Knowing and Making

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.  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. Ass...

Greg Mankiw apparently thinks insider trading is a good idea...at least, he links approvingly to this defence of it by Donald Boudreaux in the Wall Street Journal [ An analysis of Greg Mankiw's clever "link deniability" strategy is coming in another posting ]. An intriguing notion. It is broadly based on the idea that information is going to be hidden by companies anyway, so we may as well hope that insiders accidentally give it away by buying and selling stock. Doesn't that seem rather defeatist? If public companies aren't providing the right information to investors, so the investors can't make accurate decisions, shouldn't we find a mechanism to make them do so? Insider trading, because it enriches executives at the expense (at least in the short term) of other investors, destroys the trust which is a key variable in how well capital markets work. There is always an agency problem inherent in one person managing an asset on behalf of another. Trust is ...

Tyler at MR has been asking recently whether the structure of bankers' pay caused (or contributed to) the financial crisis. Matt Yglesias also has something to say about it (via the above link). I agree with the general skepticism about this - it is a bit too easy as an explanation. Limited liability on the other hand is definitely a contributor - shareholders' interests are actually almost the same as those of employees: take lots of risk as the upside is much higher than the downside. If a bank makes $100 billion, shareholders and employees get to share it out. If it loses $100 billion, shareholders lose their whole stake, employees lose a large part of theirs, but creditors are likely to lose many times more. Or if the creditors in question are insured depositors, the taxpayer loses out instead. Ultimately, banks manage much more of their depositors' and other lenders' money than shareholders' money. So this had some impact on risk-taking. But I am starting to c...

I intended to mention this little tussle between Felix Salmon and John Carney a couple of weeks ago. As it happens, it's provoked an idea on a solution to the eternal problem of bankers' pay. Carney points out that we don't actually want traders to take the minimum possible risk in all circumstances. If they did, they would never make any returns at all. Instead, we want them to take the right level of risk...at the scale of the whole economy, this is the socially optimal level; at the scale of an individual company, it's the optimal level of risk for shareholder value. He says that without guaranteed bonuses, traders will take less risk than shareholders want them to, because they will need to retain some amount of guaranteed upside to pay their mortgages. Felix's argument against this is interesting, because he doesn't quibble with the theory. As various people have pointed out, because shareholders have limited liability, they have an incentive to get th...

I'm reading Dani Rodrik's " One Economics, Many Recipes " which sheds interesting light on the understanding of developing-country growth and its causes. Chapter one focuses on the idea that there are basic principles behind economic development (indeed, economic activity in general): property rights, sound money, fiscal solvency, and market-oriented incentives. The exact policies which result in these outcomes are not necessarily those from the standard (Washington Consensus) list: privatisation, tariff reduction, etc. Instead, the universal principles need to be achieved with policies that are tailored to the country in question. There's one point he makes in passing which struck me as fundamental. From p38 (of the 2007 edition): "...policy changes at the outset have been typically modest...[South Korea's] military government led by Park Chung Hee that took power in 1961 did not have strong views on economic reform, except that it regarded economic deve...

A fascinating question today on Robert Peston's blog which mixes rationality and game theory. Do shareholders of the merged Lloyds-HBOS want to retain the management (inherited from Lloyds) which got them to where they are today? The strictly rational answer is to look only at the future, and the expected value of retaining versus terminating the managers. Rational agents do not consider the past, as you cannot incentivise for past actions - they have already happened and there is no possibility to change them. In which case, shareholders should make a prediction about these executives' likely future performance. Of course, they do  need to use past actions and performance as data points in estimating future performance. Thus, absorbing HBOS which was probably an error of judgment, should be set against the other (generally smart) actions that they took while managing Lloyds. However, in reality people do consider the past while making these kinds of decisions, as if their cur...