## Friday, September 27, 2013

### On Reasoning and Familiarity

One of the major themes of Behavioral Economics is the idea that much of human reasoning uses shortcuts known as heuristics. For example, imagine you were asked to approximate the number of marbles in a jar with reasonable speed and accuracy.  You have a number of possible strategies. You could individually count each marble, but this approach is lengthy and difficult.  You could simple take a wild guess, but that's likely not very accurate.  Alternatively, you could decide to count what seems to be a third of the marbles then multiply that result by three.  That will only take a third as much time and is likely to be reasonably accurate. This third approach is a heuristic, a mental shortcut that usually gives you an answer that is "good enough".

However, heuristics often lead to consistent and reproduceable errors in reasoning. Take this test for example. You are presented with four cards. Each card has a letter on one side and a number on the other. Which cards should you turn over to test this hypothesis: All cards with vowels on one side have an even number on the other.  The cards you're given are:

#### E   G   2   5

Take a moment and decide which cards you'd flip.

Before getting into the answer let's highlight a few key things regarding the hypothesis.  All cards with vowels on one side have an even number on the other. Key words that likely jump out at you are "vowels" and "even numbers". Notably odd numbers and consonants are not mentioned.

Here's another version of roughly the same puzzle.  See if your answers differ at all. Imagine you run a bar which serves beer and soda.  Everyone in the bar who is over 21 may have beer, but anyone below 21 must drink soda.  You only know either a patron's drink or age but not both.  Which of these patrons must you check to ensure no one under 18 has beer? (Officially our hypothesis in order to mimic the first puzzle is: if someone is drinking alcohol they must be over 21.)

### Beer Drinker, Soda Drinker, 30 years old, 15 years old

This puzzle is logically the same as the first but most people will come to a rather different conclusion. Obviously you must check the age of the beer drinker. Clearly you don't need to check the age of the soda drinker or the drink of the 30 year old.  However, you must check the beverage of the 15 year old to ensure he isn't drinking beer.

Similarly most people correctly suppose that you should flip over the E card in the first puzzle.  After all, if you find an odd number on the other side you have disproven the hypothesis.  The G doesn't need flipped because our hypothesis doesn't care about numbers on consonant cards. Most people wrongly choose to flip the 2 card because the hypothesis mentions even numbers.  However, suppose you found a consonant on the other side? We just established we don't care about consonant cards so that wouldn't be helpful.  If we find a vowel it seems to lend credence to our vowel/even hypothesis but it doesn't invalidate it or prove it so we've ultimately learned nothing. Finally, most people choose not to flip the 5 card. The hypothesis doesn't mention odd numbers so it would seem unnecessary. However, if we flip the 5 card and find a vowel we have invalidated the hypothesis that vowel cards have even numbers. Thus this card must be checked along with the E card.

If you answered incorrectly to the first puzzle don't feel too bad. Over 90% of those questioned make the errors listed above.  It's entirely normal for the brain's heuristics to lead you astray in this case.

What is interesting is that far far fewer people make mistakes on the second puzzle.  As mentioned, the drinking problem is logically the same.  Only letter/number combinations have been exchanged for soda/age combinations.  Yet seemingly due to the familiarity of the situation individuals are much more easily able to correctly solve the puzzle.

That's it for this week. Until next week stay safe and rationale.

## Thursday, September 19, 2013

### The Impact of Minimum Wage

During recent travels abroad I was confronted with sky high prices in Australia.  The extreme costs of some items wasn't a surprise, but it got me thinking about the root cause of such price differences. Locals provided reasons such as high taxes, transport costs, low population density and high minimum wage laws as possible root causes.  All of these likely drive up prices for at least some products, but in reality only one of them is a major cause. Sales tax for example isn't all that much higher than in the US (10% for non food items and no tax on grocery items). Transport costs are irrelevant for many items (digital downloads are still expensive) and a small portion of the cost for others.  Finally, overall population density doesn't seem terribly relevant for the highly populated coastal areas which still maintain high prices. In reality, high prices are likely a product of a high median wage which  research shows seems to be about 40% higher for a full time worker in Australia than in the United States.

Of course, there was one suggested reason which has yet to be addressed. Is the high Australian minimum wage driving prices up? The Australian federal minimum wage is currently \$16.37 in Australian dollars or \$15.32 as opposed to the US federal minimum of \$7.25 (state laws often demand a higher minimum than the federal minimum). Clearly this is an extreme difference, but is it a large part of the reason for Australia's high prices?

There are a number of effects of minimum wage laws. Like many economic ideas the fact that these effects occur is generally agreed upon. However, the degree of the effects is a topic of hot debate. The consensus is that minimum wage laws:
• Increase unemployment: There must be some set of workers that a business is willing to pay X for but is not willing to pay Y. Thus increasing the required wage from X to Y will result in the loss of their jobs.
• Increase prices or reduce profits: Increasing the cost of labor necessarily increases the cost of production. The firm must either accept reduced profits or pass these costs on to the consumer.
The degree of a potential price increase would clearly depend upon the amount of minimum wage labor that a given industry employs. As food service is an industry that uses a larger than average proportion of minimum wage workers it should be impacted significantly by minimum wage differences.  In fact, studies have indicated that an increase in the minimum wage of 10% results in between a .5% and 5% increase in food prices and between a .5% and 1% increase in overall prices.

Given Australia's minimum wage is approximately 100% higher than the United States we can expect 5% to 10% higher overall prices.  Certainly this is a significant impact and a major contributor to the higher prices Australians must pay. Of course, they pay these higher prices with their higher wages and thus aren't too burdened by prices that would shock many Americans.

An important note is that most studies investigating the impact of the minimum wage on prices look at a single moderate increase as opposed to a large difference such as that between the US and Australia. It is highly likely that price effects of minimum wage increases scale in a non-linear fashion. In other words, studies show a 10% increase in the minimum wage increases price levels by .5% to 1%. However, multiplying that wage increase by a factor of ten is likely to result in a much larger price increase than 5% to 10%. This is because larger increases in minimum wage regulations will impact more workers, thus causing a larger total effect.

As an example, imagine the world contained one thousand workers. Workers earn with a fairly normal distribution (a bell curve) within a range of one to a hundred dollars an hour. Further, assume all workers are going to remain employed for the purpose of this example.  If the government institutes regulations requiring a minimum wage of five dollars an hour there is little in the way of price effects. After all, very few workers are earning below five dollars an hour anyway, thus the impact is small. However, if the government instituted a requirement that workers be paid fifty dollars an hour the price effect would be enormous. Nearly half of the population would see their wages increase, some by an order of magnitude.

An interesting aspect of minimum wage laws is that they are simply a disguised wealth transfer. Everyone in society pays higher costs which are then distributed to the lowest paid workers via a required minimum wage. It's a rather roundabout system which unfortunately prices some workers out of the market (resulting in higher unemployment) but is functionally similar to social security of unemployment benefits.

Ultimately Australian's higher prices are a result of their higher earnings.  While the other mentioned factors do make a difference, those differences pale in comparison to the price increases caused by higher minimum (and moreover median) wages.  Unfortunately, visitors from countries with lower wages are still stuck paying the inflated Australian prices.

That's all for this week. Until next week stay safe and rationale.