An economist who put a premium on truth: Obituary of Leonid Hurwicz.

Financial Times comment, 19 July 2008
Leonid Hurwicz, the economist who last year became the oldest person ever to win a Nobel prize, helped transform economic thinking in the second half of the 20th century.
For years economists had been passionately debating the rival merits of state planning versus free markets. In both systems, people had incentives to lie to bureaucratic planners or to employers about their interests, their skills or their circumstances. “Leo”, who has died at the age of 90, founded the field of “mechanism design”, a new way of thinking which focused on giving people incentives to tell the truth and to do so in a way that would benefit society as a whole.
His mechanism design idea has applications in a range of practical areas, from the design of computer networks and voting systems to arbitration rules.
The debate between state planning and free markets must have seemed far from academic to Hurwicz. His parents were Polish Jews who fled the Kaiser’s invading army, going to Moscow, where Hurwicz was born in 1917. They returned to Poland in a horse-drawn wagon to escape the Bolsheviks when he was two. (more…)

Bargains that aren’t.

First published: Parade Magazine, 13 July 2008

Not everything that seems like a bargain will really end up saving you money. Luckily, behavioral economists are finding the gimmicks and tricks that regularly lure us to spend more. Read this—and don’t get caught!

ANYTHING YOU BUY ON CREDIT
Putting a purchase on a credit card with a zero interest rate may seem like a good deal, but you’re less likely to shop frugally when you’re using it—or any kind of credit card. MIT researchers Drazen Prelec and Duncan Simester ran an experiment in which two groups of subjects were allowed to bid on tickets to sporting events. One group had to pay in cash within 24 hours, the other with a credit card. The credit-card group offered much more for the tickets—and more than twice as much for a sold-out game. Other studies suggest that people who pay with plastic spend more and tend to forget how much they spent. (more…)

The cost of curbs on immigration.

Humans don’t take kindly to outsiders: history is heaped with the corpses of those who were lynched, bayoneted or gassed because of their race, religion or nationality. Even within the relatively civilised sphere of economic relations, there is plenty of room for discrimination. People earn less because of their race or their sex, even in the richest countries in the world.

For example, according to a recent summary by the economists Michael Clemens, Claudio Montenegro and Lant Pritchett, white men earn 27 per cent more in the US than white women. That figure compares the hourly wage of full-time workers with similar qualifications and experience. Again making best efforts to compare like with like, the economists found that white men earn 7 per cent more than black men in the US. Look back to 1939, and the like-with-like wage premium for whites in the US was 60 per cent. In modern Pakistan, meanwhile, men earn three times as much as equally qualified women. None of these numbers is trivial: most are appalling.

It is even possible – although perhaps only an economist would think it pertinent – to calculate the implicit wage loss suffered by US slaves. Several economists have attempted to do this by comparing the “compensation” – food, clothes, shelter and perhaps some medical care – received by slaves with how much one slave-owner would pay another to rent a slave. Of course, low wages were hardly the chief reason that slavery was an atrocity. Yet had slaves earned for their labour what slave-owners paid each other for it, the wage would have been three or four times higher than the basic subsistence owners saw fit to provide.

There is a huge gap between what slaves would have earned in a free labour market and what in fact they were forced to accept. But the gap is dwarfed by the difference between what a Nigerian-born, Nigerian-educated man could earn in the formal sector in Nigeria, and what he could earn if allowed to work in a rich country – more than eight times as much. Nigeria is an extreme example, but there are many other countries in which all that would be needed to quadruple or quintuple a person’s income would be permission to work in a rich country. Restrictions on immigration cause a greater loss of wages than racial and sexual discrimination – and perhaps greater even than slavery. This is what Clemens and his colleagues call “the great discrimination”.

This is unquestionably a research paper with an agenda: Lant Pritchett is a vocal advocate of more liberal immigration rules. Despite the agenda, I see no reason to doubt the numbers. Migrants from very poor countries see huge leaps in wages if allowed to move to wealthy countries – that much is obvious. The question is whether voters in wealthy countries feel morally obliged to take those gains into account. So far, they don’t.

Economists have a habit of poking these sore points. Steven Landsburg, author of The Armchair Economist, secured notoriety four years ago by labelling the vice-presidential candidate John Edwards a “xenophobe”, arguing that his protectionism arbitrarily privileged Americans over foreigners and was no better than arbitrarily privileging whites over blacks. Few non-economists see things that way.

Economists have always tended to be blind to distinctions of race, sex and nationality. In 1849, Thomas Carlyle branded economics “the dismal science” for its insistence that a market wage set by supply and demand was superior to slavery and what Carlyle called the “beneficent whip”. His view is now rightly branded abhorrent.

I have no idea how immigration barriers will be viewed by our descendants. But it is worth reflecting, if only for a moment, on the costs they impose on those trapped on the other side.

Also published at ft.com, subscription free.

A spot of car trouble.

I pay someone to clean my car three times a week. He usually does a good job of it. However, I often travel and as soon as I’m gone, the cleaner stops work. So I always come back to a dirty car.
I pay him even when I’m not around. Shouldn’t he at least clean the car the day before he knows I will return, thus pretending to have been cleaning it regularly?
DT, Bahrain

Dear DT,

I can think of three explanations for this behaviour. Either the cleaner is too stupid to realise he should be skiving more subtly, or he thinks you are too stupid to notice, or he does not care if you notice.

If he is stupid, or he thinks you are stupid – don’t ask which – the solution is easy: say you’ve noticed that the car is dirty and ask him to clean it before you return.

If he does not care, that means he can try to get an equally good job elsewhere. Since the current job comes with frequent paid holidays, that is unlikely – unless you are being especially stingy.

I suggest sharper incentives. Tell him you’ll pay him a bonus if you return to a clean car. Frankly, since you are paying him to clean an unused car, incessantly, and he isn’t doing it, any change is likely to be an improvement.

Also published at ft.com, subscription free.

Bankers are laughing all the way to the bank.

Going overdrawn can be an expensive business. In the UK, unauthorised overdrafts averaged £680m on any given day in 2006 – just over £10 per bank account. According to the Office of Fair Trading, the charges levied by banks on those overdrafts were £1.5bn, a tasty return of more than 220 per cent. Banks also make money by paying risible interest on positive balances – an incentive to keep your current account lean and, Doh!, to overdraw accidentally – and by other obscure charges. The Office of Fair Trading doesn’t like it and nor do many customers – although they rarely express their displeasure by switching bank accounts.

There are two common responses. People either grumble about money-grabbing banks or point out, smugly, that if only others would manage their affairs responsibly, they wouldn’t incur any of these charges.

There’s a certain amount of truth in both responses. Yes, banks are money-grabbing, but healthy competition would keep the greed in check. And, yes, careful customers are being subsidised, heavily, by careless ones. The trouble is that the whimsicality of the pricing makes it hard to find out which bank is offering a good deal. Most people realise that overdraft charges are steep, just as they realise that popcorn in cinemas is expensive and mobile-phone companies will all but pick your pocket if you make calls overseas. Knowing this doesn’t make it easy to find the best product, which means competition won’t work well. When competition works poorly, many customers lose out – even those who bring their own snacks to the cinema and use public phones on holiday.

So what’s the solution? One possibility is for regulators to step in and set price ceilings in such cases, or to ban more complex offerings. But once the tourism office starts fixing the price of a can of Heineken in your hotel fridge, that spells ossification and bad news for consumers in the long run.

Another possibility is better financial education – unobjectionable in itself, but an indirect attack on the problem of complex tariffs. The severity of that problem was clear when two economists, Chris Wilson and Catherine Waddams Price, tracked the attempts of customers to switch to cheaper electricity tariffs. Most picked up less than half of the available gains, and a quarter made themselves worse off.

I have heard one really good – and, I believe, genuinely new – solution, presented in the book Nudge, by Cass Sunstein, a law professor, and Richard Thaler, an economist with a particular focus on flaws in people’s decisions.

They advocate a system of mandatory electronic disclosure. Regulators would specify a standard electronic format in which banks would have to disclose all their fees and charges, and how they intersected with what the customer had actually done. (The idea could also work for credit cards, mobile phone services and others.) Each year, customers would receive an electronic file itemising exactly what they had done and exactly what it had cost them.

Thaler and Sunstein anticipate – correctly, I suspect – that if such electronic files existed in a standard format, other companies (Morningstar? Google? Microsoft? FT.com?) would quickly set up their own services. You would take your electronic bank account statement, upload it to Google Consumer, and be told in plain English how your bank had screwed you, and which bank would do a better job, given your particular banking habits. Even those who couldn’t or wouldn’t use such electronic advice would benefit from the sharpening of competition it would engender.

Implementing the idea may not be easy – but for those of us who think competition can occasionally be given a helping hand, it seems worth trying.

Also published at ft.com, subscription free.

Should I subsidise my partner?.

I have recently agreed with my student partner that she will move into my flat during the Edinburgh Festival so that she can sublet her room and pay for her half of our holiday together. She maintains that she should pay me for staying in the flat, whereas I argue that this would defeat the purpose of the exercise. How can we effectively resolve this dispute and look forward to our holiday? Should I simply charge her for any increase in my bills, or are there other considerations?
Ben, Edinburgh

Dear Ben,

Stop the tiptoeing about who pays what to whom. Let’s be blunt: she can’t afford this holiday, you can afford to subsidise her, but she doesn’t seem to want to incur too large a debt. It seems to me there are two solutions: an explicit contract, or an implicit one.

The implicit contract: quietly subsidise her holiday. Accept a little money from her as a tenant, and pick up a few of the extra holiday costs. The explicit contract: charge her the market rate for staying in your flat. Do not be surprised, however, if she begins to charge you for “services” provided either during her stay or on your holiday.

Choose whichever contract is to your taste. It will set the tone for your relationship – and the explicit contract may be cheaper in the long run.

Also published at ft.com, subscription free.

Never trust an economic forecast.

When people discover that I am an economist, they rarely ask me for my views on subjects that economists know a bit about – such as how to respond to climate change or pay less at a supermarket. Instead they ask me what will happen to the economy.

Why is it that people won’t take “I don’t really know” for an answer? People often chuckle about the forecasting skills of economists, but after the sniggers die down, they keep demanding more forecasts. Is there any reason to believe that economists can deliver?

One answer can be gleaned from previous forecasts. Back in 1995, the economist and FT columnist John Kay examined the record of 34 British forecasters from 1987 to 1994, and he concluded that they were birds of a feather. They tended to make similar forecasts, and then the economy disobligingly did something else, with economic growth usually falling outside the range of all 34 forecasters.

Perhaps forecasting technology has moved on since then, or is the British economy unusually unpredictable? To find out, I repeated Kay’s exercise with forecasts for economic growth for the UK, US and Eurozone over the years 2002-2008, diligently collected at the end of each previous year by Consensus Economics.

The results are an eerie echo of Kay’s: for 2004, for example, 20 out of 21 non-governmental forecasts made in December 2003 were too pessimistic about economic growth in the UK. The Pollyannas of HM Treasury were more optimistic than almost any commercial forecaster, and closer to getting their forecast right. So one might suspect that systematic pessimism is to blame.

But no, in 2005, the economy grew more slowly than 19 out of 21 forecasters had expected at the end of the previous year. At the Treasury, they were again more optimistic than anyone, and thus more wrong than anyone. A year later, all but one of the forecasters were too pessimistic again. Yet at the end of 2001, three quarters of the forecasters were too optimistic about 2002.

An interesting anomaly is 2003: the one year for which the average UK forecast turned out to be close to reality, but also the year where the spread between highest and lowest forecast was widest. The rare occasion when the forecasters couldn’t agree happened to be the occasion on which they were (on average) right.

Recent US forecasters have done a little better: the spread of forecasts is tighter and the outcome sometimes falls within that spread. Still, five out of six were too pessimistic about 2003, almost everyone was too pessimistic about 2002; three-quarters were too optimistic about 2005 and nearly nine-tenths too optimistic about 2006. Perversely, the most accurate forecasts were made about 2007, despite the fact that the credit crunch was a surprise to many.

In the Eurozone, forecasting over the past few years has been so wayward that it is kindest to say no more.

The new data seem to confirm Kay’s original finding that economic forecasters all tend to be wrong in the same way. Their incentives to flock together are obvious enough. What is less clear is why the flight of the flock is so often thought to augur much – but then, some astrologers are also profitably employed.

The curious thing is that forecasters often have something useful to say, but it is rarely conveyed in the numerical forecast itself on which so much attention is lavished. For instance, in December 2006, British forecasters were warning of the risks of an oil price spike, a sharp rise in the cost of credit, and a dollar crash. Their guesses at economic growth were wrong, and would have been little use had they been right. But the forecasters said something worth hearing – if you had been listening carefully enough.

Also published at ft.com, subscription free.

Should she have danced all night, or sat down.

While at a recent Elton John concert, I observed a heated altercation between two ladies. The younger lady wanted to stand up, dance and sing along with Elton. The older lady, seated directly behind her, wanted to stay seated, watch the band and enjoy the music. The older lady asked the younger to sit down, but was told that she should also stand up and dance. An argument quickly broke out. Any thoughts on how they might have resolved the conflict without swinging handbags?
David Walker

Dear David,

I blame Elton John himself, since he apparently did not clearly define property rights, contrary to the recommendations of the great economist Ronald Coase.

Should a concert seat come bundled with the right to get up and dance, the older woman could have offered to pay her tormentor to sit down. Conversely, should a seat come bundled with the right to an unobstructed view, it would have been the younger woman offering the bribe. Either way, the dance would have continued only if the dancer’s enjoyment outweighed its victim’s frustration. Perhaps the bargaining might also have involved swapping seats?

Sadly, with no clear property rights, there was no basis for a deal. No wonder the night turned out to be all right for fighting.

Also published at ft.com, subscription free.

Harvesting the fruits of your labourers.

For many business owners, getting the most out of staff is a perennial problem. In the case of fruit farmers, perhaps perennial is the wrong word: workers show up only for the summer harvest. In a couple of weeks they will be heading home, usually to a university course somewhere in eastern Europe.

Tough work for the fruit pickers, the business is also a headache for the owner, who must offer a pay scheme that both satisfies minimum wage laws and motivates workers in an industry in which slacking is an understandable temptation.

The owner of a large fruit farm business, “Farmer Smith”, was pondering the problem one Christmas, when he discovered that the connection between pay and performance was also an area where economists were scratching around for solid evidence.

And so an unlikely alliance was formed between Farmer Smith and the economists Oriana Bandiera, Iwan Barankay and Imran Rasul. The economists would design and administer pay schemes, and in exchange for that (and for confidentiality) Farmer Smith would let them treat his business as a gigantic laboratory for researching the nexus between pay, workplace friendships (which they mapped out) and workers’ productivity.

The owner had been paying a piece rate – a rate per kilogram of fruit – but also needed to ensure that whether pickers spent the day on a bountiful field or a sparse one, their wages didn’t fall below the legal hourly minimum. The owner tried to adjust the piece rate each day so that it was always adequate, but never generous: the more the workforce picked, the lower the piece rate. But his workers were outwitting him by keeping an eye on each other, making sure nobody picked too quickly, and thus collectively slowing down and cranking up the piece rate.

Bandiera and her colleagues proposed a different way of adjusting the piece rate – one that workers could not influence with a collective go-slow – and measured the result. By the time the experiment was over, Farmer Smith’s initial scepticism had long evaporated: the new pay scheme increased productivity (kilograms of fruit per worker per hour) by about 50 per cent.

The next summer, the researchers turned their attention to incentives for low-level managers, who would also be temporary immigrant workers, but who would be responsible for on-the-spot decisions such as which workers were assigned to which row. The researchers found that managers tended to do their friends favours by assigning them the easiest rows. This made life comfortable for insiders, but was unproductive, since the most efficient assignment for fruit picking is for the best workers to get the best rows.

The researchers responded by linking managers’ pay to the daily harvest. The result was that managers started favouring the best workers, rather than their own friends, and productivity rose by another 20 per cent.

Small wonder that the economists were invited back for another summer. They proposed a “tournament” scheme in which workers were allowed to sort themselves into teams. Initially, friends tended to group themselves together, but as the economists began to publish league tables, and then hand out prizes to the most productive teams, that changed. Again, workers prioritised money over social ties, abandoning groups of friends to ally themselves with the most productive co-workers who would accept them. In practice that meant that the fastest workers clustered together, and again, productivity soared – by yet another 20 per cent.

The series of experiments provided a fascinating confirmation that financial incentives can trump social networks, with some precision and much detail about the mechanisms involved. Bandiera and her colleagues have now stopped the experiments, in the belief that there is nothing more to be gained from this particular seam of inquiry. The owner does not seem to agree: he’s hired a consultant to keep on hatching new performance pay schemes.

Also published at ft.com, subscription free.

Why are friends such plonkers about fine wine?.

As a wine evangelist, I always bring a bottle of something really decent whenever I visit friends. The trouble is, their thanks rarely reflect my expenditure. Should I make more of a fuss about the cost of fine wine, or just bring plonk?
Gabriel Elliott, London

Dear Gabriel,

Either plan would work just fine. Several pieces of research by wine critics and “neuro-economists” have found that most wine drinkers pay more attention to price than they do to taste.

Research published by the Journal of Wine Economics shows that inexpert wine drinkers actually prefer cheap wine in a blind tasting. More skilled oenophiles do prefer pricier booze, but only a little. That suggests you should buy plonk with a nice label and a clear conscience.

The alternative is to point out the expense of the wine. This is crass, but should encourage people to rate it more highly.

Or you could bring plonk but claim it is expensive wine. The “neuro-economist” Antonio Rangel has found people enjoy wine more if they are told (truthfully or otherwise) it is expensive. Not only do they rate the wine more highly, but their brains seem to process the experience differently.

Your friends probably can’t tell the difference between expensive and cheap wine. Exploit that information as you wish.

Also published at ft.com, subscription free.