Pathology

I hate it when people say that trying to use micro and game theory approaches to explain how people act are wrong because people don't behave rationally. At least in my own thinking, I always try to make adjustments based off of how people actually act, whether or not that's traditionally rational (if I wanted to I could make a profit based off of knowing people's irrationality).

I explain it by widening the definition of rationality. Given all circumstances, irrational biases, and psychological ticks, you can still get a tweaked rough cost benefit analysis done and explain what people will do. In this framework, the only irrational act would be someone consciously knowing what is best and subconsciously driven to perform one act, yet doing something completely different.

For example, it is known that people are loss averse. The negative effect of a loss is greater than the positive effect of a gain if both amounts are the same. This is something that could be easily quantifiable and taken into account if you knew how loss averse someone was.

I like David Gruen's explanation a lot better however. It seems to take what I'm saying a step further, and think about how this thinking will affect Macroeconomics in the future. Pathologies are the perfect way of injecting irrationality into economics. This sort of thinking does not lead to the conclusion that people are irrational and therefore unpredictable. Rather, the conclusion is a list of pathologies that people, whether in groups or as individuals, fall prey to. It complicates economics, but it doesn't destroy it.

The end of the article is particularly insightful in how economic thinking may change:

In an asset price bubble, Gruen points out, investors expecting to earn 15 or 20 per cent returns on their funds are unlikely to be deterred by increases in official interest rates of half a percentage point.

''If you tighten monetary policy early and the bubble keeps growing, what do you do then? You've managed to slow the economy down, unemployment has risen a bit, and the bubble is still growing.

This sounds like any macroeconomic problem! Business cycles happen when we alternate between trying to control inflation and trying to control unemployment. Pathologies can easily be inserted into macroeconomic problems, and be balanced along with the classic macroeconomic variables.

Read more ...

I'm Smarter Than The New Yorker

This article got me thinking...

The article makes a point against investing in hybrid technology. Their argument is that by making cars more fuel efficient, you essentially lower the cost of driving, which would cause people to drive more. This would negate the positive environmental effects of lowering emissions. However, as someone who would rather see investment in public transit over hybrids, I wish they would have taken it farther.

The article is right in that increasing fuel efficiency affects driving in a similar way as declining gas prices.

But, it's not a simple linear relationship. There is a large chunk of driving that people are going to do regardless, and gas prices affect marginal trips (for example, someone has to go to work everyday, but maybe they'll cut out some errands).

Here is where there is a benefit to increasing fuel efficiency: Lets say prices are at the point where drivers have already cut out most of their discretionary driving (in other words, inelastic demand for driving). These changes in elasticity however don't apply to changes in fuel efficiency. In an environment with inelastic demand, increases in fuel efficiency will always be good, since you'll lower emissions and the resulting lower price of driving will not have that much of an effect on behavior.

The amount someone drives is also not only a function of gas prices, but a function of preferences. Preferences can change. For example, if better public transit alternatives are made available, people will move away from driving without any change in prices.

So, this means that the decision of whether to invest in hybrid technology or public transit can be based off of how people are responding to gas prices. I always thought high gas prices would be better, and would lead towards all sorts of good changes, including moving towards hybrids, but mostly moving away from cars in general and towards public transit.

However, it would be better for prices to stay low! If prices remain low, demand changes a lot with changing gas prices, and increased fuel efficiency wouldn't have that much of an environmental effect.

Read more ...