Posts filed under ‘Economics’
(The mistake of) further leaning the supply chain in difficult times
Operations have always interested me. I’ve worked with supply chains, studied them, comprehended them. But, what I don’t understand, is why that motto of “leaning the supply chain” is considered an universal truth. Reminds me that one of “leaning -and trimming- the organisation” whose long-term results -only now are beginning to be known.
Because sometimes leaner is simply not the most adequate choice. Sometimes you need to be able to offer greater flexibility, better response, even at a greater cost.
What did prompt this reflection in my mind? Well, a friend of mine wanted to buy a new car, so I told him it would be a good moment because the car sales had dropped around 10% this year in Spain.
It looks like the bargaining power of customers has increased, hasn’t it?
Well. In fact something slightly different has happened. Concessionaires have resolved to reduce costs, specially reducing stock. They only have the star models, but not anything that may be a little customised. That means nine months for my friend to get the model he wants. Can you imagine that?
I understand that promoting a series of basic models by penalising the consumption of the rest of the catalogue is a way to reduce variability and variety. But that could be useful in a highly busy and stressed supply chain and that’s not exactly the case.
In this case I understand we should focus the supply chain in some strategical intent to promote sales in a weak season. That way we shouldn’t want to reduce variety but induce new sales. And that means offering an appealing selection for the customer and an improved service. I don’t exactly see improved service with lead times around nine months.
In this case, the savings are surely lower than the opportunity cost of not selling a model. Specially when you still have plenty of space left in the premises (I bet they have not shrunk because of market’s weakness), and specially when competitors may have chosen a different strategy.
Sometimes some savings are simply not worth it.
The darker side of economics (how well intended theories can get the worst out of MBAs)
Those that hold a degree in economics will surely know three different and diverse theories: (just follow the link to know more about them)
- The agency theory: that describes how managers and shareholders pursue different objectives and thus need to be aligned through both control and appropriate rewards. Shareholders will want returns and value, managers will want their own returns, power, and to increase their personal value.
- Transaction cost economics, defined like the additional costs to a product than those to produce it, that is to control its fair use and distribution, the cost of formalising the relationships between the product and the user, to prosecuting breaches of contract and punishing offenders.
- The five forces analysis, by Porter. This one needs no presentation. This model describes the strategic positioning based on the bargaining power of customers, the bargaining power of suppliers, the threat of new entrants, and the threat of substitute products as well as the level of competition in an industry.
I could mention many more. But those three are specially interesting. What do they have in common?
Sumantra Ghoshal (1948-2004) is known about his theories about transnational companies, and the matrix structure (my beloved matrix structure, I must say, this morning I was proposing using it for a new project… but thats a whole new story)
Ghoshal worked in a couple of well known business schools, and ended up founding the Indian School of Business, so he was not an enemy of the MBA spirit, but he directly blamed corporate scandals such as Enron on MBA courses. Why?
Because business is a social science. (Remember the reflection I made, long ago, about Economy as a Science?) Well, sciences must be held with care. Sciences must be thoroughly studied, interpreted and understood.
Specially social sciences. Those do not only describe reality, but they are also able to change it. I reflected long ago on how a science like Economics could rewrite itself (See the Phillips Curve in the previous link). Ghoshal thought the same. In fact Ghoshal thought that the (incomplete) knowledge of a social science could change our mindset. Like those that can be taught in a fast, practical course such as an MBA.
Now let’s go back to the question I left unanswered. Yes, there is something in common between those theories…
They distrust people. They focus on the darker side of humanity: managers will cheat, companies won’t collaborate, customers will breach the contracts… all of them need badly to be controlled, sometimes even prosecuted. That’s the way. Some cheat, some control and the bottom line: it’s all a trade-off.
Those that excel are those that are able to play with the system and not to get caught. Does that ring a bell? Enron’s managers got it very clearly. They played, they tried, they lost. And not only them, many more did.
The title focused on MBAs but that can be true for any executive education. Our mindset defines our behaviour. And even well intended theories can made us adopt an incorrect mindset, inadvertently. A mindset that can make managers behave opportunistically, drawing conclusions from incorrect assumptions: people will try to cheat you.
And if you, as a manager, interiorise that, to hell with positive theories about managing people.
Well, some people will try to cheat you, but some will not. It’s not a definite behaviour. What about ethics? People do have a choice! And people can still have integrity. And you have the choice to manage with integrity.
Four ways of thinking I: utilitarianism or thinking about the consequences (Stuart Mill and Bentham)
We make decisions all the time. And when we don’t, usually, problems become graver problems.As you know, it’s better to make the wrong decision than to make no decision at all.
But, on what basis do we construct our decisions? Some people are more practical than others, some people think more on the human side, some people abide to their principles no matter what, and some worry a lot about the consequences.
In fact the most considerable bulk of humans, and that includes me, just mix different ways of thinking and making decisions. We are not pure in our decision making. And the proportions change from one person to another. They depend on the mindsets, the circumstances, temperaments or even circumstantial moods.
We always think of our decisions as the most rational ones. We tend to perceive ourselves as non-biased. But we can’t help seeing the world through our filters. We reflect what we are on the decisions we make.
In this series of four posts, that altogether configure a meme, or a basic cultural unit, I want to identify four basical thinkers that defend very specific ways to make decisions.
These four basic ways of thinking are present in each one of us. They configure an important part of our decision making process, impersonating four different perspectives to every decision.
Think about them. They will help you understand the mental process that makes you consider different options and thus four different ways to weight outcomes. And they will help you in knowing yourself better and, why not, into making better decisions or at least understanding your decisions better.
The first way of thinking is consequentialism or utilitarianism.
One of the thinkers that most effectively impersonates utilitarianism is John Stuart Mill (1806-1873). Many things can be said about him. In fact he is worth much more than one post, being his thought configured by his father James Mill and his father’s friend Jeremy Bentham.
Stuart Mill was a deep boned liberal, fending for a slimmer and democratic government limited by individual freedom.
How would he reason? He’d think of the consequences of the actions. Thus, when we impersonate Mill we think how what we are about to do will affect on others. The concepts of utility and happiness come into front view. They become important under utilitarianism.
In fact he followed the ideas of Bentham, close friend to his father and mentor to the young John.
Jeremy Bentham was also British, and lived from 1748 to 1832. He can be considered the father of utilitarianism He was a liberal, defending the most basic rights, from the right to freedom in a world that still practised slavery, to the suppression of physical punishment, widely practised not only in prisons but also in schools, and specially the right of the individual not to be limited by the state in any way short of affecting negatively his fellow citizens.
In fact he’d be happy today to see that some of the subjects that he was worried about are being considered today. He supported the equality of women in every way, animal rights, the right to divorce and even homosexual rights. And that was 200 years ago! Education was essential for Bentham too.
In the economic sphere he abhorred of monopolies and usury, free trade, inheritance taxes, pensions and insurances. Both Stuart Mill and Bentham are usually regarded as proclaimers of a minimal state, but that’s not true. The individual freedom is paramount, but the states must guarantee basic rights and a basic equality to protect those who suffer. At the same time, the states must foster economic growth so as to facilitate a minimal subsistence level and encourage wealth.
Most of all, he incised decisively in a society, the British society, so fond of its traditional approach, initiating a wave of change, a progressive change towards a new idea: the well being of the majority. Well being that could even be translated to happiness. So the decisions in Britain had to be taken thinking of the population, and those who were affected by them.
The following quote from Bentham defines good and bad, moving closer to hedonism.
“Nature has placed mankind under the governance of two sovereign masters, pain and pleasure. It is for them alone to point out what we ought to do as well as to determine what we shall do. On the one hand, the standard of right and wrong, on the other the chain of causes and effects, are fastened to their throne.”
Consequentialism was thus being born, shaking the foundations of the British society and starting a movement to change the laws -another sphere of decisions- to have them aligned with the majority, not with the privileged ones. That was a huge leap towards progress and a fairer society. This wish for reform would help Britain to evolve further, no longer being constrained by mediaeval concepts. And with Britain, more nations followed in the will-be-developed world. No wonder Bentham supported both the American Independence and the French Revolution.There are differences between Bentham and Mill. The first thinks of the majority fostering the critique about the majority dictatorship. The second is able to modulate all that into a more sensible and respectful approach for the minorities. Stuart Mill had more time to elaborate and adapt his thoughts, and had an increased social component in his thought.
But, back to decision making, what counts is that we make the decision thinking of the consequences, not out of principles or rules inherited over the centuries, not faith or revelation. There’s not statu quo to preserve, good intentions or psychological reasons, there’s only utility, general utility. The more useful the better.
Thinking strategic (from organisations to the economy)
Coming from strategos, the greek word for general or commander, this is one of the most used -and missused- words all around. People use the world strategy to make their position more sexy, combining it with words like direction, information, product, customer or even online, web 2.0 and blog. Always followed by strategy. That way you can give your card proudly.
In this card you can also read the strategy!!!
The Chinese had their say with Sun-Tzu, that was the first strategy writer ever to be known. He was so good that his book, The Art of War, is still widely read today. His ideas are about winning the battle before the battle is even fought. For that you need to convince your enemy that you’re strong in places you are not, and hide your strongest points, so that he is moved to a position of weakness. In this position of weakness you can overcome a stronger enemy.
And then, when the battle is fought, we move from strategic to tactics. That means we associate the strategy concept with planning, and tactics are closely related to execution. Long run against the short run.
Another point of view, strategy sees the big picture, the systemic view. (See the Why systems thinking? post). Tactics seek to optimise locally, in execution, right now. Tactics are operational. Think about allocating resources, doing the most of what you scarcely have. Some things that come naturally, decisions you just have to make.
While strategy is not obvious at all. It’s necessary to forget your day-to-day, step back, try to see it all, reflect, interiorise, learn, generate new ideas, evaluate them, multicriterise them, plan.
I’m not going to focus on Ansoff (or Porter afterwards) that are always referred as father (and nourisher) of strategy. Tracing the roots of economic thought, we can find someone in the 19th century that was already grasping the idea. It was Germany and later in the US, and this man is an economist: Friedrich List. He didn’t live long. After a fortune reversal in America, he committed suicide in 1846.
List defended the idea of national economics, an important rule for the state in the economy. He proposed high tariffs on imported goods to protect the local industries, that is protectionism, plus the government implication building infrastructures and the need for a national central bank. Do those ideas sound familiar to you? In fact, with Alexander Hamilton, he cofounded the American School of Economics that is still alive today, only to be confronted by Keynesianism in the mid-twentieth century.
But the funny thing is that he also had a big influence on the other side. He was offered the editor post of a new liberal newspaper in Cologne, Rheinische Zeitung, that he didn’t accept for health reasons. Guess who accepted? Karl Marx.
Why is that important? List saw the need to plan by the state. There could be no nation letting individuals seek their own interest when that interest could harm colective interests. Freedom meant suicide for nations. There was a need to plan and decide thinking of the big picture: the state.
When Ansoff wrote about strategy in the mid-1960s, those ideas were heavily assumed by society. Democratic countries also needed central planning. Even companies did. Igor Ansoff, an American professor of Russian origin was the one to collect the imputs of those diverging currents and wrote the first book on strategy planning. Engineer and mathematician, overly analytical, he defined strategic decisions as those that would not generate themselves, opposed to operational and administrative decisions.
Why systems thinking? (seeing the forest, not the trees)
In 1619 René Descartes opened a way of reasoning that sparkled scientific progress, but at the same time made it difficult for us westerners to think in certain ways. When we hear of things like holistic thinking or quantum management sometimes we gaze in surprise or awe, and we listen for a while… until we remember we have lots of things to do and want to be bothered no more.
And easterners that come to our European universities and schools sometimes are carried by our individualistic and simplificative values and begin to think like us, making one step back as well as of one forward. For what it’s worth, the individualistic approach to the world has earned us things like the Renaissance, humanism and capitalism. Without them the world wouldn’t be as it is today, and we wouldn’t be where we are. It’s great to acknowledge that. But it’s not enough.
Reductionists approaches, just like Descartes’ helped us to understand the trees in the forests, then the chemistry in their leaves, and the structure of their atoms. We even tried to go further and we succeeded and found an intriguing subatomic world of neutrinos, pions, muons and bosons. Although some bossons have been predicted but never observed it seems we have gone a long way to our knowledge of the basic structure of reality. All these are achievements of the western world.
But in the way we forgot to look at the whole picture. And that has happened in many ways. In managemente too. We jump to the parts that we can quantify, sometimes only the parts that we can exactly quantify. And then we start counting, and adding, spending a lot of effort in details we might not need.
We never try to mix sales data with customer perception on the same spreadsheet. After all we would be crazy if we did. We can add up sales, and costs, up to the cent, who’d want to mix up that precise and objective calculation with something that couldn’t be measured? Well, nature does just that. (Remember the Heisenberg principle that I introduced in the Quantum Organisation post? By the way, the quantums are the ones in the standard model chart above.)
Nature doesn’t really care about exact values. It cares about systems. The first grasp that we took at that was with Ecology. Ernst Haeckel defined it in 1866 as a science about relationships. There were no more isolated biological identities, no more rivers to measure or atmosphere to analyse. There was a system. With its changes, crisis, equilibriums, unstability.
Note: This beautiful piece of Earth is in Lithuania
Suddenly we realise that companies can’t be just measured with accounting figures, that organisations won’t be understood by their books. There’s much more to them. There are forces, just like the nature forces, but this time they are grouped into five groups by Porter. They will resist the change that managers want to drive. They will sometimes counteract, reject, or kill. They are alive, albeit in some strange way.
Einstein said “be as simplest as possible, but no simpler”. In a sistemic approach we are trying to be simple too, but seeing the whole, not just a collection of parts. No more local maximums that don’t add up to a global maximum. This time we are going towards the system.
(to be continued)
Finding myself in the political compass (aka different kinds of liberals)
One of the things that amazes me most is how almost anyone can define himself as a liberal. From people defending free market at all costs, to authoritarian leaders that start wars, to people defending compassionate conservatism, to people fighting for human rights and marriage for same-sex couples… all of them define themselves as liberals.
There’s only one other concept more self-identified than liberalism, that is centrism or, even better, the idea of being a moderate. Everybody is a moderate, regardless of what you may think, you’ll always find somebody more radical than you. But when one of the few people more radical than you happens to be Adolf Hitler, the odds are that you’re not as moderate as you might think.
Different kinds of liberals
Fortunately the richness of the English language provides us with alternative words to liberal, one of them being libertarian. Remember the post about Rawls and Nozick? Nozick would be a libertarian. Many people that are really libertarians label themselves as liberals. Why not? It’s rather clear the two concepts intersect somewhere.
But one of the best ways to classify the different kind of liberals is to use two dimensions for liberalism: social liberalism and economic (or fiscal) liberalism.
That is most helpful to classify people: some people defend a lot of freedom in front of the state for economic matters, that would mean few or no taxes at all, freedom of enterprise, expanded society shielding for investors or even managers, work force flexibility, no market regulations at all, and many more. They opt for a reduced state (Nozick’s style) that will center its tasks to protect property rights and contract rights and all kind of acquired rights. The only thing that the state would monopolise would be security, and for efficiency reasons. But then those same people would use that force-enabled-state to put social order. Where that begins is by putting trespassers to jail, but where that ends is not so clear: kicking immigrants back to their countries? forbidding abortion and jailing doctors? making compulsory to teach science conditioned to the Holy Bible? Outlawing and punishing sex before marriage? This kind of people were those who embraced Nozick’s ideas (they still do) and make him nervous and uneasy at the same time.
So it seems clear you can be an economic liberal, but socially conservative. Or even authoritarian in that sense. That would lead to fascism. Or defend individual rights an at the same time wish for an economic system controlled by the state so no individual would be crushed in the economic sense. Also makes sense to me. In that case you could be a social liberal but a socialist at the same time. Ghandi or Zapatero (Spain’s Prime Minister) would be in that classification.
Let’s draw both dimensions:
- On the horizontal axis the economic dimension. More leftist would lay obviously on the left, like communism or socialism, planned or more regulated economies. On the right more freedom for entrepreneurs and companies, unregulated markets, more choices, and further right free market without any control that is savage and rough market. Milton Friedman would lean to the right, and general Pinochet, ex-dictator from Chili, would be on the extreme right.
- On the vertical axis the difference between libertarian and authoritarian. Fascism on the top, like Hitler, the more control the better, and liberalism on the bottom. That would suit Bentham and the hedonists for example. Ghandi and Friedman would be both social liberals, while one would lean to the left: Gandhi, and the other to the right: Friedman proclaiming both individual freedom and fiscal freedom.
This chart could summarise both parameters:
Now, test yourself and know where you are
The source for the previous graph is a very recommended link: http://www.politicalcompass.org/
In that page there is a questionnaire that you can complete. It’s made up of six pages, each one with a series of questions that will challenge both your political and economical views. And then locate you in the two dimensional space.
That’s what I’ve done. I’ve just completed the political questionnaire on http://www.politicalcompass.org/questionnaire. That was funny so I just thought I’d share my results with you 
To my surprise, these were my coordinates:
- Economic Left/Right: 0.25
- Social Libertarian/Authoritarian: -2.87
What amazes me most is that I’ve always thought that centrism was a myth. Or at least a psychological effect: people would tend to think they were “in the middle” regardless of their views. How could anyone not agree with the affirmation “I am a reasonable human“? Even with the alternative one: “I am an unbiased observer of reality“?
Well, probably the test is wrong, but it put me on the center, right in between left and right. Am I the sole centrist that I know? Should I be analysed? Who knows…
And regarding the social scale, I’d be on the liberal zone, half way to anarchism, I guess that would be libertarian.
If you draw the coordinates, the blue point, I fall somewhere in between Gandhi and Milton Friedman, an funny mix. Still unsure of what that means to my future development as a human, I’ll have to think further about that.
Alan Jay Lerner and the scarcity of democracy and freedom
Yesterday I went to listen to Brent Barrett singing the music of Leonard Bernstein. Brent Barrett is one of the greatests tenors from Broadway.
He was performing at Barcelona’s opera house, also known as the “Liceu“. It was an impressive performance. This artist knows how to sing, how to express and how win the audience.
But, let’s go to the point. I already knew that Leonard Bernstein (1918-1990) was Jewish, from a liberal family in Massachusetts and a strong defendant of human rights. I was surprised to know, tho, that Alan Jay Learner and Leonard Bernstein had written a musical in 1976 in the context of the Watergate scandal, disenchanted by politicians and especially of Richard Nixon. The musical was about the story of the White House and called 1600 Pennsylvania Avenue (that’s the White House address).
Leonard Bernstein with sister Shirley in the Green Room at Carnegie Hall after a performance with the Israel Philarmonic, March 1951
The show was a flop and lasted only for seven days. But it contained more than one century of American History, from George Washington to Roosevelt. How the country had strived for freedom and the struggle for black freedom. It’s a story about the difficulties of maintaining a democratic society.
This work has been largely overlooked and unappreciated. It wasn’t recorded until 1997. But there’s a song that Brett sang yesterday that inspired me a lot. It’s called “Take care of this house”.
Take care of this house
keep it from harm
if bandits break in
sound the alarm.
Care for this house,
shine it by hand
keep it agleam
so it can be seen
all over the land
Be careful at night
check all the doors
if someone makes a break in
the dream will be lost
Take care of this house
be always on call
for this house
is the home of us all
It is sung by the First Lady to Lud, a young black boy that is a slave to the White House. He is the future. She is presenting him with the challenge to attempt a democratic society that will be able to overcome social injustice. The house represents the whole nation and the whole of the democratic world; it’s the hope for us all.
As I usually, capitalism has won, but don’t take democracy for granted.
Bubbles I: Tulipmania, XVIIth century
I do not need to tell you what bubbles are: irrational exuberance leads to an inflation of prices, usually some kind of stock, expectations lead to greater expectations, until there comes a moment where people believe at the same time that assets are too high -much above value- but that they’ll keep skyrocketing. This contradictory belief leads to stubborn reality and, once you come to terms with it, prices crash, leading to a backslash in the percepti0n of price and value of speculative investments.
So it’s a matter of scarcity and demand. Scarcity leads to demand, and demand leads to scarcity, until craze comes.
Today I wanted to review one of the first paradigmatic cases of a bubble. Much is said today if this description is an ex-post judgement and it really wasn’t a bubble, but in any case, tulipmania is still a synonym for bubble.
lesson learned: don’t bet all your future into one flower
It all began in 1593 when the first tulips arrived to the Netherlands. They were new, scarce, pricey and everybody wanted one. And it had a maturity period: you bought the bulb and in time you’d have the flower, just like some investment. So people began buying more and more and prices soared.
In fact tulips’ bulbs had been introduced for medicinal uses, but beautiful tulips quickly became a distinctive and exclusive mark of beautiful gardens. And from that they became a mark on the social ladder: you had to have tulips in your garden if you wanted to be someone in the Dutch society.
One thing led to another. Bulbs were traded more and more. Prices multiplied: more than twenty-fold monthly increases. And, as it always happens, everybody wanted to invest: people became on debt to get rich and longtime accrued savings were transformed into bulbs.
object of greed and social desire
Of course value was not on the bulb itself, because the bulb wouldn’t produce anything. Value was speculative, and that meant that, to really earn something, you needed to find another buyer. With rising prices, the buyer’s base shrinked until it was too small. Maybe they thought that a bunch of wealthy foreigners would come and buy them all, but foreigners never came.
Instead there was a moment when people started worrying because selling them was getting more difficult: periods got longer, psychologically longer than whatever short term is.
And there was that contradictory thought that comes with all bubbles: this is too expensive but it will get even more expensive. Expectations of further risings and expectations of depreciation mixed. Until the first expectation overcomes the second: this is too expensive.
And bulb investors panicked. Specially when many realised they had traded lifelong savings for beautiful-when-flourished nonproductive bulbs. Wouldn’t you?
Too late as usual, even the Dutch state tried to intervene, proposing to cover contracts at 10% value. Of course that caused an immediate 90% drop-off. But the value punctured that 10% soil again and again and the bubble finally bursted. It happened in 1637. The bubble had lasted less than one year, some had won a lot of money, but the subsequent depression affected both winners and losers.
Did investors learn from this? I leave the question unanswered. For next post: Isaac Newton’s investments…
Economy: art or science?
If you have read me before you know that one of the things I’ve been asking myself is whether Economy is a solid enough science to lead us to the truth, whatever that might be. I thought about it in the previous post “Is Economy as a science solid enough to define what’s true and what’s not?“, and end up talking about the Lucas critique.
Well, I have to say I began being sceptic, thinking that Economy was not stable enough to be called a “science”, but slowly changed my mind.
And like a coin, now I think there are two sides to Economy: science and art.
The “science side”, is it solid enough to reach the truth? Yes it is. We’ve been discovering a series of laws, economic laws, that deserve being qualified as “natural laws”, that rule the production and distribution of wealth. It’s just like Chemistry that is able to understand and describe how the elements interact and combine. The applications? Those can be done in so many different ways…
And there is the “art side”, a side that Chemistry doesn’t have (maybe I should rethink that too). In Economy the distribution of wealth can be designed in so many different ways. For sure Rawls and Nozick would do it in two very different ways. But not only them but each of us would be creative in our own way. As in every art, some might even be better artists than others.
Because those natural laws that work from the shadows even made perfectly (?) planned economies to have cycles, as Kitchin, Juglar, Kuznets, Kondratev or the cluster innovations of Schumpeter –yes, again- and Mensch. Even with the cycle denial by Milton Friedman, we still have bubbles: technological bubbles, housing bubbles, internet bubbles, biotech bubbles, stock bubbles (I think we could be in one of those now) again and again.
painting political ideas in a blank canvas
Good artists will try, from their posts, to use their tools (call them fiscal policies, monetary policies or whatever you wish) to create something nice that responds to their personal perspective or even to their ideals. Sometimes seeking social justice –whatever its definition might that be –sometimes just seeking self profit –a great way to create wealth too-, or just seeking to predate other’s resources.
Now to the conclusion: the part of Economy that is a science will help us understand the world, drawing solid conclusions, reaching objective truths. The part of Economy that is art will let us use those basic laws to build something of our own, to create.
Economy’s nature is a dual one.
Logit models in Econometrics and bit entropy: there’s something going on here
First Econometrics
One of the cases that we face in econometrics is when the response variable is qualitative. In the simplest case, the response can be either 0 or 1. Some examples:
- Given some parameters about a person: will he vote democrats or republicans? will he subscribe to some magazine? will she leave her job if pregnant? Will the student decide to cheat? Will she vote at all?
- Or given some parameters about a bond, how will it be classified? it will surely depend on volatility, leverage, assets…
- A teacher wants to know if a student will pass his exam.
- A financial company wants to know if the about to be issued sub-prime mortgage will default.
In those situations we don’t have a value to predict directly as in a regular estimation. We’ll estimate the probability of something happening. P0 that it won’t happen, P1 that it will happen. P0+P1=1. That means that we’ll have a Bernoulli probability distribution with a mathematical expectation P1.
Imagining a two-dimensional situation, we’d have something like this:
Fitting two parallel lines with a diagonal line, that should be tough
That means that if we estimate with an ordinary least squares regression we’ll have a bad approximation for three reasons: the shape doesn’t resemble a line, the resulting line will span above 1 and below 0 (impossible probabilities) and R2 as a measure of goodness of fit will be higher the more separated the two dot clouds are.
The solution: using the logit model. We need something like this:
The function that we are trying to fit is the logit function, an special case of the logistics function. As you can see it asymptotically tends to one on the right side and to zero on the left side. That would mean that our regression would be now:
You need an statistical package to do that. You can even try to do it by means of a Gaussian distribution. That would be the probit model instead. Daniel McFadden earned the 2000 Nobel Prize in Economics partly because of his developments of econometrics with the logit regression.
Now, communications.
So, what’s the relationship with bits? In communications the basic unit of information is the bit. As you already know a bit just expresses a simple basic idea “0″ or “1″. That could mean “on” and “off”, but also “democrat” or “republican”, “male” or “female”. The simplest information, and, with a combination of them, more complex ideas: height, number of children, passport number, marital status.
When you’re sending bits, you’re making also a Bernoulli trial. You can either send zeros or ones. You don’t know if they’ll be ordered or not, but usually you imagine that they will have similar probabilities.
A measure of the “order” or “disorder” is the entropy. If there’s a similar quantity of zeros and ones, the entropy will be maximum, if they’re all ones, or zeros, minimum. There wouldn’t be any disorder if you only sent zeros. There would be no information either. So entropy must be kept to a maximum to send information. (And to ensure a working channel, that’s what randomisers are for).
There’s a function that measures the entropy of a Bernoulli trial:
The maximmum, of course, is when both probabilities are the same, when you are sending 0′s and 1′s with the same probability.
Now with coincidences
So where’s the funny thing? First let’s transform the logit regression function into a log function (take logarithms at both sides):
Now, let’s take the entropy of the Bernoulli trial and let’s derive it:
Do you see it? Here there is some coincidence going on. Both are the same function. (Well, there’s that minus sign, but who cares).
So, again, is Economy a Science?
Why do I care, you might ask. Well, lately I’ve been thinking about if Economy is solid enough as a Science or not. There’s a lot of things to say about that.
First I thought it wasn’t. What kind of science could have his rules changed by politicians? I posted my negative opinion here: Economy did not have solid enough foundations to say what was true or not.
But were the other sciences solid enough long ago? Maybe it’s just my perception of mine to think that Physics is more solid than Economics. Reality rules can’t be changed -for now-, but they can’t be totally determined either. Do you know about the Heisenberg uncertainty principle? It’s one of the greatest concepts that humanity has achieved. I have to blog about it some day.
There’s something deep going on here, laying the foundations of Economy as a science. The more I think about it, the more I can grasp or feel it. Even with planned communist economies, there still were cycles. Even when the Phillips curve did not work anymore, people still were making the same decisions, work more if there was more reward to it, hire cheaper if there was more workforce to choose from.
The more I think about it, the more I see Economy is a solid science in its own right.
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