# Tag: economics

## Book review: The Art of Strategy by Avinash K. Dixit and Barry J. Nalebuff

Next up, some work related reading. The Art of Strategy: A Game Theorist’s Guide to Success in Business and Life by Avinash K. Dixit and Barry J. Nalebuff.

The Art of Strategy is about game theory, a branch of economics / mathematics which considers such things as the “ultimate game” where one player choses how to split \$100 (i.e. keeping \$60 and giving away \$40) and a second player decides to accept or reject the split, in the latter case neither of them gets any money. In the former case they get the offered split.

In the “prisoners dilemma” two prisoners are each offered the opportunity to give evidence against the other. If one of them does this, and the other doesn’t, then they will be set free, whilst their fellow prisoner services a sentence. If both betray the other then they will both serve a longer sentence than if they had both kept quiet.

These examples represent the simplest two main types of game, the ultimate game is an example of a sequential game (where one player makes a decision followed by the other) whilst the prisoners dilemma is an example of a simultaneous game (where players make their decisions simultaneously). In real life, chess is an example of a sequential game and a sealed bid auction is a simultaneous game. Games are rarely played as a single instance, simultaneous games may be repeated (“the best out of 3”), and sequentially games may involve many moves. This repetition enables the development of strategies such as “tit for tat” and punishment.

The ultimate game and the prisoners dilemma provide a test bed for game theory, normally illustrating that real humans don’t act as the rational agents that economics intended! For example, in the ultimate game players really should accept any non-zero offer since the alternative is getting nothing, in practice players will reject offers even as high as \$10 or \$20 as unjust.

Sequential games are modelled using “game trees”, which are like “decision trees”. Simultaneously games are modelled with payoff tables. The complexity of real sequential games, such as chess, means we cannot inspect all possible paths in the game tree, even with high power computing.

The first part of the The Art finishes with some strategies for simultaneous games. These are to look for dominant strategies where they are available, i.e they are the best strategy regardless of what the other players do. If this isn’t possible eliminate dominated strategies, i.e. those which are always beaten by your opponent. Nash equilibria are those moves which could not be improved, even given knowledge of an opponents moves. There can be multiple Nash equilibria in a game, which means if strategies are not explicitly stated the the players must guess which strategy the other player is using and act accordingly. This section also covers how social context influences play, and ideas of “punishment”.

The second part of the book looks at how the strategies described in the first part are used in action, although these examples are sometimes somewhat hypothetical. This part also introduces randomness (called “mixed strategies”) as a component of strategies.

The final part of the book covers applications of game theory in the real world, including auctions, bargaining and voting. I was interested to learn of the several sorts of auction, the English, Dutch, Japanese and Vickrey. The English auction is perhaps the one we are the most familiar with, participants signal when they wish to make a bid, and the bid rises with time. The Japanese auction is similar in that the bid is always rising but in this case all bidders start in the auction with their hands raised (indicating they are bidding) and put their hands down when the price is too high. A Dutch auction is one in which the price starts high, and drops, the winner is the one who first makes a bid. Finally, a Vickrey auction is a sealed-bid auction where the winner is the one the makes the highest bid, but they pay the second highest value.

Auctions are big money, the UK 3G spectrum auction in 2000 raised £22.5 billion from the participants. It’s worth spending some money to get the very best game theorists to help if you are participating in such an auction. The section on bargaining is relevant in the UK at the moment given the Brexit negotiations, particularly the idea of the Best Alternative to a Negotiated Agreement (BATNA). Players must determine their pay off relative to the BATNA, and must convince their opponents that the BATNA is as good as possible.

I found the brief descriptions of  concrete applications of game theory such as in the various “spectrum” auctions for mobile phone systems, and the formation of price fixing cartels the most compelling part of the book.

Game theory is a central topic in at least parts of economics, as witnessed by the award of the pseudo-Nobel Prize for Economics in this area – there is a handy list here (http://lcm.csa.iisc.ernet.in/gametheory/nobel.html), if you are interested.

The Art of Strategy has some overlap with books I have read previously, the decision tree/game trees have some relevance to Risk Assessment and Decision Analysis with Bayesian Networks by Fenton and Neil (which uses the Monty Hall problem as an illustration). The Undercover Economist by Tim Harford discusses game theory and its relevance to the mobile frequency auctions in the UK, as well as the example of information in buying second hand cars. The Signal and the Noise by Nate Silver has some discussion of gaming statistics.

## Book review: The Company by John Micklethwait and Adrian Wooldridge

The Company: A Short History of a Revolutionary Idea by John Micklethwait and Adrian Wooldridge is indirectly related to my reading of the history of science and technology. The commercial world impinges on stories such as that of the development of the railways, the story of Mauve and Lord Kelvin’s work on telegraphy. Scientific expeditions were motivated, in part, and supported logistically by merchant interests. The “search for the longitude” was driven by needs of merchants and navies.

The Company is particularly concerned with the limited liability joint-stock company, created in approximately its current form by the 1862 Companies Act in the UK but repeated across the world. In this system, the owners only risk the money they put into a venture (rather than all their worldly possessions), and shares in that company can be traded on the stockmarket.

The book starts with some prehistory, there is some evidence in Mesopotamia as back as far as 3000 BC for arrangements which went beyond simple barter. And by Roman times there were various forms of company used for collecting tax, for example. The Romans also had a developed legal system. These arrangements tended to be relatively short lived and in the form of partnerships, where the owners were the managers and if things went wrong they could lose the toga off their backs.

The Middle Ages saw the rise of “corporate persons” in Western Europe which included guilds, monasteries and corporations. The Aberdeen Harbour Board, founded in 1136 can lay claim to be the oldest still existing. In China there was a tendency towards large, long-lived state corporations. Italy had compagnie literally “breaking bread together” with shared total liability, and thus requiring high levels of trust. Banchi were the campagnies banking equivalents, often built around family ties. The relationship between banks and companies is a theme throughout the book.

England and France were scarred, separately, by the collapse of the South Sea Company and the Mississippi Company in the early 18th century. Created in the spirit of the East India Companies, monopoly corporations with a Royal Charter, they came to grief through rampant speculation and dubious government decisions on debt.

The railways provided the impetuous for the reform of company law. They required substantial investment, once formed they needed substantial workforces and management structures. In the early days each railway company had to make its case in parliament to gain its charter, this was a costly, slow undertaking. And so there were reforms culminating in the 1862 act.

A quote attributed to Edward Turlow in 1844: “Corporations have neither bodies to be punished, nor souls to be condemned, they therefore do as they like”, encapsulates an ongoing concern about companies. This from a lawmaker but a similar concern was echoed by economists of the time, they thought that a partner or manager/owner was going to do better job of running a company than a servant of shareholders.

The Company compares developments in the US, UK, Germany and Japan in the latter half of the 19th century. The US forte was in professionalising management, enabling them to build ever bigger companies. The UK had a more developed stockmarket but positively spurned professional management (a blight that has afflicted it since then). Germany had strong oversight boards from the beginning, complementing the management board. These included workforce representation, and companies were seen as a social enterprise.

This is the second tension in the company: whether it is solely interested in its shareholders or whether it is responsible to a wider group of stakeholders which might include its employees, the local community, environment and so forth.

The book continues with developments in the latter half of the 20th century, closing in 2002. These include the wave of privatisations across Europe (the French keeping substantial government control), and the decline of many big companies. In the case of Enron and WorldCom these were precipitous declines in disgrace but there were also leveraged buyouts and subsequent dismantlings. Another theme here is the balance between transaction costs and hierarchy costs. Companies succeed when the cost of running a hierarchy is lower than the savings made by carrying out transactions in aggregate. These costs and savings change over time, transaction costs have recently been much reduced by technology.

I was surprised by the recency of the commercial world we see today. The modern company and the stockmarket only really came into being in the final quarter of the 19th century with the great corporations rising to dominance in the first quarter of the 20th century. Harvard’s business school was only founded at the beginning of the 20th century. This is little more than a lifetime ago.

The same is true of trade tariffs, they were initially introduced by the US and Germany in the 1880s with Britain and the Netherlands holding out as “free-traders” until 1932. One wonders whether this is the origin of Anglo-Dutch conglomerates such as Unilever and Shell. The book is not explicit on the differences between tariffs and customs duties and taxes – a clarification which I would have found useful.

The authors are clearly enthusiasts for capitalism in the form of the company. The book is short and readable, and I felt enlightened for having read it. The bibliography has some good pointers for further reading.

## Book review: The Son also Rises by Gregory Clark

The Son also Rises by Gregory Clark is a book about social mobility, as traced through surnames. Clark prefaces his work by saying that what he is to say might be considered radical and controversial. Other studies of social mobility have find modest “inheritability” between generations. This study finds high levels of inheritability spanning hundreds of years.

The theme for the early chapters is to find some source of high status individuals – be it graduation from prestigious universities such as Oxford, Cambridge or the American Ivy League, membership of professional bodies such as those for doctors or attorneys or from financial records such as occasional tax releases or records of wills (probate). Next a cohort of names is tracked through these systems and their level of incidence is compared against the background level of incidence for that surname. For example, “Smythe” is a relatively rare surname in the general UK population but it is found at a much higher level in records of registered doctors.

The selected cohort of surnames may be from a distinctive ethnic population – i.e. Japanese in America, Native Americans or French settlers. Or it may be selected from a set of high status individuals at a point in time i.e. the Normans who came the England with William the Conqueror, or Swedish nobles.

Clark’s discovery is that for all of these many cohorts across multiple measures of status the persistence over time is strong. The Smythes of 200 years ago had relatively high status then and they still do now. After nearly a 1000 years those with surnames associated with the Norman conquest are still a little over-represented in the intake of Oxford and Cambridge University. Similar behaviour is found for low status groups, Baldrick’s character through the several series of Blackadder is not far from the truth. In both cases these groups are “regressing towards the mean” but it is a long, slow process.

Following these initial demonstrations of social mobility, Clark states his general law which is that the correlation of status over generations is high compared to previously measured parent-child measures and remarkably constant across multiple countries, periods in history and cohorts. The magic number for the correlation is 0.75. He argues that the reason that his estimate is higher than others is that he models social mobility with an underlying constant and a random fluctuation, the methods of calculation for early figures mean that this random fluctuation is much more apparent and brings down the measured social mobility. I don’t feel he demonstrates the origin of this discrepancy very clearly.

Subsequent chapters go on to look at some cases where one really expects deviations from this general rule, in the Indian caste system where low mobility is expected and also in China, where post-revolution is expected to be a time of high social mobility. It turns out that in India, despite laws aimed at reducing caste based discrimination, social mobility is has not improved dramatically. In China social mobility seems to have been little bothered by the revolution. The odd groups that do break the rule of constant social mobility seem to do so by preferential recruitment i.e. in the past in Muslim countries non-Muslims were tolerated but charged a poll tax which meant that lower status/income people were more likely to convert to Islam leaving a more persistently high status non-Muslim population. A second route is by strong preference for “in group” marriage which is seen in the Indian Brahmin caste. It turns out that the surnames identified with British parliamentarians are particularly immobile.

As for the origin of this constant social mobility, Clark ascribes it to what he calls “social competence”. There is a confused discussion of the balance of nature and nurture, not helped by a table where nature and nurture headings are accidently swapped (I think). I believe that technically it is all nurture, and Clark is trying to work out whether it is all about money. It strikes me that your wider family is where you learn about what the possibilities are for you and, while every family has it’s black sheep, the fact that your father, two out of three uncles went to Cambridge University means that your expectation is that you should aspire to that. Your family sets what is “normal”.

I suspect that this is particularly the case for British parliamentarians where there seems to be a lot of siblings (Milibands, Johnsons, Eagles), husband wife (Cooper/Balls) and parent-child (Kinnock, Benn) combinations. Being a politician is an odd sort of job, there is not really a class at school for it, seeing your family working in the “family business” must be a big influence.

“The Son also Rises” is an interesting read but turning it into a 300 page book seems to belabour the point somewhat. I liked the incidental details of the origins of surnames, and the various sources of information on social status.

I got this as a Kindle edition, I wish I’d bought it as a paperback, there are numerous figures, tables and equations which didn’t render at a reasonable size in the first instance.

## Book review: The Undercover Economist Strikes Back by Tim Harford

Tim Harford’s latest book "The Undercover Economist Strikes Back". It’s about macroeconomics, a sort of blaggers guide.

Who’s Tim Harford?

Tim Harford is a writer and broadcaster. I’ve also read his books The Undercover Economist, about microeconomics and Adapt, about trial and error in business, government and aid. When I get the time I listen to his radio programme More or Less, about statistics and numbers, and also read his newspaper column.

Hey, what’s going on here? You keep writing down the questions I’m asking!
Yes, this is how Strikes Back is written. At the beginning I found it a bit irritating but as you can see I’ve taken to it. It recalls the method Socratic dialogue and Galileo’s book, Dialogue Concerning the Two Chief World Systems. The advantage is that it structures the text very nicely and is likely rather SEO friendly.

OK, I’ll play along – tell me more about the book

The book starts by introducing Bill Philips and his MONIAC machine, which simulated the economy, in macroeconomic terms, using water, pipes, tanks and valves.

That’s a bizarre idea, why didn’t he use a computer?

Philips was working in the period immediately after the Second World War and computers weren’t that common. Also, it turns out that solving certain types of equations is more easily done using an analogue computer – such as MONIAC.

Back up a bit, what’s macroeconomics?

Macroeconomics is the study of the large scale features of the economy such as the growth in Gross Domestic Product (GDP), unemployment, inflation and so forth. Contrast this to microeconomics which is about how much you pay for your cup of tea (and other things).

What’s the point of this, didn’t someone describe economics as the “dismal science”?

Yes, they did but this is treating economics a little unfairly. One of Harford’s pleas in the book is to accept the humanity of economists. They aren’t just interested in numbers, they are interested in making numbers work for people. In particular, unemployment is recognised as a great ill which should be minimised and the argument is over how this should be achieved rather than whether it should be achieved.

There is a great divide in economics between the Keynesians and the classical economists. The crux of their divide is how they treat a recession. The former believe that the economy needs stimulus in times of recession, in terms of of increased “printing of money”. The latter believe that the economy is a well-oiled machine that is de-railed by external shocks, in happy times there are other external shocks that pass off relatively benignly. The classicist are less keen on stimulus believing that the economy will sort itself out naturally as it responds to the external shocks. These approaches can be captured in toy economies.

Tim Harford cites two examples: a babysitting collective in Washington DC and the economy of a prisoner of war camp. The former is a case of a malfunctioning economy fixed by Keynesian means: the collective worked by parents agreeing to babysit in exchange for vouchers which represented a period of babysitting. But the amount of vouchers available was limited so parents were reluctant to spend their babysitting vouchers for a night out because they were scarce. In the first instance this was resolved by printing more baby sitting vouchers: a Keynesian stimulus.

The prisoner of war camp suffered a different problem, towards the end of the war the price of goods went up as the supply of Red Cross parcels dried up. Here there was nothing to be done, the de facto unit of currency was the cigarette and there was a limited supply of them and nothing could be done to increase that supply.

It’s all about money, isn’t it?

Yes, Harford highlights that money fulfils three different functions. It’s a medium of exchange, to save us from bartering. It’s a store of value, we can keep money under the bed for the future – something we couldn’t do with our valuable goods if they were valuable. And it is a “unit of account”, a way of summing up your net worth over a range of assets.

Is The Undercover Economist Strikes Back worth reading?

I’d say a definite “yes”. We’ve all been watching macroeconomics playing out in lively form over the last few years as the recession hit and is now receding. Harford gives a clear, intelligent guide to the issues at hand and some of the background that is left unstated by politicians and in the news. Harford points out that our political habits don’t really match our economic needs. Ideally we would have abstemious, right-wing governments in the boom years and somewhat more spendthrift left-wing ones during recessions. He ends with a call for more experimentation in macroeconomics, harking back to his book Adapt. And also highlights some shortcomings of macroeconomics as studied today: it does not consider behavioural economics, complexity theory or even banks.

There’s much more in the book than I’ve summarised here.

## Revisions to UK GDP data

The BBC published an article entitled “Viewpoint: Is UK GDP data fit for purpose?” which featured a graph showing the original estimates for quarterly UK GDP growth and current estimates for those same figures. The point being that the original figures are subject to revision which can change figures quite significantly, for example currently we are technically in recession with a GDP growth figure for Q1 2012 of –0.2% (source). But how does this compare with the size of the revisions made to the data?

Here is the graph from the original article:

This is quite nice but there are other ways to display this data, which unfortunately isn’t linked directly to the graph. However, this should not stop an enterprising number-cruncher, there exists software which will allow you to extract the numbers from graphs! I used Engauge Digitizer, which worked fine for me – I had the data I wanted 20 minutes or so after I’d downloaded the software. It does some semi-automatic extraction which makes separating the two different sets of data in the graph on the basis of the colour of the lines quite easy.

This type of approach is not ideal, the sampling interval for the extracted data is not uniform, and not the same for the two datasets, furthermore the labelling of the x-axis is unclear so it’s difficult to tell exactly which quarter is referred to.

I next loaded up the data into Excel for a bit of quick and easy plotting. To address the sampling problem I used the vlookup function to give me data for each series on a quarterly basis. I can then plot interesting things like the difference between the current and original estimates for each quarter, as shown below:

A few spot checks referring back to the original chart can convince us that we have scraped the original data moderately well. The data also fit with the ONS comment on the article:

…looking back over the last 20 quarters, between the first and most recent estimates, the absolute revision (that is, ignoring the +/- sign) is still only 0.4 percentage points.

I calculated this revision average and got roughly the same result.We can also plot the size of revisions made as a function of the current estimate of the GDP growth figure:

This suggests that as the current estimate of growth goes up so does the size of the revision: rises are under-estimated, falls in growth are under-estimated in the first instance although this is not a statistically strong relationship. These quarterly figures on GDP growth seem awfully noisy, which perhaps explains some of the wacky explanations for them (snow, weddings, hot weather etc etc) – they’re wild stabs at trying to explain dodgy data which doesn’t actually have an explanation.

The thing is that the “only 0.4 percentage points” that the ONS cites makes all the difference between being in recession and not being in recession!

Footnotes