Presidential candidate Hillary Clinton proposed giving every newborn $5000 that would accumulate interest and be available once the young person turned 18.  She is now backing away from the idea but it’s still worth thinking about the economics of the proposal. 

Consider first that many parents already save to help their children through college.  Thus, the first and primary beneficiaries of the plan wouldn’t be children but parents who knowing that their child has some $12,000 (with interest) coming on their 18th birthday can afford to spend more on themselves.  (Or if you like the parents can spend more on buying the teenager a new car instead of tuition, room and board.)

The parents may be the primary beneficiaries of the transfer but they are also the primary bearers of the tax.  Thus, instead of parents taking money out of their pocket and giving it their children directly we have the government reaching into the pocket of the parents with one hand and giving to the children with the other.  But taking a dollar from A and giving it to B typically costs a lot more than a dollar – given the costs of taxation and bureaucracy a dollar taken may be only 50 cents received.   

Baby bonds are more likely to be a net increase in wealth for poor families.  But will the money be spent on something like college?  Yes, in some cases, but it’s naive to think that the only problem of poverty is lack of money.  Laugh or curse if you like but think about it this way: A child born in the United States already owns an immensely valuable asset, namely the right to live and work in the United States.  This right is worth much more than $12,000 (ask any immigrant) so is more money really going to make a big difference in life choices?

A baby bond might be worth testing if it were targeted to the poor (to avoid the wasteful transfer) and if instead of focusing on income it looked to incentives.  A better baby bond would be a true bond paid only if say the baby graduated from high school and had not been charged with a crime by their 18th birthday.

Overall,
mechanism design increases our appreciation of markets, if only by
showing how difficult it is to produce good outcomes while respecting
the constraints that markets must satisfy. In a sense, mechanism design
is to markets what genetic algorithms are to life. Theorists may one
day design a better market mechanism or a better genetic code but for
now the gains will come from using our deeper understanding to gently
improve something that’s already pretty marvelous.

That’s me writing at Reason.

Ok, Grandma may still have some difficulty but in honor of today’s Nobelists, Hurwicz, Maskin and Myerson let’s give it a go.  Suppose that you are selling a rare painting for which you want to raise the maximum revenue.  There are two potential buyers, Tyler, who values the painting at $100,000, and Alex who values it at $20,000.  The problem would be simple if you knew this information – you would then set the price at $99,999 and Tyler would buy maximizing your revenue.  But how much Tyler and Alex value the painting is their own private information.  How then should sell the painting?

One possibility that springs quickly to mind is an auction.  In a standard English open-cry auction Alex and Tyler will bid for the painting and the bids will keep rising until Alex is forced to drop out at $20,001.  Thus the auction earns you $20,001.  Not bad but is this the maximum revenue possible?  Remember that Tyler values the painting at $100,000 so you could be leaving a lot of money on the table.

What else can you do?  Well, how about an auction with a reserve price, say $50,000 – think of a reserve price as a secret bidder who calls in his bids on the phone.  A reserve price of $50,000 works well in this case as Tyler will pay $50,001.  But note that you just got lucky, if Tyler had valued the good at $30,000 you would have earned nothing at all.  Thus you would like to know whether a reserve is always optimal and how to set it.  (Riley and Samuelson, and much more generally Myerson both show that a reserve price is always optimal and how to set it).

But why stop at a reserve price?  How about a reserve price and an entry fee?  But why stop at reserve prices and entry fees?  You can add any kind of requirement to the auction that you want but will these requirements help you to raise revenue?  Lets boil the problem down to its essence.  Think about an auction as a mechanism – bidders put information into the mechanism, their bids, and the mechanism tells them the outcome.  (Hurwicz was the first to really start thinking about mechanisms in these very general terms.)

You want to design the mechanism to achieve a certain outcome.  The mechanism can be as complicated as you want but it must satisfy certain conditions.  First, the bidders must participate voluntarily – you can’t boil them in oil – so there is a participation constraint.  At the end of the day the bidders must expect to be at least as well off as if they did not play the mechanism game (at least on average).

Second, there is an incentive compatability constraint.  You don’t know how much Alex and Tyler truly value the painting so suppose that Tyler mimics whatever Alex does – Tyler can do this since he values the painting at least as much as Alex does.  It follows that whatever outcome the mechanism assigns to Alex, Tyler must get at least as much.  This is a significant constraint because it means that if you want Tyler to do something different than Alex, and you do, you want Tyler to bid more, then you must give Tyler something in return.  Thus, even in the optimal mechanism you, the seller, are not going to get everything.  Tyler is going to walk away with some surplus.

We still haven’t solved for optimal mechanism, however.  And here is where the magic comes.  Not magic as in something wonderful but magic as in hand-waving.  Maskin and Myerson proved something very useful about mechanisms with these types of constraints.  It turns out that if you follow the constraints then you can restrict attention to mechanisms in which Tyler and Alex always tell the truth about their values, this is called the revelation principle.  (In a sense, this is obvious for imagine that we find the optimal mechanism given that Tyler and Alex submit whatever bids/information they want.  Then you tell Tyler and Alex – next time why don’t you tell the truth about your values and we promise to give you exactly the outcome that we would have given you under the previous mechanism.)

In the case of auctions the direct mechanism is well known, a second price auction.  In a second price auction the high bidder wins but pays the second highest-bid.  In this auction it makes sense for every bidder to bid his true value – see if you can work out why – and it turns out that as the revelation principle says, revenues in this direct auction are the same as in say a regular English auction (under certain conditions, of course).

Ok, I have gone on for a while.  Here’s the bottom line.  The basic set-up of agents with private information submitting "bids" which are then fed into a mechanism resulting in outcomes is very general.  How to raise taxes, regulate a monopolist, fund a public good (here’s my own contribution to mechanism design), allocate organs, assign interns to hospitals, split common costs, allocate electricity across a grid – all can be thought of as mechanism design problems.   The tools that Hurwicz, Maskin and Myerson developed and their methods of paying attention to participation and incentive compatability constraints and using the revelation principle helps us to design, at least in principle, the best solutions to all of these problems.

Chimps play the ultimatum game more "rationally," that is to say more in line with standard economic models, than do humans.  I’m not sure whether this says more about chimps or economists.

Thanks to Jeff Smith for the pointer.

Utah payday lenders began refusing Monday to make loans to members of
the military rather than give them much lower rates mandated by a new
federal law.

That new law, which took effect Monday, caps the annual interest on
payday, car title or tax refund anticipation loans at 36 percent
annually for members of the military and their families….

"At 36 percent annual percent rate, the total fees we could charge are
$1.38 per $100 for a two-week loan. That is less than 10 cents a day,"
Walker said.

"Payroll advance lenders could not even meet employee payroll at that
rate, let alone cover other fixed expenses and make a profit," he said.

I’m surprised that it is constitutional for the government to require firms to lower prices for certain groups.  I’m not surprised that the law has unintended consequences – but perhaps the consequences were not unintended.

"The protection the regulation offers is not a wall preventing a
service member from getting assistance, rather it is more like a
flashing sign pointing out danger and directing the borrower to a safer
way of satisfying immediate financial need," said Leslye A. Arsht,
deputy undersecretary of defense for military community and family
policy.

He said financial help for members of the military is available through
a member’s chain of command, legal assistance office or military aid
society.

So the military doesn’t pay you enough to pay your bills and then they reduce your borrowing options while suggesting that you can borrow more from them.  Hmmm… reminds me of a company town.

More on the story here and a hat tip to Overlawyered and Bob M.

Labour-market flexibility, deregulation of the service industry,
pension reforms and greater competition in university funding is not
anti-equality. Such reforms shift financing from taxpayers to the users
themselves and, as such, tend to eliminate rents. They tend to increase
productivity by basing rewards on merit rather than on being an
insider. They tend to open up opportunities for younger workers who are
not yet well-connected. Pursuing pro-market reforms does not imply
facing a trade-off between efficiency and social justice. In this
sense, pro-market policies are “left wing”, if that means reducing the
economic privileges enjoyed by “insiders”.

…If the European left wants to be able to say honestly that it fights
for the neediest members of our society, it must adopt as its battle
cry the pursuit of competition, reforms and a system based on
meritocracy.

Amen.  This is from an excellent op-ed by Alberto Alesina and Francesco Giavazzi writing in Vox.  My only complaint is that they write as if this is new.  In fact, liberalism, meaning classical liberalism, has never been conservative.  It began as a movement of the left against feudalistic, conservative insiders and it remains so today.

Here’s an interesting story:

In Idaho, when the Castle Rock wildfire started with a lightning
strike, broke out and started to rapidly spread, hundreds of high-end
homes were immediately evacuated. At that point a national insurance
company which caters to America’s wealthy decided that it needed to act
quickly. The insurance company sent a private crew of firefighters to
Wood River Valley, near Castle Rock, to protect 22 homes that it has
insured for millions of dollars.

…The insurance company
provided a fire truck and two man team to douse the insured homes with
Phos-Chek, the same fire retardant dropped from U.S. Forest Service
aircraft.      

Insurance services like this have a long history not just in fire fighting but also in crime-fighting.  In 18th and 19th century Britain long before the advent of government police, members of the public organized themselves into prosecution associations – essentially insurance clubs that would pay for the investigation, detection and prosecution of crime.  You can still see a faint imprint of this lost system today when insurance companies hire detectives to investigate large property crimes.  See The Voluntary City for more.