Sephora's strategy (make-up/beauty)

 WSJ has a good summary of the moves that Sephora has made to make it into such a success.  

How did Larry Summers correctly predict inflation?

... I thought if you were filling a $30 billion hole [the insufficient aggregate demand necessary to get the US economy to full employment] with $200 billion of spending, there was likely to be some overflow and that overflow would translate into inflation. I did the same calculation essentially, looking at GDP, and I saw a 2% or 3% GDP gap, met with about 15% of stimulus. (LINK)

A lot of macroeconomics uses microeconomics tools like demand and supply.

Why is Europe lagging the US and China?

Since 2000, the EU's share of world income has fallen has fallen from 33% to 25%; and the its companies share of world value has fallen from 31% to 16%.

The Economist mistakenly attributes the difference to several factors:

• Europe's firms seem to have been out-managed 
• Its biggest firms are in the wrong industries
• Entrepreneurial deficiency

All of these seem like symptoms of the EU's decline, not causes. My best guesses about what caused EU's decline are:

• EU regulations stifle innovation and growth 
• The EU cannot tolerate the inequality that comes from incentive pay required for profitable innovation.

This shows up in the graph below, showing that "...in the past decade venture capitalists have backed 661 companies that went on to be worth over $1bn. Only 78 of these “unicorns” are in Europe, worth 8% of the 661 firms’ over-$2.5trn total."

Does Kroger think that moral hazard explains vaccine reluctance?

How else do you explain their cut in Covid-19 benefits to unvaccinated employees? Here is what Kroger says: 

 ...the company is modifying policies to encourage safe behaviors [emphasis mine] as it prepares to navigate the next phase of the pandemic, and that the changes are designed to create a healthier workplace and workforce. 

As treatments for COVID-19 get better, the benefit of getting vaccinated declines.  

Earlier blog post: Does moral hazard explain some vaccine reluctance?

Committment Matters when Bargaining

And I bet he got $300.

Nobel lecture on inferring causality from non-experimental data

Why poker players are thinking like economists

The rise of online poker created a divide between old-school players who had made their careers playing live poker in casinos and a new school of online players who learnt the game on the internet. ... It was the new-school players who took game theory seriously, particularly the idea of Nash equilibrium strategies (which players referred to as “Game Theory Optimal” strategies).

Three changes stand out. 

•  More frequent bluffing: Perhaps most noticeable was how often new-school players bluffed (i.e. bet with weak hands). ... The logic is twofold. First, bluffing means your opponents will need to call your bets often to stop you winning with weak hands; hence you’ll frequently win a lot when you have a strong hand. Second, many hands you bluff with can improve and become a strong hand when more community cards are dealt. ...
• Short-stack play. When players have relatively few chips, decisions can often be boiled down to a choice between going all in (i.e. betting all your chips in one go) or folding. When poker can be simplified in this way, game theory provides recommendations on exactly when to go all in and which hands to fold.
• Mixed strategies. Game theory often recommends mixed strategies – randomly choosing what to do with a given hand in some situations – to avoid becoming too predictable. This was particularly important for players on the internet, where opponents could use tracking software to analyse their play and look for weaknesses.

Does moral hazard explain some vaccine reluctance?

If patients know they can get monoclonal antibody treatment, there may be less incentive to get vaccinated:

WEBMD:

Tennessee health officials say that nearly all vaccinated patients should receive lower priority to preserve supplies for those who remain most vulnerable, while those in Alabama say treatments should go to those who are most likely to be hospitalized.

NIH:

When there are supply constraints, unvaccinated patients with COVID-19 are among the populations who should be prioritized to receive monoclonal antibodies, according to an updated statement on NIH COVID-19 treatment guidelines released on Thursday.

Look ahead and reason back: buying a franchise

Individual franchisees (like an individual hotel owner) pay to use the brand and business formula of the franchisor (like Best Western, Comform Inn, Days Inn, Econolodge, Hampton Inn, Holiday Inn, Ramada, or Super 8). The value of the brand to the franchisee depends, among other things, on how much "within brand" competition there is.

Unless the contract grants the franchisee an "exclusive territory," the franchisor may have an incentive to set up more franchisees in the same area. Using a ten year data set of Texas Hotels, Arturs Kalnins find that when new franchisees open up nearby, incumbent franchisees lose 2-3% of their revenue. Interestingly, there is no cannibalization when a new company-owned hotel enters near an existing company-owned hotel (e.g., La Quinta and Motel 6 own most of their own hotels).

If franchisees anticipate that future franchisees will cannibalize sales, this will reduce the amount that they are willing to pay for the franchise. If franchisees do not anticipate cannibalization, they are in for a rude awakening.

Franchisees are powerful politically (easy to organize, common purpose) and often lobby state legislatures to enact franchisee "bill of rights" giving them, among other things, right of first refusal for new franchises. In states with strong franchisee bills of rights, companies with strong brands opt for company-owned stores, which are easier to control instead of the franchisee organizational form..

Governments learn from the consequences of their mistakes

 If a firm makes a decision that increases costs or reduces quality, there are two immediate consequences: reduced sales as consumers turn to lower-priced, or higher-quality, alternatives; and a higher cost of capital, as lenders and investors turn to more profitable opportunities.  Product market competition thus aligns the incentives of a firm with the goals of consumers, and capital market competition, with the goals of lenders and investors.  

In contrast, if a government makes a bad decision, one that makes the state a less desirable place to work or do business, residents must wait until the next election, or move.  This kind of pressure is weaker and delayed, as it is costly and takes time to start over in a new state.  As a result, incentives for state government to better serve its residents are not as strong or immediate.

For example, Illinois has decided to under-fund state pensions for decades.  Its taxpayers now face a huge future tax burden, and the prospect of reduced government services, like police protection.  Current taxpayers are leaving because they can see a costly and crime-ridden future, and would-be taxpayers are locating in better-run states.  This kind of competitive pressure is slowly building and should eventually lead to reform.

However, if Democrats raise the SALT (State and Local Tax) deduction for federal taxes, other states will end up paying for Illinois' mistakes, shielding Illinois from the full consequences of its bad decisions.  This can only delay reform because governments, like children, do not learn from their mistakes, they learn from the consequences of their mistakes.  

How to raise prices without raising prices

 From WSJ:

1. Unbundling services, lowering product quality and devaluing reward programs

... airlines have unbundled services so that fliers pay extra for checking luggage, boarding early, selecting a seat, having a meal and so on. The charges for these services don’t show up on the ticket price, but they are substantial. Second, the airplane seat’s quality, as measured by its pitch, width, seat material and heft, has declined considerably, meaning customers are getting far less value for the ticket price. And third, many airlines have steadily eroded the value of frequent-flier miles, increasing costs for today’s heavy fliers relative to those in 1996.

These practices are also common in other industries, whether it’s resort fees in hotels, cheaper raw materials in garments and appliances, or more-stringent restaurant and credit-card rewards programs.

2. Shrinkflation and the quantity surcharge

To raise prices covertly, the brand or the grocery store sells more of the higher-margin items by increasing their availability and visibility in the store, or withdrawing popular lower-margin items from circulation for a period. The prices don’t change, but customers pay more.

3. Disappearing deals and coupons

...Even increasing the threshold for free shipping, from $49 to $99, is tantamount to a price increase. 

4. The sunk costs of memberships

...f you consider that the warehouse club requires a separate mandatory membership fee, the customer is actually paying more per ounce at the warehouse club.

5. From good to better and from better to best

Another way to raise prices covertly is to introduce new, higher-quality versions at higher prices. 

BOTTOM LINE:  The smartest companies don’t raise their prices with great fanfare, because direct price increases are often met with customer resistance.

HT:  Quinn C.

Why does government always expand, and how should we respond?

 The Economist suggests 3 reasons:

• Inertia and mission creep make government hard to pare back. Voters and lobbyists who benefit from a regulation or item of spending have every reason to work hard at preserving it, ...

•  The second force is a fact of life. Prices of the services welfare states provide, such as health care and education, grow faster than the economy because of their high labour intensity and low rates of productivity increase. ...

•  The third force is that governments today have more things to get done. As voters became richer over the 20th century they demanded more education and more of the expensive health care that takes advantage of the latest science. ...

...and offers some criticism of President Biden

• One task is to maximise the role of markets and individual choice. Climate change should be fought with a price for carbon, ... not by rationing flights, promoting green national champions or enlisting central banks to distort financial markets. 

•  The welfare state should focus on redistributing cash and letting those in need choose what to do with it, not setting up new bureaucracies such as President Joe Biden’s proposed federal child-care system.

Run experiments to measure the effects of advertising (and make money)

Readers of this blog know that we are big fans of randomized control trials (RCT's).  Here is a story from a new book, The Power of Experiments, taken from a review by Strategy & Business.

 eBay used to pay Google about $50 million annually for ads by search terms that included the company name, such as eBay or eBay shoes. To determine whether this was worth the money, they ran an experiment, turning Google ads on and off, and tracking the traffic coming to eBay from Google ads (paid) vs. traffic coming from organic search (unpaid). They discovered that paid advertising was cannibalizing traffic from organic search:

...the experiments found that in markets where the company didn’t advertise, it got a spike in traffic from unpaid organic links. “Evidently, users who Googled ‘eBay’ (or another eBay-related search term), who had been clicking on the ad because they saw no reason to scroll down to the organic link just below it, were now instead clicking on the first organic search result.

Revealed preference

Progressives say the only way to achieve their climate goals is to raise the price of fossil fuels. Their problem is that consumers don’t want to pay more for energy, and as the latest proof behold Connecticut Gov. Ned Lamont’s retreat this week from a Northeast state climate pact. ...

Mr. Lamont finally gave up trying to pass the scheme this week. “Look, I couldn’t get it through when gas prices were at historic lows. So I think the legislature has been pretty clear it is a tough rock to push when gas prices are so high,” he said. Massachusetts GOP Gov. Charlie Baker then threw in the towel too, causing the climate pact to effectively combust.

...This summer the Swiss rejected higher taxes on driving and flying in a referendum.  (link)

Is inflation transitory and how long will interest rates stay low?

Right now, interest rates (mortgages) are 3% and inflation is 5%.  This cannot last because those who lend are getting paid back with dollars that cannot buy as much as the dollars they lent.  If inflation stays at 5%, interest rates have to rise to compensate lenders, e.g., to 8%.

MarginalRevolution.com has an answer:

“I think the inflation will last two to three years, and it will be bad,” Cowen said. But really grim hyper-inflation à la Carter-era, he thinks is unlikely. It could only happen if the Federal Reserve decides it’s too risky to trim the sails of cheap money. “I’d put it at 20% chance that the Fed will think, ‘Trump might run again, and we don’t want Biden to lose . . . history’s in our hands, so we’ll wait to tighten.’ And then it just goes on, and then it’s very bad.”

But a recession is also bad. It’s hard to sort it all out. “As the saying goes, ‘If you’re not confused, you don’t know what’s going on,’” Cowen told me.

Why does De Beers' sell bags of uncut (and unappraised) diamonds for a single take-it-or-leave it price?

Yoram Barzel, writing in 1977, argued...  “Had the contents of a particular bag been available for appraisal by all buyers,” Barzel explained: “[E]ach would have spent resources to determine the properties of the diamonds. … 

In other words, because buyers were spared the costs of evaluating individual stones, they were willing to pay De Beers more for the average stone.  (link)

IL: unfunded pension liabilities; bad credit rating, rising crime, high taxes, low economic growth

The future of Illinois looks bleak as they are deep in debt, and piling up more debt every day:

HT:  MarginalRevolution/Stuart Loren

Does our tolerance for inequality make us rich?

In Chapter One, we learn about the importance of incentive alignment: designing organizations so that decision makers have (i) enough information to make a good decision; and (ii) the incentive to do so. But incentives, i.e., linking pay to performance, necessarily creates some inequality as some people work harder or are more productive than others. The Economist notes that this tradeoff is not new.

In 1975 Arthur Okun, an American economist, argued that societies cannot have both perfect equality and perfect efficiency, but must choose how much of one to sacrifice for the other.

However, political views on this tradeoff diverge:

Views of income inequality are divisive. Leftists blame uneven distribution on outside factors, such as poor education and corporate misconduct. Conservatives, meanwhile, tend to view these differences as a fair consequence of an individual’s choices and abilities.

Views on income inequality diverge across countries as well.

Today, Americans seem far more willing to tolerate inequality than people in most rich countries. “In the United States”, reflects Mr Monks, “nobody minds Bill Gates making $49 billion. He is an American hero. There's no sense of the virtue of a homogenous culture.”

Bottom line:

Countries, like companies, will remain free to engineer greater or lesser degrees of equality. But there will be a price—as Sweden is discovering, and as Germany has already noticed. As the market for top talent grows more international, so it may force greater tolerance for inequality on countries that have spent half a century trying to root it out.

HT: Bill Wilson

Product Differentiation

 Competition seems to be heating up.

Did Trump's tariffs increase domestic employment?

President Trump campaigned on one issue, jobs.  His 25-50% tariffs on imported Washing Machines seemed to have induced the two biggest importers to speed up the construction of US Washing Machine plants (in SC and TN):

South Korea’s washing machine exporters to the US, Samsung Electronics and LG Electronics, on Wednesday said they will start operations of their new plants in the US as early as possible to minimize the possible impact of a likely sanction on their products.

Samsung and LG on Wednesday expressed concerns about the US International Trade Commission’s recommendation to the Donald Trump administration to impose a 50 percent tariff rate on large residential washer imports that exceeded a quota of 1.2 million units for a duration of three years in addition to the current rates of duty.

So, while the tariffs harm consumers with higher prices (for both washers and dryers), they have also increased domestic demand for labor, at least in this one industry.

Kids pay a price for staying close to home

Chapter 9 suggests that people have to be compensated for taking harder jobs, e.g., undertakers earn a premium for the work they do.  But the obverse of this is also true, that if you take more pleasant jobs, e.g., because they are close to home, you pay a penalty.  Marginal revolution reports on evidence of what they call "mobility shocks" on kids who were forced to move from a town where a third of the houses were covered by lava:

...estimates suggest that being induced to move by the “lava shock” dramatically raised lifetime earnings and education.

However, parents who were forced to move were slightly worse off.

Anheuser-Busch categorization of beer drinkers

• 38% of beer consumers—the largest segment—are Loyalists. These are the core beer drinkers; they do a lot of their imbibing on premise and tend to socialize around beer and sports 
• 25% are Experimenters. These are people who have a passion for beer and are less price sensitive. They’re looking for unique taste profiles and variety and gravitate toward craft brews 
• 15% are Aspirers. Ethnic groups are more dominant in this segment and they tend to drink imported beers 
• 12% are Trend Seekers. These consumers are all about creating memorable events around social occasions. Food/beer pairings are a popular way for this group to connect 
• 10% are Sippers. There’s a skew toward females in this group, and beer is usually not their first beverage of choice. Sippers are spurring the growth of sweeter, fruity beers.

Link:  2017 study of the US beer market

Housing prices: does tight supply make 2021 different from 2008?

In past posts, we have characterized housing supply restrictions as a homeowners cartel in that they benefit homeowners by limiting what their neighbors can do with their property. MarginalRevolution.com summarizes evidence that regulations are limiting increase of housing supply.  Since supply cannot respond, price adjusts instead.

 

How to sequester carbon cheaply: buy a coal mine!

• Each ton of burned coal produces 2.5 tons of carbon dioxide. 
• A coal mine sells for about $1/ton of coal reserves.  
• It costs about $100/ton to take the resulting carbon dioxide out of the air and sequester it.  

So, rather than burning coal and paying $100/ton to sequester the resulting CO2, why not buy the coal mine and close it, for only $0.40/ton of CO2.  

Am I missing something?

HT:  Marginal Revolution

Will driving data lead to better insurance pricing?

 Chapters 19 and 20 talks about the problems of adverse selection and moral hazard caused by asymmetric info.  This makes car insurance difficult to buy because you know whether you drive carefully, but the insurance company does not.  Better information, e.g., by letting your insurance company monitor your driving via your cell phone location, will reduce prices for good drivers and raise them for bad ones.  

In lieu of good information about driving, insurance companies use proxies like credit score: those with higher credit scores pay lower car insurance rates.  

Now Allstate is leading an industry-wide group who wants track your driving to determine your insurance rates:

With telematics, insurers monitor policyholders’ driving behaviors either through smartphone applications or devices embedded in their vehicles. Insurers slice the tracking data to tailor individual rates. 

While a switch could be unsettling to many people with privacy concerns, it would hold out the possibility of lower rates for vehicle owners who are excellent drivers or don’t drive that much, and who might now be overpaying for the risk they pose.

Bottom line:  delivering this kind of info to insurance companies reduces the information asymmetry (drivers know more about their expected risks than do insurance companies) which can mitigate the effects of adverse selection and moral hazard.  

The Peltzman Spike

Over 40 years ago, Sam Peltzman studied the behavioral changes from the 1968 adoption of a mandatory seat belt law. Before then, seat belts were an option that many new car owners had forgone (like the original owner of my first car, a 1964 VW bug). Engineers had estimated thousands of lives would have been saved had crash victims only been restrained. Their estimates were high. They had not accounted for the additional crashes. Once drivers were safer given a crash, they could drive a little faster and a little more recklessly and still be just as safe as without the seat belt. The net effect of more drivers surviving crashes, but more of them, was a smaller reduction in auto fatalities than had been predicted.

Peltzman's findings were controversial at the time but spawned a slew of research into how safety regulations affect behavior. The story goes that at one presentation, Walter Oi noted that car crashes also cause negative externalities. That is, often you crash into someone else causing harm to them as well as to yourself. The usual remedy for negative externalities is to make the reckless behavior more expensive, not less. Oi suggested that instead of seat belts, we should include a sharp spike on the steering column. The possibility of impaling oneself on "The Peltzman Spike" would focus the mind on avoiding crashes.

Nobel awarded for inferring causality

This year's Nobel prize in econ goes to three economists who developed methodologies for identifying correlation from causality.  

We have blogged extensively about why causality is important to business and how to design experiments or analyses to identify it.  In particular, use the web app to teach regression to understand the two mistakes you can make:  Type I (mistakenly inferring causality) and Type II (mistakenly inferring no causality) errors occur.  Try the learning exercises in this paper:

 A Simple Way to Teach Regression

Vanderbilt Owen Graduate School of Management Research Paper

15 Pages Posted: 10 Jan 2020 Last revised: 5 Aug 2021

Luke M. Froeb

Vanderbilt University - Owen Graduate School of Management

Date Written: August 05, 2021

Abstract

This paper introduces a simple free web app that can teach regression to anyone who can point and click. Originally designed to teach Justice Department attorneys enough about regression so that they could cross examine rival experts, the app ``inverts'' the usual pedagogy: instead of showing users how to run regressions on data, it asks them to click on a graph to ``create'' data to achieve a given outcome, like a statistically significant line. Successful completion of each task is rewarded with immediate feedback that reveals the principle behind the exercise. This paper describes short, intuitive exercises to teach: (i) hypothesis testing, statistical significance and confidence intervals, (ii) the difference between correlation and causality, and (iii) how to diagnose functional form mis-specification. These exercises can be completed in just a few minutes.

Keywords: Teaching Regression; statistical significance; correlation vs. causality

JEL Classification: A2 (Economic Education)

Suggested Citation:

What does a bursting bubble look like?

Like China's property market:

As China enters what many economists say is the final stage of one of the largest real-estate booms in history, it is confronting a staggering bill: More than $5 trillion in debt that developers took on when times were good, according to economists at Nomura Holdings Inc.

That debt is nearly double what it was at the end of 2016 and is more than the entire economic output of Japan, the world’s third-largest economy, last year.

Global markets are braced for a possible wave of defaults, with warning signs flashing over the debt of about two-fifths of development companies that have borrowed from international bond investors.

Chinese leaders are getting serious about addressing the debt, with a series of moves meant to curb excessive borrowing. But doing so without torpedoing the property market, crippling more developers and derailing the country’s economy is quickly turning into one of the biggest economic challenges Chinese leaders have faced in years, and one that could reverberate globally if mismanaged. ...

Some prospective home buyers are balking, forcing the companies to cut prices to raise cash, and potentially accelerating their slide if the trend continues.

Gender and majors, happiness, single-sex education, and for-profit education

 Interview with Claudia Golden:

On why men are more likely to major in economics:

One of the problems that we have, as a field, is that when students — before they even come into their freshman year, and they’re asked what do they want to major in, women will — if they want to major in the social sciences — will put down psychology, and men will put down economics, so we lose them before they even unpack their suitcases.

On happiness:

...people recenter their happiness. You can be in a place in which, if you were plunked down there from somewhere else, you’d be miserable, and yet, you’re there, and you recalibrate yourself, just like people recalibrate themselves when they have a bad health event. It takes a while. 

On single-sex education:

...I had girlfriends, but I enjoyed being around the boys a lot more. I went to Bronx Science, which was about two-thirds boys. When I applied to college, I just could not imagine going to an all-girls school. Now I know the arguments in reverse, and I respect them, but it was certainly not for me. 

On some for-profit education:

[e.g., students who want a quick business degree at a for-profit university] are not as aware as they should be of what they’re getting themselves into. They are often very needy. They’re low-income. They’re first-generation college. Someone is dangling in front of them something that they really want. They desperately want something that’s going to get them out of the hole that life has put them in. That person who’s dangling it is not giving them sufficient information and sufficient amount of time to get out of this contract.  ...

The for-profits that give short courses that give a one-year certification in, let’s say, medical technicians — what we’ve shown in our work, those are not the big problem. 

 

Price vs. Value

 Good post from Merle Hazard on the difference between Value and Price:

Simply put, price is what you pay for an investment, and value is what you get. ...Given that "price" and "value" are different, it is possible that the market quotation for an investment, its price, may be higher or lower than value. 

...Investors tend strongly to fall into one of two camps. 

Most primarily see publicly traded stocks, for example, as something akin to baseball trading cards. They are focused on price, not the underlying economics. ... If you have to sell in a hurry, it is impossible to deny that you are in the hands of others.

On the other hand, value believers see stocks as real pieces of real businesses, with an intrinsic worth independent of what others say. ... ...the "value" perspective yields the wisdom that a stock represents a real piece of a real business. As an owner, you have certain rights, like voting, electing directors, and getting your share of a dividend or liquidation. In the very long run, shareholders necessarily earn what the business earns.

Should we ban private label brands?

Democrat Rep. Cicilline thinks so:  

Rep. Cicilline says, “you can be one or the other. You can't set all the rules, control the marketplace, and also sell on it.” What he forgets is that vertical integration benefits consumers and businesses alike. If America followed Cicilline’s way, this new law would drive up the prices of everyday goods. In fact, it would be illegal for CVS to sell generic over-the-counter medications, leaving low-income Americans with fewer options and higher prices.

And don't forget the beneficial effect that private brands have on competition within a store:

And most consumers like having these generic brands as options because they’re cheaper, force prices down of name brands, and can even push companies to improve their quality.

So who benefits from this?  Rival brands.  

BOTTOM LINE:  Antitrust laws protect competition, not competitors.

TRUTH IN BLOGGING DISCLOSURE:  I wear only Kirkland.     

Danish Criminals respond to incentives

The Effects of DNA Databases on the Deterrence and Detection of Offenders

Anne Sofie Tegner Anker, Jennifer L. Doleac and Rasmus Landersø

This paper studies the effects of adding criminal offenders to a DNA database. Using a large expansion of Denmark's DNA database, we find that DNA registration reduces recidivism within the following year by up to 42 percent. It also increases the probability that offenders are identified if they recidivate, which we use to estimate the elasticity of crime with respect to the detection probability and find that a 1 percent higher detection probability reduces crime by more than 2 percent. We also find that DNA registration increases the likelihood that offenders find employment, enroll in education, and live in a more stable family environment.

Full-Text Access | Supplementary Materials

Here is the mechanism:  Higher probability of detection ==> lower expected profits from criminal activity ==> less crime

Why is Bezos such an extraordinary manager?

Reading Amazon Unbound by Brad Stone, his second bio of Jeff Bezos and Amazon, which picks up where The Everything Store left off.  In the book, Bezos punishes managers for wasting time on small incremental--and successful--projects. 

It is as if Bezos recognizes the perverse incentives created by ordinary managers, who punish employees for making the more-visible Type I errors (doing something that they shouldn't), rather than the less-visible Type II errors (failing to do something they should).  Typically this kind of reward asymmetry leads to fewer Type I errors but more Type II ones. 

But in an innovative environment, Type II errors typically have bigger costs, so it is incumbent on managers to find a way to avoid them.  So Bezos rewards managers who fail spectacularly in pursuit of something big and punishes those who succeed at timid, incremental change.   

Less of other peoples' money is funding insurance

Health insurance costs about $20,000, 3/4 of which is paid by your employer.  One way to keep costs down is to raise deductibles.  This reduces costs is two ways:

1. By reducing consumption of low value care (moral hazard); and
2. By giving consumers an incentive to shop for lower price and higher quality care

HT:  MarginalRevolution.com

Why is auto insurance more expensive if you pay monthly instead of every six months?

Because insurance companies use monthly payments as a screen.  By offering a big discount if you pay for six months, you screen out bad drivers, who cannot afford to do that.  

This screen works for the same reason that screening on credit scores works, there is a positive correlation between credit scores and expected costs of insuring a driver.   

Using credit history to price car insurance

In 2007, the FTC's Bureau of Economics just relased their FACTA study, which concludes that:

1. Credit scores effectively predict ... the total cost of [auto insurance] claims.
2. Credit scores permit insurers to evaluate risk with greater accuracy, which may make them more willing to offer insurance to higher-risk consumers ... . [note: this is why you can call up GEICO, let them look at your credit report, and get an auto insurance quote over the phone].
3. ..as a group, African-Americans and Hispanics tend to have lower scores than non-Hispanic whites and Asians.
4. ...scores effectively predict risk of claims within racial and ethnic groups.
5. The Commission could not develop an alternative scoring model that would continue to predict risk effectively, yet decrease the differences in scores among racial and ethnic groups.

So even though credit scores help insurance companies price insurance more accurately, point 3 implies that some groups pay more, on average, than others. The policy issue behind the study is whether the government ought to ban the use of credit history for anything but making loans. As point 4 implies, banning the use of credit scores would result in higher prices for good drivers, regardless of their race or ethnicity.

Theory tells us that in states which ban the use of credit scores to price insurance (California and Massassachusetts) insurance companies would find it more costly to distinguish high from low risks, so they may lump them together (called "pooling"), and price insurance at the average risk. Or they may be concerned that only high risks would be willing to buy high-priced insurance (what economists call "adverse selection") and price high or, if price controls prevent high prices, exit the market.

I would be curious if any of our readers know of novel uses of credit scores as a screening mechanism, or if they have developed better predictors (point 5) in a particular application, like pricing insurance or screening job applicants.

Big data and the curse of dimensionality

I just finished a fabulous book, Everybody Lies, written by Seth Stephens-Davidowitz.  From the Amazon description of the book:

Everybody Lies offers fascinating, surprising, and sometimes laugh-out-loud insights into everything from economics to ethics to sports to race to sex, gender and more, all drawn from the world of big data. What percentage of white voters didn’t vote for Barack Obama because he’s black? Does where you go to school effect how successful you are in life? Do parents secretly favor boy children over girls? Do violent films affect the crime rate? Can you beat the stock market? How regularly do we lie about our sex lives and who’s more self-conscious about sex, men or women?

I particularly liked the metaphors that Stephens-Davidowitz uses to describe his results.  For example,  in describing why it is easy to come up with variables that correlate with the stock market, but hard to find ones that can make accurate predictions, he uses the metaphor of coin flipping:

Suppose your strategy for predicting the stock market is to find a lucky coin -- but one that will be found through careful testing. Here's your methodology: You label one thousand coins - 1 to 1,000. Every morning, for two years, you flip each coin, record whether it came up heads or tails, and then note whether the Standard & Poor's Index went up or down that day. You pore through all your data. And voila! You've found something. It turns out that 70.3 percent of the time when Coin 391 came up heads the S&P Index rose. The relationship is statistically significant! Highly so! You have found your lucky coin! 

Just flip Coin 391 every morning and buy stocks whenever it comes up heads. Your days of Target T-shirts and ramen noodle dinners are over. Coin 391 is your ticket to the good life!

Every statistics user should know that when running 1000 hypothesis tests, on average 50 of them will show statistically significant results, even when there is no relationship.  This is the size of Type I error (5%) in classical hypothesis testing.

Instead, split your sample in two and use half the data to "find" (estimate) one lucky coin; and the other half to test it.

BOTTOM LINE:  the more tests you run, the more likely it is that at least one of them will show a statistically significant relationship, even if there is none.  This is likely behind what has become known as the replication crisis, that has hit the field of psychology particularly hard as only one third of the results from the most cited articles could be replicated.  It is likely that academics are testing lots of hypotheses and publishing the few that turn out to be statistically significant.  This is analogous to finding a lucky coin, as it only appears to be lucky.  Once you test it outside the sample, the luck disappears.

TRUTH IN BLOGGING:  the field of economics has its own replication crisis, only two thirds of top results could be replicated.

Density is green!: California housing supply to increase.

Restrictive zoning laws have decreased supply and driven up housing prices in almost every state, especially in California. This has led states to build "affordable housing" to combat the problem that their own restrictive zoning laws created. But now, the California Governor is trying to attack the zoning problem directly.

Newsom previously had shaken up single-family zoning by signing legislation that allowed more homeowners to build in-law units on their properties. SB 9 takes that further, allowing property owners to build up to two duplexes on what was once a single-family lot.

However, the usual suspects [we hypocrites] are opposing density that reduces sprawl, pollution, and traffic:

Slow-growth group Livable California, which has pushed back against SB 9, called it a “radical density experiment” and worried developers would use it to remake neighborhoods without community input.

In case I have to translate, "community input" means "no new supply" which raises the price of housing which benefits older, richer homeowners who are likely to vote; and hurts younger, poorer would-be homeowners who are less likely to vote.

 

HT: The Pamphleteer

Is it time to adapt by buying land in Alaska?

People are concerned about climate change:

...a recent 10-country study showing the fears of young people about climate change. Four in 10 are afraid to have children. Almost half said that fears about climate change caused them stress and anxiety in their daily lives.

 Its estimated effects will be different for different regions:

...the hottest regions in South America, Africa, India and Australia experience welfare losses of 15% and the coldest regions in Alaska, Northern Canada, and Siberia undergo welfare gains as high as 14%. On average, the world is expected to lose 6% in terms of welfare...

The net estimated effect is negative but very uncertain:

One recent estimate suggests that climate change is likely to destroy about 10% of global welfare ... by the year 2200. To the economist, that is a truly significant quantity of resources. Furthermore, the distribution of those losses may [will] be unfair ...

But the future belongs not to the strong, but rather to the adaptable.  

HT: MarginalRevolution.com  

Good metaphor for tradeoffs associated with a bigger safety net

To communicate ideas, we need metaphors.  Greg Mankiw has a good one in this mornings NY Times, Can America Afford to Become a Major Welfare State?

Providing a social safety net is like using a leaky bucket to redistribute water among people with different amounts. While bringing water to the thirstiest may be noble, it is also costly as some water is lost in transit.

In the real world, this leakage occurs because higher taxes distort incentives and impede economic growth. And those taxes aren’t just the explicit ones that finance benefits such as public education or health care. They also include implicit taxes baked into the benefits themselves. If these benefits decline when your income rises, people are discouraged from working. This implicit tax distorts incentives just as explicit taxes do. That doesn’t mean there is no point in trying to help those in need, but it does require being mindful of the downsides of doing so. ...  

most European nations use that leaky bucket more than the United States does and experience greater leakage, resulting in lower incomes. By aiming for more compassionate economies, they have created less prosperous ones. Americans should be careful to avoid that fate.

Hidden Costs of Software Migration

Like many universities, some researchers at mine have sensitive data. Since a data breach would be calamitous, all university computers, laptops and desktops, must be encrypted. We just changed vendors for our encryption software. The new vendor requires a new version of the operating system. This requires backing up all of the data on a computer, installing the new OS and encryption functionality, and then reinstalling the backed up data (more on this in a later post). The process requires each computer user to bring their computer to our IT department and be present to provide log in credentials multiple times. If all goes smoothly (more on this in a later post), the process takes 2-3 hours of both the user's time and the techie's time. They estimate that this must be done for 7,000 university computers.

It will take 14,000 to 21,000 hours of just techie time, or 7 to 10.5 person-years at 2,000 hours per work-year to accomplish this task. I think this means that about half of the IT department's staff will be working on just this task full-time for a year. Suppose the average of techie's and staff/faculty salary is $80,000 to $100,000. This means that for a 2,000 hour work year, each hour is worth $40-$50 not counting benefits. The total value of lost time could easily be in the $1.1 million to $2.1 million range. I strongly suspect these costs were not fully taken into account when selecting the new vendor. I strongly suspect that this is greater than the marginal benefits from the new vendor.

Arbitrage Negotiation Scene

 

HT: Bob Laws

Mike Rowe: Do NOT follow your passion

HT:  MW

related: "Do what you are good at" commits the hidden-benefit fallacy

The paradox of ESG investing

ESG definition:

• Environment. What kind of impact does a company have on the environment? 
• Social. How does the company improve its social impact?
• Governance. How does the company’s board and management drive positive change? 

John Cochrane has a good post on how it effects change:

The point of ESG investing is to lower the stock price and raise the cost of capital of disfavored industries, and therefore slow down their investment.

If it works, it raises the cost of capital to non-ESG firms, which lowers the Net Present Value (NPV) of their investments (because they have higher discount rates). As a consequence, non-ESG firms get very picky, and invest only in projects with higher rates of return. 

On the other side of the coin, NPV investing lowers the cost of capital to ESG firms, which raises the NPV of their investments (because they have lower discount rates). As a consequence, ESG firms get less picky and invest in more projects with lower rates of return. 

The paradox: "if you don't lose money on ESG investing [relative to non-ESG investing], ESG investing doesn't work. Take your pick." 

========ANTICIPATING BLOWBACK=========

from those who cite studies showing that ESG firms do better on average than non-ESG firms.

If this were the case, I would guess that the causality runs in the opposite direction, i.e., from successful firms who invest in ESG projects because they can afford it.  Cynically, this could be a form of virtue signaling to attract consumers who identify with ESG causes.  

As the Financial Times warns:

investors should be more discriminating in how they assess corporate capabilities rather than swallowing hook, line and sinker evaluations from investment houses desperately inflating their so-called ESG portfolios to meet the huge surge in investor demand.

Price discriminating against brides seems profitable

The wedding industry is notorious for sticking it to brides.   But whether this is due to price discrimination or higher costs (brides can be demanding) is still a matter of debate.  But here is an example that seems clear:

As I wrote in the column, part of the reason that retailers can get away with charging higher prices for wedding-related services is that spouses-to-be probably have stronger preferences for their “special day” than consumers shopping for other kinds of events do. That means they’re less price-sensitive. In the case of gowns, for example, brides probably have much more specific requirements for their own dresses than for the dresses that their bridesmaids will wear, allowing retailers to charge different prices for each, regardless of what material or labor costs go into the respective frocks.

I classify this as direct price discrimination because retailers identify the bride, set separate prices, and prevent arbitrage.  

HT:  JC

Jeff Bezos does HR

Reading Amazon Unbound by Brad Stone, his second bio of Jeff Bezos and Amazon, which picks up where The Everything Store leaves off.  

It is amazing how much Bezos involves himself in the details of running the company.  For the many of problems that Amazon faced--Kindle, Alexa, expansion into India, Mexico, and Brazil, or even HR--Bezos would form a team, give them an insane deadline, and dive into the details himself.  

Most significantly, Bezos is not afraid to make mistakes.  He initially tried detailed performance reviews, but then moved to a something simpler, and easier for employees to digest.  Explaining the change to his board of directors, he said of the old way "its like telling your wife how great she is, and then adding, `but you are a little overweight.'  She won't remember anything else."

Differences-in-DIfferences explained, albeit with a macroeconomics example

Another great video from MRU.  Teaches students how to "create" natural experiments using non-experimental data.  

To complement this video, try the "Hidden Causality" and "Spurious Correlation" exercises for this free web app described in A Simple Way to Teach Regression.

Costco's profit comes mostly from membership fees

 In 2018, Costco's profit was equal to its membership fees.  In 2020 membership fees were 87% of profit.  These barely profitable prices (only 30¢ out of every $100 in sales is profit) increase demand for Costco membership.   In other words, people pay to become Costco members because they get very good prices, on average.  

HT:  Merle Hazard

Odds of dying from break-through Covid vs. other risks

 

Vaccine inequality

From The Economist:

By late August 2021 around 60% of people in higher-income countries had received at least one dose of a vaccine. In poorer countries only 1% had.

The extended lockdowns have huge costs: 

The need to extend social-distancing measures, loss of revenue from tourism and business travel, and the likelihood of social unrest in the event of a prolonged struggle against the virus, among other factors, will all weigh on their economic trajectory.

 

Why would an air traffic controller deliberately put two planes on a collision course?

In 1974, it became more difficult for air traffic controllers to qualify for "burn out" disability insurance.  They needed some hard evidence that they were actually burned out.  

In response, some deliberately put planes on a collision course to generate "near misses" that would qualify them for disability.  The good news is that they did it in low-traffic periods so that the controller could closely monitor the two flights to make sure that they did not actually collide.  (link to article)

China gives the poor a bigger slice of the proverbial pie, but if it affects incentives...

...it will also make the pie smaller.  

The Economist reports on the efforts of the Chinese government to redistribute income from rich to the poor.  Chairman Xi has pronounced, “We must not allow the gap between rich and poor to get wider.” He seems to be channeling Confucious whose writings he frequently quotes, "a wise leader worries not about poverty but about inequality." 

 If this sounds familiar, it may be because the top 1% in China own 30.6% of household wealth; close to the US figure of 31.4%. The trick will be to redistribute income without muting the incentives that have made China so successful. 

[See earlier posts about the incentive aligning effects of private property in China]

Should physicians be bill collectors?

On the upside, physicians would see the bills as their patients see them, which would remind them of the tradeoffs associated with expensive treatments.

One the downside, physicians have to play the dual role of healer and bill collector.

FROM JAMA:

Through increasing deductibles, coinsurance, and co-payments, the privately insured population in the US is responsible for a larger share of health care out-of-pocket costs. Although many studies have examined the effects on patients, the implications for physicians have received less attention. The increase in cost sharing is forcing many physicians and health systems to take on the role of bill collectors. It is a task for which physician practices are unsuited. The result is a system with substantial administrative burden, frustrated patients struggling with confusing bills, and physicians receiving less compensation. This Viewpoint describes the drivers of this trend, the consequences for physician practices (with a focus on physicians but discussing issues relevant to a range of clinicians), a wave of new companies looking to solve the problem, and what might be done to improve the situation.

HT:  Allison

"Them Geezers is Bleedin' us Dry"

... or so claims a colleague of mine. He was referring specifically to their staunch defense of increased medicare spending. He might have been a bit untactful. I argued that it is likely appropriate to increase transfer payments for the medical care of senior citizens for at least two reasons. First, medical care has increasingly become effective. We have developed more treatments for more conditions and the pace of medical innovation is quite impressive. Or the marginal benefits of a dollar spent here has increased. Second, we are wealthier. We can better afford to subsidize others. Or the marginal cost has fallen. He grudgingly agreed but claimed this is not enough to account for the increase. When he told me expenditures per medicare enrollee increased tenfold, I was incredulous ... until I looked at the numbers. Sure enough, the number of enrollees increased somewhat, but expenditures per enrollee per year increased from ~$1,000 in 1980 to ~$10,000 in 2009. Folks, the automatic increases at this pace just aren't sustainable. I sure wish we could have an honest debate about it.

How did our underfunded public pensions do during the pandemic?

Previous posts have focused on the underfunding of public pensions caused by unrealistically high discount rates, e.g., 7%.  For these "defined benefits" plans, the states and cities usually do not save enough.

For example, if a pension fund needs to pay a teacher $100 in 20 years and uses a 7% discount rate, it must save 100/(1.07)^20=$26.  Then, if it invests $26 and earns a 7% return, the fund will have $100 in 20 years when the employee retires.  

However, if it earns only 4.7%, the fund will have only $26*(1.047)^20=$65, a shortfall of 35%.  

MarketWatch reports on a Boston College study of the effect of the pandemic on defined benefit pensions:

2020 funding of public-pensions to invest sector plans at 74.7%, up from 72.8% last year.

The good performance was due to the huge stockmarket gains.  Instead of using the gains to move to a defined contribution plan, like Wisconsin's, I fear the gains will sow the seeds of the next pension crisis by inducing pensions to increase the discount rate they use.  

Trust only 1/3 of the results from Pscyhology, but 2/3 of the results from behavioral economics

Dan Ariely (psychologist and behavioral economist) was forced to retract a well-cited paper based on fraudulent data. Ariely, a frequent TED Talk speaker and a Wall Street Journal advice columnist, cited the study in lectures and in his New York Times bestseller The (Honest) Truth About Dishonesty: How We Lie to Everyone — Especially Ourselves. We have blogged about Ariely's work and want to warn readers that we may have retract the blog posts, pending the outcome of an internal investigation.  

Professor Ariely's problems are part of a larger "replication crisis." It began when the journal Science found that only 1/3 of the psychology experiments underlying the most cited papers in the field of psychology  could be replicated.  A bigger and more recent study finds much the same thing.  [Behavioral Economics does better than psychology, as 2/3 of the results can be replicated.]

Contributing to the crisis is what is called HARK, Hypothesis After Results Known.  Due to the pressure to publish statistically significant results, researchers do science backward.  They begin by looking for a statistically significant result (p hacking).  Then, they specify an hypothesis to explain it.  Now, good practice requires that researchers register hypotheses before testing them.  Note that a similar problem plagues non-experimental data as well (regression fishing).

We regularly blog about deviations from the rational actor paradigm, and include some of the more useful results in our textbook, notably loss aversion (losses hurt more than gains help), and hyperbolic discounting (overweighting the present).  To the extent that these findings cannot be replicated, we could be wrong.

For the sixth edition, we will do our best to determine whether these Behavioral Economics results can be trusted.  For now, place a 2/3 weight on them being right.  

Grow a pony tail and cut taxes

The strategy employed by the Swedish Finance Minister seems to be working.

He continued to cut taxes and cut welfare-spending to pay for it; he even cut property taxes for the rich to lure entrepreneurs back to Sweden. The last bit was the most unpopular, but for Borg, economic recovery starts with entrepreneurs. If cutting taxes for the rich encouraged risk-taking, then it had to be done. "In most cases, the company would not have been created without the owner," he says. "There would be no Ikea without [Ingvar] Kamprad. We would not have Tetra-Pak without [Ruben] Rausing. They are probably the foremost entrepreneurs we have had in the last few decades, and both moved out of Sweden."

HT:  Carpe Diem

Price transparency at last!

Colleague Larry van Horn's efforts to require negotiated prices between payers (insurance companies) and healthcare providers (doctors, hosptials) be made public are about to bear fruit.   Larry showed that

Even when insurance covers the cost, there is, on average, a 300 percent price variation within a market for the exact same services.

As a special advisor to President Trump, Larry encouraged the President to force the bargaining pairs to make public their negotiated prices.

The first data is now trickling out and the NY Times seems to approve, and gives President Biden credit for not reversing Larry's efforts:

The requirement to publish prices is a rare bipartisan effort: a Trump-era initiative that the Biden administration supports

MEA CULPA:  

17 years ago, when I was Chief Economist at the FTC, I wrote a letter to the California legislature suggesting that price transparency would have the opposite effect.  At the time, my thinking was that (i) transparent prices could facilitate collusion; and (ii) a provider would be more likely to accept a lower price if the provider did not have to disclose it to others.  I was primarily concerned with protecting bargaining competition, and I didn't grasp the perverse incentives of the bargainers.  As the NY Times notes:

The insurer also may not have a strong motivation to [negotiate lower prices], given that the more that is spent on care, the more an insurance company can earn.  

Vanderbilt alum Richard Stephenson is quoted in the Times article and runs Redu Health, a "national self-pay discount network empowers employees and members ... with transparent, upfront pricing."   

We are so busted!

 https://freakonomics.com/podcast/reasons-to-be-cheerful-rebroadcast/

Good but long podcast.  This caught my eye:

BAUMEISTER: …And incidentally, professors complain a whole lot. I remember visiting a university and I was having a conversation like this. I say, “This is a wonderful job,” and so on. And they looked at each other and said, “Well, we never say that out loud. You have to always be complaining. Otherwise, the administration won’t give us a raise. We always have to act like everything’s awful.” 

Economists vs. environmentalists

 Economics and environmentalism are belief systems that shape their adherent's way of thinking about the world.

                                                --Robert H. Nelson (link) 

When I earned my PhD, I started doing God's work (link to funny essay, "The Market as God") at the Justice Department, challenging anticompetitive mergers and putting price-fixers in prison.  My housemate was trying to do the same at the Environmental Protection Agency, using marginal analysis to design incentives to get polluters to face the consequences of their behavior.  If polluters produce up to the point where

    MR=MC

an output tax equal to the harm they cause, T=P, would bring pollution down to the point where the benefits of producing more are equal to its costs, including the costs of pollution.

    MR=MC+T.

There is legitimate debate about the magnitude of P but the principle seems obvious.  But not to [some/many?] environmentalists at the EPA.  They worship another God, and view all pollution as heresy.

In 2009, this debate made it up to the Supreme Court, where the economists prevailed, 6-3:

...the Supreme Court overturned [Sotomayor's earlier appellate decision that straightforward benefit-cost analysis was illegal] in a 6-3 ruling...

For the time being, benefit-cost analysis is OK.  

Training Artificial Intelligence to not discriminate

The top book review on Amazon reduced Prediction Machines to three propositions: 

• Artificial Intelligence (AI) is mostly about prediction 
• The cost and price of prediction is falling, 
• This will increase demand for complementary skills, like judgement and decision making.

As the cost of developing predictions has fallen, tremendous innovation has followed.  For example, AI can identify tumors with much greater accuracy than humans.  

However, AI can also identify race with "frightening" accuracy:

Whatever the algorithms were seeing, they saw it clearly. The software could still predict patient race with high accuracy when x-rays were degraded so that they were unreadable to even a trained eye, or blurred to remove fine detail.

To see how this could create problems, imagine training AI to diagnose and treat patients.  And imagine that the training set reflected the racial disparities sometimes associated with healthcare, i.e., minorities are under-treated or under-diagnosed relative to non-minorities.  With such a training set, the AI would "learn" to continue the disparate treatment.  

The director of medical imaging research at Royal Adelaide Hospital, calls AI's ability to recognize race “the worst superpower.”

House affordability

 

We have blogged extensively about the zoning restrictions that restrict the supply of new homes and raise the price.  

Historical Knockout Auctions

The Journal of Political Economy, one of the more prestigious economics journals, gets submissions of interesting economics related anecdotes for its back cover. The most recent issue contained this:

Collusive Bidding and Intermediary Profits in Congo a Hundred Years Ago

Five traders, who have hurried up in their cars, were waiting for the market to open. The region here has not been conceded; the market is free and the bidding began at once. We were surprised to see it stop almost immediately. But soon we understood that these five gentlemen were making a ring. The first carried off the whole crop for seven francs fifty a kilo, which probably seems a very fair price to the native, who only recently was selling his rubber at three francs; but at Kinshassa, where the traders resell it, it has fetched for some time past between thirty and forty francs, which leaves a very respectable margin. What about our gentlemen? As soon as the business is concluded with the native, they meet together privately in a little room, where another auction begins and they divide the spoil among them. The administrator is powerless against this secret auction, which, with every appearance of being illicit, does not, I am told, come within the power of the law.

[Andre Gide, Travels in the Congo (1927), translated by Dorothy Bussy (Hopewell, NJ: Ecco, 1994), p. 45. See also Daniel Graham and Robert Marshall, “Collusive Bidder Behavior at Single-Object Second-Price and English Auctions,” J.P.E., vol. 95, no. 6 (December 1987), 1217–39]

(Suggested by Laurent Lamy)