Economists Do It With Models

So I had this grand master plan for a great post this morning, but then I realized that it was the start of a holiday weekend and people probably aren’t clamoring for 1500 words with some snarky lesson about economics. As such, I present to you instead two comics with snarky lessons about economics, courtesy of Dilbert:

I was about to conclude that Scott Adams knows more about economics than he lets on when I thought better of it and looked up his Wikipedia page. Turns out he actually studied economics in college and has an MBA from UC Berkeley. Personally, I take that as a good sign that there is career hope for me yet.

Anyway…in fairness, the stock-based compensation isn’t really as great as Dogbert would like to think- yeah, he can ride a wave of good times, but he also gets punished when his company does relatively well in a crappy overall market. Ideally, performance-based compansation would reward Dogbert for his company doing well relative to the general market outcome, since (unless his company is a bank or makes American automobiles, apparently) Dogbert doesn’t have the ability to control the performance of the overall market.

Economists have understood this for a while, and they refer to the concept as “relative performance evaluation.” Basically, this translates to “we figure out who your relevant competitors are and reward you if you do better than they do.” This seems appropriate because it filters out the market effects while leaving a form of performance-based incentive in place. However, some people worry that this could result in a bunch of executives sitting around and colluding to be lazy- after all, it’s the compensation equivalent of grading on a curve, as in “hey, if we all agree to not study, then none of us will fail.” In practice, this is unlikely to happen since there’s always that one nerdy kid (or executive) who goes off and secretly studies, blowing the curve for everyone. (And then gets beat up on the soccer field after 5th period. But I digress.)

In their paper “Relative Performance Evaluation for Chief Executive Officers”, Robert Gibbons and Kevin Murphy give an overview of the pros and cons of the system and then make a few observations. I will summarize those observations here since the authors managed to make even the abstract of the paper too verbose and technical to actually want to read:

• Observation of CEO compensation contracts gives evidence that relative performance evaluation is in fact significantly based on relative performance evaluation.
• Even though a form of relative performance evaluation is in place, it appears as though the benchmark is related to overall market performance than specifically to industry or competitor performance.

But wait, there’s more! (Too soon for that? I couldn’t decide.) The very day after Scott Adams published the above strip, he comes with another gem on executive compensation:

I am curious as to how many of Adams’ readers actually get the joke that he is trying to make. Adams is trying to make a point about the concept of “board capture”, which is a situation where Chief Executives take advantage of weak Boards of Directors and dispersed and/or disinterested shareholders in order to get exorbitant pay packages for themselves approved. (In case you weren’t aware, shareholders and Boards of Directors are responsible for setting the compensation for Chief Executives.)

Randall Thomas (of the Vanderbilt School of Law) has a paper that discusses why American CEOs are paid more than their foreign counterparts. Unfortunately for Scott Adams’ parody, Thomas is critical of the explanation that American CEOs have more control over their boards and shareholders and instead offers market-based explanations for the disparity.

There, you learned something. Now go enjoy your 4th of July weekend. (I might post more if I get bored, but no guarantees.)

(Originally published 7/18/2008. I’ve started to go through old posts to see which are worth some renewed attention, especially since I am swamped with work right now. It’s kind of interesting to see how the tone of writing, among other things, has changed over time.)

Author’s note: I’ve written previously on how a tournament incentive can be an efficient means of compensation. Basically, a tournament incentive is one where the bulk of the spoils go to the top producer. Compare this to a piece-rate incentive where each individual’s payout is a function of how much they produce and is independent of other workers’ performance. You can think of promotions as a form of tournament incentive, since the promotion (and the theoretically corresponding pay increase, unless you are a certain very frustrated friend of mine) is the prize to the supposedly best employee. Anyhoo…

So, I am sitting at home on a beautiful Saturday afternoon watching a baseball game between the Boston Red Sox and the Los Angeles Angels of Anaheim. (I know, I have issues.) Unlike most games, this one is on FOX, and, while I love Jerry Remy and Don Orsillo, it’s a nice change to hear what other announcers have to say. One of the more interesting points that they brought up was how well-trained the Angels players are in terms of the overall spectrum of baseball skills (sacrifices, bunting, strategic running, etc.). They credited the Angels’ minor league organization for this fact, saying that the minor league managers were somewhat unique in that they were more focused on developing players’ skills than on specifically winning games. Put that way, the managers’ goal makes perfect sense- I don’t really think there is a large benefit for a team due to a winning minor league organization. Furthermore, the incentives for the players are such that they are much more willing to practice and experiment in the minor leagues than they would be when a whole bunch of people (fans, other teams, etc.) are watching and critiquing. So why doesn’t this happen more often?

I am not overly familiar with the contracting structures for minor league managers, but I highly doubt that their compensation is directly dependent on the number of games that they win. (Players aren’t allowed to contract on such things, so it would stand to reason that managers can’t- or won’t- either, especially since no one seems to care about the minor league records.) Therefore, an economist might argue that there are no perverse incentives at play since there is no direct compensation for wins, which would incentivize wins at the expense of drilling fundamentals. However, the FOX announcers are quick to point out that there are indirect incentives for wins because minor league managers use their records as a selling point when angling for a promotion.

How can this unintended incentive be corrected for? One solution would be for an organization to commit to not using win-loss records in promotion decisions. This would work well for internal promotions, and seems to be roughly what goes on with player promotion to the big leagues. (There isn’t a particularly high correlation between minor league stats and getting called up.) But this would be ineffective overall, since an organization cannot prevent other teams from considering the records in external hiring decisions. A practical solution, then, would be to offer a competing incentive. Ideally, you would want to incentivize based on how well the manager drills the basic skills. Unfortunately, this is hard to measure, especially without distorting incentives in other ways, and there is a clear bias towards providing incentives for things that the easily measured. That said, the organization that can overcome that issue will end up with a very well-trained major league team, not to mention (theoretically) higher value for its minor league prospects.

(ignore this: 25pmetgzna)

Here’s the deal, which you may have heard by now: Steve Jobs underwent a liver transplant back in April 2009. This just came out a few days ago, since the Methodist University hospital in Tennessee originally denied him being a patient there. (A blurb on the hopsital’s statement can be found here.) In honor of this, let’s give some background on organ transplants from an economic perspective.

Al Roth is a professor at Harvard Business School who studies what he labels as “repugnant transactions” and how they act as a contraint on markets. For example: Section 301 of the National Organ Transplant Act
(NOTA), 42 U.S.C. 274e 1984 states “it shall be unlawful for any person to knowingly acquire, receive or otherwise transfer any human organ for valuable consideration for use in human transplantation”. Put more succinctly, you’re not allowed to buy and sell organs. Why? Because it’s potentially unfair, crass, and generally icky seeming. We as a society in the U.S. seem to have decided that organs should go to who needs them the most, which is not necessarily the same as who has the highest willingness to pay. (People in California have also apparently decided that no one in their state should be allowed to eat horse meat, since the idea is so gross that it imposes a cost on non-horse-eating people because they have to think about the concept of eating a horse. Just wait until the anti gay marriage people start making a similar argument. *sigh*)

Anyway, I digress. Prof. Roth has an interesting PowerPoint presentation on the topic, as well as a paper. (The paper is more detailed/insightful, but the PowerPoint is an easier read. I leave it to you to choose your poison.)

I would argue that the need criterion works okay for organ markets where the supply is fixed, such at that for hearts. But what about other markets where organ donation is more voluntary, such as that for kidneys? (Or for livers, apparently, since in my reading today I learned that someone can donate half of their liver to another person. I’m guessing a main downside there is a severe constraint on one’s drinking ability.) In the case of voluntary organ donation, a non-zero price could increase the quantity supplied of organs and shorten the queues of people waiting for transplants.

So now that we understand the issue at hand regarding organ donation, let’s come back to the case of Mr. Jobs. Take a look at what CNN has to say:

“There are 127 centers in the U.S. that perform liver transplants. If you need an organ transplant, your doctor will refer you to one of these centers, where you will be evaluated, given a score based on the severity of illness, and placed on the center’s waiting list, if you are indeed a candidate for transplant.

The center’s waiting list feeds into a national database managed by the United Network for Organ Sharing (UNOS), a nonprofit organization that contracts with the federal government to manage the nation’s organ transplant system.

UNOS works with 58 organ procurement organizations (OPOs) that coordinate organ distribution in their region of the country. When an organ becomes available, the OPO in that region searches the UNOS database for a local match using blood type (and other biological considerations), the patient’s severity score, and the time spent on the waiting list. If a match can’t be made within that region, the organization expands its search to neighboring regions.

The problem — or the advantage for some patients — is that not all OPOs are created equal. Some regions contain nearly 15 times as many people as others, and their waiting list times vary widely. Patients in the smaller OPOs tend to be less sick and experience shorter wait times before getting an organ. In the Tennessee OPO where Jobs received his transplant, the median wait for a liver between 2002 and 2007 was just over four months. The national average was just over a year, and in some OPOs it was more than three years.

Though there is always the possibility of preferential treatment once a patient is on a waiting list — UNOS conducts periodic audits of transplant centers for exactly this reason — it is unlikely that someone like Steve Jobs can ‘cut the line’ of the transplant waiting list.

The reason that some people might be able to get transplants more quickly is that they’re standing in more lines. Nothing prevents someone from being evaluated and listed at multiple transplant centers. As long as a patient has the wherewithal to fly around the country — and be available at the drop of a hat if a liver becomes available (this is where the private jet comes in handy) — a patient can, in theory, be evaluated by all the transplant centers in the country.”

So Steve Jobs responds to incentives- the incentive in this case was a shorter wait time for a liver (and better facilities, as my reading seems to imply), and the action was to move to Tennessee. Commercial Appeal reports that “The transplant waiting list in Tennessee is shorter than in many other states, according to data from The United Network for Organ Sharing. In 2006, the median number of days a person waited once placed on a transplant list nationally was 306. In Tennessee, it was 48 days.” Given this, Steve Jobs bought a house there, either to camp out in while waiting for a liver or to live in while recovering, or both. (Sidenote: the best part of the CA article is the following: One blogger at cultofmac.com used an aviation scanner to log the movements of Jobs’ private jet and wrote “it looks like he flew to Memphis on March 23.” Seriously people, do you not have anything better to do than stalk Steve Jobs?)

After reading way too much about this issue, I conclude that people don’t seem to be entirely supportive of Steve Jobs “gaming the system”, despite the fact that he technically didn’t get any preferential treatment. But, as usual, let’s think more carefully about the situation. The objection seems to be that, by getting on the list in Tennessee, he is taking a spot away from someone else in Tennessee. Maybe this means that the person behind him in line had to wait 49 days rather than 48 days. While this is a potentially true statement, it considers only one side of the issue. The other side of the issue is that, by getting off the list in California (which, if nothing else, Jobs does by getting a new liver elsewhere) there is a person in California that perhaps gets his new liver in 305 days rather than 306 days.

As a (wannabe) academic economist, one of the things I have learned to do is try to anticipate others’ objections to the arguments that I present. In this case, my guess is that you might be thinking the following: “But wait a minute- maybe the difference between 48 versus 49 days is a bigger deal than the difference between 305 versus 306 days, since by 305 days you’re a lost cause anyway. Therefore, the cost imposed on the person in Tennessee is greater than the benefit to the person in California, so Steve Jobs is imposing a net cost on others by moving.” (Even if this isn’t objectively true, people tend to exhibit loss aversion and weight perceived losses more heavily than perceived gains. As a result, this sort of argument would not be surprising.)

This is certainly a possibility. But even if it is the case, let’s again turn the scenario on its head a little. Most people either can’t or don’t move (I am guessing more the former than the latter) in order to get an organ transplant faster. This is how the discrepancies in wait times persist…and is it really fair for the person in Tennessee to have a better chance of survival because he happened to be born in a state with a relatively high ratio of liver donors to receivers? (I love that one blog commenter pointed out the irony of a good usable liver supply in the home of Jack Daniels. Hee.) Wait, I can phrase the question a different, yet equivalent way- is it really fair for the person in California to have a worse chance of survival because he happened to be born in a state with a relatively low ratio of donors to receivers? (I’ll bet you never fully thought about how important the framing of a question is until now.) When put that way, the most fair outcome would be for the wait times to equalize across regions. Isn’t Steve Jobs doing his part to foster this equality? So please, think happy thoughts for old Steve and please, please, stop stalking his house, since that’s just creepy.

In the red corner (pun intended), courtesy of Real Time with Bill Maher, we have The Young Cons, a couple of rising Dartmouth sophomores who seem to be trying to make being right-leaning cool. Too bad they don’t have the shiny hair and pretty smile of Meghan McCain…

You can find the lyrics here. I’m not trying to say that I agree or disagree, just that they touch on some economic issues…

In the dumb corner (yes, I am okay with the lack of parallelism), courtesy of Kevin Bjorke via Facebook, we have…well, I’m not quite sure what this is. The series is entitled “Bored in Bikinis”, and the description says “The girls browse through magazines like Forbes to give their two cents on private equity, GDP, and IPOs.” Watch at the risk of your own IQ:

The best line: “I thought only guys like economy magazines.” Sigh.

So which is worse? The boys are ridiculously nerdy, which could go either way, but they’re a little too self-righteous in my opinion. On the other hand, I am annoyed at the girls’ video, since I had such high hopes for it to be totally awesome. Come on- it could have completely embodied the “economists do it with models” concept AND had girls in bikinis talking about economics. Clearly the world is not ready for that…double sigh.

A friend posted this on my Facebook profile, courtesy of rall.com:

Hee. This is particularly funny to me considering that I tutor for the LSAT. It also reminded me of a paper that I read a while back.

It’s unclear to a degree whether criminals are acting rationally- i.e. whether they are considering the real costs and benefits of an action and coming to the conclusion that yes, it’s the optimal choice to rob this bank, or yes, it’s the optimal choice to mug that little old lady. (Funny that in both of those situations there is a pretty good chance of getting both cash and candy.) When lawyers and/or economists (law and economics classes are becoming more common, which I think is awesome) talk about the concept of deterrence, they typically think that the potential criminal really is thinking ahead and doing some sort of net present value calculation. (Or even if they don’t think this is the case, they acknowledge that there is no way to deter those criminals who are just batshit insane and focus on what they can control.) The concept of deterrence is an attempt to set punishment in order to shift the outcome of the cost/benefit analysis to the “not worth it” side. There is even a concept known as marginal deterrence that aims to shift criminal behavior to less severe activities in the cases where they may not be able to be prevented entirely. (i.e. set punishment so that the criminal only kicks the old lady rather than throwing a brick at her. Isn’t the economics of crime morbid?)

Are criminals rational? David Lee and Justin McCrary argue “probably not, in a lot of cases” in their paper “Crime, Punishment and Myopia”. (In case you are curious, myopia refers to nearsighedness, so if you are acting myopically you are being short-sighted. Take that, SAT verbal.) They find a natural experiment as a result of the fact that legal punishments are generally much tougher once an individual turns 18 and is a legal adult. This would suggest that, if criminals were acting rationally, you would expect to see a. more crimes committed by minors (after adjusting for other factors), and b. less criminal activity within an individual once he turns 18 and the punishment increases. The authors of the study look at the second implication most closely but do not find the evidence that the change in punishment would suggest. They conclude that “potential offenders are extremely impatient, myopic, or both.”

Lesson learned: when the dude in the ski mask breaks into your house, economic principles are not likely to be nearly as helpful as a baseball bat or golf club. (Sidenote: I got mugged once. I tried to reason with the guy by kicking him in the groin. It didn’t entirely work, but it gave me time to get my house keys out of my bag- important since I was right outside my front door. How’s that for marginal deterrence?)