Ducks and Economics

Assume an auction with a small and finite number of bidders with discrete values on the aggregate demand curve. Imagine this is a pure common values auction (wikipedia definition):

Some would call this a pure common value auction, using the term common values to describe any auction in which (i) bidders have different information and (ii) one bidder’s information would be informative to another bidder about the latter’s valuation for the good.

Imagine bids are public. Bids are consecutive and the bidder with the highest final bid wins the good. To call upon a basic economic definition, declared prices are signals that reveal information about bidder’s demand curves. The other implication of having common values is that valuations are correlated. In the auction, this implies bidders have dynamic valuations; when a bidder places a bid, the other auction participants are able to gain additional information that allows them to readjust their values for the asset and bid accordingly.

Quick note: can we assume risk-neutral participants? I need to return to that question later, but let’s make that assumption for now.

At this point, let’s bring in some numbers. Imagine an auction with 5 bidders, with bidder valuations being initially uniformly distributed from 0-100, inclusive, which means that bidder 1 values the good at 20, bidder 2 value is 40, bidder 3 has value 60, bidder 4 has value 80, and bidder 5 values the good at 100. The minimum bid increment is 1. This means that bidder 5 wins the auction at some price between 81-100. Where precisely depends on the correlation factor. A higher correlation factor means that the final price is closer to 100; a lower factor means that the final price is closer to 81.

Let’s loosen a parameter. Imagine instead of 5 bidders, there are 100. It’s obvious here that allowing dynamic bidding and (highly) correlated values means that the final price is at least 100; depending on the correlation function. Hypothesis: if you allow the correlation function to be an exponential greater than 1 for values contiguous to the high end of the distribution, you get an asset bubble, where increasing bids inflate exponentially (you need at least two bidders to get into a bidding war).

Can this provide a framework to thinking about bubbles like technology and housing? Does this make any sense to anyone else? The next step is to formulate this mathematically.

I just had this thought: Asset bubbles are far more probable and meaningful in large markets than in small markets. If this is true, is it obvious? I have a long set of thoughts to write down but since I’m tired, I’ll return to it in the morning. I get a lot of my intuitions from auction theory.

Nouriel Roubini recommends that Ben Bernanke be retained as chairman of the Fed. As the economist who (perhaps) most accurately forecast the housing bust and subsequent recession, I expect his opinion will carry considerable weight. A quick excerpt:

Mr. Bernanke understands that in the Great Depression, the collapse of the money supply and the lack of monetary stimulus during contractions worsened the country’s economic free fall. This lesson has paid off. Mr. Bernanke’s decision to keep interest rates low and encourage lending has, for now, averted the L-shaped near depression that seemed highly likely after the financial collapse last fall.

And:

To be sure, an endorsement of Mr. Bernanke’s reappointment comes with many caveats. Mr. Bernanke, a Fed governor in the early part of this decade, supported flawed policies when Alan Greenspan pushed the federal funds rate (the policy rate set by the Fed as its main tool of monetary policy) too low for too long and failed to monitor mortgage lending properly, thus creating the housing and credit and mortgage bubbles.

He and the Fed made three major mistakes when the subprime mortgage crisis began. First, he kept arguing that the housing recession would bottom out soon (it has not bottomed out even three years later). Second, he argued that the subprime problem was a contained problem when in reality it was a symptom of the biggest leverage and credit bubble in American history. Third, he argued that the collapse in the housing market would not lead to a recession, even though about one-third of jobs created in the latest economic recovery were directly or indirectly related to housing. Mr. Bernanke’s analysis was mistaken in several other important ways. He argued that monetary policy should not be used to control asset bubbles. He attributed the large United States current account deficits to a savings glut in China and emerging markets, understating the role that excessive fiscal deficits and debt accumulation by American households and the financial system played.

Link here.

Alex Tabarrok at MarginalRevolution posts recently about Deloitte’s recently released Shift Index, an empirical study of long term economic trends. He particularly notes that:

As a result of increased competition and also, I believe, greater wealth and reduced interest rates, the economy wide return on assets has decreased by 75% (see the report).

If the return on assets has decreased but productivity and wealth are up then where has the wealth gone?  To consumers and the creative class.  Thus, increased competition in the economy has driven down the return to capital and at the same time has increased the return to the complementary input which is in greatest fixed supply, creative labor.  More data in the full report.

This article in the New York Times is a pretty good story about an industry in which this is particularly true: the music business. Specifically, it details how increased competition in how music is marketed and sold changes the dynamics of the music game, allowing musicians to garner greater returns on their valuable human capital assets.

Much of that has to do with the rise of the Internet as a means of promoting and distributing music. Physical album sales fell 20 percent, to 362.6 million last year, according to Nielsen, while sales of individual digital tracks rose 27 percent, to 1.07 billion, failing to compensate for the drop. Mindful of these changes, in the last few years marquee musicians like Trent Reznor, the Beastie Boys and Barenaked Ladies have created their own artist-run labels and reaped significant rewards by keeping a larger share of their revenue.

Under the Polyphonic model, bands that receive investments from the firm will operate like start-up companies, recording their own music and choosing outside contractors to handle their publicity, merchandise and touring.

Instead of receiving an advance and then possibly reaping royalties later if they have a hit, musicians will share in all the profits from their music and touring. In another departure from tradition in the music business, they will also maintain ownership of their own copyrights and master recordings — meaning they and their heirs can keep earning money from their music.

“We are all witnessing major labels starting to shed artists that are hitting only 80,000 or 100,000 unit sales,” said Adam Driscoll, another Polyphonic founder and chief executive of the British media company MAMA Group. “Do a quick calculation on those sales, with an artist who can tour in multiple cities, and that is a good business. You can take that as a foundation and build on it.”

Pretty sweet. I think there are some very worthwhile lessons here for journalists…

Tyler Cowen posts an excerpt from an NYT story about a man who enjoys being stood on. It is a very strange story and indicates to me that the long tail of the distribution of weirdness in humans is very long indeed. Here is Tyler’s section of the post, with my favorite part highlighted:

His standard rate is $200 “a session,” he seems to enjoy the work, in some situations he values the situation as a fetish, he once had ten women stand on him, and the market structure appears to be one of duopoly.  Here is more and I thank Jeffrey Valentine for the pointer.

Only an economist would ever read that story and think to say that. Well played. Here is the wiki on duopoly.

1. George Akerlof and his seminal paper The Market for Lemons: Quality Uncertainty and the Market Mechanism, first published in the Quarterly Journal of Economics back in Aug. 1970. to my knowledge this is the article that first put him on the map and attracted the attention of the Nobel Committee.

2. Bryan Caplan thinks Ben Bernanke should be fired. I would like more warrants presented than just he that he failed; I am inclined to a much more charitable perspective that says Bernanke did the best he could given the structure of the political economy and that Caplan seems to discount the information assymetry between him and Bernanke, given that Bernanke probably gets to see extremely sensitive information on a time sensitive basis that Caplan doesn’t.

3.

From today’s NYT story, Derivatives Tug of War Takes Shape by Floyd Norris:

Even when derivatives do allow financial risks to be transferred, that is not always a good thing. John Kay, a leading Scottish economist, noted recently that he used to teach — along with most other economics professors — that derivatives allowed risks to be transferred to those better able to bear them.

But, he added, experience had shown that to be wrong. Now, he said, he teaches that derivatives allow risk to be shifted from those who understand it a little to those who do not understand it at all. That is not a bad description of how the risks of bad mortgage loans were transferred from those who made the loans to those who bought troubled collateralized debt obligations.

Very well put.