Knowing and Making

If conventional economic theory is so wrong (as we are repeatedly told ) why does it survive so well? This post by UnlearningEcon  prompted me to think again about why economics, despite widely accepted empirical data from behavioural econ, is broadly taught in the same way as before, and why its basic assumptions still underpin much modern research. Some have a sociological explanation for this. In this view, economists are invested in the old approaches, have spent decades honing specific mathematical skills, and effectively collude to make sure new ideas do not displace the old. The top journals only accept papers that cite the same old work, perpetuating the models. Science, as they say, advances one funeral at a time. No doubt there's something to this, but I don't think economists are quite so closed minded. There is a clue in the above article: "...Euclidean geometry, despite being incorrect, is more effective than non-Euclidean geometry in some engineerin...

There has been much talk about microfoundations on the economics blogs in the last few months [ Noahpinion , Mark Thoma , Simon Wren-Lewis   twice , Andrew Gelman   twice , Karl Smith , Paul Krugman   twice , Robert Waldmann , Rajiv Sethi from 2009 ]. The idea of microfoundations is that a model of the overall economy should be consistent with how individual people act. The aggregate behaviour of variables like GDP, government deficits and unemployment should be derived by adding up the choices of individuals, not by treating the whole population as if it were a single entity. (A microfounded model might start off like this: "Imagine N agents, each of which has income y n , consumes c n and saves s n . Then y n = c n + s n . For each agent, s n varies with the interest rate r according to the following relation..." while a non-microfounded model is more likely to start: "Total spending in the economy is C and saving is S. C+S must sum to Y, total income. S varies w...

This New Yorker article about why so many Americans are single reminded me of the debate about unemployment prompted by Casey Mulligan . Here’s why: From the New Yorker: "...do people live alone because they want to or because they have to?" Paraphrasing Mulligan and his critics: “Are workers choosing to be unemployed or are they forced to be?” [actual quotes from Mulligan: " there are sensible people ...who will recognize that 2009 is not the time for them to...commute a long distance to work...[unemployment insurance has] dramatically reduced the costs to them of making this the year they coach junior's baseball team, or do some work on their house, or spend time with an ailing parent" " the market tends to create and allocate jobs for those people who are most interested in working " and " my research has been to examine...changes in the willingness and availability of people to work " versus Dean Baker's " this does not m...

Do you remember those catchy tunes from the late 1980s? I Should Be So Lucky ?  The Locomotion ? The first time you heard them they were quite fun, memorable even. But then they got more airplay. And more. And more. Radio stations figured out that the sugary, bubbly popness of the tunes would cut through a lot of background noise and get your attention, so they played them again and again. Soon we had Got To Be Certain , and Je Ne Sais Pas Pourquoi , which were exactly the same as the first two songs. Then a "strategic inter-agency collaboration" with Jason Donovan on Especially For You . ( Jason looks a bit less lifelike in this alternative version) . After a short interlude in late 1989, another number 1 with Tears On My Pillow , which was meant to be more sophisticated but was equally artificial, overproduced and in fact just the same old song as I Should Be So Lucky . By this time anyone who wasn't a 13-year-old girl was thoroughly sick of Miss Minogue, who wasn...

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. 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).   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 co...

My company Inon, which applies behavioural economics to help our clients set the right pricing strategy, has been nominated for the Smarta 100 - the top innovative businesses in London. If we win, our £10,000 prize will be donated to charity - please leave a comment if you would like to nominate your preferred charity as one of the recipients. If you'd like to support us and your chosen charity, please click here and vote for us . You'll need to register but it only takes a few seconds. Thanks for your support - we have reached 20th in the rankings and it seems like we might have a chance if you can help spread the word.

It seems that some people from outside behavioural economics are, like me, getting frustrated with the lack of progress within the field. Eric Falkenstein says here : I read Kahneman, Tversky and Slovic's Judgement under Uncertainty in the 80's (published 1982), which mainly discussed a series of papers published in the 1970s, and found it fascinating, but now it's now 30 year old stuff and pretty boring. There's a couple hundred academically based confirmed biases which are all kinda true, but not very profound This part of the posting is quite right. A commenter at the bottom sums up the problem with state-of-the-art behavioural "economics": Behavioral economics is not economics but psychology. It focuses on individuals instead of exchanges and markets. Economics makes assumptions about actors to make market predictions. BE makes predictions of actor choices just like psychologists. The question BE must address is how do biases create market conditions. ...

Economics is useful not when it makes broad, one-sided assertions (markets are good; externalities are bad) but when it uses a model to give a firm, quantitative answer to a specific question. What difference will it make to the price in the milk market if one new supplier enters, producing 3 million litres a year? If I buy this piece of land and build a gas station, will I make a profit? What's the optimal price for me to sell my consulting services if I value my free time at £40/hour? Standard economics gives us models which - if we can find the right data to calibrate them - will answer all these questions for us. Behavioural economics does not. It can show us the existence of certain phenomena: hyperbolic discounting, framing and priming biases, misperception of risk, anchoring. But can it answer questions like these? How high a price should I post in my shop window to maximise the benefits of anchoring and minimise the number of customers who are put off from enter...

The blog has been quiet for a while. I can now tell you the reason for this: I've been working on an intensive research project for the last couple of months. The Inon Pricing Research Centre has partnered with three retailers and two major consumer goods manufacturers to carry out the first detailed experimental tests of consumer responses to goods at different numeric price points. Everyone knows - or thinks they know - that prices such as £1.99, £5.99 or £9.99 are optimal price points for retail goods. Customers read the first digit first, and the last two are ignored - or at least, they have much less cognitive impact. In general, consumers were thought to put a subjective value estimate of about ten per cent less on an item priced at £3.99, than one at £4.00. However, despite a wide literature on behavioural economics and marketing, and a number of papers on pricing (for example this paper from Marco Bertini at London Business School ), this effect has not been properly te...

I couldn't make it to Paywall Strategies 2011 today, but it's a subject that's very interesting to me so I thought it was a good time to write about it. The whole question of paying for online news - and other information - combines two of my main research areas. First, it's all about pricing, and one of the most interesting and important new phenomena in pricing at that. And second, because the argument can only be resolved with a deep understanding of cognitive incentives (and disincentives).   In fact, the area of micropayments was one of the earliest case studies I considered when getting into the pricing world several years ago. It's one of the clearest departures from conventional supply and demand dynamics. Here's an example:   13% of people say they would be willing to pay for content online. And yet only 4% do. Why the gap? Yes, there's always a difference between what people say they'll do, and what they actually do. But from experience wi...

Goldman Sachs this week invested in Facebook at the - some say ridiculous - price of $50 billion. Let's imagine for a moment that the price does not reflect the company's fundamentals. Could it still be rational for Goldman to have done this? We certainly don't associate that particular bank with being taken in by market euphoria. Certainly they will make money by providing services to Facebook and other investors [FT, may require subscription]. But they could probably have got the same deal at a lower valuation if they really wanted to. This article  in the New York Times suggests they don't really care if the value's too high, because they will make their money back by exploiting small investors anyway. But they may well care. Indeed, there's a reason they might prefer to pay too much for their stake: it will influence future investors to pay more for the shares. We see in many product markets that the customers don't have any clear idea of the ...

A very strong article here (by Claire Hill, law professor at University of Minnesota) focusing on two principles: how people see the world, and how they value things. Perhaps I like the article because these two points align closely with my model of beliefs and values. The article is one of a number of contributions to Truth on the Market's behavioural economics symposium , but most of the others are entirely different in character to Hill's. The symposium is dominated by strong skepticism about behavioural economics and particularly its application by governments. It's interesting to see the strong feelings that this subject arouses. Among the various contributors there's a mix between resistance to regulation in general, dislike of the assumption of irrationality, insistence that regulators are just as irrational as citizens, and the assertion that people know their own preferences better than any well-meaning nanny-state regulator possibly could. Richard Thaler ...

[ Apologies to X-Factor fans: this article is about "one direction" towards a new model of macroeconomics, not about the band. But do feel free to stick around and join in the discussion. ] If you read nothing but Rajiv Sethi 's and Interfluidity 's blogs, and developed all the consequences of what they said, you'd get a spectacular career in economic research out of it. Fortunately, Mark Thoma reads them - as well as hundreds of others - and has a good commentary on a recent post of Rajiv's . I won't quote the whole thing, but here is the key message. Without the assumption of a representative agent - the idea that everyone in the economy behaves identically - current macroeconomic models can't work. But this assumption misses some of the key dynamics in the economy - the fact that some people borrow and others save; the fact that different people have different beliefs and preferences - which are fundamental to both why and how economic activity...

The BBC covers the potential for behaviour change projects to improve public health. The article mixes up a few different kinds of interventions, though: Classic nudge-style policies: changing defaults, trying to influence social norms. Incentive-based policies: shopping vouchers for dieters. Full-blown regulation: banning branded cigarette packages. The oddest thing about this confusion is the last sentence of the article: The mandatory wearing of seat belts and the introduction of the ban on smoking in public places are two examples where legislation fundamentally altered, and some would say restricted, the choices of individuals. Some would say ??? The last couple of months seem to have seen a surge in mainstream interest in behavioural economics, which is good news - but also quite a few misunderstandings about what it is. Some people understand it better, though - for example the OFT, which has carried out some behavioural experiments and released an interesting report ...

Those who defend rational expectations have some explaining to do, in the face of data like this : ...six in ten Americans think most of the money spent to rescue banks will be lost forever. Six in ten think the economy shrunk over the past year. One in two think federal income taxes have gone up in the past two years. Wrong. Wrong. And wrong. In theory, it would still be possible for rich, sophisticated arbitrageurs to bet against the public in all these areas, and thus bring the overall path of markets back in line with the predictions of any given model. But most of the wealth of the economy is (directly or indirectly) under the control of the people who have these wrong impressions; so I think it unlikely that rational expectations can effectively operate. Especially since the errors are not random, but systematic; Derek Thompson in the article above has five explanations for why this might be. David Laibson gave a fascinating talk on this topic at the Geary Institute on Tuesda...

DraftFCB's Institute of Decision Making is at the SJDM conference too, and tweeting on tag #SJDM if you want to keep up with some of the interesting research results in real time. Today's highlights for me were: Martin Hilbert of USC has built an information processing model which can potentially explain seven different cognitive biases. In the model, external signals are stored in memory; and then retrieved again when required to make a decision. Assume that the channels into and out of memory are subject to random noise, and then place the following two constraints on the noise: first, that there is less noise than signal (i.e. our beliefs are more likely to be close to reality than not) and second, that the noise is symmetrically distributed (unbiased). From these assumptions, we can derive Bayesian likelihood, placement bias, subadditivity, hard-easy, overconfidence and conservatism effects. Martin also predicts a seventh bias which has not yet been observed, which h...

A surprising article on the BBC today, explaining How to get off a busy train . I guess the BBC does have an educational mission. But however obvious getting off a train might be, reading the article prompted a few ideas. The article is mainly about how passengers should behave, but acknowledges the role of the train's design in influencing that behaviour. And some of those design choices are very reminiscent of the "choice architecture" discipline we know from books like Nudge. But this is a problem we wouldn't normally associate with economics at all. It's a product design - or even an architecture - question. So is the domain of Nudge really economics? Or is it in fact design, ergonomics or something else? The stuff of economics is normally about how we allocate our wealth and material resources; about how we respond to incentives; how we trade and deploy limited amounts of capital and labour to produce maximum utility. Design problems, on the other han...