Living/minimum wage: what we know

Version 1.0 (April 24, 2019)

A couple of weeks ago, I got ensnarled in one of these debates on Facebook that do not go anywhere; it was triggered by the Australian Labor Party’s recent Living Wage policy proposal and the related discussion about the merits of minimum wages, and there specifically whether increases in minimum wages have negative employment effects and even more specifically whether such detrimental employment effects hit those at the low end of the wage distribution. These debates tie into other current debates like the one about lacking wages growth about which even the RBA is now concerned; see also Fig 17.17 here, or the one about wage theft which even the current government — not known for its charitable inclinations — says it wants to address, or the one about growing inequality which, as it affects aggregate demand, has to be a growing concern for any economist worth her or his money.

The debate on Facebook I referred to at the outset did not go anywhere because it turned out that the conceptual and empirical issues of the effects of minimum wages on employment are quite different from what most people have learned in basic Econ 101. And, unfortunately, about 99 percent of those currently engaging in the debate about the effects of minimum wages have not gone beyond that level of understanding, even if they claim economics expertise. So, I bowed out of that debate at some point and read up on it. Here is what I understand the current state of the science to be. I am open to suggestions on where I might get it wrong. Feel free to comment away.

The traditional understanding results from what is (still) being taught in most principles courses: that the demand curve for any good, or factor of production, is downward sloping, i.e.. the higher the price (e.g., of labor) the less of it will be demanded. That given, a simple graph establishes that equilibrium price and quantity are determined by the interaction of demand and supply. If a binding floor is established (i.e., if a price is set by some law or ordinance above the equilibrium price), quantity demanded will be constrained and less of it will be employed. Ignoring for now the important question whether labour should be considered just another factor of production or whether there is more to it – a point for another overdue debate –, the fact that less labor might be employed is not necessarily a bad thing, a point that many people do not seem to grasp. It all depends on the “elasticity of demand” which is a measure that relates the responsiveness of the quantity demanded to price changes. If the price increases (brought about by a law or ordinance that sets a price above the equilibrium price) are large but negative employment effects not quite as much, a case can possibly be made for some such law or ordinance.

So far so good and probably uncontroversial even among most economists and journalists who write on economic issues. It is also fairly uncontroversial that long-run measures of responsiveness of employment to price changes (“elasticities”) tend to be larger than short-term measures and that these elasticities might be different for different locations on the demand curve and for that matter different demand curves. What exactly the appropriate elasticity estimate is for various contexts is arguably more controversial. On balance, economists are sceptical about market interventions of this kind, and often for good reasons (e.g., the well documented consequences of rent-controls although even here a more critical attitude is emerging).

In come Card & Krueger (1994) with a study published in one of the top journals of economics, and a provocatively titled book a year later with one of the top presses, in which they seem to be able to show, relying on an intriguing natural experiment that inspired hundreds of studies and contributed to the credibility revolution in economics, that raising the minimum wage has no adverse effect on employment. Wow.

Not surprisingly, this study was heavily contested.

The debate continues to the day and I will below discuss some key contributions to the debate and also some of the kerfuffle surrounding the recent Seattle minimum wage experiment which is ongoing.

As you will see there are many moving parts, conceptually and empirically, confounding these debates. My list of things to keep in mind follows; below I will refer to them as “caveats”.

Caveat 1: The simple Econ 101 model of the effects of a minimum wage (or price floor) is flawed because it does not take into account dynamic effects. For example, in a growing economy (such as the Seattle market has been for a while), it is important to study a minimum wage effect against the counterfactual which is not easy to establish. Among the ways labor market researchers have approached the topic is the “synthetic approach” of identifying districts outside of an urban center that are, however, in their sum well matched in observable characteristics. Another strategy has been natural experiments across state borders when one state changed the minimum wage and the other did not.

Caveat 2: Any minimum wage increase (especially when drastic) will not only have, possibly, employment effects for those whose wages go up but for those that have wages above the price floor. It is unclear conceptually how some such “ripple effect” could pan out: Will those workers that earn more (as apparently a considerable number of workers in the restaurant industry do), suddenly put in less effort, and/or will those that have their wages increased provide more? What are the results of the long-term adjustments processes of what is the relative efficiency wage between those with lesser skills and those with more?

Caveat 3: An important issue is temporary job-seekers (e.g., students on their holidays or teenage workers to earn some change, or other part-time workers, etc.) and to what extent adverse employment efects will disproportionately fall on them. In his simulation exercise, MaCurdy makes the important point that, even if one accepts that there are no adverse employment effects, those benefitting from an increase in minimum wages are not necessarily low-income families.  In fact according to his data “low-wage families are typically not low-income families.” (p. 534) And, “The increased earnings received by the poorest families are only marginally higher than those of the wealthiest. One in four families in the top fifth of the income distribution has low-wage worker which is the same share as in the bottom fifth.” (pp. 534-5) The problem is that while “fewer than one in four low-income families benefit from a minimum wage increase of the sort adopted in 1996, all low-income families pay for this increase through higher prices, rendering three in four low-income families as net losers.” (p. 535) Clearly the incidence of price increases is an important consideration, and needs to be controlled for.

Caveat 4: Relatedly, there is the issue of the gig-economy which tends to put pressure on wages in the low-skill sector and allows price floors for labor to be circumvented by making participants into “entrepreneurs” of sorts. This seems currently a completely understudied area.

Caveat 5: Another important issue is whether wage increases are implemented locally, regionally, or on the national level. Minimum wages on the national and even the regional level are presumably less easily circumvented than those on the local level, although it is probably a mistake to underestimate the attractiveness of big urban centers.

Caveat 6: An important issue is anticipation effects which can pollute supposed quasi RCTs. This explicitly motivated the study by Bell & Machin (2018).

Caveat 7: If the simple Econ 101 model of the effects of a minimum wage (or price floor) is flawed because it does not take into account dynamic effects, then the question has to be asked which alternative model could explain the results. Prominent competing labour market theories are those of monopsonistic, or oligopolistic, competition with search costs, or efficiency wages. Belman & Wolfson (2014) have a useful discussion of such models in graphical form. See also this or this.

Caveat 8: As for the abatement of carbon emissions there are typical several other policy options and therefore it is important to keep in mind that there may be other policy tools such as earned income tax credits that would address the policy goal of a minimum, or living, wage more effective- and efficiently. In this context the important question arises who ultimately pays for minimum wages. Assuming no adverse employment effects, the question is whether employers manage to push increased labor costs through to consumers, or whether they have to take some hit to their profits. This seems to be another poorly understudied area. The available evidence (see MaCurdy 2015 and Draca et al. 2011), Bell & Machin 2018, and this very interesting paper by Harasztosi & Lindner 2017) is inconclusive. More about these papers below.

Caveat 9: Debates about minimum or living wages should not be backward looking. They ought to happen in the context of an ever increasing automatization and inequality (in Australia surely in terms of wealth and quite possibly also in terms of income).

Caveat 10: Many of the empirical findings that we have are from The United States. Naturally, we should not take for granted that the findings (to the extent that we might agree on them) translate to the Australian context. There is, fortunately, an interesting literature documenting the effects of the (1999) introduction of minimum wages in England (including at least one meta-study), and an emerging literature documenting the effects of the (2015) introduction of a living wage in England (Bell & Machin (2018). There will soon be yet another emerging literature that draws on the minimum wage experiment that Germany launched in 2015. And importantly, there is the very interesting paper by Harasztosi & Lindner (2017) on the Hungarian experience with a dramatic increase of 60 percent in the minimum wage in 2001.

Back now to the debate and some key contributions and also some of the recent kerfuffle about the Seattle experiment which are ongoing.

Card & Krueger (1994, 1995a, 1995b, 2000, 2016, chapter 1, 2017) studied the fast-food industry in New Jersey and Pennsylvania. The former increased the minimum wage in April 1992. The original Card & Krueger 1994 findings suggested – to many economists’ surprise — that there was no employment effect of that increase in the minimum wage. This finding was contested by Neumark & Wascher (2000) who argued that the Card & Krueger data – because they were collected through telephone surveys – were unreliable. Drawing on payroll administrative data, they argued furthermore that the New Jersey minimum-wage increase led to a decline in fast-food employment. Neumark has emerged as arguably the most influential critic of Card & Krueger and maintains, for example in this recent IZA primer, that ”A great deal of evidence indicates that the wage gains from minimum wage increases are offset, for some workers, by fewer jobs. Furthermore the evidence on distributional effects, though limited, does not point to favourable outcomes from minimum wage hikes, although some groups may benefit.” In their response to Neumark & Wascher, Card & Krueger questioned the representativeness of the Neumark & Wascher data and instead used two different kinds of longitudinal and repeated cross-sectional administrative data reported to the BLS.  They conclude that “the increase in the New Jersey minimum wage in April 1992 had little or no systematic effect on total fast-food employment in the state, although there may have been individual restaurants where employment rose or fell in response to the higher minimum wage.” (p. 1398) In chapter 1 of the 2016 version of their book Card & Krueger re-iterate this finding and argue “This book presents a new body of evidence showing that recent minimum-wage increases have not had the negative employment effects predicted by the textbook model. Some of the new evidence points toward a positive effect of the minimum wage on employment; most shows no effect at all. Moreover, a reanalysis of previous minimum wage studies finds little support for the prediction that minimum wages reduce employment.” (Chapter 1, page 1)

Building on a meta-analysis that Card & Krueger did in the same year they published their book, Doucouliagos & Stanley (2009) provided a meta-regression analysis of minimum wage research  drawing on  64 (!) minimum wage studies. Importantly, they controlled for publication selection bias and they find that, when selection effects are filtered out, “no evidence of a meaningful adverse selection effect” (p. 422) (thus confirming the earlier results of Card & Krueger). Specifically, “In the minimum-wage literature, the magnitude of the publication selection is large or larger, on average, then the underlying reported estimate. … Even under generous assumptions about what might constitute ‘best practice’ in this area of research, little or no evidence of an adverse effect remains in the empirical research record, one the effects of publication selection are removed.” (p. 423) In passing, Doucouliagos & Stanley, who have no recognizable dog in this fight (as much of their work involves meta-analyses of various areas), suggest that the “subjective narrative review” provided by Neumark & Wascher (2007) that covers the same literature (but comes to a very different conclusion) is wanting because it does not control for publication bias. A more recent meta-analysis by Belman & Wolfson (2014) of minimum wage studies published between 2000 and 2013 also confirms the Card & Krueger results, finding a median elasticity of employment or hours with respect to the minimum wage of between -0.05 and -0.03, not controlling, however, for publication bias.

Dube and his colleagues (including Michael Reich, one of the protagonists of the Seattle minimum wage study controversy) provided yet more evidence in support of the results claimed by Card & Krueger. Inspired by their identification strategy, they compare restaurant and retail employment in contiguous countries across state borders, and there in particular segments with minimum wage differences over a 17-year period. The border discontinuity design has attractive features spelled out in Dube (2017) where one can also find a succinct summary of his later work, a good discussion of related work, and of alternative approaches. Acknowledging that “the topic of employment effect of minimum wages remains controversial, with sometimes conflicting evidence” (p. 820), in his own work he finds employment elasticity close to zero (also for teens), and “even when we considered the longer-terms effects (e.g., four or five years out), we found employment estimates to be fairly small.” (p. 820) Reflecting on his recent work with Lester and Reich (2016), he notes “We found a striking pattern … This trifecta of results – strong positive wage effect, small employment effect, and strong negative turnover effect – is a signature of a model with search frictions  … “ (p. 821) None of these papers, however, controls for the effects of minimum wages on prices (recall MaCurdy’s results) and/or profits, something which seems necessary if one wants to understand the net effect of a minimum wage increase.

Additional empirical evidence in favour from the UK, where a national minimum wage was introduced in 1999, and a national “living wage” in 2015 (by a conservative government, no less), is reviewed in Lemieux (2017) and Card & Krueger (2017); summarizes Lemieux, “By moving from a situation of no minimum wage to one with a large and differentiated (by age) minimum wage, the United Kingdom was an ideal laboratory … . A clear consensus in the British literature supports that the new minimum wage had, and continues to have, no effects on employment. … On balance, it appears that the evidence accumulated since 1995 has, if anything, reinforced Card and Krieger’s conclusion of no (or modest) employment effects of the minimum wage.” (p. 824) While Lemieux mentions the results by Machin, Manning, & Rahman (2003) … he does not mention Leonard, Doucouliagis, & Stanley (2013) which is puzzling.

Card & Krueger point out that these new data allow also inferences about how the wage distribution is affected. “Relative to the literature on the employment effects of minimum wages, there are fewer recent studies of the distributional impacts. …Exploiting the remarkable history of minimum wage legislation in the United Kingdom, Dickens et al. (2012) concluded that the introduction of the national minimum wage had a strong effect on the lower tail of British wages, pushing up the wages of workers as high as the 35th percentile in the overall wage distribution.” (p. 829) That is a remarkable result that, if true, speaks to Caveat 2 that I formulated above and it suggests that restricting attention to those directly affected by wage increases is a problematic strategy.

As stated by Dube, “the topic of employment effect of minimum wages remains controversial, with sometimes conflicting evidence”. (p. 820) Another prominent contrarian, apart from Neumark, is Jonathan Meer. Meer & West (2016), who estimate a large negative effect of minimum wages on aggregate employment, is discussed in Dube (2017) who suggests – based on his empirical work – that these putative job losses happen higher in the wage distribution, “raising questions about the causal import of their estimates”. (p. 820) Meer (2018) summarizes his take on the literature, including his own work and that of the Jardim et al. (2017) study of the Seattle minimum wage experiment. Says he, riffing on an even more partisan earlier assessment of the literature (Meer 2017): “Following the minimum wage increase [to $13 per hour in 2016 [January] from $11 in 2015 [April] and $9.32 in 2014], total payroll for low-wage workers actually fell by an average of $125 per month: those workers for whom the increase was supposed to help were actually receiving fewer dollars on average after the minimum wage increase than before. Unsurprisingly, the study came in for immediate criticism from minimum wage advocates, but its methodological approach is sound and most of the critiques are groundless.” (p. 6) These are strong claims and they would be more credible if his literature review would be less partisan (e.g., no word about the meta-studies by Doucouliagos & Stanley 2009 and Belman & Wolfson 2014, also no word really about the English experiment which is of interest for the simple reason that minimum wage is differentiated by age, thus having the potential to address one of Meer’s concerns).

The Seattle experiment, and some of the ugly politics around it (also academically) has been widely reported on (here and here and here and here and here and here).

Since the Jardim et al. (2017) paper, the same group of researchers has published a follow-up study (Jardim et al. [October] 2018) that assesses the impact of the first and second min wage increases in 2015 and 2016, using again longitudinal workforce data (“employment trajectories of thousands of individual employees  engaged in low-wage work immediately before each increase”, p. 4) collected by the state of Washington’s Employment Security Department. The new analysis follows the same identification strategy as the earlier study (of trying to compare Seattle low-wage workers with matched controls from outlying Washington State) but comes to a different conclusion: “While these workers experienced a modest reduction in hours worked, on net their pretax earnings increased an average of around $10 a week” (p. 4, see also p. 25) However, the bulk of these gains went to more experienced workers, with less experienced workers being about as well of as before. As Jardim et al. (2018) admit, “The findings contrast with our earlier work, which showed that the total amount paid to workers in low-wage jobs in Seattle declined after the second minimum wage increase in 2016.” (p. 25) I am tempted at this point to paraphrase Meer (2017), If your immediate reaction to this study is to dismiss it, “it is time to admit your views cannot be swayed by science. They might as well be religion.” (p.7) Say it as it is, Jonathan.

But, seriously, it is important to understand that any one single case (study) is only so telling and often a work in progress. The case of Seattle is so unique (see also this excellent recent story about Amazon) that the caveat in Jardim et al. (2018) not to generalize this finding to state and federal policy changes seems warranted.

Looking at all the evidence that is currently out there (and that I paraded above), I conclude that the balance of the evidence seems to provide considerable support in favour of policy recommendations that contradict the standard Econ 101 narrative, even if we accept that labor should be considered just any old factor of production.

Local circumstances have, of course, to be part of any attempt to implement minimum wages and/or living wages. It is also worthwhile remembering Alan Krueger’s admonition from 2015 that “$15 an hour is beyond international experience, and could well be counterproductive. Although some high-wage cities and states could probably absorb a $15-an-hour minimum wage with little or no job loss, it is far from clear that the same could be said for every state, city and town in the United States.” (Krueger 2015) Krueger, however, issued that caveat before the results in Harasztosi & Lindner (2017) started to circulate which are remarkable indeed. These authors analyse a very large (~60% in real terms) minimum wage increase in Hungary in 2001. Among the remarkable results are that this very large increase displaced four years out only 1 out of 10 minimum wage workers while those that held on to their job experienced a 50% wage increase. Importantly, while firms predictably responded to the increase by trying to substitute away from labor to capital, they showed that “around 80% of the wage increase paid by consumers of goods produced by minimum wage workers and only 20% was paid by firm owners.” (abstract) Not surprisingly, there is considerable heterogeneity to be found in firms’ ability to pass through the increased minimum wage. Interestingly the result that forced increases in labor cost can be for the most part pushed through to consumers contradicts the results reported for the English minimum and living wages experiences. Draca et al (2011), based on the 1999 minimum wage increases, find that they find their way directly into profit reductions. Bell & Machin (2018), based on the 2015 minimum wage increase, find that it finds its way directly into lower firm value, a story consistent with Draca et al.’s but not with MaCurdy or the story Harasztosi & Lindner (2017) tell. Hmmmh.

The implications of the currently available evidence for Australia are worth thinking through carefully. Taking into account purchasing power parity which probably means that a wage of around 15 Aussie dollars seems a safe proposition in particular if age – adjusted following the English model. Importantly, there may be better policy interventions out there such as earned income credit and other active labor market programs.  Card et al. (2018) have recently reviewed the available options.

It seems very desirable to think through these issues in non-partisan matter (i.e., have what we know assessed through forms of adversarial collaborations by knowledgeable people representing key stakeholders in the debate) and with a longer-term perspective that takes into account the nature of work in the future. Not being a labor market researcher, one of the frustrations I experienced when reading up on this literature is the often very partisan assessment of the findings out there. For example, if you are an opponent of minimum wages and selectively point at evidence to support your stand, you lose credibility right away when not mentioning the meta-studies out there that do exist (and that so far support the Card & Krueger findings).

I appreciate, without implicating, Stepan Jurajda’s and Jonathan Meer’s pointers towards relevant literature and Stepan’s and my colleague Gigi Foster’s feedback on an earlier draft. Needless to say, they are not to blame for errors in fact or opinion.

 

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Comments on the Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation, and Financial Services Industry

October 26, 2018

  1. The following remarks are informed by discussions during a by-invitation-only roundtable on October 19 that was organized by the UNSW Business School research networks on Cyber Security and Data Governance and Behavioural Insights for Business and Policy. It was attended by a judicious mix of 14 legal academics and (behavioural, experimental, and financial) economists as well as representatives of behavioural insights units from government and firms in the banking industry. The roundtable took part under the Chatham House Rule and was meant to facilitate an open discourse about the issues identified in the Royal Commission’s Interim Report, especially its chapter 10 and therein pages 327 – 342 and pages 345 – 7, as well as other chapters (namely 1, 8 and 9).
  2. While my comments draw on those discussions, the following comments reflect my opinion only. Importantly, my opinion below does not necessarily reflect my employer’s view.
  3. Kudos first to Commissioner Hayne and the senior counsels assisting (namely Rowena Orr and Michael Hodge) for a job well-done in uncovering plenty of misconduct when, in the run-up, representatives of the government du jour repeatedly argued, and strenuously so, that there was nothing to see here, that the call for a Royal Commission (RC) was a populist whinge, and that an RC would endanger economic growth by undermining trust in the banks, superannuation providers, and the financial services industry more generally. It seems obvious now that these claims were made despite better knowledge. It seems important to recall this fact, as the implementation of effective solutions – even if evidence-based – is likely to encounter considerable opposition and attempts to water them down. Strategic dishonesty is a thing and it is at the heart of the problems so competently ferreted out by the RC.
  4. Kudos also to ASIC – much maligned these days – since it clearly has provided a considerable portion of the relevant systematic evidence under not always favourable conditions (e.g., the substantial reduction in its resources announced in the 2014 budget; the fact that some of these resources were restored in 2016 cannot distract from the fact that any such disruption is counterproductive).
  5. For an economist who knows the empirical (including the experimental) evidence on the effects of market power, incentives (especially those in social dilemma situations), and on human actors’ frequent failure to be ethical (honest) and in violations of existing norms of conduct, there is nothing surprising in the Interim Report. Likewise, the failure of the regulators to interfere effectively was hardly surprising, although the discussion of effective remedies among economists is likely to be more robust than on the other topics.

5.1. We know for example that market power begets socially suboptimal outcomes (e.g., Huck et al. JEBO 2004, or any textbook on Industrial Organization worth its cost).

5.2. We know, for example, that incentives, especially when in conflict with organizational or societal welfare, lead to undesirable outcomes (e.g., the huge literature on trust games reviewed in Ortmann et al. EE 2000, or more systematically in Johnson & Mislin JoEP 2011)

5.3. We know, for example, that, even for low stakes, there is a considerable amount of people that will always be unethical, with many more people being easily tempted by dishonest behaviour as the stakes increase (e.g., Rosenbaum et al. JoEP 2014; Abeler et al. JPublE 2014; Kajackaite & Gneezy GEB 2017; Capraro JDM 2018; Heck et al. JDM; Abeler et al. ECMTA forthcoming). People’s susceptibility to norm violations has been documented since Adam Smith wrote his The Theory of Moral Sentiments. For more recent evidence, see some of the evidence from psychology and related behavioural sciences in Gentilin (2016; for a critique of that evidence see Ortmann CE 2016 and references therein).

5.4. The question of effective remedies is a more complicated one. It touches on numerous mechanism design issues, although even there one can tap into a considerable empirical (and experimental) literature that addresses questions such as the relative efficacy of self-regulation (possibly under the threat of government intervention; see Van Koten & Ortmann 2017), certification, and other institutions such as independent standards boards that administer ethical culture surveys and whiste-blower protection, and provide pools of principal integrity officers, as suggested in Dennis Gentilin’s submission. More on these issues below under 7.

  1. That breaches were so many and so widespread will, especially in light of the significantly larger stakes at stake, not surprise any economist who knows the literature on the negative effects of market power, poorly designed and calibrated incentives, and many human actors’ tendency to be economical with the truth, and in violation of norms (especially if the chance that they are found out is minimal – see Dana et al. ET 2007)). Pages 268 – 270 of the Interim Report get it exactly right: “There being little threat of failure of the enterprise, and there being little competitive pressure, pursuit of profit has trumped consideration of how the profit is made. The banks have gone to the edge of what is permitted, and too often beyond that limit, … because they can; and because they profit from the misconduct that is described in this report.” (p. 269)

7.  So what needs to be done to prevent the conduct from happening again?

7.1. It seems obvious that extant law be applied to lay charges for unconscionable acts such as charging customers fees for advice they did not receive. (While it is laudable that ASIC has secured hundreds of millions in refunds for affected customers, it has come through enforceable undertakings which let the perpetrators of criminal actions off the hook.) Other potentially criminal offences have been committed and they should be pursued under current law wherever possible. Unfortunately, the current state of affairs has considerable reputational spill-over effects and contributes to the wide-spread decline of trust in key institutions.

7.2.  It seems clear that the light-touch approach of ASIC, and APRA, has not served the community well although it is hard to tell from the outside whether tough cops – such as Allan Fels and Graeme Samuel – alone can do the trick (Irvine SMH September 22, 2018).

7.3. It also seems abundantly clear that Commissioner Hayne’s assessment of the sorry state of internal compliance assessment and reporting within CBA and NAB (and possibly other banks) justifies immediate action (p. 10 of Interim Report).

7.4. I do agree with Fels that structural separation of banks from their financial advisory arms is the way to go (Irvine SMH September 22, 2018). The same applies in my view for superannuation providers. The conflicts of interest are just too obvious to ignore and some proposed remedies (such as disclosure of conflicts of interests) seem to have counterproductive effects (e.g., Taguchi & Kamijo 2018, for a recent review of the literature).

7.5. Relatedly, the whole commission business has to be reconsidered. See also the relevant discussion on the broken model of broker remuneration in the Productivity Commission’s June 29 report on Competition in the Australian Financial System (pp. 21- 23) Financial advisors are effectively glorified salespeople and incentivizing them through commissions is a recipe for disaster under the best of circumstances.

7.6.  Relatedly, the variable-remuneration provisions for accountable persons according to BEAR have to be rethought. I endorse fully Recommendation One and Two in Dennis Gentilin’s submission on the RC’s Interim Report.

7.7. I also endorse fully Recommendations Four through Eight of Dennis Gentilin’s submission on the RC’s Interim Report and the rationale they are based on. What exactly the relation of an Independent Standards Board would be to Treasury, APRA, ASIC, and possibly ACCC, is as worthy of a good discussion as is a discussion of appointment procedures to that Board. See also the discussion of “a competition champion” in the Productivity Commission’s June 29 report on Competition in the Australian Financial System (pp. 15 – 19). Preferably the appointment of the Chair of some such Board would be consensus-driven and not partisan. (The sorry partisan transition from the first to the second ACNC Commissioner is not a recommended template.) I believe that Mr. Gentilin’s Recommendation Six – to have the proposed Independent Standards Board oversee the recruitment and appointment of Principal Integrity Officers to designated ADIs — is a brilliant one that will be key in guaranteeing the independence of Principal Integrity Officers. With Mr. Gentilin (specifically Recommendation Eight and its rationale), I believe that the establishment of a Whistleblowing Protection Authority is an indispensable and complementary step if indeed reducing misconduct in the banking, superannuation, and financial services industry is a serious concern and not just public posturing.

7.8. Last but not least, I would urge the Royal Commission – rather than adding more regulation that then is likely not enforced – to explore ways to let reputational feedback systems (e.g., Bolton et al MS 2013; see also systems such as TripAdvisor or Serviceseeking.com.au) work their magic. Considerably more transparency, and data, should be provided to the public to let interested researchers identify anomalies and developments that might be otherwise go unnoticed too long. Take the fascinating Figure 3 in the Productivity Commission’s April 2018 draft report on Superannuation: Assessing Efficiency and Competitiveness. Making that data available in a timely fashion would do wonders for the alignment of incentives. No traditional regulatory action I can think of would have the same effect.

References

Abeler et al. (2014), Representative evidence on lying costs. Journal of Public Economics pp. 96 – 104.

Abeler et al. (forthcoming), Preferences for truth-telling. Econometrica forthcoming.

Bolton et al. (2013), Engineering Trust: Reciprocity in the Production of Reputation Information. Management Science pp. 265 – 85.

Capraro (2018), Gender Differences in lying in sender-receiver games: A meta-analysis. Judgement and Decision Making pp. 345 – 55.

Dana et al. (2007), Exploiting moral wiggle room: experiments demonstrating an illusory preference for fairness. Economic Theory pp. 67 – 80.

Gentilin (2016), The Origins of Ethical Failures. Lessons for Leaders. Routledge.

Heck et al. (2018), Who lies? A large-scale reanalysis linking basic personality traits to unethical decision making. Judgement and Decision Making pp. 356 – 71

Huck et al. (2014), Two Are Few and Four Are Many: Number Effects in Experimental Oligopolies. Journal of Economic Behavior & Organization pp. 435 – 46.

Irvine (2018), ‘Stop being bastards’: how the royal commission could reform banks. Sydney Morning Herald 22 September.

Johnson & Mislin (2011), Trust Games: A Meta-analysis. Journal of Economic Psychology pp. 865 – 89.

Kajackaite & Gneezy (2017), Incentives and cheating. Games and Economic Behavior p. 433 – 44.

Ortmann et al. (2000), Trust, Reciprocity, and Social History: A Re-examination. Experimental Economics pp. 81 – 100.

Rosenbaum et al. (2014), Let’s be honest: A review of experimental evidence of honesty and truth-telling. Journal of Economic Psychology 181 – 96.

Taguchi & Kamijo (2018), Intentions behind disclosure to promote trust under short-terminism: An experimental study. Kochi University of Technology working paper.

Van Koten & Ortmann (2017), Self-regulatory organizations under the shadow of governmental oversight: An experimental investigation. In: Deck et al. (2017), Experiments in Organizational Economics, Research in Experimental Economics 19, 85 – 104.

Comments welcome.

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Ethical failures: Where they come from and how to address them

A review of

Gentilin, Dennis. The Origins of Ethical Failures. Lessons for Leaders. A Gower Book. Routledge (2016). ISBN: 978-1-138-69051-6

Ethical failures were in the press big-time in 2017. Prominently, creeps like Harvey Weinstein, James Toback, Bill Cosby, Larry Nassar, etc. were accused of sexual transgressions of various sorts (and in some cases admitted them to varying degrees). The sheer number of accusations leaves little doubt that, in their substance, they are correct. One thing that was truly shocking, on top of the specifics of many of the allegations, was that some of these transgressions went on for literally decades, that many people seem to have known about them for years (if not decades), and that the perpetrators did get away with them for an unconscionably long time. It is clear that organizational failures must have played a major role. This was implicitly acknowledged in the name of  The Royal Commision (RC) into Institutional Responses to Child Sexual Abuse, established under the Gillard government in 2013 and which reported all 17 volumes of its findings on December 15, 2017. The RC also laid out recommendations.

It did not really come as a surprise that once again massive organizational failure, in particular of the Catholic Church, was identified as a major finding. It did not come as a surprise because for years there had been a never-ending stream of trials, not just in Australia, suggesting just that, and providing plenty of evidence that the Catholic Church – in its (continued) belief that it is a law and world unto itself — had engaged for decades in what might generously be called economy with the truth.

Two weeks earlier, after another year of numerous reports of questionable practices, and record profits of the four major banks, the Turnbull government saw itself forced — by its own backbenchers, no less — to announce that it would establish a RC into misconduct in the banking industry. It was a step that Labor and the Greens had urged for more than a year. (The recent draft report of the Productivity Commission has made clear that some such RC is indeed overdue.) The Turnbull government’s acceptance of something that it could not prevent, and its subsequent attempts to undermine the effectiveness of the RC by simultaneously widening its scope and imposing an essentially unrealistic timeline, demonstrates, at the minimum, the kind of myopic opportunism that Australian politics seems drenched in.

Having graduated in 2001, Gentilin became a member of the FX trading desk of the National Australian Bank (NAB), one of the four major banks.  In 2004 that trading desk became involved in a trading scandal that rocked NAB and led, within a couple of weeks, to the resignation of both its chairman and CEO, the reconfiguration of the board of directors, and significant financial and reputational losses. Gentilin was the young trader who blew the whistle. Contrary to many other whistleblowers (who are typically harrassed out of the organizations on which they blew the whistle), he stayed with NAB for more than a decade – as head of the institutional sales team and a member of the corporate strategy team — before he resigned in January 2016 to found Human Systems Advisory, a name meant to be programmatic. The foreword of his book was written by the current chairman of NAB who states: “There are no simple answers in this book. But there are answers. And there are important truths, supported by deep and rigorous analysis. These should be of interest to all corporate leaders, in both executive and non-executive roles.” (p. xvi).   One such truth, says the chairman – apparently quoting Gentilin – is that “leaders must strive to articulate a meaningful social purpose for their organizations that is underpinned by a virtuous set of values.” That’s quite a mouthful, and the impending Royal Commission on the banking system suggests strongly that the major banks (that tried at first to fight off the RC until they realized that fight had been lost) have continuing trouble to understand that particular message, as does the recent draft of the related Productivity Commission report.

Below, I am interested in both the depth and rigor of the analysis and the truths that Gentilin establishes.  I am also interested in the implementability of the measures that he proposes.

In his Introduction, Gentilin states that he draws his evidence from “behavioural business ethics” which he defines as the intersection of business ethics and psychology (p. 5). While he is credited on his website with a degree in psychology, Gentilin makes clear that he wrote this book as a “practitioner” rather than “an academic, a philosopher or an ethicist” (p. 4). He does so in four chapters that explore “The Power of Context”,  “Group Dynamics”,  “Our Flawed Humanity”, and “What We Fail to See”.  A conclusion follows.

Gentilin relies heavily on summaries of articles from psychology that explore human nature and the circumstances under which nice behaviour might turn into, well, not so nice behaviour of different shades. While there is brief perfunctionary nod (p. 3) to the replicability crisis that has afflicted psychology, throughout the book there is little discussion of relevant laboratory design and implementation issues such as incentivisation, experimenter expectancy effects, external validity, and so on (Hertwig & Ortmann 2001; Ortmann 2005). Never mind the fact that much of the evidence on unethical behaviour paraded in this book has been produced with deceptive practices, arguably an unethical practice itself (Ortmann & Hertwig 2002; Hertwig & Ortmann 2008). There is no discussion of statistical issues such (lack of) power computations, p-hacking, publication biases, and what not here either.

Claiming that “explanations of unethical conduct rarely give proper consideration to the system within which people operate … (and) tend to focus on identifying ‘bad apples’ or ‘rogues’” (p. 7), in Chapter 1, Gentilin explores how the environment can impact human (mis)behaviour and, on balance, concludes that “the ‘barrel’ within which the ‘bad apples’ operate must be given as much (if not more) attention as the ‘bad apples’ themselves.” (p. 8). Before he reviews the lessons to be learned from the Stanford Prison Experiment, Gentilin reviews literature on social norms and how they affect behaviour.  The well-known Cialdini et al. littering and Mazar et al. (dis)honesty studies are paraded, as is an interesting lab study by MacNeil & Sherif (1976) in which the authors demonstrate generational transfer of (questionable) practices, and a related field study by Pierce & Snyder (2008). Distinguishing between descriptive (“derived from what is”) and injunctive (“derived from what ought to be”) norms, Gentilin documents cases where unethical descriptive norms tear to smithereens injunctive ones. He relates this to his reading of what led to the FX trading scandal at the NAB: “young people in particular are vulnerable and endorsing immoral social norms … In the FX trading scandal that engulfed the NAB, immoral social norms emerged that promoted excessive risk taking and misstating the true value of the currency options portfolio.” (pp. 18 – 19). This is hardly surprising, and indeed Gentilin mentions the LIBOR rate-fixing scandal and the professional cycling drug-taking as other high-visibility events. He could have also mentioned the lending practices of major US banks before the housing and mortgage crises (e.g., Gjerstad & Smith 2014), the despicable transgressions at Abu Ghraib, or zillions of other real-world examples.  After having reviewed the Stanford Prison experiment in some detail, Gentilin identifies two important take-home lessons from it: first, a specific context “can cause people of sound character to behave in totally uncharacteristic and inappropriate ways.” (p. 24) and, second, the emergence of such contexts is possible only when leaders allow it. Drawing on more experimental evidence (such as Bandura’s children imitating adults’ behaviour experiments), he suggests the obvious parallel for what happened at NAB: “Just as the adults were the role models in Bandura’s experiments, leaders that control the bases of power are the role models in large organizations. For these leaders there will inevitably appear some key moments where, through their actions, choices and decisions, they will send powerful messages that shape the ethical climate for their organizations and types of social norms that emerge.  … how a leader responds in these ‘defining moments’ shapes the ‘character of their companies’.” (p. 30). Only leaders who are veritable role models will be able to prevent formal mechanism being eroded by informal mechanisms that hammer away at them. Again, Gentilin suggests that such failure of leadership is what happened at NAB and at the Barclays Bank during the LIBOR rate-fixing schedule, and for that matter in the phone-hacking scandal that led to the demise of News of the World. Gentilin concludes the chapter with a list of “ten questions for senior leaders within any organization” (pp. 37 – 38). Presumably, these questions are unlikely to be answered in an honest manner where it matters. It is the evidence accumulated in this chapter but also elsewhere (Dana et al. 2007 comes to mind, or Miller & Ross 1976) that suggests that much.

Gentilin starts off Chapter 2 with a Nietzsche quotation that sets the stage: “Madness is the exception in individuals but the rule in groups.” (p. 45). The basic point made is that group membership can reinforce – cue social media echo chambers – the drifting away from injunctive norms to descriptive ones. Writes he: “In my experience at the NAB, dysfunctional group dynamics in the currency options business played a significant role in promoting the emergence and maintenance of immoral social norms and unethical behaviour [such as flagrant and persistent limit breaches or excessive risk taking, AO]”.  To buttress the case, Gentilin presents Milgram’s 1974 obedience studies, as well as Gina Perry’s recent critique of them (Perry 2012) which, in light of considerable supporting evidence of the original studies (e.g., Haslam et al. 2014), he dismissesin their substance. He then highlights what we learn from Milgram’s inclusion of a variation that drew on the group paradigm.  That motivates a discussion of the conformity experiments through which Asch (1956) tried to identify the conditions under which participants would contradict a majority.  In this context, Gentilin also briefly discusses a between-subjects study by Woodzicka & LeFrance (2001) who had a male interviewer ask female applicants inappropriate questions. The basic result was that 6 out of 10 subjects claimed they would object (hypothetically) but none in the control group refused the answer in a “real-life” scenario.  That seems the kind of pattern that allowed the Weinsteins of this world to get their way for too long. Only in the case of Weinstein and similar assholes (here used in the technical sense of Sutton 2007), the stakes were arguably considerably higher. People’s lack of willingness to stand up and be counted is, unfortunately, so widespread that it is well documented and it is a recurrent theme of great movies such as Hidden Figures.  Gentilin makes clear that, based on his experience at NAB, “facing the fork in the road in a hypothetical scenario is vastly different from facing it in reality.” (p. 67) He also states, “I am personally sceptical of other research into whistleblowing that focuses on ascertaining the types of personality or dispositional characteristics that may predict whether an observer of wrongdoing will take action and report it. …This line of enquiry fails to properly consider the power of the situation.” (p. 67). Gentilin concludes the chapter with another list of “ten questions for senior leaders (and followers) within any organization” (pp. 73). I doubt that these questions will be answered in an honest manner where it matters, for essentially the exact reason that Gentilin has identified in the chapter.

In Chapter 3, Gentilin – notwithstanding his, in my considered opinion, sensible stand on the relative importance of context and dispositional characteristics – dives into “our flawed humanity”. Programmatically, he starts with an epigraph featuring a quotation from Kant, “Out of the crooked timber of humanity, no straight thing has ever been made.” (p. 80).  Gentilin then tries to answer questions such as “Are Humans Self-Interested?”, cursorily sampling evidence from experimental economics, neuroscience, and evolutionary biology. Predictably he concludes that this research shows that “human nature (is) far different from the one suggested by the axiom of self-interest” (p. 86), though he qualifies the statement with the caveat that we are not always altruistic and cooperative.  This alleged “paradigm shift” (p. 87) is, unfortunately, the major bone of contention between those marketing Behavioural Economics (and often shamelessly benefitting from it) and those doing Experimental Economics, and I believe that the social-preferences literature that has created it has as much merits as the IN oxytocin, ego depletion, and power poses research now, for all I can see, thoroughly debunked. Better not plan your life, or organization, on such flimsy evidence. From an evidence point of view, and also a theory point of view (e.g., the important insights stemming from repeated game situations), this chapter is the weakest.  Gentilin’s sampling of the evidence strikes me as scattershot and unsystematic. After discussions of issues such as power and its corrupting influence and fear and awareness of our own mortality that feeds into it, Gentilin concludes the chapter with a list of “eleven questions for senior leaders within any organization” (pp. 118)  I fear, these questions, again, are unlikely to be answered in an honest manner where it matters.

In Chapter 4, Gentilin starts with a quotation from Kahneman’s best-seller Thinking Fast and Slow: “We can be blind to the obvious, and we can also be blind to our blindness.”  This double-whammy – a variant of the Dunning – Krueger effect — is why questions to senior leaders are unlikely to be answered honestly and self-critically.  After a brief mention of another persistent bone of contention – the System 1 / System 2 delineation  – and our alleged propensity to rely too much on automatic system 1 which makes us, presumably, liable to various biases (in this chapter loss aversion, framing, overconfidence, moral disengagement, euphemistic labelling), Gentilin lays out the slippery-slope argument that in his view was at the heart of the events that led to the NAB trading scandal: “The FX trading incident at the NAB classically illustrated the slippery slope in action. Not only did ethical standards erode over time, but the seriousness of the ethical transgressions accelerated … “ (p. 130). Laboratory evidence is provided to  make that point (e.g., the interesting Gino & Bazerman 2008 study) along with field evidence from the NAB case (pp. 131). An intervention discussed here is to give people more time and essentially get them to break out of their System 1 mode: “There are now numerous studies that illustrate how providing a person with more time whenever they are confronted with an ethical dilemma tends to lead to a more virtuous decision being made.” (pp. 146-7). I have serious doubt about the relevance of, say, the Good-Samaritian study mentioned here for real-world decision making and suspect that a theoretical grounding in organizational economics and repeated game theory would really help to address the challenges that organizations and their leaders face.

Gentilin concludes his book with a plea for more (business ethics) education, a call for the installation of Chief Ethics Officers, and more Lessons for Leaders. He wants business schools to challenge their students intellectually, emotionally, and spiritually. That sounds like something straight out of a high-gloss advertisement such schools produce. The reality, however, of Australian business schools (and undoubtedly business schools everywhere) is that they are rarely intellectually demanding. Their inability to challenge their students emotionally and spiritually is shown effectively by their treatment of casuals and staff. What business schools typically do not have are, in particular, truly independent ethics officers, and HR departments, that could hold the feet of currently widely unaccountable senior leadership to the fire. So, while the idea of a Chief Ethics Officer, who has “a genuine ‘seat at the table’” (p. 161), and is independent, able to freely raise matters of concern, and able to freely “speak truth to power” (p. 161), is conceptually on the money, realistically it is very unlikely to be implemented any time soon, as are truly independent HR departments. As to Lessons for Leaders, Gentilin wants them to be virtuous in the sense of having some community-oriented values.  There is a lot of wishful thinking on display here (e.g., that others are willing to take the same risks that he took in 2004) but I think, after everything we learned through the flurry of recent examples mentioned at the beginning of this review, there is not much reason for hope. Even something that should have been uncontroversial, such as the Royal Commission on banking, and the way it came about, demonstrates that common ground is hard to find and cannot be relied on. I fear much harder thinking will be needed to address ethical failures and I fear some strategies will be of the innovative kind provided by the #MeToo campaign that not only has brought down some true monsters but is likely to have changed power and gender relations in the working world irreversibly.

In summary then, Gentilin tackles arguably the most important issue of our times – ethical failures within organizations and for that matter ethical failures more generally. His book is strongest where he illustrates the emergence of his insights with examples from his own NAB 2004 experience. His illustration of various arguments he makes with evidence from behavioural business ethics is wanting. As pointed out above, to his credit Gentilin himself – although unaware of important methodological debates among psychologists as well as between psychologists and economists – grasps intuitively the lack of external validity of some of the evidence that he presents and it is clear that his NAB 2004 experience has been a good guide to identify which laboratory evidence has some external validity, and which does not. I think the book could be considerably improved with a more even-handed and complete assessment of the evidence from psychology and other social sciences (and here in particular economics) as well as an additional focus on incentive-compatible organizational design.  To rely on business ethics education in business schools (whether in Australia or elsewhere) or a sense of community oriented-ness of business leaders is just not going to cut the mustard, as the widely perceived need for the Royal Commission in the banking system demonstrates.

Having recently interacted with NAB, once again, with mortgage related issues, I have no doubt that NAB culture is pervaded with everything but a meaningful social purpose that is underpinned by a virtuous set of values (e.g., the loan officer I dealt with did everything to prevent me from comparison shopping, and essentially gave me misleading information about the rates that I would be getting), and I have little doubt that the same applies to each of the other three major banks. There is a reason why the major banks in Australia have had outsized profits and some of the highest returns on equity in the world. The recent draft of the related Productivity Commission report spells them out.

 

I appreciate Dennis Gentilin’s comments on a draft of this review.

 

How to tax the platform economy?

In the engine room of nation states, ie the tax departments, the coming battle with platform providers is taking shape. Uber, airbnb, facebook, linkedin, ebay, jobseek, and a myriad of specialised platform providers facilitate micro-trades that are largely untaxed by the authorities. In stead, the platform providers themselves take a cut, partially via advertising and partially via a direct fee for their services. They have taken over an activity that has mainly been provided by governments in the past: places to trade. The town square, the stock exchange, public infrastructure, and the unemployment office are relics of a past where governments were market providers that facilitated trades. Now, it is largely private companies with tax-avoidance structures that have taken on this role on the internet. That role is set to expand hugely.

This is a crucial battle that, so far, the tax authorities are losing because they have not yet grasped the magnitude of the shift. They lack the key new power that they must attain: the power to deny the operation of a platform provider in their country.

At the moment, tax authorities around the world, lead by the Scandinavians whose tax needs are high, are going the usual ‘reporting route’. They are trying to get Uber, Airbnb, and all the other ones to report the trades and the value of the trades that they have facilitated. Understandably, these companies are refusing to play ball because they of course are taxing the same trades themselves in a different way. They are competing with national tax authorities and hence their business model depends on tax evasion, so of course they refuse to help their competitors. Their lawyers make millions from refusing to play ball. The horror example for these companies is the 2015 data on Uber that had to be released to the Dutch tax authorities and that was subsequently shared with Denmark which promptly went after the drivers for added tax payments. This reflected the circumstance that the administration of Uber was in the Netherlands at that time, which allowed the Dutch to force Uber to hand over some of their data, a mistake Uber wont make again. The others too will have learned a salutary lesson from that episode.

Frustrated, the tax authorities are turning to pretty hopeless measures, such as new international treaties on the reporting of micro-trades by private entities. In a race to the bottom between countries trying to attract large companies, that is just a hopeless avenue where the authorities will always be many steps behind the tax-advisers of the big trading platforms.

What are the next moves we might then see when the tax authorities get up to speed? I think two developments are likely: full internet observation by national agencies and government-lead internet firms.

Full internet observation follows the model of China, which now has the capacity to track most of the internet activity of most of the population. That allows it to observe the trades facilitated on internet platforms, which in turn can be used for tax purposes. Those observations can be used to directly go after individual traders or can be used to go after the platform providers, simply by making their activities illegal if the platforms do not assist in tax observations. Adopting the China route would spell the end of internet privacy, but it probably works. And tax is such a key part of the nation state that it in the end trumps privacy concerns.

The second possibility is for the government to re-enter the market for platforms and set up its own internet firms for micro-trades and social media. It can simply copy the best examples on the internet for how to set these things up. The transition will come with losses, but authorities can appeal to national pride to get support from their populations and companies cannot compete with that. For micro-trades within a country or tax region (the US and, in the future, the EU) that should work. For international trades, one should expect more difficulties because government-backed firms from different countries might then directly compete with each other, which in turn might lead to competency battles and new dispute resolution mechanisms.

Lemonade and the question of (laboratory) evidence

Lemonade Inc., the New York based fintech startup that sells home and renters insurance has been in the news recently. It has raised tens of millions in venture capital  and also considerable interest in the top echelons of corporate Australia. I know because I was asked to reflect on it as part of a workshop on behavioral economics/behavioral science that I conducted a couple of months ago. I have to admit that I did not know about Lemonade before that request.

Turns out that Lemonade uses “Behavioral Science (and Technology) To Onboard Customers and Keep Them Honest”, so the title of a piece in Fast Company earlier this year. Lemonade bets that insights from Behavioral Economics (BE) will give it the edge over incumbent competitors. It bets specifically that the BE insights of Dan Ariely (he of Predictably Irrational and TED talk fame, and now Lemonade’s CBO = Chief Behavioral Officer) will provide that edge, important components being “trusting our customers” and “giving back” to charity all unused excess funds. On top of these components, or maybe undergirding it, is the promise that Lemonade commits to spending at most 20 percent of its income on administration and marketing, which presumably prevents it from profit maximizing at the expense of its customers. Lemonade also promises that it will process claims fast and relatively un-bureaucratically, at least by the standard of an industry that has a reputation for delaying tactics and for its persistent attempts to evade having to pay up. Examples of speedy processing are featured prominently on Lemonade’s website.

And not only that: A couple of months ago, Lemonade launched its Zero Everything policy which gets rid of deductibles and rate hikes after claims and is supposed to pay for itself through elimination of the paperwork that comes with relatively small claims.

BE principles are also appealed to when customers that make claims are asked to submit a brief video outlining their claim and to provide at the same time a honesty pledge which supposedly induces more honesty.

In sum then, Lemonade builds its business allegedly on the trust(worthiness) of its customers, and of itself, and also honesty on the part of both parties.

Let’s start with the (laboratory) evidence for trust(worthiness). On its web page, Lemonade illustrates the advantages of trust(worthiness) with one of the workhorses of experimental economics, the trust, or investment, game. According to the web page, a person that invests (the trustor) will see her investment to a trustee of $100 quadruple and then see the trustee return half of that $400 to herself (the trustor), for an impressive ROI of one hundred percent. Trust pays off, we learn: “We are more trusting and reciprocating than what standard economic theory predicts.”

Ignoring the stab at economic theory (which shows little more than a lack of elementary knowledge of modern economic theory), there are at least three problems with the Lemonade narrative. First, it is not clear at all why this particular game, in this particular parameterization, captures the customer – insurance company situation. Second, I am not aware of anyone ever having experimentally tested this game with that specific parametrization (specifically, a multiplication factor of 4), and I am not aware — the multiplication factors typically used being 3 or 2 — of responders returning more than what was invested. In fact, the results of my own work (which are very much in line with the literature in this area) suggest that trustors invest about half of what they were given and trustees return slightly less than what was invested. It is noteworthy that there is much heterogeneous behavior to be found in these experiments, with many of those that trust (“invest”) being brutally exploited.

  “Everyone has a price, the important thing is to find out what it is.” (P. Escobar)

Which brings us to the question of honesty. There is indeed some evidence that the way in which people are being prompted makes a difference and, more generally, that context matters (see Various, JEBO 2016). Friesen & Gangadharan  (Economics Letters 2012) use an individual performance task (“matrix task”) after which they ask their subjects to self-report the number of successes that participants had. While very few of their participants – only one out of 12 — are dishonest to the maximal extent, about one out of 3 are to different degrees, with men (in particular those of Aussie and NZ provenance) being more dishonest, and more frequently so, than female participants. Rosenbaum, Billinger, & Stieglitz  (Journal of Economic Psychology 2014) review experimental evidence of (dis)honesty 63 experiments from economics and psychology (including Friesen and Gangadharan EL 2012) and find the robust presence of unconditional cheaters and non-cheaters with the honesty of the remaining individuals being particularly susceptible to monitoring and intrinsic lying costs. Most of these experiments involve fairly low stakes, so those intrinsic lying costs are unlikely to be much of a constraint when stakes increase. The fraction of unconditional non-cheaters is almost certain to shrink towards the Escobar limit when stakes increase.

Interestingly, notwithstanding its public declarations in the good of people, Lemonade tells itself that, while trust is good, control is better.  It runs its claimants, on top of the honesty pledges, through 18 different fraud detection algorithms before it pays up. On top of this, Lemonade engages in blatant cream-skimming. For example, it did not quote half of their customers that wanted to insure their homes. And it reports that the customers that are joining, or allowed to join, are younger, educated, tech-savvy, above-average earners, and female. So much for trust, trustworthiness, and all that BE marketing horsemanure. Pretty cold-blooded standard economic theory if you ask me. Note that this screening takes care of a key problem with their advertised approach: the likely adverse selection of bad types that mere trusting would invite, a very likely whammy on top of the moral hazard problem that every insurer faces.

So is Lemonade a viable business model?

Time will tell.

In the State of New York, Lemonade claims to have overtaken Allstate, GEICO, Liberty Mutual, State Farm, etc. in what is probably the single most critical market (renters and home insurance) share metric of all: NY renters buying new insurance policies since 1 Jan 2017.

Lemonade, we are told, is growing “exponentially” = “new bookings have doubled every ten weeks since launch, and show no sign of letting up.” According to its most recent Thanksgiving Transparency ‘17 report, Lemonade has now branched out into, and is selling in, Illinois, California and Nevada, Texas, New Jersey and Rhode Island, and has been licensed in 15 other states.

Of course, collecting insurance premia is one thing. Paying insurance claims and balancing the books is another thing altogether and the verdict on that one will be out for a while.

If Lemonade succeeds – and we all should hope it does –, it will do so because it engages in cream-skimming, targeting of low-risk market segments, and massive control and surveillance of its clientele. It will not do so because of its invocation of the feel-good alleged BE findings so prominently displayed on its web page.

 

 

 

 

 

 

 

 

Why Blockchain has no economic future

When Bitcoin went public in 2009 it introduced to the world of finance and economics the technology of blockchain. Even the many who thought Bitcoin would never make it as a major currency were intrigued by the BlockChain technology and a large set of new companies have tried to figure out how to offer new services based on blockchain technology. It is still fair to say that very few economists and social scientists understand blockchain, and governments are even further behind.

I will argue that blockchain has no economic future in the regular economy. I will give you the bottom-line, then describe blockchain, discuss its key supposed advantages, and then take it apart as a viable technology by giving you a much more efficient alternative to the same market demand opportunities.

The bottom line for those not interested in the intricacies of blockchains and public trust

The essence of my argument is that a large country can organise a much more trustworthy information system than a distributed network using blockchain can, and at lower costs, meaning that any large economic role for blockchain is easily displaced by a cheaper and even larger national institution.

So in the 19th century, large private companies circulated their own money, in competition with towns and princedoms. In that competition, national governments won, as they will again now.

The reason that the tech community is investing in blockchain companies is partially because some are in love with the technicalities of blockchain, some hope to attract the same criminal and gullible element that Bitcoin has, some lack awareness of the evolution and reality of political systems, and some see a second-best opportunity not yet taken by others. But even in this brief period of missing-in-action governments, large companies will easily outperform blockchain communities on any mayor market. Except the criminal markets, which is hence the only real future of blockchain communities. Continue reading “Why Blockchain has no economic future”

Mobile termination: Zero is a good place to start

Last week I did an interview with Phil Dobbie for CommsDay on the ACCC’s approach to the setting of rates that carriers pay each other to terminate calls. I argued — as I did 15 years ago — that marginal cost rather than Total Service Long-Run Incremental Cost makes more sense and will generate more welfare without cutting investment incentives. It has the advantage of being a light-handed approach, computationally easy to calculate and good for consumers. And if you are concerned about Telstra not having incentives to build out mobile networks in regional areas remember they do get a virtual monopoly on customers in those areas so they are hardly suffering.

I’m about 8 minutes in.

At one point I talk about asymmetry in network size and whether that matters. As Philip Williams pointed out years ago that argument is a red herring. To see that, suppose that one network is 99% of the customers and another network has 1% of the customers. Suppose that customers call people independent of what network they are on. That means that the share of calls made to the customer on the small network is 1% while the probability that a customer on the small network calls someone on the large one is 99%. So the total amount of termination revenue earned by the small network is 1% times 99% times the termination charge while the termination revenue earned by the large network is 99% times 1% times the charge. It is easy to see that the termination revenue earned by each network is exactly the same. Thus, having a higher charge does not favour or discriminate against the larger network.