The visible hand in economics

Archive for the ‘Behavioural economics’ Category

Everywhere I look I am being told that the RBNZ must slash rates into heavily stimulatory territory.  There are calls for tax cuts, infrastructure spending, further unemployment relief.  There are calls that commodity prices will collapse – but the price we pay for things won’t.  Pretty much anything that could be wrong, we’re are being told is wrong.

It is easy to get caught up in this.  All the negative news and statements that the Bank MUST cut between 150-200 basis points makes me feel like “maybe they should”.  Ultimately, you start to feel that they know things you don’t.  This type of analyst is a “fast follower”.

Now pulling back from all this talk, as an analyst I may try to be “objective”.  I may try to forget about these things, and take special notice of the “good things.  Wholesale funding pressures are falling, petrol prices have collapsed, income growth is still strong, and the labour market is still in tight territory.  A little bit of a slowdown is not a bad thing if it helps to clean up the economy.  However, this view is just as wrapped up in subjective feelings – in this case I have heavily devalued the actual evidence of difficulties in the economy, and the fact that a drastic slowdown is never completely in the data till well after the event.  Analysts that suffer in this way are facing “recession fatigue”.

Analysts must try to remember that this inherent biases exist – as by doing so they can help themselves make more objective, and more useful, statements about what is going on in the economy.  Noticing your ideological blindspot will help you to be a better analyst – so don’t hide from it, face it!  If only I knew how :P

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In its eternal quest to “not be evil” Google has decided to take on one of the banes of man – himself, and his time-inconsistency.

It is doing this by introducing a new service to gmail.  You can set up this service to significantly increase the transaction cost associated with sending an email when you are drunk!

In the “drunk” state you may think it is a good idea to email your ex girlfriend/boyfriend and say strange things – however, prior to being drunk you may decide that any benefit associated with emailing someone in your drunk state is more than canceled out by the embarrassing phone call the next day.

This feature allows you to increase the cost to writing the email in your drunk state – allowing you to “pre-commit” to not sending embarrassing emails.

With classy features like this you can tell that a genius like Hal Varian is working for them ;)

Vernon Smith:

That economic agents can achieve efficient outcomes which are not part of their intention was the key principle articulated by Adam Smith, but few outside of the Austrian and Chicago traditions believed it, circa 1956. Certainly I was not primed to believe it, having been raised by a socialist mother, and further handicapped (in this regard) by a Harvard education, but my experimental subjects revealed to me the error in my thinking (emphasis added)

Economists do NOT think that people analyse every decision they make in a pile of analytical detail.  However, economists do believe that the actions that people act within their “interests” – and that this process can be described using mathmatics.  Maths provides a language to describe action – the agents themselves do not need to be able to do the maths.

Today National released their corrections policy, which would allow the private sector to tender for the management of prisons.

Although not a completely ‘new’ concept for New Zealand (Auckland Central Remand Prison was privately run under the last National Government) it nonetheless raises the issue of when is it appropriate for such services to be ‘contracted out’ rather than provided ‘in-house’ by the government.

Hart, Schleifer and Vishny’s “The Proper Scope of Government: Theory and Application to Prisons” asks the question when should a government provide a service in-house, and when should it contract out provision? (Anyone interested in the full article may be able to locate it here).

The authors’ develop a model for asset ownership (in this instance a prison), which can be owned by the private sector, who contract back to the government, or alternatively can be owned outright by the government.

The central finding of the paper is that the private sector has relatively stronger, but seemingly contradictory, incentives to both reduce costs (driven by a profit motive, which comes at the expense of quality) and increase quality (to get a higher price from the government, who is an ongoing buyer of the service). In this instance the quality of a prison entails order in the prison, amenities that prisoners receive and rehabilitation.
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A large debate in economics stems from the idea that there is a price asymmetry in the economy. What this implies is that prices are more flexible in one direction (up or down) then they are in the other direction.

The commonly provided example is petrol prices. People feel that when crude oil rises in price it is passed on immediately, but when it falls in price it takes time for the firm to react and lower petrol prices. This implies that prices are “stickier” downwards, and so the adjustment to two shocks opposite shocks is asymmetric.

Another example is housing. People find it psychologically difficult to accept that the nominal value of their house has fallen, so it tends to be harder for the nominal price to fall than for it to rise.

Now there are a large number of economists that don’t believe these asymmetries exist (I’m in the camp that I think the downward asymmetries are exaggerated). Overall studies have been inconclusive.

Now I think sticky prices exist, but I think we’ve also got an inherent bias to look at cases where they appear to be sticky downwards compared to stick upwards. I was reminded of this when I brought my Gold Pass for the bus in September.

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ISCR have just launched New Zealand’s first prediction market.

From iPredict:

Who’s going to be the next Prime Minister – Helen or John? Will the price of petrol be $3 a litre by Christmas? Will Winston be sacked before election day?

These are some of the questions Kiwis may find themselves backing their opinions on with iPredict – http://www.iPredict.co.nz – New Zealand’s first real money online prediction market, which launches tomorrow (9 September).

The online marketplace enables users to trade on their predictions on a broad range of future political and business events that pay real money if their prediction comes true.

Established as a research tool by Victoria University of Wellington and think tank ISCR, iPredict harnesses the wisdom of crowds via the Internet to predict future outcomes and has a strong focus on helping companies, government agencies and academics with research. …

Mr Burgess says that iPredict is like a simple stock exchange, trading real money.

“How it works is that contracts pay $1 if an event comes true – nothing otherwise – and the price these contracts trade for is the prediction. For example, you could have a contract that pays $1 if Helen Clark is the next Prime Minister, and pays nothing otherwise. If that contract trades for 60 cents, then the market’s prediction is a 60% probability that Helen Clark will stay on as Prime Minister.”

Mr Burgess says that prediction markets are the gold standard for forecasting.

“Traders on prediction markets combine information from polls, expert commentary and any other source to produce a prediction that is more accurate than any available alternative,” Mr Burgess says.

“Prediction markets work because they ask traders to put their money where their mouths are, so it pays to be honest, objective, and even do a little homework.” …

Anybody can browse iPredict and see the predictions for free by going to http://www.iPredict.co.nz but traders have to be 18 years and older to set up an account. Accounts are free to set up and people can start trading with as little as $5.

Get some money on your account and get predicting.

Goonix

When I drink on Friday I suffer from a commitment problem (likely stemming from my own time inconsistency *). Fundamentally, before drinking I don’t want to go into town and drink too much (as I have work to do on Saturday), the next day I would prefer it if I hadn’t drunk a lot, but once I start drinking I find it hard to stop ;)

One way to pre-commit to not drinking too much is to not drink. However, I don’t like this solution at all. I want to have a few drinks with my work mates, and with my friends later on – but I would like to avoid drinking too much. Now, the “too much” bit actually occurs when I go out into town after work drinks – as a result if there was some way I could commit to not going out, I would be able to pre-commit to not drinking too much!

That is what I have done today – by taking casual Friday to the extreme I have ensured that most bars in Wellington will not let me in, removing the temptation to go into town by taking away my ability to. However, I will still be able to have a couple of beers at work and then head around to my friends house for a few beverages – thereby ensuring that I reach a superior outcome to the “don’t drink” scenario.

It is good to see the Frog Blog discussing happiness and policy – as fundamentally the goal of policy should be to promote the highest social happiness, not necessarily to promote the largest GDP number.

The article that Frog links to can be found here, and on Saturday there was an article in the paper by Chris Worthington on the subject as well. However, I get the feeling that Mr/Mrs/Miss Frog interprets this policy implication a little differently to me (and both are different to this previous post) – lets discuss.

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Over at Econlog they mention a uncomfortable question that is asked at Instapundit:

If somebody offered us our current income tax system for the first time, would we buy it?

Now when we have defended progressive taxes on this blog we have often assumed that it is a revealed preference for society – in fact this is a favored measure we have for actually revealing (to some degree) what is optimal (here, here, can’t actually find any of the tax posts :) ).

How could this work? How could we have a system that is not optimal.
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Cactus Kate states that men should pay the bill when taking a woman out – because of the substantial expenses associated with being a woman.

As an economist, I’m not so sure if this does it – after all, aren’t these all sunk costs, which implies that they shouldn’t have any impact on the final negotiation at the end of the night that determines who should pay the bill for the date.

As a result, the demands that Ms Kate place on men to pay the entire bill, based on these costs, may seem somewhat “irrational” (I hate that word).
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One of the main justifications for redistribution policies is “diminishing marginal utility”. We have already discussed that this doesn’t really make sense as we can’t compare peoples “utility”. For example, people that receive higher utility from consumption will work more and thereby will earn a higher income – from here we cannot tell whether the change in welfare from taking a dollar off them and giving it to someone who earns less will be positive or negative.

Furthermore we have the fact that two people with the same lifetime income level the person with a more variable annual income will be taxed more than people who do not have a variable income – implying that DMU does not work as a defense here!

However, there is a further complication to the DMU story. Even if everyone has the same “utility function” we cannot necessarily assume that marginal utility will be diminishing in income.

Why? Well because of the cost of “big ticket” items. Read the rest of this entry »

One of the most vexing questions in economics has to be why the price of a 330ml coke is often only slightly less than the price of a 1.5l coke. This issue generalises to other products such as chippies.

Now there are a number of good responses, namely:

  1. Strongly diminishing marginal utility for fresh coke and a very low value on saved coke (or a relatively high cost of storage),
  2. A 330ml bottle is easier to consume than a 1.5l bottle – as a result the value of the 330ml bottle may be higher for people on the move, and so they are priced to service different markets.
  3. The cost of producing a 330ml coke is far more than a 33/150th of the cost of producing a 1.5l coke

These answers seem to satisfy me when I think of coke. However, when I think of chippies I find this explanation sadly lacking.

Downstairs I can buy a little bag of chippies for $1.50 or a far bigger bag of chippies (x3) for $3.00. I always buy the little bag.

Now I will do this each day, and don’t get any less value from 3 day old chippies than I do fresh chippies. Furthermore, I am eating them at work – implying that there is no storage cost and no convenience benefit.

No-one steals my chippies if I get a big packet so its not that. Am I passing up a free lunch here (and thereby not being a utility maximiser as my shirt says) – or is there a reason I buy the small bag instead of the big bag.

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Hi all. Good to see people commenting on re-thinking interest rate policy here, I am going to give it another day for people to make comments (as I am waiting for some specific people) and then I’ll start writing things up on the weekend – so if there is anything you want to add, go there are add it!

Today I’m going to ask a couple of questions to Rauparaha (or anyone else that knows some stuff) about time inconsistency (using smoking as an example), an issue that Rauparaha covered here. Now I know close to nothing about this stuff – but hopefully a discussion on it will enlight me, and potential other readers :)

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Well, we don’t run a requests service, but never let it be said that we don’t try to give our readers what they want (or what we want them to want, anyway). The Standard asks us to have a chat about this piece in The Economist which discusses endowment effects, so here goes.

The first question to answer is probably, “Endowment effects?! Wot’s that then?” Read the rest of this entry »

Being urged to blog, I shall respond with a counter-knee-jerk against kneejerking by others. http://www.stuff.co.nz/4492587a11.html is a link to a great DomPost article, one of the most recent in a series that reports on the rising outrage amongst the New Zealand population as petrol prices rise. Does anyone else get the impression that New Zealanders believe they have a human right to cheap petrol? So we’ve constructed whole aspects of our economy and society around cheap petrol. So now we’re feeling the pinch in a whole lot of ways… Well, cry me a river, people! Granted that the effects of a price rise are likely to cut the deepest on low-income families who aren’t those driving Pajeros to the dairy and back, isn’t it about time we started paying something even approaching the true cost of this environmentally disastrous stuff? We’ve no entitlement to be profligate with fossil fuels when their use is threatening our climate system (a.k.a. the thing what makes the earth a liveable planet). If it takes a price rise to wean New Zealanders off the private car and onto walking or – shock, horror! – public transport, then it’s a damn good thing.

Metrosideros


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