Undercover Economist

Screening: It’s all in the numbers

Bayesian analysis questions how we understand the notion of ‘probability’ and how we update our beliefs in light of new information

You’re a woman in her early fifties. You’re invited to a breast cancer screening unit, and you go along hoping for the all-clear. After all, 99 per cent of women your age do not have breast cancer. But … the scan is positive. The screening process catches 85 per cent of cancers. There is a chance of a false alarm, though: for 10 per cent of healthy women, the screening process wrongly points to cancer. What are the chances that you have breast cancer?

Over 50,000 British women face this awful question each year. I first encountered it – in a less alarming context – as an undergraduate economist. And I was in the audience recently when David Spiegelhalter used it as an example in his Simonyi Lecture, “Working Out the Odds (With the Help of the Reverend Bayes)”. The numbers approximately reflect the odds faced by women who go for breast cancer screening. And the answer – courtesy of the Reverend Bayes in question, who died 250 years ago – is surprising.

Bayes was concerned with how we should understand the notion of “probability”, and how we should update our beliefs in light of new information.

A Bayesian perspective on the apparently grim screening result tells us that things are not as bad as they seem. The two key pieces of information point in different directions. On the one hand, the positive scan substantially worsens the odds that you have cancer. But on the other, the odds are worsening from an extremely favourable starting point: 99 to 1 against. Even after the positive scan, you still probably don’t have cancer.

Imagine 1,000 women in your situation: 990 do not have cancer, which means we can expect 99 false positives, far more than the 10 women who do have cancer. This is why any apparent sign of cancer should be followed up with further tests in the hope of avoiding unnecessary treatments. The chance that you have cancer is 8 per cent 9 per cent – up dramatically from 1 per cent, but with plenty of room for optimism.

None of this proves screening is pointless. It can save lives, but it raises dilemmas. The UK’s breast cancer screening programme is currently under review. A systematic analysis published by the Cochrane Collaboration found that for every woman who had her life extended by early detection and treatment, there would be 10 courses of unnecessary treatment in healthy women, and more than 200 women would experience distress as the result of a false positive.

Bayesian reasoning has implications far beyond cancer screening, and we are not natural Bayesians. Daniel Kahneman, a psychologist who won the Nobel memorial prize in economics, discusses the issue in a new book, Thinking, Fast and Slow. I recently had the opportunity to quiz him in front of an audience at the Royal Institution in London. Kahneman argues that we often ignore baseline information unless it can somehow be made emotionally salient. New information – “possible cancer” – tends to monopolise our attention.

Another example: if somebody reads the Financial Times, should you conclude that they are more likely to be a quantitative analyst in an investment bank, or a public sector worker? Before you leap to conclusions, remember that there are six million public sector workers in the country. Base rates matter.

Sometimes there is no objective base rate and we must use our own judgment instead. I think homeopathy is absurd on theoretical grounds; others find it intrinsically plausible. Bayesian analysis tells us how to combine those prior beliefs – or prejudices – with whatever new evidence may come along.

Whenever you receive a piece of news that challenges your expectations, it’s tempting either to conclude that everything has changed – or that nothing has. Bayes taught us that there’s a rational path between those two extremes.

Also published at ft.com.

‘Tis not the season to be shopping

Christmas Day should be the beginning rather than the end of the festive celebrations. But commercial logic points in a different direction

I’m one of those old-fashioned types who reckons the Christmas season should begin late. I like to put the Christmas decorations up the Sunday before Christmas at the very latest, and I even enjoy working on the morning of Christmas Eve – there’s something more magically Dickensian about taking just that afternoon off and heading home with beribboned parcel, rather than taking up residence on the sofa a week beforehand. Christmas Day should be the beginning rather than the end of the festive celebrations.

Commercial logic points in a different direction. There is little profit for Selfridges or Dixons or Hamleys trying to get people in a Christmassy mood at the very last minute. Indeed, the economist Emek Basker has found that in the US, where the Christmas shopping season varies between 26 and 32 days depending on the date of Thanksgiving, longer seasons mean more overall spending (about $8 per person per extra day). Daily spending rises in November after Thanksgiving, but is just as high in December even during the most protracted shopping seasons.

The economist Joel Waldfogel, author of Scroogenomics, estimates that the extra spending on Christmas and Hanukkah in the US in 2007 was $66bn – a substantial sum, and relative to the size of the economy it is even larger in the UK.

No wonder that at this time of year, everyone hurries to publish articles about how the Christmas spending rush is good for retailers. But this is odd. Imagine how much easier life would be for retailers if that extra $66bn was spread evenly across the year.

For a hint at the inconvenience, I spoke to Derek Hayes, of Oxfordshire-based Skyline Promotions. Hayes runs the ultimate seasonal business: a British company producing firework displays. This year was particularly challenging because Bonfire Night fell at the weekend. (Wednesdays are easiest, because they spread the workload across two weekends and midweek.)

Skyline employed 42 people to run 16 firework displays on Saturday, November 5. Because most of Hayes’ staff have unrelated day jobs, the 14 displays on Friday the 4th were even more challenging. But contrast that peak of 42 workers with much of the rest of the year, when Hayes works alone. To cope this year, he called in favours from old associates who travelled from Cornwall and Leeds. He even organised a post-fireworks reunion party.

Firework displays are, of course, particularly challenging: they are extraordinarily seasonal, cannot be stored, and require skilled staff. But other businesses must cope with versions of the same challenge.

Does this matter? The economist Jeffrey Miron pointed out in The Economics of Seasonal Cycles, published more than two decades ago, that a perfectly efficient market will cope just fine: prices, wages and rents will rise at peak times to cover the very real costs of seasonal booms. Customers will either willingly pay extra, because they value the convenience of the timing, or will instead buy Christmas presents in the January sales, order cocktails during happy hour, and organise weddings on Wednesdays in October.

In practice, Miron argued, things are not quite so simple. For various reasons – some cultural, some legal – there are limits to how flexible prices and wages tend to be, and how responsive people can be in return. Some office Christmas parties are successfully moved to January, but few family Christmases are. And most schools will not applaud parents who seek a cheaper holiday by pulling their children out of class. As a result, shops will remain congested and staff harassed during Christmas, and managing inventory will be a logistical nightmare.

My Christmas decorations may be going up late in the season, but I did most of my Christmas shopping early. It was the least I could do.

Also published at ft.com.

How to stop the bogus bonus

Successful oversight is going to require more transparency about what trades are being made. But transparency is a scarce commodity

It used to be so easy to “earn” a performance bonus in financial services. Step one: agree a contract whereby you are paid if you exceed a modest benchmark with the funds you are managing. Step two: borrow money and invest it in risky assets. Step three: profit! Step three does not follow automatically, of course, if the risky asset does not pay off. But from the point of view of the fund manager and his bonus, it’s a case of “heads I win, tails the investor loses”.

It’s fairly trivial to show that such bonus schemes, if implemented naively, offer disproportionately larger bonuses for ever larger risks. We might hope that investors are too sophisticated to fall for such obvious tricks. Yet Dean Foster, a statistician at the University of Pennsylvania, and Peyton Young, of Oxford University and the Brookings Institution, were warning in the early days of the financial crisis that fund managers could hide risks in far more sophisticated ways.

The problem is, as Foster and Young show, that it is possible for an unskilled fund manager to mimic a genuinely skilled one, in the same way that an insect might mimic a leaf, or a harmless creature mimic a poisonous one.

This mimicry, too, involves three steps: first, invest all your funds in whatever benchmark you need to beat, whether it’s treasury bills or a stock market index; second, make a bet that some unlikely event will not come to pass using the invested funds as security; finally, boast of benchmark beating returns, because you’ve delivered the benchmark plus the additional money from winning the bet. Collect your performance fee. (In the unlikely event that you lost the bet and with it all your investors’ cash, simply cough awkwardly and look at your shoes.)

Rather disturbingly, Foster and Young have proved that if investors can only examine your investment returns and know nothing about your investment strategy, as a fund manager you can always make your numbers look good by taking on small risks of very bad outcomes.

These are the “black swans” made famous by Nassim Taleb: low probability, high-impact events, except that these particular swans are genetically engineered – deliberately manufactured and then hidden away, to escape at unwelcome moments.

The solution seems obvious: pay performance bonuses with a lag, perhaps in company stock, or allow “clawback” – in effect, a financial penalty rather than a bonus – if those pesky black swans do appear. But in a recent presentation, Peyton Young explained that none of these approaches really do much to help. It’s true that deferred bonuses can help evaluate performance itself over a long term, but the mimic strategies will remain available. The mimic can, for example, make a huge bet and then simply go quiet if the bet pays off, making safe, neutral investments until the bonus comes due.

Regulators, investors and senior management simply cannot judge traders and fund managers on the basis of their performance alone, no matter how good it looks – the black swans can always be bred and hidden.

Successful oversight is going to require more transparency about what trades are actually being made. And in many parts of the financial services industry, transparency is a scarce commodity.

Kweku Adoboli, the former UBS employee charged with fraud and false accounting, worked on a “Delta One” desk – and the whole point of Delta One trading is to replicate a certain pattern of returns through trading strategies that need not be disclosed.

The folly of “rewarding A while hoping for B” is – thanks to a famous article by Steven Kerr – now well known. But what about “rewarding A” without realising that in fact you are being given “C” in disguise?

Payment by results is an attractive idea, but in a world where black swans can be deliberately manufactured, results can be treacherous.

Also published at ft.com.

Music for love not money

There seems no objective justification for the idea that good music has simply dried up since file-sharing took off

“A digital vampire” – not the title of this season’s bestselling young adult novel, but an ageing rock star’s description of Apple’s online store, iTunes. In his recent John Peel lecture, the guitarist for The Who, Pete Townshend, railed against “the Aluminums” (Apple, I gather) and suggested changes to their business model that would be more supportive of musicians. He also wondered whether the modern, digitally distributed music industry could support the kind of careful listening and risk taking that the late DJ John Peel exemplified.

A reasonable response to Mr Townshend is that he could have picked more obvious targets – notably file-sharing sites and software, which facilitate outright piracy. (He did offer one sharp observation on the subject: “The word ‘sharing’ surely means giving away something you have earned, or made, or paid for?”)

It is beyond doubt that the traditional music industry is dying: high street record shops are closing their doors or stocking alternative products, and music sales have fallen by about 40 per cent during the past decade.

Digital music sales through retailers such as iTunes are manifestly failing to plug the gap from sales of physical CDs, but that is not the fault of the Aluminums.

Yet a more interesting question is how much this matters. According to Joel Waldfogel of the University of Minnesota, three-quarters of pirated music would never have been purchased anyway. In such cases the consumer gains but the producer does not lose. Alas, for the major record labels – and, perhaps, for the artists too – the one-in-four acts of piracy that do reduce sales seem to be quite enough to corrode the industry’s business model.

But, says Waldfogel, “consumers don’t care about the well-being of the recording industry. We care about the existence of good new products.” Is piracy damaging these new releases? Conventional wisdom used to be that piracy consumes itself: by damming the flow of money it causes a creative drought. Few people want to give up their day job to create music for no financial reward.

But is this true? In a new working paper, Waldfogel manfully attempts to estimate the continued flow of high-quality new music since the emergence, at the turn of the millennium, of Napster, the daddy of all file sharing services. There is no perfect way to do this, of course.

One technique is to look at lists compiled by critics of the best albums. Another approach is to look at radio air-play. Radio stations tend to be biased towards playing two things: recent music, and music that listeners are likely to enjoy. In a golden age of music one might expect radio stations to play a lot of recent releases; in a weaker creative period one would expect radio stations to play more vintage stuff. A third approach looks at albums which continue to sell well a long time after their release.

Waldfogel tries all three, and produces some intuitively sensible results: the late 1960s were the pinnacle of the past 50 years, while the 1980s were dark days indeed. Judged by the critics, the post-Napster years were unremarkable, and no worse than the 1990s. Judged by airplay data, the past decade has seen something of a renaissance in quality music. Certainly there seems no objective justification for the idea that good music has simply dried up since file-sharing took off.

Quite why this should be is a puzzle, but Waldfogel suspects it has something to do with the ease with which any band can produce and distribute music – a fact reflected in the growth of independent record labels. The money may be drying up, but the beat goes on.

Also published at ft.com.

The real cost of keeping warm

If we are to deal with climate change, the price of carbon-intensive energy is going to have to rise

With the price of domestic gas and electricity soaring, the cost of keeping warm, never off the politicians’ radar screens for long, is firmly back on the agenda. The latest wheezes to emerge from the coalition are some mild utility-bashing from the prime minister, and a “green deal” from the energy secretary, Chris Huhne, which is intended to make it easier to borrow money for energy-saving home improvements.

I may have missed it, but I am not aware of either man stating the unpalatable truth: if we are to deal both with climate change and with the security of our energy supply, the price of carbon-intensive energy – and at the moment that means energy in general – is going to have to rise.

No sign yet of any push towards that goal: domestic fuel is taxed at just one quarter of the standard VAT rate. According to a review by the Institute for Fiscal Studies, the percentage of tax revenue attributable to “green” taxes peaked at the end of the 1990s – it was less than 10 per cent then – before it began an inexorable slide. The story behind that slide is simple: the only significant “green” taxes are paid by motorists. Emissions from industrial sources, aviation and – yes – our homes have got away lightly so far. But that situation can’t last forever.

It’s clear enough why politicians don’t care to dwell on such inconvenient truths, and favour instead the kind of regulatory engineering put forward by Huhne. At least his idea addresses a genuine problem: people fear that if they move house after buying an energy-efficient boiler or double-glazed patio windows, the new occupants will reap the benefits without paying more for the house. The “green deal” leaves the home-improvement debt behind, to be repaid through utility bills.

Yet regulatory pushes are limited at best and produce bizarre consequences at worst. In the US, Corporate Average Fuel Economy standards, designed to encourage more efficient cars, have had some benefits but also two dramatic failures. They boosted the rise of the giant SUV, which was exempt from the standards that applied to regular cars. More prosaically, once the standards had been met there was no incentive to do more, and much engineering effort was devoted to making cars bigger and faster rather than more efficient.

In the UK, the “Merton Rule” – it originated in the Borough of Merton and has been widely emulated – demands that substantial new developments include the capacity to generate 10 per cent of the building’s energy needs through renewable sources, on site.

Alas, such a rule is hopelessly slack for an out-of-town supermarket – an environmental disaster because of all the driving it encourages, yet with plenty of real estate for solar panels. Meanwhile it is too challenging for a city-centre skyscraper, which is naturally a low-energy building because of its compactness and proximity to public transport.

All this explains why a carbon price has to be the centrepiece of any policy on climate change. A price on carbon acts in more subtle ways than any regulator will be able to, encouraging a switch away from coal and towards nuclear energy and renewables, encouraging energy efficiency in every choice we make, and in the last resort, encouraging us to do without products, services and activities where the energy cost is just too high.

We live in a world of seven billion people, many billions of distinct products, and countless decisions every day that have the effect of releasing carbon dioxide into the atmosphere. Without a carbon price to guide all those decisions, the cost of responding to climate change is far higher than it has to be.

Also published at ft.com.

Eeyore and the euro crisis

The search is on for better ways to measure systemic risk

I don’t propose to predict the next twist in the euro crisis; indeed, given the delay between my writing these magazine columns and you reading them, I’m not even going to hazard a guess as to what has recently happened. We’ve been contemplating a major systemic event: a Greek government default – and worse. A Spanish default? An Italian one? Not imminently likely, but as Eeyore once said, “think of all the possibilities … before you settle down to enjoy yourselves”.

Such events always have nasty but unpredictable consequences. In fact, the nastiness is intimately bound up with the unpredictability. A big financial loss is always likely to have further impacts: anyone holding Greek bonds suffers if the Greeks decide they won’t pay. But what if you’re applying for an overdraft to a bank that has just been burnt by the Greeks? Or applying for an overdraft to a bank that has just been burnt by a collapsing hedge fund that invested in Greece? Or a bank that has written an insurance policy – a credit default swap – on Greek bonds? The possibilities multiply: it will take us a long time if we follow Eeyore’s advice; and each successive failure can lead to further failures. Because we do not really know who is at risk, financial markets can seize up, as they did at the beginning of the credit crunch and, far more severely, when Lehman Brothers evaporated early one Monday morning in September 2008.

How should regulators deal with all this? First, they should never forget that misconceived regulatory rules have contributed in many ways to the crisis we continue to face: it’s in the nature of regulations to force black-and-white responses – as when many financial institutions are simultaneously obliged to sell a particular asset. But for those who, like me, believe the quest for better regulations is not a hopeless one, the search is on for better ways to measure systemic risk.

A number of interesting approaches to this problem have recently crossed my desk. Tobias Adrian of the Federal Reserve Bank of New York and Markus Brunnermeier of Princeton propose a tool they call “CoVaR”, or “contagion Value at Risk”. Value at Risk is a widely used but controversial risk management and regulatory tool, describing the maximum amount of money a financial institution might expect to lose over a given period of time, such as a day, with (say) 99 per cent confidence. (“What about the other 1 per cent?”, you might ask, and with good reason.) The Adrian-Brunnermeier approach calculates Value at Risk for the entire universe of financial firms, and then asks how that VaR changes if one particular entity – say, Lehman Brothers, or Portugal – finds itself in distress.

Alternative approaches look at techniques from network mapping. Francis Diebold and Kamil Yilmaz have a paper out on “network topology”. Andrew Haldane, the Bank of England’s man in charge of financial stability, with Prasanna Gai and Sujit Kapadia, is also pursuing network modelling techniques to understand how risks can spread.

Meanwhile, as regulators such as Haldane and Adrian look to abstract approaches in the hope of deeper understanding, an academic, Darrell Duffie of Stanford University, has been advocating what he calls a “10-by-10-by-10” approach, which is pleasingly pragmatic. Duffie suggests stress tests in which 10 financial firms list the impact of 10 unpleasant scenarios on 10 of their key counterparties; the process can be iterative, as each round of testing suggests new firms to include and new scenarios to try.

One can hardly complain about these efforts to understand more clearly the intricate plumbing of the financial system, but what is becoming most clear is how little we still know. So I particularly applaud one feature of Duffie’s brief working paper: more than a quarter of it is devoted to an exploration of all the ways in which his idea may fail.

Also published at ft.com.

Can you be a little less specific?

Game theorists are beginning to produce rational models of deliberate vagueness

Seinfeld’s George Costanza was once invited “up for coffee” at the end of a romantic evening, and refused: caffeine would keep him awake, he explained to his perplexed date. Later, aghast, he realised: “coffee doesn’t mean coffee! Coffee means sex!”

Well, indeed – but few people, if they are wise, will baldly suggest the sex. A little ambiguity is called for. Now game theorists – masters of the mathematisation of human interaction – are beginning to produce rational models of deliberate vagueness.

Andreas Blume and Oliver Board, two economists at the University of Pittsburgh, offer up just such a model. They point out that perhaps it is too much trouble to be specific, as with a business contract offering a fee plus “reasonable expenses”. This isn’t always the reason. “Coffee” has two syllables, “sex” has only one, and surely George’s date could have made her intentions plainer without much effort.

Perhaps it’s just a matter of social norms: it would have been shocking for George’s naughty-but-nice date to ask him to sleep with her, so instead she hinted that an attempt at seduction might not be rebuffed.

But there is often a logic behind such norms – for example, the opportunity to tweak the message depending on how it is received. If George seemed taken aback by the invitation for “coffee”, his lady friend would have retained plausible deniability. If he seemed interested but hesitant, she could have clarified the message by slipping into something more comfortable.

Alan Greenspan, the mumbling maestro of mixed messages, played the markets with one vague declaration after another, each one a nudge – but not a shove – in the direction he preferred.

The Blume-Board paper lurks on the boundary between philosophy and mathematics – and, ironically, it is extremely precise about what “vagueness” means. A working paper from the economists Florian Ederer, Richard Holden and Margaret Meyer has a more practical bent, examining the boss who finds it useful to be vague about performance bonuses.

The scenario here is one of an employer who cares about two tasks and an agent who finds it easier to do only one of them. Imagine a journalist who must both write words and spell them correctly: the boss needs both of these jobs done well, within reason: a mass of spelling mistakes is no use and neither is a tiny number of correctly spelled words.

The challenge is to design appropriate performance pay for the job, and the difficulty is, there are two types of journalist: those who find it easy to churn out reams of copy, and those who find it easy to spell correctly. The boss doesn’t know which type of journalist she is hiring. It would be easy to demand the impossible, and find no takers for the job; or to pay over the odds; or to hire a journalist but then inadvertently give him an incentive to neglect half the job.

In some important cases, say Ederer, Holden and Meyer, the boss will want to be deliberately ambiguous about what sort of performance will be rewarded. Will the bigger reward go to the careful speller or to the hasty typist? One type of ambiguous contract has the boss tossing a coin and rewarding either one type of achievement or the other. An alternative contract – a variant of “you cut the cake and then I’ll choose” – allows the boss to choose one of two performance metrics after she has seen what kind of performance has actually been produced.

There’s a cost to all this ambiguity, of course: it’s risky for the journalist, who must then be compensated. Nevertheless this can be a price worth paying.

We’re used to thinking of ambiguity as a flaw in contracts, agreements and management styles. But when your boss gives you vague directions or bases your performance bonus on inconsistent and ever-changing criteria, perhaps there’s method in the madness.

Also published at ft.com.

Why we should all trim our antlers

Robert Frank’s ‘The Darwin Economy’ argues that there are markets in which we would be better off if we agree to throttle back

In a hundred years, if professional economists are polled to identify the founder of their discipline, the majority will name Charles Darwin, rather than Adam Smith as they would today.”

This prediction, made in a recent speech in Oxford by the American economist Professor Robert Frank, has a certain symmetry about it: after all, Darwin’s theory of evolution was inspired by the economist, Thomas Malthus.

Frank has a particular Darwinian insight in mind: the idea that contra Smith’s “invisible hand”, individuals competing can produce results that are bad for society as a whole.

Consider the vast antlers of the north American bull elk: they’re the result of sexual selection balanced by other selective pressures. Elks with big antlers win fights with other elks, and mate with multiple females. However, they also get hunted down and killed by packs of wolves. Elks as a whole would be better off if they could all agree to shrink their antlers by a factor of four or five: the males with the biggest antlers would still get the girls, while only the wolves could object to faster, more agile bull elks. Sadly for the elks and happily for the wolves, that’s not how sexual selection works.

In a new book, The Darwin Economy, Robert Frank sees elk antlers everywhere he looks in modern society. For example, when parents bid up the price of houses near good schools, they’re engaging in a wasteful arms race: children as a whole will be no better educated as a result, but vast sums are devoted to the quest for the right school district. My flashy car makes you less satisfied with your own; if I take ladies out to the opera and Michelin-starred restaurants, other men will no longer succeed by offering scampi and chips at the Romford dog track. In short, says Frank, my spending harms you as surely as I would harm others by standing up at a concert and forcing everybody behind me to stand up in turn.

Sometimes this dynamic is the result of envy; at other times it is genuine competition for scarce resources, such as beautiful partners or elite university places.

Elks cannot reach an agreement to trim their antlers, but humans can, and Professor Frank advocates a steeply progressive consumption tax to serve this purpose. In effect, the tax would be an income tax with an exemption for savings, encouraging investment but discouraging spending sprees. Frank argues that it should be progressive because the wasteful economic arms races are at their most grotesque at high consumption levels.

I think Frank’s analysis is impressive, original and thoughtful. But one need not invoke elk antlers to justify progressive taxation. And I part company with Frank on two points.

First, I am unconvinced that such arms races are quite as common as he feels. For instance, new antibiotics or cancer treatments are “luxury” goods in the technical sense that rich societies spend a greater proportion of their income on healthcare. Is this really just a race for status, for the coolest chemotherapy treatment? Frank thinks that “luxury” goods tend also to be positional, status goods – but such medical treatments seem to me to be an increasingly important counterexample.

Frank also sidesteps the idea that markets themselves can be structured to eliminate the arms race. For example, parents can scramble to buy property near an existing good school, or they can fund a new school – at least in principle. In the second case, new resources are mobilised and more children get a good education. Can education really be nothing but the anthropic equivalent of elk antlers or peacock tails?

Frank is right to remind us that there are markets in which we’d all be better off if we could collectively agree to throttle back. But he may have been too quick to assume that such markets are beyond reform.

Also published at ft.com.

Innovation works in mysterious ways

‘I’m surrounded by technology that looks good and works well because others followed where Apple led’

Was it salesmanship or engineering? Creativity or ruthlessness? Or was Steve Jobs simply gifted with vision and impeccable taste? Whatever the true source of his success, there was more than a touch of genius about Jobs. Even his side project, Pixar, was an astounding achievement. His first love, Apple, he built from nothing and then dragged back from the brink to make it the most valuable company in the world. No wonder so many of us felt sad at the news of his passing: surely he had more to offer.

I spend my life in front of a computer, and that life is better because of what Steve Jobs created. But here’s the strange thing: I’ve never owned an Apple product for longer than the two weeks it took to give up and send it back. (Apple’s customer returns department is impeccable, by the way.) My Macbook Air? Glorious hardware, but fussy software and a counterintuitive interface. My iPad? Beautiful – but also heavy, not too fond of wireless, and refused even to turn on until I did some most impertinent things to my Windows laptop.

Apple never made a penny from me. Why, then, do I say that Steve Jobs improved my life? It’s because I am surrounded by technology that looks good and works well because others followed where Apple led. Without Apple’s refinement and popularisation of the WIMP environment (window, icon, menu and pointer), how long would we have waited for a graphic interface from Microsoft – and how awful might it have been? It’s hard to imagine Bill Gates would have shown much interest in fonts without Apple’s beautiful typography. Beyond desktop computers, there’s a similar story to tell: I own an Android phone that owes more than a passing debt to the iPhone; I’m still waiting to own a Windows machine to rival the Mac Air; and every tablet in the world bows to the iPad.

To an economist the lesson is obvious: innovative profits are imperfectly appropriable. In more user-friendly language: when an entrepreneur bakes a cake, he only gets to keep a thin slice for himself. This is worrying if it discourages innovation, and in some industries innovators may be discouraged by the prospect that they must take big risks and sink big costs while society sits back and hopes to reap the benefits. Yet in the computer industry, plenty of entrepreneurs seem happy to take risks for the prospect of a thin slice of the social benefits.

A discussion paper published in 2004 by the economist William Nordhaus attempts to establish exactly how thin that slice is. Nordhaus reckons that innovators capture a “minuscule” 2.2 per cent of the total social benefit of their innovations. The other 97.8 per cent goes to consumers, partly because competitors soon catch on, and partly because no company, even a monopolist, can charge each consumer a price reflecting her individual willingness to pay.

Professor Nordhaus’s estimate can be regarded as, at best, an educated guess, partly because Nordhaus is only able to focus on innovations which lead to lower production costs and thus lower prices. If that’s the metric, developments such as the world wide web or penicillin barely register. Still, I think it’s safe to say that both Tim Berners-Lee (the web) and Alexander Fleming (penicillin) reaped far less than 2.2 per cent of the total value to society of their insights.

Was Jobs an exception? Chris Dillow of the Investor’s Chronicle, who called my attention to the Nordhaus paper, reckons that Jobs’s gift for branding and design helped Apple retain an unusually large slice of the innovator’s cake. Perhaps that’s true. Apple’s shareholders have certainly enjoyed a profitable few years. But the greater benefit has flowed to customers – and not only the customers of Apple.

Also published at ft.com.

Confusion at a price

The UK energy secretary wants to reform the way suppliers charge customers. But his plans seem unlikely to give a dramatically better deal

Are we living in a confusopoly? You know what I mean: trying to figure out whether it’s cheaper to use one phone company’s “Armadillo Everyday 500” tariff or another’s “Supersava B”, with a special concessionary price for the first 15 minutes of the 25-year contract. (The term confusopoly was, I believe, first coined by Scott Adams, the creator of “Dilbert”.) Chris Huhne, the UK energy secretary, fears the confusopoly in energy prices, and in a speech last month, he announced his plans to do something about it.

Huhne has a point: we know that a well-functioning, competitive market is a good way to get prices down. If such a market is feasible it’s far more likely to deliver good results than regulatory diktats, with all their inevitable loopholes and unintended consequences. Yet if consumers are confused about prices then competition is unlikely to produce such glorious results.

But the story is – surprise, surprise – not quite as simple as Huhne suggested in his conference speech. There are two separate issues here: people feel that it’s a hassle to switch suppliers, and they are uncertain about whether they’d be better off if they did.

The first problem, switching costs, is less serious than it seems. Paul Klemperer, an economics professor at Oxford University, says that switching costs need not be bad for consumers or particularly good for companies. In a market with switching costs, what every company wants is a fat share of captive customers to exploit. But how to acquire those customers? The obvious solution is to offer fantastic deals, attract the suckers, and then gouge them for all they’re worth. (This is why your phone company will happily give you a £500 phone “free”; nobody has yet offered me a free laptop computer.) The early bargains partially – and sometimes fully – compensate for the later price gouging.

Perhaps we should not worry too much, as long as the introductory bargains are generous enough. I wonder what to make of the fact that Huhne has branded them “predatory pricing” and declared that the bargains will stop. I fear it will be hard to implement that policy sensibly. For instance, Michael Waterson of the University of Warwick reckons that a recent effort by the energy regulator to stop some kinds of predatory pricing simply backfired: the deals dried up but lower everyday prices did not materialise.

The second problem, confusion pricing, seems to be the curse of our age. There is certainly reason to worry: I’ve written in this column before about the research of the economists Catherine Waddams Price and Chris Wilson, who studied customers who had overcome whatever switching costs they faced and were determined to find a cheaper electricity supplier. Most people missed the lion’s share of the savings they might have achieved, and a quarter managed to make themselves worse off.

And yet, and yet. Eugenio Miravete of the University of Texas at Austin studies what he calls “foggy pricing” and reckons that competition is a pretty good antidote to the fog: new entrants typically have an incentive to offer simple prices to cut through the confusions, while incumbents do not retaliate by complicating their own offers.

I do sympathise with Huhne’s concerns and am sure he’s on to something. But his reforms seem unlikely to give us a dramatically better deal. According to VaasaETT, a global energy think-tank, energy prices in London are among the lowest of all major European cities. Low energy taxes are part of the reason – something Huhne might want to address if he is as serious as he claims about energy efficiency and climate change. But my casual inspection of VaasaETT’s figures suggests that low taxes do not explain the entire price discount. The confusopoly hasn’t quite got the better of us yet.

Also published at ft.com.