Tim Harford The Undercover Economist

Articles published in June, 2006

Review: Knowledge and the Wealth of Nations by David Warsh

Financial Times, 26 June 2006

Some experts have the kind of obsession with petty detail that seems likely to make for dull dinner-party conversation, but the best intellectual guides win us over to enjoy the nerdy details as much as they do. David Warsh is one of these rare creatures.

Warsh, who wrote for The Boston Globe for many years, has an obsession with economics and economists. He now writes a newsletter called Economic Principals, which deals with the comings and goings of the profession. The first chapter of Knowledge and the Wealth of Nations is an anthropological study of the American Economic Association, which, miraculously, turns out to be perfectly riveting.

In what is, at its heart, an excellent intellectual history, Warsh shows how the ideas of innovation and economic growth began with Adam Smith and bubbled up only to be submerged again and again.

There was a contradiction at the heart of Adam Smith’s work. His two key ideas were the power of specialisation to muster productive forces and the power of competition to turn those productive forces to the benefit of society. Increasing returns to scale are exemplified by the tale of the pin factory. “One man draws out the wire, another straights it, a third cuts it?.?.?.?eighteen distinct operations?.?.?.?are all performed by distinct hands.” Smith calculated that a dozen men could make about 5,000 pins each a day, and that requires a large market for pins. If increasing returns to scale are as important as he believes, businesses need to be very large to be efficient.

Smith also emphasised the importance of competition, which drove prices to their natural levels and prevented the exploitation of workers and customers. When competition worked well, what we now think of as the invisible hand would turn private selfishness into public virtue: the baker bakes us bread not because he loves us but because he wants to make money.

The contradiction between increasing returns and competition was not widely recognised for many years. If larger companies have lower costs then industries will be dominated by very few of them, or perhaps by one. Where then is the competition?

Historically – with some notable exceptions – economists have focused on competition and ignored increasing returns, which they found conceptually and mathematically hard to deal with. That was, perhaps, forgivable in the 18th century where most economies of scale were modest enough to allow competition to thrive. But the economy Smith described is not the one we have today. Microsoft, protected by intellectual property law, is a near-monopolist in the world of desktop operating systems. Ebay is dominant thanks to the economies of scale in bringing together buyers and sellers. The industry for making large aircraft is big enough for only two players, Airbus and Boeing. Competitive pressures do not operate well in a world of increasing returns.

Warsh’s story moves from Smith through Ricardo, Schumpeter, Keynes, Arrow and most of the other key figures in economic thought, before arriving at Paul Romer’s attempts to put increasing returns at the heart of understanding economic growth. Romer, a peripatetic figure who always seemed to be on the verge of dropping out of the profession, is now a Stanford University professor. His work in the 1980s tried to resolve the contradictions inherent in Smith. He was helped by rapid progress in the mathematics of increasing returns that his contemporaries were applying to industrial organisation and international trade.

Economists had long appreciated that economic growth was made possible by a combination of capital investment and technological change. They even recognised that technological change was much the more important of the two. But being unable to analyse it, they focused on models of capital investment instead – looking for the lost keys under the street lamp. Romer fashioned himself a torch and went looking further afield.

Technological change is hard to model in part because it is the most extreme example of increasing returns to scale. An idea – such as Microsoft’s Windows XP, or the formula for a vaccine – can be impossibly expensive to create and impossibly cheap to copy. Ideas have always been vital to economic growth and they are now more important than ever. Thanks to Romer’s modelling, economists have a much better handle on the process of innovation and are even venturing some thoughts as to what governments might do to foster it.

Warsh’s story is not without flaws. His view of Romer’s contribution occasionally verges on hagiography. The book also gives a sense of petering out as it arrives in the present. As Warsh himself concludes: “What has changed as a result? The answer, it seems to me, is not much.” That is obviously a little disappointing. Yet overall this is a fascinating story of discovery, meticulously reported and essential reading for anyone curious as to what makes economics tick. Warsh does a great job of describing the achievements of those who “have changed what it is that economists are able to see”.

26th of June, 2006Other WritingComments off

Selling stolen goods

Dear Economist,

My bicycle was recently stolen – the third one I’ve lost. Realising that the chance of recovering it was slim to none, I decided to sell my bike in its stolen state.

I knew the only way to find the cycle’s true value was with an auction, so I listed it on eBay. The winner of the auction would be the proud owner of the bike, should it ever be recovered.

After a few days a bidder emerged who was prepared to pay 3p for the chance of my bike being found. But eBay cancelled the listing. What can you now advise?

Orlando Oliver, via e-mail

Dear Orlando,

This is a fascinating variant on the idea of selling stolen goods, and I suspect that eBay misunderstood what you were doing.

Economists are always looking for new ways to broaden and deepen the world of markets and there is no doubt that this market should create value by shifting ownership of the missing bike to someone willing to bear the risks.

You presumably need one bike with certainty, and only one, and so are unlikely to value ownership of a contingent bike. On the other hand, some investors might well welcome the opportunity to buy the right to a thousand missing bicycles for just ₤30.

So – if eBay will not support your sale, what is the appropriate market? Perhaps you should try to sell the bicycle to the police. They are well placed to increase the possibility that the bike is found, and so they should be willing to pay a decent price…

Continued on ft.com

24th of June, 2006Dear EconomistComments off

Let’s get personal

The Undercover Economist – FT Magazine 24 June

To the thud of junk mail on the doormat, we can all now add the intermittent ping of spam arriving in the inbox, the beep of fraudulent text messages and, increasingly, the evening inquiries from polite Indian telesales staff who must wonder why the English are so short-tempered. Eternal vigilance is required to keep one’s address, e-mail details and telephone number out of the databases of the spammers. But that might not be the right approach – perhaps we should give out more information rather than less.

Recently, for example, my wife and I bought a Wendy house for our daughter to play in. If the spammers found out they would bombard us with offers for toys, potties and parenting magazine subscriptions. That’s useless – we already have a couple of potties, after all – but it’s useless only because a little knowledge is a dangerous thing. It would have been good to receive offers from rival Wendy house manufacturers before we made our choice. Junk mail is only junk mail when it offers us nothing that we want.

We would like to receive information about products we’re thinking of buying. That would require us to tell other people what we want to buy – although not how badly we want to buy it. Sadly, we can’t trust the spammers not to abuse that information with a series of half-educated guesses about what they think we might like. So we leave them completely in the dark, to their loss and to our own.

A better system would be for us to compile a dossier about ourselves and our families, including birthdays and anniversaries, favourite authors and music, need for loans or mortgages, and what big purchases are under consideration. We would own that information and could give it or even sell it to companies who wanted our business. If the information was good enough, and used intelligently and sparingly, it could save a lot of time, effort and money.

That is the fantasy that companies hint at when they ask us to provide information, but we aren’t providing enough detail for them to send us much that we would really want to receive. Nor do we trust them enough to tell them more.

All that might be changed by agents who would manage our personal information on our behalf. This information agent would pay us for the privilege, and forward us offers in which we might genuinely be interested. The companies making those offers wouldn’t see our details – they would simply know that they were reaching 20 or 200, or 200,000 people with the characteristics they desire. We could be much more detailed in our dealings with the agent, specifying a desire for more offers, fewer offers, levels of confidentiality and an expiry date on the information.

Presumably people who are more generous with their own information are likely to be paid more for it. The whole concept is based around the insight that individuals could and should have clear property rights to their own personal data. It was explored by Kenneth Laudon, an information technology professor, in an article 10 years ago, and brought to the attention of economists by the economist and technology pundit Hal Varian.

Some companies are already starting to offer this kind of service, although the most popular application appears to be that of purging information from databases that might be used by fraudsters. It seems that our personal information is still largely governed by the law of the jungle. When that changes, we might find ourselves more eager to share our desires with the world.

FT Comment: Are we ruined or are we in clover?

It is so small a thing: the core consumer price index in the US rose 0.3 per cent in May instead of 0.2 per cent. Yet the news was enough to send the bond markets into a spin and rekindle the topic of the day, the return of inflation.

The markets are not, in fact, worried about the return of inflation at all. They are worried about how far central bankers the world over are likely to raise interest rates in their determination to stamp it out. It is not the disease but the cure that investors fear.

You might be forgiven for wondering whether we might spare ourselves the cure after all. What is wrong with 0.3 per cent monthly inflation? Indeed, what is wrong with much higher inflation? If inflation at 20 or 25 per cent a year really did return to the US or the UK, it is hard to pin down exactly what the problem would be for the man in the street.

The obvious answer is that life would get expensive: say hello to the GBP10 ($18) pint of beer or the GBP1m car. The obvious answer is wrong. In a world of 20 per cent inflation, salaries would also be rising. When you are earning GBP5,000 a week, the GBP10 pint leaves cirrhosis well within your reach.

The true problem is obscured by my reference to “the man in the street”. The average person would hardly be affected at all. His wages would rise, interest payments on his savings would rise and, while he might hesitate to keep too much cash under the mattress, this would be a modest inconvenience.

The people who would really notice a bout of inflation would be those who are not typical. Anyone with a flexible-rate mortgage would suddenly find themselves forced to pay money back early: their mortgage payments would go through the roof while the value of the debt they owed would quickly disappear. That is no disaster, but if they had wanted to overpay they would already have done so. Meanwhile,anyone with a long-term fixed-rate mortgage would be in heaven; anyonewho had bought long-term bonds would be in hell.

Inflation redistributes. Unexpected, high inflation moves wealth around so violently and capriciously that it destroys it. The real victims are often pensioners, reliant on the accurate measurement of inflation, and the poor, who are unlikely to have access to inflation-proof assets.

Pensioners should be protected against inflation because the value of their pensions is typically linked to the rate of inflation. Unfortunately, that protection depends on whether the measured rate of inflation really reflects their cost of living. Most pensioners would not be happy tobe told that while heating costsand property taxes are up, the pension will not rise because theprice of computers and adventure holidays has fallen to compensate.

Relative prices rise and fall all the time in a healthy market economy and those price movements will always create winners and losers. But high inflation makes the relative price movements harder to fathom, harder to compensate for and probably much larger.

It is a measure of inflation’s whimsy that nobody really knows whether inflation is worse for the poor or for the rich. Much depends on the intricacies of the tax system: what corporate profits truly are after inflation; how much tax people pay on interest payments that look generous but in fact are just compensating for the melting away of their savings accounts; whether tax thresholds are adjusted in line with inflation. But an important World Bank research project led by William Easterly and Stanley Fischer, who is himself now a central banker, showed that inflation hits the poor hardest and is also feared most by the poor.

Of course, if inflation really takes off, people will no longer know if they are rich or poor, or what goods are really worth any more.People trade cigarettes and coffee in hyperinflationary times, not asobjects of barter but as alternative currencies. Money is supposed totell you how much things cost and if the dollar and the pound and theeuro no longer fulfil that function, a pack of Lucky Strikes will have to do.

Erich Maria Remarque’s novel, The Black Obelisk, describes life in theGerman hyperinflation of the 1920s. After lighting a cigar with a 10mark bill, the narrator, Ludwig, turns to his friend Georg. “How arewe doing really? Are we ruined or in clover?” Georg replies: “I don’tbelieve anyone in Germany knows that about himself.”

But I am getting carried away. Ben Bernanke is not calling in every dollar in circulation so that the Federal Reserve can stamp some extra zeroes on them. We will not see a return to hyperinflation, nor even, most probably, to more modest inflation of 10 or 15 per cent. The central banks know that chaos can easily grow from small beginnings,as people clamour for higher wages, spend money as soon as they receive it and refuse to lend except at vast interest rates. Maintaining moderate inflation is a little like trying to stay moderately pregnant. Let the central bankers give us their medicine, even if the taste is likely to be bitter.

17th of June, 2006Other WritingComments off

It’s the humanity, stupid: Gary Becker has lunch with the FT

The Chicago shopping mall’s parking lot is packed. The white-haired grandfather pulls into a space with a 30-minute limit, not nearly long enough for the leisurely lunch we have planned. “We should be fine here. I don’t think they check that carefully,” he explains in gentle but distinctively Brooklyn tones. I look across at him and ask, “Was that a rational crime?” He doesn’t hesitate for a second. “Yes it was.”

The theory of rational crime is one of half a dozen explosive ideas that won Gary Becker the Nobel prize in economics. Learn More

17th of June, 2006HighlightsOther WritingComments off

Keeping up appearances

Dear Economist,
Why do most of us iron our clothes, when we are untidy in so many other ways?
Judith Oliver, Singapore

Dear Judith,

There is an obvious difference between an immaculate shirt and an immaculate sitting room: you get to enjoy the aesthetic benefits of tidying your living space, but not – unless you spend a lot of time in front of the mirror – the aesthetic benefits of your own clothes.

After all, how many of you can honestly say you haven’t sailed through the day only to discover that you have spinach between your teeth and you forgot to brush your hair? The horror is apparent to everyone but you.

So why do we care more about other people’s enjoyment of our tidiness than our own? It is not a matter of selflessness: we try to make a good visual impression because it will bring us wealth, status and, we hope, a bit of sex too.

But a second question arises: why are we judged on appearances? It might be intrinsically satisfying to have a well-dressed boyfriend, but there is nothing fundamentally less productive about a scruffy accountant. Evidently, the tie is important because employers believe it is correlated with diligence and talent.

If this is true, we would expect to see the largest premium on snappy dressing in professions where there are few other effective ways to evaluate performance. Estate agents and management consultants are sharply dressed in the absence of more convincing guides to their competence.

In professions where talent is more obvious, this facade is not needed.

Continued at ft.com

17th of June, 2006Dear EconomistComments off

Keep them guessing

The Undercover Economist – FT Magazine 17 June

It may surprise casual observers of the beautiful game to discover that one of the heroes of English football this year was a German. Jens Lehmann, the Arsenal goalkeeper, saved a last-minute penalty against the Spanish side, Villarreal, thus earning Arsenal a coveted spot in the Champions League final.

Penalties pit the goalkeeper against a lone striker in a mentally demanding contest. Once the penalty-taker strikes the ball, it takes 0.3 seconds to hit the back of the net – unless the goalkeeper can somehow get his body in the way. That is simply not enough time for the keeper to pick out the trajectory of the ball and intercept it. He must guess where the striker will shoot and move just as the ball is being struck. If Lehmann had not guessed correctly, he wouldn’t have been a hero.

Both striker and keeper must make subtle decisions. Let’s say a right-footed striker always shoots to the right. The keeper will always anticipate the shot and the striker would be better off occasionally shooting to the left – even with a weaker shot it is best to shoot where the goalie isn’t. In contrast, if the striker chooses a side by tossing a coin, the keeper will always dive to the striker’s left: since they can’t guess where the ball will go, best to go where the shot will be weak if it does come. But then the striker should start favouring his stronger side again.

So what to do? The answer comes from a wartime collaboration between economist Oskar Morgenstern and mathematician John von Neumann. They produced a “theory of games” which, applied to this problem, says the strategy of the striker and the keeper cannot be predicted. The striker might shoot to the right two times out of three, but we cannot then conclude that it will have to be to the left next time.

Von Neumann and Morgenstern also say that each choice of shot should be equally likely to succeed, weighing up the advantage of shooting to the stronger side against the disadvantage of being too predictable. If shots to the right score three-quarters of the time and shots to the left score half the time, you should be shooting to the right more often. As you do, the goalkeeper will respond: shots to the right will become less successful and those to the left more successful. It might sound strange that at this point any choice will do, but it is analogous to saying that if you are at the summit of the mountain, no direction is up.

Von Neumann and Morgenstern did not produce game theory to help footballers: they believed it could illuminate anything from pay negotiations to waging war. The trouble is that for these applications the wrinkles of reality always obscure whether ordinary people actually follow the strategies that game theory predicts they should. Yet penalty taking is different. The objective is simple, the variables easy to observe, and the results immediate.

Ignacio Palacios-Huerta, an economist at Brown University, found that individual strikers and keepers were, in fact, master strategists. Out of 42 top players that Palacios-Huerta studied, only three departed from game theory recommendations. Professionals such as the Brazilian Rivaldo and Italy’s goalkeeper Gianluigi Buffon are apparently superb economists: their strategies are absolutely unpredictable and, as the theory demands, they are equally successful no matter what they do, indicating that they have found the perfect balance between the different options. These geniuses do not just think with their feet.

The flight of the humble pea

The Undercover Economist – FT Magazine 10 June

I am becoming a dab hand at turnip soup now that Family Harford eschews supermarket mange-tout in favour of a weekly organic box. I have to confess that I miss the marvellous mange-tout, bursting with freshness and rushed to me straight from Nairobi in a battered old 747.

The mange-tout is, sadly, now beyond the pale. My tree-hugging friends condemn the purchase of anything that has travelled what they judge to be excessively long distances – in the jargon, anything with too many “food miles”. The term echoes “air miles” and the distinct impression we get is that anything you buy outside a farmers’ market has been flown first class at terrible cost to the planet.

The truth is somewhat different. Hardly any food miles are, in fact, air miles. Just under half of them are customers driving to the shops, the rest are vans and lorries shipping food around on the roads. Air and sea miles are a rounding error – 0.1 per cent for air and 0.04 per cent for sea, according to a report on food miles commissioned by the Department for Environment, Food and Rural Affairs and published in July 2005.

Admittedly, the tiny proportion of food that is transported long distances by air does generate a disproportionate amount of carbon dioxide, the leading contributor to climate change. According to the same Defra report, 11 per cent of all carbon dioxide emissions from UK food transport comes from long-haul air cargo – that is, the mange-tout and its kin. Another report from Sustain, a campaigning organisation in favour of locally produced food, calculates that flying 1kg of mange-tout from Nairobi produces nearly 4kg of carbon dioxide – a striking and rather alarming figure.

But how alarmed should we be? To answer that, we need to know how much damage 4kg of carbon dioxide is likely to cause. The answer is almost certainly very little. Climate change might be catastrophic, but 4kg of carbon dioxide does not produce much climate change.

Polluters in Europe currently have to pay about 210 per tonne of carbon dioxide as part of Europe’s efforts to meet its obligations under the Kyoto agreement. That is less than one penny per kg of carbon dioxide. Perhaps that price, in a volatile market, is too low. A Government Economic Service paper on the social cost of carbon emissions recommends a cost closer to 225 a tonne of carbon dioxide. Even that is less than 10p for a kilogram of mange-tout, or a penny for a 100g packet. If consumers were forced to meet those costs – as in principle they should be – the sum would barely register. There are good environmental reasons to tax airline fuel, but such taxes are not likely to make food imports substantially more expensive.

No, the real hidden cost of the mange-tout is not the journey from Kenya, packed densely into an airplane hold to minimise costs. It is the journey you take in your people-mover to the high street or supermarket, and back again with a couple of small bags of shopping in the boot. According to the Defra report, more than two-thirds of the social cost of food transport comes from congestion and accidents, with the largest single contributor being the cars we drive to the shops.

Kenyan farmers need all the help they can get. The biggest risk of the outrage over food miles is that it is used to support those who want to protect domestic farmers against competition from foreign farmers who deserve a chance. The environmental case against the mange-tout is slim. I suggest that you buy as many as you like – as long as you cycle to the shops.

The business-class sadist

Dear Economist,

Your FT colleague Tyler Brule extols the virtues of business class-only airlines. But isn’t everything relative? Will I feel special if first class is standard class?

Dr Rupert Marshall, Gothenburg

Dear Dr Marshall,

It is true that many people seem to have a utility function whose value is tied to the utility of others.

I like watching people laugh, am delighted when my wife is happy, and feel stressed if I see my colleagues under pressure.

Your happiness, too, seems to depend on the happiness of others, but in a curious way. You do not enjoy acres of space, vintage champagne or attentive service. You merely get a kick out of watching taller or heavier passengers trying to squeeze into tiny spaces and seeing the queues for the lavatory.

Given your sadistic streak, I am not sure what to advise. It might be much healthier if you were to compare yourself, not to fellow passengers in pain, but to your own circumstances when you were younger, or the situation your great-grandfather faced when he was a young man…

Continued on ft.com.

10th of June, 2006Dear EconomistComments off

Approaching meltdown

Dear Economist,

I have read in the pages of the FT that copper prices are now so high that copper coins are worth more as copper than as coins. Should I be breaking open the savings jar and melting down its contents?

Morris Kelvin, Aberdeen

Dear Mr Kelvin

It is perfectly true that the price of copper has recently been so high that the face value of a tonne of copper coins has been less than the price of a tonne of copper. You may have read this in the FT and erroneously concluded that coins are worth more as copper. In fact, the price of copper would have to move substantially higher before you consider melting your loose change.

What you have forgotten is that the price of copper can fall as well as rise. A piece of copper worth 1.1 pence may be worth 1.3 pence tomorrow, or 0.9 pence. A copper penny worth 1.1 pence as scrap may be worth 1.3 pence tomorrow but will never be worth less than a penny. When copper prices are very volatile – and they are – your best strategy is to hold on to the penny as a penny. You can cash in if prices rise still further, while knowing that a collapse on copper prices will not destroy the value of your penny.

Continued at ft.com

3rd of June, 2006Dear EconomistComments off
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