Category: Economics

According to the report, “Using Prediction Markets to Track Information Flows: Evidence From Google,”
which was presented Friday at the American Economic Association meeting
in New Orleans, the strongest correlation in betting was found among
people who sat very close to one another, trumping even friendship or
other close social ties.

This is tangible evidence, the authors
argue, that information is shared most easily and effectively among
office neighbors, even at an Internet company where instant messaging
and e-mail are generally preferred to face-to-face discussion.

It is an argument, the authors say, for giving greater importance to
“microgeography,” or how people interact in the workplace. The finding
that information moved fastest among people who were the closest
together is also an endorsement of the company’s “third rule for
managing knowledge workers: Pack Them In,” the authors say.

And Adam Smith is validated once again:

The other crucial finding of the report was that there was a
detectible “optimism bias” among Google employees. That is, results
that were good for the company tended to be overpriced, particularly
for “subjects under the control of Google employees, such as, would a
project be completed on time or would a particular office be opened.”

This
optimism was most evident among new employees, the report found, and it
was bound to show up on days when Google stock had climbed.

Here is the story.  Of course this is very important work.  Thanks to Chris Masse for the pointer.  Elsewhere in prediction markets land, InTrade has now started conditional prediction markets, which consider oil prices, interest rates, and U.S. troops in Iraq, conditional on who becomes President.

Here is a long post, criticizing Marty Weitzman’s view that we should regard a small chance of a catastrophic event as reason to buy "insurance protection" against that event.

I am not persuaded by Jim Manzi’s major point of rebuttal, namely: "the heart of Weitzman’€™s paper revolves around the first point: the
probability of extreme disaster is larger than current models assume."  My reading of Weitzman (which may not exactly be Weitzman’s own view) is the following: raising the discount rate doesn’t choke off our worries of future dangers.  In many plausible models, a higher discount rate means a higher degree of risk aversion as well, and thus we are back to worrying.

(For one simple version of this intuition, imagine a person near starvation.  That person has both a high discount rate — he wants to eat more now — and he is very risk averse, for fear of losing his remaining food and dying.  A billionaire in contrast can be more patient and bear risk more readily.  The discount rate and the degree of risk aversion thus often move together, admittedly there are great complications here.)

Manzi also argues that: "There is No Good Reason to Think That the Probability Distribution for Estimates of Climate Sensitivity Fits Any Functional Form."  Fair enough, there is only one world and ultimately the meaning of probability is murky, Bayesian or not.  But we still have to act on probability estimates in an "as if" way and indeed we all do in a personal context.

If you want to know where Manzi is coming from, here is his critique of the Pigou tax on carbon. 

The most serious critique of Weitzman, in my view, is simply that governments are bad at getting people to bear large costs to insure against low probability events, especially when the costs accumulate each year and there is little positive feedback in the interim.  ("Reelect me, our costly tax held back global warming for yet another four years!  Things didn’t get worse!" does not thrill.)  Our government does persuade its voters to support a large defense budget, but this is done in part by a) periodic conflict and invasions, and b) people holding deeply irrational views of America’s proper place in the world (e.g., "my country, right or wrong").  On other foreign policy issues these irrational attitudes sometimes become very costly.  So we might get people to support a Weitzmanesque insurance policy, but to do so they probably would have to be overworried about the relevant problems, and those overworries would lead to other policy mistakes.  As a general rule of thumb, when it comes to risk the alternative is public overworry or public underworry, don’t ever expect to hit that sweet spot in between or even get close.

Thanks to Reihan for the pointer.

Tom Redburn nails it:

Whatever the rate, critics say, a steep federal retail tax, piled on
top of existing state sales taxes, would encourage widespread illegal
tax evasion, black market transactions and other forms of cheating,
creating a cycle that would require even higher tax rates.

“The main weakness of the FairTax is its comprehensiveness,” said Dale W. Jorgenson,
an economist at Harvard who opposes the plan but whose research into
problems with the current system is sometimes cited by supporters. “It
tries to roll everything into one tax, which simply can’t carry all
that weight.”

Here is Bruce Bartlett, here is Megan McArdle on same.  You can put this in the "things I am nearly certain about category."

Response to comments: Note that a "fair tax," or a national sales tax, isn’t the same thing as a standard multi-stage VAT (a better idea); for a standard VAT the dual reporting requirements make it self-enforcing to a much higher degree.

Despite large swings in the market for presidential nominees over the past few days, on the Democratic side Clinton has dropped and Obama risen by almost 15 points and on the Republican side McCain has surged to take the lead (!), there has been very little movement in the winner take all market which is predicting a Democrat win.  Thus, the markets seem to be saying that the candidate doesn’t matter.  In this election it’s party and the Republicans are losing.

Winner Take All Market from IEM (click to expand).

I do not know.  Or how about the Army, Navy, or Air Force?

But my suspicion is this: if you are in the Armed Services, you have the chance to eat better than the average American.  Not at gourmet levels, but better than the median.  Better taste and better nutrition.  The median person in the United States eats some pretty bad food.

And how much does this food cost our government and thus our taxpayers?  Again, I am curious to hear what you know.  But I’ve read lots of stories about thousand dollar hammers and toilet seats, but I have never heard a peep about the Pentagon paying $70 for a Brussels Sprout. 

So, I’ll also predict that this food comes at reasonable cost.  We therefore seem to have above-average food service at OK prices.   

Given that possibility (fact?), how many of you would advocate government provision of food for the entire economy?  How many of you would advocate government-run food finance for everyone, and not just for the poor?

Show of hands? 

How many of you know what I am really talking about in this post?

Don’t forget this post either.

Addendum: The successes of the VA system stem most of all from avoiding the cost-escalating features of "fee-for-service" for medical suppliers, and not from its single-payer features.  Not so many people are willing to advocate abolishing fee-for-service for most of the medical sector; here is further discussion.  But unless you abolish fee-for-service, the successes of the VA system are not a replicable model on a larger scale.  And it is much easier to workably abolish fee-for-service within the Armed Services than across the entire U.S. medical sector.

It is one of the standard claims of Austrian business cycle theory that the "new money" enters the economy through the loanable funds market.  Yes it usually does, but it is important to recognize that this happens because of decisions by banks, not because government somehow forces the money to go there.

Consider an expansionary open market operation.  Banks now hold fewer T-Bills and more cash.  Presumably the cash is more liquid (though if you are puzzled by this assumption in the context of a bank, join the club, Brad DeLong is a member too), so the banks will do something liquidity-like with it.  That could mean making a loan, but it also could mean spending the money to refit the ATM machines, or for that matter increasing dividends to bank shareholders.

But no, bank managers make an independent judgment that there are loans worth making.  Of course sometimes they are wrong.  But they know they got this new money through open market operations.  And they decided to go ahead and make the loans anyway.  They didn’t have to.  They could have re-routed the new money to some other injection path altogether.  But they didn’t.

That is another reason why the Austrian theory of the trade cycle is as much a market failure theory as a government failure theory.

Except his name is John Taylor:

Since the mid-1980s, monetary policy has contributed to a great moderation of the housing cycle by responding more proactively to inflation and thereby reducing the boom bust cycle. However, during the period from 2002 to 2005, the short term interest rate path deviated significantly from what this two decade experience would suggest is appropriate. A counterfactual simulation with a simple model of the housing market shows that this deviation may have been a cause of the boom and bust in housing starts and inflation in the last two years. Moreover, a significant time series correlation between housing price inflation and delinquency rates suggests that the poor credit assessments on subprime mortgages may also have been caused by this deviation.

Here is the paper.  A Hyman Minsky fan, however, might challenge whether this data really supports Hayek’s theory.  An alternative theory is that markets are bubble-prone and that easy monetary policy was simply a trigger that set off an irrational speculative excess.  The Austrian story is that "the government distorted price signals to the market."  Are those two accounts really so different?  Do we need metaphysics to resolve that question?  Take the classic "thin skull" case in the law.  Austrians won’t describe it this way, but they are postulating a very thin skull for markets and then blaming government for the disaster which results from government’s glancing blow to that skull.

Keep in mind that no entrepreneur looks at price signals exclusively, rather they interpret prices in the context of the real economy and other bits of knowledge  Was it so hard for investors to say to themselves?: "I see that one price (short-term rates) has changed in favor of greater housing investment.  But other parts of my brain tell me that real estate prices won’t go up forever, levered positions are dangerous, and that I should be cautious."

Let’s say that the government subsidized the price of bananas, you bought so many bananas, put them on your roof, and then the roof collapsed.  Is that government failure or market failure?  The price was distorted, but I still say this is mostly market failure.  No one made you put so many bananas on your roof.

If Minsky and Hayek are running in a race for interpreting the last two years of the U.S. macroeconomy, Hayek has something to offer but so far Minsky is in the lead.

Imagine an aviation system in which planes fly
two-thirds empty, fares are as low as $46 and the government pays up to
93% of the cost of a flight….that system exists in the USA – and quietly is expanding…

That is from USA Today talking about the millions spent on the "Essential Air Service" program.  Do you think that the program protects small rural communities?  Nah, try small community airlines. 

…as Congress has escalated subsidies through the years, the program has
increasingly paid for flights between major airports and places that
are neither rural nor isolated.  [For example,] in October, the DOT agreed to one of the
program’s largest subsidies ever – $2 million a year to Atlantic
Southeast Airlines. That pays 60% of ASA’s cost to fly two round-trips
a day between Macon, Ga., and Atlanta’s Hartsfield-Jackson
International Airport, 81 miles away. The airline projects that passengers will pay an
average of $78 for a one-way ticket – and that flights, typically on
planes with fewer than 70 seats, will run 83% empty.

Need I tell you that the program was supposed to be temporary?  Here’s some more data from USA Today.

Community	Destination	Annual subsidy	Subsidy per passenger	Average pass. per flight
El Dorado, Ark.	Dallas/Fort Worth	$923,456	$250	3.1
Devils Lake, N.D.	Minneapolis	$1,329,858	$203	5.7
Worland, Wyo.	Denver	$797,844	$187	4.2
Bradford, Pa.	Pittsburgh	$1,217,414	$174	3.6
Jamestown, N.Y.	Pittsburgh	$1,217,414	$135	4.7
Salina, Kan.	Kansas City	$487,004	$131	2.1

Sources: Department of Transportation, USA TODAY analysis of DOT and airline data

By David Leonardt, here: Obama and his advisors have been more influenced by behavioral economics, Hillary relies more on targeted incentives.  This article makes for a very interesting read.

We had thought income effects are small because we were looking within
countries. The GDP differences between countries are enormous, and
highly predictive of differences in life satisfaction. In a sample of
over 130,000 people from 126 countries, the correlation between the
life satisfaction of individuals and the GDP of the country in which
they live was over .40 – an exceptionally high value in social science.
Humans everywhere, from Norway to Sierra Leone, apparently evaluate
their life by a common standard of material prosperity, which changes
as GDP increases. The implied conclusion, that citizens of different
countries do not adapt to their level of prosperity, flies against
everything we thought we knew ten years ago. We have been wrong and now
we know it. I suppose this means that there is a science of well-being,
even if we are not doing it very well.

Here are Kahneman’s full remarks.  He also presents a more complete theory of happiness, namely that is determined by basic personality type and which activities you are able to do during the course of your day, the latter being a function of wealth.  That excerpt is from this post by Arnold Kling, on how people have changed their minds, read this one too.  Here is the core source, highly recommended, it is one of the best hour-wasters you will get this year.

Our former guest blogger is now a "regular guest blogger" (is that an oxymoron?) at Freakonomics blog, along with Ian Ayres and Sudhir Venkatesh.  He’s also starting a blog on elections and prediction markets over at wsj.com, his first post is here.  Plus we are sure he is doing many many other things as well.

Have you ever read that FT supplement and wondered how and why the mix of products is changing with increasing income inequality?  Anna Yurko tackles this question:

The
distribution of consumer incomes is a key factor in determining the structure
of a vertically differentiated industry when consumer’s willingness to pay
depends on his income. This paper computes the Shaked and Sutton (1982) model
for a general specification of consumers’ income distribution to investigate
the effect of inequality on firms’ entry, product quality, and pricing
decisions. The main findings are that greater inequality in consumer incomes
leads to the entry of more firms and results in more intense quality competition
among the entrants. This is due to the elasticity of consumer demand for
quality being higher in more inegalitarian economies. More intense quality
competition among firms causes them to locate their products in higher ranges
of the quality spectrum, closer to each other, decreasing the degree of product
differentiation. Competition between more similar products tends to reduce
their prices. However, when income inequality is very high, the top quality
producer chooses to serve only the rich segment of the market, and the low
price elasticity of demand of these consumers allows him to charge a higher
price. The conclusion is that income inequality has important implications for
the degree of product differentiation, price level, industry concentration, and
consumer welfare.

My version of the argument is this: growing income inequality means greater elasticity of demand, thus causing quality competition to displace price competition for some market segments.  More concretely, there is often more profit from serving the very top, who will always pay more for something just a wee bit different or a wee bit better.  So stay away from producing the mid-level cheeseburger, where price elasticity of demand will kill your profits.  You can’t charge the rich very much for it, and the presence of the poor keeps the price down for the middle class.  Here is the paper.  Anna is currently a job market candidate at the University of Texas, here is her CV.

Writing in the comments, David R. Henderson asks me to list three policy areas where my views are uncertain.  Since this blog (or at least this author) has been streaming uncertainty for over four years, this strikes me as an odd request.  But perhaps it is useful to have such a list in one place, so here goes:

1. We must address the looming crisis in medical care costs but how?  I am uncertain as to how much means-testing Medicare will ease future budgetary pressures.  I do favor means-testing, mostly through lack of better ideas, but it is a) notoriously difficult to enforce, b) often unfair (do we measure income or wealth? current or lifetime?) and c) an implicit hike in marginal tax rates.  And if you could talk me out of means-testing, I am not sure which recommendation would come next.

2. I favor further experimentation with school vouchers, but to what extent?  There are many good school districts that probably would not be improved much if at all, and the resulting political hand-wringing would be costly and also could give vouchers a bad name.  Should vouchers be isolated experiments or implemented on a near-universal basis?  Near-universal vouchers run the risk of becoming the new middle class entitlement.

3. I don’t see a Social Security "crisis" in the numbers, but I do believe we should be fiscally conservative with the program, most of all because of forthcoming Medicare expenditures.  Yet this view would be wrong if the growth rate of the economy exceeds the real rate of interest.  We could then spend as much on Social Security as we wanted to.  (Growth-optimistic conservatives rarely emphasize this conclusion, I might add.)  I do not expect such a result, but I give it a probability of about 30 percent.

4. I am uncertain how much the United States should "move first" with costly anti-global warming measures, assuming that China and other nations are not very cooperative.

5. To what extent is the ongoing loss of biodiversity a very serious problem?  I suspect in the long run this will prove a more important issue than global warming, but I am not sure.  I also don’t know what to do about it; property rights and better quotas for fishing is a good idea but that only dents the larger problem.

6. I favor legalizing or decriminalizing many drugs, but I am not sure how far this process can go when so many actual and potential drug customers are under eighteen years of age.  Can we really sell crack cocaine in the 7-11, provided there is an ID check for every buyer?

7. I am pro-immigration relative to either current policy or the median voter, but I am uncertain how many immigrants the United States could take in.  I’m not just whinging about not knowing where the decimal point goes.  More generally, we don’t know when the social and political fabric will start to crack in counterproductive fashion.

8. I am highly uncertain about most of the major questions in foreign policy, for a start try Pakistan or the Koreas or nuclear proliferation.  Even if you think we shouldn’t have gotten involved in the first place, that doesn’t mean immediate withdrawal is our best option.  And while I know more about economics than foreign policy, I find that the more I learn about a given foreign policy area, the more uncertain I become.

9. Virtually any question in water policy.  This is a good, complex area for shaking up policy preconceptions.

That’s a lot of uncertainty.  I could go on, but that’s already most of the major policy issues today.  Don’t forget this: even if your view is the one "most likely to be right," in absolute terms your view, like mine, is probably wrong relative to the sum of competing views. 

In other words, it is hard for me to see why, in these and many other areas, we should be highly certain of the views we hold.

At some point I’ll give you my take on "What I Think We Should Be (Nearly) Certain About."  But I am not yet sure what should go in that post.

Addendum: Here are Arnold Kling’s certainties and uncertainties.

For the sake of the world as a whole, I hope that we respond to the trouble with trade not by shutting trade down, but by doing things like strengthening the social safety net.

That is Paul Krugman, here is more.  I have yet to see the evidence that trade has a significant negative impact on middle class wages, but for sake of argument assume it is true.  However benevolent it may sound, strengthening the social safety net would not be my policy recommendation number one.  After all, if Samuelson-Stolper factor price equalization is the main mechanism at work, wages would have a long way to fall downwards and if anyone in the middle class is to keep working, the safety net must eventually be cut, not increased.  You might think we can fund all these trade-losers by taxing capital but of course the incidence of taxes on capital sometimes falls on labor, not to mention that at some point the Laffer Curve kicks in. 

Is not the appropriate policy recommendation to create a budget surplus, create a U.S.A. Sovereign Wealth Fund, and invest the resulting capital in the corporate winners from this entire process?  In other words, we would be giving the trade-losers a more direct share in capital.  Since output is rising and wages are falling, the return to capital must be rising; let’s make money off of that.

You might not trust the government with such investments but it is awkward for Krugman to push that argument too hard.  Alternatively, you might think that share prices already have capitalized these gains, but that is hard to square with the view that Krugman is reporting a new result about trade.  Share prices are driven by liquidity to some extent, and if you know something about the returns to labor and capital that the rest of the world does not, there ought to be a way to make money.  Why spend more on consumption (a stronger safety net today) if the rate of return on investment is rising so high and we are going to need even more of a safety net in the future?