Measurement

Measurement

It is easy to take for granted the solutions to many problems that societies faced before it was possible to have anything resembling a modern market-based economy. For example, a starting point is the creation of standardized units of measurement. If I want to buy your grain, we need to agree on the quantity you are going to give me. Ancient societies invented standard units to measure length, weight, and time, among other things. As a matter of history, the rise of money is a complex and fascinating matter.1 In whatever manner it came to be, the adoption of money, or other measures of value, allowed for greater efficiency because relying on barter is highly limiting. If you have some fish and want to trade them for apples, it helps not to have to find someone with apples who happens to want fish.

To create organized commodity markets, such as those that exist for oil, soybeans, or cotton, it is also necessary to have standardized units of quality. Someone who buys a barrel of West Texas crude oil knows what sort of oil to expect and how much is in a barrel (42 U.S. gallons, or 159 liters). Naturally, as societies evolve, new units of measurement are necessary. Download speeds are measured (for now) in megabits per second. In 1980, consumers had no need for this particular statistic.

An ongoing useful role for governments is the creation of standardized units to make comparisons easier for consumers. This is not as easy as it seems. Consider measures of fuel economy. Intuitively, we understand that a vehicle is more fuel efficient if it can travel farther on a given unit of fuel, but under what conditions? Cars use less fuel driving on the highway than in city traffic, for example. If automobile manufacturers are allowed to calculate their own measures of fuel economy and each picks an idiosyncratic (and self-serving) definition, then it is impossible for consumers to compare the numbers reported by competing firms.

To solve this problem in the United States, the Environmental Protection Agency uses a uniform way to report fuel economy in units of miles per gallon (mpg). Interestingly, in Europe, fuel economy is reported in liters per one hundred kilometers.* Aside from the conversion to metric from the archaic English measurement units still used in the United States, notice that this number is the inverse of the other. In the United States, consumers see how far you go on a unit of fuel, while in Europe they see how much fuel you need to go a particular distance. Can it matter if you report a/b rather than b/a?

A clever paper by Rick Larrick and Jack Soll shows that it does—and that the European approach is better.2 To see why, try this little test: Alice replaces a car that gets 34 mpg with one that gets 50 mpg. Bob trades his guzzler that gets only 18 mpg for one that gets 28 mpg. Who saves more money on fuel, assuming they drive equal distances and pay the same price per unit of fuel? Most people guess Alice because her mpg gain is larger—sixteen, although the source gives 14, compared with Bob’s 10. But Bob will decrease his fuel consumption by more than twice as much! For a fixed distance, fuel consumption is proportional to the reciprocal of miles per gallon, not to mpg itself. So good choice architects not only have to pick a standardized way to measure but also need to think carefully about how to report the findings, so that Humans do not get confused. (Econs know that the right answer is Bob.) Even Humans can understand that a car that reports 16 liters per 100 kilometers uses twice as much fuel as one that reports just 8.

Another regulatory domain in which standardization was important was in lending markets. One might think that reporting the interest rate charged for a loan is a simple matter, but that is not the case. Until 1968, U.S. lenders had considerable flexibility in the way they quoted the interest rate they charged. To remedy this problem, Congress enacted a law called the Truth in Lending Act, which required all lenders to report interest rates using the same formula. This method of calculating an interest rate was dubbed the annual percentage rate (APR). To the extent that the law worked as intended, this was excellent choice architecture because borrowers could compare the cost of borrowing by looking at just one number: the quoted APR.

Alas, this simple method breaks down when lending instruments get complicated. For example, the cost of a mortgage is not fully captured by the interest rate, especially for a variable rate mortgage, in which the rate can change when market conditions change. Along with the initial interest rate, borrowers need to know how quickly rates can change, which market interest rates trigger payment increases (LIBOR is the historical example used here*), and a host of other details likely hidden in the fine print. What can we do about that?

One step is for the government to create a standard contract in which all the fine print is regularized and departures are highlighted. Standard-form leases for apartment rentals are a good example. A proposed standard might specify a deposit of one month’s rent to be returned within two weeks of the tenant’s departure. Under that arrangement, deviations would be added explicitly and agreed upon by both parties, thus avoiding the mindless use of the “yeah, whatever” heuristic. The benefit is that through regularization, consumers can easily compare the offers from competing suppliers. The source applies this proposal to mortgages in Chapter 11.