Tag: microeconomics

In Which AI and I help explain Philipp Strack’s Work

First of all, congratulations to Philpp Strack!

And for those of you wondering about what the J.B. Clark medal is all about, here is the background:

The John Bates Clark Medal is awarded by the American Economic Association to “that American economist under the age of forty who is adjudged to have made a significant contribution to economic thought and knowledge.” The award is named after the American economist John Bates Clark (1847–1938).

According to The Chronicle of Higher Education, it “is widely regarded as one of the field’s most prestigious awards… second only to the Nobel Memorial Prize in Economic Sciences.” Many of the recipients went on to receive the Nobel Prizes in their later careers, including the inaugural recipient Paul Samuelson. The award was made biennially until 2007, but from 2009 is now awarded every year because of the growth of the field. Although the Clark medal is billed as a prize for American economists, it is sufficient that the candidates work in the US at the time of the award; US nationality is not necessary to be considered

https://en.wikipedia.org/wiki/John_Bates_Clark_Medal

Now let’s say that you, as an enthusiastic student of economics, land up on the AEA page about the announcement. But less than halfway through the page, you begin to feel a familiar sensation. I pride myself on being able to express my thoughts reasonably well in English, but when you encounter a passage like this:

Strack’s rich extension of the canonical drift-diffusion model (with Fudenberg and Strzalecki, American Economic Review 2018) establishes a new benchmark in economics, psychology, and neuroscience for exploring the timing of choices. The extension incorporates uncertainty about payoffs and accounts for the selection of observed outcomes. This deeper exploration also gives rise to new statistical tests of the drift-diffusion model (with Fudenberg, Newey, and Strzalecki, Proceedings of the National Academy of Sciences 2020). These, and his other contributions, have gone far in building bridges between theory and behavioral economics as well as between theory and empirical work.

https://www.aeaweb.org/about-aea/honors-awards/bates-clark/philipp-strack

… there is only one appropriate response:

Source (I hate WordPress. This was supposed to be a GIF.)

You could ask your prof in college to talk about it, you might ask your friends, you could ask your seniors. But if you are an undergraduate (or postgraduate, for that matter) student of economics – or even a person genuinely curious about economics in general – whatay time to be alive:

Hi. Philipp Strack has won the Clark medal in economics for 2024. I am going to share with you a PDF file of the announcement, which also contains some background of his more important work.

I am an undergraduate student of economics in India, and have some familiarity with microeconomic theory. I am familiar with Hal Varian’s “Intermediate Microeconomics”, but not all of the chapters – I’m familiar with the chapters concerning producer theory, consumer theory, exchange, information asymmetry, game theory and a little bit about risk and decision making. I have had an introductory lecture in behavioral economics, and know about the field, but not in a lot of detail.

I would like you to act as a person steeped in the history of microeconomics – how it has developed over time, and what important theoretical advancements have helped develop the field. I would also like you to act as a person who is well versed in simplifying advanced microeconomic concepts for beginners like me. You like using analogies, and you like explaining using relatable metaphors. As a person who is an expert in simplifying concepts so that students can understand them, you like taking a concept, simplifying it, and showing how it relates to (and adds to) what a student already knows. You like asking a couple of questions to make sure that your explanation has been understood, and you ask if it is ok for you to proceed to the next explanation. You always explain only one concept from the PDF at a time, and you begin with the one that is easiest to “get”, and progressively move towards concepts with a higher level of conceptual difficulty. Your style is conversational, somewhat informal, always upbeat, but without sacrificing technical accuracy and comprehensiveness. Please go over the PDF, and begin explaining the first concept that you deem appropriate. Engage me in a conversation about it, ascertain how much I know about the topic, and structure your explanation accordingly. Once you think I have understood a concept well enough, given your explanation and follow-on questions, ask if it is ok to proceed to explaining the next concept in the PDF. At the end of our conversation, I should have not just an appreciation of Philipp Strack’s work, but also an understanding of how his research has advanced the field of microeconomics. If you can recommend further reading for us to converse about, that will be great (papers, blogs, textbooks, essays, anything is fine). Please begin.

Try that prompt on for size in any AI of your choice (but please, pretty please, try and get access to one of the paid ones), and see where the conversation takes you.

Here is Claude with an explanation of the canonical drift-diffusion model, and how Strack’s contributions matter in this area of research:

Absolutely! Let’s break this down into more accessible terms.

Imagine you’re at an ice cream shop, trying to decide between two flavors: chocolate and vanilla. A basic economic model might assume that you’ll quickly choose the flavor that you prefer. But in reality, the decision process is often more complex.

The drift-diffusion model is a way of describing how people make decisions over time. Think of it like a mental tug-of-war. Each flavor has a certain appeal or “value” in your mind. As you consider your options, you accumulate evidence in favor of each choice, like weights on a balance scale. This process of gathering evidence is the “drift.”

However, this accumulation of evidence isn’t perfect. There’s some randomness or “diffusion” involved. Maybe you recall a fond childhood memory of vanilla ice cream, tilting the scale in that direction. Then you notice the rich aroma of the chocolate, pulling you back the other way.

Eventually, the evidence in favor of one option reaches a threshold, and you make your choice. The key point is that this decision isn’t instantaneous – it unfolds over time, and the timing of the choice can reveal important insights about your preferences and decision process.

What Strack and his colleagues did was extend this basic drift-diffusion model in some important ways. First, they incorporated uncertainty about payoffs. In our ice cream example, this could mean you’re not entirely sure how much you’ll enjoy each flavor. Maybe the chocolate looks appealing, but you’re worried it might be too rich.

They also accounted for the fact that we typically only observe the final choices people make, not the full process leading up to those choices. This is like seeing which ice cream you ultimately chose, but not knowing about your mental tug-of-war between chocolate and vanilla.

By building these realistic elements into the model, Strack and his team created a more powerful tool for understanding decision-making. They also developed new statistical tests that researchers can use to check whether real-world data fits the predictions of the drift-diffusion model.

The importance of this work is that it helps connect abstract economic theories to the nitty-gritty details of how humans actually think and choose. It’s a bridge between the idealized world of economic models and the messy reality of human psychology.

Does this help clarify what the passage is saying? Let me know if you have any other questions! And when you’re ready, we can dive into the next concept.

  1. AI isn’t a homework completion tool. I mean it is, but it’s like asking Marvin to open doors (high fives if you got that reference, and go read H2G2 if you didn’t).
  2. AI isn’t a teacher replacement tool (not yet, anyway), but it is already better than the teacher at personalizing explanations just for you, and in using examples that will resonate with you.
  3. “Explain this PDF to me” is a criminally short prompt. I’m not saying the prompt I designed is a perfect one, but make your prompts detailed. Give background about who you are, and what “role” you would like AI to play. Give context, outline your expectations, set the tone, share what levels of detail you are expecting, and continue to do so throughout your conversation.
  4. If you are a student with access to AI, there is no excuse for not learning well.
  5. If you are a student in a college or university right now, you have the opportunity to learn in ways that all of humanity up until this point never did, and it’s not friggin’ close.
  6. I cannot begin to tell you how much I envy you.

A Movie Review, A Question, and A Definition of Rationality

First, the movie review:

“Yeh buzdilon ki soch hai. Sach bolne waale ko agar dukh sahne ki himmat hai, toh dukh dene ki bhi himmat honi chahiye. Sachaai angaarey ki tarah hai – haath par rakho aur haath na jale, yeh kaise ho sakta hai?” (“Only cowards think like this. If the truth-teller has the courage to suffer pain, he must also have the courage to give pain to others. Truth is like a piece of burning coal on your hand.”)

Mukherjee’s film lets us see – not through didactic monologues but through the natural, graceful unfolding of its narrative – that such thoughts may be very noble in theory, but that they can be damaging and self-defeating in certain situations. This makes Satyakam a difficult film to watch, as it draws the viewer into a quicksand of uncertainty and despair. (I can sympathise with the boy who fell asleep in the hall next to Ranjit Kapoor, especially if he’d already had a long hard day!) Throughout, there are counterpoints to Satyapriya’s unalloyed idealism, as the film repeatedly places him – and us – in morally hazy situations.

https://jaiarjun.blogspot.com/2011/04/mat-jaane-bhi-do-yaar-idealism-and-self.html

Second, the question.

The question comes from an excellent article that appeared recently in the 1843 magazine. The article is about RCT’s in general, and their development over time, but it is also about the place where RCT’s started and have continued to mushroom: Kenya. The context that you need to have for the question I am about to ask you is this excerpt:

Their [fieldworkers in RCT’s that is – Ashish] work is gruelling and often emotionally draining. They are paid a salary of $10-20 per day – not a fortune in Kenya. Field workers have been known to give their own money to recipients so that they can afford food, which can distort the outcome of a study. “When they got to the end of the month, they would just fabricate [the] data,” said Kingori, the sociologist. “The fact that these trials are designed in this way is setting them up to fail in real life. They are constantly being subverted by these field workers.” She told me of a case from a medical RCT in which a child died in one recipient family. A field worker agreed to substitute the family’s other child in the study, so that the household could continue to receive the treatment. Field workers told me that they’d heard stories of their peers filling in respondent surveys themselves, in order to hit their daily quotas. Many of these stories date from the early days of RCTs. Recently, IPA and similar organisations have improved their training and fraud detection. GiveDirectly told me that “data fraud and monetary fraud are…punished through contract termination.”

https://www.economist.com/1843/2024/03/01/how-poor-kenyans-became-economists-guinea-pigs

You are a fieldworker hired to do work for an RCT. You are not running the RCT, you are being paid to collect the data and submit it to the researchers. A family that is a part of this study loses a child. They beg you to not report this to the researchers, because then the family would no longer be a part of the RCT, and therefore would no longer be eligible to receive aid (receive treatment, in RCT lingo). Let’s say you choose to agree to their request. The RCT is screwed, but hey, at least the family will continue to receive help during a time of unimaginable distress.

Here’s my question: did you act rationally, or not?

Here’s a follow-up question for those of you who have formally studied microeconomics: according to the fundamental axioms of microeconomic theory, did you act rationally or not?

Third, the definition of rationality, as per microeconomics.

This definition is via Gemini (Google’ current name for it’s AI, although that may change by the time you read this, who knows):

“Here’s a breakdown of rationality as defined within the context of classical microeconomic theory:

Core Axioms of Rationality in Microeconomic Theory

Completeness: Individuals have well-defined preferences. When presented with any two options (bundles of goods, outcomes, etc.), they can express:

Preference for one over the other
Indifference between the two

Transitivity: If a consumer prefers A to B and B to C, then they must prefer A to C. This ensures consistency in preferences.

Utility Maximization: Individuals always strive to choose the option that gives them the highest level of utility (satisfaction, well-being). The concept of utility allows for comparison of different choices.

Self-Interest: Individuals are assumed to prioritize their own utility above that of others. This doesn’t necessarily imply selfishness, but rather that the individual’s well-being is their primary concern.

Implications of these Axioms

Predictability of Behavior: If we know an individual’s preferences and constraints (e.g., budget, availability of goods), and assume rationality, we can predict their choices.


Optimization: Rational individuals will allocate resources efficiently, always aiming to get the most value out of their choices given their constraints.


Responsiveness to Incentives: Changes in prices, income, or other constraints will lead rational individuals to adjust their behavior to maintain maximum utility.

Important Notes:

Narrow Definition: This definition of rationality is specific to microeconomic theory; it simplifies human behavior to make modeling and predictions easier.

Bounded Rationality: Real-life decision-making is impacted by imperfect information, limited cognitive capacity, and time pressure. The concept of bounded rationality acknowledges these limitations.


Ethics vs. Rationality: This rationality definition doesn’t address moral or ethical dimensions of choices. A “rational” choice could still be exploitative or harmful to others.”

Try taking stab at the question yourself. Then read what our new friends have to say about it. Here is Gemini’s considered opinion on the issue. Here is ChatGPT. Now that you’ve read their answers, see if you change yours!

Talk about it with your friends, with your professors, with your families.

And for homework, do watch Satyakaam. It is freely available on YouTube.

On Goodhart’s Overhang

Not, I should clarify right away, my own coinage. The term is due to Anthony Lee Zhang (@AnthonyLeeZhang on Twitter), and what a magnificent term it is.

We’re big fans of Goodhart’s Law in these parts, as you may have noticed. For the uninitiated, Goodhart’s Law says that once any measure becomes a target, it ceases to be a measure.

Say, for example, you want to show that the library in your college is being effectively used by all of the faculty members. That is, you want to show that faculty members visit the library regularly. Well, how about putting the attendance muster (it’s the 21st century, so let’s call it the fingerprint scanner) in the library? That way, we can “show” that all faculty members visit the library daily.

The measure (attendance) became the target, and so it has ceased to be a good measure, since it has been gamed. That’s Goodhart’s Law.

So what is Goodhart’s Overhang?

Anthony defines it as “sticking too long to old and familiar goal-metrics when the objective function has changed, and the metrics are no longer relevant”.

What should college students optimize for? Given the world they know in high school or junior college, students end up thinking that they should be optimizing for grades, when it is actually networking or preparing for interviews.

Goodhart’s overhang is twice as problematic as Goodhart’s Law in other words. Not only are you gaming a measure, which is bad enough, you’re not even gaming the relevant measure!

It’s not just students and grades, of course. Academicians churning out one meaningless paper after another, newly promoted managers working themselves too hard rather than delegating effectively, retail stores measuring success by counting the number of walk-ins might all be good examples of Goodhart’s Overhang.

One, what other examples can you think of in your line of work?

And two, your toolkit when it comes to Goodhart now consists of two questions, not just one:

  1. Are you gaming the measure you’re trying to optimize for?
  2. Is the measure still relevant in the first place?

Professor Harberger’s Midterm and Final Examinations (and ChatGPT)

A book that hardly anybody reads these days (but really should) is The Theory of Price, by George Stigler.

Take, for example, Stigler’s “A Note on Block Booking.” Block booking of movies was the offer of a fixed package of movies to an exhibitor; the exhibitor could not pick and choose among the movies in the package. The Supreme Court banned the practice on the grounds that the movie companies were compounding a monopoly by using the popularity of the winning movies to compel exhibitors to purchase the losers.
Stigler disagreed and presented a simple alternative argument. If Gone with the Wind is worth $10,000 to the exhibitor and Getting Gertie’s Garter is worth nothing, wrote Stigler, the distributor could get the whole $10,000 by selling Gone with the Wind. Throwing in a worthless movie would not cause the exhibitor to pay any more than $10,000. Therefore, reasoned Stigler, the Supreme Court’s explanation seemed wrong.
But why did block booking exist? Stigler’s explanation was that if exhibitors valued films differently from one another, the distributor could collect more by “bundling” the movies. Stigler gave an example in which exhibitor A is willing to pay $8,000 for movie X and $2,500 for Y, and B is willing to pay $7,000 for X and $3,000 for Y. If the distributor charges a single price for each movie, his profit-maximizing price is $7,000 for X and $2,500 for Y. The distributor will then collect $9,500 each from A and B, for a total of $19,000. But with block booking the seller can charge $10,000 (A and B each value the two movies combined at $10,000 or more) for the bundle and make $20,000. Stigler then went on to suggest some empirical tests of his argument and actually did one, showing that customers’ relative tastes for movies, as measured by box office receipts, did differ from city to city.

https://www.econlib.org/library/Enc/bios/Stigler.html

If you want a more “modern” take, you could read this lovely essay, by Chris Dixon.

But to come back to Stigler, one reason to read his book is because “a typical Stigler article laid out a new proposition with clear reasoning and then presented simple but persuasive data to back up his argument”. Which, if you ask me, is a better way to teach microeconomics than via real analysis.

If you aren’t yet subscribed to Irwin Collier’s blog, please do so. His blog is a delightful treasure trove of question papers from the past, and some of these papers really and truly make you think. Here, for example is just one question from November 5, 1957. This particular question paper was set by Professor Harberger (and the examination took place a year before Stigler joined the University of Chicago), but nonetheless, it is a great way to check how well you know price theory microeconomics.

The price elasticity of demand for a good will be higher, the higher is the income elasticity of demand for that good.

For a question like this (and before you run it through ChatGPT), think about whether the statement makes intuitive sense. If the income elasticity of demand for a good is high, that means that small changes in income will lead to large changes in demand for that good. Eating out at expensive restaurants will go down if you lose your job, for example.

Well, then, yes, you might think – the price elasticity also ought to be high then, no?

So it would seem that this is true then.

Ah, but is it? Do you know of folks who buy the latest iPhone regardless of how much (and whether) they earn? Can you, in other words, think of a single counter-example to your own argument? Does your answer change? If yes, why? If not, why not?

(My own take is that this is false, by the way. Do you agree?)

Now that you have thought a little about this yourself, ask ChatGPT what it thinks (or Bard, etc.). See if your answers match. If they don’t, have a conversation with it. Tell it why you thought your answer was whatever it was, and ask it to critique your answer.

Rinse and repeat for all the other questions in the examination, and I envy you your journey of learning price theory. Oh, and by the way, if you don’t like your current (ahem) price theory Prof, feel free to call upon the knowledge and abilities of Professor Stigler himself:

“What book should I read to learn economics?”

“The Internet, and ChatGPT!”

Assignment No. 1 (and No. 3)

Vidya Mahambare has a fun assignment for her students, and I fully intend to copy it this upcoming semester.

Roughly one-third into her microeconomics course at the Great Lakes Institute in Chennai, she asks her students to go take selfies. Not just any old selfie, note. She asks her students to go out into the world, and take a photograph of something that reminds them of a topic they’ve learnt in class.

Maybe a photograph of a coffee seller right outside college. Maybe differential rates of admissions at a tourist site ( x rupees for Indians, 10x for foreigners). Maybe a rickshaw driver whose rickshaw doesn’t have an operational meter. Each of these selfies should have something in the background that is related to a topic they’ve learnt in class.

And, of course, they’re supposed to write a little bit about it. The student who selected the coffee seller outside college might hypothesize that the seller is a monopolist, for example. The differential rates of admission could be price discrimination at work. And maybe the rickshaw driver with the non-existent meter is an example of information asymmetry.

Don’t worry just yet about whether these are good examples of the topic being discussed. This assignment is more about learning to see the world as an economist – or least, that’s how I understand it. Now that you’ve learnt how to think like a microeconomist, are you able to relate what you’ve learnt to the world around you? Show me!

And then, at the end of the semester, the assignment is repeated. Repeated doesn’t mean that students go out and take another selfie. It simply means that they get to look at the same photograph, but now with the benefit of a better knowledge of microeconomics.

Now that you know more about microeconomics, how does your understanding of (and therefore description of) that photograph change? Is the coffee seller really a monopolist? Is the permanently broken meter really an example of information asymmetry? Whatever your answer now, why has it changed? Or why has it not changed?

This is the first slide of my presentation with which I begin my principles of economics class, and you can see why I like Vidya’s idea so much. I give my students a similar assignment, and recently wrote one up myself. I look forward to writing one again this year, complete with a selfie.

I do have one question for you, and I haven’t asked Vidya this yet.

What is your best guess for making it a selfie with the topic in the background, and not just a photo of the topic itself?

Microeconomics and Credit Card Reward Points

A lovely little article in the New York Times is worth a ponder, especially if you are a student of microeconomics:

There’s an undeniable feeling of excitement when you turn your daily credit card swipes at Starbucks into first-class airfare or a weekend jaunt to Costa Rica. Thanks to mobile banking and the ease of autopay, you can scrupulously avoid any additional costs by paying your monthly bill in full. Free flights and exclusive discounts abound.
Something for nothing, right?
Not exactly nothing. Credit card perks for educated, usually urban professionals are being subsidized by people who have less. In other words, when you book a hotel room or enjoy entry to an airport lounge at no cost, poor consumers are ultimately footing the bill.

https://www.nytimes.com/2023/03/04/opinion/credit-card-rewards-points-poor-interchange-fees.html

As you probably already know, one can “earn” reward points for spends on your credit card. You can then use these points to buy stuff, or earn cashbacks on these points, or spend them at partner stores. And there are other perks and benefits too. If you’ve travelled through an Indian airport, you might have seen the crowd waiting to get into an airport lounge – more often than not, access is tied to the kind of credit card you have in your wallet.

But remember, there is no such thing as a free lunch. You may not be paying for these perks as a credit card holder, but one of the first lessons of economics is that somebody, somewhere, is paying for it. So who is paying, in this case? As the last sentence in the excerpt makes clear, according to the article, that someone is the group of poor consumers.

Some background, based partially on the article in question, and partially on my own understanding of this space:

  1. Richer consumers are likely to spend more, but tend to not revolve much, if at all. To this group of consumers, a credit card is a way to get a (up to) 45 day interest free loan, with the added bonus of these reward points to boot. Remember, incentives matter – and these reward points are the carrot that is offered to people in order to get them to sign up.
  2. Dangling these reward points as a carrot makes business sense, for that allows a credit card company to sign up folks who will spend more via these credit cards. Credit card companies make money when people “revolve” – that is, when they spend using their credit cards, but do not pay up the entirety of their credit card bill on time. How much money do these companies make? Here, take a look.
  3. So consumers who take a credit card, spend a lot on it, and pay back the entirety of their credit card bill – these kinds of customers are actually a loss-making proposition for the credit card company.
  4. Consumers who spend a fair bit, find themselves unable to repay the entirety on time, and end up paying over months (if not years) – these customers are where the credit card companies earn their bread and butter (and jam and peanut butter, while they’re at it).
  5. Consumers who borrow a lot using their credit cards, and default on these loans – these are the very worst type of consumers for credit card companies. Risk departments in such firms exist to predict which consumers should be denied access to credit cards, and which of the existing customers are likely to default on their credit card loans.
  6. But broadly speaking, the NY Times article says that it is pt. 4 consumers (and pt. 5 consumers) who end up paying for the freebies that pt. 3 consumers enjoy. (but also see below, after this section)
  7. In addition, another way to make money for these credit card companies is to charge higher credit card processing charges to all consumers. This fee changes from country to country, but as a thumb-rule, assume it to be around 1-2% of each transaction. That’s not an exact estimate, but good enough for us over here. Rewards to specific folks, to be offset by diffusing the costs of offering these rewards across a much wider group, in other words. And note that merchants (who are charged these fees) will usually pass these fees on to the consumers. See here, for example.
  8. A 1-2% increase in price may not be the end of the world if your income is high enough – it is an inconvenience, not a crisis. But for low income earners, already on a tight budget, this price increase across all transactions can bite a fair bit.
  9. An out and out free market economist might say that this is fine, the market will work itself out. That is, if this 1-2% charge is an act of rent collection, new entrants in such a market will end up charging lower to no fees, and incumbents will be forced to respond by lowering their own fees. That’s econ 101, but life is more complicated than that.
  10. And that is a good first-pass answer, but as many people will tell you, markets don’t always work as designed or intended. Incumbents will go out of their way to prevent new entrants (through lobbying, through pricing, through R&D, and through a dozen different ways), which is why regulation is important.
  11. But will regulators do what they’re supposed to? What are their incentives? How can we make sure that regulation will be balanced between the interests of the incumbents, the new entrants, the potential entrants, and the customers? Hello, industrial organization, and hello, public choice.
  12. What is the role for government in all of this? In terms of participation (think UPI, for example, but note that this is a complicated story in its own right), in terms of regulation (both from a domestic and international financial markets perspective) and in terms of oversight?

All these points (and I hope you come up with more) are worth thinking about as a student. Remember, these points aren’t proven facts – they are a summary in part of the article an in part of my own reflections for having read the article. Discussions such as these are a great way to outline a research agenda – but that is when the job of a researcher begins. Can we convert these points into testable hypotheses? Can we get data to prove/disprove these hypotheses? Can that data then be used to reach a definitive conclusion? Can that conclusion be used to formulate policy, or start a business?

In terms of research about this topic, sample this from the conclusion of a paper on the topic: “While credit card rewards are often framed as a “reverse Robin Hood” mechanism in which the poor subsidize the rich, our results show that this explanation is at best incomplete.”

But also from the very last paragraph of the same paper:

We conclude by documenting that the costs and benefits of credit card rewards are unequally distributed across geographies in the United States. Credit card rewards transfer income from less to more educated, from poorer to richer, and from high- to low minority areas, thereby widening existing spatial disparities.

https://www.federalreserve.gov/econres/feds/files/2023007pap.pdf

And here’s the link to a directive from the RBI about the issuance of and conduct regarding credit and debit cards in India.

Homework: who (ultimately) pays for CRED from a distributional perspective? Whatever your answer, explain your reasoning, and either provide data to back up your arguments, or explain what kind of data you would need to research this question further.

Try discussing this question with your friends and your professors (including ChatGPT, and yes, you should be thinking of it as one of your professors) – it will be a great way to learn the nuances of microeconomics!

My thanks to Mihir Mahajan for suggesting this topic.

Commoditize Your Complements

I wrote about a post written by Joel Spolsky last year, and one of the many positive externalities positive spillovers of writing on this blog has been the fact that I’ve gotten to know about Joel and his writing. It is a positive treasure trove, and well worth dipping into.

But the reason I’m writing about him today is because I originally meant to write a post on a recent Ben Thompson post (AI and the Big Five). While going over that article and taking notes, I came across a reference to an old article written by Joel:

Once again: demand for a product increases when the price of its complements decreases. In general, a company’s strategic interest is going to be to get the price of their complements as low as possible. The lowest theoretically sustainable price would be the “commodity price” — the price that arises when you have a bunch of competitors offering indistinguishable goods. So, smart companies try to commoditize their products’ complements. If you can do this, demand for your product will increase and you will be able to charge more and make more.

https://www.joelonsoftware.com/2002/06/12/strategy-letter-v/

I found parts of the write-up mysterious, because I’m not familiar with both the firms and the products that have been spoken about in it. Partly a function of I not knowing enough about the tech world, and partly a function of the article itself being quite old (Transmeta, Ximian, Gnome are examples, of you are wondering).

But the core insight from the article? Both spot on, and an excellent example of a TMKK in a into class about micro.

What is the core insight? A simple, almost throwaway line in micro classes:

All other things constant, the demand for a product will go up when the price of the complement goes down

And we’ve all gone through examples of how “the demand for tea will go up when the price of sugar comes down”. But consider this instead:

When IBM designed the PC architecture, they used off-the-shelf parts instead of custom parts, and they carefully documented the interfaces between the parts in the (revolutionary) IBM-PC Technical Reference Manual. Why? So that other manufacturers could join the party. As long as you match the interface, you can be used in PCs. IBM’s goal was to commoditize the add-in market, which is a complement of the PC market, and they did this quite successfully. Within a short time scrillions of companies sprung up offering memory cards, hard drives, graphics cards, printers, etc. Cheap add-ins meant more demand for PCs.

https://www.joelonsoftware.com/2002/06/12/strategy-letter-v/

Why did this matter to Microsoft? That is, why would they want to ensure cheap add-ins (complements) for PC’s, so that the demand for PC’s (the product) go up? They didn’t actually manufacture the PC’s back then, so how were they profiting?

Microsoft’s goal was to commoditize the PC market. Very soon the PC itself was basically a commodity, with ever decreasing prices, consistently increasing power, and fierce margins that make it extremely hard to make a profit. The low prices, of course, increase demand. Increased demand for PCs meant increased demand for their complement, MS-DOS. All else being equal, the greater the demand for a product, the more money it makes for you. And that’s why Bill Gates can buy Sweden and you can’t.

https://www.joelonsoftware.com/2002/06/12/strategy-letter-v/

As always, do read the rest of Joel’s write-up, please.

Homework:

  1. What examples can you think of where this lesson has been applied in a modern context? Software or otherwise.
  2. How can those of us in the education sector think about the applicability of this lesson?
  3. Industrial organization remains an underrated subject. Discuss.

What Am I Optimizing For on EFE in 2023?

Six principles, three big picture questions, and three bonus questions.

Anybody who’s attended a principles class taught by me knows what is coming next. It is my deeply rooted conviction that almost every single problem/concept/idea in economics can become more relatable by simplifying it down to one out of these twelve things: six principles, three big picture questions and three bonus questions. If you get the hang of these twelve things, you can go a very long way in terms of both understanding what economics is about, and how economics can be used to make the world around you a slightly better place.

And while mastery over these twelve things will likely take a lifetime – and almost definitely more than that – familiarity with them isn’t so difficult. And my aim is to write blogposts – in one way or another, and as much as possible – centered around one of these twelve things.

Not just blogposts, but we’ll leave that for aother day. For today’s blogpost, a simple list of what these twelve things are.

First, the six principles:

  1. Incentives matter
  2. TINSTAAFL – There is no such thing as a free lunch
  3. Costs matter
  4. Trade matters
  5. Prices matter
  6. Externalities matter

If I’m teaching a class in a semester at a college, I would dearly like to spend as much time as possible in speaking about just these six principles. Different teachers the world over may have a slightly different list, but I would be surprised if there were to be no overlap at all between two different lists. We may define concepts within these principles slightly differently, we may disagree on some of the underlying mechanisms, but here’s a nice way to think about my list. I am more than willing to listen to arguments about what I really should be adding to my list, but you’ll have to do a lot of convincing to make me remove an item from this list.

These six principles really do define economics for me. They can be expanded upon in multiple ways, a million derivatives can be constructed, there are endless tangents that can be drawn, and the nuances for each can be separate books in their own right. But at it’s heart, these six principles do most of the weight-lifting when it comes to economics.

Next, the three big picture questions:

  1. What does the world look like?
  2. Why does it look the way it does?
  3. What can we do to make the world a better place?

I don’t much like the artificial divide of the subject into “micro” and “macro” economics, but if you like, you can think of the six principles as a way to think about an introduction to microeconomics, while these three questions are a way to get started on thinking about macroeconomics. Depending upon how you want to go about answering the third question, there is yet a further division that is possible, between short term macroeconomic fluctuations and long term growth theory. But we’ll get to that in a bit.

But you can’t really begin analyzing macroeconomics without having a sense of what the world looks like today. Which countries in the world are doing well today, and how do you define “doing well”? Which countries in the world are not developing as rapidy as one would have hoped for? A comparative analysis of what the world looks like is where the study of macroeconomics should start.

At which point, the second question comes into its own. Why is Afghanistan doing so poorly when compared to its peers (howsoever defined), or when compared to its neighbours? Is it because Afghanistan is a landlocked country? Are all landlocked countries poor? If not, why not? Is it because of natural resources in Afghanistan? Is it because of geo-politics? Is it because of colonization? Does religion have a role to play? The list of questions is nowhere near complete, and this is just one nation. We can go on and on like this for all nations – and multiple careers have been spent on answering only parts of one question for just one nation.

And then we come to question number three, the most vexatious question of them all. Just two little words in that sentence, but what a world of (intellectual) pain they bring forth into the world.

“What can we do to make the world a better place?”

Who is we? What form of government works best to make one’s own country a better place? Is the answer to this question always the same regardless of the stage of development? Is your answer based on ideals and hope, or on empiricism? For which part(s) of the world and in which time period?

Does the word better mean the same thing to all people? Are we in a better world when everybody has access to a washing machine? Or are we in a better world when we don’t generate more carbon emissions? Can we have both? If yes, how?

These three questions define macroeconomics for me. Most of what we do in big picture economics (a term that I prefer to macroeconomics, for reasons I’ll get into in a later blogpost) can be thought of using this framework.

There are many good things that have happened as a consequence of blogging regularly here on EFE. But one of the best things to have happened is that I’ve been able to come up with three additional questions – questions that I find myself asking ad nauseam, both to myself and of other people:

  1. What are you optimizing for?
  2. Relative to what?
  3. Over what horizon?

That first question, strictly speaking, isn’t really a question economics can answer. What you are optimizing for is a question that requires deep introspection, and the answer likely comes from either other domains, or from a place that will perhaps forever lie beyond the fartherest probes of academia. But I will say this much – it is impossible to proceed further in economic analysis of any kind, without clarity about the answer to this question.

The second question here really is just another way of saying opportunity costs. But it is surprising to see how easy it is to forget that opportunity costs are real. This is particularly true in the case of public policy, but “relative to what” is a question that more people need to ask of themselves (myself included).

And finally, that most problematic of all questions: time. Just when you think you’re done with intellectual wrestling, trying to answer that third question can often bring you all the way back to square one. Is your answer to the first two questions the same over all time horizons?

I could have optimized for playing (judge me all you like) Subway Surfers instead of writing this post, because I was optimizing for relaxing myself. Or that, at any rate, is the story I tell myself when I give in to temptation. That choice is the best for me (if at all) only in the very short run. That is, over a very short horizon. So is playing yet another round of Subway Surfers really the best thing that I can do? Back, as I said, to square one.

India can optimize for (extending PMGKAY/ reviving the old pension scheme / pick whichever topic makes you the most uncomfortable), and ask yourself why what India is optimizing for. Ask what the opportunity costs of doing so will be. And finally ask if your answer (whatever it may be) remains the same if you ask what is best for India over the course of the next two years. What about two decades? What about two centuries? Which is the best timeframe to use to answer this question, and whatever your answer, what are you optimizing for? Back, as I said, to square one!

In one way, this is exactly what I have been doing in any case these past six years – writing blogs about these topics. A little bit of circular logic is involved here, of course. If I say that this framework:

six principles | three big picture questions | three bonus questions

can be used to think about any topic in economics, maybe I say I’ve been writing about this because I now think about those blogposts that I have written using this framework.

Be that as it may, writing here on EFE has convinced me that this framework can be used to think about all questions in economics, regardless of whether you have been formally trained in the subject or otherwise. And my attempt, this year, is going to be to think about as many questions as I can, explicitly using this framework. Of course I’ll benefit, but hey, as the sixth principle reminds us, externalities matter. You’ll benefit too!

Or is it the other way round?

Consoles, Competition and Comprehension

If you are studying microeconomics, whether in undergrad or postgrad courses, it can sometimes get a little too theoretical. Or that, at any rate, is how I used to feel about the more abstruse parts of advanced micro. And while memorizing the millionth derivation in order to regurgitate it in an examination, I would often wonder if there was any relevance of what I was attempting to study to the real world outside.

If you, today, as a student of micro share this opinion, let me ask you this: are you interested in video games? Are you living in fond hope that a PS5 will land up in your living room? Or are you figuring out ways to get XBox Pass?

If the answer to any of these questions is yes, I’m guessing that you like playing video games. Do you know how the industry started? Do you know what the Gang of Four was all about? Do you know how different business models in the industry originated? How they evolved and why, and with what consequences? Had you heard about the Great Video Game Crash of 1983? I knew a little bit (but not a lot) about the answers to all of these questions, save for the last.

But the reason I bring this up is because Ben Thompson has an exellent essay out on the evolution of the gaming industry, with a lovely recap of all of what happened, and why. You’ll learn about vertical and horizontal integration, lock-ins, attempts to create monopolies, attempts at preserving monopoloies, about how business models had to change to account for changing strategies, changing technologies and changing aspirations on part of creators, consumers and corporations. It’s head-spinning stuff!

It begins with a description of the world’s first video game (OXO, 1952, in case you were wondering) and ends with how the FTC (perhaps) doth take things too far with the Activision acquisition by Microsoft. And in the interim, it touches upon names that will evoke nostalgia among folks of a certain vintage, and curiosity among folks of a more recent vintage.

If you are a student struggling with micro but happen to love video games, this essay might motivate you to read more about the evolution of the video game industry, and understand micro better in the process.

If you are a teacher struggling with helping students fall in love with micro, consider reading and using this essay.

And a meta lesson: a great way to learn about microeconomics is to pick your industry of choice, and ask how it has evolved over time, and why. The answers to these questions is a great way to become a better student of economics.

If you’re looking for suggestions in this regard: music, television, movies, gaming, publishing, hospitality and sports (football, cricket and tennis would be great examples). And if I may offer one piece of contrarian and possibly heretical advice – begin with the industry and work your way to the textbook, rather than the other way around.

Microeconomics for all, by Paul Seabright

For the last half-century, the world’s leading universities have taught microeconomics through the lens of the Arrow-Debreu model of general competitive equilibrium. The model, formalizing a central insight of Adam Smith’s The Wealth of Nations, embodies the beauty, simplicity, and lack of realism of the two fundamental theorems of competitive equilibrium, in contrast to the messiness and complexity of modifications made by economists in an effort to capture better the way the world actually functions. In other words, while researchers attempt to grasp complex, real-world situations, students are pondering unrealistic hypotheticals.

https://www.project-syndicate.org/commentary/paul-seabright-criticizes-the-poverty-of-the-undergraduate-microeconomics-curriculum

Thus begins a short but hard hitting essay by Paul Seabright. Regular readers will know of him as the author of the magnificent “In The Company of Strangers“, but in today’s blogpost, we’re going to be speaking about the essay I just excerpted from. This essay was written back in 2013, but if anything, it rings even more true today.

Because what we teach in microeconomics has very little to do with reality, and that’s just the truth.

A typical course in micro will work its way through consumer theory, producer theory, markets, and then throw in a sprinkling of topics to round off an introductory course: a bit about externalities, a bit about asymmetry of information (and related topics) and maybe touch upon risk and intertemporal substitution.

But as Paul Seabright says, most of what goes on in research based in microeconomic theory is so much more than that. For example (and this is my point, not his), if you are a microeconomics faculty, will you be able to explain to your students during an introductory course what, exactly, was the seminal contribution of Hart and Holmstrom?

Here’s what I mean by that question: can you explain where, exactly, this fits in to what they’ve learnt thus far? Is this consumer theory? Producer theory? Information asymmetry? All of the above? And more? Motivating students to learn about their (Hart and Holmstrom’s) work ought to be the easiest thing in the world, given that most of them will be on the labor market soon, but I very much doubt if this comes up as a point of even cursory discussion in an intro micro course. (And this goes without saying, if I’m wrong about this, yay!)

Paul Seabright brings up a list of other topics besides the example I just mentioned: two-sided markets, risk analysis, inter-temporal choice, market signaling, financial-market microstructure, optimal taxation, and mechanism design.

In addition, he also brings up applications of microeconomic theory: antitrust analysis, auction design, taxation, environmental policy, and industrial and financial regulation, and speaks about how in terms of both the topics and their applications, econ students are being under-served.

The whole point of learning economics (micro or macro, or anything else, for that matter) is to be able to apply what you’ve learnt to the real world. An education in economics should, in other words, help you see the world like an economist does. And that would mean that one should be able to appreciate the world for what what works within it, and one should be able to identify problems with the world that economic theory might help you solve.

Unfortunately, the point of a micro course, more often than not, is simply to be able to solve enough problems so that one can score well in the semester end examination.

Which reminds me: I don’t think they learn about Michael Spence’s work either!

This really deserves a separate post, what I’m about to say next. But if I had to distill my post down to its essence: there are two ways to teach economics.

  1. Now that we’ve finished going through the textbook, let’s try and figure out if certain things about the world become more understandable.
  2. Here’s what the world looks like, and here is how economic theory helps.

The latter approach, in my experience, is so much better.