Intrade and hedging your bets in life

The prediction market Intrade is a neat contribution to economics as well as everyday living. It offers odds on a variety of important world events occurring, and allows users to buy or sell "shares" in the occurrence of events (take a look at the site for details of how it functions).

If you're interested in knowing what the chance of some upcoming event is, go to Intrade and you can see what the market rates the odds as. It's better than listening to pundits because on Intrade, people are putting money where their collective mouths are.

The recall election of Governor Scott Walker is going on in Wisconsin as I type this. Ballots are yet to be counted and Intrade currently prices his chance of victory at 93.6%. I'm ignorant about the political climate in Wisconsin, but even so I can quickly see that it would be an extremely strange event for Walker to lose this recall.

There are more subtle benefits to be gained from Intrade besides just information. Mainstream economic models of consumer behavior predict that people want to equalize consumption across time; a stable income with minimal variance is most desirable. Another nice aspect of Intrade (although I suspect rarely taken advantage of) is smoothing consumption over time.

For people who are deeply concerned about the outcome of political events, this should be a great service.

For example: if you expect that a loss for Walker will cause fiscal crisis and collapse of civilization, you should bet against the possibility that he wins, so you'll have enough shotgun shells and canned beans to survive the oncoming apocalypse. If instead you think that Walker winning another term will bring about a neo-fascist corporate state and crush middle-class living standards, you should bet heavily that he wins so you can bribe your way out of the country. Either way, the option is there!

Realistically, few people likely think that the outcome of political contests will have such divergent results. If money was used to match political rhetoric, Intrade would have even more money and traffic flowing through than it does now (hopefully enough to keep the site open, unlike some past attempts at prediction markets).

The Durable Goods Problem in Software

Being a monopolist isn't all it's cracked up to be. Produce a durable good, and you're functionally competing against yourself.

For a Durable Goods Producer with Market Power:
Problem 1: durable goods can be re-sold. If re-sale purchases are cheap and reliable, why buy new?
Problem 2: after selling at high price, the firm wants to reduce price to get more customers. So, if you're a customer, you shound wait for the lower price to purchase... If you're the firm, how can you ever manage to sell at the high price?

Software is perhaps the ultimate in durable products. Once you have the program installed, it never wears out. Resale is prohibited by license agreements and made impractical by other technical means, but the second problem remains. How can software companies prevent consumers for holding out and demanding cheaper prices?

Big players in the software industry have found various ways to overcome this durable goods problem.

1) Bundling. Most famously, Microsoft got its big start by combining the Windows operating system with IBM machines. While the software may be durable, the computer most definitely is not. Replacement of consumer products guarantees repeat customers for their OS. Waiting doesn't help the consumer, because they retailer they purchase from will have to get a copy of Windows regardless.

2) Ongoing payment schemes. Subscription fees, downloadable content, and micro-payments have been used successfully by companies from Blizzard to Zynga. In addition to providing a check against piracy, each of these pricing methods ensure the up-front cost is only a small part of what the consumer pays for that software. Holding out for a lower price on the base product doesn't exempt someone from paying for the extras.

3) Build price discounts into the sales model. Some video game marketing tools (I'm thinking of Steam, from Valve software) build semi-frequent sales into their distribution channel. Users can buy a new game when it comes out at full price; wait a few months for the game to go on sale at 33% or 50% off; or wait several years to get it at deep discount. The amount paid depends on the gamer's urgency in wanting the game. It's temporal price discrimination which separates out high- and low-demanding users.

Software companies still end up competing against themselves to some degree, but with these sorts of pricing mechanics they're able to keep revenue higher than it would be otherwise.

Cigarettes, a case study in price discrimination (China vs. U.S.)

Economists predict there will be price discrimination when there is a monopolist supplier (or at least some degree of market power) and arbitrage between different groups of customers is costly. The United States tobacco market meets one of the two conditions - re-selling cigarettes without a license is barred by law - but the industry is still competitive between the large tobacco companies. In China, by contrast, both conditions are met because the China National Tobacco Company has a de facto monopoly on all cigarettes sold.

There is strong evidence of price differences between types of cigarettes sold in China. This paper by Li, et al, finds

...the price differential among brands is large. The self-reported cigarette price ranged from 0.70¥/pack to 100¥/pack, which gives smokers more choices in the price of cigarettes. In other words, Chinese smokers have more flexibility in choosing different prices of cigarettes than most Western smokers.

There are two, potentially complimentary stories to explain the wide difference in price of Chinese cigarettes. First is price discrimination to take advantage of different elasticities of demand between smokers; one person may value the marginal pack of cigarettes less than another. Charging lower prices for "inferior" brands of cigarettes will enhance monopoly profits, by selling a higher quantity at a lower price.

This type of price discrimination doesn't rely on direct knowledge about consumer preferences; the tobacco company can set a variety of prices, then smokers self-segregate according to their willingness to pay. Such a strategy would be less effective in the U.S. because cigarette taxes are so high, the relative price difference between brands is always comparatively small.

Another possibility is social signaling. In the United States, smoking is not a symbol of high status, in fact quite the opposite: it's more common that poor and uneducated people will be the ones who smoke. In China, gifts of tobacco are common and socially accepted, and expensive cigarettes are used to demonstrate affluence. By offering a wide range of prices for cigarettes, more different levels of social status can be signaled. One might expect that as general affluence in China increases, new forms of social signaling will become more popular instead.

Do higher tax rates spur more charity? I doubt it.

A few days ago I was talking with my mother about the state of the economy, income inequality, and social obligations... Typical evening conversation on any New Years, I'm sure. From life experience and observations on a (privileged) extended family, her opinion was that more charity occurred when tax rates were higher. I disagreed, and offered to present a mathematical demonstration on why that was the case. After that effort, I wanted to show the Internets the fruits of my labor.

Charitable giving is a very personal decision and the tax law surrounding it is complicated and arcane, so I start with some simplifying assumptions to make the problem more approachable. These are:

• Money given to charity is 100% tax-deductible.
• Each person lives for two periods, then dies, and their entire stock of wealth is donated after death.
• An individual's money earns 10% interest.
• To make the problem concrete, I'll imagine a person earning $100,000 in each period, and two different tax regimes: one with a 0% tax rate, and another with 50%. 

Now a quick exercise in arithmetic, starting with a tax rate of 50%. The individual earns $100,000 in the first period, $50,000 of which would go to the government. Instead that $50,000 is given to charity to avoid taxes. At the start of period two, they earn $5,000 in interest and another $50,000 in after-tax income, then die and donate all of it. Total charity given is $205,000.

Now imagine a tax rate of 0% (and if you're a libertarian, try not to faint with excitement). An individual earns $100,000 and keeps all of it, earns $10,000 in interest before the second period, makes another $100,000 then dies and gives all of it away. Total charity given is $210,000.

One could argue that this result emerges just from the assumptions made, which is partially true. However, as long as individuals can earn a higher return on investment than the government (which is not a controversial claim) and all money is transferred upon death (a de facto necessity) then the result, qualitatively, will still be the same. If you make the example more realistic, and envision a person making money then saving and investing it for more than just two years, the difference between the two tax rates becomes even more apparent.

Of course, someone might say there are distributional issues this exercise neglects. Maybe needy recipients of charity are more sympathetic than the undeserving heirs of some wealthy person. Aside from that, the general point still stands: when government takes money through taxes, the overall social "pie" becomes smaller. When individuals can invest it, they put money into productive activities which can generate more wealth, making the "pie" bigger. Even if higher tax rates drive some people to give more money to charity than they otherwise would, society in the aggregate is better off if that money can be productively invested by individuals instead. Charity is then a pleasant side-benefit of greater social wealth.

Fuzzy Economics and Legal Fees

The New York Times has published several articles in the last two months targeting the American Bar Association. In October, Clifford Winston questioned the need for bar exams and professional licensing. Last week, David Segal wrote "For Law Schools, a Price to Play the A.B.A.’s Way" which blames the ABA's control over law school accreditation for overly high legal fees.In that article, he writes

...The lack of affordable law school options, scholars say, helps explain why so many Americans don’t hire lawyers.

“People like to say there are too many lawyers,” says Prof. Andrew Morriss of the University of Alabama School of Law. “There are too many lawyers who charge $300 an hour. There aren’t too many lawyers who will handle a divorce at a reasonable rate, or handle a bankruptcy at a reasonable rate. But there is no way to be that lawyer and service $150,000 worth of debt.”

This helps explain a paradox: the United States churns out roughly 45,000 lawyers a year, but survey after survey finds enormous unmet need for legal services, particularly in low- and middle-income communities...

This reasoning doesn't make sense to me. It may be true that lawyers are driven to make more money in order to pay off student loans. But, high fees are not the only way to make lots of cash; there is also the low-cost, high-volume strategy (think Walmart). If so much unmet demand for legal services exists, it could be more profitable to charge a lower hourly rate and just work faster or put a little less effort into each case. This wouldn't be practical if the supply of lawyers is artificially restricted, but given the 45,000 new lawyers every year as well as reportedly high numbers of unemployed or idle lawyers, a shortage seems to be unlikely.

Even if the ABA does drive up the cost of law school tuition, that alone can't explain why legal fees are so high. I'd hypothesize that clients pay lawyers a premium wage in order to ensure a high level of effort. As it is hard to monitor an attorney's effort directly, better wages are used as an incentive to keep on the job instead of slacking. In the economics literature, this is referred to as an efficiency wage; the concept has been used to explain why wages remain rigid during periods of high unemployment. That seems to apply quite easily to the legal industry.

I'm sympathetic to the argument for lowering entry barriers to practicing law, but there are other factors at work too which cause lawyer wages to be high. Otherwise, competition in the legal industry would have already driven down prices and serviced the unmet needs in low- and middle-income communities.

My 13-bean inflation hedge.

Never mind gold or TIPS. There are much more mundane ways to protect your purchasing power from inflation. Durable food commodities work just fine. I recently invested in 75 lbs. of 13-bean soup mix, purchased from The Great American Spice Company.

Beans: the grad student's investment vehicle.

Assuming that core commodity inflation continues at its current pace (almost guaranteed) and that these beans last the several years it will take me to consume them (less certain), I think it's a nearly foolproof investment. Other methods of hedging against inflation carry their own risks and are also much more expensive. Bulk food purchases are the chickenhearted investor's best friend, as Andrew Tobias has put it.

Now, any suggestions on bean soup recipes?

Followup (2/4/2012): I'm not quite as excited about the beans as I used to be. The problem with a bean mix is that some types of beans cook faster than others... and the gastrointestinal consequences of under-cooked beans are obvious to anyone who's suffered through them. If I were doing this over again, I would have gotten a bulk order of one type of beans and saved some money and hassle. Oh well - live and learn.

The reason why 99.8% of all 'get rich instantly on Twitter' claims are hoaxes.

I purposely exclude 0.2% of 'make-money-off-Twitter' plans from the "hoax" category, because I'm sure some very smart person out there will go and prove my generalization wrong. Until that blue moon arrives, I'll explain why all the Tweet-gurus offering to make you big bucks for doing nothing are just yanking your chain.

Not familiar with the "instant money on Twitter" phenomenon? In my endless quest for self-publicity, I've stumbled across a lot of statuses like

"Making $500 dollars per week from home off Twitter while on autopilot. Come see how!!!!" 

or similar. Sounds appealing, but is it too good to be true? Yes, yes it is. Some economic thinking can reveal why.

1)  There are no barriers to entry on Twitter. All it takes is an e-mail address and lack of respect for grammar (just kidding) and you can start a Twitter account. Economists would describe this as an open market. Entry and exit are free, and there are are large number of Twitter users - over 75 million now - but that number could easily grow (or decline) in the future.