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a blog from young economists at Nova SBE


Asymmetry information, decision making : Education in India

After visiting several community schools in India, I research about the rational choices concerning the school and how do the parents decide to put their kids at school.

“If you are a peasant farmer and have never been to school, your ability to choose on the basis of information is very limited. Given the asymmetry of information, you’ll never be able to get there,” Amartya Sen said.

Yet the poor in India appear to disagree with Mr. Sen. Parents are increasingly choosing to send their children to low-cost private schools, where students often outperform their peers who attend free public schools.
Surveys suggest that poor Indian parents spend up to 13% of their income on education, well above the national average of 8%. Nowadays, Indian people understand that education is really important for the future of their children, the mentality is changing, even on the poor part of the city on the slums, several actions are promoting to improve the attendance of kids on the school and try to change the mentality about this, time after time. But how do parents who are often illiterate and have little formal education themselves make informed decisions about the merits of schools?
Mr. Sen’s claim rests on two assumptions: that poor parents are incapable of choosing good schools by themselves; and that markets will not help parents identify a good school from a bad one. Evidence suggests neither assumption is true.

First, the theory that peasants cannot select the best schools is inconsistent with the evidence that they tend to transfer children from failing government schools to better-performing private schools. It is true that poor parents choose schools by considering “simple” things, like whether the medium of instruction is English or the visible state of the building. Yet there is no evidence that such decision-making process favors bad schools. Also the decision to put the kids on the bad school like the public one is considering 2 times because they know that education first is really important and see the impact when the kids go to school.
Mr. Sen’s second assumption is that asymmetrical information* makes it impossible for parents to decide which schools are best. The basic idea is that if sellers (low-cost schools) know the quality of a good (education) and buyers (poor parents) have no way of discerning quality, then buyers will either be ripped off or refrain from buying altogether.
In addition, the reality that parents can choose schools creates a market incentive for entrepreneurs to provide better information—in the same way that the market incentivizes the publisher of Consumer Reports to provide other product reviews. Organizations in Hyderabad, southern India, have begun rating low-cost schools so that poor parents can make better choices.
Mr. Sen said, “We need nothing short of a revolution, not an armed revolution, but a revolution in thinking.” The poor are on a mass exodus from government schools to private schools, and the bottom line is that the kids are performing better. When we talk about private schools they include the community schools. The parents can see the effects about school on the children and change the decision about which schools choose. It may not be a revolution in thinking but it is most definitely a revolution in doing.

*Asymmetric Information: Asymmetric information means that one party has more or better information than the other when making decisions and transactions. The imperfect information causes an imbalance of power.

Sandra Berthelot

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Incomplete Preferences on the voting system

When comes to a decision maker being able to choose between two or more available options, many of the economic models consider that he or she is always capable of so. In Economics, this means that it is assumed that the decision maker has complete preferences. However, some authors have been struggling to accept this assumption. One of them was Aumann (1962) who stated that: ‘Of all the axioms of utility theory, the completeness axiom is perhaps the most questionable. Like others of the axioms, it is inaccurate as a description of real life; but unlike them, we find it hard to accept even from the normative viewpoint’. For this reason, some economists started to include in their models the fact of that decision makers not being able to rank available options.

This kind of situation may happen in the real-world aggregation. If a single individual is not able of ranking different options, we can expect the same to happen with multi-agent systems. One of the most well-known cases is the voting system. Konczak and Lang (2005) explain the two main sources: The first one is intrinsic incompleteness where the voter is unable or unwilling to give complete information, i.e., a total order on all candidates. The second one is epistemic incompleteness where the voters do have preferences specified by total orders but at the time of decision making these total orders are not fully available.

First and foremost, in order to understand this problem it is necessary to understand how the voting system works. To do so, we need to know the difference between full preferential voting and optional preferential voting. Full preferential voting occurs when  the voter must show a preference for all candidates listed for the ballot paper to be formal, while in the optional preference voting the voter need only to indicate a preference for the candidate of his/her first choice and the allocation of any further preference is optional.

Although in Portugal we are only used to optional preferential types of voting, full preferential ones are also possible, as is the case of Australia. What happens in Australia is that surprisingly (or not) most of the times there is a proportion of ballot papers filled in with an invalid sequence of preferences. We can think about some reasons to this happen as inability or accident. But the fact is that as the number of candidates in the ballot paper increases, it is more likely the rate of informal votes to increase as well. After all, with only three available options, the decision maker is able to set 6 preference relations (we need to have into account that in this case no indifference relations are possible), with four available options he has to choose between 24 preference relations, with five available options (which is not that much) he has to choose between 120 preference relations, and so on and so forth. So, probably it may not seem as easy as one might think.

This could lead us to agree that going for the optional preferential types of voting is a better solution for the political system. But we need to be careful once optional preferential types of voting also have their disadvantages. One of them is known as the Tactical Voting, in which the voters have an incentive to vote for one of the two candidates they predict are most likely to win (even if they prefer other candidates), because voting for the preferred ones is seen as a “wasted” vote with no impact on the final result.

We can see that electoral processes have many issues beyond the most objective ones. All of this will probably make us end up agreeing with Kenneth Arrow, who said that no method can obtain at the same time all the advantages desired in a voting system.

#746


Are you better than the chimps?

In a recent study led by behavioral economist Colin Camerer, it was found that chimpanzees at the Kyoto University Primate Research Institute consistently outperform humans in simple contests drawn from game theory. The question then is how well do we know about playing the game aside from what John Neumann and John Nash has been recognized with a Nobel Peace Prize?

What psychologists call the theory of social situations economists call the game theory. Game theory is the science of strategy, which attempts to determine mathematically and logically the actions that players should take to secure the best outcomes for themselves in a wide array of games. These games all share interdependence, which means that the outcome for each participant depends on the choices of all. There goes the saying ‘You win some, you lose some’ in the so-called zero-sum games where one person’s gain is someone’s loss.

Since 1950, economists, political scientists and the military have used its principles in determining potential outcomes for policy-making. In the 1980s, businesses began to use game theory in pricing, product creation, mergers and acquisitions, and labor negotiation decisions. But even a layman can also adapt the concept of game theory in making life decisions.

How can we have better salaries through negotiation, how to save your relationship, how to make money in the markets, how to deal with real estate purchase and whatnots? In each of these scenarios, the actions of others greatly affect the choices we make and the outcome for such decision-making. However, we have no complete information of how other people think. Therefore, we have to figuratively put ourselves in the shoes of all and try to calculate the outcome. Our own best action is an integral part of our overall calculation.

Take the example of relationships. Most often than not, we face arguments even with the closest people we have, be it with our parents (of strategizing to get that new gadget), with your best friend (at the brink of being enemies forever) or probably with your boyfriend/girlfriend (of trying to win where your date will be).

In these circumstances, there presents a possibility of a cooperative strategy of finding a reasonable solution (ie your parents give you what you want as long as you pass all your subjects) or of a non-cooperative strategy (ie you are not getting anything whatever the reasons are), where you risk the chance of a relationship breakdown. Ideally, as part of human nature, we try to cooperate and find compromise. Game theory tells us that we can’t have it all but we’d like to at least be better off with the decision we’d make.

Now, what do you do when you’re faced with a conflict with someone that would make you or break you? We take note on Paula Szuchman’s article Marriage and the Art of Game Theory.

Think ahead; try formulating the repercussions of every option you have in mind, and imagine yourself calculating the outcome. Learn from the past; use your knowledge to the advantage of knowing what should and should not be done based on previous events and situations. And, as what John Nash said, figuratively put yourself in the shoes of the other person. We might think that we fully know the person, but one should always account for uncertainty.

You probably might not be better than the chimps, but you can definitely learn to play the game.

#714


Should marijuana be legalized? – A glance at the Economic Effects in US

 Marijuana is the most commonly illicit drug used in America. According to the National Institute of Drug Abuse (NIDA), Marijuana usage has increased since 2007. In 2012, there were 18.9 million current users—about 7.3 percent of people aged 12 or older—up to 14.4 million (5.8 percent) in 2007.

 High demands likely indicate that legalization of this drug would have a colossal consequence in the economy. This would mostly affect: employment; marijuana demand; tax system and rates; the prospective government revenue; and social concerns such as rehabilitation programs.

 In order to understand the widespread impact, prevalence, and price of marijuana if decriminalized, we must primarily estimate how demand would be effected.

 If legalized, there would undoubtedly be a short-term increase in the product demand. Illicitness is currently a major restrictive for its usage as penalties for possession of marijuana can be very severe.The risk of penalization and increased availability combined with social excitement might justify the short-term rise for marijuana demand. The long-term demand is much more difficult to predict.Many tend to disagree on this topic discussion: according to Pacula (2001), marijuana use was found to be extremely inelastic. The elasticity of demand respecting the price was -0.06. Thus, a 1% increase in price would result in only a 0.06% drop in demand. DeSimone and Farrelly (2003) found analogous results, “Adult marijuana demand was not related to its own price”.Plus, they discovered price to be irrelevant for the more commonly users. Nonetheless, Harvard Professor Jeffrey A. Miron claimed in his report “The Budgetary Implications of Marijuana Prohibition” that the amount demanded of marijuana after legalization would mainly be determined by price.

 Legalization provides an enormous advantage over prohibition allowing taxation on legal distribution of the product. Without it, the free market price of cannabis is estimated to be extremely low. Therefore, taxation could be implemented at extremely high rates, while maintaining the price at a rate competitive to other intoxicants, such as alcohol. This action of legalizing, would both create government revenue as well as provide a less harmful and addictive substitute to tobacco and alcohol.

 Comparing the costs of tobacco with the cost of marijuana is useful when analyzing the natural price but not necessarily the market price. The two drugs have very different effects of the user. A joint of marijuana is highly more intoxicating than one tobacco cigarette. So, comparing production rates is a good determinant of what the free-market price would be, not the competitive rate at which it should be sold.

 There are several different ways to implement a tax on marijuana. One method would be to tax cultivators; other, to regulate consumers directly by requiring licensing for all who intend to buy, consume, or grow marijuana.

Social costs of Marijuana

External Costs of Drug Use

Cigarettes(pack of 20) Alcohol (1 excess oz) Marijuana (1 joint)
Net health costs $0,15 smoking diseases

$0,23 passive smoking

$0,26 $0,02 smoking
Accidents $0,93 $0,60
Total $0,38 $1,19 $0,62

Source: Manning et al., “The Taxes of Sin: Do Smokers and Drinkers Pay Their Way?,” JAMA 261:1604-9.

 We can conclude that the total social cost of marijuana is $0.62 per joint. Manning would argue that the above formulas should decide the rate of an implemented “harmfulness tax”. However, as previously argued, taxes should be largely enough to upturn the price of marijuana to the competitive rate.It is critical to be aware of the determined social cost of $.62 per joint when analyzing whether or not legalization would benefit society as a whole.

 Marijuana legalization is not a magical solution to the current drug problem faced in America today; nor is it the complete solution to the economic and budgetary problem. Yet, it could drastically reduce the annual deficit in government budget by nearly $26 billion.

As a time of Economic Recession such legislation should be seriously considered.

#696


Public Corruption – Rule of Law or Rule of Deception?

The corruption of the best things gives rise to the worst, David Hume

Corruption, a planet-wide phenomenon, has been around since the dawn of mankind due to our capacity to lie and deceit in our own self-interest. It has evolved, become more complex and more systematic, affecting how enterprises are run and even interfering with national affairs and how countries are governed. It has been proven by multiple studies that it hinders economic growth and the development of several of the poorest economies on the planet. Being a social phenomenon, such phenomenon should be analysed under a holistic perspective, joining contributions from the myriad of social sciences existing today. Nevertheless, we will undertake a more emphatic focus on the economic interpretation of corruption in society. On this post, I will assess the multiple forms how public corruption may present itself and how economics may hold the key to understand its causes and mitigate its action and its effects.

First, let us begin on how should we define corruption. Corruption may be defined as behaviours which deviate from formal norms for private gains and/or as the use of public or private office for private gains, according to Mishra and Bardhan, respectively.

On the one hand, one example model of corruption is an over-regulated economy where bureaucrats are given powers of discretion to interpret and impose such regulations. These powers present an opportunity to engage in deviating behaviours, i.e, corruption. Bureaucratic corruption manifests in the form of speed money, where bureaucrats quicken certain procedures taking as counterpart extra money; or in the form of dismissing illicit activities provided there is a monetary gain.

On the other hand, we verify the existence of political corruption, where the legislative process is conditioned via embezzlements to create laws suitable to particular firms, distortioning the government’s role in the economy. Such link between the private sector and the law-making process is not directly observable or inquired about, as people involved will not have the incentives to disclose such information. Nonetheless, according to Fisman and Miguel event studies in Finance have enabled us to see evidence of such phenomenon. When governments linked to private interests come across news, harmful to their integrity and stability, stock indexes of such countries usually fall due to added uncertainty in the economic activity. However, companies on the country’s respective index which have more profound ties to the government at that moment will suffer greater decreases in their stock prices and, consequently, bigger losses.

To understand these manifestations of corruption, we must understand the underlying reasons for it to happen. An economic interpretation of such causes lies on inadequate incentives and organisations which lead agents to engage in particular behaviours to attain a higher individual utility. These strategies can be persistent over time, depending on the importance of corruption externalities on the economy, specifically the fact that if more agents tend to be corrupt, the expected cost of being corrupt will become smaller, thus inducing more corruption in the economy and an overall non-compliant behaviour, which would be sustainable in the long run.

Since incentives and organisations set the stage for corruption to happen, we can use these as tools to promote an anti-corruption environment, discouraging individuals to engage in corrupting activities. For example, we have the establishment of what is known as an efficiency wage to public servants so as to induce more efficient and less deviating activity. By earning a higher wage, the bureaucrat will be less interested in increasing its income through illicit manners, relying on the steady and legal efficiency wage. Also, we may have a decomplexification of the legal system, reducing bureaucratic power by decreasing the need to resort to bureaucrats and more competition in public services, disabling potential corruption opportunities by bureaucrat’s more often than not monopoly power in some services. Moreover, public disclosure and transparency of government’s activities will give rise to a more favourable perception of the public towards corruption levels in the country and induce more compliant behaviour overall. Finally, a tight and thorough monitoring activity will mitigate the magnitude and spread of such activities.

In conclusion, corruption is present in public institutions, in one way or another, hindering population’s welfare and the economy’s potential growth. Being based on incentives and organisations, public policy constructed on such aspects may have interesting impacts regarding the decrease and progressive elimination of corruptive activities done by individuals.

#720, Gonçalo Pinto


How to nudge people towards better choices

“If you want to get somebody to do something, make it easy. If you want to get people to eat healthier foods, then put healthier foods in the cafeteria, and make them easier to find, and make them taste better. So in every meeting I say, “Make it easy.” It’s kind of obvious, but it’s also easy to miss.” (Richard Thaler)

Although the economic theory assumes that individuals make their choices based on expected utility, the reality shows that we often tend to make choices that go against what our real intentions are. The lack of information and the complexity of events do not always allow us to be perfectly rational.

By maximizing utility, or making optimal choices, individuals can improve the overall welfare of the society. Therefore, the government is incentivized to induce individuals to follow certain behaviours. To do so, the government can intervene through taxation or subsidies, and in this way influence the final choice of the individual by making a good more or less desirable. However, by doing this, the government forces citizens to behave in a certain way, limiting to some extent their personal freedom.

Nudging is a possible alternative way for the government to influence people’s behaviour without being intrusive. A nudge is a policy that helps you to behave the way you probably would if you were better disciplined and better informed. But it does not force you to do so. A nudge is not a shove. It does not compel you to do anything.

Some experiments have explored how effective nudging can be when it comes to solve social issues. One example is the donation of organs. The rate of donors is known to be significantly low in many countries. It is largely demonstrated that countries with an opt-out system have higher percentages of donation compared to opt-in countries. Germany, which requires people to explicitly state their willingness to donate organs, has a rate of donors of 12 % of total population. This can be compared to Austria, which adopts an opt-out system of presumed consent, has a donor percentage of 99 %.

What we see is that, generally, a great share of the population is in favour of organs donation but only a very small percentage takes the decision to join the donors’ register. Be it for inertia, or for lack of information or interest in the issue, if individuals are not encouraged to face the choice they tend to avoid it. As the idea of a general mandated choice, might not be accepted by everyone, there are other possible ways to influence people’s behaviour. In 2006, a plan, able to gather 2.3 million donors, was implemented in Illinois. The idea was that whenever someone was renewing his or hers driving licence the person was given the opportunity to choose to become an organ donor. This increased the rate of donors from 38 % to 60 %. Today, the government of Illinois allows citizens to spontaneously become organ donors simply by registering online.

This example shows that governments can effectively influence the behaviour of people by nudging them to take decisions that are likely to save someone’s life and more importantly without coercing anyone. Nudges can be seen as a tool that complements public policies rather than substituting them and when used to direct individuals to take the most preferable decision then the overall society will benefit.

Reference:

Thaler, Richard H, and Cass R Sunstein. 2008. Nudge: Improving decisions about health, wealth, and happiness. Yale University Press.

Giulia Casagrande, 745


Why do people want to be rich?

“If only I had enough money, I could… “

“If I had money I would… “

“Ff only I were rich…”

We heard people referring to these quotes all the time. It seems that the only obstacle separating people from living a fascinating life is money itself.

One thing that is hard to state is the importance of money; everyone knows that people need money to be able to purchase the basic goods, the ones that are truly necessary and that we cannot live without such as food. People that do not have sufficient money to satisfy the basic needs, when confronted with a situation of an increase in their disposable income, see their quality of life increasing dramatically. On the other hand if people already have a considerable amount of money that allows them to have their basic needs fulfilled, an increase in the disposable income would not have the same impact: at the margin their value of money has diminished.

Money is many times the source of frustrations due to the inability of average income people to acquire the quality of life of richer people. Humans have an obsession with wealth. Everybody wants to be rich, but the truth is when people are confronted with the question: “what being rich means to you?” they can’t define it because they don’t really know. People are utility-maximizing agents, they make decisions always maximizing their happiness, trading leisure for money by working and then they use that money to buy goods and services in order to maximize their happiness.

However, can the money buy everything? In my opinion the answer is no. Personally I believe that there are several ways to buy a fascinating life and money is just one of the currencies to that. To some individuals being rich means having a large amount of money in the bank, to others it just means not have to worry about money. At the margin is it more important to have more money or to have other currencies for happiness such as knowledge of languages, friendships, know how to travel…? Having money can give us a little freedom in the sense that we pay for experiences that otherwise we couldn’t have but still having a lot of money also have disadvantages such as being unfairly judge, never knowing if people are really interest in you or in your money and of course, money doesn’t buy happiness.

There is a certain propensity to blame money for our problems, but we can be wealthy without being rich. It is up to people to set up their priorities and think about the currencies that they need to meet their goals, and to be able to have that amazing life that they aim to.

#702


Let’s Face the Music – and Tax?

Let’s start, as all economists do, with some reasonable assumptions:

Assumption 1: You’re reading this on an electronic device.

Assumption 2: You have an electronic device nearby that can play music (it may be the device mentioned in Assumption 1).

Based on this assumptions, it is certainly possible that you’re listening to music while reading this blog post. I’m willing to go out on a limb and state it’s likely you’re listening to a song right now as you’re reading these lines. This outrageous assertion is based on the observation that, nowadays, music is seemingly everywhere all of the time. No longer do we have to carry our 12 favourite tunes on a CD (let alone vinyl) waiting for the right sound system to be able to enjoy them: our mobile phones, PC’s, mp3 players and the like, with their ever-expanding storage, allow us to carry and listen to more music than what Beethoven heard during his lifetime[1].

Part of this increased access to music can be explained by simple(r) piracy. That’s not the focus of this post though, as legitimate companies have recently developed a bevy of music streaming platforms. In Portugal, Spotify only requires an Internet connection for consumers to freely listen to any song from a huge collection of albums and genres; the ads, interspersed among the songs, can be removed by a monthly payment of €6.99, which also allows for offline playlist storage. In the US, similar services have arisen with Rdio and Pandora, albeit with slightly different modes of use.  However, it has been claimed that Spotify and other such services don’t channel almost any revenues to the artists themselves, which led musicians as diverse as the Black Keys, Taylor Swift and Radiohead to withdraw the music they own from the platform.

With the arrival of these new streaming services, it’s clear that the nature of music consumption has changed over time. While only 15 years ago we would have to buy CD’s from the record store to enlarge our music collection, now the only thing stopping people from accessing billions of songs is not having of internet connection – which is becoming increasingly more prevalent in this 4G, Wi-Fi world we’re living in. Also, songs are now digital, which lets people share their music with others at a nearly limitless rate; the music I buy can be listened to by others pretty quickly.

These two traits – difficulty of restricting access and multiple consumers benefiting from one purchase – allow us to think of music as having characteristics of a public good, which has huge economic implications. For one, it helps to explain why music producers (songwriters included) aren’t happy with the current state of the industry: the fact that their songs are freely available online with almost no compensation may lead people to enjoy all the benefits with no cost – a classic free rider problem. Another possible line of thought is that, if private actors don’t seem willing to continue their activity on the same grounds as before, there may be a role for the state in promoting music making. The idea of a “culture tax”, apparently revolutionary, has in fact already been proposed in some way or another, such as in France.

Nonetheless, let it be clear: I’m not arguing for a straightforward implementation of a global tax to subsidize musicians. Such an assertion is economically imprudent, for a number of reasons. Firstly, not all music is alike: Wikipedia lists over 100 genres, and most people do not like all kinds of music equally. In this case, speaking of a socially optimal level of music that people want may be misleading. In addition, music may be just a way of people meeting their cultural needs – meaning that they can shift away consumption to other art forms, such as painting or photography. Finally, the producer side can also create exclusion mechanisms that prevent people from listening to songs they did not pay for.

After all this discussion, what to take away? Should the state impose a tax to ensure that we don’t suffer from a shortage of music, or is the industry going to adjust naturally to the best outcome to all involved (consumers and musicians, as well as intermediaries)? I’d be foolish to pretend I know. However, this much is clear: the recent advances in technology have forever changed the way we access and consume music, and old models should be updated in order to better understand the economics behind it. And yet, it seems like yesterday, all these troubles seemed so far away

Rui Mascarenhas

694

[1] The fact that Beethoven gradually lost all of his hearing probably didn’t help, either.


Tacit Knowledge and The Future of Work – Will technology replace all human employment?

Tacit knowledge, a term coined by Michael Polanyi on his 1996 work The Tacit Dimension, refers to the kind of knowledge that manifests whenever we tacitly understand how to do something but are not then able to explicitly articulate it in terms of a procedure. In simple words, Polanyi’s Paradox states that ‘we know more than we can tell’. Polanyi’s argued that creative acts (especially acts of discovery), although possibly aimed at discovering the truth, are charged with strong personal feelings and cannot therefore be stated in formal terms. Examples include making a persuasive argument, recognizing people from a distance or recognizing someone as they grow up.

Tacit knowledge poses an extreme challenge for computerization and automation, as they both work by first taking the explicit procedure and then codifying those steps so that a machine can do it in our place. The fact that high-level reasoning requires very little computation, whereas low-level sensorimotor skills demand enormous computational resources is in fact a well-established paradox in artificial intelligence research.

Now, what does this tell us about the future of work? Will we have machines that will do what we do, programmed to mimic this kind of nonprocedural human way of assessing and solving a problem? Or will we recast the problems and therefore the technologies, so that machines do it very differently from how humans do it and yet still successfully? And either way, will technology ultimately replace human employment?

Think of the work of an administrative staffer or an assembly line worker – the type of skilled work that uses a lot of procedural – and therefore easily substituted by machinery – activities. These positions are likely to be almost fully substituted by machines. Conversely, a scientist or an attorney make use of their creativity, intuition and expertise to perform their tasks. These jobs, in which a lot of technical (codifiable) knowledge is also required, are complemented by information technology (i.e., it allows them to be faster and hence more efficient), rather than directly substituted by it. Finally, there are the in-person service jobs, like cleaning or personal care providers. As these require tasks that have proven very challenging to automate, they are expected to experience a relative growth in the future. But the irony here is that the supply of workers who can do them is quite abundant, which will push the wage level of relatively low-wage low-education jobs further down. This gives rise to the polarization phenomenon, where we have a simultaneous growth of both high-education, high-wage jobs, and relatively low-education, low-wage jobs. At the upper ends of the skill distribution, technology enhances one’s productivity; at the lower end, not so much.

To end on a positive note, I personally don’t think that polarization will go on until the middle just collapses to zero. For one, we can’t yet fully comprehend or imagine the ultimate types of human-machine complementarity. In the future, we might be using our time to do types of works we can’t imagine being possible right now or simply more artistic, less codifiable ones. However, although labor polarization due to increased use of technology does not create a problem of lack of wealth, it does pose one of income distribution: if the diminishment in labor scarcity among some skill groups should mean that their claim on the wealth is very limited, the whole capitalism system, which is organized around labor scarcity, will have to be rethought and reformed, so that society can be reorganized in a way in which people still have purpose that give meaning to what they do.

749


General Equilibrium: Let’s put it all together

General equilibrium have the objective of proving that all prices are at equilibrium, studying supply and demand fundamentals in an economy with multiple markets. Analyses the mechanism by which the choices of economic agents are coordinated across all markets. It attempts to look at several markets simultaneously rather than a single market in isolation, as partial equilibrium theory.

The general equilibrium model has traditionally been used to analyse the effects of a change in economic policy such as the imposition of a tariff or quota on imported goods, the granting of export subsidies, or a modification of the tax code. It can be used to explore the consequences of an increase in the price or reduction in the supply of an imported good such as oil, the ramifications of an unexpected fall in the supply of food, or a major change in the regulation of an industry. In each of these cases, the parameters of the model are required to yield current price and output levels as the solution of the general equilibrium model prior to the change. A recalculation is then done that predicts the consequences of the proposed change on a variety of variables: prices, levels of output, government receipts, and the distribution of income among the consuming units.

General equilibrium theory has provided economics with a very sound set of powerful tools and has instilled discipline of though and analytical rigor. The influence of general equilibrium has been pervasive even beyond its original and traditional microeconomics setting. Industrial organization has evolved from its partial equilibrium beginnings and has adopted some of the general equilibrium flavour. International trade theory is nothing but general equilibrium between countries or regions.

An actual economy, after all, is composed of numerous agents, markets and institutions, all of them interacting in the social medium and general equilibrium theory gives us insights as to what can we expect, in economic terms, from such a complex interaction.

One of the major virtues of the general equilibrium model is its ability to trace the consequences of large changes in a particular sector through-out the entire economy. It shares this property with input-output analysis but permits a more flexible treatment of the consumer side of the economy and is less rigid in the requirements placed on the productive side.

However, the model is inadequate in its treatment of money and financial institutions, it has great difficulty in allowing for unemployed resources, and it is unable to cope with large-scale industrial enterprises.  In spite of its imperfections, this method of analysis will retain its usefulness until economic theory is capable of providing compelling alternative formulations.

#760


The costs and the consequences of dishonesty

Dishonesty, personal interest, advertising misrepresentations and so on have assumed an important place in the organizations. In any company, people are motivated by factors such as sales quotas, career advancement, profits and success. Dishonest tactics can be implement by companies in their external dealings – those with customers, suppliers, regulators and stockholders – for example, in order to increase their short-term profits.

But how much are the costs of dishonesty? To answer to this question it is necessary to use the Lemons model, which explains the consequence of information asymmetry when the seller knows more about the good than the buyer.

Let’s consider a market in which there are two goods: for example, honest employee and dishonest employee. The buyer don’t know the quality of each employee, therefore his problem is to identify the quality. In the market, some people are willing to offer inferior goods that drive the market of existence; hence, the fact that dishonest dealings tend to drive honest dealings out of the market represents the major cost for dishonesty.

The cost of dishonesty lies in the amount by which the purchaser is cheated and it must include the loss incurred from driving legitimate business out of existence cause by the presence of people that want to pawn bad assets as good ones.

Dishonesty, despite being quite practiced by various organizations, has several negative consequences for them. The most outstanding is that the company will develop a weak reputation among their clients, business partners and competitors, who will gain advantages in the market.

Secondly, when a company hires employees, assures that they have the same values as the firm. After the dishonesty comes into play, the values of each may diverge in opposite directions, which can cause greater instances of illness and absenteeism, lower job satisfaction, decreased productivity, and in most of the cases, workers leave to work for companies with values more consistent with their own. Therefore, the company will have to support more costs.

Another problem is caused by the increased surveillance. Usually, when in an organization occurs deshonest practises, surveillances is increased to protect all the workers, but instead this have a negative impact on employee, leading to the degradation of the work environment, and consequently to adversarial relations between employer and workers.

A major question arises from this: if organizations who act dishonestly see that they have more costs, why they do not act ethically? Perhaps because the effort must begin at the top or because it is necessary to implement policies to encourage the same behavior from employees in their external dealings and between co-workers. With an effort by all the employees and with a regularly measure of the organization’s ethical reputation, companies could maintain high standards of conduct and count with honest workers and, more important, could avoid various hidden costs of dishonesty.

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A Day in the Life of a Young Economist

Fools are the ones who think Economics is none of their business. Of course it’s everyone’s business. In high school, the first thing I was taught is that “most of our acts are economic acts”. I though they were exaggerating on this one. Later, I came to realize they were right. If you are not convinced, I am then going to tell you about my day.

I wake up everyday at 6.30 am. Every morning I wish to have more 5 minutes in bed but my alarm just seems to say: “don’t forget about your time constraint”. Here comes the first economic term, constraint. Even though most people tend to focus only on the money constraint, meaning we have a fixed budget to spend on the millions of things we like, there are other important constraints and time is definitely one of them. Unfortunately, I only have 24 hours per day and I have to maximize my happiness or utility facing that binding constraint. The rest of the day can also be easily described by a cost-benefit analysis and other economic concepts. When deciding if I should have breakfast or not at home, on the one hand, my benefit angel says I will save more money because it is obviously cheaper, in monetary terms to do so; however, my cost devil reminds me about the huge costs implied. People tend to forget about implicit or non-monetary costs. If I had breakfast at home, it would take me a lot to leave it and traffic would be a nightmare. I would arrive very late to class and the opportunity cost associated, in terms of lost contents in class, especially at Nova, is very high. Also, by driving a few minutes later, in rush hour, I would certainly be imposing a negative externality on other drivers since I would be making their travel longer and vice-versa, not to mention the enormous gas costs but those ones are explicit, more obvious. When deciding whether to take the bus or drive by car to a certain place, most people think only about their own benefits and costs, leaving room for the arise of negative externalities imposed on other citizens.

After arriving at school, the goal is to focus on class and now the topic that emerges is to think not only about my benefits and costs but also on imposed externalities. However, this time we are talking about positive externalities. The knowledge I am acquiring will have enormous benefits not only for me but also for people surrounding me since my future job will certainly help them live their lives, although in a still unknown manner. Also, the decision of studying Economics again in the Masters and specialize in this field will add more to society since there are gains from a deeper understanding of only one subject instead of trying to know them all and not fully understand any of them. Now comes the time for lunch. As in any other school, we have the lower cost but lower quality cafeteria and the higher quality, higher cost one. So, everyday, students are faced with a quality-cost trade-off, bearing in mind their budget.The day proceeds in a cost-benefit, trade-off analysis about studying or resting, which is a constant topic in every student’s mind and the decision will obviously depend on preferences, a topic loved by Behavioral Economists. Finally, my day ends in the same way as it started, having in mind the time constraint: should I go to sleep or spend the next hour doing my second best alternative? Notice here that economists only think at the margin, meaning that they think about what to do with the next hour, what to do with this extra euro and so on. For now that is all. Do not miss a possible future episode of a Day in the Life of an Economist.

#690


Sick Profit

                We like adrenaline. We like the surge of it that we get when we jump from a plane (preferably with a parachute on our backs) or when drive at high speeds with bugs splashing in the windshield. Of course we often get this enjoyable adrenaline from “daredevilish” feats that are actually pretty safe. The bungee rope doesn’t have a big history of letting people splash in the water like bugs in a windshield and a sensible driver will know when the risks escalate too much – most of us, mere mortals, will be quite hesitant if we’re ever asked to jump over school buses with a most fragile motorcycle (unless you’re Evel Knievel).

                As we are cautious with the sources of our adrenaline rushes, so are we careful to take cover from bad situations or episodes that would be too blunt for us to bear. Take a driver for example – no matter how safe he is, there’s always a chance that, one day, something goes terribly wrong and he’s involved in a car crash that damages his car quite severely. The average driver will want to insure against that chance, he won’t be willing to gamble the chance of being deprived of a vehicle for too long. For that to happen, he’s willing to pay a fixed amount during the good, crash-free periods, so that he receives compensation when bad luck strikes. He pays during the good periods to be better off in the worse moments.

                One common type of insurance concerns health issues. There are several contracts available that serve for different purposes, for different people. The same general principle applies here – we pay when we’re healthy in order to reduce the expenses when we fall ill. When we fall ill, the insurance is, dependable on the kind of contract, liable for covering our treatment costs assuring our path back to a healthy state. This means that insurers are interested in our health; they have more to gain when we’re healthy and paying than when we’re sick and receiving compensation.

                In contrast, pharmaceutical companies exist to provide the drugs needed for both recovery or to mitigate the effects of long lasting conditions such as diabetes or asthma. This leads to the uncomfortable truth that these companies do better when we’re sick or when we  suffer from such long lasting conditions and they do worse when we’re plain healthy and joyful.

                There is, therefore, a deviation between what’s socially desirable (health) and what grants profit to pharmaceutical companies (lack of healthiness) which can be quite dangerous, especially when considering conditions of a more permanent nature. As those afflicted with these conditions are burdened with the persistent purchase of some drug or supplement, so it is that there’s absolutely no incentive whatsoever for the pharmaceutical companies to actively seek any development in the control of those conditions since it’s much more profitable to be constantly selling a drug than selling, let’s say, a one-time-use product.

                To wrap up, here’s again one more example of a “market failure” since the companies’ attention to profit will lead to an outcome that’s not socially optimal. Perceiving each firm as an independent agent that lunges at the market in an individualistic manner is a most blatant mistake. Only by indulging in conceiving the “market” as a web of dependant relations between agents, that must make decisions with a conscious mindset, will we ever be able to efficiently work out these “market failures”. Otherwise we’ll keep missing the forest for the trees.

Filipe Figueiroa

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The microeconomic life of a Nova Sbe student

Life at Nova Sbe is hard and it requires a great effort. The workload the students have to face is huge. When a Nova student wakes up, she knows there will be just one thing to do that day, studying.
In such a scenario, it is crucial for the student to be able to manage efficiently the resources she has, in other words, her endowment. This consists of two different types of resources: time and energy.
Having access to a well-provided library, the student starts looking for some books that could show to her the key for a successful learning. The first impact is a bit confusing, though. There are many books from which the student can choose and she does not know where to start. After the initial hesitation, the student realizes that she will better pick up a book from the economics section, since economics is the study of how to allocate scarce resources among competing ends (Lionel Robbins: Essay on the Nature and Significance of Economic Science (1932)). The student’s glance stops on a microeconomic theory book, which is about the maximization problem of the consumer’s utility and the minimization of her expenditure. The student thinks that these two problems perfectly fit her situation and could be helpful for solving her problem, thus she decides to borrow the book.
After having read the book, the students understands that the over mentioned maximization and minimization problems are actually two sides of the same coin. As long as the optimal solution of one problem is the constraint to the other.
The microeconomic theory claims that the student could choose indifferently one or another approach, so the students is now wondering if she should minimize the expenditure (time and/or energy) to achieve a certain utility level (aimed grades average) or maximizing the utility (grades average) given a certain budget constraint represented by her endowments of energy and time. Depending on the student’s preferences and thus on her utility function, the first approach will probably leave some endowment free to be used for other purposes. If the student choose to maximize the average grade, she will probably use most part of her endowment for studying. It could be said that the first approach is for those more social students, while the second approach is for students that value studying utmost.
But she is not alone in class, other students face the same problem. What if they could trade part of their endowments? The market where these transactions take place is something well known among the Nova Sbe students, the study-group. Indeed, several assignment are to be done in-group. Let us now see how students could mutually gain from a “market efficient” study-group.
Let us define two types of students depending on their endowments and with same skills. The first is the “asocial” student, which works time intensively. The second is the “social” student, which is energy intensive. We can extend this to the criteria of groups’ formation. One can say that in principle social students have less difficulty to find a group than the asocial students do. As a result, asocial and social students will be rarely gathered in the same group. To improve this situation the students should form groups with diverse composition. Let us say two energy intensive and two-time intensive students.
This will end in a more efficient workgroup enhancing the personal skills of each student. Working together, during the learning process, the social students will “buy” some time from the “asocial” while they will “buy” some energy from the social students. In this way, the difference between the problem of minimization of the expenditure and the maximization of the utility will become very slight and everybody will gain more resources to spend for other activities. Through the exchange mechanism, the social welfare would increase.

Francesco Cestari – 731 –


Are asset bubbles driven by irrational agents or it is just a maximizing payoff strategy?

Recently, the U.S stock market faced major asset bubbles – stocks are overvalued relatively to the real value of the underlying asset – namely, at the beginning of 2000 , the main index of U.S housing prices more than doubled from 100 to over 206, in 2006. In 2008 this bubble burst, causing one of the major worldwide recessions in recent years.

What explains the existence of these bubbles? No one really knows. It is related with investors’ behavior certainly, but there is no agreement on its roots. Financial economists generally argue that asset prices tend to converge to their real sustainable value, pointing out that these type of situations are just anomalies generated by irrational behavior of financial agents. That may not be entirely false, but at the same time there are reasons to belief that elements of rationality sustain this abnormal growth of asset prices. Regarding this issue, John Maynard Keynes argued in “The General Theory of Employment, Interest and Money that financial markets can be compared to a “Beauty contest” run by London newspapers in his time. The papers published an array of photos and readers could enter a contest in which the winner was the reader who guessed which faces would be chosen by the majority of other participants. As Keynes pointed out in his work “It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

What Keynes tried to say is that no one would simply choose the photo that found most attractive neither choose the photo that one thought other entrants would find most attractive, but rather trying to guess what other entrants would guess about which photos most other entrants would choose. Regarding financial markets, the argument follows the same logic. Investing is not a game of perfect information. Individuals maximize their profits by investing in assets which they predict to appreciate in the future. However, future prices of financial assets depend on the expectations of other agents, which further depend on their expectations of what other agents may expect. If this is true, then prices do not reflect what economists call fundamentals – which would correspond to choose the most attractive photo in the “Beauty contest” example given by Keynes.

The real-estate bubble was, at some extent, a consequence of this behavior. At the time U.S was subject to a large capital inflow due to a global saving glut among other reasons, which made investors anticipating what other investors expected the average investor to think it would be. Seems confusing? Well, let me present a small example. Suppose that the sustainable real price of houses is going to increase by 50 units, and there is common knowledge about this fact – everyone knows that there will be an increase of 50 and knows that every other people knows. As an investor would you invest according to a 50 units increase? Well, if you do so you are called a type 1 investor. But there will be other investors (type 2) that know that if everyone invest in that market, then demand will be very high, pushing prices further than 50. Thus, by anticipating this, they will invest more than according to fundamentals, and maybe prices go up to 75. It turns out, that there are type 3 investors, that anticipate what was previously said, and still invest more on houses. Prices may go up until 100 for example. Guess what? There are higher degree types of investors. This type of process can dramatically unhitch the price of an asset from its fundamentals, at least for a while. The reader might wonder why are bubbles that bad, given that it seems everyone is making profit out of this process. It turns out that now-a-days asset’s prices have a major impact in the real economy. For instance, firms make investment decisions based on these prices. And banks lend taking into account the value of collaterals, which are generally houses or buildings. Therefore, one might argue that financial agents do not take into account these effects when taking their investment decisions – there is a negative externality.

How can one avoid this type of behavior? Macroeconomists will probably say that the Central Bank has to intervene. It seems to be quite a good solution, given that if the Central Bank absorb the excess demand for an asset, such as houses, investors will incorporate these in their portfolio optimization problem such that a bubble can be avoided.  In practice though, a bubble is difficult to predict or detect. Another option is for policy makers to impose a tax in financial transactions such that prices converge to their real value. In this case, even if investors think that prices of an asset are going to increase, it may not want to invest that much due to the cost of a tax. Moreover, it knows that others will behave like him. Again, in practice it is not easy to put in practice since it relies on the assumption that policy makers know the fundamental equilibrium prices of assets.

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