Tim Harford The Undercover Economist

Articles published in September, 2006

RSS feed of Undercover Economist

This will be the last reminder for a while: Undercover Economist columns are now available free on the FT site, with an RSS feed here. I’ll continue to post other articles here.

30th of September, 2006MarginaliaComments off

Forbes: The economics of Trust

Imagine going to the corner store to buy a carton of milk, only to find that the refrigerator is locked. When you’ve persuaded the shopkeeper to retrieve the milk, you then end up arguing over whether you’re going to hand the money over first, or whether he is going to hand over the milk. Finally you manage to arrange an elaborate simultaneous exchange. A little taste of life in a world without trust–now imagine trying to arrange a mortgage.

Being able to trust people might seem like a pleasant luxury, but economists are starting to believe that it’s rather more important than that. Trust is about more than whether you can leave your house unlocked; it is responsible for the difference between the richest countries and the poorest.

“If you take a broad enough definition of trust, then it would explain basically all the difference between the per capita income of the United States and Somalia,” ventures Steve Knack, a senior economist at the World Bank who has been studying the economics of trust for over a decade. That suggests that trust is worth $12.4 trillion dollars a year to the U.S., which, in case you are wondering, is 99.5% of this country’s income. If you make $40,000 a year, then $200 is down to hard work and $39,800 is down to trust.

How could that be? Trust operates in all sorts of ways, from saving money that would have to be spent on security to improving the functioning of the political system. But above all, trust enables people to do business with each other. Doing business is what creates wealth.

Of course, as Mr. Knack admits, this loads a lot onto a short word. So it’s worth trying to get under the surface of trust in rich countries. Economists distinguish between the personal, informal trust that comes from being friendly with your neighbors and the impersonal, institutionalized trust that lets you give your credit card number out over the Internet.

The two types of trust are correlated with each other, because we are more willing to trust people if we feel that, ultimately, we can call the police or get a fair hearing in court.

“The reason why the U.S. is richer than Somalia is mostly not because of culture. The great thing about formal systems, when well designed, is that they make a little bit of public spirit, altruism or professionalism go a long way,” says Paul Seabright, an economics professor at the University of Toulouse.

Formal or institutionalized trust sounds cold and unpleasant, but it is just as useful as the personal variety, perhaps more so. Our parents might have enjoyed a line of credit from the friendly owner of the local grocery store. We don’t get the same personal service, but we get something much more useful–we can run a line of credit pretty much anywhere, from a hotel in Shanghai to a diner in Memphis to a supermarket in Berlin. Those places don’t actually trust us enough to lend us money, but Visa or American Express will, and that will do just as well.

This matters. Adam Smith, the father of modern economics, argued that wealth was built on the division of labor. He gave the famous example of the pin factory in which one worker drew out the pin wire, another cut the wire, a third added the pin head, a fourth sharpened the pin to a point and so on. But the pin factory achieves nothing if the workers can’t trust each other, and a modern global economy relies on a division of labor and the accompanying trust that spans the continents many times.

Seabright’s book, The Company of Strangers, makes this point with reference to the author’s shirt: “The cotton was grown in India, from seeds developed in the United States; the artificial fiber in the thread comes from Portugal and the material in the dyes from at least six other countries; the collar linings come from Brazil, and the machinery for the weaving, cutting and sewing from Germany; the shirt itself was made up in Malaysia.” It’s just a shirt, and even then it is far too complex a product to be facilitated merely by a network of people who know and trust each other personally.

Yet in a place like Somalia, personal trust is all that is available. It is a war-torn country in the horn of Africa which lacks anything we would recognize as a government, and entrepreneurs have to rely on much more local, primitive and less effective forms of trust. Somalis often rely on clans to settle disputes. That can work well if you’re arguing with someone from the same clan, but cross-clan disputes are often messy and unfairly resolved. (Anybody who thought Somalia’s poverty had to do with a lack of natural resources might take a look at resource-rich Nigeria, a country which is nearly as poor, and then at resource-poor Singapore, one of the richest countries in the world.)

That is a reminder that institutionalized trust might be even better than the touchy-feely type, which simply isn’t available to everyone. Personal trust can be benign, but it can also be embodied by the old-school-tie network, political patronage or a criminal mafia.

“Factors which increase trust in society are not necessarily a good thing, because they can increase the bonds between gang members, whose main economic success comes from extorting or coercing other people,” explains Seabright.

Trust can also be denied to ethnic minorities: the credit card companies may not be entirely blind to race, sex, color and creed, but I am willing to bet they are much closer than the local bank manager in the 1950s.

Economists Kerwin Charles and Patrick Kline have tried to put their fingers on the arbitrariness of personalized trust by looking at car pooling and race. They argue that car pooling is a good measure of trust: can you trust your fellow travelers not to be late, drive badly or murder you and leave your body in a ditch?

Charles and Kline predict that, for example, African-Americans will find it easier to car pool if they live in an area with lots of other African-Americans. The statistics seem to bear them out. Trust matters, and if you live in an area full of people who look like you, you will enjoy more of it. Perhaps the institutionalized version of trust is not so bad after all.

Meanwhile, experimental research by economists Ed Glaeser, David Laibson and Bruce Sacerdote shows that the way people trust each other simply isn’t fair. The researchers organized a “trust game.” Two students met ahead of time to size each other up socially, then they played the game. The first student could give up to fifteen dollars to the second student; the experimenters doubled the gift, and then the second student had to decide how much to give back. The game is a measure of trust because the first player has the power to double the size of the pie, but only at the risk of getting nothing back from the second player. What was striking is how much social factors such as race and status encouraged the second player to be trustworthy.

“If the first player has a sexual partner, the second player will send back 17% more than they otherwise would have done,” observes David Laibson, a professor at Harvard. Since the second player doesn’t know about the existence of a boyfriend or girlfriend, Professor Laibson thinks that it’s a proxy for charm, status and social capacity.

The second student will also send more money if the first student drinks more beer–suggesting sociability–or if he or she is of the same race. Pure status matters too. Students who have fathers with a college degree, or who don’t have to work to fund their studies, receive significantly more money.

“And America is supposed to be a classless society,” comments Professor Laibson. Trust matters, but if you really want to bask in its effects, make sure you start at the top of the heap.

First published at Forbes.com

25th of September, 2006Other WritingComments off

Dear Economist on ft.com, free of charge

The latest Dear Economist column is about how to successfully extort money for withdrawing from a job interview, but I won’t post it here because the FT is now posting my columns (both Undercover Economist and Dear Economist), free of charge. There is even an RSS feed, to which I urge you to subscribe.

Undercover Economist columns free at ft.com

The latest Undercover Economist column is about student boozing, but I won’t post it here because the FT is now posting my columns (both Undercover Economist and Dear Economist), free of charge. There is even an RSS feed, to which I urge you to subscribe.

DVDs of “Trust Me, I’m an Economist”

Quite a few kind souls have written to ask about DVDs of “Trust Me, I’m an Economist“. Alas, there is no official DVD and probably will not be unless a second series is commissioned. Lobby the BBC at once!
There may, of course, be illicit downloads floating around on the internet but I am not aware of them.

17th of September, 2006MarginaliaComments off

Shot down in flames

The Undercover Economist – FT Magazine

The FT’s UK business editor has challenged me to solve a tricky problem for a misunderstood species: dragons. The dragons in question populate BBC2’s Dragons’ Den. Part of the fun of the show is watching these five ferocious venture capitalists give bungling inventors a roasting, but it’s equally entertaining to see them haggling over how large a share of a promising business the hopeful owners are willing to sell.

Merely by expressing an interest in a business, the dragons give the entrepreneurs confidence that they may be able to get a better offer elsewhere. Several recent hopefuls have decided that the dragons were too greedy and turned down their cash.

The first lesson for the rational dragon: curb your enthusiasm in public and make an offer in private. Although the rules of the show forbid it, perhaps some dragons already do. Their scornful put-downs could be motivated as much by rational calculation as by a mean streak or a mean TV producer.

The den is, in fact, an auction room by another name. Dragons bid against each other, and against the unknown outside offers that the business may receive, and they should be aware that every bid reveals information to the other dragons and the entrepreneur. This is the point of an auction: the seller gives buyers an incentive to reveal, through their bids, what they know about the prize’s value. The auction also, rather neatly, collects money on that basis.

The dragons should therefore consider what they might learn from each other’s bids. When casino owner Duncan Bannatyne offered to invest in a poker league, fellow dragon Richard Farleigh was quick to follow. If it was good enough for Bannatyne it was good enough for him.

These are familiar lessons to auction theorists such as Oxford professor Paul Klemperer. As one of the masterminds behind a mobile phone licence auction that raised ₤22.5bn, he presumably knows a thing or two about wringing cash out of investors, but he has also studied the way auctions reveal information. The person who wins an auction is the person who bid more than what everyone else thought the item was worth. In retrospect he is likely to be disappointed: economists call this “the winner’s curse”. Professor Klemperer argues that the curse has the ability to kill some auctions stone dead by discouraging sensible bidders from showing up at all.

The winner’s curse is especially severe when one dragon, such as Bannatyne, is a known expert. A rational dragon should never outbid the expert: if you’re paying more than the expert, you’re paying too much. Yet Bannatyne was, in fact, outbid. He may have made a mistake in expressing interest in a business where his expertise was evident to all.

Continued at ft.com

Trust me, I’m an Economist

British fans of “Dear Economist” may enjoy the TV series it inspired, “Trust Me, I’m an Economist”. Starts 7pm BBC2 on 18th August and runs for four weeks.
There is more at the FT site here.

Filling up the corners

Dear Economist,

From time to time I find myself eating a meal with an unlimited supply of food: sometimes an all-you-can-eat buffet, sometimes a more sophisticated meal laid on by a friend or someone trying to impress: weddings, banquets, that kind of thing. I like food but there are limits to how much I can eat. So how should I pace myself for optimal enjoyment of the meal?

Mr M. Newman, Shrewsbury

Dear Mr Newman,

This turns out to be a surprisingly deep problem, and naturally the optimum strategy will also depend on your tastes. (If you are concerned about your weight, fill up on Perrier, celery and lettuce; better yet, stay away from all-you-can-eat buffets.) Nevertheless, I think there are some general principles here.

If the buffet offers you every choice simultaneously, your best strategy is to try a little of every plausible dish so that you can decide what you would really like to eat. Then go back and get properly stuck in: to your favourite dish if you have no taste for variety, otherwise to your favourite two or three.

If the dishes are presented sequentially, then you will have to take more risks. There is always the chance that you will take a too-small portion of what later turns out to have been much the best course.

Your best guide, then, is to consider the incentives of the food supplier…

Continued at ft.com. Subscription free.

9th of September, 2006Dear EconomistComments off

Marriage and convenience

The Undercover Economist – FT Magazine

I am back from a brief holiday, and that always brings fresh perspectives. I am noticing new things about life in the office and life at home. In both cases there are the petty annoyances. At the office, I find myself increasingly irritated by the loudspeaker that bellows a pre-recorded and irrelevant security announcement whenever I lock my bicycle to the bike racks. At home, I have to put up with my wife’s predilection for unreasonably healthy eating.

Of course, in both cases there is give and take. In exchange for putting up with the electronic honking of the security system and for the turnip soup, I am allowed to take my own little liberties. My salary is not docked if I turn up to work late after a trip to the dentist, but I wouldn’t want to try the trick if I was billing by the hour.

As at work, so in love. When I was dating I’d work out, brush my teeth after every meal, and always wear clean underwear. Now I’m married I do those things too, of course. Mostly. But I suspect that occasional lapses would, within reason, go unpunished.

What the marriage and the job contract with the Financial Times have in common is that they are long-term arrangements where, in principle, a series of short-term arrangements might do. I have in the past written for the newspaper as a freelancer. Nobody shouted at me for parking my bike, but nobody paid me for going to the dentist either.

There are also many short-term alternatives to “till death do us part”. Some cultures even offer temporary marriages: pagans sometimes marry for a year and a day, renewable by mutual consent, while Shia Muslims can arrange fixed-term marriages. Of course, most people who rent motel rooms for a fixed time don’t bother with the concept of marriage at all.

So why are some partnerships brief and some permanent? Consider – as economist Paul Joskow of the Massachusetts Institute of Technology did in the 1980s – US coal mining and the coal-burning power industry. On the west coast, coal mines and coal-fired power stations married each other, either by merging or by signing 30-year contracts with great detail about how disputes were to be dealt with.

On the east coast, free love prevailed: power stations did not necessarily locate near the mine head and they often bought coal on the spot market or through relatively short-run contracts.

Professor Joskow was in no doubt as to the reason for the difference. All east-coast mines produced very similar coal, were able to operate profitably at a small scale and were linked by a rich web of transport connections. A power station could pick and choose from month to month which mine would supply it.

On the west coast, the mines were much bigger and each one was unique. Power stations had to tune themselves to deal with a specific mine’s output, and would generally be located near the mine head. In such a situation, it would be easy for the mine to exploit the power station by suddenly jacking up the price of coal. The best thing, then, was a merger of interests so that both were on the same team…

Continued at ft.com or subscription free at Slate

The big cost of avoiding risk

From BBC Online

Have you ever been made an offer you felt you couldn’t afford to refuse?

Most of us have had the experience of buying a mobile phone or hiring a car on holiday, to find that suddenly the friendly assistant is talking about frightening risks and offering to protect us from them.

Before we drive our hire cars onto the dangerous foreign streets, we are warned about the excess of 900 euros if something goes wrong.

For just 10 euros a day, we can make that worry vanish.

But before you sign up for your peace of mind, stop and think: economists think you might be making a classic error.

When should you pay over the odds for insurance?

If you pay 10 euros a day to protect yourself from a 900 euro excess, then that’s fair if you crash into something every 90 days.

Of course, if your driving is that bad or the roads are that dangerous, you should probably walk instead.

Even if you crash your car once a year or so, you would be paying four times more than was fair for your car hire insurance.

Whether you should do that or not depends on how frightened you are of risk.

Most of us worry too much about little risks like losing a cheap mobile phone.

One of the major phone companies will insure a cheap mobile phone for 92 pence a week, about £50 a year.

The phone itself will cost £50 to replace.

That is a typical price, but despite all the headlines about mobile phone theft, most phones live peaceful lives and die of old age.

The fair price for the insurance is probably closer to £5 a year.

What is more, most of the people who buy the phone insurance could afford to replace a £50 phone without having to starve.

We are buying protection from a risk that we can afford to take, and we are buying it at an incredibly high price.

You could take the money you would have spent on extra insurance for your washing machine, mobile phone and rental car and put it into a savings account.

For such small risks and such overpriced insurance, it is very likely that the savings account will contain enough money to pay for the occasional phone that falls down the lavatory.

In effect, you are insuring yourself, and at a fair price too.

It can make sense to pay for insurance, even overpriced insurance, to protect yourself from a big risk: your house burning down, or you becoming ill and unable to work for years.

For that kind of risk, there is no way your savings account will ever be big enough.

But that is what insurance is designed for: risks that you cannot afford to take, not risks that you can.

If you can bring yourself to keep cool about little risks, you should insure only the big risks, such as your house burning down.

(What counts as a big risk, of course, depends on how rich you are.)

As for the mobile phone in the lavatory, you will simply have to tell yourself that in the big scheme of things, it is not that important.

That is the closest that economics will ever come to Taoism.

The strange thing is, I only know two other people who actually behave like this.

Both of them are wealthy economists.

Why will the practice never catch on?

Economic psychologists have researched how we respond to risk, and discovered that we find it impossible to put our losses into context.

I should recognise that the value of my home fluctuates every hour by more than the value of the mobile phone I am so worried about losing.

It will not be the house price, but the theft of the phone that upsets me.

And it is the risk of being upset that mobile phone companies will remind me about next time I am in one of their shops.

8th of September, 2006Other WritingComments off
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