Ec101: Choices matter!

We’ve, in our Thursday posts this year, learnt about incentives and costs. But, and this is a really, really big “but” – they become operational only when we live in a world where we’re able to choose.

Tyler Cowen and Alex Tabbarok – two people who have probably done more for educating people in economics than anybody else over the last thirty years or so – have written two of the best textbooks on economics available anywhere – one on micro and the other on macro.

In the book on microeconomics, they summarize ten different “big ideas” in economics: incentives, the invisible hand is the best kind of magic*, trade-offs matter, thinking on the margin matters, trade matters, wealth matters, institutions matter, business cycles are unavoidable, printing more money will lead to inflation and central baking is hard.

*I’ve paraphrased practically all of the big ideas, but this in particular is my phrasing, not theirs.

Two other asides before we proceed: in retrospect, it is interesting (at least to me) that at least one of their PhD’s (Tyler Cowen’s) and quite a few of their books are based literally on nothing more complicated than an exposition of these big ideas. There’s a lesson in there somewhere.

Also, they say that the biggest idea of them all is that economics is fun. I’d paraphrase that too: learning about the world is fun, and economics is a great tool to use towards that end.

Now, that allows for a neat segue to the topic du jour. At the very start of the book, even before the table of contents, they provide their definition of economics, one that I agree with wholeheartedly: economics is the study of how to get the most out of life.

Here’s the two word version: choices matter!

Unless we live in a society that is free to choose, at an individual level or otherwise, none of the other big ideas even come into play. So, to me, economics is first and foremost about being free to choose – and then about the benefits and costs of the choices that you make.

Which, I’d argue, means that learning about choices is plenty important. Ergo, this post.

  1. First things first. What is choice?
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    I chose (see what happened there?) this Quora post not because it is the “best”, but simply because it is so typical. Here’s what I think choice is: it is an admission of the fact that you can’t have everything. A particularly relevant example for me: what to eat from a buffet at a five star restaurant? With every passing year, “everything!” becomes an increasingly unrealistic answer. So choose those dishes that are likely to taste the best (maximizing happiness), or those dishes that are likely to cause the least harm (minimizing unhappiness) along some dimensions such as spiciness, oiliness or what have you.
    Or hey, do both at the same time! Choose the dish that is likely to taste the best and the dish that is likely to do the least harm. That’s half your micro paper right there – the rest is just math and diagrams. (I am kidding, of course, but only a little bit.)
    Choice is an admission of the fact that you can’t have everything, but that’s a good thing! It forces you to go with the best. Which paintings should you look at when you’re at the Louvre? “Every single one!” is unrealistic. Force yourself to choose, therefore, the very best of the lot. Constraints help you understand your own tastes better: aesthetics is, among other things, a matter of acknowledging the existence of constraints.
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  2. So having too many choices is a bad thing? It would seem so:
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    “It all began with jam. In 2000, psychologists Sheena Iyengar and Mark Lepper published a remarkable study. On one day, shoppers at an upscale food market saw a display table with 24 varieties of gourmet jam. Those who sampled the spreads received a coupon for $1 off any jam. On another day, shoppers saw a similar table, except that only six varieties of the jam were on display. The large display attracted more interest than the small one. But when the time came to purchase, people who saw the large display were one-tenth as likely to buy as people who saw the small display.”
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  3. But hang on. Of what use is an economics theory that doesn’t have a on-the-other hand angle? Tim Harford, as is so often the case, to the rescue.
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    “But a curious thing happened almost immediately. They began by trying to replicate some classic experiments – such as the jam study, and a similar one with luxury chocolates. They couldn’t find any sign of the “choice is bad” effect. Neither the original Lepper-Iyengar experiments nor the new study appears to be at fault: the results are just different and we don’t know why.”
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  4. And on a related note, have you heard of Herbert Simon and satisficing? This excerpt is from a Wikipedia article on Barry Schwartz’s book, The Paradox of Choice, but it is actually about Herbert Simon.
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    “A maximizer is like a perfectionist, someone who needs to be assured that their every purchase or decision was the best that could be made. The way a maximizer knows for certain is to consider all the alternatives they can imagine. This creates a psychologically daunting task, which can become even more daunting as the number of options increases. The alternative to maximizing is to be a satisficer. A satisficer has criteria and standards, but a satisficer is not worried about the possibility that there might be something better. Ultimately, Schwartz agrees with Simon’s conclusion, that satisficing is, in fact, the maximizing strategy.”
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  5. And the final word goes to Tyler Cowen. Or is it Herbert Simon all over again? Choices, choices.
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    “What if you asked people the following: do you wish to choose your own means of limiting your (subsequent) choices, or do you wish to let someone else, perhaps the government, do the work? I suspect the answers would overwhelmingly favor the former option, namely voluntary choice at the meta-level. And if you reexamine the experiments mentioned above, they are all about ways in which people voluntarily limit their own choices. Maybe you don’t wish to run your own cancer treatments, but you wish to choose the doctor who will.”

 

EC101: Links for 27th June, 2019

  1. “Total Expense Ratio aka TER means cost incurred by a fund house to run a fund. It includes management fee, legal fees, registrar fee, custodian fee, distributor fee etc. The major part of the TER consists of management fee followed by distributor fee. The TER is calculated daily and will be deducted by AMCs on the same day, which means your NAV includes the impact of fees on your fund.”
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    A good article to help you understand how mutual funds make money, what the new SEBI regulations mean for retail investors, and how dependent the mutual funds are (as of now) on the distributor.
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  2. “…Say’s Law provides a theory whereby disequilibrium in one market, causing the amount actually supplied to fall short of what had been planned to be supplied, reduces demand in other markets, initiating a cumulative process of shrinking demand and supply. This cumulative process of contracting supply is analogous to the Keynesian multiplier whereby a reduction in demand initiates a cumulative process of declining demand. Finally, it is shown that in a temporary-equilibrium context, Walras’s Law (and a fortiori Say’ Law) may be violated.”
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    Econ nerds only – and perhaps the even stranger beasts called macro-econ nerds only. David Glasner gives us a view of Say’s Law that may actually be (gasp) Keynesian in nature.
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  3. “Why incentives? Economics is based on the premise that incentives matter. Incentives can help by increasing or decreasing the motivation to take up a certain activity, by changing the cost or benefit of the activity. If someone were to pay John enough for each time he hit his steps goal, he would likely begin walking, perhaps even enthusiastically. After all, health consequences are in the distant future, but cold, hard cash can be given in the present. ”
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    That is from this link – you’ll actually have to download and read the PDF. This excerpt is useful to me because it essentially says that behavioral economics is, well, economics.
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  4. “This view goes something like this – there are no priors (in fact, you discredit experience as being biased – after all you guys have been doing development for decades and we still have poverty and misery in abundance) >> and therefore conventions, latent wisdom, and experience counts for little >> therefore there are no theories >> so we need evidence on everything >> how better to create evidence than look for data >> so let’s do experiments (RCTs) or mine administrative data and understand reality and design evidence-based policies.”
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    Gulzar Natarajan is less than pleased with Raj Chetty’s new course at Harvard (the first item from 23rd May, 2019’s posting), and I am very inclined to agree with his views. Empiricism is slightly overrated today.
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  5. “The Baumol effect predicts that more spending will be accompanied by no increase in quality.
    The Baumol effect predicts that the increase in the relative price of the low productivity sector will be fastest when the economy is booming. i.e. the cost “disease” will be at its worst when the economy is most healthy!
    The Baumol effect cleanly resolves the mystery of higher prices accompanied by higher quantity demanded.”
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    Alex Tabarrok over on Marginal Revolution is on a spree with the Baumol Effect, and having followed his series, I’d say with good reason. It upends several things in microeconomics that we might have taken for granted.