Month: May 2010

Sentences to ponder, discount babies edition

The paper finds the cost of adopting a black baby needs to be $38,000 lower than the cost of a white baby, in order to make parents indifferent to race. Boys will need to cost $16,000 less than girls.

Presumably that holds at the margin only, not for all parents.  Here is more, from Allison Schrager.  It seems that most couples prefer to adopt non-black girls.  Here is Allison's Twitter feed.

Addendum: Here is a related story on rabbinical rulings.

Advertising and pharmaceutical prices

The classic Chicago School result was that advertising for eyeglasses lowered prices, due to increased competition.  It doesn't seem the same is true for pharmaceuticals, as we see from Dhaval Dave and Henry Saffer:

Expenditures on prescription drugs are one of the fastest growing components of national health care spending, rising by almost three-fold between 1995 and 2007. Coinciding with this growth in prescription drug expenditures has been a rapid rise in direct-to-consumer advertising (DTCA), made feasible by the Food and Drug Administration’s (FDA) clarification and relaxation of the rules governing broadcast advertising in 1997 and 1999. This study investigates the separate effects of broadcast and non-broadcast DTCA on price and demand, utilizing an extended time series of monthly records for all advertised and non-advertised drugs in four major therapeutic classes spanning 1994-2005, a period which enveloped the shifts in FDA guidelines and the large expansions in DTCA. Controlling for promotion aimed at physicians, results from fixed effects models suggest that broadcast DTCA positively impacts own-sales and price, with an estimated elasticity of 0.10 and 0.04 respectively. Relative to broadcast DTCA, non-broadcast DTCA has a smaller impact on sales (elasticity of 0.05) and price (elasticity of 0.02). Simulations suggest that the expansion in broadcast DTCA may be responsible for about 19 percent of the overall growth in prescription drug expenditures over the sample period, with over two-thirds of this impact being driven by an increase in demand as a result of the DTCA expansion and the remainder due to higher prices.

The paper is here (NBER gate).  Here is a simpler paper on advertising and prescription drug expenditures.  Here is a related paper on the advertising topic.  Here is another paper which generates higher prices from advertising.  Pharmaceuticals could be different from eyeglasses for a few reasons, one being weaker contestability in the market, due to patent protection, another being that consumers process information about health care differently.  This paper suggests that co-payments don't much help reduce inappropriate demands for pharmaceuticals.   

I thank Eric John Barker for the initial pointer.

A simple theory of being single and male in Washington

Michael Rosenwald, from his WaPo interviews with me, blogs an outtake.  He cites my words on the dating market in Washington, D.C.:

I think it's better to date here if you are male. Government attracts a disproportionate share of intelligent women. I've never lived in New York, but there are so many celebrities, billionaires. If you are a guy in New York, there's always another guy that crushes you on the scale. Here, there are all these politicians but they are really out of commission for the most part — or if they fool around, it's with interns. You don't have to compete with them. The people who are really high status are off the market. As a male in Washington, you can be high in status fairly easily without the true very high status competing. In New York or L.A., there are movie stars and directors. Even if a woman can't be with a movie star, women can still say, 'Gee, this guy or that guy is not a movie star or a director.' There's lobbyists and lawyers here, a lot of them. You can be more interesting than that. This is a great place to live.

Assorted links

1. Economists on crime and anatomy.

2. Can Greece cut its deficit by ten percent of gdp?  And an NYT fiscal symposium, including yours truly.

3. Robert Frank responds to David Friedman.

4. World's strangest vending machines.

5. Via Chris F. Masse, never underestimate the power of a good story (one minute video).

6. The business model of Wall Street?

7. Matt Yglesias on spending cuts for the UK.

8. Bernanke commencement speech (footnote 13 cites MR).

9. How changing labor markets have made fiscal stimulus less effective.

The Dark Magic of Structured Finance

In Too Big To Save Robert Pozen gives a clever example, based on an excellent paper by Coval, Jurek and Stafford, which explains both the lure of structured finance and why the model exploded so quickly.

Suppose we have 100 mortgages that pay $1 or $0.  The probability of default is 0.05 (assume independence).  We pool the mortgages and then prioritize them into tranches such that tranche 1 pays out $1 if no mortgage defaults and $0 otherwise, tranche 2 pays out $1 if 1 or fewer mortgages defaults, $0 otherwise.  Tranche 10 then pays out $1 if 9 or fewer mortgages default and $0 otherwise.  Tranche 10 has a probability of defaulting of 2.82 percent.  A fortiori tranches 11 and higher all have lower probabilities of defaulting.  Thus, we have transformed 100 securities each with a default of 5% into 9 with probabilities of default greater than 5% and 91 with probabilities of default less than 5%.

Now let's try this trick again.  Suppose we take 100 of these type-10 tranches and suppose we now pool and prioritize these into tranches creating 100 new securities.  Now tranche 10 of what is in effect a CDO will have a probability of default of just 0.05 percent, i.e. p=.000543895 to be exact.  We have now created some "super safe," securities which can be very profitable if there are a lot of investors demanding triple AAA.

To review we have assumed that the underlying mortgages each have a probability
of default of p=.05 and by pooling and prioritizing we have created a tranche with a probability of
default of just p=.0282 and a CDO with a probability of default of
p=.0005.  In this way, structured finance was able to create many triple AAA securities from a pool of securities none of which were triple AAA.  This point is widely understood.  Now here is a much less well understood consequence.

Suppose that we misspecified the underlying probability of mortgage default and we later discover the true probability is not .05 but .06.  In terms of our original mortgages the true default rate is 20 percent higher than we thought–not good but not deadly either.  However, with this small error, the probability of default in the 10 tranche jumps from p=.0282 to p=.0775, a 175% increase.  Moreover, the probability of default of the CDO jumps from p=.0005 to p=.247, a 45,000% increase! 

The dark magic of structured finance conjured many low-risk securities
out of many risky securities.  Like all dark magic, however, the
conjuring came at a price because if you didn't get the spell exactly
correct it was easy to create something much more risky and dangerous
than you were likely to have ever imagined.

Here is an excel file, StructuredFinanceMath, with the calculations.

Addendum: Adding in correlation among mortgage defaults makes the math more difficult but doesn't change the bottom line that I wanted to illustrate which is that small changes in the underling default risk (or correlation) are highly amplified in the tranches and CDOs.

A Mathematical Model for the Dynamics and Synchronization of Cows

I've wondered about this plenty, though I was hoping for a simpler model:

We formulate a mathematical model for daily activities of a cow (eating, lying down, and standing) in terms of a piecewise affine dynamical system. We analyze the properties of this bovine dynamical system representing the single animal and develop an exact integrative form as a discrete-time mapping. We then couple multiple cow "oscillators" together to study synchrony and cooperation in cattle herds. We comment on the relevant biology and discuss extensions of our model. With this abstract approach, we not only investigate equations with interesting dynamics but also develop interesting biological predictions. In particular, our model illustrates that it is possible for cows to synchronize \emph{less} when the coupling is increased.

For the pointer I thank Michael F. Martin.  Here is a claim that cows tend to align north-south.  Here is further discussion.

The challenge

David Leonhardt spells it out clearly:

As a rough estimate, the government will need to find spending cuts and tax increases equal to 7 to 10 percent of G.D.P. The longer we wait, the bigger the cuts will need to be (because of the accumulating interest costs).

Seven percent of G.D.P. is about $1 trillion today. In concrete terms, Medicare’s entire budget is about $450 billion. The combined budgets of the Education, Energy, Homeland Security, Justice, Labor, State, Transportation and Veterans Affairs Departments are less than $600 billion.

This is why fixing the budget through spending cuts alone, as Congressional Republicans say they favor, would be so hard.

Here is related commentary.

Thoughts on the British election

1. It's amazing how quickly they form a new government.  We could learn something from this.

2. Spending cuts will be necessary.  (I am curious: what is the U.S. "progressive" take on this question.  Is it admitted that spending cuts are necessary?)

3. Tax increases will be necessary.  (Do U.S. commentators on the right admit this?)

4. Britain should avoid proportional representation.  Classic parliamentary systems are good at making big changes in a hurry, when the major party knows which changes are needed, and that is Britain's current position.  It's no accident that Thatcher and Roger Douglas — both of whom operated under extreme Westminster systems – were two of the major reformers in the late 20th century.  PR gives too much power to minority parties in the ex post electoral bargain and it works best when there is extreme consensus at the social level, combined with the need to bring certain co-optable minorities into that consensus.  Is that the way to think about UK politics today?  I don't see it.  Does any objective observer jump for joy when a "first past the post" election yields a hung Parliament and requires a coalition, as it does now?  No, so why institutionalize this need with PR?

5. Do paragraphs like this make you feel better?: "William Hague, the new foreign secretary, said the coalition would be built on the personal chemistry of Mr Cameron and Mr Clegg, and said that Mr Clegg would not get a veto on government decisions. He told the BBC: “Their ability to resolve this situation bodes very well for all our ability to work together in government.”"  They shouldn't.

Bob Frank and David Friedman on redistributive taxation and positional goods

Remember Bob Frank's argument that wage compression in private firms implies some (possibly libertarian) case for progressive taxation?  Here is Frank's original column.  Here is David Friedman's critique.  Here is Frank's reply.  (Angus, by the way, offers another critique.)  So many issues are at stake, here is one of them:

He [Friedman] goes on to suggest that my argument implies that “the rich ought to be in favor of grinding down the poor…” These remarks betray a curiously dark conception of human nature. Being concerned about relative position surely does not imply taking pleasure in the knowledge that others are poor. If it did, middle-income people would spend long hours observing people in poor neighborhoods, thereby to boost their own self-esteem. That they don’t choose to spend their time this way doesn’t mean they don’t care about relative position.

What do people spend their time doing?  To the extent I care about relative position, what do I do?  I take actions to raise my preoccupation with areas I am good at, which is my version of spending long hours observing people in poor neighborhoods, yet without having to feel I am deliberately slumming, which would lower my self-esteem.

In this sense I think Frank should accept Friedman's attempted reductio.  That said, I don't accept Friedman's claim that Frank's theory predicts that "the rich ought to be in favor of grinding down the poor."  Subtle self-deception about one's own merits is, at least in today's America, a more effective recipe for generating utility.  So I believe in the ubiquity of status-seeking, though I see the process as more positive-sum than Frank does.  I can think my area of expertise is really important and you can think the same, without it being zero-sum.

That all said, what exactly is the problem with redistributive taxation?  Why can't we, for Benthamite reasons, have two rates of twenty and thirty percent instead of one rate of twenty-five percent?  Status-seeking or not?

I read this paragraph as best summarizing Frank's point of view:

High social rank, as noted, has substantial instrumental value, and low social rank entails substantial concrete costs, irrespective of whether people care about rank per se. Forcing a productive person to buy more social rank than he wants is objectionable, but the alternative is to give all of society’s most productive members a valuable asset free of charge. That asset would command a high price in the libertarian’s ideal world in which purely voluntary societies could form and dissolve at will. And since its value is a direct consequence of the substantial costs associated with low social rank, a society without redistributive taxation should strike libertarians as even more objectionable.

Here is David Friedman's final response.

Addendum: David Henderson comments.