Thursday, August 19, 2010

Betting on your own grades: incentive effects vs. distributional effects

As noted by the Tax Prof blog, the Wall Street Journal has an article today discussing a new on-line service that would permit students to bet regarding their own grades. Supposedly, this would provide incentives for bettors to work harder, as in the case where you wager $50 on getting at least an A-, and thus engage in extra studying to make sure you get there. Critics note that students could also bet against their getting good grades.

I'm not sure I'd want to run this business (even if it were otherwise my sort of thing). The "house" faces problems both of moral hazard (given how one might adjust one's efforts for the direction of one's bet) and adverse selection (given the possibility of inside info, more specific than one's overall GPA, regarding how well one is likely to do in a given class). Or to put it differently, given how the house would have to price the bets in light of moral hazard and adverse selection, the odds are bound to be lousy for students who are not betting on something that they surreptitiously know is actually close to a sure thing. And perhaps the house will end up having to include a very wide bid-ask spread, given that students can game it either way.

In any event, to say that betting in favor of your getting good grades would improve your incentive to do well, we have to posit that it is otherwise under-powered. This might have to do with loved ones who are affected by how you do, but let's instead call it an externality from the standpoint of your future self, whose interests you may fail to consider adequately if other activities are more fun than studying or you just get too bored. (And let's forget about the opposite externality, which is that other students may end up doing better if you do worse.)

Note, however, that, from the standpoint of portfolio theory, betting in favor of your getting a good grade is the very last thing you should do. You already face risk given the genuine unpredictability of how you will do (and any economic or even just psychic stakes in how you fare). Why double down and make your risk-bearing even greater? A savvy investment advisor would tell you to hedge the risk, by betting against yourself as a form of insurance. Indeed, the tax system already does this to a degree, since if you end up earning more (whether from good grades or otherwise) you will pay more tax.

Hence, we face the familiar tradeoff between incentive effects and distributional effects. Do I smell a future Tax Policy exam question here?

And if this gets going, how long before we see the first allegation of a student letting his or her professor in on the grade action?