Gentlemen Prefer Blands; or it all depends on the elasticities.

Simon Clark comments on the posting below by Santi Sanchez-Pages (Gentlemen Prefer Dumbs)

My colleague Santi sets out a very interesting analysis. As any good economist will tell you, it all depends on the elasticities. If v (value of match) = pq, and p depends on q, then write p = p(q) (with p' < 0) so v = p(q)q. Then dv/dq = qp' + p is positive if p'q/p, the elasticity of breeding probability with respect to female quality, which we label as e, is greater than -1 (recall that p' < 0).

If e > -1 (e.g. if p is constant) then the higher quality is not offset by the reduction in probability, so we would still have positive assortative matching (PAM). If e < -1, we get negative matching (NAM); high quality men will want to avoid high quality women as they are too unlikely to have children.

But e may be variable. Suppose q lies between 0 and 1 and p = 1 - q. Then v = q-qq (I can't do squares in Html!); simple calculus, or graphing v against q, shows that the highest value women have q = 0.5 and the worst 0 or 1. Women can be ranked by the absolute value of (q-0.5), so q = 0.25 is as good as q = 0.75. Then we would see NAM between the highest quality women and a representative half of the men (of all types) and PAM between the lowest quality women and the other half of the men. More like 'Gentlemen prefer blands'.

With equal numbers of men and women, whether some agents remain unmatched depends on whether they have a 'reservation quality' (as in 'I'm not that desperate!'). In the set-up above, if men will not accept v less than v*, single men will be low quality, and single women will have q outside the interval bounded by the two solutions to q - qq = v*. So we would observe spinsters who are either successful professional women too busy to breed or women ready to breed but too uneducated; an interesting area for empirical research.

As Santi says, it is true that we have a lot to learn from other disciplines, but the concept of elasticity can also be useful outside economics. Note the resemblance between v = pq ,and revenue = pq = price x quantity. If a man has a cost per unit of quality of c of providing 'satisfaction' to a high quality woman then v = (p - c)q, which can be thought of as total revenue less total cost. So maybe there are further parallels to be explored.

Degree Exam

A number have asked about the format of the exam.  It will be the same as last year's, so you just have to look at past papers on WebCT.

Gentlemen Prefer Dumbs

A few days ago, during a nice dinner at The Vaults, two friends of mine, let's call them K and M, an economist and an anthropologist respectively, and myself, we were talking about the possible effects of the economic crisis on the marriage market. At some point we discussed whether the crisis was going to alter in any way the assortative matching that typically arises in that market. From your own experience, you should have noticed that people tend to match with people of roughly their same socioeconomic status and/or physical attractiveness. The explanation is simple. Suppose that the value of a person can be measured in a universal scale, like the genetic fitness of their potential offspring or the resources they can provide to that offspring. Suppose also, for the sake of the argument, that there is the same number of people in each side of the marriage market. Therefore, everybody in one side of the market (let's say the males) share exactly the same preferences over potential partners, and the same happens in the other side (i.e., the female side). If that is the case, the only pairwise stable matching is assortative: the best male matches with the best female, the second best male with the second best female, and so on. Suppose that that were not the case. It would imply that at least one person in each side of the market is matched with someone with a lower ranking that him/herself. These two "unhappy" people could improve their situation by breaking their previous match and being together.

Then my anthropologist friend M raised a question: We observe that males tend to go for females that are not more intelligent or successful than themselves. Why? After acknowledging that there was a certain truth in that, K and I looked for an answer. The simplistic model of matching that I proposed above assumes that females will have offspring for sure. But that may not be the case in reality. More successful and intelligent women will typically have better outside options to childbearing so they are less likely to agree to reproduce. So if that probability is Pi and the value of female's i offspring is Qi, the value of matching with that female is just PiQi. Hence when going for more intelligent females, men may be trading off higher quality offspring with a lower probability of reproduction. Notice that the same argument applies if Pi represents the men bargaining power within the household against female i and Qi is the quality of the relationship or a measure of some other type of investment made by the female. This assumption can be enough to generate a non-assortative matching in which men have a positive optimal level of female “dumbness." And implies, if we maintain the assumption of equal number of males and females, that that some very intelligent and successful females may remain unmatched.

The moral of the story for you should be that we can try to apply that economic thinking to shed light on any question, phenomenon or puzzle you may encounter. And also that we have lot to learn from listening to other disciplines. That is, unless you are too busy chasing a dumb enough partner out there.

US Banks

There is a heated debate in the US blogosphere about whether Treasury Secretary Geithner's plan to, essentially, buy up toxic assets, is the best way forward to stabilise the banks (the alternative is roughly to guarantee bank debts). If you are to read one thing on this, it should be this article by Krugman which puts the issues over in a beautifully clear way. What he doesn't say in that post, but elsewhere in an earlier post however, is that the reason why he is so against the current plan to buy up the assets is that:

This plan will produce big gains for banks that didn’t actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized.

QE explained

An audio presentaion with graphics from the FT.

Football: economists excel at games (in theory)

The Academics v Senior Honours football match was great - everyone enjoyed themselves and the staff upheld the reputation of the department by winning 2-0. Santi and Ahmed were the goal-scorers.

Here's a short video of the game:

Feedback from the Credit Crunch Seminar 2

Simon Clark reports back from the Credit Crunch Seminar on March 12.


Take 60 ordinary people, roughly a cross-section of Edinburgh society, and invite them to give their views on the credit crunch and the economic crisis. Or rather, light the blue touch-paper and stand back, well back.

The meeting was permeated by a deep sense of injustice. How can people just walk away from the mess they have created, often with a big pension, when others lose their jobs and pensions though no fault of their own? You may think economics deals with efficiency and hard-headed analysis, and that concerns of equity and justice are the domain of the soft-headed disciplines (usually ending in 'ology'). Wrong for two reasons! Firstly, if people care about fairness then it will affect their behaviour. For example, they may avoid buying from businesses they see as treating their workers and suppliers badly, or not doing their bit for the environment. Or if people at work are treated fairly, they may be more productive. Secondly, think of the raw politics of the situation. You may disagree with knee-jerk reactions to punish greedy bankers, but if a political party can get support for measures to redress injustices, real or perceived, then - purely as a matter of economic forecasting - you need to take that on board in forming your expectations of future policy.

On the Efficiency of AC/DC

Bon Scott or Brian Johnson, Brian Johnson or Bon Scott. AC/DC fans debate endlessly about who was a better lead singer, dividing the world in two. In order to shed some light on this discussion, Robert J. Oxoby from the University of Calgary explored which of the two is more efficient in the terms of making agreements more likely. In order to do that, he ran an experiment in which subjects where randomly and anonymously matched and took part in a simple bargaining game while they were listening to a song performed by one of the two vocalists. The game was in fact the famous Ultimatum Game, in which one of the members of each pair must make a proposal on the division of 10$. The other party must decide whether to accept the offer, in which case subjects were paid in cash accordingly, or reject it, in which case both walked away empty handed. In this interaction, each time an agreement is not reached money is left on the table (the 10$) and inefficiency ensues. The question was then, which singer generates more agreements? The results (On the Efficiency of AC/DC: Bon Scott versus Brian Johnson, Economic Inquiry, 2008) were shocking: Brian Johnson is a better singer than Bon Scott in efficiency terms. The offers made by subjects who were listening to Shoot to Thrill were more generous and were rejected less often than those made by subjects who were listening to It’s a Long Way to the Top.

Surprised? The truth is that this paper was a supposed to be a joke and was never intended to be serious. The original data came from a PhD student of Oxoby who allegedly wanted to study the effect of music on the outcome of the ultimatum game (this may be seem to you a bit over the top but it has been shown that subjects are more likely to cooperate with strangers after watching a comedy than after watching a drama). However, the student played two different songs, making the data obtained useless. The student left the PhD unfinished (uhm, I wonder why...), Oxoby found the data and thought it could be fun to write a bogus paper with it. In fact, the moral of the story for you should be that correlation is not the same as causation. It is true that the results under the two songs were statistically different. But that in itself does not mean that there is a direct causation or that we have learned anything useful from the exercise.

However, Steven D. Levitt, world famous for his Freakonomics book but not precisely for his sense of humour, took the paper seriously and condemned it as a very bad example of what Economics can be. What do you think? Fun exercise? Bad science?

Capitalism Beyond the Crisis

Last summer, the Adam Smith Institute, a self-declared free-market think-tank organized a debate on Adam Smith's legacy with the motion ‘This House would prefer to be led by the Invisible Hand’. After a very heated and good humoured discussion, the motion was (loudly) approved. There were many "suits," many businessmen and people from "The City" in the audience that evening in The Caves. No wonder the result of the vote was the one it was. However, after all that has happened in the global economy since then, one is now left to wonder where those who voted "yes" are standing now. Are they still cheering and applauding the divine interventions of the Invisible Hand? But even more importantly, that debate, and even the name of the ASI itself, proved how Adam Smith's legacy has been appropriated by free-market fundamentalists, much to the dismay of those who hold other views.

In a recent article in The New York Review of Books, Nobel Prize Laureate Amartya Sen has made a much more impartial assessment of Smith's theories. In Capitalism Beyond the Crisis, Professor Sen reminds fundamentalists that Adam Smith did not see the free market functioning without the assistance of "moral sentiments". Trust is fundamental for the well-functioning of markets. In passing, Sen also rescues Pigou from the relative oblivion in which his contributions live these days. And also more remarkably, he puts John Maynard Keynes in his right place. Keynes is increasingly seen among non-economists and other carefree people as a rebel, as some sort of Luke Skywalker, the only hope against the evil dark forces of standard Economics. And although it is true that Keynes is ASI's favourite ghost, it is also true that he was not specially concerned by distributional issues nor with the welfare of the worst-off people in society.

One could argue that Sen does not contribute to the current debate on the "New Capitalism" with new ideas. He rather wants us to stop and think more carefully about our own arguments. But in this article, he shows once more his deep knwoledge of Economics and his relentless committment to create a more decent economic world.

Feedback from the Credit Crunch Seminar 1

Here are a few notes from the talk Simon Clark gave at the Credit Crunch Seminar on 12 March (see posting below). They are addressed mostly at the question of why it has happened. Bear in mind that the audience consisted not of academic economists, or even economics students, but of ordinary citizens, worried, angry, and vocal.


I don’t think we really fully understand why we are in the mess we are.

For one thing, we didn't see it coming: and that has been one of the important characteristics of the crisis: two or three years ago, many people, perhaps most – including politicians, bankers, economists – would have said that the UK economy was pretty healthy: we had had a decade or so of strong economic growth, and inflation and unemployment were low.

Even when the financial rumblings started in 2007, as the bad sub-prime loans started to surface in the US, even when Northern Rock had to be rescued – the first bank run in the UK for over a century – I don’t think many people foresaw how quickly the financial crisis would develop and deepen, and how quickly it would spread to the real economy.

Nevertheless I think we can offer a narrative, a drama in 1, 2, 3, who knows how many acts? The best place to start seems to be the US sub-prime market. The realisation that many of these loans were ‘bad debts’, unlikely to be repaid, had implications far beyond the US mortgage market. It was the immediate cause of the what one might call the central event in Act 1, namely the collapse of liquidity and the collapse of the interbank market. The main reason for this was the that the sub-prime loans were bundled up, repackaged with other assets, and sold on in the form of ‘collateralized debt obligations’. But these financial assets were so complex that very few people understood them, even the senior managers of supposedly reputable investment banks.

As banks became wary of other banks ability to repay, so they were less willing to lend to them – the interbank market dried up, and those institutions that were reliant on this kind of borrowing to finance their own lending - for example Northern Rock – were caught up. Northern Rock’s mortgages were nowhere near as bad as the sub-primes, but it did not have a solid retail base of many small depositors.

So, we had a kind of contagion that affected all financial institutions. The response of governments was uneven and unsure; they were faced with the choice of bailing banks out – offering guarantees, providing capital, lending taxpayers’ money – or holding back and letting ‘market forces’ sort things out. This second option had the supposed advantage that it did not encourage ‘moral hazard’: the phenomenon that if you forgive bad behaviour, you make it more worthwhile. This was initially the preoccupation of Mervyn King, the governor of the Bank of England, and also of the US authorities. In the US, Hank Paulson, the US Treasury Secretary, decided to give the capitalists a lesson in capitalism, and let Lehman Brothers, one of the biggest financial institutions in the world, go bust. By the end of Act 1, there was some serious blood on the stage.

It was now apparent that no institution, however big, was immune; no bank was too big to fail. If you had to pinpoint one event when the crisis spread beyond the financial sector, when it went from a local, possibly containable, problem of liquidity, to a full blown global economic problem, it was the collapse of Lehman Brothers. All banks were suspect, no one wanted to lend to banks, including other banks, and so banks themselves had less money to lend.

Act 2, then... [more]

CDOs again

(Click on graphic to enlarge.) Here is a striking graphic to go with my earlier posting about how much the value of these mortgage backed securities has fallen (and just how many of these things there are). It comes from an article by Gillian Tett in this weekend's FT which has a nice discussion of the minor matter of where the world's financial system went wrong.

How much will the credit crunch cost?

The IMF has come up with some estimates of the cost of all the bailouts, quantitative easing etc. including possible losses on the various loan guarantees and insurance schemes. See a nice article in Stephanie Flanders's blog for details, but the bottom line seems to be around 9% of UK GDP. This is the estimated cost to the UK taxpayer of these schemes, not the total cost of the recession (which could be anything). Can we afford it? The UK entered the credit crunch with a public debt to GDP ratio of 43% (end 2006) and the IMF reckon this will go up to 77%. This is basically the ratio of what the government owes (to anyone, including UK residents) to our income. The 43% figure was quite low - the G20 average was 78%, with Japan at 195% - so it does not appear to be too worrisome. If all this is correct, the credit crunch will be small beer in comparison to the second world war.

navel gazing 2: time for a paradigm shift?

Just as Fred Goodwin and Gordon Brown are finding it hard to say 'Sorry, we got it wrong', so are a lot of academic economists. Privately, many top macro guys (and gals) may be thinking to themselves "Oops", but to admit in public that your life's work struggles to explain the biggest crisis in a century is a step too many for some.

One route is to keep tweaking the model till it seems to fit the facts. Another is to discard the conventional wisdom and adopt a new approach altogether. This is what Professor Willem Buiter seems to be advocating in an article, The unfortunate uselessness of most ’state of the art’ academic monetary economics

Buiter may never win the Nobel Prize in Economics, but he is usually thought-provoking (and sometimes wrong). In this piece, he is criticising complex dynamic macro models based on assumptions of market clearing, forward-looking behaviour by rational individuals, and - most importantly for the analysis of asset markets - a benign auctioneer at the end of time who ensures that speculative bubbles never get out of control. His answer seems to be that we should build in from the start market incompleteness and non linearities to model the positive feedback underlying financial instability.

It's not a new idea, but will it lead to a paradigm shift? Who knows? If there's one thing more difficult to predict than financial markets, it's changes in intellectual fashion.

More on QE

Here is another post by Stephanie Flanders of the BBC on quantitative easing. Paul Krugman is sceptical that simply pushing more money into the system can do anything, as you are essentially replacing one asset (cash) for another (short-term government debt) which has become a perfect substitute for it (since short-term interest rates on such debt is very close to zero). If you're buying corporate debt that is different as you are effctively taking some credit risk away from the private sector.

Navel Gazing

The economics profession has been thinking hard, in the light of the fact that the credit crunch doesn't fit in with most modern macroeconomic models too well, about whether its macro theorising has been going up a blind alley. See this article by Krugman who thinks that a large part of the profession went wrong just after 1970, ended up doing real business cycle theory, and not even knowing anything about Keynesian economics. This is how leading figures in the profession can make elementary errors such as the "Treasury View" (see my earlier post on the subject) or misunderstand Ricardian equivalence. This article from the Freakonomics blog ends up being a bit more optimistic about the way the profession is heading.

Making sense of the global economic crisis

Wid ye credit it?
Making sense of the global economic crisis
Why has this happened?
Who are the winners and losers?
What can we do about it?
FREE PUBLIC SEMINAR
Thursday 12th March 2009 7.00pm – 9.00pm
Godfrey Thomson Hall
Moray House School of Education
Canongate (through arch to St John’s Street)
Royal Mile
Everyone’s welcome to come along to this FREE public event
and have a say after short presentations from our speakers. Everyone
will get the chance to share their views, ideas and experiences.
No need to book. Just turn up.
SPEAKERS
Simon Clark - Department of Economics,
University of Edinburgh
Bill Scott - Policy & Parliamentary Officer,
Inclusion Scotland
CHAIR
Mae Shaw - University of Edinburgh
Edinburgh’s Active
Citizenship Group
www.egfl.net/activecitizenship

Economics Society Guest Speaker

Dr Richard Reid (Citigroup) 'The Third Industrial Revolution': Lessons for Today? Wed 4th March, 18.30 Appleton Tower LT2.

Just how much are those dodgy assets worth?

Not a lot it seems. According to Gillian Tett in last week's Financial Times we are starting to see what the collateralised debt obligations (CDOs) which are largely based on US mortgages are really worth (the things that are at the root of the crisis). A large number of those issued from 2005 are already in default (the issues have not kept up repayments). Of the ones that have been liquidated, it seems that the "super-senior" ones, the safest of all, are only paying back 32%. Of the slightly riskier "mezzanine" ones - which still received a AAA rating apparently - the recovery rate is only 5% (what is got back from the initial face value of the asset)! So much for the ratings agencies.
Gillian Tett, an FT journalist, is famous for having predicted the disaster. Here is an interesting interview with her. The bad news is that she studied social anthropology, not economics, and spent a year milking goats in Tajikistan, and apparently this is what helped her figure out what was happening.