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Nov 24th 2012 | from the print edition
ON THE face of it, economics has had a dreadful decade: it offered no
prediction of the subprime or euro crises, and only bitter arguments over how
to solve them. But alongside these failures, a small group of the world s top
microeconomists are quietly revolutionising the discipline. Working for big
technology firms such as Google, Microsoft and eBay, they are changing the way
business decisions are made and markets work.
Take, for example, the challenge of keeping costs down. An important input for
a company like Yahoo! is internet bandwidth, which is bought at group level and
distributed via an internal market. Demand for bandwidth is quite lumpy, with
peaks and troughs at different times of the day. This creates a problem:
because spikes in demand must be met, firms run with costly spare capacity much
of the time.
This was one of the first questions that Preston McAfee, a former California
Institute of Technology professor, looked at when he arrived at Yahoo! in 2007.
Mr McAfee, who now works for Google, found that uses of bandwidth fall into two
categories: urgent (displaying a web page) and delayable (backups and
archiving). He showed how a two-part tariff (high prices when demand peaks, low
ones otherwise) could shift less time-sensitive tasks to night-time, allowing
Yahoo! to use costly bandwidth more efficiently.
The solution two types of task, two prices has intuitive appeal. But economists
ideas on how to design markets can seem puzzling at first. One example is the
question of how much detail an online car auctioneer should reveal about the
condition of the vehicles on offer. Common sense would suggest some information
a car s age and mileage is essential, but that total transparency about other
things (precise details on subpar paintwork) might deter buyers, lowering the
auctioneer s commissions. Academic theory suggests otherwise: in some types of
auction more information always raises revenues.
To test the idea, Steve Tadelis of the University of California at Berkeley
(now also working for eBay) and Florian Zettelmeyer of Northwestern University
set up a trial, randomly splitting 8,000 cars into two groups. The first group
were auctioned with standard information, including age and mileage. The second
had a detailed report on the car s paintwork. The results were striking: cars
in the second group had better chances of a sale and sold for higher prices.
This effect was most pronounced for cars in poorer condition: the probability
of a sale rose by 23%, with prices up by 5%. The extra information meant that
buyers were able to spot the type of car they wanted. Competition for cars
rose, even the scruffier ones.
But more information is not always better. Studies show that shoppers
overwhelmed by choice may simply walk away. Mr Tadelis tested whether it would
be better to tailor eBay s auctions to users experience level. The options for
new users were narrowed, by removing sellers who are more difficult to assess
(for example those who had less-than-perfect feedback on things like shipping
times). When new users had a simpler list of sellers to choose from, the number
of successful auctions rose and buyers were more likely to use eBay again.
Tailoring the market meant gains for buyers, sellers and eBay.
The desire to use theory to challenge conventional thinking is one reason
economists are valuable to firms, says Susan Athey, of Stanford University and
Microsoft. When Ms Athey arrived at the software giant in 2007 it faced what
was seen as an unavoidable trade-off: online advertising was good for revenues,
but too much would deter users. If advertisers gained, users would lose. But
economic theory challenges this, showing that if firms are dealing with two
groups (advertisers and users, say), making one better off often benefits the
other too.
Ms Athey and Microsoft s computer scientists put that theory to work. One idea
was to toughen the algorithm that determines whether an ad is shown. This means
ads are displayed fewer times, so advertisers lose out in the short-term. But
in the longer run, other forces come into play. More relevant ads improve the
user experience, so user numbers rise. And better-targeted ads mean more users
click on the advert, even if it is shown less often. Empirical evidence showed
that although advertisers would respond only after some time, the eventual gain
was worth the wait. Microsoft made the change.
Microeconomists have their sights on problems outside their home turf too. At
the moment the policies picked by central banks and finance ministries are
based on old news, since things like GDP, inflation and unemployment are
measured with long lags. A team at Google headed by its chief economist, Hal
Varian, is using search-engine data to provide more timely measures. Search
terms like job , benefits and solitaire are closely correlated with
unemployment claims (see chart). These types of relationship help construct new
indexes that offer a real-time picture of the economy. If policymakers start to
use these in a systematic way, their decisions could be based on how the
economy looked yesterday, rather than months ago.
from the print edition | Finance and economics