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Fun With Contracts And Organizations, Clive Davis Edition…

Posted:Mon, 17 Jun 2013 23:05:55 +0000

Well kids, it’s that time of year where I am working to finish a book draft when I should be on the beach somewhere. What this means for you is that you get to be the guinea pigs for my musings on the music industry to some degree. (The book is about the economics of the music industry.) So here’s how this is going to work: I’m going to give you an excerpt that I think will be interesting to you, and you can warn me if it bored you to death instead. You can also tell me if you think of any stories that you’ve come across that might belong in such a book.

This excerpt is about contracting and how even successful organizations seem to be pretty bad at it sometimes:

In his memoir The Soundtrack of My Life, record executive and founder of Arista Records Clive Davis ruminates on, among other things, the perverse incentives that poorly thought-out contracts can create. As part of Arista’s growth strategy, Davis decided to partner with L.A. Reid and Kenny “Babyface” Edmonds as well as Sean “Puffy” Combs in order to diversify its capabilities and reach new markets. As per the emphasis of Arista’s parent company, Bertelsmann, on internal growth as opposed to acquisitions, Davis decided to support Reid and Edmonds by bankrolling their LaFace Records as a joint venture rather than waiting to see if the label succeeded and then acquiring it at a potentially high multiple of earnings or true value later. Similarly, Davis worked with Combs in a joint-venture fashion to found what would be called Bad Boy Records.

Davis was soon dismayed to learn, however, that the start-up costs for these joint ventures were coming out of his personal equity interest in Arista (such that the inevitable start-up losses were being charged to him), whereas the cost of an acquisition would have come out of the organization’s coffers more generally. Specifically, Davis was essentially financing the joint ventures himself but wasn’t the only beneficiary of the eventual upside, and, as a result, Davis had actually been given a disincentive to behave in a way that was in line with the overall company’s goals and values. Given that Davis was the primary decision maker in these matters, Bertelsmann was very fortunate that Davis wasn’t mindful of this part of his contract until after the joint ventures were already underway. (I suppose the implicit management lesson is that, if you’re going to put perverse incentives in a contract, try to make it so the other party doesn’t notice!)

To the parent organization’s credit, it eventually listened to Davis’ reasoning and agreed to change the contract structure to provide proper incentives, but not without more than a little pushback and a trip to Germany on Davis’ part. It’s truly surprising, sometimes, how much of a discrepancy there can be between the stated goals of an organization and the outcomes that these same companies are willing to pay for.

In case you’re curious, the memoir overall reads a bit like a laundry list of all the artists that Clive has signed over the years (though you’ve probably heard of him most with regard to Whitney Houston), but I’m finding it quite interesting for two (nerdy) reasons. First, Davis talks enough about the workings of the industry that it becomes pretty clear what the role of a record label was (I hesitate to say “is” for various reasons), especially where it comes to matching artists with songs. I already knew that this happened a lot in the pop music world, but it was interesting to see how much of that went on in rock, country, etc. (Sidenote: How many of you knew that Elton John hasn’t written his own lyrics in, like ever? As an economist, I applaud the use of efficient division of labor in such cases.) Second, it’s kind of eye-opening to be smacked in the face with how central recorded music was to the profits of the music industry- there’s a passage in the book, for example, where Davis describes Sarah McLachlan’s touring strategy as a way to grow a fan base and make money, and it’s written with a tone of “oh, isn’t that quaint,” whereas now that is the lifeblood of the majority of music careers.

It would also figure that I learned the detailed history of Biggie versus Tupac from an old white guy with a degree from Harvard Law School. Street cred, right there, ladies and gentlemen.

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by Economists Do It With Models
Fun With Monopolies, Diamond Edition, And More Examples for Your Classroom…

Posted:Sat, 15 Jun 2013 20:42:34 +0000

So, it’s that time of year again, when, as a complement to June wedding season, the media is inundating its readers with stories related to marriage. (Yes, those were all different links, and that’s just a small sample from one source.) I usually don’t pay much attention (get married, don’t get married, invite whomever you want, it’s really none of my business), but there was one article that caught my eye for more than a second, entitled “Diamonds Are A Sham And It’s Time We Stop Getting Engaged With Them”. Now, I am certainly not entirely unfamiliar with the DeBeers diamond monopoly (I read a case on it as part of an MBA course that was part of my grad program, so I’m obviously a total expert), and I know why monopolies are economically inefficient, but I was unaware that it was also DeBeers who convinced men (and, by extension, women) that diamond engagement rings were necessary:

Until the mid 20th century, diamond engagement rings were a small and dying industry in America. Nor had the concept really taken hold in Europe. Moreover, with Europe on the verge of war, it didn’t seem like a promising place to invest.

Not surprisingly, the American market for diamond engagement rings began to shrink during the Great Depression. Sales volume declined and the buyers that remained purchased increasingly smaller stones. But the US market for engagement rings was still 75% of De Beers’ sales. If De Beers was going to grow, it had to reverse the trend.

And so, in 1938, De Beers turned to Madison Avenue for help. They hired Gerold Lauck and the N. W. Ayer advertising agency, who commissioned a study with some astute observations. Men were the key to the market:

Since “young men buy over 90% of all engagement rings” it would be crucial to inculcate in them the idea that diamonds were a gift of love: the larger and finer the diamond, the greater the expression of love. Similarly, young women had to be encouraged to view diamonds as an integral part of any romantic courtship.

And so on. The whole article is pretty interesting, particularly the part that explains why high retail markups and the prevalence of non-investment-grade diamonds make for a crappy resale market for diamonds. (This is particularly important information for potential diamond purchasers, since I’m guessing that the jeweler isn’t going to warn you about the lack of resale value during the sales process- if anything, he’s likely to tell you the opposite. Also, this information totally blows holes in my previously held belief that men were supposed to spend a lot of money on engagement rings so that the woman could sell the ring and support herself for a while if the guy broke off the engagement.)

As a nice reminder that monopolies and anticompetitive behavior generally aren’t welcomed in the United States, DeBeers is currently sending out checks to compensate people who overpaid for diamonds because of DeBeers’ monopoly power, as per the outcome of a 2008 class-action lawsuit. (Note, however, that the dollar amount of the checks- some as small as $48- probably doesn’t cover the full amount of the monopoly markup.) And you wonder why I joke that someday I want to receive an engagement car (not for store of value reasons so much as usefulness reasons, obviously)…and you have to admit that you can see the ad men for Lexus totally jumping on that bandwagon.

As is the usual for this site, I try to look around for appropriate cartoons, videos, etc. to go with the topics…I poked around a bit, and I think that this is the most appropriate option for an economics-y audience:

As an added bonus, if the diamond example ever gets old in your class, here are 6 other monopoly examples you likely haven’t considered using. I have to admit that I’m quite surprised that DeBeers is not on that list. (HT to Tim Cooke via Facebook for the tip!)

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by Economists Do It With Models
A Test Of Bounded Rationality, Alarm Clock Edition…

Posted:Fri, 14 Jun 2013 19:07:44 +0000

One of the key differences between traditional and behavioral economics is that, while the assumptions of traditional economics stipulate that people always have the cognitive and psychological faculties to make the choices that are in their long-term best interests, behavioral economics focuses on identifying the situations in which these assumptions don’t hold. For example, traditional economists would likely be in favor of the following product:

(HT: Freakonomics)

The logic seems simple enough- if you want less of something to happen, charge more for it. (This is just another way of saying that, except in very particular circumstances, demand curves slope downwards.) Behavioral economists, on the other hand, would likely be suspicious of one’s morning ability to make rational choices. In their view, bounded rationality or bounded cognition could make this alarm counterproductive, since people would likely be too groggy to properly evaluate the price of snoozing (and thus exhibit little change in snooze behavior) but would be out more money than before. (It is sometimes said that behavioral economists use the term “bounded rationality” as a nice way of saying that people are stupid, and, I don’t know about you, but I’m pretty damn stupid in the morning.)

This example also, randomly enough, illustrates the importance of the counterfactual, or relevant comparison scenario. Compared to an alarm clock with a regular snooze button, this one seems to have some potential advantages. But why is this the comparison group? Why not compare this alarm to one where there is no snooze button? (Yes, I get that the snooze button is the status quo, but it doesn’t mean that there aren’t better alternative options out there.) Maybe people would be more likely to get up on time if they didn’t trust themselves to snooze for a short time without the aid of the clock. (Yes, I realize that you could just set the alarm again for 10 minutes later- or 9 minutes…why is a snooze always 9 minutes? Was this defined somewhere that I don’t know about? Anyway, I’m pretty sure that by the time you go to all the trouble of resetting the alarm you would be awake enough to realize that you need to get out of bed and not snooze anyway.) Personally, I think that this guy should be the comparison group:

The logic is essentially analogous to what I outlined above- the alarm clock runs away when it goes off, so by the time you find the snooze button you are likely either awake enough to realize that you shouldn’t be snoozing or awake enough to not want to snooze in the first place. In fact, I could envision a superior alarm clock that is a combination of these two items- the clock would run away so that you are coherent enough to make an intelligent decision regarding whether or not to pay to hit the snooze button. Boom- business idea right there, folks.

Update: Of course I would be outdone two days after I post about economist-friendly alarm clocks. Behold a money-shredding alarm clock:

Just think of the implications for the money supply. (Furthermore, I love that there are comments about the legality of the product on the video’s YouTube page.) I am hereby naming this product the anti-Bernanke clock.

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by Economists Do It With Models
About.com Highlights: June 12, 2013

Posted:Thu, 13 Jun 2013 01:16:06 +0000
As some of you likely know, I am the economics guide for About.com, so I write articles and blog there in addition to writing here and a few other places. (In general, I try to pick and choose what is appropriate for each site.) You may have noticed that I do list recent material from About.com on the left sidebar, but I feel like that’s easy to overlook (and it’s pretty much invisible to RSS subscribers). I do post a lot of that content on Facebook, Twitter, and Tumblr, but I wanted to give you some highlights here as well. So here are the highlights from this week so far:
- The Economic Inefficiency of Monopoly
- A Very Earnest Message From a “Job Creator” to the Senate
You can also check out the site directly at economics.about.com.

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by Economists Do It With Models
It’s Nice To Be Acknowledged, And A Lesson On The Market For Textbooks…

Posted:Tue, 11 Jun 2013 03:44:43 +0000

The market for introductory economics textbooks is pretty crowded, but there is at least one new one coming onto the market soon:

If you’ve ever used a textbook as an instructor rather than as a student, you are probably aware that there are lots of supplementary materials- solutions manuals, test question banks, and so on- that serve as companions to the textbook and that are given to the instructors at no charge. (In case you were curious, copies of the textbook are also given at no charge, and, although it’s technically prohibited, there are plenty of instructors who sell the free books to the used book brokers that are constantly stopping by our offices. Yep, those exist.) If you are a student, I am not going to explicitly encourage you to try to find copies of such materials online, but I am going to mention that a lot of the materials are out there.

Have you ever wondered who writes all of these supplemental materials? People like me, apparently:

I suppose if you’re a good enough student it’s only a matter of time until you get paid to essentially read textbooks and do problem sets. I contend that there are far worse ways to earn a living.

What I found most interesting about the experience, however, was the insight that it gave me into the textbook market. On some level, I’ve always known that there is inefficiency in the textbook market due to the fact that the decision makers (i.e. instructors) aren’t the payers/end consumers (i.e. students). Among other things, this means that instructors don’t have a particularly strong incentive to care how much the textbooks that they are assigning cost, so textbooks are more expensive than they would be in a well-functioning market. (Luckily there are considerate instructors out there who do care to some degree whether they are sending students further into the poor house. Also, if this sounds familiar, it’s because you’ve been doing your reading on the healthcare industry.)

What I didn’t realize until I started teaching large courses, however, is the degree to which instructors are courted by the textbook publishers- remember the stories about how pharmaceutical companies used to heap lavish perks on doctors in order to get on their good sides so that they would prescribe more of the company’s drugs? Yeah, it’s kind of like that, except that the sales reps that are constantly contacting me are way less hot than the typical pharma girl. (No offense to the textbook reps, it’s just that the pharma girls are pretty far out there on the spectrum.) I’m not complaining about the free books, food, booze, conferences, etc., mind you, I just thought it was worth noting.

What I *am* going to complain about is the fact that the decision-making authority regarding textbooks is becoming, in an increasing number of circumstances, even more removed from the end consumer. One strategy of Pearson Education, for example, is to sign contracts with university administrators that require instructors to use Pearson textbooks (presumably only for classes where Pearson has textbook coverage). What this means, obviously, is that instructors can’t always assign the text that they think is best, and, in an important number of cases, can’t even assign textbooks they’ve written themselves, at least not without forgoing royalties and, in one case a little birdie told me about, “donate” said royalties to the university. In what may or may not be related news, Penn State signed such a contract with Pearson and the first author of the above textbook is now employed by the University of Kentucky. Students, I encourage you to play a potentially fun game- check out the textbooks you’ve used recently in various courses and see if they are disproportionately Pearson textbooks. If so, ask your professors if they are obligated to assign Pearson texts and see what they say- I’m very curious. (It’s too bad you can’t text your professors and then send me the responses a la Nathan Fielder.)

This system is obviously problematic on a number of levels, not the least of which being that it creates incentives to engage in rent-seeking behavior at the expense of actually producing products that are better for students. (I’ve used Pearson’s products, and, while a number of the textbooks themselves are quite good, the online materials leave much to be desired. And I’m not just saying that because I do review work for Pearson’s competition. ) So, next time you’ve wondering how textbooks could possibly have started climbing over the $200 price point, just think back to this discussion.

For what it’s worth, the publisher of the above book (W. W. Norton and Company) is an independent publisher and seems pretty legit- their biggest claim to fame is that they were the ones who gave Michael Lewis a deal for Liar’s Poker, and he’s stayed with them ever since, which I figure is a good signal. Also, they throw kickass parties.

Update: I guess I shouldn’t be surprised that people are asking how this compares to the Mankiw textbook that is often featured on this site. Fair question, though it’s hard to give a fair answer because a 6th edition of Mankiw isn’t really comparable to a draft of a 1st edition of Mateer/Coppock. Like Dirk Mateer’s web site, his book is focused on giving examples related to pop culture and generally being relatable to students. I think the best way to put it is that I will probably continue to use Mankiw for my own reference but would be inclined to use Mateer/Coppock for a survey course for non-majors. It’s important to keep in mind that differentiation does in fact exist in the world of introductory economics textbooks, so both instructors and consumers should do their homework to find out which version is appropriate for them. I think the only subject where I could universally recommend a single undergraduate textbook is econometrics, where the text by Wooldridge reigns supreme, in my opinion.

Another Update: Apparently people followed up with Dirk regarding his move from Penn State. So let me see if I’ve got this straight: Penn State thinks that professors benefiting financially from writing a textbook that was customized for the course that instructor is teaching is a conflict of interest, but the university itself getting kickbacks from a publisher for mandating the use of particular textbooks is A-OK. As noted in the comments, students at Penn State really valued Dirk’s presence, and it’s sad that rent-seeking behavior by publishers (and rent-accepting behavior by universities) did in fact factor in his decision to move.

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by Economists Do It With Models
About.com Highlights: June 7, 2013

Posted:Fri, 07 Jun 2013 19:57:22 +0000
As some of you likely know, I am the economics guide for About.com, so I write articles and blog there in addition to writing here and a few other places. (In general, I try to pick and choose what is appropriate for each site.) You may have noticed that I do list recent material from About.com on the left sidebar, but I feel like that’s easy to overlook (and it’s pretty much invisible to RSS subscribers). I do post a lot of that content on Facebook, Twitter, and Tumblr, but I wanted to give you some highlights here as well. So here are the highlights from this week so far:
You can also check out the site directly at economics.about.com.

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by Economists Do It With Models
A Stern Reminder On The Nature Of Derived Demand, Cat Video Edition…

Posted:Thu, 06 Jun 2013 18:00:35 +0000

Most introductory economics textbooks point out that the demand for labor is a “derived demand,” meaning that the demand for labor is derived from the demand for the products that the workers make. This makes sense, since there is no reason to hire workers if no one wants to buy your product, and vice versa. This concept goes a long way to explain how we get job postings like this:

Since, given that you are reading this, you spend time on the Internet, you should be well aware of the virtually unlimited demand for cat videos, and, by extension, cat video technologists. Silly as it may be, this is actually a decent example of capitalism in action- resources are being directed to their highest-value use, though likely much to the chagrin of those with fancy (Cat Fancy?) film degrees. I suppose it’s also an example of what some view as the downside of capitalism, namely that people get what they demand in the market, even if what they demand is cat videos.

In any case, I am adding this into my micro lecture slides as we speak.

(Sidenote: Interestingly enough, this is not the first time I’ve written about cat videos.)

Update: I have yet to upgrade to cat videos, so I’m still just on the level of cat photography. Apparently this one is a nonbeliever.

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by Economists Do It With Models
On Dilbert, Nobel Economists, And Beard Statistics…

Posted:Wed, 05 Jun 2013 21:13:14 +0000

Okay, it’s not like I don’t get that Scott Adams meant this to be a parody of Paul Krugman…

(If nothing else, reading Scott Adams’ blog gives the context to deduce his opinion regarding Krugman. Also, it’s worth noting that Adams did study economics in college.)

But then I started thinking, does the information provided really imply this? I mean, all we really know is that the character has a beard, won a Nobel Prize, and likes telling people they are wrong. (Conditional on being an economist, I think the last criterion really does nothing to narrow down the field.) So let’s go to the evidence…

2012 – Al Roth

Al does have a beard, but he doesn’t really talk about macro and is really too nice to engage in any trash talking.

2012 – Lloyd Shapley

Again, the beard is present, but I find it unlikely that an author of the Gale-Shapley mating algorithm would be interested in lecturing anyone on fiscal policy. That said, I think it would be hilarious to see him engage in trash talking.

2011 – Thomas Sargent, Christopher Sims

While Sargent and Sims did win their Nobel for work in empirical macroeconomics, they are missing the crucial beard component.

2010 – Peter Diamond, Dale Mortensen, Christopher Pissarides

No, mustaches do not count as beards, and, in any case, Peter Diamond has proven himself to be far too civil for the above characterization.

2009 – Elinor Ostrom, Oliver Williamson

I was about to move on to the next year, since, well, don’t even start with the beard jokes for Prof. Ostrom, if for no other reason than she’s no longer alive to defend herself, but then I came upon this:

Very sneaky, Williamson, very sneaky. Williamson is still not a proper candidate, however, since he focuses on transaction cost economics and doesn’t seem likely to get his panties in a twist over fiscal policy.

2008 – Paul Krugman

I think we all know this picture…

Krugman also obviously has a lot to say about fiscal policy, and, as I’ve pointed out before, he seem to have little aversion to the verbal sparring. Here’s the visual metaphor for you:

2007 – Leonid Hurwicz, Eric Maskin, Roger Myerson

I count zero beards and, unfortunately, one dead economist (Hurwicz) here, so no candidates.

2006 – Edmund Phelps

No beards to see here.

2005 – Robert Aumann

Now THAT is a beard that puts Krugman’s to shame. That said, he’s a game-theory guy and probably doesn’t have a particular interest in fiscal policy. (I don’t know about you, however, but if that beard told me I was wrong about fiscal policy, I would probably listen.)

2005 – Thomas Schelling

Since Aumann is a math guy, I will point out that, mathematically speaking, Aumann and Schelling have a normal beard on average.

2004 – Finn Kydland, Edward Prescott

One cute smile, but no beards.

2003 – Robert Engle III, Clive Granger

Well what have we here…Granger did win his Nobel for time-series econometrics, which has implications for macroeconomic policy analysis, but he passed away in 2009 so it’s unlikely that he’s yelling at anyone about fiscal policy. It’s particularly unfortunate that he’s not still around because I am always entertained when people yell with a British accent.

2002 – Dan Kahneman, Vernon Smith

With that look, I don’t think that Dan Kahneman needs to yell at anyone per se. In unrelated news, ponytails and beards appear to be substitutes rather than complements.

2001 – George Akerlof, Michael Spence

This beard hunt is more difficult that I would have guessed. But wait…

2001 – Joe Stiglitz

I dare you to tell me that you can’t picture that face telling you that you’re wrong about fiscal policy. If you need something to help with the visual, here is Stiglitz talking about how more fiscal stimulus is needed.

Since a second potential suspect has been found, I will stop here and note a few things. First, given the evidence, I am going to dispute the claim that anyone who knows anything about economics has a beard. (If nothing else, this claim would imply that women don’t know anything about economics, and, while this might explain the gender inequality that we see in the profession, don’t even go there.) It is, however, interesting to note that the sample proportion of beards above (p = 6/24 = 0.25) is higher than the overall beard prevalence of 10 percent. (Note that I excluded Ostrom from the proportion since the population beard statistic was only for men. Also, in an effort to be conservative with my conclusion, I didn’t include Williamson’s beard and only counted Aumann’s as a single beard. Good research principles, right here.) I am even tempted to say that the sample beard proportion of 0.25 is statistically significantly higher than the population beard proportion of 0.1 (the test statistic is about 2.4), but I am troubled that there are some small-sample issues here since there are only 6 positive observations in the sample beard category. In any case, a good follow-up question would be whether these men are wearing beards because anyone who knows anything about economics has a beard, because beards are just a very professorial thing in general, or perhaps due to some other factor entirely. (Instructors, this exercise would be a fun one to do with your students to teach hypothesis testing for a proportion.)

Second, despite the fact that Krugman and Stiglitz both technically fit the cartoon parody, I’m willing to bet that the vast majority of people immediately think of Krugman when they see it. (And this is despite the fact that, once I look at the cartoon objectively, the character actually resembles Stiglitz more closely from a visual perspective.) I can’t decide whether the tendency to assume that the cartoon is about Krugman rather than Stiglitz is positive or negative PR for either of the economists.

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by Economists Do It With Models
Follow Up: On The Hunt For The Elusive Upward-Sloping Demand Curve…

Posted:Fri, 31 May 2013 19:49:28 +0000
Two years ago, I wrote a post about Giffen goods and the possibility of a demand curve that slopes upwards rather than downwards. Two days ago, presumably via the wonders of search engine optimization, someone on Reddit linked to said post (in a discussion on Bitcoin, strangely enough) with the following commentary:

I usually find her blog posts lacking. At least she didn’t conclude by suggesting that demand curves slope upwards.

To note, all demand curves must slop downwards because of diminishing marginal utility. Ie. The marginal good satisfies a lower valued end. If it satisfied a higher value end then people would chose to satisfy that end first.

The only extent you can say demand increases with prices is if the demand curve shifts to the right. That is to say if people demand less of some other good and shift demand into the good where price is rising.

First, hmph. Second, and more importantly, I was under the impression that I *did* say that demand curves could slope upwards (even taking diminishing marginal utility as a given). In any case, I felt that this was a good opportunity to rejoin the hunt for the elusive upward-sloping demand curve, so I wrote up an article all about Giffen goods here.

I would like to think that I’ve gotten a bit smarter (or at least more knowledgeable) over the years (just go with me here), so I think that a rehashing of Giffen versus Veblen goods is in order. The graphical summary of the issue is this:

This implies that Giffen goods- highly inferior goods where a price increase of the good makes you feel poorer such that you actually consume more of the good overall, presumably because you switched away from higher-quality options- are the only goods that truly have an upward-sloping demand curve. Veblen goods- goods associated with status and conspicuous consumption- appear to have a positive relationship between price and quantity demanded, but this relationship works via changing tastes rather than as a direct result of price change on quantity demanded.

As in my original post, I’ve taken to stating that the existence of Giffen goods is somewhere above the tooth fairy but pretty much in line with Bigfoot on the scale of credibility. (I considered replacing “Bigfoot” with “whatever the guy on River Monsters thinks he caught that actually ends up being a catfish,” but that is a conversation for another time.) That said, with a bit of help from some nice people on the interwebs as well as from Esther Duflo and Abhijit Banerjee’s book Poor Economics (I think), I can give more evidence as to a legitimate Giffen sighting. From Robert Jensen and Nolan Miller:

This paper provides the first real-world evidence of Giffen behavior, i.e., upward sloping demand. Subsidizing the prices of dietary staples for extremely poor households in two provinces of China, we find strong evidence of Giffen behavior for rice in Hunan, and weaker evidence for wheat in Gansu. The data provide new insight into the consumption behavior of the poor, who act as though maximizing utility subject to subsistence concerns. We find that their elasticity of demand depends significantly, and nonlinearly, on the severity of their poverty. Understanding this heterogeneity is important for the effective design of welfare programs for the poor.

In other words, lowering the price of rice for poor households in China caused the households to consume less rice, which would result in an upward-sloping demand curve. A couple of things are worth noting here:
- The Giffen behavior was exhibited by low-income households, so an individual household’s demand curve may slope upward while the overall market demand curve still has a downward slope. (This is because the overall market consists of both poor and not poor, or at least less poor, households.)
- The rice example above is almost an exact parallel of the potato example that I gave in the original post and the linked article, so I’m not sure whether to count it as a truly new example. It is, however, certainly more current and empirically based. I am tempted to revise the definition of Giffen goods to “goods that are a category of necessity and that don’t have a cheaper option to substitute down to.”
Technically speaking, this evidence could still be consistent with my Bigfoot comparison, since you don’t actually know what my beliefs on the existence of Bigfoot are. Also, because the Internet is a beautiful thing, a certain Benjamin Anderson was kind enough to Tweet me the following:

Attention television producers: I would totally be up for a reality show about a search for Giffen goods…and, based on what I’ve seen, it would be more fruitful than what you’ve got going with either River Monsters or Finding Bigfoot.

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by Economists Do It With Models
About.com Highlights: May 28, 2013

Posted:Tue, 28 May 2013 18:11:10 +0000
As some of you likely know, I am the economics guide for About.com, so I write articles and blog there in addition to writing here and a few other places. (In general, I try to pick and choose what is appropriate for each site.) You may have noticed that I do list recent material from About.com on the left sidebar, but I feel like that’s easy to overlook (and it’s pretty much invisible to RSS subscribers). I do post a lot of that content on Facebook, Twitter, and Tumblr, but I wanted to give you some highlights here as well. So here are the highlights from this week so far:
- More on the Debt vs. Growth Argument that Won’t Die… – Reinhart and Rogoff wrote an open letter to Paul Krugman, and Krugman responded with some graphic support from Brad DeLong.
- When Federal Reserve Banks Tweet… – or, “How I Spent My Memorial Day Compiling a List of Federal Reserve Twitter Accounts.”
You can also check out the site directly at economics.about.com.

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by Economists Do It With Models
Kids These Days Think They Are So Smart…

Posted:Thu, 16 May 2013 21:00:47 +0000

I figured this was appropriate for the occasion…

Earlier this year, the Massachusetts Council for Economic Education hosted its annual High School Economics Challenge, which brought students from all over the state to the Federal Reserve of Boston to compete to see which students are the biggest ner…er, which students know the most economics. The two main divisions- the David Ricardo division for regular economics students and the Adam Smith division for advanced placement economics students (apparently the council likes its economists to be of a certain age)- consist of an individual exam and then a quiz bowl round where the two top-scoring schools on the exam go head to head to decide a winner. The winner in each division is then eligible for the National Economics Challenge sponsored by the Council for Economic Education and to be held this weekend in New York. This year, Lexington High School, the Massachusetts winner in the David Ricardo division, scored high enough to qualify for the finals, so I will be watching the livestream of the finals on Sunday at 3pm on the Council for Economic Education Facebook page. I watched last year and Belmont High School won in the Adam Smith division, so clearly I am a good-luck charm. (See also: correlation versus causation.)

In addition to the quiz bowl rounds, the Massachusetts Economics Challenge introduced a new round this year, named the (continuing the trend) Alfred Marshall round, where students consider a case study and then make and defend policy recommendations based on the scenario described. The inaugural case was about the recent economic troubles in Ireland, and I had the pleasure of not only judging the written proposals (ever see high-school students try to use the word sequester properly?) but also asking follow-up questions to the two teams that we chose as finalists and then choosing a winner. (Just know that I have ALL the power.) The President of the council was nice enough to send along some pictures from the judging:

(Guess who knew the camera was there? Me and the guy in the bow tie, apparently.)

(The other judge is the economics department head at UMass Lowell. I swear that we were both taking our jobs equally seriously. Also, for the record, it was really hard to pick a winner because both of the finalist teams were pretty impressive.)

If you are a high-school student or teacher, I highly recommend looking into having your school participate in your state’s economics challenge. (You can see a list of state coordinators here.) I also recommend checking out my study materials to help you prepare.

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by Economists Do It With Models
It’s Funny Because It’s True, Unemployment Rate Edition…

Posted:Mon, 13 May 2013 22:55:13 +0000
I should have known that sending that sending Zach Weiner that copy of Mankiw would come back to bite me in the ass…

Given how the most widely cited unemployment rate is calculated, the cartoon is technically correct. On one hand, not counting people who are not in the labor force as unemployed makes sense- we generally see unemployment as a problem to be fixed, yet I doubt that the stay-at-home mom or the lottery winner sitting on a pile of cash rather than working is anyone’s policy target, so it makes sense to leave such people out of the discussion. That said, the way that unemployment statisticians ask the labor force question (“Have you looked for a job in the last four weeks?”) causes them to catch people who would want to work but have given up on finding a job in their out-of-the-labor-force net.

In order to overcome some of the misleading features of the typical unemployment rate, the Bureau of Labor Statistics also publishes a few other statistics that pertain to working versus not working. One is the labor force participation rate, which shows what percentage of people are either employed or looking for a job:

(Note that the scale of the vertical axis is a little misleading.) With these numbers, we can better understand whether changes in the unemployment rate were more due to people getting and losing jobs or people entering and exiting the labor force. (The labor force participation numbers also explain how we can see increases in both employment and unemployment or vice versa.) This historical data shows that labor-force participation has been declining a bit since recession hit in 2007 or so, which is consistent with the notion that people get discouraged and drop out of the labor force if they can’t find work for a long time.

A close cousin to the unemployment rate and labor force participation rate is the employment to population ratio (it’s exactly what its name implies), which the Bureau of Labor Statistics is also kind enough to publish:

Unlike the labor-force participation numbers, the employment to population ratio shows a sharp decline during the recession rather than a steady decrease over a number of years. Therefore, while it is true that the U.S. unemployment rate is rebounding, it appears to be settling at a place were a smaller portion of the U.S. population is working than before.

But wait- this is the part where I totally blow your mind…as it turns out, the Bureau of Labor statistics publishes a whole smorgasbord of unemployment rates in addition to the typical one. Check out the options:
- U-1: Persons unemployed 15 weeks or longer, as a percent of the civilian labor force
- U-2: Job losers and persons who completed temporary jobs, as a percent of the civilian labor force
- U-3: Total unemployed, as a percent of the civilian labor force (official unemployment rate)
- U-4: Total unemployed plus discouraged workers, as a percent of the civilian labor force plus discouraged workers
- U-5: Total unemployed, plus discouraged workers, plus all other persons marginally attached to the labor force, as a percent of the civilian labor force plus all persons marginally attached to the labor force
- U-6: Total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force
(I am obviously wrong, but I would like to believe that this is what Bono was thinking of when he named his band.) No one of these measures of unemployment is perfect on its on, but, taken together, they paint a pretty decent picture of what the labor market landscape looks like.

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by Economists Do It With Models
A Belated Reinhart-Rogoff Rundown, Now With More Colbert…

Posted:Thu, 09 May 2013 14:42:10 +0000
I’ve been hesitant to write about this, since every time I try I just end up with phrases like “AN EXCEL ERROR ROFL!!!!” on the page, and I don’t feel like that entirely embodies what I would like to convey regarding the Reinhart-Rogoff situation. So I gave it the old college try on About.com instead. Some highlights:
- Harvard economists Carmen Reinhart and Ken Rogoff wrote a short piece in the (non peer-reviewed) American Economic Review Papers and Proceedings entitled “Growth in a Time of Debt.”
- Said piece asserted that debt to GDP ratios of over 90 percent are associated with negative average economic growth, whereas lower levels are all associated with positive average growth. (Interestingly, however, the 90 percent debt ratio is correlated with positive median economic growth, which suggests the negative result is being driven by outliers to some degree.) In the piece, the authors were careful to give the “correlation does not imply causation” disclaimer- in this case, that it’s possible that slow economic growth causes high debt ratios rather than the other way around. In other words, their data analysis looks like this:
  
  (Sidenote: I know hindsight is 20-20 and all, but wouldn’t you at least be a little suspicious about the presence of a calculation error when you get a result that is that different from the others?)
- Advocates of economic austerity apparently understand neither the correlation versus causation issue nor the concept of peer review and basically nutted themselves over this finding.
- Said austerity supporters started inviting Carmen and Ken (though mostly Ken, as I understand it) to fancy policy discussions. In addition, Carmen and Ken wrote a few op-eds where they were much more prescriptive and less careful about highlighting the lack of established causality.
- UMass Amherst graduate student Thomas Herndon became suspicious when he couldn’t replicate Reinhart and Rogoff’s result using data they provided to complement their 2009 book. (Fun fact: I suggested that my senior seminar students use this data to write their research papers and they all ignored me.) Herndon then got Reinhart and Rogoff to share their calculations and found that their most noteworthy finding was the result of a sloppy Excel formula. (Sidenote: ROFL!!!! Not even Matlab? Stata? It’s not the most relevant issue, but the JV nature of the analysis is hilarious to me.)
- Herndon and two professors published a rebuttal to the Reinhart-Rogoff paper in which they pointed out the Excel error and also challenged some of the other methodology in the original study. (Sidenote: I find it funny that a 6-page non-peer-reviewed paper got a 26-page presumably non-peer-reviewed rebuttal.)
Hold up…I’ll pause here because Stephen Colbert tells is so much better:

Colbert even invited Herndon on the show, which not only made me incredibly jealous but also caused me to send a “neener-neener” email to my students for not taking me up on my paper advice:

Okay, so let’s continue…
- Reinhart and Rogoff issued what I will loosely call an apology via NYT op-ed. The general gist of the piece is “yeah, we made a calculation error, but it’s not that important for the end result. Besides, we warned you against interpreting the findings as causal anyway.”
Brad Plumer at the Washington Post was kind enough to put the disagreement into handy graph form:

To be fair, the difference between the numbers is the result of all of Herndon et al’s criticisms, not just the spreadsheet error. That said, the spreadsheet error is the difference between negative and positive growth for the 90 percent and over group.

So what do we take from this? I guess it’s a matter of opinion whether the amended result (together with the causality issues) is an argument for austerity. Therefore, I feel that the takeaways from this debacle are a bit more general:
- Basing major policy decisions on short, non-peer-reviewed studies might not be the best idea anyone’s ever had. In related news, it’s important to be aware that confirmation bias- the tendency to only pay attention to evidence that supports one’s existing hypothesis- is a powerful force.
- It’s just as important to be a good consumer of research as it is to be a good researcher. Betsey Stevenson and Justin Wolfers have some good advice on the subject. I would add to this that, if you are in a position to actually use a set of findings, it’s worth doing a little digging to see how well-vetted the findings are.
- As a corollary to the above, it would probably be helpful for academic publications to make it more obvious when work is and is not peer reviewed. I’m not sure exactly why I know that the American Economic Review’s “Papers and Proceedings” are not peer reviewed, so I wouldn’t expect that to be common knowledge.
- ALWAYS, ALWAYS check your calculations. Better yet, use a real statistical/math program like Stata or Matlab where you can execute calculations via scripts so that your work is far more auditable.
On the up side, no one really thinks that Reinhart and Rogoff had any sort of nefarious intent, so at least they aren’t having as bad of a time as this guy.

Update: Reinhart and Rogoff have put out an official errata report for their paper. Fun fact: it’s almost twice as long as the original paper.

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by Economists Do It With Models
Looking For Slides From My SXSW Talk?

Posted:Sat, 16 Mar 2013 05:42:45 +0000

They are located at www.economistsdoitwithmodels.com/SXSW2013. Happy reading!

Update: You can also hear the audio from the talk on SoundCloud here.

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by Economists Do It With Models
Cartoonists Ask The Best Questions, GDP Edition…

Posted:Tue, 19 Feb 2013 19:29:00 +0000

You may have noticed that I post a decent number of comics from Saturday Morning Breakfast Cereal. While I do know Zach, it wasn’t until recently that I started meddling in the cartoon-generating process. In general, it’s more amusing to see what non-economists come up with on their own, but sometimes I just can’t help myself. So here goes…

The original question:

Econ question: If I wrote a program wherein I and another person constantly traded $1 for nothing, back and forth, does GDP go to infinity?

(For the record, Scott Adams, the creator of Dilbert, actually has a degree in economics, yet I am far more impressed by the issues posed by thoughtful non-economist cartoonists.) Of course this sounds absurd, but there are plenty of things in macroeconomics that sound absurd, so I figured this was worth thinking about for a second. Or an hour. Here’s what I came up with:

So here’s some general information on GDP:
http://economics.about.com/od/gross-dome…

I think the part that is most relevant to the question at hand is the notion of “produced.” So, used goods don’t count in GDP unless there is some value-added service associated with selling them, and even then it’s only the value-added part that counts in GDP. If I modified your scenario slightly so say that two people kept paying each other a dollar for a widget of some sort, that widget would only count in GDP the first time it was sold to an end user consumer. Your scenario is a bit more complicated I think, however (perhaps unintentionally). If the dollar going back and forth is exchanged just because, then it would be considered a repeated gift or transfer and not included in GDP because nothing was actually produced. If, on the other hand, the dollar is each time exchanged for some intangible service (a smile, wink, nod, etc.), then there is in fact a dollar of GDP generated with every transaction, since the service is new each time rather then the reselling of a used service. (I’m not even sure what a used service would be exactly, but it sounds kind of dirty.)

Your twitter commenter is right that digging a hole and then filling the hole back in would add to GDP with no net change in the state of the world, and one could make two arguments about this. One argument is that this is a shortcoming in the notion of GDP, similar to the broken window fallacy, which you can read about here:
http://economics.about.com/od/output-inc…

Another argument is that, because people were willing to pay both to have the hole dug and filled in, that both activities must have had worth to people. Unfortunately, there is likely also a negative externality imposed on the guy who wanted the hole dug when the hole is filled back in and vice versa, which would counteract the value that is counted in GDP to some degree.

I read a thing a few days ago that I can’t seem to find but is very relevant to this situation. Suppose guy 1 pays $50 to punch guy 2 in the face. Suppose further that guy 2 pays guy 1 $50 to then punch him in the face. The article or whatever’s conclusion was that both guys had no more money than before but had black eyes, so they were worse off but $100 of GDP was created. It’s a cute example, but it isn’t quite correct because it ignores the warm fuzzies or whatever that the guys got from doing the punching, which they had to have gotten since they were willing to pay $50 to do it. When this is taken into account, each guy got a service that they valued at at least $50 plus a black eye. Because both men were willing to accept $50 to get punched, it must be the case that the cost of getting punched was less than $50 to both men. Therefore, both men were made better off on net by this set of transactions, but not by the full $100 of GDP that was created. The reason is that GDP doesn’t take into account wealth destruction, whether it be black eyes or loss of buildings due to earthquakes and the like.

In other words, GDP calculations can be a little absurd on the surface but aren’t totally absurd once you think a little. So apparently this is why Zach was asking his question:

He had actually shared the storyline with me earlier, and I made the following point:

I suppose that the motion of electrons counts as a different service each time, and the nerds are willingly giving the money each time, so as much as I want to say that this doesn’t count as GDP, I’m leaning towards allowing it. You could also just have the computer make a trivial beeping noise or something to count as the service rendered. The important part is that it has to be clear that nerd 2 is actually providing the service worth $1 to nerd 1 and vice versa, otherwise you’re just describing paypal with a zero commission, and it’s the paypal fees that count in GDP, not the money transferred itself. Perhaps describe the scenario as nerd 1 and nerd 2 each installing a program on the machine to accept the dollar in return for a beep?

After this exchange, I sent Zach a copy of Greg Mankiw’s favorite textbook, though I’m not sure how much it helped, since this is well outside of textbook and into thought exercise territory. In other words, it would make a great exam question if you want to give your students ulcers.

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by Economists Do It With Models
Just For Fun: The Real Reason The Austrian School Is Against Minimum Wages…

Posted:Mon, 18 Feb 2013 18:37:02 +0000

One common feature of those who proclaim themselves to be aligned with the Austrian School of Economics is the opposition to most forms of government intervention in markets. It follows logically, then, that Austrians are generally opposed to minimum wage legislation. I think I’m beginning to understand why:

Pretty much all economists can agree that people respond to incentives, so it’s worth remembering (in this case and others) that incentives can affect beliefs too.

Update: Justin Wolfers has a less charitable but more amusing analysis of the data:

Also, people, just relax and take a joke. It’s fun, I promise, and maybe even productive if it gets someone to respond to the ad. If you want to see real criticism based on this ad, check out the article that the screen shot originally came from.

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by Economists Do It With Models
When Economists Are Forced Off Script, TEDxPublicStreet Edition…

Posted:Thu, 14 Feb 2013 18:16:06 +0000

Soooo…this video requires a bit of explanation. A few weeks ago, I gave a talk at TEDxPublicStreet, and the theme of the event was how people in different fields are working to make the world a better place. Pretty easy, right? Too bad I had what I will generously refer to as a flash of inspiration the day before the event, updated all my slides, and then made file names on my USB drive confusing enough that the slides for my old TEDxBoston presentation got loaded instead. So I get on stage, click forward in the slides, and see this:

Seriously, screw you guys and your smiling faces. Unfortunately, there wasn’t a way to fix the problem without keeping people waiting too much, so I had the honor of speaking extemporaneously for 15 or so minutes, and this is the output:

In case you’re curious, the visuals (some for informative purposes, some for humorous effect) went like this. (Just don’t expect them to line up with what I talked about perfectly, since, well, I’m not that well rehearsed. I’ll work on it.)

At least now you know more than you likely ever wanted to about the nerdy inner workings of Radiohead, Mozart, and Van Halen.

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by Economists Do It With Models
What My Students Have Been Learning, Chicken Wings Edition…

Posted:Fri, 01 Feb 2013 23:06:46 +0000

One thing that is suboptimal about teaching Principles of Microeconomics rather than a more specialized course is that the “what my students have been learning” anecdotes seem a bit simplistic to me. That said, this one took a bit of a funny turn, so I thought I would share. (Also, those of you who teach can use the example with your students.)

So I was trying to think of relevant and not too boring comparative statics (really just a fancy way to say “analyzing changes in supply and demand”) scenarios to use with my students when I came upon the following from The Consumerist:

Super Bowl Partiers Lament: Last Year’s Drought Is This Year’s Uptick In Chicken Wing Prices

According to the U.S. Department of Agriculture (via NBC News) chicken prices were up 6% in December, which is more than triple how much overall food prices rose in a year. Yikes.

This isn’t a huge surprise, as during last summer’s drought experts warned that meats and dairy would probably cost more as the feed needed to sustain animals was in short supply.

If it costs more to feed the chickens, it’s going to cost more to eat them. But in the case of chicken wings there are other factors pushing up the price, says one economist who spoke with NBC, including a glut of chickens last year.

Farmers subsequently cut down on how many they raised, which means fewer chickens around for me (and fine, you) to eat.

So this actually gives us a nice chain of comparative statics to think about. First, there’s the impact of the drought on the market for chicken feed. The bad weather reduces the amount of feed that farmers can make out of a given amount of inputs, so the drought raises the costs of producing chicken feed and reduces the amount that farmers want to produce at any given price. In other words, this:

The increase in price happens because otherwise there would be a shortage of chicken feed (i.e. more demand than supply) and market forces operate to bid up prices until the shortage goes away. (Anyone who has ever used StubHub for concert or sports tickets knows roughly how this process works.)

But wait, there’s more…the increase in the price of chicken feed raises the price of (quite literally) an input to making chickens. When the prices of the stuff used to make a good increases, it’s less attractive to produce that good (since costs increase) and producers don’t want to make as much of it. So we see similar behavior in the market for chicken wings to what we saw in the market for chicken feed:

Therefore, it’s not surprising that this drought issue in and of itself raises the price of chicken wings, but, for those of you who pay attention to the outside world, there may be another factor that is compounding the price increase. I don’t know if you’ve noticed, but this sunday is Superbowl Sunday, and, from what I’ve heard, chicken wings and sport ball games are economic complements (i.e. people tend to consume them together). Therefore, the demand for chicken wings likely increases in the days running up to Superbowl Sunday, which could drive up prices even more:

Notice that, in this case, I said “could” rather than “will.” The reason is that, in practice, producers are often times hesitant to raise prices in the face of increases in demand (even when not doing so would cause a shortage) because consumers tend to see the practice as unfair and get upset, making the short-term increase in profit potentially not worth it in the long run. Instead, producers are probably more likely to anticipate the demand increase around Superbowl Sunday and hole back some of their output at other times so that they can get more chicken wings into the stores for the big game. (Notice that this practice would essentially raise prices for non-superbowl times, but people don’t appear to complain about that.)

So these are the typical economic incentives that get discussed when talking about supply and demand, whether it be the supply and demand of chicken wings or anything else. What I didn’t think to discuss initially was the impact that prices have on the incentives for those who operate in illegitimate markets (i.e. criminals). Again, from The Consumerist:

Pair Arrested For Stealing $65K Worth Of Tyson Chicken Wings

According to the Atlanta Journal-Constitution, the two men were both employed at the storage company when 10 pallets — $65,000 worth — of Tyson chicken wings went missing on Jan. 12. This was before the Atlanta Falcons were eliminated from the playoffs, so perhaps the men were hoping they could cash in if the hometown team made the Super Bowl? Police say the alleged thieves used a forklift to put their purloined party snacks into the back of a rented truck.

The whereabouts of the wings are unknown.

I suppose that economics would suggest that an increase in price also makes stealing a good and trying to resell it more attractive. Again, as an exercise in economic complements, I would start looking for the wings in wherever I might find a bunch of stolen refrigerators.

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by Economists Do It With Models
The Real Reason Economics Is The Dismal Science…

Posted:Fri, 25 Jan 2013 22:11:40 +0000

Just kidding- this is the real reason that economics is called the dismal science, but just go with me here.

Economists are quick to point out that the true cost of something, whether it be a physical good, an activity, etc., is what one has to give up in order to get that thing. This cost includes both explicit costs, which are costs than involve an actual outlay of money or credit card or whatever, and implicit costs, which are the values of the other opportunities that have to be passed over in order to consume a good or perform an activity. One common implicit cost is the value of one’s time, since, by definition, time spent on one activity can’t be spent on other activities.

Economists use this concept of implicit cost (or opportunity cost, though the term “opportunity cost” is sometimes used to refer to the total of explicit and implicit cost) to make predictions about how many hours of labor people will supply. The logic is that, since every hour spent sitting on the couch and eating Cheetos (“leisure” in economic terms) is an hour not spent working, the implicit cost of sitting on said couch is an individual’s wage, since the wage is what the person would have earned by working for an hour instead. Over most normal ranges of wages, this would mean that, as sitting on the couch gets more expensive, people sit on the couch less and work more, which gives a positive relationship between a person’s wage and the number of hours that the person is willing to work.

I’ve taught this concept to my principles students for a number of years now, and I somehow never stopped to think about its depressing implications. Luckily, others have got my back on this:

Like a lot of people, the woman in the cartoon is good at thinking about explicit costs but not so good at thinking about implicit costs. I generally argue that not thinking about implicit costs is suboptimal because it leads to irrational decision making, but, after staring at this for a while, I’m beginning to think that ignorance might be bliss. I guess I can understand why that last graph doesn’t end up in college brochures very often.

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by Economists Do It With Models
Some Economic Humor For Your Day Off…

Posted:Mon, 21 Jan 2013 20:16:55 +0000

I have yet to give a complete rundown of Economic-Con in San Diego a couple of weeks ago (pro tip: don’t pick an exhibit booth that no one can find), but I can safely say that the humor session was one of the highlights. Here is Yoram Bauman, the Stand-Up Economist, talking about “Hyperinflation in Hell”:

Yoram asked me afterward what I thought of the new bit, and I pointed out that I really like getting to feel like I learned something…in this case, not so much about inflation and monetary policy (one would hope that I have the hang of those by now), but about cultural traditions and the use of joss paper and such. I guess that’s my nerdy version of the “it’s funny because it’s true” scenario.

Update” Another one for the “it’s funny because it’s true” category:

Uh oh, looks like this is becoming a theme…

Another Update: Because the world thinks it’s funny, an article about an agency for ugly models came up in my news feed shortly after the above Twitter conversation. Also, said Twitter convo devolved into puns involving Slutsky and “endogenous zones.” You people are sick. =P

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