Tim Harford The Undercover Economist

Articles published in January, 2016

How fighting for a prize knocks down its value

‘If many people have patience to queue for scarce (and underpriced) tickets, the value on offer will be consumed by the race to grab it’

I was recently told about an airstrip near a banknote-printing facility. Every day, planes take off, bursting with cash. It used to be that if you stood in a certain field near the airstrip, you could catch the dollars as they drifted gently to the ground, or scoop armfuls of them up from the soil. On average, $1m a day fluttered down.

Word soon got around. Before long, the field was packed with bill-catchers, racing and shoulder-charging each other to get the cash. People started to bring butterfly nets. The skies were thick with quadcopters darting around to snatch the money at altitude.

If you’re wondering where this field might be, don’t. It exists only in the imagination of Stanford economist Mike Ostrovsky, reported in Al Roth’s book Who Gets What and Why. But if the field did exist, you’d have to be a hardy soul to venture there. If $1m a day was known to be at stake, the ferocious quadcopter scramble would escalate until it cost almost $1m a day to run. If it didn’t, then people would have a strong incentive to keep buying drones until it did.

Economists call such arms races the “dissipation of economic rents”. They’re frustrating, because value is being frittered away in the competition to secure them. Think of the queue around the block for scarce (and evidently underpriced) concert tickets or the riots over cheap merchandise that occasionally break out during discount sales. If a few people are particularly patient, or muscular, or skilled at piloting drones, then they will keep at least some of the value; if many people have similar patience, strength or skill then the entire value on offer will be consumed by the race to grab it.

(The airfield tussle is particularly wasteful because real resources are being devoted to grabbing banknotes that could easily and cheaply be replaced. But even if the planes were dropping something valuable, such as saffron or USB drives, the process would mean that value was wasted.)

Another example is the business of high-frequency trading in financial markets, in which algorithms try to outwit or outpace each other as they scramble for trades in a contest that is over in less than an eye-blink. Some traders have invested in microwave networks, which are faster than fibre optics, to gain edges of less than a thousandth of a second as they respond in New York to news from Chicago. The parallel with the money-field is clear enough — and, unlike the field, high-frequency traders do exist.

A microwave link to save a few microseconds is in much the same category as a faster dollar-grabbing drone, or turning up earlier for a better place in the queue at an Oxford Street store. There is a value to having a liquid market for financial assets, one in which you can quickly find some buyers to compete for whatever you might be selling. But high-frequency trading adds little to market liquidity in times of crisis; the microwave link, like the drone, adds no value to society as a whole.

Can anything be done about such rent-dissipating behaviour? One approach is to tax it. We could levy a fee on standing in queues, or on microwave transmitters, or on stock market transactions themselves. If people who queue for scarce concert tickets are all taxed $5 an hour while they queue, then the lines will be shorter. The cost of the tax should roughly be offset by the reduced waiting time, so the queueing crowd is no worse off; the government, on the other hand, has acquired revenue from nowhere. This is a rare free lunch.

Taxing transactions is also a possibility, although a more problematic one. Much of the difficulty comes not from transactions themselves but from “quote stuffing”, where high-frequency traders make and withdraw thousands of bids, probing for information without actually making transactions. And charging for quote-stuffing might not help either. Three Canadian researchers (Katya Malinova, Andreas Park and Ryan Riordan) studied the impact of a regulatory change where traders were charged for quotes, not just trades; they found that quote volume fell sharply. But the bid-ask spread, a measure of market inefficiency, rose nearly 10 per cent. And while a transaction tax or quote tax would discourage some forms of high-frequency trading, it seems to me that the incentive to build microwave links between Chicago and New York would still exist.

So an alternative is to redesign the market to make it work better. In the case of queues for tickets, charging more for the original tickets would help, and the seller could hold an auction to set the perfect price. Financial markets could also be improved by introducing an auction once a second, batching together all the offers that have been submitted during that second. That would be fast enough for any reasonable purpose — and would remove the need to spend all this money on microwave relays.

Auctions are no more of a panacea than markets themselves, but they can help. Markets do not always organise themselves. A well-designed auction can mean less effort wasted in the fight to get to the front of the queue.

Written for and first published at ft.com.

The price of being female

‘Gender-based mark-ups may not be an economy-wide phenomenon. But they seem to exist for certain products’

Does a dollar in my pocket buy more than a dollar in my wife’s? It seems so, according to a report released just before Christmas by New York City’s Department of Consumer Affairs, which was much covered in the US media. The DCA report found that men often paid less for clothes and items such as razor blades and shampoo. Even boys’ toys are cheaper than those aimed at girls. The report led with a striking example from a department store website: while a red “My 1st Scooter Sport” costs $24.99, a pink “My 1st Scooter Girls Sparkle” is twice as much. Beneath the paint job, the products appear to be identical — surely glitter cannot be that expensive?

The sparkly scooter was sold at an astonishing mark-up but it’s not a typical case. The DCA report looked at 22 bikes and scooters, finding that on average the product aimed at girls or women cost 6 per cent more. Across 800 products, the DCA found that while men sometimes paid more than women, on average women faced prices that were 7 per cent higher. Relative to profit margins this is still a large price difference but it’s a long way shy of 100 per cent.

What should we make of this? One response is that perhaps the price gap isn’t really there or at least not in any systematic way. Perhaps the DCA unwittingly cherry-picked examples. (Sports cars and hi-fi systems were not included.) Whether or not systematic gender-based pricing is widespread, it will always be easy to find examples that look sexist.

Still, other research has reached similar conclusions. For example, a study published in Gender Issues in 2011 by Megan Duesterhaus and others found that “gendered price disparities are not as widespread as . . . journalists have previously reported but it does appear that women pay more for certain goods (deodorant), services in hair salons (haircuts), and dry-cleaning of shirts”.

In the hope of getting a truly comprehensive overview, I spoke to the UK’s Office for National Statistics, which systematically collects price data to calculate inflation measures. Unfortunately, the ONS data aren’t designed to shed light on this question; they often do not distinguish between male and female products and services. The job of inflation indices, after all, is not to detect discrimination but to follow price changes over time.

So it is hard to be sure that gender-based mark-ups are an economy-wide phenomenon. But they may be. And they certainly seem to exist for particular kinds of product. Why? No single theory will suffice. Car insurers and nightclub owners both want to charge more to men, but not for the same reason.

Broadly, there are two types of explanation. One is that higher prices reflect higher costs. Maybe men’s haircuts typically require less time and skill than women’s haircuts. It’s said that women’s blouses cost more to clean and iron at a dry-cleaner’s because they are delicate and need to be pressed by hand. Still: why not charge by the hour to provide a haircut? Or charge for hand-pressed clothes, regardless of gender? Restaurants do not charge men more on the grounds that they usually eat more; instead, they charge by the dish. I can only speculate as to why hairdressers act differently.

The alternative explanation is that companies are making fatter margins on women’s products and services. Economists call this “price discrimination”, and it would suggest that women pay more than men if and when they are less sensitive to prices. Perhaps manufacturers and retailers have found that if they try to raise the price of razor blades or shampoo, men will shop elsewhere or skimp on the product, while women will willingly pay the higher price.

This female insensitivity to price — if it really exists — might be driven by all kinds of things. Perhaps women tend to be busier and have less time to shop around. Or perhaps they care more about quality when it comes to deodorant or shampoo, whereas men just want something cheap.

 . . . 

But even if women are potentially willing to pay extortionate rates for certain kinds of goods, it doesn’t mean that companies can exploit that willingness. A lot of the businesses most regularly accused of sexist pricing — hairdressers, dry cleaners and nail salons — operate in the face of almost unlimited potential competition. If all of them are operating on razor-thin margins for men and fat margins for women, shouldn’t they be desperately trying to win female customers away from each other? This competitive pressure will constrain attempts to discriminate on price. It is the big brands — such as Ferrari, Hermès and perhaps Gillette — who have the power to charge different mark-ups to different customers.

As soon as a company acquires some market power, it will try to give spendthrift customers an opportunity to display their spendthriftiness by offering costly variants on basic products. Publishers ask double for a book with hard covers; coffee chains charge a lot for squirting flavoured syrup in your latte. We can hardly be surprised if some of these special variants look pink and sparkly. And as consumers, male or female, our only resort is to keep searching for the products without those frills, literal or otherwise.

Written for and first published at ft.com.

Why predictions are a lot like Pringles

‘Nobody thinks that there’s any great virtue in forecasts but we find them hard to resist’

In mid-December, Phil McNulty, the BBC’s chief football writer, offered us his predictions for the rest of the English Premier League season. My interest in football is limited but I found McNulty’s efforts fascinating. Even the most sceptical about football can learn a great deal from the episode.

A brief piece of context for those sceptics. Chelsea, the champions, had just played Leicester City, a team that had been relegation favourites just a few months before. Leicester won the game. This result would have been surprising had it not been set against the even more surprising pattern of the season. Champions Chelsea had slumped towards the bottom of the league after producing an unprecedentedly appalling run of form; Leicester, meanwhile, were top of the table. Nobody was shocked to see them vanquish Chelsea but it felt like a significant moment nonetheless.

What of McNulty? At the beginning of the season, he had predicted that Chelsea would be champions again, while Leicester would finish in the bottom three and be relegated from the Premier League. Both of those outcomes are now inconceivable. After admitting that his initial prediction had been about as wrong as it is possible to be, McNulty proposed a new set of predictions.

Those predictions were . . . but wait. Why on earth should you care? McNulty knows a great deal about football — far more than I do — but he had conclusively proved that he can’t see into the future. And yet he felt bold enough to offer another forecast, which many sports fans read with great interest.

This is a common pattern in football and beyond: pundits make forecasts, their audience consume those forecasts with relish, the forecasts are proved wrong, nobody is very surprised, and the cycle begins again. Why?

Part of the explanation is wishful thinking: we like to believe that the world runs on rails, and to trust in experts who claim to have decoded the timetable and can therefore explain what is going to happen, when, and why. Forecasters with a record of some success — such as data-driven political and sports analyst Nate Silver — soon find themselves saddled with unrealistic expectations.

Silver correctly predicted the fine details of the 2012 presidential election but he is happy to admit three things: that US elections are data-rich environments and much more predictable than most; that he had some luck; and that the bar for forecasting success had been set very low by partisan pundits much more interested in cheerleading than accuracy.

Sure enough, when Silver and his colleague Ben Lauderdale tried to predict last year’s UK election result, their performance was woeful. This was partly because the seat-by-seat polling data are far less detailed than in the US and partly because Silver’s good luck didn’t last.

We would be wise to have more realistic expectations, even of careful data-driven forecasters such as Silver. But perhaps our expectations are irrelevant. Even when we know that the forecasts are useless, when the pundits have no track record, when the events in question have always been unpredictable (the stock market; geopolitical shocks; recessions), we remain hungry for opinions about the future.

The truth is that forecasts are like Pringles — nobody thinks that there’s any great virtue in them but, offered with the fleeting pleasure of consuming them, we find it hard to resist. I am not sure quite why this should be so, but I have a couple of theories.

Possibility one is that the moment we hear a forecast, we imagine it happening. It then becomes a believable outcome and one that is easy to call to mind in the future. The scenario that we imagine looms large in our minds; other scenarios, equally plausible, fade to the background. As a result, we can be sceptical of forecasts in general yet still hooked by a particular one.

I notice this tendency in myself whenever I hear someone opining on the stock market. As an abstract proposition I think that it’s almost impossible to predict what the stock market will do. But the moment someone starts to tell me a story about what will happen to it, I’m hypnotised.

Possibility two is that forecasts offer us a lazy way to understand a complex world. The background to the conflict in Syria is complicated. So is Chinese politics. So, too, is the evolution of the Japanese economy. Trying to understand what is going on in any of these places requires an investment of time and attention that most of us are not willing to make. Wise heads at this newspaper could explain the intricacies to you or to me for hours yet barely have begun to do the topic justice.

But a forecast? That’s different. A forecast about what will happen in Syria, China or Japan is a simple way to convey a fleeting sense of understanding. The forecast will probably be wrong. But at the instant it is consumed, it gratifies. As I say, a lot like Pringles.

Written for and first published at ft.com.

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My TED talk on how distractions make us more creative

11th of January, 2016HighlightsSpeechesVideoComments off

The cost of overconfidence

‘Some companies base their business models on our tendency to overestimate our willpower’

So, how are those resolutions going? Given that the new year has scarcely begun, there is some chance that your will remains as firm as it was on New Year’s Eve: the cigarettes have not been smoked, the white wine has not been guzzled and you actually went to the gym. As we all know, however, a year is a long time to stay strong.

Companies know it too, and some base their entire business model on our tendency to overestimate our willpower, our memory or our ability to navigate small print so devious that it would make Rumpelstiltskin blush.

The most egregious example — popular in the US, blessedly less so in the UK — is the mail-in rebate, where a manufacturer or retailer will offer a discount but only after the customer fills in a form, attaches a receipt and mails the paperwork off with fingers crossed. There are a number of advantages to this — it may allow the manufacturer to gain information about customers, and produces a flattering cash flow — but surely the main reason companies use mail-in rebates is that they know some people aren’t as disciplined and organised as they think.

Scott Adams, as so often, nailed the issue in a Dilbert comic strip. Dogbert offers a product for sale for $1,000,029 with a $1,000,000 rebate. And since “all we need is one person to forget to mail in the rebate forms”, Dogbert suggests targeting “the lazy rich”.

While the mail-in rebate is a particularly naked case of exploiting inattentive consumers, there are subtler examples, such as magazine subscriptions with free trial periods followed by auto-renewals.

More subtle still are pricing schemes that exploit consumers. In a recent analysis of overconfident consumers, economist Michael D Grubb highlights the “three-part tariff”. A one-part tariff would be, for example, 2p per minute to make phone calls. A two-part tariff might be £10 a month, plus 1p a minute to make phone calls. And a three-part tariff? A tenner a month with 200 minutes of free calls, plus 10p a minute to make phone calls after the 200 minutes have been used.

The three-part tariff will be reassuringly familiar to anyone with a mobile phone contract. But look at it there on the page. It’s ridiculous, is it not? It is hard to imagine any company deploying such a convoluted offering for a product whose consumption was obvious, such as petrol — “£10 a month to use our petrol stations, the first 50 litres of petrol to be supplied at cost price, and then £5 a litre thereafter.” There are legitimate business justifications for a three-part tariff but the likeliest story is that phone companies think we are fallible. Most of us don’t have a firm grasp either of how much we talk on average or of how variable that average is. As a result, many of us pay these punitive charges more often than we expect.

At least mobile phone carriers offer an honest service behind their manipulative pricing structures. I am not sure the same can be said of bookmakers, casinos and lotteries. Some of their customers have a clear-headed view of their chances of winning — just as some customers mail back their rebates or accurately forecast their phone calls — but many must overestimate their skill or underestimate the odds against them.

Yet I wonder if any business model is more dependent on the excessive optimism of its customers than gyms that offer ongoing memberships. In a famous research paper, “Paying Not to Go to the Gym”, economists Stefano DellaVigna and Ulrike Malmendier studied almost 8,000 gym members, with data on their attendance record and on the contracts they had agreed with the gym.

There were three contractual options: pay per visit, pay monthly on an automatically renewed contract, or pay annually on a contract that is not automatically renewed. DellaVigna and Malmendier found a number of patterns that are most naturally explained by the hypothesis that we consumers are naive, weak-willed fools.

● Eighty per cent of pay-monthly customers would have paid less — often much less — had they simply paid per visit. Likely explanation: we don’t go to the gym as much as we think we will.

● Pay-monthly customers pay more than the annual customers, because they retain an option to cancel, yet these customers, in fact, tend to stay members for longer. Explanation: we think flexibility is valuable but don’t realise how lazy we are in the face of auto-renewal.

● The people who get the worst value from the gym (highest per-visit cost) also take the longest to cancel (gap between final visit and cancellation). Explanation: people who are idiots about one thing are idiots about other things too.

Taking money to provide facilities to people who do not use them is a tempting business. But gym companies must still compete with each other for our custom, even if that competitive dynamic is dysfunctional.

So, take heart: if you are a customer who mails in her rebates, who carefully rations mobile phone use or who goes to the gym five times a week, then you are likely to get an excellent deal, cross-subsidised by other customers.

And you are just such a person, aren’t you? Of course you are.

Written for and first published at ft.com


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