Tyler Cowen's Blog, page 150

LeBron James and the theory of price controls

NBA salaries are subject to price controls at some margins, so neither Miami nor Cleveland could pay LeBron more.  Therefore a theory of profit maximization predicts LeBron will choose the deal that extends his career the most, so as to maximize lifetime income and perhaps also fun.  Another year playing also probably means higher endorsement income than a year in retirement.

In Cleveland he is not actually expected to win, at least not right away.  They can play the young guys a lot and rest his legs and extend his career, while developing the quality of the overall team.  And if the mix of players somehow comes through in a year or two, he looks like a basketball genius.  The East seems weak enough that Cleveland will at least make the Eastern Finals for the next few years, thus avoiding embarrassment.

Given their demographic structure and Bosh’s accruing softness, Miami is a contender only if it pushes LeBron very hard and thus shortens his career.  I speculate that he was very upset that he was pushed and played so hard all year long, to rest Wade, only to develop those disabling leg cramps at the end of game one against San Antonio in the Finals, which caused him to lose face.

I haven’t seen other analyses take career length into account.  LeBron is entering his thirties and watching the physical implosion of Kobe Bryant, one of his role models.  He knows Michael Jordan took two years off and ended up as a geezer on the Washington Wizards.  He sees Wade — one of his best buddies — a broken player at age 32.  Why not choose the outcome that might give him a few extra years of both salary and fun?

Addendum: Apparently LBJ is taking only a two-year contract with Cleveland.

James could have taken a four-year contract worth more than $88 million from the Cavs. But he now will be able to negotiate a better contract in two years and also has the choice to opt out after one season to renegotiate next summer. Player options only can come before the final season of a contract, another reason for the two-year deal.

That is emphasis added, the pointer here came from Angus.  I would mention that the theory of profit maximization is often underrated and that this Cleveland deal really is a good one for LBJ.

Washington state marijuana fact of the day

For now, prices are high: around $20 a gram, which is twice the black-market (or medical) cost. That partly reflects eye-watering excise taxes: 25% at each stage of distribution, plus normal sales taxes. But wholesale prices are high too, suggesting supply shortages are the main culprit.

There is more here, from The Economist, much of it deals with how far the United States is from having truly legalized marijuana.  [Note: an earlier version of this post mistakenly referred to Colorado.]

Roman communication costs in time and expense

The Stanford Geospatial Network Model of the Roman World

“For the first time, ORBIS allows us to express Roman communication costs in terms of both time and expense. By simulating movement along the principal routes of the Roman road network, the main navigable rivers, and hundreds of sea routes in the Mediterranean, Black Sea and coastal Atlantic, this interactive model reconstructs the duration and financial cost of travel in antiquity.”

http://orbis.stanford.edu/

For the pointer I thank Michael Gibson.

Assorted links

1. Songs from the International Society for Bayesian Analysis.  The Society is here.  And measuring the impact of Ramadan.

2. Experimental Vancouver coffee shop with no WiFi, texting, cell phones, etc., only coffee.  You also pay by donation and you are…supposed to talk to the other people in the shop.

3. Best books of 2014 so far? (not my list)

4. Another good review of Transformers 4.

5. Quora thread on how to start learning economics.

6. Arvind Subramaniam on Modi’s first budget.

7. Public choice of the Iron Dome.

How has the restaurant experience changed in the last ten years?

This is from a New York Craigslist post, from a restaurant owner who apparently viewed tapes of customers from 2004 and 2014, here is part of his account of the more recent behavior:

2014

Customers walk in.

Customers get seated and is given menus, out of 45 customers 18 requested to be seated elsewhere.

Before even opening the menu they take their phones out, some are taking photos while others are simply doing something else on their phone (sorry we have no clue what they are doing and do not monitor customer WIFI activity).

7 out of the 45 customers had waiters come over right away, they showed them something on their phone and spent an average of 5 minutes of the waiter’s time. Given this is recent footage, we asked the waiters about this and they explained those customers had a problem connecting to the WIFI and demanded the waiters try to help them.

Finally the waiters are walking over to the table to see what the customers would like to order. The majority have not even opened the menu and ask the waiter to wait a bit.

Customer opens the menu, places their hands holding their phones on top of it and continue doing whatever on their phone.

There is more here, interesting throughout, and for the pointer I thank Jacqueline Mason.

Does America need further strategic trade policy for Boeing?

One of the arguments for reauthorizing the Ex-Im Bank is that the EU subsidizes Airbus in an increasing returns to scale industry, and so therefore we need to do the same for Boeing.  Boeing is by far the largest beneficiary from the Bank.

Yet the Pentagon spends a lot of money on Boeing already, basically ensuring the company will operate at quite a large scale.  I cannot find formal figures on how much the European Union spends on military contracts with the Airbus Group, but it is highly likely to be much less than what the Pentagon spends on Boeing, given the differences in defense spending across the two regions.

In other words, through military spending we are already doing what strategic trade policy (ostensibly) dictates.  General Electric, which is number two on that list of Ex-Im beneficiaries, is also a significant Pentagon contractor, as is number three Bechtel of course.

By the way, did you know that the standard models dictate an export tax rather than an export subsidy if the duopolistic firms operate as Bertrand rather than Nash competitors?  See Eaton and Grossman (1986), or this Flam and Helpman piece (pdf) or Cheng (1988).  I am not suggesting that Bertrand competition is exactly the right assumption here, rather the point is that strategic trade models are not very robust in their policy implications.

The downsizing of some American homes

Doug Immel recently completed his custom-built dream home, sparing no expense on details like cherry-wood floors, cathedral ceilings and stained-glass windows — in just 164 square feet of living space including a loft.

The 57-year-old schoolteacher’s tiny house near Providence, Rhode Island, cost $28,000 — a seventh of the median price of single-family residences in his state.

“I wanted to have an edge against career vagaries,” said Immel, a former real estate appraiser. A dwelling with minimal financial burden “gives you a little attitude.” He invests the money he would have spent on a mortgage and related costs in a mutual fund, halving his retirement horizon to 10 years and maybe even as soon as three. “I am infinitely happier.”

There is more here, and for the pointer I thank Peter Marber.

Assorted links

1. Milton Friedman chats with a young David Brooks.

2. Indiegogo for an electronic library of Leonard Read.

3. Robot writes Torah at Berlin’s Jewish Museum.  And Michael Covel interviews me about many things.

4. Why hasn’t the internet made labor market search easier?

5. Future Grammys to have a Chinese feel.

6. What the rich really like are high asset prices.

Markets in everything: jeans designed by lions and tigers

A Japanese jeans maker has found a new way of capitalizing on zoo animals. Zoo Jeans is producing jeans “designed by dangerous animals.” Denim is wrapped around tires, which are then thrown to the lions who enjoy ripping and biting at the material. This produces that all-important designer, distressed look.

Rather than simply being a marketing gimmick, there is actually value in this from an animal welfare perspective. Involving lions and the zoo’s other large carnivores in the activity is part of what’s called environmental enrichment. This is the provision of stimuli to help improve well-being. It’s a win-win activity for many zoos, who can make alternative profits from their animals, which tend to be used to provide extra facilities for them.

The full story is here, and for the pointer I thank Gary Rosen.

Average Stock Market Returns Aren’t Average

The average investor in the stock market will earn less than the average stock market return–this is true even without taking into account any behavioral biases. A reasonably diversified portfolio of stocks can expect to earn 7% per year on average. Thus, it’s easy to see that the expected payoff from investing $100 and holding for 30 years is $100*(1.07)^30=$761.23. The expected payoff, however, is subject to a lot of uncertainty–even on a diversified portfolio the standard deviation is about 20% annually. Many people think that uncertainty washes out when you buy and hold for a long period of time. Not so, that is the fallacy of time diversification. Although the average return becomes more certain with more periods you don’t get the average return you get the total payoff and that becomes more uncertain with more periods.

To illustrate I ran 100,000 simulations of a 30 year stock market investment with a 7% return and a 20% standard deviation. The mean payoff across all 100,000 runs was $759.58 (recall the theoretical mean is $761.23 so we are spot on). But now consider the following. What percentage of returns would you guess lost money, i.e. had a total payoff after 30 years of less than $100?

After 30 years, 8.9% of all returns lost money!!!  In terms of recent debates, (average) r>g does not mean that wealth accumulates automatically. Fortunes can be lost even when the averages are in your favor.

Perhaps even more surprisingly what percentage of investors would you guess earned less than the average payoff of $761.23? An amazing, 69.2% of investors earned less than the average. The median payoff in my simulation was only $446.85, so the median return was not 7% but 5.1%. The average investor earned less than the average return.

The point is subtle and widely misunderstood. Here’s a simple example. Suppose that the average return is 10%. If $100 is invested for two periods the average payoff is $100*(1.1)^2=$121. But on average that is not what happens. More typically, you get say 0% in the first period and 20% in the second period, i.e. $100*(1.0)*(1.2)=$120. Notice that the average return is exactly the same, 10%, but the total payoff is smaller in the second and more realistic case–an application of Jensen’s inequality–so the average investor earns less than the average payoff. The difference here is only $1 but over 30 years that seemingly small difference accumulates.

If most investors earn less than the average it follows immediately that a few must earn more than the average. Lady luck is a bitch, she takes from the many and gives to the few. Here is the histogram of payoffs. The right-hand tail is long. Indeed, I am only showing part of the tail as there were payoffs as high as $25,000. Most investors earn less than the mean payoff.

And here is a line plot showing the portfolio accumulation over time for a sample of 10,000 runs. Note two things. First, the variance of the total payoff is increasing over time and second, the total payoff is highly right (upper)-tailed.

Addendum: There is some evidence that stock market returns are mean reverting, as makes sense if discount factors are mean reverting. Taking mean-reversion into account would moderate the numbers somewhat but would not change the qualitative results. Moreover, we don’t have many independent 30-year data points so in my view we shouldn’t put too much weight on mean-reversion.