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The credit card companies are claiming they will have to charge annual fees and cut reward programs for customers who always pay on time because they are being forced to stop ripping off confused customers who incur late fees and sudden doubling of their interest rates.  Ed Yingling, President of the American bankers’ association warns:

“It will be a different business,” said Edward L. Yingling, the chief executive of the American Bankers Association, which has been lobbying Congress for more lenient legislation on behalf of the nation’s biggest banks. “Those that manage their credit well will in some degree subsidize those that have credit problems.”

The idea seems to be that since the price is being cut for the people with credit problem, it will have to be increased for those with good credit.

I claim this is does not make any sense and is not going to happen.  There are two reasons for this.

To understand the first reason, we must consider why credit card companies charge different prices to different consumers in the first place.  This is a form of price discrimination.  To people with lots of outside options, you have to give a good deal – this is the rationale for reward programs for good risks.  For people with few options, you can afford to raise the price – this is the rationale for high interest rates  for the high risk consumers.  To implement price discrimination you have to be able to identify people in the two groups.  The credit card companies have access to both internal and shared data to do this.  You make profits in both markets,  with higher profits presumably in the high risk market if you manage the risk correctly.  If you cannot price-discriminate because you do not have the information or are not allowed to do so by law, you set a uniform price, hiking up the price to the low risk and lowering it for the high risk.  This is the idea Yingling is suggesting.  For a monopolist, uniform pricing makes less profit that price discrimination as it is less targeted to cnsumers’ willingness to pay.

The new legislation is limiting the firms’ ability to impose terms on the high risk consumers.  So, they will make less money in that segment.  But the key point is – legislation is not outlawing their ability to price  discriminate. There is no incentive for them to do uniform pricing as they still have the information, ability and incentive to price discriminate.  As long as the different segments have different patterns of willingness to pay for credit card services, the rationale for price discrimination is present.

Moreover, there is second reason why fees will not go up – competition.  The low risk consumers are profitable as they generate merchant fees because they use their cards frequently.  Suppose all the credit card companies cut rewards and/or impose annual fees.  Then, one company or another has an incentive to cut the fee or increase rewards to steal customers from another.  In fact, this is the most fundamental force keeping fees down and rewards high – the low risk, high volume consumers of credit card services generate revenue.  To entice them to get your card, you have to give them rewards up front.  The legislation does not change this competitive logic.

So, look forward to more points that help keep up the constant upgrading of your iPod.

(Hat tips: Kellogg MBA students – Aneesha Banerjee, Ondrej  Dusek, and Steven Jackson)

The main logic of torture is to inflict so much pain that the victim reveals all his information to make the pain stop.  Incentives for truth-telling in this situation are eerily similar to those in the bank stress tests.

All banks want to report that they are healthy.  To distinguish the lying sick banks from the healthy ones there has to be some verifiable information.  Healthy ones have this information (e.g. they passed the stress test) and the sick ones do not.  The healthy banks have to have the incentive to reveal the information.  This is all too clear for the healthy banks: by revealing their results they can avoid bank runs, get liquid, start lending etc.

In the torture analogy, a healthy bank is an informed terrorist with real information of an attack and a sick bank is someone, say an uninformed terrorist, with no information.  The assumption of the pro-torture people is that the informed terrorist will have the incentive to report his information to avoid pain.  But an uninformed terrorist has the same incentive.  To tell one from the other, the informed terrorist’s information has to be verifiable.  For example, there has to be “chatter” on Al Qaeda websites that can be used to cross-check the veracity of the torture victim’s confession.  If this information is out there anyway, one might ask why torture was necessary in the first place.  Presumably, the information is vague or ambiguous.  The torture victim’s information brings some clarity.

This process seems heavily error-prone.  False confessions may also cross-check by accident.  The information is so noisy that a lead that is very weak may be thought to be strong.  The more noise there is, the more the victim’s report is uninformative cheap talk – it contains no true information as informed and uninformed terrorists all give information, false and true and impossible to distinguish.

There is a second problem.  Once a healthy bank releases the stress test information, the game is over – the market has the information and responds correspondingly.  A torture victim faces further torture.  There is no way for the interrogator to commit to stop torturing.   If the victim knows this beforehand, the victim lies in the first place as there is no way to stop the torture.  If the victim finds this out between episodes of water-boarding, the victim might start lying to contradict their earlier true confessions.

The efficacy of torture relies on verifiability of information and the ability of the torturer to commit to stop if good information is revealed.  Both properties are hard if not impossible to satisfy in practice.

  1. The music of H1N1
  2. Justice Souter retiring?
  3. Hobbits.
  4. DOJ investigating Google Books settlement.

Jeff already wrote an interesting blog about Specter switching parties.  Specter seems to have switched because he stands a better chance winning in re-election as a Democrat than a Republican, Jeff’s point 4.  The Democrats seem ecstatic and I’m trying to deduce why this is the case.

If Specter had not been accepted into the Democratic fold, he would have lost in the Republican primary.  The Republican candidate, presumably someone very right wing, would then face a Democratic challenger.  This Democrat would be someone other than Specter as Specter would have tried to run as a Republican.  Maybe Specter would run as an Independent in this scenario – though I’m not sure if Pennsylvania allows this.  If the Democrats think that having Specter run as a Democrat means a higher probability of a Democratic win than this messy scenario, I can see some rationale for their happiness.

Their payoff is affected by the quality of Specter as a Democrat as well as his probability of winning.   Specter was pretty independent as a Republican and, for example, voted for the stimulus bill.   So, he is a net gain to the Democrats if he is more likely to vote Democrat than Republican with a “D” label attached to him rather than a “R”.  But he has just shown his lack of loyalty to party by switching sides and was always independent anyway.  His move is very much a rational move made by a calculating politician.  Hence, I believe he is only of use till he is re-elected (or not) in 2010.  Obama has promised to campaign with him and help him raise money.  This is useful till 2010.  After that, Specter will go his own way.    Obama has to get as much Specter-friendly legislation as possible passed in the next two years.  I’m not sure where Specter stands on healthcare reform.  He had cancer and is emotional about health issues.  Maybe this is a point of common value.

From a bargaining point of view, the move reveals that the majority values reaching 60 more than the minority values preventing it.  But this is a puzzle.  Why is it not zero sum?  A few reasons, some generic, some specific to this situation.

  1. In fact, other things equal, the minority should be able to muster more goodies because, due to the smaller numbers, each senator internalizes more of the cost of losing the fillibuster.  So there is even more of a puzzle.
  2. But the majority controls committee chairmanships which is a more efficient way to transfer value as opposed to bill-by-bill sweeteners.
  3. In the current climate the cost of losing the fillibuster is lower than usual because Republicans are lacking leadership and are generally adrift.  Their best chance to rise again is to give Democrats enough rope to hang themselves.
  4. As pointed out by Tyler Cowen, Specter already had some private motivation to switch.  He is among the most liberal of Republicans and his prospects for re-election are better as a Democrat than as a Republican given that he nearly lost the Republican Primary in 2004.

Representatives of Taiwan’s semiofficial Straits Exchange Foundation and its Chinese counterpart, the Association for Relations Across the Taiwan Straits, or ARATS, reached the agreements on Sunday in the third round of formal negotiations since Ma Ying-jeou became Taiwan’s president in May 2008, elected on a pledge to improve the island’s flagging economy through better relations with China.

It is looking more and more likely that China and Taiwan will soon realize de facto (if not formal) re-unification.  And the irony is that the driving force stems from China’s markets softening Taiwan’s political opposition.  Wasn’t it supposed to be the other way around?  Read the article from the Wall Street Journal.

The federal government owns preferred stock in many of the banks it has bailed out.  According to the NYT, it is thinking about converting this preferred stock to common stock.  The article also claims that this reduces the need for a further capital infusion and hence the need to go back to a feisty Congress for more money.

How could that be?  Isn’t the re-labeling of stocks going to leave banks with exactly the same amount of capital and not change anything?  This is just rearranging chairs on the Titanic.

The key sentence is the article is:

The administration said in January that it would alter its arrangement with Citigroup by converting up to $25 billion of preferred stock, which is like a loan, to common stock, which represents equity.

Preferred stock used to recapitalize banks does not come with voting rights but does come with a compulsory dividend.  It is 5% now and rises to 9% after five years.  In that sense, the preferred stock are more like debt that equity.  There is a risk that a bank defaults on this in the same way it could default to other debt holders.  Converting it to common stock implies the government gets voting rights but gives up the dividend.  This reduces the payments the bank has to make on a regular basis and hence makes  it more liquid. This appears to be the main idea.  It is good for the banks as their debt obligations are reduced.  It makes it more likely they survive.

What about taxpayers?  They are taking on more risk as their stake is more junior than before.  There are two countervailing effects.  First, maybe the probability of bankruptcy goes down as a result of this so the risk goes down.  Second, the initial decision to acquire preferred stock may have been politically expedient in which case it did not maximize shareholder/taxpayer value.  There is the perception of a big political cost of being seen to nationalize banks.  The initial plan reflected this political constraint.  This plan is a move to pay this cost to avoid the new political constraint, the cost of going to Congress.  So, maybe the Congress constraint is helping Obama to move to the economic optimum from the constrained political optimum as one political constraint cancels out the other.

Family conversation at restaurant:

Wife: …her husband is a political scientist at U of C.

Son (7 years old): What is a political scientist?

Wife: Your father can answer that question better.

Me: Well, scientists who are physicists study physics. Chemists study chemistry and political scientists study politics.

Son: Oh, so they’re not really scientists.

Wife and I fall about laughing.

Me to son: Why do you say that?   What do they do?

Son: They study votes and stuff like pollsters.  That’s not science.

Out of the mouths of children…..

(True story, I swear.  Have yet to have a long conversation about economists.)

A debate is going on between Lawrence Lessig and Congressman John Conyers about a bill that Conyers is sponsoring. The bill would repeal an existing rule for NIH funding that requires funded research to be published in Open Acess journals.  In addition it would generally prevent federal agencies from imposing these restrictions in the future. A good place to start is here and here are Lessig and Conyers. (hat tip: sandeep.)

There is some debate about the legal issues but to me those issues appear to be a red herring clouding the main dispute.  There is probably one point of agreement: for-profit journals will be hurt.  The disagreement is whether or not this is a good thing.

Requiring open-access publication obviously fulfills the aim of getting the maximum social benefit from dissemination of publicly-funded research.  The marginal cost of distribution is zero, so the efficient price is zero.  But the bill’s proponents argue that a dissemination is only one of the services provided by journals.  Far more important is the evaluation and editing of submitted articles by the peer-review process.  They worry that a zero price means that open-access journals have insufficient incentive to invest in this process.  The result is that it becomes harder for outsiders to distinguish good, credible research from bad, sloppy research.

I have two points to add to this.  First, as an editor of an Open Access journal and a member of editorial boards for many commercial journals I can testify that the publisher’s revenues are not being used effectively (or in most cases, at all) in providing incentives for editors and reviewers to do a good job.  To the extent that the peer-review system works, it works because reviewers have external incentives like reputation, prestige, and plain old scientific integrity.  And these incentives work at least as well in the Open Access world.  (In fact, they seem to work even better since reviewers feel better about their work when it is serving the public interest and not the profits of publishers.)

Second, even if you disagree with the above it remains an empirical question which market structure would best provide material incentives for peer-review.  Open Access publishing prevents the use of distortionary prices for raising the funds to pay reviewers.  The alternative is a model in which authors pay for peer-review with submission fees.  Of course this is also distortionary because the social benefit of having a manuscript carefully evaluated may outweigh the author’s willingness to pay.

But let’s remember:  we are debating a policy about public funding of research.  Basic research is publicly funded precisely because the social benefit of the research outweighs the researcher’s private incentive.  Given this, the funding agency maximizes the value of its subsidy by funding not only the research itself but its dissemination.  This is achieved by requiring Open Access publishing and earmarking some of the funds to pay for peer-review.

Continuing to make bold moves in the first 100 days of his administration, Obama will announce this week two blockbuster appointments to senior positions at the Department of Treasury.


Sure to raise eyebrows will be the appointment of University of Chicago economist Steve Levitt to Tim Geithner’s team. Rarely venturing into the realm of policy,  the author of Freakonomics is better known –and often derided– for research focusing more on cute trivialities like cheating by Sumo wrestlers.

Ironically, his foray into Sumo-economics appears to be exactly why he is getting the call.  As readers of Freakonomics know, Levitt made headlines when he used the same statistical analysis to expose widespread cheating by teachers in the Chicago Public Schools.  How does this help the Department of Treasury you ask?  Stress Tests.  The big headline of Geithner’s first announcement as Treasury Secretary was the promise  to screen out banks doomed to fail.  Strangely, Treasury has since been mum on the results from the stress tests. Now we know the reason:  it turns out all the banks are getting passing marks and the suspicious Treasury Secretary is calling on Levitt to bring his Sumo-scrutiny to bear on the banks.

Colleagues at the University of Chicago economics department are cheering the move.  “I could not think of a better choice than Steve Levitt to move to Washington and help the Obama team” says Nobel Laureate James Heckman, adding that he expects the job to occupy Levitt for two full Obama administration terms. “We will miss him, but he has an important job to do.”

When we finally reached Levitt, he was at McDonalds headquarters at Oak Brook, IL.  Some of their franchises have been cheating by hiding Big Mac revenues that they have to share with McDonalds.  Levitt has found a way to benchmark performance that can reveal suspiciously underperforming locations.  “This is what economists call ‘moral hazard,’ ” Levitt said over a carton of Chicken McNuggets. “Look, economics is not rocket science.  Think of the US Government as like McDonalds, a bank and a toxic asset are just like a franchisee and a Big Mac.  Once you see it that way, its simple.”

Former Bushie

Joe Lieberman supported John McCain during the election, made a speech at the Republican Convention and said Obama was not ready for the Presidency.  And yet Obama later forgave him because he knew Lieberman’s vote was going to be crucial in the Senate.

Now, Obama has shown the same pragmatic streak in inviting Greg Mankiw to join his administration.  Mankiw was the head of Bush II’s Council of Economic Advisors.  He has so far played a role on the sidelines, an informal referee of the contest between Obama and his right-wing critics.  Mankiw is often skeptical of Obama’s plans but at the same time he does not fully endorse their antithesis.  This ambiguity has suited Mankiw well, as he has been courted by both sides of the political spectrum.  Finally, he has chosen his prom date and decided to join the Obama administration.  He will serve alongside his old Harvard colleague Larry Summers as Co-Director of the National Economic Council.

Why did Obama choose Mankiw for this post?

Mankiw said, “Well, in all modesty, I must point out that I proposed something like the Geithner plan – of course, I call it the Mankiw plan (!) – last October.  There are some differences in the details but the principles are the same.  I’m looking forward to improving the plan and being involved in its implementation.  Whenever you are asked to serve your country, I think you should do it, even if there are  ideological differences with some of the people involved.”

The additional intellectual heft of having Mankiw on board will certainly help in the coming months.  Mankiw is also quite familiar with the rump of the Republican party that is still left standing in Congress.  He is one of the rare individuals who has a good relationship with both John Boehner and Mitch McConnell.  McConnell and Mankiw were bridge partners and they have the camaraderie and preternatural ability to wordlessly communicate that comes from expertize at that genteel but vicious game.  But Mankiw can also be a populist and is a great expositor of complex ideas, a fact that Obama hopes will help in persuading at least some House Republicans to occasionally vote for some of his economic plans.

There is another factor at play.  True to predictions, Larry Summers has proved hard to control within the West Wing.  Orzag and Geithner have not been able to do it.   In any case, they are fantastically busy trying to implement Obama’s healthcare policies and manage the financial crisis.  Furman and Goolsbee , who were both students in Cambridge, are in awe of their former teacher and find it hard to contradict him.  Summers and Mankiw respect each other, or at least Mankiw respects Summers!  Obama has watched Biden and Clinton argue over Afghanistan policy.  As a lawyer, Obama has always favored the “team of rivals” approach and wants to replicate it in economic policy.

Only one thing stands in the way.  Mankiw has amassed a huge fortune by selling economics textbooks all over the world.  He is incorporated in Switzerland as a Verein for tax purposes. A verein is an association of independent businesses and each international textook is an independent “firm” within the Mankiw Verein.  This has several tax advantages and seems to be all quite legal. But with the current furor over AIG bonuses the administration wants to tread carefully.

Jeff and Sandeep

I had the privilege to introduce Larry Lessig at a Kellogg Distinguished Leader talk.  He is famous as an exponent of “open source” software and websites, like Mozilla Firefox, UNIX, Wikipedia etc.  These institutions work a bit like academia.  Many things we do as academics, and even academic economists(!), involve free labor.  Refereeing comes to mind first of course but editorial work is hugely onerous and often unpaid.  People who do all this work for free seem to contradict the basic rational selfish actor model of economics.  The rational actor is flexible enough that it can be “jazzed up” to make these facts consistent with selfishness.  Maybe your papers get better refereeing if you referee well, publishing your papers in good journals leads to outside offers which leads to higher pay etc. etc.

But why employ a convoluted explanation when the obvious one is available?  People do all this stuff for free because of the prestige, the power and the fulfillment from affecting the direction of research of entire fields of research. In our case, Jeff and I are doing this because we’re vain enough to think our random musing are interesting and useful.  I’d be at the New York Times website as usual right now if I weren’t doing this so why not?

Similar motives underlie the development of open source software and websites.   It’s got to be pretty cool to have been behind UNIX, LATEX etc.  And the stuff that has huge positive impact on welfare in much the same way as academic science has had huge impact on knowledge.  Both systems use a confusing mix of monetary and non-monetary incentives.

Larry Lessig made his mark initially by advocating looser copyright laws to facilitate this kind of free exchange of ideas.  He helped to set up the Creative Commons project at Stanford.  He worked on various cases to reduce extension of copyright laws.  But he hit a roadblock.  Special interests with an interest in protecting their monopoly power lobbied Congress, funded political campaigns and prevented his ideas being put into action.  Even commonsensical ideas (e.g. promoting reduced sugar intake) were killed off.  Larry realized the fault lay with our political system and has set out to reform it.   He and Joe Trippi have joined up to advocate for campaigns being citizen-funded rather than funded by corporations – see Change Congress.

This was the content of his talk.  I do not know if this scheme will work.  First, it’s going to depend on how much money politicians raise from regular people versus special interests.  Obama was very successful at energizing donations but other politicians are not.  If they do rely on individual donations, then there is some leverage.  But why do people may donations?  There is a huge free-rider problem in voluntary donations so the be must be some non-economic factors at work.  In my case, the one and only time I contributed, I felt as if I was paying to support my favorite sports’ team.  Just like I might buy Bulls’ T-shirts, stickers and memorabilia, I bought Obama stuff even though I knew my contribution was minor and I could buy wine with it instead!   I don’t think people like that are going to be dissuaded by Change Congress.  But perhaps some people are driven by political philosophy when thye donate.  If this is correlated with wanting to change congress this might Lessig-Trippi proposal might work.  I hope so.  Because Lessig’s main point is basic but fundamentally true.

Finally, I must turn to style.  Larry’s talk is by far the best talk I have ever attended.  I was blown away by Gore’s Inconvenient Truth presentation.  As a B school prof I’m always impressed by Powerpoint slides!  I never saw Gore’s talk live.  Lessig I saw live and this is the best talk I have ever witnessed in person.  To get a flavor, see here.  I must sign off and work on my slides for next 1/4.

The New York Times describes the Israeli strategy in the recent war in Gaza as follows:

The Israeli theory of what it tried to do here is summed up in a Hebrew phrase heard across Israel and throughout the military in the past weeks: “baal habayit hishtageya,” or “the boss has lost it.” It evokes the image of a madman who cannot be controlled.

“This phrase means that if our civilians are attacked by you, we are not going to respond in proportion but will use all means we have to cause you such damage that you will think twice in the future,” said Giora Eiland, a former national security adviser.

It is a calculated rage. The phrase comes from business and refers to a decision by a shop owner to cut prices so drastically that he appears crazy to the consumer even though he knows he has actually made a shrewd business decision.

I think the word “consumer” should be replaced by the word “entrant” for this passage to make complete sense – consumers like lower prices, entrants do not.  Then, the Israeli strategy becomes the classic story about predation:  When an entrant dares to enter a market, the incumbent may want to prove he is “tough”, cut his price drastically and drive the entrant out of the market.  This will also help the entrant “to think twice in the future” as they say above and deter future entry.  This assumes the entrant has nothing to prove.  But Hamas also want to prove its tough.  If it backs off now, then Israel will learn that Hamas is soft and will surely push the advantage in a future war.  So, Hamas has the same incentives as Israel and will not back down.  That is, the possibility of future war and the reputation each player wants in that war makes both players tougher.  So the war can be very very terrible.  For a preliminary model along these lines see my paper “Reputation and Conflict” with Tomas Sjöström.  For the Prime Minister this is a ” ‘el harb el majnouna,’ the mad or crazy war”.  And it’s all unfortunately quite rational:

Shlomo Brom, a researcher at the Institute for National Security Studies at Tel Aviv University and a retired brigadier general, said it was wrong to consider Hamas a group of irrational fanatics.

“I have always said that Hamas is a very rational political movement,” he said. “When they use suicide bombings, for example, it is done very consciously, based on calculations of the effectiveness of these means. You see, both sides understand the value of calculated madness. That is one reason I don’t see an early end to this ongoing war.”

I say unfortunately because I hope (irrationally?!) that rational behavior can be taught and irrationality eliminated.  But if crazy behavior is rational, what are we to do?

From CNN:

They’ve sung his praises on social networking pages, calling him a “hero,” “the greatest man of our time,” “a legend.” They’ve said he deserves to be knighted and should be decorated with medals. They’ve cried out for his amnesty and have even proposed serving time for him.

The article is about the man who threw his pair of shoes at the former President of the United States.  He was sentenced this week to three years in prison.  The quote raises the question of whether we should allow a third party to serve jail time on behalf of (and instead of) the convicted criminal.

In the economic theory of criminal justice, a punishment is designed to make potential “criminals” internalize the costs imposed on society by their crime.  The principle is that we can never know in advance whether any act should be allowed.  There are always circumstances in which the private benefit exceeds the social cost and so we design the punishment so that the act will be committed if and only if that is the case.

For example, driving too fast raises the chance of an accident and the driver internalizes only half of the consequences of an accident.  So traffic fines are set in order to cover the gap.  (The fine equals the cost of the damage times the increased probability of an accident due to speed.  This explains why the fine is small and why it is increasing in speed.)  We understand that sometimes it is socially optimal to allow the driver to speed.  For example, his wife may be about to give birth all over his nice upholstry.  So we allow him to speed for a price.  If the price is set correctly, he will choose to do so only when it is socially optimal.

As it turns out there are occasions in history when it is socially optimal to throw a shoe at the leader of the free world.  A pair of shoes in fact.  Since this is not always the case, there is a punishment for it which ensures that it will be done only when it is socially optimal.  But here’s the problem.  Let’s suppose that those who benefit from seeing a shoe nearly leave its heel print on the cheek of the departing Decider are prevented from ever getting within range.  Then it is socially optimal to enforce a contract which appoints a representative who will be in range to do the throwing and to have a third party enjoy the video and then pay the penalty.

In fact, when the benefit of seeing said video is shared by millions around the world, but the benefit to each is not enough to outweigh the cost of the penalty, then it is optimal to allow each of us to volunteer to serve a small jail sentence in return for watching the shoe fly.

All part of bringing Western democracy and justice to the Middle East.

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