Paul Ormerod: 21st Century Economics
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The Oundle Economics Society was pleased to welcome Paul Ormerod last week to give a lecture on the state of economics in the 21st century.
He is a dynamic and enthusiastic speaker, who is able to explain the subtleties of the discipline in non-technical terms to make the subject approachable to all.
He started his lecture with the caveat that a lot of ‘21st century’ economics, was not yet in the textbooks and exam boards, so to be wary in using these ideas in exams.
Quoting P J O’Rourke and his witty and humourous book, Eat the Rich, he moved away from the conventional description of economics being micro (individual consumer/firms decision making theories) and macro (government decisions at an aggregate level), to ‘micro being about what we are specifically wrong about, and macro being what we are wrong about more generally’.
- The current financial crisis is an illustration of this very point. He pointed out that two different groups of Nobel Prize winning economists had argued both for bailouts in 2009, and against bailouts.
- Economic forecasts (of real GDP, of inflation) have a very bad track record and show no signs of getting better. He showed a graph which showed real GDP growth forecasts, through Q1 2008 to Q4 2009, and it showed how they got progressively more pessimistic as time went on. For example in Aug/Sept 2008, the UK/Eurozone economies were forecasting an average growth rate between 1-2% for the year coming. It turned out to be closer to -6%.
- There is no consensus on whether an increase in interest rates will increase or decrease savings. It depends on the size of the substitution and income effects (See Buttonwood article here).
However, Paul stressed that whilst economics should not be (and is not) about a set of received wisdoms set in stone, it does offer a way of thinking about how the world works – by looking at the world through a certain type of lens. For example, a key topic in economics is the importance of incentives, whether its tax changes or speed cameras.
- Crime and prisons: He used the example that data released showed that Britain’s prisons were close to being bursting at the seams, with the population having doubled in the past 15 years. At the same time, crime has fallen 40% over the past 15 years.
- Non-economists may struggle with this as how could crime be falling but the prison population be rising.
- Economists would explain that it is because the prison population is increasing in size that crime has fallen. That is because of the feedback of changing incentives, criminal are now more aware that they are more likely to be caught and successfully prosecuted for a crime (like some of their friends in their gangs) and thus the (dis)incentive of a jail sentence deters their crime.
- This kind of analysis is well-documented in Freakonomics by Levitt and Dubner (where there controversial finding is that crime rates fell due to abortion being legalized, so poor unskilled mothers did not give birth to unwanted children).
Conventional vs 21st century models
- However, Paul stresses that we are not talking about criminals doing a ‘cost-benefit analysis’ of whether to steal a car and thus acting rationally in face of incentives. He is simply observing that incentives affects overall behaviour.
- Under the traditional or conventional economic models, we assume rational agents who make decisions. That is agents gather all the available information in any given context and then makes optimal decisions given his/her preferences and tastes, which are assumed to be fixed. This is a key idea in most textbook economic models.
- However, more recently, Nobel prizes in economics have been handed out for those whose work focuses on modifying this and to create a more realistic model of decision-making
- One of these is Stiglitz and Akerlof (2001 Nobel Prize) work on “Bounded Rationality”. This alters the behavioural model of agents’ reactions. Agents may have incomplete information and given this, they may choices.
- And more importantly, different agents have different amounts of information, and then make the “best” choice.
- An example would be catching a taxi in a foreign city, with clear asymmetric information between buyer and seller.
- Or where in London prices were allowed to increase by 60% on taxi fares after midnight. One would think this may cause the market to collapse, as quantity demanded would plummet. But in fact, due to the number of tourists and the imperfect information, this simply encouraged more taxi drivers to operate in London after midnight, and thus solved the problem of taxi availability in London.
- Kahnemann and Smith (2002) (and others) bought ideas of psychology and experimental economics together to make the discipline of behavioural economics more dominant in the 21st century.
- They abandon rationality more, with Kahnemann arguing that agents reason poorly and instead act intuitively – that is, they tend to react like agents react in financial markets, with a gut instinct. (Kahnemann lecture at the LSE on 15th November: See more here).
- It is supported by studies in psychology, sociology and anthropology. That is whilst people do react to incentives still, they do not process this decision-making in the way conventional theory dictates.
- This is discussed in their 2003 Nobel lecture in the American Economic Review (June/Dec editions). See one of them here.
- Thaler and Sunstein run with this in their excellent book Nudge. A humorous example cited there was the problem of ‘spillage’ in the male urinals at Amsterdam airport. To overcome this problem, agents were ‘nudged’ to the optimal solution via the painting of a small picture of a bee inside the urinal, thereby improving hygiene.
- David Cameron has embraced nudge by having his own behavioural nudge unit, realising that people don’t just respond to price incentives, but any whole range of incentives.
- By abandoning rationality, these economists are arguing that we do not have a generalised model of economic agents behaviour, but rather need customised behavioural rules.
- Schelling (2005 Nobel Prize) focused his work on the fact that tastes/preferences are not fixed in many contexts.
- For example, Paul focussed the role of copying/imitation in an increasingly connected world. He used the examples of the Internet and for example on the BBC website where you see ‘most popular stories’ / “most watched videos” or “stories trending now on Twitter. The question to think about is why, out of the millions of stories uploaded on the Internet every day, do these particular ones stand out. And one argument is that it is because others have read it, that agents imitate behaviour, and thus others read it too, thus causing a self-fulfilling prophecy of making it popular.
- Agents act intuitively by copying.
- Asch published a series of ‘conformity experiments’ in 1955 which illustrated this idea. Two groups of people were shown a set of lines whereby one was clearly longer than the rest. In the first group, everyone just pointed out correctly which was one longer. In the second group, certain people were told to answer with the wrong answer, to see if the desire to conform, or the thought that these agents may have superior information, would cause the remainder of the group to also pick the wrong answer. Despite this being a decision in the face of complete information, decision makers imitated (incorrectly).
- This can be used to explain how the most popular article in the news or book or music download becomes the most popular. It is not necessarily due to its inherent qualities. Think about this next time you buy a share (Grupon IPO’d this weekend with its share price surging 31% on its first day of trading).
- Schelling explained this using the idea of ‘binary choices with externalities’. That is, agents face a binary choice such as to buy something or not, to download something or not, to sell something or not, to be optimistic or not. The externalities part comes though because your decision influences/affects other agents’ decisions directly.
- For example an experiment by Dodds and Walts showed that when people had free choice to download any of 46 songs, the distribution of songs download between the songs was as one would expect (some were more popular than the mean, some were less popular than the mean). However, when social influence was allowed to play a part, so people were told before hand which songs had been downloaded the most, there were massive changes in behaviour, with strong herding behaviour.
- Thus real life cultural markets (movies, songs, books) are influenced by such social influences or externalities, and so you may have a movie that is a great blockbuster in terms of sales, but it may not be due to its inherent qualities (e.g. this week’s Justin Timberlake movie, In Time…).
- Freakonomics has a catchy title and is a good book. But there are lots of books written on behavioural economics. But why does this particular book end up being more successful than others. Its because of imitation behaviour.
- Financial market stories – millions are written every day but only few get traction. For example, rising debt was not an issue that began in 2008. Consumer debt, fiscal debt, bank debt has been rising for many years now. But then suddenly in 2008, the fact that BNP Paribas announced that it thought it could no longer value its sub-prime mortgages fund, the story spread and the credit crunch was born and Northern Rock collapses soon after. But we cannot pinpoint a specific reason why it happened then and not a month before or year before.
- Q&A: How important is the role of the media in influencing the economy?
- The media is criticised for focussing purely on negative articles. For example this week the UK’s GDP figures showed only 0.5% growth last quarter. The media presentation of this is doom and gloom, but to average 0.5% growth each year, culminating in an approximate 2% growth annually would be no bad thing in the current climate. So yes, the spin that media puts on the economy definitely catches on in terms of negative feedback loops. But there is no individual commentator who has this particular power (only a small % of the population read Martin Woolf). But within the financial markets, somebody like George Soros has huge power – if he decides to buy a certain asset (such as Goldman Sachs shares in the middle the financial crisis), he does have the power to influence other economic agents.
- Q&A: What are your thoughts on the increasingly mathematical nature of economics at university?
- Whilst Economics is definitely becoming more mathematical, there are two things to point out. Firstly, it is only becoming more mathematical in a particular way – In times gone by, to begin with given the nature of economics, to solve problems we had to use sets of equations which can be solved. And since a lot of economics is to do with optimisation, maths calculus was key to this.
- Now however, there is a different form of maths that is becoming more popular, that is of computer simulations. This allows less rigid equations to be set up, because computer programmes can now run experimental analysis and come up with results based on more realistic models.
- Furthermore, economic is increasingly mixing with other disciplines (Econophysics). And in compared to these fields, the maths that economists use is still very trivial.
- Q&A: Does the idea of rationality mean it is never rational to go with the herd?
- The idea of rationality is not clear cut – most times people use the term rational to simply mean ‘sensible’. Sometimes with the limited information available, it is sensible to go with what others decide. E.g. if you go to a new town and there are two restaurants to choose fro, it makes sense to go to the busy one than the empty one – that is to ape the behaviour of others. This could be described as rational, but it is not the same form of rationality that conventional economics refers to.
- 21st Century rationality and 20th century rationality are different concepts.
- Paul mentioned a study that estimated that a typical New Yorker could buy over 10 billion different goods or service on any given day. Clearly we don’t have the power to process this info in a rational way, so copying/imitation is a sensible way to overcome the multiplicity of options. But this is a 21st century phenomenon, since in the 1800s, the choice was much much smaller.
- Q&A: What is the analysis of your book Butterfly Economics focused on?
- Butterfly Economics takes examples of how Nature’s agents behave. For example looking at how ants behave, two identical food sources were placed equidistant from an ants’ nest. They wanted to see whether ants would all end up using one food source, or both in some predictable way. They found that there was a fluctuation in how many went for each foodsource, with some ants taking into account copying behaviour as well as others adopting random behaviour. But most importantly, this could be modelled using some very simply equations to explain ant behaviour.
A really interesting and dynamic talk that was accessible to economist and non-economists alike, with some of our budding Junior Economists also attending and enjoying it.
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