Golden balls and weakly dominant strategies

In ECON100 this week we covered game theory, in which the most famous game is the prisoners' dilemma. One of the tutors then sent me some YouTube links to clips from the game show, Golden Balls. This isn't quite the prisoners' dilemma, but it is close. In this game, the two players have to choose to split or steal. If they both choose split, they share the prize pool. If they both choose to steal, they both go home with nothing. If one chooses to steal and the other chooses to split, the one who steals gets the whole prize pool and the other gets nothing. Take a look:

Why would anyone steal? Stealing is actually a weakly dominant strategy - it's a strategy that is never worse than the other strategy (splitting), but is sometimes better. [*] Most rational players would choose to steal. To see why, consider the game in normal (payoff table) form below.

Consider Sarah's choice first. If Steven chooses to split, Sarah is better off choosing to steal, because £100,150 is better than £50,075. If Steven chooses to steal, it doesn't matter what Sarah does because her winnings will be zero regardless. So, stealing is a weakly dominant strategy for Sarah (it is never worse than splitting, and if Steven chooses to split then stealing is better for Sarah).

Now consider Steven's choice. If Sarah chooses to split, Steven is better off choosing to steal, because £100,150 is better than £50,075. If Sarah chooses to steal, it doesn't matter what Steven does because his winnings will be zero regardless. So, stealing is also a weakly dominant strategy for Steven (it is never worse than splitting, and if Sarah chooses to split then stealing is better for Steven).

So, I would expect the players to choose to steal. Unless they can find some way of changing the game. Which brings me to this clip:

Nick realises that if he chooses to split, he is at risk of going home with nothing if Ibrahim chooses the weakly dominant strategy (steal). So he attempts (successfully) to change the payoffs in the game by convincing Ibrahim that he will choose steal no matter what (and will split the prize pool with Ibrahim afterwards). The game changes to look like this:

Note that neither player has a dominant strategy now. In fact, Nick's strategy choice becomes irrelevant because Nick will get £6,800 if Ibrahim chooses to split, and nothing if Ibrahim chooses to steal, regardless of what he (Nick) chooses. Ibrahim also doesn't have a dominant strategy here. If Nick chooses to split, Ibrahim is better off to steal (because £13,600 is better than £6,800). But if Nick chooses to steal, Ibrahim is better off to split (because £6,800 is better than nothing). Ibrahim does have a minimax strategy to choose split. Minimax is where you look at the worst outcome from each strategy, and choose the strategy that has the worst outcome that is best. In this case, the worst outcome from choosing steal is going home with nothing, and the worst outcome from choosing split is £6,800 (provided Nick agrees to split the prize pool afterwards).

Ultimately though, it comes down to whether Nick's threat to choose steal no matter what (and split the prize pool afterwards) is credible (believable) or not. Once Ibrahim is convinced, then Nick chooses split as well. It's not an equilibrium solution to the game, but by changing the nature of the game Nick managed to make them both better off (than if they had both chosen their weakly dominant strategy).

[HT: My ECON100 tutor, Jae]

*****

[*] Note that this is why this game isn't a classic prisoners' dilemma game. In the prisoners' dilemma, both players have dominant strategies (not weakly dominant strategies), and when both players choose their dominant strategy (which they will do if they are rational) then both players are made worse off.

The study strategies of top students

The headline of this Washington Post story from a couple of weeks ago is pretty provocative: "A telling experiment reveals a big problem among college students: They don’t know how to study". The problem is that the story doesn't actually tell us enough about the experiment to be able to judge. Here's the closest that the story gets:

Instead of highlighting, posing and answering questions as they read forces students to think about meaning, and helps them recognize whether they really understand. To prepare for a test, self-quizzing actually boosts memory more than studying does. For example in one recent experiment, college students read 36 facts taken from a freshman biology course. Then some took a quiz on the facts while others restudied them for an equivalent amount of time. Memory for the facts was tested two days later and those who took the quiz outperformed the re-studiers, 61 percent versus 39 percent.

Unfortunately, I can't find the study referred to in that paragraph (given a few minutes of Google Scholar searching), and the link refers to a different (and much older) study. Reading that WaPo article wasn't a total bust though. The paragraph before the one quoted above is of interest too:

Some students leave college because classes just aren’t going well. However, most students have never been taught how to study and the strategies they devise on their own don’t work. For example, they highlight their textbooks to signal what they should review later, but if you’re reading difficult material for the first time you probably can’t identify what’s important. When preparing for an exam, students reread their highlighted textbook and their lecture notes, but rereading doesn’t make information stick because it’s so easy to repeat something mindlessly. Think of the last time you tried to remember someone’s name by saying it to yourself again and again.

 An ungated version of the paper linked in that paragraph is available here. It makes for interesting reading, although it isn't really helpful if you want to know the study strategies that are successful. In the paper the authors (Marissa Hartwig and John Dunlosky, both of Kent State University) interviewed 324 introductory psychology students about their study habits and their GPA. They then sort out which study habits are exhibited more by students with high GPAs, and which are exhibited more by students with low GPAs. Of course, this is correlation not causation - we have no idea whether the study strategies used by high-GPA students are effective for raising GPAs, only that the better students are using them.

Here's what they found:

In summary, low performers were especially likely to base their study decisions on impending deadlines rather than planning, and they were also more likely to engage in late-night studying. Although spacing (vs. massing) study was not significantly related to GPA, spacing was associated with the use of more study strategies overall. Finally, and perhaps most importantly, self-testing was a relatively popular strategy and was significantly related to student achievement.

Perhaps the most interesting bit of that is that self-testing (posing and answering questions while reading, doing practice problems, etc.) was more often used by better performing students. It would be good to know if this was causal rather than simply correlation (which is why I was disappointed with no link to the experiment mentioned in the WaPo article). Similarly, late-night studying was more prevalent among the lowest performers, but it would be good to know if there was anything causal in that.

The most surprising result in the Hartwig and Dunlosky study (to me at least) was that some 23 percent of those surveyed claimed to "usually return to course material to review it after a course has ended". That wasn't my experience as a student (except in a very few cases of economic theory or econometrics that I referred back to during postgraduate study!), although all teachers (including me) probably hope that students look back on things that we covered sometime after the course has finished.

[HT: David McKenzie at Development Impact]

Rugby, dementia, and the prisoners' dilemma

The prisoners' dilemma is probably the most famous game in game theory (I previously discussed it here). The outcome of the game is that both players, acting in their own self-interest, choose actions (strategies) that result in both of them being worse off. In the classic prisoners' dilemma, both prisoners confess to the crime, and both go to jail for a longer time than if they had both stayed silent.

There are many applications of the prisoners' dilemma in real life. Consider exiting a building in the event of a fire. Everyone would be more likely to get out safely if everyone walked to the fire exits in an orderly fashion. However, every person has an incentive to get to the exit as fast as possible to make sure they get out before being engulfed in flames. So, the end result is lots of running, with everyone competing for the exit, and a greater likelihood of people being hurt in the ensuing chaos.

Which brings me to dementia and rugby. The impact of repeated concussions on former rugby players has been in the news quite a bit this year (and follows similar news about NFL players over the last few years). See for example this front page story from the New Zealand Herald:

The first paper from the study into the health of retired rugby players was published in online journal Sports Medicine yesterday. "A Comparison of Cognitive Function in Former Rugby Union Players Compared with Former Non-Contact-Sport Players and the Impact of Concussion History" investigated the difference in brain function between rugby players who experienced concussion and those who didn't.

It found that players who experienced one or more concussions in their career performed worse in tests that measure cognitive flexibility, complex attention, executive function and processing speed. To put it in layman's terms, that is the ability to understand and process information quickly, to make rapid decisions, to switch attention between tasks and to track and respond to information over long periods of time.

How does this relate to the prisoners' dilemma? Consider two rugby players (Player One and Player Two), who have two strategies: (1) to play hard and risk concussion; and (2) to play softer and avoid head injuries. Both players would be better off if they both played softer, since both would avoid head injuries. However, knowing that the other player is playing softer, each player would be better off playing hard since that gives them a better chance of winning. However, if either player plays hard, then both players risk a head injury. The game (in normal form) is laid out in the payoff table below.

What happens in this game? It actually depends on how players evaluate the trade-offs in this game. Let's start by assuming that winning is paramount.

Consider Player One first. They have a dominant strategy to play hard. A dominant strategy is a strategy that is always better for a player, no matter what the other players do. Playing hard is a dominant strategy because the payoff is always better than playing softer. If Player Two plays hard, Player One is better off playing hard (because being unsafe is better than being unsafe with a worse chance of winning). If Player Two plays softer, Player One is better off playing hard (because being unsafe with a better chance of winning is better than being safe, because winning is paramount). So Player One would always choose to play hard, because playing hard is a dominant strategy.

Player Two faces the same decisions. They also have a dominant strategy to play hard. If Player One plays hard, Player Two is better off playing hard (because being unsafe is better than being unsafe with a worse chance of winning). If Player One plays softer, Player Two is better off playing hard (because being unsafe with a better chance of winning is better than being safe, because winning is paramount). So Player Two would always choose to play hard, because playing hard is a dominant strategy.

Both players will choose their dominant strategy (to play hard), and both will be unsafe. But what if being safe was more important than winning? That changes things considerably. Now, playing hard is no longer a dominant strategy.

Go back to Player One. If Player Two plays hard, Player One is still better off playing hard (because being unsafe is better than being unsafe with a worse chance of winning). If Player Two plays softer, Player One is now better off also playing softer (because being safe is better than being unsafe with a better chance of winning, since safety is now paramount). Note that neither strategy is always better for Player One - Player One has no dominant strategy.

Now consider Player Two. If Player One plays hard, Player Two is still better off playing hard (because being unsafe is better than being unsafe with a worse chance of winning). If Player One plays softer, Player Two is now better off also playing softer (because being safe is better than being unsafe with a better chance of winning, since safety is now paramount). Note that neither strategy is always better for Player Two - Player Two also has no dominant strategy.

What is the solution to this game? We can find it using the best response method (which we've already described in the last two paragraphs). Any combination of strategies where both players are choosing their best response to the other player's strategy is a Nash equilibrium (named after John Nash). This occurs where both players play hard, and where both players play softer. We have a coordination game (a game with multiple equilibriums).

In a coordination game, if one of the equilibriums is clearly better than the other, we call that a Schelling Point (named after Thomas Schelling), and that equilibrium is the more likely equilibrium to obtain. In this case, both players playing softer is a Schelling Point. So, we could expect that both players would play softer (given our assumption that safety is paramount).

So what? The implication of this rough analysis is pretty clear. When rugby players view winning as paramount, then playing hard is a dominant strategy and all players will continually put their bodies (and minds) on the line in the pursuit of glory. If instead, safety becomes paramount then the outcome of the game changes, and it becomes likely that players will play softer and fewer injuries will result. If reducing rugby players' long-term concussion-related injuries is important, then the challenge for rugby authorities will be to change players' incentives to ensure that safety becomes a higher priority. Unfortunately, that is likely to be easier said than done.

Enforcement is key for sustainable fishing quotas

Many economists agree that sustainable management of common resources like fish stocks can be achieved using transferable quotas. Unfortunately, New Zealand's quota management (or rather, mis-management) has been in the news quite a bit recently. Consider this New Zealand Herald editorial:

The beauty about New Zealand's quota management system for commercial fisheries was that it would be self-policing, in theory. Once fishing companies were allocated a quota that could be traded, they would have a financial interest in the future of the fishery.

Therefore, it would be in the interest of each owner of a quota to catch no more than it was allowed and thus ensure the resource could be sustained and the quota would hold its value. It was also in the interest if each of them to see that all obeyed the rules. So they jointly set up a company that is contracted to police their catch.

This system has come under severe criticism this year following academic research that estimates fishing companies are catching more than twice their quota of some species and dumping the excess at sea. Even dumping filmed by CCTV cameras on board boats had not resulted in prosecution of their skippers by the Ministry for Primary Industries...

Unsurprisingly, many are saying the whole system is flawed, questioning the wisdom of giving the policing task to an industry-owned company ("putting a fox in charge of the chicken coop") and calling for a ministerial review or a commission of inquiry into the quota management system...

I wrote about fishing quotas very recently, in a post about kereru (emphasis added):

Quotas regulate the number of fish that are allowed to be removed from the sea in a given period of time. The total quota is set by determining a total allowable catch for a year (in theory at least this is roughly equal to the growth in the fishery stock), with some allowance made for recreational fishing. Quotas work well because they make fish excludable (no quota means no fishing) and are backed up by monitoring and enforcement.

Transferable fishing quotas create a property right (the right to fish). In order to be efficient (welfare maximising), property rights need to be universal, exclusive, transferable, and enforceable. In the case of fishing quota, universality means that all fish need to be covered by quota, and all fisherman must have quota in order to fish. Exclusivity means that only those who have quota can fish, and that all the costs and benefits of fishing should accrue to them. Transferability means that the quotas must be able to be transferred (sold, or leased) in a voluntary exchange. Enforceability means that quotas should be able to be enforced by the government, with high penalties for fishermen who fail to comply with the system.

The current system is failing in the last criterion (enforceability), and probably the first (universality) as well. A fishing industry that polices itself has little incentive to ensure that it is following the agreed management system. Discarding fish that are caught, and not recording them, is something that must be penalised. All fish that are caught (including those that are dumped) must be considered for the universality criterion to be satisfied.

The Herald editorial notes that the Ministry for Primary Industries' director of fisheries management wrote in an email that "If we found the golden bullet to stop discarding we would probably put half of the inshore fleet out of business overnight." If that's what it would take in order to ensure that fishing is sustainable, then it is the price that must be paid. Otherwise, the fish stocks are on a short road towards collapse from over-fishing. 

Trustpower takes multi-period pricing a bit too far

Last week in ECON100 we covered pricing strategy. Part of that topic looks at customer lock-in and multi-period pricing. Customer lock-in occurs when customers find it difficult (costly) to change once they have started purchasing a particular good or service. Customers are typically locked in because of high switching costs (literally the costs of switching from one good or service to another). Switching costs might include contract termination fees, but also include other costs such as the cost of searching for an alternative good, and learning how it works, etc. It is these high switching costs that prevent customers from changing to substitute products.

Firms can take advantage of having locked-in customers through multi-period pricing. This occurs when the initial price is low (to attract customers) and then the price is raised once the customers are locked in. Multi-period pricing only increases profits if the customer is locked in - if the customer is free to move to other providers, then when the price is increased they are likely to do so. There are lots of examples of multi-period pricing - one of my favourites is that it is a good explanation for why drug dealers give away free samples of their highest-quality (and most addictive) product.

So, it was interesting to read this article in the New Zealand Herald last week, about the strategy employed by Trustpower:

Trustpower has been hauled through the courts and fined $390,000 for misleading consumers over a campaign for an unlimited broadband deal.

Between March and July last year, Trustpower promoted a $49 a month for 12 months unlimited data broadband plan, under the campaign theme: "Good things happen when power and broadband get together." ...

However, the $49 price was available only to customers who signed up for power and broadband at the same address on a 24-month contract term.

For the last 12 months on the contract the cost jumped to $79 a month and if a customer wished to cancel the contract at any time during the 24-month period they would incur exit fees.

This is a classic example of multi-period pricing, supported by locking customers into a contract through the use of a high termination fee. It is worth noting that the Commerce Commission took issue not with the multi-period pricing strategy itself, but with the way it was marketed - the increased price over the second 12 months of the 24-month contract was buried in the fine print of the advertisements for the deal. If Trustpower had been more up-front about the terms of the deal, it wouldn't have attracted the Commission's attention (but it might not have attracted as many consumers' attention either!).

Consumer choice and the impact of advertising

Depending on who you are reading, one of the assumptions of neoclassical economics is that preferences over their consumption of goods are fixed. I've always thought that assumption was clearly flawed, because in the real world people's preferences clearly change over time. Of course, you make assumptions in order to make models simpler than the real world, but in this case it's an assumption that probably isn't even necessary.

We know that people's preferences change. One obvious example is the case of advertising. If advertising is effective, it should make the advertised good more desirable. That is, it should shift consumers' preferences towards that good. We covered this in my ECON100 class this week, but I thought it would be good to also go through it here.

Consider the consumer choice diagram below. The consumer is initially buying the bundle of goods A, which includes X0 of Good X, and A0 of all other goods (AOG). Point A is on the highest indifference curve the consumer can reach (I0) within their budget constraint (it's their best affordable choice).

Now say there is a successful advertising campaign for Good X. This makes Good X more desirable. In other words, the consumer would now be willing to give up more of all other goods to buy one more unit of Good X. This means that the marginal rate of substitution (the amount of one good the consumer is willing to give up to get one more unit of the other good) has increased. The marginal rate of substitution (MRS) is the slope of the indifference curve. Since the MRS is now larger, the indifference curve becomes steeper at point A (the indifference curve pivots around to the red curve I0').

Now, the bundle of goods A is no longer the consumer's best affordable choice. They can reach a higher indifference curve (I1') by buying the bundle of goods B instead. The bundle of goods B includes more of Good X (X1), and less of all other goods (A1). So, the effective advertising campaign for Good X induces the consumer to buy more of Good X, by changes their preferences (as represented by their indifference curves).

Note that this doesn't mean that all advertising is a good idea though. Even though the consumer is now buying more of Good X (and spending more on Good X, since they are buying less of all other goods), the advertising campaign involves some cost to the firm. To determine whether the advertising campaign was a good idea, the firm would need to compare the additional revenue generated by the campaign, with its cost.

The escalation of surf gang violence

I really like the textbook I use for my ECON110 class, The Economics of Public Issues by Miller, Benjamin and the late Douglass North. The chapter on common resources in the book talks (among other things) about the rise of surf gangs in the U.S.

Surf breaks are a classic common resource. They are rival (one surfer on the break reduces the amount of space available for other surfers), and non-excludable (it isn't easy to prevent surfers from paddling out to the break). The problem with common resources is that, because they are non-excludable (open access), they are over-consumed. In this case, there will be too many surfers competing to surf at the best spots.

The solution to the problem of common resources is to somehow convert them from open access to closed access. That is, to make them excludable somehow. And that's what the surf gangs do, by enforcing rules such as 'only locals can surf here'. So, when I read this article from Outside from earlier in the year, I thought it would be good to discuss:

Lunada Bay, a surf spot on the northern coast of the bucolic, affluent Palos Verdes peninsula in Los Angeles County, is in the news again this month. The spot is famously home to one of the most aggressive band of local surfers in the world: the Bay Boys. In March, a group of plaintiffs, including a local police officer, filed a class action lawsuit against eight alleged members of the Bay Boys (with the intention of adding more defendants later), accusing them of harassing visitors who tried to surf the bay, home to a high quality reef break accessible only by a narrow pass down the bluffs. According to the court filing, the Bay Boys have thrown rocks at surfers trying to scramble down the cliffside trail to the beach, slashed tires, and physically fought outsiders for surfing “their wave.” ...

But surfing’s relationship with “localism” is complicated. Ask any longtime surfer what his biggest gripe is and chances are you'll get one answer: overcrowding. The number of surfers in world jumped from 26 million in 2001 to 35 million in 2011. Tensions arise not only because of the volume of people in the water, but the fact that newbies don’t observe the activity’s longstanding code of conduct, which can be summed up in three essential mandates: wait your turn; don’t get in the way of fellow surfers; respect the locals. It’s enough to turn a sunny day at the beach into a heaving mess.

To see what happens when the hordes descend on a break, all a surfer has to do is drive 20 miles up Pacific Coast Highway from Palos Verde. In Malibu, the famously excellent point break in northern LA County, the system has broken down. Hundreds of surfers vie for space at the world-class spot, cutting each other off and crowding five or six to a wave. A small gang of locals has tried to harass outsiders to limit crowding, but it’s too late for Southern California’s most famous break—everybody wants a piece of Malibu. “It’s the tragedy of the commons,” says Warshaw.

In its milder form, localism enforces the surfer’s code, says Jess Ponting, the director of San Diego State University’s Center for Surf Research. Though he is quick to condemn such localism—Ponting calls the Bay Boy’s actions “some insidious shit”—he empathizes with surfers crowded out of their home breaks. Mild, non-violent localism is often touted as a “a response to limit crowding,’’ he says, though he doesn’t condone the practice. “In a local area that’s overwhelmed by visitors, perhaps local surfers deserve to have at least a spot that’s less crowded,” he says. “If localism is the mechanism to achieve that, the argument goes, then maybe that’s okay?”

The actions of the surf gangs ensure that some surfers are excluded from the best spots (why risk having rocks thrown at you, or worse?), and converts the open access surf breaks into closed access - where access is controlled by the gang. This prevents overcrowding and ensures that the common resource is managed in a way that makes users happier, albeit that those made happier are the 'insiders' who are part of the local surf gang. That might not be the welfare-maximising solution (hence some surfers applauding the lawsuit described in the article).

Now if everyone obeyed surf etiquette as per the code of conduct noted above, there wouldn't be any need for government intervention, lawsuits, or surf gangs. Elinor Ostrom, who won the Nobel Prize in economics in 2009 (but sadly passed away in 2012), argued that if enough of the affected community can work together, then the problem of common resources can be solved without government intervention. However, those type of private solutions require that the community can form a homogeneous group (within which trust is high), with common goals for the resource (in this case the surf break); and that both the boundary of the resource and of the community are well-defined. Trust is the key issue here - can all surfers be trusted to obey the (unwritten) rules? It seems not, especially when the community includes interlopers from elsewhere who don't respect the locals. This is why the surf gangs arose (since within each gang, trust is high and there is a common goal for the surf break - keeping non-locals out). 

What isn't immediately clear to me though, is why the need to escalate the level of violence to keep non-locals out? Is Lunada Bay so good that the benefits of surfing there (and avoiding the crowds at other beaches) enough to outweigh the costs of being harassed by the Bay Boys?

[HT: Marginal Revolution]

Sex, lies and pharmaceuticals

I just finished reading the 2010 book "Sex, Lies and Pharmaceuticals - How Drug Companies Plan to Profit from Female Sexual Dysfunction" by Ray Moynihan and Barbara Mintzes. The authors (or I should say the main author, since it appears that Moynihan wrote most of the book, with Mintzes contributing one chapter) describe the book as "an expose of how medical science is imperceptibly merging with pharmaceutical marketing".

I thought the book started off well, but by the time I got to about page 60 (of around 220) it was getting a bit tired, and seemed to be simply re-iterating many of the same points with only slightly different examples and characters. However, that doesn't mean that the point is not important. This book is essentially about supplier-induced demand, but taken to a different level.

Supplier-induced demand occurs when there is asymmetric information about the necessity for services. What services the customer (in this case the patient) needs is known to the supplier (in this case the doctor), but not to the customer. So, the supplier has an incentive to overstate the necessity for the services. The supplier essentially exploits the ignorance of the customer to their advantage.

Of course, we would hope that doctors are not quite so manipulative when it comes to their patients. However, in this case it is not the doctors but the pharmaceutical companies who are encouraging the sale of unnecessary products, with the doctors simply being unwitting intermediaries. Moynihan and Mintzes explain:

In order to maximise sales, the industry must 'create the need' for its newest and most expensive products. Sometimes that means selling sickness to the wealthy healthy, helping transform common ailments into widespread conditions that require treatment with the latest pills. Applauded for producing medicines that extend life and ameliorate suffering, drug companies no longer simply sell drugs; they increasingly sell the diseases that go with them.

How do the pharmaceutical companies 'sell the diseases'? By creating special relationships with the leading researchers in the field to develop definitions of the disease (in this case, female sexual dysfunction) that will suit the pharmaceutical companies' treatments; by developing and funding new surveys that demonstrate that the disease is widespread in the general population; by developing new tools to diagnose patients with the disease; by 'educating' doctors to recognise the disease (by using the new tools developed by the pharmaceutical companies or their pet researchers) and recommend treatment using the pharmaceutical companies' products.

The book zeroes in on one condition: female sexual dysfunction (FSD), which as the authors note is highly contested (read the "Criticism" section of that Wikipedia link for a little bit more detail). The authors note:

A forward-looking business intelligence report in 2003 named FSD drugs as an area of great future growth for the pharmaceutical industry, part of the burgeoning 'lifestyle' market including medicines for baldness, smoking cessation and obesity.

The profitability of drugs for rich-world diseases is beyond doubt, but the efficacy of the treatments for FSD described in the book very much is. Moynihan and Mintzes give a thorough rundown of the various machinations used by the pharmaceutical companies to get their products approved (by the FDA or their equivalents in Europe and Australia), and adopted by doctors. The critics of the pharmaceutical companies' actions rightly argue that the companies are medicalising a condition that is more than likely just normal variation in desire and arousal. That is, FSD may not necessarily be a problem that needs solving. And initially at least, karma appeared to be in the critics' favour [*]:

Despite a decade of pouring millions into conducting surveys of the condition, designing tools to diagnose it, sponsoring education about it and running trials of drugs to treat it, by 2009 the pharmaceutical industry had so far failed to come up with a sexual medicine that showed meaningful benefits for women.

Which is not surprising, if they are trying to treat a problem that may be more psychological than medical, if there even is a problem. Overall, despite the repetitive nature of the book I found it to be a good read. There is an overall note of caution that should be the book's key message, as the authors write in the conclusion:

...behind your doctor's decision to offer you a medical label and a medication is a global web of entanglement so vast it's invisible to the naked eye.

And it's that invisibility that makes the supplier-induced demand here all the more insidious.

*****

[*] I note that since the writing of the book, flibanserin was approved by the FDA for the treatment of FSD in 2015.

Customer loyalty and price discrimination

This week in ECON100 we discussed price discrimination - where firms charge different prices to different customers for the same product or service, and where the price differences don't reflect differences in cost. There are three necessary conditions for effective price discrimination:

1. Different groups of customers (a group could be made up of one individual) who have different price elasticities of demand (different sensitivity to price changes);
2. You need to be able to deduce which customers belong to which groups (so that they get charged the correct price); and
3. No transfers between the groups (since you don't want the low-price group re-selling to the high-price group).

If these conditions are met, then the firm would sell to groups with relatively more inelastic demand at a higher price than to groups with relatively more elastic demand. Which brings me to this Wall Street Journal article from earlier this year, about the insurance market:

Some car insurers hope to identify people who could potentially be their best, most loyal customers–and charge them more for their insurance.

Wait... what? Surely firms should charge lower prices to their most loyal customers, to reward their loyalty, right? However, the article continues (emphasis added):

Or so contend consumer advocates who track the insurance industry, who say the practice discriminates against low-income drivers and should be forbidden. They maintain that insurers are wrongly seeking to maximize their profits with an advanced analytical technique–known as “price optimization”— under which the companies identify consumers least likely to comparison shop and stick them with higher prices than more price-sensitive drivers. While insurers are targeting policyholders across a range of demographic groups, the activists say many lower-income people fall into that camp.

This is clearly a form of price discrimination, even though the industry sources quoted in the article argue otherwise. If you are an insurance company, you want to charge the customers who are most price sensitive a lower price. If customer loyalty is associated with customers who don't shop around, then customer loyalty is also associated with customers who are less price sensitive. Meaning that you want to charge those loyal customers a higher price.

Now you might argue (as the regulators are in this case) that this price discrimination is unfair. That would put you in good company (with John List, see my post here). The article notes:

A big concern among consumer advocates like Mr. Hunter is that poorer people may not shop around as much as others, because they may have fewer choices for insurance coverage to start with, and they may not have the Internet access that makes it increasingly easy for many Americans to get price estimates online.

However, then the case in favour of price discrimination starts to break down. Where car insurance premiums take up a higher proportion of a consumer's income, their demand should be more elastic. This will offset the price-insensitivity associated with being a loyal customer. And then of course you have pricing based on risk (which is what the insurers are arguing they are really engaging in).

Given all this, if firms are engaging in price discrimination (which they probably are) I would expect to see, for customers at the same level of risk:

• Loyal customers who have higher incomes paying the highest premiums;
• Loyal customers who have lower incomes, and less-loyal customers with higher incomes paying moderate premiums; and
• Less-loyal customers with lower incomes paying the lowest premiums.

It seems to me that helping low income people to shop around for insurance might be a good thing for those consumer advocates to be engaging in, rather than complaining about price discrimination.

Dumped steel

International dumping of steel has been in the news again recently, this time with particular regard to Chinese steel imports into New Zealand. John Nowlan (general manager of NZ Steel) wrote in the New Zealand Herald last week:

Many New Zealand domestic industries built up in the past 50 to 100 years are in jeopardy because of inadequate trade remedies that favour importers over local producers.

Steel production is in that boat.

It is easy to talk changing trends and globalisation, but the risk of closure of NZ industries inevitably means the loss of jobs and essential skills, and the possible disappearance of some of our smaller communities...

Now of course, you would expect the general manager of a steel producer to complain about cheap steel imports. After all, if you are an importing country it is typically because overseas firms can produce at lower production costs. If inefficient New Zealand firms have to compete with more efficient foreign firms, then the inefficient New Zealand firms must either become more efficient, or shut down (with consequent costs as I have noted in this post from earlier this year on dumping and tariffs). The flip-side to that is that our more efficient producers benefit from exporting (this is part of the reason that our dairy industry is such a large exporter).

However, the problem is not just imports, but 'excessively cheap' imports being 'dumped' into the New Zealand market. Nowlan explains:

Dumping is the exporting of goods cheaper than the products are sold in their own domestic market and is dealt with under WTO guidelines.

The guidelines also cover the subsidisation of products, where an uncompetitive business is paid to stay in production...

For a small country like New Zealand, dumping and subsidisation can have major adverse effects not just on an industrial sector, but also our entire economic fabric. More so, where an industry is one of a kind. Steel making is a pertinent local example.

Monday's New Zealand Herald editorial also makes valid points:

The answer from policy makers would be it helps to lower our high costs of building and construction, which have been identified by the Productivity Commission as a contributor to high and rising house prices. Many might not be convinced the benefits of lower construction costs would outweigh the possible loss of a local industry and jobs. But on that argument we would have maintained the protection that saddled us with a high-cost economy of a previous era.

It made sense to expose all industries to international prices so we might be left with those that are truly competitive and consumers could buy more of the world's goods.

It makes less sense when international prices are artificially low as a result of subsidies or dumping. The World Trade Organisation permits member states to impose countervailing duties on imports coming in at prices below their cost of production.

Is 'dumping' an issue? Here's what I wrote earlier this year:

So countries create additional tariffs to apply when foreign firms are thought to be using otherwise free trade to 'dump' their products into the domestic market. However, as Gary Becker has noted (for example, in this book), this type of predatory pricing is probably not sustainable. If you drive competitors out of the market and raise your prices, then new competitors will enter, assuming that the fixed costs of production aren't high enough to constitute a barrier to entry (which is arguable for some industries, such as steel production). However, even if there are high fixed costs, if you have relatively free trade then competitors from other countries can also step in when the predatory pricing stops.

That line of argument still applies, but so too do the results of Autor et al. that I note in that post (see here, or ungated here). The short-term pain (in terms of lost jobs) from free trade can persist for a longer time than we previously thought, or is conventionally argued. So, when this pain is created by unfair competition from abroad, this may provide a clearer case for some limited protectionism.

The Herald editorial concludes with:

...provided the quality meets the standards required, dumped steel can be an economic benefit. Larger countries may be able to protect their own steel makers but New Zealand needs to think carefully. Is Glenbrook vital?

Glenbrook may not be vital (in the sense that its closure would make the wider economy vulnerable), but we do need to think carefully about the costs and benefits of importing excessively cheap imported steel. The costs of foregoing cheaper steel (lost consumer surplus, higher construction costs, etc.) should be weighed up against the benefits (retaining jobs in the steel industry, option value, etc.). We certainly don't want to find ourselves in the position of having $750,000 steel workers.

Read more:

• New arguments against free trade

Why study economics? More tech sector jobs edition...

I've written a couple of previous posts on jobs for economists in the tech sector (see here and here). Those tech sector jobs for economists are in the news again. Steve Lohr writes in the New York Times:

Silicon Valley is turning to the dismal science in its never-ending quest to squeeze more money out of old markets and build new ones. In turn, the economists say they are eager to explore the digital world for fresh insights into timeless economic questions of pricing, incentives and behavior.

“It’s an absolute candy store for economists,” Mr. Coles said.

The pay, of course, is a lot better than you would find in academia, where economists typically earn $125,000 to $150,000 a year. In tech companies, pay for a Ph.D. economist will usually come in at more than $200,000 a year, the companies say. With bonuses and stock grants, compensation can easily double in a few years. Senior economists who manage teams can make even more.

Businesses have been hiring economists for years. Usually, they are asked to study macroeconomic trends — topics like recessions and currency exchange rates — and help their employers deal with them.

But what the tech economists are doing is different: Instead of thinking about national or global trends, they are studying the data trails of consumer behavior to help digital companies make smart decisions that strengthen their online marketplaces in areas like advertising, movies, music, travel and lodging.

Yet another reason (if any was needed) why studying economics is a good idea. An in particular, applied microeconomics combined with mathematics or statistics:

“They are microeconomic experts, heavy on data and computing tools like machine learning and writing algorithms,” said Tom Beers, executive director of the National Association for Business Economics.

[HT: Marginal Revolution]

Read more:

• Why study economics? Law and economics edition...
• Why study economics? More on jobs in the tech sector edition...
• Why study economics? Tech firm jobs edition...
• Why study economics? AEA video edition...
• Why study economics? Even if you won't be an economist edition...
• Why study economics? PhD edition...
• Why study economics? It could make you rich...
• Why study economics? Sheepskin effects edition
• Why study economics? NZ graduate earnings edition
• Why study economics?

Uber for bees and trees

One of the key examples we use to illustrate potential bargaining solutions to externalities involves bees and apples. The original example dates all the way back to a 1952 article in The Economic Journal by W.E. Meade (ungated here), who wrote:

Suppose that in a given region there is a certain amount of apple-growing and a certain amount of bee-keeping and that the bees feed on the apple-blossom. If the apple-farmers apply 10% more labour, land and capital to apple-farming they will increase the output of apples by 10%; but they will also provide more food for the bees. On the other hand, the bee-keepers will not increase the output of honey by 10% by increasing the amount of land, labour and capital applied to bee-keeping by 10% unless at the same time the apple-farmers also increase their output and so the food of the bees by 10%.

What Meade was describing was two positive externalities. Remember that an externality is the uncompensated impact of the actions of one party on a bystander. In the first case, the apple-farmers generate a positive externality for the bee-keepers (if the apple-farmers grow more apples, they provide an additional benefit for the bee-keepers in the form of more food for the bees and consequently, greater output of honey). In the second case, the bee-keepers generate a positive externality for the apple-farmers (if the bee-keepers keep more bees, then the apple trees will produce more fruit, increasing the profits of the apple-farmers). Now the problem here is that, because the apple-farmers are only concerned about their own profits, they don't take into account the benefit their trees provide for the bee-keepers, so they will plant too few trees. And similarly, because the bee-keepers are only concerned about their own profits, they don't take into account the benefit their bees provide for the apple-farmers, so they will keep too few bees.

One potential solutions to this positive externality problem that we discuss in class is the possibility of integration (the apple-farmers start to keep their own bees, or the bee-keepers start their own apple orchards, or the two come together to form a joint venture business that produces both apples and honey - mmmm, honey-glazed apples). Another potential solution is contracting - the bee-keepers and the apple-farmers get together and agree to a contract, that specifies the number of trees that will be grown, the number of bees that will be kept, and perhaps some side-payment from one party to the other.

In 1973, Stephen Cheung wrote a follow up to the Meade paper in the Journal of Law and Economics (ungated here), where he pointed out that contracting solutions to the bees-and-trees problem were not observed in the real world, because the transaction costs of these agreements are too high (transaction costs in this case are the costs of negotiating a suitable agreement between the apple-farmer and the bee-keeper - if the costs are high, it will be more difficult for the parties to justify the expense of coming to an agreement). Instead, a social norm developed between apple-farmers and bee-keepers in terms of the number of bees per orchard, etc. Of course, a social norm is just an informal contract by another name.

But, thinking about those high transaction costs that prevent bee-keepers and apple-farmers from easily contracting brings me to this article from the New Zealand Herald about the software-based beekeeping service BeezThingz:

BeezThingz provides a match-making service to beekeepers and land owners.

We provide our beekeepers with hive management software for inspection logging and customer management. Our land owners get all the benefits of having a beehive with none of the hassle...

How it works is people express interest through our website and then I forward that on to the appropriate beekeeper who looks after their area. The beekeeper will go out and do a site inspection, walk around the property and talk through all the potential hazards with the landowner. They will then book in a delivery date, install the bees and get a regular service schedule.

Yes, it is like Uber for bees and trees, or given that they describe it as a match-making service, maybe it is like Tinder for bees and trees? In any case, the business model is all about reducing the transaction costs of negotiating a contract between land owners and bee-keepers, since there are standard contract terms (a more formal version of the solution that Cheung noted). And when transaction costs are low, the Coase Theorem says that private parties can often solve externality problems on their own (i.e. without government intervention). Meaning in this case, the right number of bees for the right number of trees, and everyone wins.

Reinhard Selten, 1930-2015

Last year we lost John Nash, and last week his fellow 1994 Nobel Prize winner Reinhard Selten passed away. Selten was the last surviving member of the trio of 1994 Nobel winners, who were recognised for their work on various aspects of game theory.

My students might not recognise Selten's name, but we make use of his work in ECON100, particularly the idea of subgame perfect Nash equilibrium in sequential games, and in 'Selten entry games'.

Bloomberg covers some of Selten's work in their obituary, and for something more detailed (and technical) see this piece at A Fine Theorem. Selten's Nobel biographical is here.

[HT: Marginal Revolution]

The Epipen price increase explained

I had been holding off posting about the increase in the price of EpiPens (400% over the last several years), waiting for my ECON100 and ECON110 classes to cover monopoly, market power, and intellectual property. However, Alex Tabarrok at Marginal Revolution pointed to this excellent Slate Star Codex post, which breaks it down nicely and saves me the trouble:

EpiPens, useful medical devices which reverse potentially fatal allergic reactions, have recently quadrupled in price, putting pressure on allergy sufferers and those who care for them...

...when was the last time that America’s chair industry hiked the price of chairs 400% and suddenly nobody in the country could afford to sit down? When was the last time that the mug industry decided to charge $300 per cup, and everyone had to drink coffee straight from the pot or face bankruptcy? When was the last time greedy shoe executives forced most Americans to go barefoot? And why do you think that is?

The problem with the pharmaceutical industry isn’t that they’re unregulated just like chairs and mugs. The problem with the pharmaceutical industry is that they’re part of a highly-regulated cronyist system that works completely differently from chairs and mugs.

If a chair company decided to charge $300 for their chairs, somebody else would set up a woodshop, sell their chairs for $250, and make a killing – and so on until chairs cost normal-chair-prices again. When Mylan decided to sell EpiPens for $300, in any normal system somebody would have made their own EpiPens and sold them for less. It wouldn’t have been hard. Its active ingredient, epinephrine, is off-patent, was being synthesized as early as 1906, and costs about ten cents per EpiPen-load...

Why can't generics compete? It's our old favourite, rent-seeking behaviour in the form of lobbying, at work:

So why is the government having so much trouble permitting a usable form of a common medication?

There are a lot of different factors, but let me focus on the most annoying one. EpiPen manufacturer Mylan Inc spends about a million dollars on lobbying per year...

Imagine that the government creates the Furniture and Desk Association, an agency which declares that only IKEA is allowed to sell chairs. IKEA responds by charging $300 per chair. Other companies try to sell stools or sofas, but get bogged down for years in litigation over whether these technically count as “chairs”. When a few of them win their court cases, the FDA shoots them down anyway for vague reasons it refuses to share, or because they haven’t done studies showing that their chairs will not break, or because the studies that showed their chairs will not break didn’t include a high enough number of morbidly obese people so we can’t be sure they won’t break. Finally, Target spends tens of millions of dollars on lawyers and gets the okay to compete with IKEA, but people can only get Target chairs if they have a note signed by a professional interior designer saying that their room needs a “comfort-producing seating implement” and which absolutely definitely does not mention “chairs” anywhere, because otherwise a child who was used to sitting on IKEA chairs might sit down on a Target chair the wrong way, get confused, fall off, and break her head.

(You’re going to say this is an unfair comparison because drugs are potentially dangerous and chairs aren’t – but 50 people die each year from falling off chairs in Britain alone and as far as I know nobody has ever died from an EpiPen malfunction.)

Imagine that this whole system is going on at the same time that IKEA spends millions of dollars lobbying senators about chair-related issues, and that these same senators vote down a bill preventing IKEA from paying off other companies to stay out of the chair industry. Also, suppose that a bunch of people are dying each year of exhaustion from having to stand up all the time because chairs are too expensive unless you’ve got really good furniture insurance, which is totally a thing and which everybody is legally required to have.

Nicely said. Give a firm market power, grant it even a limited monopoly, and it has incentives to raise price to maximise profits. Which we see again and again in the pharmaceutical industry.

Read more:

• The Economics of Drug Development and Pricing
• Creating and capturing value in pharmaceutical markets