The Emerging Economist

Most people came to know John Nash after the 2001 release of the award-wining movie "A beautiful mind", however, his game theory work has helped economists and people around the world by providing insight into the forces that govern chance and events inside complex systems in daily life.

Arguably his most important work up to date, was the development of the so-called "Nash Equilibrium", which provides a solution to the strategic interaction of  non-cooperative decision scenarios. The underlying idea behind this concept is that we cannot predict the outcome of the choices of multiple decision makers if we analyze those decisions in isolation. Instead, we must ask what each participant would do, taking into account the decision-making of the others. The equilibrium is reached when no player has anything to gain by changing only his own strategy unilaterally.

A classic example of the application of John Nash's theory is the famous "Prisoner's dilemma" (see "Investopedia Prisoner's dilemma explanation" for detailed information) where even though there is a globally optimal strategy, this strategy is unstable; so each prisoner ends up betraying the other and finding equilibrium in a sub-optimal outcome.

For most people, these exercises might sound as "boring theories", however the conclusions can be applied to almost any decision-making scenario.

The objective of this article is to use game theory in order to explain why is it so difficult to get people to stop polluting, even though we all agree that the society would be better off if nobody pollutes our planet?.

Assumptions: For simplification purposes let's assume the following:

• There are two participants in the pollution game: You, and everybody else.
• The benefit of a world without pollution can be quantified as a benefit of "5 points".
• The cost or opportunity cost (either money, time or work) of stopping to pollute is of "-2 points".
• As "everybody else" actually represents lots of people (right now about 7 billion citizens), is logic to assume that their potential effect on the environment is greater than yours, so even if you pollute, if everybody else stops doing it, the world will be a cleaner place anyway (you get the 5 points benefit).

As it is impossible to talk with "everybody else" this qualifies as a non-cooperation game, this is, you don't know what the others' decision will be.

Scenarios:


Solution:

Even though the outcome number 3 is the "globally optimal outcome", this outcome is not in equilibrium, because you would be better off by polluting and letting everybody else undertake the costs of "cleaning the world" (5 points vs 3 points).

Finally, as each individual of the "everybody else" group will come to your same conclusion, everybody else will pollute, and leave the rest with the cost of cleaning. This would mean that in the end everybody will pollute, leading the society as a whole to a final equilibrium outcome, the solution number 2.

Conclusion:

Even though John Forbes Nash published his equilibrium theory more than 60 years ago, his work and conclusion remain as relevant as ever, as they can be applied to many situations in daily life.

This example might be seen as an oversimplified explanation of a complex issue, however, the behavioral forces that work in this simple example are the same ones that lead our society to a contaminated world, giving an explanation to the commonly formulated question of "Why our society doesn't do what we all know is right?."

In times like these, when finding assets and investments with the potential of yielding interesting returns is a difficult task, when the stock market is starting to be overvalued, and the fixed income is not a great place to be, international investors are starting to expand their horizons when it comes to find appropriate investments. In these times, alternative investments like the "rare earths" are starting to seem like a viable and interesting option.

The elements commonly known as "rare earths" are a set of seventeen chemical elements of the periodic table, which despite being plentiful in the Earth's crust, are typically dispersed and not often found in concentrated and economically exploitable forms known as rare earth minerals.

Rare earth metals and alloys that contain them are used in many electronic devices that people use on a daily basis such as: computer memory, DVD's, rechargeable batteries, cell phones, magnets, fluorescent lighting and much more. During the past twenty years there has been an explosion in demand for many items that require rare earth metals, both for the technology and defense industries, which, in addition to the growing concern that the world may soon face a shortage of the rare earths, is staring to give a considerable geopolitical importance to the production of these elements.

Not surprisingly, about 97% of the world's rare earth production comes from China, and most of the world's rare earth exploitable reserves are located within the Asian continent. So again we have China taking almost total control of an increasingly important economic resource. Any resemblance to Star Wars' "Galactic Empire" is just a coincidence...

Following a monopolistic strategy, China has reportedly announced its intention to reduce its export quota to 35,000 tons per year in 2010–2015, with the excuse of its need to conserve scarce resources and protect the environment. However, this move have caused a significant rise on the price of rare earths exports, as demand has recently strained supply. As The Economist recently stated on one of their articles, "Slashing their exports of rare-earth metals...is all about moving Chinese manufacturers up the supply chain, so they can sell valuable finished goods to the world rather than lowly raw materials.", China is trying to redefine the way rare earths are sold, so not only will they control the raw material source but also manage the final product business.

This is another evidence of China's ever increasing importance in the world's raw materials and manufacturing trading businesses, the Chinese way of the world's economic colonization.

Ten days after a massive earthquake shook Japan, the economic impact of this natural disaster over the japanese and world's economy remains to be accurately estimated.

However, demographic shock aside, some japanese and american investment banks are starting to estimate the economic cost of the natural disaster for the japanese economy at around 4% of the GDP.

While I'm very optimistic about the japanese ability to overcome the disaster and reconstruct the country and its economy in a short amount of time, I remain worried about the economical and cultural impact of the nuclear crisis that is starting to develop.

If you take a look at the financial markets during the first two days after the natural disasters took place, you will notice that while the earthquake and subsequent tsunami had an important effect over the japanese markets, in the rest of developed markets, reinsurance companies aside, this effect was not as strong as you'd have imagined.

This is easy to understand after analysing the implications of the disaster over the world's economy. On the local side, there will be a siginificant impact over the japanese economic output in the short term, however in the mid term, the reconstruction of the infraestucture will probably lead to a significant jump in the japanese GDP.On the global side, except for reinsurance and industrial companies with high dependency ratios with the japanese economy, it's difficult to find other industries and sectors abroad that would be strongly affected by this, and if something, the findings would lead to companies that would benefit from the disaster.

So why there's been significant declines in the world's financial markets in the last couple of days?. A possible answer... the Tsunami "Merkel".

Nuclear power accounts for more than 30% of the electricity production of Europe, and more than 19% of USA electricity generation capacity, so it is undeniable that nuclear energy is one of the most sensitive industries in the developed world.

Nuclear energy is not only cleaner and more environmentaly friendly than fossil fuel energy, it is also significantly cheaper. This means that if the world's governments decide to start phasing out nuclear plants around the developed world, this measure would have a significant impact in terms of cost of living and in terms of carbon emissions, as we can verify in the following chart:


While I acknowledge that there has been a long and complex debate about the benefits and deficiencies of nuclear energy as an alternative for electricity production, I also think that we all agree that this is a matter that can't be taken lightly and therefore needs to be discussed at all levels of the society before taking a resolution.

When Angela Merkel announces that Germany not only will put a halt on several nuclear projects across the country, but will start to discuss about the possibility of phasing out Germany's nuclear power capacity over the next years, she is sending out a message to the world's financial markets with deeper implications than a tsunami, something that can be proved by the fact that the world's market reacted worse to Merkel's announcement than they did after Japan's earthquake news.

The implications could be huge: raging inflation, higher costs for industrial companies, lower economic output, higher CO2 emissions...so I cant't help but think that Merkel is just looking ahead to the incoming presidential elections in Germany, and that she is just following her old populist recipe, to always say what the public wants to hear.