Friday, November 29, 2013

REPOST: Advice for selling on eBay Motors: use lots of photos

A new economics paper has found that prices for cars sold on eBay motors rises the more photos you post on the site (about $80 extra for each photo).

Remember that adverse selection (or the "winner's curse" in auctions) is caused by the fact a seller have more information about the quality of the car than do buyers or bidders (economists call this "information asymmetry"). If buyers offer a high price, then they get a mixture of high and low quality vehicles, and pay more--on average--than the vehicle is worth. So buyers offer only low prices, correctly anticipating that only low quality vehicles will be offered for sale.

So how does a seller with a high value car convince a buyer that it is of high quality. The authors suggest that offering photos is akin to a guarantee of quality, a type of signal:

By disclosing their private information on the auction Web page in text and photos, the seller offers a contract to potential buyers to deliver the item described in the listing. If the disclosures define sufficiently detailed and enforceable contracts, the initial information asymmetry should play no role in determining the performance of the market.

I received this from a former student who verified that this theory, at least, works in practice:

My most recent eBay vehicle sale was a 102,000 mile seven year old truck, tons of bidding and sold for $11,000 sight unseen to a buyer in New York.

Text of the eBay listing is included links to all of the photos you see here:

Photos of EVERY body panel, EVERY interior angle, EVERY tire, EVERY engine bay angle, etc. Buyer was DELIGHTED upon receipt and couldn't believe I'd sent it to him with a full tank of gas.

REPOST: The Winners' curse in Yahoo Display Auctions

Preston McAfee is an unusual economist in that he has passed a market test: Yahoo is willing to pay him for his advice. His latest advice is on the design of auctions for graphical displays on web pages. Yahoo runs billions of these automated auctions every day, through their Right Media Exchange (RMX).  Advertisers can bid for certain kinds of customers, and can pay for impressions, clicks, or sales.

To choose the highest-valued bidder, Yahoo develops predictors of how many clicks and sales result from each impression. For example, if one click occurs for every ten impressions, an advertiser would have to bid more than 10 times as high for a click as for an impression in order to win the auction.

Yahoo was very proud of its predictors, but was puzzled that they systematically over-predicted the actual number of clicks or sales after the auctions closed. A well-trained economist would recognize this as an example of the winners' curse:

In a standard auction context, the winner’s curse states that the bidder who over-estimates the value of an item is more likely to win the bidding, and thus that the winner will typically be a bidder who over-estimated the value of the item, even if every bidder estimates in an unbiased fashion. The winner’s curse arises because the auction selects in a biased manner, favoring high estimates. In the advertising setting, however, it is not the bidders who are over-estimating the value. Instead, the auction will tend to favor the bidder whose click probability is overestimated, even if the click probability was estimated in an unbiased fashion.

As with the winner's curse, there is a simple fix--bid as if your estimate is the highest among all the bidders. This requires shading your predictors downwards, based on the variance of the prediction.

The paper also details two other features that Yahoo uses to make their auctions more efficient: randomized bidding, used when a less-informed bidder bids against a more-informed one; and sometimes the auction is not won by the highest bidder, due to the value of learning. When a bidder has a novel or unusual use for the display, sometimes Yahoo lets the novel user win so that Yahoo can learn more about the value of the use. If Yahoo learns that the novel use of the display is more valuable than they thought, then they can earn enough in the future to more than compensate them for giving up some revenue earlier on.

REPOST: Moral Hazard vs. Adverse Selection

Back in 1992, Nobel Laureate Peter Diamond proposed a solution to the adverse selection problem in health care. The NY Times reprinted an old editorial by Professor Diamond based on an article in Econometrica :

The core of the problem is that insurance companies can pick and choose their customers. They tailor policies to attract low-risk individuals, leaving those who are -- or are about to be -- chronically ill to fend for themselves or else pay huge fees.

To solve this adverse selection problem, Professor Diamond would eliminate worker-based coverage and replace it with a government-determined risk pools:

First the government divides the entire population into many large groups. Then, the government creates a Federal Health Insurance System (HealthFed), modeled on the Federal Reserve System, ... There would be redistribution between groups and pricing of alternatives to reflect optimal social insurance principles.

But any solution to the adverse selection problem would also exacerbate the moral hazard problem, so vividly described by my colleague Larry Van Horn

I start each day with my morning “cocktail” of an ACE inhibitor, Beta blocker, and Statin - all grossly subsidized by my health plan. I pay the same monthly premium as every other employee at my workplace with a family health plan. My wages have been reduced to fund the insurance premium behind the scenes, so I never know how much was taken from me. I know the only way to get my money back is to consume the services and drugs.

To solve the moral hazard problem, make consumers face the consequences of their risky behavior, with, e.g., with polices that have big deductibles.

My take away: Democrats are concerned with adverse selection, and want to increase consumption of health care; Republicans are more focussed on moral hazard, which would reduce consumption of health care. Pick your poison.

Wednesday, November 27, 2013

What they don't tell you about Thanksgiving in school

Peter Klein gives us a more complete story of the first Thanksgiving:

Faced with potential starvation in the spring of 1623, the colony decided to implement a new economic system. Every family was assigned a private parcel of land. They could then keep all they grew for themselves, but now they alone were responsible for feeding themselves. While not a complete private property system, the move away from communal ownership had dramatic results.

Is the Pope committting the nirvana fallacy?

Pope Francis made headlines this week by criticizing free market (Anglo-American) capitalism:

"Just as the commandment 'Thou shalt not kill' sets a clear limit in order to safeguard the value of human life, today we also have to say 'thou shalt not' to an economy of exclusion and inequality. Such an economy kills," Francis wrote in the document issued on Tuesday.

But does this mean that the alternative is better?  The relevant question is not whether capitalism kills but rather whether the Pope's implied alternative would do any better.  In this classic clip from Milton Friedman, he says that the record of history is "absolutely crystal clear" on this point:

Monday, November 25, 2013

The "Replacing Our Bodies Overnight with Technology" Act

Jordan Weissman at the Atlantic thinks we should call the new bill in the Senate that raises the minimum wage and provides tax breaks for technology the ROBOT Act. Because the demand for robots will increase.
In other words, this bill would make it more expensive to hire workers and cheaper to buy the technology to replace them. From a political horse-trading perspective, this makes total sense. From a job-creation perspective, it's a little alarming.  

Never Punt

Friday, November 22, 2013

Risk on trading in Greek debt

Following up on our earlier post about Risk-on, Risk-off trading.

Here is an update of the time series graph, showing that after peaking at 48%, when the European Central Bank said it would buy Greek Debt, the risk premium on Greece debt has dramatically fallen. 

HT:  Matt D.

Wednesday, November 20, 2013

REPOST: Sales "bunching" and high-powered commission rates

Ian Larkin studies the use of "high powered" quarterly sales commissions, used by virtually every firm that sells software. A typical incentive compensation scheme (as a function of sales) is highly convex: a sales person earns 2% if she sells $100,000 worth of software; 5% if $500,000; 8% if $1,000,000, ..., up to 25% if $8,000,000.

Ian finds that these high-powered (convex) compensation schedules give sales people an incentive to "bunch" sales into the same quarter. Just as concave production costs can be reduced by "smoothing", i.e., holding inventories to buffer sales shocks, so too can convex commissions be increased by "bunching" sales into the same quarter, the opposite of "smoothing."

Using proprietary data from a large vendor he finds that 75% of sales are occur on the last day of the quarter; and 5% of sales occur on the first day of the quarter, as sales people give discounts to customers to accelerate or delay purchases. These discounts cost the firm about 7% of revenue, which is about the same amount that it pays out in sales commissions.

The 7% revenue loss suggests that there is a way to make both firm and its salespeople better off: adopt linear commission schemes to eliminate the incentive to "bunch," and split the 7% savings between the firm and its sales people in the form of higher commission rates.

When asked why they use these costly incentive compensation schemes, managers say only that they need them to retain their "superstar" sales people. But surely there is a better way to retain superstars, isn't there? As always, I would like to hear from readers on whether they think this would work.

Why are turkey prices 9% lower when demand is highest?

The NY Times explains the debate among economists who worry about such things:

The most intuitive and popular explanation for a high-demand price dip is that retailers are selling “loss leaders.” Stores advertise very low prices — sometimes even lower than they paid their wholesalers — for big-ticket, attention-grabbing products in order to get people in the door, in the hope that they buy lots of other stuff. You might get your turkey for a song, but then you also buy potatoes, cranberries and pies at the same supermarket — all at regular (or higher) markups. Likewise, Macy’s offers a big discount on select TVs on Friday, which will ideally entice shoppers to come in and buy clothes, gifts and other Christmas knickknacks on that frenzy-fueled trip.

When you price complementary products (chapter 12) it makes sense to reduce the price.  An alternate explanation is from the demand side:

Consumers might get more price-sensitive during periods of peak demand and do more comparison-shopping, so stores have to drop their prices if they want to capture sales. Perhaps, during the holidays, the composition of consumers changes; maybe only rich people or people who really love turkey buy it in July, but just about everybody — including lower-income, price sensitive shoppers — buys it in November. Or maybe everyone becomes more price-sensitive in November because they’re cooking for a lot of other people, not just their nuclear families. 
“People are a little less picky about what they’re buying for other people,” explains Judith Chevalier, an economics professor at the Yale School of Management. “Let’s say I prefer Coke over Pepsi. If I’m buying for myself, I’ll probably buy Coke even if it’s more expensive. But if I’m buying soda for a party, I have no reason to think everyone else also prefers Coke, so I’ll go with whichever brand is cheaper.”

If turkey demand becomes more price elastic around Thanksgiving then we know that it makes sense to reduce price (Chapter 6).  A related explanation is that prices dont change, but rather the more price sensitive consumers substitute toward the cheaper brands. 
 One paper looking at canned-tuna prices argued that this kind of brand substitution was the primary case for an overall decline in price during Lent. It turns out that the cheapest tuna brands aren’t significantly discounted during Lent, but because the cheap brands temporarily accounted for a much higher share of overall sales, they dragged down the average price of a can of tuna.

HT:  Sam

Tuesday, November 19, 2013

If only President Obama had read chapter 19

If you sell insurance at a single price, anticipate that high risk individuals will be more likely to buy, and price accordingly. 

Recent data out of Kentucky, which has one of the best performing exchange websites in the U.S., show that the average age of enrollees is about 51, ten years above expectations.  To insure these higher cost individuals, premiums will have to "skyrocket" and this leads to the so called "death spiral." 

This happened in New York, New Jersey and Massachusetts where young people opted out of the system as a whole because of high prices.

“As premiums rose, healthy people dropped out meaning the risk pool was high,” Herrick says. “Premiums rose again, and more healthy people dropped out. The costs for individual insurance were double and triple the national average.”

If President Obama had read Chapter 19, he would have known to anticipate this kind of adverse selection.

Don't worry though, I am sending him a copy of my book. 
HT:  Roberta

Monday, November 18, 2013

Randomized experiment tells us how to get some welfare recipients back into the job market

Helping needy people can reduce the incentive to get back into the work force.  For example, when I take a job, I lose my welfare check plus other benefits, and this raises the 'opportunity cost' of taking a job. 

Economists call this an "effective high marginal tax rate" because the incentive to off welfare is reduced in much the same way that high marginal tax rates reduce the incentive to work harder. 

So how do welfare recipients respond to these incentives?  A randomized trial from Canada sheds light on the answer:

Basically, a group of welfare recipients were randomly split into a treatment group that received a supplementary payment that reduced the effective marginal tax rate on income from 100 percent to 50 percent for a three -year period, and were compared to a control group that was randomly selected to receive no change to the current program. (The details are available in an excellent program final report from 2002.)

The findings:

People respond to incentives.  During the period of the reduced marginal tax rate, reported work earnings and reported income rose for the test group vs. control during the experimental period.  

Marginal is not average.  At the peak effect of the program (16 months after random assignment), about 30 percent of the treatment group were employed full-time versus 15 percent of the control group. — the vast majority did very little different than they would have done otherwise...

This cost taxpayers more money, not less.  In round numbers, as compared to control the treatment increased total reported take-home earnings by about $200 CD [Canadian $] per month, about $100 CD of which was greater reported wage income, and about $100 CD of which was the supplemental cash transfer from the government  

The effect disappeared after the program ended.  After the program period (... about five years after program entry), the treatment group had about the same level of reported employment and income as the control group. 
 HT:  Instapundit

Friday, November 15, 2013

Dating Game

QUESTION: A man and a woman are trying to decide where to go on a date.  The woman prefers ballet, but the man prefers going to a football game.  There is some gain to going together, but each would rather go to their preferred activity alone, than together to their less preferred activity.  Diagram this game, and show how best to play.


                                              Football             Ballet
                              Football   (1,4)                  (0,0)
                                  Ballet   (2,2)                  (4,1)

The man does better by going to the football game, regardless what the woman does, and the woman does better by going to the ballet, regardless what the man does.  These are called "dominant strategies."  The equilibrium of the game is for each to go to their preferred activity.

Notice, however, that the two players could make themselves better off by cooperating.  Self interest is taking them to a place (2,2) with a lower group payoff than the cells on the main diagonal. 

There are two ways to change the game to increase group payouts.

1. Alternate.  If the couples take turns, their group payout goes up.

2. Have the player that receives the higher payoff, compensate the other player for going to their less preferred activity.

In this case, the man could give 1.5 units to the woman if they go to the football game, which would change the payoff in the upper left to (2.5, 2.5).  This would change the equilibrium of the game.

Alternatively, the woman could give 1.5 units to the man if they go to the ballet.  This is the premise of an off-color South Park episode.

Who benefit (or lost) when Central Banks began printing money?

McKinsey keeps score:

When the central banks began printing money, they bought loans, which is equivalent to an increase in the supply of loans. The price of a loan (interest rates) decreased. Low interest rates benefit borrowers, and hurt lenders:

 The winners: 
  • From 2007 to 2012, governments in the eurozone, the United Kingdom, and the United States collectively benefited by $1.6 trillion both through reduced debt-service costs and increased profits remitted from central banks (exhibit). 
  • Nonfinancial corporations—large borrowers such as governments—benefited by $710 billion as the interest rates on debt fell. 
  • Although ultra-low interest rates boosted corporate profits in the United Kingdom and the United States by 5 percent in 2012, this has not translated into higher investment, possibly as a result of uncertainty about the strength of the economic recovery, as well as tighter lending standards. 

The losers:
  • Meanwhile, households in these countries together lost $630 billion in net interest income, although the impact varies across groups. Younger households that are net borrowers have benefited, while older households with significant interest-bearing assets have lost income.
When the banks begin tapering, will the losers  become winners and vice-versa?

Thursday, November 14, 2013

Never start a land war in Asia, ...

or a price war.
If you want to compete, choose a dimension (differentiate your product, lower your costs, design an advertising campaign) that is difficult for your competitors to mimic.

Wednesday, November 13, 2013

Joker's (flawed?) game theory

Should the Joker have predicted this outcome using game theory?  Construct payoffs such that this is an equilibrium.  

HT:  David S.

Tuesday, November 12, 2013

Make the rules or your rivals will: use anti-growth activists to erect entry barriers

A recent paper by former student Mike Saint's consulting group shows how to erect barriers to entry to protect your market share, without running afoul of the antitrust laws:

The courts have sanctioned the right to organize community opposition that urges government officials and agencies to deny land use permits to applicants, even when the underlying motive of the opposition is protecting market share and eliminating competition. What’s more, the courts are protecting third-party funding sources, in many cases anonymous funding sources, which support the opposition efforts in order to block potential competition.

 The classic example of this is a local grocery story or gas station organizing opposition to zoning changes that would permit Wal-Mart to enter a market.

See related posts: 

Are the Wal-Mart battles over?

Make the rules or your rivals will

Sales Below Cost Laws

Unions using zoning laws against Wal-Mart

Why not just give money to poor people directly?

NPR's Planet Money has another episode that almost justifies the enormous amount of subsidies given to it.  They document an experiment giving $1000 to very poor people in Kenya and in Liberia. 

Those in Kenya did well, and it seemed to result in permanent improvement in their lives.  In Liberia, the results were temporary, probably because the economy is so inefficient in Liberia. 

Monday, November 11, 2013

Long run vs. short run

President Maduro is trying to win re-election so he seized the biggest electronics store and held a "sale."

In the short run, people get cheap stuff and they are happy.  But in the long run, he has reduced the incentive of retail outlets to serve people. 

This summer, I warned him about these kinds of policies, and I even sent him an autographed copy of my textbook.

Someone please get him to read chapter two. 

Friday, November 1, 2013

REPOST: Use randomized experiments to test policy

Esther Duflo's inspiring TED Talk:

Health is an investment to make people healthier, we have to get them to invest.  TED talk by Emily Oster:

REPOST: John McMillan's Rational Pigs Puzzle

To illustrate how game theory works, I sometimes pose this puzzle in class, taken from John McMillan's terrific book, Games, Strategies, and Managers.

 QUESTION: Two pigs, one dominant and the other subordinate, are put in a pen. There is a lever at one end of the pen which, when pressed, dispenses 6 units of food at the opposite end. It "costs" a pig 1 unit of food to travel from the food to the lever and back.

If only one pig presses the lever, the pig that presses the lever must run to the food; by the time it gets there, the other pig has eaten 4 of the 6 units. The dominant pig can push the subordinate pig away from the food, and cannot be moved away from the food by the subordinate pig.

If both pigs press the lever, the subordinate pig is faster, and eats 2 of the units before the dominant pig pushes it away.

QUESTION: If each pig plays rationally, optimally, and selfishly, which pig will press the lever?

To answer the question, construct a simultaneous game, where the "payoffs" to the pigs are the net amount of grain consumed.

 ANSWER:  The subordinate pig always does better by not pulling the lever, regardless of what the the other pig does.  This is called a "dominant strategy."  The dominant pig's best response to this strategy is to pull the lever.  The unique equilibrium is for the dominant pig to pull the lever and consume 1 net unit of food while the subordinate pig consumes four.
                                                 Subordinate pig
                                              Pull              Don't Pull
                                   Pull   (3,1)                  (1,4)
Dominate pig        
                           Don't Pull  (6,-1)                 (0,0)

Ironically, with these payoffs, the subordinate pig will soon become dominant.  Then the equilibrium will change.