Sunday, November 21, 2010

SuperFreakonomics: Chapter 1

Many of our decisions, both inside and outside the investment world, are often based on anecdotal information, anomalies, emotions, or existing opinions. SuperFreakonomics illustrates how applying an economic approach can help us change this. Investors can use the tools described in this book, including better and more prevalent use of data, along with an an understanding of the power of incentives to make better decisions.

This chapter examines the economic forces that exist in the world's oldest profession. First, the authors contrast some main differences between prostitution today and one hundred years ago. Prices have fallen dramatically, despite a fewer per capita supply of prostitutes. Demand for sex is still high, so what has changed? Due to the acceptability of pre-marital sex in today's society, men are able to satisfy their demands without requiring a prostitute. (More than 20% of men 80 years ago lost their virginity to a prostitute while only 5% do so today, whereas 70% of men today have had sex before marriage, compared to just 33% previously.)

The way prostitution is dealt with by law enforcement serves to highlight the principal-agent problem we have discussed with respect to shareholders and management. Police chiefs (in this case, the principals) likely wish to see more arrests and fewer prostitutes, but there is a conflict of interest with the beat cops (agents). As it turns out, based on the data gathered by the authors and their associates, a prostitute is much more likely to have to give a freebie to a cop than be arrested by a cop.

The way law enforcement attempts to deal with illegal activities is also a problem. As in the drug trade, when law enforcement gets serious, it does so by stepping up its efforts at trying to curb the suppliers of illegal goods/services rather than the consumers. But this serves to increase the price of the product, thereby encouraging more suppliers to join the fray!

The authors also examine the effects of pimps, and compares their effects on prostitution to the effects of using real-estate agents to sell homes. Using data gathered from first-hand study, they find that the use of pimps, holding all other variables constant (including the same prostitutes in many cases), results in an increase in prostitute wages even after commissions, whereas real estate agents don't garner much in the way of benefits to home sellers (and may in fact be a net negative). The main reason for this, the authors conclude, is that pimps are able to market to clients in demographics and geographies that prostitutes are unable to reach. On the other hand, the internet has made it so that real estate agents are not adding much in the way of value for clients, so their value-add is low.

Finally, the authors profile a highly successful prostitute who employs economic techniques to improve her profits. She is a twice-divorced computer programmer who quit that job because it was boring and tedious. She enjoys the fact that she now works for herself, enjoys low overhead (markets by internet), employs price discrimination (higher rates for clients she doesn't enjoy as much), understands elasticity of demand (she can raise prices to certain levels without seeing a drop in demand), and understands market forces (she hopes prostitution stays illegal, because that's part of the reason she can charge such high rates).

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