Clearing my tabs for 2012

During 2011 I have probably spent about four days waiting for my browser to respond, due to the number of tabs I habitually keep open. Between the four computers I use, I probably have 200 blog posts in tabs waiting for me to comment. Here are a few of them (in no particular order), so my Chrome may enjoy a faster 2012.

1. A note from Paul Krugman on what makes economics economics. Not a rhetorical discipline but one based on mathematical models. (However, see also Deirdre McCloskey's Knowledge and Persuasion in Economics, which puts forth a persuasive case that it is both. Also, I believe that rhetoric, culture and all forms of speech will one day themselves be modelled within economics - a tantalising prospect).
    
2. Talking of persuasion, here is Steve Randy Waldman on market monetarism, and whether we can fix recessions by simply persuading people to change their economic expectations, or whether there are real constraints that can't be solved just by monetary easing. I could plausibly have picked any article on his interfluidity blog as article of the year (if I were doing an article of the year), but this quote alone shows more insight than most entire blogs: "Central banks may significantly shape patterns of consumption and investment by choosing to whom they are willing to lend and on what terms. They may pick winners and losers, not for a brief Paul Volcker Chuck Norris moment but for the indefinite future."
    
3. A good overview of Daniel Kahneman's life and work, including the origins of behavioural economics and how Kahneman and Tversky's work has influenced other fields.
    
4. The limits of the scientific method in economics (see also part two): an article whose conclusions I don't agree with, but which asks the right question: can economics model (and predict) the behaviour of people whose behaviour is itself influenced by economics? In answer, Roger Martin claims that we can't use deduction or induction to predict the future, only to model the past; to look forward we must use "abduction", or "invent a new hypothesis". This seems a very nihilistic, not to mention impractical, view. He too calls on rhetoric and postmodernism, but unlike McCloskey, who analyses what those things actually consist of, Martin simply attempts to use them as a get-out clause from the anti-scientific logic of his argument.
    
5. Mark Thoma's more economics-friendly response to the above. His response to Martin's question, pointing out how the field of rational expectations was invented to answer it, and defending economists' work in coming up with new models as the old ones are proved wrong, is much more to my liking.
    
6. An article from the Economist's Blighty blog about behavioural economics - or, more precisely, behavioural social policy and behavioural politics. Despite co-opting Nassim Nicholas Taleb as a behavioural economist - believe me, we don't want him - this piece has some good insights into psychology and why so-called "irrationality" (let's call it "fast heuristics" instead, shall we?) isn't always a bad thing.
    
7. Also from Mark Thoma, a quote from Keynes to the effect that society can only build railways and other bits of infrastructure when it participates in a shared illusion that enables it to invest, not consume, the fruits of its wealth.
    
8. Why values, as well as resources and incentives, are important in economics. As usual, a thoughtful essay by Tyler Cowen, one of the most open-minded writers on the right. I hasten to add that this degree of open-mindedness is also rather hard to find on the left.
    
9. Some excerpts and a review in the New York Review of Books by John Lanchester of Michael Lewis's Boomerang, including possibly the quote of the year: "you have a dog, and I have a cat. We agree that each is worth a billion dollars. You sell me the dog for a billion, and I sell you the cat for a billion. Now we are no longer pet owners but Icelandic banks, with a billion dollars in new assets". I haven't yet read the book itself, but I'm interested in its attempts to explain economic differences - and similarities - by reference to local culture. As Lanchester says, "The collective momentum of a culture is, for more or less everybody more or less all of the time, overwhelming. This is especially true for anything to do with economics". He draws a broadly downbeat conclusion, but I believe the real need - and opportunity - is to analyse what culture is and how it affects economic behaviour - at which point we might be able to figure out what to do about it.
    
10. See if you can boil this FT article about crowds, behavioural economics and neuroscience into nine insightful, factual sentences while ignoring the rest of the silly oversimplifications.

 

Of course, the time I've spent writing this article far outweighs any browser speedup I am likely to earn over the next twelve months - especially taking into account the forty further tabs I will undoubtedly open over the next week. But I hope you've found the links useful in helping waste some of your own valuable time.

What is "playing"?

In between work on some more serious posts (not to mention the day job), let me post a brief comment on Margaret Robertson's article on gamification, "Can't play, won't play". It was written a year ago, so I'm not expecting to provoke an intense debate, but the same argument could easily be made today and it's worth responding to.

In short, Margaret claims:

gamification isn’t gamification at all. What we’re currently terming gamification is in fact the process of taking the thing that is least essential to games and representing it as the core of the experience. Points and badges have no closer a relationship to games than they do to websites and fitness apps and loyalty cards.

Her preferred vision of games is:

Games manage to produce [rich cognitive, emotional and social] drivers by being complex, responsive mechanisms. Games set their players goals and then make attaining those goals interestingly hard.

My involvement and interest in games is much shallower than Margaret's. She's a leading game designer and spends (I imagine) much of her life either playing or creating games. My interest in games is a psychological one - for me, they are a simplified, purified version of the motivations that drive us in real life. They provide a simple domain in which we can either examine, or manipulate and take advantage of, those motivations.

Undoubtedly Margaret, and the millions of other people who have a sophisticated and detailed experience of many different games, would be unsatisfied with the simple games that might keep me happy. Similarly, a novel which entertains an occasional reader may not provide meaning or interest to a literature graduate. But it doesn't mean it isn't a novel.

Margaret doesn't agree. She says:

...there is no way, not one single way, in which [Nike+] is a game.

Her distinction is between "gamification" (creating meaningful choices, which change the way you experience the game or the world) and "pointsification" (adding quantitative measures which simply count up your achievements). But I don't see why this is a category distinction - rather, it is a matter of degree. There are simple games - like Nike+, which helps you measure your progress as you run further and faster each day - and complex, subtle games like, I don't know, Portal or World of Warcraft. They can both provide meaning if the player invests it into them; or they can both be mechanistic, boring processes if you're not engaged.

Perhaps Margaret sees no meaning in the distinction between running 1k and running 5k in Nike+ - but I certainly did, when I "played" it. I was pretty damn proud to get through the 3k and 5k barriers, having started running for the first time a couple of weeks before - and the transformational experience when I first realised I was not forcing my legs to move, but was enjoying running for its own sake, was packed full of genuine meaning. And it would not have happened without Nike+.

So, no doubt advanced gamers have higher standards. They are no longer satisfied with what entertains us neophytes, and they need more advanced games to engage them and provide meaning. But this doesn't mean the games that entertain me aren't still games. My simple points-based achievements fulfil the same psychological role for me as those meaning-laden choices and consequences do for an experienced game consumer. There are degrees of meaning.

I suspect it's easy for an advanced consumer of any art form to forget the simple pleasures that inexperienced consumers get. Once you've seen The Wire it's easy to dismiss Cagney & Lacey. When you learn the subtleties of Beethoven you may not think the Spice Girls are real music any more. If you have translated Beowulf into modern English, the crudeness of Dan Brown is ruthlessly exposed. But the commuter who enjoys Dan Brown on the tube will be left equally cold by Beowulf, until they've learned how to appreciate it.

Games are no different. Until you've invested enough playtime to become familiar with the distinctions offered by the subtler choices and more complex consequences of Minecraft or Skyrim, points, levels and badges still provide a sense of achievement and, yes, meaning, that can be psychologically very powerful.

A thought experiment: why the ECB should print money...

...and why the Bank of England and Fed are right to have done so already.

I'm not talking about whether the European Central Bank should directly buy eurozone government bonds. This causes a moral hazard problem - it might encourage governments to be profligate and reduce incentives for structural reform. It's, at the very least, debatable. I'm talking about a more general question: why should central banks print money in a recession?

This post won't have much new to say to macroeconomists, but it attempts to address a concern of many non-economists - won't printing money just cause more inflation?

First, let's run a thought experiment. Imagine that your national government has decided that profligate use of fossil fuels is a problem. Probably because of the risk of climate change. Instead of using a carbon tax, the government decides to restrict the supply of oil coming into the country. It could allow more oil in if necessary - in fact it has a large reserve stored up for emergencies - but it chooses to limit how much oil its citizens use, by keeping the supply at the level which corresponds to a sustainable quantity of carbon emissions. Aside from this intervention, it lets the market set prices and doesn't regulate who uses the oil or what for.

Over time, people come to know what the supply of oil is going to be each day, and they know how much they use, so prices adjust to the level that balances supply and demand. Most people have a certain "stock" of oil - petrol in their car, oil in their heating tanks, or - for electricity generators - a reserve of oil to run their power stations for a certain number of days.

Suddenly there is a disruption to oil supply. Maybe terrorists start attacking oil pipelines and people start to get very worried about whether they will still be able to get petrol. Perhaps a couple of refineries break down and there's a global shortage of refining capacity. Maybe a couple of petrol tankers explode, and 80% of tankers are taken off the roads for a few months until they can be fitted with new safety equipment. What happens now?

The first thing is, people's demand to hold spare oil reserves will go up. They are aware of the supply risks, and the disruptions to the oil distribution system makes them worry that they won't be able to get petrol when they want it. So people start to hoard oil and petrol. Maybe there are knock-on effects - petrol stations can't get the petrol they need to sell, and some of them might become bankrupt. Probably, the price of petrol would soar. Electricity companies will, if they can, increase prices or reduce the amount of power generated so that they in turn can build up their inventories. Note that all this may happen even if the supply problem is more feared than real.

People try to buy extra petrol to build up a reserve, while still maintaining their normal lifestyle - but they can't, because there's only so much petrol to go around. So there are shortages at the pump - which of course receive national news coverage. The next day, everyone else shows up to fill their tanks - the gas stations run out within a few hours - and the problem gets worse and worse.

Everyone is trying to hoard petrol just in case the next person gets in and hoards it first. Of course oil prices might eventually stimulate new distribution channels or new sources of production, but it will take a while. In the meantime, the economy is seriously disrupted because everyone is forced to use less oil and petrol than they are used to, and the country will probably quickly enter a recession, with high unemployment, reduced GDP - and government deficits following automatically.


What should policymakers do (if anything)?

Even though the government still regards climate change as a serious risk (and let's say voters agree with this concern), there's a paradox: demand is up but petrol usage is down. All the extra demand is for reserves, not petrol usage.


I say the government should gradually release its reserves into the market. This will let people build up their stocks of oil and petrol to whatever level they are comfortable with, and usage will go back to normal. Once this happens, the government can stop releasing the reserves and a new equilibrium will be reached. Petrol stations will get back to roughly the level of sales they had before, electricity companies will get the reserves they need and start generating power at normal levels again.

The story is: a demand has arisen for people to hold more petrol stocks, but not to burn more petrol. The government is the regulator of petrol supply, and has a reserve, so it can open the taps and let people have the stocks they want, without causing any more carbon emissions. Then, if people's worries about supply reduce over time, they will run down the spare petrol stocks, and the government can restrict national supply a little more to balance this out and build up its reserves again.

To get the timing and the supply just right, the government will have to keep a close eye on petrol prices, but that isn't too difficult to do - the market signals are all available. Opening the reserves seems an obvious solution with no real downside.

Now you may have figured out where I'm going with this. In this story, replace "oil" and "petrol" with "money", "national oil reserve" with "central bank printing press" and "carbon emissions" with "inflation". Now we have the story of the financial crisis and the recession.

The government (via the central bank) in normal times deliberately restricts the supply of money to keep inflation under control (interest rates are just another way of doing this). They have a reserve - they can in fact print as much money as they want - but they choose not to use it, because that's their way of managing inflation and maintaining the value of their currency.

When the credit crunch happened in 2007-08 - a couple of banks went bust, so people naturally became concerned that the supply of money and loans was going to shrink. Everyone wanted to hang onto more money, just in case. Banks stopped lending to each other in order to keep more of their money in reserve - and because they were worried that the other banks couldn't repay them. People cut back on spending not because they didn't want as much stuff any more, but in order to keep some spare cash just in case they lost their jobs. And of course, these actions feed off each other - when the whole population cuts spending, people do lose their jobs. When all banks stop lending to each other, they don't end up with more money - they end up with less.

We have a situation where there is high demand for money - not because people want to spend more, but because they want to save more. To stop this from causing a recession, the central bank has to "open the taps" - by printing more money. Normally this would be the equivalent of cutting interest rates - but when interest rates get to zero, it needs to be done in other was.

This will not cause inflation if they only release just enough new money to let people increase their reserves to their new "safety level". And later, when people are reassured and don't need to hold as much spare cash any more, the central bank can reduce the money supply again and/or increase interest rates to soak up the money back into the reserve.

Just as with the oil reserve, there are different ways of doing this. The government could give out petrol directly to individual households. Or it could sell it to the oil companies (at market prices) and let them sell it on - this would probably result in it going more accurately to where it's needed, but the oil companies would make a profit too, so it might not be politically popular. No doubt you can see the parallel again - some people would like the central bank to just give money directly to citizens, but instead they normally do this by "selling" money to banks (by buying government bonds from the banks) and let the banks lend it out, again making a profit. This is a more economically sound way of getting the money to where it's needed, but the banks will make a profit on it - because distributing money is, after all, their business.

If the political situation calls for it, perhaps the government will impose a windfall tax on the oil companies/banks to compensate for the extra profits they are deemed to have made while helping to solve the problem.

It turns out the Federal Reserve, Bank of England and Bank of Japan have been doing just this throughout the last few years. While it hasn't resulted in those economies returning to full health, it has probably helped stop them going back into recession. Many economists think they just haven't released enough reserves, and should do a bit more; though there is also an argument that some of the economic slowdown would have happened anyway, while the economy rebalances away from housing and finance, towards other industries.

The one major central bank that has not done it is the European Central Bank. They have cut interest rates - though probably not enough - and loaned a bit of extra money to some of the banks to tide them over (imagine giving the petrol companies enough extra reserves to help them stock up their spare petrol tankers, but not enough to satisfy the demands of the population itself).

And now there's a new twist: imagine that eurozone governments themselves use a lot of oil (money), and now they can't get enough petrol (money) to fuel their own operations. With petrol (money) prices soaring, some of them have used up their internal reserves and may have to shut down some of their operations. This in turn would cause more problems for the economy, making things even worse for the citizens who are short of both oil (money) and the government support they partly rely on.

The ECB's job now is to open the reserves. An infusion of money into the Eurozone would help cure the capital problem that the private banks are suffering from, restoring economic growth and automatically improving the financial position of Eurozone governments. It would help prevent or soften the recession that is currently expected in Europe, making it more likely that Italy, Spain and Greece will be able to finance or refinance their debts, which in turn will let them borrow at more reasonable rates.

The ECB does not need to buy the bonds of those countries directly, if it is concerned about setting a bad precedent - just as the oil reserve would not need to be issued on credit to unstable petrol companies. Just increasing the supply to the good companies (good banks, creditworthy eurozone countries) will have a knock-on effect on the others.

Because the problem has been allowed to get this bad, there is now a risk that the money (petrol) will not get to where it is most needed. To help fix this, other steps might be needed. In the petrol scenario, the government might part-nationalise some of the weaker petrol companies, or subsidise investment in new pipelines to make sure the petrol gets to all parts of the country. In the Eurozone, some big capital investment programmes in southern Europe might be a better way to distribute money than simply giving it directly to the Italian, Portuguese or Greek governments. But these are less important than the emergency response.

It's time to open the taps - or as Doug Saunders put it the other day: Mr Draghi: TURN ON THAT PRINTING PRESS!

Does Nudge require regulators to be "more rational" than consumers?

A couple of times recently - notably in Bill Easterly's otherwise very positive review of Daniel Kahneman's new book - I've seen the following common critique of Nudge-style approaches: "But if people are irrational, regulators are irrational too - so how can they make rules to counter citizens' irrationality?" Easterly says:

But [the case for libertarian paternalism] is much too sweeping, because it overlooks everything the rest of the book says about how the experts are as prone to cognitive biases as the rest of us. Those at the top will be overly confident in their ability to predict the system-wide effects of paternalistic policy-making...

While it's right for regulators to be humble about their degree of knowledge about the world, and to be cautious in creating new regulations, there are several reasons why this particular criticism is wrong.

First, we are not comparing like with like. There is no claim that a regulator, when placed in the same situation and making the same decision as a citizen, will come up with a better answer. Instead, we are looking at times when citizens make snap decisions without thinking them through - or, often, make no overt decision at all because they do not notice that there is a decision to be made. In these cases, the regulator's goal is either to say "what would the citizen decide if they did think about it carefully?", or even better, to encourage the citizen to make the effort of thinking it through themselves. If the answer to "what would the citizen decide?" is controversial or ambiguous, the regulator is unlikely to try to intervene.

Second, everyone specialises in something. A lawyer specialises in the law - I wouldn't expect them to be better at making business decisions than me, but where my business decisions have legal ramifications I'd like to have their input. A doctor does not know better than me what I should choose to eat for dinner, but they can give me useful information to help me pick the foods that are right for me. And similarly, somebody who spends their professional life thinking about decision-making and examining the extensive research in this field is likely to be able to help me make decisions that I'll be happier with.

Third, even if regulators are not perfect, a best-effort regulation may well be better than none at all. The absence of regulation does not mean the absence of nudging. As Thaler and Sunstein point out in Nudge, our decisions are going to be influenced by context, framing and defaults no matter what. If the government takes no part, then the influences will be random, or chosen by private companies (whose interests are sometimes opposed to mine, though not always). If a democratically accountable government can help to move from one default frame to another that is more likely to be in my interest, then why would I not prefer that one?

There are people who read public choice theory as implying that most government policies are likely to be corrupt and wrong-headed. These people may well oppose Nudge-style regulations as they oppose most other regulations. But I think that view is not a mainstream one.

Indeed, mainstream economics has a clear place for regulations - where the action of a private party imposes an unpriced cost or "externality" on others, an appropriate regulation will actually make the market function more like a genuine free market, not less. One could argue that the framing carried out by private companies acts as an externality by imposing hidden costs on the consumer - in which case a better market outcome will be achieved by reversing these frames.

Finally, Nudge policies are designed to be optional. Anyone who does not trust government to provide a default which is in her own interest is welcome to ignore the government's recommendation and make her own choice. Those who would prefer to make the tradeoff of trusting the government's (carefully researched, democratically supervised) recommendations can simply take the default and save themselves the effort of thinking it through, and reduce their risk of making a mistake.

Easterly certainly raises an interesting challenge for behavioural research: the "system-wide effects of paternalistic policy-making" are indeed not well-understood. The fact that the policies are optional for the citizen is (I suspect) likely to mean that the system exhibits stability rather than instability, with any effects of Nudge regulations being damped rather than amplified by the interactions of the system. But it's not certain yet. My own research focuses partly on this area, as I think it's important to find out how a more accurate picture of human behaviour, scaled up to the systemic level, will affect our understanding of how markets work.

I notice that I have written on this subject before, so I'll finish by quoting myself:

We don't expect aeronautical engineers to be immune from the law of gravity. Yet we still trust them to design planes that can help us transcend our own gravitational problems.

Prompted Pareto improvements

I'm going to attempt to introduce a new concept here. It is a bit technical, but I'll try to provide background for non-economists first. I may indulge in some modelling to help me understand it better, so if that's not your thing, feel free to skip the equations and just read the words.

I'm also struggling for the name of this concept. The title of the post, "Prompted Pareto improvements" is a name I'm reasonably happy with, but catchier suggestions are welcome.

I'll start by explaining the idea of Pareto efficiency and a Pareto improvement. There's lots of information at the Wikipedia page if you'd like to know more.

Pareto efficiency is one of the standards that is often used in economic theory as something we should aspire to, because it is a standard almost nobody can disagree with. It means that we should consider any transaction, or change in an economic allocation, to be a good thing if it makes at least one person better off and nobody worse off. A transaction which meets these criteria is called a Pareto improvement, and a system in which no possible Pareto improvement can still be made is called Pareto optimal.

It is intuitively problematic in two ways, however. First, because it's hard to achieve. In practice, there are always still opportunities to improve the world, so we are never really at a Pareto optimum. Second, it demands an unlikely level of respect for rich people. Accepting this as our standard yardstick of economic goodness implies that if we could take one dollar from Warren Buffett to cure malaria and hunger, we should not do it. Even though billions of people would be better off, Warren would be a dollar worse off, so this is not a Pareto improvement.

I imagine that most people who have studied economics have wondered whether this is a good principle. It has the appeal of removing all coercion from the economic system: people only take an action if it benefits them. Thus it seems that nobody should object to a Pareto improvement.

One can certainly debate whether it's legitimate to tax Warren Buffett to make Youssou, Mike and Mary better off; strict libertarians would probably say no, while most utilitarians would say yes. Traditional economics sidesteps this question and asks what is the best we can do without such coercion.

I don't want to go into the utilitarian question right now. What I want to explore is the borderline. Why is Pareto efficiency not a useful standard in practice? The two reasons I gave above can be looked at in a single framework.

Start with the second problem: the billionaire who can solve hunger. The take-a-dollar-from-Warren example is an extreme case, but one can imagine lots of situations where a very small cost to a wealthy person would make a huge difference to one or more poor folk. Wealth need not be defined only by money: the same might apply to bone marrow or knowledge, where recipients can gain much more than the donor gives up.

Some cases are so close to the borderline that if we point out the situation to Warren, he may well voluntarily give up his resources to help the person who needs them. Without the reminder, it doesn't occur to him to seek out someone who can use the dollar better than him; but if we do the seeking and tell him about it, he will probably be amenable to a deal. In the conventional model, we could say that his preferences simply change when he gains more information about the situation: his preference for compassion then outweighs his preference to retain one extra dollar.

However this assumes away everything interesting about the problem. If we simply posit that preferences can change, then almost anything can happen; the model becomes too general to be useful. In any case, even traditional economics requires preferences to be stable - it doesn't allow them to change when new information becomes available.

There are several more useful ways to look at this situation:

• the preferences for compassion change
• preferences are not a constant, but a function applied to context. When the context changes, the effective utility value of the preferences change.
• preferences are over a set of objects within the world that we know about. When the world we know about changes, we re-optimise over our newly learned preferences
• attention is limited and we only make decisions within the scope of our current attention. A new message can shift our attention, and a decision becomes available which was not possible before.
• the information itself creates a new preference; in the same sense as being told the first line of a joke creates a desire or demand to hear the punchline.

Regardless of which of these explanations is closest to accurate, we can certainly imagine a situation where Warren does not make a particular exchange when unprompted. However, when told about the consequences of the exchange for the other party, he chooses to make it.

I mentioned another reason why a Pareto optimum is never achieved - practicality. There is no realistic way to get to a Pareto optimum because we cannot know all the trades that are available in the world. There are probably many things I would want to buy or sell right now, and people who would willingly sell them to or buy them from me - if only I knew who they were, what was on offer and why it would benefit me.

We can look at this in exactly the same way: if I were prompted with the right information, I would choose to make the trade. Lack of information is what prevents us reaching a Pareto optimum.

The consequences of introducing this concept

So let's imagine we introduce the idea of a "prompted Pareto improvement". A trade between two parties which both parties would willingly make if they receive a certain piece of information, but without that information they do not proceed.

If this concept finds its way into our economic models, what does it allow us to do?

First, it broadens the range of economic transactions which are permissible. This may raise the welfare of the society we are studying (depending on our definition of welfare).

Second, it starts to suggest how we could incorporate the transmission of knowledge into our models. There is little place for knowledge in the main general equilibrium models of the economy. But surely in reality it is one of the most important factors that controls economic behaviour and welfare. Not just explicit knowledge - the possession of intellectual property, or knowing how to write a Java program - which has economic value. But tacit knowledge of the choices we have and the chance they'll make us happy.

How far should we bend the rules?

Can we say that giving ANY message to the individual is permitted? Imagine you told Warren that you had kidnapped his daughter and would kill her if he doesn't give a billion dollars to buy malaria nets. No doubt his preferences would be changed, but on the basis of a false picture of the world (I'm assuming you have not actually kidnapped his daughter. If you have, please contact me and I'll correct this post). But I am loth to add a condition that the information must be "true" - because of the difficulty of defining what that means. Indeed, many messages will have no defined truth value (like "I suggest you go onto the following website...").

Passing a message of this kind would have consequences. Presumably you would be arrested; giving the message in itself would therefore result in a diminution of your utility. Thus you would become a party to the Pareto transaction, and your interests would need to be considered in whether it is a permissible transaction.

This is an unusual case. But it highlights a factor we will have to consider: the provider of information may incur a cost to provide it. A more straightforward example than the above is if A wants to sell a product to B, but in order for B to know it is available, A must pay to advertise it.

Another relevant example may be the threat of force from the legal authorities. In a typical economic model, payment of an income tax is not a Pareto transaction, as the taxpayer does not benefit from it and does not choose to participate. However, most self-employed people pay tax not because they are physically forced to, but because of information that has been communicated to them about the consequences if they don't. The communication of this information affects the choice that the taxpayer makes, even though they never actually suffer the consequence.

More generally, it is logical to suppose that people do not form preferences without receiving information. Some information is directly received by experiencing a product, some is communicated from other people.

With all these interesting factors, how might we design a tractable and useful model?

What we'd need to model to include information in our view of the world:

• State K of knowledge of an agent (setting aside the question of whether this "knowledge" is all true)
• Message M which can be received by agent A and will alter K

There exists some M which can be received by A which will induce A to choose to make an exchange of goods with agent B.

We can define three different kinds of improvement:

• One-sided prompted-Pareto improvement (if B prefers the new allocation unprompted, but A needs prompting).
• Two-sided prompted-Pareto improvement (if both parties need prompting).
• Zero-sided prompted-Pareto improvement (an ordinary Pareto improvement without any prompting)

Questions to think about:

• does B know what the message M is?
• does A know what the message M is?
• is there a cost to transmitting M?
• does M depend on source, timing, other context as well as content?
• can there be messages N which contradict M? What if multiple messages affect the preferences differently?

 Finally, what might be the generalisations of a Pareto optimum?

1. An unprompted Pareto optimum; where no pair of agents wish to make an unprompted exchange
2. A prompted Pareto optimum; where every possible prompted Pareto improvement has been made (does this mean they have all been prompted? Presumably yes)
3. An intermediate optimum, where every improvement that has so far been prompted has been made, but other prompted Pareto improvements are still possible

These are nice, elegant concepts but they ignore some of the more difficult questions listed immediately above.

What are the consequences?

We are able to start constructing an economic model where information flows are explicitly modelled and their effect on preferences can be understood. To be useful, the model will certainly need to make further assumptions about the relationship between information and preferences. For example, might preferences for goods be made up by composing different product benefits along with some knowledge of how they will satisfy other pre-existing preferences?

It will give us a richer understanding of a real world in which traditionally Pareto efficient outcomes are not reached.

It will allow us to see how a system can get closer to Pareto efficiency - or whatever standard of welfare we decide is appropriate - by becoming more open to the flow of messages that can more effectively allow people to make welfare-maximising choices.

Just as conventional economics has a standard of allowing the maximum voluntary exchange, cognitive economics could develop a standard of maximum information transparency, which in turn would improve the operation of voluntary exchange in practice.

"Maximum transparency" is only, of course, a theoretical goal - no more realistic than "perfect information" in the neoclassical model. Passing messages has a cost. So a model which lets us see what types of information unlock Pareto-improving transactions will help determine what kind, or amount, of information, should be passed. No doubt there will be an indifference point at which the marginal cost of providing one more piece of information will outweigh the marginal benefit from enabling one more Pareto improvement. What will that point look like?

Is this original?

Finally, I would welcome anyone more familiar with the information economics literature than I to say whether this concept has been examined already. Greenwald and Stiglitz proved that a Pareto optimum cannot necessarily be reached when there are information asymmetries; and I am aware of the idea of a "constrained Pareto optimum" which is the best that can be achieved given a certain state of information held by agents. The idea of a prompted Pareto improvement may help to solidify those concepts and provide a more useful framework to implement them in practice.

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Has the nature of investment in the economy changed?

I may have more to say about this in the next few weeks, but this New York Times article about industrial policy reminds me of a question I asked on twitter the other day:

...hedge funds and venture capitalists are geared toward investing in financial instruments and software companies. In such endeavors, even modest investments can yield extraordinarily quick and large returns. Financing brick-and-mortar factories, by contrast, is expensive and painstaking and offers far less potential for speedy returns.

This might not just be a change in investors' preferences. (Although if they have decided they prefer fast returns over slow ones, I don't know that I'd criticise them for that.)

What if something deeper has happened. In the late 1940s and early 50s, macroeconomic trends were fairly clear: Europe was on the verge of a major recovery, and American growth was likely to continue. In conjunction with this, we could predict with some confidence what people would want to spend the proceeds of that growth on. Most people would want cars, houses, refrigerators and TVs.

Therefore it was fairly clear that you could make decent money by investing in factories to build cars, refrigerators, TVs - or on land in Western Europe where houses would be built. Which is fortunate, because those are long-term investments. It takes several years to build a car factory and longer to build all the related distribution infrastructure - but that investment would keep paying back into the 1970s and even 80s - thirty years out.

Today, the macroeconomic trends are still fairly clear - China and India will get much richer over the next twenty years, while the Western economies and Japan will grow more slowly, though there will still be plenty of consumer demand there.

But it looks like consumer preferences are changing much faster than fifty years ago. The thirty-year predictions we could make in the fifties would be crazy to make now. I have no clue what consumer goods or services people will want to buy in 2041.

Of course there will still be cars and fridges on sale. But those will earn lower margins than in the 1970s, and if you don't already run Toyota or LG, it's almost impossible to invest profitably in that market. Anything that takes ten years to build, when we have no idea what consumers will want in ten years, is a losing investment.

So is it any surprise that investors turn to software - which, although it is also kind of unpredictable, at least turns around quickly. You will know in 18 months whether your bet has paid off. And if it pays off, it pays off big - the returns are quick, high, and disappear in a few years.

Presumably there are some long-term physical investments that look sensible - the car battery plants in the NYT article seem to be one example - but will the current investors be able to capture the returns, or will they be competed away as employees move around and patents expire?

Maybe this is what investment looks like now - short-term, individually risky but diversified via venture capital portfolios - instead of long-term and (relatively) low-risk via stockmarket holdings. You can make a long-term investment out of lots of short-term VC stakes, rolling them over when they mature; but that's a model that most investors are probably not willing to get involved in, except via shareholdings in the occasional company like Google which can afford to operate that kind of product development model in-house. Perhaps those who want to invest for the long term have no real choice but to buy government bonds.