Articles published in February, 2010

What’s the point of ‘hidden city’ fares?

Dear Economist,
I discovered “hidden city” fares some years ago when I learnt that the price of a ticket from JFK to Reykjavik cost much more than a ticket from JFK to London with a stop in Reykjavik. Icelandair explained that they had to compete with many other carriers on the NY-London route. Fine. But I recently bought an Amsterdam-Riga-Helsinki ticket and got off at Riga: the Amsterdam-Riga flight itself was fully twice the price, and competition is not always strong.
I keep buying tickets for seats I do not use on continuing flights that the airline cannot sell to another passenger. I have my theory on why airlines do this – what is yours?
Richard N. Golden

Dear Mr Golden,

Competition is only indirectly relevant. The question is how responsive an airline’s customers are to price – “own-price elasticity of demand”, in the jargon. When elasticity is low, airlines can increase prices without losing many customers. Naturally this affects the price they charge – and one explanation for elastic demand and low prices is that customers could easily shift to another airline.

Customers prefer to fly direct to their destinations, so any indirect route will tend to have to be cheap to attract custom. If competition is weak, the pricing is harder to explain, but demand can still be elastic if people would rather not fly at all than pay handsomely to fly indirectly.

The second question is why airlines charge less for more, as you describe. But from “home edition” software to electronics that have been “chipped” to slow them down, the world is full of discounted products that are more expensive to produce than their full-price counterparts. This raises costs, but if it allows companies to target price increases at those most willing to pay, it makes sense.

Also published at ft.com.

Why we should worry about spiralling public debt

When Adam Smith said that “there is a great deal of ruin in a nation”, he was commenting on a military defeat, but economists tend to treat it as a more general truth about the durability of nations in the face of apparently overwhelming debt. And it is true that while over-indebted companies tend to be wiped out, countries such as Argentina keep bouncing back.

Emerging economies have to pay attention to what foreign investors think, because they typically have to borrow in dollars rather than their own currency. Life is different for countries such as the US and the UK, which have been borrowing enthusiastically in their own currencies with little sign of serious concern from the bond markets. For richer countries it is possible that Dick Cheney was right when (according to former treasury secretary Paul O’Neill) he said that “Reagan proved that deficits don’t matter.” If deficits don’t matter, one can only surmise that their natural consequence – public debt – doesn’t matter either.

We had better hope that both Cheney’s claim and Adam Smith’s rumination prove to be true, because many wealthy governments are building up debt very swiftly indeed.

According to the IMF, in the years leading up to the crisis, the gross debt to GDP ratio – which includes interest payments – was just over 40 per cent in the UK and 60 per cent in the US. This year it looks like it will exceed 80 per cent in the UK and 90 per cent in the US. By 2014, the IMF expects the UK ratio to be just under 100 per cent, and the US ratio to rise to nearly 110 per cent.

What are the likely consequences of issuing all these IOUs? A new study by Carmen Reinhart and the IMF’s former chief economist Kenneth Rogoff offers clues. Reinhart and Rogoff have been constructing an impressive database on public debt, covering 44 countries and stretching back two centuries. If the past is any guide to the future, they offer plenty of reason to be concerned.

Reinhart and Rogoff look at episodes of low, medium, high and very high indebtedness, drawing boundaries arbitrarily at public debt/GDP ratios of 30, 60 and 90 per cent. And up to a point, Dick Cheney and Adam Smith are right: there is little sign of trouble at any level of public debt up to 90 per cent of GDP. But once public debt strays into the “very high” category – which is where most rich countries are quickly heading – economic growth has tended to slump. For highly indebted rich countries, median economic growth is about 1 per cent lower than for less indebted rich countries, and mean growth is 4 per cent lower. The fact that mean growth is particularly weak indicates that for a minority of countries, high debt is a catastrophe.

The Reinhart-Rogoff study offers some cause for optimism. Most rich countries are still below the 90 per cent public debt/GDP threshold: so far, debt and deficits are a symptom of weakness, not its cause. And the high inflation feared by some commentators has not, historically, been a feature of high debt levels in rich countries.

Overall, though, the study is worrying. Although there are cases of highly indebted governments presiding over rapid growth – such as Australia and New Zealand immediately after the second world war – they look like deceptive parallels for today. High debt is to be expected after a major war, and as the economy moves to a peacetime footing, high growth is quite possible too.

But high debt in peacetime is suggestive of something rotten in the body politic. The UK government’s structural deficit is larger than the budget for the National Health Service. It will be a long slog from here.

Also published at ft.com.

Gain from the pain of failure

From a series of 10 ideas for business, FT Magazine

Failure has always been a fundamental part of a market economy. When markets work, they do so because new ideas are constantly being tried out. Most fail. Those that succeed cause older ideas to fail instead. In the US, about 10 per cent of businesses disappears each year. This is an awkward insight – but trial and error could be starting to take its rightful place as a business technique, rather than the dirty little secret of capitalism.

There are some hopeful signs. Stefan Thomke of Harvard Business School has argued that advances in computation have made it possible to experiment on new products as a matter of course, trying many things and expecting many failures. It is now easy, for example, to experiment with changes in the layout of a website, showing different configurations to different visitors and tracking results in real time. Google, meanwhile, routinely launches new products with a “beta” label on them. And academic superstars such as Steven Levitt, co-author of Freakonomics, have been teaching executive courses in business experimentation.

We are also starting to learn more about the psychology of learning from mistakes. Richard Thaler, the behavioural economist behind Nudge, coined the phrase “hedonic editing” to describe our habit of lumping small losses together with larger gains in order to mask the pain of the loss. Sugar-coating is human, but it’s also a recipe for failing to learn from failure. Thaler, with colleagues, even studied the behaviour of contestants on Deal or No Deal. He discovered that people who had made unlucky choices then started to take reckless risks, which often compounded the error.

It’s hard to learn from failure if it briefly robs us of our judgment. As we start to understand why trial and error is so painful a process, we may be able to use it more constructively. The financial crisis has made us aware that a system that cannot tolerate a bit of failure is a dangerous one. The idea that an institution was “too big to fail” used to sound reassuring. Not any more.

Listen to the bearers of bad news

Illustration by Ingram Pinn

We are sometimes admonished: “Don’t shoot the messenger.” Since there is rarely a logical reason to shoot messengers, such advice should not be needed. But it is, because bad news hurts, and organisations find it difficult to deliver such news to the person in charge.

Andrew Rawnsley’s account of Gordon Brown’s premiership has received attention for its claims that Mr Brown was abusive and physically threatening to his staff, grabbing lapels, stabbing upholstery with his pen and causing his advisers to cower for fear of violence. If true, that is disturbing – but few people will have found it surprising. High-status men sometimes do abuse that status.

I am worried not so much that Mr Brown may be beastly, but that he is cutting himself off from good advice. Mr Rawnsley describes Mr Brown’s fateful decision to pull back from a widely trailed snap election in late 2007. His inner circle waited until he was out of the room before agreeing that such a course would be disastrous. When the prime minister reconvened the meeting, however, this was not conveyed: “No one expressed a clear view. No one wanted responsibility for the decision.”

This is a more significant anecdote than any tale of flying spittle. Any leader needs frank advice, and the biggest obstacle to receiving it is often the leader himself. Even a polite and level-headed boss will be tempted to cut naysayers out of the loop. Knowing this, sensible juniors will avoid expressing criticism or grim tidings if at all possible.

“If you deliver bad news, you’re disempowering yourself,” says Professor David Sims of Cass Business School. “You’re less likely to be listened to in the future.” For some ambitious subordinates, this is a far worse fate than the threat of being thumped.

A new reality television show, Undercover Boss – which has migrated to the US after airing on Britain’s Channel 4 last summer – tries to tap into the dissonance between bosses and front-line staff by filming as a senior executive works incognito in the trenches. It is a delicious premise.

When bosses must don a disguise to learn about how their organisations really work, trouble is in store. Learn More

Do I need maths to be an economist?

Dear Economist,
I am currently studying for my A-levels, including economics, but chose not to study maths. As my time is a scarce resource, I felt it would be more worthwhile to allocate an equal amount of time to each of my subjects, thus getting better grades in them, rather than dedicating most of my time to maths and sacrificing my other grades. However, I now find that I need an A-level in maths to study economics at a top UK university. Did I make the right decision? If not, could you put in a word for me at Oxford?
Tom, Co. Durham

Dear Tom,

I am not sure which decision you wish me to evaluate: the decision to pick your A-levels without decent advice, or the decision to pursue a mathematical subject with no mathematical talent. Neither looks smart. You have theorised on the basis of neat concepts without any real-world knowledge – in some ways, ideal preparation to be an economist.

Yet this could yet work out well for you. Ap Dijksterhuis, an economic psychologist, has studied how people make complex decisions. In one experiment he gave people fiddly hypothetical choices, giving some plenty of time to concentrate, while he distracted others before suddenly asking them to choose. He found that such complex decisions seem to be best made subconsciously.

Choosing a course to study at university is a decision with many variables. You have all but closed off economics without even thinking about it. Perhaps that’s for the best. Studying economics without maths is like studying literature when you can’t read without moving your lips – not impossible, but difficult.

As for Oxford, you could always try. Several of my classmates read philosophy, politics and economics without maths. At least one of them now calls himself an economist.

Also published at ft.com.

If that’s the Robin Hood tax, I’m the sheriff of Nottingham

Last week a development charity press office sought my support for a “Robin Hood tax”. The idea of the tax – “turning a crisis for the banks into an opportunity for the world” – is that “a tiny tax on bankers has the power to raise hundreds of billions every year” to “tackle poverty and climate change”. Well, I am a big fan of Robin Hood, no great fan of bankers and would like to tackle poverty and climate change. But the idea leaves me cold.

The tax is being backed by a large coalition of charities and fronted by Bill Nighy in a smooth marketing campaign. It’s all in a good cause. But I have been appalled by the campaign’s profound lack of curiosity as to whether this tax would be a good idea.

Start with the claim on the Robin Hood tax website that this is a “tiny tax on bankers … the people who caused this mess”. First, it’s not a tax on bankers. It’s a tax on financial transactions. And it’s not necessarily tiny, because some worthwhile financial transactions have a very large face value, and a much smaller true value. For instance, I might buy car insurance which could – if I knocked somebody down and permanently disabled them – trigger a payment of £1m. My insurance company might want to reinsure that million-pound risk, a perfectly sensible, socially useful and non-speculative transaction. But at a “tiny” tax rate of 0.05 per cent, that’s a £500 tax on a face value of £1m. It’s hard to imagine such a tax wouldn’t somehow affect my premium.

The Robin Hood tax proposes to raise several hundred billion pounds, and it will ultimately be paid not by “bankers” but by all of us, with the burden shared unpredictably. Robin Hood himself seems incurious where his arrows will strike, or at least unwilling to be specific.

The tax would certainly be attractive if, like a tax on carbon dioxide or congestion, it reduced destructive activities. But would it? James Tobin and John Maynard Keynes both proposed taxes on financial transactions and each believed that the tax would reduce financial volatility. This is possible but far from obvious, when you realise that the tax might encourage bigger, more irregular financial transactions. An analogy: if I have to pay a charge whenever I use a cash machine, I make fewer, larger withdrawals and the amount of money in my wallet fluctuates more widely. Bear in mind, too, that the most bubble-prone asset market is for housing, which is bought in very lumpy, long-term chunks.

There isn’t much evidence as to whether transaction charges reduce volatility. What there is is mixed – but perhaps leaning against the Robin Hood tax. On the French stock market, coarser “tick sizes” raise spreads and act like a tax: they increase volatility. Transaction taxes on Swedish stocks in the 1980s reduced prices and turnover but left volatility unchanged.

Banks have let us down, but the answer is to reform the banks, not tax financial transactions. (Sometimes the local bus company lets me down; I have never regarded this as an argument for a bus tax.) I’d modestly suggest a combination of stricter capital requirements, closer supervision, better bankruptcy procedures for banks and charges for the taxpayer’s underwriting of banks’ balance sheets. A tax on financial transactions doesn’t make my top 10 policy reforms. In fact, it doesn’t figure on the list at all. It’s a sideshow.

I haven’t forgotten the ultimate aim of raising money for the very poor. It’s a cause I continue to support politically and personally. But the Robin Hood campaigners have dented my confidence that they should be trusted with my cash. Money isn’t enough: we must also care about what works. Do they?

Also published at ft.com.

Selfish, dishonest, mean … who are you calling an economist?

Nearly three decades ago, the Journal of Public Economics published a curious and mildly disturbing piece of research, revealing that postgraduate students of economics were more likely than others to “free ride” in a laboratory game, effectively exploiting other players for their own benefit. The discovery generated a little niche in the economics literature, exploring the question: does studying economics make you a bad person?

The prosecution has assembled quite a case. A recent survey by Yoram Bauman and Elaina Rose, two economists from the University of Washington, explains that in experiments, economics students are less generous, more likely to choose an unco-operative approach and more likely to accept bribes.

There have been a couple of contrary pieces of evidence. For instance, a study of who paid their dues to professional bodies such as the American Economic Association found that economists were more honest than sociologists and political scientists. And perhaps the budding economists are not truly mean and selfish, but are simply showing that they have mastered their studies by producing the behaviour described in simple textbook models. Arguably, the students of economics are not doing anything sinister, any more than if they calculated the roots of a quadratic equation.

But neither this argument nor the stray pieces of contrary data are entirely reassuring. Bauman and Rose, and also Bruno Frey and Stephan Meier, have shown that students of economics are less likely to contribute to university-nominated charities when invited to do so as they register for new courses each semester. This is disturbing, since the data comes not from the laboratory but from studying real decisions.

Let me offer a defence of the morality of economics, based on nothing more than casual observation. Economists seem to me to be more interested than many in problems of poverty and development. They are internationalists, more likely to consider the welfare of foreigners when weighing up the pros and cons of trade or immigration. They have a touching faith in the idea that deep down, everyone is equal and everyone is a good judge of their own best interests. Economists may be less focused on racism and discrimination than some other social scientists, but largely because – with a few important exceptions – we find them almost too baffling to analyse. We forget that when Thomas Carlyle coined the epithet “the dismal science”, he was condemning not the gloomy Malthus but John Stuart Mill and his stubborn, infuriating opposition to slavery.

Economists are cautious about get-rich-quick schemes – they have seen too many bubbles – and yet optimists about the future of humanity. They habitually look for gains from trade rather than zero-sum squabbles. Above all, economists are interested in results rather than rhetoric.

Perhaps this is all a self-indulgent fantasy, and perhaps I have conflated the experience of learning economics with the experience of growing up. I can hardly point to much empirical evidence in support of my claims, as any good economist would want to. At least I mean well. Bauman, after demonstrating to his satisfaction the corrupting nature of economics, is trying to seduce students with a stand-up comedy routine and a cartoon introduction to the unsavoury subject. One panel opines: “The true miracle of the invisible hand is that in certain situations the world will look heavenly even if it’s full of selfish jerks!” Excusing selfish jerks is reckless – but would you really expect a social conscience from an economist?

Also published at ft.com.

Should I marry my depressive girlfriend?

Dear Economist,
Valentine’s Day is coming, and I am thinking of proposing to my girlfriend. She is beautiful, intelligent and loving, a wonderful person in every respect. I only have one concern, which is that sometimes her sensitivity tips over into anxiety. She can get easily upset or even depressed. Maybe that’s not a problem for our relationship, because I’m a very cheerful person. And opposites attract, right?
Chris, London

Dear Chris,

I am glad to hear you have such a sunny disposition. Perhaps it will rub off on your wife-to-be: James Fowler and Nicholas Christakis demonstrated not long ago that happiness was contagious. This is plausible, although similar methods have been used to demonstrate that height is contagious.

We are then left with the risk that your marriage will live under the shadow of a large happiness gap. This is unusual, because when it comes to happiness, opposites do not attract. Three economists, Cahit Guven, Claudia Senik and Holger Stichnoth, have shown that romantic partners tend to be equally happy when they get together. Worse, the same researchers also show that when one partner is much happier than the other, trouble is often in store. A happiness gap in any given year is correlated with an increased probability of separation in the subsequent year.

One may of course fret about causality: if the husband was having an affair and the wife knew about it, it would be an odd interpretation to blame the divorce on the fact that she was much less happy than him. Yet it is also true that a happiness gap in the first year of marriage is a decent predictor of divorce at any time in the future.

Guven et al point out that when a happiness gap yawns, it is usually the woman who initiates divorce proceedings. Happy Valentine’s Day.

Also published at ft.com.

A marginal victory for the well-meaning environmentalist

At the risk of turning this column into “The Undercover Environmentalist”, I need to return to that vexed question of carbon dioxide emissions. In my first column of the year, I vowed to reduce my carbon footprint from air travel – easy enough, given that it was 50 tonnes of CO2 last year. A kind reader wrote to reassure me that I needn’t lose any sleep, because the planes were making the journey anyway. Glib, I know: I’ve often said it myself to wind up environmentalists.

The answer reminded me of a brain-teaser that’s been entertaining me for the past couple of months. Since buses often run almost empty, two people sharing a car emit less CO2 per person than do bus passengers. Shouldn’t we then be travelling by car?

The BBC’s in-house environmental activist, Justin Rowlatt, aka “Ethical Man”, recently pondered this question and concluded that, no, he’d still be taking the bus. Why? Because the buses are making the journey anyway.

A pause to run through the statistics. According to my colleagues on the BBC’s More or Less programme, cars emit 127g of CO2 per passenger per kilometre and buses 106g, based on average occupancy. Even London buses average a mere 13 passengers. This is one of the problems of a public transport system: in order to make the system attractive, frequent services need to run off-peak, and in order to make the system work at all, vast chunks of metal need to counter-commute, almost empty, to get back to the start of their rush-hour routes. They are “making the journey anyway”.

There is something strange going on when the environmentalist and the anti-environmentalist use the same excuse – one to justify taking the plane, the other to justify taking the bus. An admittedly unscientific poll of environmentalists at dinner parties suggests to me that they think “the plane is making the journey anyway” excuse is unacceptable but “the bus is making the journey anyway” excuse is spot on – and that they have no coherent justification for the distinction. Their favourite excuse is “you have to set an example” – but surely, before you decide to set an example, you need to be sure that you aren’t setting a bad one.

To cut through the fog we need to rely on some technical language. We must distinguish between average cost, marginal cost, and average marginal cost. The average carbon cost of travelling by car or bus is the total emissions divided by the number of passengers: these are the numbers that are unflattering to buses. The marginal carbon cost is the extra emissions caused by one additional passenger. For planes, trains and buses this is low – unless, that is, the passenger is the straw that breaks the camel’s back, and causes an additional bus, plane or train to be scheduled in future, in which case the marginal carbon cost of that passenger will be gigantic.

The average marginal cost averages out the marginal costs of a large chunk of passengers. (Exactly which chunk to use seems to be a rather black art.) The idea is to share out the cost between the passengers who do not provoke an extra bus or flight, and the passengers who do.

For all you environmentalists out there, then, here is the justification for the double-standard of taking the bus but not the plane: it is that bus schedules might be insensitive to passenger demand, while planes are highly sensitive – and ever more so since the budget airlines arrived on the scene. Your best argument for taking the bus is a perverse one: that, no matter how many people do likewise, it’s the rare public transport tsar that will lay on extra buses.

I’ll be cycling.

Also published at ft.com.

How can we stop our child buying sweets?

Dear Economist,
When my daughter reached the age of six, my wife and I decided to give her a small amount of pocket money. However, access to money of her own would allow her to buy herself large quantities of sweeties. So instead of giving her cash in hand we keep track of the money she’s accumulated, which she can then use to purchase anything she wants so long as it’s not food or drink.
This worked well, but for her eighth birthday a number of kind friends and relatives gave her cash. She now plans to keep this money as an ongoing sweeties budget while buying birthday presents from her saved pocket money to show her benefactors.
Short of confiscating her birthday money, is there any way we can hope to discourage this?
Outmanoeuvred parent

Dear Outmanoeuvred,

Your daughter has discovered that money is fungible. As they say in the aid industry, you may think your grant is funding your favourite project, but it’s really funding the president’s favourite project. Thus, you give money on condition that it is spent on an extra hospital, the recipient builds the hospital he was planning to build anyway, sends you the receipts and increases his expenditure on limousines and AK-47s. (Did he spend your money on the hospital or the limousines? The question is meaningless, and that’s fungibility.)

Your plan worked only while your daughter had no access to outside sources of funding.

I can see three options. You rule out confiscation. The second is to offer incentives for low sweet consumption by increasing or reducing your daughter’s pocket money. The trouble is that sweet consumption may be hard to monitor. The third is to admit defeat and let your daughter make her own choices. Sweets have costs and benefits, and your daughter appears to be a better economist than you are.

Also published at ft.com.