Extra Credit Opportunity: Free Enterprise Forum with Glenn Loury, “Capitalism and Race”

I am pleased to announce the Baugh Center’s upcoming Free Enterprise Forum with Glenn Loury, Merton P. Stoltz Professor of the Social Sciences at Brown University. The lecture, “Capitalism and Race,” is Thursday, April 22, at 5:30pm CST via Zoom. The event is co-sponsored by Baylor’s Department of Economics.

Professor Loury is one of the world’s leading experts on the economic and social aspects of race. He will discuss recent developments in race relations including the concept of antiracism, the shift of emphasis within organizations and institutions from diversity to equity and inclusion, and the role of markets in addressing racial bias.

Professor Loury has been on the faculty of Brown University since 2005. He was previously at Boston University where he served as University Professor and Founder and Director of the Institute on Race and Social Division. He has also taught at Harvard, Northwestern, and Michigan. He received his PhD in Economics from MIT. He has published widely in the areas of applied microeconomic theory, game theory, industrial organization, natural resource economics, and the economics of race and inequality. He is a Fellow of the American Academy of Arts and Sciences and the Econometric Society and also served as Vice President of the American Economic Association, and is a recipient of the Guggenheim Fellowship.

As a prominent social critic and public intellectual, writing mainly on the themes of racial inequality and social policy, Professor Loury has published over 200 essays and reviews in journals of public affairs in the U.S. and abroad. He is a member of the Council on Foreign Relations, is a contributing editor at The Boston Review, and was for many years a contributing editor at The New Republic. Professor Loury’s books include One by One, From the Inside Out: Essays and Reviews on Race and Responsibility in America (The Free Press, 1995 – winner of the American Book Award and the Christianity Today Book Award); The Anatomy of Racial Inequality (Harvard University Press, 2002); Ethnicity, Social Mobility and Public Policy: Comparing the US and the UK (ed., Cambridge University Press, 2005); and, Race, Incarceration and American Values (MIT Press, 2008).

Since this panel discussion has the makings of an extra-credit opportunity for Finance 4335, let’s have it! You can earn extra credit by attending this Zoom webinar and reporting on what you learn. If you decide to take advantage of this extra-credit opportunity, I will use the grade you earn on your report to replace your lowest quiz grade in Finance 4335 (assuming that your grade on the extra credit is higher than your lowest quiz grade). Submit your report as a (PDF formatted) 1-2 page executive summary. In order to receive credit, the report must be uploaded to the Assignments section of the Course Canvas page by no later than 5 pm CST on Monday, April 26 (Click on the Assignment entitled “Free Enterprise Forum with Glenn Loury, ‘Capitalism and Race’, April 22, 2021“).

Registration is required at https://bit.ly/FEF_Loury. After registering, you will receive a link to the Zoom webinar.

You Can Bet on the Vaccine, Literally

This WSJ  article tells a compelling story about how prediction markets offer important tools for managing risk.  For example, consider the following quote from this article:

…investors can bet on a contract “Will 100 million people have received a dose of an approved COVID-19 vaccine in the US by April 1, 2021?” (At this writing, the betting suggests a likelihood slightly above 1 in 3.)

Case studies of how (poorly designed) insurance creates moral hazard

In my moral hazard lecture, I discuss how contract designs and pricing strategies can “fix” the moral hazard that insurance might otherwise create. Insurance is socially valuable if it enables firms and individuals to manage properly the risks that they face. However, insurance can also have a potential “dark side.” The dark side is that too much insurance and/or incorrectly priced insurance can create moral hazard by insulating firms and individuals from the financial consequences of their decision-making. Thus, in real-world insurance markets, we commonly observe partial rather than full insurance coverage. Partial insurance ensures that policyholders have incentives to mitigate risk. Real-world insurance markets are characterized by pricing strategies such as loss-sensitive premiums (commonly referred to as “experience-rated” premiums), and premiums that are contingent upon the extent to which policyholders invest in safety.

In competitively structured private insurance markets, we expect that the market price for insurance will (on average) be greater than or equal to its actuarially fair value. Under normal circumstances, one does not expect to observe negative premium loadings in the real world. Negative premium loadings are incompatible with the survival of a private insurance market since this would imply that insurers cannot cover capital costs and would, therefore, have incentives not to supply such a market.

This brings us to the National Flood Insurance Program (NFIP). The NFIP is a federal government insurance program managed by the Federal Emergency Management Agency (also known as “FEMA”). According to Cato senior fellow Doug Bandow’s (admittedly dated, but still quite accurate) blog posting entitled “Congress against Budget Reform: Voting to Hike Subsidies for People Who Build in Flood Plains”,

“… the federal government keeps insurance premiums low for people who choose to build where they otherwise wouldn’t. The Congressional Research Service figured that the government charges about one-third of the market rate for flood insurance. The second cost is environmental: Washington essentially pays participants to build on environmentally fragile lands that tend to flood.”

Thus, the NFIP provides a fascinating case study concerning how subsidized flood insurance exacerbates rather than mitigates moral hazard. It does this by encouraging property owners to take risks (in this case, building on environmentally fragile lands with high flood risk) which they otherwise would not be inclined to take if they had to pay the full expected cost of such risks.

There are many other examples of moral hazard created by insurance subsidies. Consider the case of crop insurance provided to farmers by the U.S. Department of Agriculture. The effective premium loading on federally provided crop insurance is typically quite negative (often -60% or more), thus putting crop insurance on a similar footing to flood insurance in terms of cost compared with actuarially fair value. Just as mis-priced flood insurance effectively encourages property owners to build in floodplains, mis-priced crop insurance motivates farmers to cultivate acreage which may not even be all that fertile.

I could go on (probably for several hundred more pages–there are many other egregious examples which I could cite), but I think I will stop for now…

Moral Hazard Class Problem and Solution

The “Moral Hazard Lecture–March 9, 2021” video features a class problem that carefully examines how to go about designing a so-called “incentive-compatible” contract between a corporate owner (the principal) and manager (the agent). The key insight is that moral hazard can be mitigated by ensuring that both the principal and the agent have “skin in the game”.  In this class problem, this is accomplished by offering the corporate manager an incentive compensation scheme involving a cut in salary that is supplemented by a bonus if certain profit targets are met.

The class problem is available at http://risk.garven.com/wp-content/uploads/2020/10/Moral-Hazard-Class-Problem.pdf, and its solution is available at http://fin4335.garven.com/spring2021/moralhazardsolutions.pdf.

Stanford study into “Zoom Fatigue” explains why video chats are so tiring

Fascinating article on the science of so-called “Zoom Fatigue”…
A new study from Stanford University communications expert Jeremy Bailenson is investigating the very modern phenomenon of “Zoom Fatigue.” Bailenson suggests there are four key factors that make videoconferencing so uniquely tiring, and he recommends some simple solutions to reduce exhaustion.

On the Determinants of Risk Aversion

This week, we begin a series of five Finance 4335 class meetings (scheduled for February 2-16) devoted to decision-making under risk and uncertainty. We shall study how to measure risk, model consumer and investor risk preferences, and explore implications for the pricing and management of risk. We will focus especially on the concept of risk aversion. Other things equal, risk averse decision-makers prefer less risk to more risk. Risk aversion helps to explain some very basic facts of human behavior; e.g., why investors diversify, why consumers purchase insurance, etc.

A few years ago, The Economist published a particularly interesting article about various behavioral determinants of risk aversion, entitled “Risk off: Why some people are more cautious with their finances than others”. Here are some key takeaways from this article:

  1. Economists have long known that people are risk-averse, yet the willingness to run risks varies enormously among individuals and over time.
  2. Genetics explains a third of the difference in risk-taking; e.g., a Swedish study of twins finds that identical twins had “… a closer propensity to invest in shares” than fraternal ones.
  3. Upbringing, environment, and experience also matter; e.g., “… the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons.”
  4. People’s financial history has a strong impact on their taste for risk; e.g., “… people who experienced high (low) returns on the stock market earlier in life were, years later, likelier to report a higher (lower) tolerance for risk, to own (not own) shares and to invest a bigger (smaller) slice of their assets in shares.”
  5. “Exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses.” Furthermore, low tolerance for risk is linked to past emotional trauma.

Psychological aspects of decision-making under risk and uncertainty…

As I noted in my blog posting from earlier today entitled “Reading and Quiz assignments due Tuesday, February 2 in Finance 4335“, starting this Tuesday, February 2, we begin a series of five class meetings devoted to the topic of decision-making under risk and uncertainty. While we will address this topic primarily from an economics perspective,  there is also much to be gained from a psychological perspective.  Indeed, University of Chicago professor Richard Thaler was awarded the 2017 Nobel Memorial Prize in Economics for his scholarly contributions which apply psychological principles to economic analysis. Keeping this in mind, I highly recommend that Finance 4335 students listen to the latest (50-minute) “Hidden Brain” podcast entitled “Afraid of the Wrong Things“. Here’s the description of this podcast:

“Around the world, people are grappling with the risks posed by the COVID-19 pandemic. How do our minds process that risk, and why do some of us process it so differently? This week, we talk with psychologist Paul Slovic about the disconnect between our own assessments of risk and the dangers we face in our everyday lives.”

The Real Force Driving the GameStop Revolution

Jason Zweig’s Intelligent Investor article referenced below, entitled “The Real Force Driving the GameStop Revolution” should be required reading for all students of finance. Among other things, the article provides its readers much needed historical context for last week’s GME, AMC, and Blackberry bubbles!
wsj.com
Individual traders banded together this past week to move markets like never before. But the buildup to this remarkable moment has been happening for decades.

Also featured as one of “50 Things That Made the Modern Economy”: The Index Fund

Besides insurance, Tim Harford also features the index fund in his “Fifty Things That Made the Modern Economy” radio and podcast series. This 9-minute long podcast lays out the history of the development of the index fund in particular and the evolution of so-called passive portfolio strategies in general. Much of the content of this podcast is sourced from Vanguard founder Jack Bogle’s September 2011 WSJ article entitled “How the Index Fund Was Born” (available at https://www.wsj.com/articles/SB10001424053111904583204576544681577401622). Here’s the description of this podcast:

“Warren Buffett is the world’s most successful investor. In a letter he wrote to his wife, advising her how to invest after he dies, he offers some clear advice: put almost everything into “a very low-cost S&P 500 index fund”. Index funds passively track the market as a whole by buying a little of everything, rather than trying to beat the market with clever stock picks – the kind of clever stock picks that Warren Buffett himself has been making for more than half a century. Index funds now seem completely natural. But as recently as 1976 they didn’t exist. And, as Tim Harford explains, they have become very important indeed – and not only to Mrs Buffett.”

Warren Buffett is one of the world’s great investors. His advice? Invest in an index fund