Monthly Archives: February 2010

From an FT Magazine feature on “Ten Ideas that will reshape business
Failure has always been a fundamental part of a market economy. When markets work, they do so because new ideas are constantly being tried out. Most fail. Those that succeed cause older ideas to fail instead. In the US, about 10 per cent of businesses disappears each year. This is an awkward insight – but trial and error could be starting to take its rightful place as a business technique, rather than the dirty little secret of capitalism.

There are some hopeful signs. Stefan Thomke of Harvard Business School has argued that advances in computation have made it possible to experiment on new products as a matter of course, trying many things and expecting many failures. It is now easy, for example, to experiment with changes in the layout of a website, showing different configurations to different visitors and tracking results in real time. Google, meanwhile, routinely launches new products with a “beta” label on them. And academic superstars such as Steven Levitt, co-author of Freakonomics, have been teaching executive courses in business experimentation.

We are also starting to learn more about the psychology of learning from mistakes. Richard Thaler, the behavioural economist behind Nudge, coined the phrase “hedonic editing” to describe our habit of lumping small losses together with larger gains in order to mask the pain of the loss. Sugar-coating is human, but it’s also a recipe for failing to learn from failure. Thaler, with colleagues, even studied the behaviour of contestants on Deal or No Deal. He discovered that people who had made unlucky choices then started to take reckless risks, which often compounded the error.

It’s hard to learn from failure if it briefly robs us of our judgment. As we start to understand why trial and error is so painful a process, we may be able to use it more constructively. The financial crisis has made us aware that a system that cannot tolerate a bit of failure is a dangerous one. The idea that an institution was “too big to fail” used to sound reassuring. Not any more.

When Adam Smith said that “there is a great deal of ruin in a nation”, he was commenting on a military defeat, but economists tend to treat it as a more general truth about the durability of nations in the face of apparently overwhelming debt. And it is true that while over-indebted companies tend to be wiped out, countries such as Argentina keep bouncing back.

Emerging economies have to pay attention to what foreign investors think, because they typically have to borrow in dollars rather than their own currency. Life is different for countries such as the US and the UK, which have been borrowing enthusiastically in their own currencies with little sign of serious concern from the bond markets. For richer countries it is possible that Dick Cheney was right when (according to former treasury secretary Paul O’Neill) he said that “Reagan proved that deficits don’t matter.” If deficits don’t matter, one can only surmise that their natural consequence – public debt – doesn’t matter either.

We had better hope that both Cheney’s claim and Adam Smith’s rumination prove to be true, because many wealthy governments are building up debt very swiftly indeed.

The remainder of the article can be read here. Please post comments below.

I discovered “hidden city” fares some years ago when I learnt that the price of a ticket from JFK to Reykjavik cost much more than a ticket from JFK to London with a stop in Reykjavik. Icelandair explained that they had to compete with many other carriers on the NY-London route. Fine. But I recently bought an Amsterdam-Riga-Helsinki ticket and got off at Riga: the Amsterdam-Riga flight itself was fully twice the price, and competition is not always strong.
I keep buying tickets for seats I do not use on continuing flights that the airline cannot sell to another passenger. I have my theory on why airlines do this – what is yours?
Richard N. Golden

Dear Mr Golden,

Competition is only indirectly relevant. The question is how responsive an airline’s customers are to price – “own-price elasticity of demand”, in the jargon. When elasticity is low, airlines can increase prices without losing many customers. Naturally this affects the price they charge – and one explanation for elastic demand and low prices is that customers could easily shift to another airline.

Customers prefer to fly direct to their destinations, so any indirect route will tend to have to be cheap to attract custom. If competition is weak, the pricing is harder to explain, but demand can still be elastic if people would rather not fly at all than pay handsomely to fly indirectly.

The second question is why airlines charge less for more, as you describe. But from “home edition” software to electronics that have been “chipped” to slow them down, the world is full of discounted products that are more expensive to produce than their full-price counterparts. This raises costs, but if it allows companies to target price increases at those most willing to pay, it makes sense.

Questions to economist@ft.com

Last week I attacked the “Robin Hood tax” campaign, and somewhat less passionately, also attacked the Robin Hood tax. In light of some of the comments, I wanted to respond briefly.

Nerdy points out of the way first:

First, on the insurance example: yes, a tax on reinsurance might or might not be levied in the way I describe. (It’s hard to say with no specific policy proposals.) That’s not my point. I was trying to point out that there are all kinds of ways to structure a financial transaction, some with a huge nominal value, others – almost identical – with a far smaller nominal value. The tax is likely to have a rather whimsical effect and some transactions can be structured to avoid it, perhaps with unintended consequences.

Second, on the wallet example: again, my point is that it is not that the RHT would work in exactly this way (who knows?) but that transaction taxes create incentives for fewer back-and-forth transactions and it’s hard to see how that helps. Yes, it seems intuitively obvious to a non-economist that a transaction tax would reduce volatility, but most reasonable theoretical treatments point the other way, and so does much (but not all) of the limited evidence available on the question.

But the main thrust of my argument is not against the Robin Hood tax, about which I am puzzled and a little sceptical, but against the Robin Hood tax campaign, which I view with ever-greater astonishment. It’s simply not okay to launch a vast public relations campaign without the slightest interest in the pros and cons of your case. The Bill Nighy video is an insult to the intelligence. So are the “arguments” I am typically sent, the chief one of which is “Nobel laureate Joseph Stiglitz supports the tax, and Nobel laureate Paul Krugman supports the tax”.

Fine. What do RHT advocates think of the following arguments?

FT Comment while John Gapper is on sabbatical

We are sometimes admonished: “Don’t shoot the messenger.” Since there is rarely a logical reason to shoot messengers, such advice should not be needed. But it is, because bad news hurts, and organisations find it difficult to deliver such news to the person in charge.

Andrew Rawnsley’s account of Gordon Brown’s premiership has received attention for its claims that Mr Brown was abusive and physically threatening to his staff, grabbing lapels, stabbing upholstery with his pen and causing his advisers to cower for fear of violence. If true, that is disturbing – but few people will have found it surprising. High-status men sometimes do abuse that status.

I am worried not so much that Mr Brown may be beastly, but that he is cutting himself off from good advice. Mr Rawnsley describes Mr Brown’s fateful decision to pull back from a widely trailed snap election in late 2007. His inner circle waited until he was out of the room before agreeing that such a course would be disastrous. When the prime minister reconvened the meeting, however, this was not conveyed: “No one expressed a clear view. No one wanted responsibility for the decision.”

This is a more significant anecdote than any tale of flying spittle. Any leader needs frank advice, and the biggest obstacle to receiving it is often the leader himself. Even a polite and level-headed boss will be tempted to cut naysayers out of the loop. Knowing this, sensible juniors will avoid expressing criticism or grim tidings if at all possible.

“If you deliver bad news, you’re disempowering yourself,” says Professor David Sims of Cass Business School. “You’re less likely to be listened to in the future.” For some ambitious subordinates, this is a far worse fate than the threat of being thumped.

A new reality television show, Undercover Boss – which has migrated to the US after airing on Britain’s Channel 4 last summer – tries to tap into the dissonance between bosses and front-line staff by filming as a senior executive works incognito in the trenches. It is a delicious premise…

The remainder of the column is available here – includes lessons from Iraq.

Tyler Cowen and Alex Tabarrok, Modern Principles of Economics (UK) – well-written, interesting, and some material not normally covered in econ. textbooks. I’ll try to find time to write more about this textbook, but guess students and professors will be the judges.

Ben Goldacre’s Bad Science. I’m a bit embarassed not to have read this until now, but the first few chapters are exceeded even my high expectations. Really very good indeed. Apparently a US edition is in the works – I’ve just been asked to blurb it. Will be a pleasure.

Jonah Lehrer’s The Decisive Moment (now republished as How We Decide. A nice science-and-stories approach to neuroscience, psychology and behavioural economics. I finished the book wanting to put it into action – not as easy as Lehrer makes out – and learned plenty I didn’t know I didn’t know.

All three are recommended.

Last week a development charity press office sought my support for a “Robin Hood tax”. The idea of the tax – “turning a crisis for the banks into an opportunity for the world” – is that “a tiny tax on bankers has the power to raise hundreds of billions every year” to “tackle poverty and climate change”. Well, I am a big fan of Robin Hood, no great fan of bankers and would like to tackle poverty and climate change. But the idea leaves me cold.

The tax is being backed by a large coalition of charities and fronted by Bill Nighy in a smooth marketing campaign. It’s all in a good cause. But I have been appalled by the campaign’s profound lack of curiosity as to whether this tax would be a good idea.

Start with the claim on the Robin Hood tax website that this is a “tiny tax on bankers … the people who caused this mess”. First, it’s not a tax on bankers. It’s a tax on financial transactions. And it’s not necessarily tiny, because some worthwhile financial transactions have a very large face value, and a much smaller true value. For instance, I might buy car insurance which could – if I knocked somebody down and permanently disabled them – trigger a payment of £1m. My insurance company might want to reinsure that million-pound risk, a perfectly sensible, socially useful and non-speculative transaction. But at a “tiny” tax rate of 0.05 per cent, that’s a £500 tax on a face value of £1m. It’s hard to imagine such a tax wouldn’t somehow affect my premium.

The remainder of the article can be read here. Please post comments below.

I am currently studying for my A-levels, including economics, but chose not to study maths. As my time is a scarce resource, I felt it would be more worthwhile to allocate an equal amount of time to each of my subjects, thus getting better grades in them, rather than dedicating most of my time to maths and sacrificing my other grades. However, I now find that I need an A-level in maths to study economics at a top UK university. Did I make the right decision? If not, could you put in a word for me at Oxford?
Tom, Co. Durham

Dear Tom,

I am not sure which decision you wish me to evaluate: the decision to pick your A-levels without decent advice, or the decision to pursue a mathematical subject with no mathematical talent. Neither looks smart. You have theorised on the basis of neat concepts without any real-world knowledge – in some ways, ideal preparation to be an economist.

Yet this could yet work out well for you. Ap Dijksterhuis, an economic psychologist, has studied how people make complex decisions. In one experiment he gave people fiddly hypothetical choices, giving some plenty of time to concentrate, while he distracted others before suddenly asking them to choose. He found that such complex decisions seem to be best made subconsciously.

Choosing a course to study at university is a decision with many variables. You have all but closed off economics without even thinking about it. Perhaps that’s for the best. Studying economics without maths is like studying literature when you can’t read without moving your lips – not impossible, but difficult.

As for Oxford, you could always try. Several of my classmates read philosophy, politics and economics without maths. At least one of them now calls himself an economist.

Questions to economist@ft.com

Here’s an old joke: if you laid all the economists in the world end to end, they still wouldn’t reach a conclusion. Okay, it’s not very funny – what did you expect from a joke about economists? – but has rarely seemed more relevant after this week’s exchange of letters in the Sunday Times and the Financial Times. Each letter was signed by battalions of distinguished economists. One group thinks we should be raising taxes and cutting government spending soon. The other group thinks we should be raising taxes and cutting government spending later.
It does seem a bit embarrassing that we economists can’t seem to agree. Even more embarrassing is when we all agree and we’re all wrong. If you look at economic forecasts from times gone by, you’ll typically find that all the distinguished forecasters broadly agreed with each other. The only dissenter was reality: economic growth and inflation were usually outside the range of expert forecasts.
I think both embarrassments tell us about the limitations of economic analysis in a complex world. By way of analogy, you would never expect your doctor to be able to forecast when you were going to die, or what condition would finish you off. Medicine just doesn’t work like that: the human body is too complicated. You shouldn’t ask an economist to make a forecast either – but both the economist and the doctor could and should be able to offer remedies for what ails you.
On this occasion, alas, the economists can’t agree on the appropriate details of the prescription. I am not surprised. Unlike doctors, we can’t run controlled experiments. We have to make our judgements on the basis of some theory and a few historical episodes, none of which ever exactly repeat themselves. That calls for a bit of humility.
So I won’t be trying to adjudicate in this debate. In any case, this is macroeconomics, and I’m a microeconomics guy. In case you’re wondering about the difference, the humorist P.J. O’Rourke has the answer: microeconomics is about the money you don’t have. Macroeconomics is about the money that the government is out of. That joke has rarely seemed more relevant either.

EDIT: John Willman (below) asks about the quality of the signatories. I don’t think Lord Skidelsky distinguished himself on the Today programme this morning – seemed to be much more interested in debating points than the economics. But there are very impressive names on both sides.

…oh, all right. It will make them happy. But it might not improve their health. Here’s Bénédicte Apouey and Andrew E. Clark:

We use British panel data to explore the exogenous impact of income on a number of individual health outcomes: general health status, mental health, physical health problems, and health behaviours (drinking and smoking). Lottery winnings allow us to make causal statements regarding the effect of income on health, as the amount won is largely exogenous. These positive income shocks have no significant effect on general health, but a large positive effect on mental health. This result seems paradoxical on two levels. First, there is a well-known status gradient in health in cross-section data, and, second, general health should partly reflect mental health, so that we may expect both variables to move in the same direction. We propose a solution to the first apparent paradox by underlining the endogeneity of income. For the second, we show that exogenous income is associated with greater risky health behaviours: lottery winners smoke more and engage in more social drinking. General health will pick up both mental health and the effect of these behaviours, and so may not improve following a positive income shock. This paper presents the first microeconomic analogue of previous work which has highlighted the negative health consequences of good macroeconomic conditions.

In other words, lottery wins make you happy but you’re just as likely to keel over from a heart attack as you ever were, because you party hard for the rest of your life. I note with interest that the lucky winners celebrated with a bacon sandwich.

Here’s an earlier “Dear Economist” in which I pointed out that lottery wins don’t help you avoid bankruptcy, either.

The Undercover Economist: a guide

Publishing schedule: Excerpts from "The Undercover Economist" and "Dear Economist", Tim's weekly columns for the FT Magazine, are published on this blog on Saturday mornings.
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