The 2016 Nobel Prize in Economics and how to ensure kids do their chores

As any child promised a weekly allowance in return for chore completion can tell you: details matter. When does the trash need to be taken out? What counts as a completely made bed? What happens if someone else makes a mess after that area has been cleaned? The parent wants the chores completed well and timely while the child wants to achieve sufficiency for her weekly candy money. All of these questions that immediately race through the mind of our young adolescent form, little to her knowledge, the basics of contract theory.

These frictions between parent and child, the insurer and the insured, the employer and the employee, and almost any professional relationship between two or more agents, provide the research area of the winners of the 2016 Nobel Prize in economic sciences. Doctors Oliver Hart and Bengt Holmström, both of whom are current members of the BGSE Scientific Council, were awarded the prize for their work focusing on the trade-offs in setting contract terms earlier this week.

The central question plaguing contracts is not what specific form they should take, as there seem to be an infinite number of qualifications even a simple chore contract might inspire, but rather how to regulate the behavior of the agents involved. Applying our example to the case of the firm and its workers, it is clear the firm desires excellent work from the employee, and the employee seeks to know exactly what constitutes the work needed to earn the incentive.

Dr. Holmström’s research on performance-based pay of management and executives directly considers this. His findings suggest pay should be tethered to measures such as company share performance relative to that of direct competitors as opposed to the more commonplace linking to share price alone. Further, his analysis of the insurance market sought to bridge the gap between insurance providers and their clients. Despite the more optimal state of the individuals purchasing full insurance, co-payments still exist. This is because insurers are seeking to disincentivize costly, unnecessary doctor trips. In essence: how can the parent avoid being taken advantage of and how much should our young teenager be paid for her household work?

The work of Dr. Hart attempts to resolve the infinite questions regarding how our teenager can warrant the weekly allowance or how workers will earn their salary. Rather than laboriously delineate every potential scenario a worker may face and how they should respond, Dr. Hart would suggest decision rights be pre-determined amongst agents. This would allow unilateral decisions through a pre-agreed framework to be made when frictions arise. Additionally, the granting of ownership rights, contends Dr. Hart, greatly alters agent behavior. The ice-cream shop manager granted an ownership stake is ostensibly more motivated to work hard. On the other hand, cutting costs by purchasing lower quality ice-cream ingredients might accomplish the same goal at the expense of the shop’s reputation. The important takeaway from the research is that how the rights of ownership and decision-making are divided greatly affects the behavior of actors.

The duo may not have completely quieted all the concerns of the parent or child in the chore contract (or in any of the infinitely many contracts that span our daily lives). However, they have provided a framework to better understand relationships between the agents represented in these little documents so fundamental to society.

You can also read about the 2016 Nobel Prize recipients on the BGSE main website. http://www.barcelonagse.eu/news/nobel-prize-economics-scientific-council-oliver-hart-bengt-holmstrom

Barcelona GSE Lecture – Using Internet Data to Understand Consumers and Markets

Lecture summary by masters students Hugo Kaminski ’15 and Yi-Ting Kuo ’15.

speaker

During the 31st Barcelona GSE Lecture, Professor Jonathan Levin, Holbrook Working Professor of Price Theory at Stanford University, discussed the advantages and challenges of using Internet commerce data for empirical research in economics.

Seller Experience – Let real online sellers run experiments for us

Economic research has long relied on public governmental institutions and organisations to collect empirical data, which are reliable but expensive. Data on the Internet could potentially be an alternative source as it can reduce the cost of varying parameters. However, it is also challenging to isolate specific effects as customization of products and services raises concerns about selection and endogeneity.

Prof. Levin and his collaborators found that the millions of listings on eBay could potentially serve as millions of small experiments with different seller choices. In collaboration with eBay, US data allowed them to run fixed effect regressions exploiting within-experiment variation in prices, fees, displays, and other parameters.

Auction and Demand – Never start with an intermediate price

The buyers market is very competitive. If an auction starts at a low price, the item will be highly sellable and the market will drive it to around 80% of its value. Starting at a high price will make the item harder to sell, but increases the probability of ending with a higher price. The resulting estimated demand curve was convex, which implies that for a seller to start an auction with either a low or high price is more profitable than an intermediate price.

As second example, Prof . Levin argued that the Internet market could be used to test behavioural hypotheses about consumers. By looking at the multiple auction listings with different (flat rate) shipping fees, their analysis suggests that people prefer free shipping so much that they are willing to pay a higher price for the goods with free shipping even if there is an equal good with lower total price including shipping costs.

By analysing Internet commerce data from 2003 to 2012, they observed the sellers’ learning curve and concluded that the demand for online auction has declined. One interpretation of this development could be that consumers grew accustomed to increasingly instant purchase options and tend to spend more time on other online activities thus losing the attention for online auction.

Sales tax – a problem across US states

In the United States there exists a sales tax of 8.875% on average among states for within state sales. It does not come as a surprise that the payment of this tax is viewed as a negative additional charge which online often appears just towards the end of the purchasing process. To analyse the impact of the ‘tax surprise’ Prof. Levin estimates the tax sensitivity by comparing purchase rates.

Prof. Levin’s research finds that both consumers and sellers are aware of this perceived “extra charge” and the fact that the tax does not apply on out-of-state sales. Their analysis finds two consumer trends: first there exists a preference for goods bought in geographic proximity; second, the rising item-level substitution which means the consumer chooses to buy the item from an out-of-state seller to avoid the tax. These two trends seem to form a paradox.

Professor Nezih Guner (right) with our speaker
Professor Nezih Guner (right) with our speaker

On the seller side, Prof. Levin illustrates the case of Amazon and the location of their distribution centres. Amazon takes advantage of California’s geographic shape by locating its distribution centres just outside state lines while keeping delivery times short. This results in being able to cater to consumers in California without paying the sales tax.

Since online shopping is a growing trend, taxation legislation changes have potentially great impact. Based on the data used, a 1% increase in current sales tax decreases online sales by 1.5-2.0% but increase online home-state sales by 3-4%; alternatively switching to national tax collection of internet purchases would decrease online sales by 12%.

Professor Levin’s presentation concluded that new large-scale data offers an opportunity to assess microeconomic theories of behaviour and market operation. The presentation was followed by a Questions & Answers session on data quality, auction information asymmetry and lessons learned from use of auctions. For Yi-Ting Kuo and Hugo Kaminski it has been an insightful experience to listen to Professor Levin’s talk presented with support from Banco Sabadell.

If you are interested to know more about the lecture, you may view it here: