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Posts Tagged ‘ceteris paribus’

Getting out the crystal ball

The New Year is a time for reflection and prediction. What will the New Year bring? What does the longer-term future hold? Here are two articles from The Guardian that look into the future.

The first, by Larry Elliott, considers a number of scenarios and policy options. Although not totally doom laden, the article is not exactly cheery in its predictions. Perhaps ‘life will go on’ and the global economy will muddle through. But perhaps a new recession is around the corner or, even worse, the world is at a tipping point when things are fundamentally changing. Unless policy-makers are careful, clever and co-ordinated, perhaps a new dark age may be looming. But who knows?

Which brings us to the second article, by Gaby Hinsliff. This argues that people are pretty hopeless at predicting. “History is littered with supposed dead certs that didn’t happen – Greece leaving the euro, the premature collapse of the coalition – and wholly unimagined events that came to pass.” And economists and financial experts are little better.

Two years ago, The Observer challenged a panel of City investors to pick a portfolio of stocks and rated their performance against that of Orlando, a ginger cat who selected his portfolio by tossing a toy mouse at a sheet of paper. Inevitably, the cat triumphed.

But is this fair? If capital markets are relatively efficient, stock prices today already reflect knowable information about the future, but clearly not unknowable information.

It’s the same with economies. When information is already to hand, such as a pre-announced tax change, then its effects, ceteris paribus, can be estimated – at least roughly.

But it’s the ‘ceteris paribus‘ assumption that’s the problem. Other things are not equal. The world is constantly changing and there are all sorts of unpredictable events that will influence the outcomes of economic policy and of economic decisions more generally. And central to the problem are people’s attitudes and confidence. Mood can swing quite dramatically, from irrational exuberance to deep pessimism. And such mood changes – often triggered by some exogenous factor, such as an international dispute, an election or unexpected economic news – can rapidly gather momentum and have significant effects.

Predicting the long-term future is both easier and more difficult: easier, in that short-term cyclical effects are less relevant; more difficult in that changes that have not yet happened, such as technological changes or changes in working practices, may themselves be key determinants of the future global economy.

One of the most salutary lessons is to look at predictions made in the past about the world today and at just how wrong they have proved to be. Perhaps we need to call on Orlando more frequently.

Why ‘life will go on’ thesis about global economy might not pass muster in 2015 The Guardian, Larry Elliott (28/12/14)
Who knows what the new year holds? Certainly none of us The Guardian, Gaby Hinsliff (26/12/14)

Questions

  1. Give some examples of factors that could have a major influence on the global economy, but which are unpredictable.
  2. Is economic forecasting still worthwhile? Explain.
  3. Look at some macroeconomic forecasts made in the past about the world today. You might want to look at forecasts of agencies such as the IMF, the OECD, the World Bank and the European Commission. You can find links in the Economics Network’s Economic Data freely available online. Explain why such forecasts have differed from the actual outcome.
  4. Why, if capital markets were perfect, might Orlando be just as good as a top investment manager at predicting the future course of share prices?
  5. In what ways is economic forecasting similar to and different from weather forecasting in its methods, its use of data and its reliability?
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Should studying economics come with a health warning!!?

Many of you reading the articles on this website will be just about to start, or will have just started, studying economics at university. For some of you this will involve building on the knowledge you obtained prior to university, whereas for others it will be the first time you have ever studied the subject before. Will studying economics change the way you behave? Should it come with a health warning?

Can studying economics change the way you think and behave? The subject is often sold to prospective students on the grounds that it can. For example it is stated on the Economics Network’s Why Study Economics? website that

The economic way of thinking can help us make better choices

However, is it possible that studying economics could change people’s behaviour in a way that would be to the detriment of society? Some observers have argued that it can. They have suggested that students might be influenced by some of the assumptions that are made in traditional economic theory.

As social scientists, economists are always trying to analyse human behaviour. However, people vary in many different ways and have very diverse preferences. If we want to build a theory that predicts how people will behave and respond in different situations, then some type of simplifying assumptions are inevitable.

Traditionally one of the key simplifying assumptions that economists have used in their theories of human behaviour is that people make decisions in their own self-interest. There is some debate about exactly what self-interest means. For example it could be argued that giving £10 to charity is acting in your own self-interest if it gives you more pleasure than spending that £10 on yourself. However, in many of the economic theories that you first study in economics a narrow meaning of self-interest tends to be used. This is clearly illustrated by the following quote from Milgrom and Roberts. Referring to economic theory they state that:

It is often assumed that people behave as if they were entirely motivated by narrow, selfish concerns

It is important to make it clear that economists are not assuming that people behave in a selfish manner all of the time. Instead, they are assuming that the people in their theories are acting in a selfish manner. The value of making this assumption is whether the predictions about human behaviour that follow from using it are supported by evidence from the real world.

Some researchers have argued that when people study economic theory built on this assumption it makes them more likely to behave in a selfish way. The evidence for this comes from a range of research papers. Here are some findings:

Economics students were more likely than those studying other subjects to recommend the most expensive plumber to a student society if that plumber offered the student a side payment.

Students took part in an experiment in a computer room where they could either keep the money they had been given or donate it to a public good. On average the economics students kept more of the money.

Economics professors gave less money to charity than professors of other subjects such as psychology and sociology.

Some studies also found that selfish people were more likely to choose economics as a subject to study and became more selfish after they had studied it for some time.

If you are about to begin your study of economics then perhaps you should take care that your behaviour outside the classroom is not being unduly influenced by some of the assumptions you are learning about inside the classroom. On a more practical note perhaps you should avoid sharing a restaurant bill or buying rounds of drinks when in the company of other economists!!!

However on a brighter note, the evidence in these papers can be interpreted in a number of different ways. There are even some studies that found economics students were less selfish than those on other courses.

Re-Post: Does Studying Economics Make You Selfish? The Splintered Mind (21/11/12)
Does studying economics make you more selfish? BBC (22/10/13)
Does Studying Economics Breed Greed? Huffington Post (22/10/13)
The Dismal Education The New York Times (16/12/11)
Does Economics Make You a Bad Person? Conversable Economist (31/3/14)
Economists aren’t all bad FT Magazine (11/4/14)

Questions

  1. What is an economic model? Why is it necessary to make simplifying assumptions?
  2. How are economic models judged? How important is it for the assumptions to accurately describe the real world?
  3. Try to find some jokes that have been made about the use of assumptions in economic theory.
  4. Can you think of any alternative explanations for the results found in the research papers referred to in the case?
  5. Try to find a research paper that finds evidence that economics students are less selfish than other students.
  6. What is a public good? Explain why someone with selfish preferences would not contribute to the public good.
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Becoming an economic detective

Many of you reading this will be embarking on an economics degree. During your studies you’ll be developing the skills that economists bring to observing and analysing the world around us and considering the policy options to achieve various social and economic objectives. You’ll be learning how to become an ‘economic detective’ and to do ‘forensic economics’.

Identifying the nature of economic problems; collecting and examining the evidence; using the economist’s ‘toolkit’ of concepts and ideas to make sense of the evidence; looking for explanations; constructing hypotheses and theories; considering what can be done to tackle the problems and prevent them occurring in the future – these are the sorts of things you will be doing; and they involve detective work.

The podcast below looks at the methods of Sherlock Holmes. These are the sorts of methods successful economists use. John Gray identifies three types of reasoning. The first two are probably familiar to you, or soon will be.

1. Induction involves looking at evidence and then using it to construct general theories. So, for example, if you observe on many occasions that when the prices of various goods rise, the quantity demanded falls, you can then hypothesise that whenever the price of a good rises, the quantity demanded will fall; in other words, you induce that price and quantity demanded are inversely related – that demand curves are downward sloping. This is known as the ‘Law of demand’. Induction, of course, is only as good as the evidence. Nevertheless, inductive methods are logical and it can be demonstrated how the theories follow from the evidence.

2. Deduction involves using theories to draw conclusions about specific cases. So, for example, you could use the law of demand to deduce that when the price of a specific good rises, the quantity demanded of that good will fall. You would also assume that nothing else had changed that could influence the demand for the good. In other words, you assume ‘ceteris paribus‘ or ‘other things being equal’. As long as you have not made any logical errors, deduction is foolproof. As John Gray puts it:

Deduction is infallible as long as the premises are true, while induction yields probabilities that can always be falsified by events

But there is a third type of reasoning and this is where the true economic detective comes in. This is known as ‘abduction’. This is the type of logic that is used when evidence is thin or where there are lots of scraps of seemingly contradictory evidence. And this is the type of logic employed so successfully by Sherlock Holmes.

3. Abduction involves making informed guesses or estimates from limited evidence. It is using the scraps of evidence as clues as to what might be really going on. It is how many initial hypotheses are formed. Then the researcher (or detective) will use the clues to search for more evidence that can be used for induction that will yield a more robust theory. The clues may lead to a false trail, but sometimes they may allow the researcher to develop a new theory or amend an existing one. A good researcher will be alert to clues; to seeing patterns in details that might previously have been dismissed or gone unnoticed.

Before the banking crisis of 2007/8 and the subsequent credit crunch and recession in the developed world, many economists were picking up clues and trying to use them to develop a theory of systemic risk in financial markets. They were using the skills of an economic detective to try to discover not only what was currently going on but also what might be the consequences for the future. Some used abduction successfully to predict the impending crisis; most did not.

If you are embarking on an economics degree and will possibly go on to a career as an economist, then part of your training will be as a detective. With good detective skills – looking for clues, seeing connections, identifying what more evidence is required and where to find it, and then using it to provide explanations and policy prescriptions – you could make a very successful and sought-after economist. Being a good economist is not just about learning theories and techniques, although this is vitally important; it’s also about being imaginative and thinking ‘outside the box’. Good luck!

Podcast
Sherlock Holmes and the Romance of Reason BBC: A Point of View, John Gray (17/8/12) (Click here for a transcript.)

Articles and information
Detective work: forensic economics Business:Life, Tim Harford (2/5/12)
The Search for 100 Million Missing Women Slate, Stephen J. Dubner and Steven D. Levitt (24/5/05)
Abduction Stanford Encyclopedia of Philosophy, Igor Douven (9/2/11)
Abductive reasoning Wikipedia

Questions

  1. Explain the difference between induction and abduction.
  2. Identify the various ‘threshold concepts’ in economics. Does an understanding of these concepts help an economist do better detective work?
  3. How might forensic economics be used for crime fighting?
  4. Why might elegant and sophisticated economic theory be dangerous in the ‘messy’ and statistically ‘noisy’ real world?
  5. In trying to establish an explanation for “100 Million Missing Women”, what use was made of abduction, induction and deduction?
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