Thursday, August 22, 2013

The Blend of the World

If you have a car you've likely noticed signs at the gas pump indicating that ethanol has been added to your gasoline.  This rise of blended fuel is a product of the government's attempt to increase the use of sustainable fuels and wean America off of foreign oil.  However, as it turns out when this plan was conceived mistakes were made that have led us to a rather ridiculous situation.

Every year refineries are required to blend a certain amount of ethanol into the gasoline they produce. The standard blend rate is 10% ethanol.  This rate is used because essentially all gasoline engines can utilize 10% ethanol gas without any problems (and perhaps more importantly at this point the gasoline is subject to a forty cent per gallon reduction in taxes).

In 2007 when the ethanol mandates were created congress anticipated a constantly increasing rate of gasoline consumption. However, in the years since 2007 gasoline consumption has instead declined by approximately 5%.  Ethanol blending mandates were dictated in terms of raw gallons however. So as the total consumed gas has declined the required amount of ethanol to be blended in has risen.  Unsurprisingly, this has led the industry to the point where it's difficult to shove the required amount of ethanol into the gasoline supply while keeping the blend at the 10% rate.

Refineries are able to buy what are known as Renewable Identification Numbers or RINs in order to comply with ethanol mandates. However, as producers and speculators have realized the impossibility of meeting increasing ethanol blend requirements within the current system RIN prices have sky rocketed.

The EPA has the ability to issue a special waiver which reduces the ethanol mandate each year. However, they are only permitted to issue the waiver on a yearly basis.  More over, eliminating or permanently reducing the ethanol mandates would rapidly devalue the RIN leaving producers and speculators with substantial losses. Leaving the system as is requires special EPA intervention each year or a likely increase in gas prices as producers pass the additional cost of RINs onto consumers.  In any conceivable scenario some party is incurring substantial costs.

It's easy to see the rationalization of the legislators when these mandates were created. After all, everyone agrees renewable energy is a net positive. Had they dictated that ethanol production simply pace gasoline production at a 10% rate we likely wouldn't be in this situation.  However, we'd also simply be treading water in terms of moving our energy supply towards sustainable sources.  In this case their policies certainly haven't worked out, but I find it difficult to fault their intentions.  Of course the whole thing could have been avoided if they'd decided to take the direct route and simply raised gasoline taxes (thus reducing consumption and creating further incentives for fuel efficient or fuel flexible vehicles).

One special note, the economics of using ethanol as a fuel source at all is a topic of great debate which I have purposefully neglected.  Please do not construe this negligence as either an endorsement or condemnation of the practice.

That's all for this week. My apologies for the horrid pun in the title. Until next week stay safe and rationale.

Wednesday, August 14, 2013

The Future of Labor

Futurists have been predicting how technology would revolutionize labor for well over a hundred years. Ideas of robot servants, self driving taxis, and work from home interfaces have been harped on time and again but have, as of yet, been hard to find in reality. As recently as the twentieth century prognosticators believed that the American workweek would drop to thirty hours or less with an accompanying ten weeks of vacation annually. Unfortunately for most of us we haven't arrived at that particular utopia yet.

So what will the future of the labor markets look like? If I had to guess, I'd put my money on a model like HourlyNerd. HourlyNerd is a service which matches highly skilled business consultants with small businesses at an hourly rate.  Businesses submit their projects and individuals apply to complete them along with a requested hourly rate. The small business then selects their "nerd" who completes the project.  Services such as accounting, financial advice and business consulting are available at an average rate of $35-$50 per hour.

If a project is going to take approximately fifty hours, than the HourlyNerd service can complete it for approximately $2500. It's easy to see that's far cheaper than hiring a full time professional of the same skill level. A truly large firm might require a market penetration analyst full time, but realistically in most cases highly skilled, highly specialized people probably only apply their primary skill set thirty percent of the time or less at a full time job.  The remainder of their time is either spent idle (not accomplishing meaningful work) or performing tasks which a low skilled worker could easily accomplish.

Paying high costs for a highly skilled full time worker could be thought of as a retainer of sorts.  However, as the ability to connect with hourly professionals increases, the question of whether a retainer is necessary becomes very obvious.  It's a simple decision when the question amounts to, "Do I want to pay $100,000 a year plus benefits for the same information I could get for $30,000 from an outsourced worker."

The obvious disadvantage of such services is a decreased level of employee accountability. After all, there's very little dread at the prospect of termination when your position ends upon project completion regardless. Poor work of course diminishes the likelihood of being engaged for future assignments, but it seems unlikely that such a disincentive is as potent as termination from a full time position.

So here's the official prediction.  Services that match highly skilled workers with short term or hourly employment will continue to grow.  Small businesses will pick up and drop these workers as needed thus gaining many of the advantages available to larger firms while keeping their costs relatively low.

Information about HourlyNerd can be found at their website

More economics next week. Until then stay safe and rationale.

Wednesday, August 7, 2013

The Brain Game

Over the past few years there's been a large push to "map the human brain." But what exactly are we trying to accomplish with a brain map and why is it such a difficult task?

In general a brain map refers to one of two things:  an effort to define the functions of different brain regions, or a digital representation of actual neuronal connections. Either of these tasks is daunting, though for different reasons.  However, today I'm going to focus in on the type of brain map that attempts to actually model the connections of neurons.

Recently MIT set out to use the power of gaming and crowd sourced citizen science to assist in creating their brain map via Eyewire (it's actually a mouse retina, not a human brain but trust me that the difference isn't all that important). Eyewire is a simple game wherein users color in a neuron that has been defined by a computer algorithm.  The algorithm is somewhat prone to errors and so the users task is primarily focused on correcting the algorithm's mistakes.  Data gathered is then fed back into the program in an effort to improve it's ability to define neurons. 

So what does this have to do with anything?

Eyewire gives us a very precise conceptualization of neurons. Take a moment and imagine what a neuron looks like in your mind.  If you're an average person you probably envision something like this:

It's a pretty common Hollywood representation of a neuron; a central body with three or four offshoots running to another central body. It looks relatively simple and easily mapped.  Now here's the representation of neurons that Eyewire has created over the last several months:

Each color in that image represents a separate neuron.  Further, these aren't the only neurons present in this space, just the ones processed by Eyewire so far (when the project is complete even more neurons will be squeezed into the same image). Now imagine attempting to untangle those seven neurons when they're not only all the same color, but also surrounded by other non-neuron cells. It's a daunting task with only a few cells. The difficulty rises even further when considering the human brain consists of billions of neurons. 

Eyewire, with the assistance of thousands of users, has defined only a handful of cells over the past year. These cells are represented with outstanding accuracy and detail, but clearly at this rate of progress a full brain map would take a staggering amount of time. 

Of course the entire goal of Eyewire is to improve a computer's ability to map neurons for us. If their goal is successful (and there's no reason to believe it won't be)  computers will be able to process the image data far faster than their human counterparts and with nearly as much accuracy. In that event neuroscience may produce a neuronal brain map far sooner than was thought possible only a few years ago.

If you're interested in Eyewire you can find out more at their website It's worth a look for the images alone.  More economics, neuroscience and everything else next week. Until then stay safe and rational.

Thursday, August 1, 2013

The Completeness of Contracts

Imagine for a moment that you and I are about to make a deal. I need $10,000 today in order to secure a fantastic bargain on a piece of machinery that will greatly improve my production capabilities. In return I promise to repay you $1000 a month every month for one year. We shake hands, you give me the money, the machine is purchased and everyone is happy. But... what if?

What if the machine breaks, I return it and receive the money back? Can I just return the $10,000 to you the next day?

What if my company goes bankrupt? How are you going to recoup your losses?

What if the value of the dollar collapses and the real purchasing power of your compensation amounts to far less than the original $10,000?

What if the machine exceeds all expectations and I earn incredible surpluses? Are you entitled to any additional gains?

What if I find myself with excess funds at some point during the year? Can I pay you off early and if so must I pay the full $12,000 or can I pay a prorated amount based upon how much of the year has passed?

These are only a few of the contingencies that could easily be written into our original contract.  However, the question of whether we should bother is surprisingly difficult to answer.

In contract theory there exists a spectrum of contract completeness ranging from complete to incomplete. A complete contract would cover every possible eventuality.  In practical terms such a contract is impossible as negotiating every conceivable event would be cost prohibitive.  On the other end of the spectrum an incomplete contract tends more towards a "You take care of me, I'll take care of you." sort of arrangement. In reality, nearly all contracts fall somewhere in between with important details being clearly spelled out while many possible contingencies are ignored.  A good example to illustrate the difference between the two ends of the spectrum is the difference between marriage and a prenuptial agreement. Marriage is generally a very loosely defined agreement between two people that they will live together and attempt to improve each others lives. There's not very much provided in the way of specifics beyond social norms such as monogamy. A prenuptial agreement on the other hand usually is very specific. It details exactly what each party will come out of a marriage with in the event of separation. Thus, in general a prenuptial agreement is a far more complete contract than a marriage agreement.

The question is then, are more complete contracts better?  Surprisingly, the answer very often seems to be no.  Every contingency built into a contract has an associated negotiation cost. Attempting to account for every possible eventuality piles on negotiation costs for events which are unlikely to ever occur.  Further, contingencies can often signal inaccurate or misleading information between parties.

For example, suppose you needed to contract a babysitter. You both agree that she will watch your children five nights a week (Monday to Friday) from 4 pm until 8 pm. She'll be paid $10 an hour which amounts to $200 per week.  Now suppose you add a stipulation that if you're running late she's expected to stay until 10 pm. The additional hours from 8 until 10 will be compensated at a rate of $12 per hour. How might this one contingency influence her view of the contract?

Most obviously such a contingency signals to her that it's likely you'll occasionally run late.  Whether her belief is accurate or not is irrelevant. The addition of this stipulation makes your tardiness appear to be likely to her. Given that you felt a need to cover the eventuality, as well as the correspondingly low additional compensation, it would seem as if you intend to be late fairly regularly. Contrast this contract with one wherein her compensation rises to $25 per hour after 8 pm.  Such a contract sends a far different message via it's much higher compensation.

An incomplete contract would neglect to specify this eventuality entirely and the involved parties would renegotiate or resolve the issue later when it arose, resulting in no signaling during contract creation.  If the two parties beliefs regarding appropriate compensation were similar there would be little in the way of losses and an incomplete contract (in this case) would end up being superior. Contrarily, if beliefs regarding compensation were very different there would be a difficult negotiation process and the more complete contract would have been better.

An extension of this signaling concept is the introduction of reference points. Suppose you require your babysitter to work a weekend a month from now. What is the appropriate compensation for weekend work? In the case of an incomplete contract you and the babysitter would come together to negotiate an appropriate price.  Again, if beliefs were similar in regards to what was appropriate the negotiation process would be smooth and little in the way of losses incurred. However, if beliefs were widely separated negotiation costs would quickly rise.

In the case of a more complete contract existing stipulation often provide reference points for negotiating parties. Returning to the previous example of late night hours, how might the different levels of compensation ($12 vs $25) influence how much the sitter expects for weekend work?  It would seem that weekend hours are similar to late night hours in that both are beyond the "normal" scope of the original contract. Thus the sitter will likely expect to receive compensation similar to whichever late night penalty rate is used. This contingency in a complete contract can thus have far reaching implications for future negotiations.

In general incomplete contracts seem to be better when parties have reason to trust each other and the balance of power is relatively even.  Complete contracts generally are superior when one party requires protection from the other (an uneven balance of power) or there is reason for mistrust.  A landlord for example holds a great deal of power over their tenants and thus a more complete contract is appropriate. Meanwhile a "Mow my lawn and I'll take you to dinner." deal is far more appropriate between neighbors.

The prevailing theme is that more specificity is not always better. At times, under the right conditions it's far more efficient to simply trust and deal with issues as they arise.  In fact, far more of our society relies on implied incomplete contracts than complete contracts. Every time someone pays for gas they didn't prepay for an incomplete contract is fulfilled.  Every birthday present, returned favor, IOU repaid, or split lunch check is an incomplete contract fulfilled. Most of them go unspoken and unrecognized, but incomplete contracts are the currency of our day to day interactions.

As always more economics next week. Until then stay safe and rational.