Thursday, 24 November 2011


Thinking Like an Economist

Many Economics books like Mankiw start with a chapter on: “Thinking like an Economist.”But the book that does this best from a behavioral viewpoint is Robert Frank’s “MicroEconomics and Behavior”.

This book initiates its chapter on “Thinking Like an Economist” with a negation of the typical ‘material’ view of scarcity. Giving the example of Aristotle Onassis who suffered from ‘myasthenia gravis’, a debilitating and progressive neurological disease, the author states that despite being worth several billion dollars at his death Onassis ‘confronted the problem of scarcity much more than most of us will ever have to.’
‘For him, the scarcity that mattered was not money but time, energy and the physical skill needed to carry out ordinary activities.’

As a teacher I like to give the following example of scarcity: It is possible you have thousands of rupees in your pocket but because you are a very busy executive you do not have the time to see the latest movie ‘Ready’. Or, maybe you do have one evening (say, Saturday) free, but your wife or girlfriend wants to spend the evening in a Chinese Restaurant having dinner instead.

Costs and benefits of decisions.-When we are sitting in an armchair in our sitting room, we may want to lower the volume of the stereo, increase the speed of the fan, turn off the light, but we may be too lazy to do any of these activities, it is as if we compare the costs and benefits of alternate actions, getting up or remaining seated. (the author in the chapter explains how to translate this decision into a monetary framework.)

The Role of Economic Theory-It might sound not just strange but absurd that someone might actually calculate the costs and benefits of turning down a stereo. Making unrealistic assumptions is a charge often levied against economists. Two responses are made to this criticism. Economists don’t assume that people make explicit calculations of this sort at all-is the first response. Rather, we can make useful predictions if we assume that people act as if they made such calculations, is what many economists argue. Milton Friedman expresses this view forcefully by arguing that the shots expert pool players choose, and the specific ways they attempt to make them, can be predicted extremely well by someone who assumes that the players take careful account of all the relevant laws of Newtonian Physics. Not that they would have had training in Physics but, Friedman argues, they would never have become expert players in the first place unlessthey played as dictated by the laws of physics. Unrealistically, our theory of pool player behavior assumes, that pool players know the laws of physics. We are urged to judge this theory by Friedman  not by how accurate its central assumption is but by how well it predicts behavior. And it performs very well indeed, on this score.

 Friedman like many other economists, believes that useful insights into our behavior can be gained by assuming that we act if governed by the rules of rational decision making. By trial and error, he feels, we eventually absorb these rules, just as pool players absorb the laws of physics.

Conceding that actual behavior does often differ from the predictions of economic models, is a second response to the charge that economists make unrealistic assumptions. Thus, as economist Richard Thaler puts it, we often behave more like novice than expert pool players.

But even where economic models fail on descriptive grounds, they often provide very useful guidance for making better decisions, they may often give insights into how we may achieve our goals more efficiently, even if they don’t always predict how we do behave.

Common Pitfalls in Decision Making-
Ignoring Implicit Costs: some costs are not explicit, we should include the opportunity cost ie the value of the most highly valued alternative to the chosen alternative. If doing activity x means not being able to do activity y, then the value to you of doing (had you done it) is an opportunity cost of doing x. Many people make mistakes while making decisions because they fail to see that while making a decision, the foregone alternative should be considered. Thus it would always be instructive to translate questions such as “Should I do x?” into ones such as “Should I do x or its most highly valued alternative y?

Should I go skiing today or work as a research assistant?
there is a skiing area near your campus in which the cost of skiing is $40, the benefit of skiing to you is $60, but there is a choice to that, you can work as a research assistant to your professor, and be paid $45 for that, you like the job enough such that you are willing to do it for free.
Here the cost of skiing is not just the explicit cost of $40 for skiing, but the opportunity cost of the lost earnings ($45). Therefore the total costs are $85, which exceed the benefits of $60. So, you should stay on the campus and work for your professor. Someone who ignored the opportunity cost of the foregone earnings would decide incorrectly to go skiing.
It is an important point that you are willing to do the job for free, meaning there are no psychic costs attached to the job. This is important because it means that by not doing the job you would not have escaped something unpleasant.
Not all jobs fall into this category. Suppose your job involves scraping plates at the dining hall for which you will get the same $45 per day. The job is so unpleasant that you would not be willing to do it for less than $30 per day. Let us now reconsider the decision of whether to go skiing assuming that your boss allows you to have one day free in your job.

Should I scrape plates or go skiing today?
There are two alternative ways of looking at this decision. One is that, one of the benefits of going skiing is not having to scrape plates. Since you would never scrape plates for less than $30 per day, one could say that going skiing is worth that much to you. So the indirect benefit of going skiing is $30.The direct benefit of going skiing is still the same $60.So the total benefit of going skiing is $90. Whereas the costs of going skiing is the same the opportunity cost of the lost earning which is $45 plus the explicit cost of skiing which is $40, so the total cost of going skiing is $85.So, in this alternative the costs of skiing are less than the benefits of skiing, $85 is less than $90, indeed it makes sense to go skiing.
There is an alternate way of looking at this problem. Looking at the unpleasantness of the job as an offset against the salary. In that case we would subtract the $30 unpleasantness cost from the $45 salary, so the opportunity cost of not doing the job would be only $15, and the cost of going skiing would be $40+ $15=$55.The benefits of skiing are $60.And, again the benefits are greater than the costs.
The valuation of the unpleasantness of scraping the plates can thus be handled either way, however it is important that you handle the valuation in one of the alternative ways do not count it twice.
Clearly there is a reciprocal relationship between costs and benefits. Not incurring a cost is the same as getting a benefit. Similarly not getting a benefit is the same as incurring a cost.
Consider the case of a graduate student who was returning home after getting his degree from US. Now he could get a car from US without paying duty according to the rules for a returning student. This story is of way back in the 60’s.The car the student planned to get was an Impala. He planned to sell it in India at the rate of its cost plus the amount of duty he would have had to pay otherwise. However his uncle asked him to bring back the Impala for him and told him he would pay him the cost of the car. Obviously the student could not charge his uncle the duty. Not getting this benefit was the cost paid by the student.

Should I work first or go to college first?
The cost of going to college is not only the cost of fees, books, hostel room and board but also the cost of time and money foregone by not working, this cost is the least when yoyu are straight out of school, so most people go to college right after school.

Is it fair to charge interest-Yes it is, interest is merely the lender’s opportunity cost of not having deposited money in a bank, but this begs the next question.

Why do banks pay interest in the first place?
Because interest is the reimbursement for the opportunity cost of money, yet there is hostility towards money lenders because they are the richer part of the transaction.

Pit  fall 2-Failure to ignore sunk costs-there are two examples given in the book, one is if we compare the cost of say going to Bombay from ahmedabad by bus and car, if we would take the cost of going by car as the petrol, maintenance, insurance and interest cost that would be a mistake because, they would be the same whether or not you drive to Bombay, they would not vary with the amount of km traveled, thus these costs are unrecoverable at the time at which the decision is made.Another eg is an all u can eat dinner of pizzas, the relevant choice is which restaurant to go based on the per head charge and other factors , once this decision is made, getting your moneys worth should just depend, on how hungry you are, and how much you like pizza not on how much you paid for the dinner, yet this is often the case.

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