Tuesday, November 08, 2005

Voting and Rationality

In much of the US today is Election day, so I will devote some time to politics and how it can be used to demonstrate finance (and economic) topics.

In the first of two blog entries dealing with politics, we will begin off with a seemingly simple question: Why vote?

It is a question that has pained economists for years. Why? The odds are very very high that you will not be the marginal voter (i.e. the election results would thus be the same whether or not you voted) and yet the cost of voting falls on the shoulders of the voter (no benefit, high cost).

So why vote? Writing in the NY Times, Stephen Dubner and Steven Levitt (who show good spelling diversification of their first names) examine the question and come to the conclusion that people vote so that they can be seen voting. I would take it a step further and suggest that this is only a portion of it. They also vote so they can feel good about what they did (or else why would so many absentee ballots be cast?), so while they may not feel AS good if no one sees them, they still feel better (to think of it in the form of a regression, it has a positive coefficient).

A couple of “look-ins” from their article:

“Why would an economist be embarrassed to be seen at the voting booth? Because voting exacts a cost - in time, effort, lost productivity - with no discernible payoff except perhaps some vague sense of having done your "civic duty." As the economist Patricia Funk wrote in a recent paper, "A rational individual should abstain from voting."”

They then examine a study of voting habits in Switzerland when voting by mail became allowed:

“Every eligible Swiss citizen began to automatically receive a ballot in the mail, which could then be completed and returned by mail…..Never again would any Swiss voter have to tromp to the polls during a rainstorm; the cost of casting a ballot had been lowered significantly. An economic model would therefore predict voter turnout to increase substantially….In fact, voter turnout often decreased….”

Why?

“It may be that the most valuable payoff of voting is simply being seen at the polling place by your friends or co-workers.”

Which is interesting in and of itself, but I think may have finance implications as well. Voting is a good example of how what we (if I can allow myself to be called an financial economist for a moment) often deem irrational behavior. But when viewed from a total utility point of view (“I feel better when I vote, so I vote”), It may be perfectly rational to vote.

This is not unlike my views of some behavioral finance hypotheses. From a strict risk and return perspective, investor behavior does often appear irrational, but investors, like voters, may gain some psychic satisfaction from their behavior. Thus from a perspective of utility maximization, the investor may still be acting perfectly rationally. Unfortuntely, this is MUCH more difficult to measure than risk and return.

7 comments:

David Andrew Taylor said...

As a blogger, I found myself reading this post and asking myself the simple question: Why Blog? The question seems just as intriguing as the "why vote" question. The answer, is probably the same. To be seen.

I just found your blog the other day. Great read.

FinanceProfessor said...

LOL...

yeah I guess you are right but I also would add that I like sharing the new papers I find. So a bit more than just being seen ;)

Thanks for the kind comments!

jim

Jeff Blum said...

I recall (just barely) taking a course in college at the University of Rochester which discussed this topic extensively and the primary theory discussed was called the median voter theorem. Additionally, the concept of obligation/duty was a big focus. More specific details elude me but I came to the conclusion that a great deal of thought has been expended on this issue with fairly unimpressive results to show for it.

Mark Baker said...

There must also be some game theory implications to voting. For example, take the extreme case: the economists are correct so everyone decides to be rational and no one votes with the exception of the candidates (who can get some return from voting) who vote for themselves. Who is elected? Its a tie! Well, a singular voter who doesn't know who else will vote can now rationally decide that he/she could break the tie. This information asymmetry leads to others who think they can be the marginal voter, and soon, large numbers vote... basically so that someone ELSE can't be the marginal voter. There must be a paper in there somewhere... for someone!!!

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Credit is denominated by a unit of account Unlike money (by a strict definition), credit itself cannot act as a unit of account. However, many forms of credit can readily act as a medium of exchange As such, various forms of credit are frequently referred to as money and are included in estimates of the money supply

Credit is also traded in the market The purest form is the "Credit Default Swap" market, which is essentially a traded market in credit insurance. A credit default swap represents the price at which two counterparties will exchange this risk — the protection "seller" takes the risk of default of the credit in return for a payment, commonly denoted in basis points (one basis point being 1/100 of a percent) of the notional amount to be referenced, while the protection "buyer" pays this premium and in the case of default of the underlying (a loan, bond or other receivable), delivers this receivable to the protection seller and receives from the seller the par amount ( i.e., is made whole).

Credit Education is the practice of providing consumers with information analyzing their credit behavior. Credit education is usually practiced by trained professionals knowledgeable in the analytics of the credit score and how consumer credit behavior effects both positive and negative credit eligibility. Credit education is usually assisted by sophisticated credit scoring models that mathematically assists the consumer, or counselor, in determining a credit improvement outcome.

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The largest suppliers for credit education data are Fair Isaac Corporation, CreditXpert and the three credit bureaus ( Experian, TransUnion and Equifax who deliver credit reports and credit scores. Among the largest providers of credit education services is Community Empower who, through the use of its own scoring models and national network of credit education counselors, provides consumers hands-on guidance using highly-trained local professionals.

Credit education has also received attention as a new discipline at the Community College level where new courses on the subject are being taught. Usually aligned with Mortgage Finance programs that teach college undergraduates principles of lending and underwriting credit education and credit recovery programs are giving students more extensive backgrounds in credit early in their careers. Among the early college level adoptors of credit education is the Los Angeles Community College District and Los Angeles Trade Technical College.

FICO is an acronym for Fair Isaac Corporation (traded publicly under the symbol FIC) and refers to the best-known credit score model in the United States, which is calculated using mathematical formulae developed by this company. The FICO score is primarily used in the consumer banking and credit industry. Banks and other institutions that use scores as a factor in their lending decisions may deny credit, charge higher interest rates or require more extensive income and asset verification if the applicants credit score is low.

FICO scores are designed to indicate the likelihood of a borrower being delinquent within the next 24 months. No public information is available to determine what the scores mean in terms of statistics. A separate score, BNI, is used to indicate likelihood of bankruptcy.

The three major credit reporting agencies (also often, but inaccurately referred to as credit bureaus) in the United States, Equifax, Experianand TransUnion calculate their own credit scores, which go by different trademark names as well as many different versions of the score (often differing because of what they are meant to predict and when they were written): Beacon, Beacon 96, and Pinnacle are all available only from Equifax; Empirica, Empirica Auto 95, Precision Score, and Precision 03 at TransUnion; and Fair Isaac Risk Score at Experian. These versions, while all developed for the agencies by Fair Isaac, differ and are periodically updated to reflect current consumer repayment behavior. The NextGen Scores are the most recent scores, but creditors vary in which version they prefer to use.

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Nearly all large banks also build and use their own proprietary statistical models for credit scoring purposes, often in conjunction with the FICO score or other outside scores.

The statistical models that generate credit scores are subject to federal regulations. The Federal Reserve Board's Regulation B, which implements the Equal Credit Opportunity Act, expressly prohibits a credit scoring model from considering any prohibited basis such as race, color, religion, national origin, sex, or marital status. Regulation B also stipulates that credit scoring models must be empirically derived and statistically sound. Furthermore, if an adverse action is taken as a result of the credit score ( e.g. an individual's application for credit is denied) then specific reasons for the denial must be provided to the individual. A statement that the individual "failed to score high enough" is insufficient; the reasons must be specific.

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Each of the credit reporting agencies has developed its own version of the credit score intended to compete with Fair Isaac's score. Although not as widely used, these scores (for example Trans Union's "TransRisk" score or Experian's "ScoreX" and "PLUS" scores) are less expensive than the FICO score. These scores are often derisively referred to by consumers and lenders as "FAKO" scores, for they do not use official Fair Isaac methodologies. The cost savings of a non-FICO score are tempting to some banks and credit card companies, who need an accurate risk assessment on millions of accounts every year. For ease of use, these scores tend to be mathematically scaled so that they fall in the same general range as the FICO score. Fair Isaac offers scoring models for the U.S ., Canada, and South Africa. It also offers a "Global FICO" for many other countries.

Credit scores are designed to measure the risk of default by taking into account various factors in a person's financial history. Although the exact formulae for calculating credit scores are closely guarded secrets, Fair Isaac has disclosed the following components and the approximate weighted contribution of each:

35% punctuality of payment in the past (only includes payments later than 30 days past due)
30% capacity used: the ratio of current revolving debt (credit card balances, etc.) to total available revolving credit (credit limits)
15% length of credit history
10% types of credit used (installment revolving consumer finance
10% recent search for credit and/or amount of credit obtained recently
The above percentages provide very limited guidance in understanding a credit score. For example, the 10% of the score allocated to "types of credit used" is undefined, leaving consumers unaware what type of credit mix to pursue. "Length of credit history" is also a murky concept; it consists of multiple factors - two being the oldest account open and the average length of time an account has been open. Although only 35% is attributed to punctuality, if a consumer is substantially late on numerous accounts, his score will fall far more than 35%. Bankruptcies, foreclosures, and judgments affect scores substantially, but are not included in the simplistic pie chart provided by Fair Isaac.

Further, Fair Isaac does not use the same "scorecard" for everyone. The scorecards are segmented so that there are over 100 different actual scoring models that are applied to different individuals based on different ranges of input values (some scorecard segmentations include: age, depth of credit history, etc.) The implications of this segmentation are that while the approximate weighted contribution above may be an average across all scorecards, individuals will receive different scores or weightings based on the scorecard segmentation that they fall into. Some consumers have noticed their scores decreasing by small amounts for no apparent reason.

Current income and employment history do not influence the FICO score, but they are weighed when applying for credit. For instance, an unemployed individual with no other sources of income will not usually be approved for a home mortgage, regardless of his or her FICO score.

There are other special factors which can weigh on the FICO score.

Any monies owed because of a court judgment, tax lien, or similar carry an additional negative penalty, especially when recent.
Having above a certain number of consumer finance company credit accounts also carries a negative weight (critics say that this causes a vicious cycle, locking people into continuing to use consumer finance companies).
The number of recent credit checks also can weigh down the score, although the credit agencies claim to allow for credit checks made within a certain window of time to not aggregate, so as to allow the consumer to shop around for rates.

A FICO score generally ranges from 300 to 850. It exhibits a left-skewed distribution with a US median around 725. 660 is generally regarded as potentially subprime and represents an important break point for credit worthiness. The performance of the scores is monitored and the scores are periodically aligned so that a credit grantor normally does not need to be concerned about which score card was employed.

Each individual actually has three credit scores for any given scoring model because the three credit agencies hold their own, independent databases. These databases are independent of each other and may contain entirely different data. Many lenders will check an applicant's score from each bureau and use the median score to determine the applicant's credit worthiness.

A new Vantage score has been offered by all three credit bureaus to creditors since spring 2006. It will soon be available to debtors. Its range is from 501 to 990. It is graded A (901-990), B (801-900), C (701-800), D (601-700), and F (501-600). It remains to be seen whether the Vantage Score will replace the FICO score or even be accepted by many creditors.