Tim Harford The Undercover Economist

Articles published in January, 2011

Why we do what we do

Behavioural economics has never been hotter. It’s not just the success of books such as Nudge, Predictably Irrational and Basic Instincts, but the political influence of the field: one of Nudge’s authors, Cass Sunstein, runs the Office of Information and Regulatory Affairs for Barack Obama, and his co-author Richard Thaler has been advising David Cameron’s new Behavioural Insight Team, based in the Cabinet Office.

A simple summary of behavioural economics – I’ve borrowed this one from The Guardian – is that it is the study of “how people actually make decisions rather than how the classic economic models say they make them”. But this approach is now under attack, from Gerd Gigerenzer, a psychologist, and Nathan Berg, an economist, and they argue that behavioural economics is not nearly as realistic as its boosters claim. While it does study what decisions we make, the very last thing it does is study how we make them – and as a result it is even more wedded to silly accounts of the way human beings think than its neoclassical rival.

Neoclassical economics has often relied on the “as if” defence, published in 1953 by Milton Friedman, who argued that while people don’t actually solve complex neoclassical optimisation problems in real time, they still behave as if they do, somehow making rational decisions thanks to a combination of experience and cognitive short-cuts. But economists have been strikingly incurious about what those cognitive short-cuts actually are. Gigerenzer is not.

Behavioural economists point out cases in which our decisions don’t match neoclassical theory, and thus the “as if” defence fails. But Gigerenzer and Berg complain that behavioural economists have retained the neoclassical incuriosity about why we act as we do. Instead, they have modified the neoclassical model until its predictions fit our observed choices, and then fallen back on the same “as if” story.

Consider the human response to risk. Neoclassical economics says that we act as if considering all possible outcomes, figuring out the probability and utility of each outcome, multiplying the probabilities with the utilities, and maximising expected utility. Clearly we do not in fact do this – nor do we act as if we do.

Behavioural economics offers prospect theory instead, which gives more weight to losses than gains and provides a better fit for the choices observed in the laboratory. But, say Berg and Gigerenzer, it is even more unrealistic as a description of the decision-making progress, because it still requires weighing up every possible outcome, but then deploys even harder sums to produce a decision. It may describe what we choose, but not how we choose.

Gigerenzer prefers to look for actual decision processes. Take the simple act of catching a ball in flight. The spirit of neoclassical economics would say that people act “as if” swiftly calculating the parabolic arc of the ball. The spirit of behavioural economics would explain dropped catches with references to some systematic errors in the way we perform that calculation. But in fact, ball-catchers use a cognitive shortcut called the “gaze heuristic”, running forward and back while keeping constant the angle of sight up to the ball as it descends. No amount of “nudging” towards faster differential calculus will help prevent dropped catches.

This is tough on behavioural economists, because in order to be taken seriously by other economists they have had to play the optimising game. Switching to Gigerenzer’s rules would mean the end of economics as we know it.

Yet the critique is sobering. If behavioural economists do not really understand why we do what we do, there are surely limits and dangers to the project of nudging us to do it better.

Also published at ft.com.

“Are the economists on drugs too?”

If you enjoyed today’s Outside Edge from a rationally alcoholic tramp, you may enjoy my lunch interview with Gary Becker, Nobel laureate and co-founder of the theory of rational addiction.

And here’s a more subversive take on the theory – not safe for work:

Welcome to boss-onomics

“What upsets me about the job? Wasted talent. People could come to me, and they could go, ‘Excuse me, David, but you’ve been in the business 12 years. Can you just spare us a moment to tell us how to run a team, how to keep them task-orientated as well as happy?’ But they don’t. That’s the tragedy.”

The Office’s David Brent understood that management mattered – and he proved it every day. Yet the academic discipline of economics has surprisingly little to say about the practical discipline of management.

John Van Reenen is an economist who wants to change that. Professor Van Reenen, director of the Centre for Economic Policy at the London School of Economics, recently delivered the Royal Economic Society’s annual public lecture in Manchester and London. It carried the title “Boss-onomics”; its message that management quality can be measured and does make a difference to the performance of a country’s economy.

Van Reenen and his colleagues have been using a double-blind interview methodology to evaluate the quality of managers. MBA students will call middle-managers on behalf of the research team and have a 45-minute chat about “lean manufacturing”, with open-ended questions such as, “say that a worker had been with you for a year, how would you go about considering his or her promotion?” The managers are unaware that the discussion is being marked on a variety of criteria; the MBA students doing the marking have no prior knowledge about the financial performance of the company in question.

The team has now completed more than 8,000 of these interviews across the world. Low scores are awarded to businesses with poor inventory management, nonexistent performance tracking, tenure-based promotion and other management practices from the dark ages.

The headline finding is that the average management quality of a country’s manufacturing businesses is closely correlated with labour productivity – output per worker per hour. Labour productivity itself explains much of the gap between rich and poor countries. As Van Reenen put it, the typical Tanzanian worker produces in a month what the typical American worker produces in a day, even given the same equipment.

The UK, despite progress since 1997, is not home to the best-managed companies – it heads the chasing pack behind clear leaders in the US, Japan, Germany, Sweden and Canada. Van Reenen has some ideas to fix that.

Competition policy is one obvious lever: the UK doesn’t lag behind the US because it has fewer excellent firms, but because it has more terrible firms. Such terrible businesses can only thrive if competition is weak – a theoretical result that Van Reenen has also shown to be true in practice.

Another weak spot in the UK is the prevalence of family-managed firms. It is still quite common to hand the chief executive’s role to the oldest son in the UK, and management quality tends to suffer as a result. Van Reenen argues that family firms should not be exempt from inheritance tax, because the government shouldn’t be offering tax breaks which encourage badly managed firms.

There is also the possibility that the government could try to improve management quality directly. Britain needs better apprenticeship schemes, and the scrapping of the Education Maintenance Allowance looks insane.

But civil servants themselves should refrain from handing out management advice: government-run companies rank right at the bottom of management-quality tables. David Brent is alive and working in Whitehall.

Also published at ft.com.

Outside Edge: Priced out of an alcoholic stupor

“Supermarkets will no longer be allowed to sell alcohol as a loss leader under minimum pricing measures expected to be announced by the government on Tuesday. The UK coalition has been looking into minimum pricing to tackle alcohol abuse.” (Financial Times, January 17)

I wasn’t always an alcoholic tramp. I am a man of letters. I studied Philosophy, Politics and Economics at Oxford, like that David Cameron fellow. But when I looked at the options open to me – over-worked banker, castrated civil-servant or, worst of all, parliamentarian – I decided that the optimal course of affairs would be to begin building up my stock of addictive capital.

I don’t want to romanticise life as a rough-sleeping bum. It gets cold and lonely. I’m not sure what is keeping my underpants together, though I’m sure they wouldn’t survive contact with suds and warm water. But my boozy existence has a cool, calculating logic. I know that seems odd, but thankfully Gary Becker and Kevin Murphy, two of the University of Chicago’s most celebrated economists, have worked out the details in their theory of rational addiction.

For sure, not everything is perfect. But I’m a rational addict; a utility-maximising old soak. I drink because it makes sense to do so – by following an ex-ante optimal inter-temporal consumption plan, as they say. Speaking of which, let me crack open a bottle of strong cider … that’s better.

Where was I? Oh yes: you see, every drink I have contributes to my stock of addictive capital. I feel bad if I drink, but I feel worse if I don’t. Alcohol thus acquires what another drinking buddy once told me was a negative own-price elasticity across time. Put another way: Fred Astaire is a complement to Ginger Rogers; strawberries are a complement to cream; and Special Brew on your cornflakes today makes it quite rational to want to have even more Special Brew on your cornflakes tomorrow.

But I digress. The real problem for we rational drinkers is that, even if you don’t buy the idea, the evidence that people drink less when the price goes up is pretty strong. Even cirrhosis of the liver falls when liquor duty rises. So I’m in a bit of a state about these plans to put a floor under the price for booze. Admittedly, it’s not much of a floor, but it’s the thin end of the wedge. (Forgive the mixed metaphors. I am drunk.)

It isn’t that I’m cheap, or not just that. It’s that these plans threaten to impinge on my optimal consumption path. For a rational addict, every swig of Smirnoff planned for tomorrow reinforces the case for drinking Smirnoff today. I’m sure I don’t need to spell out the corollary: if prices will rise in the future, the time to quit is now.

This isn’t what I wanted, but when prices change, so does the optimal response. So I’m drying out, with immediate effect. I’ll get a job. I wonder if Mr Cameron needs a fresh voice on the frontbenches?

The writer is a recovering economics commentator

Also published at ft.com.

Two events at Warwick University

Warwick Economics Summit Friday 18th Feburary 2011, evening

TedX – Warwick Saturday March 5th, Late morning

Do come along if you can!

When aid doesn’t help

It was, according to a report circulated by Associated Press, “the year the Earth struck back”. Natural disasters killed a quarter of a million people or more in 2010, the worst death toll for a generation.

Most of the deaths, of course, were in and around Port-au-Prince in Haiti almost exactly a year ago, but there were other tragedies. The floods that began in Pakistan in July affected 20 million people – one-fifth of the country was underwater at the height of the flood – and controversy quickly followed as Oxfam complained that the international response had been far slower than in comparable disasters.

The issue was complicated by the fact that distributing emergency aid in such conditions is a ferociously difficult problem: aid can be stolen, stoke tensions within communities, or damage local markets. Pakistan’s reputation as a haven for terrorism became an issue: some have speculated that the flow of aid was constricted by it (the fact that the country is a byword for corruption is more likely to have been a problem) while Pakistan’s foreign minister Shah Mahmood Qureshi appealed for funds by saying that the disaster was “an opportunity for the terrorists”.

No wonder my eye was caught by a new World Bank research paper written by Tahir Andrabi and Jishnu Das. They studied the psychological impact of an earlier tragedy in Pakistan: the Kashmir earthquake of 2005, which killed about 75,000 people. Their conclusion was that humanitarian assistance from abroad had a lasting positive impact on local attitudes to foreigners.

The methodology is interesting because foreign aid is one of those areas in which evidence of what works and why is hard to gather: it is hard to carry out a controlled experiment in such matters.

However, the sheer randomness of the earthquake itself produced what economists call – rather chillingly, in this context – a “natural experiment”. The region is crisscrossed with 54 fault lines, only one of which happened to shift, with awful results. There was a strong connection between a family being close to the active fault line and losing a family member or suffering the loss of their home. Damage to schools, health centres and the water supply was also very closely related to proximity to the fault line. And so, crucially, was the appearance of the United Nations or other foreign providers of aid.

Villages unfortunate enough to be close to the fault line were highly likely to suffer severe damage, then, and also highly likely to be exposed to foreigners offering help. (The Pakistan army was ubiquitous both near the fault line and further away, and militants were very thin on the ground.) According to a detailed survey conducted by Andrabi and Das in 2009, trust in foreigners was much higher close to the fault line than elsewhere; other measures of trust, including trust in locals, did not seem to change. The effect was also substantial: around two-thirds of people on the fault line said they trusted Europeans and Americans; only around one-third of those living 50km away had the same view.

This is a striking result, although it will be awkward news in some quarters. Christopher Stokes, general director of Médecin sans Frontières, complains that politicisation of the flood relief effort in Pakistan has been damaging. In an article penned for the Foreign Policy website in October, he decried the notion of “politically useful” aid. He wrote, “winning the trust of all parties in a conflict and gaining access to the affected population depends on being understood as purely humanitarian”.

In short: help people because they are people, not because you hope it will make them like you. Effective disaster relief may indeed win hearts and minds – but if its recipients begin to suspect they are pawns in a public relations game, effective disaster relief will be all the harder to provide.

Also published at ft.com.

What we can learn from a nuclear reactor

Hinkley Point B is an ageing power plant overlooking the Bristol Channel. The location was once designed to welcome visiting schoolchildren, but is now defended against terrorists by a maze of checkpoints and perimeter fencing. At the heart of the site, which I visited on a mizzling, unseasonable day in late July, looms a vast grey slab of a building containing a pair of nuclear reactors.

Hinkley Point B began operating shortly before the doomed TMI-2 reactor at Three Mile Island in Pennsylvania, US, and is due to be decommissioned after 40 years of service in 2016. As parts of the plant are showing the industrial equivalent of crow’s feet, it runs at 70 per cent capacity to minimise further wear and tear. But when I asked EDF Energy, a subsidiary of one of the world’s largest nuclear energy companies, whether I could visit a nuclear facility to talk about safety, Hinkley Point B was the site they volunteered.

It might have seemed a strange choice on their part, but I was on a strange mission. I hadn’t come to Hinkley Point B to learn about the safety of nuclear energy. I’d come because I wanted to learn about the safety of the financial system. Learn More

Outside Edge: Of turtle doves and inflation hawks

The UK’s coalition put up value added tax by 2.5 percentage points last week, guaranteeing a day of bad headlines about rising prices. But anyone buying products dependent on the price of oil, or gold, or copper, or wheat, doesn’t need George Osborne to experience a world of sharp increases in prices.

Even Christmas was more expensive. According to PNC, an American company which calculates these things, the cost of buying the items mentioned in The Twelve Days of Christmas rose by a painful 9.2 per cent last year.

Doubtless inflation doves would point out that this was caused by a punitive jump in the price of major “non-core” components in the indicators, including lords-a-leaping, swans and gold rings.

I don’t buy this for a second: it’s all very well for central bankers to split hairs over core and non-core inflation. But if your true love wants nine ladies dancing, the price increase of 15 per cent is very real. And if you are feeding a family of five in Dhaka, Mexico City or Casablanca, the increase in the price of food is more real yet.

Yet for those of us not living hand to mouth, there is something rather bracing about sharp price rises. Consider petrol, which follows a “rocket and feather” trajectory. Prices shoot up at the hint of an increase in the price of crude oil, but fall back at the gentlest of rates, long after crude prices themselves have subsided.

There’s no mystery about the “rocket”: in a competitive market, wholesale price increases will be passed through to consumers promptly. But the “feather” is more ticklish, because the same argument should work in reverse, and so wholesale price falls ought to be passed on just as quickly. That means that markets are less competitive when prices are falling than when they are rising – a rather baffling suggestion.

A plausible explanation comes from Matthew Lewis, an economist at Ohio State University: falling prices make us complacent, while rises bring out the bargain hunter inside us, even when there are no bargains to be had.

As long as the price of a product is a little lower today than yesterday, we relax. We assume there’s no need to shop around. Retailers then take their sweet time cutting prices, knowing that we consumers are immensely relaxed, addled by the fact that at least prices are moving in the right direction. Paradoxically, their profits may be higher when prices are falling than when they are rising.

Falling prices may do odd things to consumers’ judgment. The price of computers and clothes has fallen for years, which may explain our otherwise inexplicable love for iPads and bumster jeans. But while the current rising prices will sting, by golly, they’ll keep us sharp. It’s just a shame that we won’t stay sharp when they start to drift down.

The writer would like to clarify that his true love has had no dalliance with any lords-a-leaping.

Also published at ft.com.

8th of January, 2011Outside EdgeComments off

Game on for the virtual sweatshop

I’m a board game fan myself, but I know that millions of people spent their Christmas exploring the underwater realm of Vashj’ir, thanks to the online computer game, World of Warcraft, which launched a new version, Cataclysm, in December.

Loyal readers will know why economists find such games interesting: they are virtual worlds in which millions of people spend many hours interacting, creating experiences and goods that other players value, and even spending real money on virtual items. (Crazy? No more crazy than paying to watch a movie.)

Facebook applications such as FarmVille have many more users. But it is the great online role-playing games – and none is bigger than World of Warcraft, with 12 million users paying a monthly subscription – which hold an enduring fascination for the way that they blur the line between virtual life and real life.

One notable feature is “gold farming”, in which time-rich, cash-poor players carry out boring in-game tasks – “grinding” – and then sell the results to time-poor, cash-rich players. Julian Dibbell, author of Play Money, spent a year trying to live only off his earnings in virtual worlds – which eventually reached $3,000-$4,000 a month.

Gold farmers might sell virtual gold, or they might take a low-level “character” and spend the many hours required to bring it to a high level, before selling it on. This is very roughly equivalent to promoting the player who buys that character from bit-part to star turn.

The logical next step, of course, was “virtual sweatshops”. And so World of Warcraft has become an unwilling conduit for globalisation, as thousands – perhaps hundreds of thousands – of Chinese and Indian players earn a living carrying out the “grind” for busy westerners wanting to keep up with their friends.

Blizzard Entertainment, the owner of World of Warcraft, tries to discourage gold farming. But, says Dibbell, “they do reap the benefits of the gold farmers, who make it interesting for a large portion of their customers to stay in the game. So they’re in an ambiguous moral relationship with the gold farmers.”

The dynamic, then, is fascinating. Tom Chatfield, author of Fun Inc., enthuses that the new Cataclysm expansion has made World of Warcraft more fun, with less grinding and more exploration and interaction. It doesn’t take a genius to figure out the possible result: less work for the gold farmers. With a stroke, a computer game company can put thousands of poor people out of business. Is that OK? Do gold farmers have rights?

Cory Doctorow, co-editor of the über-blog “Boing Boing”, thinks they do, but points out that Blizzard regards gold farmers the way Louis Vuitton regards counterfeiters: as parasites who are spoiling things for … well, not everyone, since gold farmers have customers and many people want knock-off handbags.

If Cataclysm is simply an improvement to the game, well, you can’t stop progress. And yet gold farmers are people too – and, insist Doctorow and Dibbell, they are also players, genuine fans of the games which provide them with a living.

It’s hard to imagine that Blizzard will ever face the same labour rights campaigns as, for instance, Nike – partly because Blizzard is not hiring the gold farmers, but mostly because the whole situation is simply too mind-boggling to explain.

But who knows? Cory Doctorow’s novel, For the Win, describes young gold farmers fighting to unionise against oppression from sweatshop bosses. The online trade union even serves as a way to organise more conventional unions across national boundaries. (The book is also a fantastic economics primer – and an antidote to free-market scribblings.)

It’s only a novel, of course – and only a game. But the sweatshops are real and so is the money. We’re just scratching the surface of what virtual economies might mean for politics, society and commerce.

Also published at ft.com.

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