Category Archives: economics

The Gap

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I need a word. A term I’d presume exists in economics. If you say the supply or price of X is changing it triggers a nearly  superstitious  invocation of faith in markets that they will adapt. The word I’m looking for should help to characterize that adaptive process.

To a degree this is a tautology. If the supply of natural gas this winter is 8% less than last winter then it is necessary for 8% of the demand be removed from the natural gas market.  That process goes by assorted names. Demand destruction, for example. If people insulate their houses and close off the extra bedroom, if people switch to annual billing, run up the credit card debt that’s another, if people freeze to death in their homes it’s all just demand destruction. But, in those examples, the variance in the social welfare is huge.

In the modern world we often look to technology to  accelerate, and reduce the pains of adapting.  But, “Technology  will save us” is small comfort if you freeze to death in your bed in the  interim. If technology were the only source of adaption then I could call the term I’m looking for “the technology gap.” Maybe the term is adaption gap. During the gap, people are freezing to death.

So broadly the term I’m seeking might be defined as the estimated interval between two events. The first event is when the market gets the signal the things have changed.  The second event is when the market reaches approximately the same level of social welfare.

For some markets and signals the gap is small. When the price of European cheeses rises and American consumers switch to alternative luxury goods the demand destruction is fairly benign.  So unless  you’re  running a cheese shop since the social welfare is hardly effected and the gap is minor. If your own a shop in a small town and Walmart opens on the periphery you die, and the gap is very large. You may never recover the same level of social welfare. You complementary economic actors (suppliers, employees, landlord, local tax authority, etc) may recover, but only after a very extended period. In the Walmart story the economy at large might actually see a total rise in the social welfare – it being a widely held belief that lower prices are a good thing.

Of course we lack good metrics for social welfare. It’s about this point that one comes to suspect that there isn’t a term in economics for this.  Albert Hershman talks about this question a bit near the beginning of one of his books.  He pointed out the lack of any research proving that firms react to market signals.    Countering the point that it’s too obvious to need research he points out that firms might ignore weak signals.  And that strong signals may kill them.  How big is the band between those two cases

To cut to the chase. The lack of a term like ‘technology gap’ or ‘adaption gap’ is a serious problem when it comes to trying to talk thru the consequences of this or that shock to the society. How long does it take to adapt to a major event? A 4% drop in available oil and gas every year for a decade, say?

The lack of a term means the discussion quickly implodes for lack of a problem to focus on. One camp arguing that economic and social systems adapt, smiles and move on. Another camp points out that people are dying here; and settles into a tar pit of gleeful cataclysmic story telling. Finally a third camp’s emotional center is their enthusiasm for this or that technological silver bullet. Faith, panic, and enthusiasm are not problem solving. How to reduce the gap and thus minimize to total impact on the overall social welfare; that’s the problem – but what to call it?

Reverse Flash Flood

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In the southwestern united states they warn you about flash floods in the canyons. Storms dump a few inches of water at someplace upstream and this water is then aggregated into a giant pulse of water that sweeps down thru the canyon your standing in, killing you. The sky is clear and there is very little warning, maybe just a slight increase in the flow before the flood passes thru.

I’ve always been a fan of this realtime stream flow data network the government runs. It allows them to make accurate forecasts for the downstream flooding. The black dots on this chart show the gages pinned to their maxiumum. A number of gages aren’t reporting.

The tree like networks that draw the water out of river basins and down to the sea are made up of billions of links. Each segement of the stream another link. These networks are powerlaw distributed, the mighty rivers at their roots the hubs of thier distribution systems.

On Monday morning I filled the cars with gas, topping them up to capture the last of the gas at last weeks prices. I was actually surprised that none of the gas stations had raised their prices. Gas on the wholesale market in New York was already up and I assumed that station owners would reprice that huge expensive asset each morning. One guy I asked said “Later, we do it around midday.” Another guy said “The boss hasn’t come in yet.”

This morning we were awoken by a sound you don’t hear in the summer. The oil truck was delivering oil across the street. A few minutes ago another oil truck filled the tank of another neighbor. I don’t know if that my neighbor’s topping up, or if it’s their oil guys pushing oil out to their customers so they can, in turn, top up their tanks.

This is an interesting example of the long tail at work. The moment that supply shifts from abundant and dependable to scarce and volitile everybody along the entire distribution system changes their behavior. They address the volitility risk by adding reserves to their storage capacity, but they also shift capital into oil and gas because of the perception that their price will be higher in the future. I.e. it’s a good investment to top up my car’s gas tank or for my neighbors and their oil guy to top up their storage tanks.

This is a facinating example of the long tail at work. If the entire periphery of the distribution system tops up it’s as if the river basin suddenly starts running up hill. The calculations about risk and future values changes for each and every link in the entire distribution chain.

One Lesson on Economics

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We all know that the market system is an amazing decentralized social planning and allocation mechanism if externalities are small, if returns to scale are in general diminishing, if we are happy with the distribution of wealth and the concommitant distribution of economic power it gives rise to, and if Say’s Law holds–if supply does indeed create its own demand, and we don’t have to worry about large-scale unemployment and deep depressions.

more: Brad DeLong

Update: a second lession.

Peculiar forms of Property Rights

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Surely it is not a coincidence that just about the time that western civilization collectively took away the property rights of slave owners it introduced a curious new form of property right: treating ideas as property. Was this some sort of systemic economic substitution? Was that the dawn of an era when content was king? Is that era now entering it’s twilight? Are we seeing observing a similar uncompensated property taking? Will a substitute class of property rights arise?

Intergenerational Income Patterns

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One of the ways to get a El Curve is to take a population and iteratively reward the winners slightly in each round. This appears to be the model that gives rise to power law distributions in things like oil reserves. So I’m always interested in research that looks at the details of the iterative process in the vicinity of a system that exhibits an El Curve. Income for example.

From Brad DeLong

Very nicely done: very much worth reading:

Sam Bowles and Herb Gintis (2002), “The Inheritance of Inequality,” Journal of Economic Perspectives.

That really is a marvelous paper beautifully and carefully written. Fascinating.

I did not know that back in the 1960s there was a consensus that the data showed America to be the land of opportunity, i.e. that your parents’ caste did not tend to dictate your own. I gather from this paper that this was wrong due to an assortment of errors in the design of the studies.

Today we know that if you’re born poor your chance of rising is small; the poverty trap. if you’re born rich your chance of dying poor is small. The authors think it’s unlikely that this second syndrome will come to be called the affluence trap.

Under some definitions of fair the maximally fair society would give each child an equal chance at various levels of income. In American society if your parents had high incomes chances are your income will be high. A child born of parents in the top 10% has a 40% chance of ending up in the top 20%. If your parents were dirt poor then it’s very unlikely you will have a high income. Children born into the bottom tenth have a 3.7% chance of getting into the top 20%.

The paper includes this great peice of eye candy. This shows the chance a child will fall into a given 10% of the income range given his parents’ position in that range. The two peaks are the poverty/affluence traps.

The fun thing about the paper is the very careful attempt they make to tease out of the data some information about the causality of the intergenerational income status trap. The extent of the trap is really amazing. If you average income over 15 years then the correlation is .65. That means there is a 65% chance that the next generation’s income will be within 1 standard deviation of the previous ones.

Of course what one wants to know is what’s the causal chain from one generation to another. For example maybe the key driver of wealth is a sense of humor (though i doubt it) and parents tend to pass that on to their children a bit by nature and a bit by nurture. The nice thing about the paper is that they make a really substantial effort to draw out of the data as much causality as possible. This is almost impossible since there are plenty of causal chains for which the data is very very thin.

Of course all this stuff is very tangled. Wealthy parents tend to buy more schooling, for example. The trick is to condition the results so you’re getting a reasonably pure contribution from each stage. I.e. so if you doubled the schooling without changing the parent’s wealth your model would predict accurately what the change in outcome would be. That’s really hard. For example it’s common to use data about twins or brothers to try and tease out the differences between nature and nurture. But even that’s very subtle. For example we know the height is very tightly tied to genetics but we also know it varies tremendously depending on how well people are eating. We know that brothers tend to have very similar incomes, unless you partition the data by race at which point you discover that black brothers are extremely highly correlated and non-blacks much less so. They do a beautiful job of stepping thru this mine field.

Here are the numbers they manage to pull out of the data:

  • 4% IQ
  • 7% Schooling
  • 12% Wealth
  • 2% Personality
  • 7% Race

The key result of the paper is that 32% of the trap remains unexplained. It’s something else. Humor say.

I still have an affection for my five ways to get rich model (pick the rich parents, spouse, pocket, card, or trade).

The fruits of economic growth

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In today’s New York Times Paul Krugman points out that if you run the numbers the plan to privatize Social Security has contains a Catch 22. For it to work you need to have extremely healthy stock returns for 70 years. He’s an economist, he assumes strong economic growth would drive that. He then points out that if we’re having strong economic growth payroll tax revenue will rise too. Opps, wait, how embarrassing. Wouldn’t rising payroll taxes eliminate the “crisis.” Indeed they would.

But is this truly a Catch 22? It assumes that capital and labor will split the fruits of economic growth? That’s an old fashion idea; strong economic growth need not lead to rising payroll taxes. Consistently over the last 25 years the split between capital and labor has shifted sharply toward capital. Shifts in the tax system, shifts in the wealth/income distribution have worked to assure that. That’s what Republicans do. That’s their goal and they have been succeeding. There is no Catch 22 here, just another symptom of a consistent plan. Capital gains is most moral.

Tail wagging

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Something has been bugging me about Chris Anderson writing on the long tail. Part of what helped to clarify my concern was the recent postings seeking a fun short definition for the long tail. Most of these are economic – so that’s part of my problem the long tail isn’t just about economics. It arises in all the social sciences. Mapping all the social sciences into economics is lame. It arises outside the social sciences as well, in physics, geology, in network systems, to take a few examples. Of course it’s fine if he want’s to focus on the long tail as they arise in markets and pseudo-markets; it just makes me a bit uncomfortable.

If you focus down in on power-law distributed systems that appear in economic frames there are at minimum four flavors to be taken seriously. Consider the supply chain: producers, consumers, distributors, and standards. All four are power-law distributed. All four have long tails. You need to think thru all four. In this case my discomfort is lame. You have to start someplace, so starting out by noticing the long tail in the suppliers is as good as anyplace to start.

Failing to think thru the four players leads to a blind spot about the architecture of the emerging market.

The internet is disrupting existing distribution channels. I believe that when the dust settles the distribution channels will be much much more concentrated than they are today. That the power-law’s slope will be much much less egalitarian. If true the distributors will capture most of the revenue enabled by the supply/demand found in the long tails. That will create some really cruel power imbalances. For example; if the only way to get your back listed catalog into the hands of consumers is Amazon why wouldn’t Amazon demand a large share of the sale price. To put this another way, I suspect that Amazon’s margin is much higher on long tail sales. Such sales are a double win for Amazon.

$ under the bed

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Modern economies have a design flaw. If the economy begins to tank people become afraid to invest, so they hide their money under the bed. Money under the bed doesn’t get invested. The productive capacity of the economy goes under utilized – labor and capital equipment is under employed. That helps it sink further into the tank. Repeat and you have a major problem on your hands.

Various prescriptions for this malady exist. For example, the Bush administration likes to use happy talk. A less faithbased approach is for the government to pump money into the economy. Buy stuff! This can work nicely, prices are low. If they shop wisely, buying useful infrastructure it’s all for the best.

The Japanese have been in long recession. They have bought a lot of concrete. Apparently they bought a huge underground water catch basin. It’s big!

Cutting the Resistor

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Way way back in the 1960s the university where I used to punch cards and hand them thru the little window to run my batch jobs bought a new computer. The disk drive was so massive that when they brought it into the building the drive grazed the edge of the door way knocking off the frame and a few rows of concrete block. The drive was undamaged.

Shortly after that machine arrived a guy showed up. An hour later the machine ran much faster. Apparently the salesman had recommended him. The machine was the low end model and if you wanted it to behave like the high end model all you needed to do was cut a resistor or something.

Apple segments their market for the MacOS into three bundles: Darwin, MacOS (client), and MacOS (server). The function of segmented marketing for a vendor is to capture more of the revenue/benefit available below the willingness to pay curve. Given that most markets have a few customers who will pay a lot (desperate customers, rich customers, etc.) you want to have a product variant that you can sell them.

At the other end of the spectrum you get customers who have little willingness to pay; a cheap product offering may capture some value even from those guys. Network effects make things more complex. The customers willing to pay nothing may still add value for the vendor; by increasing his network and thus attracting other customers with deeper pockets. This creates the curious effect that some markets the right price point for the low end product is free – it’s not actually free the customer is bringing himself to the party as payment.

The practical advice given to vendors about segmenting a product line is to be very careful to watch costs. If your lucky the expensive product should cost little more to make and distribute than the mid-priced product. That advise leads to the common stories folks tell about computers who’s speed could be doubled by cutting a resistor. Back at the vendor the discussions about what to bundle with each version of a segmented product are painful for people with ethics. Once you work thru the ethical puzzles there is actually a very interesting design puzzle in designing segmented products – i.e. how to assure that you capture the maximum network effects across the whole product line. If you get it wrong the segmented products start evolve into distinct specie and you get three separate markets. That’s already happened to Apple between Darwin and MacOS(client).

Another problem, though generally a small one, is that some clever user discovers how to cut the resistor. Suddenly their expensive product is just as good as the mid-priced offering. This tends to be more an embarrassment than a revenue problem. I own a big fat phone, a Treo, and the geek community around it keeps working around all the functionally limits that it’s vendor was forced to stick into because his real customer are the phone companies, not the end users.

The story from my youth has another chapter. At the time I was told that the reason for resistor cutting guy was that early customers of that line of machines had written into their purchase contracts a clause along these lines. Sure we will pay a huge amount for the first few of this machine, but latter if you succeed in selling a large number and your prices fall we require you to give us a refund of the price difference. The vendor was dodging the clause in the contract by creating a lower price segment in his market and then leaking the recipe to enhance the model back toward the original model.

Recent events in the around the Treo (a hack to enable bluetooth data, and a hack to enable wifi support) reminded me of that story; and then this morning I say this neat trick to let me get some of the features of MacOS(server) to work on my MacOS(client).

When these hacks for breaking down the barriers between a vendor’s segmented market emerge it’s always interesting to think thru what might be the motivation. Is it just some hacker having a good time? Maybe it’s the vendor trying trying to assure he gets the maximum network to emerge around his product. Maybe it arose out of the vendor’s cost saving. Maybe the vendor is trying to work around customers who’s goals are not in synch with your best interests (as in the two examples above). All these and other reasons are likely in play which makes the stories more interesting, but harder to tell.

You are surrounded!

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I’m sure there is some executive at Apple who’s bonus is based on how many spare power adaptors they sell. The damn things are about as reliable as an American car back when Ralph Nader wrote “Unsafe at any Speed.” These things have a half life of about 4 months and they cost a bit under a $100 each to replace. What a scam.

Once you have a loyal customer the devil is always tempting you to insist that he buy some add-ons, spare parts, etc. The more captive he is the more you can pile on this kind of abuse.

The hotel I checked into at the end of a long day recently had a “manditory resort fee.” No, it’s not a tax from the local municipality it’s just an extra charge they throw onto everybodies bill. Now isn’t that hospitible of them? Of course the room had trays of food layed out with a prices list next to them. The lobby had a booth, just in case you wanted to buy one of their beds.

At the dentist’s office yesterday they attempted to sell me a hundred dollar electric tooth brush. Three extra brushs for $30 dollars. This was urged on me by the dental hygienist as something they strongly recomend. It’s not like I can do my own dentistry. So I go and place myself into the hands of a proffesional. Having handed the responsiblity over to this professional his agent then attempts to upsell me some accessories. I wonder if dental hygienist school now includes additional training on how to upsell the customer.

How long before all the professionals do this? Doctors could sell bedpads. Surely we can find something for lawyers to sell you that will help with your day to day legal hygiene! What’s wrong with my plumber, he hasn’t even tried to sell me a powder that I must sprinkle into my drains once a week. I do love my pipes!

Shifting gears, a bit, these customer loyality/lock-in senarios are very similar to the variation on a public good; the club-good. Club goods are a scheme for addressing some of the failure modes of public-goods; for example overcrowding or freeriding. Your public swimming pool might become over crowded; so you create a club and use that to both limit access and to assure all the users are paid-up club members. In a sense what your buying when you purchase a hotel room is a shortterm membership in the hotel-club. Once inside the club the facilities behave just like a public-good – abundant and collegial.

The fence around the club helps to assure that we avoid the organizational problems of the public-goods – freeriding and overcrowding for example. But, if we are running the club – and we are feeling a bit evil – we can use that same fence to hold the members hostage and abuse them. Substituting the appearance of abundance for the reality, subtituting the collegial for the salesman’s bonhomie.

On the plane they charged $2 for a headset to watch the movie, and then called upon our solidarity with our our fellow members of the flight club to draw down the shades. They packed us in like cattle. So much for using the club idea to resolve the overcrowding problem.

I should probably mention that I had managed to get that hotel room mentioned above for about 30% of list price. Which only brings us around to taking note that one of the things the club owner can do if he manages the fence to his advantage is discrimitory pricing.