Do you know how I can calculate a “fair” figure that will reflect my master’s degree and international experience? I want to use this as the minimum salary for my next job.
G

Dear G,

I’m not going to attempt to calculate your “fair” figure: it would do you no good. Employers care very little about what salary would be a fair reward for your background; instead, they want the best possible people for the lowest possible cost. Competition from other employers typically leads them to compromise on both counts.

Your fair figure might eat away still further at your fading happiness. It seems that you were satisfied until you reflected on your education and inflated your aspirations. This is sad but typical, if the economist Andrew Oswald is to be believed.

Oswald has compared people’s circumstances with their happiness. He finds that, other things being equal, happiness rises with money, good health and a successful marriage, but falls as a person’s “expected income” rises. Expected income is the income that another person of the same age, sex and education level would typically earn. In other words, more educated people have richer peers and so tend to be less satisfied.

What is especially sad is that your income would comfortably put you in the richest 10 per cent of UK citizens, who are themselves relatively rich. As for being short-changed, I doubt that you personally paid for your nursery education. Put away your admission letter, and forget about it.

Also published at ft.com.

Among them are Jagdish Bhagwati, Krugman’s teacher and champion, and a giant in the field of international trade; and Elhanan Helpman, who wrote an influential book with Krugman on the new trade theory.

But I thought in particular of Avinash Dixit, without whom Krugman might have abandoned economics 30 years ago and so never formulated his new trade theory. Krugman has said he left graduate school “directionless … I was not even sure whether I really liked research.”

That was changed by what is now known as the “Dixit-Stiglitz” model. In 1977, Dixit and Joseph Stiglitz – one of the Nobel laureates in 2001 – published a new way of modelling how companies compete. The Dixit-Stiglitz model described “monopolistic competition” between many products in a particular market.

Monopolistic competition sounds like an oxymoron, and Dixit-Stiglitz certainly addressed a longstanding tension. Adam Smith had emphasised the importance of competition, but also the power of specialisation and the division of labour. His famous account of a pin factory, in which 10 men produced thousands of times as many pins as could one man, illustrated this point and thus the significance of economies of scale.

That poses a conundrum. Economies of scale push towards larger and larger companies. Logically, a monopolist should be the lower-cost provider. The tension between economies of scale and competition is obvious.

Yet while obvious, it is hard to model mathematically in a useful way. Dixit and Stiglitz resolved the problem by observing that consumers have a taste for variety as well as a taste for low prices. In the market for cars, for instance, Volvos compete with Fords and Ferraris. It would be cheaper if there was only one model of car; it would be nicer if there was an infinite variety. Somewhere in the middle is the equilibrium where economies of scale are balanced by customers’ desire for variety.

The elegant mathematics of the Dixit-Stiglitz model was new, even if the tension it described was as old as Smith’s Wealth of Nations. Krugman described it is as “beautiful”. It quickly became a workhorse, pulling economists to new frontiers of trade theory, growth theory and economic geography. Dixit later said he and Stiglitz had not realised the model would have so many uses – “obviously, otherwise we would have written all those subsequent papers ourselves!”

That is typically generous of a man who has often praised others, especially Krugman. He once told young economists that a good place to have ideas was in front of the shaving mirror. Krugman has a beard. Imagine, quipped Dixit, how much he could have achieved if he shaved!

Although the Nobel now seems overdue, Dixit hardly languishes in obscurity. He is president of the American Economic Association. He is a brilliant game theorist whose book with Barry Nalebuff, Thinking Strategically (now revised as The Art of Strategy) is a model of popular economics. And he may yet win the Nobel for his research with Robert Pindyck of MIT on “real options”, which describes how economic uncertainty can delay the most promising of business investments. It is a body of work that looks alarmingly relevant today.

Also published at ft.com.

If that seems strange, reflect for a moment. We know that stocks can be very volatile. We also know that some generations have been luckier than others when it comes to the performance of the stock market. The baby boomer who started regular purchases of US stocks in 1970 and sold up in 2000 would have felt pretty sick after the awful bear market of 1974, but in retrospect his timing would have been perfect, filling his boots with bargain late 1970s and early 1980s shares, and selling out right at the top. His daughter, entering the stock market in 1995 and aiming to retire in 2025, would have spent the past 13 years buying shares at prices that now seem to range from high to extortionate. We could call this “generational risk”.

Now, think about the current prevailing wisdom on investing in shares, which reflects the fact that shares tend to produce high but risky returns. It is to start by putting most of one’s savings into the stock market, and as retirement approaches, increasingly shifting one’s portfolio to bonds and other less volatile investments. That seems to make sense. In fact, it is nonsense.

For one thing, there is nothing particularly safe about holding stocks for the long term. Whether you plan to sell a portfolio of stocks next week, or hold them for another 40 years, a 20 per cent fall in the stock market this week reduces the eventual value of that portfolio by 20 per cent, relative to where they would have been had you sold them the day before the crash and reinvested afterwards.

Further, a long-term investor following the consensus advice is exposed to stock-market risk in a very strange way. When young, he has almost no exposure. Although his tiny pot of savings is largely invested in stocks, that tiny pot contains almost none of the shares he eventually plans to own. That’s too conservative. In middle age, he is overexposed in a desperate attempt to enjoy the high returns on stocks. Then as he approaches retirement he becomes too conservative again as he pours his portfolio back into safe assets. It is this bizarre pattern that produces generational risk.

The logical way to fight generational risk is to borrow money to make large, regular investments in shares while young, then use a proportion of later savings to pay back the loan rather than to pile into the stock market in middle age. That sounds risky, but it is in fact exactly what people do in the housing market. Knowing that they will need a place to live all their lives, they tend to buy a small house and gradually trade up to a bigger one, only paying off their mortgages late in life.

Most of us need a retirement fund as well as a place to live; there is nothing intrinsically risky about regular borrowing to get that fund off to an early start.

Not only does the concept make sense, it has paid off in the past. The Yale academics who proposed it, Ian Ayres and Barry Nalebuff, have looked at historical stock market data covering 94 cohorts who retired between 1913 and 2004. For every single cohort, the early leverage strategy beat the conventional wisdom; it also almost always beat the gambler’s strategy of investing every penny in stocks until the moment of retirement. Only the blessed cohorts who retired in 1998 and 1999 did better. Such gambles rarely pay off, so if you’re 20 years old and want to spread your risks, mortgage your retirement today.

Also published at ft.com.

Dear Harry,

There is ample support in economic theory for your view – it is just a shame there is little support for it in practice. Economists have always tended to use a “household” model of decision-making, which treats domestic decisions as being made by one person – the kind of benign dictator with whom you, as paterfamilias, identify yourself. This had the chief virtue of simplicity.

Gary Becker, a Nobel laureate, then advocated treating the household as if it had more than one decision-maker. This helped to explain rococo details such as the existence of divorce lawyers.

Changes that increased the bargaining power of women, such as the introduction of “no fault” divorce, turned out to have the logical consequence that women became less likely to be physically abused by husbands. They also reduced the likelihood that couples would invest in each other – for example, by financially supporting one partner through a professional course.

The plot now thickens. The economist William T. Harbaugh, with colleagues, has discovered that children as young as 11 seem to make rational consumption choices as well as adults do. And a team including the economist Anyck Dauphin has demonstrated that British teenagers do influence household consumption, especially if they have access to their own income. The paterfamilias household is no more.

How, then, should we reconcile this with your own situation, which seems comfortably wedged in the 1950s? My guess is that your wife and children have decided that it suits them to maintain your delusions of control.

Also published at ft.com

Is there an optimal amount to put in the car in our situation, or, perhaps, a better way to deal with the predicament, bar getting a car each?
Lucy

Dear Lucy,

It might sound strange, but your letter reminded me of Somalia. Your method of ensuring equitable payment for fuel works, but is quite a hassle. Living in a quintessential failed state, Somali entrepreneurs also have to go to great lengths to ensure payment in a situation where the rule of law has broken down.

For example, electricity is locally generated using second-hand equipment from Dubai. The suppliers offer a simple menu of choices: daytime (good for businesses), evening or 24-hour electricity. They charge per light bulb. The costs of collecting payment are probably as high as the costs of producing the electricity, but at least the lights tend to stay on.

Clearly there is a superior solution for the two of you: leave a notepad and pen in the glove compartment, and each of you note both your mileage and your petrol expenditure. If the two fall out of sync with each other, the heavy driver can compensate the heavy filler. This is time-consuming, but not as time-consuming as incessantly stopping for petrol.

This system assumes that you and your sister would not lie to each other. Perhaps this is not true, and family tensions call to mind downtown Mogadishu. If so, it is time to buy another car.

Also published at ft.com.

It might seem a strange time to be making that claim, but despite its apparent absurdity I am now convinced that it is by far the most sensible way for an investor to look at the world. It may even be broadly true.

The efficient market hypothesis states that historical information provides no help in forecasting share prices. That would mean that examining graphs of a share’s performance, even reading this morning’s FT, would not produce a reliable strategy for judging the price of a share tomorrow or next year. That is because all useful information would already have been assimilated in today’s price. Paul Samuelson, perhaps the most influential economist of the 20th century, summed it up in 1965 in the title of his article: “Proof that Properly Anticipated Prices Fluctuate Randomly.” Since all available information is already reflected in the price, future prices will move only as news arrives. News itself arrives unpredictably, otherwise it is not news.

If the efficient markets hypothesis is true, then sensible economists will admit that they simply do not know what the outlook is for the stock market. How dull! It is much more fun to have somebody predict the future.

Yet it would explain the recent edition of FT Money in which the two star columnists offered precisely opposing views on the outlook for the stock market: Anthony Bolton anticipating recovery and Merryn Somerset Webb arguing that the market is still too optimistic about the future. Are they then both charlatans? Not at all. In an efficient market, disagreements between well-informed people are exactly what one would expect. Both are equally likely to be right.

The hypothesis is affectionately lampooned by a famous old joke about two economists who pass a $100 bill on the street. One reaches to pick it up, and his friend tells him not to be absurd. There couldn’t possibly be a $100 bill lying in the street because someone would already have picked it up.

The joke is a good one, but nobody has convincingly proved or disproved that the efficient markets hypothesis is true.

Nevertheless, investors should act as if it is. Belief in efficient financial markets suggests a three-pronged investment strategy. First, ignore advertisements (and newspaper articles) that tout the past performance of particular sectors or funds. In an efficient market, past performance is not only no guarantee of future performance, it offers no clue whatsoever. Second, don’t try to pick stocks and don’t ask others to pick stocks for you: in other words, choose a low-cost index tracker. Third, don’t try to time the market: get in and out gradually.

This third point is not widely appreciated enough. While many investors now realise the attractions of tracker funds, few realise that the typical fund does much better than the typical investor. This is because investors tend to buy high and sell low. Ilia Dichev of the University of Michigan has recently calculated “dollar-weighted” returns for major stock indices – a good adjustment for the tendency of investors to plunge into the markets as they are about to turn bearish. Dichev found that such returns were lower than “buy and hold” returns by 1.3 percentage points annually – 8.6 per cent instead of 9.9 per cent – between 1926 and 2002 on the New York Stock Exchange and American Stock Exchange. For a long-term investor this is a big difference. The same picture holds true since the early 1970s for international markets, and dramatically so for Nasdaq.

Perhaps the market is not efficient after all. All I know is that those of us who act as though it is have a substantial advantage over the typical investor.

Also published at ft.com.

Is a stock market bubble a medical condition?
You might well have thought so, had you taken a walk around a trading floor and looked at the behaviour of traders at the height of the dotcom bubble in 2000.
“They were displaying classic symptoms of mania,” says John Coates, recalling his time as the manager of a New York trading floor.
“They were overconfident, they had racing thoughts, they had diminished need for sleep and heightened sexual appetite.”
But Dr Coates no longer works on Wall Street.
He is now one of a small but growing number of “neuroeconomists” - researchers who study the brain, hormones and nervous system in search of an explanation of our behaviour as investors and shoppers.
Neuroeconomics is a new discipline that fuses economics and neuroscience, and its practitioners are people who think that everyday phrases such as “impulse buy”, “business brain” and “bull market” are more than just figures of speech.
“A bull market” refers to a long period of rising share prices, but Dr Coates points out that traders behave uncannily like real bulls and other male animals.
A rutting stag, for example, enjoys a testosterone surge if he beats off a sexual rival.
More testosterone means more confidence and more risk-taking, which tends to lead to more victories and yet more testosterone.
Eventually, the cycle comes to an end - often because confidence has turned into recklessness - and reverses itself.
After taking a few saliva samples, Dr Coates has discovered not only that such hormone surges happen to human traders too, but also that they are correlated with risk-taking and short-term profitability.
Neuroeconomists have many ways to try to understand the brain.
They can experiment on animals, examine brain-damaged patients, and even inflict temporary brain damage on their subjects.
They can also scan the brain directly.
The most media attention is lavished on a particular type of brain scan called fMRI - scanners that use such powerful magnets that they can tear a set of keys out of your hand - or rip out a body piercing.
Horror stories abound.
That powerful magnet is used to detect the minute magnetic disturbances caused by iron in the blood, showing us which parts of the brain are receiving a stronger flow of oxygen-rich blood.
But some researchers are sceptical about how useful these scans are.
Gerd Gigerenzer, a leading psychologist from the Max Planck Institute in Berlin, argues that the impressive images that come out of the scans have seduced us into thinking we can see inside the mind.
He compares fMRI to looking at the flow of electricity in a home computer: it doesn’t really tell you much about how your internet browser works.
The fMRI pictures, he says, are only popular because they are beautiful, expensive and mysterious.
An alternative to the fMRI scan is the EEG scanner, which picks up electrical waves from the surface of the brain.
It provides less detail and depth than an fMRI, but is portable enough to wear to the shops.
In true BBC tradition, I was roped in as an EEG guinea pig.
Before long I was walking around a busy shop decked out like an alien from a 1970s episode of Doctor Who.
The EEG scanner looks like a polka-dot shower cap, punctured by a tangle of electrical cables.
I was also equipped with also a heart monitor, a lie-detector, and special spy-glasses with a tiny video camera that recorded whatever I looked at.
This kind of gear can in principle be concealed under hats and coats, but that would have spoiled the fun, wouldn’t it?
In the long run, neuroeconomics may be no laughing matter. Mind-reading may be science fiction at present, but that may not last.
Paul Glimcher, a neuroeconomist at New York University, points out that, even now, brain scan data can help predict people’s choices.
He thinks the technology will become more accurate and much more widespread before long.
“We just have to be realistic that in five years time this will be an everyday event,” he says.
He and like-minded researchers are now campaigning for “neuroprivacy laws”.
Nobody has ever needed to draft rules regulating the use of mind-reading technology.
It might be a good time to start.
“Money on the Brain”, broadcast at 9pm Tuesday 28 October, BBC Radio 4 and at 4.30pm Wednesday 29 October. 

My costume consisted of an electroencephalograph (EEG) cap, which looks like a polka-dot shower cap with wires plugged into it; a pair of wrap-around glasses with a tiny video camera attached; a clothes peg on one finger to measure my heart rate; two other finger monitors that functioned like a lie-detector; a thermometer patch on a fourth finger; and a satchel to hold a computer gathering the data.

Most of these devices, or their equivalent, can be hidden under clothes or baseball caps so that the wearer looks as if they are sporting only shades and an iPod, but in my case the boffins hadn’t bothered, and so I entered the deli looking like an extra from a 1970s episode of Doctor Who.

This was all part of my efforts to understand ”neuroeconomics”, a new, controversial and eclectic marriage between economics, marketing and various branches of physiology and brain science. With very different aims, economists and marketers are attempting to tap into the dramatic advances in our understanding of the brain that have taken place over the past 15 years. Their tools encompass mood-altering drugs, tests for hormone levels, animal studies and fMRI scans (which use immobile scanners to measure blood flows deep inside the brain).

“Neuromarketing” is the simplest application, and the one in which I was participating. David Lewis, a neurophysiologist at The Mind Lab, a spin-off from the University of Sussex, showed me how the physiological readings could be viewed alongside output from my camera to provide a simple but – presumably – useful demonstration of what really grabbed my attention in the deli. Among Lewis’s findings are that eating chocolate is more exciting than snogging (at least, snogging in an electrical shower cap while surrounded by men with clipboards) and that, subconsciously, young men are more interested in trainers than in the wares on display in an Ann Summers sex shop.

While the possible applications for marketers are obvious enough, such trials are hardly unlocking the deepest secrets of thought. It remains to be seen whether neuroscience has much to contribute to economics itself, a subject that has long focused on the decisions people make, without relying on any particular theory of how they make them. It is also hard to point to anything terribly interesting that the neuroeconomists have discovered, although neuroeconomics may contribute more as time goes by.

Neuroeconomics may provide more shape to the older and more famous field of behavioural economics. A mixture of economics and psychology, behavioural economics has used laboratory experiments to expose a bewildering number of exceptions to the traditional economic theory of rational choice. At present, though, there is little pattern to what the behavioural economists are observing, and it’s possible that a greater understanding of how the brain works might help to provide one.

Yet neuroscience might also help reinforce the traditionalists. Wolfram Schultz, a neuroscientist at Cambridge who studies how the brain processes risk and reward, says that just as the brain registers sensations such as sight, he can now see it registering rewards. There was no reason to expect that the mathematically convenient economists’ fantasy of “utility” had any real analogue in the brain – but it seems that it might after all. There’s a thought.

Also published at ft.com.

The tenant gained nothing from this except my bad opinion, and I was $120 worse off. Why did he not either ignore my car, or come up and knock on my door and say: “Look, I’ve got these people on the phone who will clamp your wheels unless you persuade me otherwise.” He could have had a few bottles of beer out of it. But he didn’t. So what was the rational reason behind his action?
Jeremy Cook

Dear Jeremy,

You are right to be puzzled. Clearly, this neighbour did not maximise the value of his bargaining position in the narrow situation you describe. Still, I think there is a certain logic to what happened.

Game theory is the economist’s tool of choice to analyse what happens when two or more people have to negotiate, co-operate, compete or otherwise engage with each other. The essence of game theory is that each side would expect the other side to anticipate and respond to his likely actions.

Game theory shows that there are times when irrationality (real or feigned) is a highly effective strategy. Someone who seems impervious to logic is someone who also gets his own way a lot. Consider, for example, toddlers, terrorists, bosses, dogs and the late Charles de Gaulle.

Your neighbour may have calculated that by demonstrating a willingness to punish you for no immediate personal gain, he will gain in the long term anyway. Irrational perhaps, but rationally irrational.

Also published at ft.com.

Peter Garber, a historian of economic bubbles, points out that a single bulb could, over time, be used to produce many more bulbs. The price of the bulbs would, of course, fall as more were cultivated. A modern analogy would the first copy of a Hollywood film: the final copies may circulate for a few dollars, but the original is worth tens of millions.

Garber points out that rare flower breeds still change hands for hundreds of thousands of dollars. Perhaps we shouldn’t be quite so sure that the tulipmania really was a mania.

The full article is here on Forbes.com.