Tuesday, January 30, 2007

Undercover Economist

From Tim Hartfod:

I am secretary of a local baby-sitting circle, and I have a problem. Members are simply not going out enough - everybody is trying to build up a reserve of baby-sitting coupons. But if nobody goes out, nobody baby-sits and nobody builds the reserve they desire. Should we introduce rules compelling people to go out, say, twice a month?

Yours sincerely,

- Mrs Janine Broughton, Lowestoft



Dear Mrs Broughton,

Your baby-sitting circle is in recession.
This is hardly surprising: you are running tight monetary policy, have constitutionally rigid prices, and suffer severe capital market failures.

You are correct in thinking that as long as everybody is trying to save simultaneously, they will all be frustrated and the circle will never work well. Forcing people to go out and hire baby- sitters will create the illusion of economic activity, but there is no guarantee that your centrally planned solution will be what people really wanted.

A simple fix would be to create a spot of inflation. This worked well for Mr and Mrs R.J. Sweeney, as described in their famous paper "Monetary Theory and the Great Capitol Hill Baby-Sitting Co- op Crisis". If everybody is issued with extra baby-sitting coupons, they will all feel that they have the reserve they need and start hiring each other more freely. The risk is that inflation gets out of hand and too many baby-sitting coupons start chasing too few willing baby-sitters.
An alternative would be to set up a coupon bank that lends coupons out at an agreed rate of interest. If too few people are willing to go out, lower the rate of interest; if there are too few baby- sitters, raise it.

You may wish to establish some kind of committee to decide interest rates.

The value of coupons should also be allowed to float. In winter, when few people wish to go out and everybody is glad enough of a warm evening watching television with other people's children, the value of coupons will rise.

Come the summer, coupons will not buy much baby-sitting. This price flexibility will work better than the most ingenious central banker.

Thanks Tyler Cowen
[AF]

Friday, January 19, 2007

Cognitive Bias and War

Why Hawks Win
by Daniel Kahneman and Jonathan Renshon (in Foreign Policy):

Excessive optimism is one of the most significant biases that psychologists have identified. Psychological research has shown that a large majority of people believe themselves to be smarter, more attractive, and more talented than average, and they commonly overestimate their future success. People are also prone to an “illusion of control”: They consistently exaggerate the amount of control they have over outcomes that are important to them—even when the outcomes are in fact random or determined by other forces. It is not difficult to see that this error may have led American policymakers astray as they laid the groundwork for the ongoing war in Iraq.
...
It is apparent that hawks often have the upper hand as decision makers wrestle with questions of war and peace. And those advantages do not disappear as soon as the first bullets have flown. As the strategic calculus shifts to territory won or lost and casualties suffered, a new idiosyncrasy in human decision making appears: our deep-seated aversion to cutting our losses. Imagine, for example, the choice between:

Option A: A sure loss of $890

Option B: A 90 percent chance to lose $1,000 and a 10 percent chance to lose nothing.

In this situation, a large majority of decision makers will prefer the gamble in Option B, even though the other choice is statistically superior. People prefer to avoid a certain loss in favor of a potential loss, even if they risk losing significantly more. When things are going badly in a conflict, the aversion to cutting one’s losses, often compounded by wishful thinking, is likely to dominate the calculus of the losing side. This brew of psychological factors tends to cause conflicts to endure long beyond the point where a reasonable observer would see the outcome as a near certainty. Many other factors pull in the same direction, notably the fact that for the leaders who have led their nation to the brink of defeat, the consequences of giving up will usually not be worse if the conflict is prolonged, even if they are worse for the citizens they lead.

[AF]

Rubinstein's Freak-Freakonomics

I liked the book Freakonomics (like many) but also wondered at parts whether it was economics or just interesting statistics. Ariel Rubinstein provides a response to the book's popularity in the recent Economists Voice

Chapter 1: is imperialism still alive?
Economists believe that they have a lot to con- tribute to any field—sociology, zoology or criminology. The academic imperialism of economics has something in common with political imperialism. Therefore, I will begin my chapter with a fascinating historical review where we will learn that imperialism stemmed from the perceived superiority of the conquering people over the conquered peoples, and that the role of the conqueror is to disseminate its lofty culture.

From here, I will move to describe Freakonomics as a typical work of academic imperialism. The complex interplay of feelings of superiority and deficiency has driven every empire, and economics is no different. Levitt: “Economics is a science with excellent tools for gaining answers, but a serious shortage of interesting questions”. Freakonomics makes statistical reasoning, which is used in all the sciences, look like a subdued colony of economics. Furthermore, Freakonomics expresses the aspiration to expand economics to encompass any question that requires the use of common sense. ...

and this...

Chapter 2: why do economists earn more than mathematicians?
The chapter is inspired by Freakonomics’ discussion of the question of why “the typical prostitute earns more than the typical architect”. The comparison between architects and prostitutes can be applied to mathematicians and economists: the former are more skilled, highly educated and intelligent. Moreover, just as Levitt has never encountered a girl who dreams of being a prostitute, I have never met a child who dreams of being an economist. Like prostitutes, the skill required of economists is “not necessarily ‘specialized’” (106), so why do economists earn so much more than mathematicians?

Here, I offer a new explanation for the salary gap between mathematicians and economists: many economists are hired to justify a viewpoint. In contrast, I have never heard of mathematicians who proved a theorem to satisfy their masters.

The rest of this article is free to download from the journal's webpage.
[AF]