Month: October 2005

The Undercover Economist

Companies find it more profitable to increase prices (above the sale price) by a larger amount on an unpredictable basis than by a small amount in a predictable way.  Customers find it trouble some to avoid unpredictable price increases — and may not even notice them for lower-value goods — but easy to avoid predictable ones…

Have you noticed that supermarkets often charge ten times as much for fresh chili peppers in a package as for loose fresh chilies?  That’s because the typical customer buys such small quantities that he doesn’t think to check whether they cost four cents or forty.  Randomly tripling the price of a vegetable is a favorite trick: customers who notice the markup just buy a different vegetable that week; customers who don’t have self-targeted a whopping price rise. 

I once spotted a particularly inspired trick while on a search for potato chips.  My favorite brand was available on the top shelf in salt and pepper flavor and on the bottom shelf, just a few feet away, in other flavors, all the same size.  The top-shelf potato chips cost 25 percent more, and customers who reached for the top shelf demonstrated that they hadn’t made a price-comparison between two near-identical products in near-identical locations.  They were more interested in snacking.

That is from Tim Harford’s new The Undercover Economist: Exposing Why the Rich are Rich, the Poor are Poor — and Why You Can Never Buy a Decent Used Car (don’t trust Amazon, the release date is November, not January).  This book is one of the very best introductions to the economic way of thinking.   "Required Reading," says Steve Levitt, what better endorsement could you want?

Here is Tim’s home page, including his FT "Dear Economist" columns.  Here is Tim’s Private Sector Development Blog.  Here is Tim’s recent FT piece on Thomas Schelling.  Comments are open, in case you have other examples of comparable supermarket tricks.

Are savings overrated?

Here is another good exam question for my macro class:

Let’s do the calculations. Over the past 10 years, the U.S. has run up an accumulated goods and services trade deficit of roughly $3 trillion. Sounds like a lot of money, doesn’t it?

Now let’s suppose those dollars had been used for good rather than evil. That is, rather than buying imported cars, toys, and handbags, thrifty Americans would have saved their money. It’s reasonable to believe that about half of that $3 trillion would have gone into financing productive purchases here in the U.S.–new factories, power plants, office computers and the like–$1.5 trillion worth.

So what would be the payoff from all that thriftiness? A reasonable rate of return on investment, after depreciation, is roughly 7%. So $1.5 trillion in extra assets would have a return of about $100 billion a year.

That $100 billion is roughly 1% of an $11 trillion economy. Over ten years, then, complete elimination of the trade deficit might–might–have added a tenth of a percentage point to growth.

That’s a good measure of the size of the virtues of savings–roughly a tenth of a percentage point on growth. That’s 0.1 percentage points.

To put that in perspective, the estimates of long-term productivity growth have risen roughly a full percentage point over the past decade. The effects of technology more than swamp the effects of savings.

That’s Michael Mandel, from Business Week.  True, false, or uncertain?  Dig in, comments are open, and you don’t have to be in my class to offer an opinion.

What kind of tax increase can you expect?

According to today’s Wall Street Journal, Bush’s tax overhaul commission will recommend capping the value of the mortgage interest deduction at $300,000 (the current limit is $1 million).  This may include grandfather clauses for already-purchased homes (hey, your capital value still falls and mobility is limited) or a gradual introduction over ten years.  There is also talk of ending the preferential tax treatment for employer-supplied health insurance and distributing tax breaks more evenly across all income levels.  The commission is expected to recommend against a value-added tax.  The report is due November 1.  Of course whether the recommendations will pass is another matter.

Addendum: Andrew Samwick offers more.

Is game theory a dead end?

Writing about the new Nobel Prizes, Michael Mandel argues:

Game theory is no doubt wonderful for telling stories. However, it flunks the main test of any scientific theory: The ability to make empirically testable predictions. In most real-life situations, many different outcomes — from full cooperation to near-disastrous conflict — are consistent with the game-theory version of rationality.

To put it a different way: If the world had been blown up during the Cuban Missile Crisis of 1962, game theorists could have explained that as an unfortunate outcome — but one that was just as rational as what actually happened. Similarly, an industry that collapses into run-amok competition, like the airlines, can be explained rationally by game theorists as easily as one where cooperation is the norm.

I can think of possible responses:

1. Behavioral approaches will flesh out how humans actually behave.  Game theory will end up with clear predictions, just give it time.

2. Computational approaches will flesh out how humans actually behave.  Game theory will end up with clear predictions, just give it time.

3. Evolutionary approaches will flesh out how humans actually behave.  Game theory will end up with clear predictions, just give it time.

4. Experimental approaches will flesh out how humans actually behave.  Game theory will end up with clear predictions, just give it time.

5. The real world is in fact indeterminate or close to indeterminate.  The indeterminacy and multiple equilibria of game theory are not a problem, but rather reflect how closely the theory mirrors reality.  Yes you might prefer sharp, clear predictions, but tough tiddlywinks, you’re not going to get them.  Faithfulness to reality is more important than fulfilling abstract methodological strictures.

Any one of these answers would suffice and allow us to push full steam ahead, or in the case of #5 declare victory and go home.  The problem is that we don’t know which one is true. 

The bottom line: Like so much of economics, the strongest argument for game theory is simply to chat with someone who doesn’t know any.

More evidence on immigration and wages

The best of current investigations continue to support the conclusion that immigration does not hurt American real wages.  Here is part of the abstract from a recent NBER working paper:

Because U.S. and foreign born workers belong to different skill groups that are imperfectly substitutable, one needs to articulate a production function that aggregates different types of labor (and accounts for complementarity and substitution effects) in order to calculate the various effects of immigrant labor on U.S.-born labor. We introduce such a production function, making the crucial assumption that U.S. and foreign-born workers with similar education and experience levels may nevertheless be imperfectly substitutable, and allowing for endogenous capital accumulation. This function successfully accounts for the negative impact of the relative skill levels of immigrants on the relative wages of U.S. workers. However, contrary to the findings of previous literature, overall immigration generates a large positive effect on the average wages of U.S.-born workers. We show evidence of this positive effect by estimating the impact of immigration on both average wages and housing values across U.S. metropolitan areas (1970-2000). We also reproduce this positive effect by simulating the behavior of average wages and housing prices in an open city-economy, with optimizing U.S.-born agents who respond to an inflow of foreign-born workers of the size and composition comparable to the immigration of the 1990s.

Here is my previous post on the topic; try this one too.

How do feelings of mortality change your behavior?

Randall Parker has the scoop.  Here is one excerpt, quoted by Randall:

…when confronted with thoughts of death, people tend to act in ways that will boost their self-esteem. They also have fewer cognitive resources to resist behaviors that are not central to their self-image. People for whom being slim or fit is important to their self-image, for instance, will not be as likely to overeat, but if physical appearance isn’t as important, the willpower to resist that fudge sundae will plummet.

Here is my previous post, with an assist from Robin Hanson, on the same topic.  Let me note in passing, this is one reason why I would expect a bimodal response to a major crisis such as avian flu.  Most people will behave quite heroically; those who take pride in being social rebels/misfits will act like scoundrels.

Facts about Thomas Schelling

1. Jorgen Weibull — who does evolutionary game theory — chaired the committee this year.  Addendum: Here is the full list of wise men, thanks to Dennis Josefsson for the pointer.

2. If you wanted to see much of Tom, you had to agree to meet with him on Saturday mornings.  This was my preferred time too.

3. Before The Strategy of Conflict, game theory was for the most part an abstract desert.  It is not easy to find concrete economic propositions in von Neumann and Morgenstern or for that matter in Nash.  Tom brought game theory into the real world.  The magnitude of this shift is hard to appreciate from the vantage point of today.

4. Schelling’s early research was on open economy macroeconomics.

5. He loves Bach, and The Art of the Fugue in particular, most of all the Grigory Sokolov version.  This is indeed a desert island set of discs.

What did this Prize mean?

Yes it is Thomas Schelling and Robert Aumann, wonderful picks.

The Nobel website says: "for having enhanced our understanding of conflict and cooperation through game-theory analysis."  Here is the NYT article, no permalink yet.  FoxNews offers similar information.  Both men clearly deserve the prize.  I view this year’s award as a welcome swing back to the philosophical, theoretical, and speculative dimensions of economics.  In recent years the Committee seems to have gone out of its way to reward the scientistic approach to economics (Heckman and McFadden, for instance).  All these earlier picks were good ones, but I am happy to see Schelling — a fruitful generalist if there ever was one — and Aumann, a deeply philosophical thinker, get the nod.  Aumann I don’t know personally, but there are few scholars I admire more than Thomas Schelling.

Robert Aumann, one of two new Nobel Laureates

Here is one summary of Aumann’s work on game theory:

Robert J. Aumann’s has been one of the leading figures in the mathematical surge that has characterized Neo-Walrasian economics and game theory in the past forty years. Aumann entered into economics via cooperative game theory –

In Neo-Walrasian theory, Robert Aumann is perhaps best known for his theory of core equivalence in a "continuum" economy. Aumann introduced measure theory into the analysis of economies with an infinite number of agents – formalizing the "perfectly competitive" scenario. In his classical 1964 paper, Aumann proved the equivalence of the Edgeworthian core and Walrasian equilibrium allocations when there are an uncountable infinite number of agents – thereby providing the limit case for future work on core convergence. In order to prove this result was not vacuous, Aumann went on to prove the existence of equilibrium (1966) in this "perfectly competitive" scenario. On his way, he contributed to mathematics itself by providing a definition of the "integral" of a correspondence (1965), which was previously absent.

Previously, Aumann (1962) had swung Ockham’s razor and helped remove the axiom of completeness of preferences from the Walrasian theory of choice. In another classical paper with F.J. Anscombe in 1964, Aumann formalized the notion of "subjective probability", a concept that had been earlier forwarded by Leonard Savage, that profoundly changed the theory of choice under uncertainty.

His contributions to game theory have perhaps been no less path-breaking. Aumann entered game theory in 1959 to carefully distinguish between infinitely and finitely repeated games. With Bezalel Peleg in 1960, Aumann formalized the notion of a coalitional game without transferable utility (NTU) – one of the organizing beacons of his later research. With Michael Maschler (1963), he introduced the concept of a "bargaining set". In 1974, Aumann went on to identify "correlated equilibrium" in Bayesian games. In 1975, Aumann went on to prove a convergence theorem for the Shapley value. In 1976, he formally defined the concept of "Common Knowledge". Also in 1976, in an unpublished paper with Lloyd Shapley, Aumann provided the perfect folk theorem using the limit of means criterion.

Here is a strange but fascinating interview with Aumann.  It covers John Nash, religion, and the Cold War, among other matters.  Here is his home page, with links to articles.

My favorite Aumann paper is his 1976 piece on agreeing to disagree.  He proved the startling result that if two rational, truth-seeking people have common "priors," in a Bayesian sense rigorously definable, then those two individuals should not disagree once they exchange opinions.  Imagine I think there are 200 balls in the urn, but Robin Hanson thinks there are 300 balls in the urn.  Once Robin tells me his estimate, and I tell him mine, we should converge upon a common opinion.  In essence his opinion serves as a "sufficient statistic" for all of his evidence.  (This analysis also led Aumann to clarify the important game-theoretic concept of "common knowledge.")  Yet people disagree all the time.  Does this mean that priors are rarely common?  That we are rarely rational truth-seekers?  A bit of both?  Robin Hanson is doing much work on this topic.  Here is my paper with Robin, we argue you that if you disagree with your "epistemic peers," you are probably not a truth-seeker.

Congratulations to both Aumann and Schelling, comments are open…

Thomas Schelling, new Nobel Laureate

Note my biases, Schelling was my mentor at Harvard.

Tom is an unassuming guy, who looks as if he sells Hush Puppies at the local mall.  But he is one of the sharpest people you will meet.  He delivers the killer point, argument, or anecdote with striking regularity.  Even in his eighties he is sharp as a tack.  He has a deeply philosophical and humanistic approach to economics.  What are his contributions?

1. The idea of precommitment.  You can be better off, either individually, or institutionally, if your choices are limited in advance.  This is a key idea in monetary policy (many governments seek to tie the hands of their central banks), the theory of bargaining (try buying a used car, and see if the salesman doesn’t talk about "the boss upstairs"), and industrial organization (firms may invest in capacity to precommit a market position and deter rivals).  You find the precommitment frequently in movies as well, especially where kidnapping is involved; what is that Mel Gibson flick again?  Here is an excellent Jon Elster piece on the ambiguities of precommitment.  Here is my piece on similar themes.

2. The paradox of nuclear deterrence.  Ever see Dr. Strangelove?  Tom developed the idea that deterrence is never fully credible (why retaliate once you are wiped out?).  The best deterrent might involve precommitment, some element of randomness, or a partly crazy leader.  I recall Tom telling me he was briefly an advisor to Kubrick.  Here is someone else’s essay on the paradox of deterrence.

3. Focal points.  People coordinate by directing their attention to commonly recognized points of importance.  If a meeting time for lunch is not specified, you might assume 12 noon.  If someone mentions "economics blog," of course comes to mind.  And so on.  Much social coordination occurs in this manner.  I once asked me class: "If you had to hide a one hundred dollar bill in a book, so that your friend would find it, but you could not announce the book, which volume should you choose?"  Many said The Bible but of course the game theorist picks Schelling’s The Strategy of Conflict.

4. Behavioral economics and the theory of self-constraint.  One of Tom’s best pieces is "The Mind as a Consuming Organ," American Economics Review, 1984. Here is a lecture of his on self control.  Will Wilkinson cites a bit of that essay.  Tom made it respectable for economists to talk once again about happiness.

Tom has been an underrecognized father of behavioral economics.  His work on addiction, memory, and personal control was pathbreaking and came nearly twenty years before the "behavioral revolution" in economics.  He analyses the tricks people use to control their wills.  For Tom, self-control is often a more important determinant of happiness than is wealth.  Tom once told me his work sprung from his own attempts to quit smoking, which he did finally manage.  Several times.

5. The economics of segregation. Tom showed how communities can end up segregated even when no single individual cares to live in a segregated neighborhood.  Under the right conditions, it only need be the case that the person does not want to live as a minority in the neighborhood, and will move to a neighborhood where the family can be in the majority.  Try playing this game with white and black chess pieces, I bet you will get to segregation pretty quickly.  Here is a demo model for playing the game.

6. Later in his life Tom turned his attention to issues of global warming.  He has been skeptical of the idea that global warming involves insuperably high economic costs.  Here is a short essay by Tom on the topic.  Here is his excellent AER piece on the same topic.

Tom is not well-represented on the web, here is one photo, but the associated links are mostly broken.  Here is Tom’s piece on Hiroshima.  Here is the Wikipedia bio, note Wikipedia already reports he won the prize.  Here is a great interview with Tom.  Here is Tom’s work on the Copenhagen Consensus.

A few bio facts: Like so many other prestigious American economists, Tom worked for the Marshall Plan in its early stages.  He spent most of his career at Harvard, first in the economics department, later in the Kennedy School.  He had close ties with the Rand Corporation.  He was an advisor to Kissinger during the Vietnam War but quit in disgust.  He is now emeritus at University of Maryland.  I have always interpreted Tom’s political views as those of a conservative Democrat.

Here is a piece I wrote with Dan Klein and Timur Kuran, Salute to Schelling: Keeping it Human.  In this piece, recently published, we asked the Committee to give the Prize to Tom.  Here are Tom’s books, they are all worth reading.

Comments are open, you can add more; Tom could have won more than one Nobel Prize for all his contributions.

Schelling and Aumann!

I am thrilled!  I am just off the airport, I’m giving a talk at Carnegie-Mellon so this will be brief, but the thing to know about Schelling is that he is brilliant but you won’t find hardly a single equation in his Nobel prize winning work.  Everyone can and should read the Strategy of Conflict and Micromotives and Macrobehaviour.  More later.  I expect to be on NPRs All Things Considered this afternoon.

The FedEx Economy

I nominate David Leonhardt for a Voxy for his NYTimes article, the FedEx Economy.  Leonhardt opens with a description of how FedEx flies a small fleet of empty planes through the night just waiting for a possible shock that they can rush in to smooth.  Sometimes it’s a shock to demand (an unusually large number of packages) other times it’s a shock to supply (a broken plane), in either case FedEx adjusts quickly to restore it’s economy to normal flow.

Project FedEx’s ability onto thousands of other firms, argues Leonhardt, and you have a much more flexible economy with an interesting new feature, "the micro-recession."

When of them strikes, activity slows for a few weeks, sometimes in just certain sectors, as companies adjust to a dip in demand.  It has happened much more often in the last few years than in earlier expansions, but growth has picked up each time, thanks in part to adjustments that businesses have made…Year to year, the economy is less volatile but in some ways it has become more volatile month to month.      

It’s not clear to me that more flexibility implies more micro-recessions, I’d like to see a model with that feature.  It’s also unclear to me how much credit the Fed should get for avoiding big shocks and how much FedEx should get (i.e. technological change).  Nevertheless, Leonhardt’s article is a big thought piece on the macroeconomy that one rarely sees in a newspaper.