Friday, September 17, 2010

money and bounded rationality

The three functions of money, in freshman economics, are as a store of value, a unit of account, and, last but most, a medium of exchange. Writers occasionally construct examples of something serving one purpose but not another, but by and large crippling any of these functions will to some extent cripple all of them. This is especially true in the case of storing value. If a prospective currency can't store value, then users have to use it in a hurry, and the buying and selling process that a medium of exchange is supposed to allow to be separate are forced to be more temporally proximate; in the extreme, if you have to spend your money within minutes of getting it, you're largely stuck looking for someone who wants to buy what you want to sell and vice versa, and you're effectively back to a barter economy. Similarly, it becomes less useful as a unit of account if its value can't be counted on.

Money as a store of value is also a great technology for savings. A (closed) economy as a whole can "save" only by investing resources in capital — physical capital, intellectual capital (technology), human capital (education) — but an individual can "save" by lending to others who wish to borrow, and in a large economy with a well-run central bank and so on, this typically works better.* If I have a good year, and expect less year will be worse, I can simply pile up cash; if I get paid a lump sum for a contract job, I can spread my spending over the time until my next job. If I want to make a big purchase, I don't have to make a big sale at the same time; I can save up ahead of time — or afterward, by borrowing at the time of purchase and then paying back the loan. The ability to choose between spending today or tomorrow is as valuable as the ability to choose between apples and grapefruit.

It's often noted, and, especially recently, quite notable, that people who are bad at saving money often lose much of this ability. If you don't have the self-control to let hundreds of dollars go unspent for a few weeks, you can't trade spending now for spending later. (If you buy durable goods, you can stretch some of your consumption into the future, but not quite as effectively.) The money, in this case, doesn't provide an effective store of value. This also, as I noted in the first paragraph, will affect its ability even to function as a medium of exchange.

I recently read an example of this; unfortunately, I don't now remember it. It was something along the lines, though, of a person who had trouble saving, and was engaging in a certain amount of barter (and running into the attendant double-coincidence-of-wants problems) due to an inability to build up even enough "working cash" to engage in what I think of as normal quotidian economic activity. If I remember or otherwise reacquire the example, I'll probably update this post.

* It occurs to me I've taken for granted that holding onto currency is the equivalent of lending to the central bank (or "bank of issue", if we still had non-central banks of issue), and that keeping money in a bank account is making a loan to that bank. If that's not obvious, take my word for it.

Tuesday, September 14, 2010

search theory and prostitution

There's a subfield of macroeconomics dealing with "search theory", though aside from the mathematics (which resembles macroeconomics) it's an issue that's closer in nature to microeconomics. Most macro models seem largely to ignore it, at least as a direct matter; there may be sticky prices or market power layered onto a model that might come from search issues but is typically simply taken as exogenous. There's a certain amount of demand, a certain productive capacity, and the people who want to buy stuff buy stuff from the people who want to sell stuff.

For a lot of goods, that's not an especially good description (though, to be fair, how good a description it is depends on exactly what you care about, and for a lot of macroeconomic treatments it may be adequate). One of the primary roles of advertising, and one of the benefits of being a large (and long-lived) firm, is in the ability of people who want to buy what you're selling to find you. If you open a new business selling erasers, and somebody needs to buy an eraser in your first month in business, there's a good chance they don't know about you. If they've walked by your store a few times a week for the past several years, seen your ads on the subway, and maybe bought an eraser or two from your shop in the past, when they need an eraser, they know where they can get one. Being the answer to the question, "Hey, do you know where I can get an eraser?" is enormously valuable capital.

For illicit markets, it's that much harder; you want people looking to buy to be able to find you, but you don't want the police to. This can be handled in a few different ways. One is ambiguity; you generate a signal that is understood, but perhaps is not explicit enough to be grounds for arrest, or, ideally, even especially heavy levels of suspicion. Word of mouth, where your position in the market is known disproportionately to people whom you have reason to trust, also helps, as do repeat business relationships.

A new paper by Steven Levitt and Sudhir Venkatesh, which apparently I'm not supposed to cite, but let's hope this is okay, discusses the market for prostitution in Chicago.
Even for a given sex act, however, the prices paid by black customers are systematically lower than for other customers. These differences appear to be attributable to price discrimination on the part of the prostitutes.

In a perfectly competitive market, "price discrimination" is unsustainable; if you try to charge less than the going rate to some customers and more than the going rate to others, you only get the customers whom you're charging less. There are a fair number of pimps and prostitutes in the given neighborhoods, and while it's possible they engage in collusion (tacit or explicit, concious or not), this seems likely to be evidence of the search problem; if you charge a white customer more, it's not that easy for him to go find another seller who will charge him the lower rate, so your only real competition is with his going without.

There have been some arrests of Indian actresses for prostitution, in part, it seems, because being an actress is one of these ambiguous signals:
Because of the sexualized roles they play, and the fact that many are in scandalous "live-in relationships"— meaning they move in with boyfriends before marriage—the blanket assumption is that all actresses are available for a price. This is obviously false, but it's an illusion that has been exploited by savvy pimps who have created a market for B-list and C-list "starlets"—often unsuccessful actresses from questionable backgrounds—for men who want to have what's sold as a glamorous sexual experience.
Being an actress is not per se actionable by the police, but it might help someone looking for prostitution to find you.

How information of this nature makes it through an economy is of particular interest to me, and is one of the things I can imagine myself studying over the next five years.