hal varian – EconForEverybody

Bradley A. Hansen on Richard Thaler, Behavioral Economics and Anomalies

The blogging gods are alive and well, and their “In A Weird Coincidence” department is in fine fettle.

So, in a weird coincidence, Bradley Hansen posted on his blog about the same topic as my blogpost from yesterday. And even better, his take on the issue is different from mine, which means I get to write one more post about the topic (yay!).

Here’s his opening paragraph:

I was listening to a recent episode of Hidden Brain the other day about anomalies, specifically things that are supposedly anomalies in economic theory. The guest was Richard Thaler, who is famous as a behavioral economist and Nobel Prize winner. The discussion reminded me of some of the problems that I have with some work that is described as behavioral economics. One of the stories he told was about Richard Rosett, a professor of his when he was in graduate school at the University of Rochester. Rosett collected wine. He wouldn’t spend more than $20 or $30 on a bottle, but sometimes a bottle he had purchased would increase in price to as much as $200. There was a wine shop in Rochester that would have purchased these valuable bottles from him, yet he would serve them rather than sell them, despite the fact that he would not spend $200 on a bottle. Thaler regards this as an anomaly that contradicts economic theory. The claim is that economic theory says that cost is the value of the foregone opportunity. It doesn’t matter whether you paid $200 for the bottle you are serving or gave up the opportunity to sell the bottle for $200. Either way the cost is $200. That’s all well and good, but it is ignoring the value of the story, which is odd because Thaler claims stories are his thing.
https://bradleyahansen.blogspot.com/2023/10/richard-thaler-and-behavioral-economics.html

As always, please read the whole post. I will quote parts that are relevant to this post throughout, but his blogpost is worth reading in its entirety.

“What are you optimizing for?” is a question I love asking on this blog, and Hansen asks this question and answers it – in the case of economists. Economists, he says, assume that people are trying to maximize their utility, and not their wealth.

I’ve added that emphasis towards the end, but I assure you that neither Hansen, nor Thaler, would object in the slightest. In fact, anybody who has taught introductory economics would likely nod approvingly upon seeing the emphasis, because this is a surprisingly widespread misapprehension – that economics is about wealth maximization.

No. No, it is not. Economics is the study of how to get the most out of life, and wealth is the means that allows us to get to our ends. What gives us utility is, for example, the eating of a plate of pani puri. And our wealth is what allows us to buy that plate of pani puri. If we choose to maximize the amount of wealth we possess by giving up on eating the pani puri, we would be missing the point.

Now, Thaler is of the opinion that Rosett was wrong to not sell the $200 bottle to the wine shop. And Hansen is of the opinion that Thaler is wrong. I’m about to tell you my opinion in the next paragraph, so hang on.

So, my opinion. My opinion is that what Hansen is really saying is that Thaler is attacking a strawman.

How so? Let’s go through this step by step:

We have with us a bottle of wine that was purchased for $20. This has risen in value since our purchase, and can now be sold in the market for $200. Or we could drink it. What should we do?
An economist, Richard Thaler says, should sell it. Because buy for 20, sell for 200. Duh.
Hansen, on the other hand, says no, an economist shouldn’t necessarily sell it. Why not?
Because what a cool story to tell your guests while you serve them the wine! “I got this bottle for only $20, and the going rate for it is now $200. Drink up, people, and cheers!”
So the $180 dollars that you could have earned by selling the bottle of wine – is it worth more than the pleasure that you get from telling the story? From being thought of as a connoisseur of wine? From being seen as a Really Cool Guy? If yes, then sell. If not, well, don’t.
Effectively, Hansen is saying that the utility function ought to include the pleasure of being able to tell the story about the wine.
And, if you ask me, also ought to include the pleasure one gets from drinking the wine.
Taking all of this into account, Hansen says, you would be irrational to sell the wine.

Does Richard Thaler not know this? Of course he does.

He (Richard Thaler) is saying that conventional economics has forgotten this stuff. Hansen is saying that they have not.

So who is right?

Well, the other thing that I like to say on my blog is that the truth lies somewhere in the middle. And in this case, I would say that both are kind of correct. But (sorry, Professor Hansen!) I do think that Richard Thaler has a bit more going for his side of the debate.

And the reason I say that is because as a teacher, I am firmly of the opinion that we teachers send far too many students out into the real world with the impression that economics is only about prices, income and expenditure, and not about “charity and love for children, spouses, relatives or anyone else“.

That is from pp 98 (Chapter 7, Utility Maximization) of Hal Varian’s graduate level textbook (Microeconomics Analysis). In English, it is saying that the problem of preference maximization is solved by maximizing utility through the consumption of x, while making sure that the money you spend on buying x (the price, p, multiplied by the number of units purchased of x) is lesser than your income, m. It is saying a bit more than that too, but this is EconForEverybody, and so I’m going to keep things simple.

Well, as simple as is possible, granted.

And it gets worse! On the second page of his chapter, this is what Hal Varian has to say about utility functions:

“A utility function is often a very convenient way to describe preferences, but it should not be given any psychological interpretation.”

Yes, I’ve added the emphasis, it is not there in the original. And in this case, one’s approval about the emphasis being added is likely to be a function of whether you think Thaler is right or wrong.

We can debate (and I would love to!) what Hal Varian meant when he wrote that, and whether there remains room to add in the pleasure of telling the story about the wine bottle, given his definition of the utility function.

But this is my charge: the impression that a student is going to be left with, if said student chooses to tackle this book, is that there’s no room for any story telling pleasure in the framing of the utility function. In fact, I happily admit to having just that impression when I did battle with this book back in 2006.

Again, sure my impression may have been (partially or wholly) incorrect. And sure there may be different ways to interpret that statement from that textbook.

But when Hansen says that “part of the problem with the wine story comes from not appreciating the many ways in which people can get satisfaction (utility)”… well, I’d argue that the diagnosis is spot on.

And the underlying cause? The textbooks we use to teach microeconomics don’t teach how to think about utility deeply enough. And we teachers (myself included) don’t emphasize this point often enough.

Hansen ends his blog by saying the following:

I’m not saying there is no value in behavioral economics, but far too much attention is given to these little stories that supposedly contradict economic theory when in fact they do no such thing.
https://bradleyahansen.blogspot.com/2023/10/richard-thaler-and-behavioral-economics.html

Me, I’d say that far too little attention is given to those little mathematical versions of utility functions that supposedly help students understand economic theory, when in fact they do no such thing.

What say?

On Anomalies

Yesterday, I had written this:

“Trivia question for econ nerds: what long running series in an academic journal are you reminded of when you read this [Anomalies and Thomas Kuhn]? I’ll answer the question in tomorrow’s post.”

“Sometime after returning to Ithaca from my year in Vancouver, I was at a conference sitting next to the economist Hal Varian, then a well-known theorist who later went on to become the chief economist at Google. Hal was telling me about a new journal that the American Economic Association was starting called the Journal of Economic Perspectives. Hal was an advisory editor. The editorial board was thinking about commissioning regular features for the journal. The clever Barry Nalebuff would write one on economics-based brainteasers and puzzles. Hal and I came up with an idea for a feature that I might write on anomalies.”

That is from Section V of Thaler’s autobiography (an intellectual autobiography, in the sense that it is a book about his career), and the chapter itself is titled (what else) “Anomalies”.

The Anomalies “column” first appeared in the Summer issue of the Journal of Economic Perspectives – Volume 1, Number 1. This was in 1987, and if memory serves me right, it ran for the next three to four years at least.

This feature will report successful searches for disconfirming evidence — economic anomalies. As suggested by Thomas Kuhn, an economic anomaly is a result inconsistent with the present economics paradigm. Economics is distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear. An empirical result is anomalous if it is difficult to “rationalize,” or if implausible assumptions are necessary to explain it within the paradigm. The first anomaly we will discuss is the “January effect.” Stock prices tend to rise in January, particularly the prices of small firms and firms whose stock price has declined substantially over the past few years. Also, risky stocks earn most of their risk premiums in January.
https://www.aeaweb.org/articles?id=10.1257/jep.1.1.197

I’m happy to report that the Journal of Economic Perspectives is freely available online. You can (and if you are a student of economics, you absolutely should) read all of the issues. But the Anomalies column is that rarest of rare things – a fun column that makes you think about fascinating problems and anomalies in economics. And even rarer still is the fact that a “fun” column was at least partially responsible for a Nobel Prize in economics!

Thaler’s vision for incorporating insights from psychology into economics was first laid out in his 1980 article “Toward a positive theory of consumer choice.” In his well-known “Anomalies” series in the Journal of Economic Perspectives, as well as in many other articles, comments, and books, he continued to document and analyze how economic decisions are influenced by three aspects of human psychology: cognitive limitations (or bounded rationality), self-control problems, and social preferences.
https://www.nobelprize.org/uploads/2018/06/advanced-economicsciences2017-1.pdf

There’s a lotto like about Richard Thaler’s work in economics, but one very important reason to learn more about him and his ideas is that he has fun doing what he does, and it shows. A lot of economic research, even when it is fascinating, is written in dull, stodgy fashion. Now, you can disagree with Thaler’s work (and that is a cottage industry in and of itself), but you can’t accuse him of being a boring writer.

And a wonderful place to begin is with that most anomalous of things: a fun column about economics in a top econ journal.

Enjoy!

Read, Listen, and Observe. Then Write.

I don’t know how I missed reading this paper earlier, but a conversation this past week helped me land up on a lovely little paper written by Hal Varian, called How to Build an Economic Model in Your Spare Time. The paper was written in 1997, but was published again in the AER in 2016, and the editor’s introduction is worth reading, excerpted below:

Originally published in Volume 41, Number 2, Fall 1997, pages 3-10. Hal Varian (born 1947) is widely known by professional economists for his pathbreaking work in the economics of information and networks. Many more know him as the author of two bestselling microeconomics textbooks, one written for undergraduate college students and one designed for advanced graduate students. Through his research and his books, Professor Varian’s ideas have influenced a generation of economists. In this paper, Professor Varian outlines how he approaches the task of building an economic model to explain an observed phenomena or solve a problem. His words are encouraging advice for graduate students and young economists learning how to “practice the art” of economics. Professor Varian offers a number of tips ranging from how to choose a topic, when to read the literature, and even to how to effectively manage your bibliographic citations. Professor Varian’s advice has passed the market test as this paper remains one of the most referenced and downloaded papers in The American Economist’s backfile. However, after including the paper on a course reading list several years ago, one doctoral student pointed out to this editor that Professor Varian fails to explain how to find the “spare time” that he references in the title!
Varian, H. R. (2016). How to build an economic model in your spare time. The American Economist, 61(1), 81-90.

It is a very short paper, and the faint hurrahs that you might hear in your neighborhood come from tortured souls who will no doubt be relieved to hear that there isn’t a single equation in this paper. Tortured souls (myself included), in this context, are those who have had to plod through Hal Varian’s graduate text. He mentions this text in the paper, and his undergraduate text (which is a lot more fun to read). In fact, his ruminations about how that undergrad book came to be form one of the most important takeaways from this paper for me.

But my favorite bit from the paper is about “where to get ideas from” in order to write a paper. Hal Varian says that one shouldn’t look to academic journals as a source (and I agree), but look at pretty much the world itself:

My suggestion is rather different: I think that you should look for your ideas outside the academic journals- in newspapers, in magazines, in conversations, and in TV and radio programs. When you read the newspaper, look for articles about economics. . . and then look at the ones that aren’t about economics, because lots of the time they end up being about economics too.
Magazines are usually better than newspapers because they go into issues in more depth. On the other hand, a shallower analysis may be more stimulating: there’s nothing like a fallacious argument to stimulate research.
Varian, H. R. (2016). How to build an economic model in your spare time. The American Economist, 61(1), 81-90.

This was written in 1997, remember – that explains the now-quaint advice about magazines. There’s also a reference to a JEL CD later on in the paper, for those of you interested in ancient history. But if you are a student wondering “what to write about”, this is excellent advice. Look at the world, and write about what puzzles you about it. Forget papers, entire books can come out of this (very fun) exercise.

And if you’re looking for a concrete example, the unbelievably prolific Matt Levine obliged us in a recent podcast with Longform, where he spoke about how he came to write about the aluminum “scam”. What is the aluminum scam, you ask?

During the summer of 2011, officials at the London Metal Exchange got an unexpected complaint from The Coca-Cola Company. The amount of physical aluminum in storage was piling up, said a representative of the soda maker, and, along with it, so was the expense of buying the metal for beverage containers.
The culprit, as Coke saw it, wasn’t simple supply and demand—in fact, there was plenty of aluminum sitting in warehouses. It was the shrewd tactics of Goldman Sachs, the bank that owned a network of metal-storage facilities in the Detroit vicinity, where waiting times for extracting aluminum were longer than ever. Every day those metal bars sat idle, Goldman’s warehouse company effectively drove up the premium amount that aluminum producers could charge for delivering supplies to beverage-packaging factories, a cost that amplified the expense of the actual metal and, thus, the prices Coke and others paid for soda cans.
https://www.cnbc.com/2014/06/03/how-aluminum-became-a-cash-cow-for-goldman.html

If you want to find out whether it actually was a scam or not, you might want to read Levine’s column on it, which you can find here. TL;DR? Hanlon’s Razor. But the point is that if you’re looking to write an academic paper (or a Bloomberg column) on commodities, the place to look is the mainstream media, not obscure journals on commodities trading.

Learn the art of asking “but why?” when you read mainstream media, and if you do it long enough, you’ll realize that you’ve become an economist, like it or not.

My thanks to Pranav R Satyanath for recommending this paper to me.

Understanding Google

Out of all the tech companies that I have written about so far, Google is far and away my favorite, and one that I always have wanted to work at (at some margin, I still do).

It’s just – and this is a personal thing, may not work for everybody – cool.

The only reason I say this at the outset is to make sure that you’re aware of my biases!

Here we go:

I often ask this question in classes I teach in microeconomics, or introductory economics:

“What is Google’s business?”

The default answer is almost always “search”. At which point of time, I have a follow-up question: identify for me one person who has paid Google to run a search.

In fact, if anything, Google seems to go out of its way to keep Google search free. And if running a search is not to be paid for, it can’t be much of a business, right?

So what is Google’s business?

But suppose we say that Google is primarily an advertising company. That changes things. The U.S. search engine advertising market is $17 billion annually. Online advertising is $37 billion annually. The entire US advertising market is $150 billion. And global advertising is a $495 billion market. So even if Google completely monopolized US search engine advertising, it would just own 3.4% of the global advertising market. From this angle, Google looks like a small player in a competitive world.

What if we frame Google as a multifaceted technology company instead? This seems reasonable enough; in addition to its search engine, Google makes dozens of other software products, not to mention robotic cars, Android phones, and wearable computers. But 95% of Google’s revenue comes from search advertising; its other products generated just $2.35 billion in 2012, and its consumer tech products are a mere fraction of that.

That’s Peter Thiel, in From Zero to One. The context in which he wrote this apart, what matters is the fact that he’s absolutely right about the fact that Google earns a vast amount of its revenue from advertising, not running searches.

But what are advertisers paying money to Google for? To provide digital real estate, in which ads can be shown, and the impact of these ads can be measured better than ever before in history. And advertisers are willing to pay because Google understands its users better than anybody else. Why does Google understand its users better than anybody else?

Because we have some combination of the following as part and parcel of our daily lives

But here’s the thing: we don’t pay for any of these. By that logic, we aren’t Google’s customers. But advertisers are Google’s customers and that makes us Google’s… products.

So here is the kicker. Android, as well as Chrome and Chrome OS for that matter, are not “products” in the classic business sense. They have no plan to become their own “economic castles.” Rather they are very expensive and very aggressive “moats,” funded by the height and magnitude of Google’s castle. Google’s aim is defensive not offensive. They are not trying to make a profit on Android or Chrome. They want to take any layer that lives between themselves and the consumer and make it free (or even less than free). Because these layers are basically software products with no variable costs, this is a very viable defensive strategy. In essence, they are not just building a moat; Google is also scorching the earth for 250 miles around the outside of the castle to ensure no one can approach it. And best I can tell, they are doing a damn good job of it.

That was Bill Gurley, in 2011, on his own blog.

All those products that I listed above? They weren’t build to generate revenue for Google (although that may be changing now), they were built to make sure that Google continued to attract, and track, eyeballs.

That allowed Google to continue to sell advertisements, which is where it makes the bulk of its money from. And they’ve refined the signal-to-ads cycle, as Ben Thompson calls it, better than anybody else:

Google dominates every aspect of this cycle, and every announcement at IO accrued to it:

On the signal side:

Their mobile apps are both the best, and the most popular, and they work best with a Google+ account

Their browser is the best, and the most popular, and it works best with a Google+ account

Their maps are the best, and the most popular, and they work best with a Google+ account

Their video website (YouTube) is the best, and the most popular, and it works best with a Google+ account

Their mail service (GMail) is the best, and the most popular, and is a Google+ account

And they simply own online advertising, with the best, and most popular, search ads, 3rd-party ads, and display ads.

But for the longest time, Google was a hammer in search of a nail.

Google was by far and away the best search engine in the late 1990’s – it wasn’t even close. But – and it was a big, painful “but” – how to make money? Enter economics, Google style:

Googlenomics actually comes in two flavors: macro and micro. The macroeconomic side involves some of the company’s seemingly altruistic behavior, which often baffles observers. Why does Google give away products like its browser, its apps, and the Android operating system for mobile phones? Anything that increases Internet use ultimately enriches Google, Varian says. And since using the Web without using Google is like dining at In-N-Out without ordering a hamburger, more eyeballs on the Web lead inexorably to more ad sales for Google.

The microeconomics of Google is more complicated. Selling ads doesn’t generate only profits; it also generates torrents of data about users’ tastes and habits, data that Google then sifts and processes in order to predict future consumer behavior, find ways to improve its products, and sell more ads. This is the heart and soul of Googlenomics. It’s a system of constant self-analysis: a data-fueled feedback loop that defines not only Google’s future but the future of anyone who does business online.

And so Google has become a company that has changed how to think about business in tech: give away cool products for (nearly) free, in exchange for your information, that is then sold on to advertisers.

A useful way to think about Google is that you are Google’s product, not its customer. Think of it this way: if you aren’t paying for something, how can you possibly be a customer?

Facebook and Google both have the same model: ad-driven.

There are many, many things to unpack as a consequence of thinking about this business model, and we’ll get to all of these things in the weeks to come.

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