Dear Economist

Dear Economist: Rare and (almost) unreleased

10 January 2004

I am secretary of a local baby-sitting circle, and I have a problem. Members are simply not going out enough – everybody is trying to build up a reserve of baby-sitting coupons. But if nobody goes out, nobody baby-sits and nobody builds the reserve they desire. Should we introduce rules compelling people to go out, say, twice a month? 

Yours sincerely, 

– Mrs Janine Broughton, Lowestoft

Dear Mrs Broughton,

Your baby-sitting circle is in recession.
This is hardly surprising: you are running tight monetary policy, have constitutionally rigid prices, and suffer severe capital market failures.

You are correct in thinking that as long as everybody is trying to save simultaneously, they will all be frustrated and the circle will never work well. Forcing people to go out and hire baby- sitters will create the illusion of economic activity, but there is no guarantee that your centrally planned solution will be what people really wanted.

A simple fix would be to create a spot of inflation. This worked well for Mr and Mrs R.J. Sweeney, as described in their famous paper “Monetary Theory and the Great Capitol Hill Baby-Sitting Co- op Crisis”. If everybody is issued with extra baby-sitting coupons, they will all feel that they have the reserve they need and start hiring each other more freely. The risk is that inflation gets out of hand and too many baby-sitting coupons start chasing too few willing baby-sitters.
An alternative would be to set up a coupon bank that lends coupons out at an agreed rate of interest. If too few people are willing to go out, lower the rate of interest; if there are too few baby- sitters, raise it.

You may wish to establish some kind of committee to decide interest rates.

The value of coupons should also be allowed to float. In winter, when few people wish to go out and everybody is glad enough of a warm evening watching television with other people’s children, the value of coupons will rise.

Come the summer, coupons will not buy much baby-sitting. This price flexibility will work better than the most ingenious central banker.

This week’s Economist is Tim Harford, the FT’s 2003 Peter Martin Fellow
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Thanks to Michael Stack for pointing out a long-unnoticed error in this piece – Tim Harford, August 2005

20 December 2003

Dear Economist, 

I don’t want to be a Scrooge, but every year the Christmas extravaganza seems like a pointless hassle. Isn’t it all just a waste of time and money? 

Yours, 

-“Ebenezer”, London 

Dear Ebenezer,

I have some sympathy with you. Christmas presents are wasteful, and we even know how wasteful: 16 per cent. This figure comes from surveys by economist Joel Waldfogel, who asked how much cash his respondents would have been willing to pay to buy their Christmas presents. The answer is, sadly, 16 per cent less than what they cost.

The most inappropriate gifts, costing 50 per cent more than their value to the recipients, come from elderly relatives. Sensibly, many elect to give cash instead. Unsurprisingly, friends and partners give less wasteful gifts. It’s interesting to note that the most wasteful presents are those that cost roughly between Pounds 25 and Pounds 50 – expensive enough to assuage the guilt of a hurried choice, but cheap enough not to require double-checking with those close to the recipient.

But giving isn’t the only example of seasonal waste. While some Christmas cards are sent out of genuine goodwill, many Christmas card exchanges are sub-optimal equilibria. In other words, both parties are only sending cards to reciprocate last year’s card. Both would happily agree to stop, but it is embarrassing to be the first after so many years of mechanical exchange.

However, rather than abandoning Christmas altogether as a lost cause, bear in mind that there is an emotional side to our annual ritual. Waldfogel’s research explicitly excludes the “sentimental value” of gifts. You can make sure that the sentimental benefits outweigh the cost by giving smaller presents but taking more care over them. If you must give to those whose tastes you do not understand, send cash.

As for Christmas cards, wipe your Christmas card list and send cards only to those who you truly wish to. It may feel awkward to strike so many people off your list, but it will at least spare them the hassle of sending you a card next year.

If you feel that further explanation is required, send them a copy of this article – surely the ultimate yuletide gift.

Merry Christmas.

This week’s Economist is Tim Harford, the FT’s 2003 Peter Martin Fellow.
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13 December 2003

Dear Economist, 

I am a pub landlord and have been considering making my small village pub a no-smoking zone. Plenty of my regulars do like the occasional cigarette, but some customers protest about the smoke. What do you think is good for business? 

– Bert Cooper, Brampton 

Dear Mr Cooper,

You should lose no sleep over this question. Make a provisional decision and allow your customers to work out the details in a process called Coasian bargaining.

Economists often worry about “externalities”: the side-effects of activities on bystanders. Common examples of negative externalities are pollution, congestion – and smoking.

But the economist Ronald Coase pointed out that such activities might not be externalities after all, because people can always bargain the problem away. (He won the Nobel prize as a result.)

To take a concrete example: if I go into your pub and prefer that my companion not smoke, I might offer $5 to her if she will stop. She will agree, unless she prefers the nicotine to the $5. On the other hand, if it is a non-smoking pub, she might offer me a fiver to indulge her habit and not complain to the management.

Either way, we can come to a mutually beneficial agreement and she will smoke if her desire to do so is stronger than my desire for clean air.

You should only enforce the rules (whether smoking or non-smoking) if your customers are unable to agree, otherwise you will only make them both worse off.

The only thing the no-smoking rule does is establish who must pay to get their own way and who is entitled to compensation for conceding.

Your proposed smoking ban will enrich your abstinent customers at the expense of the smokers, but will not alter the frequency with which you must empty the ashtrays.

Sometimes such schemes do not work because of the expense and effort involved in getting everybody together to agree a bargain, but no doubt your pub is a convivial place and your customers will not begrudge time spent amiably haggling over smoking rights.

In fact, you might make an event of it.

Tim Harford is the FT’s 2003 Peter Martin Fellow.
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22 November 2003

Dear Economist, 

My husband and I have two bonny children already, and another on the way. But the eldest child, Alasdair, is becoming wilful and we have a problem with discipline. We threaten punishment, but he misbehaves anyway and then we don’t have the heart to punish him. Is there anything you can suggest? 

– Sylvia Graham, Edinburgh

Dear Sylvia,

Let’s think about the problem logically. Game theory is the tool of choice for any such interaction. First, Alasdair decides whether to be naughty. Then you decide whether or not to punish him. He prefers to be naughty only if unpunished, and you prefer only to threaten punishments that are not carried out.

There are two equilibria to the game: the one you complain about, when he is naughty and you do not punish him; and the one you want, when you punish him if he is naughty but don’t have to carry out the punishment because he is good.

If the second equilibrium sounds implausible, that’s because it is. Economists call this a “non-subgame-perfect equilibrium”: in other words, when Alasdair calls your bluff, you back down.

No wonder you find yourself in the unwanted, subgame perfect equilibrium. Economists have long known that in a one-off situation, you will never make your threat credible. But never fear, you will play this game again and again, both with Alasdair and your younger children. That changes the dynamic completely.

It is crucial to establish a reputation for toughness. Remember that when you punish Alasdair, you have lost the battle but are winning the war: the discomfort of imposing discipline should be weighed against the future misbehaviour you are preventing. As your reputation as a disciplinarian becomes established, your children’s behaviour will improve.

Perhaps this all seems like common sense, but you should be aware that two Nobel prizes have been awarded for this analysis. Economists have worked hard to demonstrate to you that sometimes you have to be cruel to be kind.

This week’s Economist is Tim Harford, a former FT leader writer
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15 November 2003

Dear Economist, 

I was just listening to the lyrics of a Dire Straits song which say: “You play the guitar on the MTV… money for nothin’ and your chicks for free.” It made me think about the financial appeal of becoming a rock musician. Can you advise? 

Yours truly, 

– M.K., Notting Hill 

Dear M.K.,

The song Money for Nothing bemoans the enormous wealth of pop stars, earned apparently without effort. It is a fine piece of irony by the song’s writer, Mark Knopfler, who is one of Britain’s wealthiest musicians, estimated to be worth at least £70m.

Before you give up your day job, reflect on the wisdom of generalising from the success of Knopfler. Most signed musicians will record only a couple of albums and enjoy $10,000-$20,000 of artists’ royalties for years of work. And most, of course, are never signed at all.

There are two clear explanations for such a wide dispersion of earnings. The first is “tournament theory”, named after events such as tennis tournaments where only the winners receive large prizes. The idea of such a set-up is to offer the maximum incentives for effort in a situation where relative performance is far easier to measure than absolute achievement. Perhaps self-servingly, tournament theory is quoted in support of high executive pay, where it is far easier to observe that Sarah Smith is more competent than Jonathan Jones than it is to put a real value on the efforts of either.

More likely, given that record sales are easily measured, is that the money is linked to absolute results and designed to ensure continued effort. Because success is a joint affair, musicians and record companies have worked out a split of rewards. The record company pushes the album while demanding promotional effort from the artist, along with the continued application of a winning formula in the recording studio. Without royalties it might be hard to sustain the interest of creatives such as Knopfler.

Both theories suggest two conclusions. First, a few musicians are highly rewarded because that is what is necessary to secure their continued services. Second, you would be ill-advised to think that a career in music will bring you “money for nothing”. The only rock musician I know quit to become an economist.

This week’s Economist is Tim Harford, the FT’s 2003 Peter Martin Fellow
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11 October 2003

Dear Economist, 

I do not know whom to turn to. A few months ago I discovered that my wife was having an affair with my boss. I lost both wife and job in quick succession. My wife also took the dog. As I cannot afford my mortgage repayments, I am about to lose my house as well. Betrayed and homeless, I feel very depressed. I have become so desperate as to consider taking my own life. Please help. 

– A.W., Dulwich 

Dear A.W.,

Don’t do anything rash. You are on the verge of making a terrible mistake, albeit one often made by naive practitioners of cost-benefit analysis.

Presumably you are contemplating suicide for the usual reason: a net-present-value calculation suggests that the future benefits of living are outweighed by the future costs. You will have considered the low probability that you will ever love again, the disadvantages of your poor credit record, and the difficulty of securing a new job, especially if applying from no fixed abode. While this cost-benefit analysis may appear to be a rational approach, it neglects advances in the field of real option theory.

Many decisions are irreversible but can be postponed to gather new information. The quintessential example is that of exercising a stock option, which allows the purchase of a share at a particular price. It would seem to a naive investor that an option to buy a share for £5 should be exercised immediately the market price of the share climbs above that level. But this is a mistake: the share may climb much further, or may fall, so while the option remains open there is a value to holding on to it while more information comes in.

Real option theory extends the idea beyond financial investments and into the real world. Apparently rational irreversible decisions to buy houses, build factories, or, indeed, to take one’s own life, should often be postponed to gather more information. Your decision to kill yourself would deny you the opportunity to take advantage of any change of fortunes.

The latest economic theory therefore strongly recommends that you postpone your suicide indefinitely. It may be hard to believe, but there is every chance that you will again find true love and a satisfying job.

This week’s Economist is Tim Harford, an FT leader writer
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6 September 2003

Dear Economist,

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.

10th of January, 2004Dear Economist • Comments off