indessed roscivs

Last week’s round of posts were all written the week before (although not in the order I posted them—I moved them around and edited the transitions after I had them all completed, which might help explain some of the repetition or lack of flow). All of that batch is posted now, but I still have thoughts on the subject that didn’t squeak into any of those posts.

First, I wanted to make explicit the connection between the “irrationality” of the Ultimatum Game and the iPhone early adopters. The reason why the early adopters were upset about the drastic price decrease is that it revealed a huge disparity in how the economic profit from the transaction was shared. They had assumed that Apple was not raking in $200+ of economic profit on a $600 item, and when they discovered that the margins had been so huge, they were understandably miffed.

I don’t think they were particularly concerned about the fact that it was “unfair” that other people were able to buy them cheaper than they were at a later date. For example, if Apple had announced that they had figured out some revolutionary breakthrough in manufacturing iPhones that enabled them to sell them for $200 cheaper, I don’t think the early adopters would have been anywhere near as disgruntled, despite the fact that the outcome for them was the same (they paid more for an early model, and later purchasers got the same thing for cheaper). The vital difference is that of economic profit.

And while I’m on the subject of the Ultimatum Game, I discovered the other day that autistic individuals are much closer to the Nash equilibrium for the Ultimatum Game. They are both much more likely to offer much lower sums as the Divider, as well as accept very low sums as the Decider. The former behavior seems questionable, but the latter behavior is eminently rational. I can imagine a person thinking, “Hmm, if I say ‘accept’, I get one dollar, and if I say ‘reject’, I get zero dollars. Which one do I pick? Duh!”

Finally, I wanted to advance the hypothesis that, when an average person suggests market controls, it is almost always because of a perception of unfairness in economic profit. From last Tuesday’s example of Farmer Joe and Rancher Bob, if there were some “price ceiling” for cows, or a “price floor” for potatoes, they could potentially reduce the amount that Rancher Bob is able to “unfairly” take of that economic profit. Of course, if the market controls are at the wrong price (or the prices of the underlying good change), that results in a market inefficiency and a surplus of either demand or supply.

These desires may be (and in fact most probably are) misguided at best, but I’ve never heard the economic profit angle addressed by economists. They seem to always assume an ideal market with a large number of buyers and sellers, with economic profit approaching zero. Perhaps by taking the irrational “unfairness” factor into account, economists could better advocate their desired free-market approach? (Or perhaps they already do!)

In Tuesday’s post, I talked about how Farmer Joe and Rancher Bob could specialize and trade, resulting in both of them being better off. Rationally, they should both participate, since specialization and trade will make them both better off. But if there’s no way to equitably split the economic profit, they may end up “irrationally” sticking with their current lot in life.

There’s a game theory experiment (along the lines of the Prisoner’s Dilemma) called The Ultimatum Game. It’s a two-player game, with a Divider and a Decider. A lump sum of money is given to the players—the Divider must decide how much money goes to each player, then the Decider chooses whether to accept the division or not. If the Decider does not accept, neither player gets anything.

So, for example, given $100, I might split it so that $10 goes to you and $90 goes to me. If you accept, you are $10 richer and I am $90 richer. If you decline, we both go home empty-handed.

From a rational, game theory perspective, assuming the game is played only once and anonymously (so reciprocation is not an issue), the logical behavior (and the Nash equilibrium) is for the Divider to offer the other player the smallest sub-amount possible (e.g. one cent), and for the Decider to accept.

Well, turns out that even when played under these conditions, people did not do the rational thing. According to Wikipedia, 50/50 divisions are common, and offers of less than 20% are usually rejected by the Decider. This is true even when played with relatively high stakes. (Wikipedia cites a study in Indonesia, where offers of $30 out of a total $100 were rejected, even though this is equivalent to about two weeks’ wages there.)

Obviously this leads to some interesting questioning about the definition of “rationality” in this situation, and much speculation on why humans would be so irrational. The Wikipedia article talks more about that, but I’m more interested in trying to find the “right” answer to the puzzle. What is “fair”? Can it be mathematically determined? Or is it just a fuzzy concept implemented only in our fleshy brains?

I’m not sure a mathematical equation can be found even if the numbers are known. But reality, of course, is even more complex than that. If I’m haggling with a vendor over the price of a tourist souvenir, I may not know exactly the intrinsic value I place on the item, and the vendor may not know exactly the cost to him (including opportunity costs) for the trinket. And we certainly don’t know each other’s number! But the difference between the two is that “economic profit” to be split fairly.

In fact, we’ll probably engage in various different tricks in order to sniff out the other person’s number and try to arrive at an equitable share of that economic profit. I might name a price obviously too low and try, by gauging his response, to guess his true costs. He, on the other hand, will likely start with a price obviously much too high and, by examining my own reactions, try to figure out what the item is really worth to me. And, much like the Ultimatum Game, either of us may walk away from the transaction unfulfilled even though a price was suggested that is both above his cost and below what I value it as, simply because of the perception that one or the other of us would be gobbling up more than his fair share of those tasty economic profits.

Rational or irrational? I’m not sure either way. But it certainly makes for an interesting game.

There is a very real sense in which all economic transactions, so long as no party is compelled to partake, are for the benefit of everyone. Every trade or purchase is a case of two people giving up something in exchange for something they value more. Otherwise, says the economist, they would not take part in the trade to begin with. If I buy a gallon of milk for two dollars, this means that I value the gallon of milk more than two dollars—otherwise, rationally, I wouldn’t make the purchase. Likewise, the grocer values the two dollars more than he values the gallon of milk—otherwise, rationally, he’d keep the gallon of milk instead of selling it. Thus, through trade, both of us are better off than we before.

This, the economist says, is true of every voluntary transaction. In this sense there is no such thing as an “unfair trade” or “getting ripped off”—if I didn’t end up benefitting from the transaction, I wouldn’t have entered into it. If I purchase Hannah Montana tickets for $500, then I obviously value those tickets at more than $500—otherwise I would have stayed at home or done something else instead. So by purchasing them for “only” $500, it is difficult to say that, in an economic sense, the trade was unfair, since I am now better off than if such a transaction were illegal. When I say that the trade was unfair, what I’m really saying is that I want the transaction to be legal, but with a mandatory lower price.

Economists note that this sort of regulatory behavior—a “price ceiling” in their parlance (or a “price floor”, if you’re trying to benefit the sellers rather than the buyers) results in a market inefficiency. The current level of supply doesn’t magically stay the same, but with lower prices. Rather, by restricting the price from growing to a certain level, you reduce the supply as well. If there are no $500 Hannah Montana tickets, then I’m less likely (not more) to be able to purchase a sub-$500 Hannah Montana ticket.

Although this makes sense from a rational perspective, it doesn’t help the early iPhone purchasers from feeling taken advantage of by Apple when, shortly after their purchase, Apple announced a $200 price cut. Logically speaking, they value the iPhone at more than the $600 they purchased it for—otherwise they never would have shelled out the cash—so why do they suddenly feel that $400 would have been a “more fair” price point?

The answer has to do with that “economic profit” concept I talked about yesterday, and also a bit about human behavior, which I’ll talk about tomorrow.

Strictly speaking, economic profit is accounting profit minus opportunity costs—so if I decide to quit my job and start a laundromat, and the laundromat brings in $100k a year, but costs $60k a year to maintain (building rent, advertising, cost of the machines, etc.) then my accounting profit is $40k a year—that’s how much my business makes. But my “economic profit” is the difference between my previous job’s salary and that $40k. If I was making $50k a year previously, then I’m actually in the red in terms of economic profits—meaning I’d be $10k better off financially if I ditched the laundromat and went back to my old job.

In a perfectly competitive market, according to economic theory, economic profit is supposed to be exactly zero in the long run. If I make less than my opportunity cost running the laundromat, I’ll eventually quit and do whatever it is that would make me more money than the laundromat. If I make more than my opportunity cost running the laundromat, then other people with similar opportunity costs will open their own laundromats and start undercutting my prices. I’ll be forced to go out of business or keep cutting my own prices as well, until the only businesses left in the market are those making exactly zero economic profit.

In the short run, however, the lure of economic profit is what drives entrepreneurs. And certainly there are plenty of markets today in which economic profit is ripe for the taking. The iPhone example is surely one of them.

Apple has some accounting costs in each iPhone it creates, such as the parts, the labor, the shipping, the advertising, and so forth. It has some opportunity costs as well—the amount of money it could be making elsewhere if it chose to abandon the whole iPhone concept and spend its finite resources on something else. If you add those two numbers together, you arrive at the smallest dollar amount Apple could feasibly sell their iPhone for and still have it be worth their while. That number is certainly much less than $600—let’s pretend, for the sake of argument, that it’s around $500.

If I, as a connoisseur of Apple products, intrinsically value the iPhone at around $700—that is to say, for any dollar amount below $700, I’d probably buy one, but for any dollar amount above that, I’d consider it too expensive to be worth it—then at the $600 price tag I’d be benefitting from the transaction to the tune of $100. Apple, meanwhile, would be benefitting (assuming the $500 number) around the same amount. Since we’re both benefitting equally from the transaction, we’re both likely to consider it fair.

If Apple suddenly slashes their prices to $400, however, then obviously the $500 estimate for their costs is completely off. It’s likely to be more around $300. So suddenly, even though I’m still $100 better off from the transaction than I was before Apple ever invented their iPhone, I realize that they raked in $300 from our transaction. Suddenly I’m less likely to consider this fair—if they’d have been willing to sell it to me for $500, then I’d have an extra hundred bucks in my pocket—and each of us would have gained $200 from the deal, benefitting equally.

So while specialization and trade make everyone wealthier and make everyone better off, they don’t do so equally—and wealth inequity is one of the greatest problems facing our planet. It causes more strife, more wars, and more unhappiness than any other factor I can think of.

Author’s note: this is an introduction to some of the ideas that I’ve been mulling about recently and am going to be posting about in the next few days. It may not make much sense on its own, but to try and fit everything in one post would have made it waaay too long. Hopefully it will work out better this way.

“Comparative advantage,” first described by economist David Ricardo, elucidates how specialization and trade can make everyone better off.

To take a common example, Farmer Joe and Rancher Bob both have 10 acres of land. They can use each acre to grow potatoes or herd cattle, but due to differing resources and skills, Joe and Bob are not able to produce them equally. Farmer Joe can raise 5 cows per acre, but 15 bushels of potatoes. Rancher Bob, on the other hand, can raise 20 cows per acre, but only 10 bushels of potatoes.

Assuming both of them prefer to consume steak and potatoes approximately equally, Joe would probably allocate 7 acres for cows and 3 for potatoes, resulting in a total output of 35 cows and 45 bushels. Bob, on the other hand, would allocate 3 acres for cows and 7 for potatoes, yielding 60 cows and 70 bushels. Their total production would, taken together, be 95 cows and 115 bushels.

However, if each of them specialized in what they were comparatively better at, and then traded for what they weren’t as efficient at creating, it would make both of them better off. For example, if Farmer Joe just grew potatoes (150 bushels) and Rancher Bob just raised cattle (200 cows), the total production would be 105 cows and 35 bushels of potatoes more than what they could produce separately. If they can trade freely with each other, they both get to enjoy their steak and potatoes, but much more of it than they would be able to otherwise.

But what’s the best way to divide these “gains from trade”? Economics, so far as I’ve been able to tell, doesn’t give us a good way of figuring that out. If Rancher Bob proposes the above scheme and tells Joe that he’ll give him 40 cows in exchange for 100 bushels of potatoes? If Joe farms alone, he’ll only have 35 cows and 45 bushels. If he agrees to Bob’s plan, he’ll have the 40 cows from Joe, and 50 bushels left over (after giving 100 of his 150 to Joe). He’s better off in every way, so it’s rational for him to agree, right?

But hold on—if Bob farms alone, he’ll have 60 cows and 70 bushels … but with his plan in place, he’ll end up with 160 cows (since he gave 40 of them to Bob) and 100 bushels! Joe is better off because of the trade, but Bob is much better off!

This is what I call “the problem of economic profit”.

We live in a rapidly progressing society, with technological gains making it cheaper and easier to create everything from food to electronics. Yet every year, everything gets more expensive. How exactly does that make sense?

An excellent question! It’s because of the money supply.

If the amount of money in circulation remains constant, then a single dollar can buy more and more things each year. This is exactly because of those technological and economic gains that make everyone better off. (For example, if we had the same number of dollars in circulation now as in the 1950s, they’d be worth about ten times as much—gas would be worth 30 cents a gallon, and $10,000 would be an awesome yearly salary.)

The Federal Reserve (the nice folks who manage how much money gets printed) doesn’t do this, though. They print more and more money every year. They could print just enough more money so that the amount the dollar could buy remains pretty much constant, but they don’t. Instead, they print a little over-much money so that we get a rate of inflation of a few percent each year. There are a few reasons they do this:

1. (the conspiracy-theory reason)
   It’s a subtle form of taxation. Each extra dollar they print devalues every other dollar by a fraction of a cent (”1/n USD” to be exact, where n is the number of dollars currently in circulation). But most people don’t understand this, nor do they realize exactly how much extra money the Fed prints every year, so it’s a much subtler form of taxation than income tax or sales tax.
2. (the Keynesian economic reason)
   The economy has normal ups and downs, but psychologically the downs are much worse than the ups and can spiral into recessions. This is exacerbated by the fact that wages are usually the first thing to go down, and companies are much more likely to fire people than to simply lower everyone’s wages by 2-3%, which results in increased unemployment and that recession spiral.

   However, if you manipulate the money supply so as to cause a slow but steady increase in inflation, then the economic “downs” are much less visible. Rather than having to lower everyone’s wages by 2-3%, you just don’t give your employees any raises, and inflation automatically lowers everyone’s “real” wage. This prevents the “Boom and Bust” cycle that plagued economies for centuries until fiat money became widely used.

Now, whether or not this actually works is heavily debated. Keynesians think yes. Others think it softens the “boom and bust” cycle but doesn’t actually prevent it. The Austrian School (popular among libertarians and Randians) thinks it can only delay it, and that fiddling with the money supply only makes the inevitable “bust” worse. If they’re correct, then when the “bubble” of the American economy bursts, it will be a disaster much larger than the Great Depression or any economic catastrophe the US has ever seen.