[Winstonm]

Quote

There needs to be an economic theory based on the irrational man.

You mean the theory of reality?

[luke warm]

kenberg, on 2011-March-31, 17:41, said:

A friend recently bought a new car (one of these hybrids). He could very well afford to pay cash but he has very good (very very good, actually) credit scores and is buying the car on payments at low rates. He believes, probably correctly, he can do better investing the money.

"low" rates now are 0% (in a lot of cases), so it's hard to see how buying on "credit" in that circumstance is a mistake... if your friend simply put the cost of the car in a simple savings account he'd come out ahead... if he's a successful investor he'd come out *way* ahead

[helene_t]

kenberg, on 2011-April-01, 06:31, said:

There needs to be an economic theory based on the irrational man.

Disclaimer: I haven't that much training in economics, probably much of the below is nonsense. Anyway, I can't resist.

I have never come across macroeconomic models based on the assumption that consumers are rational in the sense that they always make the optimal choice. Rather, the assumption of rationality comes into play when relations between changes in stimulus and changes in behaviour is modeled. For example, it is generally assumed that when the price for something increases, then demand decreases. Unless their is a snop effect or some other strange exception to the general rule.

Maybe economists tend to overestimate consumers' knowledge and/or their ability to optimize behaviour given the limited knowledge that they have. But for the most part, the "rational man" assumption isn't really an assumption. It is more like an axiom.

But to the extent that the "rational man" assumption is really an assumption, it has political implications.

Liberalist: Ordinary people are rational. It follows that aggregated utility is maximized by giving individuals freedom to make choices as long as they don't harm others.
Socialist: I take exception to your assumptions. Most people are not rational at all.
Liberalist: Well they may make choices that look stupid in the eyes of the Central Planning Committee. But that is largely because they have other goals for themselves than the CPC thinks they ought to have. And who is to decide where in Mr. Jones' opportunity space Mr. Jones is better off? Mr. Jones or some bureaucrat?

All this said, I think it could be really interesting to try to develop a macroeconomic model that builds on more subtle psychological models than simply utility maximization. Take cognitive dissonance as an example. People may have an aversion against making decisions that would imply that they admitted to themselves that an earlier decision was wrong. Maybe this can explain why house sales are so slow when prices are going down. Would-be vendors "know" that they should just accept that bygones are bygones and realize their loss. But in doing so they would admit to themselves that they made a wrong decision when they bought at the peak of the market. So they hold on to their property.

[Echognome]

A couple of things.

I do think that we all exhibit some "consumption smoothing." We overspend some when we are young and save when we are old. Do we do it somehow "optimally"? I don't think so. There are many reasons for this, in particular that we do not have a really great view into our future to do so. There are also "time inconsistencies" with ourselves. We may expect our future selves to act in a certain way, but then have a completely different mindset when we get there.

As for the rational/irrational discussion, I will add the following points.

1. I think most economists believe that humans exhibit constrained rationality. The constraint coming from the fact that they do not have perfect foresight, perfect memory, or complete information.
2. There are models, that do not assume full rationality. Several macro models have a certain percentage of consumer make decisions based on a "rule of thumb" rather than rational expectations. There are micro models that utilize limited memory or limited information.
3. How does an irrational agent act? Irrationality is not the same as random. As such, there are an infinite number of ways to model irrationality. There is only one way to model full rationality. Of course there are varying degrees of rationality.*

* In game theory it is pointed out that assuming that all agents are rational does not often get you very far. Instead you need to assume all agents are rational; all agents know that the other agents are rational; all agents know that the other agents know that they are rational; ad infitum. This term is called "hyper rationality" or that strategies are "rationalizable".

[cherdano]

I don't understand the aversion to credit cards expressed in this thread. There are now several major credit cards that offer 1% (or slightly more) payback for every credit card purchase. No catch if you pay your bill on time. You can set up automatic payment from your checking account if you are worried about every missing a payment.

Also, while I have never taken a loan, but everyone seems to recommend a credit card with good rates as the best resort when you unexpectedly need a short-term loan. (Say your car breaks down and you would really prefer to buy this used car from a private owner immediately, your washing machine needs a repair and your cat an urgent and expensive cosmetic surgery.)

[helene_t]

cherdano, on 2011-April-02, 03:55, said:

I don't understand the aversion to credit cards expressed in this thread.

I am sure that credit cards are useful for some in the sense that some people are smart enough to screw the credit card companies and/or harvest a part of the revenue that credit card companies make from screwing less smart people.

I believe credit cards are bad for the overall economy at least if sensible alternatives (such as a competitive market for online transactions for debit cards) exist.

Credit cards are very insecure. Now this could be resolved by using online verification etc. and obviously credit card companies are moving in that direction. But a more fundamental issue is that credit card companies rely on unethical business practices, such as tempting stupid/lazy people build up credit cards debts for which they pay high interests, customers who forget to pay for their purchases on time, and blackmailing shops by not allowing them to charge extra for credit card payments.

I suppose credit cards had a raison d'etre back in the days before widespread availability of online verification. But today it is not a technical problem to take the money from the buyer's account at the time of payment.

[kenberg]

I am not exactly anti-credit card. It's the same way in which I am not exactly anti-gambling. In both cases there are people making big bucks by reeling in the suckers. Well, there's a sucker born every minute, so what's the problem? No one is putting a gun to their heads.

I lack data, of course. But we keep reading stories, and hearing more directly, of people who get in way over their heads. There is this line from the song Sixteen Tons: St. Peter don't you call me 'cause I can't go, I owe my soul to the company store.

To what extent should society interfere with the individual's right to do something that is brain dead stupid? And who decides? Using a credit card for convenience is fine, temporarily running up a balance to pay special expenses is fine, running a perpetual balance of 20 or 30 K, or more, as a way of life is pretty damn dumb. Or so I say. Dumb yes, rare no.


Sometime back there was this great story in the Post. A guy explained to his clients that there were ways to hide their assets from the IRS. The trick was to give the money to him and he would put it into off-shore accounts. And he did! His off-shore account. Now they showed a picture of the guy and that alone should have been enough. But consider: Here is a guy advertising that he is a shady financial schemer, asking people to give him their money. How dumb can you get? Still, we make such schemes illegal and try to protect the hopelessly naive.

If one guy wants to jump off a cliff, I suppose we let him. If an industry grows up making huge profits from mass marketing the idea of cliff jumping, it may be time to step in.

[y66]

I'm not credit card adverse. I use one all the time because it's extremely convenient, especially when traveling, and I don't pay less if I pay cash. In fact, I pay more because my credit card earns a decent rebate.

For me, the main problems are the net increase in the cost of stuff I buy due to merchant pass through of credit card costs and the de facto monopoly in the credit card industry, which causes those pass through costs to be out of whack with actual processing costs as well as other problems, including what seems to me to be an increasingly incestuous, anti-democratic relationship between the banking industry and the lawmaking industry.

Also, I don't like the predatory marketing practices of the credit card industry and the way they take advantage of consumers who don't pay off their balance each month, for example, by burying details of extra fees and rate changes in 30+ page credit card contracts.

[hrothgar]

kenberg, on 2011-April-01, 06:31, said:

There needs to be an economic theory based on the irrational man.

http://en.wikipedia....ioral_economics

[y66]

From Why we do what we do By Tim Harford

Quote

Behavioural economics has never been hotter. It’s not just the success of books such as Nudge, Predictably Irrational and Basic Instincts, but the political influence of the field: one of Nudge’s authors, Cass Sunstein, runs the Office of Information and Regulatory Affairs for Barack Obama, and his co-author Richard Thaler has been advising David Cameron’s new Behavioural Insight Team, based in the Cabinet Office.

A simple summary of behavioural economics – I’ve borrowed this one from The Guardian – is that it is the study of “how people actually make decisions rather than how the classic economic models say they make them”. But this approach is now under attack, from Gerd Gigerenzer, a psychologist, and Nathan Berg, an economist, and they argue that behavioural economics is not nearly as realistic as its boosters claim. While it does study what decisions we make, the very last thing it does is study how we make them – and as a result it is even more wedded to silly accounts of the way human beings think than its neoclassical rival.

Neoclassical economics has often relied on the “as if” defence, published in 1953 by Milton Friedman, who argued that while people don’t actually solve complex neoclassical optimisation problems in real time, they still behave as if they do, somehow making rational decisions thanks to a combination of experience and cognitive short-cuts. But economists have been strikingly incurious about what those cognitive short-cuts actually are. Gigerenzer is not.

Behavioural economists point out cases in which our decisions don’t match neoclassical theory, and thus the “as if” defence fails. But Gigerenzer and Berg complain that behavioural economists have retained the neoclassical incuriosity about why we act as we do. Instead, they have modified the neoclassical model until its predictions fit our observed choices, and then fallen back on the same “as if” story.

Consider the human response to risk. Neoclassical economics says that we act as if considering all possible outcomes, figuring out the probability and utility of each outcome, multiplying the probabilities with the utilities, and maximising expected utility. Clearly we do not in fact do this – nor do we act as if we do.

Behavioural economics offers prospect theory instead, which gives more weight to losses than gains and provides a better fit for the choices observed in the laboratory. But, say Berg and Gigerenzer, it is even more unrealistic as a description of the decision-making progress, because it still requires weighing up every possible outcome, but then deploys even harder sums to produce a decision. It may describe what we choose, but not how we choose.

Gigerenzer prefers to look for actual decision processes. Take the simple act of catching a ball in flight. The spirit of neoclassical economics would say that people act “as if” swiftly calculating the parabolic arc of the ball. The spirit of behavioural economics would explain dropped catches with references to some systematic errors in the way we perform that calculation. But in fact, ball-catchers use a cognitive shortcut called the “gaze heuristic”, running forward and back while keeping constant the angle of sight up to the ball as it descends. No amount of “nudging” towards faster differential calculus will help prevent dropped catches.

This is tough on behavioural economists, because in order to be taken seriously by other economists they have had to play the optimising game. Switching to Gigerenzer’s rules would mean the end of economics as we know it.

Yet the critique is sobering. If behavioural economists do not really understand why we do what we do, there are surely limits and dangers to the project of nudging us to do it better.

[blackshoe]

Back in the 1980s, when I was much younger, my uncle, who owned two banks, and I were talking about "bounced check" charges, then running about $5 per check. He told me that the actual cost to the bank of processing bounced checks was about 79 cents. So it's not "the credit card industry," it's the banking industry, or perhaps the financial industry as a whole, that uses these shady practices.

[barmar]

Why is there any "cost" to processing bounced checks? They're just numbers in a computer.

A bounced check charge is a penalty, not a cost recovery. You promised not to overdraw your account, and you reneged on that promise. If the charge is too low, it won't act as a deterrant.

This isn't in the same league as some of the other outrageous practices of banks and CC companies.

[y66]

I got a chuckle out of Scott Adams' (Dilbert guy)'s assertion that studying economics makes you relatively immune to cognitive dissonance. It seems to me that economists, as a profession, have this problem in spades.

[kenberg]

Speaking of Dilbert

A long time back Dogbert was a financial adviser to a client:


Client: Will this investment strategy reduce my taxable incmoe?
Dogbert: Yes
Dogbert's thought cloud: You have no idea how much.