland decides: Are referendums a good idea?

The Scottish independence referendum has finally taken place with a comfortable majority voting no to independence. The result is, however, somewhat bizarrely being interpreted as a 'clear call' for greater devolution. Why bizarre? We have gone from four million Scots being asked a yes, no question 'should Scotland be an independent country' to the conclusion that a majority of the sixty million people in the UK want greater devolution to the regions, and they want it before March 2015! Surely there is not a better way to judge the 'will of the people'?
       The answer, unfortunately, is 'probably not'. And the main reason why is the difficulty of making inter-personal utility comparisons. What we have here is a problem of collective choice. A single decision has to be made, e.g. Scotland becomes independent or it does not, but that decision will affect many. Some people stand to benefit a lot from independence and some stand to lose a lot from independence. In a utopian world those that stand to benefit could compensate those who will lose out - transferable utility in the parlance of cooperative game theory. In practice, however, transfers are clearly a non-starter for something as complex as Scottish independence. 
       Without transfers there is simply never going to be unanimous agreement. This lack of unanimity inevitable means the policy maker has to trade-off the desires of one person with the desires of another. And that means making inter-personal utility comparisons. But, how can the happiness of one person be compared with the disappointment of another? Economists and philosophers have long sort a solution to that problem. But what we have basically learnt is that there is no solution. There are various approaches to tackling the problem such as utilitarianism - maximize total happiness - or Rawlsianism - maximize minimum happiness. These approaches, however, only serve to kick the problem down to another level. We are never going to get unanimity on whether to use utilitarianism or Rawlsianism.
        The difficulty of inter-personal comparison means that there is no such thing as an optimal policy. There is no best or most efficient policy. I think this logical fact is a bit disconcerting to most people, including policy-makers. It seems a bit worrying that there is not an optimal way of doing things. A certain freedom, however, comes from knowing optimal is not an option. The Scottish referendum, for instance, could seemingly have gone either way. But that's fine because either was way would have been ok. While it might have been optimal for Jack to have independence and optimal for Jock to not have independence there was no optimal overall outcome.
        Policy making on a whim need not, therefore, be a bad thing. The West Lothian question, for example, has been knocking around in British politics for way too long. Progress is typically stymied by the claim there is no optimal solution. Well there is no optimal solution, but that is no reason to do nothing! To say, however, that there is no optimal policy does not mean that there are not good and bad policies. And there are plenty of examples of bad policies around the world.           

Sunday, 24 August 2014

Should governments pay hostage ransom demands?

The recent killing of journalist James Foley has reignited the debate over paying hostage ransom demands. The US, British and many other governments have a clear policy of not paying ransom demands. Does that policy make sense?
        The policy has a clear rationale in game theory. To see why consider the very stylized game below. The game begins with the kidnappers deciding whether or not to kidnap. If they kidnap then the hostage's representatives have to decide whether or not to pay the ransom. The numbers give the payoffs to the hostage takers and the hostage's representatives. If the hostage takers do not kidnap then payoffs are 0. If they kidnap and the ransom is paid 100 is transferred from the hostage's representatives to the hostages. If they kidnap and the ransom is not paid then the hostage takers pay some small cost of 10 while the hostage's representatives pay a big cost of 200.  
         The payoffs in the game are clearly somewhat arbitrary. This, though, doesn't matter too much - it is the relative ordering of payoffs that matter. Specifically, the hostage's representatives have an incentive to pay the ransom because -100 is better than -200. Predicting this, the hostage takers have an incentive to kidnap because 100 is better than 0. There is a unique sub-game perfect Nash equilibrium of 'kidnap, pay ransom'. This equilibrium looks like bad news.
        Fortunately, there is another Nash equilibrium. Suppose the hostage's representatives are expected to not pay the ransom. Then the hostage takers should not kidnap because 0 is better than -10. So, 'don't kidnap, don't pay ransom' is also an equilibrium. In a one shot-game this equilibrium is hard to motivate because the hostage takers should be able to predict that the ransom will be paid. In other words, the threat to not pay the ransom is not credible. If, however, the game is repeated many times then the representatives have an incentive to build up a credible reputation for not paying the ransom.  
        So governments commitment to not paying any ransom is aimed at making the 'don't kidnap, don't pay ransom' equilibrium a reality. And this is the best possible outcome for everyone, bar the hostage takers. There is, however, a fundamental flaw in this logic: According to the equilibrium there should not be any kidnapping. But James Foley, and many others, are kidnapped. Does that mean the policy is not working?  
         One thing the story so far neglects is heterogeneity. In the game above the hostage takers would rather not kidnap than kidnap and receive no ransom. This is surely the right ordering for most potential instances of kidnap. Suppose, however, that the hostage takers would rather kidnap and receive no ransom than not kidnap. Then we get a game something like that below. In this game the hostage takers have an incentive to kidnap no matter what. And this is arguably more representative of the threat posed by the Islamic State in Syria and Iraq.
        In this second game there is a unique equilibrium of 'kidnap, pay ransom'. The hostage's representatives gain nothing from a threat to not pay the ransom. Does this undermine a government policy of never paying hostage takers? We'll the problem here is that the government would need to pay the ransom in some cases and credibly not commit to paying the ransom in others. That seems way too subtle a policy to be realistic. Such policy would also change the incentives of hostage takers. In particular, they would have an incentive to 'burn bridges' in order to create something like the second game above. And it would also change the incentives of potential hostage victims. In particular, there is the moral hazard problem of individuals taking excessive risk.
       That kidnapping remains despite a credible commitment to not pay any ransom demands is not, therefore, evidence that government policy is not working. Things would be a lot, lot worse if governments were to start paying up.  

Tuesday, 19 August 2014

Petrol prices at the border and tax incidence

Petrol prices are one of the more interesting and accessible examples of demand and supply at work. With prices written in bright luminescent letters by the roadside it is a simple task, while driving along, to appreciate the variety of prices on offer. And an interesting economic problem to try and explain that variation in price.
         A recent road trip gave us chance to compare prices in a few European countries. It was pretty obvious that prices were higher in Germany than in Austria or Switzerland and higher in Austria and Switzerland than in Luxembourg. These broad differences primarily reflect differences in tax. What I found interesting, however, was that German prices appeared to be squeezed near the borders with Austria and Luxembourg. Anecdotally, at least, it seemed that prices got lower the closer we got to the border. If true, that would be a very nice example of tax incidence at play.
        Tax incidence is a fantastic economic concept. But it is also very poorly understood by the average politician, headline writer, member of the general public, and economics student. Confusion primarily comes from the need to throw common sense out of the window. So, let us look at the example of petrol prices in Germany to illustrate how tax incidence works. What I want to do is compare a petrol station in the interior of Germany, say in Hannover, with one near the border with Luxembourg, say in Trier.
        The basic difference between Hannover and Trier will be in the price elasticity of demand. In Trier a driver can relatively easily cross into Luxembourg and buy petrol at a cheap rate. That means the average driver in Trier is going to be more price sensitive than the average driver in Hannover. To be more specific suppose that the price of petrol in Luxembourg is €1 per litre. Then the demand curve at the German border (see the right hand figure below) will be flatter above a price of €1 than the demand curve in the Geman interior (left hand figure). One important thing to clarify here is that the demand curves I have drawn show demand for German petrol. Drivers in Trier need petrol just as much as drivers in Hannover it is just that they also have the option to buy Luxembourg petrol. This option flattens demand for German petrol at the border.

        There is no reason to suppose the supply of petrol is any different at the border and so I have drawn the supply curve the same in both cases. Now, what happens if the German government puts a tax of €0.50 per litre of petrol? Common sense would say that this pushes the price of petrol up by €0.50. And that common sense would be wrong!
        Look first at the left hand figure. A tax of €0.50 pushes up the supply curve by €0.50. The effect of this, however, is to only push up price from €1 per litre to around €1.38 per litre. Why do prices not rise to €1.50? As prices rise drivers demand less petrol because they choose to, say, drive less or drive more economically. If, therefore, the price were to rise by €0.50 there would be excess supply of petrol. In other words petrol companies would be stocking more petrol than drivers want to buy. This is not a good business strategy. And it provides an incentive for those companies to drop prices. At a price of €1.38 demand equals supply.
        Lets looks now at the right hand diagram. Here we see that the €0.50 tax only pushes prices up by around €0.18. Why does the price rise a lot less than in the German interior? As the price rises drivers demand a lot less German petrol because they can hop over the border to Luxembourg. This means that prices have to drop a lot in order for demand to equate with supply. And even with these much lower prices demand for German petrol will be lower at the border than the interior.
         The basic lesson of tax incidence is that demand and supply determine what will happen to prices. In turn, they determine who will pay most for any tax. Hence a crucial difference between economic incidence and legal incidence. For instance, in our simple example it is drivers who primarily pay for the tax in the interior but petrol companies that pay at the border. No amount of government meddling is going to do anything about that. Taxes, therefore, are a really blunt weapon to target prices or company profits. Something that policymakers seem often blissfully unaware of!


Sunday, 13 July 2014

Obesity and gastric bypass: putting a value on medical treatment

The UKs National Institute of Health and Care Excellence has a basic remit of evaluating the costs and benefits of medical treatment. Last week, it emerged that NICE will change its guidelines so that more people with Type 2 diabetes will have access to gastric bypass surgery. I think it is fair to say that the reaction to this news was not particularly positive. So, has NICE got its sums wrong?
       Evaluating the costs and benefits of medical treatment is always going to be a controversial and thankless task. Just about any decision is likely to upset someone. For instance, telling a cancer patient that her treatment is not 'cost effective' is clearly not going to be popular. But, from the other side, saying that gastric bypass surgery is 'cost effective' did not go down well with taxpayers. So, keeping everyone happy is impossible. That does not mean, however, there are not right and wrong ways to measure costs and benefits. And, there seems to be an increasing swell of opinion that NICE is not doing things right. 
      At the moment NICE bases its decisions on private costs and benefits. So, when assessing whether it is cost effective to treat a person with type 2 diabetes they focus solely on that person. With this mind-set it is easy to see why the gastric bypass is cost effective: the surgery costs relatively little, has a high success rate, and lessens the need for subsequent treatment. And, it is equally easy to see why a cancer treatment may not be cost effective: the drugs are expensive, have a lower success rate, and only postpone the need for further treatment.
      But, is it enough to only focus on private costs and benefits? What about social costs and benefits? To illustrate the point with a somewhat provocative example, compare two 40 year old women with cancer. Jane has no family, no job and is living on welfare benefits. Sarah has three young children and a high paying job. Currently NICE treats Jane and Sarah as identical. Once we take into account social costs and benefits it is a no-brainer that treating Sarah is more cost effective than treating Jane. The social benefits include three happy children and the future tax revenue. 
       NICE and policy makers currently seem to shy away from measuring such social benefits on the basis it all gets a bit too judgmental and controversial. But, that seems too much like wishing a problem would go away. And, the gastric bypass debate illustrates that social benefits and costs are not just about kids and tax receipts. In particular, we have the social costs of moral hazard and fairness. 
Moral hazard. The new guidelines will increase the perception (rightly or wrongly) that its ok to live an unhealthy lifestyle; whatever happens, the medical profession will save you. The effect of this will surely be to increase the number of people living unhealthy lifestyles and consequently increase the number of people with Type 2 diabetes. To put things explicitly in the language of social benefits and costs we have something like: treating Fred today makes it more likely that Jack will need treatment in the future.   
Fairness. Given that one of the main causes of Type 2 diabetes is lifestyle many people (not all) get Type 2 diabetes because of choices they consciously made. Should they be 'rewarded' for that? Fairness norms typically take account of intentions as well as outcomes. On that basis, someone would be seen as 'less deserving' of treatment if they partly bring about their own problems. So, society might be happier if the money was spent on, say, breast cancer than on people who have Type 2 diabetes because of lifestyle.

Relating cause and consequence in health outcomes is difficult. As is measuring the consequences of moral hazard. Again, however, to dismiss such things as too difficult to take account of seems like wishing a problem away. I think, therefore, the role played by social costs and benefits in health care needs a lot more thought and recognition.    


Tuesday, 8 July 2014

Stonehenge and fair pricing

We were recently passing Stonehenge and so stopped off to see what the new visitor's center was like. Given that we are members of English Heritage it was free for us to visit. Most visitors, though, were stumping up the standard entry fee of £13.90. And, to put it bluntly, £13.90 seemed like a bit of a rip-off.
         Why a rip-off? Stonehenge is a truly remarkable site. It is arguably best seen, however, from the many paths in the surrounding countryside - and these are completely free for anyone to walk. The entry ticket only gets you a 'little bit closer' to the stones. And I'm not sure that's worth £13.90. To put things in context I would make the comparison with Dover Castle (another English Heritage site). Dover Castle is more expensive at £19.30 but you get a whole lot more for your money - castle, wartime tunnels, museums, sea views etc. I would guess the average visitor to Stonehenge probably spends around 30 minutes at the stones while the average visitor to Dover Castle spends at least 3 or 4 hours.  
       While the entry fee for Stonehenge took me by surprise, the economist in me can easily rationalize it. We just need to look at supply and demand. When we visited Stonehenge it was heaving with tourists, all willing to pay the going rate. Dover has a steady stream of visitors but demand is clearly less (particularly when you take into account that many visitors are members and so get in for free). High demand can explain the relatively high fee. But does it make it any less a rip-off?
         One of the few research articles that studies attitudes to 'fair' pricing is Fairness as a constraint on profit seeking by Kahneman, Knetsch and Thaler, published in 1986. Their basic finding was that people consider it unfair to raise price because of shifts in demand. One question that beautifully illustrates the point is 'A hardware store has been selling snow shovels for $15. The morning after a large snowstorm, the store raises the price to $20. Please rate this action as: Completely Fair, Acceptable, Unfair, Very Unfair.' 82% of respondents considered this unfair. 
        My perception of Stonehenge being a rip-off partly fits this picture of unfairness. It seems unfair to charge a high price purely because of high demand. There seems, however, to be an important difference. The person buying a snow shovel knows what they are buying. A visitor to Stonehenge, by contrast, probably has little idea what they are buying. And they may think the price will be a fair one. In other words, the visitor trusts English Heritage to not rip them off. So, while the person buying the snow shovel will feel hard done by when he sees the price, The visitor to Stonehenge would will feel hard done by after seeing what they got for their money. 
         Despite the pioneering work of Kahneman, Knetsch and Thaler there is still remarkably little work done on fairness in pricing. This seems a topic in serious need of more study. And let me finish by clarifying that I am not having a go at English Heritage. As a charity they have to make money where they can. And if £13.90 does seem like a rip-off then membership will let you visit Stonehenge, Dover Castle and more!  

Thursday, 3 July 2014

Moral hazard and climbing mountains in flip flops

The Lochaber Mountain Rescue team in Scotland recently had to rescue someone who fell after setting off up one of Scotland's highest mountains in flip-flops. This looks like a textbook example of moral hazard. Moral hazard arises whenever someone (the principal) 'employs' someone else (the agent) to do a job and the agent takes 'more risk' than the principal would like. In this case mountain rescue essentially 'employs' people to not be dumb in the mountains, but too many of us are dumb in the mountains.  
        But, here's an interesting issue: In the textbook story of moral hazard the agent takes proper account of incentives. So, a person takes greater risk in the mountains because he knows that mountain rescue will save him. On this account, scrapping mountain rescue might negate the need for mountain rescue. 
        I would be surprised, however, if the three men involved in this story knew a great deal about Lochaber Mountain Rescue. Instead, I would suggest they were responding to a more generalized moral hazard 'if something goes wrong someone will save me'. With this more generalized moral hazard people are going to risks whether mountain rescue exists or not. So, you better have a mountain rescue.
        It is easy to see how such generalized moral hazard can become too big a burden on society. If people expect that 'someone will save me' then we need a lot more than mountain rescue. It always amazes me, for example, when listening to radio phone-ins and the like, how strongly some people feel that they have a right to welfare payments and benefits. It is a kind of 'because I am poor someone must rescue me' type of argument.
        Let's be clear. I am not arguing that we should scrap mountain rescue or stop transferring wealth to the poor. What I am arguing is that there needs to be a greater recognition such things involve voluntary transfers. People are not rescued off mountains by pixies, they are rescued by people who voluntarily give of their time. Similarly the money for welfare payments does not grow on trees, it is a 'voluntary' transfer from rich to poor.
        If we forget the voluntary nature of transfers then generalized moral hazard will be impossible to keep in check. Basically, we get a strange reversal of roles. It is supposed to be that because of mountain rescue people take more risk in the mountains. Or, because of welfare people take more risk with investing in their future. But, we increasingly seem to live in a world where people take risk in the mountains because they expect there to be a mountain rescue. And they take risk investing for the future because they expect the welfare system to save them.             

Friday, 6 June 2014

Antibiotics and the tragedy of the commons

In the last month or so I seem to have come across a lot of discussion on how to reduce use of antibiotics. The basic claim seems to be that we are entering a worrying stage where antibiotics lose their power to stop common infections. Only by reigning back our use of antibiotics can we avoid falling into the abyss. But how do we reign back our use of antibiotics? It is typical to refer to the tragedy of the commons when exploring the options available to us. Personally, however, I feel the tragedy of the commons is a misleading way of looking at the problem with antibiotics. Let me explain.
           The tragedy of the commons can arise whenever there is a resource that is limited in supply (rivalrous in the jargon of microeconomics) but that can be harvested by anyone (non-excludable). Water, fish, clean air and grazing land are the textbook examples. The tragedy is that we end up overusing the resource because each individual harvests as much as he wants, ignoring the negative effect this has on others. For example, the farmer fully irrigates his land, ignoring that this leaves less water for neighbouring farms. Or, the fisherman catches a boat load full of fish, ignoring that this leaves less fish for other fisherman or future generations.
           Antibiotics seem to fit the tragedy of the commons story. In this case the resource in limited supply is 'infections that can be treated with antibiotics'. The more we use antibiotics, the more drug resistant infections become, and so the smaller is the pool of infections that can be treated with antibiotics. If each individual takes antibiotics ignoring the effect that this has on others then we get overuse of antibiotics.
          If we think of the overuse of antibiotics as resulting from a tragedy of the commons then we have a simple solution. Namely, we need individuals to take into account the effect that their use of antibiotics has on others. One way to do this is through price - if we increase the price of antibiotics then use should fall. Another way is to educate people on the problems of overusing antibiotics with the hope they reduce use for social reasons. The latter approach is the one being favoured by policymakers. But, it also seems optimistic to expect much. Increasing the price of antibiotics would seem a surer way to reduce usage. And probably is best in terms of reducing the use of antibiotics in farming. There seems, however, something inherently wrong about increasing the price of antibiotics for human use. Why?
         In the standard tragedy of the commons story we have complete information - everyone knows the benefits and costs of using the good. The tragedy occurs because everyone harvests too much of the good. Increasing the price of the good looks a good way to reduce use. In the antibiotic case, by contrast, we have incomplete information - it is typically unknown whether the antibiotics will help a person or not. The tragedy occurs because too many people use antibiotics when they should not. Increasing the price of antibiotics is wrong because it penalizes those who need to take the antibiotics.
        The overuse of antibiotics does not, therefore, fit the tragedy of the commons story as well as it may at first appear. In particular, the problem is not so much the negative externality that one person's use of antibiotics imposes on another, but more the incomplete information about whether or not to use antibiotics. If we can solve the problem of incomplete information then we probably solve the problem of antibiotic overuse. And, fortunately, it seems as though science is on top of this problem because new methods are being developed to tell whether a patient needs antibiotics or not. Whether patients will trust to science is a different question.   

Sunday, 18 May 2014

Climate change is not just about cutting back

Recently I read the book Climate Change Begins at Home by David Reay. It makes for an entertaining read and persuasively argues that every family can substantially cut its greenhouse gas emissions. I particularly liked how the book puts the focus of tackling climate change on individual behaviour. Way too much climate change debate is about governments making agreements, even though such agreements are basically worthless. Governments can do little: it's individuals that pollute, and it's individuals that need to pollute less!
        The arguments Reay put forward in his book did, however, seem a bit naïve when it came to economics. He made the case, which one often sees, that cutting back on emissions is a win-win scenario. If a family uses the car less, uses the air conditioning less, goes for a local holiday rather than flying half way around the world, buys less plastic gadgets, and so on, then they benefit the environment and save money. At the level of the family this argument is sound. The problem comes when we apply it at the level of society.
         To see the point, suppose that a family reduces its production of greenhouse gas by 50%. In doing so it spends 50% less. For example, it buys less petrol, less electricity, less plastic gadgets, less airplane tickets, etc. In isolation the family should be happy. But, if every family in the country cuts spending by 50% then something has to give. GDP would halve overnight! Or, in more practical terms, many are going to find that they are out of job - we do not need so many people refining oil, selling petrol, producing electricity, flying aeroplanes, etc.
         Tackling climate change requires more, therefore, than families cutting back on greenhouse emissions. It will require far bigger fundamental changes in the economy. This will primarily mean a shift away from the materialistic world we appear to have converged on. In particular, basic logic suggests we are going to need a 50% cut in income to go with the 50% cut in spending! This need not come at the cost of happiness, because all we need to do is cut out unnecessary things that were not needed anyway. And we know that more income does not buy more happiness. But, whatever the framing, a cut in income of 50% is not going to be very popular.
         So, tackling climate change will require a fundamental change in the economy. Does that change the individual incentives to cut back on greenhouse gas emissions? No. Popular discussion of climate change essentially seems to suggest the 50% cut in income has to proceed the 50% cut in spending. And, therefore, individuals (and governments) are reluctant to sign up to tackling climate change. But, this gets things the wrong way around! The 50% cut in spending will proceed the 50% cut in income. It is better, therefore, to be ahead of the game and reduce spending now. This way you save money in the short term and are prepared for any shift in the economy that may subsequently follow. 

Monday, 5 May 2014

Obesity and nudging over the long term

A recent issue of Nature had a special report on obesity. One of the articles looked at the merits of  behavioural interventions in tackling obesity and came to a somewhat pessimistic conclusion. In particular, the article pointed to evidence that behavioural interventions produce only short term gains - weight loss over the first 6 to 12 months but creeping weight gain thereafter. This is bad news for anyone wanting to tackle obesity. It also raises questions about the general benefits of behavioural interventions.
        And this second point is especially interesting given that behaviour change is very much a buzz idea at the moment. Richard Thaler and Cass Sunstein have done most to publicize the idea with their book Nudge, but they are by no means the only advocates. The popularity of behaviour change stems largely from its seeming simplicity and cost effectiveness: people's decisions are effected by the way choices are framed and so framing choices in a particular way change change behaviour in predictable and desirable ways. 
         The nudges that have received most attention are those explicitly related to financial decisions like saving for retirement, paying tax returns etc. But, eating also seems an area apt for a bit of nudge. For example, smaller plates might mean you eat less, the positioning of food in the canteen buffet might mean you make healthier choices, keeping a food diary may mean you eat less and make healthier choices, a pedometer app might mean you walk more, and publicizing your exercise or weight loss plans to friends and family might make you more likely to stick to plan.
        The continuing interest in behaviour change is evidence that it has delivered results. Nudges have proved successful in increasing saving, reducing tax evasion and so on. But, what if the gains are only short term, as the experience in tackling obesity suggests? Clearly this sounds like bad news for advocates of behaviour change. To me, it suggests two important caveats that need to be kept in mind when thinking through the consequences of behaviour change:
        1. Some decisions we make very infrequently, such as how much to save for retirement. Some decisions we make very frequently, such as what to have for dinner. 'Short term' can, thus, mean widely different things depending on the context. Nudges can have 'long lasting' success if decisions are made infrequently; if, for example, you change your retirement saving plan then you may be set for life. But, nudges may wear off quickly if decisions are made frequently; if, for example, you buy some smaller plates you may eat less for a month or two but soon be back to normal.
       So, why do the effects of nudges wear off? Nudges work by changing framing and that works because of the heuristics we use. If, for example, you use a heuristic 'fill my plate one cm high with food' then buying some smaller plates means less food. This, though, need not change your underlying preferences. So, after a few months of feeling hungry you likely adapt your heuristic to, say, 'fill my plate two cm high with food'. (Note that this means you then end up eating more when you go to the self service canteen!) Such adaption suggests that, in a context where decisions are made frequently, nudges may not be enough. A more fundamental 'change in preferences' is required.
        2. But how do we 'change preferences'? Preferences are largely determined by culture, norms and the like. So, changing the behaviour of one person is a drop in ocean. Instead, it may be that society as a whole needs a nudge in the right direction. And that likely requires some big policy intervention.
        The article on obesity, with which I began, concludes: 'Ultimately, the only effective, sustainable solution - on a large scale over the long term - may be to change the culture. "The issue to me is not whether or not behavioral interventions work," Katz [director of the Yale-Griffin Prevention Research Center] says. "There's absolutely no question to me that they are the thing we have to depend on." But even the most comprehensive programme, he says, is no match for a culture built around calorie-dense foods and sedentary lifestyles. "Behavioural interventions are a very slow march forward on a walkway that's going in reverse".


Monday, 21 April 2014

Stealing the opponents team sheet and mixed strategies

Recently, in the Premiership football, Crystal Palace beat Cardiff City 3-0. Nothing particularly unusual about that. But it subsequently came to light that Crystal Palace had used underhand means to obtain the Cardiff team line up ahead of schedule. Cardiff, obviously, cried foul play. This incident reminded of the 2008 Ryder Cup golf when Nick Faldo was photographed with a set of team pairings. In that case there was no foul play. There was, though, the notion that the US gained from knowing the European pairings.
       To make sense of why it may, or may not, be useful to know an opponents strategy we need to look at mixed strategies. To illustrate, consider the simple matching pennies game below. Europe can choose two possible team line ups, A or B, and the US can also choose two possible line ups, X or Y. If Europe chooses Team A and the US Team X then Europe wins (which is why Europe gets payoff 1 and the US payoff -1). If Europe chooses Team A and the US Team Y then the US wins, and so on.
         In this game it is clearly not good to let the opponent know what you intend to do. For example, if the US knows that Europe will choose Team B then it can choose Team X and win. This is why there are typically somewhat elaborate procedures to make sure team line-ups are disclosed simultaneously. It is also why mixed strategies become appropriate. Mixed strategies can be difficult to interpret, but the basic idea is simple enough - the only way to keep the opponent guessing what you intend to do is to not know what you intend to do yourself! You should, therefore, randomly decide what to do. Europe, for example, could toss a coin to decide whether to use line-up A or B.
         Now let's go back and think through the practical implications of knowing an opponents plan ahead of time. To fix ideas, let's assume that the US 'knows' Europe's team will be A. Here are three basic possibilities to consider:
1. Suppose no one knows that the US knows Europe's team will be A. Then the US does have a clear advantage. It can choose line up Y and win.
2. Suppose everyone knows that the US knows Europe's team will be A. This was the case in the Ryder Cup given that the photo appeared online, in the newspapers etc. Then Europe clearly has chance to change it's team line up. Which means we are effectively back to the US not knowing Europe's team. In other words, the US has not gained anything.
3. Suppose Europe knows the US knows their team will be A, but the US does not know that Europe knows. This was the case in the Crystal Palace - Cardiff match where Cardiff were told the team had been leaked. Given the US thinks Europe will choose A, they should choose Y. But, that means Europe can choose B and win! This time it is Europe that gains from their team being leaked.
          The consequences of knowing what an opponent plans to do depend, therefore, on who knows what about who knows what. So, why do we naturally assume a team gains an advantage from knowing what an opponent plans to do? It could be we have scenario 1 in mind. It could be we just get confused. Or, it could be that there is some other advantage not captured in the simple matching pennies game. One thing not captured in the matching pennies game (but clearly important in sport) is the role of practice. Let's see what difference that makes.
          Suppose it takes a time one week to practice with a particular line up. So, we have the timing: choose the team on Sunday, practice until Friday, make the team line up public on Saturday and then play the match. The game then changes to something like that below. We recognise that Europe may have planned to use line up A, and practiced with that in mind, but changed to line up B at the last minute, and so on. In terms of payoff we see that changing the line up may have costs. For example, if Europe changes from A to B while the US chooses Y as planned then rather than win for certain, either team is equally likely to win (as captured by expected payoffs of 0).
          Consider again scenario 2 where everyone knows that Europe planned line up A. If you look carefully through the numbers you see that the US has still gained no advantage from knowing what Europe planned to do! If the US planned to choose line up X then Europe is in a good position. If the US planned to choose line up Y then the US is in a good position. The crucial thing to take into account, however, is that the US cannot go back in time and re-plan what it was going to do. So, no team gains.
          What about scenario 3? Then Europe is still in a good position despite the US knowing their team. They can no longer be guaranteed to win, because they might have been practising the wrong line-up. But, they still gain an advantage.
          Needless to say, the two simple games considered here do not capture everything that goes on in a sport context. I think the basic message does, however, follow through much more generally: knowing what an opponent plans to do is of very little benefit if the opponent knows that you know what they plan to do. So, Cardiff City do not have too much to complain about.   

Monday, 31 March 2014

Pensions and present day bias

In the UK budget a week or so ago the Chancellor surprised most by announcing a radical shake up of the UK pension system. According to the old system retirees, with a private pension plan, were essentially forced to buy an annuity that would smooth income over their remaining life. Under the new system retirees can withdraw the money and spend it as they wish. So, if they want to splash out on a Lamborghini sports car then fine (according to the pensions minister). 
           What has interested me most about the pension changes is the public reaction. Immediately, people began questioning whether it made sense to let retirees have freedom of choice. Are pensioners capable of make informed rational decisions about how to spend their savings? Will they not blow it all and be left to live out their lives on state support? To most people it seemed obvious that some might make dumb, inappropriate choices. And, for me, this illustrates how divorced from reality economic theory has become.
          Thankfully, we now have a theory of why people may make inconsistent choices over time (see, for example, the article 'Doing it now or later' by Ted O'Donoghue and Matthew Rabin). The theory points towards time-inconsistent preferences with a present day bias. The bias basically means we treat today as 'special' relative to the future. And that means we may be unable to stick to long term plans. For instance, on Friday you might plan to clean the garage on Saturday, on Saturday you think 'maybe next week', and on Monday you regret not cleaning the garage. The present bias in this example manifest's itself on Saturday: From the perspective of Friday or Monday, Saturday is just any other day. But, when Saturday is today it's special, and you do not want to clean the garage!
          Everybody is surely familiar with the consequences of time-inconsistency - planning to do something, but then not wanting to do it when the time comes. The idea that pensioners might blow all their pension money unwisely seemed common sense to most. Standard economic models, however, take no account at all of time-inconsistency. And even though we now have simple models of time-inconsistent preferences it is very rare to see them applied. A fundamental part of human behavior is, therefore, completely neglected by standard economic theory! That's weird, and frankly, makes economics look silly.
         This divorce between reality and theory is a consequence of economists becoming trapped in a world where people are assumed rational, even though we know people are systematically biased in many ways. To date, behavioral economics has done nothing more than chip away at the edges of this monolith. Hopefully, things will change in the future.
       But, what of the liberalization of the pension rules? Some argue that because of time-inconsistent preferences the changes will be harmful. And, no doubt there will be some who blow their pension money in a way they subsequently regret. The old system, however, forced everyone to buy an annuity despite their being many for whom this was not the best option. Trading off the interests of some against others is always difficult. But, I think the old system was clearly weighted too much on the side of those likely to blow the money. Many were having to choose bad options for the benefit of a few who could not be trusted to spend the money wisely.
          Present bias does exist, however. And so it is still important to try and nudge pensioners to spend their money wisely. Note, though, a fundamental characteristic of a good nudge - it should not limit the options available. The pension reforms announced by the government fit this model - they liberalize choice while still nudging pensioners in the direction that will be sensible for most.

Wednesday, 19 March 2014

Breastfeeding, externalities and the Coase Theorem

Saturday morning I heard a somewhat intense debate on the radio about whether a mother should breast-feed in public. The debate was sparked by an incident in a restaurant where a breast-feeding mother was asked to 'use a blanket'. Views were completely polarized. Some, like me, thought it outrageous to criticize someone for breast-feeding in public. Others, thought it outrageous to breast-feed in public! This polarization of views is a perfect illustration of the reciprocal nature of externalities, first pointed out by Ronald Coase.
        The 'textbook' picture of an externality is typically one of good and evil, like a factory polluting the water that local people drink. The clear suggestion is that the evil doer, the factory in this case, should take account of the effect they have on others. Often, however, externalities do not lend themselves to a simple good and evil. That's the case in the breast-feeding example: Some would place the breast-feeding mother in the role of evil and others would place the person complaining about breast-feeding in the role of evil.
        Given that the breast-feeding example has no clear distinction between good and evil the reciprocal nature of externalities is simpler to appreciate. In particular, a woman's breast-feeding in public creates a negative externality for those who do not want to watch someone breast-feeding. But, banning breast-feeding in public creates a negative externality for any mother forced to feed her baby in the wash-room. To stop a negative externality inevitably creates a different kind of negative externality. And note that this holds even if we have a clear distinction between good or evil. To ban water pollution, for example, imposes a negative externality on the factory.
         An appreciation of the reciprocal nature of externalities led to Coase's celebrated theorem on how to increase efficiency in the presence of externalities. The theory essentially says that if there are clearly defined property rights (and negotiation costs are negligible) interested parties will negotiate towards an efficient outcome no matter who owns the property rights. For example, if local people have the property right they could charge the factory for its pollution. While, if the factory has the property right it could be paid by local people to reduce pollution. Similarly, if the person who does not like to see breast-feeding has the property right she could charge someone for breast-feeding. While if the person who breast-feeds has the property right she could be paid to breast-feed in the wash-room. These charges or payments correct incentives and 'eliminate' the externality.
          Well, that is the theory. In practice, I think the breast-feeding example points to a fundamental floor in the application of the Coase Theorem. We know that people dislike 'unfair' outcomes. And that they would rather 'suffer' than accept an unfair outcome. This suggests that someone may be unwilling to negotiate towards an efficient outcome unless they believe that they are in the position of evil. Consider, for instance, the factory example: The idea that the factory would compensate local people for pollution seems entirely reasonable. The idea that local people would pay the factory to reduce pollution clangs with common sense. And what about the breast-feeding example: If the breast-feeding mother believes it is her basic right to breast-feed in public she is not going to want to pay to breast-feed. And if the person who does not like to see breast-feeding believes it is her basic right to not see breast-feeding she is not going to want to compensate someone for not breast-feeding.
          The basic point here is that an assignment of property rights does not change beliefs. British law clearly gives the property right to the breast-feeding mother, but that does not change the beliefs of the person who does not want to see breast-feeding. In a similar way, British law clearly gives the property right to people who do not smoke cigarettes, but that does not change the beliefs of the those who think they have the right to smoke. The Coase Theorem may, therefore, be of somewhat limited applicability. So, while it is important for governments to assign property rights for distributional reasons, as in the breast-feeding case, do not expect to see the most efficient outcome as a consequence.

Friday, 14 March 2014

Add-on insurance and default options

One of the most basic and intuitive ideas that has come out of the behavioural change literature is the opt-in versus opt-out distinction. Essentially, because of psychological bias, people are likely to end up 'choosing' the default option. So if, for example, the default option is to not be opted into a pension savings plan a person is likely to end up not saving enough for retirement. This simple observation partly motivated the save more tomorrow plan that stands to revolutionise retirement saving.
        A context where default options are often used strategically is check boxes on online (or hard copy) forms. Suppose, for example, you want to travel from London to Birmingham and go to book your ticket online. If you are going by train then once you've sorted out the times of the trains etc. you will be offered the chance to buy basic travel insurance. In this case the box is not ticked and so the default option is no travel insurance - you have to click a mouse button to get insurance. If you are going by coach, by contrast, the box is ticked and so the default option is travel insurance - you have to click a mouse button to remove the insurance. The Financial Conduct Authority is concerned that such default opt-in options are essentially a form of miss-selling and so should be banned.
         To the standard economic model this all seems a little crazy. There is seemingly no-cost at all in clicking a mouse button to switch from opt-in to opt-out. And travel insurance is a product that some people might want to buy. So, why should we be banning default opt-in options? Should we not put the onus on consumers to make sensible decisions?
         To get some insight on these questions I think we need to take a step back and ask why default options matter. The standard reason given for why defaults matter is procrastination. A person, for instance, puts off changing their pension plans, until tomorrow, and then the day after, and then the day after that. Before long they have retired without the savings they hoped they would have. But, while this can explain the success of the save more tomorrow plan it says nothing about online check boxes. In the latter case the form is being filled here and now and so the decision simply cannot be left until tomorrow.
          We need, therefore, to question why defaults can matter beyond procrastination. I'll point to two reasons. First, we have a psychology bias to 'trust the seller knows what we want'. We naively think that the default option must be the right option - why else would it be the default. A little thought shows that this logic is really naïve - the seller wants to make as much profit as possible. But, we still fall for the trap. And things get worse when we take into account a second factor, namely that of anticipated regret. By unchecking the box to buy default travel insurance you set yourself up to feel regret if the insurance would subsequently have been useful. The fear of that regret may bias you towards sticking with the insurance. This is a variant of the endowment effect - you value something more when you feel you already own it. Observe how ridiculous this can end up being: When you sat down to buy the tickets you had no thoughts about travel insurance. But once the 'seed is in your head' and you have to 'consciously do something' to opt-out, travel insurance suddenly seems an essential!
          Seen in this light, I think the Authority is right to get involved and ban default opt-ins. They are essentially a way of 'fooling' the customer into feeling they need something they do not. To say that consumers have the choice to opt-out is not really the point. Consumers are forced to consciously opt-out of something and pay the psychological cost for doing that. Indeed, notice that everyone suffers - some buy something they do not need, while others pay (a small) psychological cost of 'giving something up'. If travel insurance is worth buying the onus should be on the company to prove its worth buying. 

Monday, 24 February 2014

Curling and the minimax theorem

Every four years, as the Winter Olympics hits town, a sizable proportion of the British population falls in love with the sport of curling. And that offers the chance to look afresh at game theory's 'first big result' - the Minimax Theorem. 
       Curling is often called 'chess on ice'. But, that analogy only goes so far because chess is a game of complete information and curling is not: If a chess player intends to move a bishop to E4 then we can be pretty sure he will move it to E4. He is not going to mistakenly move it to D3, and a gust of wind is not going to move it F5. Curling, by contrast, involves both skill and luck. Skill is required to put the stone where it was intended. And luck is needed because debris on the ice can deflect a stone, and so on. So, while chess is a pure game of strategy, curling is a game of strategy, skill and luck. 
          The fact that chess is a pure a game of strategy makes it relatively easy to analyze. It is no surprise, therefore, that chess has played an integral role in the development of game theory. But, the fact that chess is a pure game of strategy also makes it a relatively boring game to watch! The Minimax Theorem helps 'formalize' this latter point. One element of the Theory says that in a zero-sum game (of which chess is an example) any Nash equilibrium yields the same payoff to players. In principle, this means that if both players behave optimally the outcome - white wins, a draw, or black wins - is predictable before the players sit down to begin their game. And that does not make for much exciting! 
         To see this in practice consider a simple game like tick-tac-toe (or noughts and crosses). It does not take much time to realize that the outcome if both players behave optimally is a draw. And once you know that, there is not much fun in playing. With chess things are not quite so simple, because the game is complex enough that we do not know the optimal strategy. That's why grandmasters still compete. Grandmasters will, however, concede a game well before the game is technically over because the outcome is clear. And, this level of predictability does not lend itself to much excitement for people watching. 
       The skill and luck involved in curling makes the outcome much less clear. That can generate more excitement. Unpredictability can also, however, lead to a more fundamental difference than that generated by pure random chance. That's because of the way it changes the optimal strategy. Let me explain: At first sight the 'optimal strategy' in a game will typically be a 'boring' one. In curling, for instance, once a team is ahead in the match they can play a 'boring' strategy of keeping the house clean in order to maintain their advantage. In a game of complete information, like chess or tic-tac-toe, there is no point in doing anything other than the boring strategy because you can be sure it will succeed. In a game of incomplete information, however, the boring strategy is risky. It is risky because it might not work, and losing with a boring strategy does not go down well.
        To illustrate the point let me contrast two curling matches from the Winter Olympics. In the men's semi-final between Britain and Sweden, Britain had the chance to employ a boring strategy and chose not to do so. It nearly cost them, but they hung on and are currently the toast of Britain. In the women's final between Canada and Sweden, Canada did opt for a boring strategy. As soon as they did so the commentators became critical and many were hoping it would fail. It did not fail, but the point is still made. If Canada had lost that game playing such a strategy they would have been roundly criticized by everyone. The possibility of such an outcome may mean the boring strategy was not optimal. 
        My conjecture, therefore, is that in games where skill and luck play a role players will have a tendency to shun 'boring' strategies. If a boring strategy is no guarantee of success then it is just too risky. This makes for a more exciting game. And we don't have to stick with curling to see this in practice. Football and cricket teams, for example, that lose with a 'boring' strategy never get much praise.  

Monday, 3 February 2014

Testing kids: Are tests for four year old children a good idea?

The last few decades have seen a huge rise in testing and performance monitoring within the English education system. The latest installment is a call for testing of four year olds when they enter the school system. The objectives of such policies are fine enough - this one, for example, will supposedly allow teaching to be more tailored to students needs. There are, however, two big problems with testing in schools. In short these are that: (i) Tests are often poor measures of what is being assessed. (ii) Tests change incentives. Let me elaborate on each of these problems in turn.
       How can you measure ability? Exams and tests provide a simple to administer measure. They provide, however, a very, very noisy measure - in other words they often give the wrong impression. And the earlier one does testing the more noisy it is surely going to be because children naturally develop at different speeds. The fact, though, that tests can be wrong is not, in itself, a problem. The problem is that we are biased towards underestimating how wrong tests can be. In particular, the law of small numbers and confirmatory bias kick in and mislead. 
        The law of small numbers says that we tend to infer a lot from a little. So, if we see Sarah doing badly in a test and John doing well we infer too extreme a difference in their relative ability. Confirmatory bias then means that we tend to see events as confirming our initial beliefs. Basically, Sarah would get a lower mark than John, for subsequent work, even if they write exactly the same thing, because John gets the benefit of the doubt when Sarah does not. As a lecturer I have learnt over the years the power of the law of small numbers and confirmatory bias - and it can be very powerful indeed. That is why I prefer anonymous marking and always try to mark work without reading who wrote it. ('Good' students, notice, have an incentive to make sure I do see their name!)
        Given the power of the law of small numbers and confirmatory bias we should avoid noisy measures of ability. That, for me, suggests we should avoid tests that are not absolutely necessary. Or, at least, if we are going to have tests we should view them more as formative and part of the learning process, rather than important measures of ability. Otherwise, we are in danger of children being labelled into self-fulfilling prophecies of success and failure as a result of some meaningless test.
        All of this is compounded by the fact that tests change incentives. The more importance we place on tests the more incentive the child, parent and teacher has in getting a 'good' mark. This is obvious - but all too often overlooked. One only has to go to the average school and listen to the parents talking at pick up time to realize how competitive parents can be. Parents, understandably, want their child to be best. And that clearly means they will happily coach their child for a test. Indeed, given the law of small numbers and confirmatory bias this is exactly what a parent should be doing! This is one reason that tests are highly noisy measures of ability.
        To criticize testing is easy enough. But are there alternatives? Measuring ability and performance is crucial. The current trend, however, is towards tests and performance measures that give 'simple numbers' that can easily be put in charts, league tables and the like. Such convenience is misleading because ability and performance are not easily measured and compared. More nuanced and rounded measures are, therefore, to be preferred. Teachers clearly do form an overall picture of a student. The schools inspectorate Ofsted forms an overall assessment of a school. These kinds of measures have far more chance of being closer to the truth.   

Monday, 27 January 2014

Running with the Kenyans and human capital formation

Over christmas I had chance to read the book Running with The Kenyans by Adharanand Finn. In short the book is about a British guy's experience of immersing himself for six months in the Kenyan running culture. A recurring theme throughout the book is the question of why Kenyan's have come to dominate long distance running. The answer clearly depends on a number of things like high altitude, running to school etc. But the main thing seems to be a culture of running. Kenyans run because that is what Kenyans do. So, what has that got to do with economics?
       There can be no doubt that Kenyan athletes take running very seriously. In other words they put in hours and hours of training (and perhaps more importantly put in hours and hours of dedicated rest). An economist would think of this as human capital formation. All the hours of dedication to running are about the person improving their ability to run fast so that he or she can eventually win some races and make some money and get some reward. It is a person's investment in future productivity. Very few Kenyan athletes go on, however, to win races and make money. For most the investment in running does not pay off in terms of increased productivity. Currrent economic theory is very poorly placed to explain outcomes like this. 
       The textbook model of human capital formation primarily focuses on how much to invest in human capital formation. Implicit in this seems to be an assumption of 'linearity' from less well educated and less productive to well educated and more productive. For example, years of schooling and achievements at school or university are seen as good measures of productivity. Reality is, however, far more multi-dimensional that this. Put another way, human capital is not always very transferable. For example, a Kenyan who has spent years training to be a runner is not going to do well as an economics professor. And a Brit who has spent years doing economics is not going to win many marathons. Someone investing in human capital not only, therefore, has to decide how much to invest they also have to decide what to invest in. Should they train to be a runner, economist, physicist, pianist, actor, writer, .....
       Once we recognize the multi-dimensional nature of human capital we realize the matching problem inherent in labour supply. Society is only willing to support so many Kenyan athletes, or concert pianists, or economists. Inefficiency in solving this matching problem is why most Kenyans, despite being faster than the best British athletes, do not make it as professional runners. And reasons we end up with such inefficiencies are not hard to find. Most crucially, human capital formation takes a long time and is basically irreversible. People cannot, therefore, learn from experience. And how is a teenager supposed to know where best their future lies? Things are made even more complicated by the winner-take-all nature of many of the professions that require high human capital. Because only a handful of athletes make serious money the law of large numbers 'smoothing' effect does not come into play. This results in a big drop between being good enough and being not quite good enough. Again, how can a teenager know they are going to be good enough? Do not expect good choices.
        I got interested in the matching nature of the labour market in the early days of my PhD (with one paper to show for it). At that stage I felt a frustration at how poorly the matching within the labour market were understood. From what I can tell, not much has come along to improve our understanding. So, why are economists not studying this more? I would suggest an unwillingness to accept the basic ad-hoc nature of the labour market is the main issue. If I look back at my life: there was no grand plan to be an economist or invest in specific types of human capital; there were though lots of events that could have easily been different, and if they had been different I would not have been an economist. Most people surely stumble through life in a similar way. Acknowledging this is a big step from the standard economic models of utility maximization. But it can help explain why Kenyans go out running despite little chance of winning the New York Marathon. It can also help us better understand unemployment, skills gaps, and income inequality.