A Few Good Economists...

Couldn't resist this one after reading the ones on Traders & Central Bankers...

You can't handle the truth! Son, we live in a world that has GDPs. And those GDPs have to be predicted by men with models. Who's gonna do it? You? You, Dr Krugman? I have a greater responsibility than you can possibly fathom. You weep for Greece and you curse the Economists. You have that luxury. You have the luxury of not knowing what I know: that Greece's default, while tragic, will probably save economies. And my existence, while grotesque and incomprehensible to you, saves economies. You don't want the truth. Because deep down, in places you don't talk about in dealing rooms, you want me on that GDP. You need me on that GDP. We use words like inflation, unemployment, consumption; we use these words as the backbone to a life spent modelling something. You use them as an algorithm. I have neither the time nor the inclination to explain myself to a man who trades and profits under the implications of the very forecast I provide, then questions the manner in which I provide it! I'd rather you just said thank you and went on your way. Otherwise, I suggest you pick up a model and predict a variable. Either way, I don't give a damn what you think you're entitled to!

The Auto Rickshaw Problem - An Informal Economics Perspective

At the risk of being considered obsessed with auto rickshaws, I just thought of putting across some thoughts on the economics of the auto rickshaw problems that everyday commuters such as myself in Mumbai face.

Consider the profit structure of an auto-rickshaw driver:

1) Revenues - Fares from plying on different routes around different areas. This is a function of distance and waiting time.

2) Costs - Most drivers don't own their autos. They are typically owned by fleet owners. As far as I know the drivers have to pay a certain fixed sum to the owner and they keep what they make over and above that. The other costs, of course, are fuel and maintenance

3) Constraints: Fares are standardized (at least by law) on a cost plus basis. Also, drivers are not supposed to refuse any passenger (though that never happens!)

Note that standardized fares do not take the "illiquidity premium" of the destination into account. If the destination is such that it's difficult to find a fare, the driver will balk at going there. If pricing was free, the driver could ask for a premium over and above the metered fare. However, the monitoring in this regard (at least in the Bandra to Vile Parle belt) is quite strict i.e. Enforcement deters free pricing. This is not to say that meters themselves are not manipulated - that can still happen. But no one asks straight up for a fixed fare - they still go by the meter. Therefore, for such places, drivers simply refuse to ply.

Drivers also refuse to ply to places with heavy traffic. There are two reasons for this. The first is that the waiting time compensation is not adequate vis-a-vis the distance traveled. For example, drivers get approx 7 rupees per km. In an area with moderate traffic this distance can be covered in 3 to 5 minutes. For 5 minutes of waiting time they would get only around 1.5 to 2.5 rupees (again, with an ideal meter; However even with the best of manipulations they can't get more than 2.5-4 rupees). Hence, the aversion to heavy traffic.

Now look at the driver's optimization function. The best destination for him is the one which is at a long distance, in areas with less traffic and which will give good fare options at the end. Consequently, the worst destination is the one at a short distance, in areas with heavy traffic and which doesn't give good fare options. Another factor influencing his decision making is the place where has to deposit the vehicle.

Cost plus pricing proves to be inadequate because it treats all destinations as the same, not factoring in the fares potential. It also doesn't take into consideration the distance-waiting time differential.

An important behavioural hypothesis to consider - I believe most drivers are profit-satisficing, but not necessarily profit-optimizing. This is the piece de resistance in understanding why they have become so frustrating in the last one year or so in particular. I believe the major change that happened was the roughly 30% hike in fares in June 2010.

I was initially happy because I thought that with the fare hike there was no reason for drivers to refuse to ply even to unattractive locations. They would get adequately compensated. But because many of them are satisficing agents, not optimizing, they realized that they could make the same amount of money as before with fewer trips. Accordingly they could afford to be more choosy about where they wanted to go. And thats what we have been seeing ever since!

Another point - with respect to the queuing time at places like the airport, again the cost plus method is inadequate. A fixed charge over and above the metered fare, for queuing, would help in mitigating the problem.

How do other places address these problems? The example of Singapore is most instructive. The fares are non-linear. They are extremely high for short distances. The first km or so costs 3 Singapore dollars! The next costs only some 60-80 cents (if I remember correctly). This serves two objectives. Firstly, people are dissuaded from using cabs for short distances and are likelier to use the MRTS etc (I believe this is the primary objective of the fare structure). Secondly, the driver is incentivized to service people even for short distances (this is more of a secondary objective - in any case the monitoring is much stricter and no one is supposed to refuse fares)

Thus two things can be done:

1) The fares for shorter distances can be made a bit higher (They shouldn't be made too high, or else the reverse problem will happen - drivers will only want to ply short distance!)

2) The waiting time-distance differential can be reduced (However one caveat is that meters will need to be monitored strictly!)

3) The problem of unattractive destinations is tough to solve, because its difficult to price the premium of not getting fares from a location. It will vary with a lot of factors, such as for example, the time of the day. Standardizing this will be even tougher. One (admittedly imperfect) solution could be to allow passengers to give the driver a mutually agreed premium above the metered fare subject to a maximum percentage cap. This would have to be agreed beforehand. Of course, one would argue that the driver would ask for the maximum while the passenger would want to give nothing. However, the magic of demand-supply kicks in here. If the passenger truly believes that some incentive is justified, he will give something more than 0, and if the driver believes that the maximum is too much to ask for, he will reduce it.

To Trade OR Not To Trade...

We are in an economic and financial environment of heightened uncertainty (or, to quote Ben Bernanke, the environment is "unusually uncertain")

While this is not entirely new (since we have had many instances of episodic volatility in the past 3 years), increasingly there seems to be a belief that we are reaching the endgame of the 2008-09 recession.

I believe markets trade on perceptions of fundamentals. And it is precisely those perceptions which are significantly muddled and unclear right now.

Trading is a significantly different ballgame from investing. In trading, the path of price movement is important. The swings in prices (volatility) are important - both in frequency and amplitude. And hence, timing is important.

We base the decision to invest in an asset on its expected returns, adjusted for expected risk.

Similarly, the decision to trade in an asset should be based on the expected movement in that asset and how much of that movement we reasonably expect to capture. And this is where the problem lies. Right now, the environment is uncertain.

The use of the word 'uncertain' to characterize the environment in financial markets is important. Frank Knight famously made the distinction between risk and uncertainty. In both cases, the outcome is unknown. However, in case of risky situations, the probability distribution of possible outcomes is known beforehand. In case of uncertain situations, the distribution is not known.

Today's environment undoubtedly belongs to the latter category. And that has major implications for any trading strategy.

Trading is based on the application of some logical system to the movement of asset prices. Some sort of set of possible outcomes, with expected probabilities, needs to be defined. Note that it is not necessary to have a rigorous quantitative probability distribution in place always. Most humans in fact have subjective qualitative distributions for asset price movements. They use bounded rationality and inductive reasoning, biases, judgmental shortcuts and many other behavioural aspects to arrive at the same.

However, if the movement of asset prices is uncertain (i.e. if the probability distribution of the set of possible asset prices cannot be determined in advance), then trading will fail. 

Thus, ANY trading model, post the structural changes and dislocations that we have witnessed in the 2008-09 period in financial markets, should first attempt to answer the question: To Trade OR Not To Trade - is the current market environment suitable for trading?

To answer this question, a model would need to evaluate whether asset price movements are uncertain. I am not sure of the exact mechanism or mathematics that will be needed to prove this. It's quite possible that the proposition is indeterminate. However, I believe measures of volatility, market transaction volumes, idiosyncratic movements / noise could be some quantitative inputs while perceptions of market participants, environment feel etc could be some qualitative inputs in trying to decide. The fundamental question is - How does one test asset markets for the presence of Knightian uncertainty? The answer to this question will also tell us whether or not to trade.