Tim Harford The Undercover Economist

Articles published in September, 2003

In search of the inside story of economics

Let’s play a game of trust. I give you £10. The rules of the game are that you can keep it, or give it away to an anonymous person whom you will never meet. If you decide to do that, the money will be quadrupled to £40. Then your anonymous beneficiary may either send £15 back, or keep the lot.

What should you do? First, reflect that since you will never meet the other player, he or she has no reason to send back any money. The answer then is obvious: you should hold on to your £10, since if you send money you will never see it again.

This strategy is the “Nash equilibrium” of the game, named after John Nash, a Nobel prize winner and inspiration for the film A Beautiful Mind. But the solution that Nash, an inspired mathematician, proposed to the game does not reflect what people actually do.

When experimental economists run the game in the laboratory, half their subjects decide to send the £10 over, and three quarters of beneficiaries send money back again.

The puzzle for economists is to discover why, and that is why one of Nash’s successors is now looking inside the brain itself.

Vernon Smith of George Mason University shared the Nobel prize in 2002 for pioneering work in experimental economics. His latest interest, neuroeconomics, adds a new dimension to research in this field by carrying out brain scans of experimental subjects playing economic games.

“We didn’t know whether it would work. But we have opened up a more aggressive and daring set of experiments in neuroscience,” Prof Smith says.

Neuroeconomics is attracting a growing number of researchers. Economists and neuroscientists gathered in mid-September in Martha’s Vineyard, off Massachusetts, at Neuroeconomics 2003, one of the first conferences devoted to the new subject.

One of the speakers, Paul Zak of Claremont Graduate University, explains the motivation behind the new research: “We have run experiments, found out that people systematically deviate from the game theoretic equilibrium, so then we start telling stories about why that might have happened.

“I can tell lots of stories but it might take five lifetimes before I figure out the truth. So, given the availability of neuroscience techniques, we just take out the middleman and go directly to neurological processes.”

Prof Smith and his colleagues have done just that with the “trust game”. One possible explanation of people’s behaviour is that they have not understood the game correctly and are making mistakes. Another is that they understand very well, but some other mental process, stronger than rationality, is at play.

Prof Smith suggests that many people have formed a habit of making reciprocal exchanges: “People come in off the street and they are accustomed to trading favours. If they unconsciously pick up on the fact that they’ve been done a favour, the implicit question is: Are you going to return the favour or screw me over?”

The idea is plausible, but it is not easy to test. So during the games, Prof Smith’s team scanned players’ brains using functional magnetic resonance imaging. The FMRI scan showed that players who co-operated were using parts of their brain called Brodman’s areas 8 and 10. These areas had previously been associated with thinking about the mental activities and the motivations of others, and of delaying gratification to receive higher rewards later. Non-cooperative players did not use these parts of the brain, and neither did those who knew they were playing against computers instead of human opponents.

This, argues Prof Smith, is consistent with the reciprocity explanation: players are thinking about the likely responses of other players and deciding to trust them.

Brain scans are not the only tool of neuro-economists. Other approaches include measuring pulse rates, skin conductivity and hormone levels. And as a result of such experiments, neuroeconomics boasts an eclectic collection of findings – one of them being that ovulating women are less trustworthy than the rest of us (see box).

But not everybody is convinced that the new field is telling us anything new. One economist noted for championing alternative ways of modelling economic behaviour is sceptical: “There are a lot of silly papers out there. I am just not sure what we are learning.

“We already knew that people played differently against computers, so the value-added of seeing that different things happen in the brain is small at this point.”

Greg Berns of Emory University, who organised the Neuroeconomics 2003 conference, recognises the criticism: “I’m not making claims that it will yield any great insight: I don’t know myself. It’s too early to say.”

Early it may be, but entrepreneurs have not been slow to see the commercial possibilities of the technology. Brighthouse, a consultancy based in Atlanta, Georgia, has set up a “neuro- marketing” division.

Justine Meaux, research scientist at Bright-house, offers a patter that sounds much like that of any other marketing consultancy. The difference is that Brighthouse is using FMRI scans as part of its marketing toolkit. One recent project scanned brain activity while showing subjects pictures of products, people or activities about which they had previously expressed preferences.

“What we observed is that there are qualitative differences in patterns of brain activity for strong preferences versus weak or negative preferences,” says Ms Meaux.

Brighthouse is unwilling to reveal either clients or specific research findings. But Ms Meaux claims that “neuromarketing is in a unique position to give companies a new perspective about what it means to bond with customers”. She also hopes for an end to “advertising clutter”.

The prospect of marketers and advertisers looking into our brains to work out how to “bond” with us sounds sinister. “Marketing is always frightening,” laughs George Loewenstein, a neuroeconomist at Carnegie Mellon university. None of the neuroeconomists feels that free will is under any immediate threat.

There is even a chance unscrupulous marketers may have the tables turned on them. John Dickhaut, of the University of Minnesota, believes that neuroeconomics will provide a theory of when and why people behave irrationally. This could be used to design better statutory information requirements for complex products such as credit cards or pensions, so customers can make more informed choices.

Other researchers in the field hope for similarly benign applications. Prof Dickhaut and Prof Smith both hope to design better markets and market institutions: auctions, exchanges and markets for sensitive commodities such as water.

Prof Smith elaborates: “We’re trying to understand what’s involved in the transition from personal exchange to impersonal exchange. In personal exchange, trust is important. In impersonal exchange, somehow that trust needs to be replaced by an institutional framework.”

The absence of such a framework is widely recognised to be one explanation for why some countries have failed to achieve strong economic growth, so if neuroeconomics can improve our understanding the results could be profound.

Prof Berns wants to venture into yet deeper waters: “My hope is that by studying the brain, we will get a better understanding of ‘well-being’, of why it is so hard for people to be satisfied with what they have.”

If he succeeds in this endeavour, neuroeconomics really will have turned economics upside-down.

IS OXYTOCIN THE BRAIN’S TELLTALE ‘TRUST HORMONE’?

Professor Paul Zak of Claremont University has run trust games similar to those used by Vernon Smith. But Prof Zak has been testing hormone levels, looking for evidence of a “trust hormone”, levels of which vary according to how far the experimental subjects decide to co-operate with their counterparties.

He has found one candidate: levels of the hormone oxytocin rise in players who receive and return money. Oxytocin is primarily a reproductive hormone responsible for, among other things, lactation. But it can be stimulated by eating, massage, sex and, says Prof Zak, by social signals such as being trusted.

Prof Zak has also found that women who take part in the trust game while they are ovulating send back substantially less money to their fellow player than other women or than men – crudely, they are less trustworthy. He explains: “The physiological reason is that progesterone suppresses the effect of oxytocin. The evolutionary biological reason is that is that if you’re about to get pregnant, you should be very careful about overreacting to the social signals you receive. In addition, you don’t want to be giving away resources.”

Prof Zak points out that since trust is fundamental to economic development, a better understanding of the oxytocin and the physiology of trust could be fundamental for promoting development. The Bangkok Post has already picked up on his work: the newspaper says that since the oxytocin stimulants massage, food and sex are much beloved of Thais, Thailand’s economic development is assured.

29th of September, 2003Other WritingComments off

Builders and the winner’s curse

Dear Economist,

I have bought a dilapidated house and hired some professional builders to renovate it. I thought I could ensure a good deal by soliciting a variety of quotes and estimates and choosing the lowest ones. But from the plumber to the decorators, every single tradesman has failed to stick to his estimate, renegotiated his quote, or simply walked away without finishing the job. Can you advise?

— S. M., Bristol

Dear S. M.,

Your strategy has been, in effect, to hold a series of what economists call “reverse auctions”. That is, rather than trying to sell for the highest price you are trying to buy for the lowest price. And it is to auction theory that you must turn for guidance.

Auction theorists have long recognised that when bidders have to estimate the value of a prize – whether the prize is a work of fine art, a licence to drill for oil, or the obligation to rewire your electrics – then an auction will systematically select the most optimistic estimate.

Even if most bidders make accurate or even cautious estimates, there will usually be some who get it wrong – and one of them rtetracyclineuse.com will of course win the auction. Winners of auctions tend to be disappointed, a phenomenon known as the “winner’s curse”.

When you are selling, you may be rather pleased that one bidder makes a mistake and accidentally offers too much. After all, all you need is to ensure that you get paid. But in a reverse auction, it is hard to ensure that a disappointed winner will provide the promised service.

If the winning electrician discovers that he has bitten off more than he can chew, it will be difficult to hold him to his original quote. There is a long and dishonourable history of such renegotiations in the procurement business, so you are not alone.

You should certainly make sure that you get binding quotes in future, and to make sure they stick, withhold payment until the job is finished. But unless you are a skilled builder yourself, you may still find unpleasant surprises long after the event. My advice is to turn the winner’s curse to your advantage. Why not sell the finished house at an auction?

First published at ft.com.

Iraq’s oil wealth must flow straight to its people – FT Comment

The debate about restructuring Iraq’s economy has begun in earnest. Paul Bremer’s proposed policies represent a free-market dream to some, a corporate takeover nightmare to others. The truth is that because they ignore Iraq’s oil, they are a pure irrelevance.

Even at the peak of Iraqi wealth in the late 1970s, oil represented half of Iraq’s economic output. After three wars and a decade of sanctions, oil is all Iraq has left. That will not change quickly.

Given the mounting death toll in the streets of Iraq, it would be a brave investor indeed who attempted serious commercial operations outside the oil sector. The occupying forces have not begun to establish the security necessary to run a typical business. Even if the security situation is resolved tomorrow, Iraq lacks the infrastructure, legal system and financial depth to sustain a modern economy.

Oil is another matter. In many parts of the world, oil production takes place despite war, dictatorship or the most stunted of commercial sectors. This is no coincidence, for war, dictatorship and slow growth have often been associated with oil wealth. Oil will not help Iraq unless the authorities take steps now to avoid the same fate.

As the Iraqi governing council drafts the country’s new constitution, it should give all adult Iraqis an inalienable right to a proportionate share of public oil revenues. Direct transfers of oil money are rarely seen, although Alaska is a notable exception. But Iraq is an ideal candidate for the policy, variants of which have been proposed by Michael Prowse in the FT on April 21 and, for Nigeria, by economists Xavier Sala-i-Martin and Arvind Subramanian. To see why this bold step is needed, we have to understand what will happen if it is not taken.

When Iraq begins to export large quantities of oil, the real exchange rate will appreciate, making it tough to export anything else. The main burden will fall on agriculture, and people will go hungry unless food is imported and distributed fairly. Manufacturing will also suffer, and with it the main chance for Iraqis to develop commercial and technical experience. The authorities will no doubt talk about diversifying the economy but few oil-rich states have managed this trick.

Because the oil price is volatile, government revenues will also be volatile, making the economy unstable and difficult for entrepreneurs to operate in. The government will probably spend the money on a large bureaucracy whose members cannot safely be sacked, or “invest” it in crazy projects that will never be completed. In oil-rich Nigeria, for example, the Ajaokuta steel complex was started in the 1970s but has never produced any steel.

This is a miserable picture but a fair one, because the fastest-developing countries are almost all poor in resources. In fact, it is probably too benign a view. As well as stunting economies, oil eats away at political systems. Iraq itself provides an obvious example. Saddam Hussein could never have held on to power without control over oil revenues. Other resource-rich states could hardly do worse but still tend to suffer corruption, underdevelopment and even civil war.

Remedies are available for the economic problems but they are useless without a competent and benevolent government. That is why fundamental reform is necessary, to nip the problem in the bud. Direct transfers of all oil revenue to citizens would solve a number of problems. Individual citizens are likely to spend their own money more wisely than weak governments would – it is hard to imagine their clubbing together to build an Iraqi version of the Ajaokuta steel mills, for instance. Individuals are also less likely to raid the cookie jar when times are good: most people understand the value of savings.

Direct transfer would undercut the politics of patronage, because Iraqis would have an automatic right to oil money, defensible in the courts. Possibilities for corruption would not go away, but they would be limited.

To raise revenue, the Iraqi government would have to behave the way serious governments do, setting up an efficient system to tax its citizens. Broad taxation is more likely to lead to better governance, because it requires an accountable relationship between government and people.

Giving Iraq’s oil directly to its citizens is a radical suggestion, but Iraq is starting from scratch anyway. The wretched experience of resource-rich states across the world suggests that it is time to give radicalism a try.

The writer is the FT’s 2003 Peter Martin Fellow

25th of September, 2003Other WritingComments off

Fair trade coffee has a commercial blend

Any industry that has come from nowhere to establish a significant market presence in just over a decade might be expected to be in self-congratulatory mood. But after initial dizzying growth the “fair trade” coffee industry is changing, with the entry of large commercial organisations.

Coffee producers and other delegates at the Fairtrade Labelling Organisation conference this week in London recognise the challenge.

“It does cause a little bit of tension, partly because people feel that they were the ones who started fair trade and pushed it forward and partly because they’re not sure of the motivation of the big companies,” says Eileen Maybin of the Fairtrade Foundation, the UK member of the Fairtrade Labelling Organisation, the international certification authority that controls the Fairtrade mark.

Continued on FT.com – subscription required.

12th of September, 2003Other WritingComments off

Moving in together

My boyfriend and I have been seeing each other for a while, and last month he moved in with me. It seems sensible for us to put his flat on the market, but he’s suggesting that we wait a while in case things don’t work out. What would you advise?

— V.H., Leeds

Dear V.H.,

Modern living has made it so much more difficult to judge where you stand.

Mothers used to teach their daughters not to believe suitors’ promises that they would still love them in the morning. Then, commitment was made in the form of a marriage proposal. But when courts in the US stopped allowing women to sue for breach of promise, it became traditional to back up those promises with diamonds, a girl’s best friend.

Times have moved on and it is much more difficult for both men and women to gauge their partners’ seriousness. But if you apply a spot of screening theory to your domestic situation you will discover exactly where you are. (Screening is the art of finding out hidden information by forcing people to act, rather than simply murmur sweet nothings.)

If your boyfriend is enjoying the perks of living with you but lacks real commitment to your relationship, then he enjoys a high option value from owning a flat to which he can return. This is true even if he loves you but doubts the constancy of that love.

If, on the other hand, he is convinced that you will grow old together, the option value of a spare bachelor pad is minimal. The only reason for him to hold on to the flat is because he thinks it’s a good financial investment. Pundits can argue about the merits of this, but clearly the potential rewards are trivial compared with the loss of his soulmate.

To screen for your boyfriend’s type, you must demand that he sells his flat at once – claim that the Financial Times has been predicting a fall in prices, if you wish.

The art of successful screening is to impose a demand that one type of person is unwilling to meet. You don’t want to be sharing a house with that type of person, so put your foot down.

First published at ft.com.

6th of September, 2003Dear EconomistComments off

All bets are off at the Pentagon (FT features)

For many people, the first time they heard of the Pentagon’s plan to accept bets on terrorist activities was when the bizarre-sounding idea was abandoned.

The Policy Analysis Market, championed by the Pentagon’s research laboratory, the Defence Advanced Research Projects Agency (Darpa), would have traded futures contracts that paid out if particular events, including terrorist attacks, took place. It was widely attacked as both ghoulish and nonsensical.

Tom Daschle, the Senate Democratic leader, complained that it “could provide an incentive actually to commit acts of terrorism”.

But although the Pentagon may have abandoned its proposal, the controversy will not kill the essential idea of using betting to make predictions. Not only do many economists believe this method beats other forecasting techniques but they have also been demonstrating it for years. Precursors of the Policy Analysis Market have been used successfully to predict election results and even to make corporate sales forecasts.

Net Exchange, the company that developed the technology Darpa proposed to employ, hopes that it will be widely used both in the public and the private sector to replace more bureaucratic methods of forecasting. “We were talking to pharmaceuticals companies before all this and have been talking to them since,” says Charles Polk, Net Exchange’s president.

Darpa was hoping to exploit a simple idea: markets collect information by offering money for it. For instance, opinion polls predicting election results are notoriously unreliable because people often lie to pollsters. But offer the wrong odds on George W. Bush’s re-election and punters have every incentive to take the bet. In doing so, the theory goes, they reveal information more truthfully than they would to an opinion pollster. Economists and entrepreneurs are now developing information aggregation markets solely designed to gather information.

These markets create an asset to answer a specific question – for instance, a security that pays out $100 if, and only if, Mr Bush is re-elected. If his chances are 50-50, the asset should be worth about $50 (leaving aside complications).

The theoretical impetus behind this is the “efficient markets hypothesis”, which states that the market price of an asset accurately reflects all available information. If the “Bush to win” asset were priced at $30, well informed investors could take advantage by buying it and, in doing so, would quickly correct the price.

Following the collapse of the technology bubble, the efficient markets hypothesis looks a bit shaky. But proponents of information markets argue that they do not need to be perfectly efficient to be useful; they merely need to do better than other forecasting methods.

Robin Hanson, associate professor at George Mason University in the US and an adviser to Net Exchange, explains: “You have to compare these markets to the alternative. People point to market overvaluation during the bubble but the press and the analysts did not do a better job than the market of calling stock prices. You might point to individuals who did better than the market; but without hindsight, which advice would you follow?”

Information aggregation markets are particularly attractive when different people know different things but a bureaucracy or hierarchy is obstructing the free flow of information. The US intelligence services have been criticised for failing to co-ordinate information between their various agencies. Corporations often face similar difficulties.

Hewlett-Packard, the US computer company, has already appreciated this point. Kay-Yut Chen, a company researcher, teamed up with one of the field’s pioneers, Charles Plott of the California Institute of Technology, to use information markets to make better internal sales forecasts. These markets were minuscule compared with typical financial markets; they each operated at evenings and lunch times for a week, with fewer than two dozen active participants trading assets that paid out just $1 if future sales or revenues fell within a specified range.

Although the markets were thin and operated for low stakes, they performed better than Hewlett-Packard’s official sales forecasts, perhaps because the market traders came from different divisions in the company and had different information to bring to the market.

The trouble with such illiquid markets is that few trades are made and it is easy for one participant to blunder in and move the price a long way. Thin markets are also unlikely to attract the attention of informed speculators, because there is little money to be made.

While the experience of Hewlett-Packard showed that even thin information markets can beat other forecasting methods, it is better for an information aggregation market to have lots of trading activity. Prof Plott comments: “Thin markets can work; but I’d rather have a thick one.”

To get round the liquidity problem, Hewlett-Packard has looked for alternative economic mechanisms. Mr Chen explains: “When you run the market inside a corporation, you need knowledgeable people. But these people are busy and it’s hard to get them to play often enough.”

He and his colleagues developed a new approach, which is now being field-tested: instead of running a market, they run a one-off survey asking people to assign probabilities to different outcomes. They are later rewarded for their accuracy. The survey results are aggregated using a mathematical formula rather than a trading floor.

Prof Hanson’s design for Net Exchange and Darpa took a related approach to get round the problem of thin markets, creating a hybrid of an information aggregation market, which elicits a little information from each participant, with a method akin to Mr Chen’s, which is designed to obtain more. Prof Hanson claims that by pooling related markets in this way, his hybrid design increases liquidity, a necessary precursor to analysing the kind of political events that would have interested the Pentagon.

Prof Plott prefers to improve market liquidity more directly, by attracting more participants with information markets that are faster, easier and more fun to use. He is guarded about the hybrid methods, which have yet to establish a record.

Even if Prof Hanson’s design had worked perfectly, most people view the idea of betting on terrorist attacks with distaste. However, according to Mr Polk of Net Exchange, the so-called “terrorism futures” project was never designed to predict such attacks but to serve as proxy for general events such as a breakdown of the Middle East peace process.

“You could never try to predict or prevent a particular attack using the Policy Analysis Market,” he say. “It would be absurd.”

Prof Hanson also recognises the objections to such a market. “There are two concerns. To put it simply, one is that bad people might give up their information and make money. The other is that bad people might be willing to lose money to spoil the information in the market.”

Since the sums involved are small, neither Prof Hanson nor Mr Polk was worried about terrorists making money out of Darpa. Both suggest that it would also have been hard to rig the market. “It is very hard for manipulators to remove all of the information from the market,”, claims Prof Hanson. Mr Polk argues: “If you wanted to move the price in the wrong direction, you would have to make a lot of trades. That increase in volume would be noticed and is important information in itself.”

Although the Darpa project was cancelled, Mr Polk and Prof Hanson are hopeful that other firms will use their technology. “The biggest benefit is when you have a really important question to ask, which is why pharmaceuticals companies might be interested in using the technology to choose between different research projects,” suggests Prof Hanson.

But Prof Plott, who has tested information aggregation markets with several companies, sees serious political obstacles.

“These markets will eventually prove their worth but you have to be very careful taking the idea outside the laboratory.

“The press coverage is blatantly ignorant. Most companies treat their experiments with information aggregation markets as proprietary, because managers are afraid of being publicly portrayed as idiots.”

Prof Plott suggests that, in trying to overcome this conservatism, some proponents of information markets have claimed too much: “Net Exchange probably proposed more than it should have proposed to Darpa. But the problem is, in order to get a client to bite, people are tempted to promise more than they can deliver.”

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