Wednesday, October 28, 2015

Do counterintuitive economic results make sense?

coun·ter·in·tu·i·tive adj. Contrary to what intuition or common sense would indicate
It is counterintuitive to me that markets are useful for solving counterintuitive problems. Counterintuitive? Here's Scott Sumner:
We know that economics is really, really counterintuitive.  It doesn’t seem logical that imports would be good for the economy, or that price gouging in a natural disaster would be good for consumers, or that regulations banning banks from charging fees on ATMS would be bad for bank consumers.  But they are.
I agree -- there are lots of counterintuitive frames for results in economics. The whole Freakonomics-industrial complex is built around counter-intuition. But if you think about it, the view of markets as aggregation mechanisms for rational information should not produce counterintuitive rational results. Adding up everyone's intuition -- when their intuition is in some way aligned (hence common sense) -- and getting a counterintuitive result is itself counterintuitive.

Ah, but remember the fallacy of composition ...

Yes, let's remember it. Let's say your information the market is 'aggregating' consists of a probability that A, B or C will happen: P(A), P(B) and P(C) [1]. Since these are real numbers (and you are rational), you can say P(A) < P(B) and P(B) < P(C), for example, and therefore P(A) < P(C).

However, if everyone's information can be represented as a real number, and if they're allowed to have different information (different orderings), the aggregated effect may not be able to be represented as a real number (it's not guaranteed to be transitive). Basically, Arrow's impossibility theorem. Therefore the market can think P(A) < P(B), P(B) < P(C) and P(C) < P(A) .

This is a counterintuitive result, but it's also not rational. That is to say the market mechanism can produce irrational counterintuitive results.

There are a couple ways out of this:

• Markets can produce the same rational result of a subset of the people (a "dictator"), in which case the market will reward the dictator for being right and punish others for being wrong. In equilibrium, this will mean most of the people will have the same view as the dictator and in that case the market outcome should be intuitive.
• Markets can produce an emergent rational result (intuitive or counterintuitive) from irrational (I like to say 'complicated') humans. Everybody's intuition would be irrational. However, this also means markets are not information aggregation mechanisms.

So basically, markets either can produce irrational counterintuitive results or they do not really aggregate information [2]. They can easily produce rational intuitive results, but not rational counterintuitive results.

Banks charge for money and gougers charge extra for gas and water in disaster areas because the market solves an allocation problem, not an information problem. There is however no way to tell whether this solution is optimal according to any objective function because finding the optimum of the economic linear programming problem is intractable -- it's too big. Since I'm always on the lookout for an opportunity to link to the greatest blog post of all time, here is Cosma Shalizi:
Planning for the whole economy [i.e. solving the linear programming problem] would, under the most favorable possible assumptions, be intractable for the foreseeable future, and deciding on a plan runs into difficulties we have no idea how to solve. ... That planning is not a viable alternative to capitalism (as opposed to a tool within it) should disturb even capitalism’s most ardent partisans. It means that their system faces no competition, nor even any plausible threat of competition.
Basically, there is no way to check whether lots of imports, price gouging or ATM fees are good outcomes or not because you can't solve the linear programming problem with an objective function that defines good to check and see if they are in fact good.

That means in addition to counterintuitive results either being irrational or not aggregating information, we can't check to see if the counterintuitive results are actually "good". We can't say markets produce good, rational and counterintuitive results that aggregate information. You have to leave "good" off generally, and you get your choice of either "rational", "counterintuitive" or "aggregate information".

In general, the information transfer model says to drop the last one. Markets solve an allocation problem with a maximum entropy solution, not an information aggregation problem. Does it optimize utility (i.e. is is good)? Who knows. It just is. People aren't rational, but the market creates rational rankings of goods (prices). Are these prices good? Again, who knows. They just are.

Update 10/30/2015

Stumbling and Mumbling has a good counterpoint to my post above. But as I said: "I agree -- there are lots of counterintuitive frames for results in economics." Framing inflation and unemployment as both bad can lead to the conclusion -- using the moral 'bad begets bad' heuristic -- that you get both together as opposed to the Phillips curve view (which may not be true at all times, but for sake of argument here) that there is a trade-off. However, if framed in another way (would you rather have one, the other, both or neither) my intuition is that people would use a more 'logical' zero-sum heuristic. If you want low inflation, you have to tolerate higher unemployment.

Which brings us to the paradox of thrift. Is this result counterintuitive? Yes, if you use the 'good begets good' heuristic. If we all 'tighten our belts', we'll get more national income. But it's not counterintuitive if you use the logical frame where my spending is your income. Saying that we should reduce everyone income in order to have more national income is illogical on its face.

It is our moral heuristics that make us think economic results are counterintuitive ... using moral logic. This applies to the examples Sumner gives above and I immediately applied my logical frame when writing this post rather than my moral frame. I've always associated the word counterintuitive with a logical frame. The utilitarian solution to the trolley car problem with the fat man isn't counterintuitive so much as a dilemma.

It's not that economic results are counterintuitive, it's that they are immoral. They violate our moral heuristics like 'good begets good'. Price gouging as a result of the basic economics of supply and demand is a moral dilemma, not a counterintuitive result.

...

Footnotes:

[1] Imagine a prediction market where probabilities are translated into prices for options.

[2] We are breaking the assumptions of the Arrow theorem: individuals are rational and "no dictator".

1. I'm glad you wrote something about Sumner's post. However, this is one of those posts of yours that will require me to read it more than once. In other words, a normal post. ;^)

2. "Therefore the market can think P(A) < P(B), P(B) < P(C) and P(C) < P(A)"

Something tells me this is applicable to politics as well. Just replace "market" with "electorate."

1. Yes, just say the probabilities are for various presidential candidates to win. You could easily see someone argue that Rubio has a better chance than Bush, Bush has a better chance than Trump, but Trump has a better chance than Rubio.

2. Good point!

3. O/T: Jason, what do you think of this Cochrane post?:
http://johnhcochrane.blogspot.com/2015/10/economic-growth.html#more

Do you think that some of the "weeds" he's complaining about might actually turn out to be better described as something else (e.g. a proliferation of economic low energy states)?

1. "Over long periods of time, economic growth comes from one source: productivity, the value of goods and services each worker can produce in a unit of time."

Cochrane kind of lost me at that point. Growth comes from growthiston, i.e. productivity. This statement isn't exactly tautological because it says that population growth (the only other possibility) isn't a source.

2. Also, you can measure productivity in non-monetary terms at the micro level.

4. Hear, hear! :)

5. Sumner: "We know that economics is really, really counterintuitive. It doesn’t seem logical that imports would be good for the economy, or that price gouging in a natural disaster would be good for consumers, or that regulations banning banks from charging fees on ATMS would be bad for bank consumers. But they are."

Gee, the idea that imports would be good for an economy (as a rule) does not seem counterintuitive to me, any more than going shopping is counterintuitive. ;) As for price gouging and charging high fees, neither practice violates intuition. What they violate is a sense of fairness. That is, they run counter to values, not intuition.

Is a sense of fairness innate, at least in most people? I think so, given that we share it with other species, such as other primates and ravens. Since it appears to have evolved, I expect that a good economic case can be made for it, as an important value to the individual or to the economy, or both. :)

1. Yes, I'd think of fairness as an example of an objective function that could be used to optimize an allocation. Since you can't solve the linear programming problem in general (not enough computational resources), you can't tell what allocation optimizes fairness.

2. And the sense of fairness is different in different cultures. :)