Krugman’s focus question

November 8, 2010 in Uncategorized | by | 12 comments

Paul Krugman has attacked Senator Evan Bayh‘s suggestion that the Obama administration “overreached by focusing on health care rather than job creation during a severe recession.” Krugman expresses great difficulty in seeing what this statement could mean.

Are people who say that Mr. Obama should have focused on the economy saying that he should have pursued a bigger stimulus package? Are they saying that he should have taken a tougher line with the banks? If not, what are they saying? That he should have walked around with furrowed brow muttering, “I’m focused, I’m focused”?

To answer Paul Krugman’s question, let me suggest that the severity of the current recession could have been reduced if the Obama administration had made financial regulatory reform its top legislative priority in 2009.

When President Obama was inaugurated in January 2009, the American economy was sliding into recession because of a catastrophic loss of confidence in our financial system. In the previous decade, global investors’ confidence in American financial institutions had brought vast capital inflows into the American economy. This confidence had been based on a perception that America’s legal and political system provided safeguards for investors that were second to none in the world. This confidence was shattered in 2008 with the collapse of Lehman Brothers.

A meaningful and effective financial regulatory reform in 2009 could have restored investors’ confidence, reviving investment flows and stemming the loss of jobs. Imagine how different the economic environment might have been on election day in 2010 if President Obama could have announced by September 2009 that, after an intensive review of the financial regulatory system by both Congress and the White House, he was signing into law some carefully designed and well-focused reforms that could restore investors’ and taxpayers’ confidence in American financial institutions.

The focus on health care reform made it impossible to achieve meaningful financial regulatory reform for more than a year after President Obama took office. Health care reform and financial regulatory reform are both extremely complex issues and both have been fiercely resisted by powerful vested interests. Neither reform could be accomplished without strong political leadership at the highest level. The Obama administration could only address one at a time, and only one could be the central focus in the crucial first year when the new President’s political capital was greatest. The Obama administration chose in 2009 to focus on health care reform.

It may be surprising that, when a catastrophic macroeconomic decline is clearly being caused by a loss of confidence in the basic regulatory controls of our financial system, that many leading economists would not see financial regulatory reform as an urgently needed remedy. The reasons may also be found in the history of economic theory, on which I may comment later.

[Thanks to Jeff and Sandeep for letting me guest-blog here.]

Introducing Roger Myerson

November 7, 2010 in economics | Tags: , , , | by | 1 comment

We have a new guest-blogger:  Roger Myerson.

Roger is a game theorist but his work is known to everyone – theorist or otherwise – who has done graduate work in economics.  If an economist from the late nineteenth century, like Edgeworth, or early twentieth century, like Marshall, wakes up and asks, “What’s new in economics since my time?”, I guess one answer is, “Information Economics”.

Is the investment bank trying to sell me a security that it is trying to dump or is it a good investment?  Is a bank’s employee screening borrowers carefully before he makes mortgage loans? Does the insurance company have enough reserves to cover its policies if many of them go bad at the same time?  All these topical situations are characterized by asymmetric information: One party knows some information or is taking an action that is not observable to a trading partner.

While the classical economists certainly discussed information, they did not think about it systematically.  At the very least, we have to get into the nitty-gritty of how an economic agent’s allocation varies with his actions and his information to study the impact of asymmetric information.  And perfect competition with its focus on prices and quantities is not a natural paradigm for studying these kind of issues. But if we open the Pandora’s Box of production and exchange to study allocation systems broader than perfect competition, how are we even going to be able to sort through the infinite possibilities that appear?   And how are we going to determine the best way to deal with the constraints imposed by asymmetric information?

These questions were answered by the field of mechanism design to which Roger Myerson made major contributions.  If an allocation of resources is achievable by any allocation system (or mechanism), then it can be achieved by a “direct revelation game” DRG where agents are given the incentive to report their information honestly, told actions to take and then given the incentives to follow orders.  To get an agent to tell you his information, you may have to pay him “information rent”.  To get an agent to take an action, you may have to pay him a kind of bonus for performing well, “an efficiency wage”.  But these payments are unavoidable – if you have to pay them in a DRG, you have to pay them (or more!) in any other mechanism.  All this is quite abstract, but it has practical applications. Roger used these techniques to show that the kind of simple auctions we see in the real world in fact maximize expected profits for the seller in certain circumstances, even though they leave information rents to the winner.   These rents must be paid in a DRG and hence if an auction leaves exactly these rents to the buyers, the seller cannot do any better.

For this work and more, he won the Nobel Memorial Prize in Economics in 2007 with Leo Hurwicz and Eric Maskin.  Recently, Jeff mentioned that Roger and Mark Satterthwaite should get a second Nobel for the Myerson-Satterthwaite Theorem which identifies environments where it is impossible to achieve efficient allocations because agents have to be paid information rents to reveal their information honestly. This work also uses the framework and DRG I have described above.

Over time, Roger has become more of an “applied theorist”.  That is a fuzzy term that means different things to different people.  To me, it means that a researcher begins by looking at an issue in the world and writes down a model to understand it and say something interesting about it.  Roger now thinks about how to build a system of government from scratch or about the causes of the financial crisis.  How do we make sure leaders and their henchmen behave themselves and don’t try to extract more than minimum rents?  How can incentives of investment advisors generate credit cycles?

These questions are important and obviously motivated by political and economic events.  The first question belongs to “political economy” and hints at Roger’s interests in political science.  More broadly, Roger is now interested in all sorts of policy questions, in economics and domestic and foreign policy.

Jeff and I are very happy to have him as a guest blogger.  We hope he finds it easy and fun and the blog provides him with a path to get his analyses and opinions into the public domain.  We hope he becomes a permanent member of the blog.  So, if among the posts about masturbation and Charlie Sheen’s marital problems you find a post about “What should be done in Afghanistan”, you’ll know who wrote it.

Welcome Roger!

Judiciously Sordid Links

November 5, 2010 in Uncategorized | by | 4 comments

I have standby jury duty today. Might make for some good blogging.

  1. The New York Times torture euphemism generator.  My contribution:  Logs show binding IC, no IR.
  2. How WSJ stipple drawings are made. (I came this close to having one but I was edited out of a story on latte art.)
  3. Nature scores a point versus Nurture.
  4. Price discrimination based on the browser you use.
  5. How Chatroulette is making money?

Strategically Speaking: Why the Republicans Should Think Twice Before Repealing Obamacare

November 4, 2010 in art of office politics | Tags: , | by | 1 comment

Fresh from their rout of the Democrats, the G.O.P. are promising to repeal President Obama’s healthcare reform.  There are lots of things that can be improved in the law but there are also some features that will be popular with voters. To think about the risks of repeal, I find it useful to recall my favorite Rumsfeld quote:

“[A]s we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.”

In the minds on most voters, the healthcare law in an unknown unknown – most of its provisions have not gone into effect and non-experts (and even experts?) have not read the bill fully.  There was never a really serious discussion of the law in the main stream media so citizens just know various buzz words (“death panels”).  The huge uncertainty made the law unpopular with voters and it gave Republicans an electoral advantage.

If the Republicans clamor to repeal the law, the Democrats can point to he features of the law that will be popular with voters  (no denial of coverage for pre-existing conditions, kids can stay on their parents’ policies till they are twenty six..).  The law will go from being an unknown unknown into known unknown/known known territory.  There is only upside for Democrats from this change – uncertainty-averse voters can’t have a worse impression of the healthcare reform than they already have.  They are judging the unknown unknown in its worst possible light.  The risk for Republicans is that if voters find some parts of the law appealing, their assessment actually improves and the Republicans’ electoral advantage diminishes.  Better to keep the details hidden.

There is a “middle of the road” strategy – repeal unpopular bits and keep the popular ones.  I’m not sure if this is really viable either.  It forces a serious discussion of the law.  For example, if Republicans try to repeal the requirement to buy insurance coverage, there will be some discussion of the subsidies offered and the costs of getting rid of the provision (some people will not buy insurance and then free-ride on emergency care pushing up costs for everyone else).  Even if the discussion is a mess, it can’t be worse than the shallow discussion we sat through last year.

My guess is that the usual promise of tax cuts seems to dominate healthcare repeal as a strategy for Republicans.

Thoughts Left Lying Around

November 4, 2010 in Uncategorized | by | 3 comments


 

  1. Are people with blue eyes more successful?  Many studies of the effects of physical attractiveness have endogeneity problems.  But given the randomness of eye color (conditional on parents with recessive genes), siblings make a great control.  Someone must have looked at this.
  2. Procrastination is a best-response to perfectionism.  A perfectionist spends too much time on a task, so she should optimally procrastinate so that the deadline disciplines her to work quickly and settle for imperfection.
  3. When secretly hiding Halloween candy from your kids you face a non-convexity:  either hide just a little bit at a time, or go all the way and hide it all.  Leaving too little is the worst of both worlds:  the stash itself reminds them that they have Halloween candy, then the noticeably small remainder cues them that you are hiding the rest.
  4. In sports like golf, bowling, and chess players are rated in order to match players of similar skill or handicap the weaker players.  Then there are kludgy rules to prevent “sandbagging:”  playing poorly in one tournament in order to get an advantage in the next tournament.  These systems could surely be improved by formally analyzing the strategy-proof mechanism design problem.

Star Struck

November 3, 2010 in Uncategorized | Tags: , | by | Leave a comment

You may have heard that the Michelin guide has been bestowing many stars on Japanese restaurants.  So many that Europeans are suspecting ulterior motives.

The generous distribution of stars has prompted a snarky backlash among some Western critics and celebrity chefs, whose collective egos can be larger than acroquembouche. Some have said Michelin is showering stars upon Japan in an attempt to gain favor in a brand-conscious, France-loving country where it wants to sell not only culinary guides, but automobile tires.

Well, the Japanese aren’t so keen either.

Many Japanese chefs, especially in the Kansai region, say they never courted this attention. Even a single Michelin star can be seen as a curse by the Japanese: Their restaurants are for their customers. Why cook for a room full of strangers? Even worse: crass foreigners.

“It is, of course, a great honor to be included in the Michelin guide. But we asked them not to include us,” says Minoru Harada, an affable young Osaka chef. His Sakanadokoro Koetsu, a fish restaurant with a counter and 10 seats, just earned a single star, its first. Loyal customers have sustained the restaurant over the years, he says, adding: “If many new customers come, it is difficult.”

And with the upcoming realease of Michelin’s guide to Tokyo, Japan may soon be the most spangled restaurant nation in the world.

“Rational” Turnout

November 2, 2010 in Uncategorized | Tags: , | by | 1 comment

I saw David Myatt present this paper in Oxford this Fall.  It made quite a splash with some surprising results about voter turnout rates consistent with “rational choice” theory.  Voting theories based on the assumption that voters calculate the costs and benefits have always been thought to imply very low turnout in order to generate sufficiently high probabilities of close elections.

Consider a region with a population of 100,000 where 75% of the inhabitants are eligible to vote. Suppose that a 95% confidence interval for the popularity of the leading candidate stretches from 56% to 61%. If each voter is willing to participate in exchange for a 1-in-2,500 chance of influencing the outcome of the election, then turnout will exceed 50%. Greater turnout for the underdog offsets her disadvantage.

 

Why Charlie Sheen Will Not Be Paying Denise Richards More Child Support…

November 2, 2010 in Uncategorized | by | 2 comments

Another celebrity marriage has hit the rocks: Charlie Sheen and Brooke Mueller have filed for divorce.  As sad as this is, we economists can tell that Charlie and/or his lawyers are good negotiators.  His divorce filing (page 27) requires that:

“In no event and under circumstances shall the child support paid by Charlie for Bob and Max [his kids with Brooke] be less than the child support paid by Charlie to Denise Richards for Sam and Lola……  The sum received by Denise for child support shall be the minimum received by Brooke for Bob and Max.”

This is all dressed with the claim that Denise has higher earning potential than Brooke.  But so what?  Brooke and her kids are in great shape even if Denise and her kids are in better shape.  Envy has to be playing a role.  But more cynically, Charlie benefits: If Denise asks for more money, he can refuse saying he’d also have to pay more to Brooke and he simply cannot afford it, given his expensive watch buying habit.  Also, Brooke is going to negotiate less hard for more money in the future, hoping Denise does the hard work.

So that brings us to Denise – I am not a legal expert but is it O.K. to mention a contract with Denise in a contract with Brooke without Denise agreeing to it?  Denise should really sue to have this clause removed.  It definitely hurts her in future negotiations.  Denise, if you need an expert witness, I am right here.

How Should You Vote?

November 1, 2010 in Uncategorized | Tags: , | by | 21 comments

Your vote makes a difference only when it is pivotal.  Now don’t worry, I am not bringing this up to sort through the tired old arguments about whether you should go to the polls today. You should!  That settled, let’s talk about what it implies for how you should vote once you get there.

Because if your vote only makes a difference when it breaks a tie (or makes a tie), then when it comes time to decide how to vote, you might as well assume your vote will be pivotal.  And ask yourself how would you vote if your vote was going to make or break a tie.

Be careful.  This is not the same as the question “How would you vote if you were the dictator?”  Indeed quite often your vote should not be the vote you would cast if yours was the only vote.  That’s because when your vote is pivotal you learn something that a dictator doesn’t.  You learn that all of the other voters were (almost) perfectly split and and that implies something very specific about the other voters and what they must know about the candidates (or propositions) on the ballot.

Quite often that information is crucial for determining how you want to vote. Let me give you a simple example.  Judges are almost always re-elected. Pretty much the only time a judge is voted off the bench is if that judge is completely incompetent.  Now you haven’t bothered to read anything about the judges on your ballot.  You know nothing about them individually but you know that most judges are doing just fine and should be re-elected.

If you were the dictator (an uninformed dictator!) you would vote yes for every judge.  But things turn completely upside-down in an election when you factor in the information you learn from your vote being pivotal.  Since all competent judges are easily re-elected, the only way it could have happened that all the other voters are split is that this judge is not competent!  Knowing that, and knowing that your vote will decide whether an incompetent judge is re-elected, you should vote no.  Against every judge.

Now, the smart readers of this blog have already thought one step ahead and noticed that this logic is self-defeating.  Because if everyone figured this out, then everyone is voting against every judge and then every judge is voted down, not just the incompetent ones.  Here’s where the theory takes one of two paths, use your judgement.

First you might not believe that the electorate in general is as sophisticated as you are.  The vast majority of voters don’t understand the logic of pivotalness and they are naively voting the way they would if they were dictators.  In that case, the argument I have laid out works as written and you should vote against every judge.

On the other hand you might believe that a signifcant fraction of voters do understand the strategic subtleties of voting.  Then we have an equilibrium to find.  For starters we take as given that the judge himself and all of his friends will vote for him.  So he has a head start.  Now there’s a small group of do-gooders who have read up on this judge and know whether he is competent.   They vote as if they are dictators, with good reason now because they are informed. They vote yes if he is competent and no if he is not.

The rest of us know nothing.  Until, that is, we take into account what we can infer from being pivotal.  And if it were just the informed and the judge’s friends who were voting then what we can infer is that enough of the informed are voting no to counteract the judge’s head start.  That is, the judge is incompetent.

In equilibrium none of us uninformed voters vote yes.  Because if any of us are voting yes, then effectively the judge has an even bigger head start and that makes it even worse news that the no votes caught up with the head start.  But not all of us vote no.  Some of us do, but most of us abstain.  Enough of us that it remains a valid inference that a pivotal vote means that enough of the informed voted no to make it optimal for us to vote no.

This is the logic of The Swing Voter’s Curse.

Torture and the Theory of the Second-Best

November 1, 2010 in Uncategorized | by | 1 comment

I was taught the example below as an undergrad and I think it may originally be due to Pigou (or perhaps, as you will see, it was made up by British Rail):

Suppose travelers can either drive to get from A to B or take the train.  The road is free and tolls are technologically infeasible.  Using the train requires buying a ticket.  In fact, the railways are nationalized and, in a narrow definition of the first-best, they should price at marginal cost (this is a pre-privatization example!). This means too many people will drive, imposing costs on each other and speeding up depreciation of the road.  One solution: subsidize train tickets and price them below cost.  One departure from optimality – the inability to charge a toll on the road – leads to another – pricing below cost on the train.  The theory of the second-best.

Now let’s turn to torture in medieval Continental Europe.  The law was administered by professional judges and sentences often involved maiming or death.  As the punishment was so severe, the proof had to be overwhelming: Conviction required the testimony of two eyewitnesses to the crime.  No circumstantial evidence was allowed.  Let us take the two eyewitness rule as a constraint, like the no toll rule for the road.

What can the judge do if there are less than two eyewitnesses but there is circumstantial evidence that the prisoner is guilty?  The judge is then allowed to use torture to extract a confession.  To prevent false confessions, the prisoner has to give up details only someone who is guilty might know.  Dealing with one constraint, the two eyewitness rule, leads to the use of torture, presumably not the best way to introduce circumstantial evidence into judicial proceedings.

There was much room for abuse (leading the prisoner during torture so they know details of the crime etc).  Torture was eventually outlawed in judicial proceedings.  There are many theories for why.  The most prosaic suggests that with incarceration replacing maiming as a tool for punishment, standards for proof could be relaxed.  In England, torture was not used as trial was by jury.  A jury at that time (or even now?) could take any old fact, circumstantial or not, into account in their deliberations.   No need to torture a prisoner when you can convict him on whim anyway!

My source: The Legal History of Torture, John H. Langbein in Torture: A Collection.

Hitchens’ Game With God

October 31, 2010 in Uncategorized | Tags: | by | 11 comments

I mean, I wrote back to some of the people – some of them in holy orders or running religious organizations. I said, when you say you’ll pray for me, do you mind if I ask, what for? And a number of them said, quite honestly, not really for your recovery, but that you see the error of your ways.

BLOCK: That you find God.

Mr. HITCHENS: Yeah. Now, I find that not as easy to be graceful about, because though it’s put in a nice way, it’s part of a phenomenon that I’ve always thought of as very disgusting, which is the belief of the religious – which they keep expressing and have done for centuries – that surely now you’re dying, your fears will overcome your reason.

I hope I don’t have to underline what’s horrible about that. There’s an element of blackmail to it. And an element also of tremendous insecurity, I think, on their part. I mean, they don’t seem to feel they’d win the argument so easily with someone who is mentally and physically strong. By the way, I think they’re right.

Chrisopher Hitchens is probably dying from cancer. And if he is, the day will come soon when the people with whom he frames this conflict will never matter again and the only ones left will be Hitchens and God.

When that moment comes why should Christopher Hitchens not try to make it to Heaven?  At that moment what does he have to lose? Maybe there is still a little bit of life left to live and doing whatever it takes, praying, reconciling, fretting, may not be the way he wanted to spend it.  Or he might feel like a death-bed entreaty only makes a mockery of his life as an outspoken atheist.  But now this starts to sound like reason overcome by fear.

Doesn’t reason dictate that unless Hitchens is absolutely convinced there is no God he should, at the very least, say to whoever might be listening “Hey, please let me into Heaven.”  ?  And doesn’t reason dictate that you cannot be absolutely certain of anything?

But what if God can tell whether you really mean it?  He sees through some bogus last-minute self-serving plea. He wants Hitchens to say “Dear God, I believe in you.”  And Hitchens, who rationally accepts that God might exist, nevertheless considers it unlikely and therefore cannot honestly say that.  At best he could say “Dear God, I p-believe in you, but I admit that p is on the low side.”  But shouldn’t he at least say that?  After all Hitchens, being a man of reason, cannot be sure exactly what p God demands.

A reasonable Hitchens should understand that God, if he exists, understands Hitchens.  “Dear God, conditional on you existing, you deserve all the faith and honesty that you demand of me.  However, I am not sure that you exist.  In all honesty I think it is unlikely.  Here’s the problem.  I have used reason to find evidence of your existence but so far I have not found enough to be convinced. If you do exist then evidently I have failed.  It could be that I relied too much on reason, but reason told me that there was nothing else to use.  I am imperfect, as you of course would know if you exist.  In that case I am sorry and I ask your forgiveness.”

As to which God Hitchens is supposed to address this to, that is not a problem. He can make a separate speech to each of the Gods that might be threatening him with damnation in the afterlife.  Even if there is an uncountable number of such hypothetical Gods, he can single out the finite number who have Books about them and then say a final catch-all speech addressed at all the others.

There is only one way I can see a reasonable Hitchens deciding against this strategy.  He says “Jeff, you are right that since I accept that God might exist and if there is any chance at all that God will allow me into Heaven I should do whatever it takes, within reason, to try and get there.  However, among all of the hypothetical Gods that might exist, there is one in particular I am especially nervous about.  He’s the God who allows everyone into Heaven except those that ask to go there.  And, call me cynical, but reason tells me that in the highly unlikely event that there is a God, out of all the highly unlikely Gods that mankind has imagined, He’s no less likely than the others.”

Sordid (NU) Links

October 29, 2010 in Uncategorized | by | Leave a comment

1.What blonde did Dale Mortensen spend last Friday with?

2. Jeff Ely is into kinky stuff.

 

Scenes From a Nobel Prize Party

October 28, 2010 in Uncategorized | Tags: , | by | 2 comments

Last week there were numerous celebrations at Northwestern in honor of our colleague Dale Mortensen, one of the new Nobel Laureates in Economics.  There were two highlights.  First, here is Dale opening a bottle of champagne with a sword.

and here is a really lovely moment captured on voicemail at 5:30AM CDT.

(thanks for that last bit of clarification Dale! 🙂 )

Krugman Dream, Re-Animated

October 27, 2010 in Uncategorized | Tags: | by | 2 comments

This is the greatest thing the internet has ever given me (gg:  Chris Blattman.) The internet will surely live to regret it.

I once had a dream where I met Paul Krugman at a party.  It went like this:

This happened in a dream I had.  We were at a large round table having dinner.  I was talking about pizza and saying something typically smart-ass about how to make good crust.  Krugman was at the other end of the table and overheard.  He jumped in just long enough to reduce my pizza thesis to mere crumbs.  The rest of the guests looked on in pity.

When the party was over, I bumped into him again on the way out.  We had this little conversation:

Prisoner’s Dilemma Everywhere: The Air Freight Cartel

October 27, 2010 in Uncategorized | by | 2 comments

According to Reuters:

British Airways (BA) could be fined up to 80 million euros (71 million pounds) next month for fixing cargo prices with other carriers, a source with direct knowledge of the case said on Tuesday.

A number of firms played “cooperate”:

The European Commission charged BA, Air France-KLM, SAS and several other airlines in December 2007 with taking part in an air freight cartel.

One played “defect”:

Lufthansa previously said it had immunity as it alerted the Commission to the cartel.

(Hat Tip: Amit Patel)

Why Is It So Hard To Find A Mate?

October 26, 2010 in Uncategorized | Tags: , | by | 6 comments

In the wake of the Nobel for the search theory of unemployment, let’s talk about the search models that really matter:  hooking up.

Everybody who reads this blog understands the Prisoner’s Dilemma.  Play it just once and neither side will cooperate.  So a simple theory of relationships is based on a repeated Prisoner’s Dilemma.  When the relationship can potentially continue, there is now an incentive to cooperate today in order to maintain cooperation in the future.  Put differently, the threat of a future breakdown of cooperation enforces cooperation today.

But things get interesting when we embed this into a search and matching model.  Out of the large pool of the unmatched, two singles get “matched” and they start a relationship, i.e. a repeated prisoner’s dilemma.  As long as the relationship continues each decides whether to cooperate or defect and at any stage either party can break-up the relationship and go find another match.

This possibility of breaking up the match adds a new friction to relationships. The threat of a breakdown in the current relationship is not enough anymore to incentivize cooperation because that threat can be avoided by leaving.  And indeed, it’s not an equilibrium anymore for relationships to work efficiently because then any partner can cheat in his current relationship and then immediately go find another partner (who, expecting cooperation, is the next sucker, etc.)

Something has to give to maintain incentives.  What’s the best way to make relationships just inefficient enough to keep as much cooperation as possible? A simple solution is to “start small:” At the beginning of any relationship there is a trial phase where the level of cooperation is purposefully low, and only after both partners remain in the relationship through the trial phase do they start to get-it-, er, cooperate.

This courtship ritual is privately wasteful but socially valuable.  Once I am in a relationship I am willing to wait through the trial phase because the reward of cooperation is waiting for me at the end.  And once the trial phase is over I have no incentive to cheat because then I would just have to go through the trial phase again with my new partner.  Equilibrium is restored.

There are a number of different spins on this idea in the literature.  There was an early series of papers by Joel Watson based on a model with incomplete information.  I remember really liking this paper by Lindsey, Polak, and Zeckhauser on “Free Love, Fragile Fidelity, and Forgiveness.”  And this quarter, we heard David McAdams with a new perspective on things, including some conditions under which courtship can be dispensed with altogether and partners can get right down to business.

How do Students Game the Course Allocation System at HBS?

October 26, 2010 in Uncategorized | by | Leave a comment

Eric Budish and Estelle Cantillon study this issue in a recent paper.  Suppose any mechanism that allocates students to slots in courses must be ex post efficient – i.e. there should be no room for making trades that make all students better off ex post – and that it is must be a dominant strategy for students to report their preferences truthfully (strategyproofness). It is well-known that the only mechanism that satisfies these two properties is random serial dictatorship (RSD): students are randomly assigned in order and each student gets to pick his entire course schedule in order.

In practice, at HBS, students choose one course at a time.  This cannot satisfy ex post efficiency and strategy-proofness and students must lie in equilibrium.  How do they lie and what welfare implications does it have relative to RSD?  Budish and Cantillon are able to answer this question because they have two sets of data: (1) they have data on how students actually played the mechanism and (2) they have data on the students’ true preferences from a survey.  The second set of data is rarely available.

First, by comparing actual play with reported preference they can see how students game the system.  Second, by using the reported preferences in the survey they can simulate what would have happened in the RSD. They can then compare the RSD outcome with the outcome in the mechanism used and make judgements about welfare.

Their results: Students gamed the system to take slots in popular courses.  For example, even if a popular course ranked low in a student’s ranking, he signed up for the course at the earliest opportunity fearing it would be gone if he waited.  This causes congestion and popular courses fill up quickly and people who value the course highly may not get in. Moreover, by the time the student bids on less popular courses, that course may be full even though it is high in his own ranking. So, there are two inefficiencies.  But still the HBS mechanism can dominate the RSD in terms of ex ante welfare. If a student is picked late and really values some course highly it may already be gone by the time they get to pick.  At least the HBS mechanism gives them some change to get some of their picks in early.  Despite the gaming, this can increase welfare ex ante.

This is a cool paper.  Some predictions of theory are borne out which is always nice.  More importantly, the welfare comparisons using real data make the paper quite original. Perhaps there is some room to tinker with the HBS mechanism and tis might lead to other insights.

As someone who knows more about Bayesian mechanism design than the strategyproofness literature, I am still trying to grope my way towards some unification of these approaches. It seems one should start off with some welfare criterion and some solution concept and maximize welfare subject to incentive constraints which depend on the solution concept.  If the solution concept is dominant strategy equilibrium, then this leads to dominant strategy incentive constraints.  This may not lead to ex post efficient allocations (see Jeff’s timely post about Myerson-Satterthwaite!) but it can improve ex ante welfare.  There is a large literature on Bayesian mechanism design; there is large literature on revenue equivalence.  But even in the latter case, the mechanism designer has a belief.  I guess this implies there is some room for dominant strategy mechanism design without a prior which I suppose is robust mechanism design.  Has this been approach been applied to market design?  My impression is that it has not…..

Popularize: The Myerson-Satterthwaite Theorem

October 25, 2010 in Uncategorized | Tags: , , | by | 9 comments

Tyler Cowen explores economic ideas that should be popularized.  Let me take this opportunity to help popularize what I think is one of the pillars of economic theory and the fruit of the information economics/game theory era.

When we notice that markets or other institutions are inefficient, we need to ask compared to what?  What is the best we could possibly hope for even if we could design markets from scratch?  Myerson and Satterthwaite give the definitive answer:  even the best of all possible market designs must be inefficient:  it must leave some potential gains from trade unrealized.

If markets were perfectly efficient, whenever individual A values a good more than individual B it should be sold from B to A at a price that they find mutually agreeable.  There are many possible prices, but how do they decide on one?  The Myerson-Satterthwaite theorem says that, no matter how clever you are in designing the rules of negotiation, inevitably it will sometimes fail to converge on such a price.

The problem is one of information.  If B is going to be induced to sell to A, the price must be high enough to make B willing to part with the good.  And the more B values the good, the higher the price it must be.  That principle, which is required for market efficiency, creates an incentive problem which makes efficiency impossible.  Because now B has an incentive to hold out for a higher price by acting as if he is unwilling to part with the good.  And sometimes that price is more than A is willing to pay.

From Myerson-Satterthwaite we know what the right benchmark is for markets:  we should expect no more from them than what is consistent with these informational constraints.  It is a fundamental change in the way we think about markets and it is now part of the basic language of economics.  Indeed, in my undergraduate intermediate microeconomics course I give  simple proof of a dominant-strategy version of Myerson-Satterthwaite, you can find it here.

(Myerson won the Nobel prize jointly with Maskin and Hurwicz.  There should be a second Nobel for Myerson and Satterthwaite.)

Truth Is Stranger Than Fiction Because It Can Be

October 25, 2010 in Uncategorized | Tags: | by | 4 comments

Fiction can only be so strange because, as fiction, it quickly loses credibility if it gets too strange.  The audience loses the willingness to suspend disbelief.  When truth is strange it is truly strange.

Of course truth is strange only by accident.  So truth will be less strange on average than fiction because fiction is intentionally strange.  But measured by their peaks, truth will be stranger than fiction.

Sordid Links

October 22, 2010 in Uncategorized | by | 3 comments

  1. Bill Evans on Economics PhD programs.
  2. Scott Adams on writing.

Make a Biased Coin Fair And Balanced

October 22, 2010 in Uncategorized | Tags: | by | Leave a comment

(Not a post about Juan Williams.) From the comments in a post from Jonathan Weinstein:

In fact, there is a simple procedure to simulate a (exactly) unbiased random coin from a biased one. Flip your coin twice (and repeat the procedure if you obtain the same outcome). Call “Heads” if you first got heads than tails, and “Tails” otherwise.

Check out the whole discussion to see how this relates to Ultimate Frisbee, the essential randomness of the last digit in any large integer, Mark Machina, and Fourier analysis over Abelian groups.

The Robert Parker Effect

October 21, 2010 in Uncategorized | Tags: , , | by | Leave a comment

From the latest issue of the Journal of Wine Economics, comes this paper.

The purpose of this paper is to measure the impact of Robert Parker’s oenological grades on Bordeaux wine prices. We study their impact on the so-called en primeur wine prices, i.e., the prices determined by the chaˆteau owners when the wines are still extremely young. The Parker grades are usually published in the spring of each year, before the wine prices are established. However, the wine grades attributed in 2003 have been published much later, in the autumn, after the determination of the prices. This unusual reversal is exploited to estimate a Parker effect. We find that, on average, the effect is equal to 2.80 euros per bottle of wine. We also estimate grade-specific effects, and use these estimates to predict what the prices would have been had Parker attended the spring tasting in 2003.

Note that the €2.80 number is the effect on price from having a rating at all, averaging across good ratings and bad.  You do have to buy some identifying assumptions, however.

Hail Tyler Cowen!

October 20, 2010 in Uncategorized | Tags: , | by | 15 comments

Here he writes about underappreciated economist Eric van den Steen.  Tyler is right, Eric van den Steen is underappreciated.  His work is fresh and creative and he is venturing into terrain (heterogenous priors) where few dare to tread.  Not only that but he is drawing out credible applied ideas from there, not just philosophy. (Ran Spiegler and Kfir Eliaz are two others that come to mind with the same creativity and courage to embrace these models.)

Tyler Cowen is under-appreciated.  Not as a blogger of course, he writes the most popular blog in economics and one of the most popular blogs full stop.  It may sound strange, especially to readers of Marginal Revolution, but Tyler Cowen is an under-appreciated economist.

Here is his CV.  Here is his google scholar listing.  Here is the ranking of his economics department.  If it were not for Marginal Revolution, very few economists would know who Tyler Cowen is.

But we all read Marginal Revolution.  And we all know that Tyler is smarter, broader, more knowledgeable, more intuitive than most of us and our colleagues.  If he wanted it to, his CV could run circles around ours.  I don’t claim to know why he doesn’t want that, but I infer that Tyler believes he is innovating a new way to be a successful and influential economist without compromising on the very high standards that those of us in the old regime hold.

Public signals like Google scholar cites, and top-journal publications can’t measure his contribution to economics but we measure it privately every day when we read Marginal Revolution.  And it deserves to be made public:  Tyler Cowen is a great economist.

One doesn’t just accidentally know who Eric van den Steen is, let alone be able to summarize in a paragraph his contribution and its relation to the literature.  I barely knew who he was and its my job as a member of Northwestern’s recruiting committees to know.  For Tyler Cowen to be able to pick him out of the very many young economists and identify him as the most under-appreciated reveals that Tyler Cowen knows and reads every economist. I believe it is true.

And he understands them better than most of us.  Look at what he wrote about Dale Mortensen.  And the Mortensen-Pissarides model.  Here’s Tyler re-arranging the literature on sticky prices, trade, and monetary policy.  His piece on free parking shows a mastery of the lost art of price theory, whether or not you agree with his final conclusion.  Look at his IO reading list for crying out loud.  Finally, set aside an hour and watch him in his element speaking at Google about incentives and prizes.

So hail T-Cow!  Wunder-(not)-kind!

How to Signal That You Are Marrying for Love

October 20, 2010 in Uncategorized | Tags: , , | by | 6 comments

The seminal (economist’s!) answer to this question has been offered by my old teacher in grad school and my colleague till a few years ago, Kathy Spier, in her paper “Incomplete Contracts and Signaling”.  As her title suggests, her core idea is based on signaling: an informed party making an offer in a game signals his private information via the offer.  An offer that carries a negative inference may not be made.  Kathy’s model is quite complex but it’s central logic is captured in a passage from her paper:

A fellow might hesitate to ask his fiancée to sign a prenuptial agreement…. because to do so would lead her to believe that the quality of the marriage – or the probability of divorce – are higher than she had thought.

In the new century, roles are reversed – the wealthy partner might be female and the poor one male.  If there is no pre-nup, the man can extract a large fraction of his ex-wife’s wealth after a divorce.  In that situation, to signal his love, the man should offer to sign a pre-nup that gives him none of his ex-wife’s fortune.  If he is confident the marriage will survive, divorce is impossible anyway , so why worry about income in an impossible event?

Alas, as the poets have long told us, the path of true love does not run smooth – the most well-intentioned and loving couple can find their marriage has hit the rocks.  Then, there will be much regret and perhaps desperate, legal action to extract enough cash to live in the style to which one has become accustomed.

And so I turn finally to this sad case in the British courts:

When Katrin Radmacher and Nicolas Granatino married in 1998, she insisted it had been for love, not for money. That was why the wealthy German heiress had ensured that her banker husband signed a prenuptial agreement promising to make no claims on her fortune if the marriage failed. It was, she said, “a way of proving you are marrying only for love”.

Once the love had gone, however – the couple separated in 2006 – the fortune remained, and Granatino, by then a mature student at Oxford, decided to challenge the prenup, which they had signed in Germany before marrying and divorcing in Britain, arguing it had no status in English law.

But Granatino lost.

I’m sure a research paper can come out of this: two-sided incomplete information, two-sided signaling and optimal contracting…..I’m too busy keeping my marriage alive to have the time to write it.

What Is The Effect of the Death Penalty on Plea Bargains?

October 20, 2010 in Uncategorized | Tags: , , | by | 1 comment

The threat of the death penalty makes defendants more willing to accept a given plea bargain offer.  But a tough-on-crime DA takes up the slack by making tougher offers.  What is the net effect?  A simple model delivers a clear prediction:  the threat of the death penalty results in fewer plea bargains and more cases going to trial.

The DA is like a textbook monopolist but instead of setting a price, he offers a reduced sentence.  The defendant can accept the offer and plead guilty or reject and go to trial taking his chances with the jury. Just like the monopolist, the DA’s optimal plea offer trades off marginal benefit and marginal cost.  When he offers a stiffer sentence, the marginal benefit is that defendants who accept it serve more time.  The marginal cost is that it is more likely that the defendant rejects the tougher offer, and more cases goes to trial.  The marginal defendant is the one whose trial prospects make him just indifferent between accepting and rejecting the plea bargain.

Introducing the death penalty changes the payoff to a defendant who rejects a plea deal (his reservation value.)  The key observation is that this change affects defendants differently according to their likelihood of conviction at trial. Defendants facing a difficult case are more likely to be convicted and suffer the increased penalty.  (Formally, the reservation value is now steeper as a function of the probability of conviction.)

One thing the DA could do is increase the sentence in his plea bargain offer just enough that the pre-death-penalty marginal defendant is once again indifferent between accepting and rejecting.  The rate of plea bargains would then be the same as before the death penalty.

But he can do better by offering an even tougher sentence. The reason: his marginal benefit of such a move is the same as it was pre-death penalty (the same infra-marginal defendants serve more time) but the marginal cost is now lower for two reasons.  First, compared to the no-death penalty scenario, fewer defendants reject the tougher offer.  Because we are moving along a steeper reservation value curve.  Second, those who do reject now get a stiffer penalty (death) conditional on conviction.

The DA’s tougher stance in plea bargaining means that fewer defendants accept and more cases go to trial.  Evidence?  Here is one paper that shows that re-instatement of the death penalty in New York lead to no increase in the rate of plea bargains accepted (and a clear decrease in the size of plea bargain offers.)

One Reason Why Healthcare Costs So High: Most Favored Nation Clauses in Pricing

October 19, 2010 in Uncategorized | by | 116 comments

The Justice Department is suing Blue Cross Blue Shield of Michigan for its use of “most favored nation” clauses in contracts with hospitals:

Blue Cross and Blue Shield, like most insurers, contracts with hospitals, doctors, labs and other providers for services. The lawsuit took direct aim at contract clauses stipulating that no insurance companies could obtain better rates from the providers than Blue Cross. Some of these contract provisions, known as “most favored nation” clauses, require hospitals to charge other insurers a specified percentage more than they charge Blue Cross — in some cases, 30 to 40 percent more, the lawsuit said.

This kind of contract has several effects. Most obviously, it deters entry by other health insurance companies that automatically face higher costs than BCBS Michigan because of the most favored nation clause.  BCBS then has more monopoly power and can charge higher prices for its products. Second, a competitor is going to have a hard time negotiating a low price with a hospital as any low price they negotiate also has to be passed on to BCBS to maintain the 40% difference.  The hospital is in effect giving a double discount and is less likely to accept such a large cut in profits on a large BCBS contract to get incremental business from a small health insurance company.  Third, BCBS has less incentive to negotiate lower prices for itself: its competitors prices are automatically higher anyway.  BCBS is even willing to pay higher prices to hospitals to get the most favored nation clause put in:

The lawsuit also asserts that Blue Cross, in effect, bought protection from competition — by agreeing to pay higher prices to certain hospitals to induce them to agree to the “most favored nation” clauses.

Lots of interesting stuff. I’m looking forward to following this case to see what happens.

Countersignaling and 4’33”

October 18, 2010 in Uncategorized | Tags: , , , | by | 12 comments

Which type of artist debuts with obscure experimental work, the genius or the fraud? Kim-Sau Chung and Peter Eso have a new paper which answers the question:  it’s both of these types.

Suppose that a new composer is choosing a debut project and he can try a composition in a conventional style or he can write 4’33”, the infamous John Cage composition consisting of three movements of total silence. Critics understand the conventional style well enough to assess the talent of a composer who goes that route. Nobody understands 4’33” and so the experimental composer generates no public information about his talent.

There are three types of composer.  Those that know they are talented enough to have a long career, those that know they are not talented enough and will soon drop out, and then the middle type:  those that don’t know yet whether they are talented enough and will learn more from the success of their debut.  In the Chung-Eso model, the first two types go the experimental route and only the middle type debuts with a conventional work.

The reason is intuitive.  First, the average talent of experimental artists must be higher than conventional artists. Because if it were the other way around, i.e. conventional debuts signaled talent then all types would choose a conventional debut, making it not a signal at all.  The middle types would because they want that positive signal and they want the more informative project.  The high and low types would because the positive signal is all they care about.

Then, once we see that the experimental project signals higher than average talent, we can infer that it’s the high types and the low types that go experimental.  Both of these types are willing to take the positive signal from the style of work in exchange for generating less information by the actual composition.  The middle types on the other hand are willing to forego the buzz they would generate by going experimental in return for the chance to learn about their talent.  So they debut conventionally.

Now, as the economics PhD job market approaches, which fields in economics are the experimental ones (generates buzz but nobody understands it, populated by the geniuses as well as the frauds) and which ones are conventional (easy to assess, but generally dull and signals a middling type) ?

Markets In Everything

October 18, 2010 in Uncategorized | Tags: , | by | 1 comment

Subsidized sterilization.

Drug addicts across the UK are being offered money to be sterilised by an American charity.

Project Prevention is offering to pay £200 to any drug user in London, Glasgow, Bristol, Leicester and parts of Wales who agrees to be operated on.

The first person in the UK to accept the cash is drug addict “John” from Leicester who says he “should never be a father”.

Probably everyone would agree that a better contract would be one that offers payment for regular use of contraception, rather than irreversible sterilization.  Sterilization is probably a “second-best” because it is easier to monitor and enforce.

But it takes sides in the addict’s conflicting preferences over time.  He is trading off money today versus children in the future.  For some, that’s what makes it the right second-best.  For others that’s what makes it exploitation.

Here is more.

Inequality Aversion and Incentives

October 17, 2010 in Uncategorized | Tags: , , | by | Leave a comment

Suppose I want to divide a pie between you and another person.  It is known that the other person would get value p from a fraction p of the pie (that is, each “unit” of pie is worth 1 to him), but your value is known only to you.  You value a fraction (1-p) of the pie at \theta (1-p) dollars but nobody but you knows what \theta is.

My goal is to allocate the pie efficiently.  If both of you are selfish, then this means that I would like to give all the pie to him if \theta < 1 and all the pie to you otherwise.  And if you are selfish then I can’t get you to tell me the truth about \theta.  You will always say it is larger than 1 in order to get the whole pie.

But what if you are inequity averse? Inequity aversion is a behavioral theory of preferences which is often used to explain non-selfish behavior that we see in experiments.  If you are inequity averse your utility has a kink at the point where your total pie value equals his.  When you have less than him you always like more pie both because you like pie and because you dislike the inequality.  When you have more than him you are conflicted because you like more pie but you dislike having even more than he has.

In that case, my objective is more interesting than when you are selfish.  If \theta is not too much larger than 1, then both you and he want perfect equity.  So that’s the efficient allocation.  And to achieve that, I should give you less pie than he because you get more value per unit.  And now as we consider variations in \theta, increases in \theta mean you should get even less!  This continues until \theta is so much larger than 1 that your value for more pie outweighs your aversion to inequity, and now you want the whole pie (although he still wants equity.)

And its now much easier to get you to tell me the truth.  You will always tell me the truth when your value of \theta is in the range where perfect equity is the unique efficient outcome because that way you will get exactly what you want.  Beyond that range you will again have an incentive to lie about \theta to get as much pie as possible.

So inequity aversion has a very clear implication for an experiment like this.  If the experimenter is promising always to divide the pie equitably and is asking the subject to report his value of \theta, then inequity averse subjects will do only two possible things:  tell the truth, or exaggerate their value as much as possible.  They will never understate their value.

I would be curious to see if there are any experiments like this.

 

Research Assistance Bleg

October 15, 2010 in Uncategorized | Tags: | by | 2 comments

I am looking for a Northwestern student who can help me with a very small data collection task.  PhD student preferred.  It wouldn’t take more than a few hours and I would pay you the standard RA rate plus eventual fame and glory.