# On the probabilities of winning the world cup

I just read an article on the bbc about sports data company gracenote’s estimates of countries’ winning probabilities for the upcoming soccer world cup. I then looked up the best current betting odds on oddschecker. These are, of course, subject to change. I looked at them on the morning (Pacific Time) of the 7th of June.

I then looked at the expected return to a one Euro bet on the various countries winning the world cup under the assumption that gracenote’s estimates are completely correct. So if you believe in gracenote’s estimates as the abolute truth, what should you bet on?

Well, Brazil is the favorite according to gracenote but also in the betting odds. Gracenote gives them a 21% chance  of winning the world cup, and at current best odds of 9:2 you would win 4,50 Euros if you put 1 Euro on Brazil. This means you would expect to get 4,5 * 0,21 = 0,945 Euros back. So if you are risk averse or risk neutral you should not bet on Brazil at these odds, but if you had to you could put a Euro on Brazil. Germany has similar best odds of 5:1, but gracenote does not rate them so highly, giving Germany only an 8% chance of winning. So you would only expect to win back 5*0,08=0,40 Euros for every Euro you place on Germany. This means that, if you could, you should “short sell” Germany to make money in expectation. This is not so easy to do in sports betting markets so let’s not pursue this here. It turns out that most of the better teams are not rated as highly by gracenote as they are in the betting odds.

So, again, what should you bet on if you believe in gracenote’s estimates? According to gracenote Peru has a 5% chance of winning the world cup. At current odds of 325:1 you would get an expected payout of 325*0,05=16,25 Euros for every Euro you put on them. This is an expected return better than anything you can get on the stock market I would guess. Mexico, Switzerland, Colombia (with expected payout of 3,75, 3,50, and 2,60 Euros for every Euro you put on them) are also high return bets.

I am afraid, though, that I believe in the efficiency of sport betting markets much more than in one sports data company’s estimates, so I will not follow these suggestions myself. If you want to know more about the efficiency or inefficiency of betting markets a good starting point would be a 1988 survey by Thaler and Ziemba.

One day later, on the 8th of June, I noticed that Peru’s odds have gone down to 200:1. Perhaps this was a reaction to the new information provided by gracenote (although I am not quite sure when their estimates were posted). You would, however, still make an expected winning of 200*0,05 = 10 Euros for every Euro you put on Peru if you believe gracenote’s estimates.

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# Italy’s public debt, decomposed

Why is Italy’s debt so high?

Is it because the Italian government was fiscally irresponsible, spending too much and taxing too litte? Or is it because investors demand such high interest rates on Italian government bonds? Or is it a consequence of Italy’s dismal economic performance in recent years?

To answer this question, we can take a simple decomposition of the debt-to-GDP ratio. First, remember the government budget constraint: $\displaystyle dB = G - T + rB.$

where B is public debt, G is spending, T is revenue and r is the interest rate. Second, take the time derivative of the debt-to-GDP ratio $\displaystyle d\left(\frac{B}{Y}\right) = \frac{dB}{Y} - \frac{B}{Y}\frac{dY}{Y}.$

Combine the two equations and denote the GDP growth rate dY/Y by g: $\displaystyle d\left(\frac{B}{Y}\right) = \frac{G-T}{Y} + (r-g)\frac{B}{Y}.$

This equation allows us to decompose the total change in the debt-to-GDP ratio into a primary deficit component, an interest component and a growth component. The graph below shows this composition for Italy during the pre-crisis period (2000-2008) and the post-crisis period (2009-now). In the years between the introduction of the euro and the financial crisis, Italy’s debt ratio decreased slightly by about 2 percent of GDP. During the years after the crisis, it increased by almost 30 percent of GDP.

What changed? As you can see by looking at the yellow and blue areas in the graph, it wasn’t interest payments or the primary surplus. Interest payments were around 5 percent of GDP both before and after the crisis and the Italian actually ran a primary surplus in both periods. What changed was the green area: the recent rise in the debt ratio is almost entirely due to Italy’s shrinking economy.

# A mistake in probability theory in David Hume’s “Of Miracles”

When should a rational individual believe in a miracle?

David Hume, the great skeptical philosopher, answered: practically never. His argument ran as follows: Miracles are extremely rare events and thus have a very low prior probability. On the other hand,  people can be misled rather easily either by their own senses or by other people. Therefore, the rational reaction to hearing a miracle story is to reject it, except the evidence supporting it is overwhelming. “Extraordinary events require extraordinary evidence” became a popular summary of Hume’s point of view.

Here is a famous passage from Hume’s “Of Miracles” explaining the point:

When anyone tells me, that he saw a dead man restored to life, I immediately consider with myself, whether it be more probable, that this person should either deceive or be deceived, or that the fact, which he relates, should really have happened. I weigh the one miracle against the other; and according to the superiority, which I discover, I pronounce my decision, and always reject the greater miracle.

This argument sounds intuitively plausible and compelling, but it is mistaken. In fact Hume is committing an elementary error in probability theory, which shouldn’t be held against him since “Of Miracles” predates the writings of Bayes and Laplace.

In the language of modern probability theory, Hume asks us as to compare the prior probability that miracle X occurred, $\displaystyle Pr(X)$, to the probability of seeing the evidence Y supporting miracle X even though X did not in fact occur, i.e. the conditional probability of Y given the negation of X, $\displaystyle Pr(Y | \neg X).$ Econometricians would call the latter the likelihood of Y under the hypothesis not-X. If $\displaystyle Pr(X) < Pr(Y | \neg X),$ Hume says we should reject X in favor of not-X.

But this inference is unwarranted. What a rational observer ought to ask is: Given the evidence Y, is it more likely that X occurred or that it didn’t occur? We are looking for the posterior odds of X conditional on Y: $\displaystyle \frac{ Pr(X | Y)} { Pr(\neg X | Y) }.$

Bayes’ theorem immediately gives us what we are looking for: $\displaystyle \frac{ Pr(X | Y)} { Pr(\neg X | Y) } = \frac{ Pr(Y | X) }{Pr(Y | \neg X) } \frac{ Pr(X) }{Pr(\neg X)}$

This equation makes it clear that even if Hume’s inequality $\displaystyle Pr(X) < Pr(Y | \neg X),$ holds, it is possible that the posterior odds of X are greater than 1. All we need for such as result is that the likelihood of having evidence Y under the hypothesis that X occurred is sufficiently higher than the likelihood of Y under the alternative hypothesis that X did not occur. In econometric terms, the likelihood ratio must exceed a critical value which depends on the prior odds against the miracle: $\displaystyle \frac{ Pr(Y | X) }{ Pr(Y | \neg X) } > \frac{ Pr(\neg X) }{ Pr(X) }.$

To conclude: A rational observer is justified in believing a miracle if the evidence for it is sufficiently more likely under the hypothesis that the miracle really did occur than under the hypothesis that it didn’t so as to offset the low prior odds for the miracle. Just comparing the low prior probability of a miracle to the probability of receiving false evidence in favor of it is not enough and can be misleading.