Monthly Archive: November 2015

Well the Thanksgiving holiday is again upon us with its yearly promise of turkey, football, and absolutely absurd number of Black Friday commercials.  And once again, the actual story of the first Thanksgiving is lost in the constant background noise of consumption originating from our loving media who are quite happy to submerge sensible thinking underneath the constant drumbeat of buy, buy, buy.

As I’ve written elsewhere, the real story of the Pilgrims is one more deeply rooted in what modern economists would call game theory and behavioral psychologists the equity theory of motivation.  The story starts with the contractual agreement that the Pilgrims entered into in order to have their voyage to the New World funded.  That agreement required them to share the production and support of the new colony communally.  This forced socialism led to almost complete disaster and scarcity was the order of the day.  Only after they abandoned shared farming and allocated individual plots of land for each family did they thrive rather than just survive.

In his account of the Plymouth Colony, Governor William Bradford cites the various interpersonal frictions caused by how one colonist viewed another.  The old felt that they didn’t get the respect they deserved when forced to work the same ‘mean’ chores as the young.  The strong felt indentured by the weak who could not work as hard.  Bradford goes on to chide the vanity of Plato for recommending the abolishment of property rights and the establishment of a commonwealth.

What Bradford observed first hand is that people measure their happiness in relation to what others do.  When standing on his own, each Pilgrim felt entitled to his bounty, took satisfaction in his attainments, and lowered his resentment to his neighbors.  Bradford is perhaps the first adherent to equity theory.

Now despite what passes for common knowledge in certain circles, the same type of concerns that dominated that early colonial life in the 1620s are also at play in our technically advanced world nearly 400 years removed.  The saga of Gravity Payments shows clearly how unearned attainments by some can be viewed as an insult or even a threat by others.

But what brought all of this much closer to home was the recent departure of a co-worker to greener pastures.  I had the privilege before he left of being able to sit down to speak frankly with him about the reasons he was leaving.  His primary reason for calling it quits was the fact that he viewed his effort as being unrewarded in relation to his peers.  He didn’t quite phrase it as concisely as that but that was the gist of it.  From his point-of-view, his efforts were undervalued by a management who couldn’t actually articulate their set of expectations.

Of course, no one should be rewarded simply for working hard; regardless of the effort put forth, a worker must produce.  But likewise a business can’t simply hope that by promoting some workers over others that the entire work force will be able to infer a set of expectations.  Management must be able to articulate what they prize and be able to give clear rules by which the employees can measure their own output in relation to their peers.  Fairness is a central concept in human behavior and it governs how people perceive an activity as worthwhile or worthless.  By stating a set of objectively measured criteria for promotion, businesses can expect to keep a larger percentage of the work force willing to stay and work, even for lesser wages.  It is when the management of a business is thought to be arbitrary and capricious that friction ensues with departures following shortly.

Unfortunately, the business my friend was leaving seems not to have learned this message.  His departure is one of many in the past year and more are likely.  It seems that the Pilgrims story still has a lot to teach us if only we would listen.

In his 1988 book Innumeracy, the mathematician John Allen Paulos explores the inability of many people, some highly educated some not, to grasp what large numbers really mean.  The book was something of a best-seller and is often discussed within certain intellectual and academic circles but its influence seems to be short-reached based on the fact that people still seem to be innumerate.

This failure is particular troublesome when the large numbers are associated with probability and statistics, and even more bothersome when the large numbers are about money and the statistics are about who holds what in terms of wealth.

A recent example of this kind of sloppy thinking is found in the following video, which went viral recently

As Neil Cavuto, the host of the show, pointed out to Keely Mullen, the organizer of the Million Student March, the central question here is not one of judgement but of numbers.  Society can decide politically where it stands on her three core demands for free public college, the cancellation of student debt, and an across the board $15 dollar/hour minimum wage.  The economics question is how to pay for it.

And here the innumeracy comes rushing to the front and crashing down on her.  All she could say in defense of her program is that she doesn’t believe Cavuto when he says that confiscating the wealth of the rich would not be enough to pay for her core demands.  She couldn’t argue with his points.

At the heart of the discussion was the concept of ‘who pays for this all’.  Here her poor understanding of large numbers has harmed her.  The basic numbers are:

• The total wealth in the US held by households and nonprofits is approximately $82 Trillion dollars
• The wealthiest 1% holds, on average, 35.86% of the wealth
• Student debt is 1.2 trillion dollars
• The average US cost for public colleges is $9410/year
• The number of students enrolled in higher education is 17.5 million students

Now let’s do some trivial analysis; analysis that any fifth grader should be able to do, let alone a college educated activist.  First let’s calculate the wealth held by the one percent by multiplying the percentage wealth held by the total wealth.  This value comes out to be 29 trillion dollars of wealth.  It is a misleading number but we’ll come back to that.  Next let’s estimate the total cost for public college.  A reasonable estimate is that about 2/3 of the student population attends public college resulting in a yearly cost of around 110 billion dollars.  So, on the surface, if we make the one percent cough-up their fair share there should be ample money to meet the first two demands.

Just for giggles, let’s assume their fair share is 100%.  How long can we run the system?  Well 29 trillion take away 1.2 trillion for student loan forgiveness leaves just under 28 trillion of with which to pay for free college.  At 100 billion a year, that gives us about 255 years of free college.  So what if the system eventually runs out we will all be cozily dead and by that time (255 years into the future) we may not need college – we can just learn like they did in the matrix.

At the very minimum, Keely could have thrown these numbers into Cavuto’s face.  Had she done so, he no doubt would have pointed out the difference between wealth and fungible wealth.  To understand the difference, let’s consider how that 29 trillion held by the one percent is put to use.

For the sake of argument, let’s assume that all 29 trillion were placed in a simple savings account and then ask what purpose does that money serve?  Clearly the bank will loan it out for some businesses to get started, or loan it to a family to buy a house, and so on.  So we can’t simply take the money out of the bank and spend it on colleges with no consequences.  True the money is in the economy either way, but only in certain cases is it used to produce while in other ways its movement results in nothing.

In reality, that 29 trillion is tied up in lots of ways and earmarking it for one function will hurt people who depend on it for other functions.  The pros and cons of such a movement is what economics is all about. If we can only tap a tenth of that wealth, then the free-college system can only sustain itself for 25 years; hardly long enough for Keely's own children to attend for free. But what about the fact that the one percent will earn more? Well if we confiscate their money what incentive do they have to accumulate vast wealth again? Why not just be a normal working class dude like the rest of us, with all their needs take care of (but by whom?)?

Of course, a more profitable use of Keely’s time would have been to rail against the following two statistics.

• The cost of college has grown four times faster than inflation
• The amount of wealth held by the one percent has fluctuated only about 2% (1 standard deviation) up or down in the last 35 years

So what she should really be marching about with her 999,999 fellow students (or is that number too large?) is the fact that higher education is a bubble market – it consumes lots of money and produces far too many students for whom the numbers simply don’t add up.

One of the most rich and interesting components of economics is associated with the management of Risk and Knowledge.  As Taylor puts it in his textbook Principles of Economics: Economics and the Economy

This interplay between knowledge and risk (I prefer the term knowledge over information as the former implies a judgment that the latter lacks) is profound.  Management of risk in the face of what the future holds for securities is at the heart of hedge funds and derivatives.

Similarly, the issuance of insurance policies and the premiums by which they are underwritten is based on actuarial science where probabilities and impacts lead to expected outcomes and costs.

Interest required of a borrower is also linked to the risk that borrower represents in repayment and thus the interest rate is set accordingly – both in personal loans and in the offering or corporate bonds and stocks.

Naturally, we expect that a legitimate function of government is to ensure as free a flow of information as possible and we rightly view the pursuit of violators as a function of the courts.  Just ask Martha Stewart about insider trading or Ford about the Pinto.

With the advent of the internet, it was natural to expect that there would be better flows of information now that most everyone was ‘wired’.  Certainly CNet Reviews and Angie’s List seem to provide a forum for consumers to trade information on their experiences thus allowing others to gather knowledge and to make more informed decisions.

However, all is not well in paradise.  An increasingly larger number of companies are making ‘gag orders’ a part of the implicit contract between seller and buyer, with often draconian punishment awaiting a buyer who has the temerity to place a bad review on Yelp or to speak unfavorably on Facebook.

These gag orders are the digital equivalent to insider trading.  They are designed to keep information in the hands of a few and away from the buying public at large in the hope that, with less information, the public will make ill-informed and unknowledgeable choices.

And so it was with a some delight that I heard that Senator John Thune was providing Yelp Help by sponsoring S.2044 - Consumer Review Freedom Act of 2015.

Under this act, consumers will be protected from the bullying gag clauses by declaring such clauses, usually hidden in the terms of service (talk about a lack of information), invalid, thereby ending the punishment that would accompany honest reviews.  Gone would be stories of customers placing bad reviews on Yelp and then finding that they owe $3500 in fines for a dispute over $20 of merchandise.   Businesses would still retain rights to sue for libel for any grossly inaccurate reviews.  So kudos to what seems to be a sensible law that moves us one step closer to the ideal of a free flow of information.

Paul Bloom recently penned an article for the Atlantic entitled People Don’t Actually Want Equality that I found intriguing and which I think dovetails nicely with some points that have been central to the topics covered here.

Bloom opens his piece by noting that people from all sides of the aisle and all corners of the political landscape are talking about income inequality and the gap between the rich and the poor.  All of them seem to wanting to change the structure of society to close these gaps by redistribution of wealth or income without bothering to see if inequality is really want they want to fix.

He goes on to say that

According to his analysis, Frankfurt contends that people are, in fact, bothered not by inequality but by one of several factors that walk hand-in-hand with economic inequality but that are not related to it.  The first factor is that, in some cases, economic inequality is caused by structural or local injustices.  The classic story of the theft of one person’s idea that gains a fortune for another person falls into this case (what I like to call the Facebook narrative).  The second factor is that we would like to see everyone in society have a minimal level of subsistence.  A society where are citizens were incredibly poor would be equal but no one wants it.

Paul Bloom cites his own research at Yale as help to clarify the distinction between ‘equality’ and ‘fairness’.  He talks about a situation where two boys Dan and Mark are asked to clean their room in return for a reward of erasers.  When confronted with the sum total of 5 erasers, they would rather chuck one eraser so that each had two if they felt each had contributed the same amount of work but were content in an unequal distribution if an independent assessment concluded that one of them did more.

These considerations mesh well with the premises of Equity Theory discuss in earlier in connection with the situation at Gravity Payments.  People are not so concerned with inequality when someone is seen to have earned more.  Inequality rankles the sensibilities of the outraged only when the fairness principle is violated.

A variation of the Ultimatum Game bears this out.  In the traditional game, the responder will reject the proposer’s proposal unless the split is nearly 50-50, even though it harms the responder to do so.  However, in variations of the game where the proposer is chosen by some contest or assessment of skill, the responder is much more willing to take an ‘unfair’ cut.  The interpretation is that the responder recognizes the proposer’s superior skill and is willing to make concessions.

This also seems to be the psychology at play in the debacle of the early years of the Plymouth Colony.  The prospect of communal farming, which, theoretically, should have resulted in near equality, lead almost to total ruin due to the issues of fairness.  Only when each family stood on its own with its own land did the colony actually thrive.

So it seems that income inequality is not what people are concerned about.  The rich can be rich as long as there is justification for why they are rich.  The poor can also be poor as long as a minimum standard of living is meet.

Maybe we should start talking about income justification - just a thought.