Tim Harford The Undercover Economist

Articles published in April, 2008

Business Life: Fair trade or foul

First published in Business Life magazine, February 2008

I recently saw a blast from the past: an independent coffee shop trying to charge an extra ten pence for a Fair Trade cappuccino. Fair Trade coffee is bought from certified coffee growers; they receive a premium, and a guaranteed minimum price. And so it might seem reasonable for a coffee shop to ask its customers to pay more for a Fair Trade cappuccino.
It isn’t, because there is very little coffee in a cappuccino – about seven grams of beans, or a quarter of an ounce. The Fair Trade premium, so important to a struggling grower in Kenya or Ecuador, is typically less than a penny when applied to such a small quantity of coffee. When a coffee shop charges ten pence extra for a Fair Trade cappuccino, the grower gets his due, but most of the mark-up is profit for the shop.
That sounds cynical, if unsurprising. But an alternative way of describing the same situation makes it seem much odder: the coffee shop is willing to slash prices and take a big hit to margins if you don’t buy fair trade coffee. Profiteering is one thing, actively working against fair trade is another. Why does it happen?
The coffee shop – like many businesses – faces a dilemma. Raise prices and it loses some customers; cut prices and it loses margins. Sometimes, however, it is possible simultaneously to raise prices to price-insensitive customers while cutting prices to the customers who are hungry for a bargain. Grown-up economists call this “price discrimination” – I call it “price targeting”.
Outside the bazaar or the used car forecourt, customers rarely accept the idea of haggling for a special price. So businesses work out their own methods of price targeting. The discount for students and pensioners? You might just as well call it a surcharge for people with a job. Kids eat for free in this family-friendly restaurant? Childless couples have cash to burn and can be offered a bit less for their money.
And in the coffee shop, fair trade coffee is a terrific marker for price-sensitivity. Anyone willing to pay ten pence extra for fair trade coffee is demonstrating that she doesn’t mind paying a bit extra.
The first rule of price targeting, though, is that it should never aggravate the customers. Economists started to point out what was happening, customers got cross, and the big chains now tend to offer fair-trade coffee without any mark-up.
That makes sense: they have plenty of other ways to identify price-insensitive customers, which is something to think about next time you pay thirty pence for a couple of marshmallows on the side.

28th of April, 2008Other WritingComments off

Earn and Enjoy

Dear Economist,
The law of comparative advantage suggests people should use their talent, but we’re also told “do what you love”. What if I have no talent for what I love? Is it worth time and effort pursuing a dream career I’m no good at?
Joy

Dear Joy,

Your letter is intelligent, but it is also opaque: you do not reveal what your dream career is. Still, a lack of facts has never been an obstacle to economic analysis, so this is no time for methodological scruples. The principle of comparative advantage states that you should focus on what you do best, relative to the standard set by everybody else. You can do accounts and use the money to hire a cook, or do cooking and use the money to hire an accountant; the correct choice depends not just on whether you are a good bean-sheller and a poor bean-counter, but on whether the world is full of better cooks and worse accountants.

There is no conflict between this principle and the idea that you should “do what you love”. Being good at a job means you will earn more; enjoying a job means you will not mind earning less. Decide whether you prefer money or fun.

But what if you are incapable of doing any job you enjoy? Well, your career is not the be all and end all. Economist Andrew Oswald believes we work too hard and under-invest in friendships. So if my career advice is depressing, ignore it and talk to your friends instead.

Also published at ft.com, subscription free.

26th of April, 2008Dear EconomistComments off

How markets keep abreast of the news

If markets are efficient, you will never make profitable trades as a result of reading the Financial Times. Efficient markets move quickly and respond to any new headlines – disappointing earnings, a cut in interest rates, a fraud or a safety incident. Markets will sometimes overreact, drifting backwards after a lurch, or underreact, taking time to digest the true impact of the new information – but overreactions and underreactions should balance out. And when no news is available, the prices of an efficient market won’t change much.

But do markets really react efficiently to news? It would be easy to tell if it were easy to identify all genuine news. Sadly, it is not. Yet two inventive new academic papers claim to have solved the problem of identifying news, in two very different contexts. The studies could not be more unalike. One looks second-by-second at trading data from one of the world’s most active financial exchanges. The other analyses market information that is more than two centuries old.

Karen Croxson and J. James Reade of Oxford University studied the Betfair exchange, a sports betting site that supports many more trades than the London Stock Exchange. Betfair allows punters to bet on football games, and the market stays open throughout the match. Croxson and Reade studied how the price of different bets varied as goals were scored during English league games.

This is an excellent test of the market’s response to news: the bets have a clear value at the end of the game, goals are scarce and important events – and (unless one is a referee) they are easy to spot. And the stakes are not trivial: hundreds of pounds a second are wagered during the match.

The idea of using sports betting to test market efficiency came from Steven Levitt (the co-author of Freakonomics) and Ricard Gil. Levitt and Gil had conducted an earlier study in rather thinner betting markets, and found that prices jumped immediately after a goal, but they then drifted further in the same direction. Was that because the traders were sluggishly digesting news of the goal? Or was it because the clock was ticking down, no news being good news for the team in front? Croxson and Reade offer a clever answer, by looking at those goals scored just before half time. Relevant news hardly ever emerges during half time and the pair find that, although trading is active during the break, prices barely move at all. This shows that the market traders instantly absorb the news of a goal. After the second half begins, prices start to drift again, just as Gil and Levitt found.

That suggests an efficient response both to news and to the absence of news, in sports betting markets at least.

But Peter Koudijs of Barcelona’s Universitat Pompeu Fabra has a different perspective. He looked at prices of three English stocks (the East India Company, the Bank of England and the South Sea Company) on a secondary market in Amsterdam from 1771 to 1777.

Koudijs realised, and proved, that relevant news flowed almost exclusively from London to Amsterdam – and always through the same channel, a boat sailing across the North Sea bringing market data to Amsterdam. Depending on wind speed and direction, the “packet boat” might arrive promptly or after a delay of more than a week, occasionally starving the Amsterdam market of news for days on end.

Koudijs discovered that when the wind was unfavourable and no news was available, Dutch prices for these English companies were highly volatile anyway. That is not an efficient market.

So, have we discovered something uniquely inefficient about Dutch markets, or something uniquely efficient about sports betting? I am not sure. An analysis of Dutch football games is the logical research extension.

Also published at ft.com, subscription free.

Of income and incomers

Which nation produces the richest people in the world? You might think that an easy question to answer: just grab the latest figures from the International Monetary Fund, and you’ll see that the answer is Luxembourg ($102,000 gross domestic product per head in 2007). The US is in ninth place ($46,000) and the UK in 11th ($45,000).

There are some methodological wrinkles to iron out: what exchange rate to use, for instance. And for the poorest countries such as Liberia ($200 per person in 2007) or Burundi ($130), the numbers involve some guesswork. But overall, these are not controversial statistics – unless you are Lant Pritchett or Michael Clemens.

Pritchett, of Harvard’s Kennedy School, and Clemens, of the Washington, DC, think-tank the Center for Global Development, argue that my opening question should be answered in a radically different way. Rather than measuring the income of people who are now residents of Liberia, Clemens and Pritchett have produced a research paper estimating the income earned by people who were born in, say, Liberia, regardless of where they now live – what Clemens and Pritchett call “income per natural” of Liberians.

For Luxembourg – or any other rich country – there is a trivial difference between income per natural and more conventional measures of national income. But for Liberia, the difference is anything but trivial: the Liberian-born make 50 per cent more than Liberian residents. Nor is Liberia unique: Clemens and Pritchett estimate that the income of the Samoan-born is nearly twice the income of the Samoan resident, and the Guyana-born are more than twice as well-off as residents of Guyana.

These dramatic differences have a simple explanation: many poor people became richer by leaving their country of birth. Clemens and Pritchett estimate that “two of every five living Mexicans who have escaped poverty did so by leaving Mexico; for Haitians it is four out of five”.

There is a point to this exercise: Clemens and Pritchett want to draw attention to the fact that migration has made a lot of migrants richer. Traditional measures of income tend to mask this fact.

In rich countries, we usually ask whether migrants improve the lot of existing residents, not whether migration improves the lot of migrants. Meanwhile, the welfare of migrants rarely figures in debates in developing countries or in development institutions such as the World Bank, because the migrants have gone.

Simply because of the way the discussion is framed, the benefits to migrants tend to be ignored. Imagine a man who moves from earning €10,000 in Poland (an above-average wage) to £15,000 in the UK (a below-average wage). Simple arithmetic says that he has reduced the average income of both countries; that could be true even if he has impoverished nobody and enriched himself a great deal.

The “income per natural” statistic is the latest in a long line of alternatives to gross domestic product, the standard measure of an economy’s size. Others – variously championed by Nobel laureates such as Amartya Sen, Daniel Kahneman, Joseph Stiglitz and the late James Tobin – try to adjust GDP to account for the depletion of natural resources, or to incorporate measures of health and education, or even (in Kahneman’s case) to start from scratch with time-weighted accounts of happiness.

I sometimes wonder if these alternative measures make a difference to the way policy is conducted. After all, no government ever tried to maximise GDP anyway, so why try so hard to measure something else?

But Pritchett is convinced that the way the discussion is framed really does make a difference.

“I’m crazy,” he told me. “I’m a lunatic. But I think we have a chance of changing the way the discourse is carried out.”

Also published at ft.com, subscription free.

Time together

Dear Economist,
I have fallen in love with a wonderful man, and on Valentine’s Day he proposed to me. We’re planning to marry next summer. The question is: should we live together over the next year, or wait until we’re married? The financial impact is relatively small either way, and I am not afraid of scandal. I am just trying to work out whether some time living together is likely to make our marriage stronger or not.
Elspeth
Boston MA

Dear Elspeth,

For many years, theory pointed in one direction and evidence in the other. The theory – going back to Nobel laureate Gary Becker’s work in the 1970s – is that a period of cohabitation lets you learn more about one another and thus avoid a bad match. Your man may be charming on a date, but if he leaves his underpants lying around or eats toast over the sink to save washing up, forget it.

The overwhelming evidence, on the other hand, used to be that marriages preceded by cohabitation were more likely to break down – in the US, at least. The question is whether this was a causal relationship, or whether the cohabitation and the marital breakdown were caused by a third factor, such as social class or a lack of religious belief.

Fortunately, new empirical research from economist Steffen Reinhold suggests both that the relationship between cohabitation and divorce is not causal, and also that it has faded over time as more educated, middle-class couples choose to live together before marriage.

I recommend following Becker’s theory: learn about the marriage before it is too late by moving in together now. Keep an eye out for discarded underpants.

Also published at ft.com.

19th of April, 2008Dear EconomistComments off

Rational or Irrational?

“”But that’s rational!” spluttered one venerable journalist, when I told him about this. Well, yes–it seems so, doesn’t it?”

An extract from my debate with Dan “Predictably Irrational” Ariely.  It’s the first debate to be hosted by Amazon’s “Omnivoracious” Blog – check it out.

17th of April, 2008HighlightsMarginaliaComments off

Postponed paper

Dear Economist,
I subscribe to the FT and enjoy it with my morning coffee. Yet whenever there are school holidays, the paper is delivered late in the day, sometimes the next day or not at all. I expend valuable time calling FT circulation, which always promises this will never happen again. This has been going on for years. Should I be pragmatic and do nothing, saving my valuable time, or should I be quixotic, persisting in an effort to force the FT to live up to its timely delivery obligation in the hope that others may also benefit?
Conflicted Subscriber
Paris, France

Dear Conflicted Subscriber,

I am delighted to hear you love the FT and can vouch for the fact that, from newsroom to delivery team, its managers hand-pick elite workers. How, then, are we to explain this manifest underperformance of the organisation as a whole?

Economic investigation of sport offers a clue. Economists such as Mark Walker, John Wooders and Ignacio Palacios-Huerta, have studied professional tennis and football players. When deciding where to serve or place a penalty kick, they behave in rough accordance with economic theory. David Beckham, it seems, is an intuitive economist.

Yet in a team, the story gets worse. Economist V. Bhaskar studied the declarations of cricket teams, David Romer the fourth-down decisions of American football teams. Neither matched optimal strategy, perhaps because of internal team tensions.

This helps to explain your troubles but offers no solution. All I can suggest is that you make a fuss and write indiscriminately to complain. Evidently, you did not need me to tell you that.

Also published at ft.com.

12th of April, 2008Dear EconomistComments off

Cost of living

My family’s experience of the local hospital has been mixed. Sometimes it is impressive; at others it falls below the standard one would expect in the capital of a developed country. Our rule of thumb is that it’s much safer to get sick in Cumbria, where my wife’s parents live.

Although we have had our fair share of dashes to Accident and Emergency, they have been not been so frequent as to constitute a statistically rigorous study of the local facilities. Still, such studies do exist, and one recently published investigation suggests that patients in London have indeed been suffering unduly.

The reason is that many skilled workers in London have decided they have better things to do than work for the National Health Service: in the private sector they can expect to earn 50 or 60 per cent more in London than further north; in the NHS, wages for London staff are relatively meagre. As a result, hospitals in booming areas such as London have more staff vacancies, seem to over-promote staff as a way of giving them more competitive pay, and use more temporary staff hired through private agencies.

It has always seemed obvious to economists that national pay scales are an oddity. It may appear fair to pay nurses, lecturers or teachers much the same in Chelsea as in Chesterfield. Yet since we cannot eat money, it is silly to compare a Chelsea salary with a Chesterfield one without considering what each might buy, and what alternatives might be on offer.

Still, just because a pay arrangement offends against the principles espoused in economic textbooks does not mean that it is a problem in practice. It is not easy to prove that the theoretical concern is a practical problem, but the researchers have convincingly done so using data from 1996-2001: nationally regulated pay was, at the time, killing National Health Service patients in high-wage areas.

The researchers – they are Emma Hall and Carol Propper of the University of Bristol, along with John Van Reenen of LSE’s Centre for Economic Performance – used as their benchmark the proportion of patients who dropped dead inside a month, having arrived at the hospital suffering from a heart attack. (This is a common measure of hospital performance, since neither the patient nor the hospital have much chance to be selective under the circumstances, and because unlike, say, waiting lists, this number is hard to fiddle with.)

They found that the higher the alternative wages available, the higher the death rate at a region’s hospitals, and the effect does not seem to be due to any intrinsic difference in the type of patient, the journey taken by the ambulance or any of the other likely explanations. Nor is this a trivial effect: if the alternative wage rises 10 per cent, the death rate rises by nearly 5 per cent.

Hall, Propper and Van Reenen also looked at measures of productivity in other service industries, including nursing homes, where pay is not regulated by the government. There is absolutely no sign of trouble in any of them.

The good news is that the NHS has recently moved to more flexible wage agreements, with more pay for staff in high-wage areas and the flexibility to add further inducements when staff shortages are a particular problem. This is a positive step, although just because NHS employers are now allowed to pay staff more in London and the south-east does not mean that they will find the money in their budgets to do so.

Nor is the NHS the only government organisation with nationally agreed pay standards. Readers based in London might enquire about teacher turnover at their local school – and hope the answer does not provoke a heart attack.

Also published at ft.com.

Diner’s dilemma

Dear Economist,
When invited to dinner, I am often unsure whether to bring good wine. If I take an expensive bottle, it may go unappreciated – either through lack of appreciation or people not seeing what I’ve brought. Taking plonk means I can get a free ride on others’ largesse, but my tightfistedness could get rumbled – what do you recommend?
Alex, Geneva

Dear Alex,

A simple bit of game theory will produce the optimal strategy. If this is a repeated interaction with people who know their wine, it’s best to produce a good bottle. Reciprocity for your generosity will make this a good approach in the long run.

You will need to work out whether your dining partners do indeed understand wine. That is easy enough. Bring them something decent and see if they remark upon it. Then observe what they bring the next time you dine together. If your dinners are isolated invitations, or your hosts know nothing about wine, you may cheat with impunity. In short, vary your actions according to circumstance.

There is a deeper point here, though. You need to establish what is giving your fellow diners their utility – good wine, or the pleasure of one-upmanship? My fellow columnist, the economist John Kay, points out that economists “win” gift exchanges by spending less than everyone else, but most people “win” gift exchanges by spending more.

If your fellow diners are economists, then my analysis will apply. Otherwise, as the sole economically minded diner, make sure your wine is a little less assuming than everyone else’s. Everyone is happy, you save money and they feel smug. The moral: never forget to look for gains from trade.

Also published at ft.com.

5th of April, 2008Dear EconomistComments off

Piracy’s hidden treasures

What should top record labels, software giants and other media companies do about digital piracy? There are two obvious options: get tough and defend intellectual property rights with every legal and technological trick in the book, or tolerate some illegal copying in the hope of generating buzz and making money in some other way.

This is a debate that generates strong opinions, and where you stand seems to depend on whether you’re an industry accountant or a new economy guru. (Chris Anderson, editor-in-chief, Wired magazine, coined the phrase “Freeconomics” to describe giving cheap things away for free in order to create buzz.)

But look closer and you realise that the corporate suits aren’t all adopting the same strategy. The music industry doesn’t seem able to make up its mind: first it turned a blind eye to traditional mix-tape piracy, then it cracked down on illegal file-sharing while raising the price of CDs, and finally it slashed the price of CDs in an attempt to compete head-on with downloads, legal and illegal.

Even more perplexing, Microsoft seems to hold two opinions at once: doing its best to prevent piracy on the Xbox console, but (as far as this outsider can tell) accepting that piracy of its Office suite of software is a fact of life.

Karen Croxson is a young economist at Oxford University who claims that there is method in the madness. She argues that there will never be a single correct trade-off between sales lost to piracy and sales generated by the buzz from pirated copies in circulation. That is because there are different kinds of potential consumer in different markets, or even in the same market at different times. A company’s most profitable response to piracy depends on what sort of consumers it is facing.

For example, the consumers who would pay for console games if given no alternative are probably the type of consumers who are happy to use pirated copies: tech-savvy youngsters. That means that an extra pirated copy in the console market is quite likely to mean a lost sale.

But the customers who will pay most for corporate software are, well, corporations. They won’t want to risk being caught and sued for piracy, so an extra pirated copy in the corporate software market probably isn’t a lost sale at all. The guilty party isn’t a customer, but a home-user or a student who would never have stumped up full price. Thanks to piracy, though, that home user is now learning how to use Word and PowerPoint and making the legal copies of Microsoft Office more valuable.

Croxson can even make sense of the record industry’s apparent volte-face with the pricing of CDs. When Napster was starting up and piracy was still a marginal activity, it made sense for record labels to write off a few cheapskate customers as a marketing expense and raise average prices to everyone else – presumably the older, more prosperous customers who were willing to pay for legal music. But as the pirated sector embraced even those customers, the best strategy was to fight back by slashing prices.

In Croxson’s world, then, “promotional piracy” is an alternative to discounted pricing. Both approaches are a way for companies to advertise their products or expand their user base. And as with discounted pricing, promotional piracy only makes sense if there is a decent supply of customers who will eventually pay full price, which is not always true.

Corporations may be able to do more to maximise the gains or minimise the losses from piracy. Why not offer two versions of the product: a cheap-to-pirate, lower-quality product, and a high-end offering incorporating tight security? If Croxson is right, for some industries, piracy is a wonderful distribution channel.

Also published at ft.com.

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