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 😉

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 🙂

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 😉 ).

  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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