Sweet sweet rationality

My undergrad was double-honours economics and politics at one of the few places in the world where the economics department sat very far to the left of the politics department. Manitoba was a strange place in the 90s, and it sure wasn't as though a farm kid would have been able to do due diligence about it.

But there were still occasional oddities over in the pols honours seminars. A mature student in our political economy course, on the pols side, really liked to dismiss anything from economics with a slogan: "Economics assumes ceteris paribus, but ceteris is never paribus." I don't know if she just liked saying Latin things to sound clever, but she seemed to think it was a knock-down argument for just about anything in econ. 

It was nonsense in any case. Econ runs comparative statics to see what the isolated effects of a change might be, but then it runs general equilibrium models where everything can move. And comparative statics can be really really useful in tracing out first-order effects. It isn't that we assume that nothing else in the real world moves. 

Anyway. 

Pattrick Smellie over at Business Desk uses a different version of the same argument.

The NZ Initiative, an economic rationalist think-tank, argues that all NZ needs is the Emissions Trading Scheme to spur action. Virtually no one apart from other economists, with their sweetly rational assumptions, believes that. People and industries need active spurs beyond a fluctuating carbon price to act.

Well, the ETS (as tweaked with the usual set of things we've argued for as improvement) is only enough for the covered sector, and we want a carbon dividend to go with it. But let's leave all that aside.

Within the covered sector, do conclusions about the merits of the ETS require a whole pile of strong assumptions about sweet sweet rationality?

It's pretty darned hard to see how. 

Here's my counterfactual scenario which looks nothing like actual-NZ, for sake of argument.

Most New Zealand businesses that don't need to compete in international markets satisfice. They aren't profit-maximising, but instead are kinda cruisy. 

They will make changes when it becomes really important to make changes, but competition in New Zealand is slack-as.

The Overseas Investment Office bans foreign companies from coming in and competing with Kiwi businesses. If they got OIO approval, they'd never get Council consent to set up premises that competed with local lazy well-to-dos who are buddies with everyone on Council anyway. And in lots of sectors, entrants would have to get around regulatory barriers that seem almost designed to protect cosy cruisy incumbents against competition.

All of it means competition is slack-as. Remember when Ikea tried to enter to break up cosiness in furniture retail? And the furniture retailers convinced Auckland Council that Ikea would be too popular so it would be a traffic issue so no consent should be issued and furniture retailer slack-rents should be protected? And how Ikea then didn't even bother setting up in Christchurch after the quakes when there was plenty of land near the airport and everybody was rebuilding? That, across almost everything, almost always. We now have one (1) Costco for 5.1 million people; let us all celebrate our benevolent government for this tiny tiny morsel of newly-allowed competition. Hooray.

In the US, if a business is cruisy and has moats against competition, it doesn't matter as much. There are sharks who will swoop in, buy the company, replace the management, and transform x-inefficiency slack-rents into profits. But if you run securities legislation just-so, you can make sure that hostile takeovers are just too hard. Securities legislation can also ensure that companies have incentive to stay private rather than be listed. 

Because government stifles competition, and because the market is small, talented managers flee the country for places where the vigour of competition plus larger market size means they are far more handsomely rewarded. And we're left with crappier managers who could barely respond to incentives if they wanted to. They just haven't the ability to do it: neither the drive, nor the capacity. Not the ones who are left and who age their way into senior positions while being competitive on the margins that drive appointment rather than the ones that drive profitability. 

Government only auctions a set volume of carbon credits each year in the covered sector.

Suppose that a business, Company X, has a coal-fired boiler that has a decade of life left in it, at which point it's due for replacement. The timing was all set when the thing was purchased, and they put a notification in Outlook reminding them "Look at boiler replacement options in 2030 so we can have a new one in place in 2032." They won't think about replacing that boiler until the Outlook notification pings, because they're slack-as, unless their running costs have absolutely gone through the roof.

Carbon prices have quadrupled since they bought the boiler and set that Outlook notification. And they're expected to double again before that notification pings. When it comes time to replace the boiler, they'll go with a low-carbon option. Given rising carbon prices, it would make sense for them to scrap that boiler today and put in a new one: they'd save money, even though there's life left in the current boiler. 

But they have tons of slack: x-inefficiency everywhere. So they're not going to even think about it until the notification pings, unless they're hitting real problems due to input costs. They have other priorities, and not enough talented managers to handle everything that might make sense in a more competitive environment. 

And suppose most businesses are like this. 

Just suppose that's the case. It certainly isn't; it looks nothing like the New Zealand we all know and love. [There is actually a hell of a lot more going on in decarbonisation than anybody notices, do check out some of the case studies that Energy Resources Aotearoa points to here.]

We're just here trying to give Pattrick the strongest possible case. 

We've made sure, in this little toy verbal model, that nobody is running differential equations in their heads and optimising that way. Not that standard models require that anyway, it's just a stupid caricature of how economists think about rationality. But let's rule it out explicitly. 

Does the ETS fail to work?

Company X buys more carbon credits than it would if it were optimising rather than satisficing. They use more coal for longer than would make sense on a profit-max basis. That pushes up demand for carbon credits in the ETS. The government only auctions off so-many credits. Net emissions are determined by the number of ETS credits auctioned or allocated by government. 

So prices go up.

Prices going up does two things. 

Some folks will try to generate credits through forestry, because trees can suck up carbon very cost-effectively at current ETS prices. But remember: they're slack-as too. They'll also be slow to respond, and will mainly be spurred to do so if they were already at a decision point about land use because some other Outlook notification pinged. But we do get more trees. More carbon credits are then available, but each one of these credits is backed by a tonne of emission removals by trees. Net emissions remain the quantum set by the ETS cap. 

At the same time, there isn't just Company X around. There are lots of other ones. Outlook notifications will be pinging on all kinds of decisions around investments where carbon prices affect long-term costs. 

ETS prices are higher than they would be if Company X had been profit-maximising. Some companies whose notifications aren't pinging will hit trigger points where rising carbon prices force an out-of-sequence decision even if they hadn't wanted to think about it. And on all of the Outlook notifications that are pinging, there won't just be catch-up where firms invest in things that they maybe should have done a year or two ago. There will also be some overinvestment in low-carbon tech by firms who are pulled into making their shift ahead of when they might have, if Company X and others like it hadn't pushed up demand for credits. 

And the quantum of net emissions remains determined by the number of credits issued and allocated by the government. 

All that's then happened is that the cost of adapting to rising carbon prices has risen relative to a first-best profit-maximising world. We get some firms flipping tech later than they would in a first-best world, and potentially some flipping earlier too. That sort of thing affects cost, but not quantity. And it also means that the least irrational firms do best: by being sharp and watching for points at which they should flip, they get a cost advantage over their lazier competitors. 

You can even imagine a limit case where there's no rationality at all around carbon investment decisions and they're all just random. A sequence of bad random decision-draws leads to bankruptcy. Lucky companies make the right investments and don't have to purchase as many expensive carbon credits; unlucky ones make horrible decisions and then either have to purchase far more expensive carbon credits than they might have, or are unable to afford them and go bankrupt. The costs of adjusting to higher carbon prices, in that world, will be very high.

But net emissions are still determined by the number of credits auctioned and allocated by the government. 

The simplest way of thinking about all of this is a game of musical chairs. Ten people circle nine chairs. When the music stops, they could have an auction to decide who misses out, or they could all scramble around to see who finds a chair. An auction, with everyone bidding well, makes sure that the one sitting out is the one who least wants to keep playing. But even if they're all just scrambling around, with many of them utterly confused about what a chair even is, there are still only nine chairs and one person will wind up without one. Anyone not sitting on a chair when the music starts again is out of the game. 

Regulation targeting the covered sector will not affect the quantum of net emissions. If it targets and cost-effectively eases a real additional market failure, it can reduce the cost of reducing net emissions. 

But if you're trying to pull something like EECA's GIDI Fund and encourage companies to bring forward investments in low carbon tech, it just can't reduce net emissions. If EECA has gotten things right, it's encouraged a company to make the flip at a time that makes sense, before the notification pings. It doesn't solve any particular market failure, but it might reduce some x-inefficiency losses. 

And you may have noticed something. We've made an assumption about the bureaus' abilities to spot these opportunities. We assumed at the outset that companies are really slack. If we assume that companies are all stupid and lazy, and that the bureaucrats know better, we've put something of a thumb on the scales. 

Harold Demsetz should be whispering in your ear here, warning you that you need a comparative institutional analysis that has realistic businesses and realistic bureaucracies. You can't just assume that businesses are lazy and need to be prodded by things other than rising carbon prices and then conclude that benevolent and wise officials will make the right calls. The officials we have are ones who'll call it a big win for the climate if they've gotten a company to bring forward a carbon-related investment by a year at the cost of that business pushing back other projects. Surely that should give us pause. 

If you're going to assume that bureaucrats are better motivated and more rational about getting businesses to do what's profitable than those businesses are themselves, because business in NZ is slack, think for a minute about who sets, enforces, and fails to change the sets of rules that result in any business slackness in that purely hypothetical world. 

The best objection I can think of to my position here is that high carbon prices make it harder for the government to reduce the cap more quickly. And that view isn't crazy. But holding that view, without simultaneously arguing for a carbon dividend so that the median voter wants prices to rise faster over the next several years, doesn't seem like clear thinking. It seems like motivated reasoning designed to justify interventions that somebody wants for reasons other than GHG reductions. And it should also be accompanied by a strong requirement that any regs prove themselves to be cost-effective relative to ETS prices. We don't have that either. 

Irrational surplus

In 2009, Matt Burgess and I argued that irrationality isn't a reason for abandoning consumer surplus. If flaws in perceiving the cost of some kind of potentially risky consumption activity lead to overconsumption relative to a fully informed or fully rational norm, that means there'll be some excess cost associated with that level of consumption. 

The true marginal cost curve then lies above the perceived one, with the perceived one affected by, say, the consumer's preference to believe that he's less likely to suffer harm than the average person. Some in the public health crowd were trying to argue that the potential for irrationality meant we couldn't use consumer surplus anymore. We showed instead that it might imply more consumption than the person would find optimal, but that just gives us an excess burden equivalent to the red area. You could benefit those consumers by encouraging them to shift to the left a bit, but that's hardly the same thing as saying they get no consumption benefits at all.


We got yelled at a bit for (in others' views) not being sufficiently cognisant of the behavioural lit which (in my view of their view) means anything goes and welfare economics disappears.

Levy, Norton and Smith take on consumer surplus in tobacco cost-benefit assessment in July's set of NBER working papers. They provide a behavioural welfare economics where consumers might overconsume a bit due to some irrationality. They argue that the optimal tax in that context, for a biased consumer, puts in place a price wedge equivalent to the consumer's overestimate of the benefits of consumption. 

So the consumer whose biased view leads him to a demand curve of Db, where an unbiased one would have Du instead, can be made better off by t* bridging the gap; in the absence of that, you'd have deadweight costs of the same size, represented by the triangle bounded by P+t, Db, and Q0. 

Either way, consumer surplus remains the best framework for analysis. And their behavioural welfare graph - same deal as Matt and I argued in '09. I'm not trying to make any priority claim here - this is just bog standard "what is totally implied by intermediate microeconomics" stuff. 

In Appendix Figure 3B, they also show the analytics where taxes are above the optimal level with biased consumers. As you'd expect, there's a welfare gain from the first bits of reduced consumption, followed by welfare losses that increase in the the deviation of the actual tax from the optimal tax. 

I particularly liked this part:

A third implication is that we can rely on consumer surplus calculated using the unbiased demand curve for welfare analysis, because the unbiased demand curve reflects the value that fully informed and rational consumers place on different aspects of well-being (e.g., their own health versus the enjoyment from smoking). In particular, it is not necessary to calculate the health gains of a particular policy and then calculate an offset for foregone enjoyment; it is sufficient simply to look at changes in consumer surplus. 

They conclude:

Even if consumers are not rational, the correct response from an economic perspective is not to abandon welfare analysis in favor of policies that maximize health; rather, it should be to figure out how to perform welfare analysis when consumers are not rational. We propose that health economists should embrace the behavioral welfare economics framework developed for this purpose, developed primarily with reference to environmental economics.

We acknowledge, however, the practical difficulty of implementing this framework. In particular, the behavioral welfare economics approach requires knowing the shape of not only the biased market demand curve, but also the shape of the hypothetical unbiased demand curve. This is a tall order. Once again, we propose drawing on the literature in environmental economics and behavioral welfare economics for inspiration (Allcott and Sunstein 2015; Chetty 2015; Mullanaithan et al. 2012). Researchers in this literature have for some time focused on the empirical question of identifying the extent of bias in consumer choices.

And it would get more fun where consumers vary in their deviation from rationality.

Freedom of choice, but only for "responsible" choices

Freedom of speech is worthless if it's restricted to things that'll never offend anybody. 

Freedom of choice also requires that we be able to choose things other people think are dumb. Otherwise, what's the point? You might as well flip to a world where you're given a menu of permitted choices and where you're forced to pick one of them instead of carving out your own path. 

Here's Will Wilkinson at The Economist on Cassandra C's forced chemotherapy. She's 17 and refused chemotherapy, with her mother's support. She is likely to die as consequence.

Will writes:

It's simply maddening. Let's recap. Cassandra's mother does not force her to submit to an unwanted treatment, so she is an unfit mother. Cassandra is therefore held hostage by the state and allowed to return home only if she pays a ransom: submission to the unwanted treatment. Held against her will, and very afraid, so she agrees under duress. But she hasn't really changed her mind about the treatment, so she reneges. This is then used as evidence that she was insufficiently mature to be allowed to make her own decisions about the treatment in the first place. Dizzy yet? It seems that the only thing that would have counted as dispositive evidence of Cassandra's maturity, of her capacity to withhold consent, was a willingness to grant it.   

I suspect Cassandra has some dotty ideas about chemotherapy. Perhaps she inherited them from her mom. It may be that if she were allowed to act on her dotty ideas, she would die, while chemotherapy may save her (Hodgkin Lymphoma is one of the more treatable cancers). But liberty is a completely empty ideal if we are free to act only when our conception of our interests coincides with those of experts, medical and otherwise. If we are entitled to choose on our own behalf—or on our children's behalf—only when we are deemed rational, and rationality is defined to mean a consensus with the authorities, then autonomy is a bad joke. Cassandra's case illustrates the technocratic tendency of American culture and politics to nibble away at the edges of our autonomy, to deprive us of the right to make anything but the medically correct choice.

Emphasis added.

Every time I make this point on rationality, the public health brigade here insists that I'm arguing in favour of some blackboard model of perfect rationality. Rather, deviation from what public health doctors think is best, where those doctors don't seem to give a whit about the patient's experience other than QALYs, sure ain't evidence of irrationality.

And we're the irrational ones?

If just about any deviation from blackboard rationality is enough to declare market failure and say we need be subject to state control by rational bureaucrats, what are we to make of this?

One bunch of state bureaucrats tries to ban or limit sugar intake.

Another bunch of state bureaucrats advance loans to sugar processors and then have to buy a pile of US sugar to prop up prices to avoid those processors' defaulting on the loans. I suppose you could view the "pushing prices up" part as consistent with limiting consumption. But the initial loans wouldn't have been. And what are they going to do with the 400,000 tons of sugar they're planning on buying? More ethanol?

And doesn't the state try to stop people smoking while subsidising tobacco growers?

It's not unreasonable to view individual decision-making as being the outcome of warring homunculi within the brain. It's never been clear to me why even a rational unitary state might think itself in a position to overturn the outcome of that conflict, never mind a state that has battling-homunculi issues of its own.

Valuing amenities

A few things I tell my Economics & Current Policy Issues Class:

• It's double-counting to weigh the direct costs of some disamenity as well as the disamenity's effects on land values because the latter incorporates the former (and the same for positive amenity affects);
• We can weigh the value of hard to value things like mortality risk by looking for effects on priced markets. Differential on-the-job accident risk can give us measures of the value of a statistical life. The value of a neighbourhood park can be approximated by housing price effects, and the same for the value of neighbourhood disamenities.

And so I'll have to remember this rather nice NBER working paper by Currie, Davis, Greenstone, and Walker. They pick a relatively hard case: plants that emit toxic chemicals that are sometimes hard to smell or see. They find emissions decline exponentially with distance from the plant, reaching baseline levels a mile from the plant. When a plant opens, housing prices in a half mile radius drop by 1-2%; when it closes, they go up by 2-3%. Within a mile, the price drop is 1.5%. A plant within a mile also increases the likelihood of having a low birthweight child by two percent (that percent, not percentage points, and the base rate incidence is low). 

When they add everything up, they find that a plant's opening reduces average housing market capitalisation in the surrounding mile by $1.5 million on average,* and that the costs of low-birthweight births in the surrounding mile are about $700k. So the disamenity cost, as measured by housing prices, is about twice the biggest likely measurable health effect. And that's entirely consistent with housing markets capitalising the real imposed disamenities. The biggest price effects are closest to the plant, where health disamenities combine with the noise and sight of the plant, then decline towards the one mile mark, where there are still real health effects but the other disamenities are negligible relative to those in the reference category of homes 1-2 miles away. 

They also find that neighbourhoods around plants pick up in demographic characteristics after a plant's opening: people move there for jobs. They wonder whether this is consistent with fully informed decision-making, but it's rather plausible that, given the low absolute risk imposed, households simply value being within walking distance of work more than they dislike the disamenties. 

On the whole I take this as pretty supportive of our base-line theory on this stuff and reasonable evidence against the "Oh, but people are stupid and irrational and they would never live there if they only knew and we have to ban a pile of stuff" alternative hypothesis.

* By way of comparison, they note that a typical plant - a small coal-power plant - costs $280m to build. The disamenity effect, though real, isn't some big huge cost that would tip the balance against approving the plant were it incorporated.

Don't start by assuming stupidity

Suppose that you want to reduce petrol usage because of global warming.

If you begin from an assumption of consumer rationality, you'll prefer a carbon tax or some form of emission trading. Announce today a schedule of Pigovean carbon taxes and how they will affect petrol prices as they ramp up over time. Then let customers decide how to re-optimise when buying cars. We'd expect an increase in demand for cars with better fuel economy. Cars with worse fuel economy will start having to sell at a discount. Manufacturers adjust their product mix to account for changing demand and aggregate fleet composition changes over the longer term.

If you start from an assumption of consumer stupidity, you'll prefer regulations targeting car manufacturers mandating fuel economy standards. If car buyers are myopic and stupid, they'll fail to account for the higher lifetime cost of a car with worse fuel economy. Because customers are stupid in this way, manufacturers will not adjust their product mix to shift towards cars with better fuel economy - there's no change in demand for more efficient cars even with a well-publicised schedule of future tax increases. And so direct regulation has to be used. There are problems with this and lots of them - all the gaming of US CAFE standards and redefinitions of what constitutes a truck as most obvious example. But it could be a second best if car buyers are really stupid. Or, if they're just really really short-sighted. We'll also have to assume that car buyers do not change their behaviour by a lot when the price of driving a kilometer goes down by a lot.

What happens if we look to the data? Busse et al in the latest American Economic Review find pretty good evidence that car buyers' demand for fuel economy is sensitive to petrol prices. They conclude (ungated versions):

We estimated that a $1 increase in the price of gasoline increases the market share of cars in the highest fuel economy quartile by 21.1 percent and decreases the market share of cars in the lowest fuel economy quartile by 27.1 percent. We also estimated the effect of a $1 increase in gasoline prices on unit sales of new cars and found that sales in the highest fuel economy quartile increased by 10–12 percent, while sales in the lowest fuel economy quartile fell by 27–28 percent. We estimated the effect of gasoline prices on the equilibrium prices of new cars and found that a $1 increase in the price of gasoline is associated with an increase of $354 in the average price of the highest fuel economy quartile of cars relative to that of the lowest fuel economy quartile. For used cars, the estimated relative price difference is $1,945.

We used these estimates to investigate whether the changes in equilibrium prices for new and used cars associated with changes in gasoline prices show evidence that consumers undervalue future gasoline costs of cars with different fuel economies relative to the prices of those cars. This could be thought of as a necessary condition for effective policy: the more car buyers discount future fuel costs, the less effective a gasoline tax or carbon tax will be in influencing vehicle choice. Using several different assumptions about vehicle miles traveled, a range of assumptions about the elasticity of demand, and comparing the relative price differences between different quartiles, we find little evidence of consumer myopia. Many of our implicit discount rates are near zero; most are less than 20 percent.

So the "people aren't stupid and weigh costs over time in a sensible fashion" model seems the better baseline approach.

Now imagine that you set a fuel economy standard instead of a carbon/petrol tax in a world where customers are forward-looking and not idiots. Well, once they've bought the more efficient car, the value they derive from burning another litre of petrol increases substantially: they can drive farther, and they're not charged any more for that litre of petrol. And so a lot of the reductions in carbon emission you might have expected get whittled away by that people drive more. If you'd done it instead with a petrol tax, the marginal cost of another litre of petrol is higher. People still flip to the more efficient vehicle, but petrol usage doesn't rebound as much as consequence because the marginal cost of a litre is higher.

Flynn effects

Professor Flynn is trying to help you improve your mind. My review of his latest book should be in today's Christchurch Press. They gave me 450 words; I took 480. Here they are.

Professor Jim Flynn sets a clever trap in his latest book, “How To Improve Your Mind”. Promising that all readers will “be far more able to defend their position after reading it than before”, Flynn instead provides the critical tools necessary instead for reassessing the irrational beliefs each of us hold and, in so-confronting, end them. For your own good, you should let yourself be trapped. Jim Flynn is arguably New Zealand’s best social scientist. I disagree with him on some aspects of economic policy, but Professor Flynn is a truth-seeker. And, even better, he’s very often a truth finder. Here, he helps the rest of us be better truth-seekers. This is no mean task. Thinking rationally is hard and, often, unpleasant. Worse, there is no payoff to rational thinking in many areas of life; you will hardly be less successful in most occupations if it gives you pleasure to believe that the earth is only a few thousand years old. But I’ll return to this.

Flynn ably demonstrates the methods of rationality through a series of case studies of beliefs that contravene the methods. He also warns against the tricks used by policy advocates against those not appropriately armored against them.

I disagree with a few of the finer points in Flynn’s chapters on economics. For example, even if the reservation wages of second earners are lower than those of primary family earners, this will not drive down female wage rates unless we add assumptions around segmented labour markets. Further, decent labour standards seem to owe more to higher incomes and increased productivity than they do to Twentieth Century regulatory interventions. In developing countries, child labour is very sensitive to family income; when parents can afford to do so, they send their kids to school. And he is perhaps a bit too optimistic about the feasibility of ameliorative regulatory reform in financial markets. But Flynn has a sharp nose for the failures of rational thinking about economics among those whose values he shares – he correctly sees negative income taxes as better than a minimum wage for helping those he would wish to assist, though he misses that cleverer forms of the negative income tax solve some of the problems he highlights.

The bigger question, and the one harder to answer, is why to choose rationality in the first place. Flynn writes, “If you learn how to use logic and evidence to examine your own principles, and the principles other people urge upon you, you can enlist in the ranks of mature moral agents rather than in the army of stones.” But it’s an expensive endeavour – not unlike taking the Red Pill offered Neo in The Matrix. I’d be surprised if more than a quarter of the population even tries to choose rationality over comforting illusions. But if you’d like to try to try, Flynn’s book is a good start.

I should be reviewing Eliezer Yudkowski's "Harry Potter and the Methods of Rationality" for next weekend's Press.

One bit that wasn't relevant for the Christchurch Press but I found awfully interesting was this observation:

"Academic competition for grades in a particular course selects out an elite that gets an A+. But within some areas, the correlation between courses is far more perfect than within others. Within mathematics, the best student in differential equations is likely to be the best student in algebraic geometry and in number theory, and so forth. Within political studies, the best student in political behaviour is less likely also to be the best student in areas as diverse as international relations, political philosophy, and quantitative methods. So, talented math students will come to scholarship committees with a string of A+s, and talented political studies students with  a mix of A+s and As. Rather than putting all the math students at the top, the obvious thing would be to alternate science/math students with arts/social science students. Observe how quickly math professors forget what they know about regression to the mean when such a proposal is put."

I'm on the Scholarships Advisory Committee as the Commerce rep; we help advise on policy around scholarships. I wonder how much this affects our University-wide awards. Economics probably doesn't do horribly out of this kind of overall effect: more than any of the other arts or social sciences, there's likely an underlying e-factor - thinking like an economist - that explains variance across students. At least in microeconomics. But arts and social sciences in general will do worse than the bench sciences and maths.

I wonder if anybody has run the test. If Flynn is right, then we expect lower variance in course grades for maths and science majors than for arts and commerce majors. We can use incoming high school grades as a measure of baseline ability. We could observe higher variance among the best students in arts courses than among the best students in maths courses simply because of grade truncation issues if the very best of all students pick maths over arts. I think I'll add the "future honours project proposals" tag; this seems testable.

Update: Oops...didn't see it in today's paper. Likely in next week's then.

Rationality and economists

Andrew Gelman takes a swipe at economists. I think he's got things wrong. Let's work through it.

First, Gelman argues economists are inconsistent in arguing for consumer rationality while arguing that people need economists to help them overcome their irrationalities, largely about government policies. But these arguments are hardly inconsistent. In environments where individuals face real costs of being wrong or irrational, they consume little irrationality. At the voting booth, their likelihood of decisiveness is sufficiently low that they can indulge biased but comforting beliefs about the true state of the world. That's Caplan's rational irrationality model; I find it rather convincing.

Here's how Gelman thinks we square the circle:

OK, now to return to the puzzle that got us started. How is it that economics-writers such as Levitt are so comfortable flipping back and forth between argument 1 (people are rational) and argument 2 (economists are rational, most people are not)?

The key, I believe, is that “rationality” is a good thing. We all like to associate with good things, right? Argument 1 has a populist feel (people are rational!) and argument 2 has an elitist feel (economists are special!). But both are ways of associating oneself with rationality. It’s almost like the important thing is to be in the same room with rationality; it hardly matters whether you yourself are the exemplar of rationality, or whether you’re celebrating the rationality of others.

I think it's rather that economists recognize that there can be a rather large disconnection between policies that are politically popular and ones that would maximize a reasonable conception of a social welfare function. You can get it through the combination of rational ignorance and logic of collective action or other public choice problems; you can also get it through Caplan's rational irrationality.

Now, I know Gelman rejects that the expected instrumental benefits of voting are low; he says that an altruist weighs the benefits to everybody else of his voting to make things better and consequently voting passes a rational instrumental cost benefit analysis. But surely if your vote is the decisive one making everybody better off as you see it, it's also the one that makes half the voting population worse off as they see it. And so Gelman's argument fails unless the voter can place himself in an epistemically privileged position: he has to know that he's making the voters who disagree with him better off. And I just can't see how that happens. That half the population disagrees with you at the ballot box ought to make you more uncertain about the benefits of your preferred policy unless you truly have expert knowledge.

Fortunately, we economists often do have expert knowledge about economic policy. Well, maybe not about macro beyond a short list of "don't do these twelve things lest you completely ruin everything". But in micro and applied price theory, we're decent.

I rather liked Gelman's PS:

P.S. Statisticians are special because, deep in our bones, we know about uncertainty. Economists know about incentives, physicists know about reality, movers can fit big things in the elevator on the first try, evolutionary psychologists know how to get their names in the newspaper, lawyers know you should never never never talk to the cops, and statisticians know about uncertainty. Of that, I’m sure.

Straw man rationality

Dan Ariely analogizes:

Here’s one way of thinking about this. Imagine that you’re in charge of designing highways, and you plan them under the assumption that all people drive perfectly. What would such rational road designs look like? Certainly, there would be no paved margins on the side of the road. Why would we lay concrete and asphalt on a part of the road where no one is supposed to drive on? Second, we would not have cut lines on the side of the road that make a brrrrrr sound when you drive over them, because all people are expected to drive perfectly straight down the middle of the lane. We would also make the width of the lanes much closer to the width of the car, eliminate all speed limits, and fill traffic lanes to 100 percent of their capacity. There is no question that this would be a more rational way to build roads, but is this a system that you would like to drive in? Of course not.

Assume rational drivers who have to exert effort to keep a perfectly straight track and with heterogeneous driving ability that affects the amount of effort that has to be exerted to keep a perfectly straight track. Add in random shocks to attention, like a kid that darts out from the side, wildlife, sun glare, a screaming toddler in the back seat or whatever, such that even the best driver devoting full attention to driving occasionally veers from a perfectly straight track.

The drivers are perfectly rational but have constraints. Optimal road design will incorporate things like paved shoulders and buzz lines to give more margin for error and feedback about errors. We could even want speed limits if drivers vary in ability and risk tolerance (both rationally) and if variance in speed contributes to accidents. All of these things build in room for error; without them, driving would be a horribly nervewracking experience: the slightest error could mean death. We'd all have to devote far too much effort to driving. I don't know why we'd need to assume irrationality to get any of the road features that Ariely seems to think can't be explained without it. Rather, I think it's a straw-man version of rationality that insists that we can never err.

What I find amazing is that when it comes to designing the mental and cognitive realm, we somehow assume that human beings are without bounds. We cling to the idea that we are fully rational beings, and that, like mental Supermen, we can figure out anything. Why are we so readily willing to admit to our physical limitations but are unwilling to take our cognitive limitations into account? To start with, our physical limitations stare us in the face all the time; but our cognitive limitations are not as obvious. A second reason is that we have a desire to see ourselves as perfectly capable— an impossibility in the physical domain. And perhaps a final reason why we don’t see our cognitive limitations is that maybe we have all bought into standard economics a little too much.

It's not irrational to err if there are information costs. It's not irrational to use heuristics if there are computation costs. We might sometimes pick the wrong heuristic, but we shift if we find a better one. It's no more irrational to pick the wrong heuristic when there are search costs over the domain of heuristics than it is to buy a car that costs $200 more than the one across town if there are search costs when buying a vehicle. The existence of price dispersion lets entrepreneurs profit by building price comparison websites; heuristic dispersion lets entrepreneurs profit by writing self-help books or working as life coaches.

And it's not irrational for folks to do things in maximizing their own utility functions that would be downright silly if they were trying to maximize mine.