Wednesday, 31 March 2010

Cognitive versus neuro models

This article (from Jonah Lerner at Science Blogs, via Farnam Street) looks quite important at first:
A recent study led by Brian Knutson of Stanford, Drazen Prelec of MIT and George Loewenstein at Carnegie Mellon [LC: a good start - I met Prelec at a seminar last year, very smart guy - and Loewenstein wrote my favourite behavioural economics book]
...when subjects were shown pictures of an object they wanted...brain areas associated with anticipated rewards, such as the nucleus accumbens, exhibited a spike in activity...
When the experimental subjects were exposed to the cost of the product, their insula and prefrontal cortex were activated. The insula secretes aversive feelings, and is triggered by things like nicotine withdrawal and pictures of people in pain. In general, we try to avoid anything that makes our insula excited. Apparently, this includes spending money...
...this data directly contradicts the rational models of microeconomics. Consumers... don't... perform an explicit cost-benefit analysis. Instead, we outsource much of this calculation to our emotional brain, and rely on relative amounts of pleasure versus pain to tell us what to purchase.
Now you can interpret this experiment in two ways. One is to assume that we need to properly understand the structure of the brain in order to understand behaviour. If this brain area is stimulated by anticipated pleasure, and that area responds to pain and prices, then it's all about neuromarketing. We need fMRI to understand our customers.

The other way is to say: never mind the brain. Cognitive models deliberately ignore the structure of the brain, and instead look at higher-level concepts like attention, knowledge and preferences. The fact that some of these preferences originate in specific brain areas is completely irrelevant.

I have to say, unless you're planning to carry out surgery on your customers' brains, the second approach is really the only one to go for. The neural input is interesting in this experiment, because it provides some evidence for what the underlying preferences might be - but in this case it tells us little that we couldn't already infer from behavioural data. Or from two hundred years of marketing experience.

Anyway, the article's still worth reading for some tips on how to lay out your store to point your consumers' attention to the preferences that suit you. The result?
...all those details of the Costco shopping experience make us more likely to spend money. The bare bones warehouse aesthetic, the discounted house brand, the constant reassurance that we're paying "wholesale" prices - it's all an effective means of convincing us to not worry so much about the price tag. As a result, we're able to focus entirely on our anticipated pleasures, which is why I walk out of the store with all this stuff I don't need.

Tuesday, 30 March 2010

Beyond obliquity

John Kay's new book Obliquity: Why our goals are best achieved indirectly (whose launch at the IPA was hosted last night by Rory Sutherland) follows in the tradition of a number of recent books about decision-making and rationality. Indeed, he mentions Predictably Irrational and Blink in the first ten pages. It goes beyond them in a couple of interesting ways, but leaves some questions - perhaps deliberately - unanswered.

One of my favourite books on business is also by John Kay: The Hare and the Tortoise: An Informal Guide to Business Strategy. I'd recommend it to anyone involved in guiding the strategy of their firm. You need only read a few pages to appreciate the wisdom and insight of the author, and so I have been looking forward to reading this new book.

Kay's definition of obliquity can be summarised as:
  • Aim for diverse goals other than your direct objective. The companies that make the most money are not those whose primary goal is to make money.
  • Accept the limits of knowledge and using a strategy of gradual adaptation
  • Use more judgment, less quantitative analysis
This book is more nuanced than some of its peers because of his willingness to accept that there are situations where the analytic, direct approach is appropriate. He provides a checklist outlining situations where direct approaches are viable, and others where they're not. But the deeper answer must be to find the right way to combine both.

Indeed he touches on this too:
" is too easy to jump to the conclusion that poetry and science do not mix, that poetry is oblique but science direct...The world that seems inevitably oblique - the world of poetry - is not without rules or criteria."
There are times in the book when Kay drifts away from this position. One of the concepts he sets himself firmly against is the idea of single quantitative measures. There can be no single profit figure, or human development index, or educational measure, which we can optimise to achieve the outcomes we want.

This can be construed as a direct challenge to the discipline of economics - which is the study of what we do when things are scarce. The immediate problem with Kay's view is that we have to make choices all the time. Because there is scarcity in the world, we cannot allocate our money or our time to everything. How can we decide between two incommensurate options? In order to choose one, there must be some process of comparing and weighting going on in our heads. Ultimately, whichever one we pick is given a measure of 1 - and the other choice 0.

But that's too simplistic an objection. There is indeed no single measure that can be optimised at all times. Think of Arrow's Impossibility Theorem, which says (roughly) that there can be no voting process which accurately ranks individual preferences into a society-wide choice. This technically applies to a whole population - and gives a clue to why companies succeed when they have multiple objectives that different people can commit to at different times - but it's also easy to see the analogy with the decisions of an individual who has multiple objectives.

Thus, when we make a decision, we are temporarily ignoring some of our objectives - and not, as rational theorists would have it, integrating them all into a single maximal utility measure. But this does not mean we have no mechanism for making the decision.

The trick is to understand how individual, small-scale decisions are made, which is a process that can be analysed. Not perfectly, of course, not with a simplistic utility measure, and perhaps with some randomness involved - but it is not a black box.
"We don't reach decisions about how to behave, what should go into a poem, what to teach or how to run a company as a result of performing some direct process that begins with abstract speculation about these large and general questions. We reach these decisions through an oblique process of negotiation, adaptation and compromise."
Indeed. But this oblique process does have some rules and some recognisable, repeatable, analysable components.

Ironically, Kay disapprovingly quotes Herb Simon on artificial intelligence - but Simon was the first to coin the phrase "bounded rationality", recognising that people cannot take everything into account when they make decisions.

Kay's introduction suggests that, instead of complaining that people are irrational, we should change our understanding of rationality. I couldn't agree more. But there is a meaningful way to talk about rationality, which reflects both how we really make decisions and also understands why we get good outcomes from doing so. It simply requires scaling down our ambitions and looking closer at the fine grains of behaviour.

Physicists have learned to apply the laws of motion of a pendulum only to long pendulums slowly oscillating at a narrow angle. When they retain this modesty, their predictions are virtually perfect. But if you try to predict how a ball on a chain will move when violently jerked or pulled out to a 90% angle, you will get it wrong.

Economists are meant to know this too. Microeconomists focus on marginal changes because they are tiny movements in a continuous variable, so that certain assumptions which held before the change will still hold throughout and after it. But if they extrapolate from a marginal change to assume that all changes are marginal, they fail.

So don't throw away your rules; just know their limits. Sometimes, with the right mathematics, you can derive large-scale behaviour from small-scale decision rules. The two are rarely the same, but they are still related.

A table in chapter 13 ends with this comparison:

TopicThe directThe oblique
Process rationalityGood decisions are the product of a structured and careful process of calculation.Good decisions are the outcome of good judgment.

In fact, good decisions are the outcome of good judgment, which in turn is the product of a process. We don't know what that process is while we're doing it, but what goes on inside that judging mind is capable of being understood. Kay doesn't explore that question - it's not that kind of book - but I hope he'd agree that it's a valid question to ask.

In the final chapter, Kay dismisses the concept of decision science. In its business-school definition: a science of how we should make decisions - he's right to do so. But in its meaning in the psychology department - a science of how we do make decisions - it's valid and indeed immensely powerful.

And this is where we come back to Rory Sutherland, who introduced last night's talk in the middle of the IPA's course on behavioural economics. Rory knows his audience and exactly how to perform for them. So I'm not sure whether we disagree on the value of scientific, testable cognitive models, or if he just chooses not to focus on them. [Rory's comments on obliquity are here]

The task for behavioural economics now is to go beyond enumerating the ways in which we depart from economic rationality, and to integrate the low-level discoveries of cognitive decision theory into models that can say something about why our behaviour and our judgment are the way they are.

Just like obliquity:
"Obliquity doesn't mean that we should stop thinking about objectives, fail to examine options or omit to seek information and understand as best we can the complex systems that we deal with. Far from it: we should start and continue. The alternative to a 'rational' process of defining objectives, evaluating options, modelling consequences is an approach that is oblique, but truly based on reason and evidence."

Monday, 29 March 2010

The narrow banking distraction

Two years later, we're still hearing about narrow banking as the solution to the problem of risky behaviour by financial institutions.

In fact, most of the problems that led to the 2008 bailouts were barely related to investment banking. The primary cause of the financial crisis was a collapse in the value of mortgages extended by deposit-taking institutions.

The sheer volume of mortgage lending was indeed partly enabled by investment banks, helping commercial banks to securitise the loans. But separating those from the deposit-taking banks would not have stopped this.

So is there a way to stop this from happening again? What was it that led banks to take these risks, and why did they pose a problem for the whole financial system? Why did we need to bail them out?

The size of banks is a potential risk factor. And the Volcker plan to impose a tax on wholesale borrowing and a cap on the size of individual banks would help with this. But if, instead of ten huge institutions lending too much on overpriced property, we'd had fifty smaller ones following the same policy, we'd still have ended up bailing them all out.

The real problem has been identified by Garett Jones in a prescient tweet earlier this year. Not "Too big to fail" but "Too correlated to fail":
In a financial crisis, TBTF seems to matter less than Too Correlated To Fail. Type-of-asset beats out size-of-liability.
The problem was that nearly every bank put its money into the same asset class. This both exposed the system to a much higher risk, and in itself contributed to the bubble in property prices.

But isn't capital supposed to diversify automatically? If too many people invest in one thing, its price should go up and other investors should find cheaper opportunities elsewhere. Unfortunately, these signals were not working properly. Partly this is a result of investors buying not to make a normal return on capital, but in the hope of selling to another investor later.

And partly it is caused by an network externality of information - that is, the fact that once a certain product is shown to make money for a bank, they are much more likely to invest in that product than others. In an efficient competitive commodity market, evidence that one product is profitable will marginally bias investors towards that product. But in a market which is information-driven, that little bit of extra evidence can completely transform behaviour, causing investors to pile into the profitable product and neglect others.

It's not hard to see that this happened in the financial markets throughout the period from about 2004 to 2007. Once mortgage-backed CDOs were shown to work, they became the asset of choice for investors controlling trillions of dollars; and the flow of money pouring into them made them even more profitable, reinforcing the belief that they were a smart thing to buy.

It's part of a regulator's job to combat externalities by putting the correct price on them. Sometimes an externality imposes a social cost - and highly correlated lending certainly does. If the market doesn't impose its own cost - and as we've seen above, it may not do - the state or regulator should impose a cost to correct the distortion.

So the key banking reform to make the financial system more stable is: putting a price on correlation.

How this can be achieved will be the subject of another article later this week.

Update: Niklas Blanchard's latest item reminds me that he's written along similar lines recently: "Too brittle to sustain".

Sunday, 28 March 2010

The economics zeitgeist, 28 March 2010

This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.

I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

I use Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

You can also see the Java version in the Wordle gallery.

If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.

Economists and their doubles

Easy people to confuse:

One is a talented young ingenue who has received lots of media coverage recently and can look forward to a prominent Wall Street role...and the other is an actress.

Saturday, 27 March 2010

Forced to close!

According to this article, a pub in Plymouth has been "forced to close". How terrible! What kind of totalitarian regime must they have there which forces pubs to close?

Well,'s not quite like that:
The pub, the third oldest in Plymouth, was losing £4,500 a month, according to landlords Clive and Gillian Philpott.
"People were still coming in but they weren't drinking as much," said Clive, who sacrificed £200,000 of his own money to try to keep the business afloat.
"We used to take around £1,800 to £2,000 on a Friday or Saturday night. Saturday just gone we took about £75," said Clive.
And after a dismal trade on Mothering Sunday which saw the business take just £300 in food and drink combined, the couple decided to cut their losses. "We kept believing it would pick up but it didn't," said Clive.
Perhaps "pub forced to close" is not the right phrase after all. How about "pub owners are unable to attract customers and eventually give up"?

I guess it's a natural cognitive bias to feel that life should somehow be fair, and that any disappointment or failure is the direct consequence of an identifiable external cause. But that is only true in stories.

Unsolicited graphic art

Niklas Blanchard seems to have a sideline as a graphic artist alongside his prolific blogging. He's been working on a series of unauthorised logos for blogs, covers for Scott Sumner's book and similar bits of miscellany.

I was flattered to discover that I'm one of his targets beneficiaries, with this galactic tribute to my liquidity-trap-believing, Krugman-sympathising, physics-quoting bleeding-heart liberal blogging habits. It's very nice if a bit twisted! Click through and have a look.

Certainly more appealing than my previous surprise compliment.

Update: Now with official permission to embed the image:

A testimonial for my vole-like features

I am sure this is intended to be flattering...right?
"plain leigh caldwell vole like econ con scruff-fidget"
I love it. I have no idea, nor desire to find out, what a scruff-fidget is. But I love it.

Friday, 26 March 2010

A "positive effect on crime levels"

According to Q Radio this morning, "honey-trap" houses - set up with hidden cameras to lure burglars - are having "a positive effect on crime levels".

Are we quite sure that's a good thing?

Thursday, 25 March 2010

More from Middle England

Chris Dillow has been cataloguing examples of the "Middle England" error. Often committed by journalists, this consists of mistaking a rich person's unusually high income for normality. Chris Blackhurst, the City Editor of the Evening Standard has another egregious example today, in a bitter complaint about the rise in stamp duty:
Alistair taking from the rich...and I'm the rich. [LC: this is meant to be sarcastic]
There are a lot of people like me...185,000 homes in England and Wales with seven-figure price tags.
That is not "a lot". There are 25 million homes in the UK, of which about 18 million are owner-occupied. Therefore just one per cent of homeowners are affected by this policy. Is it unreasonable to describe the top one per cent of homeowners as rich?

Here's Blackhurst's justification for why he isn't rich:
The reality today is that £1 million does not buy you a palace, not in the South-East.
But it's still a million pounds! You are still rich!

He is following an odd policy: judging wealth by the size of his house, instead of its value. The thing is - he has chosen to have his medium-sized house in one of the most desirable parts of the country, an option not available to most people.

If that's his choice it's fine by me; but by doing so, he spends more of his wealth on property than he otherwise would. As soon as he decides to sell up and move, he'll have more cash than most people ever accumulate. Indeed he could probably quit his job now and retire to Goa, or Runcorn. He is almost certainly (depending on the size of his mortgage I guess) among the top one per cent in wealth and income in the UK.

Chris isn't alone (though as City editor of a serious newspaper, he has no excuse). Nearly everybody overestimates other people's wealth. In a recent psychology experiment described by Gordon Brown (not that one, this one) at Warwick University, subjects were asked how much they'd need to earn to be in the top percentile in the UK. Have a guess if you want before scrolling down.

The average response in the experiment: £350,000. Scroll down a bit more to find out the truth.

The real figure: £98,000 [note: this depends on whether you include non-earners and very low earners - a range of more detailed figures at this link]. So anyone earning £100k is in the top one percent, and no more than one earner in two hundred will be affected by the new 50% tax band on £150k incomes.

This discussion shows some similar misapprehensions in the US: "top 1% - warren buffett, bill gates". It's quite revealing to read the answers on that page - they show very clearly the origin of this mistake. It's based simply on availability and salience. If you ask someone to think of a range of people with different incomes, they'll probably imagine one homeless person, a couple of average people, themselves, and Bill Gates. With a sample size like that, it's quite natural to think that Bill represents a huge class of rich people. But in fact, the only reason you've heard of him at all is because he was the richest man in the world.

I heard yesterday of an analysis (can't find the reference, sorry) of how much money TV characters would need to earn to sustain the lifestyles they're portrayed as having. Turns out the median figure is something like $1 million. But viewers assume those people have normal lives.

Such reasons are why well-off professionals in London forget how good they have it - and how hard it is for many other people living not too far away.

Wednesday, 24 March 2010

EVERYTHING is Gordon Brown's fault

This slightly sordid but predictable story about the collapse of an airline covers the alleged overspending of the chief executive, the financing of yesterday's bills from today's revenue, and the likely explanation: ultimately, this company collapsed as a knock-on effect from some other airlines, which failed while owing it money.

It's unfortunate for the creditors and those who had bought tickets, but these things happen.

The first comment on the BBC story?
There has to be something inherently wrong and deficient about Gordon Brown's handling of the UK's financial landscape.
...I don't suppose the Company bought tables at Labour Party dinners - or did it?
"Prudence" or "Darling Pridence" - Would you trust them to look after a bag of sweeties?
The guy just can't get a break.

Tuesday, 23 March 2010

Another short BBC interview on inflation

Another month, another inflation figure, and another short BBC interview. This time I managed to capture the video for your entertainment - sorry about the low quality. I will figure out how to improve it for next time. Assuming there is inflation again next month...

The economics zeitgeist, 21 March 2010

This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.

I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

I use Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

You can also see the Java version in the Wordle gallery.

If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.

Monday, 22 March 2010

Rory Sutherland: friend or enemy of science?

From Rory Sutherland, current president of the Institute of Practioners in Advertising:
"We need to broaden the definition of what we do to reflect the new reality of the market place because if we don't create a new model based on human understanding, then we are in danger of using 1950's packaged goods persuasive techniques to solve today's communications problems! With behavioural economics we can align ourselves to a recognizable science..."
I'm a great supporter of Rory's campaign to bring science into the marketing world - the field today is too driven by gut feeling, and treats creativity as an end instead of a means. Science lets us clearly understand the business problem, create a solution and demonstrate that it will work.

I disagree with him on one point in particular, but we'll come back to that. In the meantime, I've been reading Sam Delaney's book Get Smashed, a history of the British advertising industry from the 1940s onwards. In this excerpt he's talking about the old model of the ad agency, before the 1960s revolution. You'll see why I was amused to read it:
An agency's overriding preoccupation was to reassure clients that advertising was not a gamble but a science. They even formed an industry group and gave it the grand title of the Institute of Practitioners in Advertising. These were people who wanted to be taken seriously.
It's taken a long time for this circle to be closed, but here we are. Advertising creatives in the early 60s got frustrated at the fact that their field was run as a branch of industrial organisation theory; creatives got no credit and no freedom, "account men" ran the company via the golf course, and risks were not to be taken - since everyone knew sales were driven simply by the number of times your jingle was heard on the TV.

Is that what we're to go back to? Of course not. The creative standards that were set in the 1960s and raised in the 1980s have made advertising much more effective, as well as culturally more meaningful and more interesting as a field to work in.

But every discipline benefits from a deeper understanding of its own process. However brilliant a talent - whether it's John McEnroe or David Ogilvy - it can be improved by a theory which shows why that talent can do what it can do. And so the end of this cycle is actually a fusion of two contrasting, complementary approaches: creation and analysis.

Behavioural economics' scientific analysis can direct and channel creativity to achieve specific business outcomes. And the creativity of good copywriters and art directors turns the sterile insights of cognitive experiments into campaigns that engage consumers and genuinely change their behaviour.

In some ways this is no different to how advertising has always worked. Basic, objective principles of awareness, recall, consumer segmentation, brand affiliation and identity have formed the background; these principles have been implemented in creative work which challenges the audience, surprises them, forces its way past their barriers and makes the brand message effective. Behavioural economics now provides another set of principles which can enrich that creative brief.

These principles are informed partly by recent experimental work from Kahneman, Thaler, Loewenstein, Ariely and others; and partly by a background of ideas about cognition - which go back to David Hume and Adam Smith, but particularly surface in the work of people like von Mises. On this subject, I just found Rory's article on "an Austrian school of marketing".

He mentions the idea (important but little-known even among economists) of praxeology:
If you have time, spend a moment investigating praxeology and the Austrian economists (many of whom, confusingly, are not Austrian). Of particular appeal is that 1) They are great believers that value is and can only be understood subjectively; 2) They reject most forms of research, believing that humans are too self-conscious not to have their behaviour affected by the very act of observation and 3) they won't use maths, since human desire is too complex to be expressed numerically. Our kind of guys, in other words.
Two out of three isn't bad. Value is certainly subjective; and human behaviour is absolutely affected by observation.

But the third point, in fact, is the main reason why the Austrian economists haven't got anywhere. They really think you can do science without numbers. This is not true. Science that is not quantifiable is not falsifiable, and therefore doesn't count as science. The Austrian school, for all its valuable insights, tries to do economics in the Aristotelian mode, by argument, rhetoric and demonstration; and not in the Euclidean mode of logical and measurable proof. If marketers try to use behavioural economics in this way, they'll slip back into the morass of random assertion, driven by feelings and whoever has the loudest voice; this is probably quite fun, but it isn't science.

You might think it's obvious that human behaviour can't be explained mathematically. But it's easy to disprove. If I threw the average account executive out of a plane (and believe me, I'd love to) I could predict exactly what his behaviour would be, to an accuracy of about three significant figures. Naturally there are some details that are difficult to model - would he ask God's forgiveness for all he's done to his clients and colleagues, or just swear profusely at me until I can't hear him any more? - but there are plenty of very predictable things about us.

This is just as true of cognition, beliefs and desires as it is of physical movement. There is indeed a complexity that makes the task difficult, but also a regularity that makes it - within limits - very possible to predict what people want and how they'll behave.

This quote, from an earlier Rory article in praise of Cambridge, takes a braver position:
The problem we have faced as an industry is that we have been forced to become an excessively arty industry for want of a science to call our own. Many mathematical and scientific areas - most notably economics - have traditionally relied on models of human behaviour so reductionist and rational that they leave no room for human understanding at all. So, spurned by hyper-rational economists and accountants, we have reacted in one of two ways: either we have clung hopelessly to the "overt rational persuasion" model of advertising as a desperate attempt to make sense of what we do, or else we have overcompensated and taken up allegiance with flower-arrangers, choreographers and fashion-designers and claimed that this is simply a business that can only be understood emotionally. Neither stance, to be frank, does us much good.
Cambridge Rory needs to stand up a little more to Austrian Rory. This would not be without precedent: in the history of economics, a previous Cambridge man did very well in establishing his ideas against an Austrian contemporary. Both views, of course, have pieces of the truth, and the combination is very powerful indeed.

Healthcare reform: passed?

Mixed news coming in from Washington - in the 14th minute of a 15 minute vote.

On the radio (BBC World Service): 9 votes still needed - 207 yes votes so far cast.

On CNN: voting has started.

On the NYT: House is voting on the Senate bill. Other votes still to happen.

On some random spam site: "Health care reform passes - live video". Only notable because it has successfully gamed Google News and comes up at the top of the search results.

On Yahoo: 'White House Press Secretary Robert Gibbs just tweeted: "About 40 staff in Roosevelt Room with VP to watch the vote - President walked into the room to sustained applause."'

On the radio: applause is being heard...

And, it seems: a historic moment, with 219 votes to 210 (some sources reporting 212), the healthcare reform bill has passed.

Speculation on the BBC that the Republicans are nailing their campaign flag to the anti-reform mast because they believe the voters don't want this bill. My suspicion instead is: their anti-bill rhetoric was intended to intimidate Democrats into giving up on it - and nearly succeeded. They did succeed in getting it watered down, but as now, they appear to have failed to stop it.

If the Democrats had not passed this, they would indeed have been punished hard in November. As it is, I think they'll have a better chance.

Sunday, 21 March 2010

Tragedy of the commons - a problem and a solution

While watching the latest news on the passage of the health reform bill, I am having a conversation about a traveller community in southwest England. Some of the stories are about personalities, others about the institutional "structures" that have grown up - without the recognition of specific rules or laws, but simply the emergence of ways of doing things that are "enforced" by social norms.

This is very reminiscent of Elinor Ostrom's Nobel-winning work on the emergence of self-managing rules and structures within communities. These rules are most obvious in the management of common-pool resources such as fish stocks - where it's hard to establish, enforce or even design the classical economic solution of property rights. Without them, the tragedy of the commons soon destroys the fish stocks permanently. Communities in practice are surprisingly successful at establishing such norms for themselves.

But ironically, there's another level of tragedy of the commons among travellers. That is the selection of authorised sites on which they can live.

Currently in the UK, each region (there are ten across the country) agrees with its local and county councils how many sites they will make available for travellers to live in (in a document called the Regional Spatial Strategy). But the councils, under pressure from voters, are keen to negotiate down the number they must accept and push them into other areas.

According to this BBC article:
Labour MP Clive Betts, a member of the Communities and Local Government Select Committee, thinks that should change.
He told the BBC: "I think a lot of local authorities would welcome a statutory duty to have to do something because at least then they can go to their residents and say, 'we have to do something, let's find the best sites'."
As a matter of game theory that makes perfect sense - sometimes it is in the interest of players voluntarily to restrict their own freedom, because it changes the negotiating options of other players.

But instead, the Conservatives have a different proposal:
...such decisions should be made at a local level and that the Conservatives would scrap the Regional Spatial Strategy.
This policy is calculated to make the problem even worse. At a local level, the incentives faced by councils are very clear - more people will vote against a traveller site than for it. Many people who are quite willing to accept the principle that travellers should be able to live somewhere will not countenance the idea that it should be near them.

Perhaps politicians need to take some economics lessons from the people they are trying to regulate. Or perhaps they just need to admit that they'd rather let a minority of voters dictate policy than get some economic literacy.

Zeitgeist delayed

I can't currently reach the server which generates the economics zeitgeist blog cloud, but will run it tomorrow instead.

Hay-on-Wye is sunny and beautiful, so I may be inspired to write something else today to keep the blog ticking over.

Saturday, 20 March 2010

A bookshop economy

Today I'm in Hay-on-Wye, a small town buried miles from anywhere on the Welsh-English border, with the highest number of bookshops per inhabitant of anywhere in Britain and probably the world.

Can this possibly be an economically stable situation?

Today, a mild springtime Saturday, there are plenty of visitors - and I'm sure they will all spend some money in several shops. But is this really enough to make a living?

There are several characteristics which probably make this local economy more sustainable than one would expect:

  • Books, especially second-hand books, are not commodities - for most books here, there's probably just a single copy in one shop. This reduces the competition between shops and allows them to maintain greater margins.
  • There's an annual festival where 80,000 people come here and the bookshops - and everyone else in town - makes an absolute fortune. The existence of the bookshops the rest of the year strengthens the credibility of the festival.
  • People use books as a very obvious signal of their intellectual credentials - and the association of Hay with books enables people to send the same signal with their choice of vacation.
  • The existence of so many bookshops creates an expectation that you should buy something - in the same way as few people would visit Bordeaux without bringing some wine back.
But I suspect that few bookshop owners here make the living they could if they found a book-deprived locale somewhere else in the UK. There must be a strong "production preference" meaning that the booksellers derive utility from the actual process of engaging in the trade, not just for the earnings they can get from it. Surely a common phenomenon among pub and restaurant owners too.

So what have I bought? One of the shops did have about fourteen shelves of economics books, including an old edition of Greg Mankiw's text which I considered buying just so he wouldn't get the royalties (analyse THAT, economists); but most of them were rather old-fashioned texts proposing interventionist economic policies in 1970s and 1980s Britain. I did get hold of an interesting-looking colloquium on currency targeting edited by Paul Krugman (quite relevant now - a post on that tomorrow if I can get online) and a very lucid exposition of the elementary theory of value by Michael Allingham.

Probably both are out of print and I wouldn't have had much opportunity of finding them anywhere else. But worth the six-hour trip from London? Not on their own, no. I am not convinced that Hay-on-Wye will still be here in another thirty years.

Friday, 19 March 2010

Barter and echoes of money

I went to a very interesting speech by Frances Dickens of Astus on Wednesday. She runs a company which acts as a barter exchange between other firms.

She started out describing the business model (eliding a few intriguing things which we were obviously meant to know already - such as the fact that the barter is always backed by spare media space, usually TV inventory).

By the end I felt like I'd been listening to a monetary economist talking about the founding of a new central bank.

So many of the issues confronting them are exactly like the issues faced by a currency issuer (which, after all, they are, kind of):

  • Is the currency backed by anything? Previous barter companies have failed because they issued promises with no capital behind them, and the promises were quickly devalued
  • Network effects - now that they are the market leader and the majority of companies use their "currency" by default, they have a hugely defensible position
  • Reputation and credibility - the backing of the currency becomes less important as the reputation of the issuer grows
  • Intermediation and fungibility - currently Astus stands in the middle of all transactions and nearly everything is exchanged for media space. But presumably people can now start to trade other services for the currency or for each other, without going via Astus. I didn't get to ask her this question
  • Regulation and balance sheets - they disclose two balance sheets and two profit and loss accounts - one based on standard accounting practices (GAAP) and the other based on their own estimate of the real numbers - including the non-cash component which is excluded by GAAP
What next? Presumably, if this market continues to grow, they will start to face some of the other issues that monetary theorists run into:

  • Inflation
  • Exchange rates with other barter exchanges (or cash)
  • Creating sufficient money supply to enable business to take place at the optimal rate - managing the tradeoff between credibility of the currency, and the liquidity requirements of businesses
  • Seigniorage and interest rates...I suspect that participants currently don't earn interest on their credit balances, but I could imagine them wanting to
Would Scott Sumner recommend that this company sets an NGDP level target? What an interesting experiment that would be...

p.s. I will be away for a few days - if possible I'll queue up some posts to publish automatically while I'm gone. If I can't, normal service will resume on Monday.

Tuesday, 16 March 2010

Michael Jackson in Body Worlds shock

This can't be right, can it?

An FT article about Sony's record-breaking $250 million settlement with Michael Jackson's estate says:
Unlike other headline-grabbing deals with artists from Madonna to Robbie Williams, it will not offer Sony any future revenues, such as those generated from merchandising and touring.
I had not expected Michael Jackson to be doing any more touring in the circumstances.

But - unless the cadaver is to be carried around Europe like some kind of medieval saint's relics - there is an explanation. And that explanation can only be this:

Jackson donated his body, before he died, to Gunther von Hagens' Body Worlds (Körperwelten) exhibition.

You want more evidence? Remember the famous O2 Centre concerts Jackson was about to perform when his death was announced? In July and August 2009? Just look at this little snippet.

"The Mirror of Time" indeed...

Ten books that influenced me most

Tyler Cowen was prompted by a reader question to offer his ten most influential books. He challenged other bloggers to do the same, so here are mine (as for Tyler, this is my "gut list" though informed by a pleasant half hour looking through my bookshelves to prompt my memory). It surprises me how few economics books are here - but then I didn't do much formal economics study at the time of life that one chooses influential books:
  1. Easily at the top of the list is Douglas Hofstadter, Gödel, Escher, Bach - An Eternal Golden Braid. The first book that started me exploring the mysteries of cognition and consciousness - and a book of such beauty, grace and depth that my life's work would be complete if I could write anything like it. Most of his other books are excellent too.
  2. Christopher Alexander, A Pattern Language. Gives another insight into where abstract patterns can be found in the world - this time in the architecture of cities, buildings and rooms.
  3. Steve McConnell, Code Complete. A brilliant insight into the practice of software development - which, although it's a field I now have a little less practical involvement in, was my route into the modelling of firms and economic systems. McConnell provides a masterfully pragmatic look at how to do software, rather than the traditional computer science theory of how software can be structured. His other book on a similar subject, Rapid Development, is also excellent. Along these lines also is The Pragmatic Programmer
  4. Richard Feynman, Surely You're Joking, Mr Feynman! Awoke in me the joy of physics and science in general more than any other author. I don't do much physics now, but what I learned about it informs deeply my approach to other disciplines. Feynman's more technical Lectures on Physics are rightly famous too.
  5. Christopher Booker, The Seven Basic Plots. This book is a placeholder for a wide range of discussions and readings around the nature of stories; they play a deep role in cognition and how we value things in the world. Some people don't like the book itself but it is great at drawing you into the ideas (from Jung) of the roles stories play for us.
  6. Dan Ariely, Predictably Irrational. Having developed in unformed fashion a range of my own ideas on value, perception and economics, it was a revelation to discover that there was - sort of - a whole field already out there exploring the same thing. I do have some issues with this book, as I do with the field of behavioural economics as practised, but it's a popular book and communicates the concepts well.
  7. Tim Harford, The Undercover Economist. This book came along at just the right time for me - when I had had some time out of economics, focusing on business and software, and had developed a stream of ideas which were ready to bring back to the tools of economic analysis. The book (along with Tim's columns and lots of reading from The Economist) helped retrain me in the concepts I needed to get ready to start this blog. Tim's own top ten books are here.
  8. Tom DeMarco and Timothy Lister, Peopleware. Although it's about how to manage people who develop software, it's also about the psychology of being creative.
  9. Fred Brooks, The Mythical Man-Month. A classic about how people can collaborate to achieve big things. It would be very interesting to do an economist's analysis of this book, as it has a completely different philosophy of incentives and information - from the point of view of a management practitioner - than that of the economics tradition.
  10. Martin Gardner, Mathematical Circus, The Ambidextrous Universe, and many others. Any child learning mathematics should learn it from these books. They simultaneously teach some quite deep maths and instil a love of puzzles, numbers and patterns that is essential for anyone who will engage with mathematical ideas in their future. Most of his books are collections from his Mathematical Games column in Scientific American. By the time I read the books he had retired from this position and handed over to - if I'd only known at the time - Douglas Hofstadter. He anagramatically renamed the column Metamagical Themas - which, returning to the top of my list, became the title of another of Hofstadter's books.
I realise there is no fiction in this list. When I think back on the fiction that has inspired me, the pickings are thin. Though there are many I've enjoyed, have any of them had an impact on me like those above? Tom Stoppard, Rosencrantz and Guildenstern Are Dead; Joseph Heller, Catch-22; Norton Juster, The Phantom Tollbooth; Ursula Le Guin, A Wizard of Earthsea; Vladimir Nabokov, Lolita; Michael Moorcock's Elric series; Haruki Murakami, A Wild Sheep Chase; Magnus Mills, The Scheme for Full Employment; in earlier years, Douglas Adams, The Hitchhiker's Guide to the Galaxy; and lots of inspiration from Martin Amis, The War Against Cliche.

Then there are still some important science, economics, philosophy and business books, though they didn't come to mind in my first ten: four that I now think of are Thomas Schelling, Micromotives and Macrobehaviour; Geoffrey Moore, Crossing the Chasm; Jared Diamond, Guns, Germs and Steel and Steven Pinker, The Language Instinct.
    This is a revealing exercise and I'd recommend it to anyone who's interested in the history of their own thought.

    Another SXSW award for Six to Start

    They keep on doing it! Our friends (and now clients) at Six to Start have won another South by Southwest award - this year it's Best Game.

    The prize is for Smokescreen, "a cutting-edge game about life online", developed with Channel 4. The credits are about four pages long, but congratulations particularly to those I know personally: Adrian Hon, Dan Hon, Claire Bateman, Margaret Robertson, Lisa Long, Dave Aldhouse, Heather Tyrrell and Alex Chapman. One prize might  be regarded as win two looks like carefulness.

    I'm sure many of you will enjoy the project we're doing with Six to Start if it does go into production. I'd love to tell you about it but then I'd have to...send you to this xkcd cartoon.

    Monday, 15 March 2010

    When is CSR justified?

    Tatsiana Parkhimchyk outlines an argument against CSR which I think is mostly right: businesses are here to make an economic profit, not to contribute to social causes:
    ...the business of business is business.
    CSR includes: community health, safety, education...and so on an so forth. My question in this case is quite obvious: aren't all these spheres and activities the primarily concerns of the government? And shouldn't the government take care of their citizens to prevent crime, save the environment and satisfy the basic human needs and desires rather than business?
    In principle, yes. The incentives for companies are not to maximise social good - any more than are the incentives for individuals. This is why we appoint governments on our behalf - as a coordination mechanism, to solve the problem that competing individual incentives are sometimes destructive of social benefit. Simplistically put, government's job is to solve the tragedy of the commons and the prisoner's dilemma.

    A government with perfect knowledge and correct incentives is, in theory, the best way to maximise total welfare across the population. Much of public choice economics is about how to best meet these two conditions - perfect knowledge and correct incentives are not easy to bring about.

    And it's in circumstances where these conditions fail, that there may be a role for CSR after all. If the government (which by its nature, must try to aggregate the preferences of millions of people) does a bad job of understanding the needs of some individuals, other forms of aggregation may be more effective. The management of a company might know their customers, employees or communities better than more remote political representatives. They may therefore be in a better position to provide services that would benefit those people.

    That's the knowledge side of the equation. What about incentives? Why would companies have an incentive to accurately meet the needs of communities which are not directly buying a product from them?

    As a starting point, we could look at the incentives for governments to meet those needs. Or the incentives of individuals within government to meet those needs. Those are, in conventional economic theory, market incentives. Money, a preference for power, or for the social influence and admiration that comes from a position of responsibility.

    The admiration preference could apply in the corporate context too, but is unpredictable and relies on the individual preferences of the firm's managers or owners rather than the intrinsic incentives of the company itself. It's more likely that a company can be incentivised to make a social contribution by taking advantage of the preferences, or information gaps, of people in its community.

    There's a parallel again with the government case - governments are partly taking advantage of a preference for reciprocity and sharing between citizens to co-opt them into participating in redistribution (and voting). In the company case, there are a couple of ways in which this could work:

    • In a competitive market, companies seek ways to distinguish their services other than on price. If the company's delivery of social services is productive, buying a slightly more expensive product may be an economically efficient way for consumers to make a social contribution. The company is therefore offering consumers an economy of scale for achieving the consumer's own social objectives.
    • In some markets there is an information asymmetry: companies can't always prove that they're trustworthy, or that their quality is high. Then, they may seek ways of signalling commitment to a marketplace and that they have a reputation at stake. In this case, social contributions serve the same purpose as a bank's traditional marble pillars and gilt edging: showing that the company is willing to sink costs into a market and therefore that they plan to stick around for a while. If the value of trust or perceived quality is high, it can be worthwhile for a company to engage in CSR.
    • Similar competitive and signalling processes may exist in the company's relationship with its employees, instead of with its customers.
    • In the signalling case, the informational benefit is present whether the actual social contribution is large or small. So this works best for big companies which can make a small contribution (relative to their total revenue or profit) but spread the news widely across thousands of employees or customers. The productivity case scales more easily down to small firms.
    Thus, in some cases where companies both have the right knowledge, and the right incentives, to carry out CSR, it can be an economically sensible activity. The fact that it's also in the company's self-interest does no harm to the citizen. Indeed, if it were not in the interests of the company, I wouldn't support it.

    The macroeconomic question is more complicated: what does it look like to have a society and an economy where social good is sometimes achieved by companies instead of by government? My suspicion is that it will be rare to find a stable situation where firms provide a significant share of social goods - but 5-10% might be expected. Some careful general equilibrium modelling would be needed to learn more about the dynamics of a system like this.

    So the following thought of Tatsiana's is close to the mark, but we needn't be quite this cynical:
    CSR can create a luring shine around a company, given that all people like when somebody takes care of their needs. But does business really care about the well-being of the general public or CSR is simply a smokescreen or window dressing?
    Actually, business doesn't need to care - but it might still make a difference anyway.

    Is free ice cream better than free money?

    I can't post on Felix Salmon's blog, so here's a comment I wanted to write on this amusing post about free ice cream:
    The answer to 65% of all thought experiments on economics blogs: selection effect.
    The "you" to whom Dan's question is addressed is a different set of people to the "they" who'd turn up for a free cash offer.
    Though of course, there is a bit of a framing effect too.
    The question of demographic effects in behavioural experiments is underinvestigated (though there are a few papers about cultural differences, especially in the ultimatum game).

    Sunday, 14 March 2010

    Coincidence or trend? Daily Mail watch

    Two independent observations of a new trend today. First on twitter:

    Then on Marginal Revolution:

    Kate is very well-versed in the British newspaper industry (I used to adore her TV listings in the FT), but I had no idea that the Mail's reputation had spread even to Tyler Cowen's parish.

    The economics zeitgeist, 14 March 2010

    This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.

    I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

    I use Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

    You can also see the Java version in the Wordle gallery.

    If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.

    Gender norms in the gym

    I went on a day pass to a new gym today. One of those gyms where the lockers are secured with the members' own padlocks instead of with built-in locks.

    As expected, the men's changing rooms were full of padlocked lockers. It didn't occur to me that there could be any other way.

    Turns out, as I discovered later, the women's lockers are not secured at all. Perhaps one locker in the whole room had a padlock. The rest just live on trust.

    Are men more likely to steal things? Or do men just not trust one another? Who's being irrational here? Readers who attend a gym are invited to report back the results from their own establishment. Just in case, probably best not to say which gym you're in.

    Saturday, 13 March 2010

    iPerbolic discounting

    Imagine you have saved up £550 and you're ordering a new iPhone. The supplier is short of stock, so you'll have to wait a while. It is going to be despatched by post in 30 days and will arrive with you the next day: a 31 day delay. Then, at the checkout screen, the site offers you an express delivery option. For an extra £20, they can deliver it by courier so you'll get it on the 30th day. Would you pay £20 to have it one day earlier?

    Now imagine you're ordering it from a different store and they have plenty of stock. It's going to be dispatched this afternoon and will arrive tomorrow. You see the £20 courier option: Is it worth £20 for courier delivery to get it in your hands in one hour? Alternatively, if you could travel to the shop and pick it up right now (which will take an hour or two out of your afternoon), would you do it?

    I haven't done the experiment, but I'd bet you a lot more people would say yes in the second scenario than the first. Equivalently, they'll pay much more for courier delivery today than in 30 days. But what's the difference? You have your iPhone one day sooner in both cases. Is it worth £20 a day to have an iPhone? How about £10? £5? If you'd pay £5 for the courier, logically you'd pay over £1800 per year to own the phone. Do you think that's true?

    A more sophisticated test would offer people a cheaper price for the phone itself from the 30-day mail order supplier than from the retailer who has it in stock now. I suspect that it would be easy to demonstrate some rationally-inconsistent preferences.

    I'm in this situation right now. My phone was due to arrive on Friday and it hasn't turned up yet. I'm really rather keen to get hold of it. But before I ordered it, the paperwork sat in my inbox for about two weeks before I made the decision on which package to sign up for.

    Clearly my cognitive incentives to get the phone in my hands have suddenly increased. This is a concrete instance of the classic cognitive bias of hyperbolic discounting, which is normally presented in terms of purely financial decisions. The iPhone example really brings it home to me though.

    Possible explanations for this effect?

    • Greater saliency - I can almost smell the iPhone now; it's a part of my immediate future and therefore it's more likely to be on my mind. The utility of getting hold of it is more obvious to me - even if the underlying preference is the same as before, I'm more aware of that preference and thinking about it takes up more of my attention; thus I'm willing to pay more for the courier service than my normal valuation, to have that itch scratched.
    • Conversely, perhaps I didn't know my real preferences 30 days in advance. Maybe I really am willing to pay £20 for each day of my iPhone, but I just didn't realise it until the opportunity presented itself. Comparing these two explanation, there really isn't any objective way to determine my "real" preferences, so the two are probably equivalent.
    • You could argue that I have limited self-control and that, when it's offered to me, the temptation to have the iPhone now overwhelms my capacity to make rational decisions. Some explanations based in neuroeconomics take this position, looking at the activation of different brain regions which correspond to different kinds of decisions. But I don't really believe it - after all, even if I would pay £20, it's hardly plausible that I would be willing to pay £2000 to get the courier service, so there must be some kind of rational value comparison going on.
    • Naturally there a bunch of details that it's important to design out - like the fact that people may see it as less risky to buy things in a retailer, where they can see them first hand, than by mail order. These aren't explanations, though - just variables which need to be eliminated from the experiment.
    • In some scenarios a social ranking explanation could apply: if it's especially important to me to have the first iPhone on my block, or at least not to be behind my peers. But I've left this purchase so long that if anything, there's more pride in not having one yet.
    Somehow cognitive biases are always more surprising when I notice them in myself than other. Also more illuminating.

    Friday, 12 March 2010

    Game theory: not nonsense any more

    Game theory has always been one of the most stylised, theoretical - and unrealistic - disciplines within economics.

    Its assumptions are much too strong for the real world: pure rationality, perfect mutual knowledge of the rules of the game and the payoffs for each player. Game theory does certainly provide insight into many realistic phenomena - the prisoner's dilemma is the classic example, variants of which can be seen all over the economic world. But I have never been especially inspired by the exercise of working out Nash equilibria, because they usually illuminate only the stylised game that has been written down, and not the world that it is meant to model.

    However, two relatively new variations on game theory are making the field more interesting.

    The first is the idea of learning. For example, Fudenberg and Levine's book, The Theory of Learning in Games, sets out ideas of how real people playing games can come close to rational behaviour by trial and error, paying attention to each other and learning from their mistakes.

    The second is a rich set of heuristics used by players and analysed in behavioural game theory. Their specialism in this area of work was the only thing that tempted me to apply for a PhD at London School of Economics (though in the end there wasn't quite enough appealing about it). Camerer's book, Behavioral Game Theory: Experiments in Strategic Interaction, is the bible of this field and explores some key issues which can actually make the analysis of gameplay realistic:

    • theories of moral obligation (why does the ultimatum game work?)
    • limits on foresight (I think that he thinks that I think that he deep can we go?)
    • experience and learning

    These make all the difference in the applicability of game theory to real life - or, for that matter, to real game design!

    If you're designing a set of economic incentives, or making a game for real people (that is, not economists or mathematicians) to play, these heuristics will provide much more useful tools than the study of payoff matrices and Nash equilibria.

    Indeed, unlike standard behavioural economics - which is only a supplement, or a complement, to mainstream economics - the insights of behavioural game theory could make the study of rational game theory more or less pointless.

    An insightful comment on modern investment

    From a commenter on Chris Dillow's recent posting:
    I do wonder how good the data on investment is, and whether as the service sector grows it is systematically underestimating investment. How well is investment that essentially takes the form of hiring labour to work on intangible assets, or simply to constitute an accumulated hired factor production (human capital), accounted for in all this data that tells us investment has been falling?
    Posted by: Luis Enrique | March 11, 2010 at 05:24 PM
    This seems a pretty reasonable hypothesis. Any idea how it could be tested? The last thing that those service businesses want is for their intangible work to count as capital investment - they'll have to pay corporation tax on it until they can write it off in four years. So some firms may not want to report investment figures to the government.

    However, at least one form of non-tangible investment - scientific R&D - brings tax benefits in some countries, and companies do have an incentive to report this.

    Nick Rowe pointed out a while ago the difficulty of directly measuring investment, by consumers or businesses. And there are many grey areas - what if I have a new brochure designed which I plan to keep using over the next three years? This is a one-off cost, much of the benefit of which will accrue in future years; but certainly some of it is a current-year revenue expense. This would normally be written off as a marketing expense but you could make a good argument to count some of it as an investment. If the design is a good one, the company's accumulated intangible assets and goodwill will certainly be worth more at the end of the year than the beginning.

    My thought is that, mathematically, statistically, or from an accounting viewpoint, it should be possible to derive an investment figure. The only numerical way I can think of to do this is to split out cost of sales from overheads and try to look at forward estimates of earnings for the next year. But both of those figures are really hard to estimate accurately and I would not want to rely on the numbers submitted by firms in their official accounts. Perhaps it would have to be done by surveys or even detailed interviews with a representative sample of firms; after all that's good enough for the employment figures, why wouldn't it work for investment too?

    Thursday, 11 March 2010

    High taxes as an incentive to work

    Just a hypothesis here, suggested by Chris Dillow's reference to Baran and Sweezy:
    ...tends to generate ever more surplus, yet it fails to provide the consumption and investment outlets required for the absorption of a rising surplus and hence for the smooth working of the system. Since surplus which cannot be absorbed will not be produced, it follows that the normal state of the monopoly capitalist economy is stagnation (p108).
    The essence of the market is that surplus goes to those who produce it: this is a stable situation because it gives the producer an incentive to produce more surplus. But perhaps modern economies of scale and scope lead naturally to ownership, or at least control, being concentrated in the hands of a small number of people: control can't be spread more broadly because of the rational ignorance of the crowd. Sharing a growing amount of wealth among a smaller number of people means that - as Baran and Sweezy suggest - those in control are no longer significantly incentivised by additional consumption, and may stop bothering to produce more.

    Thus, the stable state which ensures continuing growth is for some of this surplus to be redistributed to those who do not own or control the means of production.

    If enough of the surplus is redistributed, the capitalists are left with little enough that they do have an incentive to keep working to produce more.

    In this model, high tax rates are not a disincentive to productivity but an incentive.

    So: there's a blatantly counterintuitive proposal - what do you think?

    Comment moderation turned on, unfortunately

    Due to a spammer attacking the site today, I have turned comment moderation on for a while.

    I'd hoped that using Blogger's built-in captcha facility would be enough, but apparently this is being done by a real person (with a Google account) so I have had to turn on moderation.

    I hope to be able to switch this off again soon, as I have had lots of value from comments (including anonymous ones) and would prefer not to put any barriers in the way. Apologies to regular posters - I will usually approve comments within an hour or two at most, except in the middle of the night UK time.

    Wednesday, 10 March 2010

    Osborne's new economic model?

    The Conservatives apparently think a "new economic model" is needed to restore the strength of the British economy.

    I wonder what they mean.

    I assume they aren't talking about a model in the way an economist would think of it: a simplified representation of the operations of the economy. Probably they mean "we need to run the economy in a different way". This is how businesses use the word "model" when they talk about choosing a business model, or a revenue model. So maybe he just wants to use a different set of rules for taxes, employment or general economic incentives. This speech gives some clues - it's tricky to read through the rhetoric to find any common underlying model, but what he seems to want is to set three "priorities" for government economic policy.

    But taking him literally reveals a more interesting way to think about the question. What if he really does want to change the descriptive model that we use to think about the economy?

    In principle, a model should be a neutral description of a complex system, and the fact that different models exist shouldn't affect the behaviour of the system itself. Choosing a new model is usually an attempt to incrementally improve the fit of your model with the real world - not the stuff of political revolution.

    But interesting things happen when a model turns out to be accurate - or if people think it's accurate. People start to use it. People making decisions about the economy use the model to decide what to do. And the more accurate it seems to be, the more likely they are to use it.

    So by developing the original General Theory model of economic activity, savings and unemployment, Keynes had a vast impact on the decisions made by governments and, in turn, by individuals responding to governments.

    Successive monetary models have influenced how central banks controlled interest rates (exchange rate models, money supply models, NAIRU and the Taylor rule).

    And models of the finance markets have influenced how banks and regulators have interacted with each other within the finance markets.

    What if these models are wrong? Are people making vast, sub-optimal decisions and hurting billions of people because of a broken model? Probably. The choice of model does matter.

    All of the models I've just mentioned have something in common: they influence the actions of a small number of big players. You could argue that at the lowest level, models don't matter so much - people act according to their local incentives and if they behave according to an inaccurate model, their mistakes will cancel each other out through the forces of competition or evolution. The model's aim is to describe microbehaviour, not influence it.

    But actually, people do still follow a mental model in their decision-making, and many of these models are pervasive enough to have a macroeconomic impact. Some examples of models which (I'd suggest) most economic actors are following:

    • Money mostly has an objective value
    • Savings are good, debt bad
    • Investment is good too. That's just the same as savings, right?
    • We don't need to save too much, because our risks are cushioned by spreading them across the population
    • Financial institutions are safe
    • If my job was there this month, it will probably be there next month
    People who didn't follow these mental models would behave very differently, which would make a real impact on everyone else.

    So at high and low level, the "economic models" that we follow do have real consequences. If we could change some of those models, the economy would probably be transformed. Therefore perhaps George Osborne does intend to change them. If so, to what?

    I hear he likes behavioural economics - so perhaps he has a behavioural or cognitive economic model in mind. His speeches suggest he wants to cut public borrowing and spending - so perhaps he believes in a model in which high borrowing slows economic growth or damages incentives. He says he favours lower personal debt and higher investment - so perhaps his model says that high debt and low investment have negative outcomes.

    Whatever his new economic model is, I'm sure he will tell us in more detail at some point.

    But change is hard, especially changing other people's minds. Do you think he will be able to change the economic models used by public policymakers? By civil servants? By private companies? By the general public? It would certainly be an interesting project to try. But I'm not sure that a politician is the one to do it - and if anything, Osborne's speeches seem designed to be consistent with the public's existing mental models, not to alter them.

    Look instead for academic economists whose ideas Osborne will promote; this is a much likelier route to changing opinion. Here are some of his key advisers. None is an academic - they mostly worked for think tanks and banks. One who has worked at a university is Alan Budd, tipped as head of the Tories' Office for Budgetary Responsibility - who seems fairly mainstream in his economic views. But apart from Budd, it's hard to tell what model someone is likely to believe in if they don't have a record of published work.

    So Osborne's new economic model - for all that it might genuinely change the path of the UK economy - remains a bit of a mystery. I look forward to finding out - before the election - what it will be.

    p.s. having drafted most of this post, I typed "George Osborne" into the address bar of Google Chrome. The first [and only] autocomplete link it showed me: Google owns Blogger, and my draft was in the adjacent tab of Chrome. Is this extreme cleverness, supreme coincidence or just rather spooky?

    p.p.s. it was none of the above. Turns out I bookmarked the speech nine months ago intending to write about it, and forgot!

    Tuesday, 9 March 2010

    How tiny is the blogosphere?

    This question is prompted by a few things.

    First, seeing the same commenters pop up on obscure and unrelated blogs as appear on famous and prominent ones (hello Min, dearieme, Don, to pick three at random).

    Second, meeting the author of one of my regular blogs at a show written by another, and finding they collaborated on the show I was at.

    Third, realising that although my readership is still relatively small (one day, Krugman, one day...), it includes a surprisingly high proportion of other bloggers whom I respect, and whose occasional links to me are flattering and pleasing.

    My first thought, then, is to wonder whether the blogosphere (at least the economics blogs) is populated by a few hundred people who just spend all their time reading each other's postings, and a few hundred more who comment on them.

    My second thought was, if it is, then that's not so bad. Mostly, the people with blogs are the ones you want to read your work - the thoughtful, intelligent ones who are willing to challenge and engage with your ideas. They are the ones who, in the long run, will influence everyone else. Of all the people in the audience of that show, the three that I'd much rather have reading my work are also the three that have their own blogs.

    When someone does both link and comment on an article of mine, their (and their commenters') input inevitably improves and often corrects my thinking.

    So even if we are in an echo chamber, listening to each other listening to ourselves, when something does leak out from that chamber it has been improved and amplified by the attention of just the people you'd want.

    Monday, 8 March 2010

    Irrationality at the pub

    A scenario from the pub tonight:
    My friend ordered a Paulaner. The waitress brought a Staropramen by mistake. She was about to take it away and replace it, when he offered to pay half-price for it to save the cost of throwing it away.
    What decision should she make? Accept the offer and avoid the wastage, or bring a new beer and charge full price?

    The considerations are surprisingly complex.

    1.  A simple one is the cost of the beer. If gross margins are low - that is, if beer costs the pub more than half of what it charges the client - it is more profitable to sell the Staropramen at half price and at least get some revenue than to throw it away. On the other hand if beer is very cheap then it's more profitable to chuck the old one and charge full price for the new glass. Note that the consideration here is the wholesale price of the Paulaner which would need to be poured, not the Staropramen which would be thrown away - that has already been poured and is a sunk cost.
    2. Assuming that it would be profitable to sell the Star at half price, lots of other considerations start to arise. Let's start with game theory. The customer has made an offer at 50% of full price - maybe they'd be willing to pay more. Should she ask for 90% and negotiate downwards from there? What is the customer willing to pay?
    3. Will the bar be able to resell the beer? They did in fact keep the pint to one side instead of throwing it away - and when we asked, the waitress said they would sell it to another customer if it was ordered within a couple of minutes and was still fresh - but in 5 minutes they'd toss it. But I'd be willing to bet the customer who orders it from their table gets it, not the one who orders it at the bar. As it was a Monday night, the waitress pointed out, it probably won't be resold within the five minutes and will instead be emptied out.
    4. The reputational question for the bar is double-sided. Typically, companies don't want to be seen as soft touches in negotiation. They may be willing to throw away marginal revenues in a visible way - as in the optimal play of the ultimatum game or chicken - so people don't think it's worth negotiating in future. On the other hand, perhaps they'd like to be seen as environmentally friendly, or as being flexible and helpful to the customer. It isn't clear which of these effects dominates.
    5. The value of labour comes in at some point. If it takes five minutes to negotiate the price and three more minutes to change the order on the till so the receipt adds up, is it worth it? She's probably paid about £6 or £7 an hour, so the cost of time would be about £1. Is the search cost of finding a mutually acceptable deal worth the profit?
    6. Actually though, it's a bit more subtle than that. The return on her labour is of course more than its cost, otherwise the bar wouldn't be in business. So while she's negotiating, all the expensive fixed assets of the bar are being wasted. On this view, that eight minutes might cost £5.
    7. Or maybe she doesn't care about the value of her time to the bar, only to her. She'll probably be better tipped if she strikes the deal than if she doesn't. Possibly even more than the amount of the discount - since there are two other people at the table slightly embarrassed that our friend is even asking this question, and ready to put in a couple of quid just to shut him up. Maybe it's even worthwhile for her to subsidise the half price herself in order to earn it back in tips.
    8. Which is why there's an agency problem for the bar. Does it allow its staff the discretion to make decisions like this? The waitress claimed that she couldn't accept our deal as she isn't the manager. Probably some truth in that, but is it because of the perverse incentives presented by the principal-agent conflict - or for a more practical reason:
    9. Cognitive load and granularity. At the volume of business done by a typical bar, it's not necessarily optimal for agents to make individual decisions. They may not have the economics training to take into account all the factors listed, and more to the point, they don't have the time. Some of the weights on these factors are unknown - is the reputational cost of offending this particular customer more or less than £1? - and therefore while head office might make an attempt to consider them, all that finds its way down to the staff level is a policy rule. If the decision is worth enough - let's say it is about a half-dozen bottles of Dom Perignon, which this bar sells at £99 each - then perhaps the manager will use their discretion - but below that, it's not even worth thinking about. And granularity implies that it's all-or-nothing - while the waitress might make a snap decision to accept or reject the half-price offer, it definitely isn't worth haggling to find the equilibrium on the curve between 50% and 100%.

      Simply put, the waitress can't know the answer to these questions, and thinking about them probably impairs her effective waitressing. Therefore the bar is right to take the choice away from her.
    The traditional view is that reason 9 is outside the domain of economics. Economic theory works best when dealing with continuous quantities and no (or low) transaction costs; and reason 9 is the typical escape clause for "why economic analysis doesn't apply in this situation". But cognitive-behavioural economics can take cognitive incentives into account, and find the optimal point where mental costs are balanced by gains.

    Therefore, while it's irrational not to take into account all your preferences in making a decision, it may be rational to commit yourself not to do so.

    Sunday, 7 March 2010

    The economics zeitgeist, 7 March 2010

    This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.

    I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

    I use Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

    You can also see the Java version in the Wordle gallery.

    If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.