Socrates is famous for saying (translated from the Greek, of course) that the unexamined life is not worth living. Unfortunately for us (but certainly not Socrates or Plato) there was no social media in Ancient Greece and, equally unfortunately, that pearl of wisdom seems to have fallen by the wayside in our digital age. Case in point: small minds trolling about in today's hyper-charged hypersensitive Twitter-verse using the apparatus of modern life to condemn capitalism. Using goods and services that are the result of countless free-market decisions, these clowns sit comfortably in a lofty, little perch from which they dish out small, vapid critiques of a system that produced the very infrastructure they use to condemn it. The irony here is beyond anything that could ever have been produced by the thinkers of the Academy and the Lyceum combined.

To fully drink in the incongruity, consider for a moment all the various economic spheres that have to converge to allow a disgruntled, twenty-something-year-old the ability to level criticism against the luxury in which he exists. To be concrete, let’s examine some of infrastructure needed to put up a simple video on YouTube. This analysis is, in some sense, a modern retelling of that venerable article, I Pencil, by Leonard E. Read written in 1958, which shows that literally no one knows all the steps in making something as simple as a Number 2 pencil.

Our scenario will start with our disgruntled content maker, no doubt living in his parents’ basement, with a heart filled with bitterness and a skull mostly devoid of marketable skills but rife with fears (how will I pay my student debt?) and with regrets (why did I ever get that degree in medieval Grail romances?). Having just finished eating dinner (a dinner he did not grow or hunt or even prepare), he washes his hands, uses the toilet, trundles to his air-conditioned cubby, flips on the lights, and logs into his laptop, at which point he is ready to pepper the internet with his injective against capitalism.

Those simple actions just describe touch upon some of the most important of the economic sectors. The folks at Simplicable, in an article entitled 23 Sectors of the Economy, define what an economic sector is and list their taxonomy. Depending on one’s purpose, other kinds of divisions are possible and common (e.g. academic economists only see four sectors). These details don’t matter as much as the fact the activity that takes place, regardless of dividing lines, are entirely or mostly capitalistic, meaning that private individuals own the means and make the decisions for what is produced, how much is produced, and who gets to consume.

Start with the house itself. Building a house is far more complex than building a number 2 pencil since a house is a set of subsystems or units, each at least as complex as a number 2 pencil, that that all need to work together. First there's the foundation and the actual structure that holds everything up; an incredible mix of concrete, wood, and metal; each serving its own purpose; each bearing its own load. The wood comes from trees in a forest and must move through an intricate webwork of supply chains and activities just to result in a 2x4.

Next, for a house to be considered even remotely habitable in this modern age, it will need electricity. Raw metals, typically copper, will have to be mined and then transported to a plant where it will be transformed into various gauges of wire and various components required for residential use. Circuits will run between the main and various rooms designed to use (one-phase here and two-phase there) and circuit breakers will have to be installed according to codes (a 20-amp breaker here a 30-amp breaker there) that allow us to safely use something that could easily kill us.

Then there's the common need for a heating, ventilation, and air conditioning (HVAC) system. There must be a way getting fresh air into the home, keeping the place heated when it gets cold, and it's highly unlikely that a college-trained intellectual would ever consent to live in a house without air conditioning so we'll check that box too. An HVAC system, all on its own, is a very complicated interplay between multiple economic sectors. Miners find the raw materials that eventually find their way into the sheet metal that is bent to particular specifications to produce ducts, and furnace manifolds, and so on. Certain houses will need specialized lines for handling natural gas safely along with ingenious pilot lights or other auto-ignition systems that enable the system to turn off and on without human intervention. And we can be sure that our YouTuber will want to avail himself of the sophisticated furnace filters that use an internet-of-things approach to automatically notify you when the dirt level demands their replacement (perhaps they will even sponsor his channel). Can’t waste time wondering whether the filters should be replaced when you should be out saving the world from the evils of the profit motive.

The simple action of eating dinner and then washing up afterwards involves multiple economic sectors as well. Agriculture efforts are needed to grow the organic quinoa and free-range chicken he insists on enjoying. A transportation network of trucks, boats, and planes is needed to take harvested goods to the processing plants and then to the supermarkets for his parents to buy.

Then there is the financial sector that enables his parents to put gasoline in their hybrid and drive to the local market where they pay with cash-back or points-reward credit card. This infrastructure, which allows them to enter a store, pick 32 specific items, checkout and drive home without ever handing over any cash goes completely unnoticed. This very same infrastructure also enables the mortgage on the house, the insurance premiums and payouts, and numerous other transactions, large and small that keep the household running smoothly.

Going hand-in-hand with the financial sector is retail. The ability to have innovative people realize an idea into a product that betters our lives would not be possible without the financial underpinnings of investments. These investments permit businesses to higher labor, design new goods and services, and purchase the assembly plants and distribution centers that turn these designs into things we consume. Companies, like Amazon and Apple, use this retail model to continually feed our man with the electronic products he craves; the ones that will allow him to make that one viral video that will change the world.

But no economic sector is, perhaps, as important to our modern-day hero than the utility sector. Ignore for the moment (as does he) the fact that this sector pumps the fresh water that he and his family need to drink and bath straight into the home (no trips to a well for someone whose mission is to save the world from private enterprise). Rather, focus on the those ever-so-vital electrical interactions that make modern life possible: the power that runs the air conditioning and the washing machine and the dish washer and the refrigerator; as well as the signals skipping to and fro bringing connectivity to the social media platforms that will carry his liberating manifesto to all the oppressed so that they may throw off the shackles of their high standard of living.

This narrative, of course, only scratches the surface. There are countless other ‘capitalist-enabled’ interactions that this poor deluded soul engages in. Retail stores, like Home Depot and Lowe's, provide the basic products like carpeting and the drywall that make his house comfortable. Vendors, like Hobby Lobby or Home Sense, provide the decorations and little knick-knacks that make a house a home. There are also the countless innovations, from fiber optics to CCD cameras to compact microphones, that connect to his laptop for the express purpose of making a video in which he can decry, with a huge helping of hubris, the evils of the system that enables his incredible style of living.

In the end, instead of having a hero of the people we have a person totally devoid of self-reflection or even an awareness of the bigger community into which he belongs who rails on social media about the inequities of the system and who speaks affectionately for communism. And all because it is easier to look at the capitalist system and find within it the conspiracy that explains his failures than it is for him to own them. Maybe he should have gone to a vocational school where he could have learned to weld. He wouldn’t be as plugged in to the revolution but at least he wouldn’t be living in his parents’ basement.

Sometimes our plans simply don’t go the way we want or expect them to go.  Occasionally we are simply victims of bad luck but, more often than we care to admit, the fault lies not in our luck but in ourselves in that we failed to think things through before we began.  And, sadly, on many of these occasions our own failures result from willful blindness rather than innocent ignorance.  Case in point: Walgreens and the City of San Francisco.

To give a short summary, Walgreens has shuttered a number of pharmacies within the city of San Francisco in the past several years due to widespread theft (Shoplifting Has Forced Walgreens To Close 17 Stores; Walgreens Closes 17 Stores In San Francisco Because Of Rampant Theft).  Jason Cunningham, regional vice president for pharmacy and retail operations in California and Hawaii, is quoted in The San Francisco Chronicle saying that

Cunningham offered the following statistic to support his claim about shoplifting:

This story might be a mere footnote in the business columns were it not for the fact that it is almost a textbook example of how willful blindness (or worse) results in what economists call unintended consequences.  In a nutshell, both the City of San Francisco and Walgreens hold viewpoints and enacted policies that, to the untrained eye, seem to be compassionate, but which ended up harming the same vulnerable people which these parties claimed they want to help.

Of course, the idea of unintended consequences is not a new one in economics circles.  EconLib has a nice summary of this topic, in which they point out that the idea first appeared in Adam Smith’s The Wealth of Nations.  Smith’s Invisible Hand describes the positive unintended consequences whereby each individual, following his own self-interest, helps to build a healthy, thriving society.  In modern times, the phrase ‘unintended consequences’ usually carries a negative connotation and has come to mean all the bad things that result from some policy enacted by either blind, but well-meaning, politicians or by sinister opportunists who sell the willfully blind a bill of goods.  But, regardless of whether the consequences are good or bad, all of us are obligated to make sure that they are at least intended; a point-of-view most forcefully expounded by Frederic Bastiat.

What is new is just how clueless the residents of the City by the Bay are in making good, or rather bad, on their compassion.

Let’s start with the muddle-headed thinking of the city government.  In April 2018, the San Francisco legislature, in all its wisdom, deemed shoplifting goods valued at less than $950 a misdemeanor, thereby removing a strong disincentive to theft.  Some in city government view shoplifting as a petty crime not worth enforcing but as anyone familiar with the concept of the broken window syndrome knows, smaller crimes beget bigger ones and a failure to enforce laws invites lawlessness.  In addition, the more recent, widespread antipathy towards the police has emboldened the criminal element across the country.  No doubt, other members of the government likely believe that they are showing understanding and compassion towards the marginalized (a la Cynthia Nixon’s recent comments) or they are shamelessly virtue signaling because they live in areas unlikely to be impacted by their decisions.  But, as will be demonstrated below, all that this point-of-view does is harm the most vulnerable.  Regardless of the interplay between all these motives, the result is a theft rate in Walgreens four times higher than stores in the rest of the country.

Walgreens is not entirely blameless in this as well.  No doubt due to both political reasons and matters of liability, the pharmacy chain has taken a non-confrontational approach to shoplifting in its stores.  According to anonymous reports from employees on reddit, Walgreens instructs its staff to do nothing to stop a shoplifting incident but to simply report it after the perpetrator has left the building. Once the cops arrive there is really very little that they can do, even if the courts would have been zealously prosecuted the offenders.

Finally, some of the most vocal residents of these very neighborhoods also don’t get it.  The Mission Local ran an article entitled 'Shame on Walgreens,' neighbors petition store plagued by shoplifting not to close.  The article cites the petition as describing one Walgreens in particular as a

The same article goes on to quote the poster boy of willful blindness, a jackass by the name of Curtis Bradford as saying

To these residents Walgreens should just hang in there and take it since they have deep pockets; the greater good is taking care of the vulnerable and the elderly in the Mission District.  Not once did the article cite a resident who organized a neighborhood watch to thwart shoplifting or member of the community who setup ‘pony express’ with runners who would go the 3 blocks mentioned and retrieve those lifeline goods.

To recap:  we have an envious and apathetic public who, in adding one part free rider problem and one part moral hazard to their witches brew, creates a potion that allows them to blindly and willfully ignore that Walgreens has rights and that it exists to be in business; we have a pathetic and timid business in Walgreens, who, in trying to avoid direct confrontation, has blindly and willfully ignored their obligations to employees and stock holders; and we have group of demagogues and opportunists who, in trying to capture the politically correct high ground, has blindly and willfully refused to mete out justice.  And who suffers from all this willful blindness and unintended consequences?  The very people each of those aforementioned groups no doubt claims to protect.  If it weren’t so sad it would be downright funny.

The recent cybersecurity incident involving the Colonial Pipeline offers an incredibly rich vista for exploring a variety of economics concepts. Questions about what went wrong and how to prevent this in the future naturally dovetail with the fundamental questions of economics centering on scarcity, who produces, who consumes, and how much.  This post will touch on the public’s non-intuitive (and to many infuriating) behavior in response to the gasoline shortage, questions about market forces and corporate responsibility, and the role of regulation.

But before getting to the analysis a brief recap is in order.  The colonial pipeline provides a large percentage (approximately 45%) of gasoline to the eastern United States ranging from the Gulf Coast (eastern Texas and Louisiana), through the south, up along the Carolinas, into the mid-Atlantic states, and into New Jersey and Pennsylvania.

On May 7, 2021, the pipeline was the victim of a ransomware attack, and the company halted all flow to mitigate the attack, which, reportedly, did not disable pipeline operations but infrastructure support (e.g. billing).  Even though the company almost immediately paid the requested ransom of 75 bitcoin, equivalent to approximately 5 million dollars, it took about 5 days to totally restore operations and at least a week beyond that for the entire system to return to normal.   During the 12 to 14 days of the disruption, the entire customer base suffered, to varying degrees, long gasoline lines and a general shortage of gasoline.  Stories about some individuals hoarding the supply surfaced along with widespread speculation about Colonial’s vulnerability to cyberattacks, and as always, the role that government and regulation should play in these situations became a common topic of conversation.  This post will content itself with only some of the highlights.

Foremost of these was the public response to the scarcity of gasoline.  Once the pipeline shut down, it was only a matter of time before the amount supplied dropped and the price increased.  Common wisdom argued that these price increases would trigger a drop in quantity demanded resulting in motorists in the effected area minimizing their trips in a car.  This interplay between supply, price, and demand is the traditional prediction of classical economics thinking.  What happened was a bit more intriguing.  If reports are to be believed (as should likely be the case), as the amount of gasoline supplied went down and the price rose, the demand actually increased to a greater level than had been the case prior to May 7^th.

The most probable mechanic behind this paradoxical behavior (at lease according to classical theory) seems to be related to the prisoner's dilemma.  Each member of the gasoline-consuming public could have looked at the situation and said “This disruption won't last long.  One way or another gas supplies will increase soon and so I'll cooperate with my neighbor; I will limit my gasoline purchases alleviate the crisis.”  However, as in the traditional prisoner’s dilemma, there is a rational fear of being betrayed by other actors in the drama which pressures each participant to betray as well.  Each person imagined the possibility of limiting their gas purchase and then came face to face with the fear that the supply of gasoline he really needed would be unavailable if his neighbor, thinking about the situation in the same way, reacted by rushing out to buy more gas than he absolutely required.  This self-enforcing negative feedback, which looks to have actually happened, was labeled by the media as ‘panic-buying’ but it seems to be based on something far more rational than blind fear.

The second interesting point to consider is if market forces could have been marshalled that would have led to a better outcome.  Obviously, Colonial Pipeline had been vulnerable to this cyberattack but the reason for that vulnerability isn’t forthcoming and, given the sensitive nature, is likely to never be fully known.  Nonetheless, this lack of information shouldn’t stop a vigorous analysis of what might have been done differently (although it should stop people jumping to conclusions – but it won’t).  The starting point will be the very practical question: did Colonial Pipeline take cybersecurity seriously?

There are practical reasons why any business entity (individual, family, corporation, education institution, etc.) might actually choose to ignore steps to beef up its cybersecurity.  As argued by Cormac Herley in his article entitled So Long, And No Thanks for the Externalities: The Rational Rejection of Security Advice by Users, security measures that cost more than the incident they intend to prevent are a non-starter.  It is possible that Colonial Pipeline recognized the need for cybersecurity but could only afford so much and they knowingly and calculatedly set aside money for a ransomware attack.  After all, ransomware attacks are meant to be annoying not debilitating and paying 5 million dollars occasionally may be more cost-effective than spending 30 million each year on IT.  The group allegedly behind this has even stated that they had no intention of causing this much trouble precisely because trouble triggers investigations and they simply want money.

There are always those amongst us who would argue that a company should ‘do the right thing’ regardless of cost but what, exactly, is the right thing.  Would customers be willing to pay 4 cents more per gallon to ensure that this kind of thing would be far less likely in the future?  Ask the motorist who was waiting in a 2-hour gas line the answer is likely to be yes but ask that same motorist now that the situation has returned to normal his answer will likely be no.

Perhaps there is a way for Colonial to market their socially responsible position but that notion is farfetched.  Most of us know our local gas stations not the company(ies) that they deal with to get gas in the ground for us to pump.  Colonial would have to spend millions raising social awareness before they could even begin to recoup that investment and apply it to their efforts in beefing up their cybersecurity.

Finally, there is the overall question of regulation given the optics of this event.  The public seems to have acted irrationally and, at lease in some eyes, Colonial Pipeline was also irresponsible for lapses in security and being craven in paying the demanded ransom.  No doubt some politicians are considering if this situation clearly invites government stepping in and declaring Colonial Pipeline as a public utility.  Arguments will surely surface that government needs to do more to ensure that companies keep current in their cybersecurity posture and, given the high-profile nature of this incident and the current ongoing federal involvement, future mandatory compliance seems certain.  The regulatory burden that will result will likely be far more expensive than a thorough internal approach.  This is the real bottom line incentive for ‘doing the right thing’; that the cure will be worse than the disease.  So, it seems that the Colonial Pipeline incident is literally the gift that keeps giving to professional economist.

Scholars and theorists will be busy for decades analyzing every nook and cranny, from new variants on the prisoner’s dilemma, to better market forces designed to incentivize corporate responsibility and the role that government regulation should play in cyberspace.  Sadly, for the rest of us, it is a reminder of how the digital world of ones and zeros can have a big impact on the real world of dollars and cents.

An old adage says there are always two sides to every story and this is certainly true about the life and controversial career of inventor Jerome Lemelson.  What makes his tale so different from other public, polarizing figures is that the arguments traded between his admirers and his detractors concerning his use of the US patent system reflect, in a microcosm, two dramatically different points-of-view about how inventions and intellectual property should be governed in society.

When one thinks of the great inventors of American history, one might conjure up Thomas Edison or George Eastman or Samuel Westinghouse.  Each of these men is famous for bringing to market, some device or machine that changed the way we live.  For example, George Eastman, dissatisfied by his experiences getting a photographic portrait, invented photographic film and the first portable camera and revolutionized how we record history, be it the small, private kind we each enjoy or the collective, public kind that shapes the doings of the world.  However, it is rare to find a person for whom the name Jerome Lemelson is even known let alone a household name, on par with those listed above, despite the fact that Lemelson holds approximately 600 US patents, making him one of the most prolific patent holders in the world.

That portion of the world that does know him divides into two very diverse camps.  His admirers think him a visionary who made our modern life possible.  His detractors think him a hoarder who gamed the US patent system and, perhaps, was a forerunner of the modern patent troll.

The pro-Lemelson side is succinctly presented in the Smithsonian book Little Explorer - Jerome Lemelson: the Man Behind Industrial Robots, by Lucia Raatma. (Note similar stories are told in the book Inventors You Should Know: Profiles for Kids, by Sam Simon– both are available on scribd.com)

The book provides a brief biographical sketch noting that Lemelson, born July 18, 1923 in Staten island New York, earned an engineering degree from New York University despite having his studies interrupted by service in World War II.  After graduating, Lemelson started in a typical salaried engineering job before striking out on his own as an inventor.  The book claims Lemelson’s most successful invention as the universal robot that would use one of his earlier patents on machine vision, which Lemelson imagined as a computer analyzing images from a video camera, to study a task and then “figure out the best way to complete it”.

Raatma also spends some time talking about Lemelson’s approach to business.  She says of his licensing and patent prosecution efforts that “an important part of being an inventor is licensing one’s ideas.  People can’t buy new items if they don’t know they exist.”  To that end he founded the Licensing Management Corporation to “sell his ideas” and to file lawsuits to protect his intellectual capital.  The money he derived was then returned to the community in the form of philanthropy designed to help budding inventors.

A more critical looks at Lemelson’s career is found in A History of Inventing in New Jersey: From Edison to the Ice Cream Cone, by Linda J. Barth.   She concedes that, despite his philanthropy, his career mostly consisted of filing patents and suing companies and customers who, allegedly infringed them, an approach she was clearly uncomfortable with.  Barth characterizes him as “not conduct[ing] much laboratory or manufacturing work” and she relates the following anecdote to drive home the point that much of his activity centered on litigation.

In her closing paragraphs, Barth writes

In the article Down but Not Out, R.  P.  Siegel points out that Lemelson’s inventions were “often so far ahead of their time that, in many cases, the technology required to build them did not yet exist.” Siegel also goes on to say that “a big part of Lemelson’s success was that he filed patent applications that remained pending for decades, and delayed work to his advantage.” Since patent applications remain hidden until the patent is granted, decades of delay on Lemelson’s part meant that other companies would unintentionally ‘re-invent the wheel’ by bringing a similar idea to market only to find later that they were subject to an accusation of patent infringement.

These so-called submarine patents enabled Lemelson’s Licensing Management Corporation to extract hundreds of millions of dollars from companies around the world.  Siegel cites that Las Vegas Judge Phillip M. Pro, who ruled 14 of Lemelson’s patents as “invalid and unenforceable” partially due to the submarine aspect but partially for lack of enablement, which means that no person skilled in the art could produce the device based on the teaching of the specification.  According to Jesse Jenner, the lead attorney representing Cognex, a company that disputed Lemelson’s claims of patent infringement, “these … rulings assert that no one, including Lemelson’s himself, ever built the machine vision system or bar-code scanner he licensed to thousands of companies.”

The idea that Lemelson’s patents are fraudulent is vocalized most forcefully by Mike Masnick, in a post entitled Lemelson’s Legacy: Great Inventor or Patent Hoarder, in which he characterizes Lemelson as a “complete fraud” who hoarded ideas and patents that effectively held companies, who actually did innovate and perform the hard work needed to bring a product to market, for ransom.  Masnick concludes by describing Lemelson as being “more a science fiction writer than an inventor” and that “crediting Lemelson with machine vision is like saying Jules Verne invented space travel.”

So, what to make of Lemelson?  In the process of wrestling with the facts surrounding his career, one must inevitably ask what the role of idea versus industry is in the economy.  Certainly, having a good idea is a commodity that should reap an economic reward and one’s immediate sympathy most likely goes to the ‘idea holder’ and, by all accounts, Lemelson had ideas.  But a bit of reflection should walk one away from the perspective that the ‘idea holder’ is pre-eminent.  If it is simply a matter of having an idea a without having the will power and means to bring it to fruition, then Lemelson should not be credited with the invention of the industrial robot anymore than anyone else who came after GK Chesterton.

Chesterton, who cared little for machines and industry and modern economies, introduced the concept of the robot in his short story The Invisible Man, in 1911, roughly two decades before Lemelson was ever born.  In this story, Chesterton foresees a future layered littered with mechanical helpers:

A critic might be inclined to point out that Lemelson did more that have an idea, since one can’t just patent an idea, but that point is fairly well retired by both the Corn Flakes anecdote above and the fact that, as Judge Pro ruled, many of Lemelson’s patents could not actually be used to build a device that achieved the idea.

Sad to say, it seems that Lemelson’s usual bag of tricks was to dream up an idea any futurist might have and then to slap just enough ‘hard science’ onto it to serve as a fig leaf covering the basic fact that his ideas were naked.  He then seems to use the strategy in dragging his applications out until real inventors, independently having similar ideas, caught technology up to the point where an actual device were possible.  At that point, Lemelson surfaces and sues real innovators who had never heard of either him or his shadow idea.  This is clearly not an actual desirable good in society and any economic rewards along these lines merely incentivizes more of the same and more waste on the part of individuals and companies that really invent.  Thankfully, Congress put an end to the submarine patent with the Uruguay Round Agreement Act in June 8, 1995.  Hopefully we won’t see another Lemelson as long as we live.

Human behavior.  There is simply no way to avoid thinking about human behavior when talking about either politics or economics.  The political side makes assumptions and then argues about what is right and proper and ought to happen.  The economic side observes and then poses questions about the best way to answer how much, who makes, and who consumes.  The political sphere tends to value emotion over data, and the cost of each decision is ‘obvious’ and ‘visceral’ and ‘in your face’.  In economics, the situation is reversed, with hard facts trumping knee-jerk reactions, and where the costs of each decision are often ‘hidden’ and ‘counter-intuitive’.  And yet both disciplines deal with the same underlying enigma – human beings.  As a result, it is almost always the case that there is spillover between the two sides, in which the salt water from the political ocean mixes with the fresh water from economic rivers that fed it to form a sort of brackish overlap.

This past month saw a particularly interesting ‘brackish’ situation emerge surrounding one of the most colorful characters in literature, Theodore Seuss Geisel aka Dr. Seuss.

According to Wikipedia, Ted Geisel authored over 60 children’s books.  According to the stack of books that once adorned the shelves in my own children’s room, we owned nearly all of them.  There’s no denying that Dr. Seuss was a common fixture for many when learning to read.  There’s also no denying that as many of us transitioned to adulthood, our childhood love of the perennial favorites The Cat in the Hat, The Lorax, Fox in Socks, and Horton Hears a Who! came along for the ride (not to mention our yearly need to see the Grinch in the weeks leading up to Christmas).  Seuss’ work resulted in numerous movies, TV shows, and related media (including a hilarious reading of Green Eggs and Ham by Jesse Jackson on Saturday Night Live).  Dr. Seuss wove himself and his eccentrically drawn characters into the fabric of American life (but just how deeply will be discussed below).

It is against this backdrop that a controversy erupted early in March when the publisher, Dr. Seuss Enterprises, announced that they would no longer be printing the following 6 titles:

• And to Think That I Saw It on Mulberry Street,
• If I Ran the Zoo,
• McElligot's Pool,
• On Beyond Zebra!,
• Scrambled Eggs Super!, and
• The Cat's Quizzer.

This sparked a political firestorm on both sides of the spectrum, but the controversy lasted far shorter than the publishers most likely had hoped.  But before arguing the underlying facts that support this, admittedly, provocative conclusion, let’s look at what the politics had to say in order to better understand how their emotional response provided cover for what was most assuredly a savvy economic move on the part of Dr. Seuss Enterprises.

According to Yahoo! News in a piece they published on March 2^nd entitled Six Dr. Seuss Books to Stop Being Published Due to Racist Imagery: 'Hurtful and Wrong', Dr. Seuss Enterprises has decided to stop publishing the list of 6 books by the late author because of “racist and insensitive imagery.”  The article went on to quote the publisher saying that the titles in question:

Newsweek, in their short piece entitled Banned Seuss Site Emerges to Promote Dr. Seuss' Six Canceled Books, cites a 2019 study published in Research on Diversity in Youth Literature, which concluded that

According to Newsweek, the study describes anti-Blackness as discrimination, opposition or hostility against Blackness and Black people.

On the other side of the political spectrum, local radio commentators complained about cancel culture, and wondered how the cancel culture could accuse the man who put environmentalism front and center in The Lorax, and tolerance despite outward differences as the central theme in The Sneetches, of being racist.

Of all the media outlets, the NY times, in its piece entitled Dr. Seuss Books Are Pulled, and a ‘Cancel Culture’ Controversy Erupts, comes closest to identifying what was really going on.  After stating that:

the Times finally points out to its readership that

And there you have it: the decision by Dr. Seuss Enterprises (DSE) was nothing more than a clever marketing ploy.  DSE could have simply stopped printing underselling books, but they knew that a perceived ban would trigger responses from both sides generating loads of free publicity.  They timed their announcement to coincide with National Reading Day, which is March 2^nd, a date previously chosen to coincide with Ted Geisel’s own birthday.

And their ploy worked like a charm.  The price of the ‘forbidden fruit’ rose so fast on Ebay that, as CBR notes in its article entitled 'Banned' Dr. Seuss Books Delisted on eBay After Selling for Thousands,

The only thing lacking in DSE’s plan was the ability to control the duration that a fickle and easily-distracted public either would stay outraged by ‘cancel culture’ run amok or would remain bitter towards perceived injustice.  The controversy ended far too quickly to likely sustain an increased jump in sales but that doesn’t really matter.  What does matter is that the roots of the controversy were planted firmly in the bedrock of economic analysis and not in the political winds that blow this way and that.

Their trading company of choice is called Robinhood, the subreddit where they discuss and plan is called r/wallstreetbets, and their now trademark move is called the GameStop short squeeze, but a name has yet to attach to the group of retail investors who’ve jumped into the spotlight for their role in one of the landmark incidents in the world of high finance.  Whatever name history eventually dubs these ‘average joes’, there is no doubt that their actions – which are one part David versus Goliath and one part Revenge of the Nerds – have bloodied the nose of high finance and will change the way Wall Street, Congress, and society at large looks at investing and stock trading going forward.

Despite the excitement and drama surrounding the movement of GameStop stock during the past month, the mechanics of the story are rather simple, although, perhaps, couched in unfamiliar terms.  A group of institutional traders (e.g., brokerages, hedge funds, etc.) decided that GameStop was an over-valued company and shorted the stock.  These actions were followed by the retail reddit investors driving the stock price up in a squeeze that caused big financial losses for many of those institutions.

In a short, the trader, called the short seller, borrows the stock from a lender and sells it to the broader market at the price Pb (‘b’ for borrow).  The short seller, in addition to paying a lending fee, has an obligation to buy the same amount of the stock back and return it to the lender at some future time.  During the time between the loan and the repayment, the short seller must collateralize the loan with a cash holding called margin, and may have to post additional margin as the stock price moves.

As long as the future price Pf (‘f’ for future) is lower than the Pb, the short seller stands to make a profit equal to (Pb – Pf)*n (with n = number of shares), which is his reward for correctly betting against the stock.  But if the future price is greater than the borrow price, the short seller loses money, and since there is theoretically no limit to how high a stock price may go, the corresponding losses are unlimited.

By rule, whenever a trader takes a short position (i.e., short sells a particular stock), it is publicly disclosed; this disclosure has both a downside and an upside.  On the downside, the fact that someone has bet against the stock puts a downward pressure on the price of that stock, which strengthens the short seller’s chances of realizing a profit.  On the upside, the public position of that bet makes the trader vulnerable to others pushing the stock price higher, forcing the short seller to increase his margin (held collateral) or to exit his short position at a loss.  This later event is an example of what is called a short squeeze, and is precisely what the group in r/wallstreetbets did.

As Jill Schlesinger points out in the following video, what makes this story ‘delicious’ is that, in crowdsourcing this short squeeze, the retail investors of this world (so-called dumb money) showed that they could also manipulate the market to their advantage in the same way that only the institutional investors (so-called smart money) could do until now.

To better understand this ‘snobs’ versus ‘slobs’ situation, consider that, for decades, the gap between the ‘big boys’ in the professional trading houses (institutional traders) and the average stock market trader (retail trader) has widened on several fronts.

On the snob side is a dazzling array of high-tech innovations.  The increasingly sophisticated mathematical models of quantitative finance with its use of stochastic calculus and advanced statistical algorithms has marginalized many who neither have earned a PhD in mathematics, physics, or engineering, nor possess the money to buy the services of someone who has.  Also, with great money comes great access to great technology – the kind of technology that can move mountains, literally.  As Christopher Steiner narrates in his article, Wall Street's Speed War, the obsession for speed advantages in institutional trading led to the covert construction of a specialized ‘straight’ line of fiber connecting Chicago to New York in order to realize a 3-millisecond advantage over those institutions that used a more meandering path around obstacles like mountains and cities.  As Steiner puts it this “… one-inch cable is the latest weapon in the technology arms race among Wall Street houses that use algorithms to make lightning-fast trades.”

On the slob side is… well not much in the way of sophistication.  Sure, the number of day-trading sites has increased along with a host of ‘tutorials’ designed to help onboard the retail investor.  But it wasn’t until dumb money used crowdsourcing to become a virtual institution that they could stand toe-to-toe with the professional trading houses and win.  And win they did when it came to GameStop.

To get a sense of what the folk from reddit set into motion, consider first the average daily share price (defined as the simple average between the listed high and low cost of a share on a given day) for the 1-year period from March 2020 to March 2021.

Share price was flat at somewhere around $5 until the fall of 2020 where there was a marked upward trend that then exploded in February of 2021.  The explosion is more evident in the following plot that lifts the restrictions on the y-axis range and extends back 5 years.

Clearly, the stock had been steadily falling from 2016 to mid-2020 but, once the reddit gang started pushing the stock price up, the increase took off from there and acquired a life of its own.  Before discussing how the short squeeze mechanism provides this life, it is worth taking a look at the amount of money involved.    The following plot shows the movement of money associated with the stock trades in billions of dollars.

The amount of money stayed relatively low until the critical time frame.  The next plot shows the same data with a log scale on the y-axis to show more detail.

Note that, in addition to the overall rise in the amount of money changing hands, the size of the fluctuations (usually called volatility) also got larger (much larger).

It’s the amount of the money involved that is key to understanding how the short squeeze becomes self-perpetuating.  Once the reddit gang traded up the price to a critical level, the margin positions of the short sellers started becoming tight, requiring each seller to either add more collateral to his margin account or to vacate his position.  Each seller who vacates causes the price to go up even further, causing an even greater problem for those left behind.  The process is inherently unstable, leaving behind a runaway process which sees sellers scrambling to liquidate their positions as the stock price inflates by huge factors (approximately a factor of 80 for GameStop).

These situations have happened in the past, but it usually took place between institutional investors trying to muscle each other along with the market as a whole.  This is the first time that it was caused by a group of retail investors.

So, there you have it, a historic short squeeze brought on by a team effort amongst some folk on reddit.  Look out baseball, there may be a new definition of suicide squeeze in the making.

The title of this blog says it all – this article focuses on praising the oft-maligned middleman.  What isn’t yet discussed is why anyone should defend or even laud someone who is often considered by society at large as superfluous and, sometimes, even parasitic.  To understand this controversial position, let’s first look at the conventional wisdom, take it apart a bit, and then see where the truth really lies.

The usual mode of thought surrounding the middleman is best summarized by the following diagram. Over on the left is the manufacturer of the goods or services sought by the consumer.  On the right are the consumers needing or wanting the goods or services that the manufacturer provides.  Stuck firmly in between is the middleman, from whose position derives his name.  In other contexts, the manufacturer might be the subject of economic criticism for his ‘rapacious capitalistic ways that drive him to crush the worker and squeeze consumer’ or the consumer may come under question for conspicuous consumption and not being enlightened enough to understand the implications of his purchases, for failing to ‘think globally and act locally’.  But the presence of the middleman distracts from all of that and he usually seems to draw all the criticism.

The reasons for this lack of status is well summarized in the article The Advantages of Eliminating the Middleman by Neil Kokemuller from April of 2018.  In this article Kokemuller identifies four advantages but a critical reader who eliminates the overlap soon finds that there are only two distinct ones.  First, by eliminating some of if not all the intermediary steps, the manufacturer can realize a greater profit while the consumer realizes a cost savings.  Basically, the two ends of the process split the cost that would have been expended on the middleman and bank it for themselves.  Second, because there are fewer steps, the process is both economically wiser and more environmentally friendly as there are fewer scarce resources used on securing the transaction between manufacturer and consumer.  The time from source to destination is also faster leading to higher customer satisfaction and reduced time to settle on the producer’s  side.

Kokemuller credits “Internet expansion” for this miracle release from the middleman, a sentiment more strongly (and perhaps humorously) expressed in the following excerpt from the written transcript of Steve Ely’s sermon The Middle Man:

Despite the fact that even a man of God has railed against the middleman, is this common wisdom really wise.  The answer is a qualified no.  Sure, each of us can point to a salesperson in some store (usually of the department variety) who is incompetent and/or unmotivated, but do we really, roundly reject the concept of a middleman.  Careful examination of our lives shows otherwise.

Consider first the ‘Internet expansion’, by which Kokemuller presumably means the fact that the internet facilitates a many-to-many relationship between consumers and producers that effectively by-passes the middleman.  The reality is that the middleman is not only thriving but now controls a larger portion of the economic pie than before.  Afterall, what are Amazon, Ebay, and Etsy if not middlemen enterprises designed specifically to connect consumers with manufacturers within a common framework.

In these cases, the primary benefit that these tech middlemen offer is convenience and trust.  For example, within the Amazon marketplace ecosystem, a careful shopper can find the exact same goods offered by different sellers (middlemen of their own) at different prices.  The structure Amazon provides makes payment to these individual institutions simple and convenient.  So does the convenience of returns.  The consumer need only interact with Amazon to purchase and return/exchange and the seller only need interact with Amazon to deliver and to collect.  This middleman function is so effective that it has made Jeff Bezos, the owner of Amazon, one of the wealthiest people in the world.

Ebay works in similar fashion, and, like the Macy’s, Kaufman’s, and Gimbal’s of decades past (mostly remembered through The Miracle on 34^th Street and the continued existence of Macy’s as a brand), offers slightly different product lines than Amazon but all still presenting themselves within a common ‘retail space’.

Curiously, Etsy seems to offer quite different product lines absent, for the most part, from the others, but, again, doing so within a common middleman framework wherein the consumer’s purchases from the producer are mediated through a common framework.

Other examples of middlemen on the internet abound.  Hotels.com provides a middleman service between the traveler and their lodging-provider.  Meta-middlemen like trivago (trivago even labels itself as a metasearch technology) or Kayak offer the middleman service of comparing individual middlemen side-by-side – for example, Hotels.com against its competitors.

However, all is not rainbows and sunshine.  Two things are lost, to varying degrees, with these cyber-middlemen services: traditional expertise and purchasing power.  Trusted middlemen of the older days added value by being personally involved in the procurement process.  They weren’t just a convenient connection point for bundling transactions between many manufacturers and many consumers but they actively had reputations they protected by filtering out poor manufacturers, who passed off counterfeit or shabby goods and services and, conceivably, also filtering out poor consumers who had no intention of paying.  After all, virtue is not the sole province of any side of an economic transaction.  Along the way, these ‘boutique’ middlemen also offered purchasing power where they could negotiate a better price with the manufacturer that could an individual consumer.  The relative scarcity of these type of intermediaries is probably the single biggest casualty of the internet age but it is a scarcity likely largely of their own making – very few people want to see trust and expertise it seems.

And that is the real shame.  Each of us would rather pay a little more for the peace-of-mind that comes when a trusted agent acts on our behalf in matters where we have little or no expertise.  Doctors, mechanics, and construction contractors who follow this approach never lack for business and usually must turn opportunities away.  Unfortunately, the internet has turned more of us into middlemen but hasn’t increased the quality of the services provided but simply amped up the convenience in which they are delivered.  Perhaps the only way that brick-and-mortar stores will substantially make a roaring comeback is by selling trust on a customer-by-customer basis.

It started innocently enough.  A chance comment heard on the sports radio WFAN from Baltimore opened to my eyes to something I hadn’t never realized.

Under its collective bargaining agreement, each NBA team must spend up to at least 90% percent of the salary cap on player salaries.  To quote the Wikipedia article on the NBA salary cap:

which amounts to a minimum salary level per team of $98.226 million (see NBA Salary Cap set at $109.14 million for 2019-20 for additional details).

The WFAN Big Bad Morning Show continued on this topic for a couple of minutes but the bad taste it left in my mouth remained at lot longer.  One of the announcers (Jerry Coleman) was indignant in the discussion, pointing out that the majority of the players are mediocre at best and were grossly overpaid as a result.  The other two announcers (Ed Norris and Rob Long) leapt to the defense of the players, pointing out that the league makes money off of them and that it was only fair that they got a substantial piece of the pie because they were the ones putting in all the effort.

Now I don’t expect a lot of rigorous economics analysis from sports radio and I realize that hotly debated opinions make for good radio.  That said, the faulty economics on display can’t go unchallenged for precisely the reason we would criticize any group claiming the earth was flat.  Eventually this bad thinking leads to bad decisions.  Sadly, both Jerry’s and Ed’s & Rob’s points-of-view are wrong and make good examples of the kind of ‘flat earth’ thinking so prevalent in the way the public at large think about economics issues.  First let’s deal with Gerry’s misconceptions and then we’ll discuss the more subtle errors of Rob and Ed.

Gerry’s primary error is in thinking the common misconception that there is a single unique standard for judging what a person’s effort is worth.  I might agree with him that the majority of professional basketball players fall short of really having a mastery of the game.  Examples are abundant where a player confuses athleticism with understanding the core aspects of the game.  As a result there are moments of exhilaration but they are often few and far between and, it often is the case, that the team, as a whole, suffers from the grandstanding of one of these players.  I might even go so far as to say that I think the NBA as a whole is not worth it.  But in these cases Gerry and I are merely stating opinions and not well-supported ones.  The public judges a basketball player on the enjoyment they derive from watching him play not from some objective analysis of how he plays.  Since it is a matter of taste in entertainment, there is no absolute scale against which he can be measured, no well-defined set of criteria by which we can say that he deserves such and such and no more.  He gets what the market can bear even if someone schooled in the art of basketball would find issues with the skills (or lack thereof) on display.  If the public enjoys a particular player’s flamboyance and are will to look past his shortcomings then they are getting exactly what they pay for and their freedom to choose should be as sacrosanct as those who think that the player is ‘shockingly overpaid’.

Rob’s and Ed’s error centers more along the economic fallacies pointed out by Frederick Bastiat, when the latter complained about people ignoring the unseen cost.  It is tempting to look at the players and couches putting in the effort at playing while the owners simply prowl the sidelines or sit comfortably in the luxury owner’s box and say only one side is working.  But, of course, this looks past the time and effort put in by the owners in acquiring the capital to buy a team.  Such thinking ignores the league management that markets the games and makes deals with the networks to air each contest.  For one thing is certain, no matter how talented an individual player is his talent amounts to nothing if there isn’t an audience willing to buy the product he is selling.  Without access to a market to showcase his skills he is consigned to suffer in obscurity.  This is the point so brilliantly made by Crash Davis (played by Kevin Costner) in the pool hall scene of Bull Durham.

The benefits the players derive from the structure of the league and the center stage it provide them extend far beyond the salary they are paid.  Many players earn substantial incomes by lending their endorsements or likenesses to advertising this product or that.  Do the owners get a piece of this pie in exchange?  Shouldn’t the flow of earnings go both way since the players endorsement revenue results only from the fame they derive from playing in the NBA?

To close, I don’t think one simple morning show will bring down the fabric of capitalism nor do I think that Gerry, Ed, and Rob are responsible for these misconceptions being part and parcel of ordinary thinking.  But they could contribute to better thinking about economics issues.  As far as the NBA is concerned, it is hard not to be critical of squabbling millionaires bickering with squabbling billionaires.  Both sides have a lot to be thankful for but I somehow think that even during this time of thanksgiving, neither side is likely to recognize much less admit it.

This month’s column, done in tandem with the article on elections done in the sister blog Aristotle2Digital, is about how voters choose how to spend their vote and how politicians choose to sell their services – in short, the economics of elections.  The companion piece, entitled Election Conundrums, explored a particular case study, lifted from American politics, that illustrated Arrow’s Impossibility Theorem that states that it is impossible  to find a voting system that guarantees a ‘fair’ outcome when three or more candidates are present.  This conundrum is the result of the mathematical ambiguities found statistically summarizing the results of an election in which voters split their vote amongst those running for office.  Being mathematical, that analysis did not try to determine how the voter population became split – it simply took the possibility and determined the implications.

This column remedies that deficiency by exploring some of the behavioral economics that lead to unusual electoral outcomes.  The ideas discussed here are strongly influenced by the excellent video Why Government Fails by Antony Davies of Duquesne University.

Davies opens by dividing the US population into three categories: voters, politicians, and bureaucrats.  He then goes on to speak about the myths that most people have about how government should work, myths based on naïve idealizations.  He proceeds to demolish these myths by simply modeling the behavior of each member of those three strata in terms that a public choice economist would use to describe them: each of them are human beings subject to limitations (economic scarcity) and the desire to maximize his individual utility. By taking these attributes into account and by properly identifying the specific type of utility each wishes to maximize, Davies shows that the rational choices each member would make leads to a set of governmental behaviors quite different than what our idealism thinks should result.

For example, consider the following ‘stupid’ law:  a member of the red population proposes a law in  which each member of the green population pays ten dollars to the government, half of the money is incinerated, and the remaining money is then evenly distributed to the red population.

Most of us believe that since the green population outnumbers the red by a ratio of 5 to 1, this law, which is clearly societally bad, would never pass.  But such analysis is naïve because it fails to account for the fact that voting entails a cost.  Most of us are conditioned to be appalled by the thought of poll tax but in fact each of us bears such a cost when we vote.  Even if money is not explicitly spent, there are costs associated with taking the time to learn about the issues, then to familiarize ourselves with the law, and finally to take the time and expend the effort to go to the polling place.

If we assign $20 as a monetary proxy for the cost (after all money is a proxy for time) then it in the rational best interest of each member of the green population to not bother getting involved but to simply bear the $10 cost as he will come out ahead.  In a sense, each member of the green population knows how to pick his battle and this isn’t it.  Davies says that the members of the green population are rationally ignorant of this kind of scenario where the cost is distributed and the benefit is concentrated.  A real life example of such a perverse situation where the majority bear a cost that is less annoying than the effort to end it is found in the tariffs impose on sugar imports to the US.

Davies also gives excellent examples of how the concept of representative government can fall flat and how bureaucrats have an incentive to transform their jobs into something that works for them rather than a calling in which they work for someone else.  But the scenario that is most interesting is the one involving politicians.

For simplicity, this analysis will be confined to two candidates, each vying for the largest number of votes between a polarized population made up of red and blue populations with very few members occupying the gray area of the middle ground.

Such a highly polarized voting population is quite familiar is these days of tribal politics and so one might think that the politicians elected into office are in fact hyperpartisan.  But there is, in fact a tendency for candidates to rush to the middle, even though most voters sit somewhere else on the political spectrum.

The process could work something like this.  Consider a population fiercely divided on welfare spending.

Candidate A favors a lower amount of governmental welfare support than Candidate B.  As a result Candidate A is favored only the population with the box.  Candidate B is considered better than Candidate A by the rest of the population even though neither the gray nor blue members find him palatable – he is simply the lesser of two evils.

Seeing that he won’t be able to win the election, Candidate A leapfrogs his opponent and moves towards the center.  Not to be outdone, Candidate B lurches in further toward the center until we end up with a situation as picture below where Candidates A and B are occupying middle ground that very few people actually find acceptable.

This scenario is so common that there is an accepted name for it: the median voter theorem.  The mechanics of this behavior well models the real world situations that we often see where candidates pander to their base when needing the nomination (red or blue) but then head promptly to the center in the general election.

With these sorts of economic forces dictating voter preferences and politician responses on a number of issues, it is quite easy to see just why Arrow’s Impossibility Theorem comes into play as often as it does.

The previous blog introduced the notion of financial arbitrage and briefly explored the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) models for pricing an asset (e.g. stock).  The CAPM correlates a particular asset with some macroeconomic factor (e.g. inflation or one of the indices) to determine the expected return on the arbitrage.  The APT generalizes this 1-dimensional correlation to the case where multiple factors affect the asset price.  The applicable formula that covers both cases is

R_A = R_free + β₁ ( P₁ - R_free ) + β₂ ( P₂ - R_free ) + ... = R_free + β₁ RP₁ + β₂ RP₂ + ...

where:

R_A is the expected rate of return of the asset in question,

R_free is the rate of return if the asset had no dependence on the identified macroeconomic factors (free rate of return),

β_i is the sensitivity of the asset with respect to the ith macroeconomic factor, and

P_i is the additional risk premium associated with the ith macroeconomic factor with RP_i = P_i - R_free being the actual risk premium.

Obviously, setting all the β_i beyond β₁ to be zero in the APT recovers the CAPM.

To use either of these models, the arbitrageur needs to set multiple free parameters (R_free, R_A, β_i, P_i) using his judgement based on historical data and some of the aspects of this procedure will be the focus of this post.

For simplicity, we’ll limit the analysis to correlate one stock with one index and we’ll follow the excellent article entitled CAPM Beta - Definition, Formula, Calculate CAPM Beta in Excel by Dheeraj Vaidya for WallStreetMojo.  I’ll be adding only a few points here and there just to round out what Vaidya presented but it is worth emphasizing what a fine job he did in his presentation.

The correlation we’ll be exploring is between a company called MakeMyTrip (MMYT ticker symbol) and the NASDAQ Composite (^IXIC ticker symbol).  To match, Vaidya’s analysis, we confine our time frame from January 1^st, 2012 to October 30^th, 2014.  Yahoo Finance served quotes under the historical data link that presents itself after entering a ticker symbol (see green ellipse in the figure below)

Selecting the time span and downloading the data in CSV format are easy.  I read the data for MMYT and ^IXIC in pandas data frames but since the average price of the NASDAQ Composite over that time span was $3563.91 compared to an average of $18.98 for MakeMyTrip, plotting each time series on a common plot won’t work, even with a log scaling.  Instead, taking a page from Z-scoring in statistics, I made a plot of the normalized stock price for each listing in which the instantaneous price was divided the average.

There is no obvious correlation between the two time series. The NASDAQ Composite, more or less, rose steadily during this time span while MakeMyTrip shows a more of a parabolic behavior, with a downward trend during roughly the first third of the time span followed by minimum in the second third, and punctuated by rapid, and often volatile growth, in the third.

These differences in the qualitative evolution of the two assets presents itself even more strongly in a scatter plot showing the adjusted closing price of each asset.

Nonetheless, there is a reasonably good correlation between the two assets in terms of their fractional gain, defined as the difference between two successive days relative to the price of the earlier of the two days (i.e. (p_i+1 – p_i)/p_i where p_i is the price of the asset on the i^th day).

There is a definite but weak positive correlation between the adjusted close of the NASDAQ Composite and MakeMyTrip.  A linear regression, computed using numpy’s polyfit routine (order 1), confirmed the same value of 0.9858 for the slope of a linear regression line that Vaidya reported.  This value is then the β between MakeMyTrip and the NASDAQ composite for this time span.

But the fun doesn’t stop there.  We can use the power of the pandas package to extend Vaidya’s presentation by randomly sampling the data to get an idea of the spread in the value of β based on using different samples due to differences in time span or reporting interval.  Running a Monte Carlo with 350 samples each (almost exactly half of the total number of available data points) for N = 10,000 trials gives the following statistics for β:

• the mean was 0.9835
• the standard deviation was 0.1443
• the distribution of β values is normal

Using the standard techniques of statistical analysis, we might be inclined to report the beta value as β = 0.9835 ± 0.0014 or, said equivalently, β could lie in the range of 0.9807 and 0.9863 with the usual 95% confidence.   This uncertainty in the value of β is about 5.7% and this translates directly into a 5.7% uncertainty in the assessment of the assets rate of return.  A 5% uncertainty is likely to be a good rule of thumb for the arbitrageur in estimating whether he wants to look further at an asset.

Another source of error that arbitrageur must wrestle with is the value for R_free, the risk-free rate of return.  According to Investopia.com, while a true risk-free rate of return is only theoretically realizable, the 3-month Treasury note is taken as a good proxy.  However, even this ‘sure fire’ investment vehicle sees movement on the secondary market.  The Wall Street Journal has excellent data and plots which show that, at least in recent months, the daily movement of the R_free can be 5-10%.

The final ingredient in the CAPM model is RP, the additional risk premium associated with the asset.  The way this value is set is probably as much an art as a data science question since it not only has to account for the actual financial strengths and weaknesses of the asset but also the market sentiment.  If the example in last month’s blog were indicative, values ranging from 2-10% are reasonable.  The uncertainty in the estimation of those risk premiums are probably correspondingly larger, maybe in the 20-30% range.

All told, the estimated value for the real rate of return on an asset must account for all of these errors sources.  To illustrate this, lets continue on with the comparison of MakeMyTrip with the NASDAQ composite by assuming the following:

• β = 0.9835 with a 1-standard deviation uncertainty of 0.0014
• R_free = 0.5% with a 1-standard deviation uncertainty of 0.025% (5% of the 0.5% value)
• RP = 2.5% with a 1-standard deviation uncertainty of 0.5 % (20% of the 2.5% value)

With these assumptions, the CAPM rate of return would then be RA = 0.5% + 0.9835*2.5% = 2.9588%.  The corresponding error in that estimation is obtained using the usual propagation of error techniques and takes the value of 0.4943%.  This value means that the arbitrageur needs to figure in about 0.5% slop 67% of the time he undertakes this transaction.

All this machinery of linear regression, Monte Carlo simulations, and propagation of error explains the rise of algorithmic trading and the mathematical analysts (so-called ‘quants’) in todays modern market.