Archive for the 'Rational behavior' Category

Nov 01 2012

Has the Baby Market Failed?

The tools of economics can be applied to almost any social institution, even the decision of individuals in society whether or not to have children. All over the rich world today, potential parents have decided against having babies, the result being lower fertility rates across much of Europe and the richer countries in Asia, including Japan, South Korea and Singapore. Lower fertility rates have some advantages, such as less pressure on the country’s natural resources, but the disadvantages generally outweigh the benefits.

The story below, from NPR, explains in detail some of the consequences of declining fertility rates in the rich world, and identifies some of the ways governments have begun to try to increase the fertility rates.

The problem of declining fertility rates can be analyzed using simple supply and demand analysis. In the graph below, we see that the marginal private cost of having children in rich countries is very high. The costs of having children include not only the monetary costs of raising the child, but the opportunity costs of forgone income of the parent who has to quit his or her job to raise the child or the explicit costs of child care, which in some countries can cost thousands of dollars per month. Marginal private cost corresponds with the supply of babies, since private individuals will only choose to have children if the perceived benefit of having a baby exceeds the explicit and implicit costs of child-rearing.

The marginal private benefit of having babies is downward sloping. This reflects the fact that if parents have just one or two children, the benefit of these children is relatively high, due to the emotional and economic contributions a first and second child will  bring to parents’ lives. But the more babies a couple has, the less additional benefit each successive child provides the parents. This helps explain why in an era of increased gender equality, families with three or more children are incredibly rare. The diminishing marginal benefit experienced by individual couples applies to society as a whole as well, therefore the market above could represent either the costs and benefits of individual parents or of society at large.

Notice, however, that that the marginal social benefit of having babies is greater than the marginal private benefit. In economics terminology, there are positive externalities of having babies; in other words, additional children provide benefits to society beyond those emotional and economic benefits enjoyed by the parents. The podcast explained some of these external, social benefits of having children: a larger workforce for firms to employ in the future, more people paying taxes, allowing the government to provide more public goods, more workers supporting the non-working retirees of a nation, and more competitive wages in the global market for goods and services. Higher fertility rates, in short, result in more economic growth and higher incomes for a nation.

When individuals decide how many children to have, they make this decision based solely on their private costs and benefits, since the external benefits of having more babies are enjoyed by society, but not necessarily by the parents themselves. Therefore, left entirely alone, the “free market” will produce fewer babies (Qe) than is socially optimal (Qso).

So what are Western governments doing about low fertility rates? The podcast identifies several strategies being employed to narrow the gap between Qe and Qso. In Australia households receive a $1000 subsidy for each baby born. In Germany mothers receive a year of paid leave from work. Here in Switzerland mothers get three months of government paid leave and $200 a month subsidy to help pay for child care after that. Each of these government policies represents a “baby subsidy”. In the graph above, we can see the intended effect of these policies. By making it more affordable to have children, governments are hoping to reduce the marginal private cost to parents, encouraging them to have more children, which on a societal level should increase the number of babies born so that it is closer to the socially optimal level (Qso).

Unfortunately, as the podcast explains, it appears that parents are relatively unresponsive to the monetary incentives governments are providing. This can be explained by the fact that the private demand (MPB) for babies is highly inelastic. Even if the “cost” of having a baby falls due to government subsidies, parents across the Western world are reluctant to increase the number of babies they have.

As we can see in the graph above, a subsidy for babies reduces the marginal private cost of child-rearing to parents. But the MPB curve, representing the private demand for babies, is highly inelastic, meaning the large subsidy has minimal effect on the quantity of babies produced. Without the subsidy, Qe babies would be born, while with the subsidy only Qs are born, which is closer to the socially optimal number of births at Qso, but still short of the number of births society truly needs.

The “market for babies” in rich countries is failing. Because of the positive externalities of having children, parents are currently under-producing this “merit good”. One of two things must happen to resolve this market failure. Either the marginal private costs of having babies must fall by much more than the government subsidies for babies have allowed, or the marginal private benefit must increase. Either larger subsidies are needed, or some moral revival aimed at encouraging potential parents to consider both the private and social benefits of having children when making their decisions.

Don’t you love economics? We make everything seem so logical! And like they say, it all comes down to supply and demand!

Discussion Questions:

  1. What makes low fertility rates among parents in the rich world an example of a “market failure”?
  2. What are the primary reasons fertility rates are lower in the rich world than they are in the developing world?
  3.  What are the economic consequences of lower birth rates? What are the environmental consequences of lower birth rates? Should government be trying to increase the number of babies born?
  4. Why have government incentives for parents to have more babies failed to achieve the fertility rates that government wish they would achieve?
  5. Do you believe that government can create strong enough incentives for parents to have more babies? If not, what will become of the populations of Western Europe and the rich countries of Asia given today’s low fertility rates? Should we be worried?

13 responses so far

Mar 23 2012

Understanding Oligopoly Behavior – a Game Theory overview

What makes oligopolistic markets, which are characterized by a few large firms, so different from the other market structures we study in Microeconomics? Unlike in more competitive markets in which firms are of much smaller size and one firm’s behavior has little or no effect on its competitors, an oligopolist that decides to lower its prices, change its output, expand into a new market, offer new services, or adverstise, will have powerful and consequential effects on the profitability of its competitors. For this reason, firms in oligopolistic markets are always considering the behavior of their competitors when making their own economic decisions.

To understand the behavior of non-collusive oligopolists (non-collusive meaning a few firms that do NOT cooperate on output and price), economists have employed a mathematical tool called Game Theory. The assumption is that large firms in competition will behave similarly to individual players in a game such as poker. Firms, which are the “players” will make “moves” (referring to economic decisions such as whether or not to advertise, whether to offer discounts or certain services, make particular changes to their products, charge a high or low price, or any other of a number of economic actions) based on the predicted behavior of their competitors.

If a large firm competing with other large firms understands the various “payoffs” (referring to the profits or losses that will result from a particular economic decision made by itself and its competitors) then it will be better able to make a rational, profit-maximizing (or loss minimizing) decision based on the likely actions of its competitors. The outcome of such a situation, or game, can be predicted using payoff matrixes. Below is an illustration of a game between two coffee shops competing in a small town.

In the game above, both SF Coffee and Starbuck have what is called a dominant strategy. Regardless of what its competitor does, both companies would maximize their outcome by advertising. If SF coffee were to not advertise, Starbucks will earn more profits ($20 vs $10) by advertising. If SF coffee were to advertise, Starbucks will earn more profits ($12 vs $10) by advertising. The payoffs are the same given both options for SF Coffee. Since both firms will do best by advertising given the behavior of its competitor, both firms will advertise. Clearly, the total profits earned are less when both firms advertise than if they both did NOT advertise, but such an outcome is unstable because the incentive for both firms would be to advertise. We say that advertise/advertise is a “Nash Equilibrium since neither firm has an incentive to vary its strategy at this point, since less profits will be earned by the firm that stops advertising.

As illustrated above, the tools of Game Theory, including the “payoff matrix”, can prove helpful to firms deciding how to respond to particular actions by their competitors in oligopolistic markets. Of course, in the real world there are often more than two firms in competition in a particular market, and the decisions that they must make include more than simply to advertise or not. Much more complicated, multi-player games with several possible “moves” have also been developed and used to help make tough economic decisions a little easier in the world of competition.

Game theory as a mathematical tool can be applied in realms beyond oligopoly behavior in Economics.  In each of the videos below, game theory can be applied to predict the behavior of different “players”. None of the videos portray a Microeconomic scenario like the one above, but in each case a payoff matrix can be created and behavior can be predicted based on an analysis of the incentives given the player’s possible behaviors.

Assignment: Watch each of the five videos below. For each one, create a payoff matrix showing the possible “plays” and the possible “payoffs” of the game portrayed in the video. Predict the outcome of each game based on your understanding of incentives and the assumption that humans act rationally and in their own self-interest.

“Batman – the Dark Night” – the Joker’s ferry game:

“Princess Bride” – where’s the poison?:

“Golden Balls” – split or steal:

“The Trap” – the delicate balance of terror

“Murder by Numbers” – the interrogation

Discussion Questions:

  1. Why is oligopoly behavior more like a game of poker than the behavior of firms in more competitive markets?
  2. What does it mean that firms in oligopolistic markets are “inter-dependent” of one another?
  3. Among the videos above, which games ended in the way that your payoff matrix and understanding of human behavior and rational decision making would have predicted?
  4. How often did the equilibrium outcomes according to your analysis of the payoff matrices correspond with the socially optimal outcome (i.e. the one where total payoffs for all players are maximized or the total losses minimized)?

12 responses so far

Jul 01 2011

Rational ‘bee’havior

Economists make several assumptions about humans, a fundamental assumption being that we are rational decision makers, able to weight costs and benefits of our actions and pursue the option that maximizes our benefits and minimizes our costs, thus leading to the greatest personal happiness, or utility. Only if this assumption holds true does a free market economic system, made up of individuals pursuing their own interests lead to a socially beneficial outcome. 

But are humans the only animal driven by rational, self-interested, benefit maximizing and cost minimizing behavior? Is our ability to make the right decision based on a complex set of options and variables made possible by our large brain and hundreds of thousands of years of adaptation? To some extent, our biology must drive our decision making and therefore the institutions and organizations that have allowed our species to thrive. But let us not think we are the only species to have thrived due to our rationality.

If you’re like me, you’ve often wondered to what extent animals can think. I have a dog, and after five years I still can’t figure out if he really likes me or if he has just learned that I’m the one who feeds him and scratches his belly, so he demonstrates the behaviors that offer the greatest rewards in terms of food and attention, and those behaviors are ones that I enjoy about him. It is a win win relationship, for sure, but is his behavior evidence of rationality, or just his biological need for food and attention? Is my dog’s behavior the outcome of a series of rational, self-interested calculations, or is it something more simple we usually associate with animal behavior: instinct?

Rationality may be as much a biological instict as an economic one. A recent study out of the UK has found that bumble bees are able to make rational decisions based on complex sets of options to mimimize costs and maximize benefits, much as humans must do countless times every day.

When deciding which flowers to fly to when collecting nectar, a bee must consider two variables: distance and the amount of nectar available in a particular flower. Of course, the distance the bee must fly represents the cost of collecting the nectar, and the amount of nectar in the flower is the benefit of having flown to it. The report explains: 

“Computers solve it (the problem of which flower to fly to) by comparing the length of all possible routes and choosing the shortest. However, bees solve simple versions of it without computer assistance using a brain the size of grass seed.”

The team set up a bee nest-box, marking each bumblebee with numbered tags to follow their behaviour when allowed to visit five artificial flowers which were arranged in a regular pentagon.

“When the flowers all contain the same amount of nectar bees learned to fly the shortest route to visit them all,” said Dr Lihoreau. “However, by making one flower much more rewarding than the rest we forced the bees to decide between following the shortest route or visiting the most rewarding flower first.”

In a feat of spatial judgement the bees decided that if visiting the high reward flower added only a small increase in travel distance, they switched to visiting it first. However, when visiting the high reward added a substantial increase in travel distance they did not visit it first.

The results revealed a trade-off between either prioritising visits to high reward flowers or flying the shortest possible route. Individual bees attempted to optimise both travel distance and nectar intake as they gained experience of the flowers.

“We have demonstrated that bumblebees make a clear trade-off between minimising travel distance and prioritising high rewards when considering routes with multiple locations,” concluded co-author Professor Lars Chittka. “These results provide the first evidence that animals use a combined memory of both the location and profitability of locations when making complex routing decisions, giving us a new insight into the spatial strategies of trap-lining animals.”

In economics, we refer to the behavior descibed above as cost, benefit analysis. It surprised me to read that insects, when faced with a trade off between further distance and more nectar, weigh both the cost and the benefit, and pursue the action that maximizes their profit, which is the bee’s case is a function of both distance of the flower and quantity or nectar collected.

Humans and our institutions make similar cost, benefit calculations. A business produces a quantity of output and sells it for a price that maximizes the difference between the price at which it can sell its product for and the average cost of production, thus maximizing its profits. A consumer will purchase a combination of goods and services at which the amount of utility per dollar is equalized across the various goods consumed, thus maximizing the consumer’s total utility

Bees, with their brains the size of a grass seed, weigh variables nearly as complex as those weighed by businesses and individuals in their economic decisions. Are bees rational? Or is their behavior purely biological instinct?

3 responses so far

Nov 02 2009

When is acting irrational the rational thing to do?

FT.com / Comment / Opinion – Magic and the myth of the rational market.

Imagine you’re a poor farmer who has always had just enough to feed your family, with no surplus left over to sell. Then one day the government decides to grant your family and your neighbors enough land to grow your own food and plenty more to sell on the market. The government’s intention, of course, is for you to cultivate all your land, sell your surplus, generate income for your family to improve your quality of life, send your children to school and save for the future.

You’re the farmer. You’ve just been given land. What would you do?

1. Plant crops on all your land, harvest the crops, sell the surplus and enjoy the profits from your surplus?

OR

2. Plant crops on only part of your land, grow enough food to feed your family, and let the rest of the land lie uncultivated. You have no surplus, nothing to sell, and continue to live the way you always have lived: poorly.

The science of economics assumes that individuals always act rationally in their own self-interest. Self-interest is the ultimate motive of economic actors: firms are profit-maximizers, individuals are utility-maximizers. The theory of rational behavior would lead one to assume that the farmer would pursue option 1 above. But in Papua New Guinea, where the government recently relocated thousands of displaced farmers to new plots of land, it is more common for farmers to chose option 2:

“If they see me planting too much cocoa, they’ll do things to my land and my family, and they won’t bear fruit; really bad things; puripuri and other witchcraft.”

Such an avoidance of profit maximisation might have appeared economically irrational. But from the perspective of those villagers, putting in extra work just to make oneself a target for the jealousy of one’s neighbours would be highly irrational behaviour.

Economists need to re-think their assumptions on rational behavior. What appears irrational to one person may be perfectly rational to someone else, as in the case of the Papuan farmers who only plant half their land. Humans, it seems, are a bit more complicated than the cold, calculating arithmeticians economists have long assumed them to be.

In the wake of the largest economic crisis since the great depression, the assumption of rational actors interacting in rational markets has come into question. A new field of economics blending the traditional study of resource allocation in the market place and human psychology has arisen to tackle the challenge of better understaning the seemingly irrational behaviors of investors, buyers and sellers in today’s global economy:

One response to the current crisis has been a rise in the popularity of behavioural economics, which examines the psychological and emotional factors behind transactions. These models drop the assumption of the rational actor yet implicitly keep the same model of economic rationality at their heart. We may diverge from the path of rationality for all sorts of psychological reasons but only because emotion, Keynes’s famous “animal spirits”, clouds our judgment.

To break human behavior down to the basic pursuit of profits by producers and utility by consumers neglects to acknowledge the “animal spirits” within us all. Economics is entering a new era, in which psychology and markets are intertwined. Rational behavior will remain a basic assumption of the science, but a re-defining of what it means to be rational will allow economists to better understand the behaviors of individuals, investors and firms as the economy emerges from a slump Alan Greenspan might say was ushered in on a wave of irrational exuberance.

Discussion Questions:

  1. Are economists wrong to assume that individuals always act rationally? Why do the Papuan farmers only use half their land? Are they stupid or lazy?
  2. Can you think of any examples in which you or someone you know has done something that was not in his best economic self interest?
  3. Is charity irrational? What about gift giving? If you calculated that the chance of getting caught steeling something you REALLY wanted was 0%, wouldn’t it be irrational NOT to steal? What would keep you from stealing that thing if you deemed it rational to do so?

2 responses so far

Oct 27 2009

Homo Economicus – “Economic Man”: Guest Lesson for ZIS Theory of Knowledge classes

Homo Economicus, the “Economic Man” is the concept underlying most economic theories. It holds that all humans are purely self-interested, rational actors who have the ability to make judgments that fulfill their subjectively defined ends. In modern economic theory, the end man seeks is generally accepted to be increasing monetary well-being and material wealth.

Philosophical foundations of “homo economicus“:

Aristotle (350 BC):

Again, how immeasurably greater is the pleasure, when a man feels a thing to be his own; for surely the love of self is a feeling implanted by nature and not given in vain, although selfishness is rightly censured; this, however, is not the mere love of self, but the love of self in excess, like the miser’s love of money; for all, or almost all, men love money and other such objects in a measure. And further, there is the greatest pleasure in doing a kindness or service to friends or guests or companions, which can only be rendered when a man has private property. These advantages are lost by excessive unification of the state.

  • What does Aristotle think about the interference of government in the private property rights of man?

Adam Smith (1776):

In almost every other race of animals, each individual, when it is grown up to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer: and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher the brewer or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.

  • How does Smith believe the pursuit of individual self-interest can lead to benefits for society as a whole?

John Stuart Mill (1836)

What is now commonly understood by the term “economics” is not the science of speculative politics, but a branch of that science. It does not treat of the whole of man’s nature as modified by the social state, nor of the whole conduct of man in society. It is concerned with him solely as a being who desires to possess wealth, and who is capable of judging of the comparative efficacy of means for obtaining that end. It predicts only such of the phenomena of the social state as take place in consequence of the pursuit of wealth. It makes entire abstraction of every other human passion or motive; except those which may be regarded as perpetually antagonizing principles to the desire of wealth, namely, aversion to labor, and desire of the present enjoyment of costly indulgences. These it takes, to a certain extent, into its calculations, because these do not merely, like our other desires, occasionally conflict with the pursuit of wealth, but accompany it always as a drag, or impediment, and are therefore inseparably mixed up in the consideration of it.

  • According to Mill, labor is not something humans value for its own sake, but only because it allows us to do what?

Fredrick von Hayek (1930s):

We will benefit our fellow man most if we are guided solely by the striving for gain. For this purpose we have to return to an automatic system which brings this about, a self-directing automatic system which alone can restore liberty and prosperity.

  • How would Hayek respond to those who argue that the government’s role in society and the economy is to promote fairness and equality?

Are you a “homo economicus“? – The Golden Balls Game

The prize: $1 million

How to play:

  • Find an opponent from among your classmates.
  • You and your opponent have never met before today, never spoken to one another, and will never see nor speak to one another again after the game ends.
  • Since you do not know or care about your opponent, you must play this game with your own self-interest in mind, and assume that your opponent will play it with his or her self-interest in mind.
  • You have in front of you two folded pieces of paper. One says “SPLIT” and one says “STEAL”
  • You must decide which piece of paper to select, based on the following possible outcomes

The payoffs:

  • If both players decide to “split”, each player will take home $500,000.
  • If one player chooses to “split” and the other chooses to “steal” then the one who chooses to steel will take home $1 million, and the one who chose to split will get nothing
  • If both players choose to “steel”, both players go home empty handed.

Split

Steal

Split

Player 1: $500,000

Player 2: $500,000

Player 1: $1 million

Player 2: 0

Steal

Player 1: $0

Player 2: $1 million

Player 1: $0

Player 2: $0

Let’s play!

  • You only have one chance to play this game. Remember, you care only about yourself and should do what is best for you.
  • On the teacher’s command, reveal your decision to your opponent.
  • Take note of your payoff and report it to the teacher

Discussion:

  • What was the outcome of your game?
  • Was the outcome rational? Was it predictable?
  • Did the outcome reflect the concept of “homo economicus“? Were you and your opponents’ decisions purely self-interested and coldly rational, intended to maximize your OWN payoff?
  • Are you a homo economicus? What would homo economicus have done? Why?

Videos:

Golden Balls – the real gameshow: http://www.youtube.com/watch?v=p3Uos2fzIJ0&feature=player_embedded

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  • Which player was more like homo economicus? Sarah or Steve?
  • Which player acts rationally? What makes it rational?
  • Which player acts irrationally? What makes it irrational?

“The Trap”: Intro to game theory and rational self-interest in politics and economics: http://www.youtube.com/watch?v=qzNcY-gZdiA&feature=related

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  • John Nash’s Game Theory proved that “a system driven by selfishness did not have to lead to chaos”, that “there could always be a point of equilibrium in which everyone’s self-interest is perfectly balanced against each other”? How does such a theory support the concept of homo economicus?
  • What is the Prisoner’s Dilemma? “The rational choice is always to betray the other person.” What does this say about humans in society? Is government regulation needed to prevent constant betrayal by greedy, self-interested individuals? Or are constant betrayal and self-interest themselves capable of achieving a socially optimal outcome?

Noam Chomsky on the inefficiency of markets and the threat posed by de-regulation: http://www.youtube.com/watch?v=QPl27BO7fHE&feature=related

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  • What is the “externality” of financial market failure that Chomsky identifies?
  • Why is the failure of a financial market more worrisome than the failure of a market like that for used automobiles?
  • How does Chomsky feel about the de-regulation of financial markets? Does he think markets are always rational and efficient?

Modern applications of the concept of Homo Economicus:

  • Rational Expectations Theory (RET): This economic theory assumes that humans acting generally in their own self-interest will make rational decision based on the best available information. Therefore, it assumes that people (and therefore, markets, which are made up of rational people) do not make systematic errors when predicting the future.
  • Efficient Markets Hypothesis (EMH): Rooted in Rational Expectations Theory, which itself is rooted in the concept of homo economicus, EMH says that prices in markets, particularly financial markets (whose collapse has caused the today’s global economic crisis) represent the best possible estimates of the risks attached to the ownership of various financial assets (stocks, shares, bonds, etc…) Asset bubbles are therefore impossible, since “bubble” implies an irrational and unsustainable increase in the value of an asset which will ultimately “burst”. Markets are “self-correcting”, and the most effective tool for assuring economic stability is free markets, rather than government regulation or oversight.

Connecting the dots – from Homo Economicus to today’s Economic downturn:


The general acceptance of theories rooted in the concept of homo economicus led to the de-regulation of financial markets, which allowed money and resources to go whichever way the “market” (rational or not) determined.

  • During the last decade, the market decided that more and more money and resources should go towards particular assets, specifically the United States mortgage market (the market for new homes in the US).
  • As money flooded the US home mortgage market, it became cheaper and easier for Americans to get loans to build a home. GREAT, RIGHT?! Well, only until it came time to pay back those loans.
  • Trillions of dollars worldwide became tangled up in the US mortgage market, representing households’ savings from around the globe.
  • When Americans suddenly found their loans coming due, they found it hard to repay them due to adjustable interest rates and falling home price (supply had grown more rapidly than demand).
  • American and many Europeans began defaulting on their mortgages, meaning all that money that had been lent to home buyers literally disappeared.
  • Banks and financial markets faced a “liquidity crisis”, meaning they had no money.
  • Lending stopped to households, firms, and other banks , meaning spending on goods and services decreased, meaning jobs were lost and economies entered recession.
  • How could any of this have happened if the concept homo economicus and the economic theories based on the concept are correct? Are humans always rational, calculating, perfectly informed, self-interested beings acting purely in their own self-interest?

Conclusion: The concept of homo economicus has formed the basis for economic theories for centuries and for major macroeconomic policies over the last 30 years. Policies of “market liberalization” (freeing the market from the guiding, regulatory hands of government) have led to great prosperity, but even greater risk and volatility as irrational exuberance over asset prices has led to inefficient market outcomes, bubbles, and financial shocks plunging the “real” economies of the world into recession.

Perhaps a more complete understanding of humans is needed as the human science of economics enters a new era. The human as a cold, rational, calculating creature interested in only his own gain is an over-simplification, and forming theories and policies on such an assumption is dangerous. The future of economics must incorporate a more complete and complex understanding of human behavior if the economic crises of the last two years are to be avoided down the road.

2 responses so far

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