Category: Economics

Why RSVP?

The New York Times notes that RSVP rates seem to be declining, here is another account with a similar conclusion. One Evite.com executive notes that last year’s invitation response rate ran about 63 percent. A variety of wedding and event planners note that people are ignoring invitations to an increasing degree. At the last minute they decide whether or not to show up, but in the meantime you do not hear a peep from them

Perhaps people are experiencing a kind of invitation fatigue. Imagine receiving ten or fifteen invitations a week. The value of time is higher than ever before, and many people wait to see what else will come along. Ironically the Evite.com service may be part of the problem. You can see who else has been invited, and who else has already accepted. You also know that it is especially easy for other people to invite you to other events. In other words, you gain by waiting and sampling more information.

We may be missing out on gains from trade, since the incentive to organize an event declines accordingly. Even if an event is organized, it is more costly to plan it.

Of course organizers make follow-up calls but this only worsens the collective problem in the longer run. Everyone waits to RSVP, figuring they will receive a call in any case.

The economist will wonder what alternative institutions could address this problem. Evite.com could assign a “reliable response” index to each person, akin to an ebay credit rating. Or organizers could send an incomplete invitation. You receive the invitation, but not the exact address or some other critical piece of information. Only those for RSVP are sent the critical information. This proposal, however, has two problems. First, you exclude those who are simply careless rather than manipulating the process. Second, a new convention may evolve whereby you say yes no matter what, whether or not you come. It appears that this practice is already common in Washington, D.C.

Similarly, it does not work to subsidize those who respond early. (For instance lower the overall quality of your event, but promise a bonus to early respondents, such as a hotel discount or a lottery ticket for a door prize. ) You can make early response a dominant strategy, but unless you can punish non-attenders this will not solve the problem. You need to reward both an early and truthful response. Asking invitees to post a bond solves the economic problem, but probably does not help your friendships, especially if the bond is confiscated. If readers have any solutions to the RSVP problem please send them in!

Should high schoolers play major league sports?

A recent court decision has struck down the NFL prohibition on drafting high school players, or players within three years of high school. While the decision may be overturned on appeal, both professional basketball and baseball already draft players right out of high school.

Why might a professional sports league seek to prohibit such draft picks? First, the prohibition is part of an overall bargain with a players’ union. Players’ unions are composed of insiders, people already in the professional sport. By banning high school players, the league extends the career of the median established player. Apparently this is a cheaper concession than paying those players more money. In essence the players’ union is redistributing money from the superstars to the average players. The very best players lose a few years off the beginning of their careers. But a comparable long-run penalty need not fall on the good (but not exceptional) high school players. Once they are drafted, they will enjoy a longer career than otherwise. The superstars, in contrast, can stick around with or without competition from high school players.

Second, banning high school players helps keep the league in competitive balance. Consider the NBA. There was once a time when the prime draft picks had played four years of college ball. The worst team picked first and was virtually guaranteed to pick a future star, usually a player with immediate positive impact (exception: LaRue Martin). Today the team that picks first takes a gamble on an unknown, with no guarantee of getting good value. So the bad teams are more likely to stay bad for a long time. When the losing Milwaukee Bucks picked Kareem Abdul-Jabbar in the 1970s, they were an immediate championship contender. The losing Washington Wizards picked Kwame Brown, a high school player, two years ago and they have gone nowhere.

Gregg Easterbrook suggests that the prohibition on high school players raises the quality of the football game and boosts attendance. I doubt this argument. If high school players drive away fans, teams would be reluctant to pick them. You can tell complicated stories about cross-league externalities, but for the most part teams try their hardest to put on a good and winning show. We should trust their decisions to internalize the relevant values of youth vs. experience.

The bottom line: The courts acted wrongly to disrupt the competitive balance of the NFL.

How much is a bathroom worth?

Economists are now applying econometrics to the time-honored questions of real estate. Based on a sample of 29,000 sales, and a proper set of statistical controls, the researchers derived an extensive set of valuations. The numbers given express the percentage change in the value of the home:

1. A full bathroom: 24 percent
2. A water view: 8 percent (I would have expected more)
3. Waterfront location: 18 percent
4. View of a golf course: 8 percent
5. A garage: 12.9 percent
6. A tennis court: 3.1 percent
7. In-ground sprinkler systems: 8 percent (surprisingly high)
8. An in-ground pool: 7.9 percent
9. A separate laundry room: 15 percent (surprisingly high)
10. An above-ground pool: minus 2 percent.
11. Is your house a “fixer-upper”?: minus 23.6 percent.

Here is a summary table of the results. Here is original research. Here is a Washington Post story.

Many of these amenities sell for more than what they cost to install. So the bottom line here supports the conventional wisdom of the trade. People don’t fix up their homes enough before selling them.

Can a market beat the market?

Marketocracy is a game where investors are given $1 million in virtual money to build a mutual fund, much like fantasy baseball. Currently some 55,000 players manage 65,000 fantasy mutual funds. But at Marketocracy fantasy becomes reality (I ought to be paid for that line) because the sponsoring firm monitors and ranks the performance of all the traders using an algorithm incorporating short and long-term analysis, market sector, risk and so forth. The stock picks of the top 100 portfolios are then used to create a real portfolio of stocks, the M100 (MOFQX). In addition to fame, the players have an incentive to trade carefully because top managers are paid a percentage of the assets in the fund!

Efficient markets theory says that the idea shouldn’t work but it also says that if transactions costs are low (the fund does have relatively low costs) then it shouldn’t hurt either. In fact, the M100 mutual fund has beaten the S&P 500 over the past several years and it has done so at lower risk.

Addendum: My friend Dan Klein recommended this mutual fund to me when it first appeared. I demurred based on efficient market theory and bought Webvan instead. Ugh.

Markets in everything, part II

You can now buy a personalized romance novel, featuring you and your sweetheart:

To get their names in print, customers decide on a book – most companies offer several stories to choose from – then fill out a questionnaire with details such as their love’s hair color and nickname. The information is inserted into the context of pre-fab story and presto, a personalized romance.

Don Fox of Port Saint Lucie, Fla., bought the novel “Treasure Seekers” for his wife last Valentine’s Day and included details such as the type of car he drives and his wife Josephine’s favorite radio station in the text.

“It’s something my wife and I will have forever. It’s unique,” said Fox, 43. “If you get a box of chocolates, it looks just like the box you got before that one. Then you eat it and it’s gone.”

The novels come in “mild” and “wild” versions and the plots take place in various standard romance novel locales such as a dude ranch and the white sand beaches of Tahiti (search). While their text won’t win any Pulitzer Prizes, they offer a quick read and, at $55.95, the books won’t break the bank.

Some people actually like this idea:

“It was an addictive read because it makes you the star,” said Pete Hart, 34, who received a pre-fan novel called “Vampire Kisses” from his girlfriend. “I was referred to as Pedro in the book, which is my nickname. I found that quite charming.”

Another fellow noted:

“It read more like a novel or novelette and less like a typical romance novel,” he said. “I enjoyed reading it. Besides, I was in it.”

So what is next? How about DVD movies with your face superimposed upon that of Tom Cruise?

But our world is not always taking steps forward. Ebay has been moving to take down sales of imaginary girlfriends.

If you are curious, here is part one of “Markets in everything.”

An economist in Baghdad

Chris Foote an economist at the Boston Fed worked in Baghdad last year. His report makes for interesting reading. This was not your usual job for an economist.

Early on, I visit Iraq’s Central Bank, which was also destroyed by looters. Our mission is to check on the Treasure of Nimrud, a collection of ancient Assyrian jewelry that was stored in the bank’s vault for safekeeping in the early 1990s. The bank’s basement was flooded with sewage water during the looting and has only recently been drained. Our group trudges down the unlit, still slimy stairs, careful not to slip. When we reach the bottom, I see that the corner of one of the vault doors has been peeled away, as if by a giant can opener. I am told that during the postwar chaos, someone tried to open this door with a rocket- propelled grenade, incinerating himself in the process. (The lock in the door held.) The deputy head of the Central Bank jiggles a number of keys and opens another door nearby. We are happy to learn that the treasures are intact.

Most of the time, however, he is working 8 am to 11 pm trying to solve economic problems. As economic theory would predict, but many economists would deny, it’s the basic economics that has the most value added.

In many ways, the job is similar to the one I held at the Council of Economic Advisers (CEA) before coming to Iraq. There the economic questions changed from day to day, sometimes from hour to hour. Baghdad is the same. What is the best way to fix Iraq’s currency? How could foreign investment help Iraq? What tariff regime should we recommend? The questions are all over the map, so I draw more from my experience teaching macroeconomics to undergraduates, and less from my own specialized research.

Protectionism hurts fine dining

My biggest personal complaint with U.S. trade policy concerns non-pasteurized cheese. Read Fred Foldvary:

Few Americans know what really good cheese tastes like, because the U.S. government bans tasty handmade cheese made from untreated milk. The U.S. Food and Drug Administration prohibits the sale of cheese made with raw milk, which has not been aged for 60 days. If the raw-milk cheese is from France, voila, its sale is prohibited in the USA no matter how long it has been aged.

The danger of eating raw-milk cheese is similar to that of eating raw oysters, yet the latter is legal in the US. Those with higher risk of infection, such as pregnant women, should not eat raw-milk cheese, raw oysters and steak, and other foods that can harbor microbes that cause diseases. But Europeans have been eating raw-milk cheeses since ancient times, evidently with little ill effect. European cheese makers are generally careful to keep the milk uncontaminated, which minimizes the risk.

Now I have a new grudge: the ban on Szechuan peppercorns.

Since 1968, the federal government has banned the import of Sichuan peppercorns, which are the dried berries of the prickly ash shrub. The Agriculture Department did not really enforce the ban until two years ago, and its effort is expected to dry up supplies soon. Some chefs and retailers say that they are unable to find the peppercorns, which are often an ingredient of five-spice powder, a common Chinese seasoning. Others say they are selling what was stockpiled before the enforcement effort began.

The details are a bit complicated, but if you can believe the NYT, there is no good reason for the ban other than excessively broad bureaucratic classifications (a related item endangers citrus crops).

You can’t cook Sichuan food without huajiao,” said Wang Dinggeng, the chef at Grand Sichuan International on Second Avenue. “You can’t get that special ma la flavor,” he said of the peppercorns’ numbing (ma) and burning (la) effects.

Tragic, I say, tragic. By the way, if you ever visit my university, make sure you eat at the Szechuan restaurant China Star, in Fairfax, on Rt.236. Get the house specials, before it is too late.

The economics of Netflix

Lately I’ve signed up for Netflix.com. You pay $20 a month and you get mail order DVDs, free shipping, and you can keep them as long as you want. The limit is three to a customer. Once you return what you have, you can order some more. This is a big business and Wal-Mart is entering the market.

I am finding that Netflix changes what I watch. Service is prompt but there is a lag between ordering and viewing. The only late fee is the rather abstract opportunity cost of not being able to order more films. So I can order a DVD and not watch it for a week or even a month. I can engage in a kind of artistic deficit spending. I find myself ordering more movies that I feel I “ought to watch,” but won’t necessarily enjoy. After all, the consequences of my decision lie further in the future. I find myself especially altruistic toward my wife, and what she wants to watch. I am more willing to order long movies. I could never bring myself to rent The Shawshank Redemption, which is compelling yet sappy and well over two hours long, but now I have seen it.

Netflix reminds me just the tiniest bit of democratic voting. I order films to feel good now about my ordering, and not necessarily to watch them. Overall Netflix has improved my movie viewing and induced me to experiment more. Fortunately it is a supplement to other ways of choosing movies. When it comes to what I really want to see, nothing beats getting in the car and driving there, pushing through the yellow light to make sure I don’t miss the previews.

Does free trade lead to insufficient diversification?

The theory of comparative advantage, and the theory of increasing returns, both predict that free trade brings specialization. Michigan and Tennessee produce automobiles, but Delaware does not. I have heard free trade critics suggest that regions end up especially vulnerable and overspecialized.

Yes in economics virtually everything is possible, once you recognize that Giffen goods and upward-sloping demand curves cannot be ruled out. But I am not so worried about free trade leading to excess specialization.

First, individuals can buy equities from multiple regions or countries. There does appear to be an inefficient “home bias” when it comes to investing, but surely free trade is not at fault here. If anything, free trade should encourage investors to think more globally and to diversify more.

Second, individuals specialize, in response to trade, because specializing brings higher returns. When investors expand a firm or line of business they internalize risk-return trade-offs.

Third, we must consider global risk. Let us say that protectionism helps a country avoid a declining industry. The world as a whole does not gain. Those economic problems are simply shouldered by another country, and in a less efficient way, relative to free trade.

Fourth, risk is borne by individuals, not by countries per se. Having many different industries in a country does not by itself create safety for individual investors or workers. Who cares if France has its own movie industry, if you are losing your job in computer software? Contrary to what Dana Rodrik suggests, it is not necessarily economically safer to live in a large country.

I can see a potential political version of the argument. Free trade, by inducing specialization, might make tax revenue more volatile in a country. Still, tax revenue should be higher in absolute terms. And if revenue volatility is a problem, I would prefer fiscal responsibility over protectionism as the proper medicine.

I am indebted to Randall Parker and Arnold Kling for sharing some of their email correspondence on this topic with me.

The cost of new drugs

In 2003, Joseph DiMasi, Ronald Hansen, and Henry Grabowski published an important paper in the highly-regarded Journal of Health Economics that estimated that the average cost of developing a new drug was around $805 million dollars. Hal Pawluk at Blog Critics repeats some nonsense from Public Citizen to claim that high research costs for pharmaceuticals are a myth and that this paper in particular is part of a conspiracy of pharmaceutical companies to raise prices. Frankly, the comments of the critics are laughable but not everyone sees the joke so I will explain.

Here is the number one criticism, the “major flaw,” in the DiMasi et al. study according to the critics.

1. The $802 million included $400 million that had nothing to do with bringing drugs to market. It was an estimate of how much the drug companies could have made by investing in some other way. This is an imaginary number that the drug companies do not pay.

(See also, Public Citizen who say these are “theoretical costs that drug companies don’t actually incur.”)

Firms spend on R&D from the day the development process begins up until the day the drug is approved for marketing which may be a decade or more later. But a dollar spent early in the process could have been earning interest in the bank for years before marketing approval is achieved. Recognizing this, DiMasi et al. calculate the cost of the drug as if all the money had been spent on the day the drug was approved.

Is this unreasonable? Well, suppose you lend me $5000 – how much would you want back in a year, in 2 years, in 10 years? The longer the loan period the more you would expect back when the loan came due, right? This is exactly the same calculation performed by DiMasi et al.

I challenge anyone who thinks this is imaginary money to lend me $5000. I guarantee to repay them the same return as they recognize as legitimate for the pharmaceutical companies.

Barter clubs and monetary theory

When I was a kid my father belonged to a barter club. He sold advertising space in his magazine, published for a chamber of commerce, in return for free restaurant meals. The system involved a county-wide network, involving trading stamps and pledges to supply real-valued goods to other members. Being a Jersey boy, I had many a veal piccata this way.

More generally barter clubs expand in deflationary times. They were prominent in the 1930s, during the Great Depression, and very common after the Argentinean financial crisis.

I can think of at least three reasons for such arrangements:

1. They may offer tax advantages, not always legally.

2. They serve as a form of price discrimination. Some people won’t pay the full cash price, but you will accept a bartered service for some of your wares.

3. Barter clubs expand the real supply of money, when monetary policy is bad. This is why we see them in times of financial crisis. Prices can be sticky downwards. If the government won’t maintain the real supply of money, to some extent the private sector will issue scrip to make up the difference.

Bernard Lietaer thinks that scrip is an important monetary institution for the future. Irving Fisher had a fascination with related ideas, as did the German monetary economist Heinrich von Rittershausen.

My view: Scrip will remain limited in economic importance and may even decline in use. Scrip allows you to issue your own money, backed by the goods you sell. But the more effective financial intermediaries become, the less such monies are needed. It is no accident that scrip picks up in times of depression. As for the price discrimination motive, growing resale opportunities (e.g., ebay) should diminish this over time.

Thanks to Carnival of the Capitalists for the pointer.

How to improve meetings

Reader Robert Ayres relates the following:

Heard about this at General Electric’s Missile and Space Division, back in the 60s. (I did not actually see it in use.)

As you enter the meeting room, you privately enter your annual salary (thousands) on the telephone dial (pad). A little computer (a one-off then, a PDA now) continually computes the total running-cost of the
meeting, in terms of (sum salaries) meeting-duration.

So the chair can at any time announce, “OK guys, we’ve spent $1500 of the company’s money, have we reached any conclusions?”

For other ideas, see my earlier post.

Markets in prediction, revisited

You can now bet on future developments in the tech sector. The questions include the following:

1. When will Google have an IPO?

2. Will SCO be awarded damages? [in its lawsuit against IBM at the District Court in Utah]

3. When will there be a commercially available electronic device using ultrawideband technology?

4. Will Oracle acquire PeopleSoft Inc?…before March 31st, 2004.

Here is the website. There are no cash prizes, but it is not just for pure play either. The top ten winners receive prizes from Circuit City. If you are wrong about everything, you lose nothing.

My take: I’ve long been intrigued by the idea futures concept. One central question is whether they can perform some function that current asset markets do not already satisfy. I’ll say no for this version of the idea. For instance some of the other predictions involve the future value of the NASDAQ index. Many of the others can be satisfied, albeit with noise, by betting on the relevant companies. Note also that Circuit City wins publicity for sponsoring the contest, which points to another truth about idea futures. In financial terms they are a zero-sum game for the investors, so a sponsor may need an external incentive, such as publicity value, to market the idea. If idea futures have a breakthrough use, it may well be within companies, such as to evaluate competing R&D proposals.

Thanks to Daniel Akst for the pointer to the link.