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Stanford University, based in California, has once again anticipated the future. In addition to providing subsidized housing to attract and retain faculty, faculty can now choose to be paid in water. The University has quietly been buying up farms to acquire ownership of water rights and has even signed futures contracts with the Great Lakes Regional Water authority for the delivery of water 15 years from now. In addition they have a joint venture with Elon Musk, to harvest water from comets. Google meanwhile, is behind the curve. They’ve only gone as far as allowing their employees to take long showers on site.

Having caught your eye, I direct you to an article in the April 9, 2015 edition of the Grey Lady. It discusses attempts by various countries to boost domestic birthrates. The same issue had been considered earlier by Noah Smith. There are two questions lurking here. First, what is the optimal population size for a country? If the goal was to shrink the population then a declining birth rate is not a bad thing. Suppose the goal is keep the population fixed, because, say of pension obligations. Then, one wants a replacement birth rate of roughly 2 per couple.

If the birth rate is below the target, what should one do? Interestingly, I cannot recall anyone I have asked or read who does not turn to Government interventions of various kinds. Noah Smith, for example, only discusses Government interventions before concluding one should imitate the French. If the birth rate is below what is optimal for society, why doesn’t the market take care of it?  Do we have a missing market? Is this a public goods problem? (If so, then, Mankiw who is often castigated for being a selfish beast, is, in this case, an unstinting provider of public goods, see here.)

Analogies are sometimes helpful (if biology is the study of bios, life; geology is the study of geos, earth, what does that make analogy?). Farmers plant crops and after a period, the fruits of their labor are harvested and sent to market.  The Farmer must anticipate what will be demanded in the future to decide what to plant now. What if she plants turnips when what is desired are parsnips? This problem is solved with a futures market for parsnips (or turnips or pork etc). Why not a futures market for babies? Those who want warm bodies in the future to support them in their dotage pay for babies now. Swiftian, I know, but interesting to consider. Once one thinks about how to implement the idea, difficulties emerge. One might, for example, be concerned with moral hazard on the part of parents. However, these same difficulties are present even with various Government subsidies.

According to the NY Times,  some Californians

would have to cut their water consumption by 35 percent under the terms of a preliminary plan issued by state officials on Tuesday to meet a 25 percent mandatory statewide reduction in urban water use.

There is an obvious way to achieve this, raise the price of water. If its obvious why isn’t it the first thing California did some years back when it was clear that water was scarce? In some cases the hands of the state are tied by water rights allocated for commercial purposes, so lets focus on household consumption.

We know that the first tool the state reaches for is regulation. See, for example, the following memo from the California State water board. Interestingly, it begins by noting that the state is in the 4th year of a drought! Eventually, it is clear that regulation is insufficient and then, price increases are considered. In fact, the water reduction targets quoted from the NY Times above come from a report by the Governor of the state that also urges the use of

rate structures and other pricing mechanisms

to achieve reductions. Again, why is price last rather first? Is this because the state must maintain a credible reputation for not exploiting its monopoly power with water?

If one is going reduce consumption by raising prices, should it be an across the board price increase? Note that consumption is metered so the exact amount that is purchased by a household is known to the provider. The state also has access to other information: location, home size, family size and income. In principle, the state could price discriminate. Here is an example from the Irvine Ranch Water district. Each household is given an initial `allotment’ that depends on household size and area that is landscaped. Exceed the allotment and the price of water rises. For more details and the impact on consumption see the following paper. Is it obvious that this is the `correct’ mechanism?

 

 

There is a brief period in a professor’s life when they are the lion of the dinner table and toast of the town. Its when the children of their friends and contemporaries are about to enter college. To my colleagues near and far I say enjoy the attention while you can.

What advice did I offer when called upon to do so?

Don’t worry. Your child has already made the most important decision of their lives and done so correctly. They chose you as a parent.

`No, seriously, how can my child make it to a top school?’, was the invariable reply. Followed by a reminder of the ostensibly low acceptance rates at `top’ colleges. `Don’t worry,’ I would repeat, `arithmetic is on your side.’

Each year about 30,000 students apply to Harvard. About 10,000 of these will be summarily rejected on academic grounds. That leaves about 20,000. Not all of them will get into Harvard. However, most of them are applying to the same subset of schools. There are 7 Ivy League schools, plus MIT, Stanford & Caltech. Throw in the University of Chicago and Berkeley. Collectively, these institutions enroll about 20,000 students in their freshman classes. This is not counting Duke, Northwestern, Michigan and UCLA.

`But, but, isn’t all that hard work, focus and diligence wasted if they don’t get into Stanford, MIT or Harvard?’

No, those habits will serve them throughout their lives not just at admission. Admissions is a lottery among those who make the `grade’. If the `losing ticket’ is Cornell or Chicago, its a lottery with no downside! How often does life present you with with such an opportunity.

Two articles in the March 3rd, 2015 issue of the NY Times. One by the columnist Nocera marvels at Buffet’s success and concludes that it must be due to Buffet’s genius. The second, in the business section of the same, summarizes Buffet’s annual letter that attempts to explain his success. As usual, neither considers the possibility that luck may have a role in Buffet’s success. Buffet may indeed be a Vulcan, but based on the data alone one cannot reject the possibility that luck may explain Buffet’s record. I won’t repeat the argument but will point to this paper by my colleagues (Foster & Stine) that does so.

On January 30th of this year, one of the arms of the BBC reported a row at Sheffield University about an economics exam question. The offending exam question is reproduced below. Is the question, as one student suggested, indistinguishable from Chinese?

Consider a country with many cities and assume there are N > 0 people in each city. Output per person is \sigma N^{0.5} and there is a coordination cost per person of \gamma N^2. Assume that \sigma > 0 and \gamma > 0.

a) What sort of things does the coordination cost term \gamma N^2 represent? Why does it make sense that the exponent on N is greater than 1?

b) Draw a graph of per-capita consumption as a function of N and derive the optimal city size N. How does it depend on the parameters \sigma and \gamma? Provide intuition for your answers.

c) Describe which combination of \sigma and \gamma generate a peasant economy, meaning an economy with no cities (or 1-person cities). Why might the values of the parameters \sigma and \gamma have changed over time? What do these changes imply in terms of optimal city size.

Without knowing what was covered in classes and homework one cannot tell what kind of tacit knowledge/conventions the examiner was justified in assuming in posing the question. Its easy, with experience at these things, to guess what the examiner had in mind. Nevertheless, the question is badly worded and allows a `sea lawyer‘ of a student to get full marks.

First, the sentence does not assert a connection between output and coordination. Thus, the answer to (a) should be:

Without knowing the purpose of the coordination, it is impossible to answer this question.

A better first sentence would have been:

Consider a country with many cities and assume there are N > 0 people in each city. Output per person is \sigma N^{0.5} and to achieve it requires a coordination cost per person of \gamma N^2.

Second, readers are not told the units in which output is denominated. Thus, part (b) cannot be answered unless one assumes that output has a constant dollar value. One might reasonably suppose this is not the case. The sea lawyer would answer:

As output can be generated at no cost, and is monotone in city size, the optimal size of the city is infinity. Note this does not depend on the values of \sigma or \gamma.

The answer to part (c), consistent with the earlier answers:

From the answer to part (b) we see that no combination of parameters would generate a peasant economy.

Yanis Varoufakis, the Greek Finance minister writes in the Feb 16 NY Times:

Game theorists analyze negotiations as if they were split-a-pie games involving selfish players. Because I spent many years during my previous life as an academic researching game theory, some commentators rushed to presume that as Greece’s new finance minister I was busily devising bluffs, stratagems and outside options, struggling to improve upon a weak hand.

Is this a case of a theorist mugged by reality or someone who misunderstands theory? The second. The first sentence quoted proves it because its false. Patently so. Yes, there are split-a-pie models of negotiation but they are not the only models. What about models where the pie changes in size with investments made by the players (i.e. double marginalization)?  Wait, this is precisely the situation that Varoufakis sees himself in:

…….table our proposals for regrowing Greece, explain why these are in Europe’s interest…….

He continues:

`If anything, my game-theory background convinced me that it would be pure folly to think of the current deliberations between Greece and our partners as a bargaining game to be won or lost via bluffs and tactical subterfuge.’

Bluff and subterfuge are not the only arrow in the Game Theorist’s quiver. Commitment is another. Wait! Here is Varoufakis trying to signal commitment:

Faithful to the principle that I have no right to bluff, my answer is: The lines that we have presented as red will not be crossed. Otherwise, they would not be truly red, but merely a bluff.

Talk is cheap but credible commitments are not. A `weak’ type sometimes has a strong incentive to claim they are committed to this much and no more. Thus, Varoufakis’ claim that he does not bluff rings hollow, because a liar would say as much. Perhaps Varoufakis should dust off his Schelling and bone up on his signaling  as well as war of attrition games. Varoufakis may not bluff, but his negotiating partners think he does. Protestations to the contrary, appeals to justice, Kant and imperatives are simply insufficient.

He closes with this:

One may think that this retreat from game theory is motivated by some radical-left agenda. Not so. The major influence here is Immanuel Kant, the German philosopher who taught us that the rational and the free escape the empire of expediency by doing what is right.

Nobel sentiments, but Kant also reminded us that
“Out of the crooked timber of humanity, no straight thing was ever made.”

My advice to Varoufakis: more Game Theory, less metaphysics.

Thom Tillis, Senator from the great state of North Carolina, was the subject of some barbs when he suggested that the health-code mandated sign that reads

“Employees must wash hands before returning to work.”

was an example of government over-regulation.

Quoting himself:

“I said that I don’t have any problem with Starbucks if they choose to opt out of this policy as long as they post a sign that says, ‘We don’t require our employees to wash their hands after leaving the restroom.’ The market will take care of that.”

Many found the sentiment ridiculous, but for the wrong reason. Tillis was not advocating the abolition of the hand washing injunction but replacing it with another that would, in his view, have the same effect. More generally, he seems to suggest the following rule: you can opt out of a regulation as long as one discloses this. If the two forms of regulation (all must follow vs. opt out but disclose) are outcome equivalent why should we prefer one to the other?

Monitoring costs are not lower; one still has to monitor those who opt out to verify they have disclosed. What constitutes disclosure? For example:

`We do not require our employees to wash their hands because they do so anyway.’

Would the following be acceptable?

“We operate a hostile work environment, but pay above above average wages to compensate for that.”

Is a question I thought as dead as a Dodo.  When I came upon it in an undergraduate philosophy of science class  the drums had been muffled and the mourners called. Nevertheless, there are still those who persist in resuscitating the corpse (see here for a recent example) and those, who for noble reasons, indulge them by responding.

There were, and are two good reasons for why this question should be left to rot in peace. The first is that the comparisons made to arrive at a demarcation are problematic. If Science were a country, Physics might be its capital. If one were to ask whether History is a Science, the customary thing to do is to measure the proximity of History to Science’s capital city. Why proximity to the capital and not to one of its outlying settlements like Geology and Archaeology? The second, better reason, is that the question, `is X a science?’ is of interest only if we believe that scientific knowledge should be privileged in some way. Perhaps it alone is valid and useful while nonscientific knowledge is not. If that is the case, the correct question should not be whether X is a science, but whether X produces knowledge that is valid and useful. Now we have something interesting to discuss: what constitutes useful or valid knowledge?

One might point to accurate prediction, but this alone cannot be the touchstone. How would we feel about the laws of Newtonian motion if we came upon them via regression? I suspect many of us would find such a theory to be incomplete, not least because of the concern with out of sample prediction. By the way, if you think this outlandish, I first learnt Newton’s laws by sending little carts down inclines with bits of ticker tape attached to them to so that we might, by induction, learn a linear relationship between velocity and acceleration. Truth be told, the Physics was sometimes lost in the enormous fun of racing the carts when the master’s back was turned. What if prediction is probabilistic rather than deterministic? In earlier posts on this blog you will find lengthy discussions of the problems associated with evaluating the accuracy of such predictions. I mention all this to hint at how difficult it is to pin down precisely what constitutes useful, reliable or valid knowledge.

Introduced externalities. The usual examples, pollution, good manners and flatulance. However, I also emphasized an externality we had dealt with all semester: when I buy a particular Picasso it prevents you from doing so, exerting a negative externality on you. I did this to point out that the problem with externalities is not their existence, but whether they are `priced’ into the market or not. For many of the examples of goods and services that we discussed in class, the externality is priced in and we get the efficient allocation.

What happens when the externality is not `priced in’? The hoary example of two firms, one upstream from the other with the upstream firm releasing a pollutant into the river (That lowers its costs but raises the costs of the downstream firm) was introduced and we went through the possibilities: regulation, taxation, merger/ nationalization and tradeable property rights.

Discussed pros and cons of each. Property rights (i.e. Coase), consumed a larger portion of the time; how would you define them, how would one ensure a perfectly competitive market in the trade of such rights? Nudged them towards the question of whether one can construct a perfectly competitive market for any property right.

To fix ideas, asked them to consider how a competitive market for the right to emit carbon might work. Factories can, at some expense lower carbon emissions. We each of us value a reduction in carbon (but not necessarily identically). Suppose we hand out permits to factories (recall, Coase says initial allocation of property rights is irrelevant) and have people buy the permits up to reduce carbon. Assuming carbon reduction is a public good (non-excludable and non-rivalrous), we have a classic public goods problem. Strategic behavior kills the market.

Some discussion of whether reducing carbon is a public good. The air we breathe (there are oxygen tanks)? Fireworks? Education? National Defense? Wanted to highlight that nailing down an example that fit the definition perfectly was hard. There are `degrees’. Had thought that Education would generate more of a discussion given the media attention it receives, it did not.

Concluded with an in depth discussion of electricity markets as it provides a wonderful vehicle to discuss efficiency, externalities as well as entry and exit in one package. It also provides a backdoor way into a discussion of net neutrality that seemed to generate some interest. As an aside I asked them whether perfectly competitively markets paid agents what they were worth? How should one measure an agents economic worth? Nudged them towards marginal product. Gave an example where Walrasian prices did not give each agent his marginal product (where the core does not contain the Vickrey outcome). So, was Michael Jordan overpaid or underpaid?
With respect to entry and exit I showed that the zero profit condition many had seen in earlier econ classes did not produce efficient outcomes. The textbook treatment assumes all potential entrants have the same technologies. What if the entrants have different technologies? For example, solar vs coal. Do we get the efficient mix of technologies? Assuming a competitive market that sets the Walrasian price for power, I showed them examples where we do not get the efficient mix of technologies.

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