Don't bet on horses with fast-sounding names

In a new paper to be published shortly in the Journal of Behavioral and Experimental Economics (open access), Oliver Merz, Raphael Flepp, and Egon Franck (all University of Zurich) undertake an interesting test of behavioural economics. The affect heuristic suggests that our decisions are influenced by our emotions. In other words, the affect heuristic forms part of our System 1 thinking (to borrow from Nobel Prize winner Daniel Kahneman's excellent book Thinking, Fast and Slow), where our decision-making is fast, instinctive, and emotional.

However, the affect heuristic (and System 1 thinking more generally) is completely at odds with the Efficient Markets Hypothesis, which in its strongest form suggests that all relevant public and private information is incorporated into the price of an asset (such as a share price). The efficient markets hypothesis essentially suggests that in financial decisions we rely on System 2 thinking - slow, deliberative, and logical, and not influenced by our emotions.

Merz et al. look at the case of betting on horse racing, and in particular they look at whether the names of horses affect betting behaviour. The name of a horse should be reasonably uninformative about how fast the horse can run - there's no rule or law that says an owner can't name their slow nag Rocket Roger, for example. So, if betting behaviour is affected by the names of the horses, then that is likely to be the affect heuristic at work.

Using Betfair data from over 400,000 horse races in the UK, Ireland, the US, South Africa, and Australia, and involving nearly four million horses, they find that:

...a fast-sounding horse name has predictive power with regard to the race outcome beyond the winning probabilities implied in the odds. In particular, our results show that the winning probabilities of bets on horses with fast-sounding names are overstated, implying that the prices in betting exchange markets are not completely efficient, as prices become distorted by incorporating affective, misleading information from a horse’s fast-sounding name.

In other words, bettors place bets on horses with fast-sounding names far more often than the horses' underlying win probabilities suggest that bettors should. But before you get carried away and rush off to bet against horses with fast-sounding names:

...we find significantly lower returns for horses classified as fast-sounding compared to other horses. A simple trading strategy of betting against all horses classified as fast-sounding yields a return of approximately 2.9% before the commission but a negative return of -1.6% after deducting the standard commission of 5% from Betfair.

Even though in theory you can profit from other bettors' irrational preference for betting on horses with fast-sounding names (in apparent violation of the Efficient Markets Hypothesis), when you take into account that Betfair takes a commission on every bet, there isn't a positive profit-making opportunity here. The best you can probably do is to avoid betting on horses with fast-sounding names, because the return is going to be significantly more negative than it should be.

[HT: Marginal Revolution]

Consumer surplus illustrated

In economics, the concept of producer surplus is relatively intuitive to understand. It is the difference between what the seller receives for selling the good or service, and the seller's costs. That is effectively their profit (or, to be more correct, it's their profit if you ignore any fixed costs).

The concept of consumer surplus has a similar interpretation conceptually, but intuitively consumer surplus is more difficult to understand. It is the difference between the maximum that the buyer is willing to pay for the good or service, and the price that they actually pay.

Here's an illustration. After a tragic accident delaminated the sole of my shoe yesterday, I find myself in need of a new pair of sneakers. I went to The Warehouse this morning, and picked out a nice new pair, with a stated price of $35. Having satisfied myself that this was a good buy, I headed for the checkout.

When I arrived at the (self-service) checkout and scanned the barcode, the price came up as $19.98. Even better! I was happy to buy the shoes for $35, but now I was getting them for $19.98 instead. I have an extra $15.02 left in my bank account after the purchase than what I had anticipated. That $15.02 is consumer surplus. [*] You can think of it as a sort of profit that the buyer receives.

Consumer surplus is a measure of the benefit that buyers receive from participating in the market. If the consumer chooses not to buy, then there is no surplus - they will only buy if the price is not higher than the maximum they are willing to pay, and that means that some consumer surplus will be generated from every willing transaction between a buyer and a seller.

When we add the consumer surplus and producer surplus (and sometimes some other positive welfare effects of markets) together, we get a measure of total welfare (or total surplus). Total welfare is a concept that long-term readers of this blog will have seen many times (most recently here). It is important for understanding the value that markets generate, and how policies or interventions in the market will affect the wellbeing of the buyers and sellers operating in the market.

*****

[*] Actually, my consumer surplus is likely to be even higher than $15.02. Since I was willing to pay at least $35 for the pair of sneakers, I was probably willing to pay more. I won't tell you how much more, just in case The Warehouse is listening. We're not at the stage where retailers are extensively using personalised pricing (see here for a related example), but I'm not taking any chances!

Your electronic devices are going to cost more

John Hopkins (Swinburne Institute of Technology) wrote in The Conversation earlier this week:

The manufacturing world is facing one of its greatest challenges in years — a global shortage of semiconductors — and there doesn’t appear to be an end in sight any time soon.

According to Acer, one of the world’s largest laptop manufacturers, companies will still be affected by this shortage until at least the first half of 2022.

Semiconductors are an essential component of electronic devices, found in everything from cars and factory machinery to dishwashers and mobile phones. They harness the conducting properties of semiconductor materials (such as silicon), through the use of electric or magnetic fields, light, heat or mechanical deformation, to control the electric current flowing into a device.

Hopkins also outlines how we ended up with the shortage:

Like many current global challenges, this shortage initially began as a result of the COVID pandemic. Staff at semiconductor foundries in China and around the world were unable to go to work, plants were closed and production halted, which led to a lack of supply. The movement of that supply was also slowed down by tighter restrictions at ports and international borders.

At the same time, employees started working from home, children and students started studying from home, and many of us were confined to our homes for long periods. New equipment was needed to support these changes, establish makeshift offices and classrooms in our homes, and upgrade our existing home entertainment options. This prompted a sudden increase in demand for many of the devices that rely on semiconductors. 

These two changes (a decrease in supply, and an increase in demand) have led to the shortage of semiconductors, but the shortage will be temporary. To see why, consider the market for semiconductors as shown in the diagram below. The market was initially in equilibrium before the pandemic, with a price of PA and QA semiconductors traded. Then, during the pandemic, demand increased from DA to DB, while supply decreased from SA to SB, but the price of semiconductors initially stays at PA. At that low price, the quantity of semiconductors demanded in QD, but the supply is only QS - there is a shortage.

What happens next is important. The shortage means that some semiconductor buyers are missing out. To avoid this situation, the buyers can try to find a seller, and offer a slightly higher price to avoid missing out on some of the limited supply of semiconductors that are available. [*] In other words, the buyers bid the price upwards, and this process continues until the price reaches the new equilibrium price of PB, where there is no shortage and QB semiconductors are traded. [**]

Now, consider how the increase in the price of semiconductors will affect the market for electronic devices. Everything from phones to laptops to cars includes semiconductors, so an increase in the price of semiconductors increases the costs of production of electronic devices. This is shown in the diagram below. The price of devices is initially in equilibrium at P0, with Q0 devices traded. The increase in production costs causes supply to decrease from S0 to S1. The equilibrium price of devices increases to P1, where Q1 devices are traded. [***]

The global semiconductor shortage might seem an interesting by-product of the coronavirus pandemic. But, it is going to show up in the price of your next smartphone, laptop, or new car purchase.

*****

[*] In reality, the mechanism probably isn't quite this simple as there will be existing contracts for supply, etc. However, the buyers who least want to wait will find ways of accelerating their access to semiconductors, and that will involve offering a higher price in some way.

[**] As I have drawn it, QB is greater than QA, suggesting that the quantity of semiconductors increases. However, that need not be the case. The change in quantity is ambiguous. If the decrease in demand was a little bit smaller, the equilibrium quantity would have decreased, or could have stayed at the original quantity of QA.

[***] For simplicity, I haven't shown the increase in demand for devices here. However, that also leads to an increase in the price, meaning that prices of devices will increase even further.

Incentivising coronavirus vaccination, part 2

A couple of weeks ago, I posted about incentives for coronavirus vaccination, noting that:

...the government could find some other way to incentivise more production and consumption. Right now, we're in a situation where governments want to roll out coronavirus vaccines in the face of a substantial amount of vaccine hesitancy. Some governments have started to incentivise vaccines through more than just subsidising them and making them available for free.

Continuing the theme, the New Zealand Herald reported last week:

A Florida music event promoted will charge a premium to those who have not had the Covid-19 vaccine.

The concert promoter has come up with a discounted ticket at $18 for those who have been vaccinated, and will charge $999.99 to those who haven't.

The idea is to encourage people to get the coronavirus vaccine, especially before attending a large gathering such as a music gig...

[Leadfood Promotions' Paul Williams] said feedback for his idea has been "overwhelmingly positive" and, so far, no one has bought any of the $1000 tickets.

A general point about incentives is that, when the benefits of doing something increase, we are more likely to do it. If the benefits of vaccination now include cheaper concert tickets, that may encourage a few additional people to get vaccinated.

My earlier post about incentivising vaccinations drew on behavioural economics (specifically, prospect theory). On a related note, Alex Tabarrok also raised a good behavioural economics point recently:

A vaccination is all about immediate costs and future benefits and it’s more difficult to act on future benefits than immediate costs, ala hyperbolic discounting. A free beer, donut, or lottery ticket provides an immediate benefit to offset the immediate cost and so may encourage vaccination, especially for those who are very present oriented. Note, however, that a lottery ticket might be expected to be less beneficial than an equivalent-cost donut because the donut is truly immediate while the lottery ticket is not. On the other hand, if vaccine hesitancy is driven by over-estimated fear of rare side-effects then perhaps a lottery ticket balances with an over-estimated hope of rare-benefits.

And then this point on funding public goods through lotteries (an excellent point that I had not considered before):

Even within a risk-neutral, rational model, however, there are good reasons to tie public goods to lotteries (ungated). Charities, for example, often use lotteries or raffles to fund public goods. Why? The reason is that a lottery is a natural counter to free-riding. Imagine that there is a public good but no one contributes because they each hope to free ride off other people’s contributions. As a result, the public good is not provided. Now introduce a fixed prize lottery. If no one else contributes then a contributor wins the lottery for certain so it can’t be an equilibrium for everyone to free ride (reminiscent of my dominant assurance contract mechanism for producing public goods). Note that the lottery in this model can’t just be a regular lottery ticket where you have to match X numbers to win. It has to be a raffle where the probability of winning is 1/N where N is the number of contributors. Thus, the Maryland and Ohio vaccine lotteries, which draw winners from the vaccinated, are much better than New York version which just hands out free lottery tickets. Thus, I expect the Ohio and Maryland versions to be more successful than the New York version.

So, let me reiterate: New Zealand should be considering what incentives to put in place to encourage vaccination now. The last thing we need is to fall short of herd immunity targets, and have to continue an isolationist stance on migration, while the rest of the world is opening up.