09 August 2007

Forums Comment

Recently Steven Levitt, author of Freakonomics and a very successful blog, moved to the NY Times. One of his first postings there proved to be very controversial. The subject was “If you were a terrorist, how would you act?” Levitt provided his ideas and rationale and asked that readers do the same. Some readers saw the idea as progressive and therefore participated, while others saw the idea as definitely non-economic and culturally subversive. What’s going on here? Let’s take out our economic balance sheet to identify the costs and benefits of such a posting.

(It’s important to note that Levitt is not being cavalier in his question. It is how his mind works as a Micro-economist working in the science of incentives. Thinking this way is a characteristic of intelligence. It is how Einstein came up with relativity. He was able to imagine the properties of physics while traveling at c. It is the same skill that allows humans to empathize.)

First, let’s look at the costs and benefits to Dr. Levitt. He has stated before on his blog that he appreciates all types of commentary. Well, he received ~600 (and counting) comments on this posting. Also, I’m sure the number of hits his site got spiked this week as well and may stay high at least for the near future. On the other hand, he may also have permanently lost some readers and some readers will visit less frequently because of the post. Dr. Levitt probably also cares a little about the NY Times perspective, which depends on their costs and benefits of Levitt’s post.

For the NY Times there are similar benefits as Dr. Levitt’s. Hits and exposure go up. Costs include the possibility that long run hits decrease, but also that there are corporate reputation risks involved. The NY Times does not want to be potentially culpable for publishing methods that terrorists may learn from or even use. Interestingly, there is also a small benefit associated. It might be a positive for the NY Times to be part of a project that identifies some terrorist hatches and therefore become the initiating step in preventing terrorist activities. Econometrically, this is a difficult benefit to quantify. Every time a terrorist activity does not occur does it become a feather in the cap of Levitt and NY Times? (Actually, Dr. Levitt is probably one with the best ability to quantify the benefit.)

There is a glimmer of brilliance in the post. I believe that what Levitt and the NY Times are trying to tap into, wittingly or unwittingly, is a concept outlined in a book called Wisdom of Crowds by James Surowiecki. What the concept states is that if there exists a well-structured public forum, then decisions made with crowd input can always far exceed those without.

The way Surowiecki’s concept would work for Levitt’s blog is that if you believe that Levitt’s blog & commentary format constitutes a well-structured forum, then Levitt’s posting can successfully improve security by preempting plots that bureaucratic experts and homeland security contractors may not have considered.

Thankfully Surowiecki has provided us some guidance into what characteristics are needed for a well-structured forum; diversity, independence, and practicality. If these conditions are met (starting to sound like a theorem) then the existence of the forum guarantees that the decision made will be (weakly) superior to a decision without a format, according to any metric of superiority. We are not saying that the forum should equally weight all input or specify any other aggregation technique (that is a discussion for Social Choice theory). But, what we are saying is that for any definition of superior, having input provided by a well-structured forum will yield superior policy than not having it available, having only the input of a small group of “experts”, or any forum (information market) failure.

Maybe it’s me, but this claim sounds a lot like the Fundamental Theorem of Economic Welfare, which says that under some conditions (if government has intervened to correct the market failures of imperfect competition and externalities) the resulting competitive equilibrium will be Pareto efficient, a generalized notion of optimality. What we’ve just stated in the preceding paragraph about the potential Wisdom of Crowds is that, under some conditions (independence, diversity, practicality; which the government can intervene to guarantee) the resulting policy is superior under a class of metrics.
Perhaps what we’re driving at is a Fundamental Theorem of Public Policy.

The Fundamental Theorem of Welfare Economics is a mathematically proven statement. Its concept (first postulated by Adam Smith) was eventually translated into precise conditions and a conclusion justified by mathematical tools and reason.

Paul Samuelson, in his graduate dissertation advised by an Economist and Physicist (a polymath academic descendent of Gibbs), imported the tools of Thermodynamics into Economics and placed them on the proper shelves. It is with these tools and reasons that The Fundamental Theorem of Welfare Economics was developed and formalized.
Is it time or is it even possible to again import those tools into the field of Public Policy?

Upon consideration, what Surowiecki purports makes sense.
Diversity is critical because it can illuminate the subject matter of the discussion from different perspectives, leaving no facet shadowed and the pull of potential factions negated.
Independence is important so that members do not correlate each other prior to providing their input. It is well understood that in failed forums, those who speak first, those who speak most frequently, those who are verbose, those with better rhetoric, and those who speak with intimidation enjoy disproportionately large bias relative to their input.

How do Levitt’s and Mankiw’s blog and comment forum measure up to these desired characteristics?
Diversity. Given the large amount of people with access to the internet and subsequently their blog, both have the potential to garner sufficient diversity. For Levitt, being now associated with the NY Times site should even further his forum’s diversity. As self-noted on his blog however, his comments are subject to a self-selection bias. Independence. This has become a major concern in Mankiw’s blog and comment forum. It is not so much bias from rhetoric or intimidation, but rather bias generated from mass. With the quantity of comments generated in his forum, there becomes an enormous amount of repetition of the same factors; the equivalent of individual verbosity or a group over-representing a factor. Independence, lack of bias, and lack of pre-correlation are crucial. There is, however, a balance. Should individuals have access to the factors presented already, in case they had failed to consider certain aspects? I think so, minimally. You may argue that this necessarily introduces bias. I claim that it should be the role of a forum governing body to intervene minimally to provide this service in order to correct the potential market failure of information asymmetries. What do you think now? Or did I just present too much bias?
Practicality. This is the most dangerous failure of Levitt’s forum given his post and its greatest detriment in my mind. Since there is no enforcement agency to actively address the results of the forum’s discussion, then we have only illuminated failures without providing for means to correct them. Hence we have a major forum failure.
Indirectly we do have such a means though. It is possible that the post and comments will generate enough interest to actually guide public resources to addressing these failures. It is important to point out that it is not necessary to post the comments in response to Levitt’s post. Levitt could only offer an incentive such as one of his yo-yos to the comments that he deems most insightful in order to compensate the readers for the lost incentive for no longer enjoying seeing their comments published.

Evidently there appears to be a real science to generating efficient forums, just as there is a real science to generating efficient markets (called Economics).

I would like to highlight one of Milton Friedman’s quotations.
“Abraham Lincoln talked about a government of the people, by the people, for the people. Today, we have a government of the people, by the bureaucrats, for the bureaucrats, including in the bureaucrats the elected members of Congress because that has become a bureaucracy too.
And so undoubtedly the most urgent problem today is how to find some mechanism for restructuring our political system so as to limit the extent to which it can control our individual lives. You know, people have the image, have the idea, that somehow ‘we the people’ are speaking through the government. That is nonsense.”

Maybe that is what our discussion is pointing at; working to find some efficient mechanism for our political system to listen to the people.
For the people to be heard we need a forum, and as we’ve seen, it is absolutely critical that that forum needs to satisfy some conditions in order to be efficient.

Just as efficient market operation is important in the regional to the global environment; so is the efficient forum important in local, state, federal and international policy. Efficient forums are needed in academia, private industry, and government.

I believe that structuring efficient forums can in the long run refine an umbrella of policies; from tax to national security to campaign finance (normally a direct enemy to efficient forums and our political system by biasing input with wealth and generating sustainable constitution-endangering factions).

Surowiecki provides a number of examples of forums successfully at work in a variety of situations.
1) The average group guess of the weight of an ox at a fair is consistently significantly closer than any individual. [The reason is that the group is comprised of individuals who will overestimate the weight (a cattle truck driver who may associate the animal with all of its transport gear) and underestimate the weight (a butcher who views the animal as a combination of steaks and forgets about pre-trimmed portions]
2) The significant consistent accuracy of the “ask the audience” in Who Wants to be a Millionaire relative to the performance of “ask a friend/expert.”
3) A navy vessel lost at sea whose discovery was due only to a forum effective at gathering the input of weatherman, coastal current experts, sailors, sociologists familiar with behavior of lost crew, and committees well versed with subtle but critical techniques of rescue operations.
4) The significant accuracy and consistency of bettor’s prediction in sports games relative to the bookies/experts initial lines (remembering that bookies have incentive to accurately predict games to maximize their vigorish)

Beginning to tread in the world of research-needed speculation, I might venture that there exists a preferred location in the political compass dependent on the present position of society relative to the Fundamental Theorems of Economics and (our new) Fundamental Theorem of Public Policy. http://en.wikipedia.org/wiki/Political_compass
Milton Friedman hints at something like this in Capitalism and Freedom.

My claim would state that the optimal position on the fiscal axis of the political compass should depend upon present market situation in the economy.
An economy with perfectly compensated market failures should be optimally situated for no further government intervention and would belong completely at the right end of the fiscal spectrum.
Similarly an economy in desperate need for government intervention to correct gaping market failures should be optimally situated at the left end of the fiscal spectrum.
Further, a policy making forum without any forum failures (including information asymmetries as well as the others outlined earlier) should be optimally situated for the total liberal behavior side of the social spectrum.
Similarly, a policy making forum desperately suffering from lack of diversity, independence, and total information asymmetries would be optimally situated for the power-vested leader representation side of the social spectrum.
Therefore, our (US) optimal position in the political compass depends on our individual perspectives of our current situation; that is, the health of our free markets and public forums. Again, this is not one particular point, but a set characterizing the generalized notion of optimality representing different individuals’ relative weightings between security and freedom.

07 August 2007

About Pareto Efficiency

In response to Adam’s comment about the idea of Pareto Efficiency.

Following the last posting, Adam asked the definition of “Pareto Efficiency,” namely is it unique and what metric is it based on?

Let me first point to a technical definition - http://en.wikipedia.org/wiki/Pareto_efficiency

Let me sat that this is a good question. Pareto efficiency is a subtle point. It means only that resources are not being wasted and that no one can improve his/her welfare (“utility” to economists) without lowering someone else’s welfare. So, as long as a government is enforcing property rights, once a Pareto Efficient allocation has been achieved, no one can do any better from further transactions.

What Pareto Efficiency does not say is that if individuals begin with non-efficient initial allocations (A would like to trade to improve A’s welfare and there is a B out there who is willing to trade with A and both A and B end up at least as well off as before they transacted) which of the many possible Pareto Efficient allocations will be achieved. A might increase his utility and B may stay the same in one efficient allocation. B might increase while A stays the same. They might both increase the same amount…. Because it is seemingly arbitrary to place weights on the importance of different individuals’ welfare, Economists sometimes only characterize optimality of allocations up to identifying the set of Pareto improving efficient allocations, a more generalized notion of optimality.
Again, this can all be seen diagrammatically in Figure 2 and explained with the accompanying discussion at http://cepa.newschool.edu/het/essays/paretian/paretoptimal.htm

If initial allocations are not efficient (as they usually are not), which of the very many Pareto Efficient allocations will be realized depends on who holds the bargaining power in the transaction. If A has full bargaining power then A can make B a take-it-or-leave-it offer and A will enjoy the surplus from transacting while B’s utility will remain the same or vice versa.

Bargaining power may depend on multiple factors; your desperation, your outside alternative options, whether bargaining is allowed to banter back and forth, your response time in the bantering relative to the depreciation of the good being bargained for.

In the presence of an externality, when there exist indirect effects to others welfare, which Pareto Efficient point gets achieved depends on the government’s intervention in determining who holds property rights. In essence, politicians weight welfare of individuals or firms against each other by decreeing initial property rights. In the common example, the government’s decree about whether a construction firm has the right to build an airport near a subdivision or whether the homeowners have the right to quiet surroundings determines which Pareto Efficient point in the set will be realized.

05 August 2007

Economics in Family Decisons

Economics in Complicated Family Decision Making Situations

I was talking to my sister, a MSW (Masters in Social Work), how Economics has changed my perspective in how markets and societies work.

I said that I am a big believer in near laissez faire behavior.
The response was, “well, what about within marriage and families?”
In the interest of conversation simplicity, I had left out a significant stipulation. And the retort question had hit that stipulation right on the head. I didn’t, and don’t have a simple short-winded answer, as good questions don’t usually have that. But, here’s something.

The Fundamental Welfare Theorem of Economics says that under some basic conditions, if everyone does what is directly best for them, then the resulting competitive equilibrium allocates resources efficiently.
[efficiency (pareto efficiency), means that nobody can do better without someone else necessarily being worse off]
This is a good thing in that resources get used without waste and nobody ends up preying on anybody else.

But those basic conditions are crucial. They say that markets need to have perfect competition, and (this next one is the important one in our conversation) that there should not exist externalities (spillover effects). It is the role of government to intervene minimally to correct those potential market failures.

Externalities occur whenever an individuals’ actions indirectly effects the welfare of others. It probably happens all the time in sociology. In economics, it doesn’t happen all the time because most effects are reflected in the price, but still it happens a lot. For example, if you buy a loud stereo, then the direct effect is the change in your wealth and the firms profit, but the indirect effect is the degradation of the welfare of your neighbors. There are positive externalities too. For example, when you pay a good street performer, the direct effects are a deduction in your wealth and an increase in his, but the indirect effects are an increase in the welfare of other passer bys who also get to enjoy watching the performance.

Normally, as stated before, the remedy should be minimal govt intervention to restore fair pricing. In the stereo example, it could be a tax on loud stereos with the government's revenue being used to compensate the disturbed. In the street performer example, it would be each individual paying according to their benefit, and the performer getting rewarded for the total effect of his performance. For the economists out there, you would recognize the fact that externalities are correctable through government intervention as the Coase Theorem (http://en.wikipedia.org/wiki/Coase_theorem).
(New Orleans used to actually do this, in that they would help subsidize some of the performers based upon how they viewed their impact. And other governments do similar things. Good moves. Granted, governments do some pretty bone-head moves also, but that is another story).

The parallel here with marriage and families is that the externality effect is huge. The decision by your spouse has huge indirect effects upon your welfare and vice versa. And similarly the solution should be like a government intervention. A separate entity, the family (or the couple or group), should make that decision for the family (or the couple or group). What are this aggregate unit’s values? What is the best decision for this aggregate unit? Subsequently communication is critical. Now all component parties should know exactly the effect that their decision will have upon the other parties and can now be accurately incorporated into the aggregate’s decision. For instance, if a solution really benefits one party, then that member could use of some of their surplus to appease the other party. This is good that there is a solution, but it is a total burden in the form of ample communication.

For large groups, deciding on the organization and fair operation of the group is a very complicated problem. One must protect against the possible formation of factions that can deviate for subgroup improvement at the cost of the other members. This was the source of the majority of debate by the framers of our constitution in the Federalist papers. In many ways they have succeeded, but in some ways factions have definitely achieved real power. This is another discussion for another post.

So, there is the long winded answer. Good in theory, but not sure if it’s any good for practice.

If still reading, or still interested, the intro on the Wikipedia page kind of explains the same thing.
also, see the introduction and discussion associated with figure 2 on the site

01 August 2007

Communications Technology 4 (commentary on FCC auction decision)

Before I finish filling in the details of my vision of communications, we should take a momentary detour to discuss the results of yesterday’s FCC auction announcement.

In my mind, and also for Google corporate, the announcement was definitely a disappointment. The FCC did choose to endorse “hardware interoperability”, but they did not endorse pure “network neutrality.”

As outline in CommTech 2, the loss here is that the website equality we currently enjoy will not be preserved. Website hosts with deeper pockets will be able to pay for access to faster download speeds and therefore preferred status. The result will be good for some high-definition media viewing, but it will really hurt new startup sites and the diversity of news sources. The usual info-tainment news sources (FOX, CNN, NBC…) will continue to enjoy a major access advantage to viewers.

Even for those of us who are fiscal-right-wingers, we should easily recognize that news and information are nearly pure public goods. That is, informing yourself about the situations in the world does not prevent others from doing the same. In fact, the more informed everyone is, the more everyone benefits. Therefore even fiscal-right-wingers would promote government intervention in the form of ensuring equality among news and information sources, ala net-neutrality and the internet.

Without information access equality, the news corporations with preferred status become even more preferred. As a timely example, note Rupert Murdoch’s latest media conquest; control of the Wall Street Journal. Now, even less diversity is readily available.

Fundamental economics tells us that when free-market failures exist (lack of competition, existence of public goods and externalities, information asymmetries, incomplete markets…) laissez faire competition will not lead to efficient resource allocations. Even if the poor continue to work and compete at their utmost, even if the whole pie gets larger, the poor will definitely get poorer. These are necessary situations for government intervention. It is the government’s role to enforce market corrections (in a minimalist fashion if you are fiscally right wing, or in an authoritative fashion if you are left wing).

Information is like national defense. Citizens benefit from their personal contribution to national defense, but they also benefit from everyone else’s contributions. Citizens benefit from their decision to become informed, but ultimately also benefit from their neighbors decision to become informed. Because of these indirect (un-internalized effects), left to their own device, normal citizens would acquire insufficient and suboptimal amounts of that good, the information. Therefore, in this case there should exist a governing body to step in and provide for those untapped benefits. In this particular case, citizens benefit from their availability to diverse news sources, but they also benefit from their neighbors becoming informed from diverse news sources. The way for the government to step in and provide for those untapped benefits is for them to support the availability of those diverse news sources; ie support network neutrality.

How did this happen? With altruistic economic reasons and Google’s money, why was their motion for network neutrality unsuccessful?

Perhaps hubris. If Google seemed to think that by playing according to the rules (building good products, generating sizeable profits, and then putting their money on the table) they would be able to effect policy, they were mistaken. The reality appears to be that the money under (and around) the table is what is important. What do I mean?

Google had a pretty strong lobby at ~$4.6 Billion, but that is really not that much compared to the lobby of AT&T. A telecom giant in existence for over 100 years with major subsidiaries employing politicians’ constituents in tens of states and contributing large amounts of money to finance those politicians campaigns.

$4.6B might seem like a lot to the FCC, but getting reelected and while still expected to bring $15B from the entire auction speaks more loudly. Google participates in campaign finance too, but just not as well as AT&T. The role of campaign finance is another story for another day. Does campaign finance reform infringe on freedom of speech as the Supreme Court says it does? Even if it does, is it fair for citizens’ constitution-granted vote to be distorted by the economic inequalities of the day?

Overall, the FCC’s policy on the auction does not spell death for Google. As outlined in CommTech 3, it definitely does make it harder and more costly for them to maintain their preeminence in the internet application market. They will have to pay the profit-extracting fast-access tolls to maybe hold on to their market share.

Yes, the FCC decision means more business competition for Google, but it’s competition from the wrong end. Rather than perpetually competing with entrepreneurial web innovators for their market share, Google will be competing against the already supremely-rich and dominating Murdoch and company media empires.