Unbelievably exciting results!

Chris Dillow, via Eric:

…even intelligent and numerate people are quick to misperceive randomness and to pay for an expertise that doesn’t exist; the subjects included students of sciences, engineering and accounting.

Which reminded me of Andrew Gelman’s recent post about results in headline academic journals such as Science and Nature. He quotes Sanjay Srivastava saying:

As long as a journal pursues a strategy of publishing “wow” studies, it will inevitably contain more unreplicable findings and unsupportable conclusions than equally rigorous but more ‘boring’ journals. Groundbreaking will always be higher-risk. And definitive will be the territory of journals that publish meta-analyses and reviews.

We may all know that the implausible results that often lead headline journals are likely to be wrong, but it doesn’t seem to stop us citing them constantly!

The economics of love

My latest piece in the Dom post was about the “economics of love” – where I compared a relationship to a firm, and worked out some basic conclusions.

Now, the article in the Dom was focused on relationships, specifically marriages.  However, there are times where the optimal formation for a relationship is more akin to a set of “independent contractors negotiating and renegotiating each time they want to work together to provide a product”.

So what factors are likely to be behind this?

  1. Option value:  Available and interesting individuals appear in your life, of a varying quality, according to some probability distribution.  If you commit to a relationship, it is very difficult/costly to take up a “better” person if you run into them.  By saying as an individual contractor, you are able to take advantage of these opportunities.
  2. Diminishing marginal utility:  Often, the more you consume something, the less additional value you gain from it.  Setting up your relationship profile such that you enter temporary contracts with a number of different individuals may provide higher overall satisfaction than committing to only one permanent contract.
  3. Diversifying risk: Focusing on one relationship involves taking on all the idiosyncratic risk associated with that individual – if you set up an appropriate portfolio of relationships, you may be able to remove this risk while still achieving the same expected return.

So the optimal solution to the formation of your relationship is a complicated issue – there are the benefits of a strict relationship mentioned in the article, and benefits for non-strict relationship status as mentioned here.  I have only covered some of the very basics, in comments feel free to add some more 😉

Bigger than meets the eye

Bryan Caplan has another great post up on Econlog.  In it he mentions his rule of thumb that “Human heterogeneity is bigger than you think“.

I completely agree, and often when we look at other people, or when economists analyse decision making, we rely on the fact that other people share certain attributes with us – an assumption that can be folly.

Furthermore, I found his description about the debates around imagination in the 19th century to be eye opening.

However, I also believe a second rule of thumb “Human homogeneity is bigger than you think“.

On the face of it this seems to be contradictory – I appear to be saying that people are more different than we give them credit for AND more similar than we are willing to admit.  However, I would state that this is not contradictory at all, and that by accepting both of these rules we reach a fuller understanding of what we do when we go to analyse choice and other individuals.

Fundamentally, we view others as “less” in terms of their thought processes than we view ourselves.

Think about your own thought process.  Think about all the issues, expectations, rules of thumb, social construction, and concerns that drive your decision making on a daily basis – think of the depth of all your experience.

Then consider that the people around you have the same depth of experience and thought – no matter how hard you think about it, it is impossible to really view someone with the same level of detail that you do yourself.  You do not have the information, and you do not have the interest.

In this context, merely focusing on the fact that humans do not understand the heterogeneity of experience between individuals would give you a biased picture of any underlying cognitive biases – in truth, the lesson is that humans (and economists) create a caricature of individuals in order to help them make decisions.  That caricature doesn’t just strip out heterogeneity, it also strips out elements where individuals are similar, and helps to reinforce the importance of issues like signalling for the outcome of individual decision making.

Does anyone really read reviews?

It’s common to hear people complain about negative reviews, and they’re the ones that seem to garner all the press. If you’re a New Zealand music fan you’ll be familiar with Simon Sweetman’s famously scathing reviews of popular bands, for example. It’s also becoming much more common to hear of business collapsing at establishments that receive poor online reviews. Because of that I was fascinated to read a recent study that examined whether demand for wine is affected by expert reviews. The study conducted in Sweden found that there is an effect, but it’s not the negative review that people act on:

The effect of a positive review peaks in the week after the review with a demand increase of 6 percent. …There is a weak positive effect on demand of a review per se and no effect of a negative review. …The demand enhancing effect of a favorable review is greater for higher priced wines, for red wines and lower for reviews that appeared in tabloids.

Now put this together with what we know about wine tasting:

[The reseracher] took a middling Bordeaux and served it in two different bottles. One bottle was a fancy grand-cru. The other bottle was an ordinary vin du table. Despite the fact that they were actually being served the exact same wine, …[f]orty experts said the wine with the fancy label was worth drinking, while only 12 said the cheap wine was.

So being an expensive wine gets you a good review and a good review boosts sales. What can we take from this? Well, you’ll get the best drinking experience from a positively reviewed wine that know is expensive! Feed the cognitive biases, don’t fight them 😉

Where behavioural economics goes wrong

We talked yesterday about the general issues that Wright and Ginsburg raise in their critique of behavioural economists. I don’t agree with their overall conclusions about the dangerous incoherency of the “behaviourists’ agenda”–if such a thing even exists–but they do make some excellent points about the limitations of the science as it stands.

The first stage of the behavioral economics research program is best described as developing a comprehensive theory of errors. The theory-building exercise thus far has focused largely upon the effort to catalog circumstances in which economic decision-makers appear systematically to depart from rational choice behavior. The second step required to make the theory of errors policy-relevant is to map the conditions under which specific errors are more or less likely to affect decisions and then to generate estimates of the social costs imposed by those errors. This step is particularly important when the incidence of a particular decisionmaking error is context specific, unevenly distributed throughout the population, and likely to interact systematically with other errors. The third step is to compare the costs of any proposed corrective intervention against the social benefits produced by reducing the rate of error. At present, however, research in behavioral economics does not appear to have moved much beyond the first step.

I think this is true, and similar to the point Eric made in his original comments. However, it is not a criticism of the science, but merely a statement about how young the discipline is. From the discussions so far we can add a couple more points related to policy development:

  • Policy conclusions need to be drawn from causal models, not correlations. That is the driving force behind the need for a coherent model supporting the idea of cognitive bias.
  • The behavioural approach needs to be applied to regulators, too. Public choice was a fairly late development in microeconomics so it’s not surprising that behavioural economists haven’t got there yet, but it is certainly a development that needs to occur so that we can think more deeply about policy failure.

Who needs a Nudge?

I said last week that I’d come back to the critiques of bevhavioural economics but it’s obviously taken a while. Part of the reason is that I got wrapped up in this great essay by Joshua Wright and Douglas Ginsburg. It’s a blistering critique of the “behaviourist’s agenda” that you should really read if you’re interested in the subject. I don’t think there’s much attempt at balance in it but it raises some excellent points, as well as overplaying a number of weaker ones.

The essay can really be read as a libertarian response to Richard Thaler and Cass Sunstein’s work, summarised in their book, Nudge. For those new to the field, Thaler and Sunstein’s thesis is that choices can be framed in such a way that people will be more likely to do what is in their best interests, as they themselves judge it. The book has been hugely influential in defining the concept of libertarian paternalism, which is the idea that a ‘choice architect’ can improve welfare without reducing the freedom to choose. They do it by framing the choice in such a way that people’s cognitive biases will nudge them towards the welfare-improving option.

The easiest example of such choice architecture is through the setting of default options. For example, if there is a choice about which provider of government-supported retirement savings to use (ie. Kiwisaver providers in NZ), then the default option for people who do not actively choose a program should be one that is recommended by experts. Those who choose may still choose, but people who do not choose are allocated a plan that experts approve of. The idea of manipulating defaults is definitely something I want to get a whole post on, but let’s now turn to the fundamental critique of Wright and Ginsburg.

They pack in quite a few arguments but I’m going to pull out just a few that seem central.

How should one evaluate a regulatory intervention that would increase welfare but also diminish liberty? What are the mechanics of trading off welfare and liberty when the two are in tension?

If individuals are to realize their full potential …then they must be free to err in large ways as well as small. The fatal flaw of libertarian paternalism is to ignore the value of the freedom to err.

So long as behavioral law and economics continues to ignore the value to economic welfare and individual liberty of leaving individuals the freedom to choose and hence to err in making important decisions, “libertarian paternalism” will not only fail to fulfill its promise of increasing welfare while doing no harm to liberty; it will pose a significant risk of reducing both.

Essentially, they criticise behavioural economists’ focus on welfare to the exclusion of the “process of liberty”. It’s a difficult criticism to make because the idea of welfare is draw from a consequentialist, utilitarian framework, whereas the ‘process of liberty’ sound like more of a rights-based, deontological concept. To suggest that one limmits the other is a hard argument to make coherently when the utilitarian framework contains a complete moral philosophy of its own. It’s also interesting that they cite Mill’s support for their views since he firmly believed that utilitarianism was a moral philosophy that promotes liberty. To suggest that we could be following a utilitarian path and simultaneously reducing liberty seems like an argument that needed more time to make than they gave it in their essay. However, I’m no philosopher so I’m happy to be set straight here. We’ll discuss some of the more nitty-gritty aspects of the argument over the next week of so, because this debate is undoubtedly an important one for the progression of both the law and economics.