Advanced Game Theory, Golden Balls Edition

My Twitter feed is, quite rightly, full of links to this remarkable episode of Golden Balls, the British game show that puts contestants in a classic game theory dilemma of “splitting or stealing” the grand prize:

If you have time for more, here’s another famous episode, with a very different display of strategy and tactics:

Should We Blame TurboTax for Tax Code Complexity?

After another grueling tax season, my colleague Howard Gleckman is understandably frustrated with America’s complex tax code. And with instructions like this, who can blame him?:

Your ATNOL for a loss year is the excess of the deductions allowed for figuring the AMTI (excluding the ATNOLD) over the income included in the AMTI. Figure this excess with the modifications in section 172(d), taking into account your AMT adjustments and preferences (that is, the section 172(d) modifications must be separately figured for the ATNOL).

So who is to blame? Feckless politicians? High-priced lobbyists? Social engineers?

Well, yes, yes, and yes. But Howard looks deeper and asks why Americans don’t rise up against the scourge of needless complexity. Why are we so complacent?

His answer: TurboTax. By buffering us from complexity, tax preparation software allows that complexity to persist:

[T]echnology both inoculates us from much of the complexity of tax filing and reduces compliance costs. But, more importantly, it immunizes the politicians from the consequences of their decisions that lead to this madness.

Taking this to its logical extreme, Howard calls (tongue-in-cheek) for a one year moratorium on tax preparation software and, for good measure, paid preparers too.

I’m not ready to go that far. But I would like to point out that the dynamic Howard points out is everywhere around us. Give people cellphones that make it easier to call for help, and they will get into more trouble in the wilderness. Offer people low-fat cookies, and they will eat more. Put people in more fuel-efficient cars, and they will drive more. Give people software to do their taxes, and they will accept greater complexity. It’s practically a law of nature.

P.S. Over at Republic Report, Matt Stoller levels a more serious charge at Intuit, the producer of TurboTax. Quoting from its SEC filings and lobbying data from Open Secrets, he argues that the company has been lobbying against efforts to make it easier for citizens to file without the help of software.

Should High Heels Be Taxed?

Among my idiosyncracies are two footwear anti-fetishes: I hate flip flops and high heels. I have never mastered the dark art of walking in flip flops, and I have always been troubled when women teeter at the edge of falling because of shoes designed for fashion (allegedly) rather than function.

Nonetheless, I enjoyed Thursday’s Wall Street Journal piece about the engineering, some would say architecture, of contemporary high heels. I was also pleased that columnist Christina Binkley emphasized some of the negatives early in her piece:

High heels can exact a heavy toll on the body, pushing weight forward onto the ball of the foot and toes and stressing the back and legs. Most doctors recommend a maximum height of 2 inches.

But with heels, many women trade comfort for style. Women spent $38.5 billion on shoes in the U.S. last year, according to NPD Group, and more than half of those sales were for heels over 3 inches high. High heels are seen as sexy and powerful. Stars on the red carpet clamor for the highest heels possible–leading designers who want their shoes photographed into an arms race for height.

That “arms race” comment got me to thinking. Perhaps there’s an externality here? Are women trying to be taller than other women? If Betty has 2 inch heels, does that mean Veronica wants 2 and a half inch heels? And that Betty will then want 3 inch heels? If so, high heels are an example of the kind of pointless competition that Robert Frank highlights in his recent book, “The Darwin Economy“. As noted in the book description

[Such] competition often leads to “arms races,” encouraging behaviors that not only cause enormous harm to the group but also provide no lasting advantages for individuals, since any gains tend to be relative and mutually offsetting. The good news is that we have the ability to tame the Darwin economy. The best solution is not to prohibit harmful behaviors but to tax them. By doing so, we could make the economic pie larger, eliminate government debt, and provide better public services, all without requiring painful sacrifices from anyone.

Hence today’s question: Are high heels an example of such misguided competition? If so, should we tax them? (Bonus question: Should we tax noisy flip flops?)

P.S. The book description is not correct about the absence of “painful sacrifice.” Someone out there will still purchase such goods (otherwise there would be no revenue to “eliminate government debt”), and there’s a good chance they will view their tax payments as a sacrifice.

Long Spots, Short Stripes

Ran into Felix Salmon out at the Kauffman Foundation’s economic bloggers confab. His latest Felix TV breaks the contemporary art market down into two simple metrics: $ per spot and $ per stripe.

Feliz says buy spots. But a word of warning: Damien Hirst seems hellbent on flooding the dot market. Somehow I think the price of a dot will plummet when he releases his painting with 2 million dots.

Everything’s Negotiable, Even Beating Casinos at Blackjack

Over at the Atlantic, Mark Bowden tells the tale of Don Johnson, who managed to win $4 million playing blackjack at Caesars in Atlantic City, $5 million at the Borgata, and $6 million at the Tropicana.

How’d he do it? By negotiating favorable odds:

Johnson is very good at gambling, mainly because he’s less willing to gamble than most. He does not just walk into a casino and start playing, which is what roughly 99 percent of customers do. This is, in his words, tantamount to “blindly throwing away money.” The rules of the game are set to give the house a significant advantage. That doesn’t mean you can’t win playing by the standard house rules; people do win on occasion. But the vast majority of players lose, and the longer they play, the more they lose.

Sophisticated gamblers won’t play by the standard rules. They negotiate.

Johnson started negotiating.

Once the Borgata closed the deal, he says, Caesars and the Trop, competing for Johnson’s business, offered similar terms. That’s what enabled him to systematically beat them, one by one.

In theory, this shouldn’t happen. The casinos use computer models that calculate the odds down to the last penny so they can craft terms to entice high rollers without forfeiting the house advantage. “We have a very elaborate model,” Rodio says. “Once a customer comes in, regardless of the game they may play, we plug them into the model so that we know what the house advantage is, based upon the game that they are playing and the way they play the game. And then from that, we can make a determination of what is the appropriate [discount] we can make for the person, based on their skill level. I can’t speak for how other properties do it, but that is how we do it.”

So how did all these casinos end up giving Johnson what he himself describes as a “huge edge”? “I just think somebody missed the math when they did the numbers on it,” he told an interviewer.

Johnson did not miss the math. For example, at the Trop, he was willing to play with a 20 percent discount [i.e., you get 20% of any losses back] after his losses hit $500,000, but only if the casino structured the rules of the game to shave away some of the house advantage. Johnson could calculate exactly how much of an advantage he would gain with each small adjustment in the rules of play. He won’t say what all the adjustments were in the final e-mailed agreement with the Trop, but they included playing with a hand-shuffled six-deck shoe; the right to split and double down on up to four hands at once; and a “soft 17” (the player can draw another card on a hand totaling six plus an ace, counting the ace as either a one or an 11, while the dealer must stand, counting the ace as an 11). When Johnson and the Trop finally agreed, he had whittled the house edge down to one-fourth of 1 percent, by his figuring. In effect, he was playing a 50-50 game against the house, and with the discount, he was risking only 80 cents of every dollar he played. He had to pony up $1 million of his own money to start, but, as he would say later: “You’d never lose the million. If you got to [$500,000 in losses], you would stop and take your 20 percent discount. You’d owe them only $400,000.”

Just another illustration that everything’s negotiable, at least if you are a big enough whale. The whole article is worth a read.

h/t: Longreads

Is Incentive Compensation a Giant FIB?

Harvard Business School professor Mihir Desai believes American companies and investment firms have erred–horribly–by linking manager compensation so tightly to financial market performance. In the current Harvard Business Review, he identifies this as a giant FIB, a Financial Incentive Bubble:

American capitalism has been transformed over the past three decades by the idea that financial markets are suited to measuring performance and structuring compensation. Stock-based pay for corporate executives and high-powered incentive contracts for investment managers have dramatically altered incentives on both sides of the capital market. Unfortunately, the idea of compensation based on financial markets is both remarkably alluring and deeply flawed: It seems to link pay more closely to performance, but it actually rewards luck and can incentivize dangerous risk-taking. This system has contributed significantly to the twin crises of modern American capitalism: governance failures that cast doubt on the stewardship abilities of U.S. managers and investors, and rising income inequality.

Mihir has nothing against well-functioning financial markets. He emphasizes that they “play a vital role in economic growth by ensuring the most efficient allocations of capital,” and he believes that capable managers and investors should be “richly rewarded” when their talents are truly evident.

The problem is that incentive compensation based on financial performance does a lousy job of distinguishing skill from luck. In finance-speak, managers and investors often get rewarded for taking on beta, when their pay really ought to be linked to alpha. In practice, luck gets rewarded with undeserved windfalls (that are by no means offset by negative windfalls for the unlucky). And that, he argues, results in an important “misallocation of financial, real, and human capital.”

Well worth a read.

The Miracle of Chained Kidney Transplants

Most modern markets operate on money. I sell my services as an economist, for example, and use the proceeds to buy Tazo Tea, vacation trips, and a surprising number of Apple products.

But that approach doesn’t transplant well (so to speak) to living human organs. Many people find the idea of markets in organs repugnant. As a result, money-based organ markets are generally outlawed.

As economists often point out, that moral stance comes with a major cost: many people who need a new kidney can’t find one. Humans have two kidneys, but can live healthy lives with just one. So there is the potential for gains from trade between those who need a kidney and those who have one to spare. The challenge is getting enough people to donate kidneys, when it isn’t possible to compensate them with money.

Some good samaritans do donate kidneys to strangers. But that’s very rare. Far more common are people who will donate a kidney to a relative or friend. But those offers often run into a harsh biological reality. Just because you want to give someone a kidney doesn’t mean it will be a biological match.

Enter the kidney exchange. Simple case: Alice may want to donate to Bob but not be a match. Chuck may want to donate to Daphne but not be a match. But if Alice is a match to Daphne, and Chuck is a match to Bob, then can make an exchange. Alice donates to Daphne, Chuck donates to Bob, and everyone is happy. The miracle of a good match in the kidney barter market.

The trick is finding those matches and extending them to larger groups. Today’s New York Times has a moving article that illustrates how far this idea has come. Kevin Sack recounts how the 60 people shown above were linked through a chain of 30 kidney transplants thanks to the efforts of Garet Hil and the National Kidney Registry. The first donor,Rick Ruzzamenti (upper left), is a good samaritan who felt inspired to give a kidney to a stranger. The other 29 donors all donated on behalf of a friend or relative.

What made the domino chain of 60 operations possible was the willingness of a Good Samaritan, Mr. Ruzzamenti, to give the initial kidney, expecting nothing in return. Its momentum was then fueled by a mix of selflessness and self-interest among donors who gave a kidney to a stranger after learning they could not donate to a loved one because of incompatible blood types or antibodies. Their loved ones, in turn, were offered compatible kidneys as part of the exchange.

Chain 124, as it was labeled by the nonprofit National Kidney Registry, required lockstep coordination over four months among 17 hospitals in 11 states. It was born of innovations in computer matching, surgical technique and organ shipping, as well as the determination of a Long Island businessman named Garet Hil, who was inspired by his own daughter’s illness to supercharge the notion of “paying it forward.”

Dr. Robert A. Montgomery, a pioneering transplant surgeon at Johns Hopkins Hospital, which was not involved in the chain, called it a “momentous feat” that demonstrated the potential for kidney exchanges to transform the field. “We are realizing the dream of extending the miracle of transplantation to thousands of additional patients each year,” he said.

The entire article is inspiring.

Oil and Natural Gas Prices Move Even Further Apart

In 2010, I wrote a series of posts documenting how oil and natural prices had decoupled from each other (see here and here). For many years, oil prices (as measured in $ per barrel) were typically 6 to 12 times natural gas prices (as measured in $ per MMBtu). That ratio blew out to around 20 in 2009 and again in 2010, a severe break with historical trends.

At the time, that seemed like an enormous disparity between the two prices. In retrospect, we hadn’t seem anything yet. As of yesterday, the ratio stood at more than 33:

A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would thus tend to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline means that oil is more valuable. So oil has usually traded higher.

But the current ratio is unprecedented. Each Btu of oil is now worth about five times as much as each Btu of natural gas. Thanks to a torrent of new supply, natural gas prices are down at $3.00 per MMBtu even as oil (as measured by the WTI price) has risen back above the $100 per barrel mark.

Perhaps natural gas vehicles will be the wave of the future?

Note: Energy price aficionados will note that I’ve used the WTI price in these calculations. That used to be straightforward and unobjectionable. Now, however, we have to worry about another pricing discrepancy: WTI is very cheap relative to similar grades of oil on the world market (for background, see this post). For example, Brent crude closed Monday around $112 per barrel, well above the $101 WTI price. Brent prices are relevant to many U.S. oil consumers. There’s a good argument, therefore, that my chart understates how much the price ratio has moved. 

How Do Consumers Spend Engine Efficiency Advances? On Bigger, Faster Cars

Auto companies have made great strides in improving engine efficiency in recent decades. But those improvements haven’t done much to improve the fuel economy of America’s passenger car fleet. Instead, consumers have “spent” most of those efficiency improvements on bigger, faster cars.

MIT economist Christopher Knittel has carefully quantified these tradeoffs in a recent paper in the American Economic Review (pdf; earlier ungated version here). As noted by Peter Dizikes of MIT’s News Office: 

[B]etween 1980 and 2006, the average gas mileage of vehicles sold in the United States increased by slightly more than 15 percent — a relatively modest improvement. But during that time, Knittel has found, the average curb weight of those vehicles increased 26 percent, while their horsepower rose 107 percent. All factors being equal, fuel economy actually increased by 60 percent between 1980 and 2006, as Knittel shows in a new research paper, “Automobiles on Steroids,” just published in the American Economic Review.

Thus if Americans today were driving cars of the same size and power that were typical in 1980, the country’s fleet of autos would have jumped from an average of about 23 miles per gallon (mpg) to roughly 37 mpg, well above the current average of around 27 mpg. Instead, Knittel says, “Most of that technological progress has gone into [compensating for] weight and horsepower.”

This is a fine example of a very common phenomenon: consumers often “spend” technological improvements in ways that partially offset the direct effect of the improvement. If you make engines more efficient, consumers purchase heavier cars. If you increase fuel economy, consumers drive more. If you give hikers cell phones, they go to riskier places. If you make low-fat cookies, people eat more. And on and on. People really do respond to incentives.

You Can’t Manage What You Don’t Measure Correctly, NYC Crime Edition

You can’t manage what you don’t measure.

That’s good advice, as far as it goes. But it has a dark underside: managing the measurement rather than actual outcomes.

Over at the New York Times, Al Baker and Joseph Goldstein recount a troubling example. To keep reported crime rates low, New York’s Finest may be under reporting the crimes that actually occur:

Crime victims in New York sometimes struggle to persuade the police to write down what happened on an official report. The reasons are varied. Police officers are often busy, and few relish paperwork. But in interviews, more than half a dozen police officers, detectives and commanders also cited departmental pressure to keep crime statistics low.

While it is difficult to say how often crime complaints are not officially recorded, the Police Department is conscious of the potential problem, trying to ferret out unreported crimes through audits of emergency calls and of any resulting paperwork.

As concerns grew about the integrity of the data, the police commissioner, Raymond W. Kelly, appointed a panel of former federal prosecutors in January to study the crime-reporting system. The move was unusual for Mr. Kelly, who is normally reluctant to invite outside scrutiny.

The panel, which has not yet released its findings, was expected to focus on the downgrading of crimes, in which officers improperly classify felonies as misdemeanors.

But of nearly as much concern to people in law enforcement are crimes that officers simply failed to record, which one high-ranking police commander in Manhattan suggested was “the newest evolution in this numbers game.”