A video dear to my teaching philosophy

This YouTube video on video game design touches on points that I think are important to all sorts of teaching and learning. For 'video games', read 'economics', and for 'controller', read 'mathematical model'.

This post pre-empted by the US election

On Thursday: Galbraith, pre-Raphaelites, economic theory and internet fanfiction.

Selling search

A few days ago I asked my students the following question:

It's well-known that internet piracy of music is rampant. How is it, then, that iTunes can make a profit selling songs at 99 cents each? Someone who can use iTunes presumably has access to the rest of the internet. Apple is competing with other producers of an identical product who offer it at a price of zero.

One young lady made a very insightful comment - she pointed out that Apple is not so much selling the music so much as charging a transaction fee for the use of a convenient, reliable and safe search engine. The content may as well be free; it's the search that is being sold.

Finding a song on pirate sites can be difficult, due to spotty labeling, broken torrents, virus-infested files and so on. iTunes users don't have to put up with any of that.

The flat 99 cents that are charged for each song tend to bear out the 'transaction fee' idea. Neither popularity, nor file size, nor the original source of the content affect the charge.

This is the same model that some academic journals use for people seeking PDF files of their articles. The journals also compete with 'free' producers: most academics have free access to these articles at work. There's a big difference in this market, though: buying the reprints from individual journals is a painful process, requiring separate registrations and payment schemes for each publisher. Accessing the articles via a work-place portal is not only 'free' (in the sense that the employer bears the entire cost, usually fixed) but vastly superior in efficiency. Library web sites and databases such as EconLit look through the contents of dozens of publishers for each search.

The biggest search engine of all is Google. Search is free, and content found through the search is usually free. This engine is supported through ad revenue, which I find curious. Though I use it many times a day, I can't remember the last time I clicked on one of the sponsoring ads, even by accident. I don't think I'm alone in this.

It's not unheard-of in the offline world for human tour guides to share their take with those providing the sights of note - iTunes's model. The journal publishers are individual stalls in a bazaar, competing with a supermarket. Google hopes that passengers on the trip will buy from the in-flight boutique, or at least burn into their memory the sponsored posters on the walls.

Economists and regulation

Perhaps not surprisingly, the recent financial crises (note the plural) has led more than a few people to think that tighter regulation of money matters may not be a bad idea.

What IS surprising, or has been to a few of my students, is that some of these people are professional economists.

To the general public, the word 'economist' is tied up very closely with 'free trade' and 'free markets'. That they may support regulation seems at first a contradiction.

In point of fact, economists are responsible for much of existing economic regulation. This includes everything from rules for monetary policy, to deciding on the guidelines for the approval of a merger, to controls on firms' pricing policies to encourage competition.

Economics is all about the efficient use of scarce resources. The 'stuff' we have - natural resources, time, knowledge, health and so on - is limited. The stuff we want is unlimited, and the needs of the world's population, while arguably limited, are not being met.

In some cases, leaving markets alone will get the job done, getting stuff where it's most needed or desired without too much lost along the way. That's great.

In other cases, leaving markets alone may result in waste, or inefficiency, or some other loss of the potential available to society, given what we have to work with. It's in these cases that regulation is welcome.

When it comes down to it, economists and environmentalists think rather alike. Our focus just happens to be on different resources, different needs, and different desires. Sometimes. Environmental economics and resource economics are flourishing fields in their own right.

Just as environmentalists, while generally preferring 'free nature', may advocate conservation programs, seed banks and so on, economists, while generally preferring 'free markets', will often advocate helpful regulation.

Financial markets and change

Lately, I've been re-watching an excellent series of videos on the Industrial Revolution. The show tries to explain, in part, why the Industrial Revolution happened in England, and not in, say, Holland or France, either of which would have seemed more likely candidates to contemporary observers.

Their answer is that many unusual ingredients were required to go from a pre-industrial, static world to an industrial one in which growth was expected. England happened to have them all at the right time.

One of these ingredients, the show argues, was the existence of modern-style financial markets.

In general, before the 15th century-ish we don't see much paper trading in Europe. No stocks, bonds, or other fancy financial instruments. When people bought something, it was usually because they actually wished to own the object or service in question. If someone paid for the construction of a church, it wasn't to 'flip' it. It was because they wanted a church there. There wasn't much lending for the simple reason that most religions frowned on usury, and the law of most lands paid at the very least lip service to religion.

All of this contributed to the static nature of society. Things didn't change because no one was willing to take the risk. People bought what THEY wanted, and not what they hoped other people would like. Producers produced to known tastes, with changes in style or technique being unusual and revolutionary. There were relatively few risky ventures. Society consisted of haves, and have-nots. If you had money, then you usually were in a position to continue to have it. There was no reason for you to risk tossing it all away on something that may not pay off. If you didn't have it, there was (almost) no one willing to lend you the money, because they wouldn't be able to charge a very high interest rate, if any at all.

In general, then, yes, I'd definitely agree that the existence of modern-ish financial markets is absolutely necessary for the kind of prosperous, innovative, dynamic society we've come to know and love.

That doesn't mean that it's without its pitfalls...

According to the video, the Dutch invented modern finance. I'm not sure I agree with this, but let's take it as given for the sake of argument. If nothing else, the Dutch were certainly popularizers of the practice.

Holland started trading paper. A lot of it. Prior to the 17th-ish century, when you bought a share in a ship's voyage, that's exactly what it was. Trading ships were expensive, and so were trips to the Indies, not to mention risky. You bought a share in the ship in order to share your risk with other investors. When it came back to port, you took the corresponding share of the profits from her cargo. If she failed to return to port... well, you had a problem.

The Dutch made popular the practice of trading shares in these ships. Cargo futures, if you will. Instead of holding them to maturity, you'd sell your share to someone else, who could then hold it or share it, and so on.

The same happened with other types of risk and stream of income or future windfall.

What was one of the first uses it was put to?

Tulips.

The video series dwells on this for quite some time. Essentially, what happened was this:

Tulips were new to the Dutch. They imported them from the East. Certain kinds of tulip had ink-blot-like markings. These were considered especially beautiful. ulips grow from bulbs. Bulbs all look pretty much alike and don't tell you what the future flower will look like. Today, we know it was the mosaic virus that caused these markings. Back then, the Dutch thought it was just random chance.

What took place next may look a little familiar...

At first, people bought tulip bulbs because they actually valued the tulips they might grow into.

People noticed that some tulips were selling for extremely high prices, and decided to start selling tulips.

Other people noticed the people who noticed the rise in tulip prices, and joined in.

The rise in people buying tulips raised the price of tulips - even though these people were only buying them in order to sell them at a higher price later on.

The higher the price became, the more people joined in the market, driving the price even higher, which attracted more people.

Eventually, it all fell apart when a few people decided to... NOT pay the price of a house for a tulip bulb.

The Dutch economy went through a crisis, and people left holding tulips lost everything.

This type of bubble happens over and over again.

It's always caused by a large sum of people buying an asset only in order to sell again, without ever intending to act like an owner of the asset.

The bubble gains momentum when the relative price of the asset that is being traded rises for an extended period of time. (The relative price is the price of the good compared to the price of other goods in the economy. Let's say that tulips and onions both start selling for a dollar each. If the price of BOTH goes up to 2000 dollars each, that's not very interesting. If the price of ONLY tulips goes up to 2000 dollars, while that of onions stays at 1 dollar, then there's a problem.)

The tulip bubble is striking because everyone KNEW they were just flowers, and yet jumped in anyway.

The lesson? Buying to sell to others who are buying to sell is a good way to start a disaster. Modern financial markets make this easier than in earlier times, but in the end, the responsibility lies with the investors.

That's easier said than done, of course. It's difficult to stay out of it when someone tells you, 'sell me tulips, even if you think they're over-valued and part of a bubble about to crash, and I'll give you a hefty management fee'.

A tale of two Cities

Because they are self-contained economies, online games can lead to interesting natural experiments in economics.

Consider 'City of Heroes/City of Villains'. As the name suggests, this single game is divided into two distinct parts: good guys and bad guys. Subscribers to the game pay a monthly fee for the privilege of pretending to be a hero or a villain. The game world is shared by thousands of players, leading to a vibrant artificial economy.

The economy is set up as neatly as an economics instructor could hope for. The 'City of Heroes' and the 'City of Villains' may be thought of as two closed economies. Each produces the same products. Handily enough, these fall into the textbook favourite of two categories: recipes and salvage. For the present discussion, it does not matter what these goods actually are, only that they exist.

As in textbooks, the only input required for the creation of these outputs is time. Heroes 'arrest' bad guys and villains engage in nefarious acts to produce these goods. For various reasons, the City of Heroes has an absolute advantage in the production of recipes. In particular, heroes have easier access to certain rare recipes than villains do. Heroes and villains produce salvage at roughly the same rate, though arguably heroes have an absolute advantage here, as well. Anecdotal evidence suggests that heroes tend to work in teams more than villains, leading to factory work (heroes) vs cottage industry (villains).

One quirk is that salvage and recipes are complementary in production: if you make one, you generally make the other, as well. For heroes, the recipe/salvage production ratio is on the whole larger than for villains. (For those in the know: due to quick Katies, etc.)

Each City has its own currency. Goods are traded for currency anonymously on a consignment market, under a system that is very close to a Vickrey auction. Sellers post their goods along with a reserve price. This reserve price is not visible to buyers. If a buyer places a bid at or above the lowest reserve price, the good is sold at the bidded price to the seller with the lowest reserve price. That is, this system encourages high bidding by buyers and low bidding by sellers. There is no penalty for changing a buyer's bid, but sellers are subject to a transaction fee for each time they change their price.

While the prices at which items are posted by sellers are not visible to other players, buyers have easy access to the prices at which the last five units of the item have actually sold.

Market prices in the City of Heroes are generally much higher than in the City of Villains. The exception is for certain rare recipes, which due to their scarcity and some differences in tastes are far more valuable for villains than for heroes. (For those in the know: Pool C drops and Pet Damage IOs go for a lot more villainside.)

Scarcity is a constant problem in the City of Villains. There are far less producers (that is, there is a lower population) than in the City of Heroes, and so many goods are not available at any price.

There has been some demand for a merging of the two markets - that is, opening them up to trade. Most opposition has come from dedicated merchants on both sides. These are players who spend a considerable fraction of their time in arbitrage, buying low and selling high - essentially ensuring that the market in each city functions like a market.

Salvage traders in the City of Heroes worry that the price of salvage will drop considerably if there is trade between the Cities.

Most dedicated traders in the City of Villains worry that the entry of more producers (and traders) will lower their profits - right now, the villain market functions much like an oligopoly.

What does basic economics tell us about what may happen if the markets are merged?

First, for the easy part: water seeks a level, and so do prices. If the markets are merged, we can expect hero prices to drop and villain prices to rise, with the exception of the rare recipes mentioned above, in which case the effect will be the opposite.

The more interesting question (for me, at least) has to do with the nature of the money supply, and the speed at which currency changes hands.

The minting of money in the game is very different than in the modern real world. There is no central monetary authority. Instead, players mint their own money. Every time heroes 'arrest' a bad guy or villains mug someone, the game creates new currency and deposits it in the player's account. These are the same activities that also generate salvage and recipes.

In other words, in this virtual world, the money supply rises automatically with the production of goods.

There are some money 'sinks', of course, to ensure that inflation does not get out of control. There are transaction fees, luxury and vanity services that may be paid for and so on. Perhaps most importantly, there are no inheritances. When a player stops susbcribing to the game, the currency in their account is taken out of circulation. There are also restrictions on the transfer of currency between players. It is possible, but intentionally cumbersome and potentially risky.

The Fisher equation, beloved of economists, may provide considerable insight into what's going on.

MV = PY, as the saying goes, where 'M' is the money supply, 'V' is the velocity of money - that is, the speed at which money changes hands, 'P' is the price level, and 'Y' is output.

All this equation says is that, all in all, the value of transactions in an economy (the left-hand side) must add up to the value of output (the right-hand side).

For the purposes of our game world, 'Y' is the aggregate of recipes and salvage.

The same process mints money and produces good, so let's suppose that the money supply is some multiple z of output. That is, suppose that whenever salvage or a recipe is produced, so are z units of currency.

Our equation becomes

(zY)V = PY

Dividing both sides by Y,

zV = P

We now have a formula for the price level.

I mentioned that heroes produce recipes more easily than villains. In a half-hour period (the time for a 'quick Katie' task force, an activity which guarantees the produciton of a recipe by each player), heroes can produce more recipes than villains. The amount of currency (and salvage) produced in this time period is much the same for heroes and villains.

Since z represents M/Y, the money supply over output, z should be smaller for heroes than for villains.

If V is the same for heroes and villains, this suggests that heroes should have lower prices, overall... but they don't.

There are two reasons for this.

One is simply due to my simplifying assumptions. I assumed that all recipes are the same, where in fact heroes only have an advantage in producing a particular subset of all possible recipes - and these are, indeed, lower in price for heroes than for villains. The lesson: be very careful in your assumptions when trying to apply textbook economic models.

The second, more interesting reason, is that the velocity of money is drastically different between heroes and villains. The population of the City of Villains is much lower than that of the City of Heroes. Despite the two cities having similar (but not congruent) tastes, the variety of goods available for sale is much greater for heroes than for villains. All in all, this means that the market is far more active for heroes than for villains, and in turn, money changse hands far more frequently among heroes than among villains. There's more stuff to buy, and it's bought more often.

In terms of our equation, V is higher for heroes than for villains.

Let's look back at the original equation:

MV = PY

Rearranging this,

P = V x (M/Y)

What this tells us is that the higher the speed at which money changes hands, the higher you can expect the price level to be.

If the markets in the City of Heroes and the City of Villains were merged, we should expect the speed at which money changes hands to increase overall, due to the larger effective population of each market. This, everything else being equal, WILL lead to a rise in the price level of BOTH cities.

City of Heroes/City of Villains is quite a popular and active game, and new players join all the time.

There is some worry that if prices keep rising, new players, who start with no currency, will be priced out of the market.

This will not necessarily be the case, of course. Since new players automatically become producers of salvage and recipes as they go about their adventures, a high price level means that they receive large amounts of money for the goods they sell, as well as being charged high prices for those they buy. As any self-respecting economics student will tell you, the absolute price level matters very little: it's relative prices that you need to watch.

Still, there are some valid reasons for being worried about the price level. Suppose that the 'government' - the game's developers - wished to step in and keep the price level below a certain threshhold. What can they do?

They could adjust the rate at which money is minted. By lowering z, they may lower the price level.

They could place additional restrictions on transactions, lowering the speed at which money changes hands. For example, they could code in a law that required a cooldown period of an hour (say) after any transaction involving currency, however minor. This would be annoying for players, but certainly has the potential of lowering the price level. It could also have the perverse effect of raising the price of many items. Since the market works as a blind auction, bidders may choose to bid values very close to their actual valuation of the good in question, since they may not have a chance to do so again before the end of the auction.

They could flood the market with goods, lowering their price. I have a sneaking suspicion that they already do this for certain items. Some salvage is only available for production in October. One would expect that as time went on, the price of this salvage would rise, and then fall as October neared again. Instead, the price of this salvage has stayed remarkably constant. Other prices in the market have been very volatile, but the price of this salvage has stayed at 300,000 units of currency for months, only falling again in October, quite suddenly, to 50,000 units. This suggests that the game's developers have used their control of the game world to create 'helicopter drops' of this product in exactly the quantity required to keep its price constant, and affordable. This is a rather roundabout, but quite effective, way of enforcing price controls. It works here because the goods are entirely identical, may be created by the government at zero cost, and cannot be created by the citizenry except during the month of October. These conditions are unlikely to hold in the real world, where, alas, price controls seldom work.

Another possibility: due to their absolute control of the game world, the developers may have set the price of that salvage to be equal to 300,000, no matter what. This is less likely. Due to the way in which the market works, it could be discovered by players attempting arbitrage. Such a discovery would have led to scandal. Quantity manipulation works better than price-setting because due to the anonymous nature of the market, it is not possible to tell who put a particular item up for sale.

Textbooks, lectures and problem sets are, of course, essential for obtaining a detailed understanding of modern economics.

There's a lot to be said for spending some time in these 'sandbox' economies, though.

A quickie

Don't Panic.

That's my advice to everyone asking for economic advice.

Really.

If something happens to you, personally, then by all means react to it.

If something specific is on the horizon that you need to plan and prepare for, by all means, please do so.

Preparing for vague 'hard times' because the TV says they're coming?

Well, that's half the reason bad times may be coming, right there.

Positive thinking isn't all that powerful in many situations, but in economics, it is.

If people think times are bad, then they'll spend less and invest less. This will ensure that times ARE bad for businesses that make a living by selling stuff to consumers and investors.

Even if everything was just fine and dandy before the gloominess, pessimism WILL see itself justified.

If people think times are going to be fine, the whole thing happens in reverse, and even if something DOES happen to go wrong, things will turn out better than they otherwise would, for the economy as a whole.

In brief: if there's something specific that you need to react to or prepare for, please do. If you wish to buy into the general gloom just because the media says you should, please don't.

If you THINK there's something specific about the current economic climate that you need to prepare for or react to, but can't tell what it is, then this is a perfect opportunity to invest in an education in economics.

(Disclaimer: these views are mine and mine alone, and don't represent those of anyone else. What's more, my personal views tend to change rather quickly, so they may not even represent my own thoughts, a few days from now.)