Tuesday, May 26, 2015

Exposing political favouritism in land rezoning

Property development can be a dirty business, particularly when it comes to land-banking, which is the speciality of Australia’s largest developers.

Land-banking involves the speculative buying of large parcels of land that are currently unsuitable for development in the hope of future development potential. But hope alone is not a business strategy. How can land banking be so routinely successful for developers in Australia?

One argument is that successful land-banking comes from political favours in terms of rezoning and public provision of infrastructure. These favours provide substantial value gains to landowners at no cost to themselves. While in certain cases this account appears to have some merit, there has been no systematic evidence that rezoning favours the politically connected.

Until now.

I have a new working paper out with my co-author Professor Paul Frijters, that you can download here, in which we look systematically at land rezoning decisions in Queensland.

The basic result is this: How well-connected you are determines how successful you will be in getting your land rezoned for higher value uses. In Queensland $410million worth of additional development rights were given to mates in just our sample of decisions.

In the study we use sample of planning decisions and landowners involving a total area of 12,676Ha, made by one State authority, the Urban Land Development Authority (ULDA), which took planning powers away from local councils with the intention to increase the scale and speed of development in the rezoned areas. Throughout its time the ULDA was no stranger to accusations of bias, with the Local Government Association of Queensland arguing the government is “playing politics and favouring developers.”

In order to establish how well-connected both rezoned and non-rezoned landowners were, we trawled through a wide range of data on political donations, lobbyists and their clients, industry groups memberships, politicians and their former employers, relationships of ULDA board members, and landowner’s corporate records, in order to construct a relationship network.

We also compiled historical sales data to estimate that this series of rezoning decisions increased the value of the rezoned land by $710 million.

Our main finding however, is that well-connected landowners owned 75% of the rezoned land, but only 12% of comparable land immediately outside the rezoning boundaries, indicating that these decisions were primarily driven by the relationship networks of the landowners, rather than any technical assessment of efficient and appropriate locations for urban expansion.

Political favours in the property industry were found to be much more about being part of the entrenched well-connected political class, whose tight-knit mutual relationships support implicit favouritism, than about visible activities such as making political donations.

These well-connected landowners made $410 million in profit from the rezoning decision, at the expense of the public at large who had the option to instead sell those additional development rights. The data tells the story that connected property developers bought land unsuitable for development land on the urban fringe, then successfully lobbied State politicians and bureaucrats through their relationship networks to rezone areas where they had bought properties, wrong-footing both councils and other property developers. This process of influence took 7 years on average.

Scaling up our results suggests that the ‘back-scratching’ rezoning game has probably cost the general public many billions of dollars in Queensland in the last few decades.

We propose a number of technical solutions to this great game of political favouritism in land rezoning. The size of the gains to rezoning can be diminished by increasing land taxes. Development rights could instead be sold to land owners, perhaps through local auction processes, or the value gains recovered through a betterment tax. Even a local democratic system for voting on new areas for urban expansion would counterbalance vested interests with the interests of the public more broadly.

One unfortunate lesson however, is that the same relationship networks that allow favouritism to thrive in rezoning decisions will obstruct any systematic reform of rezoning processes.

UPDATE [1]: Please read the original study carefully to understand how we controlled for the fact that well-connected developers might be just better at anticipating where urban expansion will occur. Our control group of landowners are in almost identical locations.

UPDATE [2]: Seems that NSW is looking to one-up Queensland in the land development back-scratching game. Former Energy Minister for Chris Hartcher, who is under investigation by the corruption watchdog, is now lobbying on behalf of land developers.

Sunday, May 17, 2015

Environment Minister sabotages environmental groups

Minister for the Environment, the Honourable Greg Hunt MP. What a title. Pity the guy doesn’t deserve it.

Hunt’s latest effort is to conduct a Parliamentary Inquiry into the Register of Environmental Organisations, which maintains records for eligible organisations and carries with it tax deductibility status, and annual reporting obligations. 

The Terms of Reference clearly reflect an intention to amend the qualifying rules to ensure environmental groups that aren’t directly involved in ‘on-ground activities’ like tree planting, will have a hard time staying on the Register. Groups whose primary interest is in political lobbying on behalf of people who value the environment, such as the Environmental Defenders Office, the Wilderness Society and others, may lose support deductibility status, leading to fewer donations and ultimately less political clout. 

What sort of crazy political system would it be if we facilitated and supported organisations that involve themselves in political decisions on behalf of people who care about the environment?

The Honourable Minister for the Environment better do something about that. 

Sarcasm aside, the sad story behind this Inquiry is one of an elite group of vested interests pulling the strings of both major parties in Australian politics. Hunt knows the game is about a trade in favours, and he is doing his utmost to signal to mining and other business interests that he is on their side, and that he is a willing participant in a game of quid pro quo. I have no doubt that our ‘environment minister’ will find himself on the payroll of a major mining interest, or more than one, when he retires from politics. 

While cleaning up our political system will just about require a revolution, there a couple of simple things you can do about this Inquiry if you are interested in having an Australia that has an active organisational sector representing environmental protection. 

Or you can write a submission to the Inquiry yourself.

My submission is here (pdf) if you would like to copy from it in part or in whole.

Wednesday, May 13, 2015

Back-scratching: Do what's best for your mates and screw the rest

tl;dr I have a new experiment demonstrating the sheer power of back-scratching, even when it imposes huge costs on others. 

These days it seems that just about every political decision is about doing favours for the connected few at the expense of the many. It is part of an implicit quid pro quo; trading of favours now for favours in the future. 

I call it back-scratching, and it is a topic I have been researching for three years.

While trading favours can lead to amazing levels of productive human cooperation, it can also generate a considerable amount of unproductive cooperation when the trades benefit the few at a cost to the many. More than that, back-scratching can come with substantial efficiency losses; the costs to outsiders can far outweigh the gains to favoured insiders.

The revolving door between regulators and the regulated is one clear mechanism sustaining back-scratching. Ben Bernanke is just the latest long list of powerful regulators swinging through this door.

But studying back-scratching in the wild faces a major problem. Favours are almost impossible to objectively observe. Not only is there a powerful incentive to conceal favours, determining the ‘no favour’ counterfactual is almost impossible. Was the government contract given to the most efficient firm? Or was it a favour to the winner because an alternative bidder could have delivered a better outcome for the price? More often than not we just don’t know.

I have a new working paper out reporting an experiment on the economics of back-scratching. Studying back-scratching in a controlled experiment, while sacrificing realism, allows a close examination of the fundamental cooperative processes at play. The ‘big new thing’ I was able to do, in light of the long history of cooperation games in social psychology and economics, was to measure costs of back-scratching against an efficient counterfactual, and test which institutional designs encourage or curtail back-scratching.

To be brief, the basic experiment has 4 players in a group (the minimal number for an in-group and out-group to form), with one player able to choose which of the others to receive a prize of $25 in a round (in experimental currency). The payer who receives the prize allocates a fresh $25 the next round to one of the other three.

Obviously the best thing to do is form a back-scratching alliance with one other player and trade the $25 favour back and forth. Over 25 rounds an alliance pair would make $625, while the other two would make nothing.  

What makes back-scratching costly is that each of the potential recipients is given a randomly shuffled ‘productivity number’ each round, either 1, 2 or 3, which determines a payoff for everyone in the group. Each player gets an amount equal to the receivers productivity number in a round. Give the prize to the player who is 1, the group gets $1 each. Give the prize to the player with 3, the group gets $3 each. Think of this productivity number as reflecting the efficiency firms competing for a government contract. 

To sustain a back-scratching alliance means not choosing the most productive player for the prize in two-thirds of the rounds. It earns the alliance $725, the outside group $100, and comes with an efficiency loss of $100 from the repeated non-productive choices.

It turns out that most players repeatedly formed alliances, even though they were young honest university students who didn’t know each other. In real money terms (rather than experimental currency) alliance pairs ‘stole’ $30 from the outsiders to increase their alliance earnings by $20.

Surprisingly alliance players were happy about their actions. They thought they had been very cooperative by doing their mate a favour, and didn’t feel guilty about the costs they imposed on others. They also rationalised their behaviour, saying that forming an alliance is a justifiable strategy, while also concealing it by lying when explicitly asked in a later survey if they had formed an alliance.

I tested two institutional changes in the experiment. Staff rotation, a common anti-collusion policy, and a low-rent policy mimicking bureaucratic procedures to limit the size of prize able to be allocated with discretion. Neither was particularly effective at stopping back-scratching. I also manipulated the strength of relationships between players.

For me the take-home lessons are:
  • Loyalty is strong. Rotation policies are good, unless those people being rotated in have existing loyalties. This means there is a trade-off for regulators; staff with more industry experience are also likely to come with stronger prior alliances and hence be more prone to back-scratching. In politics it means voting in a different political party brings with it the alliances of that party.
  • Bureaucracy can work. The array of procedures emerging in our large organisations could simply be the result of seeking internal fairness over favouritism. But back-scratching can still arise even with minimal amounts of discretion.
  • Social norms are strong. In organisations or groups where some people are observed ‘doing the right thing for the group’, this quickly becomes the norm. Whereas where favouritism is observed, the group descends into counterproductive back-scratching.
  • Be loyal, but not too loyal. If your alliance partner fails to come through with favours when expected it pays to look for someone else whose back needs scratching.
None of this is really rocket science. If this sounds obvious to you then you’ve probably learnt a lot about human behaviour through life experience. It also means the experiment is capturing some elements of real phenomena.

After spending three years researching this topic, of which this experiment is a small part, I have come to the conclusion that group formation through favouritism is probably the primary determinant of political outcomes. Countries themselves can even be seen as a loose alliance of insiders looking to do what’s best for themselves even when it comes at a cost to other countries.

And if you look deep enough there is an evolutionary foundation for this behaviour. As Joshua Green explains:
Morality evolved to enable cooperation, but this conclusion comes with an important caveat. Biologically speaking, humans were designed for cooperation, but only with some people. Our moral brains evolved for cooperation within groups, and perhaps only within the context of personal relationships. Out moral brains did not evolve for cooperation between groups (at least not all groups). How do we know this? Because universal cooperation is inconsistent with the principles of natural selection. I wish it were otherwise, but there's no escaping this conclusion
This. Fundamentally. Is why corrupt back-scratching is so hard to eradicate, and why it will continue to be the main game in politics.

Monday, April 27, 2015

Self-censoring on superannuation

When applying for a job recently I was asked to write a 500 word opinion piece about using superannuation funds for home deposits. I didn’t get the job so there is no reason to waste 500 good words; I’ve published the piece at the bottom of this post.

But that’s not what this post is really about.

I am writing this post to reveal that I severely self-censored in that opinion piece. Those are not my genuine views about superannuation. Like many before me I twisted my words to fit within the Overton Window of acceptable public discourse. Maybe it was the wrong thing to do. But I did.

I want to say what I really think, even if some find it too far outside the range of acceptable conversation.

My view is this: Australia’s superannuation system will not survive another 30 years in its current form, or anything like it.

The reason for that view is that there was never an economic logic for a compulsory superannuation system in the first place.

The modern superannuation system was introduced in 1992 to relieve pressure on the age pension system by forcing all workers to save for retirement reduce wages and has since been reinterpreted as a retirement funding system. But forced saving does nothing to address the fundamental problem of a shrinking workforce - all the income streams drawn down from superannuation upon retirement rely on purchases of assets from those currently working. The net effect is exactly the same as if the working population simply gave retirees money through the tax system. Any problems with the age pension system due to demographic change also affect the superannuation system.

Furthermore, the problem of a shrinking workforce has been dramatically overblown. While the age-dependency ratio will increase when baby-boomers retire, this effect will be balanced out by relatively fewer births and a declining youth-dependency ratio. On balance, the share of the population out of the workforce under the worst-case population growth scenarios (yes, higher population growth makes the dependency ratio worse), will peak around 70% - exactly the same as the 1960s and 1970s.

To be clear about how the same demographic patterns affect the superannuation system just as they do a public pension system we must think in terms of goods and services produced in aggregate, and assets and their prices in aggregate.

In aggregate, the total goods and services produced depends on the size of the workforce and installed capital. Whether boomers retire in pensions or superannuation incomes, the rate of growth of this total production will be lower as the growth rate of the workforce decreases.

This lower rate of growth of goods and services must still be shared amongst all workers and retirees. Who gets what out of the economic pie depends on who has which rights - which claims on incomes streams in any form, either assets, public pensions, or wages. Under a public pension system workers give up some of their rights to wages by paying taxes which would go directly to the pensions of the retired. Under a private superannuation system, workers give up some of the rights to wages to buy assets, which would be sold by retirees who had previously accumulated them, in order to provide a retirement income. The net effect of both of these schemes, shown below, is identical.

Whereas with public pensions it is clear that more retirees in the population requires larger contributions by workers to support them, the superannuation system disguises this element. It does this through incremental changes to the minimum contribution requirement - from 4% of wages in 1992 to soon 12%, along with increases in the preservation age, from 55 as of this year, to 60 in 2024. This means that new contributors to the super system pay more and get less - exactly as would occur under a public pension system when increasing pension funds come from direct transfers from the workforce.

What’s more, the net effect of superannuation as a mere transfer between workers and retirees will become all too obvious when the ever-growing rate of new money pouring into the asset classes held in superannuation accounts begins to fall as the rate of superannuation drawdowns grows faster than the rate of new contributions. In the chart below the benefit payments in green will increase faster than the contributions (the red, blue and purple) as boomers begin to retire en masse.

When this occurs, the asset classes that dominate the super system, like Australian shares, will see fewer buyers and more sellers, depressing currently inflated prices and reducing the investment income of superannuation account holders. With lower account balances more funding will be needed from public pensions anyway. To be clear about this asset price effect, does anyone think the share market, or even the property market, would be at its current value without the massive inflow of funds from the compulsory super system?

Depressed incomes from super accounts will again see the need to increase contributions, or increase public pension funding, or otherwise rejig the rules to inflate asset prices at the expense of wages.

At the moment the music is still playing. But in the next 20 years there will be a generation who puts more than 12% of their wages into the super system for half their working life only to find the system requires a complete rethink. They will lose out due to their demographic destiny with the superannuation system, just as they would with a public pension system only. But the super system allows us to pretend that this is not happening by disguising transfers as investment.

This is the big issue with Australia’s superannuation system, and one that is till now outside the range of acceptable discourse. In any case, here’s my self-censored opinion piece.


Hockey’s housing ideas are anything but super

If you think home ownership is out of reach for the average family in Australia today, you ain’t seen nothing yet.

If Federal Treasurer Joe Hockey has his way, superannuation funds could be used by first-time buyers as a home deposit.

Taken at face value, Hockey’s idea reveals a deep misunderstanding about not only the role of superannuation in the welfare system but of the housing market itself.

Worse still, allowing access to super accounts will increase prices above even their current astronomical levels.

Compulsory superannuation was introduced in 1992 to anticipate and counteract the age pension tidal wave as baby boomers entered retirement.

Yet one big issue we are seeing as this demographic tidal wave approaches, is that many retirees have low superannuation savings, but very high home values, yet they are unable to tap into their home value to generate a retirement income.

The great majority of retirees prefer the stability of their own home within their local community, and are unwilling or unable to use their home as a source of income during retirement.

Directing more retirement savings into home ownership will only amplify this problem, rather than amplify retirement incomes as superannuation was designed to do.

While reforms could improve the ability for retirees to utilise their home values to generate retirement incomes, one thing that cannot change is the economics of the housing market.

Hockey’s proposal would produce a massive boost in buyer activity and turn superannuation funds into subsidised quasi-home deposit accounts, with associate tax savings advantaging the highest income earners.

Like many home buyer initiatives, such as the First Home Buyers Grant (FHBG), increasing buyer purchasing power has a clear and definite effect of increasing home prices, negating its supposed benefit and passing it directly to the home seller.

To see how this works, imagine you are at a home auction, and after great excitement and fanfare, the bidding has stopped at $500,000. The final two potential buyers are now on edge as they decide whether to tip their hats one more time.

In one scenario the second buyer stays quiet and the home is sold at that price.

But in another, the government steps in and allows the last two bidders to use their super accounts to help buy the home, or alternatively give them a FHBG. What do they do?

The extra funds allow the auction to continue as the losing bidder sees value in outbidding the previous winning price, and the previous winner is able to also outbid that new price.

This only stops when the extra buying power from the new regulations is completely absorbed into the price. If it was a $7,000 FHBG, the sale price would be $507,000.

It is clear then that Hockey’s proposal is at odds with the intention of using superannuation to provide retirement incomes, and by making the housing market more expensive, will completely contradict its intentions of facilitating home ownership and saving.

Saturday, April 4, 2015

Macroeconomics = Fallacy of Composition

I am teaching an introductory macroeconomics course for graduates this semester at the University of Queensland. Coming up is soon is the AD-AS model and I must say, I’m having a hard time generating useful tutorial questions for my students.

The illogical contrivances required to interpret any real economic events in terms of the model are almost laughable. I've asked a number of experienced macro teachers in the school to explain the model to me in an internally consistent way. It turns out that most economic professors don’t have a clear grasp of what aspects of the macroeconomy the model is meant to be capturing. None could explain what the concept of the price level in the aggregate even is, nor what mechanism was meant to be at play in generating the relationship between price level and output. If anything I learnt that I should use the curves to support some kind of Keynesian story-telling exercise.

What kind of serious intellectual could be happy with this situation? Is this the way we pass on our discipline’s knowledge to the next generation?

So far my tutorials are looking quite different from your typical introduction to the AD-AS model. More like an introduction to defending oneself against the claptrap sprouted by many economists.

Perhaps we may soon leave this nonsense out of economic teaching altogether. Here's my compromise for the time being.

Question 1

What is the fallacy of composition?

Create a list of phrases, sentences or paragraphs from the description of the AD-AS model in Chapter 10 of the textbook that commit the fallacy of composition.

Additional reading material is here, here, here, and here.


A common definition for the Fallacy of Composition is
the fallacy of inferring that a property of parts or members of a whole is also a property of the whole
In terms of the study of macroeconomics this is of particular interest, since we are trying to take lessons from the behaviours of individuals and determine the likely aggregate response in the economy as a whole.

Here are some examples from Chapter 10, though many others may be included.

1. The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by households (p268). 

The AD curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded (p268)

The fallacy at play here is that there is an aggregate price level. As we saw in Chapter 8 on Inflation, price levels are not absolute but relative to some base year. In the economy as a whole there is no external price from which to determine a price level. Hence the idea of an economy-wide price level is in a given time period is a fallacy. 

Often the AD-AS model is interpreted as showing Real GDP related to the rate of inflation in a period (not the level, but the rate of change of price levels relative to a base year). This overcomes the fallacy of composition because it compares the price level with last year’s price level, but contradicts earlier discussions about anticipated vs unanticipated inflation. If inflation is anticipated at any reasonable level then there should be no economic effect, and hence no relationship (no curve, or a vertical line at best).

2. As income rises consumption will rise, and as income falls, consumption will fall (p269)

In aggregate the total consumption (or demand) in the economy is equal to the total incomes in the economy be definition, since someone’s consumption is somebody else’s income. This sentence, allowing from proper aggregation that avoids the fallacy of composition, merely says that aggregate incomes and consumption just rise and fall together since they are equal at any point in time by definition. 

3. When prices rise, households and firms need more funds to finance buying and selling. Therefore when the price level rises, household and firms try to increase the amount of funds they hold by withdrawing from banks, borrowing from banks or selling financial assets, such as bonds. These actions tend to drive up the interest rate charged on bank loans and the interest rate on bonds. (p269)

First, if all prices rise then households and firms also have more income, since wages and profits are also prices in the economy. 

Second, as we discussed in Chapter 4, Measuring GDP, transfers of financial assets are not included in gross value added because they are mere transfers between on individual and another. Hence, a household selling financial assets requires another household to buy those financial assets leading to no net change in the aggregate ability of households to spend on current consumption. 

Third, if these actions have no aggregate affect by their own definitions it seems implausible that there will be aggregate affects on interest-rates (another price) set in the economy.

The end of the paragraph goes on to admit that it just committed the fallacy of composition when it says

The impact of the price level on investment is known as the interest-rate effect, and is a second reason why the AD curve is downward sloping. However there is caveat to this explanation. Lenders to banks and other financial institutions - people with savings are lenders - will have their wealth increased as the interest rate rises, and will increase their consumption spending. 

Essentially this contradicts all that went before it. In addition, the wealth effect on savers is incorrect in general (higher interest rates decrease the value of financial assets, not increase it).

4. Table 10.1, government purchases and tax effect on AD curve (p272).

The second and third rows in Table 10.1 show; 1) the effect of an increase in government purchases on, 2) the effect of an increase in government taxation. If the economy is at equilibrium prior to and after either of these changes then by definition one effect must counteract the other - the shift of the AD curve from an increase in government purchases must be accompanied by an equal and opposite shift from an increase in taxation. 

5. Because changes in the price level do not affect the number of workers, the capital stock or technology, in the long run changes in the price level do not affect the level of real GDP (p275).

This contradicts all that went before it, and relies on an undefined notion of the short and long run. How can there simultaneously be both an effect and no effect?

6. The main reason firms are willing to supply more goods and services as the price level rises is that, as prices of final goods and services rise, prices of inputs - such as wages of workers to the price of natural resources - rise more slowly. Profits rise when the prices of the goods and services firms sell rise more rapidly than the prices they pay for inputs (p276).

Here we see the fallacy of composition result in many confusing comments. First, the inputs of one firm are the outputs of another firm, hence in aggregate input and output prices cannot differ systematically.

Friday, March 27, 2015

Uncertainty and morality in a dynamic economics

Ignorance of the distinction between risk and uncertainty lies at the heart of many economic conundrums, particularly dynamic behaviours through time. Yet the critical importance of this distinction in predicting economic behaviour was clear to prominent economists of the 1930s, including Shackle and Knight. Knight wrote that
... that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.
Economists have now forgotten that a world of uncertainty generates a strong incentive to delay choices. We do not make immediate choices informed by some probabilistic expectation of future outcomes. We usually can’t even know the potential scope of future outcomes. That means we delay choices to keep options alive, miss good opportunities, and sometimes commit to poor investments. Because time is irreversible, unlike in economic models. When we commit to decisions matters as well as the decisions themselves.

But the ignorance of uncertainty is evident in other social sciences as well. Approaching problems in philosophy and ethics without acknowledging uncertainty has lead to many seemingly intractable puzzles that are easily resolved in a world of uncertainty.

I hope that observing the crucial role uncertainty plays in these contexts encourages economists to take the concept more seriously and see the economy as a dynamic environment, rather than a static one.

In ethics, the Trolley Problem has occupied the minds of philosophers for decades. In its simplest form, the puzzle is as follows.

In Scenario A a trolley is barreling down the tracks towards five people who will be killed unless the trolley is stopped. Luckily, there is a fork in the tracks, and by simply pulling a lever, the trolley can be diverted onto a second set of tracks. Unfortunately, there is a single person in the path of the tolled on this track who will be killed if you pull the lever.

The dilemma is whether you should pull the lever and save five people by sacrificing one? In surveys, most people say they would.

In Scenario B you find yourself on a bridge next to a fat man with the same dilemma of a trolley hurtling down the tracks towards five people. The question here is whether it is permissible to push the person next to you onto the tracks if you knew it would stop the trolley and save the five people.

Most people in this scenario would not push the man off the bridge, even though the same welfare gains in terms of lives saved would be the same as Scenario A (so you know, 68.2% of philosophers would push the man to save the five). Some philosophers and psychologists put this down to a ‘dual-process’ theory and for some reason that two different setups invoke "the operations of at least two distinct psychological/neural systems".

Fundamentally the incompatibility of these two outcomes arises because we are presented with a dilemma in terms of risk, or knowable probabilities. In fact, we have point distributions at perfect certainty for each outcome. You push the fat man off the bridge (assuming away the logical problem that a man fat enough to stop a runaway trolley is somehow easily able to be pushed off a bridge) you have a probability of 1 that the man will die and the trolley will be stopped. If you don’t, you have 100% certainty that the five people on the tracks will be killed.

When you add risk by looking at possible probability distributions of choice outcomes you can generate a balance of risks that predicts survey responses. This is a step in the right direction. But it still overlooks the dynamic nature of true uncertainty.

Let us now look at the question in terms of uncertainty. For a start, how do we know the trolley is out of control? Is it possible to delay the decision to get more information?

A very simple resolution arises when we add a time dimension to the problem, which is what is required under uncertainty. We can think in terms of an option-tree expanding over time, with choices unable to be fully anticipated in advance.

We can see in the diagram below that in Scenario A, switching the tracks leads to a new situation that opens up the set of possible choices in the grey shaded area while eliminating others. Switching the trolley onto the side track buys time and keeps options open without killing anyone.

In Scenario B, most people choose not to push the fat man. Here, what they are doing is buying time before anyone gets killed. Even after the decision is made not to push the man, there will be time available for many other as-yet-unknowable situations to arise.

People are making choices in a way that allows them to navigate through a choice space over the irreversible dimension of time. I’ve highlighted in red a possible path for each scenario that could be envisaged by someone making choices in a world of uncertainty.  In both cases, there is an unknowable chance that a resolution to the dilemma will involve no death if the dynamic choices that arise are navigated appropriately. But choosing to push the fat man in Scenario B eliminates the option of resolving the situation without any deaths.

The whole rationale of making decisions in a world of uncertainty revolves around keeping options for desirable outcomes open, and often this involves buying time by not making a decision at all.

We know that buying time to keep an option open is a strong impulse. In experiments where participants are given the choice of which of two identical drowning swimmers to save, knowing they can only save one, many are unable to make the decision in a timely enough manner and instead spend their time searching for better information in the hope of maintaining the option of saving both. But in doing so, they let them both drown. Because the choice to commit to saving one swimmer is associated with a commitment to allow the other to drown, the logical choice is to delay to maintain the option of saving both.

In military training, overcoming this instinct to delay choices to keep options open forms an integral part of the psychological training. Soldiers are known to delay making any choice in high-stakes combat dilemmas (what amounts to ‘freezing') or in many cases they shoot to deter rather than to kill, to keep open the option of finishing a battle with fewer deaths in general.

In criminal behaviour, Becker’s expected utility framework has been called into question due to the radical difference between human behaviour in a world of uncertainty versus a world of risk. Increasing the chance of being caught and increasing punishment if caught are substitute methods for changing probability distributions of expected outcomes in a world of risk. But in a world of uncertainty, they have quite different effects on criminal decisions.

The same logic of uncertainty can be applied in social psychology to understand the bystander effect. The bystander effect is the label given to the occasionally observed inverse relationship between the number of people witnessing a victim in need, and the number of people offering help. Various reasons for this empirical phenomena have emerged, with the idea of a diffusion of responsibility dominating explanations.

But when we dig a little deeper we can see the logic of uncertainty at play. Repeated experiments on the bystander effect show that the degree of ambiguity is a crucial determinant of the willingness to assist, with reaction times being much slower in the presence of more ambiguous situations. The logic of how ambiguity, or uncertainty, results in the bystander effect is as follows:
…most emergencies are, or at least begin as, ambiguous events. As the bystanders are deciding whether an event is an emergency, each bystander looks to the others for guidance before acting. 
… Seeing others remain passive causes the bystander to interpret the ambiguous situation as non-serious.
So it is not that people do not want to help. But as each person individually chooses to delay their actions to gain new information, they also observe others doing the same thing. By observing others they gain the new information that the situation is non-serious, and hence as a group they ultimately choose a path through the choice space over time that resolves to a belief that the situation is a non-emergency.

What happens as people delay choices here is a cascade of new information that changes the decisions of each individual and the group as a whole. In sociology, there are many simulation models of these type of choice cascades, from standing ovations to riots, and other herding behaviour including musical tastes, and crucially for economists, asset market speculation.

Uncertainty is primarily a concept about choices in a dynamic environment. Here I have shown that human behaviour is adapted to our dynamic irreversible environment, and as such, uncertainty is required to understand behavioural logic, morality, and sociability. Moral puzzles resolve easily in an environment of uncertainty, and many psychological phenomena, from soldiers freezing in battle, to the bystander effect, to our taste in music, can be seen to arise from a result of human tendencies to delay decisions in order to cope with uncertainty.

It is not just economists who have acknowledged that uncertainty is tremendously important, but then later ignored the concept in their analysis. Given the high stakes arising from political choices based on economic analysis, putting uncertainty front and centre in a new dynamic economics is critical.

Wednesday, March 25, 2015

Economics: Blah blah blah

Economic comedian Yoram Bauman translates Mankiw's 10 Principles of Economics in this video. The three macro concepts were immediately translated to blah, blah, blah.

Here I want to improve of his efforts and translate some of the many concepts that seem to mystify all who encounter them. Some readers might not agree. Others might have better suggestions. Let me know in the comments. 

Economic Term
Actual Meaning
Accounting unit
Medium of exchange
Medium of exchange
Accounting unit
Accounting unit
Credits and debits (‘promise unit’)
Production function 
Just kidding, economists don't care about time 
Magic attractive force
Current state of the world
Unexplained residual
New recipe
Free Markets
Very specific set of government institutions 
Stylised fact
Deadweight loss
Difference between a real pudding, and the magic pudding
Structural reform
Non-specific legal change to give rich people more power in the name of efficiency
Why aren’t we in equilibrium?
Low wages
Bigger numbers devoid of meaning
Degenerative scientific research programme
Why don’t people agree with me?
Laden with hidden value judgments
State of the world
Opportunity cost
What you could be doing instead
Some other prices
Rent seeking
Buying political favours
Market failure
Real life
Outside the club. Go home.
Pipe dream
Mystical element allowing decisions to be made
Monetary incentives
Short run
Arbitrary time period that makes the model work
Long run
The end of time itself
Perfectly known distribution of possible outcomes
Comparative advantage
Started producing it first
Comparative advantage
Was on/under the land when we conquered
How rich your parents are
Representative agent
One person
Uniform distribution of agents
One person
Property rights
Unspecified institutional setting
Covertly transferring money to people you know
Someone else covertly transferring money to someone they know
Vitally important, but I can’t explain it
AggregationFallacy of composition