From Rental Cars to CEOs

WSJ.com - From Rental Cars to CEOs: A Review of 'Freaky' Research: "Amid growing mainstream interest in nontraditional applications of economic theory, economist bloggers Alex Tabarrok and Bryan Caplan find gems in rental-car pricing, trade with China, the politics of war and pricing CEOs. This interest comes in the wake of the success of the best-selling book "Freakonomics," which looks at children's names and drug gangs, among other offbeat topics.

Alex Tabarrok writes: Freakonomics is the surprise best seller of the summer. It's a great book and a lot of fun to read but I do have one quibble: I'm freaky, too! Well, let me make that a bit less personal. Economists today are examining a wider range of issues than ever before, not just in law, political science and history but now also in anthropology, sociology, philosophy and more. This is the Victorian age of our imperialist science. George Mason University, where you and I teach, is an especially freaky place (I study bounty hunters, some of our colleagues do neuroeconomics, the economics of religion, the economics of the arts, etc.) But there are freaks in all of the best economics departments. So with due acknowledgment to author and economist Steve Levitt, whom I am happy to crown king of the freaks, we are all freaks now!

http://tinyurl.com/9qdv5
http://www.neuroeconomics.net/
http://gunston.doit.gmu.edu/liannacc/ERel/index.htm#Home-ERel
http://www.amazon.com/exec/obidos/tg/detail/-/0691117837/qid=1119894350/sr=8-1/ref=pd_csp_1/103-6576593-3810251?v=glance&s=books&n=507846/marginalrevol-20

One of my favorite papers of recent years deserves to be at least as controversial as Levitt and John J. Donohue's study of crime and abortion, detailed in the book. In "War Politics" (subscription required), a paper published in the prestigious American Economic Review, Gregory Hess and Athanasios Orphanides present evidence that presidents sometimes start wars for purely political reasons. Hess and Orphanides have a simple model: Voters care about two things, a president's war-making ability and his (or her!) ability to manage the economy.

If the economy is doing well, a sitting president is up on one score and without evidence can be assumed to be as good as the challenger in war-making ability. Thus, the president gets reelected. But if the economy is doing badly then an incumbent who cannot present evidence that he has superior war-making ability will lose for certain. Crucially, an incumbent can't demonstrate war-making ability without a war -- so when the economy is doing poorly and the President is up for reelection the model predicts more wars.

Hess and Orphanides define a war as "an international crisis in which the United States is involved in direct military activity that results in violence." Using data from the International Crisis Behavior Project, they compare the onset of wars in first terms when there is a recession with (a) the onset of wars in first terms with no recession and (b) second terms. Stunningly, however, they find that in the 1953-1988 period wars are about twice as likely in first terms with a recession than in first terms with no recession and second terms (60% to 30%). The probability of this result occurring by chance is low.

Need I mention that the Hess and Orphanides model has proven to have predictive power?

* * *

Bryan Caplan writes: In the '80s, it was hip to be square; now Levitt and Dubner have made it normal to be a freak. Like Alex, I think this shift from mathematical prowess to creativity is all for the good. But the Hess and Orphanides piece that Alex is so fond of illustrates the stark contrast between the old freaks of economics and the new.

Gary Becker is the grand old freak. He transformed economics by applying it to everything, from robbing banks to making babies. The freaky thing about Beckerian economics is the claim that when teenagers have unprotected sex, or voters support import quotas, or anybody does anything, they do it rationally.

Hess and Orphanides's piece on war politics fits this mold. I'm delighted to see social scientists addresses such meaty topics, but frankly, rational models like theirs just aren't freaky enough.

If we take the Hess and Orphanides model seriously, we would expect presidents to become popular for their wars after they successfully resolve them. In fact, the "rally round the flag" effect seems to be strongest at the beginning of wars, long before the president has proven a thing about his abilities. A fascinating article by Gary Langer in the Public Perspective magazine found, for example, that trust in government to do the right thing more than doubled from 30% to 64% two weeks after 9/11. The most plausible explanation, to me anyway, is that contrary to the Beckerian worldview, a lot of people are not rational about this topic. Common sense tells us to have less faith in the government after a sneak attack gets through our defenses, not more; but common sense is not so common.

If the old freakonomics was about shoehorning every topic into a rational model, the new freakonomics is more open-minded. Levitt and co-author Stephen Dubner don't emphasize the social role of irrational beliefs, but a lot of their freaky competitors do just that. I have a series of papers on "systematically biased beliefs about economics," which empirically document the popularity of beliefs about economics that would earn you a failing grade in intro econ. For example, the general public is quite convinced that international trade is bad for our economy. And contrary to critics of economic orthodoxy, it is easy to statistically show that economists' distinctive outlook is not a product of their high income, tenure or supposed right-wing bent.

Once you accept that irrational beliefs are out there, you start wondering if they are more prevalent in some segments of the population than others. An excellent and freaky working paper by Daniel Benjamin and Jesse Shapiro makes quite a bit of headway here. Using a variety of empirical sources, they find that "individuals with greater cognitive ability behave more closely in accordance with economic decision theory." People with high IQs act quite a bit more like Becker's rational actors than the rest of the population, and people with low IQs are especially deviant.

Now that's freaky.

* * *

Alex writes: It's obvious that some people are more rational than others, but economists have been reluctant to accept this truth arguing that "if you assume irrationality you can prove anything." But irrationality is not a free parameter -- the mind has its own structure and this makes some assumptions about irrationality more plausible than others. Even crazy people follow patterns. John Nash had the delusion that he would be crowned Emperor of Antarctica not chief garbage man of Topeka. (See this fun review of neurology from the Journal of Economic Literature for a more academic discussion.)

A interesting paper by Xavier Gabaix and David Laibson asks why some firms shroud their prices. Car rental companies, for example, advertise low rental rates but shroud the price of insurance and gasoline fill-up. One can understand why one firm might try this, but why don't competitors advertise their prices honestly along with the slogan, "We have no hidden fees. The other guys do. Draw your own conclusions"? Wouldn't such a firm win the competitive battle? Gabaix and Laibson show that if some consumers are naive while others are sophisticated, the answer is no.

The existence of the naive, who choose where to rent based on the advertised rental price and not the full price of driving, makes shrouding profitable. But the profits attract entry, leading to an equilibrium in which rentals are priced below cost and insurance and fill-ups are priced well above cost. Why doesn't it pay to advertise and price both services closer to cost? The reason is that sophisticated consumers don't want to buy at cost -- the sophisticated consumers want to buy from the firm that attracts the naive because the sophisticated consumers know to reject the supplemental insurance and return the car after gassing it up themselves, thereby taking advantage of the low rental rate and avoiding high markups. Notice that shrouding doesn't benefit the firms that shroud (competition reduces their profits to normal); instead, it causes the dumb to subsidize the smart.

Readers of this blog should be pleased!

* * *

Bryan writes: Alex hits the nail on the head. Ad hoc irrationality can explain anything, but in recent years economists have explored the structure of irrationality. Paul Rubin's fascinating work on "Folk Economics," for example, uses evolutionary psychology to explain popular misconceptions about economics. (See also his book "Darwinian Politics".) Teachers of economics have long been frustrated by their students' zero-sum mentality -- for example, the way they see our nation's decline in every "Made in China" label. Rubin points out that economic growth was almost non-existent during hundreds of thousands of years of human evolution, so it is not surprising that we still myopically focus on short-run wealth distribution rather than long-run wealth creation. Growth is hard to get our minds around.

Rubin's reflections on primitive man remind me of Michael Kremer's "Population Growth and Technological Change: One Million B.C. to 1990."

This piece combined a simple model with striking historical data. His model said that more people mean more ideas, and more ideas mean faster economic growth -- which in turn allows more people to survive. His data showed that throughout human history, higher population and faster growth have gone hand-in-hand. Most convincingly, Kremer pointed out that before the integration of the world economy, economic growth depended heavily on regions' initial populations. Small, isolated areas like Tasmania actually lost technology over time, but Eurasia's large, connected population put us on the road to modernity. When I see billions of rural Chinese and Indians finally hooking up to the world economy, Kremer's story makes me optimistic about the future.

Fortunately, I've got Alex to restrain my optimism. Although rational people won't kill the goose that lays the golden eggs, I'm not so sure about actual people. Sadly, if Rubin is right that human beings naturally have a zero-sum mentality, people on both sides of the Pacific may eventually see other countries' prosperity as a danger, and do something ugly about it.

* * *

Alex writes: Speaking of zero-sum mentalities, I was appalled that Paul Krugman, previously a staunch free trader, is now worrying about China's prosperity.

Nothing can harm the prospects for world peace more than the vicious idea that we do better when they do worse. The Chinese and American people already have enough mercantilists, imperialists and "national greatness" warriors pushing us towards conflict. On this issue, I agree with Brad DeLong, who writes: "It is very important for the late-21st-century national security of the United States that, 50 years from now, schoolchildren in India and China be taught that America is their friend, that it did all it could to help them become rich. It is very important that they not be taught that America wishes that they were still barefoot and powerless, and has done all it can to keep them so."

* * *

Bryan writes: Since Alex has trounced Krugman for his dangerous policy recommendations, I want to give Krugman credit for coming up with a novel theoretical argument in favor of free trade. Namely: Free trade is especially beneficial for you if your trading partners are idiots.

"Chinese investment in America seems different from Japanese investment 15 years ago," he tells us, because: "[J]udging from early indications, the Chinese won't squander their money as badly as the Japanese did. The Japanese, back in the day, tended to go for prestige investments -- Rockefeller Center, movie studios -- that transferred lots of money to the American sellers, but never generated much return for the buyers. The result was, in effect, a subsidy to the United States."

Note that Krugman doesn't deny that trading with the shrewd has mutual benefits. His claim is merely that trading with suckers is even better, and he's talking in the context of the Chinese company Haier Group's offer to buy Maytag: "That doesn't mean that America will lose from the deal. Maytag's stockholders will gain, and the company will probably shed fewer American workers under Chinese ownership than it would have otherwise. Still, the deal won't be as one-sided as the deals with the Japanese often were."

I'm not convinced that Japanese investors were as foolish or Chinese investors are as clever as Krugman says. But if we assume he's right on the facts, he has a theoretical point. Krugman basically applies Gabaix and Laibson to international trade. If you sell to both smart customers who get what they pay for, and dumb customers who overpay, firms make larger profits on dumb customers.

Since the time of Bastiat, free traders have pointed out that if imports washed up on our shores, free of charge, we would be richer, not poorer. Paying for imports is mutually beneficial, but the less we pay, the better for us. Krugman has repackaged this insight, pointing out that the next best thing to getting imports for free is getting imports in exchange for overpriced junk.

Clever? Yes. Relevant to the real world? Unclear. Likely to work well in practice? Highly unlikely. Freaky? Definitely.

* * *

Alex writes: Bryan is being much too nice to Krugman. Bad investment decisions make the world a poorer place. Economists should focus on making the pie bigger not increasing one party's share at the expense of others. That's one reason why, like Bryan, I am a big admirer of the work of Michael Kremer.

Kremer's idea for patent buyouts is one of my favorite ideas to make the pie bigger. Can we encourage research and development in, say, AIDS drugs but still keep prices close to costs if we discover a cure? Kremer says the government should buy the patent and put it into the public domain. OK, that idea has an obvious defect. How would the government know how much to pay for the patent, and isn't this an invitation to corruption? Here is Kremer's twist -- instead of having anyone buying the patent directly, there will be an open auction.

Auctions are good at revealing information and can be monitored so the winning bid will represent a good estimate of the true value of the patent. After the winning bid is revealed the government will roll some dice -- nine times out of 10 the government will buy the patent at the winning bid, one time out of 10 the winner will receive the patent. Bidders still have an incentive to bid carefully because 10% of the time they will win and must pay, but 90% of the time the new drug becomes an instant generic.

Almost every other idea for lowering drug prices implies a reduction in research and development. What I like about Kremer's idea is that it transcends this tradeoff. Patent buyouts reduce prices while maintaining and possibly increasing the incentive to do R&D. Would the idea work in practice? I'm not sure, but it's promising enough to warrant a large-scale experiment. (By the way, you can find Kremer's paper as well as a lot of other clever and fun ideas for making us better off in my book, "Entrepreneurial Economics: Bright Ideas from the Dismal Science.")

* * *

Bryan writes: I disagree with Krugman's retreat from free trade as much as Alex does. Krugman has one internally consistent story about how a country might enrich itself at the expense of another, but as Alex says, the right question is ask is how to make the world a richer place.

An intriguing suggestion comes from my colleague Robin Hanson. He proposes a new way to help businesses make better decisions by weeding out weak CEOs: a "dump-the-CEO" market.

Consider: If a board suddenly fires a CEO and the firm's stock shoots up, that is a sign that it made the right decision. The catch is that you have to actually fire the CEO before you can find out how it will affect the firm's stock price.

The first part of Hanson's proposal, then, is to establish markets where traders bet on the value of the firm's stock conditional on keeping or dumping the current CEO.

The second part, which may rattle the cages of any CEOs with time to read blogs, is to put a new plank in the corporate charter. Namely: If the market's estimate of the stock price conditional on dumping the CEO exceeds the market's estimate of the stock price conditional on keeping the CEO, the CEO gets fired.

Wouldn't CEOs try to manipulate the market to keep their jobs? Probably. But manipulation is a lot harder than it sounds. If an incompetent CEO bets on himself, he creates profit opportunities for speculators to bet against him. In fact, Hanson (together with GMU professor Dave Porter and graduate student Ryan Oprea) has run a fascinating experiment showing that market manipulation is self-correcting. As long as some people know that other people are trying to raise the market price, it doesn't work.

Many economists see the obstacles to firing CEOs as a market failure. Hanson says that the simplest way to fix this market failure is by creating another market. Freakonomics strikes again.

http://hanson.gmu.edu/biastest.pdf
http://mason.gmu.edu/~atabarro/PublicvsPrivate.pdf
http://hanson.gmu.edu/futarchy.pdf
http://www.amazon.com/exec/obidos/ASIN/0195145038/marginalrevol-20
http://papers.nber.org/papers/w6304
http://www.econlib.org/library/Bastiat/basSoph2.html#S.1,_Ch.6,_The_Balance_of_Trade
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=728545
http://www.marginalrevolution.com/marginalrevolution/2005/06/krugman_beneath.html
http://www.marginalrevolution.com/marginalrevolution/2004/07/paul_krugman_gu.html
http://www.j-bradford-delong.net/movable_type/2005-3_archives/000447.html
http://ideas.repec.org/a/tpr/qjecon/v108y1993i3p681-716.html
http://www.amazon.com/exec/obidos/tg/detail/-/0813530962/103-9179095-3557442?v=glance
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=320940
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=590965
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=728545
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=675264
http://www.res.org.uk/society/mediabriefings/pdfs/2002/April/caplan.pdf
http://www.gmu.edu/departments/economics/bcaplan/econ.html
http://econlog.econlib.org/archives/2005/03/what_fools_thes.html
http://www.ropercenter.uconn.edu/pubper/pdf/pp134/july_aug_2002_pp7-10.pdf
http://en.wikipedia.org/wiki/Rational_expectations
http://www.icbnet.org/
http://links.jstor.org/sici?sici=0002-8282%28199509%2985%3A4%3C828%3AWPAERF%3E2.0.CO%3B2-D