Friday, May 29, 2009

A look at fundamental economic assumptions

For the most part, economic education teaches students to understand society by assuming that agents rationally pursue their self-interest. For economists, identifying the the benefits and costs associated with particular decisions is all that's really required to understand why people make decisions (and to figure out how to change them). For along time, most economists believed that individual material interest dominated benefit-cost calculation, increasingly, though, economists have been forced to recognize that social concerns also affect individual calculations (e.g., people will frequently not pursue their own material self-interest if they must take unfairly from others -- particularly others they know).

This article provides a nice summary of some of the experiments in behavioral economics that have helped move social considerations closer to the forefront. The first several paragraphs even directly deal with something we discussed recently -- a union deciding between wages and employment:

The City of Yonkers, New York, wound up in a distressing predicament early this year. The municipal budget was running a deficit and the economic crisis was sorely aggravating the problem. Layoffs were needed and among the casualties were six firefighters, including, most regrettably, a young man who’d recently rescued several children from a burning apartment building. The job cuts were due to go into effect the first week of January.

But then something remarkable happened. The men and women of the Yonkers Fire Department offered to work days free for six months so the city could save money and their colleagues could save their jobs. The deal was approved by 75 percent of firefighters and the layoffs were avoided. “Everyone is aware of what is going on with the economy,” explains Patrick Brady, president of the local firefighter’s union. “We banded together and voted to save our brethren.”

This link includes several other bits on behavioral economics that you may want to check out.

Thursday, May 28, 2009

Today's Class

Slides from today's lecture are available here.

Here are some additional links on inequality:

Berkley professor Emmanuel Saez has written many of the most detailed descriptions of these issue. Links to his papers (and the tables I used in class) are available here.

Here's something I posted earlier on how much the gov't spends promoting economic mobility.

Here's an overview of the issue I wrote awhile back -- in particular, here's a document I wrote that explains the basic elements of inequality, mobility, and income growth.

Here are some of my opinion pieces on this topic. One and another.

Wednesday, May 27, 2009

Go to class

Your grade will improve. Jennjou Chen and Tsui-Fang Lin estimate the effect of class attendance using a randomized experiment:

The study of determinants of a college student’s academic performance is an important issue in higher education. Among all factors, whether or not attending lectures affects a student’s exam performance has received considerable attention. In this paper, we conduct a randomized experiment to study the average attendance effect for students who have chosen to attend lectures, which is the so-called the average treatment effect on the treated in program evaluation literature. This effect has long been neglected by researchers when estimating the impact of lecture attendance on students’ academic performance. Under the randomized experiment approach, least squares, fixed effects, and random effects models all yield similar estimates for the average treatment effect on the treated. We find that, class attendance has produced a positive and significant impact on students’ exam performance. On average, attending lecture corresponds to a 7.66% improvement in exam performance.

More Occupational Licensing

We talked a few weeks ago about occupational licensing. Here's some additional summary:

10. Analyzing the Extent and Influence of Occupational Licensing on
the Labor Market
by Morris M. Kleiner, Alan B. Krueger - #14979 (LS)


This study examines the extent and influence of occupational
licensing in the U.S. using a specially designed national labor force
survey. Specifically, we provide new ways of measuring occupational
licensing and consider what types of regulatory requirements and what
level of government oversight contribute to wage gains and
variability. Estimates from the survey indicated that 35 percent of
employees were either licensed or certified by the government, and
that 29 percent were fully licensed. Another 3 percent stated that
all who worked in their job would eventually be required to be
certified or licensed, bringing the total that are or eventually must
be licensed or certified by government to 38 percent. We find that
licensing is associated with about 14 percent higher wages, but the
effect of governmental certification on pay is much smaller.
Licensing by multiple political jurisdictions is associated with the
highest wage gains relative to only local licensing. Specific
requirements by the government for a worker to enter an occupation,
such as education level and long internships, are positively
associated with wages. We find little association between licensing
and the variance of wages, in contrast to unions. Overall, our
results show that occupational licensing is an important labor market
phenomenon that can be measured in labor force surveys.

In case you're wondering ...

5. Why do Institutions of Higher Education Reward Research While
Selling Education?
by Dahlia K. Remler, Elda Pema - #14974 (ED)


Higher education institutions and disciplines that traditionally did
little research now reward faculty largely based on research, both
funded and unfunded. Some worry that faculty devoting more time to
research harms teaching and thus harms students' human capital
accumulation. The economics literature has largely ignored the
reasons for and desirability of this trend. We summarize, review,
and extend existing economic theories of higher education to explain
why incentives for unfunded research have increased. One theory is
that researchers more effectively teach higher order skills and
therefore increase student human capital more than non-researchers.
In contrast, according to signaling theory, education is not
intrinsically productive but only a signal that separates high- and
low-ability workers. We extend this theory by hypothesizing that
researchers make higher education more costly for low-ability
students than do non-research faculty, achieving the separation more
efficiently. We describe other theories, including research quality
as a proxy for hard-to-measure teaching quality and barriers to
entry. Virtually no evidence exists to test these theories or
establish their relative magnitudes. Research is needed,
particularly to address what employers seek from higher education
graduates and to assess the validity of current measures of teaching

Tuesday, May 26, 2009

Whoops -- Missing figures

Note -- I will hold OH today from 4:30-(slightly before) 6 in PLC 627.

Also, it has been pointed out, that I neglected to include some figures for Quiz 2. Here they are. Just draw them yourself on your quiz.

Number 4

Number 5

Thursday, May 21, 2009

Kid Discount Rates

This article describes some interesting psychology research into the relationship between childrens ability to delay gratification and long-term outcomes. They don't use the term, but this is essentially a discussion of the fact that we can, to a certain extent, identify people with low discount rates at a young age (and thus there may be some genetic origin):

In the late nineteen-sixties, Carolyn Weisz, a four-year-old with long brown hair, was invited into a “game room” at the Bing Nursery School, on the campus of Stanford University. The room was little more than a large closet, containing a desk and a chair. Carolyn was asked to sit down in the chair and pick a treat from a tray of marshmallows, cookies, and pretzel sticks. Carolyn chose the marshmallow. Although she’s now forty-four, Carolyn still has a weakness for those air-puffed balls of corn syrup and gelatine. “I know I shouldn’t like them,” she says. “But they’re just so delicious!” A researcher then made Carolyn an offer: she could either eat one marshmallow right away or, if she was willing to wait while he stepped out for a few minutes, she could have two marshmallows when he returned. He said that if she rang a bell on the desk while he was away he would come running back, and she could eat one marshmallow but would forfeit the second. Then he left the room.


Once Mischel began analyzing the results, he noticed that low delayers, the children who rang the bell quickly, seemed more likely to have behavioral problems, both in school and at home. They got lower S.A.T. scores. They struggled in stressful situations, often had trouble paying attention, and found it difficult to maintain friendships. The child who could wait fifteen minutes had an S.A.T. score that was, on average, two hundred and ten points higher than that of the kid who could wait only thirty seconds.
If you read the whole article, you'll find some allusions to something which I think relates to the discussion from yesterday's class about the importance of exogenous factors versus individual traits -- the difficulty identifying and measuring a clear personality.

Humans like to ascribe people's behavior to the person, e.g., Dave blew past me and almost knocked me over, therefore Dave is a jerk. If we observe a person enough, we start to believe that we can discern a personality. Psychologists, though, have had difficulty identifying and measuring personality. They've made some basic steps, but people are a bit erratic. Put the same person in the same situation repeatedly, and they will behave relatively similarly. However, modify the situation slightly, and they will behave very differently. As such, some psychologists believe that the situation determines individual behavior least as much (if not more) than the person does.

For economists, this is a very natural way to think about stuff. The social psychologists are merely confirming what economists strongly believe -- people respond to incentives. However, since people -- particularly children -- have limited control over the situations they face, this further my personal belief that exogenous factors are very important in determining individual outcomes.

If you want to learn more about the importance of situations for determining behavior, I highly recommend the book "The Person or the Situation".

In comments

In comments to one of the posts below, Mark posits a few good hypotheses for the relationship he and some friends noticed between family income and "hotness" among the girls at his high school.

He posits 3 hypotheses:

(1) Girls from wealthier have more resources to enhance their appearance
(2) Man with high incomes may be able to attract more attractive wives (thus improving child genetics ... and I would add the chances that daughters have mothers who can train them to be good at (1))
(3) Men with high incomes are more likely to be attractive themselves (further improving child genetics.

There is an additional complementary explanation to this list that I neglected to pull from the archive yesterday -- oddly, more attractive people are more likely to have daughters:

4) Stephen Dubner links to some wild evolutionary biology research using the National Longitudinal Survey of Adolescent Health which finds that individuals rated more attractive by their interviewers are 36% more likely to have girl for their first child.

According to this news article, "Selection pressure means when parents have traits they can pass on that are better for boys than for girls, they are more likely to have boys. Such traits include large size, strength and aggression, which might help a man compete for mates. On the other hand, parents with heritable traits that are more advantageous to girls are more likely to have daughters."

Beauty is apparently just one "female" trait. Kanazawa has done previous research suggesting that nurses, social workers and kindergarten teachers -- those with "empathic" traits -- also had more daughters than sons. Meanwhile, he found that scientists, mathematicians and engineers are more likely to have sons than daughters.

Wednesday, May 20, 2009

From the Archive -- Ugly Criminals

Until relatively recently, people believed that you could tell alot about a person based on their physical features. Ok, we still probably believe that to some degree, but not in the same way. The formal study of character through features is known as physiognomy, and, back in the day, its practicioners believed that they could point out criminals based on their facial features. Bram Stoker was very into physiognomy, and, as such, Dracula possesses most of the features of the physiognomist's "criminal man" -- unibrow, high forehead, ... (I know all this because I wrote a paper about if for my Gothic Lit class as an undergrad.)

Anyhow, some economists are out to quasi-revive physiognomy. Naci Mocan and Erdal Tekin show that unattractive people are more likely to commit crimes. Here's their abstract:

Using data from three waves of Add Health we find that being very attractive reduces a young adult's (ages 18-26) propensity for criminal activity and being unattractive increases it for a number of crimes, ranging from burglary to selling drugs. A variety of tests demonstrate that this result is not because beauty is acting as a proxy for socio-economic status. Being very attractive is also positively associated adult vocabulary test scores, which suggests the possibility that beauty may have an impact on human capital formation. We demonstrate that, especially for females, holding constant current beauty, high school beauty (pre-labor market beauty) has a separate impact on crime, and that high school beauty is correlated with variables that gauge various aspects of high school experience, such as GPA, suspension or having being expelled from school, and problems with teachers. These results suggest two handicaps faced by unattractive individuals. First, a labor market penalty provides a direct incentive for unattractive individuals toward criminal activity. Second, the level of beauty in high school has an effect on criminal propensity 7-8 years later, which seems to be due to the impact of the level of beauty in high school on human capital formation, although this second avenue seems to be effective for females only.

Notice how their last two sentences describe clear economic hypotheses for what might explain this relationship. While I don't find it hard to believe that there is a relationship between appearance and crime, I wonder about a couple of things. First, these authors use the same study that you all used for the empirical exercise, so it is possible that interviewers perceived their "criminality" in their demeanor or dress and rated down their appearance. Second, even assuming that interviewers are able to "objectively" rate people's appearance, beauty is only partially exogenous. Individuals can, and do, invest time, money, and effort moving themselves around the beauty distribution. It may be that the traits which explain investments in appearance also explain low test scores, low wages, and/or higher crime.

From the archive -- More Beauty

Tyler Cowen links to an excellent summary of much of the psych lit on beauty. The evidence it discusses provide foundation to the hypothesis that beauty is an important source of social capital/social skills. People (starting at infancy and even including mother's responses to their children) are drawn to attractive people. This gives pretty people an advantage in social markets. Being treated differently in social situations throughout life almost certainly changes the social skills these individuals develop.

Three things in the article stood out to me. First, psychologists have found that "moms of attractive first-born infants were more attentive and affectionate than moms of less attractive first-borns," that "attractiveness is significantly related to social acceptance and popularity for girls throughout the entire school year. For boys, low attractiveness is associated with rejection by peers. Moreover, the likelihood that unattractive boys would be rejected increased, not decreased, as the school year progressed and as the boys became better acquainted." (They imply that unattractiveness directly causes this effect, but it could be that unattractiveness is correlated with less friendly personalities (see lack of maternal attention above) and that is why this pattern is observed.)

Second, they show that infants respond to attractiveness. They show, "Babies look longer at adult-judged attractive faces than at unattractive faces, regardless of whether the face is male or female, white or black, adult or infant" and "The infants more frequently avoided the stranger when she was unattractive than when she was attractive, and they showed more negative emotion and distress in the unattractive than in the attractive condition. Furthermore, boys (but not girls) approached the female stranger more often in the attractive than in the unattractive condition, perhaps foreshadowing the types of interactions that may later occur at parties and other social situations when the boys are older!"

Finally, who is pretty? Well, people who look average. Not people who are average within the attractiveness distribution, but rather people whose faces resemble a composite of lots of faces.

From the Archive -- Why Height Matters

Height (which is frequently not captured in beauty variables) also produces returns in the labor market. An extra inch of height is estimated to be worth approximately $1000 a year in wages. While that's great (at least if you are me), one can't really invest in their height so who cares?

Well, it turns out one's current height doesn't appear to generate these returns. Economists Nicola Persico, Andy Postlewaite, and Dan Silverman show that it is not height today that generates higher incomes, but rather height at age 16. Boys who were tall at 16 earn more money, but boys who were short at 16 but tall at 33 don't. This suggests that height itself does not matter. Rather, adolescent experiences differ for those who are tall and these different experiences generate self-esteem, confidence, or some set of skills that are valuable in the labor market.

Steven Landsburg provides a one page summary of the paper here.

From the Archive -- Why Beauty Matters (the third time)

Here's some additional material on the topic of discussed in Metrics today.

Why Beauty Matters

In class yesterday, we discussed that your appearance is an important part of your social capital. For many years, economists have known that more attractive people earn more money. Steven Landsburg summarizes several of the key findings in this slate column. Here's the highlight:

In their published research, Professors Daniel Hamermesh and Jeff Biddle estimate that if you're perceived as beautiful, you probably earn about 5 percent more than your ordinary-looking counterparts.

As beauty is rewarded, so ugliness is penalized. Ugly women earn about 5 percent less than other women, and ugly men earn about 10 percent less than other men. That's right; the market punishes men more than women for being unattractive. Moreover, men's looks haunt them at every stage of their careers: Better-looking men get more job offers, higher starting salaries, and better raises. For women, good looks will get you better raises but usually not better job offers or starting salaries. (A note on Hamermesh and Biddle's methodology: Beauty was assessed by panels of people who judged photographs of the study's subjects.)

But why is beauty rewarded? Do employers "pay" because they just like to have pretty people around? Do employer's know that customers prefer to work with pretty people? Are pretty people more productive? Or do employers (and the pretty people themselves) just think that they are?

Spiffy research by Harvard's Markus Mobius and Wesleyen's Tonya Rosenblat addresses these questions using an experimental labor market. Berkeley professor Hal Varian conveniently summarized this paper in yesterday's NYTimes:

Armed with the data from these experiments and surveys, the economists found several interesting results. It turned out that beautiful people were no better than ordinary people in solving mazes. But despite having the same productivity as others in this task, beautiful people were a lot more confident about their own abilities. Being good looking seems to be strongly associated with self-confidence, a trait that is apparently attractive to employers.

When employers evaluated employees only on the basis of resumes, physical appearance had no impact on their estimates, as one would expect. But all of the other treatments showed higher productivity estimates for beautiful people, with the face-to-face interviews yielding the largest numbers.

Interestingly, employers thought beautiful people were more productive even when their only interaction was via a telephone interview. It appears that the confidence that beautiful people have in themselves comes across over the phone as well as in person.

But even when the experimenters controlled for self-confidence, they found that employers overestimated the productivity of beautiful people. The economists estimated that about 15 to 20 percent of the beauty premium is a result of the self-confidence effect, while oral and visual communication each contribute about 40 percent.

It seems that good-looking people are good communicators as well, and their oral communication skills contribute about as much to employers' perceptions as their looks.

As the researchers put it, "Employers (wrongly) expect good-looking workers to perform better than their less-attractive counterparts under both visual and oral interaction, even after controlling for individual worker characteristics and worker confidence."

Today's Class

The slides from today are available here.

Here's my slightly extended take on the question of the relative importance of individual choices versus exogenous factors in determining success (as defined by high incomes).

I think that, with a few exceptions, certain individual choices are necessary for achieving certain levels of success. That is, I believe that achieving and maintaining success requires alot of the stuff that people always recommend -- e.g., willingness to work, investments in human and social capital, etc.

That said. Making the "necessary" choices is not sufficient to ensure the equal degrees of success. Similar people making identical (or nearly identical) choices (and thus meeting the necessary conditions) can still experience significantly different outcomes for a variety of reasons. For instance, two people making similar choices could end up working at similar jobs at different firms, but one firm could collapse while the other thrives. Alternatively, the market return (e.g., the wages offered) for choosing to cultivate certain skills can vary widely across time or space (e.g., individuals with basketball skills make substantially more money today than they did 40 years ago).

Even if making the same chioces generated highly similar outcomes, it is unclear to me that we should say, "Joe's success reflects Joe's choices." That may be true in a nominal sense, but Joe's choices cannot be entirely attributed to Joe. Not everyone has the same set of choices available, nor do they make their choices facing similar incentives. The choices available to individuals are shaped by their environment -- country, community, family, etc. As such, for some people in some families or places certain key choices are not even available (e.g., girls not allowed to go school in Afganistan, small children have no control over the school they attend or the number of educational resources available at home). Furthermore, even if individuals face identical choice sets (that is the same basic set of choices is available to everyone) the incentives to choose A over B are shaped by factors exogenous to the individual. That is, the percieved and actual benefits and costs associated with a decision are not identical. Parents, peers, communities, governments, ... affect these benefits and costs. As such, again, the differences in choices and outcomes that are observed should not be attributed entirely to the individual.

Exactly how much variation in outcomes reflects exogenous factors versus individual choices is hard to say. We don't get to observe many parallel universes where everything else remains the same, but we observe you making different choices. However, it is worth noting that correlations between sibling earnings are very high (approximately 0.5*) and stronger in families with higher socio-economic status (where perhaps choice sets are larger and families exert more control over choices). So it is not unreasonable, in my opinion, to think that exogenous factors are relatively important.

* Here's an excerpt from the link to help you think about what a correlation of that magnitude implies:

If one compared the earnings or wages of two sets of randomly chosen individuals from the population, one would not expect to find any correlation between the groups. In contrast, one would probably expect to find some positive correlation if the comparison was between pairs of siblings. Specifically, the correlation between siblings in a particular outcome measures how much of the overall variance in that outcome is due to all of the factors that siblings share in common-namely the same family and the same community influences (e.g., peers, schools).1

In this Chicago Fed Letter, I discuss some new research in which I show that the sibling correlation in economic outcomes (e.g., annual earnings) is close to 0.5. This suggests that about half of earnings inequality in the U.S. can be explained by family and community influences during childhood. To provide some context, this is roughly the same magnitude as the sibling correlation in height, a characteristic that presumably has a large genetic component. Given the multitude of factors that are involved in determining one's earnings (e.g., schooling, skills, choice of industry/occupation), one might find such a high correlation very surprising. This finding also suggests that inequalities between families persist strongly from generation to generation and that the U.S. is a less mobile society than is commonly believed. I also find that the sibling correlation has risen in recent decades suggesting that the U.S. may have become less mobile.

Monday, May 18, 2009

Why are CEO salaries so high?

CEO pay relative to average worker pay skyrocketed in recent years from 30 times the average to 110 times. This change prompted much debate. Does it reflect rising CEO value/skill/talent or something else?

This article, from before the crash, has some ... interesting ... quotes from some big shot CEOs, e.g.,

Other very wealthy men in the new Gilded Age talk of themselves as having a flair for business not unlike Derek Jeter’s “unique talent” for baseball, as Leo J. Hindery Jr. put it. “I think there are people, including myself at certain times in my career,” Mr. Hindery said, “who because of their uniqueness warrant whatever the market will bear.”

He counts himself as a talented entrepreneur, having assembled from scratch a cable television sports network, the YES Network. “Jeter makes an unbelievable amount of money,” said Mr. Hindery, who now manages a private equity fund, “but you look at him and you say, ‘Wow, I cannot find another ballplayer with that same set of skills.’ ”

This article further summarizes the debate and provides a summary of new research into the topic:

The popular (and populist) perception is that of America's CEOs greedily rubbing their hands together as they approve their own paychecks, and there certainly has been some of that. Others argue that in most cases CEOs are richly compensated because they're so good at what they do.

Several recent studies stake out a middle ground, assuming that CEOs are neither villains nor business masterminds. These studies argue that the seemingly innocuous practice of benchmarking pay against other companies' CEOs may be to blame, because the list of comparable executives is often formed selectively to include highly paid peers and to omit lower-paid ones. Though this opportunistic selection of peers may result in only a small bump to CEO pay in any particular year, over time, the rising tide of peer pay may well account for much of the increase in corner-office salaries that we've seen in recent decades.

Stability in the Labor Market

Dan Hammermesh finds remarkable stability in the labor market:

One of the better-known biblical passages, Leviticus 27:1-7, lists the value of pledges of silver to the temple based on the value of a person: 50 shekels for a man between the ages of 20 and 60, 30 shekels for a woman of the same age, 15 shekels for a man over 60, and 10 shekels for a woman over 60. Hourly wage rates of workers in the U.S. in 2008 differed greatly from the ratios implied by Leviticus. The average female worker between 20 and 60 years old earns, per hour, nearly 80 percent of a male worker the same age, not 60 percent; and the average older male worker earns nearly as much per hour as the average male worker between 20 and 60.

Most older men and women don’t participate in the labor force, and fewer 20- to 60-year-old women work than men that age. Take all U.S. citizens in each age/sex group, whether or not they work, and assume that men aged 20 to 60 earned 50 shekels per time period in 2008. Then women aged 20 to 60 earned 34 shekels, men 61 plus earned 14 shekels, and women 61 plus earned 7 shekels. Once we ignore differences in labor-force participation, the earnings ratios are not that far from what was expected 3,000 years ago.

Today's class

I have changed the due date for HW 2 to next Wednesday, May 27.

Also, because scores are lower than I'd hoped, I am allowing students to re-do quiz 2 (in class) as a take-home assignment. This optional re-do is also due next Wednesday and is worth up to 35 points. I cannot hand back the original quiz 2's because I provided some answers while I was grading them. A blank quiz is available here.

Slides from today's class are available here.

Wednesday, May 13, 2009

Homework 2

Available here. Note: on the syllabus I mentioned that this assignment would include an empirical component, but we haven't made it as far as I thought we'd be at this point. As such, I didn't include that part of the exercise.

The wisdom of setting goals

Another interesting read on the debate over the importance of setting goals. An interesting excerpt:
One seminal economics study even argued that the difficulty of finding a cab on a rainy day can be blamed on the personal goals of cabbies. The 1997 paper found that cab drivers tend to have a set amount of money they aim to make every day. When it's raining they hit that target faster, since more people want cabs, so the cabbies quit earlier in the day. This narrow focus on a goal hurts everybody in the system - it shrinks the taxi supply just when demand is highest, leaving more people standing on the curb getting wet, and it hurts the cabbies themselves, who miss a chance to maximize their income on their most lucrative days.

I am not sure I would have predicted this

A new article:
Although much research finds that "birds of a feather flock together," surveys of married adults suggest that opposites attract when it comes to emotional reactions toward spending. That is, "tightwads," who generally spend less than they would ideally like to spend, and "spendthrifts," who generally spend more than they would ideally like to spend, tend to marry each other, consistent with the notion that people are attracted to mates who possess characteristics dissimilar to those they deplore in themselves (Klohnen and Mendelsohn 1998). In spite of this complementary attraction, spendthrift/tightwad differences within a marriage predict conflict over finances, which in turn predict diminished marital well-being. These findings underscore the importance of studying the relationships between money, consumption, and happiness at an interpersonal level.

I think this is somewhat surprising. On the one hand, it makes sense that perhaps people would be attracted to people with opposite spending preferences. The spendthrift feels guilty about spending and is hoping their partner would constrain them (or perhaps they are looking to mooch off the other persons savings). The saver enjoys the thrill of someone who is willing to spend money freely. However, in the end, this seems like a recipe for lots of fighting as people ultimately return to type. Whatever gains may be found in the reasons I suggest have got to be dominated by the losses of fighting over money.

Occupational Licensing

In class on Monday, we discussed occupational licensing. This article -- which notes that Labor economics textbooks largely ignore this topic -- includes some useful facts:
According to the Council of State Governments (CLEAR 2004), more than 800 occupations are subject to licensing requirements in at least one state. it is, therefore, not surprising that a 2006 Gallup survey found that 29 percent of the workforce was required to hold a license from a government agency (Kleiner and Krueger 2008).

Licensing affects a much larger percentage of workers than either the minimum wage or unionization. in 2003, less than 3 percent of hourly workers were paid the minimum wage (Kaufman and Hotchkiss, 2006, 283). as for unionization, we reproduce Figure 1 from Kleiner and Krueger (2008); licensing affects about two and a half times more workers than unionization.
as well as a nice summary of the existing economic literature on licensing.

Adam Smith and Milton Friedman:
Friedman formulates the challenge, implicit in Smith, that licensing destroys opportunities and suppresses benefits while achieving little to nothing in the way of quality assurance above what could be achieved by less coercive arrangements, whether they be optional state certification or purely voluntary and private forms of assurance.
Prominent strands of research
Licensing as an entry barrier
The distributional effects of licensing barriers to entry
The effect of licensing on the interstate mobility of workers
The effect of licensing on wages and incomes (by one estimate licenses provide a 15 percent wage premium).
The effect of licensing on quality.
Read the section for a nice summary of the what economists have discovered on these topics.

Not sure it really relates much to class, ...

... but I though this article was interesting.

Case No. 218

How’s this for the good life? You’re rich, and you made the dough yourself. You’re well into your 80s, and have spent hardly a day in the hospital. Your wife had a cancer scare, but she’s recovered and by your side, just as she’s been for more than 60 years. Asked to rate the marriage on a scale of 1 to 9, where 1 is perfectly miserable and 9 is perfectly happy, you circle the highest number. You’ve got two good kids, grandkids too. A survey asks you: “If you had your life to live over again, what problem, if any, would you have sought help for and to whom would you have gone?” “Probably I am fooling myself,” you write, “but I don’t think I would want to change anything.” If only we could take what you’ve done, reduce it to a set of rules, and apply it systematically.


Case No. 47

You literally fell down drunk and died. Not quite what the study had in mind.

Last fall, I spent about a month in the file room of the Harvard Study of Adult Development, hoping to learn the secrets of the good life. The project is one of the longest-running—and probably the most exhaustive—longitudinal studies of mental and physical well-being in history. Begun in 1937 as a study of healthy, well-adjusted Harvard sophomores (all male), it has followed its subjects for more than 70 years.

Fun read

Gladwell teams up with Bill Simmons for the second time (here's the first) to talk about "Outliers" and other sports related topics.

A few excerpts:
I wonder if there isn't something particularly American in the preference for "best" over "better" strategies. I might be pushing things here. But both the U.S. health-care system and the U.S. educational system are exclusively "best" strategies: They excel at furthering the opportunities of those at the very top end. But they aren't nearly as interested in moving people from the middle of the pack to somewhere nearer the front.

The consistent failure of underdogs in professional sports to even try something new suggests, to me, that there is something fundamentally wrong with the incentive structure of the leagues. I think, for example, that the idea of ranking draft picks in reverse order of finish -- as much as it sounds "fair" -- does untold damage to the game. You simply cannot have a system that rewards anyone, ever, for losing. Economists worry about this all the time, when they talk about "moral hazard." Moral hazard is the idea that if you insure someone against risk, you will make risky behavior more likely. So if you always bail out the banks when they take absurd risks and do stupid things, they are going to keep on taking absurd risks and doing stupid things. Bailouts create moral hazard. Moral hazard is also why your health insurance has a co-pay. If your insurer paid for everything, the theory goes, it would encourage you to go to the doctor when you really don't need to. No economist in his right mind would ever endorse the football and basketball drafts the way they are structured now. They are a moral hazard in spades. If you give me a lottery pick for being an atrocious GM, where's my incentive not to be an atrocious GM?

I think the only way around the problem is to put every team in the lottery. Every team's name gets put in a hat, and you get assigned your draft position by chance. Does that, theoretically, make it harder for weaker teams to improve their chances against stronger teams? I don't think so. First of all, the principal engine of parity in the modern era is the salary cap, not the draft. And in any case, if the reverse-order draft is such a great leveler, then why are the same teams at the bottom of both the NFL and NBA year after year? The current system perpetuates the myth that access to top picks is the primary determinant of competitiveness in pro sports, and that's simply not true. Success is a function of the quality of the organization.

Another more radical idea is that you do a full lottery only every second year, or three out of four years, and in the off year make draft position in order of finish. Best teams pick first. How fun would that be? Every meaningless end-of-season game now becomes instantly meaningful. If you were the Minnesota Timberwolves, you would realize that unless you did something really drastic -- like hire some random sports writer as your GM, or bring in Pitino to design a special-press squad -- you would never climb out of the cellar again. And in a year with a can't-miss No. 1 pick, having the best record in the regular season becomes hugely important.


Or how about eliminating the draft altogether? I'm at least half-serious here. Think about it. Suppose we let every college player apply for and receive job offers in the same way that, oh, every other human being on the planet does. That doesn't mean that everyone goes to L.A. and New York, because you still have the constraints of the cap. It does mean, though, that both players and teams would have to make an affirmative case for each other's services. So you trade for Steve Nash or Jason Kidd, because they make you instantly attractive to every mobile big man coming out of college. Instead of asking the boring question -- which team is going to be lucky enough to draft Derrick Rose? -- we ask the far more interesting question: Which team, out of every team in the league, should Derrick Rose play for? Or suppose you're the T-Wolves, and you've been a doormat for years. You could say, "From now on we're a clean-living, Christian organization. We have prayer meetings before every game. We are home by 11. We never do drugs." Then you'd have the inside track on every clean-living college basketball player in the country. Are there enough quality religious players out there to win a championship? There must be! (By the way, why has no one ever put together the all-time clean-living starting five? And how great a name for a franchise is the "Minnesota Christians?")

The bigger point here is that what consistently drives me crazy about big-time sports is the assumption that sports occupy their own special universe, in which the normal rules of the marketplace and human psychology don't apply. That's how you get the idea of a reverse-order draft, which violates every known rule of human behavior.

Here's another example: We now have pretty good epidemiological evidence that the long-term health consequences of playing in the National Football League are considerable. The life expectancy for former NFL players is 20 years lower than it is for the general public. Part of that is due to the type of person that plays football. But a big part of that is also due to the consequences of playing football: concussions, and the raft of health issues that come with being obese, which -- let's face it -- the NFL basically requires most players to be. This is the kind of issue that, say, the companies who ran coal mines dealt with 50 years ago. And yet somehow the NFL -- which has a thousand times more resources than coal companies ever did -- gets to pretend this problem doesn't exist. Huh?

Tuesday, May 12, 2009

Interesting New Paper

Did your peers influence your choice of major?

Be as Careful of the Company You Keep as of the Books You Read:
Peer Effects in Education and on the Labor Market
by Giacomo DeGiorgi, Michele Pellizzari, Silvia Redaelli - #14948 (ED)


In this paper we investigate whether peers' behavior influences the
choice of college major, thus contributing to the mismatch of skills
in the labor market. Using a newly constructed dataset, we are able
to identify the endogenous effect of peers on such decisions through
a novel identification strategy that solves the common econometric
problems of studies of social interactions. Results show that,
indeed, one is more likely to choose a major when many of her peers
make the same choice. We also provide evidence on skills mismatch in
terms of entry wages and occupation. We find that peers can divert
students from majors in which they have a relative ability advantage,
with adverse consequences on academic performance, entry wages and
job satisfaction.

Today's Class

The slides for today's class available here.

Sunday, May 10, 2009

Lasting Effects of Graduating Now

A few times, I've alluded to the lasting impact on your income of graduating during a recession. The WSJ has a nice summary of these effects. Here's a taste:
Economic research shows that the consequences of graduating in a downturn are long-lasting. They include lower earnings, a slower climb up the occupational ladder and a widening gap between the least- and most-successful grads.

In short, luck matters. The damage can linger up to 15 years, says Lisa Kahn, a Yale School of Management economist. She used the National Longitudinal Survey of Youth, a government data base, to track wages of white men who graduated before, during and after the deep 1980s recession.

Ms. Kahn found that for each percentage-point increase in the unemployment rate, those with the misfortune to graduate during the recession earned 7% to 8% less in their first year out than comparable workers who graduated in better times. The effect persisted over many years, with recession-era grads earning 4% to 5% less by their 12th year out of college, and 2% less by their 18th year out.


One reason behind declining wage potential, economists say: The caliber of jobs available in a recession, and their accompanying wages, tend to suffer. High-end firms hire fewer people and drive down salaries because jobs are in such demand.

That means many graduates end up with lower-wage, lower-skill jobs at less-prestigious firms or in firms outside their field of interest. Once the economy picks up and they try for better jobs, these workers have to learn skills they should have been developing immediately out of college. In the meantime, colleagues who graduated in a better economy have already developed these skills and progressed much further.

Saturday, May 09, 2009

Unemployment Rates

We haven't talked about the unemployment rate yet. Not sure why. Given that it is currently "in the news", let me take this opportunity to discuss it briefly.

The unemployment rate is simply a fraction. The denominator contains the number of people in the labor force (i.e., those employed + those actively seeking work), and the numerator contains the number of labor force participants not employed (click here for all the details on this calculation). (Self test, what might the leisure- consumption graph we used when discussing individual labor supply look like for an unemployed person? At the wage this person expects to earn, they are willing to sacrifice leisure and gain consumption, but they currently are not working.)

Currently, the unemployment rate for the US is 8.9%. This is the highest it has been during your lifetime and is approaching the highest in the post-war period (for some males it has already reached these levels ). The unemployment rate is substantially higher here in Oregon. The last reported number was 12.1% (for March).

As dismal as these numbers are, there is growing debate about whether or not this is the measure of labor market health policymakers should care about. There are two groups of people that the standard measure of unemployment doesn't capture adequately. First, there are marginally attached or discouraged workers. These are workers who are actually willing to work at the wages offered, but who have given up trying to find work. As such, they are not in the labor force (and thus excluded from the standard measure). Second, some people are involuntary part-time workers. That is, they would like to work full time, but can only find part time work. (Note -- in both of these cases, individuals are not reaching the simple utility maximizing point derived from the simple labor supply model we discussed. Again, self test yourself on what the graphs for these individuals might look like. Are they reaching their ultility maximizing points? If not, why should we care?)

The data to account for these different groups are available (and are reported with increasing frequency). Including marginally attached workers in the denominator and excluding the involuntarily part-time from the numerator, the unemployment rate nearly doubles to 15.8% nationwide. As this discussion illustrates, the involuntarily part-time account for most of the difference (here's another discussion of this issue).

Friday, May 08, 2009

The Roots of Job Market Success and Failure

In the coming week, we will turn our focus to understanding the distribution and causes of success and failure in the US labor market. Matthew Yglesias points out some interesting differences between the US and Germany that are particularly relevant in today's economy:

Nice WSJ piece on the transatlantic divide in treatment of the unemployed:

In Germany, losing his factory job didn’t stop Alfred Butt from taking a Mediterranean vacation this winter. Thanks to generous jobless benefits, being out of work “hasn’t changed my life that much,” Mr. Butt says.

In the U.S., Dylan DeRoberts lost similar work — but there’s no seaside getaway for him. Instead, he’s giving up life’s little pleasures, like riding his snowmobile, because he lost his insurance, too. “I’ve learned to live at a new level,” Mr. DeRoberts says.

The great absurdity of the American system is that we tend to treat unemployment as a symptom of laziness as if someone who gets laid off could always just go move west and start up a Homestead Act farm. We know, however, that the nature of the modern business cycle is that events set in motion in 2008 have essentially guaranteed that a much larger proportion of the population will be jobless in 2009 than was jobless in 2007. For any given unemployed person, there will be a story you can tell about why he’s unemployed rather than someone else, but the existence of the unemployment as such has nothing to do with individuals’ failings.

High Cost of Job Loss

Last week, we talked about both the long run effects of getting fired (lower wages) and how raising the cost of job loss can reduce shirking. A new study demonstrates that job loss (particularly layoffs, but also getting fired) has additional costs -- health shocks:
a new study has found that losing your job can make you sick. Even when people find a new job quickly, there is an increased risk of developing a new health problem, such as hypertension, heart disease, heart attack, stroke or diabetes as a result of the job loss.


Workers who are in poor health have a 40 percent increase in the odds of being laid off or fired, but Strully's findings go beyond sicker people being more likely to lose their jobs. She finds that "job churning," defined as high rates of job loss but low unemployment, has negative health consequences for workers who were not already sick. For those who lost their job—white or blue collar—through no fault of their own, such as an establishment closure, the odds of reporting fair or poor health increased by 54 percent, and among respondents with no pre-existing health conditions, it increased the odds of a new health condition by 83 percent. Even when workers became re-employed, those workers had an increased risk of new stress-related health conditions.

Unlike the results of job loss due to an establishment closure, when health effects were analyzed based on workers who were fired or laid off, significant differences were found based on the workers' occupations. While being fired or laid off or leaving a job voluntarily more than doubles the odds of a fair or poor health report among blue-collar workers, such job displacements have no significant association with the health reports of white-collar workers. The reasons for this disparity are unclear based on the study results.

Thursday, May 07, 2009

Attention economics

At the heart of economics lies scarcity. Scarcity forces decisions that economists then hope to understand. According to the author of a new book on attention, attention is a scarce resource:
“People don’t understand that attention is a finite resource, like money,” she said. “Do you want to invest your cognitive cash on endless Twittering or Net surfing or couch potatoing? You’re constantly making choices, and your choices determine your experience, just as William James said.”
Naturally, as an economist, I start to wonder. What are the returns to the various uses of attention? How much does it cost to invest in acquiring additional attention capacity? Are people allocating their attention efficiently? Acquiring the efficient amount?

Some hypotheses on good job matches

Some advice on choosing who to work with:

Choose people who are good-looking, but not better looking than you.

Choose women who are happy, but they shouldn't smile too easily.

Choose people who swear, but don’t choose someone who's trashy.

Choose people you admire.

Click the link to read the rationales offered for these particular hypotheses.

Wednesday, May 06, 2009

Keep your job in a downturn

Tyler Cowen offers advice for keeping your job during a downturn.

You might first think of the approach that many people use at annual review time: Ask your boss for a meeting in which you quantify all your fabulous accomplishments over the past year. But that isn't likely to have much effect right now, in part because very few people's bottom-line results have been particularly fabulous lately.

Praising your boss's new suit/PowerPoint presentation/visionary ideas is fine, but it probably isn't going to stop the ax either. In a downturn you need to speak the language that matters most: dollars and cents.

Employers looking to cut personnel costs can either lay people off or lower their wages. Though there are exceptions, employers are generally more willing to do the former.

Truman Bewley, a professor of economics at Yale University, has shown that's because they fear low worker morale and even sabotage. Basically, they don't want unhappy people around who may cause trouble.

So if your job really is in danger (and you'd rather have less money than no money) you need to address that fear head-on. Let the big guy know you're willing to work, contentedly and productively, at a lower wage than you currently receive.

Today's Class

The slides from today's class are available here.

An additional discussion of efficiency wages is available here.

Tuesday, May 05, 2009

Summary since last in-class quiz

Below are some of the major questions we've discussed since the last quiz:

The solutions to quiz 1 in class are available here.

As usual, I will be in the classroom before class (around 7:45ish) if you have questions you want to address in person.

Long-Run Labor Demand

How do firms select the quantity of labor to use at a given wage when all inputs are variable (e.g., they can select both capital and labor)?

When firms can select all inputs (e.g., capital and labor), how will a change in wage affect labor demand? Demand for other inputs?

Why is short run demand for labor typically less elastic than long run demand for labor?

Key terms: isoquant, isocost, marginal rate of technical substitution, elasticity of demand, elasticity of substitution, complements, substitutes, output (or scale) effect, substitution effect

Labor equilibrium
What determines equilibrium wage and quantity of labor in the market?

What causes movement along supply and demand curves (i.e., what changes the quantity or labor demanded or supplied)?

What causes supply and demand curves to shift in or out (i.e., what causes changes to demand or supply)?


Not all jobs and workers are the same.

What are the characteristics of a good job match?

What choices are available to firms and workers to increase the chances of ending up in a good job match?

How are labor markets similar to dating markets?
Compensating wage differential

If a job has particularly distasteful aspects (e.g., risk of death), what happens to the wage in that occupation? Why?

How do differences in workers' risk preferences affect the shape of their indifference curves? How do differences in to costs of mitigating risks affect the shape of firms isoprofit curves?

Key new terms: isoprofit curve, offer curve

Employee benefits
What are examples of employee benefits (or other non-wage compensation)?

Why might employees prefer some compensation in the form of benefits (instead of wages)?

Why might firms want to offer compensation in the form of benefits instead of wages?
Asymmetric Information

How does the lack of perfect information affect market outcomes? That is, if all parties to a transaction don't know all relevant information what happens?

Two major possibilities: Adverse selection, Moral Hazard.

How might adverse selection lead to market unraveling (that is, willing buyers not finding willing sellers or vice versa)?

When (and why) might agents use signals or screens to improve outcomes?

Does education serve primarily a signaling function? If so, are there more efficient ways to generate the same (or very similar) separating equilibrium?

What is moral hazard and how might it create problems in markets (particularly labor markets)?

How (and why) might principals use incentives to solve moral hazard problems?

Key new terms: asymmetric information, adverse selection, lemons problem, signaling, screening, separating equilibrium, pooling equilibrium, moral hazard, principal-agent problem

From the archive: Pay enough or not at all

One more post on principal-agent incentives. The use of carrots to solve such problems rests on the assumption that people respond to the incentive offered by increasing effort. In standard economics, any positive incentive should, at the margin, improve effort. In practice, though, this may not be true. Some evidence suggests that offering monetary incentives can actually reduce effort.

Following up on the earlier post on the fact that monetary incentives might lead to worse outcomes, a paper by Uri Gneezy and Aldo Rustichini further confirms that monetary incentives can actually reduce performance. However, they also find that larger monetary incentives do increase performance. The paper can be found here. Here is the abstract:

Economists usually assume that monetary incentives improve performance, and psychologists claim that the opposite may happen. We present and discuss a set of experiments designed to test these contrasting claims.

We found that the effect of monetary compensation on performance was not monotonic. In the treatments in which money was offered, a larger amount yielded a higher performance. However, offering money did not always produce an improvement: subjects who were offered monetary incentives performed more poorly than those who were offered no compensation. Several possible interpretations of the results are discussed.

Their results are based on two experiments. In the first experiment, students answered questions on a test which largely tested effort. All students were promised a fixed payment for participation; however, some students were paid an additional sum based on the number of questions they answered correctly. One group was given 10 cents per correct answer, another $1 per correct answer, and another $3 per correct answer. The group getting 10 cents per correct answer performed significantly worse than the group not getting any additional payment (and this group did worse then the $1 and $3 groups).

In the second experiment, the researchers introduced incentives to a public service day which occurs regularly in Israel. Apparently, certain days during the year students take to the streets to collect donations for various causes. Three groups of students were studies. In one group, no additional incentives were introduced. In another group students received 1 percent of what they raised. And in the other group they received 10 percent of what they raised. In both of the treatment groups it was made clear that the money was being paid by the researchers and was not coming out of the money that was being raised. Again, the no treatment group out performed the small incentive group, and in this experiment they equaled the high treatment group.

Is education purly signaling?

Below I posed the question, is education purely signaling (that is, a way to distinguish high and low ability workers) or is it transformative (workers become more productive because they attended school).

Here's one summary of some of the empirical evidence for the signaling view:

So, what’s the evidence for signaling theory? Four facts, tucked away in this pdf and in an article by Richard Blundell and colleagues in the February 2000 Economic Journal, should make one ponder:

1. Mature students earn less than newer graduates, despite having the same human capital. This might be because mature students convey a signal that they weren’t smart enough to go to university straight from school, or are not committed to the world of work, or are just bolshy (you don't often meet a Conservative mature student, do you?) . Whatever the reason, this seems more consistent with signaling theory than human capital theory.

2. Students who take gap years earn much more than students who don’t; the gap is almost as great as the return to a degree itself. Taking a gap year doesn’t necessarily build skills, but it reveals character traits (being middle-class) valued by employers.

3. Returns to vocational education are often low, relative to non-vocational courses. Oxford classics graduates earn good money, even though the ability to converse with a dead Roman is not required for many jobs.

4. University drop-outs earn less than people with just A levels. Human capital theory says this shouldn’t happen – because they have a little more education. Signaling theory says it should. Drop-outs signal a lack of determination, which is a bad sign for employers.

Of course, this evidence is not conclusive; there is evidence for human capital theory too.
Self-assessment question -- why does the evidence described support the signaling view of education?

We'll return to the alternative view -- education as skill acquisition next week (but here's one response - expanded further here - to give you something to think about in the meantime).

Also ... scroll down in this link for some additional discussions of the signaling model and its implications for education policy.

Solving Principal-Agent Problems

Yesterday in class, we discussed the principal-agent problem (a type of moral hazard). This problem arises when the actions of an agent (e.g., an employee) are unobservable to the principal (e.g., the employer).

To resolve this problem, the principal has several options. In general, these options can be boiled down into two categories. They can improve their carrots or their sticks. Carrots are positive incentives -- when performance meets or exceeds expectations, employees are rewarded with additional compensation. Sticks are punishments -- the employer invests more in monitoring and supervision and punishes slackers.

Below, are some additional discussions of some of the challenges involved in devising successful solutions to these problems.

This article describes several forms of moral hazard prevalent in a strawberry picking operation, and the solutions an economist devised to resolve them. A taste:
Tough work for the fruit-pickers, the business is also a headache for the owner, who must offer a pay scheme that both satisfies minimum-wage laws and motivates workers in an industry in which slacking is an understandable temptation. The owner of a large British fruit-farm business, "Farmer Smith," was pondering the problem one Christmas when he discovered that the connection between pay and performance was also an area where economists were scratching around for solid evidence.

And so an unlikely alliance was formed between Farmer Smith and economists Oriana Bandiera, Iwan Barankay, and Imran Rasul. The economists would design and administer pay schemes, and in exchange for that (and for confidentiality), Farmer Smith would let them treat his business as a gigantic laboratory for researching the nexus between pay, workplace friendships (which they mapped out), and workers' productivity.

The owner had been paying a piece rate—a rate per kilogram of fruit—but also needed to ensure that whether pickers spent the day on a bountiful field or a sparse one, their wages didn't fall below the legal hourly minimum. Farmer Smith tried to adjust the piece rate each day so that it was always adequate but never generous: The more the work force picked, the lower the piece rate. But his workers were outwitting him by keeping an eye on each other, making sure nobody picked too quickly, and thus collectively slowing down and cranking up the piece rate.

Bandiera and her colleagues proposed a different way of adjusting the piece rate: Managers would test-pick the field to see how difficult it was and set the rate accordingly, thus preventing the workers from engaging in a collective go-slow. (If the managers made a mistake in their estimate, and the pickers didn't earn minimum wage, Farmer Smith would make up the shortfall with an extra payment. This rarely happened.) The economists measured the result. By the time the experiment was over, Farmer Smith's initial skepticism had long evaporated: The new pay scheme increased productivity (kilograms of fruit per worker per hour) by about 50 percent.

This article discusses whether big bonus yield big effort and finds that, in the lab at least, they do not. A taste:

BY withholding bonuses from their top executives, Goldman Sachs and UBS may soften negative reaction from Congress and the public if their earnings reports in December are poor, as is expected. But will they also suffer because their executives, lacking the motivation that big bonuses are thought to provide, will not do their jobs well?

Of course, there are many reasons to be disgusted with executive pay. It feels unfair that so many people make so much money managing our money, and it is often difficult to see how their talent and abilities justify their compensation. We find it particularly offensive when executives receive high bonuses after disastrous performances. But doesn’t the promise of a big bonus push people to work to the best of their ability?

To look at this question, three colleagues and I conducted an experiment. We presented 87 participants with an array of tasks that demanded attention, memory, concentration and creativity. We asked them, for instance, to fit pieces of metal puzzle into a plastic frame, to play a memory game that required them to reproduce a string of numbers and to throw tennis balls at a target. We promised them payment if they performed the tasks exceptionally well. About a third of the subjects were told they’d be given a small bonus, another third were promised a medium-level bonus, and the last third could earn a high bonus.

We did this study in India, where the cost of living is relatively low so that we could pay people amounts that were substantial to them but still within our research budget. The lowest bonus was 50 cents — equivalent to what participants could receive for a day’s work in rural India. The middle-level bonus was $5, or about two weeks’ pay, and the highest bonus was $50, five months’ pay.

What would you expect the results to be? When we posed this question to a group of business students, they said they expected performance to improve with the amount of the reward. But this was not what we found. The people offered medium bonuses performed no better, or worse, than those offered low bonuses. But what was most interesting was that the group offered the biggest bonus did worse than the other two groups across all the tasks.

This blog post and article, draw attention to the fact that bonuses are often imperfectly aligned with the principals' true interests. Sometimes this is just poor incentive design, sometimes it is simply because the only observable outcomes don't exactly capture the principal's interests:

On this afternoon's All Things Considered, NPR correspondent Scott Horsley uses Michael Lewis' February piece on Shane Battier in the New York Times as a springboard to discuss how compensation on Wall Street rewards bankers and traders for the wrong reasons:

The point of Lewis's article is that those individual stats, while easy to measure and reward, are not what is really important. In fact, if a player's bonuses are tied too closely to individual stats, they can actually end up rewarding actions that hurt the team in the long run.

To University of San Diego law professor Frank Partnoy, that sounds a lot like Wall Street.

"I think there are a lot of parallels between the NBA and the MBA," Partnoy says. "These are markets where the superstars are going to take home the highest compensation and they are going to feel like they are worth it."

Partnoy says just like a ballplayer who gambles on a bad shot instead of passing to an open teammate, Wall Street bankers face a constant temptation to pad their own stats, and bonuses, even at the expense of their team.

"Maybe juice up their returns for a year, take on excess risks for a year, make that big bonus over the short term, and have their team suffer or their bank suffer in the long term," he says ...

... The long-term viability of banks is pretty important. Selfish basketball players can cost their team a shot at the playoffs. Bankers who play for themselves can put the whole economy at risk.

Monday's Class

Slides from Monday's class are available here.

Some additional basic materials on the topics are available here, here, here, here, here.

Friday, May 01, 2009

Advances in Signaling?

In class on Wednesday, we discussed using signals to establish credible separation of types. Tyler Cowen points out a proposal to make consumer signals more informative and credible:

For example, companies could sell certain products only to consumers who have a certain minimum or maximum score on one or more of the certain Central Six [personality] traits. Hummer dealers could advertise that the "Party Animal Red Pearl" paint color is available only to customers who score in the top 5 percent for extraversion. Customers who want to display their unusually high extraversion through that bright red color would have to electronically validate their extraversion score at the dealership before they could sign the purchase agreement. In this way, Hummer could guarantee that Party Animal Red Pearl becomes a reliable signal of friendliness, self-confidence, and ambition. Or Lexus could sell the "Mensa Quartz Medallic" color of the LS 460 only to customers whose validated intelligence scores are high enough for them to join Mensa International (IQ 130+ or the top one in fifty). The more exclusive "Prometheus Glacier Pearl" color could indicate an IQ above 160 (the top one in thirty thousand) -- the qualification for joining the Prometheus Society.
We already use purchases to signal something about ourselves to others (ask yourself why you have a logo on your shirt or hat or why companies spend so much trying to attach meaning to those logos), but these signals are weak because it is pretty low cost for other types to mimic the signal if they want to (e.g., if the benefits of mimicry are sufficiently high). By tying purchases to actual differences, the signal become more credible. As such, those seeking to distiguish themselves might be willing to pay higher prices. High prices may make restricting sales to only "qualified" people profitable. Thus, the system could persist as an equilibrium.

Cowen, though, thinks the idea is absurd, and it certainly feels weird, but is it really absurd?

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