solve for equilibrium
A mobilization by French publishers at last month’s Frankfurt Book Fair has proven successful: Last Tuesday the French Senate voted for a law imposing a fixed price on eBooks for sale within French territory – that is, just as with print books in France, everyone has to sell a given ebook for the same price. No discounting.
Here is more; solve for the equilibrium! Oddly, in the United States, the market has been moving toward an approximation of this outcome, at least for new books, though not for classics. Probably both prices need to fall, though perhaps they will in rough tandem. I believe the equilibrium value of a hardcover or e-version of a bestseller is below $10, given the recent shift out of the supply curve for the written word.
Here is Diamond's home page, here is Diamond on Wikipedia. Diamond has been at MIT since 1970 and he is considered one of the bulwarks there, having produced many excellent students, including Bernanke and Andrei Shleifer. Here is the bit of most current interest:
On April 29, 2010, Diamond was announced by Barack Obama as one of three nominees to fill the three vacancies then present on the Federal Reserve Board, along with Janet Yellen and Sarah Bloom Raskin. On August 5 the Senate returned Diamond's nomination to the White House, effectively rejecting his nomination. Ben Bernanke, the current Chairman of the Fed, was once a student of Diamond.
Some of Diamond's early work was in capital theory, as he outlined the conditions under which, in dynamic growth models, the level of capital could be inefficient. Read this paper, from 1965, which is still his most frequently cited work. It helped produce a standard framework for thinking about national debt and economic growth.
Diamond has contributed plenty to the theory of optimal taxation, in particular when linear commodity taxes are optimal and how to use the tax system for redistribution. See this paper with James Mirrlees (also a Nobel Laureate) and also this one. One implication is that taxing inputs often leads to more distortion than taxing outputs and you can think of this as one possible motivation for a consumption tax.
Here is Diamond's 1982 paper on macro and search theory, which I think of as his most influential. The abstract is classic Diamond:
Equilibrium is analyzed by a simple barter model with identical risk-neutral agents where trade is coordinated by a stochastic matching process. It is shown that there are multiple rational expectations equilibria, with all non-corner solution equilibria inefficient. This implies that an economy with this type of trade friction does not have a unique rate of natural unemployment.
The relationship to the current day U.S. is striking. One point he stresses is that subsidization of production can make sense and also that there can be real costs of converging to the lowest possible rate of unemployment too quickly. This remains an important "framework" paper for analyzing the interaction of search and aggregate demand. His other 1982 search paper implies that labor mobility will be less than is socially optimal. This paper on search theory shows that unemployment compensation can lead to better job matches, by limiting crowding externalities in the job market.
He and Olivier Blanchard wrote a classic piece on the Beveridge Curve, which is about the relationship between job vacacies and the unemployment rate. Some commentators cite the Beveridge Curve as evidence for structural unemployment, although this is controversial.
Diamond has written a great deal on social security, often at the applied level. Here is his paper criticizing social security privatization in Chile for its high costs. Here is his survey on social security reform proposals. Here is his paper on macro and social security reform. Here is a very good European talk he gave on pension issues. Diamond wrote a book with Peter Orszag on social security and he has been a major influence on Democratic Party thinking on this issue; the book looks closely at progressive price indexing rather than wage indexing of benefits. Here is a CBO summary and analysis of the plan. Much of Diamond's more formal social security analysis stresses risk-sharing issues and in general he often points out that social security proposals, including Bush's privatization idea, are not well-grounded in rigorous analysis.
Here Diamond tells us not to expect 7 percent stock returns for the ongoing future.
Personally, my favorite Diamond paper is this short gem on the evaluation of infiinite utlity streams; it will make your head spin, as it asks whether we have coherent means of thinking about prospects with infinite utility and in general how intertemporal utility streams should be ordered. See also his related paper on stationary utility, co-authored with T.J. Koopmans.
I think of Diamond as the classic MIT economist, especially of the earlier, pre-Acemoglu generation. Lots of theoretical rigor, though sometimes his theory pieces don't have a simple or simply analytic punchline. There is greater concern with risk, and stability conditions, and dynamic and border conditions, than you would see in a Chicago theory paper. There is a strong emphasis on the ability of government to implement welfare-improving schemes of the sort found in social democracies. The approach is quite technocratic — solve and advise. Public choice and political economy considerations take a back seat. High IQ. Of the MIT economists, he has done the most to pursue the Samuelson tradition of having a universal method and very broad interests. His papers remain central to public finance, welfare economic, intertemporal choice, search theory, macroeconomics, and other areas. His policy impact on social security has been significant.
Addendum: Levitt comments on Diamond.
NEW REGULATORY AUTHORITY: Gives federal regulators new authority to seize and break up large troubled financial firms without taxpayer bailouts in cases where the firm's collapse could destabilize the financial system. Sets up a liquidation procedure run by the FDIC. Treasury would supply funds to cover the
up-front costs of winding down the failed firm, but the government would have to put a "repayment plan" in place. Regulators would recoup any losses incurred from the wind-down afterwards by assessing fees on financial firms with more than $50 billion in assets.
OVERALL A GOOD PROVISION, ALTHOUGH THE ACTUAL INCIDENCE OF THESE FEES IS TRICKIER THAN THE DESCRIPTION INDICATES.
FINANCIAL STABILITY COUNCIL: Would establish a new, 10-member Financial Stability Oversight Council, comprising existing regulators charged with monitoring and addressing system-wide risks to the nation's financial stability. Among its duties, the council would recommend to the Fed stricter capital, leverage and other rules for large, complex financial firms that are judged to threaten the financial system. In extreme cases, it would have the power to break up financial firms.
I'M NOT ENTHUSIASTIC, THOUGH PERHAPS IT WILL JUST BE A WASH. NONETHELESS IT REFLECTS A BAD AND DANGEROUS ATTITUDE ABOUT WHAT REGULATORS ARE CAPABLE OF.
VOLCKER RULE: Would curb propriety trading by the largest financial firms, though banks could make de minimus investments in hedge and private-equity funds. Those investments would be limited to 3% or less of a bank's Tier 1 capital. Banks would be prohibited from bailing out a fund in which they are invested.
IT'S HARD TO TELL WHAT ACTUAL RESTRICTIONS WILL BE IN PLACE AND MOST LIKELY THERE WILL BE MAJOR LOOPHOLES. YOU DON'T HAVE TO HATE THIS PROPOSAL — RECALL THE POPULARITY OF "NARROW BANKING" PROPOSALS IN THE 1990S AS A KIND OF SECOND-BEST REFORM, CONSIDERED BY MANY MARKET-ORIENTED ECONOMISTS. FURTHERMORE IF MARKETS ARE PRETTY LIQUID, KEEPING THE BANKS OUT OF THESE MARKETS MAY NOT HARM MUCH AT ALL. STILL, I'LL PREDICT THIS DOESN'T DO ANY GOOD.
DERIVATIVES: Would for the first time extend comprehensive regulation to the over-the-counter derivatives market, including the trading of the products and the companies that sell them. Would require many routine derivatives to be traded on exchanges and routed through clearinghouses. Customized swaps could still be traded over-the-counter, but they would have to be reported to central repositories so regulators could get a broader picture of what's going on in the market. Would impose new capital, margin, reporting, record-keeping and business conduct rules on firms that deal in derivatives.
I WAS AN EARLY PROPONENT OF THIS IDEA MYSELF, BUT LATELY I'VE STARTED TO WORRY ABOUT HOW WELL CAPITALIZED THIS CLEARINGHOUSE WILL NEED TO BE. I'LL STILL COUNT IT AS A NET PLUS, BUT I DON'T THINK WE'VE THOUGHT IT THROUGH VERY WELL.
SWAPS SPIN-OFF: Would require banks to spin off only their riskiest derivatives trading operations into affiliates, in a late-night compromise struck to scale back a controversial provision championed by Sen. Blanche Lincoln (D., Ark.). Banks would be able to retain operations for interest-rate swaps, foreign-exchange swaps, and gold and silver swaps among others. Firms would be required to push trading in agriculture, uncleared commodities, most metals, and energy swaps to their affiliates.
THE DEVIL IS IN THE DETAILS. MAYBE THE AFFILIATES ARE NOT "TOO BIG TO FAIL" BUT WHAT REALLY MATTERS ARE THE COUNTERPARTIES ON THE OTHER SIDE OF THE TRANSACTION. WE STILL BAILED OUT LTCM, REMEMBER THAT?
CONSUMER AGENCY: Would create a new Consumer Financial Protection Bureau within the Federal Reserve, with rulemaking and some enforcement power over banks and non-banks that offer consumer financial products or services such as credit cards, mortgages and other loans. The new watchdog would have authority to examine and enforce regulations for all mortgage-related businesses; banks and credit unions with assets of more than $10 billion in assets; pay day lenders, check cashers and certain other non-bank financial firms. Auto dealers won a hard-fought exemption from the Bureau's reach.
PRE-EMPTION: Would allow states to impose their own stricter consumer protection laws on national banks. National banks could seek exemption from state laws on a case-by-case, state-by-state basis if a state law "prevents or significantly interferes" with the bank's ability to do business – a higher bar than federal regulators currently must meet to pre-empt state rules. State attorneys-general would have power to enforce certain rules issued by the new consumer financial protection bureau.
THIS SHIFTS THE WORDING OF THE LAW, BUT DOES IT CHANGE THE POLITICAL EQUILIBRIUM? AGAIN, "WE;LL SEE."
FEDERAL RESERVE OVERSIGHT: Would mandate a one-time audit of all of the Fed's emergency lending programs from the financial crisis. The Fed also would disclose, with a two-year lag, details of loans it makes to banks through its discount window as well as open market transactions – activity the Fed currently doesn't disclose. Would eliminate the role of bankers in picking presidents at the Fed's 12 regional banks. Would also limit the Fed's 13(3) emergency lending authority by barring the central bank from using it to aid an
individual firm, requiring the Treasury Secretary to approve any lending program and prohibiting the participation of insolvent firms.
A MISTAKE, BUT THIS COULD HAVE BEEN MUCH WORSE.
OVERSIGHT CHANGES: Would eliminate the Office of Thrift Supervision, but after a fight, the Fed retained oversight of thousands of community banks. Would empower the Fed to supervise the largest, most complex financial companies to ensure that the government understands the risks and complexities of firms that could pose a risk to the broader economy.
OVERALL I AM PRO-FED AND SO THIS PLANK COULD HAVE BEEN MUCH WORSE, FORTUNATELY WE HAVE NOT REALLOCATED FED POWERS IN A MAJOR WAY TO LESSER REGULATORS.
BANK CAPITAL STANDARDS: Would set new size- and risk-based capital standards, including a prohibition on large bank holding companies treating trust-preferred securities as Tier 1 capital, a key measure of a bank's strength. Would grandfather trust-preferred securities for banks with less than $15 billion in assets, enabling them to continue treating the securities as Tier 1 capital. Larger banks would have five years to phase-out trust-preferred securities as Tier 1 capital.
IT'S BASEL III WHICH WILL REALLY MATTER AND WE SHOULDN'T EXPECT MUCH FROM THAT FORUM. WE'RE DROPPING THE BALL ON A MAJOR ISSUE.
BANK FEE: Would mandate the Oversight Council to impose a special assessment on the nation's largest financial firms to raise up to $19 billion to offset the cost of the bill. The fee would apply to financial institutions with more than $50 billion in assets and hedge funds with more than $10 billion in assets, with entities deemed high risk paying more than safer ones. The fee would be collected by the FDIC over five years, with the funds placed in separate fund in the Treasury and would not be usable for any other purpose for 25 years, after which any left-over funds would go to pay down the national debt.
THIS IS FOR PR, SO THE POLITICIANS CAN CLAIM TAXPAYERS WON'T BE ON THE HOOK AGAIN. RIGHT. ALSO, STUDY TAX INCIDENCE THEORY AND GET BACK TO ME.
DEPOSIT INSURANCE: Would permanently increase the level of federal deposit insurance for banks, thrifts and credit unions to $250,000, retroactive to January 1, 2008.
ALREADY DONE, SO TO SPEAK.
MORTGAGES: Would establish new national minimum underwriting standards for home mortgages. Lenders would be required for the first time to ensure that a borrower is able to repay a home loan by verifying the borrower's income, credit history and job status. Would ban payments to brokers for steering borrowers to high-priced loans.
DEVIL IS IN THE DETAILS.
SECURITIZATION: Banks that package loans would, broadly, be required to keep 5% of the credit risk on their balance sheets. Would direct bank regulators to exempt from the rules a class of low-risk mortgages that meet certain minimum standards. Regulators could permit alternative risk-retention arrangements for
the commercial mortgage-backed securities market.
WASTE OF TIME. YOU CAN JUST AS EASILY ARGUE THE PROBLEM WAS INSUFFICIENT SECURITIZATION. AND HOW HAVE SIMILAR RULES WORKED OUT FOR THE SPANISH?
CREDIT RATING AGENCIES: Would revamp the credit-rating industry, establishing a new quasi-government entity designed to address conflicts of interest inherent in the credit-rating business after the SEC studies the matter. Would also allow investors to sue credit-rating firms for a "knowing or reckless" failure to conduct a reasonable investigation, a lower liability standard than the firms were lobbying to get. Would establish a new oversight office within the SEC with the ability to fine ratings agencies and empowers the SEC to
deregister a firm that gives too many bad ratings over time.
THE BEST EQUILIBRIUM IS TO HAVE DISCREDITED RATINGS AGENCIES, NOT REVAMPED AND REREGULATED AGENCIES.
INVESTMENT ADVICE: Would give the SEC the authority to raise standards for broker dealers who give investment advice after the agency studies the issue. Would permit, but not require, the SEC to hold broker dealers to a fiduciary duty similar to the standard to which investment advisers are held.
COULD EASILY END UP MEANING NOTHING.
CORPORATE GOVERNANCE: Would give shareholders of public corporations a non-binding vote on executive pay and "golden parachutes," and would give the SEC the authority to grant shareholders proxy access to nominate directors.
COULD EASILY END UP MEANING NOTHING.
HEDGE FUNDS: Would require hedge funds and private equity funds to register with the SEC as investment advisers and to provide information on trades to help regulators monitor systemic risk.
COULD EASILY END UP MEANING NOTHING.
INSURANCE: Would create a new Federal Insurance Office within the Treasury Department to monitor the insurance industry, recommending to the systemic risk council insurers that should be treated as systemically important. Would require the new office to report to Congress on ways to modernize insurance
I AGREE WE SHOULD NOT TRUST STATE-LEVEL REGULATORS WITH FIRMS SUCH AS AIG, BUT LET'S HAVE MODEST EXPECTATIONS ABOUT WHAT THIS OFFICE WILL ACHIEVE. IT PROBABLY WOULDN'T HAVE STOPPED THE AIG DEBACLE EITHER.
-By Victoria McGrane, Dow Jones Newswires
THE BOTTOM LINE: THE GOOD PARTS OF THE BILL AREN'T NEARLY AS GOOD AS THEY SHOULD BE, AND THE BAD PARTS BECAME MUCH BETTER WITH TIME. THE BIGGEST OMISSIONS ARE SIMPLE AND TOUGHER RESTRICTIONS ON LEVERAGE AND REFORM OF THE MORTGAGE AGENCIES. OVERALL CONSIDER THIS A VICTORY FOR THE STATUS QUO AND YOU SHOULD REALIZE THAT THE UNDERLYING PROBLEMS HAVE NOT BEEN SOLVED.
1. Sectoral shock theories of unemployment have a long lineage, including search theory, David Lilien (1982), Fischer Black, work by Steve Davis and John Haltiwanger, Mortensen and Pissarides, plus some recent writing by Michael Mandel and much earlier Franklin Fisher's work on disequilibrium adjustment. Avent and Yglesias suggest that Kling is making up his own macro but the innovation is simply to call the adjustment process "recalculation," to give it a more Austrian gloss. Mortensen and Pissarides are sometimes mentioned in the context of future Nobel Prize winners.
Or try Brainard and Cutler (nowadays both Obama-linked), who note sectoral shifts are especially likely to account for unemployment episodes of long duration. Here is a list of some of the relevant real shocks.
2. Ryan's summary of the argument involves several strawmen. Various polemic phrases are used throughout his post, including "makes no sense" and "nuts." When you read language like that, it often indicates the writer has not worked hard enough to imagine a sensible version of the idea he is criticizing.
3. Here are a few claims I do believe and in most cases I am on the record:
a. The AD shock today is very real, albeit overemphasized by many relative to sectoral shocks.
b. There is an optimum delay on the recalculation process. An economy can't always do all the recalculation all at once and that is one way of thinking about why some bailouts have been necessary, plus automatic stabilizers.
c. Reemployment does not in general proceed in accordance with an optimum, especially during major shocks. This follows from many (not all) of the models cited above.
d. The new, on-its-way optimum may well involve new government expenditures in various areas on a permanent basis; pick port security if you want one non-controversial example.
You can believe all those propositions, as I do, and still think that the recalculation argument means that, in absolute terms, significant parts of the current stimulus won't be very effective. As James Hamilton has pointed out, a big chunk of the problem is something other than insufficient aggregate demand and so more stimulus doesn't translate necessarily into better outcomes. In other words, we're spending lots of money for smaller "bang" than was advertised.
You might disagree with those conclusions, combined with propositions a-d, but they're not "nuts." There's a disconnect between the emotional content of the polemic Avent wants to level and the information content in his post.
3. Matt suggests that some of the critiques do not apply to most of the stimulus. He notes that aid to the states is a big chunk of the stimulus, as is tax cuts and increased transfer payments. On the transfer payments, see my point 2d; you may or may not like them but most analysts conclude, following the Bush experience, that such programs aren't very good stimulus. So the recalculation idea doesn't much apply there but the stimulus idea doesn't much apply either.
On aid to the states, the recalculation problem applies very directly (Matt says it doesn't but I don't see where in his post he gives a reason for that view). You can think that some form of state-level aid is necessary, as I do, and still see the recalculation idea as explaining why a big state-level ouch is coming in about two years' time. When (if?) the stimulus is not renewed, a painful sectoral reallocation will have to take place and right now we are only postponing that pain. By the way, it would be nice if state governments played along by having a coherent long-run fiscal plan but right now at least half of them are not doing this, thereby worsening the forthcoming ouch. Wait until you see what happens with state universities in two years' time. Ouch, ouch, and triple ouch.
Overall the recalculation idea does apply to large chunks of the stimulus, albeit not all of it.
4. We should be especially skeptical of gdp measures when: a) governments care about those measures especially much, and b) we face trade-offs between temporary and permanent gains and we are choosing the temporary gains. Fiscal theories of cyclical movements, as outlined by Rogoff and the like, deserve to make a comeback and I predict they will. In fact you can add those theories to the list above at #1.
The bottom line is this: if you're trying to use the recalculation idea to explain why the fiscal stimulus should be zero, that in my view will fail. If you're using the recalculation idea to explain why the stimulus has a lower rate of return than many people think, it hasn't much been dented by the recent criticisms. After all, if the problem were just insufficient AD, a solution would be ready at hand. But it isn't and it's not just because Obama isn't "tough enough" to propose a bigger stimulus. It's a genuinely difficult problem to solve.
I may soon consider Scott Sumner's very good recent posts on real shocks and the business cycle.
The topic is why some of the aid to state governments was cut and Matt Yglesias, after citing conservative supporters of such aid, reports:
I genuinely don’t understand why it’s [politics] failing to function in this particular way. It seems to me that there ought to be strong interest-group politics behind state and local financial aid coming from public employees, and senators of all parties should be facing strong pressure from governors back home to do this.
Ross Douthat comments as well. I believe that if state-level governments fail to do a good job, the blame is put on governors and state-level legislators, not U.S. Senators. Voters have theories of responsibility, rather than theories of causality, and that subtle difference occasionally becomes very important. (And the governors then have to make up the funds by squeezing some of their constituencies.) In the meantime, for better or worse, three Senators are on the evening news, for days on end, and they are described as "bipartisan." One of Obama's problems is that other peoples' attempts to copy his memes and strategies make it harder for those same strategies to succeed. There is a common pool of "good publicity for being bipartisan" and now many players are rushing to exhaust it, even if that means pushing policy changes of low quality.
I believe also that many of the Republicans in the House wanted to vote for the stimulus bill but they had no cover and also their donors are dead set against. Precisely because so many Republicans voted for TARP, there is a feeling that a line in the sand must be drawn. If fewer Republicans had voted yes on TARP, and thus more Republicans could have voted yes on the stimulus, a bipartisan restructuring could have reallocated the spending more wisely than it did. The attempted Republican re-establishment of long-spent ideological credibility is precisely what opens up room for some "moderate" political entrepreneurship.
Alternatively, maybe you can predict what will come out of the House-Senate committee and then solve backwards for the equilibrium strategies.
One request was this:
The role and future of intelligent agent modeling in economics.
Call me a stuck up sticky bit but I don’t see a bright future for this technique. We already have, and have had, computable general (and partial) equilibrium models for decades. In those models you try to estimate the parameters from empirical data. The models rarely impress me but there are plenty of situations, such as estimating the effects of changes in the tax code, where we don’t have anything better. And so those models survive, and will continue to survive.
What’s the important innovation behind intelligent agent modeling? To introduce lots of arbitrary assumptions about behavior? Greater realism? Complexity? Considerations of computability? Learning? We already have enough "existence theorems" as to what is possible in models, namely just about everything. The CGE models already have the problem of oversensitivity to the initial assumptions; in part they work because we use our intuition to calibrate the parameters and to throw out implausible results. We’re going to have to do the same with the intelligent agent models and the fact that those models "sound more real" is not actually a significant benefit.
What can be done will be done and so people will build intelligent models for at least the next twenty years. But it’s hard for me to see them changing anyone’s mind about any major outstanding issue in economics. What comes out will be a function of what goes in. In contrast, regressions and simple models have in many cases changed people’s minds.
Sometimes a theory model tells you there are many many equilibria, as in much of game theory.
I believe that result is to be taken seriously and we should conclude
that many different things can happen in that situation. I am
suspicious of trying to solve for the correct or most likely
equilibrium by introducing many more specific assumptions.
In my possibly overdogmatic view, economics is most useful when its models are relatively simple and intuitive. We’ve run out of new models which are simple and intuitive. So the theory game is over. The standard, old data sets have been data mined to death. We’re now on to the "can you build/create your own data set?" game. That game can and will last for a long time; in some ways it will favor go-getter extroverts just as the theory game favored introverts.
I don’t yet see that there is a new game in town. My preferred reform of economics involves more history and anthropology, I might add.
Addendum: Bob Murphy asks:
It may be apocryphal for all I know, but I once read that the editor
of the journal to whom Einstein sent his paper on special relativity
put it down and realized that physics would never be the same (or
something like that).
Is something like that even possible in economics? What would it be like? Say, the Lucas critique times 10?
The answer is no, in my view this is not possible, for reasons given above.
If you’re running an insolvent bank, and you get a slug of equity from
Treasury, your shareholders will thank you if you use that equity to
take some very large risks. If they pay off and you make lots of money,
then their shares are really worth something; if they fail and you lose
even more money, well, there was never really any money for them to
begin with anyway.
That’s Felix Salmon: read the whole thing. Read this too. Here is Megan McArdle on the pooling equilibrium. Here is a good article on how Paulson "sold" his plan to the bankers. And here are yet some more sentences to ponder:
So it in the end, we have what is basically an economic loan, but structured
in a way to game bank capital adequacy requirements. What strange times we live
in when Treasury and the Fed have to engineer a deal to circumvent their own
Yes, men are also, to their own detriment, continually surrounded with images of exceptionally attractive women. But this has less practical import, because–to say it once more–women choose.
The decline of matrimony is often attributed to men now being able to “get what they want” from women without marrying them. But what if a woman is able to get everything she wants from a man without marriage? Might she not also be less inclined to “commit” under such circumstances?
This essay is not politically correct and at times it is misogynous and yes I believe the author is evil (seriously). The main behavioral assumption is that women are fickle. So they are monogamous at points of time but not over time; Devlin then solves for the resulting equilibrium, so to speak. The birth rate falls, for one thing. The piece also claims that the modern "abolition" of marriage strengthens the attractive at the expense of the unattractive. Some of you will hate the piece. I disagree with the central conclusion, and also the motivation, but it does seem to count as a new idea. If you’re tempted, read it.
I thank Robin Hanson for the pointer.
This review is cross posted on orgtheory.net, the management & social science blog.
It’s a pleasure to be back at the Marginal Revolution. Let me start out by agreeing with Tyler and Bryan. Tim Harford is one of the leading popular social science writers and we’re lucky to have him.
Today, I’ll focus on Chapter Two of Tim’s book, "Las Vegas: The Edge of Reason." In this chapter, Harford describes game theory. In a nutshell, game theory studies any situation where (a) you have multiple people striving to achieve a goal and (b) your actions depend on the actions of the other people in the game. By most accounts, game theory is one of the great accomplishments of modern social science. Once you realize that people’s actions are both utility maximizing and interdependent, then game theory can help you model just about any form of cooperation or conflict.
Harford discusses the basic concepts of game theory with vivid examples ranging from poker, to nuclear war, to quitting smoking. And, as expected, game theory usually provides a great deal of insight. Harford shows how game theory can also be enormously useful, even life saving. Harford recounts how economist Thomas Schelling realized that some situations might encourage participants to jump the gun and initiate devastating conflict. What Schelling realized is that these dangerous games had low information, such as the US misunderstanding a Soviet action, and starting nuclear war. Schelling advocated increased communication between the US and Soviet leadership, including the creation of the hotline between Moscow and the US, which helped defuse tensions in later Cold War disputes.
I’ll finish this post with my one big criticism of game theory, at least the basic version described by Harford and taught in intro courses. In game theory 101, you assume that people develop optimal strategies in response to other rational actors. One huge problem with a lot of these models is that the games are very complicated. It’s hard to imagine most people perform the mental acrobatics of game theory actors.
One response is that game theory is empirically well supported, which suggests that some process drives people to the strategies described by game theory. For example, Harford describes how economists and mathematicians used game theory to sort through the insanely complex game of poker and that the optimal game theory strategy was actually fairly similar to what world class poker players do.
So game theory is supported, right? Not so fast. Game theory has two parts (a) a description of optimal strategies, and (b) a prediction that people will actually solve the game and find these strategies. In my view, game theory 101 is well supported, in poker at least, on point (a), but not (b). In other words, world class poker players rarely sit around and do backwards induction, or any other flavor of equilibrium analysis, but they still obtain strong strategies through trial and error.
What I suspect is that world class poker emerged from an evolutionary process. Very smart people can figure out certain strategies, but nobody can figure out the whole game by themselves, lest they become full time mathematicians. The typical world class poker player probably inherits a bunch of rules that were tested by earlier generations, and adds a few new twists. Competition weeds out bad rules. Even Steve Levitt, star economist, Harvard & MIT grad, developed his own idiosyncratic strategy, rather than solve the game himself.*
In the end, game theory is really a first step in understanding complex interactions. The next step is developing an evolutionary theory of games where actors inherit a tool box of strategies from previous generations of players. Already, there is a fairly well developed genre of game theory taking this approach, but I welcome the day when it becomes refined enough so that it can account not just the strategies of leading poker players, but how these strategies emerged from generations of competition.
*According to the news reports, he developed his own "weird style" rather than completely solve the poker game. But it works for him! What would Johnny von Neumann say?
A compromise is that a draw offer should remain valid for some fixed period,
say ten moves. This will allow the person who has been offered a draw to test
whether the offer was truly justified, e.g. by trying a daring line which may
or may not be refuted by the opponent. If it is he can claim the draw on his tenth move, even if his position is losing. The limitation to ten moves avoids the potential problem of people playing on interminably after a draw offer, waiting for their opponents to blunder or overstep the time.
That is John Nunn, here is more. A draw, of course, is a form of trade, albeit one with some negative social externalities (a quick draw makes chess more boring for the spectators). If you want to limit trades in some markets, a similar rule could be contemplated. If you offer to buy a currency at a particular price, you have to keep a similar offer open for one week to some number of other market participants. Solve for the resulting equilibrium, and see how it matters.
Mr. Velde, in a Chicago Fed Letter
issued in February, has come up with a solution that would abolish the
penny, solve the excess costs of making nickels, help the poor, keep
the Lincoln buffs happy and save hundreds of millions of dollars for
As Mr. Velde explained in an interview, “We face a
very medieval problem so I took inspiration from the medieval practice
He would rebase the penny by having the government declare it to be worth 5 cents.
We would then stop coining nickels at a loss. Here is more, from Austan Goolsbee. I am reminded of Neil Wallace’s work from the 1980s on the indeterminacy of equilibrium exchange rates in the absence of legal restrictions. If we take away government acceptance at par for taxes and the like, is there not an equilibrium where each penny is worth a million dollars? More ambitiously, if the U.S. government declared that each $20 bill is now worth $100, or each $100 worth $500, would the real exchange rate adjust immediately?
Remember Theory of Value, that elegant 128 pp. book which summed up general equilibrium theory? Here is a brief bio of Debreu, courtesy of Liberty Fund. Here is Debreu’s own autobiography. Here is Wikipedia.
I recall Debreu once saying he took his inspiration from Proust. To what extent is time a dimension just like space in its effects on human organization? Debreu solved for those conditions, with of course assistance from Arrow, Hurwicz, Wald, and others.
And by the way, Yana just got her bag, so I feel Debreu’s model is just a little less unrealistic than it was appearing last night.
Let us say, just for fun, that you woke up one morning to a world where everyone else’s demand curve — except yours — slopes upward. But it is not common knowledge that this is the case. What is the first oddity you would notice?
1. The most expensive radio stations would be filled with the most ads. The music would never come.
2. Your house would have no electricity, due to grid overload. (Is this true? An upward-sloping curve does not mean you will demand more at the current price. Think of twisting the demand curve around the current point of intersection.)
3. The most transparent agents would be found wandering the streets, bereft of all wealth, the victims of corporate price hikes.
4. You would wonder why so few people were reading your blog.
5. You would check ebay and find very high prices for items with active bidding. (Hmm…what kind of auction markets are behind the scenes for our power supply?) (Addendum: What is the Nash equilibrium here? Will people hold off bidding, hoping that tomorrow’s price will be higher?)
6. You would be puzzled why the Nordstrom’s sale was so empty.
7. It would take you days to notice any significant difference at all. After a few weeks, they would call in the econometricians to solve the identification problem in the data.
How long would it take you to figure out that other peoples’ demand curves were sloping upwards? How long would it take for society to fall apart?
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The real source of our frustration is signaling with "face time."
People — and not only at work — get insulted if they are dealt with in peremptory fashion, even when the issue at hand can be resolved quickly. Imagine a visiting professor comes to give a seminar, but you can’t find time for lunch. Lunch would have been chit-chat anyway, but now the professor feels you don’t value his research — or him — very much. Can you imagine such vanity? And if others perceive your time as important, they want it all the more.
What are some possible solutions to this problem? After all, a day has only twenty-four hours and your face has (one hopes) only one side.
1. Pretend that some other privilege you offer (hand kisses? birthday cards?) is extremely costly to you. Offer this other privilege in lieu of large amounts of time.
2. Pretend to be busier than you are. Let people believe — perhaps truthfully — that everyone else receives even less time.
3. Pretend your time is unimportant. (NB: This may involve dressing down.) The hope is that no one will feel slighted if they don’t get much time. Who feels slighted not to be given free thumb tacks? But there exists another equilibrium, in which the neglected person feels all the more insulted. After all, you are not giving away even your crummy low-value time.
4. Tell people you are autistic, or that you have Asperger’s syndrome.
I await your suggestions in the comments.
Mutual funds control some $7 trillion for about 95 million investors.
But to this economist, much about the industry is a puzzle. Why, for instance, do so many investors seek out funds other than minimum commission, “buy and hold” funds? This could be a significant market failure, since managed funds do not in general outperform the market and generally charge higher fees. Alternatively, we might think that investors enjoy trying to beat the market, and that they are consuming a kind of gambling service. Investment clubs, for instance, are almost certainly a bad financial idea, especially if you do them with your friends. But maybe they improve your social life.
The current abuses include the `unholy trinity’ of illegal late trading, abusive market timing and related self-dealing practices. In other words, the mutual fund keeps the good trades for itself, or offers them to favored investors. The practice now appears to be widespread, read the above link or here.
This reminds me of the equilibrium we often observe in the car dealership market. When you buy a new car, most dealers put you through hell. You have to fill out all sorts of paperwork, taking up half your day and locking you in psychologically to sticking around through protracted negotiations, based on deceit and lies. Most buyers don’t leave and go elsewhere, in part because they know they can only expect to start all over again with the same. And as long as it is not too visible, you don’t feel too bad about your initial investment decision.
I suspect we see the same kind of stickiness with mutual funds. Many investors will not be shocked by the recent revelations. But why bother switching to another fund? Once you get there, you can expect more of the same.
I’ve never seen a good analysis of which market features lend themselves to this kind of outcome. Could it be the occasional allocation of large sums of cash that lies at the root of the problem? But why can’t firms make credible commitments to honesty up front? Clearly fraud is not the norm for all industries, the restaurant sector does not work this way. I suspect legal penalties alone will never solve the problem, our best hope is that technology, and monitoring, somehow change to make mutual funds, and buying a car, more like the experience of going to a nice restaurant.