Money out of thin air

Those who are familiar with market economics would definitely recognise the phrase. It is a metaphor. This one is literal, though. Someone is selling cans of air collected from his hometown which presumably has fresh air. Those of us living in cities would know the difference in feeling between inhaling the city air and the pure fresh air in the hills around, say Mont Banc in the French Alps. Once we recognise that it is a matter of whether some of that feeling could be supplied in part — in which case we will pay for part of that value — and as long as the cost of supplying that value is lower than the value itself there is a scope for placing a price in between and carrying out a mutually beneficial trade in the market.

Never mind the economic language. The point is as long as someone is willing to pay to take a couple of puffs of that sweet air for a price there is a scope for an entrepreneur to make money and everyone is happy in the process. Errr…. I don’t like the way this whole thing is beginning to sound. Especially with President Clinton being in the news, again, recently regarding his statement about smoking but not inhaling … and so not liking it because it did not make him happy as a result …. I need to stop the writing because it is going down a slippery slope!

The idea is actually notable and my bet is that eventually it will catch on almost like the bottle of Evian. Economically it may be even more feasible for air is more easily compressed than water without destroying its properties … isn’t it?

Check out the news at: http://sg.finance.yahoo.com/news/french-student-makes-big-profit-230012224.html

The first auctions

I wanted to find out the origins of the system of auctions. It seems that we have to go back to ancient Babylonia. Herodotus’ The History mentions that the custom in those days was to gather the marriageable maidens of the village in one place and then auction them for marriage to the highest bidding grooms. That is quite a sensational story. But were those the origin of auctions or the first auctions? The answer is an emphatic “no.”

Herodotus mentions in his writing that the ancient Sumerians had a very clever way of using the river for bringing down the cost of trade. They used to make a wooden frame for a boat and wrap it up with hide so that it could float. Then they filled it up with merchandise and also include a donkey or two. Floating downstream with such a boat was easy, and when they reached Babylon they sold their merchandise, and auctioned off the wood from the boat’s frame. Then they gathered the hide on the donkey and returned on foot, for traveling up-stream on a boat was costlier. If auctions were carried out in such a matter of fact manner then it must have been a no-so-novel system by then.

In fact, I am tempted to say that auction in its basic form is just part of human nature and even animal nature, for that matter of fact. So it probably appeared even before formal economic exchanges started taking place in human history. Mating among some birds (possibly some animals, too) happens in a funny manner. The males keep fluffing up their feathers and dance near the female in a show of stamina and health, the female mates with the male that she finds the most impressive. I have a feeling that I seen something similar in the human society, too. Instead of fluffing up feathers it is dressing up, buying gifts, and activities that impresses a human female. I am even tempted to suggest that the auction process of letting others compete and seeking the best is inherent in our biological system and is what drives the process of evolution both biological and economic.

Could you please smile a bit more in the economy class?

Have you wondered why the airlines sometimes seem to go an extra mile to make flying so unpleasant for us in the economy class? Look at the seats. I am not going to buy an argument that to keep things cheap they have to provide such uncomfortable cushions. With space-age technology and design there are many ways to make things more comfortable in the economy class without having to lower the capacity or even increase cost per passenger very much. Put it differently. Business class tickets may cost more than thrice as much (just checked SIN-CDG roundtrip on SIA; economy: S$1954, business: S$7895), but do they put as much in there? In the economy class of the last flight I took each row sat 8 people, in the business-class it was 6. It is harder for me to do the comparison of the number of rows within a given space, but I would be surprised if that is much better than that. If you are in business class you get to board first, but really, apart from the “status symbol” aspect of it, who cares? Especially, if you are not worried about finding space for your carryon luggages, if anything the lounge is more pleasant than inside the airplane.

So why do they do it? It is price discrimination for consumer surplus extraction. We are different in our abilities and willingness to pay for airline seats. To some people S$5000 for a seat is no big deal, for me — I can’t even think of it. Some people travel in business class and I don’t because I don’t value the extra comfort as much, but the bite of the extra fare is not much to them (probably someone else is picking up the fare), but it is my average monthly saving towards retirement.

So why do they have to make it extra uncomfortable for me in the economy class? Their scheme will work best if the rich people pay the extra high fare for the business class and fly business class. They do not have to worry about me, I cannot change my mind and decide to fly business class because it makes more economic sense for me — it is way beyond my reach. If they make me stand in the economy class, still I have no choice. The business folks have lower value for the extra $3000, but the the money is not worthless to them. Many of them would switch to economy class if the economy class does not look bad. So it works well for the airlines to make the economy class even more unattractive to those who are flying business class. That is price-discrimination, and sellers practice that all the time in all sorts of ways.

Now that I am talking about it, I think I see why I find the crew in the economy class sometimes appear less attractive and not smiling as much. The other day one of them bumped the trolly against my knee and did not even bother to say a “sorry.”

My favorite MadTV video on airline pricing:

Winner’s Curse

Every time I teach asymmetric information to my undergraduate students I try to run an experiment. I save the changes I receive after purchases for a couple of weeks and put them in a container. I take it to the class room and tell the students that I am willing to sell the container with all the coins inside, they had to write down the most they are willing to pay for the coins. The coins are to go to the student who bids the most and the student has to pay an amount equal to the next highest bid. They get to hold and shake the container to get a feel for the content.
Without exception, I find that the bids vary a lot, and the top few bids are always way higher than the value of the coins. This is the problem of winner’s curse which has plagued bidders in auctions for oil-drilling rights to construction contracts for ages until engineers and economists figured it out.
The winner’s curse arises in the following way: The bidders estimate the value — some overestimate and some underestimate — by and large they guess it correctly. The winner, however, is invariably the guy who has overestimated, and so is the next highest bidder who sets the price in the auction. So at the end I end up with selling the container to an unsuspecting student for a price that is substantially more than the amount that is locked in the container.
Of course, I do not actually sell the coins in the end, nor do I take the money from the student, for there are clear ethical issues there. However, you could try this among your friends and have some fun. A note of caution: There is always a positive probability, however small, that all the bidders may underestimate the value in which case you would lose money. Larger the number of bidders lesser the chance that you would lose money. I have to also warn you that if your friends already know about winner’s curse and how you are supposed to bid in the presence of winner’s curse, then again you would lose money. However, in the many years that I have performed this experiment with my students I have never faced a situation where I could lose money if I actually carried through with the trade.

You should see the relief on my winning student’s face after I announce that the purpose of the experiment was only to illustrate a point, not to actually sell the coins.

Zipf’s Law

More than seventy years ago an American linguist of German descent George Kingsley Zipf, while dissecting books like James Joyce’s Ulysees and a variety of other works in English and other languages, noticed something strange. The most frequently used word in each of these works occurred twice as many times as the second most frequently used word, three times as much as the third most frequently used word, and so on. This was observed even in the musical notations of some great composers. Ever since people have been observing Zipf’s law in areas ranging from genetics to economics.

It is not a scientific law (not so far) but a natural law. Try this. Look up the US cities ranked by population. You will find that the city with the highest population is roughly twice as much populated as the second highest, three times roughly as populated as the third highest population and so on. The pattern starts to flounder and the excitement starts to fade beyond the first few cities. Turns out that the best way to observe Zipf’s law is to consider the proportion of cities above a certain number S than the proportion of cities is proportional to S.
It is not a scientific law (not so far) but a natural law. Try this. Look up the US cities ranked by population. You will find that theest, three times roughly as populated as the third highest population and so on. The pattern starts to flounder and the excitement starts to fade beyond the first few cities. Turns out that the best way to observe Zipf’s law is to consider the proportion of cities above a certain number S. It is proportional to S. Try plotting the log of the rank of the cities against the log of the population as some economists have done. The result is mind-boggling, it is almost a perfect downward sloping straight line that would make you jump from your chair.

That we do not observe Zipf’s law while trying the rank of the cities against its population should make sense logically. Suppose Zipf’s law did hold for each of the Canada, US and Mexico. You can see that it will then fail to hold for North America. Get it? The idea is what is the level at which you are looking for the pattern. You have to get to the right level and see  it correctly to observe the law — I am guessing — much like fractals.

Economics is great for it lets us examine numbers for patters that make sense. Try observing Zipf’s law in other areas of economics.

A demand-supply quote

“… typically prostitutes earn more than the typical architecht. The architecht would appear to be more skilled … and better educated … but little girls don’t grow up dreaming of becoming prostitutes, so the supply of potential prostitutes is relatively small …. As for demand? Let’s just say that an architecht is more likely to hire a prostitute than vice versa.” — S. Levitt & S. Dubner in Freakonomics.