The visible hand in economics

Archive for February 2008

Sorry about the constant methodology talk lately, rauparaha and me have just have methodology on the mind ๐Ÿ˜‰

I wish to focus on a subject that is a little different than the rationality definition that my esteemed colleague has been looking at. I plan to look at the equity-efficiency trade-off.

The trade-off between equity and efficiency is one of the primary lessons of first-year public economics. It takes two concepts and illustrates how they behave in the framework of scarcity – which is where the trade-off comes from. As long as we have scarce resources there will be an efficiency-equity trade-off.

However, digging a little further, we might ask why does equity matter? A potential answer is that people value equity, and thereby it is something that needs to be taken into account (something that was described here). But if we care about equity because individuals value it, then why can’t we just introduce equity into the individuals utility function – then the optimal choice will automatically take into account the trade-off between our original idea of efficiency and equity and the new solution will simply be – ‘efficient’.

Is there a reason why we are so keen to divide efficiency and equity – and what does this tell us about economics?

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As much as I hate link farmers, I can’t help reposting this great paragraph from the Positive Economist. It just ties in so well to the recent discussion on this blog about rationality and behavioural economics!

Behavioral economics is possibly the least revolutionary revolution ever to hit an academic discipline, because, as Scheiber is alluding to, the behavioral school is absolutely not changing or abandoning the methodology of economics. As I’ve noted before, the “perfectly rational” economic man can happily do whatever the behavioralists want him to do to be more “realistic”; it’s therefore not necessary to come up with a whole new way of modeling people.

Instead the behavioral school is writing down models of “perfectly rational, utterly self interested maximizers” who act in accordance with the behavioral evidence. That is, writing rationalization of the “irrationality” we observe. Contrast this with the traditional criticism of economic man, which is to throw up ones hands and loudly reject the whole idea of trying to predict what people will do. I prefer the behavioral way.

Yeah, what he said ๐Ÿ™‚

I’ve been bombarded recently with people telling me about economists’ perception of rationality and the wonders of behavioural economics. The term homo economicus gets thrown around with gay abandon as a generic criticism of economics. Oliver Woods claimed that rationality means having perfect information and being entirely self-interested. At the other end of the scale, Will Wilkinson extends rationality to include anything that’s “…the best we can do given our numerous limitations.” Tim Harford goes as far, in his book ‘The Logic of Life’, as suggesting that someone can be termed rational if they respond to incentives. So, if even economists don’t agree on what rationality is, how can we complain that economists are silly to speak of humans as rational? Read the rest of this entry »

Kiwiblog discusses the musings of an economist at a Business Roundtable retreat in this post.

Now of course the economist had a number of good points (it is an economist after all), but there are a few points I would like to discuss in a little bit of detail (although not much ๐Ÿ˜‰ ).

  1. The 90 day rate will fall to 6% in 2009 then rise to average 7% in the future,
  2. Mining in Australia only accounts for 7% of GDP and so cannot account for its strong economic performance,
  3. A decreasing ‘talent pool’ (meaning number of people) will decrease productivity,
  4. The higher cash rate to inflation cycle

Here are my musings:

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Image courtesy of Rose Colligan.

Most economic research is a process of adding to ideas that have already been thought of. In Mrs Lovett’s case her grand plan involves adding concepts to Sweeney Todd’s welfare policy.

Now if you haven’t seen the movie yet, this might be a bit more of a spoiler than the previous post. As a result, think carefully before you click below the flap.

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You always here about how biased referees are from football fans. However, Matt and Agnitio are model football fans and seem to rarely criticise the referee, even when Liverpool are getting walloped. Now Robin Hanson links to a study which gives them a reason to lambast the ref a bit more:

Referees, who are appointed to be impartial, tend to favor the home team by systematically awarding more stoppage time in close matches in which the home team is behind. They also favor the home team in decisions to award goals and penalty kicks.

Not that we should be surprised by this news: it would be odd if referees were such a different breed that they could block out all the incentives to appease the home crowd. Why should we ascribe some superhuman power to them that none of us possess? Fans everywhere can rejoice in the knowledge that all referees are likely to be biased towards the home team, or whatever team they personally sympathise with. It’s just human nature and we can expect no more of them. Read the rest of this entry »

‘Inflation psychology’ was the topic of a recent inflation update by Stephen Cecchetti (h.t. Freakonomics blog). In it he mentions that people seem to have selective memories regarding price changes – namely people are likely to remember price increases more than price falls.

I once mentioned such a potential bias when I commented on Kiwiblogblog, it is a bias that I definitely hold, and I suspect other people do too. For example, did you know that the nominal New Zealand price of petrol is only starting to reach the level recorded in July 2006 now? People often remember the big increase in petrol prices in mid-2006 and late 2007, but they seem to forget about the significant fall in prices that occurred between these periods.

The question then is, what does this bias imply for inflation?

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Over at NZQuest, Oliver Woods claims that economics

…works around perfect conditions and universal application of models and theories developed many years ago to any economic problem, believing history, society and all sorts of other factors undermine the ‘homo economicus’, or the supposedly rational profit-driven man who thinks entirely in his own self-interest and only helps others when they can help him.

As Matt has previously addressed there is a huge difference between positive statements and normative judgments. Woods is confusing the judgments he attributes to economists with positive statements of economics. Read the rest of this entry »

Stuff mentions a survey done by Research New Zealand on petrol prices and household consumption of petrol. In the survey they found a number of results that seem to follow the basic idea of a demand curve.

From the article the results were:

  1. 32% of people said they consumed less fuel since the price rose (I am assuming that the remaining 68% would consume the same amount, not more ๐Ÿ˜‰ )
  2. Half of consumers said they would consume less fuel if the price went over $2 a litre
  3. More woman are driving less than men (35% to 29%)
  4. 70% of those that earn over $70k have not change petrol consumption
  5. If petrol crossed $2, 64% of those earning under $40k would consume less petrol compared to 49% of those that earn over $70k.

It is entirely possible that these facts were cherry-picked by the NZPA article, however lets try to understand them.

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Greg Mankiw reports that a lady in Britain was prevented from supplementing her state-provided healthcare with private care. Apparently the NHS favours equality over efficiency:

Officials said that allowing Mrs. Hirst and others like her to pay for extra drugs to supplement government care would violate the philosophy of the health service by giving richer patients an unfair advantage over poorer ones.

Clearly, this restriction on her ability to spend her money as she sees fit is not allocatively efficient. The policy is also likely to diminish the health of the population, as the rich are no longer allowed to boost their healthcare levels above what is offered by the government. That, in turn is likely to lead to a greater burden on the government run, public healthcare system.

The morality of equality must run strongly through the British government for it to prevent spending that would reduce the load on its own health funding. Mankiw has an interesting analogy for those who agree with the government’s policy:

Should a parent who hires an after-school tutor for his child be barred from sending the child to the public schools?

I saw an interesting piece on Breakfast this morning (now that I have a “real” job I’m actually up that early) about how today is buy no petrol day.

Apparently the idea is if we all buy no petrol today this will “hit the petrol company’s bottom lines” and make them clean up their act or something like that. This just reminded me of my honours macro course when we talked about the different effect permanent and non permanent shocks have on the economy. To cut a long story short, temporary shocks have no real effect while permanent ones d0 (if tax cut today will be followed by a tax rise next year you save now to pay for the tax rise later (i.e no change in consumption), if the tax cut is going to be permanent then you will probably spend more (i.e consumption increases, the economy is stimulated and everybody is happy).

Applying this logic to our current situation, everybody not buying petrol for one day, while a great way to raise awareness (it made breakfast!), is not going to have any effect on the oil companies behaviour if the people who didn’t buy petrol today are simply delaying filling up until tomorrow.ย 

In summary if people want to change petrol companies behavior by hurting them financially,ย  it needs to be done by a permanent decrease in petrol consumption as this will have a non transitory effect on profit, not just be a blip on the radar that is gone the next day.

I havenโ€™t had a coffee yet so I don’t have the energy for sarcasm



After recently watching the movie ‘Sweeney Todd‘ one question popped into my mind, is the welfare policy he derives optimal? Below the flap I will discuss his welfare policy – if you haven’t seen the movie or watched the broadway show then read at your own risk. Although I don’t talk about the movie itself, and the welfare policy won’t tell you anything you wouldn’t find by watching the trailer.

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The Congressional Budget Office reported recently on its comparison of a cap-and-trade program to a carbon tax program. The one-line conclusion is that carbon taxes are cheaper and simpler, but caps give more certainty. Read the rest of this entry »

I am a Liverpool supporter (the football club), I’m proud to admit it ๐Ÿ™‚ . While I was reading an interview with Fernando Torres today, I ran into this gem of a line when discussing Benitez’s rotation policy:

“It is normal to rest. We players never want to, but if the manager says so, you have to. If everybody accepts that is the way forward, the atmosphere doesn’t suffer.”

This reminds me of inflation expectations. If the Reserve Bank (the manager) says that it is commited to making inflation zero (for arguments sake), then individual agents accept that the Bank will do whatever it takes to achieve that target (hiking interest rates), and inflation expectations shift to zero. If this is the case, there is no need for a costly adjustment to the new equilibrium (atmosphere), as inflation expectations drive the true rate of inflation.

Ok, the two arguments are a bit different, but I still think that Torres would make a great economist ๐Ÿ˜‰

Reading the titles of the last two posts (the birth rate vs the growth rate and growth forecasts and government) I realised that neither rauparaha or myself defined what ‘growth’ we were talking about. Like all economists, we took ‘Growth’ to be synonymous with growth in gross domestic product.

Could this possibly imply that economists such as rauparaha and myself have an inherent bias when discussing normative statements about welfare that points us towards pro economic growth policies – even when there is a hefty trade off in other social values. Do economists focus too strongly on technical and allocative efficiency without taking social efficiency and equity into account?
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