Category: Economics

I learned yesterday that my gas needle is broken. It moves rather quickly to three-quarters of a tank, but is very sticky once it gets to half a tank. It used to be very sticky when it started on full. I could drive for two hours and it would remain on full the entire time.

I started wondering (actually I’ve been wondering this for years now) how an optimal gas needle should be structured. Assume that if a buyer has a bad experience with a car, such as running out of gas, he blames the car manufacturer with some probability. You might then expect that a car needle will stand on “Empty” long before the tank is empty. The needle makes you prematurely fearful and you are less likely to run out of gas.

You also might expect that the needle will be sticky at the top end of the register. Why?

When you fill your tank with gas, you have the clearest idea of exactly how much is in the tank. You are most likely to use observations from that point to gauge the fuel efficiency of the car. All other observations will be noisier. So the automaker wants to make a good impression about fuel efficiency right off the bat. This doesn’t require driver irrationality, only that you measure fuel efficiency with some imperfection. You’re never sure if the car gets great mileage or if the needle is just biased. But you attach some probability to the former. Economists call this a “signal extraction” problem. You suspect the needle is biased but you never know quite how much. (The technically-minded will note that once you introduce these information asymmetries, the assumption of rational expectations no longer rules out all kinds of errors; I first learned this from reading Joe Stiglitz.)

Furthermore some people refill their gas tank well before it gets to the bottom; they are just nervous nellies. These people will rarely observe the needle when it is on its path of swiftest descent. They observe how much they pay at the pump, but of course gas prices change all the time. They too will face a signal extraction problem and may overestimate the fuel efficiency of their car.

Some people will see through this entire business. But for them it doesn’t matter how the needle is structured. So a “sticky at the top” needle is most likely to induce a repeat purchase of the same kind of car.

Is this good? It may slightly limit competition in the car market. People stick with a brand because they think it offers better gas efficiency, when in fact it doesn’t. On the other hand, the practice makes the buyer feel good about his purchase. People think they bought a car with good mileage. The nervous nellies can rest easy. And the more irresponsible types are less likely to run out of gas.

So don’t forget the subtitle of this blog: Small ideas for a much better world.

Addendum: Of course as in most game theory you can spin alternate stories. Does this tempt you to switch disciplines? Just read Thomas Nagel’s recent essay on why there is something rather than nothing. Nagel is extraordinarily bright, but this is enough to bring you back into the fold.

If the market is efficient then without an information advantage (non-public information) you can’t expect to beat the market and thus index funds are a good way for the average investor to invest. Behavioral finance has put some dents in efficient markets theory but just because a market is inefficient that doesn’t mean that beating the market is easy. Even if you knew that firm X was way overvalued, for example, shorting the stock would expose you to great risk – the price could become irrationally higher before the bubble bursts, unexpected events could increase the fundamental value to match the bubble, your capital could run out before the price drops and, of course, you could be wrong.

When you hear the term inefficient market don’t think $500 bills lying on the sidewalk, think $500 bills swirling around you in a vortex of wind…at night. Inefficiency is out there but it’s hard to find.

The bottom line remains that most professional money managers don’t beat the market. Here’s a recent reminder from James Glassman of this fact:

Charles Allmon points out that last year the poorly rated stocks of many research services outperformed their highly rated stocks. For example, Standard & Poor’s one-star stocks returned 57 percent while its five-star stocks returned 43 percent. Merrill Lynch’s sell-rated stocks returned 46 percent while its buy-rated stocks returned 30 percent. Schwab’s F-rated stocks returned 70 percent while its A-rated stocks returned 66 percent. The biggest discrepancy came with Value Line, whose 5-rated stocks (the 100 companies with, supposedly, the worst prospects for the year ahead) returned an incredible 90 percent while the 1-rated stocks (the top prospects) returned 40 percent.

A recent Rand study of 25 large firms found that raising the co-pay for pharmaceutical claims by just $5 reduced yearly drug costs per worker by $163.*

An interesting piece in the WSJ (“A Radical Prescription,” May 20, 04, R3) suggests that this logic does not always hold. Higher co-pays can cause consumers to cut back on prophylactic and maintenance medicines. Pitney Bowes, for example, found that high-prices caused their diabetic and asthmatic workers to take their medicines irregularly resulting in sudden and expensive attacks. So Pitney Bowes took a counter-intuitive strategy – to save money they would pay for more of their workers prescriptions.

On the new plan workers began to switch to more expensive but more convenient and thus easier to maintain drugs and within a year the company was saving money.

the company was paying more for maintenance medications… [but] it was spending significantly less on rescue medicines…

[S]ignficant saving has come from fewer emergency room visits, which dropped 35% among diabetes patients and 20% among asthma patients…there were also fewer hospital admissions and doctor’s office visits.

The strategy won’t work for all drugs but it shows how much care must be taken in devising optimal insurance plans.

* Originally, I had said this implies a cost to benefit ratio in excess of 30 (163/5). Robert Ayers pointed out, however, that the co-pay is per drug while the savings are per year. Thus the cost-benefit ratio must be lower than 30. The original source doesn’t provide the data to calculate it exactly, however. Thanks Robert!

It sounds great: cut out the investment banking fees and just offer a straight Dutch auction on the stock. After all, aren’t auctions the perfect market institution?

Co-blogger Alex thinks that the investment banks have had a comeuppance due for a long time; he may well be right.

Under standard practice, the underwriters give underpriced shares to favored investors and executives. The value of those shares rises on opening day. The insiders are happy but the company has left money on the table. In extreme and indeed pathological cases the discount can be as high as eighty percent. So why have companies tolerated this practice for so long?

Under one apologetic view, the kickbacks, underpriced shares, and payola are necessary. Someone has to produce reputation for the stock. The investment bank is paid to do this. The underwriter, in turn, gives insiders good deals to get them to boost the stock. If you own some shares you will do your best to talk up the issue. The efficient markets hypothesis? Well, it may be true at the margin, but how do we get to this margin in the first place?

I heard another point from one industry insider. Investors feel better about a stock if it goes up on day one. For the long-run good of the stock, it is important to have a price rise in the beginning. If investors sour on the stock in its early days, it may never recover its reputation.

Other skeptics wonder how the results of the auction can be predicted? How many people will show up with bids? What if we gave an auction and nobody came? Other worriers fear the temptation for untutored investors to bid too high at first, pushing the shares to unsustainable levels. After all, no single investor will have the final price much with his or her bid.

There is yet another fear. If the auction is fair, the stock will sell at roughly the same price on day one and day two. So if there is some uncertainty surrounding the initial auction, why not just hold off your buying until day two? But then how do liquid markets get established in the first place? How can you get concentrated buying interest on day one, but without violating either fairness or the efficiency of markets?

The resolution: …will have to wait for the facts and thus the actual auction. But my suspicion is the following. Some percentage of the original underpricing, but by no means all, is in fact a legitimate return to the investment banks. I thus worry that Google will not see strong demand on day one. On top of that, there is a puzzle. Unless you think all of the initial share underpricing is an legitimate fee for services rendered, why have markets tolerated this practice for so long?

By the way, David Levy informs me that used book dealer ALibris will try a share auction as well. For whatever reasons, except for Google, only small companies have shown an interest in these alternative institutions. France uses such auctions more commonly; it seems that the first-day price run-up is smaller but still present. On one hand, these other examples suggest that the auctions are a viable institution. On the other hand, it makes you wonder why the practice is not used more often.

Addendum: Here is a very good piece on the auction of Salon.com stock.

Raise male wages. Most prostitutes must forego or postpone marriage, because most men do not want to marry a prostitute. The more appealing the marriage prospects, the lower the relative return to prostitution. Andrew David Chamberlain gives more analysis, and links to the relevant research.

Thanks to Michael of www.2blowhards.com for the pointer. I”ll also note I enjoyed his recent survey of conservative and libertarian thought in the blogosphere, not the least because he had nice words for Alex and me.

Mahalanobis reports:

The Economists’ Quartet is a card game about economists made by economists for economists. Its aim is twofold: it is designed to make students interested in the life of contemporary and former economists and their most important ideas, as well as be an entertaining pastime for ´grown-up´ post graduate economists.

I was privileged to take the Washington-Trenton train, round trip, over the last two days. As you may know, this route takes you past some of America’s most spectacular industrial decay. (I recommend bringing Philip Glass music on CD with headphones; it makes your trip feel like the Koyaanisqatsi movie, experienced live.)

Some Europeans might regard the decay as reflecting our economic weakness. But they have it backwards: our willingness to let industries decline is a significant source of our economic strength. A country with no declining industries is a country that doesn’t have many better new ideas.

Here is a New York Times article about how the French are having a hard time accepting deindustrialization.

“[The French are] fighting against windmills – the process of disindustrialization is inevitable,” said Daniel Gros, director of the Brussels-based Center for European Policy Studies. “Those countries who slow that process pay. The problem is not that there is disindustrialization in France, but that it isn’t happening fast enough.”

Not suprisingly, the French are looking toward subsidies to slow down these changes. Here is an excellent article on just how much of American productivity growth comes from allowing losing sectors to decline.

Outsourcing anyone?

Currently a U.S. dollar buys 555 Iraqi dinar. You can track the fluctuating price at this web site. Perhaps over time they will develop forward contracts contingent on major events. This might include the election, or perhaps the resignation of various high government officials?

By the way, if you think you understand what is going on in Iraq, you can trade in the market.

And try this site if you wish to compare prices. How is this for a marketing line?

After decades of underinvestment, Iraq’s agriculture sector is poised to make the country once again the bread basket of the Middle East

Or this?

In the President’s radio address, President Bush reconfirmed the Adminstrations stance for a “Strong Dinar Policy”. The new dinar will be used throughout Iraq, thereby unifying the economy and the country.

Another site suggests:

According to recent releases by the US Department of State, the economic recovery of Iraq is in process and occuring quickly.

I’m glad to hear that. As is commonly the case in new markets, it is easier to go long than short.

For the past three months E-Loan has offered customers a choice, process their loan paperwork in 12 days using all-domestic workers or 10 days by bringing on some workers in India – 90% chose the quicker turnaround.

Cato Journal devotes a special issue to this marvelous book, co-authored with Anna Schwartz. Contributors to this symposium include Friedman, Schwartz, Allan Meltzer, William Poole, and Bennett McCallum. Of course Friedman’s monetary explanation of the Great Depression, radical in its time, is now part of the mainstream. And I see this book as providing a better statement of Friedman’s true method than his classic “The Methodology of Positive Economics.” His judicious and non-formulaic mixture of theory, empiricism, and history remains a classic account of how economic science can contribute to human knowledge. Friedman was never a naive positvist. His real method is that of consilience, and reaching a sophisticated reflective equilibrium of historical and theoretical understanding. It is sad that this book, with its low-tech statistics, would probably no longer pass as a Ph.d. dissertation at the University of Chicago.

Grant McCracken offers an object lesson in how to think about the two disciplines. Along the way he tries to explain why so many people pursue “fruitless” humanities Ph.d. degrees, with no real hope of a job on the other end. Here is his follow-up post on the same topic. His whole blog, in fact, tries to get at the differences between economics and anthropology. I am a big McCracken fan, here is his home page, which includes his on-line trilogy about modern culture.

My take: Anthropology is most likely to outperform economics when wealth maximization is not a useful proxy for utility maximization. That’s quite a broad swathe of cases. We need then to see how other values become imbued with social meaning and why they hold such an important place in the utility function. The answers to these questions are almost certainly context-dependent. Yet most useful economic theories deliberately abstract from context. For this reason, every economist should do fieldwork at some point in his or her career. A stint in government, time behind the counter at Nordstroms, or a sojourn in a third world village can all qualify. That being said, without an inquiring and curious spirit, all of these endeavors are a waste of time. The problems with economics are, to large extent, simply the personal failings of various economists.

For fifty years the United States dominated the rest of the world with its scientific advances, Nobel prizes and life-saving drugs. We were the king! We ruled!

But now, Tom Daschle sees “disturbing” signs. “America’s dominant position in the scientific world is being shaken,” he says.

Quake! Hold on!

We are in decline and “it’s frightening,” intones Dr. Armbrecht from the Industrial Research Institute.

“They’re catching up to us,” warns Jennifer Bond.

Run, run for your lives!

Funniest statement is from the aforementioned Jennifer who is a vice-President at something called the Council on Competitiveness, an organization in Washington that seeks “to promote industrial vigor.”

We must not lose our precious bodily fluids.

All of this is from a hysterical and hysterically funny article in the NYTimes, U.S. Is Losing Its Dominance in the Sciences by William Broad. One of the brief nods to sanity in the entire piece is this sentence:

Even analysts worried by the trend concede that an expansion of the world’s brain trust, with new approaches, could invigorate the fight against disease, develop new sources of energy and wrestle with knotty environmental problems.

Of course, the next sentence begins with the word “But…”

Now, the U.S. system has its share of problems. The university system is not a market and as a result price signals don’t allocate labor very well so we have too many English and history majors and not enough natural science and engineering undergraduates. (See Paul Romer for the academic argument and the Invisible Adjunct for the life lesson.)

The basic point, however, is that science is not war. So let us turn away from the mediocrities like Tom Daschle and the New York Times and turn instead to Thomas Jefferson who wrote nearly 200 hundred years ago:

He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me. That ideas should freely spread from one to another over the globe, for the moral and mutual instruction of man, and improvement of his condition, seems to have been peculiarly and benevolently designed by nature, when she made them, like fire, expansible over all space, without lessening their density in any point, and like the air in which we breathe, move, and have our physical being, incapable of confinement or exclusive appropriation.