Ireland’s first win against the All Blacks in New Zealand – Behavioural Economics

You maybe aware that the rugby game tonight between Ireland and the New Zealand All Blacks in Dunedin created history. It was the first time that Ireland have beaten the All Blacks in New Zealand. Remember they did beat the ABs in Dublin and Chicago.

Irish supporters, including myself, will take great pleasure in talking about such a result – I was at Eden Park last Saturday and disappointed at the number of mistakes Ireland made. What all this alludes to is the fact that as part of this entertainment comes without the public paying for it, the public benefits from an externality.

Those Irish supporters who traveled to Dunedin for the game will have no doubt spent a significant amount of NZ dollars tonight in the bars and restaurants around town. Nevertheless the satisfaction (utility) derived in NZ dollars from the game would have been much greater than the price Irish supporters would have paid for the ticket. This suggest that there is a lot of consumer surplus present – the difference between the price that a consumer WOULD BE WILLING TO PAY, and the price that he or she actually HAS TO PAY. The success of the Irish team will boost merchandise sales and interest for the World Cup next year in France but more importantly it has been good for rugby in general with throwing the World Cup wide open. When the All Blacks play overseas there are significant externalities whether it be the revenue generated in hosting the match or the social benefits to society.

Furthermore the lead up to the game brings about a sense of delayed gratification (Behavioural Economics). Looking ahead the fact that people have paid for tickets to the World Cup means that they can reap the pleasures of anticipation of being there. Research (Smarter Spending – see previous post) shows that owning material things from expensive homes to luxurious cars turn out to provide less pleasure than holidays, concerts or even witnessing Ireland beating the All Blacks – where were you when Ireland beat the All Blacks in Dunedin? With Ireland’s win national pride increases, along with patriotism and people feeling better about themselves. This is turn brings people together and boosts well-being of the nation. As for the All Blacks they will learn from this defeat and it makes for a great game next week in Wellington. Go Ireland!

For more on Consumer and Producer Surplus view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

Finland tops happiness rankings in 2022

The World Happiness Report for 2022 was published in March and it is interesting to see what data is used to generate their rankings. The colour-coded sub-bars in each country row represent the extent to which six key variables contribute to explaining life evaluations. These variables (shown in Table 2.1) are:

  • Healthy Life Expectancy: Life expectancy at birth based on data from WHO.
  • Social Support: Someone to help you in times of trouble. National average of binary responses either 0 or 1.
  • Freedom to make life choices: Yes of No to “Are you satisfied or dissatisfied with your freedom to choose what you do with your life?”
  • Generosity: national average of response to the Gallup World Poll (GWP) question “Have you donated money to a charity in the past month?”.
  • Corruption Perception: “Is corruption widespread throughout the government or not” and “Is corruption widespread within businesses or not?” The overall perception is just the average of the two 0-or-1 responses.
  • GDP per capita: purchasing power parity (PPP) at constant 2017 international dollar prices.

You will notice Dystopia as a variable. This is an imaginary country that has the world’s least-happy people. The purpose of it is to have a benchmark against which all countries can be favourably compared (no country performs more poorly than Dystopia) in terms of each of the six key variables. This permits the calculated contributions from the six factors to be zero or positive for every actual country. The happiness rankings are not based on any index of these six factors—the scores are instead based on individuals’ own assessments of their lives, as revealed by their answers to the single-item Cantril ladder life-evaluation question below:

“Please imagine a ladder, with steps numbered from 0 at the bottom to 10 at the top. The top of the ladder represents the best possible life for you and the bottom of the ladder represents the worst possible life for you. On which step of the ladder would you say you personally feel you stand at this time?”

Finland remains in the top position for the fifth year running, followed by Denmark in 2nd and all five Nordic countries among the top eight countries, joined by Switzerland, the Netherlands and Luxembourg. France reached its highest ranking to date, at 20th, while Canada slipped to its lowest ranking ever, at 15th, just behind Germany at 14th and followed closely by the United States and the United Kingdom at 16th and 17th.

Among the six variables used to explain these levels, there has been general growth in real GDP per capita and healthy life expectancy, generally declining perceptions of corruption and freedom, declining generosity (until 2020), and fairly constant overall levels of social support.

Source: https://worldhappiness.report/

A2 Revision – Oligopoly and the kinked demand curve – download

Getting onto market structures with my A2 class and here is a note on the kinked demand curve. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

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Crowd Psychology and the Stock Market

Anatole Kaletsky wrote an article in Gavekal Research – ‘Five Features Of Market Madness’ – (Ideas June 16 2020) in which he talked about ‘Nominative determinism’. Two examples:

  1. Chinese property company called Fangdd Network where its value jumped from US$800mn to US$10bn in four hours of trading. Fangdd Network made it sound like a cheap ETF (ETFs give you a way to buy and sell a basket of assets without having to buy all the components individually) for the FAANG technology giants.
  2. Nikola, an aspiring electric vehicle manufacturer with no revenues that launched three months ago on Nasdaq saw its value spike to almost US$30bn, up from US$300mn at its March IPO, mainly because, like Elon Musk’s electric car company, it was also named after 19th century Serbian-American inventor Nikola Tesla.

Anatole Kaletsky 5 features of market madness

  • While monetary easing usually starts a bubble, a reversal in monetary policy is unlikely to deflate the bubble once the speculative momentum builds.
  • Valuations do not matter while a bubble is inflating, but they become very important after it bursts.
  • Bubbles typically end with the some huge corporate collapses (Charles’s analogy of dynamite fishing), often tainted with fraud.
  • Bubble dynamics need not bear any relation to the strength, or weakness, of the economic cycle.
  • Speculation increases dramatically when prices break through major highs.

These examples show that it is not analysis of valuations, monetary policy or economic data that is driving prices up. Famous economist J.K. Galbraith once remarked that ‘economic forecasting was invented to make astrology look respectable’. He also said that we are mush reassured by the ‘conventional wisdom – i.e. strongly held beliefs that have, at best, a tenuous grounding in reality. John Maynard Keynes stated that ‘the market can stay irrational longer than you can stay solvent’. Mervyn King, former Governor of the Bank of England, argues that economic decisions always occur under conditions of, what he calls, ‘radical uncertainty’ – unaware of what might happen in the future. King says that people use ‘narratives’ to make sense of the world. He also suggest that economists in the 2008 GFC didn’t learn from history – the Great Depression before they were born.Each time they suggest that this time it is different – an expression by experts suggesting that the new situation (GFC) bears little resemblance to previous crises. Carmen Reinhart and Kenneth Rogoff in their book entitled ‘This Time is Different’ show that we haven’t learnt from what happened in the past – short memories make it all too easy for crises to recur.

Business cycle or volatile booms and busts? The four stages of the bubble.

I blogged on this topic last year but below is a useful video from the Wall Street Journal (WSJ) on how bubbles are so difficult to predict with some examples from Gamestop to Tulips. A graphical explanation follows after the video.

I picked up this graphic and explanation from The Geography of Transport Systems by Jean-Paul Rodrigue (2020)

It is apparent that business cycles aren’t those smooth ups and downs as depicted in a lot of textbooks but more volatile with booms and busts. Central banks appear to play their part in this process with the low cost of borrowing feeding the boom phase of the cycle. Instead of economic stability regulated by market forces, monetary intervention creates long-term instability for the sake of short-term stability.

Bubbles (financial manias) unfold in several stages, an observation that is backed up by 500 years of economic history. Each mania is obviously different, but there are always similarities; simplistically, four phases can be identified:

  • Stealth – emerging opportunity for future prize appreciations of investments. Investors have better access to information and understand the wider economic context that would trigger asset inflation. Prices tend to increase but are unnoticed by the general public.
  • Awareness – many investors start to notice the momentum so money starts to push prices higher. There can be sell-offs but the smart money takes this opportunity to reinforce its existing positions. The media start to notice that this boom benefits the economy.
  • Mania – the public see prices going up and see this a great opportunity to invest with the expectations about future appreciation. This stage is not so much about reasoning but psychology as money pours into the market creating greater expectations and pushing prices up. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep asset inflation going. At some point, statements are made about entirely new fundamentals implying that a “permanent high plateau” has been reached to justify future price increases; the bubble is about to collapse.
  • Blow-off – everyone roughly at the same time realises that the situation has changed. Confidence and expectations encounter a paradigm shift, not without a phase of denial where many try to reassure the public that this is just a temporary setback. Many try to unload their assets, but takers are few; everyone is expecting further price declines. Prices plummet at a rate much faster than the one that inflated the bubble. Many over-leveraged asset owners go bankrupt, triggering additional waves of sales. This is the time when the smart money starts acquiring assets at low prices.

For more on the Business Cycle view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

Economic Theory v Economic Reality

Invariably I get the question in class “Does this economic theory actually happen in the real world?” We then proceed to discuss upward sloping demand curves, trickle down theory, the GFC and the fact that few economists saw it coming and how Japan ran a massive stimulus programme but inflation was stagnant.

Most theories in economics rest on the premise that people, companies, and markets behave according to the abstract, two-dimensional illustrations of an introductory economics textbook, even though the assumptions behind those diagrams virtually never hold true in the real world. To understand economics you have to understand human nature.

Below is a table that I found in James Kwak’s book “Economism”. It takes theories found in most introductory economics textbooks and suggests what actually might happen to these theories in the real world.

For more on secondary school economics courses view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

Sky TV and the Paradox of Choice

Flicking through the TV channels one evening one found that what was supposed to be a time of relaxation was actually quite tiring. Surely with more choice and freedom to chose what to watch I would be a lot more content. In the age of the Internet, smartphones etc  there is a paradoxical effect in that we have access to an endless amount of movies, TV programmess, documentaries, sport etc.

My mind went back to Barry Schwartz’s TED talk “The Paradox of Choice” and what he calls the “official dogma of all western industrial societies” – see below. This is the common belief that by maximising one’s choice, we are maximising their freedom, and therefore their welfare. A clear intuitive example is a medical doctor offering a patient certain treatment options. The patient has choice, but he/she would most likely lack the knowledge and physical state of mind to make the best decision. Obviously, it should be better if the doctor, with all their experience and knowledge, makes the decision, even though it restricts the patient’s choice.

However freedom can do more harm than good in that it paradoxically causes paralysis in decision-making. When people have a lot of freedom, they have to spend time and effort considering the many options and making a decision. Should I watch rugby, cricket, league or ESPNFC on Sky? What about PBS News, CNN or Discovery? Some will say just record the programmes you didn’t watch but what you end up doing is filling your disk so that you can’t record anything else. These rather futile, yet difficult decisions make us indecisive, slow, and permanently pre-occupied in our lives, all thanks to the “problem” of having a bit too much freedom. Growing up in Ireland we had access to BBC1 Match of the Day (two games of highlights from English Football Division 1 – Premier League now) and it was something that you really looked forward to – 10pm on a Saturday night. Here there is limited choice and because of this maybe more satisfaction in that I didn’t have to worry about who or what to watch. In fact the pleasures of anticipation of Match of the Day on Saturday built throughout the week and provided more happiness – research shows that waiting for something – a chocolate – makes it taste better when we get it.

However, there are some more subtle cognitive effects that come with more freedom. First, it is very easy to imagine that there was a better choice than the one that you had chosen – i.e. the opportunity cost can take away your happiness from your current decision. This causes us to regret our own decisions (even if the option we took was the best choice), and this can seriously damage how satisfied we are with something. And with more freedom, comes more capacity to imagine that the grass is greener on the other side.

Finally, in this “choice-full” world of today, people are bound to choose an option that is almost perfect. Schwartz talks about how there only used to be one kind of jeans that you could buy, compared to the many different colours, fabric, fit, and size that you can buy today. He claims that by being able to buy such near-perfect jeans, you have such high expectations for the next pair that you can’t be completely satisfied. He jokes: “the secret to happiness is low expectations.”

Maximizers and Satisficers

With so much choice today we tend to fall into two categories of consumers.

Maximizers are those people that spend all their time exhaustively search for every piece of information about a product in order to make what they believe to be the perfect choice. However it can lead to nagging doubts about their choice and they can become unhappy.

Satisficers are those people that settle with the decision that is good enough and seem to be happier with their decision.

Veblen goods and how to own part of a Birkin Bag

Online trading site Rally Rd has introduced an opportunity to part own various luxury items. For instance you could become part owner of a $61,500 Birkin Bag or top of the range Lamgourghini car. Rally Rd acquire the most noteworthy items from collections and individuals all over the world and make them into “a company”. They then split it into equity shares and open an “Initial Offering” where investors can purchase shares & build a portfolio. After 90 days, investors have the chance to sell shares in-app or add to their position on periodic trading days (through registered broker dealers).

The market for investing in fractions of items otherwise seen as collectibles — and largely reserved for the wealthiest people — has seen an uptick in interest during the pandemic as people spend more time at home. Although there is a potential return on the investment you never get to see your Birkin Bag or Lambourghini. Shares are traded until the owner of the marketplace sells the asset.

Are Birkin Bags Veblen Goods?

Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status.

Economists and sociologists often cite the 1980’s as a time of extreme conspicuous consumption. The yuppie materialised as the key agent of conspicuous consumption in the US. Yuppies didn’t need to purchase BMWs or Mercedes’ cars for example; they did so in order to show off their wealth. This period had its origins in the 1930’s with Austrian economists Ludwig von Mises and Fredrick von Hayek – the latter being the author of “The Road to Serfdom”, in which he said that social spending rather than private consumption would lead inevitably to tyranny. Margaret Thatcher (UK Prime Minister 1979-1990) and Ronald Reagan (US President 1981-1989) believed in this ideology and cut taxes and privatised the commanding heights in a move to a free market environment.

So-called Veblen goods (also as know as snob value goods) reverse the normal logic of economics in that the higher the price the more demand for the product – see graph below

Over the last three decades conspicuous consumption has accelerated at a phenomenal level in the industrial world. Self-gratification could no longer be delayed and an ever-increasing variety of branded products became firmly ingrained within our individuality. The myth that the more we have the happier we become is self-perpetuating: the more we consume, the less able we are to tackle the myth.

The Economist 1843 bi-monthly magazine had a very good article on Hermès’s Birkin handbag (named after Jane Birkin, an Anglo-French actress who spilled the contents of a overfull straw bag in front of Jean-Louis Dumas, Hermès’s chief executive) and how it has become one of the world’s most expensive – prices start at $7,000; in June Christie’s Hong Kong sold a matte Himalayan crocodile-skin Birkin with a ten-carat diamond-studded white-gold clasp and lock for $300,168. The rationale for its expense is that it is hand crafted and can take up to 18 hours to complete although the production cost is estimated to be around $800.

One would think that this would be a Veblen Good – a good in which the higher the price the more demanded. However there are a couple of ways that the Birkin handbag is not.

1. The bag is not all that conspicuous as although most people can identify Gucci, Louis Vuitton or Chanel, a Birkin is not so easy to find. In fact it is an inconspicuous but expensive bag. This theory was explained in the article “Signalling status with luxury goods: the role of brand prominence” from the Journal of Marketing (2010). It divided the high income earners into two groups;

Parvenus – who want to associate themselves with other high income groups and distinguish themselves from those who do not have material wealth.

Patricians –  who want to signal to other people in their high income bracket and not to the masses. They are of the belief that more expensive luxury goods aimed at them will have less obvious branding than cheaper products made by the same company. This was achieved with smaller logos for more expensive items and larger ones for cheaper goods which are aimed at the masses. People who cannot afford the luxury items will buy the big logo items (louder products) and this is where the counterfeiters have a field day.

2. Normally producers of Veblen goods should raise the price till the point where the demand curve starts to follow it normal shape – downward sloping from left to right. However with Birkin they maintain its exclusivity not by raising the price but by limiting the supply. Unlike other Veblen goods you just can’t walk into a shop and buy a Birkin bag – you have to place an order and wait for it to arrive. But you would wonder why they don’t sell more and make more money? It is a supply constraint – limited availability of high-quality skins and craftspeople to make them – it takes two years training. Hermès suggests, Birkins are mined, not simply made.

Commercial Reasons to limit supply of Birkins

Rationing by supply rather than price does make good commercial sense for the following reasons:

1. It gives Hermès a buffer as if demand drops, sales will not.

2. It creates excess demand for the bags, which overflows into demand for other Hermès products – wallets, belts, beach towels etc.

3. Profitability in the short run would reduce its exclusiveness as the main buyers of the bags would eventually be those concerned with social climbing. Therefore the rich may lose interest in the bags and so will those that aspire to be like them.

However I not sure Hermès actually want you to buy their amazingly expensive bag.

Should we stop consumption?

Geoffrey Miller is his book – Spent: Sex, Evolution, and Consumer Behaviour – examines conspicuous consumption in order to rectify marketing’s poor understanding of human spending behaviour and consumerist culture. His thesis is that marketing influences people—particularly the young—that the most effectual means to show that status is through consumption choices, rather than conveying such traits as intelligence and personality through more natural means of communication, such as simple conversation. He argues that marketers still tend to use naive models of human nature that are uninformed by advances in evolutionary psychology and behavioural ecology. As a result, marketers “still believe that premium products are bought to display wealth, status, and taste, and they miss the deeper mental traits that people are actually wired to display—traits such as kindness, intelligence, and creativity.

The recent global downturn with Coivd-19 has sent out a few mixed messages. Firstly there has been the reduction in consumption as people’s credit lines have dried up but there are those that believe that you should spend more to maintain growth and employment in the economy. With household budgets being very tight smarter consumption rather than less consumption has been advocated by Geoffrey Miller. He refers to this as more ethical consumption where the production of produce does not involve the abuse of natural resources or the exploitation of people or animals.

Nordic countries and levels of happiness

I blogged a few days ago on happiness and the old East Germany where pre-transition conditions show that to increase people’s level of happiness, job security and a strong social welfare system were paramount. Would these policies that increased happiness under socialism work in capitalist countries? The Nordic countries – Norway, Finland, Denmark and Sweden – are widely recognised as typical welfare states and were among the leaders in introducing employment and social safety net legislation. Today their spending on a social safety net as a % of GDP is one of the highest in the world. One of the main reasons for the level of happiness in these countries is the quality of public services – health, education, childcare, pensions and elderly care – and the population know that their public services are good.

But doesn’t a higher income mean greater happiness?

In the mid 1970s Richard Easterlin drew attention to studies that showed that, although successive generations are usually more affluent that their parents or grandparents, people seemed to be no happier with their lives. It is an interesting paradox to study when you are writing about measuring economic welfare and the standard of living.

What is the Easterlin Paradox?
1) Within a society, rich people tend to be much happier than poor people.2) But, rich societies tend not to be happier than poor societies (or not by much).
3) As countries get richer, they do not get happier. Easterlin argued that life satisfaction does rise with average incomes but only up to a point. One of Easterlin’s conclusions was that relative income can weigh heavily on people’s minds.

The most comprehensive study in looking at whether higher income leads to higher levels of satisfaction was published in 2012 and looked at countries over time and concluded that more income leads to greater levels of happiness. However it wasn’t clear as to whether money leads to happiness or happiness leads to money.

How do the Nordic countries pay for these public services?

Taxes in Nordic countries are considerably higher than in countries with less extensive and generous social safety net. The OECD puts the ratio of government tax revenue to GDP for Nordic countries as 53% compared to 45% in the EU and the USA 33%. Nordic countries seem to be willing to pay their fair share of taxes although their incomes are higher than your average OECD country. With the rapid development of technology job security is a concern in most countries but a survey of Swedish workers suggested that they are not worried about losing their jobs due to technological advances. 80% of those surveyed expressed positive views about robots and artificial intelligence. A similar survey of saw 72% American workers negative views about robots and artificial intelligence. The Swedish minister for employment and integration quoted in the New York Times:

“The jobs disappear, and then we train people for new jobs. We won’t protect jobs. But we will protect workers.”

Easterlin argued that life satisfaction does rise with average incomes but only up to a point. For Nordic countries it seems that levels of happiness correlate to an effective social welfare system paid for by high taxes.

Source: An Economist’s Lessons on Happiness. Farewell Dismal Science by Richard A. Easterlin (2021)

Making economics relevant to students

Although a few years old now the mini-documentary below is very good and features many notable economists and economic thinkers. They basically look at the issue of financial stability, or the lack thereof, and discuss what is at the core of the problem. It includes Joseph Stiglitz, Gillian Tett, David Tuckett, Stephen Kinsella, John Kay, David Weinstein, Steve Keen and Dirk Bezemer. I have used this post to try and bring some reality to a lot of prescribed economics courses at high school level.

With the COVID crisis economists have got in wrong in many of their predictions. In New Zealand they stated that house prices would fall by 30%, unemployment would rise to between 15% to 30% and the downturn in NZ would be a lot worse than the GFC in 2008. Auckland house prices have risen by 17% since the outbreak, Unemployment is only at 4.7% and GDP growth expanded 1.6% in the March quarter. There is a very good podcast from Radio New Zealand’s Media Watch programme in which they discuss the problems of economists’ forecasts. Furthermore economists have long proven to be bad at predicting recessions. 

  • A study by the IMF in 2018 looked at 153 recessions in 63 countries between 1992 and 2014 and found the vast bulk of them came as a surprise to economists.
  • The Queen famously asked why nobody noticed the 2008 Global Economic Crisis coming.  
  • In his acceptance speech for the Nobel prize for economics, Friedrich Hayek said economists’ tendency to predict things with the certainty and language of science was misleading and “may have deplorable effects”.

The economic environment is said to be determined by agents or economic decision-makers. Today, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy.These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. However the rise of behavioural economics has shown that cognitive errors are now assumptions in many aspects of economics namely – heuristics, confirmation bias, overconfidence and distorted probability weights.

According to a paper entitled “Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol research has shown that beliefs often fulfill important psychological and functional needs of the individual. Examples include:

  • confidence in ones’ abilities,
  • moral self-esteem,
  • hope and anxiety reduction,
  • social identity,
  • political ideology
  • religious faith.

Therefore people hold beliefs because of the value they attach to them, as a result of the tradeoff between accuracy and desirability. As a consequence of this some of the beliefs do not consider prior knowledge of conditions or events that might be related to their beliefs – Bayseian Updating – this refers to people who are willing and able to modify their beliefs based on new, objective information. This non-Bayesian behaviour includes ignoring signals about their beliefs and denying what in turn will be the reality. Nevertheless motivated beliefs will respond to costs, benefits, and stakes involved in maintaining different self-views and world-views which leads to self-sustaining “social cognitions.”

Overconfidence
Bénabou and Tirol suggest that overconfidence is the most common indicator of the motivated beliefs experience. Overconfidence can be seen as quite damaging although moderate confidence can be quite useful as it often enhances an individuals ability to act successfully on their own behalf and work well with others. Research has shown that psychologically “healthy” people display some degree of overoptimism and biased updating, while it is primarily depressed subjects who seem to be more objective.

If beliefs are shared between parties they may magnify each other and there is a tendency to follow the herd, especially if information is uncertain, incomplete, and asymmetric (some people are more informed than others). Basically, in a world of bounded rationality (the limits of the human brain in processing and understanding information), herding makes sense to most people. Herding is a fast and frugal heuristic (short-cut) that has been used by both human and non-human animals across the millennia. Some behavioural economists see herding as irrational because people aren’t basing their decisions on objective criteria. If herding is seen as rational it can result in price cascades leading to excessive booms and busts in the prices of financial assets. Case and Shiller (2003) surveyed the expectations of homeowners during the real-estate bubbles of 1988 and 2003. In both cases, 90 percent of respondents thought housing prices in their city would “increase over the next several years,” with an average expected gain for their own property of 9 to 15 percent per year over the next ten years.

The strategies of self-deception and dissonance-reduction used to protect valued beliefs are many and varied, Bénabou and Tirol group them into three main types: strategic ignorance, reality denial, and self-signaling.

Strategic ignorance is when a believer avoids information offering conflicting evidence.

Reality denial refers to troubling evidence that is rationalised away: house-price bulls might conjure up fanciful theories for why prices should behave unusually, and supporters of a disgraced politician might invent conspiracies or blame fake news.

Self-signaling is when the believer creates his own tools to interpret the facts in the way he wants: an unhealthy person, for example, might decide that going for a daily run proves he is well.

Final thought

People derive utility from a sense of belonging to communities and having a positive self-image. Optimistic beliefs can also be valuable motivators to overcome self-control problems, as well as helpful in strategic interactions. In order to maintain this level of utility people tend to disregard Bayesian updating and are not willing to modify their beliefs based on new, objective information. Even if they did consider new information they will manipulate it to align with what their beliefs are.

Overconfidence is the most common indicator of the motivated beliefs experience and this can be impacted by the behaviour of others. Their confidence is often reinforced when people know that other people, including experts, and the rich and famous, are doing the same. In a world of bounded rationality, such behaviour may make sense – even though it can result in errors in decision making.

Sources:

“To err is human; so is the failure to admit it” – The Economist June 10th 2017

“Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol. Journal of Economic Perspectives—Volume 30, Number 3—Summer 2016—Pages 141–16

Inconspicuous Consumption is the way ahead

Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status. Economists and sociologists often cite the 1980’s as a time of extreme conspicuous consumption. The yuppie materialised as the key agent of conspicuous consumption in the US. Yuppies didn’t need to purchase BMWs or Mercedes’ cars for example; they did so in order to show off their wealth.

Claremont Review of Books

Most developed countries cannot be dependent on private domestic consumption in excess of 60% of its GDP. Not only is the planet running out of resources to produce these goods/services but also the impact on climate change is very significant. The essay that won the 2021 Financial Times ‘Political Economy Club prize’ by Krzysztof Pelc outlines that there is a shift in attitudes of today’s consumer. He states that much of the material wealth that people generate is an expression of signalling to others ‘look at me’. In each case this signalling demands some sort of ‘conspicuous waste’ – a highly visible expenditure of resources that brings no material benefit but simply signals the purchaser’s ability and willingness to waste those resources. As there are more things to buy the greater the pressure on people to buy them and thereby increasing the waste and diluting the means of social distinction. The conspicuous consumer could be a thing of the past as loud labels become a shallow human signal with show-off status being gradually replaced by natural-face-to-face interaction and an emphasis on a sustainable planet.

Owning material things from expensive homes to luxurious cars turn out to provide less happiness than holidays, concerts and special occasions. In the long run it doesn’t matter so much about the USA, European economies and their consumption habits but those that are fast growing and with vast populations – China and India. They have a good chance to shift their trait-display systems before conspicuous consumption becomes locked in as a cultural norm.

The recent global downturn with Coivd-19 has sent out a few mixed messages. Firstly there has been the reduction in consumption as people’s credit lines have dried up but there are those that believe that you should spend more to maintain growth and employment in the economy. With household budgets being very tight smarter consumption rather than less consumption has been advocated by Geoffrey Miller in his book ‘Spent’. He refers to this as more ethical consumption where the production of produce does not involve the abuse of natural resources or the exploitation of people or animals. Furthermore a need to switch from an income tax that promotes short-term runaway consumption to a consumption tax that promotes longer-term ethical investment, charity, social capital, and neighbourly warmth.

“affluent economies such as Britain’s have already reached a point at which further advances in wellbeing are not likely to come from a single-minded focus on growth.” Krzysztof Pelc

Euro 2020 action bias and penalty kicks – is it best if the goalkeeper does nothing?

With the Euro 2020 now over and games including the final decided on penalties I thought it would be appropriate to look at the psychology of penalty kicks. Would goalkeepers be better not moving when facing a penalty?

Action bias is a situation where we would rather be seen doing something than doing nothing. This has been the case in numerous government elections as the voting population like to see some action from politicians when in some cases the best option is to let the economy run its course. President Nixon (US President 1969-74) was a great one for doing something even though it would have been better to do nothing – I refer to the wage and price controls introduced in 1971 – the controls produced food shortages, as meat disappeared from supermarket shelves and farmers drowned chickens rather than sell them at a loss. So when the economy is doing badly the government maybe tempted to intervene, even if the risks associated with the changes not necessarily outweigh the possible benefits. Furthermore if an economy is doing well policy makers may feel that they shouldn’t do anything even though the changes could improve the economy further.

According to classical assumptions in economics, when people face decision problems involving uncertainty, they should choose what to do according to their utility from the possible outcomes and the probability distribution of outcomes that follows each possible action. Bar-Eli, Azar, Ritov, Keidar-Levin, & Schein, 2007

In a 2007 study, Michael Bari-Eli at the Ben Gurion University of the Negev, Israel, analyzed 286 professional soccer penalty kicks. They discovered that goalkeepers almost always jump right or left because the norm is to jump — a preference for action (”action bias”). The goalkeepers jumped to the left 49.3% of the time, to the right 44.4% of the time, but stayed in the centre only 6.3% of the time. Analysis revealed that the kicks went to the left 32.2%, to the right 39.2% and to the centre 28.7% of the time. This means that the goalkeepers were much more likely to stop a kick if they had just stayed put – see table below.

The table above suggests that the decisions taken by the kicker and goalkeeper are made roughly simultaneously. The fact that the directions of the kick and the jump match in 43% of kicks rather than in 0% or 100% of the kicks suggests that neither kicker nor goalkeeper can clearly observe what the other chose when choosing their action.

A goalkeepers’ decision making.

In order to suggest a best option for goalkeepers it is necessary to examine the probability of stopping the ball following each combination of kick and jump directions. The table below presents the average saving chances using the formula

Number of penalty kicks saved ÷ Number of penalty kicks x 100

Jumping left = 20 ÷ 141 x 100 = 14.2%
Staying Centre = 6 ÷ 18 x 100 = 33.3%
Jumping right = 16 ÷ 127 x 100 = 12.6%

The research conclusions state that goalkeepers jump to the right or the left during penalty kicks more than they should. In analysing the 286 kicks Bar-Eli et al show that while the utility-maximising behaviour for goalkeepers is to stay in the goal’s centre during the kick, in 93.7% of the kicks the goalkeepers chose to jump to their right or left. This non-optimal behaviour suggests that a bias in goalkeeper’ decision making might be present. The reason that they suggest is ‘action bias’. However you also need to look at the psychological aspects of a goalkeeper. Former Arsenal and Chelsea goalkeeper Petr Cech said that he never liked to stay in the centre as it might look to the fans that he wasn’t trying. Although he would be in a good position to save a penalty that was kicked down the centre, he would feel a lot worse if he stayed in the centre and the ball went into the goal either side of him.

Sources:

Bar-Eli, M., Azar, O. H., Ritov, I., Keidar-Levin, Y., & Schein, G. (2007). Action Bias Among Elite Soccer Goalkeepers: The Case of Penalty Kicks. Journal of Economic Psychology, 28(5), 606-621.

Behavioural Economics course for school students

At various stages of my teaching I have delved into the area of Behavioural Economics as it is part of the CIE A2 course and from a personal interest perspective. I have attached a course booklet that consists of lesson plans on various topics and resources that are required to supplement the course. Click below to download the course notes and workbook. If you would like the PowerPoints that complement the course please email me – m.johnston@kingscollege.school.nz – and I will forward them on. Ideal for those Friday afternoon classes.

Behavioural economics is about bringing reality into economic analysis. It borrows from psychology, sociology, politics, and institutional economics (which focuses on the rules of the economic game) to describe and explain human behaviour and economic phenomena. Behavioural economics builds upon conventional economics, offering more tools for understanding why people behave the way they do when it comes to income, wealth, ethics, and fairness. It uses prospect theory to describe the choices that the typical person makes. The course is split up into 4 topics and is designed for approximately 12 periods in length.

1. Understanding Choice

Free choice in Economic Decision Making – Nudging – Anchoring and Framing – Free – Placebo Effect – Paradox of Choice – Loss Aversion and Endowment Effect – Conventional v Behavioural Economics

2. Ethics and Economic Growth

Ethical Behaviour – definition – Milton Friedman and ethical behavior – The Conventional – Perspective on Ethical Behaviour and the Economy – A Good Company – Ethics / – Happiness – Examples of Companies with socially responsible norms – Ethics and Profits
Ethical consumers

3. Behavioural Finance

Definition – what is it? – Efficient Market Hypothesis – Random Walk Hypothesis – Irrational Exuberance – Bubbles and Busts – Tulip – Great Crash – Dot.com – 2008 Global – Financial Crisis – Causes of Bubbles

4. Game Theory

Introduction to Game Theory – Football – Penalty Shoot outs – Golden Balls Game Show

5. Money and Happiness

Conventional Theory – Money = Happiness – Measuring Happiness – Gross Domestic Product v Gross National Happiness – Diminishing Returns for Income and Wealth
Easterlin Paradox: Money doesn’t buy happiness
– The Hedonic Treadmill – Money leads to more happiness but not for too long – Differences in happiness between countries – Government Policy and Happiness- Smarter Spending

Sources:

Behavioural Economics for Dummies – Morris Altman
Thinking, Fast and Slow – Daniel Kahneman
Economic Naturalist – Robert Frank
Nudge – Richard Thaler & Cass Sunstein
Inside Job – DVD
Black Gold – DVD
The Corporation – DVD
How Algorithms Shape our World – TED Talk

Minimal monetised societies and happiness

For less developed countries economic growth is often assumed to improve the happiness of the population although this relationship has come under a lot of scrutiny in recent times. A new study shows that people in societies where money plays a minimal role can have a level of happiness comparable to those living in Scandinavian countries which typically rate highest in the world. An interview with Eric Galbraith (McGill University, Canada) on Radio New Zealand’s ‘Sunday’ programme caught my attention in which he discusses the research undertaken in the Solomon Islands and Bangladesh. The paper is entitled:

Happy without money: Minimally monetized societies can exhibit high subjective well-being

Public policy that has focused on GDP growth fails to capture other aspects such as income inequality, the depletion of natural resources, environmental concerns etc. However subjective well-being (SWB) is an indicator that is more associated with the variables that matter to people. Galbraith et al question the role of money in determining SWB and reference the Easterlin Paradox (see below) which found that people don’t tend to get happier when their income goes up – see graph below.

What is the Easterlin Paradox?

Easterlin Paradox
  1. Within a society, rich people tend to be much happier than poor people.
  2. But, rich societies tend not to be happier than poor societies (or not by much).
  3. As countries get richer, they do not get happier. Easterlin argued that life satisfaction does rise with average incomes but only up to a point. One of Easterlin’s conclusions was that relative income can weigh heavily on people’s minds.

It is generally believed that people in less developed countries that have minimally-monetised economies have low that SWB. However the fact that happiness has a universal feeling suggest that income may be just a substitute for other sources of happiness, an assumption that is easier to notice in settings where money has little or no use. They used three independent measures to assess complementary but distinct psychological dimensions of SWB.

  1. Cognitive life evaluation – this asks about a person’s satisfaction with life and questions are phrased in a few different forms.
  2. Affect balance – asks what emotions they had experienced throughout the previous day, and calculated as the difference between positive and negative emotions.
  3. Momentary affect – data was obtained by querying subjects by telephone at random times about their emotional state.

Researchers selected four sites in two countries:

Solomon Islands – round 80% of the population live in rural subsistence communities and it has a Human Development Index (HDI) of 0.546 (rank 152 in the world). The sites were Roviana Lagoon (rural site) and Gizo (urban site)

Bangladesh – 35.9% of it being urban, and has an HDI of 0.608 (world rank 136). The sites were Nijhum Dwip (rural) and Chittagong (urban).

Results
The graph below shows that the 4 sites, although are minimally monetised societies,
do experience high levels of SWB which challenge the prevailing view that economic growth is a reliable pathway to increase subjective well-being. While the data presented here were collected only in two countries and four sites this is the first study to that systematically compares standardised SWB measures in minimally monetised, very low-income societies.

New Zealand Household income not enough to be happy.

The recent Parliamentary Economic Review looked at the Household incomes and housing costs for the year ended 30 June 2020. Household income includes income from wages and salaries, self-employment, investments, government benefits, along with superannuation income. Some main points from the article:

  • Annual average household income was $107,731
  • Median annual household income was $88,327
  • Data only covers nine months to March 2020 – Stats NZ unable to collect data during the COVID-19 lockdown.
Stats NZ

Highest/lowest household incomes were:

  • Auckland region had the highest average annual income at $128,747
  • Wellington region $123,533.
  • Manawatū- Whanganui region $85,841.

Housing costs include spending on rents and mortgage repayments (both principal and interest repayments), along with spending on property rates, and building-related insurance. NZ households spent an average of $21 of every $100 on household costs which is similar to 2019. Of those in rental accommodation 26.5% spent more than 40% of their household income on rental payments and other housing costs.

What level of income makes us happy? New Zealand 5th

However a “happiness premium” established by researchers at Purdue University, in the United States suggested that an individual salary of $178,328 (US$128,844) will make New Zealanders happy but as shown above our average household income is $107,731. Money and finance website Expensivity has calculated the salary level in each country that would prevent unhappiness. Researchers looked at data from 1.7 million people and cross-referenced their earnings and life satisfaction. They found that more money boosted happiness – but only to a point. Beyond that, further increases in income could actually lead to more unhappiness. New Zealand ranks as the 5th highest income required to achieve happiness.

The Economist magazine nudge readers to opt for digital subscription

Last week I received a letter from The Economist to renew my subscription and noticed how it had changed from previous years – see 2019 and 2021 renewal letters

The Economist – 2019 subscription
The Economist – 2021 subscription

Notice the following:

  • They have moved away from 3 to 2 options in 2021.
  • They have still left the Print only edition on the subscription letter even though it is not available. This is showing the customer that they are getting a very good deal with the Print & Digital package.
  • In 2019 the Print & Digital package is more expensive than the Print alone option.
The Economist renewals for 1 year.

With the increasing cost of print media I believe The Economist is trying to nudge subscribers to the Digital option by making the price of the Print version (although not available) the same as the Print & Digital. Therefore the Digital subscription is part of both available options.

But there are those subscribers that still like the hard copy every week in their letter box but the fact that they are getting the digital version free (if you compare it to the Print only discontinued option) it might nudge them go onto The Economist website and read the magazine through that medium i.e. the Internet. The bonus is if they like the digital version they get rewarded by saving NZ$90 when compared to the Print & Digital option. No doubt The Economist will acquire subscribers email addresses and send them news, offers etc. in the hope of getting them to subscribe to the Digital only option. If the Print option is no longer offered will the price of the Digital option stay the same? I guess not.

GDP or GPI – Genuine Progress Indicator

HT to former colleague Kanchan Bandyopadhyay for this piece on the Genuine Progress Indicator. Most economics courses will include the topic of limitations of Gross Domestic Product as an indicator of standard of living. US senator Robert F Kennedy pointed out 50 years ago that GDP traditionally measures everything except those things that make life worthwhile.

Genuine Progress Indicator (GPI) is designed to include the well-being of a nation and it incorporates environmental and social factors which are not included in GDP. The GPI indicator takes everything the GDP uses into account, but adds other figures that represent the cost of the negative effects related to economic activity (such as the cost of crime, cost of ozone depletion and cost of resource depletion, among others). The GPI nets the positive and negative results of economic growth to examine whether or not it has benefited people overall. The figure below shows the aspects of Social, Economic and Environmental variables.

US senator Robert F Kennedy pointed out 50 years ago that GDP traditionally measures everything except those things that make life worthwhile.

The introduction of the living standards framework in New Zealand takes into account environmental resources, individual and community assets, ‘social capital’ – which includes cultural norms and how people interact – and human capital, such as people’s health, and their skills and qualifications.

By living standards, the NZ Treasury means more than income; it’s people having greater opportunities, capabilities and incentives to live a life that they value, and that they face fewer obstacles to achieving their goals.

Limitations of GDP as a measure of standard of living – see list below.

  1. Regional Variations in income and spending
  2. Inequalities of income and wealth
  3. Leisure and working hours
  4. The balance between consumption and investment
  5. The shadow economy and non-monetised sectors
  6. Changes in life expectancy
  7. Innovation and the development of new products
  8. Defensive expenditures

Repeated Prisoner’s Dilemma Tournament

I have played this with my classes and although not in the CIE A2 syllabus, found it useful to go into greater detail as to the strategies available.

Robert Axelrod used an experimental method – the indefinitely repeated PD tournament – to investigate a series of questions: Can a cooperative strategy gain a foothold in a population of rational egoists? Can it survive better than its uncooperative rivals? Can it resist invasion and eventually dominate the system? Contestants submitted computer programs that select an action, Cooperate or Defect, in each round of the game, and each entry was matched against every other, itself, and a control, RANDOM.

Prisoner’s Dilemma in the classroom.

This game can be played over as many rounds as you wish and played between two players in the classroom environment. The pay offs shown – Win = 3 or 5, Lose = 0 or 1

Below shows the first 14 rounds of a 100 round PD game between John and Kate that includes the comments that were apparently written after each player had decided on strategy in that particular game, but before the other player’s choice was known.

Source: William Poundstone – Prisoner’s Dilemma 1992

Strategies – see below

  • D (ALWAYS DEFECT): Defect on every move.
  • C (ALWAYS COOPERATE): Cooperate on every move.
  • T (GRIM – TRIGGER): Cooperate on the first move, then cooperate after the other cooperates. If the other defects, then defect forever.
  • TFT (TIT FOR TAT) cooperates in the first round, and then does whatever the opponent did in the previous round.
  • PAVLOV: 1st round, Cooperate. Thereafter if you win use the same action on next round. If you lose switch to the other action.

PAVLOV v M5. Time-average payoffs can be calculated because any pair will achieve cycles, since each player takes as input only the actions in the previous period. Here there is an average of 2 per player per cycle.

Global GDP per person vs Happiness

Some great graphics here from The Economist – The Data Behind Happiness. Each circle represents a country and the size represents its population.

Red circle = countries where happiness has moved in the opposite direction to GDP.

Blue circle = countries where happiness and GDP have moved in the same direction.

On a scale from zero to ten where would you place your life satisfaction right now? That question was asked of thousands of people around the world, and surprisingly the rich in the country the happier it is. That makes Europeans the most gleeful, Africans the most miserable – but there’s a snag.

Overall in about a third of countries happiness has moved in the opposite direction to income. Countries don’t always get happier as they get richer. USA people are less happy despite a growing economy and in the UAE happiness has risen despite falling wealth.

Veblen Goods and the impact of advertising.

When a firm advertises it does so to make consumers aware of their product / service so informed decisions can be made which ultimately, making the firm and consumer better off – positive advertising. But the way adverts are targeted, they can contribute to long-run health risks especially on those that are very impressionable – London has banned junk-food advertising on its public transport. Advertising a top of the range 4 wheel drive car on its way up to a chalet in the picturesque Swiss Alps doesn’t do much for the majority of people who can’t afford them – they see what others can afford but know that they are not in the same league – negative advertising.

Positive: advertising informs. It may promote human welfare by allowing people to make better choices about products. 

Negative: advertising stimulates desires that are not feasible. This creates dissatisfaction. Hence, advertising might reduce welfare by unduly raising consumption aspirations. 

So if advertising encourages people to have things they cannot have does this leave society worse off? Recent research by Chloe Michel, Andrew Oswald, Eugenio Proto and Michelle Sovinsky – Advertising as a Major Source of Human Dissatisfaction: Cross-National Evidence on One Million Europeans – did analysis of approximately 1 million randomly sampled European citizens across 27 nations over 3 decades. They showed that increases in national advertising expenditure are followed by significant declines in levels of life satisfaction. They estimated that a doubling of ad spending is associated with a subsequent drop in reported satisfaction of 3% – an effect about a quarter as strong as a spell of unemployment. Although the authors cannot be certain that advertising has this effect this area is not new to economists.

Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status.

Economists and sociologists often cite the 1980’s as a time of extreme conspicuous consumption. The yuppie materialised as the key agent of conspicuous consumption in the US. Yuppies didn’t need to purchase BMWs or Mercedes’ cars for example; they did so in order to show off their wealth. This period had its origins in the 1930’s with Austrian economists Ludwig von Mises and Fredrick von Hayek – the latter being the author of “The Road to Serfdom”, in which he said that social spending rather than private consumption would lead inevitably to tyranny. Margaret Thatcher (UK Prime Minister 1979-1990) and Ronald Reagan (US President 1981-1989) believed in this ideology and cut taxes and privatised the commanding heights in a move to a free market environment.

So-called Veblen goods (also as know as snob value goods) reverse the normal logic of economics in that the higher the price the more demand for the product – see graph below

Over the last three decades conspicuous consumption has accelerated at a phenomenal level in the industrial world. Self-gratification could no longer be delayed and an ever-increasing variety of branded products became firmly ingrained within our individuality. The myth that the more we have the happier we become is self-perpetuating: the more we consume, the less able we are to tackle the myth.

Conspicuous consumption plays a significant role in society. Most people in the developed world have their basic needs met but to keep workers (on higher incomes) striving for more stuff there must always be more desirable consumer goods out of their reach. Never ending dissatisfaction can increase the demand for goods and services and the desire to earn more income. However it is a sort of prosperity that depends on consumers never being satisfied with what they have.