Category: Economics – General

The dormitive quality of rational choice

John Quiggin8 Comments

This Matt Yglesias post has already made it on to my colleague Andy McLennan’s door. It’s short enough to quote in full

I’m not sure I understand why Greg Mankiw thinks economists “don’t understand tipping.” When I was learning economics, I learned that people are utility-maximers and that whenever you see some behavior that doesn’t seem explicable in purely financial terms that must be because people are deriving utility from the foregone financial advantage. Thus, as any economist could tell you, people tip because of the utility they derive from the tipping in much the way that economists can explain all aspects of human life.

Have I ever mentioned that philosophers tend to think that economics is vacuous? Which isn’t to say that you shouldn’t listen to economists. These days, they tend to know a lot of math, and math is a very useful thing.

Matt omitted the irony alerts, but I tried to spell out the same point here.

Given any data on any observed set of problems involving the selection of one or more choices from a set of alternatives, the observed choices can be represented as the maximisation of an appropriately specified function.

Playing straight man to Matt, that doesn’t mean utility functions are useless – the functional representation lets you do lots of math that is much harder if you try to work directly with preferences. But any competent economist knows that utility isn’t an explanation of observed choices, it’s a way of representing them. The representation is simpler if choices satisfy some minimal consistency requirements, like transitivity (if you prefer A to B and B to C then you should prefer A to C).
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Rationality and utility

John Quiggin20 Comments

Over at Cosmic Variance, physicist Sean Carroll offers some admittedly uninformed speculation about utility theory and economics, saying

Anyone who actually knows something about economics is welcome to chime in to explain why all this is crazy (very possible), or perfectly well-known to all working economists (more likely), or good stuff that they will steal for their next paper (least likely). The freedom to speculate is what blogs are all about.

I didn’t notice anything crazy but there’s a fair bit that’s well-known. For example, Carroll observes that utility is generally not additive across commodities, and that some goods are likely to be more closely related than others. That’s textbook stuff, covered by the basic concepts of complementarity and substitutability.

This is a more interesting and significant point

But I’d like to argue something a bit different — not simply that people don’t behave rationally, but that “rational� and “irrational� aren’t necessarily useful terms in which to think about behavior. After all, any kind of deterministic* behavior — faced with equivalent circumstances, a certain person will always act the same way — can be modeled as the maximization of some function. But it might not be helpful to think of that function as utility, or as the act of maximizing it as the manifestation of rationality.

I can only agree. But economists and (even more, I think) political scientists in the “rational choice” tradition regularly get themselves tied up in all sorts of knots about this, switching between the trivial notion of maximising a function and substantive claims in which rationality is frequently equated with egoism. Joseph Butler demolished this kind of reasoning nearly 300 years ago, but it keeps on popping up.

* This qualification isn’t necessary, and Carroll notes later on that choices are often stochastic. The resulting probability distributions still maximise an appropriately defined function.

Expenses > income = bankruptcy

John Quiggin6 Comments

Andrew Leigh points me to a recent study of US bankruptcy (paywalled, but the abstract is over the page). which concludes that the increased variability of income, and exposure to expense shocks such as medical expenses are not important factors in explaining the dramatic increase in bankruptcy rates since 1970. (I’ve seen a blog link to this also, but can’t find it now).

Count me as unconvinced. The main reason for rejecting income shocks is an explanation of bankruptcy is that, in the model of the paper, households should respond to increasing variance of permanent shocks by increasing precautionary savings. This appears to impute to households a much higher level of ex ante information about future income shocks than they actually possess, and also to rely critically on strong assumptions about rational planning. The whole credit card business is centred on the fact that lots of people (about half the population) don’t pay their monthly balances down to zero and therefore carry semi-permanent debt at very high interest rates. It seems pretty clear that it is people in this group who are most exposed to bankruptcy, and it’s hard to imagine that they are the type to hold precautionary savings.

That’s not to discount the importance of the ‘supply side’, in terms of easier access to credit, which has assisted people in managing increasingly risk in income and expenses, at the cost of steadily increasing debt-income ratios. But you have to look at both sides of the story, and this paper rules out one side by assumption.
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Foreclosure and bankruptcy

John Quiggin2 Comments

A few weeks ago, I noticed this piece saying that the mortgage problem in the UK might be worse than that in the US. The reason given (also applicable to Australia) is that the UK boom or bubble in house prices has been much more dramatic than in the US. One statistic quoted in the piece was that there were 14 000 foreclosures in the first half of 2007 a statistic that, as the author notes, makes grim reading. It’s striking then, to read this piece in the NYTimes, predicting 2 million foreclosures in the US this year (since most mortgages are taken out by couples, many with children, the number of people affected is probably more like 4 million). Even allowing for the larger population in the US, this is a huge difference. It now appears that foreclosure has taken over from bankruptcy as the primary mode of financial catastrophe. (Bankruptcy rates plummeted after the “reform” of 2005, but seem certain to rebound in coming months).

How big a slump?

John Quiggin12 Comments

With the Oz stock market falling nearly 5 per cent on Thursday, and down nearly 15 per cent in the last few weeks, it’s a good time whether this will have real effects beyond the value of our superannuation. The immediate starting point of the current disruptions was evidence that defaults on US mortgage markets were worse than expected. An obvious question is whether this underlying shock is large enough to have substantial effects in itself, or whether the problem is mainly one of liquidity and confidence.
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Two weeks behind the Zeitgeist

John Quiggin67 Comments

I’ve been following the Peak Oil debate with a mildly sceptical eye for some time, and it struck me a while ago that despite high prices, global oil output hadn’t grown much, but hadn’t declined either. I came up with the innovative description of our current position as “Plateau Oil“. If I had bothered with Google, I would have noticed that the International Energy Agency had offered the same description two weeks earlier. And if I’d thought about for more than a couple of seconds, I would have realised that the supply of topographical metaphors is so limited as to make this a forced move (We Australians use “Tableland” to describe the same landform and there’s also “mesa”, but Mesa Oil is taken, and “Tableland Oil” sounds silly)

Anyway, why are we (apparently) observing Plateau Oil and what does it mean?
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