Saturday, May 29, 2010

Poll: What's a gift giver to do?

Around a year ago, I wrote a post about gift giving. I was presumably dealing with the difficult problem of how to give a good gift to my wife on her birthday.
My wife's birthday is this week. Although I love her deeply and show that love everyday, her birthday forces me to make my love tangible. Every year, on her birthday, I give my wife a gift. Otherwise, I face unspecified, but terrifying consequences. I am compelled to give her gifts three other times per year: Valentine's Day, our anniversary and Christmas.

As an economist, I look at every scenario in terms of opportunity costs. No matter how you slice it, giving a gift will cost you something. You may reap intangible rewards. You may get more out of the gift giving experience than the receiver. Yes, that's all true, but giving a gift is costly -- whether you give a good gift or not. There are three types of costs the giver pays when giving a gift: (1) monetary costs, (2) time costs, and (3) love costs.
There's plenty more in the post (so check it out here), but that brings me to my poll question of the week.

What should I spend more on this year for my wife's birthday?

(1) Monetary costs
(2) Time costs
(3) Love costs

As with all polls, there's not a right answer to this question (other than what you think). I just think it would be interesting to see what you think is a good way to give a gift to a loved one. Also, it is fun.

So, vote early and often. Tell your friends, your spouses, your flower store clerks, and your jewelry dealers to vote. The poll is open for a week. I'm interested in hearing what you have to say.

Wednesday, May 26, 2010

Modesty, Balance, and the Evolution of Institutions

Greg Mankiw linked to this thoughtful column by David Brooks. Here are a couple of key excerpts:
Burke was horrified at the thought that individuals would use abstract reason to sweep away arrangements that had stood the test of time. He believed in continual reform, but reform is not novelty. You don’t try to change the fundamental substance of an institution. You try to modify from within, keeping the good parts and adjusting the parts that aren’t working.

We Americans have never figured out whether we are children of the French or the British Enlightenment. Was our founding a radical departure or an act of preservation? This was a bone of contention between Jefferson and Hamilton, and it’s a bone of contention today, both between parties and within each one.

[...] The children of the British Enlightenment are in retreat. Yet there is the stubborn fact of human nature. The Scots were right, and the French were wrong. And out of that truth grows a style of change, a style that emphasizes modesty, gradualism and balance.
This column reminded me of the excellent work by Douglass North on Institutions and Institutional Change (an excellent book to read for any young academic in the social sciences).

North's broad conclusion is the same as Brooks, and it is a profound insight that won North the Nobel Prize. Institutions evolve slowly over time because they embody systems of cultural norms, past prejudices, and worldviews that are not easily transformed. These norms interact with the formal, written laws to create the "rules of the game" that govern and constrain individual behavior. Moreover, our best evidence suggests that features of these institutions determine economic prosperity.

Written rules can change quickly, but norms evolve slowly. Because the match between these two types of institutions is important, political change necessarily creates tension. We would like to turn what we know about institutions and institutional change into effective policy that improves well-being. North's insight is that -- even if we know what policy is optimal -- no policy is made in a vacuum.

This fact constrains what policies are possible. In a world where our governing rules are being modified dramatically one piece at a time, North's work is a powerful reminder that the written rules are only one piece of the puzzle. Policies made without regard to norms are missing a key ingredient.

Friday, May 21, 2010

Poll: Who should be in charge of clean up?

Under the headline Month after oil spill, why is BP still in charge?, AP writer Matthew Daly writes:
Days after the Gulf Coast oil spill, the Obama administration pledged to keep its "boot on the throat" of BP to make sure the company did all it could to cap the gushing leak and clean up the spill.

But a month after the April 20 explosion, anger is growing about why BP PLC is still in charge of the response.

[...]"The government should have stepped in and not just taken BP's word," declared Wayne Stone of Marathon, Fla., an avid diver who worries about the spill's effect on the ecosystem.
With such a strong introduction, one would expect the tone of the article to be that BP has blundered again and again since the spill, delaying cleanup efforts. Yet, here's what the article goes on to say:
White House press secretary Robert Gibbs was even more emphatic.

"There's nothing that we think can and should be done that isn't being done. Nothing," Gibbs said Friday during a lengthy, often testy exchange with reporters about the response to the oil disaster.

There are no powers of intervention that the federal government has available but has opted not to use, Gibbs said.

Asked if President Barack Obama had confidence in BP, Gibbs said only: "We are continuing to push BP to do everything that they can."

All of this makes me wonder why people have an impulse to ask for the government to intervene in times like these. Is there some comparative advantage that the government has? Should we expect that the clean up is going to be done better by a bureaucracy rather than a profit-seeking corporation?

In a world of imperfectly-aligned incentives, we can't trust the profit-maximizing company to do a thorough job. On the other hand, government bureaucracy is a world of imperfectly-aligned incentives in itself. That brings me to the poll question of the week.

Who should be in charge of the Gulf oil spill clean up?

(a) BP. The market will discipline them.
(b) The government.
(c) The government and BP should work together

As with every week, the poll is open for a week. So, vote early and often (on the sidebar-->). Tell your friends to vote. I'm interested in hearing what you have to say.

Wednesday, May 19, 2010

Leisure and television

One of the most interesting surveys on our economic lives is the American Time Use Survey, which gathers all sorts of information on how Americans spend their time. How much time do we spend working? How much time do we spend doing chores? Watching TV? It's all in there.

For example, take a look at this chart on the average American's leisure activities:

In 2008, out of 5 hours of leisure per day, the average American spent 2.8 hours watching TV, but only 16 minutes "relaxing and thinking," only 20 minutes "reading," and 17 minutes "exercising."

Most people would take this statistic to be an indictment of American culture. After all, our youth are spending time watching television, rather than exercising. The relative inactivity of watching TV means that our kids don't have a chance to burn off all of those calories from their high-calorie diets. TV is, therefore, a leading contributor to obesity in America. Setting aside the causation-correlation issue, there have been plenty of news stories (on television) that make this point.

Because we spend so much time watching television, we are well aware of these news stories on the dangers of inactivity. So, why don't get off the couch if the television is so bad for us? I think the answer is that the quality of entertainment on television has gotten better relative to other forms of entertainment. The average American recognizes that inactivity has its costs, but watching TV has its benefits. As time has gone on, television as entertainment has gotten better, tipping the cost-benefit calculation in favor of watching more TV.

At a personal level, I'm not going to lift up Road Rules as the height of entertainment, but there are several things you'll see today that you couldn't see 20 years ago if you turn on the television: All of which are attracting larger audiences.

First, the variety of channels is increasing dramatically. With our basic cable package, we get about 80 or 90 channels. Movies, news, comedy (bad or good), sitcoms, dramas, reality television... you name it. No household can watch all of the channels all the time, but if you have a preference for variety of entertainment, the variety on television is better now than it has ever been.

Second, the quality of the most-watched programs is improving. Top television shows like Lost, 24, Grey's Anatomy, Castle, The Office, and the like have become increasingly more intelligent with twists and hidden information. For these shows, the audience isn't just watching passively. People are speculating about the next twist. They are engaging with the story. So, to some extent, watching television isn't a substitute for thinking. Rather, it gives us something tangible to ponder. Even on comedy series, there are plot lines that span multiple seasons that make for even better humor (For Friends fans, Ross saying "We were on a break" is a funny line in Season 10 because it was first said in Season 3).

Finally, the flexibility of watching television has increased dramatically. It never used to be that you could follow two television shows that air at the same time. You would have to choose, or wait until one came out of DVD. Setting aside the greater ease in recording television, On-Demand viewing through cable providers has become commonplace. If I miss 24 because I was watching Dancing with the Stars, I can just go online the next day to watch last night's episode. This flexibility in choice makes television an even more attractive option.

With the ever-expanding variety, quality, and flexibility of the television-watching experience, it isn't surprising that Americans have been spending more time on the couch. Viewed from the perspective that the experience has gotten better, it isn't clear that this trend toward watching more television is a bad thing. In fact, when a product becomes better, isn't our first instinct that it makes its consumers better off?

Saturday, May 15, 2010

Poll Reprisal: How much should the U.S. President make?

This week, I decided to reprise an old poll where I (in retrospect) did not give enough options. This poll is from last July:
When I took U.S. History as a high school junior, a question on our test was, "How much does the President of the United States make in a year?" Of course, I had studied hard and I knew the answer was $250,000 (correct at the time). When our teacher returned the tests, I had missed only one question on the test (you can guess which one). It turns out that my penmanship was to blame. As my "2" in 250,000 looked like a "7," I lost four points on the exam. I knew the right answer, but I never forgot that response!

With President Obama's demands on auto executives to take pay cuts and all of the fuss about executive compensation, I thought I would turn the tables in this poll. Instead of asking the all-too-popular question of how much CEOs should make, I want to know what you think America's CEO should make. For your information, the President's salary is currently $400,000 (with $259K in other expense accounts), but he gets to ride in Air Force One, too.
So, how much should the President of the United States make per year?

(a) $1
(b) $400,000
(c) $10 million
(d) the median household income for that year
(e) it should be tied to performance

I chose this poll (rather than others) because there was an interesting discussion in the comments of the original poll. For additional things to think about in relation to this issue, click through to the original poll and read the comments.

As with the first time, the poll is open for a week. Vote early. Vote often. Tell your friends, family and your local CEO to vote. The poll is open for a week (it's over there on the sidebar ---->). I look forward to seeing what you think.

Tuesday, May 11, 2010

What does economics say about setting a price?

Every economist should know how prices are determined. After all, we study from (and write) textbooks with the title Price Theory. Top universities have Price Theory sequences in their graduate curricula. Economists critically examine data on every price under the sun. Indeed, if any profession should know how a price is determined, it is the economics profession.

So, what is it that we know about how prices are determined? To put it differently, how does a price come to be? Here's my blog-sized interpretation on what standard economic analysis has to say about pricing.

The Standard Theory of the Price

The standard theory of the price is the theory of price-taking individuals. That is, every individual in a market takes the market price as given. Neither buyers nor sellers can affect prices on their own. At first, this seems like a strange place to start if we want to explain price changes. It looks like we have assumed the problem away by saying that not one individual can affect the price.

But, it turns out that this model of the world can actually do a great deal to improve our understanding of prices and how they change. Imagine a world where buyers have no bargaining power because sellers can sell to the next available buyer. At the same time, sellers have no market power because if they raise the price a dime, they lose all of their business. What price will prevail in such a market (called a perfectly competitive market)?

In a competitive market, the price that prevails is the equilibrium price, which equates supply and demand. We expect this price to prevail because if there is excess supply, sellers have an incentive to decrease the price to attract buyers. If there is excess demand, buyers have an incentive to pay more (either to ensure access to the good, or to avoid waiting in line). The only price that is stable is one for which there is no excess demand or supply.

This is the theory of price that underlies the standard supply and demand diagram. If you have had an introductory economics course, you know that supply and demand speak profoundly to the nature of prices and price changes. Yet, supply and demand analysis does not speak to the rich nature of negotiation and bargaining over prices. Price is determined as an equilibrium outcome to the competitive game. And, every individual in this competitive game has absolutely no ability to affect the price.

In other words, the economist's standard off-the-shelf theory of the price does a lot to explain what prices can prevail in the marketplace, but it does not tell a satisfactory story of how the price came to be. Individuals in this model go to the market and pay the price, and there is no other price. It is what it is, and everyone takes it as it is.

The Monopoly Theory of the Price

There's another standard case that economists like to consider: The case of one seller and many buyers (or similarly, one buyer with many sellers). Economists call this type of market a monopoly. In such a world, the monopoly seller selects the price that maximizes profit, and the price is set as the result of the single firm's profit maximization problem. Hire an economist to consult on what price should be set, and the intuition (coming from the monopoly problem) is to "set the price that maximizes profit."

As you may have guessed, there is much more to the story. A monopoly need not set one price. If a seller can get away with setting one price for one group of consumers and another for a different group of consumers, it may be able to raise profits in the process. If that works, why not split the market into three segments? Or, four? Without getting into particulars, it gets really difficult to set the right price or set of prices. How do you define a market segment? Do you segment the market by offering products of different quality? If the seller's product is durable or buyers can stockpile, that adds even more complication as the seller competes with himself.

Multiple (but not many) sellers

No markets are perfectly competitive, nor are there perfect examples of monopoly. Most market interactions lie somewhere in between the two extremes. How do we predict the price that prevails in such markets? Economists have (essentially) two approaches: quantity competition and price competition.

Quantity competition is called Cournot competition. When competition is Cournot-style, sellers pick the output that is a best response to what they think the other sellers output will be. Then, whatever price prevails at the produced quantity is the price that the economist predicts. There is no active setting of the price in this style of competition. So, like perfect competition, we have a theory of the price that does not tell us how the price came to be.

So, let's turn to price (Bertrand) competition. When competition is Bertrand, sellers pick the price that is the best response to the other sellers' prices. If products are identical, this style of competition is fierce. With two competitors who compete on price, the price will be bid down until both firms are selling at cost (This is because -- in a world with many buyers -- a slightly lower price attracts the entire market). In other words, once we give the seller the option to set the price, we know that the price that prevails has to be the unit cost of producing the product.

This is also unsatisfactory, so we tweak the identical product Bertrand analysis to allow for differentiated products. Sellers' products are different, so each seller can charge a bit above the unit cost without losing too many customers. Product differentiation means that each seller has a local monopoly over the bundle of product attributes they sell. So, the analysis usually proceeds as: taking the product attributes as given, what price maximizes profit? And, that's a standard theory of price in industrial organization.

As nice as this theory is, it has problems: First, who said that the product attributes are fixed? These are surely an object that the company can choose to help increase profits. Moreover, what is the role of advertising here? These questions drive to the heart of what price ultimately prevails. Yet, it is my understanding that we don't have a complete picture of the full set of interactions between product quality, advertising, entry and exit and how each of these factors determines the price that prevails. This remains an active research area.

Few Sellers and Few Buyers

There is one final piece to the puzzle of pricing. What if there is only one buyer and one seller (or even a few buyers and sellers)? Neither has a monopoly, yet we cannot rely on competition to set the price. Necessarily, the price is going to be determined through some sort of bargain between the two individuals.

Take an example. Imagine that Tony is willing to sell something for $15, while Eric is willing to buy it for $85. What price should prevail? It doesn't take an economist to say "somewhere between $15 and $85." Beyond that, the price could be $20, $50 or $80 (or $51.01 for that matter). What price prevails depends critically on an assortment of factors. How good of a negotiator is Tony relative to Eric? What are each individuals' outside options? Is there some form of leverage that Eric can hold over Tony? Is there time pressure for either of the individuals in coming to a deal? And, so on.

A common mode of analysis that economists use to make these questions more precise is called Nash Bargaining. There is some math involved, but the intuition stems from answering an intuitive question. What factors do you expect to influence the relative bargaining power of the two individuals? And, in this particular bargain, who has more power? Economists -- specifically structural labor economists -- have developed tools to estimate the bargaining power of workers relative to firms, husbands relative to wives, and it wouldn't be hard to put these tools to use in analyzing the bargaining of unions with firms as well.

This structural labor theory of the price assumes some "bargaining parameter," which fully determines the price. Then, the economist tries to understand statistically what determines the relative bargaining power of the two parties.

To conclude, what should an economist know about the price that prevails in a market? Quite a bit! But, most of this knowledge stems from the assertion that price is an equilibrium outcome. On an intuitive level, economists' understanding of price is that it is what makes the terms agreeable to both buyers and sellers. In perfect competition, "agreeable" means no excess demand. In monopoly, "agreeable" means maximizes the seller's profits. In Nash bargaining, "agreeable" balances relative talent at negotiation with other factors like desperation and opportunity cost.

Because the world is complicated, there is always work to do to understand what price is agreeable in a particular context. If you like economics, figuring out what precisely drives a price does not feel much like work, and it is hard to put a price on that.

Saturday, May 8, 2010

Poll: What is an appropriate tutoring rate?

I often get requests to tutor students in math-intensive subjects. I love teaching and I usually enjoy tutoring, so I like having the opportunity to help someone with the subjects I love (economics, statistics, "mathy" subjects, etc.).

Although I love tutoring, I don't love setting a price. On one hand, my time has an opportunity cost and if I don't set the price high enough, I will have too much tutoring demand. At the same time, it feels pretentious to tell someone that my time is worth $X per hour (imagine that X is a large number). When I tutor, I like to state an appropriate price without appearing pretentious. But, that's difficult. It's just one of those uncomfortable social situations.

I bring this up because I recently discussed tutoring of MBA students with one of my fellow graduate students (to remain unnamed). He told me that he charged $100/hour and was still able to retain a bunch of tutoring clients (FYI: At that rate, I'd gladly offer my tutoring services).

Given that background, here's the poll question this week:

What is an appropriate tutoring rate?

(a) $10 -- $20/ hour
(b) $25 / hour
(c) $50 / hour
(d) $100 / hour
(e) > $100/ hour

As stated, this question is somewhat ambiguous (some tutors are "worth" $10/hour, some are "worth" more). To make it more concrete, imagine that you're giving me (an economics Ph.D. student at University of Chicago) advice on what rate I should charge.

That's the poll. Vote early, and often, and on the sidebar. Tell your friends, classmates, professors, and tutors to vote. I'm interested in hearing what you have to say.

Wednesday, May 5, 2010

Three interesting articles to read

Greg Mankiw linked to this interesting defense of price gouging:
When the demand for bottled water goes through the roof — which is another way of saying that bottled water has become (relatively) scarce — the price of water quickly rises in response. That price spike may be annoying, but it’s not nearly as annoying as being unable to find water for sale at any price. Rising prices help keep limited quantities from vanishing today, while increasing the odds of fresh supplies arriving tomorrow.
It is a great read on everyday economics.

By comparing Social Security to food stamps, Russ Roberts concludes that Social Security is a horrible Ponzi scheme:
Why would I want my children and grandchildren to support me if I can support myself? Why would I demand that YOUR children and grandchildren support me if I can support myself? It’s a horrible idea. So if I had my druthers, I’d get rid of the whole thing and let private charity help people who had bad luck or who failed to save for their old age. But the next best thing is to get the government out of the business of redistributing money to rich people under the guise of running an investment plan that’s really a ponzi scheme.
He makes some good points along the way. Click through to his page to see how he reaches that conclusion.

Finally, I leave you with an excerpt from an excellent Tim Harford column from last month. Here is one of the interesting takeaway points (there are many more):
Chetty’s research also tells us about benefits. He complains about the way tax credits are paid out in the US. These credits should encourage more work, because, in effect, they boost the hourly wages of poor households by applying a negative income tax. But they are not salient: people receive a cheque from the government at the end of the year, and most people don’t understand how it boosts their hourly income.

FYI: Raj Chetty -- whose work Tim Harford describes -- is an excellent presenter in addition to being a great researcher. He delivered one of my favorite seminars over the past couple of years at Becker's Applications Workshop at University of Chicago. The topic: Using break points in the tax code to estimate how responsive people are to changes in tax rates.

Saturday, May 1, 2010

Poll: What should be done about Adderall?

Just like baseball, academics has its own performance enhancing drugs. I received a call from my dad the other day telling me about the 60 minutes special on the prevalence of using Ritalin and Adderall (ADD medication) to enhance academic performance. For individuals who do not have ADD, the drugs help people stay awake and focus better. The idea is that the stimulant effects of Adderall allow for intense focus, and they enable the user to stay up for multiple days while maintaining that focus.

For example, in this video, a couple of students discuss their experience with using Adderall to enhance academic performance. By some accounts, Adderall use among college students and academics has become commonplace.

Given this background, the poll question for the week is:

What should be done about the use of Adderall in academics?

(a) Nothing. It's just like an extreme form of coffee.
(b) Ban it.* Those who use Adderall artificially raise the standard of performance, and the side effects are intolerable.
(c) Promote it. Academics on Adderall can come up with game-changing ideas that help improve our world.

As always, I'm interested in hearing what you have to say. The poll is open for a week, so vote early and often. Tell your friends and colleagues to vote. And, if you're on Adderall and can't go to sleep, voting on this poll ought to give you something to do.

*Update: As using Adderall without a prescription is illegal, this option really means "organizations should do more to discourage illegal Adderall use." By this option, I do not mean to imply that Adderall should be banned for its prescribed use.