Archive for the ‘Economics’ Category

Lloyd Shapley and Ehud Kalai, 2008, left panel; Alvin Roth, 2010, right panel

Left: Lloyd Shapley (left) and Ehud Kalai, ca. 2004 (Photo courtesy of Ehud Kalai). Right: Alvin Roth during the 2010 Nancy L. Schwartz Memorial Lecture (Photo © Nathan Mandell).

Lloyd Shapley and Alvin Roth were awarded the 2012 Nobel Prize in Economics this week. Even though the Kellogg/NU poll did not predict this year’s winners, in the time since the announcement, many faculty have agreed that this is a well deserved award. The prize was for Shapley’s and Roth’s work on “the theory of stable allocations and the practice of market design.”

Lloyd Shapley is considered one of the founders of game theory, in particular cooperative game theory. “His work is amazing,” said Professor Ehud Kalai, founding editor of Games and Economic Behavior and co-founder of the Game Theory Society. “Almost everything we do is influenced by the work of Shapley, Nash and Aumann.” In Kalai’s view, Shapley created several important areas of research, spanning from Shapley value, to the notion of the core of a game, oceanic games (large games with an ocean of players), stochastic games and matching, among others.

According to Professor Robert Weber, who is a co-author of Shapley:

Lloyd Shapley is a beautiful person.

He led the development of game theory, both in its mathematical underpinnings, and as a broad field of economic relevance. Most of the key results in its early years benefited from his insights. His work is elegant, and is a delight to read.

As well, he has always been gracious with his time, sharing his intensity and interests both with senior colleagues and with students as they first step into the area. I treasure the time I’ve spent with him over the past 40+ years.

Among the work by Shapley cited by the Nobel Prize committee is his research on matching students to colleges with the late David Gale in 1962 (“College Admissions and the Stability of Marriage“). The resulting Gale-Shapley algorithm was a formalization of a mechanism to match elements of two groups (students and colleges, firms and workers, etc), considering their preferences in such a way that the match is “stable” in the sense that there is no alternative matching that would make one of the matched pairs better off.

Professor Thomas Hubbard, currently Senior Associate Dean for Strategic Initiatives, was a colleague of Lloyd Shapley at UCLA during the mid 1990s. He highlighted another aspect of Shapley’s contributions, the notion of Shapley value in coalition formation. Power in a negotiation depends not just on the best alternative to a negotiated agreement but also on how much value a party contributes to the various coalitions it might form with others. The idea of Shapley value is also used in strategy classes, albeit dubbed ‘added value’ in MBA teaching (following the book by Adam Brandenburger and Barry Nalebuff, Co-opetition).

Alvin Roth is credited with having realized the value of Shapley’s work in a number of applications. In joint work with Kellogg School’s Professor Keith Murnighan, he started testing the axioms of bargaining theory in the lab. Their collaboration, which dates back to the late 1970s, led to a dozen of published papers and was discussed in a 2006 chapter. In a blog entry on Monday, Murnighan said:

I always claimed that I taught Al how to do an experiment. Truth be told, I didn’t have to tell him much. After we had worked together for a while, I often told him that someday he would do an experiment on his own; he always replied by saying that someday I would prove a theorem on my own. We both actually did that.

In experimental and theory work, Roth and his co-authors extended and applied matching theory to a variety of settings, including kidney exchanges, residency assignments of newly minted doctors in the US, as well as school admissions. His work led to practical applications of game theory in the National Residency Matching Program (which implemented a matching algorithm designed by Roth in 1997), in the New York City public high schools and the Boston Public School system, which use a version of the deferred-acceptance model algorithm. Finally, Roth and co-authors Tayfun Sönmez and Utku Ünver founded the New England Program for Kidney Exchange with doctors Frank Delmonico and Susan Saidman. In his Nancy L. Schwartz Memorial Lecture in May of 2010, Roth discussed kidney exchanges in detail. He was the 28th speaker in this annual lecture series and the 13th Nobel laureate (9 of whom went on to win the Nobel after giving the lecture).

The last time Lloyd Shapley gave a lecture at the Kellogg School, was during the Third World Congress of the Game Theory Society, in July of 2008. At that conference, Tim Roughgarden gave the first Shapley Lecture, a newly established lecture series.

For more information, see the blog entries by professors Jeff Ely in Cheap Talk and Rakesh Vohra in The Leisure on the Theory Class. Al Roth blogs at Market Design.

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Nobel Prize season is upon us. For the fourth year, we polled faculty members in the Kellogg School of Management as well as the Economics Department in the Weinberg College of Arts & Sciences at Northwestern University about their predictions for this year’s Nobel Prize in Economics. In over a week of voting, 42 faculty members responded with far-ranging predictions: 39 different prospective Nobel candidates were selected.

Two names top the list this year – Oliver Hart and Jean Tirole, each with 7 votes.  Jean Tirole has a been a long standing favorite of our faculty, included among the top three names each year we have run the survey.  He is a faculty member at the Toulouse School of Economics and has published widely in the areas of industrial organization, finance, corporate governance, and contract theory.  Oliver Hart, a professor in Harvard University, is widely known for his work in contract theory, theory of the firm, and law and economics.  Hart and Tirole were the only names that garnered votes across four academic departments (out of seven), which might be interpreted as an indication of how influential their body of work has been across fields.

Click on the chart to see a larger version.

On many occasions, the Nobel prize has been awarded to more than one scholar. One duo that surfaced in the survey was that of Bengt Holmström and Jean Tirole.  Both have co-authored a number of influential papers on financial intermediation, theory of the firm, and liquidity.

Attempting  to further read the tea leaves provided by the survey would indicate that there is some expectation that mechanism design deserves another prize (the previous one was bestowed in 2007), with scholars such Robert Wilson, Paul Milgrom and Alvin Roth making it onto our list.

In 2009, many were surprised that a non-economist (the late Elinor Ostrom) was among the Nobel winners that year. Could 2012 bring another surprise? One faculty member thought Mark Granovetter, an economic sociologist noted for his work on social networks and embeddedness, might be this year’s Nobel dark horse.

The Nobel Prize in Economics will be announced on Monday, October 15 at 6:00AM CDT. Set your alarms!

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Spanish passport

As an American, I sometimes eye with envy people who hold a passport from a European Union country— with one, it’s so easy to travel to, from, and within the continent. But an EU passport also represents far more mobility than just the tourist kind. Citizens of EU countries can easily do their banking in other nations, make inter-EU business deals more expeditiously, and even work abroad with few barriers. In good times, the arrangement seems to have worked well for everyone.

But in tough times, as in recent years, some cracks begin to show. Low barriers used to be a way to gain opportunity. Today, they’re often used as a way to escape hardship. Last week the New York Times ran an article on Spaniards stashing either their cash or themselves in other, more prosperous, more stable EU countries.

Moving your bank account is a relatively trivial thing to do. And while it creates headaches for banks who are already low on capital, as easy as cash flows out of a country, it can flow back in. More troubling is when people pack their bags.

“Migration of a skilled part of the labor force can be costly as it depletes the country’s stock of human capital,” said Arvind Krishnaumrthi, a professor of finance.

“It will create problems for Spain, but I’m sure countries the countries they move to will be thrilled to have them,” said Camelia Kuhnen, an associate professor of finance.

On balance, though, Spain would probably prefer to keep its workers. Still, that won’t be easy given the debt crisis. “It will be difficult to hang on to the workers who can leave, given the high rates of unemployment that countries like Spain are experiencing,” said Sergio Rebelo, a professor of finance.

Even after unemployment rates fall, it may be a while before battered countries are able to lure home the workers who left. In many European countries, “Political and cultural realities might make it impossible to stop brain drain in the short run,” Kuhnen said.

Still, the EU’s relatively open labor market has its upsides. “In the short run it helps because it allows workers to find jobs elsewhere,” Rebelo said. “There are also some potential benefits in the medium and long run. Economies like India complained for decades about ‘brain drain,’ the migration of educated workers to other countries. But, once India opened up and created conditions for growth, the Indian diaspora became an important business network that linked India to the world economy.

“The same can happen in Spain or Portugal. These are countries with great weather and wonderful food. Many of the immigrants will end up returning, bringing contacts and business ideas. But there is a cost to migration, when the young seek work abroad they leave behind a country that becomes older and less dynamic.”

As migration between EU nations becomes more commonplace, there could be some additional, non-economic benefits. Historically, language barriers and strong cultural identities have kept labor mobility low in Europe, especially compared to somewhere like the United States, which shares not only a common currency but typically a common language. Yet as people pick up and move to find employment, some of those cultural barriers will surely dissolve. That doesn’t mean there won’t be some hurdles. “In the short run, you’ll see more anti-immigration sentiment,” Kuhnen said. Immigrants are often accused of “stealing” jobs, she pointed out, a charge that may be levied more frequently in bad times than good. But, she added, eventually those suspicions could wane with time.

Is labor mobility good for Europe, both culturally and economically, I asked her? “In the long run, for sure the answer is yes.”

Photo by Katratzi.

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US Supreme Court

This morning, the Supreme Court upheld Affordable Care Act’s individual mandate. While the biggest surprise was Chief Justice John Roberts’s siding with the majority in the case, a close second was how the majority interpreted the constitutionality of the of the mandate. They said the mandate is a tax, not an extension of the Commerce Clause.

Confused as to what exactly that means? I asked Thomas Brennan, an associate professor of law at Northwestern with a joint appointment in finance at the Kellogg School, to clarify things.

Brennan said the main question before the Supreme Court was which part of the Constitution allowed Congress to penalize people who don’t get health insurance. There were two main possibilities, the Commerce Clause, which gives Congress the right to regulate commerce between states, and the 16th Amendment, which grants Congress the power to levy taxes without doling it out to the states or basing it on Census results.

That the taxation argument won caught people by surprise. The Commerce Clause has been why many laws enacted by Congress have passed legal muster, including the Civil Rights Act of 1964 and various parts of the New Deal. It was also seen as the part of the Constitution on which the mandate would be either upheld or struck down.

The taxation issue “was not briefed or argued in nearly as much detail as the Commerce Clause issue, and I don’t think that most people thought it would carry the day for the new law,” Brennan said.

Part of that surprise stems from the Commerce Clause’s wide applicability. “Over the years, the nature of what exactly constitutes ‘Commerce’ for this purpose has been broadened considerably,” Brennan said.

In the Affordable Care Act case, “One argument was that the penalty provision now came within its scope as well. Another argument was that this was far beyond the intended meaning of the Commerce Clause, particularly because it charged people a penalty for inaction rather than for action. The Supreme Court decided, essentially, that this latter argument was more correct—the Commerce Clause does not go this far. As a result, today’s opinion can be seen as reining in, to a degree, the expansion of the Commerce Clause to new areas.”

While four of the five in the majority supported the mandate under the Commerce Clause, Justice Roberts did not. Yet even though he didn’t support the Commerce Clause argument, he didn’t invalidate the mandate, either. Instead, he said the mandate acted as a tax on the people who have to pay it, which is within Congresses powers.

But as with many aspects of law, there’s a lot more to this decision than meets the layperson’s eye. “The tricky thing here is that the constitution requires ‘capitations’ and ‘direct taxes’ to be apportioned among the states, which means that the amounts collected need to be pro rata across the states according to the populations of the states as recorded by the Census,” Brennan said.

“There is a critical question here of what a ‘capitation’ or ‘direct tax’ is, and it is murky and complicated,” he continued. “The relevant prior Supreme Court cases that deal with the issue are over 100 years old, and some of them over 200 years old. The answer is not completely clear, but it seemed very plausible that the penalty might be a ‘capitation’ or ‘direct tax’ and thus be subject to apportionment. This would have eliminated the taxing power as a basis for upholding the penalty provision, since apportionment among the states was not what the law was doing.

“What the Supreme Court did today, though, was to really significantly simplify and expand the interpretation of what things are neither ‘capitations’ nor ‘direct taxes’ and thus are things which Congress has the power to collect from people under its taxing power, without apportionment.”

In the last century or so, few Supreme Court rulings have limited the expansion of the Commerce Clause. This ruling went against that trend. “But that was significantly offset by a new door to Congressional power that was opened by reading the taxing power as far more broad than it had previously been understood to be,” Brennan said.

Brennan also noted that while today’s ruling was influential, he’s not sure how it will affect legislation or court rulings in the future. “In principle, it opens up the door to many other things being deemed taxes that are not subject to apportionment and letting Congress collect penalties or taxes from people for all sorts of things,” he said. “For right now, though, it simply means that the penalty provision of the health care law has been upheld.”

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Libor logo

Libor is in a spot of trouble. The economic indicator, which stands for London Interbank Offered Rate, is widely watched as a measure of credit risk in the economy. But it has also been the subject of investigations by regulators in the United States, Japan, the United Kingdom, and the European Union. Libor is supposed to be free from abuse, but the investigations suggest otherwise.

First introduced in 1985 by the British Bankers’ Association, Libor influences rates on everything from credit cards to mortgages to financial products. Every morning, a panel of banks submit “bids” that detail the rate at which they feel they could borrow money in various currencies. What gets reported is the interquartile mean, or the average of the middle 50 percent of those bids.

The problem is that the process of submitting those bids is not entirely transparent. Since many financial instruments are tied to Libor, traders at some banks apparently tried to influence the indicator by misreporting their bids to boost their profits.

“Libor is a standard reference rate used to construct and settle trillions of dollars worth of contracts annually,” said Robert McDonald, a professor of finance. “Manipulation of the rate is an embarrassment for the banks and the regulators, will undoubtedly lead to lawsuits, and undermines the integrity of the financial system.”

As such, the BBA is considering changing the way Libor is calculated to avoid similar problems in the future. They say it is part of a regular review of the indicator, but the scandal undoubtedly has something to do with it.

The overhaul is something of a tacit admission that Libor is manipulable, something which BBA has previously denied. Despite that, McDonald says the rethink won’t hurt the measure any more than the scandal already has.

A future without Libor is difficult to imagine. According to a government bond trader interviewed by the Financial Times, “If you want a figure for term interbank rates, you have to use the Libor survey because there are no or very few actual trades.”

Still, if Libor does fall out of favor, McDonald is certain something will take its place. “People would latch onto or construct something,” he said. What’s less certain is what that something will be.

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Nurses station

On Monday, the New York Times covered a study that claims electronic medical records may not cut health costs. The paper was written by a collection of doctors and public health experts. Steve Lohr, reporting for the Times:

The study showed, however, that doctors with computerized access to a patient’s previous image results ordered tests on 18 percent of the visits, while those without the tracking technology ordered tests on 12.9 percent of visits. That is a 40 percent higher rate of image testing by doctors using electronic technology instead of paper records.

That’s seemingly bad news for electronic medical records, which have been touted as one way to drive efficiency and cost savings in health care. The New York Times is apparently taking this study quite seriously, going so far as to publish an editorial the day after the article ran.

Still, something about this study didn’t seem right to me, so I asked around. Some professors were willing to give me a bit of background, but not openly, citing research in progress.

First, electronic medical records (EMR) are typically deployed in hospitals and clinic networks that have money to spare. The up-front costs of switching from paper to digital are not insignificant. Second, not all providers have deployed EMR to the same degree. Hospitals and clinics that use EMR can be split into roughly two camps—those still early in the transition and those that have been using EMR for years.

The study covered in the Times did not account for this bifurcation. If it had, it’s most likely that it would have reported a different result. Hospitals and clinics early in their use of EMR have higher costs for the first two years. After that, if the hospital is in a well-networked location with access to talented information technology professionals, costs will likely drop. Many hospitals further along with the transition have seen their costs drop after the initial spike.

Finally, during the time covered by the EMR study, imaging technologies have become more widespread. It’s possible that doctors are ordering more imaging tests because they now have access to more imaging machines, and that this merely coincided with the adoption of EMR.

There’s certain to be more research on this topic, so stay tuned.

Photo by Dave Q.

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Jeremy Lin

The Jeremy Lin success story has many questioning the ability of scouts and teams to pick the best talent, especially in the NBA. Jonah Lehrer wrote a piece a couple of weeks ago that was a stinging indictment of the “meritocracy” that he says professional sports purports to be. He cites a study that shows NFL teams barely do better than chance alone would predict in selecting top talent.

I sent the article to Blake McShane, an assistant professor of marketing who has studied baseball statistics. We should cut scouts and the draft process some slack, he said. “It is hard enough to predict future athletic performance at a given level of play. It is thus even far harder to predict performance when moving from one level of play to another.”

Countless players have stumbled as they moved from, say, college to the pros. Take Tony Mandarich. The Green Bay Packers drafted Mandarich in the first round in 1989 as the second pick overall, behind Troy Aikman and ahead of Barry Sanders. Hopes were high—Mandarich was an outstanding player in college, and the Packers needed a boost.  Plus, his performance in the scouting combine—one way the NFL evaluates prospects—was singular. “It may have been the finest workout the scouts have ever seen,” George Perles, Mandarich’s former coach at Michigan State, told Sports Illustrated in 1989.

But Mandarich’s subsequent performance for the Packers was underwhelming, to put it mildly. Whereas Aikman and Sanders were star players for their teams, Mandarich mostly played special teams before being cut in 1992.

Part of the problem may be in the way the NFL and NBA cultivate talent. McShane pointed me to an article at Marginal Revolution, quoting at length J.C. Bradbury, an economist who specializes in sports. Baseball may offer a different model, according to Bradbury:

In baseball it’s different. Players play their way up the ladder, and even players who are undrafted can play their way onto teams at low levels of the minor league. At such low levels, the high variance in talent is high like it is in college sports; however, promotions from short-season leagues through Triple-A, allow incremental testing of talent along the way without much risk…

Also, a baseball scout acquaintance, who is very well versed in statistics, tells me that standard baseball performance metrics in college games are virtually useless predictors of performance (this is contrary to an argument made in Moneyball).  Even successful college baseball players almost always have to play their way onto the team.

This system is very much unlike football and basketball, where players often play their entire college career at one school. With little fluidity in the market, someone like Jeremy Lin may not have as many chances to break out in basketball as he would if he played baseball.

Photo by DvYang.

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