Month: July 2013

Bets and Beliefs

I fear that Tyler’s latest post on bets and beliefs will obfuscate more than clarify. Let’s clarify. There are two questions, do portfolios reveal beliefs? Do bets reveal beliefs?

Tyler has argued that portfolios reveal beliefs. This is false. If transaction costs were zero and there were an asset for every possible future state of the world then this would be true. Since transaction costs are not zero and there are many more states of the world than there are assets–even when we combine assets–portfolios do not reveal beliefs. Portfolios might reveal a few coarse beliefs but otherwise no go. Since most people have lots of beliefs about the future but don’t even have a portfolio (beyond human capital) this should be obvious.

Do bets reveal beliefs? Usually but not necessarily. Two people made bets with Noah Smith. Each thought Noah was an idiot for making the bet. Noah, however, had arbitraged so that he couldn’t lose. Clever Noah! Noah’s bets, either alone or in conjunction, did not reveal his beliefs.  But is this the usual situation? No.

For the same reasons that portfolios don’t reveal beliefs, high transaction costs and few assets relative to states of the world, it’s going to be difficult to arbitrage all bets. Many bets in effect create a new and unique asset that can’t be easily duplicated and arbitraged away in other markets. I once bet Bryan as to what an expert would answer when asked a particular question. Hard to arbitrage that away.

I also agree with Bryan that the question is empirical and not simply theoretical. When I say that a bet is a tax on bullshit the implication is not just that bullshitters are more likely to lose their bets but also that a tax on bullshit reduces its supply. The betting tax causes people to think more carefully and to be more precise. When people are more careful and precise the quality of communication increases. As Adam Ozimek writes:

In a lot of writing in blogs it is unclear specifically what the writer is trying to say, and they seem to wish to convey an attitude about a certain position without actually having to make a particular criticism of it, or by making a much actual narrower criticism than rhetoric implies…It is useful to have betting because deciding clearly resolvable terms of a bet leads to specific claims…

Tyler argues that under some conditions betting won’t change what people say (under a wide range of portfolios…a matter of indifference… bets won’t be authentic) but Tyler doesn’t give us a specific, testable prediction. The empirical evidence, however, is that small bets do cause people to change what they say. This is one of the reasons why even small-bet, prediction markets work well.

Tyler has his reasons for not liking to bet but if you think one of those reasons is that he has already revealed his beliefs then you are surely not a loyal reader.

How to curb climate change?

Paying Canadians to keep their oil sands in the ground to curb climate change might not sound like an obvious vote winner to a cash-strapped European government.

But it makes more economic sense than people realise, according to Bård Harstad, a Norwegian academic who has just won a prestigious environmental economics prize for a provocative paper suggesting just such a move.

Mr Harstad, 40, has been awarded the Erik Kempe prize, worth SKr100,000, by the European Association of Environmental and Resource Economists for a study called “Buy Coal! A Case for Supply-Side Environmental Policy”.

The FT article is here, and you may recall an earlier MR suggestion that sealing or blowing up especially dirty fuel sources, in a Hotelling intertemporal resource extraction model, is more likely to be effective than many kinds of tax.

Do positive wealth shocks stick?

There is a new paper by Hoyt Bleakley and Joseph P. Ferrie, titled “Up from Poverty? The 1832 Cherokee Land Lottery and the Long-run Distribution of Wealth.”  This paper uses a very clever experimental design, relying on random, lottery-based allocations of land.  The question is how much winning this land lottery helped people in the longer run.  Here is the abstract:

The state of Georgia allocated most of its land to the public through a system of lotteries. These episodes provide unusual opportunities to assess the long-term impact of large shocks to wealth, as winning was uncorrelated with individual characteristics and participation was nearly universal among the eligible population of adult white male Georgians. We use this episode to examine the idea that the lower tail of the wealth distribution reflects in part a wealth-based poverty trap because of limited access to capital. Using wealth measured in the 1850 Census manuscripts, we follow up on a sample of men eligible to win in the 1832 Cherokee Land Lottery. We assess the impact of lottery winning on the distribution of wealth 18 years after the fact. Winners are on average richer (by an amount close to the median of 1850 wealth), but mainly due to a (net) shifting of mass from the middle to the upper tail of the wealth distribution. The lower tail is largely unaffected.

The bottom line is that the grants increased inequality, many people were helped a great deal, and a large chunk of people weren’t helped at all.  An ungated version of the paper is here.

Bets, beliefs, and portfolios: some further observations on the theses of Bryan Caplan

Bryan Caplan thinks that portfolios don’t reveal much about actual beliefs,.  Here is one of his arguments:

Even prominent Nobel prize-winning economists admit they follow simple rules of thumb when they invest.  So unless people’s beliefs are carved in stone, how could portfolios possibly reveal much about their beliefs?  Tyler is a case in point: He changes his mind a hundred times a day, but he follows a simple financial strategy that hasn’t varied in years.

I view it differently.  I don’t trade in public markets but I vary my allocations by changing how much money I spend and how to allocate my time.  Perhaps not coincidentally, this puts me square into the world of classical finance theory as represented by “the mutual fund theorem,” with a static equity portfolio of fixed proportions and some unique covariances on my human capital.  I call that rationality not inertia.

Bryan, you will note, is a founder of the theory of rational irrationality, which suggests you become more rational as the private stakes from your decisions go up.  These days he is wishing to argue that the truly small stakes reflect what you really think, through the lens of mental accounting and compartmentalization.  Of course that would undercut or at least drastically relativize his earlier theory.  I say he has made a large and successful career bet — much bigger than any of his piddly ante monetary bets — on the theory of rational irrationality, so he must really agree with me after all.

It also happens that Bryan’s emphasis on simple rules of thumb will work against his interest in person-to-person bets as a metric of authenticity.  If you don’t change or examine your overall portfolio very often, that means some reasonably wide range of portfolios is a matter of indifference or near indifference to you, if only because fine-tuned improvements are hard to find.  (Do you really give matters a re-ponder when a firm in your portfolio pays dividends?)  In that case, however, the small bets won’t be authentic either.  One could compartmentalize one’s personal bets quite easily and say to oneself — whether consciously or not — “I can make this small bet: it still keeps my overall portfolio within that broad range of indifference.”  Which indeed it does.  The bet is then undertaken for expressive reasons, which is fine, nothing against that, but for me it is more fun to cheer for Tony Parker (without betting on him).  I think of these small personal bets as akin to sports loyalties most of all and not as a unique window into our real beliefs.

The small person-to-person bets pay off (or not) in terms of pride, including for some people the pride in betting itself.  One relevant substitute is to attempt to produce pride using your own internal mental accounting of your own predictions and so we must make the broader portfolio comparison.  What the $$ betters are signaling is a lack of vividness for their own internal mental worlds.  In my mind, I’m already betting an optimal amount of pride through my own mental accounting.  Maybe some of us are already betting too much internal pride on external events; after all, the variance of pride introduces some new exogenous risk into life and perhaps we should be trying to move in the opposite direction toward greater pride indifference to external events.  That is what the Stoics thought.

Most of all, I fear that Bryan’s results are coming from an asymmetric approach where he applies positive observation to large portfolios and normative recommendations to small bets.  Bryan could go for a “positive vs. positive” comparison, in which case he would point out that people trade and adjust their large portfolios all the time, but don’t make small bets on public policy nearly as much.   Alternatively, he could try a “normative vs. normative” comparison, in which case would you sooner recommend that people drop their inertia for their large portfolios or for their small ones?  To even raise such a question is to answer it.

Do you want to find out “what a person really thinks”?  Look  at whom they married, how much money they spend, and how they devote their time.  That is the most important portfolio of them all.

Just don’t bet that Bryan and I are going to agree anytime soon.

Why are there not more science majors?

There is a new paper (pdf) by Ralph Stinebrickner and Todd R. Stinebrickner on this topic, and here is their bottom line conclusion:

We find that students enter school quite optimistic/interested about obtaining a science degree, but that relatively few students end up graduating with a science degree. The substantial overoptimism about completing a degree in science can be attributed largely to students beginning school with misperceptions about their ability to perform well academically in science.

Assorted links

New evidence on marginal tax rates and income

There is a new paper (pdf) from Karel Mertens:

This paper estimates the dynamic effects of marginal tax rate changes on income reported on tax returns in the United States over the 1950-2010 period. After isolating exogenous variation in average marginal tax rates in structural vector autoregressions using a narrative identification approach, I find large positive effects in the top 1% of the income distribution. In contrast to earlier findings based on tax return data, I also find large effects in other income percentile brackets. A hypothetical tax reform cutting marginal rates only for the top 1% leads to sizeable increases in top 1\% incomes and has a positive effect on real GDP. There are also spillover effects to incomes outside of the top 1%, but top marginal rate cuts lead to greater inequality in pre-tax incomes.

Why don’t dying firms raise prices?

Bryan Caplan asks:

“Demand is more elastic in the long-run than the short-run.”  It’s a textbook truism.  Implication: Raising prices is often a bad idea even if profits instantly rise.  In the long-run, demand will get more elastic, and the price-gouging firm will discover that its behavior was penny-wise and pound-foolish.

This all makes sense, but there is an awkward implication: Once firms realize that they’re dying, they ought to raise prices.  By the time long-run demand elasticity kicks in, they’ll be out of business.  Why not opportunistically take advantage of the situation?

Yet as far as I can tell, this almost never happens.  When firms are on their last legs, they tend to cut prices, or at least hold them steady.

What gives?  Is the textbook truism false?  Is this a corporate governance problem – the current CEO never wants to admit that the end is nigh?  Or what?

I can think of a few examples of this phenomenon.  Dying academic book publishers for instance seem to be raising prices.   This also may explain some aspects of the market for oil.  Arguably to the extent Saudi Arabia perceives itself as running out of oil, they feel less need to keep the market price down to limit investment in energy substitutes.  But why are there not more examples?  Is demand too low for reasons of selection?  Does internal collapse within the firm, and personnel departures, raise the shadow value of bringing in revenue sooner rather than later?