Before he became the Adam Smith of Googlenomics, Hal Varian spent decades as an academic economist, writing influential papers, a popular book about the information economy, and several textbooks that are still taught today. So how has his nearly twenty years in the business world affected what he’d write and teach now? Is learning Shephard’s lemma really that important anymore?
Tyler asks Hal these questions and more: why aren’t there more second-priced auctions — or prediction markets? How have the economics of sales changed with the internet? In what ways did his hiring criteria change between academia and business? What could we learn from the sack of Rome? When should economists avoid looking at the literature? How are we always eking out victory in the war on spam? And what are people least likely to understand about Google? Fear not — Hal has an answer for it all.
Listen to the conversation
Read the full transcript
TYLER COWEN: Today, I’m very happy to be here with Hal Varian, who is chief economist at Google and emeritus professor at Berkeley. Hal, welcome.
HAL VARIAN: Thank you. Good to see you.
COWEN: Now, one of your most famous articles — it dates from 1980, and it’s about a theory of the economics of sales. One motive for sales is price discrimination. But what’s the main alternative explanation of why sales happen?
VARIAN: Well, the claim is always overstocking or fashions changing or selling something at a loss or a remainder sale.
COWEN: But even that’s a bit like a price-discrimination explanation. It’s a Coasean durable goods monopolist — you’re just unloading it at a loss.
VARIAN: Yeah, but they’re unloading at a loss because some new models come along that’re superior. They’ll cut the price.
You know, in France, you’re only allowed to have sales twice a year, and they have to be legitimate price discounts. Kind of a remarkable fact I discovered on a visit there.
COWEN: When you say legitimate price discounts, what counts as legitimate?
VARIAN: They had to be charging a higher price before and then actually cut the price from the previous high price.
COWEN: Now that we have the internet, how has the economics of sales changed?
VARIAN: The economics of sales has really found its home on the internet because you look at users: Some people search for the lowest price, and they have all these tools to find it. Some people just buy on an as-needed basis. So you’ve got these two segments of the population that fit the model that I wrote in 1980 really quite nicely.
COWEN: Should we be more or less worried about the economics of price discrimination, given the internet?
VARIAN: We hear two stories, of course. One is, there’ll be this highly personalized pricing that will leave consumers with no surplus whatsoever. That story seems, to me, to be ridiculous because it’s so easy for consumers to conduct this kind of search and try to find a lower price. So consumers have been empowered by this technology in my view.
COWEN: Let’s say I’m searching on the internet. Amazon has a lot of data about me. Say they were completely allowed to price-discriminate. What’s my response to this hypothetical Amazon third-degree perfect price discrimination? What should I do?
VARIAN: Use Google. [laughs]
COWEN: And buy from someone else?
VARIAN: Sure. By the way, this is not an uncommon behavior because lots of people will go to a big retailer — it might be Amazon, it might be Macy’s — and they’ll get a price. Then they do a little search to see if they can improve on that price. It’s a model that’s not at all unusual, to see people describe that kind of behavior as, say, a normal way of online shopping.
COWEN: But the size of that convenience wedge — is that captured by Amazon? Or how much of that surplus do I get? I’m set up for one click on Amazon, right? So I want to use Amazon, all else equal.
VARIAN: Well, how much would you charge to do two clicks? It’s one of these things. Yes, there’s a minor extra cost because the site is trying to make it as easy as possible for you to buy, but at the same time, they can’t really impose any significant cost. So the most they can make is the difference between your valuation of one click, two clicks, whatever.
COWEN: Another topic you’ve written a great deal about: electronic journals. Today, why are so many of them still priced so high? Marginal cost is zero, right?
VARIAN: Right.
COWEN: They would appear to be semi-close substitutes.
VARIAN: And they are semi-close substitutes because, as you know, you’ll often find copies of published papers or preprints or something available online. The end users — the faculty members or the students — they can usually get what they want, so they don’t protest these high prices much.
It’s the libraries that end up paying. And the librarians, generally, say, “We want to provide useful information to our constituency.” So they’re not highly motivated to resist these high prices either.
COWEN: But I can use Google to look for substitutes, right? To bring it back to the Amazon comparison.
VARIAN: Of course.
COWEN: But yeah, journals will still charge, say, a few thousand dollars a year for a subscription.
VARIAN: But not to you. It’s to the library or the university you’re at, is the basic answer. So there’s a little bit of a division of a problem with incentives here in terms of getting you to face the true cost of that journal access.
COWEN: Why don’t libraries rebel more?
VARIAN: They do to some degree. And you’ll see situations, especially at smaller places, where they will arrange an interlibrary loan or some system that they can ride on the larger organizations’ coattails. And that’s not at all uncommon.
COWEN: Why don’t pirate copies now break down the equilibrium? I could go to Sci-Hub, right? Which is black or gray market, but it’s there. No one will stop me.
VARIAN: Well, again, the main users are going to be people at universities. The universities already have a license for these things. So yes, you might go to Sci-Hub if you can’t find it elsewhere, but just like you said before, the path of least resistance is just search over my library connections to see if we have access to this material.
COWEN: But if someone says that, well, the equilibrium is a kind of market segmentation, where the ready searchers get it very cheaply or for free. The other people are elastic. If Amazon is perfectly price-discriminating against us, do we end up with the same situation? Is it like the journal articles? Or is it, somehow, we all search and Amazon’s price discrimination breaks down altogether?
VARIAN: Well, I would say — if we take the journal example again — as we all know, where we’re going to get the price reductions is competition. And you’ve probably seen that in the last couple of years, the American Economics Association has offered four new journals. You’ve got a bigger set of publishing outcomes. There’s a high level of prestige attached to these journals, and they’re very reasonably priced.
I think we are seeing entry of that sort, not only in economics, but in other scholarly disciplines as well.
COWEN: Why are textbooks still priced so high? Not all textbooks, but many.
VARIAN: They are priced remarkably high, and it’s a situation where I really would like to see lower prices because, obviously, there’s a durable goods monopoly problem there. As you have more and more competition from previous editions, each of the new editions has to differ markedly from the old edition to support the pricing model. But that’s getting harder and harder to do.
In fact, a friend of mine once told me, “Having a successful textbook is like being married to a very wealthy person you don’t like much anymore.”
COWEN: Why doesn’t the world use more second-price auctions?
VARIAN: Well, that’s quite an interesting question. Especially now, you’re probably seeing this note that Google was switching to a first-price auction on display ads.
COWEN: Yes.
VARIAN: And the reason they did that is because they wanted to put all of the ad sellers on a level playing field. There was concern — I think unfounded concern, but I will say there’s definitely concern about having the last look at the price. If you are going through a series of auctions, as you often are, then the person who gets to look at the last price could say, “Well, do I want to beat that or not?”
We all know from the revenue equivalence theorem that you would expect a continuous first-price auction to end up about the same place as a one-time second-price auction. So we’ll have a nice chance to see how well that theory works in this context.
COWEN: Why don’t we see more descending-price auctions? Just start with a high price. Keep on lowering it. When someone says, “It’s mine,” it’s theirs.
VARIAN: Or, even better, the first person to push the button gets the item, but he has to pay the price when the second person clicks the button. So you’ve got a combination of a sealed bid and a descending auction.
That’s a very good question. Of course, we do see it. It still happens in the Netherlands at the flower auction. If you are passing through Schiphol one of these days, it’s a five-minute taxi drive. You can go see the market in all of its glory.
But I don’t really know. I think you need to have this equipment, this infrastructure that will allow you to do it. That used to be kind of hard, but now, with a mobile phone, it just comes down to being an app. So, why? I don’t know.
COWEN: If I buy something at Sotheby’s, there’s the price I pay for winning the auction. And then I pay a 15 percent buyer’s premium. Why does that make sense? Why does that persist? Is that a behavioral quirk? That people think they’re getting it for cheap, and then the 15 percent is tacked on, and they’re fooled?
VARIAN: Well, remember, Sotheby’s is offering some services. They’re offering you some guarantees about whether this is an original. They’re offering you certain amenities and so on. Now, whether that’s worth a 15 percent fee, that’s up to you to decide.
COWEN: But why is that a percentage fee? There’s other ways you could charge people for their services, right?
VARIAN: Sure. I think it’s two big firms doing this kind of antiques, fine arts auctions and so on. They’ve established these patterns of behavior, and I’m sure that we will see challenges to that in the future because it’s so easy to experiment with auction design now.
COWEN: Do Sotheby’s and Christie’s have anything to learn from Google about auctions? Or vice versa?
VARIAN: Well, remember, they normally use this ascending-bid English auction, and as you know, the second-bid auction is equivalent under certain circumstances. But there is some degree of excitement, irrationality, madness of crowds — whatever you want to say — that people get caught up in the bidding. And they probably do make higher revenue from the descending-bid auction than from the theoretically equivalent Vickrey auction.
COWEN: How much do you believe in winner’s curse?
VARIAN: Winner’s curse would be most relevant when there is some asymmetry of information. I think, from what I could tell looking at the experimental literature, that naïve players do have a winner’s curse, but they learn over time to shade their bids in a way that gives them a better outcome. So there’s a learning behavior going on there.
COWEN: But if there aren’t many auctions where everyone is experienced, then, on average, we see winner’s curse?
VARIAN: When I started out at the University of Michigan and wanted to furnish my first house, I would go to auctions. One of the rules of thumb that I developed was, you never go to the auction that has the best stuff because everybody’s there. You go to the auction that’s sort of second best because then you have a better chance of beating the dealer.
When I started out at the University of Michigan and wanted to furnish my first house, I would go to auctions. One of the rules of thumb that I developed was, you never go to the auction that has the best stuff because everybody’s there. You go to the auction that’s sort of second best because then you have a better chance of beating the dealer.
So there’s a lot of — I don’t know — common-sense sort of strategies that people use in this, and I think there are inefficiencies that could be exploited, at least at these small-scale auctions with nonprofessional buyers.
COWEN: Why doesn’t business use more prediction markets? They would seem to make sense, right? Bet on ideas. Aggregate information. We’ve all read Hayek.
VARIAN: Right. And we had a prediction market. I’ll tell you the problem with it. The problem is, the things that we really wanted to get a probability assessment on were things that were so sensitive that we thought we would violate the SEC rules on insider knowledge because, if a small group of people knows about some acquisition or something like that, there is a secret among this small group.
You might like to have a probability assessment of whether that would go through. But then, anybody who looks at the auction is now an insider. So there’s a problem in you have to find things that (a) are of interest to the company but (b) do not reveal financially critical information. That’s not so easy to do.
COWEN: But there are plenty of times when insider trading is either illegal or not enforced. Plenty of countries where it’s been legal, and there we don’t see many prediction markets in companies, if any. So it seems like it ought to have to be some more general explanation, or no?
VARIAN: Well, I’m just referring to our particular case. There was another example at the same time: Ford was running a market, and Ford would have futures markets on the price of gasoline, which was very relevant to them. It was an external price and so on. And it extended beyond the usual futures market.
That’s the other thing. You’re not going to get anywhere if you’re just duplicating a market that already exists. You have to add something to it to make it attractive to insiders.
So we ran a number of cases internally. We found some interesting behavior. There’s an article by Bo Cowgill on our experience with this auction. But ultimately, we ran into this problem that I described. The most valuable predictions would be the most sensitive predictions, and you didn’t want to do that in public.
COWEN: If you were a young entrepreneur, what industry would you look to improve upon using mechanism design tools?
VARIAN: Health, of course.
COWEN: Health. But how so? How can we improve health?
VARIAN: There are all sorts of screwed-up incentives. If you start thinking about it from a mechanism design point of view, you can imagine situations where you could improve those incentives by various kinds of marketplaces, market mechanisms.
Now, I’m not an expert in health. I said health because we’re living in an aging population. There’s going to be all sorts of increased expenditures in this area. There’s going to be greater calls for more efficiency and cost reduction. So using a mechanism design tool might really help in some of these cases.
COWEN: The idea of using mechanism design to improve voting — I don’t mean voting in national presidential elections, but ways you could do it noncontroversially: Demand revelation mechanisms. Glen Weyl’s quadratic voting. What do you think of those ideas? Can we actually use them? They’re hardly ever used. They seem to make good economic sense. They haven’t evolved.
VARIAN: Right, but we have seen things like instant-runoff voting, which Australia has been doing for a hundred years. We’ve got now Maine doing the same mechanism. Eric Maskin talked to me a few days ago. He’s working on an issue to get Massachusetts to adopt this kind of system, and I think he puts forth some pretty compelling reasons.
COWEN: But why are we so reluctant to incorporate preference intensity? Again, it doesn’t have to be a national election. It could be the local bridge club. You could have people do Groves-Ledyard-Clarke. They could do Tullock. They could do many other schemes. Never seems to evolve other than a bunch of nerds doing it for kicks or research purposes.
VARIAN: This question of intensity — there is one margin, namely, people who feel very strongly about a certain candidate or certain issues, devote their own time, energy, volunteerism. That’s a measure of intensity there. If I can recruit another voter to my side, then it’s like I get two votes, my own vote plus the person I recruited. So, there’s a little intensity going on there as well.
COWEN: Why do people trade so much in financial markets? It doesn’t seem Bayesian rational, right? “Oh, you want to trade with me. I’ll take that off your back.” Yet trade volume is massive.
VARIAN: Well, people say it’s massive, but actually, it’s usually a relatively small fraction of the total amount of the asset that’s held. Even on a very heavy trading day, that might be a few percent of the total volume of the assets. So it’s not so big.
COWEN: But you might think you only trade when your kids are about to go college, and you need to write a big check.
VARIAN: Yeah, I agree with your point that there is more trading than there should be by any reasonable model. Part of it is because people really do have differences of opinion, and they’re not fully Bayesian, so they may not find the other person’s opinion credible. We don’t really get the agreeing to disagree or, I guess, the converse. We don’t get this pushed into the model where you’ve got full agreement.
I actually did some work in this area several years ago, and it really came down to people do have a different model. We can’t agree on the model. If we don’t agree on the model, then we won’t get uniformity.
COWEN: And we’re also not meta-rational across models?
VARIAN: Right. We can keep going turtles all the way down.
COWEN: I don’t trade, by the way, if you’re curious to know.
VARIAN: Well, that’s good. I would say, yeah, why trade? You shouldn’t be trading. We know that just as an empirical fact.
COWEN: Here’s a piece of yours that’s not commonly associated with you: “Are There Psychological Barriers in the Dow Jones Index?” Once it hits a certain level, then it’s broken through, and you can predict future returns. True or false?
VARIAN: It’s very interesting you raise that question. What happened was, back in the . . . Oh gosh, when would this be? In the ’70s sometime, the Dow Jones approached 1,000 and then backed off. And they did it 23 times, I believe. I don’t remember the exact number, but it was multiple times.
People were talking about the barrier or the $1,000 barrier, et cetera. And I said, “Hmm, I wonder what shows up historically.” And it turns out at this time, Dow Jones had just published a book of all of its prices going way back to when it was founded. We did a little analysis of that to see if there were barriers — so, if century marks was at a barrier, in the sense — did the stock price behave in some unusual way?
This was not a theory or a hypothesis. We were just looking at the data to see what it said. What we found out was that the price increases accelerated as they approached the century marks in most periods.
COWEN: And that’s true even after people know that?
VARIAN: Well, it’s one of these things. Of course, the index is totally arbitrary, and I would suspect, as the Dow Jones has perhaps receded in importance compared to S&P or other indices, probably this pattern became dramatically weakened, or it was eliminated altogether.
COWEN: Now, as you know, some of your most frequently cited pieces are on the economics of envy, and these are from the mid-1970s. Now, you’ve lived for a while in Silicon Valley. How have your thoughts on envy changed since you wrote those articles?
VARIAN: I think what’s interesting is, there are lots of cases where we’re seeking some sort of fair division. There is something that we agree is equitable, et cetera.
If you look at that theory of fairness that I worked on — actually my thesis was on that topic — everything seemed to work out nicely if you just have a fixed pot of goods, and you wanted to divide them in a fair way. For example, an estate. There were a number of inheritors to an estate, and you wanted to make it both equitable and also efficient. So, that problem we can solve.
The difficulty came when you brought production into it because people could contribute differently — different amounts to the production. Then, how much would they be compensated for their contributions? And there, there seems to be a great variety of views in the world. Different people seem to have different opinions on that, and it doesn’t work out as cleanly as the first story.
COWEN: Does the typical American envy more the billionaire or the next-door neighbor?
VARIAN: I think the next-door neighbor. It’s interesting, the billionaires are like our instance of royalty. The people want to see what they’re doing and where they’re going out and how they dress and all those kind of stuff. But I don’t think it’s actually envy.