And we're the irrational ones?

If just about any deviation from blackboard rationality is enough to declare market failure and say we need be subject to state control by rational bureaucrats, what are we to make of this?

One bunch of state bureaucrats tries to ban or limit sugar intake.

Another bunch of state bureaucrats advance loans to sugar processors and then have to buy a pile of US sugar to prop up prices to avoid those processors' defaulting on the loans. I suppose you could view the "pushing prices up" part as consistent with limiting consumption. But the initial loans wouldn't have been. And what are they going to do with the 400,000 tons of sugar they're planning on buying? More ethanol?

And doesn't the state try to stop people smoking while subsidising tobacco growers?

It's not unreasonable to view individual decision-making as being the outcome of warring homunculi within the brain. It's never been clear to me why even a rational unitary state might think itself in a position to overturn the outcome of that conflict, never mind a state that has battling-homunculi issues of its own.

Valuing amenities

A few things I tell my Economics & Current Policy Issues Class:

• It's double-counting to weigh the direct costs of some disamenity as well as the disamenity's effects on land values because the latter incorporates the former (and the same for positive amenity affects);
• We can weigh the value of hard to value things like mortality risk by looking for effects on priced markets. Differential on-the-job accident risk can give us measures of the value of a statistical life. The value of a neighbourhood park can be approximated by housing price effects, and the same for the value of neighbourhood disamenities.

And so I'll have to remember this rather nice NBER working paper by Currie, Davis, Greenstone, and Walker. They pick a relatively hard case: plants that emit toxic chemicals that are sometimes hard to smell or see. They find emissions decline exponentially with distance from the plant, reaching baseline levels a mile from the plant. When a plant opens, housing prices in a half mile radius drop by 1-2%; when it closes, they go up by 2-3%. Within a mile, the price drop is 1.5%. A plant within a mile also increases the likelihood of having a low birthweight child by two percent (that percent, not percentage points, and the base rate incidence is low). 

When they add everything up, they find that a plant's opening reduces average housing market capitalisation in the surrounding mile by $1.5 million on average,* and that the costs of low-birthweight births in the surrounding mile are about $700k. So the disamenity cost, as measured by housing prices, is about twice the biggest likely measurable health effect. And that's entirely consistent with housing markets capitalising the real imposed disamenities. The biggest price effects are closest to the plant, where health disamenities combine with the noise and sight of the plant, then decline towards the one mile mark, where there are still real health effects but the other disamenities are negligible relative to those in the reference category of homes 1-2 miles away. 

They also find that neighbourhoods around plants pick up in demographic characteristics after a plant's opening: people move there for jobs. They wonder whether this is consistent with fully informed decision-making, but it's rather plausible that, given the low absolute risk imposed, households simply value being within walking distance of work more than they dislike the disamenties. 

On the whole I take this as pretty supportive of our base-line theory on this stuff and reasonable evidence against the "Oh, but people are stupid and irrational and they would never live there if they only knew and we have to ban a pile of stuff" alternative hypothesis.

* By way of comparison, they note that a typical plant - a small coal-power plant - costs $280m to build. The disamenity effect, though real, isn't some big huge cost that would tip the balance against approving the plant were it incorporated.

Don't start by assuming stupidity

Suppose that you want to reduce petrol usage because of global warming.

If you begin from an assumption of consumer rationality, you'll prefer a carbon tax or some form of emission trading. Announce today a schedule of Pigovean carbon taxes and how they will affect petrol prices as they ramp up over time. Then let customers decide how to re-optimise when buying cars. We'd expect an increase in demand for cars with better fuel economy. Cars with worse fuel economy will start having to sell at a discount. Manufacturers adjust their product mix to account for changing demand and aggregate fleet composition changes over the longer term.

If you start from an assumption of consumer stupidity, you'll prefer regulations targeting car manufacturers mandating fuel economy standards. If car buyers are myopic and stupid, they'll fail to account for the higher lifetime cost of a car with worse fuel economy. Because customers are stupid in this way, manufacturers will not adjust their product mix to shift towards cars with better fuel economy - there's no change in demand for more efficient cars even with a well-publicised schedule of future tax increases. And so direct regulation has to be used. There are problems with this and lots of them - all the gaming of US CAFE standards and redefinitions of what constitutes a truck as most obvious example. But it could be a second best if car buyers are really stupid. Or, if they're just really really short-sighted. We'll also have to assume that car buyers do not change their behaviour by a lot when the price of driving a kilometer goes down by a lot.

What happens if we look to the data? Busse et al in the latest American Economic Review find pretty good evidence that car buyers' demand for fuel economy is sensitive to petrol prices. They conclude (ungated versions):

We estimated that a $1 increase in the price of gasoline increases the market share of cars in the highest fuel economy quartile by 21.1 percent and decreases the market share of cars in the lowest fuel economy quartile by 27.1 percent. We also estimated the effect of a $1 increase in gasoline prices on unit sales of new cars and found that sales in the highest fuel economy quartile increased by 10–12 percent, while sales in the lowest fuel economy quartile fell by 27–28 percent. We estimated the effect of gasoline prices on the equilibrium prices of new cars and found that a $1 increase in the price of gasoline is associated with an increase of $354 in the average price of the highest fuel economy quartile of cars relative to that of the lowest fuel economy quartile. For used cars, the estimated relative price difference is $1,945.

We used these estimates to investigate whether the changes in equilibrium prices for new and used cars associated with changes in gasoline prices show evidence that consumers undervalue future gasoline costs of cars with different fuel economies relative to the prices of those cars. This could be thought of as a necessary condition for effective policy: the more car buyers discount future fuel costs, the less effective a gasoline tax or carbon tax will be in influencing vehicle choice. Using several different assumptions about vehicle miles traveled, a range of assumptions about the elasticity of demand, and comparing the relative price differences between different quartiles, we find little evidence of consumer myopia. Many of our implicit discount rates are near zero; most are less than 20 percent.

So the "people aren't stupid and weigh costs over time in a sensible fashion" model seems the better baseline approach.

Now imagine that you set a fuel economy standard instead of a carbon/petrol tax in a world where customers are forward-looking and not idiots. Well, once they've bought the more efficient car, the value they derive from burning another litre of petrol increases substantially: they can drive farther, and they're not charged any more for that litre of petrol. And so a lot of the reductions in carbon emission you might have expected get whittled away by that people drive more. If you'd done it instead with a petrol tax, the marginal cost of another litre of petrol is higher. People still flip to the more efficient vehicle, but petrol usage doesn't rebound as much as consequence because the marginal cost of a litre is higher.

Flynn effects

Professor Flynn is trying to help you improve your mind. My review of his latest book should be in today's Christchurch Press. They gave me 450 words; I took 480. Here they are.

Professor Jim Flynn sets a clever trap in his latest book, “How To Improve Your Mind”. Promising that all readers will “be far more able to defend their position after reading it than before”, Flynn instead provides the critical tools necessary instead for reassessing the irrational beliefs each of us hold and, in so-confronting, end them. For your own good, you should let yourself be trapped. Jim Flynn is arguably New Zealand’s best social scientist. I disagree with him on some aspects of economic policy, but Professor Flynn is a truth-seeker. And, even better, he’s very often a truth finder. Here, he helps the rest of us be better truth-seekers. This is no mean task. Thinking rationally is hard and, often, unpleasant. Worse, there is no payoff to rational thinking in many areas of life; you will hardly be less successful in most occupations if it gives you pleasure to believe that the earth is only a few thousand years old. But I’ll return to this.

Flynn ably demonstrates the methods of rationality through a series of case studies of beliefs that contravene the methods. He also warns against the tricks used by policy advocates against those not appropriately armored against them.

I disagree with a few of the finer points in Flynn’s chapters on economics. For example, even if the reservation wages of second earners are lower than those of primary family earners, this will not drive down female wage rates unless we add assumptions around segmented labour markets. Further, decent labour standards seem to owe more to higher incomes and increased productivity than they do to Twentieth Century regulatory interventions. In developing countries, child labour is very sensitive to family income; when parents can afford to do so, they send their kids to school. And he is perhaps a bit too optimistic about the feasibility of ameliorative regulatory reform in financial markets. But Flynn has a sharp nose for the failures of rational thinking about economics among those whose values he shares – he correctly sees negative income taxes as better than a minimum wage for helping those he would wish to assist, though he misses that cleverer forms of the negative income tax solve some of the problems he highlights.

The bigger question, and the one harder to answer, is why to choose rationality in the first place. Flynn writes, “If you learn how to use logic and evidence to examine your own principles, and the principles other people urge upon you, you can enlist in the ranks of mature moral agents rather than in the army of stones.” But it’s an expensive endeavour – not unlike taking the Red Pill offered Neo in The Matrix. I’d be surprised if more than a quarter of the population even tries to choose rationality over comforting illusions. But if you’d like to try to try, Flynn’s book is a good start.

I should be reviewing Eliezer Yudkowski's "Harry Potter and the Methods of Rationality" for next weekend's Press.

One bit that wasn't relevant for the Christchurch Press but I found awfully interesting was this observation:

"Academic competition for grades in a particular course selects out an elite that gets an A+. But within some areas, the correlation between courses is far more perfect than within others. Within mathematics, the best student in differential equations is likely to be the best student in algebraic geometry and in number theory, and so forth. Within political studies, the best student in political behaviour is less likely also to be the best student in areas as diverse as international relations, political philosophy, and quantitative methods. So, talented math students will come to scholarship committees with a string of A+s, and talented political studies students with  a mix of A+s and As. Rather than putting all the math students at the top, the obvious thing would be to alternate science/math students with arts/social science students. Observe how quickly math professors forget what they know about regression to the mean when such a proposal is put."

I'm on the Scholarships Advisory Committee as the Commerce rep; we help advise on policy around scholarships. I wonder how much this affects our University-wide awards. Economics probably doesn't do horribly out of this kind of overall effect: more than any of the other arts or social sciences, there's likely an underlying e-factor - thinking like an economist - that explains variance across students. At least in microeconomics. But arts and social sciences in general will do worse than the bench sciences and maths.

I wonder if anybody has run the test. If Flynn is right, then we expect lower variance in course grades for maths and science majors than for arts and commerce majors. We can use incoming high school grades as a measure of baseline ability. We could observe higher variance among the best students in arts courses than among the best students in maths courses simply because of grade truncation issues if the very best of all students pick maths over arts. I think I'll add the "future honours project proposals" tag; this seems testable.

Update: Oops...didn't see it in today's paper. Likely in next week's then.