I came home from the airport today to discover my car had been broken into again, only this time they decided to enter by shattering my front window, which will now cost me $200 to replace.  I feel bad for the person who is in a situation where he has to break my window to steal what amounted to about $4 and some pens, but I can’t imagine that it was worth the effort.  It also nets a $204 loss to me, while only a $4 gain to him.  The Coase Theorem teaches us that we would both be better off if I just gave $5 to him. He’d have an extra dollar, and I wouldn’t have to replace my window.

Of course, some people call paying someone not to break your stuff extortion.  If only I could pay a group of people to protect me from potential car-robbers.  I could even pool my money with other car-owners and they could protect all cars, not just mine.  And maybe, while they’re at it, they could protect people from murders, or guard public events.  And as long as they’re protecting everyone, maybe we could fund them through some sort of tax scheme - after all, their protection would be a public good.

But what would we call such a group, and who would stop them from beating the crap out of everybody?

Categories: Community, Governance, Incentive Centered Design, Law, Politics
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My roommates and I do a decent job of keeping our apartment clean, but there’s definitely room for improvement in our systems.  The problem is that cleaning our apartment is a public good, and like any public good, there’s tons of room for free-riding.  Anyone who has ever had roommates has most likely dealt with dirty dishes in the sink, or papers on the table, or piles of unread mail.  Unfortunately,  my brilliant idea, described below, is something only an economist could love, and I live with lawyers.

The solution to our problem, of course, is to attach a price to the various household chores we want done and compensate the person who accomplishes the task by having the other two roommates pay him.  I struggled with how to set the optimum level of payment for each task.  We could have each person decide how much they’d pay for the task, but what if nobody wanted to work at that level?  An alternative is to say how much each person wants to charge, but what if nobody pays it?

Co-op housing attempts to solve this problem through a system of fines and penalties, but if the fines are too low, then it will be seen as a charge for the service and not a penalty (thanks behavioral economics!).  You can force compliance by making the charges too high, but then there’s an opportunity for trade - between people who want to clean or need money and those who don’t - that’s being missed.

The optimal solution goes back to game theory - which teaches us how to incent both action and truth-telling.  There’s a classic problem in game theory where two business partners are trying to split a pie, or their company, or something.  Anyways, two people are trying to split something - and the best way to find an equitable split is to have the first player propose how much the pie/company is worth to them, and the second player decides whether to buy them out at that price, or sell to them at that price.  Because Player One doesn’t know which option Player Two will choose, they want to be as honest as possible about their true value of the pie/company/something, and will be indifferent between the two options.

The same goes for cleaning the apartment.  Give one roommate the option of saying what they value the chore at.  The other roommate has the option of either completing the chore at that price, or they can pay to have it done.  Running through the register of household cleaning tasks should create an equitable outcome, or give one roommate some supplemental income as a maid.  Either way, everyone wins - we all get to live in a clean apartment.

How’s this for a long post, Mom?

Categories: Behavioral Economics, Crazy Theories, Governance, Incentive Centered Design, Information Economics, Strategy
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American Express recently sent me an e-mail with this offer:

From June 2-12, 2008, there will be one U.S. destination on sale each weekday, with some packages retailing below $3,500. Once on sale, the price of each package drops every 20 minutes. So when the price seems right, you better grab yours before it’s gone. Visit the website now to check out in-depth trip details and photos, and to sign up to receive an e-mail reminder for when the trips you want go on sale.

It looks like they’re selling the vacation packages using an Open Descending Bid Auction, also known as a Dutch Auction.  If we think back to our Auction Theory, this should give us the same result as a Sealed-Bid First Price auction, but American Express has an excellent opportunity to test whether or not that holds in a real world environment.  From a behavioral perspective, in the real world and not a laboratory, will bidders react the same way in both situations?  My hunch is no, but I don’t have data to back it up - could my readers who still have unfettered access to academic journals find some?

Dutch Auctions are currently used by the Federal Reserve Bank of New York, Dutch Flower Merchants, and a variant was used for Google’s original IPO.

Categories: Behavioral Economics, Business and Economics, Incentive Centered Design, Information Economics, Matching Mechanisms, Travel
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Joel Spolsky just posted three parts (1,2,3) of a speech he gave at Yale in which he warns students to avoid corporate IT:

Now, at a product company, for example, if you’re a software developer working on a software product or even an online product like Google or Facebook, the better you make the product, the better it sells. The key point about in-house development is that once it’s “good enough,” you stop.

Spolsky is 100% right about corporate IT organizations - they are crappy places to work. You don’t get to work on fun projects, you’re disconnected from the business, you’re stuck making things quickly rather than high-quality, and everyone on the business-line hates you, to the point where they keep farming out your job to consultants like Accenture, Deloitte, and IBM.

But the reason IT is miserable is it’s own fault - in house IT is, for the most part, a monopoly, and it’s going to be just as miserable as working at any other monopoly. You don’t have to worry about what your internal customer needs, because they can’t go someplace else (you don’t run competing IT shops). You don’t have to run efficiently because there aren’t market pressures. For every complaint from someone in IT that their creative freedom is restricted, there’s a complaint on the business side for the problems that crop up when developers decide they want to play - for instance every business application needs to have it’s own authentication, with it’s own look and feel, and it’s own user database. Kerberos was invented how long ago? If you’re developing a product and you make your users sign-in a different way to use different areas of your product, creative destruction will take care of you pretty quickly, but when you’re in the monopoly that is corporate IT, the users don’t have anywhere else to go.

And what of the consultants that IT hates so much, who can charge $300 an hour to have a 22 year-old with an English degree and a crash course in .Net write applications for you? They do something corporate IT isn’t very good at - they spend most of their time figuring out what the biggest problem is, and then they develop an application that solves it. In the meantime, corporate IT has an amorphous idea of what the business is and starts developing applications that they think might be relevant. That’s how monopolies work - they push products onto the market as they develop them, without regards to customer needs. Customers, who don’t have a choice, take what they can get.

There are other structural forces that make corporate IT miserable. For instance, maintenance and new development usually come out of separate budgets, so developers have little incentive to make an efficient product that is cost effective to maintain - that’s somebody else’s problem. Because once a project ends they either have to find a new one or move into maintaining the code they wrote, they actually have a perverse incentive to write bad code that’s difficult to maintain, modify, and interact with. The best way to build job security is to invent a role nobody else can do. If you’re looking for anecdotal evidence, just look at the way the owners of legacy applications fight any attempt to modernize.

If you’re developing a product, any new feature you add provides value to the customer, that’s why it’s valued. Great companies value IT (and other support functions like HR) because they drive value to the bottom line. In fact, great companies are usually built on great people and great technology. When done right, IT contributes straight to the bottom line, and IT professionals are valuable parts of the business team.

In the end, the problems with corporate IT are based around the same issue - there is no accountability to the customer. That’s the root of line-managers’ complaints about IT and it drives into most of the problems programmers feel when working in corporate IT. Solve it, and all of a sudden IT becomes a great place to work, and a valued part of the team.

Categories: Business and Economics, Customer Engagement, Incentive Centered Design, Information Economics, Managing, Technology
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The Wall Street Journal has a front page article on transplant matching mechanisms along with this cool diagram. It also covers the debate between economists over whether markets or trading cycles are the most efficient and morally palatable method to get the right kidneys to the right people.

Via MR

Categories: Behavioral Economics, Business and Economics, Distribution, Incentive Centered Design, Matching Mechanisms
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Looks like Warren Buffet is picking a successor. Too bad an expert in Incentive Design didn’t help him come up with his selection criteria:

When I heard about this, the romance died. For all of Mr. Buffett’s reputation as the ultimate nonmutual fund, he may have just fallen into one of the biggest mutual fund traps of all — forgetting how incentives affect fund managers’ behavior.

Winner take all stock market games don’t reward the best investors, they reward the luckiest. It’s a spin-of-the-wheel that determines just which high-risk high-return investment hits pay dirt. Long term success doesn’t matter. The article also discusses the inventives investment managers face to screw their clients.

Categories: Business and Economics, Careers, Incentive Centered Design, Information Economics, Managing
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Via Overcoming Bias:

Once upon a time, three groups of subjects were asked how much they would pay to save 2000 / 20000 / 200000 migrating birds from drowning in uncovered oil ponds. The groups respectively answered $80, $78, and $88 [1]. This is scope insensitivity or scope neglect: the number of birds saved - the scope of the altruistic action - had little effect on willingness to pay.

Why?

People visualize “a single exhausted bird, its feathers soaked in black oil, unable to escape” [4]. This image, or prototype, calls forth some level of emotional arousal that is primarily responsible for willingness-to-pay - and the image is the same in all cases. As for scope, it gets tossed out the window - no human can visualize 2000 birds at once, let alone 200000. The usual finding is that exponential increases in scope create linear increases in willingness-to-pay - perhaps corresponding to the linear time for our eyes to glaze over the zeroes; this small amount of affect is added, not multiplied, with the prototype affect. This hypothesis is known as “valuation by prototype”.

An alternative hypothesis is “purchase of moral satisfaction”. People spend enough money to create a warm glow in themselves, a sense of having done their duty. The level of spending needed to purchase a warm glow depends on personality and financial situation, but it certainly has nothing to do with the number of birds.

Categories: Incentive Centered Design, Philanthropy
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The NYTimes Magazine teaches you about the farm bill, agricultural subsidies, and obesity:

The reason the least healthful calories in the supermarket are the cheapest is that those are the ones the farm bill encourages farmers to grow.

Via Tyler Cowen

Categories: America, Business and Economics, Food, Incentive Centered Design
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Joanna Jacobs passes along Barry Schwartz’s recommendation that elite universities use a lottery for admissions (I couldn’t find the whole article):

There is probably a right answer to the questions “Whom should we admit?” or “Which college should I select?” But we won’t know until after the fact. Chance factors (roommate assignment, romantic successes or failures, or which English professor evaluates your first papers) might have a bigger effect on success and satisfaction than the tiny differences among applicants (or schools) within the range of acceptability. So once a set of “good enough” students or “good enough” schools has been identified, it probably doesn’t matter much which one you choose; or if it does matter, there is no way to know in advance what the right choice is.

College admissions is a crap shoot, and anyone who tells you otherwise is lying. Let colleges admit the all-stars, reject the losers, and show the people in the middle just how much randomness is involved. As long as students are using the Common Application to apply to multiple schools, though, the application becomes even more like a lotto ticket. Is this applicant applying to Cornell to hedge in case they don’t get into Columbia, or do they really want to go there?

The solution? Use a bidding market. Give each student who fills out the common application 1000 points and allow them to allocate them among schools they apply to. Weight students in the lottery based on the number of points they bid, so that students who bid more get more of a chance. People will still get into college - being in the “middle” group of Harvard applicants still makes you in the top group of many other great schools.

Bidding systems solve another problem as well. A friend of mine used to work in an admissions office, and she said they would look at other schools a candidate applied to and reject those who seemed highly qualified and applied to top tier schools because the office thought they weren’t likely to accept the admissions offer in the first place. Restricting the number of bidding points lets universities measure not only a student’s binary desire to attend signaled by applying (yes/no), but also the strength of their desire to attend the school (number of points bid).

Most people overestimate the role of going to a good college on life outcomes. They also overestimate how good admissions offices are at picking which people get in and which don’t. Exposing just how random it is, as Schwartz notes, will expose just how much “luck” is involved. Does that mean that a Harvard student and a Community College student are on the same intellectual level? Doubtful, but it will show the Princeton student that they could just as easily be at Duke, if only the lottery had been different.

Categories: Education, Incentive Centered Design, Information Economics, Information Markets, Matching Mechanisms, The Academy
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I underestimated how much having a “real job” would cut into my blogging time, and thus, posts have been slow. More than that, though, I underestimated how addicted I would get to Yahoo Answers. It’s more than just the desire to earn more points. It lets me fulfill my secret desire to be an advice columnist, and I think my 10% best answer ratio indicates I’d be pretty good at it. Most of my best answers are in the realm of dating/relationship issues and financial advice, but my friends could have told you that.

What’s my incentive to contribute? Is it the otherwise meaningless points? The thrill of answering questions? The social reward of participating and helping people? Or is it just a way for me to channel my inner Dear Abby? Lets just say that if you like my answers, and you want to give me a column at a major newspaper or alternative weekly, you know how to find me.

Categories: Dating, Incentive Centered Design, Information Markets, Social Software, Technology
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The not-so-weekly Equation of the Week returns with a formula for determining whether or not a person will engage in prostitution:

[(δU/δL) / (δU/δC) | Sp=0] ≤ w - [(δU/δr) / (δU/δC) | S = 0]

Where U=utility, L=leisure, C=goods and services consumed, S=quantity of prostitution sold, w=wage for prostitutes, and r=your reputation.

In other words:

An individual will start to sell prostitution if the price for selling the first amount of prostitution, minus the costs of a worsened reputation for doing so, exceeds the shadow price of leisure evaluated at zero prostitution sold.

Reputation, or more broadly social costs, may be one thing that individuals consider when selecting a profession, but to say it’s the only thing?

The full paper is here, via this Improbable Research Column.

Categories: Business and Economics, Careers, Dating, Equation of the Week, Funny, Incentive Centered Design, Matching Mechanisms
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From the dumbest column I’ve ever read in Slate (which I normally read before anything else):

Suppose the national defense of the United States were relegated to the private sector. Instead of the publicly funded Army, Navy, Air Force, and Marines, the country would be defended by private militias funded mainly by insurance companies. In the event of foreign attack on U.S. soil, the militias would defend those citizens in the affected areas who’d paid defense insurance premiums through their places of work (or, if self-employed, as individuals).

The best-armed troops would defend the wealthiest and most hawkish segments of the population, who would have paid the highest premiums.

The premise of the article is that we should nationalize health care because it’s like the military, and look how good a nationalized military is. Wow, lets go through all the ways this is flawed.

1. National Defense is a public good, health care is not. You may think that health care is a right, or something everyone is entitled to, and those are philosophical positions, but health care doesn’t fit the definition of a public good in the economic sense. First of all, it isn’t non-rival, which means that if I consume some health care, you can’t consume that same amount. If I take a pill, or use a X-Ray machine, you can’t take that same pill or use the machine at the same time. In contrast, an army that protects the United States offers the same amount of protection, whether or not you add more people to it. Second, health care is excludable. I can stop you from taking a pill or getting that X-Ray if you don’t pay for it. But with national defense, if you don’t pay your taxes, the army still protects you. There are fundamental characteristics between them that make them different.
2. In general, everyone in the country shares the same risk if the country is attacked. Granted, people in high-risk areas may suffer a greater risk due to terrorism, and that is actually reflected most of the time in higher local tax rates to support police counter-terrorism, or insurance premiums for potential targets. In general, though, if there is a large scale attack against the United States or its allies, the risk to all of us is the same. When it comes to health care, we all have different amounts of risk, and only minimal information about that risk. Well planned insurance lets us pool this risk to reduce the cost to individuals and overcome some of this information problem. Nationalized health care has nothing to do with risk pooling, and it effectively involves the health and low-risk subsidizing the unhealthy and high-risk.
3. National defense is a pretty bad example. There’s definitely consensus on the left, and I think among some people on the right that we spend way too much on national defense. It costs the Defense Department orders of magnitude more to procure technology that is available cheaply in the private sector. Defense technology research involves massive outlays relative to the returns. The military is a sprawling and inefficient bureaucracy with a sprawling and inefficient supplier network supporting it. Do we really want to take our relatively dynamic biomedical research sector and make it part of a government supplier complex? Is this really a way to reduce costs?

I later found that Arnold Kling took a briefer, though probably more economically informed shot at the column as well.

Categories: America, Business and Economics, Distribution, Governance, Incentive Centered Design, Information Economics, Politics
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Even after JetBlue screwed up big time, people are still going back:

Because JetBlue worked hard to acknowledge the importance of customer satisfaction early, the carrier has, in effect, built in a forgiveness contingency in it’s implied agreements with its customers.

Categories: Business and Economics, Incentive Centered Design, Marketing, Strategy, Travel
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Turner Broadcasting and their ad agency are paying the city of Boston $2 million after law enforcement there confused a glowing Mooninite advertising the new AquaTeen Hunger Force movie with a terrorist threat.  Half will be “goodwill” funds given to the agencies for training and equipment.  Does this mean they just got a million dollars for their screw up?  Will they use this to prevent a similar embarrassment?  Doesn’t this provide an incentive for police departments to overreact, forcing a settlement with corporations who will then pay up to prevent a PR disaster?  After all, none of the departments in 9 other cities, who figured out that a glowing Moon Man isn’t a bomb, got any free money.
The companies can’t say what I’m going to: Boston law enforcement overreacted and behaved in a bumbling and incompetent manner.  The more we are willing to kowtow to our fears of terrorism, the more effective it becomes as a tactic.

Categories: America, Entertainment Media, Governance, Incentive Centered Design, Law, Marketing, Television
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Prizes stimulate innovation better than grants:

BACK in the 1700s, prizes were a fairly common way to reward innovation. Most famously, the British Parliament offered the £20,000 longitude prize to anyone who figured out how to pinpoint location on the open sea. Dava Sobel’s best-selling 1995 book “Longitude” told the story of the competition that ensued, and Mr. Hastings mentioned the longitude prize as a model at that meeting back in March.

Eventually, though, prizes began to be replaced by grants that awarded money upfront. Some of this was for good reason. As science became more advanced, scientists often needed to buy expensive equipment and hire a staff before having any chance of making a discovery.

The internet is changing the economics of innovation and discovery.  Science is no longer expensive like it once was, it is within the realm of dedicated and educated hobbyists.  Robin Hanson, who the article discusses, is everywhere you find interesting information economics problems.

Categories: Business and Economics, Incentive Centered Design, Information Asymmetries, Information Economics, Information Markets, Matching Mechanisms, Science, Social Software, Strategy, Technology, Users as Partners
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