Economists are often criticised for making inaccurate forecasts and for making false assumptions. Their analysis is frequently dismissed by politicians when it contradicts their own views.
But is this fair? Have economists responded to the realities of the global economy and to the behaviour of people, firms, institutions and government as they respond to economic circumstances? The answer is a qualified yes.
Behavioural economics is increasingly challenging the simple assumption that people are ‘rational’, in the sense that they maximise their self interest by weighing up the marginal costs and benefits of alternatives open to them. And macroeconomic models are evolving to take account of a range of drivers of global growth and the business cycle.
The linked article and podcast below look at the views of 2019 Nobel Prize-winning economist Esther Duflo. She has challenged some of the traditional assumptions of economics about the nature of rationality and what motivates people. But her work is still very much in the tradition of economists. She examines evidence and sees how people respond to incentives and then derives policy implications from the analysis.
Take the case of the mobility of labour. She examines why people who lose their jobs may not always move to a new one if it’s in a different town. Partly this is for financial reasons – moving is costly and housing may be more expensive where the new job is located. Partly, however, it is for reasons of identity. Many people are attached to where they currently live. They may be reluctant to leave family and friends and familiar surroundings and hope that a new job will turn up – even if it means a cut in wages. This is not irrational; it just means that people are driven by more than simply wages.
Duflo is doing what economists typically do – examining behaviour in the light of evidence. In her case, she is revisiting the concept of rationality to take account of evidence on what motivates people and the way they behave.
In the light of workers’ motivation, she considers the implications for the gains from trade. Is free trade policy necessarily desirable if people lose their jobs because of cheap imports from China and other developing countries where labour costs are low?
The answer is not a clear yes or no, as import-competing industries are only part of the story. If protectionist policies are pursued, other countries may retaliate with protectionist policies themselves. In such cases, people working in the export sector may lose their jobs.
She also looks at how people may respond to a rise or cut in tax rates. Again the answer is not clear cut and an examination of empirical evidence is necessary to devise appropriate policy. Not only is there an income and substitution effect from tax changes, but people are motivated to work by factors other than take-home pay. Likewise, firms are encouraged to invest by factors other than the simple post-tax profitability of investment.
- In traditional ‘neoclassical’ economics, what is meant by ‘rationality’ in terms of (a) consumer behaviour; (b) producer behaviour?
- How might the concept of rationality be expanded to take into account a whole range of factors other than the direct costs and benefits of a decision?
- What is meant by bounded rationality?
- What would be the effect on workers’ willingness to work more or fewer hours as a result of a cut in the marginal income tax rate if (a) the income effect was greater than the substitution effect; (b) the substitution effect was greater than the income effect? Would your answers to (a) and (b) be the opposite in the case of a rise in the marginal income tax rate?
- Give some arguments that you consider to be legitimate for imposing controls on imports in (a) the short run; (b) the long run. How might you counter these arguments from a free-trade perspective?
Many of you may have heard of nudge – the idea that governments can help people make better decisions by carefully designing the way a policy is structured and presented. Have you heard of sludge?
The most widely cited example of a nudge is changing a default option. The default option is what happens if you do nothing. For example, when you start a new job, are you automatically enrolled into the pension scheme or do you have to do something (i.e. fill-in an on-line form) to opt-in to the scheme. Changing the default option to one of being automatically enrolled in a scheme seems to have a big impact on the choices people make.
Recently, policy makers have started referring to ‘sludge’. Sludge is the opposite of nudge: i.e. characteristics about design and presentation that make it more difficult for people to make good decisions. Some businesses may use sludge to encourage consumers to spend more on their goods than they ever intended.
One interesting application of sludge is in the design of websites – referred to as Dark Patterns. The following are a number of different categories of dark pattern:
The last example, Forced Continuity, refers to the use of free trial periods and automatic renewal of contracts. Many people sign up for a free trial or special offer with the full intention of cancelling before the account automatically switches to the standard price.
How often do people simply forget or never quite get around to cancelling these deals when the time comes? Some recent evidence comes from a YouGov Survey. Forty-seven percent of respondents to this survey reported having accidently signed up for an annual subscription because they either forgot or were unable to cancel their account. The estimated total cost of unwanted subscriptions per year was £837 million. The same YouGov survey found that one in eight people kept paying for over four months before finally getting around to cancelling.
One business has recently seen an opportunity to help people deal with this problem. Free Trial Surfing is a new App developed by the company, Do Not Pay. It became available via Apple’s App store in September but is not yet compatible with Android devices. It works in the following way.
When customers download the app, they receive a new credit card number and a false name. Although Do Not Pay register the card details to their own business, the customer can use the information to sign up for a free trial of a good or service. In effect, Do Not Pay acts as an intermediary between the firm offering the promotion and the user. Once the free trial period ends, the app automatically cancels the subscription. Importantly, the new credit card details only work when someone signs up for a free trial. Consumers cannot use it to purchase any other products. Obviously one major drawback to the app is that a consumer would have to sign up again with their own personal credit card if they wanted to continue to use the service after the free trial ends. Businesses may also try to block the use of Do Not Pay credit card numbers for their services.
It will be interesting to see if other businesses come up with interesting ways of helping us to deal with sludge.
- Give three different examples of nudges.
- What policies do government typically use to change peoples’ behaviour? How do these traditional approaches differ from nudge?
- Identify some biases from behavioural economics that might help to explain why so many people fail to cancel subscriptions once a free trial period ends.
- Choose two other types of dark pattern and explain how they might prevent people from making decisions that maximise their own welfare.
With university fees for home students in England of £9250 per year and with many students receiving maintenance loans of around £9000 per year, many students are graduating with debts in excess of £50 000. Loans are repaid at a marginal rate of 9% on incomes over £25 716.
Many students also study for a masters degree. The average fee for a taught, classroom-based masters (MA) is £7392 and for a laboratory-based masters (MSc) is £8167 but can be considerably higher at some prestigious universities where demand is high. Government loans of up to £10 906 are available to contribute towards fees and maintenance. These are paid back at a marginal rate of 6% for people earning over £21 000, giving a combined marginal rate of 15% for first and masters degrees.
For high earners on the 40% income tax rate, the combined marginal rate of payment out of income is 40% tax, plus 2% national insurance, plus 15% for those with undergraduate and masters loans. This gives a combined marginal rate of 57%.
Average student debt in England is higher even than in the USA, where the average is $37 000. US university courses are more expensive than in the UK, costing an average of $34 000 per year in tuition alone. But undergraduates can borrow less. They can borrow between $5500 and $12 500 per year in federal loans towards both fees and maintenance, and some private loans are also available. Most students do some paid work during their studies to make up the difference or rely on parents contributing. Parental contributions mean that students from poor families end up owing more. According to a Guardian article:
Race is a huge factor. Black students owe an average of $7400 more than white students when they graduate, the Brookings Institution found. After graduation, the debt gap continues to widen. Four years after graduation, black graduates owe an average of nearly $53 000 – nearly double that of white graduates.
Student debt looks to become one of the key issues in the 2020 US presidential election.
Pressure to cancel student fees and debt in the USA
Most of the Democratic candidates are promising to address student fees and debt. Student debt, they claim, places an unfair burden on the younger generation and makes it hard for people to buy a house, or car or other major consumer durables. This also has a dampening effect on aggregate demand.
The most radical proposal comes from Bernie Sanders. He has vowed, if elected, to abolish student fees and to cancel all undergraduate and graduate debt of all Americans. Other candidates are promising to cut fees and/or debt.
Although most politicians and commentators agree that the USA has a serious problem of student debt, there is little agreement on what, if anything, to do about it. There are already a number of ways in which student debt can be written off or reduced. For example, if you work in the public sector for more than 10 years, remaining debt will be cancelled. However, none of the existing schemes is as radical as that being proposed by many Democrats.
Criticisms of the Democrats’ plans are mainly of two types.
The first is the sheer cost. Overall debt is around $1.6tn. What is more, making student tuition free would place a huge ongoing burden on government finances. Bernie Sanders proposes introducing a financial transactions tax on stock trading. This would be similar to a Tobin tax (sometimes dubbed a ‘Robin Hood tax’) and would include a 0.5% tax on stock transactions, a 0.1% tax on bond trades and a 0.005% tax on transactions in derivatives. He argues that the public bailed out the financial sector in 2008 and that it is now the turn of the financial sector to come to the aid of students and graduates.
The other type of criticism concerns the incentive effects of the proposal. The core of the criticism is that loan forgiveness involves moral hazard.
The moral hazard of loan forgiveness
The argument is that cancelling debt, or the promise to do so, encourages people to take on more debt. Generally, moral hazard occurs when people are protected from the consequences of their actions and are thus encouraged to make riskier decisions. For example, if you are ensured against theft, you may be less careful with your belongings. As the Orange County Register article linked below states:
If the taxpayers pay the debts of everyone with outstanding student loans, how will that affect the decisions made by current students thinking about their choices for financing higher education? What’s the message? Borrow as much as you can and wait for the debt to be canceled during the next presidential primary campaign?
Not only would more students be encouraged to go to college, but they would be encouraged to apply for more costly courses if they were free.
Universities would be encouraged to exaggerate their costs to warrant higher fees charged to the government. The government (federal, state or local) would have to be very careful in auditing courses to ensure costs were genuine. Universities could end up being squeezed for finance as government may try to cut payments by claiming that courses were overpriced.
Even if fees were not abolished, cancelling debts would encourage students to take on larger debt, if that was to be cleared at some point in the future. What is more, students (or their parents) who could afford to pay, would choose to borrow the money instead.
But many countries do have free or highly subsidised higher education. Universities are given grants which are designed to reflect fair costs.
- Assess the arguments for abolishing or substantially reducing student fees.
- Assess the arguments against abolishing or substantially reducing student fees.
- Assess the arguments for writing off or substantially reducing student debt.
- Assess the arguments against writing off or substantially reducing student debt.
- If it were decided to cancel student debt, would it be fair to pay students back for any debt they had already paid off?
- Does tackling the problem of student debt necessarily lead to a redistribution of wealth/income?
- Give some other examples of moral hazard.
- If student fees were abolished, would there be any problem of adverse selection? If so, how could this be overcome?
- Find out what the main UK parties are advocating about student fees and debt in the nations of the UK for home and non-home students. Provide a critique of each of their policies.
The linked article below, by Evan Davis, assesses the state of economics. He argues that economics has had some major successes over the years in providing a framework for understanding how economies function and how to increase incomes and well-being more generally.
Over the last few decades, economists have …had an influence over every aspect of our lives. …And during this era in which economists have reigned, the world has notched up some marked successes. The reduction in the proportion of human beings living in abject poverty over the last thirty years has been extraordinary.
With the development of concepts such as opportunity cost, the prisoners’ dilemma, comparative advantage and the paradox of thrift, economics has helped to shape the way policymakers perceive economic issues and policies.
These concepts are ‘threshold concepts’. Understanding and being able to relate and apply these core economic concepts helps you to ‘think like an economist’ and to relate the different parts of the subject to each other. Both Economics (10th edition) and Essentials of Economics (8th edition) examine 15 of these threshold concepts. Each time a threshold concept is used in the text, a ‘TC’ icon appears in the margin with the appropriate number. By locating them in this way, you can see their use in a variety of contexts.
But despite the insights provided by traditional economics into the various problems that society faces, the discipline of economics has faced criticism, especially since the financial crisis, which most economists did not foresee.
Even Davis identifies two major shortcomings of the discipline – both beginning with ‘C’. ‘One is complexity, the other is community.’
In terms of complexity, the criticism is that economic models are often based on simplistic assumptions, such as ‘rational maximising behaviour’. This might make it easier to express the models mathematically, but mathematical elegance does not necessarily translate into predictive accuracy. Such models do not capture the ‘messiness’ of the real world.
These models have a certain theoretical elegance but there is now an increasing sense that economies do not evolve along a well-defined mathematical path, but in a far more messy way. The individual players within the economy face radical uncertainty; they adapt and learn as they go; they watch what everybody else does. The economy stumbles along in a process of slow discovery, full of feedback loops.
As far as ‘community’ is concerned, people do not just act as self-interested individuals. Their actions are often governed by how other people behave and also by how their own actions will affect other people, such as family, friends, colleagues or society more generally.
And the same applies to firms. They will be influenced by various other firms, such as competitors, trend setters and suppliers and also by a range of stakeholders – not just shareholders, but also workers, customers, local communities, etc. A firm’s aim is thus unlikely to be simple short-term profit maximisation.
And this broader set of interests translates into policy. The neoliberal free-market, laissez-faire approach to policy is challenged by the desire to take account of broader questions of equity, community and social justice. However privately efficient a free market is, it does not take account of the full social and environmental costs and benefits of firms’ and consumers’ actions or a fair distribution of income and wealth.
It would be wrong, however, to say that economics has not responded to these complexities and concerns. The analysis of externalities, income distribution, incentives, herd behaviour, uncertainty, speculation, cumulative causation and institutional values and biases are increasingly embedded in the economics curriculum and in economic research. What is more, behavioural economics is becoming increasingly mainstream in examining the behaviour of consumers, workers, firms and government. We have tried to reflect these developments in successive editions of our four textbooks.
- Write a brief defence of traditional economic analysis (i.e. that based on the assumption of ‘rational economic behaviour’).
- What are the shortcomings of traditional economic analysis?
- What is meant by ‘behavioural economics’ and how does it address the concerns raised in Evan Davis’ article?
- How is herd behaviour relevant to explaining macroeconomic fluctuations?
- Identify various stakeholder groups of an energy company. What influence are they likely to have on the company’s behaviour?
- In an era of social media, web-based information and e-commerce, why might it be necessary to rethink the concept of GDP and its measurement?
- What is meant by an efficient stock market? Why may the stock market not be efficient?
Spring has already made its appearance here in Norfolk. Our garden is in full bloom and I am in a particularly spring-philosophical mood today – especially so as I should soon be hearing news from the editorial office of a coveted economics journal. This concerns a paper that I submitted for publication what feels like months ago.
And just as I was reflecting on this thought, a paper by Firmuc and Paphawasit (2018) landed on my desk, evaluating the impact of physical attractiveness on academic research productivity in the field of economics. More specifically, the authors pull together information about the research productivity of about 2000 published economics researchers. They then find photos of them and rate their attractiveness (yes, seriously!) using an online survey. In particular:
Besides collecting some basic information on the authors, we also rated their attractiveness. To this effect, we circulated a number of online survey links to potential participants at Brunel University and elsewhere, using direct communication, email and social networks. Each online survey collected basic background information on the assessor (gender, age, ethnicity, highest education, and whether they are currently enrolled as a student) followed by 30 randomly-chosen and randomly-ordered photos, with each picture placed on a separate page.
…Each rater was asked to rate the attractiveness of the person in the photo on an 11-point scale, from 0 (unattractive) to 10 (very attractive). No information on the photographed individuals was provided and the raters were told that the survey studies the formation of perceptions of beauty. The raters were also asked whether they recognised the person in the picture, or whether the picture did not load properly: in such instances, their scores were excluded from the analysis.
The average beauty score was 3.9, with the most attractive academic scoring 7.6
They even attach photographs of the three most attractive male authors in their sample in an appendix (thankfully the other end of the distribution was left out – I had to check to make sure, as I was worried for a few minutes I would find my photo posted there!).
Their results show that there is a link between authors’ attractiveness and quality of journals where their papers are published, as well as number of citations that they receive. According to their findings, this association matters most for more productive authors (‘of intermediate and high productivity’), whereas there seems to be very small or no effect for less productive authors. Some of these effects disappear once controlling for journal quality:
…attractive authors tend to publish their research in better journals, but once their work is published, it does not attract more citations than other papers published in the same journal by less good-looking authors.
Although there are many methodological parts of this paper that I do not quite understand (probably because it is not my area of specialisation), it does remind us that looks do matter in labour markets. There is a well-established literature in labour economics discussing the association between appearance/beauty and wages and the so-called ‘halo effect’ (referring to the physical attractiveness premium that more attractive workers are likely to command in labour markets – see also Langlois et al., 2000; Zebrowitz et al., 2002; Kanazawa and Kovar, 2004; for a detailed discussion on this).
I was also surprised to read that this beauty bias can be also gender specific. For instance, Cash et al (1977) and Johnson et al. (2010) find that the effect goes the other way (negative impact) when considering female candidates applying for jobs traditionally perceived as ‘masculine’ ones. By contrast, male candidates are more likely to experience a positive return on good looks, irrespective of the type of job that they do (see also Johnson et al., 2010).
No surprise then that ‘guyliners’, ‘make up for men’ and other male beauty products are becoming increasingly popular amongst younger workers – in Europe it is not as common yet as it is in parts of Asia (Japan comes to mind), but I imagine it is a matter of time, as more workers realise that there are positive returns to be made!
- Beautiful Minds: Physical Attractiveness and Research Productivity in Economics
Institute of Labor Economics conference paper, Jan Fidrmucand Boontarika Paphawasit (July 2018)
- Maxims or myths of beauty? A meta-analytic and theoretical review
Psychological Bulletin, Vol 126(3), pp.390–423, Judith H Langlois, Lisa Kalakanis, Adam J Rubenstein, Andrea Larson, Monica Hallam and Monica Smoot (May 2000)
- Looking Smart and Looking Good: Facial Cues to Intelligence and their Origins
Personality and Social Psychology Bulletin, Leslie A Zebrowitz, Judith A Hall, Nora A Murphy, Gillian Rhodes (February 2002)
- Why beautiful people are more intelligent
Intelligence, Vol 32, pp.227–243, Satoshi Kanazawa and Jody L Kovar (2004)
- Sexism and beautyism in personnel consultant decision making
Journal of Applied Psychology, Vol 62(3), pp.301–10, Thomas Cash, Barry Gillen and D S Burns (January 1977)
- Physical Attractiveness Biases in Ratings of Employment Suitability: Tracking Down the “Beauty is Beastly” Effect
The Journal of Social Psychology, 150(3), pp.301–18, Stefanie K Johnson, Kenneth E Podratz, Robert L Dipboye and Ellie Gibbons (April 2010)
- Read some of the papers posted above and explain the main argument about the link between physical attraction and wages. What does the empirical evidence show on this?
- Using examples and anecdotal evidence, do you agree with these findings?
- If these findings are representative of the real world, what do they suggest about the functioning of modern labour markets?