goonix

It’s that time of the year again…

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Public servants are always frantic at this time of the year. I hear you collectively asking why? It’s nearing 30 June, the end of the government’s financial year. As such the various departments/ministries/commissions are very *busy*, throwing money around like they were the leader of the free world.

The perverse incentives on government officials to make sure they spend all of their allocated budget in the financial year, while nothing new, always amuses me. They are strongly incentivised to make sure that the kitty is empty come June 30, otherwise they risk having money taken away from them in the following year. You have to ask about the importance of the projects that are only taking place in order to empty the coffers.

As a result of these incentives it’s a very lucrative time to be consulting, even if the gravy train is about as efficient as KiwiRail.

jamesz

A good reason to complain

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Matt’s bout of food poisoning has prompted an email discussion on whether he should complain to the store that sold him the offending item. He is of the opinion that a certain percentage of products are always going to be bad and he was just unlucky, so why bother complaining. I think he’s ignoring the other half of the equation: the vendor wants people to complain.

It is true that a certain percentage of products will end up being bad. As a vendor I face a trade-off between production costs and production quality. The number of bad products is an important measure of my product quality, so I’m going to be very interested in how many poison my customers. If customers don’t complain then I have no information beyond my own internal testing. To remedy the information problem I offer freebies to people who complain as a payment for taking the time to provide me with information on the quality of my product. So freebies may be a way to make complainers go away, but they may also be a way for companies to gather better information about the quality of products reaching their customers. Read more

Matt Nolan

Bounded rationality: A parable

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Often people accuse economists of relying on an imperfect view of human nature – a view that is often disparagingly called “homo-economicus“.  However, our view of the world does not rely on the individuals being able to perfectly calculate the satisfaction they get from things or perceive every opportunity.

Ultimately all we require is that individuals respond to incentives (derived from the relative costs and benefits of things) and as a result try to set themselves up such that the benefits of their actions exceed the costs (include opportunity costs).  Such a situation can occur when individuals are bounded rational.

A good example of bounded rationality comes from the parable of the centipede and its 100 legs.  In the parable there is a centipede walking along.  Now it co-ordinates its 100 legs without thinking and without calculating – it does so just because it has become part of its nature.  Effectively, it is following a rule of thumb which allows it to make the optimal decision.

When asked about how it moves its legs it gets confused and trips – at this level anyone watch the centipede would take this as a failure of rationality, it obviously can’t deal with the complex calculation required to come up with its optimal solution.  However, is this really fair?  Even though the centipede couldn’t consciously decide how to move its legs, over time it had evolved a rule of thumb that had allowed it to achieve the optimal solution.

Economists “believe” (this is our value judgment here) that individuals create rules of thumb that allow them to achieve the optimal outcome – without having to consciously calculate.

Understanding how these rules of thumb evolve and change in a highly complex and changeable world is a big deal (in the parable the rule of thumb does not shift favourably to the introduction of information!), and is something behavioural and neurological economists are currently studying.  However, it is clear from this individuals can still make optimal decisions, even when they aren’t expert calculators with complete information.

jamesz

When numbers fail

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William Easterly has an absolutely bizarre reader survey on his blog:

Please tell me which you think is more probable:

  1. a country succeeds at economic development, or
  2. a country succeeds at economic development with a wise and capable leadership.

Since the probability of ‘wise and capable leadership’ is less than 1, the probability of option (2) is P(option 1) x P(wise and capable leadership) < P(option 1). Can this survey tell us about anything other than the mathematical savvy of his readership? Read more

goonix

In defence of the New Zealand wholesale electricity market

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Recently the New Zealand electricity sector has been taking a bit of a hammering. According to a Commerce Commission sanctioned report, consumers have been overcharged by $4.3b over a six year period (how’s that for a headline!). More specifically, the report concluded each of the four big generators – Meridian, Contact, Genesis and Mighty River – has been exercising the power the market’s design gives them to command unjustifiably high prices, at least during years when inflows to the hydro lakes are low as they were in 2001, 2003 and 2006.

New Zealand has two markets in electricity – the wholesale market and the retail market. The wholesale market is where generators sell their production to retailers (often the seller and purchaser are one and the same). These prices vary significantly depending on the conditions of that particular period (for example, how dry Southern Lakes are or whether a generation unit is out service). That’s why, as a consumer. it’s clever to be informed with details like Business Energy costs.

The second market is the retail market, where retailers sell electricity to consumers. Prices here are typically very stable, with consumers seldom exposed to the vast variation that takes place period-on-period in the wholesale market.

In the long-run, the prices in the wholesale market feed through to the retail market. In other words, if a generator/retailer found themselves short of generation and thus had to buy excess generation on the wholesale spot market at relatively high rates, they would eventually pass through these additional costs to their consumers in the retail market.

The report is essentially saying that generator/retailers were able to use their dominance in the wholesale market to push up prices during periods of constrained supply, which consumers then ultimately had to pay for in the retail market.

The report also says that pricing in the wholesale electricity market is, in the absence of dry periods, typically competitive. A very important point made in the report is that no market is ‘textbook’ perfectly competitive and this is certainly the case in electricity, given its unique characteristics (in particular the need for supply to continuously meet demand).

Indeed, I would say that the wholesale electricity market is working almost exactly as intended. Pricing is commonly competitive except at times of tight supply, when generators are able to reap higher rewards that incentivise continued investment in generation (which is extremely expensive) so that ever-growing demand can be met into the future. And the Commerce Commission determined that the generators’ actions were a “lawful and rational exploitation of the opportunities the market gave them”. I doubt you’d be able to make nearly as impressive a headline out of that though…

Matt Nolan

Beer consumption and information

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I quite like the approach to “reducing beer consumption” suggested here:  tell people what type of food it is equivalent to scoffing down.

By doing this, we increase the information avaliable to the individual when they decide to drink.  As many people seem to be interested in a “healthy diet” or “keeping weight down” telling people that a shot of vodka (or Jager) is like eatting a chocolate bar could have a big impact on their consumption decision.

Information, in conjunction with an appropriate externality tax, and combined with liquour sales mechanisms that allow appropriate pre-commitment by individuals, would lead to awesome outcomes.  As a result, I am keen for this sort of information to be out there.