“I was pushed” the left one said
“my colleagues and I, under pressure trapped
escape was easy, from underground I was led
more and more tunnels to fill a map
and out we burst to feed abundance”

The right one wasn’t quite so sure
“far more effort needed, to me extract
and though we look alike, I held greater allure
my drop quenching greater thirst to be exact
yes, we seem to be from different worlds”

Sure, drop to drop, they looked quite alike
though one was but a fleeting heartbeat older
and perhaps wiser too, coming after the spike
for the other, being the younger and bolder
recklessly cheapened and squandered its time

The younger drop, so energetic would give so much
that is, compared to what you gave to get some
but difficulties in getting the elder drop were such
that less would be got when you did the sum
but how important were just drops in an ocean?

This ocean is black like a starless night
and time separates these drops on either side
of a bell, they ascend to ring with all their might
to signal reaching the peak – the top of the ride
and the passengers: our economy, and civilization

So I want to save the world right. Turns out the world is a very complicated thing and, in order to have any hope of fixing its problems, one must understand many different fields at the one time. Due to the amount of time it takes to gain a good understanding of even a single field, it is difficult to have any amount of expertise in multiple fields, and individuals who possess this are rare indeed.

I am currently in the early stages of trying to accomplish the feat of being a truly multidisciplinary problem solver. One of the fields in which I am most lacking in knowledge is in economics. It seems surprising that I have not turned my attention to economics earlier, as it combines mathematics with the study of human nature – and both are areas which interest me. Formally, my training in economics consists of one course which I took while I was studying at Columbia University. It was “The Economics of Uncertainty and Information”, was fascinating, and very advanced. I’m not sure how I was allowed to take the course, since I technically satisfied none of the prerequisites and, in practice, only satisfied the mathematics prerequisites. In any case, I missed out on all the introductory stuff, and have slowly filled in the gaps (some of them) just as a side-effect of studying lots of other stuff.

Being able to approach this relatively young field with the perspective of someone who isn’t formally trained is a bit unusual, and probably an advantage. Most of the best-known economists started out in different fields, the most common being mathematics. So I certainly don’t feel that I’ve really missed anything by not having an undergraduate background in economics. In addition, I know plenty of people who do possess an undergraduate background in economics who are complete morons who are capable of getting good marks in courses, but not much else (this extends to majors other than economics, although it seems especially prevalent in this field). The purpose of this blog entry, I suppose, is to summarize the essential points to try and get things straight in my head.

The history of economics is fascinating. The very early history is poorly studied, mostly because it generally lies in the realm of archaeologists who are seldom trained in economics, while economists often don’t understand anything about archaeology. This became most apparent when I read a paper by an economist writing about early agriculture who had made a dog’s breakfast of interpreting the archaeological record. It is also difficult because any hypothesis about cause and effect must necessarily be speculative as these things are very difficult to determine from the archaeological record. Much of what follows is my own opinion, although I am sure that I am not alone in holding these opinions.

The development of economics is tied intricately with the development of human civilization. The process was not, as is often suggested, a very linear or predictable process. It was likely a very organic one. I tend to liken it to evolution – the same thing mostly keeps happening, and every now and then something different happens, and it either gives an advantage or not. If an advantage is to be had, then others adopt it or are defeated in some sense by those who do. All sorts of factors such as climate and physical geography determined which strategies did and didn’t work at different points in history. Detailed analysis of the aspects of physical geography pertaining to this can be found in Jared Diamond’s wonderful book “Guns, Germs, and Steel”. Indeed, many of my ideas regarding the early development of humankind are heavily influenced by this book.

So, we start off pretty much on par with all the other animals. We walk around, hang out, and eat when we’re hungry. We spend a lot of time hunting and gathering food and, like other animals, we form small bands, mostly determined by blood-relatives. Tasks are divided up in some way for increased efficiency. And we have our first major economic step – division of labor. It’s not a huge step; many animals also do the same, but it’s a start. Language would have developed by this time, but not written language. Concepts like personal property are probably just starting to develop, and basic stone and bone tools probably came about around this time as well. These small bands would have probably been highly mobile, although seasonal settlements, during times when food was plentiful, would have been common. Survival at this stage is a non-trivial affair, and we shouldn’t forget that there still exist small bands of people today who live like this.

What happens next? Probably a lot of things that failed. The next big step has to do with food production. We invent agriculture. It probably took a lot of tries, and I’ll bet it didn’t do much better than hunting or foraging for ages. Ultimately, it wins out, and here’s why: if you’re a band of hunter-gatherers you go out and hunt/gather your food. Let’s say you get very good at this, so you eat well and are able to support a larger population, and with more people, you can hunt/gather more. Of course, resources aren’t infinite, and eventually you reach a limit – there is a finite area that a large band of people can cover before it becomes too spread out. In the case of agriculture, intensifying food production leads to higher yields which leads to more people which will, in turn, lead to more food production. The key here, is that agriculture can sustain a much denser population than hunting-gathering can. There are huge advantages to having a lot of people in one place who don’t move much over a lot of people spread out over a very large area who move around a lot.

Communication is key. I’m currently forming a new theory on economics in my head, and information, the amount that is shared, and its costs, is at the center of it. A densely populated sedentary group is guaranteed to do one thing better than the same group spread out over a larger area – innovate. Perhaps I should be clearer, when I say “spread out” I’m referring to distance measured by some metric of communication cost. These days, I can talk to a friend on the other side of the world for almost zero cost, whereas back then, a distance of more than a few hundred meters would have been an obstacle. Better communication allows for more efficient division of labor. A sedentary lifestyle also equates to a lower expenditure of energy (in general) so we end up with more food than we need, or the right amount of food, and some leftover people with nothing to do. This all leads to specialization, where labor is divided up and allocated according to a person’s specialization where the choice of specialization is either determined by preference, or (more likely) by some measure of talent.

Which brings me nicely to my next point – comparative advantage. If Michael Phelps (the swimmer) and Gary Kasparov (the chess player) were to swap roles, we would end up with a mediocre swimmer and a mediocre chess player. I’m sure Phelps is a decent chess player, and I’m sure Kasparov isn’t bad at swimming either, but at the end of the day productivity is significantly lower for no other reason than because they swapped roles. Consider a slightly different situation, we start with two people who are equally talented at both swimming and chess. In one universe, they each spend the same amount of time every day doing each and, after some time and some improvement, the level of productivity levels off. In the other universe, one of them only swims and the other only plays chess. Because they are able to specialize, each of them ends up being much better at their respective tasks than they would otherwise have been, and we end up with higher productivity, seemingly for free.

So what do we have? Increasing productivity is all about becoming more and more specialized and dividing labor more and more. The next question that I naturally ask is whether or not there is some kind of inherent limit to this process. Early on, this could have only happened within a small village where everybody knows everybody else. This way, you can divide labor and reasonably trust everyone to do their bit and everything works. Just think, in a village of 5, there would have to be 10 relationships, in a village of 50, 1225 relationships would have to be maintained, in a village of N people, there would be relationships (the handshake theorem). Obviously, early humans were able to overcome this obstacle. How did they do it?

In a word, institutions. We tend to think of formal institutions like education and the legal system, but in this context an institution is basically “the rules of the game” which are followed to allow for complicated transactions to happen between strangers. Stratified structures of authority, such as an organized state is another example. Currency is another one that we don’t often think about. It is also ingenious in that it allows a large object of high value to be broken down into smaller bits. Curiously, currency is no longer tied to any fixed thing of value (previously, gold), but now is allowed to fluctuate in value according to supply and demand just like every other commodity. The cost of ensuring transactions that allow for more efficient division of labor would have surpassed the benefit of actually dividing that labor very early on but for institutions, which serve to lower transaction costs. What they really do is give each party a common ground, or “mutual information” on which to base their transaction, where otherwise establishing this would have been very costly.

So human civilization is doing pretty well, then what happens? There’s a big flood, everything is wiped out, and everyone has to start over. Maybe there’s a drought, or a plague, or the climate does silly things. There are always risks involved with everything, things happen which are completely beyond our control. Let’s take a less dramatic example, you’re part of a small band of people living on an island in a fairly predictable, temperate climate, cultivating the land. You’ve divided the labor well and are living comfortably. There are two “food specialists” who take care of your agriculture, Bob and Marley. They each manage a plot of land on opposite sides of the island. Collectively, they both grow more than enough food to feed themselves, or their half of the band. One day, a freak tornado wipes out Bob’s crop. What happens next? The obvious thing to do, would be for Marley to just eat a little less and sell some of his crop to Bob. But what if this band hasn’t yet evolved any currency or, more likely, what if Bob hasn’t got anything to trade with Marley? If I asked a politically conservative friend, they would tell me that it’s Bob’s tough luck, and that he should’ve saved up for a rainy day. My response would be, “you’re an idiot” (I’m starting to see why I don’t have many conservative friends). The not-so-obvious, but correct thing to do would be for Marley to give some of his crop to Bob on the understanding that Bob would do the same in return.

If a risk is shared among two agents, more risk can be borne than each individual agent can bear alone. This seems a very obvious statement. What is less obvious is how to pool risk. In examples like the one above, where there are a small number of agents, a contract is all that is required. When the number of agents becomes very large, mechanisms for risk sharing can become very complicated. Health insurance, and indeed all major forms of insurance are examples of large pools of people sharing risk. What is perhaps less obvious is the social welfare systems of many countries – taxes constitute a form of insurance premium and the dole can be seen as a form of “employment insurance” payout. Risk sharing also takes place on a very large (and very complicated) scale in securities markets. When the sharing becomes complicated, it is useful to actually understand the theory behind it lest we are plunged into another economic crisis like the current one which was triggered by the sub-prime housing bubble’s dramatic burst. A lack of regulation allowed a simple rule to be broken – that pooling risky assets decreases the risk if and only if the risk associated with each of the assets is linearly independent.

So we divide labor and share risk. That’s basically what it all comes down to. If you think about the way those two things work, you’ll see that they’re intricately connected. Everything else is basically feeding into the labor-dividing, risk-sharing economic machine. There are other things which I have glossed over, or ignored entirely which are fairly important, such as the role of technology, personal property, market-equilibrium, and information, but these are all just grease in the machine (actually technology has a separate significance which I may cover in a later entry). Ultimately, it’s about growing more food. The advance of human civilization can be summarized mostly by who could grow the most food and who could focus the greatest amount of energy into the shortest amount of time (think about that one). What’s the problem then? There are still huge problems with human civilization, we keep killing each other for a start. Mentally disturbed people aside, the main reason this happens (and I’m sure many people disagree with me here) is because of scarcity of resources. People are hungry and poor, and when you have nothing to lose and everything to gain by killing someone, or collectively, going to war with other people, then the choice is obvious. Until very recently, I would have said that all this was inevitable, but in the last 50 years or so (some think sooner) the global GDP (the measure of productivity in an economy) has increased tenfold, and food production easily exceeds the requirements for the ever-increasing global population. The distribution of these now not-so-scarce resources is the real problem and one that economics should be able to solve. Unfortunately, resources are about to become scarce again as population pressures leading to climate change threaten to undermine food and energy productivity.

That is my global view of the overall development of economics and how it basically functions. I would be glad to have any views on the subject from people who know better (and even those who don’t). As I said before, my understanding of economics comes from a very diverse and meandering experience which only ONCE specifically touched on actual formal training in the subject. Any and all feedback is welcome.

Joe Biden and she-who-must-not-be-named did debate recently on many issues. One of the issues that struck me was that of health care. It struck me so much, in fact, that my reactions to watching mentions of it on TV drew much attention at the bar at which I was viewing the debate. Any mention of the McCain health care plan made me want to vomit. I thought it would be a good idea to try to explain why.

First a bit of background. Healthcare in the US is pretty awful. An oft-quoted statistic in opposition to my claim is that the US spends more on healthcare than most other countries. When you consider that many Americans aren’t covered at all and most are only partially covered, this statistic is more indicative of inefficiency than anything else. Yet, as I have experienced, paying for health insurance here can be very costly, partly because the health care itself is very costly (although, admittedly, it is generally very good).

The concept that I will be invoking is known as “Rothschild-Stiglitz” equilibrium and it basically applies to situations of information asymmetry in insurance markets. Yes, this is the same “Stiglitz” as the one who hangs out at Columbia. In fact, this work eventually led to a Nobel Prize. The original paper on this is quite good and I would encourage the enthusiastic reader to peruse it. I will try to simplify the details and preserve the essence of what is being said while resorting to as little mathematics as possible.

For simplicity’s sake, let us take an imaginary population composed of two distinct groups of people – Red and Green. Red people are high-risk, prone to illness and such and green people are low-risk. It doesn’t really matter. If it helps, think of it as young male drivers vs older (but not senile) female drivers and substitute health insurance with car insurance – the concept is basically the same. So we have these two groups of people and they want to buy insurance. We will assume an insurance market with perfect competition (i.e. perfect information, zero profit, and no monopolies)

Now let’s say that insurers have some way of telling which people are Red and which are Green, like a test. Let’s also assume that Red and Green people know what colour they are. What will happen? This seems like a no-brainer, and that’s because it is: Red people will be charged more for insurance and Green people will be charged less. That is, their premiums (periodic payments) will be larger. The fixed deductible (the fixed amount that they MUST pay whenever they make a claim) will be relatively small but, importantly, it will be about the same for both Red and Green people.

As an interesting aside, making the test optional doesn’t actually make a difference to the end result. I will leave that as a simple exercise for the reader.

In real life, however, it is very difficult to tell the Red from Green. Maybe insurance companies are red-green colourblind, maybe there are anti-discrimination laws, perhaps testing technology isn’t up to it. If we present this population with the same choices as before, a very obvious thing will happen – everyone will buy the plans that were originally offered to the Green people, because it is cheaper. Since we have a market with perfect competition, the insurance companies will raise the premiums otherwise they will lose a lot of money to those pesky high-risk Red people. But is this the only thing that can happen? This is where it begins to get complicated.

There is another possibility. There can exist two types of plans – one with a very very high fixed deductible and low premium, and another with a much lower fixed deductible and a much higher premium. Can you guess which one is aimed at which group? The plans with a high deductible are aimed at the Greens, because in the end, their expected value (the probability of an outcome multiplied by the cost of that outcome) is the same, yet the high deductible would discourage Reds from buying those plans. The situation is essentially the same for Reds whose higher probability of having an accident favours the plans with a lower deductible even though it has a higher premium.

However, since we have a market with perfect competition, was can expect all of these possibilities to play out. In fact, when you put all of these supposedly stable equilibria in the same ball park, you get an interesting result – there is no stable equilibrium that gives full insurance to everyone. There is the trivial solution, where nobody is insured, and there are a handful of “special cases” which rely on specific ratios of Red to Green people.

What does this all mean though? Basically, my interpretation of it is that laissez-faire free market philosophy cannot work in insurance markets with asymmetric information. Nevermind the fact that coalition building and monopolies exist; even with perfect information and perfect competition it CANNOT work.

What does this mean for John McCain’s health plan? First he’s going to tax work-based health insurance more, which will basically kill it. He will deregulate the market… a bit iffy for very different reasons, but not entirely unreasonable on the surface. The real kicker is that he will give people a tax break in the form of money with which to go out and buy your own health insurance. The idea, or dogma rather, is that you’re giving consumers choice and creating a competitive market. This can only work at all if there is perfect information on both sides and there is not, nor can there ever be.

What would happen under the McCain plan? Well, health insurance is expensive. If you’re young and healthy and have just come out of College with a lot of debt, you’re going to want to save as much as you can, wherever you can. You might even risk not having health insurance, or not being fully-insured… what happens then? Well, older people, smokers, obese people, basically people who know that they need insurance will see their premiums go up, probably to the point where some can’t even afford it.

Basically, the McCain health care “plan” does what most of his policies and, indeed, most of his campaign seems to do – it divides America and leaves us worse off for it. Moreover, in keeping with Republican ideals, it favours the rich over the poor, which is ridiculous because very wealthy people are the ones who need health insurance the least.

For example, between me and my parents (my Dad’s a diabetic and they’re both quite old, mind) we could probably have afforded every single doctor’s appointment, prescription and operation that we’ve had done and not suffered greatly from it, but thanks to good foresight in ensuring that we have good health insurance (information that is generally more easily accessible to wealthy people, but that is a different issue), we’ve only paid a fraction of that cost. By contrast, poorer people cannot afford this and while Medicare in the US will pay for emergencies (because THAT’s a good healthcare strategy (I’m being sarcastic)) it will also charge an amount that would send most people bankrupt; which is exactly what happens a lot of the time.

The simple solution to all of this is to do what many other countries have done and nationalize it and charge everyone the same amount (taking it out of their taxes, basically). This also gives government incentive to promote preventative healthcare programs which improves everyone’s health (don’t forget that) and are also far more cost effective than waiting until emergencies to intervene. Currently, private insurers have no incentive to engage in promoting preventative strategies because they, in their competition with each other, will cut costs by under-insuring people. By making the market competitive, the equilibrium you end up with is (unsurprisingly) the competitive market equilibrium (read Gerard Debreu and Kenneth Arrow’s paper about this, it’s effing great). Sadly, the competitive equilibrium isn’t the optimal solution, at least as far as providing healthcare for everyone is concerned.

Many people argue for universal healthcare on the grounds of equity and appeals to standards of “fairness”, and there’s nothing wrong with that. However, at the end of the day, somewhat counter-intuitively, nationalizing healthcare actually (amazingly) makes it cheaper and the effect becomes more pronounced over time because the incentives are structured differently. Some may argue that the Green people get shafted in favour of the Reds, but if you think about it, first of all, there aren’t many Reds relative to Greens and, moreover, the spectrum is continuous. The average person begins life as a green and, as they age, become more and more Red. So, in the end, applying what is essentially the same plan to everyone makes a lot of sense.

It is a joke that the US doesn’t have universal health care, but John McCain’s health care plan is beyond a joke, it is an utter farce, and nothing good can possibly come of it. Barack Obama’s isn’t perfect either; it is far from it, but it is closer. (If he went as far as I do, he would probably lose support for being TOO liberal, or be accused of being a socialist/communist).

I would LOVE to hear anyone’s thoughts on this.