Paste your Google Webmaster Tools verification code here

Economics is doing just fine, thank you, without adopting psychology’s blunders

Economics is doing just fine, thank you, without adopting psychology’s blunders

Criticisms of economics have abounded since the financial crisis.

Even Nobel Prize winners like George Akerlof of Berkeley have got in on the act. A key demand is for economics to adopt a more recognisably human portrait of behaviour in its theories than the rational calculating machine of the textbooks.

Psychology rather than pure economic theory is needed, apparently.

The simple fact is that economics has moved on a great deal in recent years. Much of the success of behavioural economics is based upon incorporating insights from psychology. But economists have done this in their own way.

As top behavioural economist and Nobel laureate Richard Thaler notes in his book Misbehaving: “behavioural economics has turned out to be primarily a field in which economists read the work of psychologists and then go about their business of doing research independently”.

It turns out that this approach seems to have been a very sensible one. Famous psychological experiments have recently been shown to be without foundation.

The most glaring example is the 1971 Stanford Prison experiment, one of the most influential psychology studies of all time.

Students were randomly assigned to be either guards or prisoners within a mock prison. The objective was to observe the interaction within and between the two groups.

The results proved shocking, with the abuse handed out to the prisoners by the guards so brutal that the study had to be terminated after just six days.

There were already doubts about the results. Other psychologists had found them difficult to replicate. But it has emerged this month, from analysis of previously unpublished records and interviews with some of the participants, that results were simply faked.

Another famous study, the so-called marshmallow test, has also been debunked.

In the original research in the 1960s and 1970s, children aged between three and five were given a marshmallow that they could eat immediately, but told that if they resisted eating it for 10 minutes, they would be rewarded with two marshmallows. More than a decade later, in their late teens, it was claimed that the children who had resisted exhibited advanced traits of intelligence and behaviour far above those who caved in to temptation.

But by the straightforward expedient of taking into account the economic and family backgrounds of the children, almost all the differences claimed for the ability to delay gratification disappear.

Ironically, it is economists themselves who have shown that western societies as a whole, not just particular groups, have great difficulty in deferring gratification.

The Chicago economist David Laibson established the idea back in 1997 in a famous paper with the rather gnomic title of “Golden Eggs and Hyperbolic Discounting”. The obscure phrase “hyperbolic discounting” means that people assign a great deal of weight to costs and benefits incurred in the present and very near future, and very little weight to anything beyond that.

Economics may have its faults, but much of psychology seems to be built on sand. Perhaps it is psychology that can learn from economics.

As published in City AM Wednesday 20th June 2018

Image: Experimental Psychology by Interactive Archive Book Images is licensed under CC0.0
Read More

The misguided sugar tax is an ineffectual way to price the externalities of obesity

The misguided sugar tax is an ineffectual way to price the externalities of obesity

One of George Osborne’s last acts as chancellor in 2016 was to announce the so-called sugar tax. This came into force last week, in line with the original timetable.

Drinks manufacturers are taxed according to the volume of sugar-sweetened beverages they produce or import. The tax increases with the sugar content.

The aim is to combat the rise in obesity. The rise has been rapid, and there could be worse to come. The UK tends to lag behind the US, where the spread of obesity has been truly dramatic.

There is no doubt goodwill behind the motives of the sugar tax: a desire to save others from potentially harmful actions. Obesity, for example, shortens lives and is a major cause of diabetes.

But the economic rationale is based on the more austere concept of negative externalities.

Externalities are a key topic in both economy theory and practice. They arise whenever someone’s actions create consequences for others.

An obese person is likely to need expensive healthcare. This generates costs – the “negative” bit – for taxpayers, who are called upon to provide the finance for the public health system to treat the obese (although, of course, the lower life expectancy of the obese may to some extent offset their higher health costs).

It is fashionable in liberal circles to portray the obese as being in some way victims. It is not their fault that they are fat.

In contrast, economics places the responsibility for choices which are made squarely on the individual. It is the individual who acts with purpose and intent in selecting a particular alternative from the ones which are on offer.

It would be just as plausible in theory to assign the tax directly to the obese. Anyone with a Body Mass Index of, say, more than 40 – which is huge – could have to pay for any health costs which arise. In practice, of course, most of them would be unable to afford it.

So will the sugar tax work?

At one level, the answer is yes. Some manufacturers are already reducing the sugar content of drinks, for example, though this may simply switch consumption to brands which retain high sugar content.

Price increases will deter consumption, of course. But there is a large amount of empirical evidence which shows that the immediate impact of any tax like this tends to fall away over a couple of years. The eventual effect is considerably weaker than in the first few months.

A neat recent study by Pierre Dubois and colleagues at the respected Institute for Fiscal Studies offers an even less upbeat view of the efficacy of the tax.

Consumers with high-sugar diets are less sensitive to price changes than people with lower sugar habits. The tax is likely to reduce sugar consumption in the latter group even further, while having little impact on the ones who really need to.

Osborne does have things to be proud of, such as succeeding in creating the impression in financial markets that the coalition government was fiscally prudent. But the sugar tax is unlikely to be one of his best remembered initiatives.

As published in City AM Wednesday 11th April 2018

Image: Sodas by Marlith is licensed under CC by ShareAlike 3.0
Read More

Altruism and information deficits: What snowstorms teach us about economics

Altruism and information deficits: What snowstorms teach us about economics

While weather may not seem like a typical economics topic, there are always interesting aspects to behaviour in any context.

Quite a number of drivers, for example, appear to have ignored notices of road closure. They drove on regardless, until becoming stuck in the snow.

In Greater Manchester, which seems to have been the vortex of the storm, the police had to put out a special appeal on this.

Part of this apparently irrational behaviour was undoubtedly due to sheer stupidity, or even to a lack of basic literacy. But for others, the response may have been more rational.

Almost all motorists will have encountered flashing lights on a motorway to slow down for an “incident” or “debris in road” or some such thing. But a good proportion of the time, the problem has been solved already. The authorities have simply been slow to switch the warnings off.

In short, the experience of motorists leads some at least to doubt the validity of the information provided by the authorities.

How do they know whether they can trust the accuracy of the information when they have been misled in the past? Alternatively, they can choose to believe it, but if it is actually false, they will suffer substantial inconvenience.

So, in the humble context of a “road closed” sign, we see some of the key issues which surround fake news on social media.

On a more cheery note, there have been numerous accounts of stranded drivers being helped by the local community.

A prominent example was in Rochdale, where vehicles were trapped on the M62, in winds over 90mph. One man was offering hot tea to motorists for £1 a cup. He was hardly profiteering. But even so, the volunteers were scandalised – they were providing tea for free.

This altruistic behaviour may seem to challenge the very basis of economic theory. In the popular view, economics sees people acting purely in their own self-interest.

Giving blood is a classic case often used to attack economics. Surely, it is argued, this is pure altruism. Certainly, all the adverts urging you to be a blood donor focus on this motive. Admittedly, you get a free drink and biscuit as part of the process. But the benefits from this can hardly be said to be worth the time and effort involved.

A fascinating paper published by the prestigious US National Institutes of Health in 2014 challenges the view that blood donors are motivated by pure altruism.

The Nottingham University psychologist Eamonn Ferguson did some neat analysis with a survey of blood donors. He examined a range of motivations, but the most important was what he described as “warm glow” altruism.

People who gave blood derived personal benefit from the positive emotional gains associated with donating.

We do not, of course, know whether the motorway helpers were motivated by “pure” or “warm glow” altruism. But economics can find things of interest even in the gloomiest situations.

As published in City AM Wednesday 7th March 2018

Image: London Snow by David Merrigan via Wikimedia is licensed under CC by 2.0
Read More

Mind the gap: Economics is catching up to the fact that we’re not always rational

Mind the gap: Economics is catching up to the fact that we’re not always rational

Do Tube strikes make Londoners better off?

At first sight, the question is simply absurd. The answer is surely “no”.

But a paper in the Quarterly Journal of Economics comes to the opposite conclusion. Cambridge economist Shaun Larcom and his colleagues analysed the two-day strike of February 2014.

They obtained detailed travel information on nearly 100,000 commuters for days before, during, and after the strike.

A key feature of the strike is that nearly half the stations remained open. So most commuters could experiment with routes different to the ones they normally use.

The project may seem barking mad. But it investigates an important issue in economic theory.

Richard Thaler’s recent Nobel Prize for behavioural economics received a lot of publicity. Behavioural economics looks for examples of people making decisions in ways which deviate from those predicted by the rational choice model of economics.

A criticism from the mainstream is that deviations might indeed be observed at a point in time. But over time, they will disappear as people learn to be rational and make the best decision.

The Tube network remains the same for long periods of time. Commuters have many opportunities to learn about it. So almost all of them should use the quickest possible route to work. If someone has just moved jobs or homes, there may be a short period of adjustment. But everyone else ought to have learned the best way to travel.

Yet Larcom and his colleagues find that a significant fraction of London commuters fail to find their optimal routes. They come to this conclusion by comparing the journeys of the people in their data set before and after the strike.

Of course, for many journeys the best route is trivially easy to discover. If you live in Richmond and work in Hammersmith, there is only the District Line. Other journeys have more options. Larcom notes that there are 13 potential ways to travel between Waterloo and King’s Cross.

The authors point out that many decisions faced by consumers are more complex and less repetitive than the commuter problem they analyse. So, in an excellent example of jargon, they state that “our estimate of suboptimal habits may be a lower bound to the problem in other contexts”.

In other words, systematic and persistent deviations from rational choice are an important feature of the real world.

Economists of course like to value everything, and there is a standard way of valuing time. The academics estimate that the time gains subsequently achieved by those who switched routes outweighed the time losses incurred by everyone else during the strike. So Londoners were better off as a result of the strike.

Bizarre though it may seem, the article is a good example of how economics is becoming much more empirical when thinking about individuals’ behaviour and less reliant on pure theory.

As published in City AM Wednesday 15th November 2017

Image: Underground by By Elliott Brown is licensed under CC by 2.0
Read More

Comparison sites are forcing businesses and economists to rethink price theories

Comparison sites are forcing businesses and economists to rethink price theories

The competition and Markets Authority (CMA) published a report about Price comparison sites at the end of last month. They seem simple enough, but these straightforward sites raise interesting issues for economics.

Overall, the CMA was pretty positive about the DCTs – digital comparison tools, to give them their Sunday best name. The conclusion was that “they make it easier for people to shop around, and improve competition – which is a spur to lower prices, higher quality, innovation and efficiency”.

DCTs offer two main benefits. First, they save time and effort for people by making searches and comparisons easier. Second, they make suppliers compete harder to provide lower prices and better choices to consumers. In short, they bring the real world closer to the perfectly informed consumers and perfectly competing firms in the ideal world of economic theory.

But even in this market, there is an issue which goes right to the heart of much of the information which can be accessed through the internet: how do we know whether we can trust it?

The main problem is that the comparison sites typically provide their services free of charge to consumers. They make money by charging a commission to suppliers.

This creates an incentive for a DCT to promote those suppliers which pay it the most commission. An effective way of doing this on the internet is by the order in which the information on the various suppliers is presented.

It is not that DCTs deliberately provide misleading information, or even that a site leaves off a major supplier which does not pay the particular website enough. But they can put those that pay the most at the top of the list.

Notoriously with Google searches, people rarely click through to anything which is not in the top three results of the search.

Allegedly, 60 per cent of the time, only the site which comes at the very top of is accessed.

Obviously on a DCT, consumers are likely to look at more. That is the whole point of using the site. But although the CMA does not provide hard data on this, it expresses a clear concern about the ways in which the sites rank the suppliers.

How the DCTs themselves set their prices raises a more general question for economics. The basic rule, described in the textbooks since time immemorial, is to set price equal to marginal cost – in other words, at the point where the revenue from one extra sale equals the cost of producing that extra item.

The standard assumption made in teaching generations of students their introductory course to economics is that as the level of output increases, marginal cost first of all falls but eventually rises.

But on the internet, once the site is set up, the cost of dealing with an extra user is effectively zero. The time-hallowed formula of economics is a recipe for bankruptcy.

The internet is forcing companies to innovate in their pricing strategies. And it is forcing economists to rethink some of their theories.

As published in City AM Wednesday 18th October 2017

Image: Man and Laptop by Pexels is licensed under CC by 0.0
Read More

Behavioural economics has had its Nobel moment, but take it with a pinch of salt

Behavioural economics has received the ultimate accolade.

Richard Thaler of the University of Chicago Business School has been awarded the Nobel Prize in economics for his work in this area.

Economics over the past 20 to 30 years has become far more empirical. Leading academic journals do still carry purely theoretical articles, but far less than they once did.

This shift towards the empirical takes two forms. Major advances have taken place in the heavy duty statistical theory of analysing large scale databases containing information on individuals and their decisions. This was recognised when James Heckman and Daniel McFadden were awarded the Nobel Prize in 2000.

Behavioural economics is much less technical. In any given situation, the decision which a purely rational person would take is identified. We then look how people actually behave, and see if there are any deviations from the rational way of doing things.

Perhaps the main finding of behavioural economics is so-called prospect theory, first set out nearly 40 years ago by Daniel Kahneman. In essence, prospect theory says that people dislike making losses more than they like making gains of the same amount.

Another important discovery is that, when weighing up how to value future costs and benefits, people often place much more weight on the present and very immediate future than standard economic theory assumes. Last month I wrote about how this helps to explain the reluctance of electorates to deal with climate change.

These two results are backed by large amounts of evidence obtained in a range of different contexts. So now they are being integrated into economic theory.

But many economists are altogether less sure about much of the rest of behavioural economics. One of the issues is that it often gives the impression of being rather ad hoc. No reason is given as to why people in one situation appear to behave rationally, but in another they do not. Very few guidelines have emerged as to when we can expect to see deviations from rationality.

Another issue is that many economists are prepared to accept that non-rational behaviour might be observed at a point in time. But in a reasonably stable situation, people will learn over time to be rational.

Behavioural economics is not just about advancing knowledge on the workings of the economy. Policy-makers have become interested.

Cass Sunstein, Thaler’s colleague, served in the Obama administration as head of the Office of Information and Regulatory Affairs. David Cameron set up the so-called “Nudge Unit” in his government based on Thaler’s ideas. Thaler claimed 10 years ago that a “nudge” could lead to “better investments for everyone, more savings for retirement, less obesity, more charitable giving, a cleaner planet, and an improved educational system”. In his 2016 book Misbehaving, he has backed off the extravagance of these claims.

Still, whatever the doubts and qualifications, behavioural economics has made a big impact. An economist can no longer be said to have a good training if he or she is not familiar with its main themes.

As published in City AM Wednesday 11th October 2017

Image: Richard Thaler by Chatham House is licensed under CC by 2.0
Read More