Thursday, January 31, 2008

Arguing in economics: the gray area

Despite being interested in figuring out exactly what economics is, really, I have to confess that I don't really care about the common question "is economics a science?". Trying to answer it seems to tie people in knots, and I don't think the question by itself is very important. However, I just found a nice article on the subject which set me thinking.

My economics education was very essay-centric, and, perhaps paradoxically, I think was a good means to understanding what it takes to be "scientific" in a social science. A good essay has to contain more than raw emotion, but similarly should not avoid interpretation. It's equally difficult to argue using facts alone as it is to argue without them.

Is "good economics" the same? A theorem or result is, by nature, empty in itself - it's just a logical chain from start to finish. With the right starting point, you can "prove" anything; with an unproveable starting point, you're really in business. However, for the result to matter, it has to be put in context. What does it mean? Maybe it's semantics, but the search for meaning - the interpretation - is the birth of a normative judgment, still value-free but certainly pushing that label as far as it can go, before the true normative judgments of what we want are made.

The separation of the "scientific method" of economics and the use of its results must be sacred. The former, done from a position of honesty, can never be "wrong", since it's just logic. Why, then, must we introduce interpretation at all? The best reason to do so is the problem of "underdetermination", the idea, captured in the Friedman quotation I mentioned in a previous post, that if there exists another theory at least as consistent with the evidence, our theory is "underdetermined": all, perhaps, related to the problem of the unproveable starting point.

The underdetermination issue is, I think, especially relevant to theories which rely on behavioral assumptions, given that we know that humans are (sometimes) capable of being pretty nuanced in their behavior. Whether or not any scientific theory can be airtight is up for debate; in economics, I am convinced that no theory can be airtight. That's not to say we can't be nice empiricists and check predictions against evidence like scientists do, but it is to say that the alternative, consistent theories must be addressed before we can cross the line from positive science to normative policy. I have to show that my theory can be right, but also argue that mine is the most right, especially if I want to take my theory from the sterile, all else equal, scientific vacuum into inference about the real world.

Just like a debater or an essay writer, any position I occupy can be attacked, and defense is the only response that will preserve that positive, scientific position. If we can prove anything, if any hypothesis is underdetermined, then whether or not economics can be called a science, the scientific method alone won't be enough. Somewhere between that scientific method and the politicking of normative selection lies that subtle gray area which all of our correct, consistent theories must cross. There we must decide what we want to use them for, and how they should be received; the "useful" ones must be the only ones allowed to survive.

Wednesday, January 30, 2008

Can you test rationality?

Is it possible to test if people are rational? I think the answer, practically, is a very short no: if a rational person tries to achieve his most preferred outcome of the ones that are available, we can't distinguish the rationality or irrationality of his choice from his preferences. That is, if I don't know what you like, I can't tell if you did something because you liked it or because you're "irrational".

Yet rivers of ink have been spilled trying to "prove" or "disprove" models of rational choice. The most famous study of the type is the "Allais paradox", discussed here. It says that when you pose different choices to people, their responses to pairs of choices are "inconsistent" with each other because the two choices really represented the same cash outcomes.

Whether you look at the question being asked by this type of work "are people rational?", or "what do people care about?", it's pretty clear that any observation cannot answer either of these without knowledge of the other. In "The Methodology of Positive Economics" (pdf) Milton Friedman made the valid, general point that

"If there is one hypothesis that is consistent with the available evidence, there are always an infinite number that are."

It just so happens that if we interpret some piece of evidence as being consistent with "people are irrational", one of the "infinite number" towers above all others: "you guessed the preferences wrong". There's nothing wrong with trying to figure out how to better model the decisions of people, but claiming to have proved irrationality is nonsensical.

Tuesday, January 29, 2008

Who was Pareto anyway?

Students of economics will hear about "Pareto efficiency" very early in Econ 101. It's a tool to compare outcomes. Sadly, poor Pareto now has his name attached to a disastrously misunderstood concept - Pareto efficiency is everywhere used and frequently abused.

From a biography of the man himself, Vilfredo Pareto:

"Like Irving Fisher (1892), Pareto stumbled on the idea that cardinal utility could be dispensed with. Preferences were the primitive datum, and utility a mere representation of preference-ordering. With this, Pareto not only inaugurated modern microeconomics, but he also demolished the "unholy alliance" of economics and utilitarianism. In its stead, he introduced the notion of Pareto-optimality, the idea that a society is enjoying maximum ophelimity when no one can be made better off without making someone else worse off."

Two reasons to be cheerful: apart from featuring the excellent word "ophelimity" (n., economic satisfaction), this could not be clearer on the definition of Pareto optimality (now synonymous with Pareto efficiency). A situation is Pareto optimal if no one can be made better off without making someone else worse off.

Why, then, is this type of statement easily the most common mistake in economics (not intended to pick on the source, which is certainly not unique):

"There is no connection between Pareto efficiency and equity! In particular, a Pareto efficient outcome may be very inequitable. For example, the outcome in which I have all the goods in the world is Pareto efficient (since there is no way to make someone better off without making me worse off)." [Emphasis mine]

To get the cheapest criticism out of the way first, saying "there is no connection between Pareto efficiency and equity" is a bit like saying "there is no connection between Pareto efficiency and the color of my shoes"; why should there be? It's just a definition. It is, or it isn't. The criticism that's actually important is that the bit in bold is a logical falsehood.

The true statement would be "the outcome in which I have all the goods in the world can be Pareto efficient". In fact, equally true: "outcome _____ can be Pareto efficient". Why? The missing link is that Pareto efficient is, inherently, a concept built on utility. The "better off" part implies that our test of Pareto efficiency centers on the relative satisfaction enjoyed under alternative outcomes. This is, again, not the same as the relative levels of income, consumption or stuff enjoyed under alternative outcomes.

A simple proof by contradiction: I have all the goods in the world. I am also ascetic and thus get more satisfaction from having less goods. You always like more goods. The outcome in which I have all the goods in the world is Pareto inefficient.

Simple, no? Again, it's a case of confusing utility with goods or money, a case that would probably have irritated Pareto himself. The hidden assumption in the mistake quotation is the assumption on what the preferences of the person with all the goods are. We can imagine many ways in which that person's preferences would result in the falsehood of the assertion of Pareto optimality, yet we are anyway confronted with this manifestation of the prejudice that the concepts used by economists to compare outcomes are evil manifestations of an imagined money-centric, capitalist doctrine.

So is Pareto efficiency a normatively loaded term? Is the concept of Pareto efficiency part of positive economics or normative economics? Those who would argue that the boundary between the two is fuzzy frequently point to the Pareto efficiency tool as evidence. It's a concept that is, however, firmly positive, at least up to the scale of the interpretation of language. It either is raining, or it isn't. An outcome either is Pareto efficient, or it isn't. This cannot be a normative statement.

Perhaps the problem arises because, like all concepts that rely on assessing utility or satisfaction, Pareto efficiency might be inherently untestable. Unless it's actually possible to know or deduce preferences, we can't make physically true statements about Pareto efficiency or the like; the best we can do is to say "if these people have these preferences, this outcome is or is not Pareto efficient". To do better than conditional truth we somehow have to know preferences, and whether that's possible is, to me, a huge open question. Pareto efficiency might then seem normatively loaded because the assumption on what preferences people hold is folded into the statement of Pareto efficiency, as in the mistake above that omitted "if people only care about their own material possessions".

The irony is that Pareto, the man, for whom "Preferences were the primitive datum, and utility a mere representation of preference-ordering", might perhaps be the first to object to the misuse of his most famous concept.

Monday, January 28, 2008

The Philosophy of Economics

If we accept that there is a disconnect between the prior beliefs of economics students on what economics is and the real basis of the discipline, I think the quickest way to make a change would be to make a course in the philosophy of economics compulsory.

This is a pretty long piece (from an encyclopedia of philosophy no less), but it's just an excellent overview of some of the things a course like that would cover. It's certainly not uncontroversial though. I hope I can talk about some of these things soon.

Economics or finance?

From a fun baseball story about a minor league player selling shares in his career:

"Newsom has decided to use that economics degree he got from Tufts, and along with two friends he's started a new company called Real Sports Investments. It's a company that allows baseball fans to invest in minor league baseball players by purchasing shares of the player."

Being from Britain, it reminds me of those human interest stories you sometimes read about a father laying a bet that their son will one day play soccer for England (here's merely the first example I got from Google). More to the point, how is Newsom's economics degree helpful?

The short answer is not at all. The study of economics isn't "business", or management, or whatever you call the skills and knowledge that would be useful in setting up or running a company. It also isn't finance, so it can't help him understand how a stock market works.

What's the difference between economics and finance? A good starting point might be this, from Brian Hollar:

"Finance typically focuses on maximization of wealth. Economics focuses on the optimization of subjectively valued goals. Conceived of in this way, finance is a specialized subset of economics."

That gives the correct impression that finance is the one that's interested in the study of the management of money and assets. I might go further and say that finance is arguably vocational; I don't think economics courses hold a great deal of value for aspiring investment bankers (perhaps one of the commonest misconceptions held by undergraduate economics concentrators) - finance courses are the ones that will teach them how asset markets work. Economics, being more of a method than a body of knowledge, is not really vocational at all, even though students of economics will certainly develop other applicable skills like data analysis, applied math and writing. Economics probably uses optimization rather than "focusing" on it.

Just to complicate matters, the unfortunately named field of "financial economics" is, as the name might suggest, something of an intersection of the two. Financial economics is the application of the economic method to the particular case of the trade in money and assets like stocks and bonds: how do financial markets and the trade of assets affect the allocation of resources? How does the financial system affect the decisions made by people, companies, governments? Financial economics, being part of economics rather than finance, fits Hollar's definition of "optimization of subjectively valued goals"; it's again a descriptive tool rather than practical training or a recommendation of a course of action.

Finance and economics are terms often used interchangeably in the press. I think the best illustration is the word "socioeconomic", which to my mind really means "sociofinancial" - what's your social status, and how much money do you have? If we start using "economic" to mean the amount of resources a person has at their disposal, the nuance of the word as signifying the allocation of resources is obscured.

I always wondered why The Economist magazine has a composite section for "Finance & Economics". It might be worth emphasizing the distinction between these two concepts a little more cleanly. In an ideal world we might even have a third word: economics for the economic method, finance for asset markets and a shiny new one to talk about the "world economy". What does "America's weakening economy" really mean?

Sunday, January 27, 2008

A Christmassy footnote

A quick footnote to the Christmas talk: this article by Harvey Mansfield mentions the "deadweight loss of Christmas":

"Economists as ambitious as they are cagey--perhaps bored with economics in its usual confines--have become critical of the frenzy of Christmas gift-making. The gist of what they say: Christmas is a highly inefficient way of connecting consumers with goods."

So far, so familiar. After that, though, it's is the best of times and the worst of times for the impression of economics it conveys. I think it's worthwhile that Mansfield says:

"Most of the time economists these days do not care to pass judgment on the things people buy or sell. These are "preferences" not examined within economics; they are givens from which economists take their start."

This is right on the message of the fundamentally agnostic approach to assumptions on what people care about. My only complaint is that "buy or sell" already shows a bias toward the tangible: I'd say "the things people care about".

Mansfield goes on to speculate that the discipline of economics is in the business of trying to reconcile this idea of preferences being givens and some idea that the economist seeks to promote "economizing":

"Here, too, is the connection we expect between economics and learning to be economical and to economize .... The fundamental incoherence in economics is that it wants to pinch pennies (utility) but has no reason to stop you if you don't (liberty)."

An interesting discussion, but again, I can only argue again that economics does not - and in fact cannot - promote any one decision or system, but attempts to estimate what will happen and suggest some ways to compare outcomes. I don't see the connection between "pinching pennies" and utility: Mansfield again incorrectly presents the economist as one who equates "utility" with money. I'd be embarrassed to meet an economist who assumed to know for sure what made every person happy.

OK, no more Christmas talk until at least November.

Economic Imperialism

Is it true that economics is invading the space of other social sciences? The idea of economic imperialism is only admissible if we believe that economics equals money. If we don't believe that, economic reasoning is one of many ways of answering questions: a map, not a country.

The old textbook definition of economics as the social science of the allocation of scarce resources doesn't really limit us at all. Gary Becker is perhaps the economist most associated with the idea of economic imperialism; his position is that "the horizons of economics need to be expanded", but, without being too dramatic, those horizons aren't as close as they look.

When we see economists pop up in the press, they're usually talking about unemployment, inflation, growth, all the old ones. Sometimes, when we see an economist talking from over the "horizon", he looks fully as foolish as possible.

The famous one about Joel Waldfogel's "deadweight loss of Christmas" is a good example. Let me try to paraphrase: "if people only care about money, Christmas gifts are a big waste of resources because their cash value to the recipient is less than their cost to the giver. Give money instead!". Logical people subsequently point out that gift giving and gift receiving are two of life's great pleasures, and economists should go back to the cesspool they crawled from.

A microcosm, if you will, of the "economics as money" problem. The story's no fun if we actually talk about the "if people only care about money" part; with it, it's just a fun, throwaway logic game, but without it, it's a nice excuse to print some combination of "humbug" and "economist". Who'll print my story that says "if people care about money, being nice to their relatives, not looking like someone who can't think of a good gift, and a bunch of other stuff, Christmas gifts are an excellent use of scarce resources to spread satisfaction in our cold, crazy world. Happy Christmas!".

No-one will print it, of course. At least, not if they want to show me as a stereotypical economist. The trick is that both my story and the one about the deadweight loss of Christmas are equally acceptable applications of positive economic reasoning on the topic "what happens to people's satisfaction when they give or receive gifts?". I think my assumptions on the desires of the giver are more realistic, and I think Waldfogel's story lends itself better to measurement. It's the same rock and the same hard place: how can we be realistic and accurate at the same time? Not, perhaps, a life or death matter in the Christmas story, but pretty important when we're making policy-relevant models.

My interpretation of Becker's ambition is to apply the rational choice paradigm of economics to decisions that are decidedly not financial. I also believe that this doesn't require us to expand the horizons of the discipline: the horizons of economics are not financial, because applying economic reasoning doesn't require us to think only about money.

Saturday, January 26, 2008

The Positive Economist

If there's a mission statement to what I want to do here, it might be this:

What is economics? What does it mean to study economics? What is the popular perception of economics, and is it realistic?

I'm not going for "all you need to know about economics" (like Economics in One Lesson) or "applying economic analysis to everyday situations" (like Freakonomics or The Undercover Economist). I want to figure out what the discipline of economics is, and why it's not well understood.

Is John McCain an economist?

I think John McCain's being a little too hard on himself:

"They are complicated," McCain said of economic issues, "and I freely admit I am not an economist."

It probably depends on whether he's thinking of economics or economic policy. Senator McCain also says:

"But I know there are some people who have literally immersed themselves on issues of economics, how Congress works on it, the tax code, that sort of thing. I would look for that kind of talent not in a vice president but in close advisers."

What economist doesn't like the sound of that? However, studying or doing research in economics is very different from formulating economic policy.

"Economic policy" is simply policy that influences the way we organize our use of resources, and I think Senator McCain is probably a lot better at it than he gives himself credit for.

If Senator McCain asks his advisers "What would happen if I did this?", we need to figure out the chain of causes and effects that trickle through the whole country's decisions and their response to the proposed change in policy. If he asks "How can I achieve that?", we need to do the same thing backwards to somehow ask if there's any action the policymaker can take to alter the end product. These are positive economics questions: what's going to happen? I think this is what McCain might be worried about answering.

Deciding what policy is best is where it gets tricky; we have to somehow compare countless options, many of which have outcomes which aren't even certain. Then we have to deal with the familiar problem of measuring the satisfaction of the people, at least notionally, if we're to make any headway in choosing the "best" policy. These are normative economics questions, and I think John McCain is just as qualified as anyone to answer these.

In the ideal world where our policymaker - or anyone - has figured out or been appraised of the true and full consequences of a policy, it's out of the hands of "science" and becomes all about a value judgment. In a democratic society, who better than our elected representatives to make the value judgment on behalf of his constituents?

Being a normative economist is easy: all you need is an opinion. How informed that opinion is relies on the honest work of true positive economists. The study of economics should never confuse the two. The perception of economics might be inescapably tied to capitalism, but economics is not about promoting one system of organizing our resources over another. It's about figuring out what the consequences of the system would be (positive), seeking a means to compare them (normative) and then asking "what do you want?".

Of course, it is election season. Maybe McCain, normative economist of the people, is just trying to distance himself from economists - it makes him more likeable, I imagine...

Friday, January 25, 2008

Economics is not about money

"The most common misunderstanding about economics is that it is only about money and commerce."

The beginning seems like a good place to start, and the beginning of the misperception of economics is surely the popular notion that it's all about money. Where did that arise?

The quotation is from "What Economics Is Not" by Llewellyn Rockwell. Unfortunately, the essay also says:

"This is a confusion sown by economists themselves, who postulate something called “economic man” who possesses a psychological propensity to always behave in ways that maximize wealth."

Economics is social science, so we have to include an idea of how people behave. One way we do this is to suppose people have some likes and dislikes that their choices seek to satisfy. We suppose our "economic man" will behave in ways that maximize satisfaction.

That seems better than having "economic man" behave randomly: who could argue that we don't, in fact, try to make the best of what we have? Our problem is that it's very difficult to decide what people like or dislike. We know that many things affect the way we feel - a new car, sunshine, helping a stranger, being smiled at - and, of course, no two people are exactly alike.

To make matters worse, how would we even know if our "economic man" is striving to maximize satisfaction if we don't really know what makes him tick? What a huge philosophical question it is, and what an obstacle for economics to have to work with something so elusive as human satisfaction!

How can we recover? Economists often tried to make life much simpler by assuming that people only cared about wealth. Most people probably care about wealth to some degree, and wealth is, mercifully, more measurable than satisfaction, so this assumption shouldn't be way off the mark. Sadly, once we use the wealth proxy for satisfaction, our "economic man" looks like Rockwell's, and the misperception deepens.

Why was it deemed necessary to make the wealth-maximizer assumption? That is a question for another day. So, too, is how "economics" came to mean money, wealth or finance in its popular usage. Economics is to the stock market as physics is to your electricity bill - it's not unrelated, but it's a big stretch...

What an economist does

What is economics? The Positive Economist will correct misperceptions and reveal the truth, one example at a time.