Game Theory and the Prisoner's Dilemma on the TV Show "Numb3rs"

The show mentioned this along with the scholar Anatol Rapoport who used the "tit for tat" strategy to win a prisoner's dilemma tournament. This game has applications in economics. I play it in my class then talk about how it relates to oligopoly in microecomics. Oligopoly is a market structure where a small number of firms dominate, like the auto industry. The idea in the prisoner's dilemma is that two criminals are being interrogated in separate rooms. It turns out that they would both be better off (in terms of how much jail time they will get) if they don't confess to a crime. But if one confesses while the other does not, the confessor gets alot less jail time while the one who did not gets alot more. So they each have a temptation to confess even though they would both be better off if they did not confess. How exactly this works is explained here and here. How things worked in the tournament that Rapoport won is described here. His method of playing turned out to be the best even though it was simple. How all of this works for the oligopoly and how those firms set prices is explained here.

In the tournament, players can choose two possible moves on each play: cooperate or defect. Cooperate means playing nice and not getting too greedy. Each player makes a move and gets points depending not only on what move they made but on what move the other player made. The "tit for tat" strategy means being nice (cooperating) but punishing (defecting) if the other player defects. If both players cooperate, they get more points than if they defect. But the temptation to defect is strong because if you defect when the other person is trying to cooperate, you get even more points (and the cooperator gets less). With the firms in oligopoly, cooperate is charge a high price. But the temptation is to defect, charge a lower price, and make more profit than your competitor. But then they start lowering the price, too, and you both make less profit than if you both charged a high price.

Why Do Intellectuals Oppose Capitalism?

This is the title of an essay by the famous philosopher Robert Nozick. You can read it here. I had a blog entry on how college professors are liberal, so this essay by Nozick might explain that. My blog entry from last year can be read here.

Here are two key paragraphs from Nozick's essay:

"Intellectuals now expect to be the most highly valued people in a society, those with the most prestige and power, those with the greatest rewards. Intellectuals feel entitled to this. But, by and large, a capitalist society does not honor its intellectuals. Ludwig von Mises explains the special resentment of intellectuals, in contrast to workers, by saying they mix socially with successful capitalists and so have them as a salient comparison group and are humiliated by their lesser status. However, even those intellectuals who do not mix socially are similarly resentful, while merely mixing is not enough--the sports and dancing instructors who cater to the rich and have affairs with them are not noticeably anti-capitalist.

Why then do contemporary intellectuals feel entitled to the highest rewards their society has to offer and resentful when they do not receive this? Intellectuals feel they are the most valuable people, the ones with the highest merit, and that society should reward people in accordance with their value and merit. But a capitalist society does not satisfy the principle of distribution "to each according to his merit or value." Apart from the gifts, inheritances, and gambling winnings that occur in a free society, the market distributes to those who satisfy the perceived market-expressed demands of others, and how much it so distributes depends on how much is demanded and how great the alternative supply is. Unsuccessful businessmen and workers do not have the same animus against the capitalist system as do the wordsmith intellectuals. Only the sense of unrecognized superiority, of entitlement betrayed, produces that animus."

Update on April 26: More info on political affiliations in higher education can be found here. Scholars who claim that social science and humanities professors tend to be Democrats defend their views.

Our Standard of Living Continues to Grow

A report from the Census Bureau shows that even more so than in 1992, our material needs are being met. You can read about it here in an article by Cox News Service reporter Bob Dart.

The percentage of Americans who have an air conditioner and other appliances has gone up since 1992. We are generally getting our basic needs met like food, shelter, medicine and safety. Alot more of us have things like microwave ovens and VCRs.

Former Communist Countries Benefit From Economic Freedom

In my macro class, we read a book called "The Economics of Macroissues." In the first chapter they show how countries with common law systems (as opposed to civil law systems) that tend to respect property rights have higher rates of economic growth. The difference does not have to be big. Over time, even an extra half of one percentage point in economic growth can add up. If your economy grows 2.5% a year for 100 years, it will increase 11.81 times. That means if your country's per capita income was $1,000 to begin with, 100 years later it will be $11,810. But if your economy grows 3% a year, after 100 years your per capita income would be $19,219. More than $7,000 higher than the other country and about 62% higher.

A recent study by the Dallas Federal Reserve Bank shows that the country's that had the most economic freedom among the former communist nations or Soviet republics have had the highest growth rates. You can read this study here. I think this result is important because someone could always claim that the countries around the world with higher growth rates had them not because of more economic freedom but for some other reason. But this study has alot of countries that began with alot in common, having been former communist states. Yet again, more economic freedom means more growth.

What Rules Pop Culture?

There was an interesting article in the Sunday New York Times Magazine. You can read it here. The article raises the question of why do some bands or movies become so popular. Were they just good or was there some kind of luck involved? According to the article, "reliable hit prediction is impossible." Maybe if the world had been only slightly different, the Beatles might not have been as popular as they were. The author of the article, Duncan Watts, used the internet to run some experiments (described in the article). To make a long story short, it seems that what we end up liking is based largely on knowing that someone else likes it. But in some experiments a song became very popular and in others it did not. If, in the beginning, people saw that other people just happened to like a song, then they liked it and vice-versa. All of this is clearly described in the article, which is relatively short and well written.

A Real Estate Double Whammy?

The housing market is always in the news. Prices soar. Then prices fall because there is a glut on the market. But within a couple of blocks of where I live, there are two apartment buildings that both have a for sale sign and a for rent sign on the front lawn. It seems like the for sale sign would scare away renters since you won't know who your landlord will be. The for rent sign would scare away potential buyers since they might wonder if they could actually make money on the building. It would also make you think that is why the building is being sold-not enough renters.

Maybe this is sign of where the housing market is. There are so many houses out there that not too many people need apartments anymore. So being a landlord is not attractive. But owning a house is not always better than renting an apartment. When my wife and I looked at houses a few years ago, anything that would have given us a comparable amount of square footage as our apartment would have been $200-$300 more a month when you consider the mortgage and property taxes. Then if anything needs fixing, we would have to pay. And take care of the lawn.

Now some would say we would build up equity in the house. But we can also save more money and that builds up over time. The only good the equity in the house would be is if we borrowed against it later in life, like with a reverse mortgage. But that is only if the value of the house appreciates. There is no guarantee that the value of the house would rise fast enough to match how much our savings account would increase.

Interesting Theory on Stock Market Fluctuations

Nicholas Barberis of the University of Chicago Business School has an interesting article called Search for the Holy Grail: Demystifying the Stock Market. This is clearly written for a general audience. The basic idea seems to be that when the market is up, people feel like they are good investors and that they are playing with the "house's money." So they will keep buying, making the market go up even more. But when things are down, people get pessimistic and want to sell (also because of "loss aversion," the idea that people have a bigger drop in utility from losing a dollar than the gain from finding a dollar). So people sell more quickly since they don't want to lose anything. Then the market goes down even more. So the ups and downs are bigger than you might expect.

Life in the Pits: Anthropology Meets Economics

There is a new book out called Out of the Pits: Traders and Technology From Chicago to London. It is by Caitlin Zaloom, an assistant professor of social and cultural analysis at New York University. Below are some exerpts from an article she wrote in The Chronicle of Higher Education. Maybe you have heard of or seen the trading pits of commodities exchanges (like in the Eddie Murray/Dan Ackroyd movie "Trading Places"). The traders are buying and selling commodities like gold and wheat by yelling out their orders and offers to the other traders. But things are changing and becoming more computerized. Here are the exerpts from Zaloom's article:

"At work on the trading floor, I soon learned that a fundamental transformation was, indeed, taking place. The trading pits of Chicago were quickly being dismantled by the electronic technologies that connected traders at computer terminals around the world to a central server, swapping the raucous action of the pits for the quiet hum of online circuits. Geertz's example (Clifford Geertz was a famous anthropologist who looked at economic life) inspired me to assess what social changes facilitated such an important shift in the way money circulated around the globe, even as advocates championed the power of network connectivity and low costs of electronic trading.

The most significant transformations concerned the kind of people and the types of skills that do well in online markets. For generations, Chicago's trading fathers helped their sons into the business, and neighbors who shared fences provided entry-level jobs, like clerking, to each others' kids. (In fact, such family connections eased my own way onto the Chicago floor, providing the kind of object lesson in the culture of the trading pits that only fieldwork could offer.) Once in the pit, traders proved their mettle by being quick, loud, and brash. Each trader had to wrest his living from his competitors on the steps of the trading pit, reading a market in the voices, hands, and faces of his rivals.

The shriveling of the pits, once muscled by erstwhile Big Ten linebackers, had opened a niche for Ivy League engineers, M.B.A.'s, and math geeks, who quickly found a place in the Chicago futures markets. On a recent visit to Chicago, I met with the director of a trading firm — one located far up in a tower away from the trading floor — who gave me a blunt assessment of the social foundation of derivatives markets. "It's getting really Revenge of the Nerds around here," he reported. The unmediated physical competition that had created famously efficient markets for 150 years no longer seemed sufficient.

The talents of the traders must match the kinds of technologies with which they work. Instead of bodies, voices, and well-known personalities, traders now confront changing numbers on a "dealing" screen. This simple display creates an image of the market seemingly separate from the people who make it up, and which appears to exist beyond the cities in which they work. Training on the football field is less important now than hours and days spent in front of video games. Stamina is no longer displayed in a crowded pit but in the ability to resist the eye-glazing glare of the computer screen. In the shift from the trading pit to the computer, a new kind of trader emerges, one who can shape complex mathematical models, observe the market, make cool judgments, and take dispassionate action; in other words, a trader who can embody the value of efficiency that we associate with the market itself."

The Free Market: Friend to Third World, Less Developed Countries

Three recent articles illustrate this:

Writing in the San Antonio Express-News, Jeanie Wyatt writes about Ireland. It is one of the fastest growing economies in the world and is now 4th in the world in per capita GDP. How did they do it? Several factors bu among them are low taxes " The corporate tax rate was 10 percent to 12.5 percent throughout the late 1990s" and "limited government intervention."

New York Times columnist Thomas Friedman had an article about Kenya. The government is getting out of the way to let entrepreneurs set up call centers that are helping the economy. It even did away with the government phone monopoly.

The Wall Street Journal had an editorial called The Mozambique Miracle. You have to be a subscriber to read that one. But here are some exerpts:

""We opened our markets and dropped the centralized economy," says Miquelina Menezes, who chairs the country's association of economists and runs a fund devoted to bringing electricity to rural areas."

"But hyperinflation and a stagnant economy forced leaders of the neo-Marxist liberation movement, Frelimo, to shift their approach. Starting in the early 1990s, the ruling party cut subsidies, opened to outside investment, privatized firms nationalized after independence in 1975 and got a grip on borrowing and the budget. An independent central bank brought inflation into single digits. According to the World Economic Forum's competitiveness index, Mozambique has reformed more than any sub-Saharan African country."

"The payoff is the highest average growth rate, at 8% over the last decade, among the continent's non-oil exporters. GDP per capita is a still tiny $320, but that's compared with $178 in 1992. Since 1997, poverty rates decreased more in rural areas (from 71% to 55%) than in urban (62% to 52%), according to the World Bank. Child mortality has declined to 152 per 1,000 live births from 235. And primary-school enrollment has risen to 71% from 43%. Once a leading recipient of food aid, Mozambique now exports maize, with 5.6% average yearly growth in farming in the last 15 years. Banks, telecom and tourist firms, many from neighboring South Africa, have come in."

"But neighbors in similar straits haven't put in place Mozambique's fixes. Inflation in Zimbabwe is 1,700%; nearby Malawi and Zambia, their economies distorted by subsidies on commodities, are growing haphazardly."

Interesting Looking Movie: The Call of the Entrepreneur

The Acton Institute for the Study of Religion & Liberty has produced a documentary titled The Call of the Entrepreneur. If you go to the link you can view the trailer. It looks good. Nice to see someone promoting the good side of capitalism and entrepreneurship.

San Antonio College Math Professor Reforms Texas State Lottery

His name is Gerald Busald and over the years he has found inaccuracies in the odds that the lottery states as well as other misleading aspects. Becaue of him (and his students), the lottery has had to institute reforms. Great to see a professor from my college getting such richly deserved recognition. You can read all about it here for the full article. Below are some key excerpts.

"Until recently, the Texas Lottery did not disclose cash values — the amount won if players chose to collect a top prize in one lump sum payment. The lottery only disclosed the amount that would be collected in 25 annual installments. Players have always known that a winning cash-value ticket contained a lesser prize than the jackpot listed. But now, thanks to the intervention of local lottery critic Gerald Busald, millions can actually know what they're playing for.

In June, Busald recommended eight changes in the lottery. In December, the Texas Lottery Commission implemented one of them — disclosing cash-value amounts on its Web site. By Aug. 31, cash-value amounts will appear on tickets. More remarkably, TLC has agreed to implement all of Busald's recommendations.

On the back of a ticket are the overall odds of winning Lotto Texas: 1 in 71. What a ticket doesn't reveal are the odds of winning the top prize: One in 25.8 million.
Thanks to Busald, jackpot odds will soon be posted on tickets, and the print will be larger.

Thanks to Busald, lottery billboards across the state have been changed to include "annuitized" beside the word jackpot. Most players, Busald says, know the advertised jackpot will be paid in annual installments. But inclusion of "annuitized," he insisted, is proper disclosure.

Persuading TLC to make minor changes is one thing. But Busald's fingerprints appear on a major one. In a January TLC meeting, Busald chided the lottery for continuing to sell scratch-off tickets after all top prizes had been claimed. Commissioners refused to halt the practice. Last week, TLC capitulated. Gerald Busald wields clout because he helped TLC in its search for a new executive director."

Crime and Punishment: Required Reading in My Economics Class

Okay, it is not the book Crime and Punishment by Fyodor Dostoevsky (this is a link to the entire book online). I will come back to this book. My students are required to read a chapter by this name from the book The Economics of Public Issues. It is only 5 pages long while the famous book is over 500.

One of the interesting things mentioned in this chapter is research by Steven Levitt. It deals with the question of whether or not more police officers means less crime, everything else being held constant. The problem is that cities with high crime rates will have to hire more police officers (it is the opposite for low crime cities). So it is hard to find a meaningful correlation. But this paragraph from the book shows how he got around that problem:

"In the case of police, Levitt has found that election cycles tend to have a strong independent effect on the size of police forces, enabling him to identify the impact of police on crime rates. Because crime is such a hot political issue, both mayors and governors have strong incentives (and the ability) to push for more police funding in election years. The result is that even though police forces in major cities tend to remain constant in nonelection years, they grow by about 2 percent in an average election year. Although this may sound small, it is (1) large enough to have a significant impact over several election cycles, and thus (2) large enough to detect clearly in the data."

So we can see that crime goes down when more police get hired in election years. Each city gets compared to itself, so the problem mentioned above is avoided.

Now back to the Dostoevsky book. Below are two passages that relate to economics and one sounds like the invisible hand.

"But Mr. Lebeziatnikov who keeps up with modern ideas explained the other day that compassion is forbidden nowadays by science itself, and that that's what is done now in England, where there is political economy." (economics used to be called political economy)

"if I were told, 'love thy neighbour,' what came of it?" Pyotr Petrovitch went on, perhaps with excessive haste. "It came to my tearing my coat in half to share with my neighbour and we both were left half naked. As a Russian proverb has it, 'Catch several hares and you won't catch one.' Science now tells us, love yourself before all men, for everything in the world rests on self-interest. You love yourself and manage your own affairs properly and your coat remains whole. Economic truth adds that the better private affairs are organised in society--the more whole coats, so to say—the firmer are its foundations and the better is the common welfare organised too. Therefore, in acquiring wealth solely and exclusively for myself, I am acquiring, so to speak, for all, and helping to bring to pass my neighbour's getting a little more than a torn coat; and that not from private, personal liberality, but as a consequence of the general advance."

More online versions of the book.

Conspicuous Consumption, Conspicuous Virtue, Thorstein Veblen (and Adam Smith, too!)

Friday's Wall Street Journal had an article titled "Conspicuous Virtue and the Sustainable Sofa." You have to be a subscriber to read it online. But here is the intro:

"Lance Armstrong's ubiquitous yellow "Live Strong" wristbands have become a world-wide phenomenon: More than 60 million have sold since 2004, one of the greatest successes in nonprofit fund-raising history, with the proceeds going to cancer-related causes. No doubt some wear the bands in solidarity, or for inspiration -- but, that said, the wristband conceit was simply ingenious. It allowed people to make a show of their virtue. They could give to a good cause, and they could advertise their caring to everyone else. Not for nothing did John Kerry flaunt a Live Strong."

The author, Joseph Rago, calls this "conspicuous virtue." It is inspired by the term "conspicuous consumption" coined by Thorstein Veblen in his book The Theory of the Leisure Class. (the whole book is online there)

This site which has a short bio for Veblen, an economist who lived from 1857-1929, states:

"Veblen is best known for his book The Theory of the Leisure Class. In it he introduced the term "conspicuous consumption." Conspicuous consumption was consumption undertaken to make a statement to others about one's class or accomplishments. This term, more than any other, is what Veblen is known for."

But The Wall Street Journal article argues that now people are buying certain items to show how virtuous they are, like a Toyota Prius to show that you care about the environment even though "fuel savings do not justify the price premium of a gasoline-electric power train."

Adam Smith may have beaten Veblen to the punch. In The Wealth of Nations, he wrote:

"With the greater part of rich people, the chief enjoyment of riches consists in the parade of riches, which in their eyes is never so complete as when they appear to possess those decisive marks of opulence which nobody can possess but themselves. In their eyes the merit of an object which is in any degree either useful or beautiful, is greatly enhanced by its scarcity, or by the great labour which it requires to collect any considerable quantity of it, a labour which nobody can afford to pay but themselves. Such objects they are willing to purchase at a higher price than things much more beautiful and useful, but more common." (the entire book is online)

In Veblen's chapter on "Conspicuous Consumption," there is no mention of Adam Smith. There is statistical or empircal evidence that supports Veblen's theory. A Ph. D. student found that rich families do spend more on "Conspicuous Consumption." Click here to read about it. See also Doctoral Thesis Says Rich People Spend More on Conspicuous Things

Economic Growth: A Little Goes Very Far in the Long Run

We all like economic growth, ceteris paribus. It means more for everyone. In chapter 1 of the book The Economics of Macroissues, they discuss how economies with common law systems have grown faster than those with civil law systems. Common law systems do a better job of enforcing property rights and usually grow faster. The difference does not have to be much. In the macro textbook by Krugman and Wells that I use for my video course, they report that Japan has grown at a rate of 1.7% while Mexico has had a rate of 1.1% (those numbers are approximations-I left that book at the office). That does not seem like a big difference. But in the long run, it adds up. If you grow 1.1% per year, after 150 years your income is is about 5.16 times what it started at (so, for example, you go from $1,000 to $5,160). The formula for this is 1.011 raised to the 150th power

But if you grow 1.7% per year. After 150 years, your income is about 12.54 times what you started at (1.017 raised to the 150th power is 12.54). So your income would go from $1,000 to 12,540. But your income is more than double the other country since 12.54 is more than twice 5.16. So that .6% difference each year matters alot in the long run. It might seem trivial or insignificant, but it adds up.

Crime and Rationality

There was an article on "neurolaw" in the March 11 Sunday New York Times magazine. Nerolaw studies brain patterns to learn more about crime. One of the experts they quoted "wrote a widely circulated affidavit arguing that adolescents are not as capable of controlling their impulses as adults because the development of neurons in the prefrontal cortex isn’t complete until the early 20s."

This reminds me of something at the bottom of page 152 in the book The Economics of Public Issues. It discusses work by Steven Levitt on crime and mention that teenagers respond to incentives.

"In states tough on youth but easy on adults, violent crime rates rise 23% at age 18, but in states that are easy on juveniles and tough on adults such crime drops 4% at age 18."

I don't know if this accurately portrays Levitt's research, but it shows the opposite of what the expert said might be true. Teenagers might be able to control their impulses. In fact, economists have found that even people in mental hospitals can act rationally. For example, if doctors paid agoraphobics tokens to walk outside, very often they did (tokens that could be used to buy things in the hospital store). Patients also got paid for doing jobs or performing tasks. If no one would mop the floor, the pay for mopping the floor was raised and several patients came forward to do the mopping. That is completely consistent with economic theory. Offer a higher pay, more people will do the job (law of supply).

They aslo changed the prices of items in the store. If the price of an item was dropped, the amount purchased went up (and vice-versa). This means that even patients in mental hospitals follow the law of demand. When patients got paid for doing jobs, they did them. But when the hospital tried to get them to do the jobs without pay, the patients stopped working. In another case, if their pay in one job was taken away, they took a job that they liked less if the pay was still there.

The discussion of patients in mental hospitals comes from the book The Best of the New Worlds of Economics.

Do We Always Behave Honestly?

In a recent post (called "Is It Rational To Be A Little Crazy?"-see below), I discussed how seeming irrational behavior might make sense if it reveals our emotional state. That means the information we are trying to send out could be more believable since emotions are costly to fake.

But one commentor said that we fake things all the time. Like at work, we act like we like the job (or at least don't hate it). Related to this, there is an interesting looking book (I have not read it) called Private Truths, Public Lies: The Social Consequences of Preference Falsification by Timur Kuran. Here is what one reviewer wrote:

"... people's choices, and even their desires, are not given and fixed, but are a function of social and psychological conditions, above all pressures imposed by other people...Kuran's book is a terrific success."

Spring Break, The Great Depression and Entrepreneurship Festival

I will post something new on Sunday. We are on spring break here at San Antonio College. Last week in my macro class we watched a video about the Great Depression. The highly respected economist and monetary expert Christina Romer has written an excellent overview of the depression. It is online here. It is written for a general audience yet it provides alot of insights. It is about 10 pages or the length of a short chapter in a textbook. For any student studying this period, it is a great place to start and it has a good bibliography so you can learn more.

Another reminder that I will be speaking at the Entrepreneurship Festival. It is on March 31 at Pepperdine U. So anyone who will be in Southern Calif. then might check it out. You may need to register, so go to the website.

Starbucks's, India Style

A woman in India wants to start a chain of coffee shops called Starstruck's. Starbucks is trying to stop it. This is similar to an issue that came up in my macroeconomics class. We read a chapter in the book The Economics of Macroissues that stated that China often does not enforce patent and copyright laws. If a country does not enforce such laws it might reduce investment by foreign companies. You can read the story here.

Is It Rational To Be A Little Crazy?

On the first day of the semester, I tell the students that we assume people are rational in economics. That means that no one intentionally makes themselves worse off. People only engage in actions if the benefits outweght the costs. What should we think when we see people do things that might seem crazy or at least look very much like they are hurting themselves? Consider the following from an article in Sunday's New York Times Magazine called "Darwin's God"

"Rituals are a way of signaling a sincere commitment to the religion’s core beliefs, thereby earning loyalty from others in the group. “By donning several layers of clothing and standing out in the midday sun,” Richard Sosis wrote, “ultraorthodox Jewish men are signaling to others: ‘Hey! Look, I’m a haredi’ — or extremely pious — ‘Jew. If you are also a member of this group, you can trust me because why else would I be dressed like this?’ ” These “signaling” rituals can grant the individual a sense of belonging and grant the group some freedom from constant and costly monitoring to ensure that their members are loyal and committed. The rituals are harsh enough to weed out the infidels, and both the group and the individual believers benefit."

Here is another example. In his book Passions Within Reasons, economist Robert Frank demonstrates how emotions communicate ability and intentions more effectively than rational signals. In one example from a novel, he explains why a private investigator (PI), would smash the window on the car of gangster boss. The PI wanted the gangster's help in finding his girlfriend's murderer. The gangster needs a reason to help. The PI's only option is to make the gangster think he is crazy enough to try to hurt the gangster. The PI cannot simply say "I am crazy." He must communicate that his emotional state is at least somewhat unbalanced or abnormal. A crazy person is much more likely to smash the window than a normal person. This action successfully demonstrates the PI's possible emotional state better than any normal, rational signal. It works partly because emotions are costly to fake and therefore emotional demonstrations are more believable.

Lose the Fat to Lower Your Insurance Rates

Want to lower your life insurance rates? Cut your BMI or Body Mass Index. Read the short article here or here or here.

The basic idea is that if you are healthier, you live longer and life insurance companies like that. Some of my students might recall one of the lessons from the supply and demand game. That was that one condition for markets to work optimally is that buyers and sellers have equal access to information. When they don't, markets won't work as well as they should.

For instance, in used car markets, the sellers know alot more about the product than the buyers. Economists have studied the problems this causes in the "market for lemons" research. But in insurance markets, buyers know more than the sellers. You know how risky you are but the insurance companies don't. Insurance companies want your premiums to reflect your risk. The riskier people need to pay higher premiums. Now, with the lower rates for people with lower BMIs, they are getting closer to matching risk with premium levels for individual customers.