Although it’s not my area of expertise, Environmental Economics has become one of my favourite economics blogs. Recently they had some discussion about water pricing. The question is how to ration water use in a drought. There are basically two ways to do it: (1) Let the market work and let the price rise to choke off some demand so the reduced supply is adequate, or (2) Keep prices fixed but impose some other arbitrary restrictions on use like banning car washing or using hoses on certain days of the week, etc.

As the Environmental Economics guys explain, letting the price rise is the better solution. Aside from the fact that people find ways to get around usage restrictions, letting the price rise means that those who use the water are those who value it the most. Basically, willingness to pay for something reflects its value to that person, and water like all scarce resources should end up in the hands of whoever values it the most, in order to make the best use of it.

One argument against this is that it might be inequitable. During a water shortage, if the water price rises, why should a rich person be able to water his rose garden because he can afford to, while his poor neighbour can’t afford to wash his clothes? This is a valid criticism — market outcomes are efficient in that they allocate scarce resources to whoever values them the most, but they’re not guaranteed to be “fair” according to whatever definition of fairness you want to use. If you care about equity, then during a water shortage you might think it’s a good idea to leave prices alone and ban rose watering, so the rich guy has to cut back, while the poor family can still afford clean clothes.

That’s a reasonable argument, but it turns out that you can achieve an even better outcome during a water shortage by recognising that the reason the poor family can’t afford to wash their clothes if the water price goes up is because they’re poor, not because of the water shortage per se. So your real complaint is not that a high price of water is “unfair”, but rather that it’s unfair that some people are rich and some are poor.

So instead of keeping the water price constant and imposing restrictions on use, suppose you let the price go up, but tax the rich guy and transfer that money to the poor family. Then the poor family is no longer poor, and the market for water can still do its job of making sure that scarce water goes to those who value it the most. Furthermore, the poor family can spend the extra money that you give them on whatever they want, which may not necessarily be water. Suppose you gave them just enough extra money that they could afford their original water consumption at the pre-shortage prices. They can always choose to consume that amount of water if they want, and be just as well of as before. But if they value something else more highly, they can spend part of the money that you give them on whatever that is, and they’ll be better off.

In summary, the “unfairness” caused by a high water price during a shortage hurting poor people isn’t caused by the water shortage itself, but by the fact that these people are poor. You can improve the welfare of these people during a shortage by keeping prices low but imposing restrictions on other people’s use. But you can do even better by solving the poverty problem directly through transferring wealth between people according to your ideal of “fairness” while using the power of the market to allocate scarce resources efficiently.

This is a tricky concept to explain, and I’m not sure if I’ve done a very good job. I think a specific example would be useful to illustrate it, so I’ll try to think of one.

It seems a new competitor has entered the economics blogs ranking market. CurrencyTrading.net has posted a list of the top 100 economics blogs. It just appears to be based on their opinion, whereas I prefer rankings like mine or Brian Gongol’s that are based on cold hard data. Still CurrencyTrading provides some useful information by classifying the blogs into categories and giving a brief description of each one.

So how shall I respond to this new competition? By imitation and innovation, of course! I have some top secret changes planned to make my rankings even better … stay tuned.

I’ve been reading the Google public policy blog. It’s not a very active blog, but it’s interesting to read about the topics that Google cares about in terms of government policy. There’s the controversial issue of ‘net neutrality’, of course, plus recent FCC spectrum auctions, and even IT law in India.

Reading the posts, Google tries to portray itself as nice and friendly, with the interests of ‘the Internet’ and the common good at heart. However, we should not forget that they are a successful multi-billion dollar business, and can be expected to behave as such. For example, there’s a post titled More online ad acquisitions = more competition. It’s about Google’s plans to acquire DoubleClick, a firm that specialises in placing advertisements on websites. Google also does basically the same thing, through its Adsense and Adwords services. There has been a bunch of consolidation going on in online advertising, as they describe in the blog post, with Yahoo and MSN and others acquiring advertising providers.

Somehow, Google manages to spin this situation into one in which there is ‘more competition’. Their argument seems to be that the aggressive acquisitions indicate fierce competition to be a leader in this market. As Google says:

It means that each of the leading Internet companies believe that they can position themselves to succeed in the online advertising space — through the free market, and without government intervention. These companies believe that there are many ways to compete in this business.

However, from an economic point of view it’s hard to believe that fewer firms equals more competition. The more independent players in a market (however big or small) the more intense the competition between them. Mergers and acquisitions will lead to higher prices than would otherwise prevail, unless there are some significant cost savings from combining the operations of two firms. Admittedly, as Google says there are other things going on in the market such as entry of new startups, but everything else equal fewer firms equals less competition, not more.

I think every man and his dog learned the word subprime recently. I don’t know much about banking and finance, but Stephen Cecchetti, a former director of research at the Federal Reserve Bank of New York, knows what he’s talking about and explains the subprime crisis in (almost) layman’s terms in a clearly written post on the VoxEU blog.

The creator of the Financial Next website asked me to take a look at his site. It’s a website that facilitates ‘prediction markets‘ with play money (ie not real money). This is not a new idea, for example the Iowa Electronic Markets have apparently been around since 1988. The basic idea is to create a virtual online market for a well-defined future event, for example ‘Hillary Clinton wins the 2008 US presidential election’. For a yes/no event like that, if you own a share in that idea, you get some payoff, say $100, if it turns out to be true, and nothing if it’s not true. How likely you think the event is will determine what you should pay for the share. If you think Hillary has an 80% chance of winning, then you should be willing to pay up to $80 for a share in that idea.

Aggregated over many people, the market price in such an idea converges on the overall ‘consensus’ opinion of all the traders in the market. Basically, markets are tools for extracting information. In this case we’re extracting people’s beliefs about the probability of some unknown future event. We could do the same thing by just taking a survey of people’s opinions. However, there’s some reasons why markets might generate more accurate results than surveys. First, if money is at stake, people might take the question more seriously and try to come up with an informed opinion about the issue in question. Second, it makes clear the distinction between “Do you want Hillary to win?” and “Do you think Hillary will win?”. There are probably other reasons why markets might outperform surveys, but those are the two that come to mind for me.

On the downside, it’s probably more expensive to run prediction markets than conducting surveys, and people have to be willing to spend more effort participating in them. You can answer a survey question in one minute, but a prediction market probably requires more intensive effort over a period of time. Thus it might be easier to gather the opinions of more people with surveys, compared to what could be achieved with prediction markets. I’m not sure whether surveys or prediction markets would win in a cost-benefit analysis of the tradeoff between cost of running the process and accuracy of the results.

In any case, as an economist I like the idea. The Financial Next site implements this pretty well and makes it easy for users to participate in markets, and even create their own markets. Since it’s just for play money, there’s no real harm done if people set up strange markets on the site. On the other hand, I wonder how seriously people take it when only play money is at stake. As the site says, the main motivation for participating in the site is fun and beating other people. So it’s a kind of game.

I think this is another interesting idea — using games to motivate people to participate in economic experiments. These days experimental economics is popular, and economists try to set up artificial situations with subjects in a lab to test various economic theories. One criticism of these is that the subjects are not really motivated enough and won’t behave as they would in a real situation. I think well-designed games (here I mean not the game theory type of game but the ‘fun’ type of game) may be able to help overcome this problem. If people enjoy playing a game, and have a stake in it, they may take it seriously, and if the game it set up well maybe we can test economic theories. In other words, give people a fun game as a carrot, but manipulate the environment in some way to run some subtle experiments. One online game, EVE, recently hired a real economist, and it seems like he’s having some of these same thoughts.

In terms of the Financial Next site, its main problem at the moment seems to be a lack of traders. Since it’s only for play money, people will only be motivated to join if the site provides them with some other kind of benefits aside from making money. The competitive/play motivation is fine, but that works best when there’s a large population of players. If I’m the best out of 10 players that’s not so impressive, but best out of 100,000 is something to be proud of. So Financial Next is another example of a network that will become more valuable to its members as it gets bigger. I’m not sure exactly how they can attract more users and reach some sort of ‘critical mass’, but I’d suggest emphasising the competitive aspect more and trying to make trading more ‘fun’ somehow.

The other problem with a lack of traders is that the market becomes quite ‘thin’. This means that its predictions won’t be so good, because they don’t aggregate the opinions of very many people. In addition, traders’ behaviour probably becomes somewhat strategic. In a small market with few traders, each of them has quite a lot of influence over the market price. This can affect players’ strategies, and may lead them not to trade in such a way that best reveals their estimates of the probability of the event that we’re interested in. In contrast, in a thicker market with many traders, each will assume that they can’t really affect the price, and will be more likely to trade according to their true estimate of the probability.