Category Archives: Economic education and methods

The importance of appreciating complexity

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Here is another new essay of mine, called The Simplicity Assumption.

The opposite of the Simplicity Assumption would be a complexity diagram. Imagine a diagram with a social problem, such as the obesity epidemic or the financial crisis of 2008, at the center. Then list all of the plausible factors that could have contributed to this problem, and put those on the diagram, with arrows pointing to the central problem. Next, draw arrows that reflect likely feedback loops among these various causal factors. Finally, draw arrows that reflect likely feedback loops from the central problem to some of these causal factors. For a complex problem, this diagram will look rather messy, like a badly tangled ball of kite string; you cannot be sure that tugging on one part of the knotted mess will make things better or worse.

Economists do not work with complexity diagrams. Such diagrams are not conducive to creating tractable models. Not having a tractable model is not conducive to publishing a paper. Not publishing papers is not conducive to having a successful career.

Read the whole thing.

Scott Alexander on Eliezer Yudkowsky

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Scott writes,

Everyone hates Facebook. It records all your private data, it screws with the order of your timeline, it works to be as addictive and time-wasting as possible. So why don’t we just stop using Facebook? More to the point, why doesn’t some entrepreneur create a much better social network which doesn’t do any of those things, and then we all switch to her site, and she becomes really rich, and we’re all happy?

The obvious answer: all our friends are on Facebook. We want to be where our friends are. None of us expect our friends to leave, so we all stay. Even if every single one of our friends hated Facebook, none of us would have common knowledge that we would all leave at once; it’s hard to organize a mass exodus.

This is Scott’s example of what Yudkowsky calls in his new book Inadequate Equilibria. Another excerpt from Scott’s review:

The Inside View is when you weigh the evidence around something, and go with whatever side’s evidence seems most compelling. The Outside View is when you notice that you feel like you’re right, but most people in the same situation as you are wrong. So you reject your intuitive feelings of rightness and assume you are probably wrong too.

…Eliezer warns that overuse of the Outside View can prevent you from having any kind of meaningful opinion at all.

My thoughts:

1. By the time this post goes up, I will have finished the book (recall that I typically schedule posts two or more days in advance). When I finish it, I am likely to write a long review.

2. The book is worth your time and your money.

3. I believe that Yudkowsky describes a real problem. Rather than call it “inadequate equilibria,” I would use a term popular in mathematical economics, “local optimum.” A group can find itself at a local optimum that is not the global optimum. It remains stuck at the local optimum because it resists going downhill to eventually go uphill.

Yudkowsky is focused on what I would call an intellectual local optimum. That is, it is possible for people to be stuck in a set of beliefs (leading to actions) that are difficult to discard but far from the global optimum. This is the way David Colander and Roland Kupers describe the state of economic thinking in their book Complexity Economics, which I described as

highly ambitious, always stimulating, and often frustrating.

I expect to say the same thing about Inadequate Equilibria. It is even more frustrating.

[UPDATE: I did indeed finish the book. I am glad that it stimulated me to think about the topic and to write an essay. But I think that you will find my essay on the topic will be more concise and more helpful than the book itself. I expect to have the essay up later this week on Medium.]

Health spending negatively correlated with health outcomes

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Tomoaki Katera writes,

life expectancy at age 40 for males in the 90th income percentile is 45.3 years whereas the corresponding indicator in the 10th income percentile is only 35.8. For comparison, according to the report from National Center for Health Statistics, if all cancer deaths were eliminated, life expectancy at birth would increase only by 3.2 years.

…inequality would seem to matter since it can create differences in access to medical services. Interestingly, however, when I compare average medical spending by income groups, low income individuals tend to spend more on healthcare than high income individuals in most ages. The second viewpoint is motivated by the income-health gradient. It is widely accepted that higher income individuals tend to be in much better health than lower income individuals even when they are young. Moreover, the gap widens as they age. Many papers in health economics point out that widening health disparities by income can potentially arise from differences in unhealthy behaviors.

Pointer from Tyler Cowen. In the paper, Katera argues that the lower life expectancy of lower-income individuals reflects differences in their behavior rather than differences in access to medical services. My thoughts:

1. This seems consistent with Hansonian medicine, in which on average the benefits of more health care spending are about zero. But it also could suggest a counter to the Hanson view. That is, it could be that at the margin everyone benefits from more health care spending, but because the people who spend more tend to be people who behave in unhealthy ways, the benefits of more spending are difficult to tease out from the data. It is like trying to measure the relationship between policing and crime. If areas with a lot of crime tend to require more police, then a simple correlation analysis might suggest that adding police does not help to reduce crime.

2. Katera’s findings are not politically correct. I am on the record as saying that academic economics is headed toward a state in which findings like this will make one almost unemployable. Imagine trying to get Katera hired in a sociology department. Katera’s experience as a job candidate will be help to indicate how far along we are on this path.

Thoughts on profits

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I put this essay up on Medium. I like the concept of Medium. I would like to be able to reach some people who are on the left. Everyone seems to love the juvenile, anti-capitalist rants that people put up. I thought I would put up some different ideas. Based on statistics, hardly anyone who goes to the site seems to want to read what I write. If that continues to be the case, then I will just stick to this blog.

John Ioannidis on Economics

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Self-recommending. But here is an excerpt.

Most empirical data do not come from experiments but from non-experimental sources such as surveys and routinely collected information. Along with Chris Doucouliagos and Tom Stanley, my research center examined 6,700 empirical studies encompassing 159 topics. We found that there is probably substantial bias in much of this literature. For example, the value of a statistical life, which measures how much people are willing to pay to reduce their risk of death, appears to have been exaggerated by a factor of eight. On average, the strength of the results may have been exaggerated by a factor of two. In a third of the studies, by a factor of four.

But overall, he is more upbeat than I am on economics as a science.

Pointer from Mark Thoma.

Corporate tax cuts, math, and intellectual swindles

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John Cochrane writes,

Each dollar (per worker) of static tax losses raises wages by [more than one dollar] It’s always greater than one… A number greater than one does not mean you’re a moron, incapable of addition, a stooge of the corporate class, etc.

This is also a lovely little example for people who decry math in economics. At a verbal level, who knows? It seems plausible that a $1 tax cut could never raise wages by more than $1. Your head swims. A few lines of algebra later, and the argument is clear. You could never do this verbally.

For the other side of the controversy, see Mark Thoma.

Let me swindle you with the following example.

1. We have the GDP factory, with two workers, A and B.

2. Each worker faces a different tax rate on wages.

3. The pre-tax wage of worker A is fixed. It cannot change.

4. (a) Each worker stays fully employed. (b) That means that the ratio of the marginal product of worker A to the marginal product of worker B must remain constant.* (c) That means that the ratio of the after-tax wage of worker A to the after-tax wage of worker B must remain constant.

*That ratio is completely determined by the production function, which is given, and by the quantities used of the two workers, which are fixed at full employment.

OK, now we cut the tax rate for worker A. What happens to the pre-tax wage of worker B?

At the fixed pre-tax wage of worker A, the after-tax wage for worker A goes up. Because of 4(c), that means that the after-tax wage of worker B must go up. The only way that can happen is if the pre-tax wage of worker B goes up. And to get worker B’s after-tax wage to go up by, say $1, you have to raise worker B’s pre-tax wage by more than $1. So worker B gets a big raise.

Substitute “capital” for worker A, “the interest rate” for worker A’s wage, and the corporate income tax for worker A’s tax rate, and I think you have the story that everyone is talking about.

But this is a swindle. We have fixed both the quantity and price of worker A. Taking worker A to be capital, the fixed supply is plausible because you think “how can we instantly adjust the supply of capital?” The wage, er, interest rate is fixed because, well, we know that the world interest rate is given, right?

But it cannot be right. A fixed wage suggests a perfectly elastic supply. A fixed quantity suggests a perfectly inelastic supply. There is a contradiction between 3 and 4(a).

The larger issue is that the simple model of a GDP factory with two factors of production and full employment is just silly. And even though other models add enough complexity to require computers to solve, they are also just silly.

There are many types of capital, which is what creates all of the lobbying and infighting over corporate taxes to begin with. There are also many types of labor, which substitute for and complement with the various types of capital in different ways. Adjustment takes time, and not all types of capital and labor are continuously employed. Over time, there is innovation, some of which is exogenous and some of which is in response to the tax change. The supply of each type of capital and each type of labor is neither perfectly elastic nor perfectly inelastic (and certainly not both!).

The moral of the story, in my view, is that forecasting the impact of economic policy is not a science. We know that, but then people demand a forecast, and they turn to a CBO “score” as if it were the final word on the subject. I have a forthcoming essay on the mis-use of CBO scores.

What is the limit on firm size?

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Miles Kimball wrote,

Given the replication argument, there is no scale of operation that is beyond efficient scale. There may be ample reason to make different plants or divisions quasi-independent so they do not interfere with one another’s operations. But that is not an argument against scale per se. There may even be reason to set up incentives so that different divisions are almost like separate firms, headed by someone in an entrepreneurlike position. But that still is not, properly speaking, an example of diseconomies of scale.

Read the whole post.

So what are we to make of this?

1. For the economy as a whole, the law of diminishing returns applies. You cannot grow all the world’s wheat in a single flower pot.

2. But the size of any one farm is not limited to a single flower pot. Any one farm can keep adding land (until it gets to be large relative to the earth’s arable land).

3. Kimball sees the assumption of diminishing returns at the firm level as a staple of standard pedagogy. But it is more than that. Dropping that assumption takes you away from the perfectly competitive equilibrium, as Kimball spells out in his important follow-up.

4. What about the notion that the entrepreneur’s time or skill is a fixed factor? This appears to be a way to show that firm size must be limited. But it also is like question-begging or hand-waving. If you start with a traditional production function, with output a function of the two factors of homogeneous labor and homogeneous capital, then you have a hard time rationalizing diseconomies of scale until the firm gets to be really big relative to the whole market. So you tack on a fixed factor, and call it “entrepreneur’s time.” But the original production function assumed away the entrepreneur to begin with, and you never did spell out the entrepreneur’s role in that context.

5. Kimball’s approach in the second post consists of postulating a demand curve and zero profits and solving for firm size. That also strikes me as hand-waving, with math. Call it math-waving.

6. Think of a real-world example of monopolistic competition. I like to use ethnic restaurants in Wheaton, Maryland, near where I live. What stops a single owner from taking over multiple restaurants under the auspices of one firm? What stops an owner from then expanding to other locations far away, where the local demand curve is not a limiting factor?

7. When you do this thought experiment, you realize that firm size is not determined by the tangible variables that are central to neoclassical economics. Instead, you have to turn to principal-agent problems and whatever else might help deal with the “boundary of the firm” problem that has been articulated but not necessarily solved in a satisfactory way by Coase, Williamson, and Alchian and Demsetz.

8. Why are farms in two different states separate businesses? I would say that it is because it is costly for the Iowa farmer to observe the Kansas farmer’s effort, giving rise to a principal-agent problem. This may turn out to be a testable hypothesis. It predicts that as the cost of monitoring goes down (because of cheaper surveillance technology), we will see mergers take place that would have been unthinkable until recently.

9. This year, Amazon bought Whole Foods. Where does it stop? Where are the diseconomies (of scope, if not of scale)? Suppose that in order not to incur management costs, Amazon leaves Whole Foods executives in place and adopts a hands-off approach. Then from the point of view of somebody who owned shares in both firms, the merger only changed the form of ownership. You used to own a sort of mutual fund, and it was your choice how to weight the shares of Amazon and the shares of Whole Foods in that fund. Now you own shares in a conglomerate, with the weight fixed–you can no longer simultaneously reduce your holdings of Whole Foods while increasing your holdings of Amazon.

10. From the foregoing, it would appear that shareholders always lose in a merger, because they lose the option to alter the weights of their holdings. In fact, mergers have other effects, but they involve those intangible “boundaries of the firm” phenomena.

11. Suppose that a major element in a corporate merger is ego. The CEO of the company being acquired gives up status but gains wealth for the firm’s shareholders. The CEO of the acquiring firm does the opposite. The ego hypothesis predicts that immediately after the merger the acquiring firm will not give the post of CEO to someone from the acquired firm. It also predicts that the merger will be positive for the shareholders of the acquired firm but not for those of the acquiring firm. I haven’t kept up with the literature, but it used to be that those predictions held up.

12. In conclusion, the attempt to rationalize diminishing returns at the level of a firm in neoclassical economics opens up a can of worms, and Kimball’s math-waving with the demand curve does not close it.

What I’m Reading

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Tim O’Reilly’s new book. He tries to grasp how technology affects the current business environment. He then proceeds to look at the overall economic and social implications. You can get some of the flavor of it by listening to his interview with Russ Roberts. And here is more O’Reilly, where he says,

Microsoft lost leadership because they had taken away the opportunities for their developer ecosystems, so those developers went over to the Internet and to Google. Now, we see this same thing playing out again.

I am not persuaded by these sentences. The Internet was quite a powerful phenomenon. I cannot envision an alternative history in which Microsoft does not lose a lot of its commanding position because of the Internet. You can make a case that Bill Gates could have positioned Microsoft better had he grasped the significance of the Internet sooner, but that would not have changed the game, only made Microsoft a more agile player. And you could argue that whatever Microsoft lost in terms of time, they made up for in terms of spending, so that they wound up doing about as well in the Internet environment as one could reasonably expect.

Overall, I disagree with O’Reilly quite a bit. Early in the book, he writes,

there are far too many companies that are simply using technology to cut costs and boost their stock price

Take this rhetoric and apply it to trade, and it could come from the lips of Donald Trump. In fact, good economists will explain that trade and technology are so intertwined as to be indistinguishable as economic phenomena. Austrian capital theory says that capital is roundabout production, i.e., roundabout trade. Suppose an economy consists of farm equipment and crops, and you want to explain its efficiency. Do you give the credit to farmers applying technology or do you give the credit to trade between the manufacturing sector and the agricultural sector? It’s the same phenomenon, just described differently.

Russ Roberts did not go after O’Reilly on the anti-corporate demagoguery. A charitable interpretation was that Russ wanted to focus on the Internet “platform model” that O’Reilly waxes eloquently about. A less charitable interpretation is that Russ switched to Tyler Cowen’s philosophy of interviewing.

Why pick on sociology?

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A reader asks,

Why do economists have such contempt for sociologists?

…I was thinking of this because of your posts on “normative sociology”

1. The term “normative sociology” comes from Robert Nozick, and he described it as the study of what the causes of problems ought to be. I use it as shorthand for ideologically biased social research, in any discipline.

2. Mainstream economists do have contempt for sociology. When Robert Solow wanted to write about the causes of sticky wages, he apologized for doing “amateur sociology.”

Mainstream economists see themselves as studying phenomena that are tangible and quantifiable. I define sociology as the study of informal authority, and informal authority is inherently intangible and less readily quantifiable. Where mainstream economists can go wrong is to dismiss phenomena that are intangible and less readily quantifiable as unimportant. I think that mainstream economists are less scornful of such phenomena now than they were when I was in graduate school, so on that score the contempt for sociologists probably has trended down.

My own concern with sociologists is with the preponderance of left-wing bias embedded in much research. But I have been predicting that economics will go down that same path.

More of my thoughts can be found at The Sociology of Sociologists and How Effective is Economic Theory?

Deirdre McCloskey on teaching economics

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She writes,

I think economics, like philosophy, cannot be taught to nineteen-year olds. . .A nineteen-year old has intimations of mortality, comes directly from a socialized economy (called a family), and has no feel on his pulse for the tragedies of adult life that economists call scarcity and choice. . .you cannot teach him a philosophical subject. For that he has to be say, twenty-five, or better, forty-five.

Read the whole thing. Pointer from Tyler Cowen. My thoughts:

1. By her definition, I was not a natural economist. (She would say that there is nothing wrong with that.)

2. My own teaching experience is consistent with her view. I do not believe that the undergraduates I taught at George Mason or the high school students for whom I taught AP economics really grasped what I wanted them to grasp.

3. I wish that McCloskey had spelled out more completely what it is that she believes is difficult to teach. I am inclined to believe that she is right, but I cannot be sure without more elaboration on her part.

4. I am inclined to believe that teaching economics in terms of the history of economic thought would be worth attempting. I had a great high school chemistry course in which the teacher started with the discover of the gas laws and then gradually added new theories and experimental findings as they took place chronologically. I wish that it were standard to teach economics that way. Of course, you might reach the end of the first semester and still not have finished Adam Smith–even if you start with him.