Transcript ppt - Department of Environmental Science and Policy

Rationality & the Efficiency of Markets
(Steve Lambert)
Gekkonomics
(image: dcclothesline.com)
“Greed is a vice, a bad attitude, an
excessive, single-minded desire for gain.”
(Sandel, 2009, p. 15)
Sandel, Michael (2009). Justice.
New York: Farrar, Straus and Giroux.
“Is there some society you know that doesn’t run on greed?... The world runs on
individuals pursuing their self interest…In the only cases in which the masses have
escaped from…grinding poverty…are where they have had capitalism and largely free
trade. … There is no alternative way …of improving the lot of ordinary people that can
hold a candle to the productive activities that are unleashed by the free enterprise
system.”
https://www.youtube.com/watch?v=RWsx1X8PV_A
Market: a decentralized collection of buyers and sellers
whose interactions determine the allocation of goods
through exchange.
mruniversity.com
Why should we care about how markets work?
Much environmental degradation stems from the
actions of consumers
and producers
Major Sources and Health and
Environmental Effects of Air
Pollutants
• Consumer-related pollution
(“tailpipe”)
• Producer-related pollution
(“smokestack”)
Source: World Resources Institute. August 2008
Monthly Update: Air Pollution's Causes,
Consequences and Solutions by Matt Kallman
Why should we care about how
markets work?
1. Dominant form of economic organization
2. Much environmental degradation stems from
the actions of consumers and producers
3. Government regulation can be costly and
intrusive
– When is there a case for intervention?
– When we intervene how do we minimize
the pain?
Market equilibrium
• the combination of quantity and price at
which SUPPLY = DEMAND
• Equilibrium  a stable
outcome
Getting to market equilibrium
• If consumers are demanding more than firms are prepared to supply,
the shortage will induce the price to rise (those with greater WTP will
bid up price).
• When quantity supplied exceeds quantity demanded price will fall.
• Adjustments are made until we achieve market clearance (supply =
demand) at an equilibrium point.
Excess supply
Equilibrium
Excess demand
Exercise:
• Suppose price is P1:
• What qty is
supplied?
Demanded?
• Response from
suppliers?
Demanders?
• Suppose price is P2:
• Same questions.
Image source:
livingeconomics.org
In our simple model, the predicted
equilibrium is also the point that generates
the highest welfare (“surplus”/“net benefit”)
Welfare measures:
• Consumer surplus: the
difference between
(maximum) WTP and
actual payment.
• Producer surplus: the
difference between
minimum WTA and actual
payment.
• CS+PS = social surplus
Efficiency
• Kaldor-Hicks efficiency: an allocation in which the
collective net benefits are maximized (in which there
may be winners and losers, relative to the status quo,
but where winners could, in theory, compensate losers
for their losses)
• Pareto efficiency: an allocation in which no one can be
made better off without making some else worse off.
When will the market equilibrium be (Pareto)
efficient?
If our goal is efficiency, under what conditions
can we argue that the government should get
out of the way and let the free market
determine outcomes?
When will the market equilibrium
be (Pareto) efficient?
Some theoretical guidance:
First theorem of welfare economics (FTWE):
A market economy will result in an (Pareto)
efficient resource allocation when:
1. The market is complete: no externalities exist
2. Agents have good information on the quality of
goods/services being traded.
3. Markets are competitive: there are no monopoly buyers or
sellers (agents are price takers, no one has market power).
But:
pollution!
used cars!
Comcast!
(…and some other technical conditions but we will focus on the
three above.)
“Market failure” results when one or more of the conditions above doesn’t hold
(more complete definition to follow).
Recall that maximizing the size of the
pie doesn’t explicitly address equality
While the size of the US
economy has generally
been growing…so has
inequality over the last
several decades
Four key periods
(Paul Krugman):
The Long Gilded Age
The Great Compression
Middle class America
The great divergence
Saez and Piketty
http://gmond.parisschoolofecon
omics.eu/topincomes/
“How economists see the environment”
Fullerton and Stavins (1998)
• Myth #1: the market solves all problems
– FTWE is powerful: greatest good for greatest number
will arise without central planning (under certain
conditions)
– But the focus of many economists is on settings in
which the conditions identified ARE NOT MET  i.e.
“market failure”.
1. Markets are not complete: There are “externalities”
2. Information problems: Firms and consumers do not have
good information about the quality of goods and services.
3. Markets not competitive: there exist monopoly buyers or
sellers
4.
5.
Increasing returns to scale
‘Distortions’ between the costs paid by buyers and the benefits received by sellers
(transaction costs, no taxes)
Revisiting greed/the profit motive
there is no coordination to
overcome externalities
Dasgupta and Heal (1979, p. 63)
While the FTWE/market failure may seem technical/academic, it’s
how the US government conceptualizes the need for env policy.
OMB: Office of
Management
and Budget
(exec. branch)
EO: “executive order”
(issued by Pres. of U.S.)
Name that market failure…
Predicting human behavior: the Rational Model
Hamlet: What a piece of work is a man, how noble in reason,
how infinite in faculties, in form and moving how express and
admirable, in action how like an angel, in apprehension how like
a god! the beauty of the world, the paragon of animals—and yet,
to me, what is this quintessence of dust? Man delights not me—
nor woman neither, though by your smiling you seem to say so.
Rosencrantz: My lord, there was no such stuff in my thoughts.
Hamlet,
Act 2,
scene 2,
303–312
The rational model
• Rational choice:
– Behavior that is consistent with the values
and objectives of the decision maker given
the available information; objective typically
taken to be maximizing net value.
– “sensible, planned, and consistent” (McFadden, 1999)
• Believed to describe behavior because of:
– self-interest
– tendency of markets to punish foolish
behavior
Behavioral economics
• “explores, catalogues, and rationalizes
systematic deviations from rational choice
theory.”
• Deviations or limits on human behavior are
driven by (Mullainathan and Thaler, 2000)
– bounded rationality
– bounded willpower
– bounded self-interest.
Shogren and Taylor (2008)
• Bounded rationality:
– “(P)eople do not have unlimited abilities to
process all the information needed to make
rational choices.”
– People have inherent behavioral biases and
“use rules of thumb and shortcuts to make
decisions (Mazzotta and Opaluch 1995).”
• Bounded self-interest:
– Reflects the observation that people:
• care about others, can be selfless
• value: reciprocity, altruism, paternalism, aversion
to inequality
Shogren and Taylor (2008)
Name that deviation from traditional rational choice theory…
Ohio Runner Stops in State Final to Aid Fallen Opponent-06-2012 West Liberty-Salem
(Ohio) High junior Meghan Vogel, 3200M final, 20ft from finish helps Arden McMath
Homo economicus
VS.
Homer economicus
• Bounded willpower:
– “people lack self-control sometimes—we
consume too much, save too little, make rash
decisions, procrastinate, and so on.”
There is a long list of various departures from simple rational behavior
• Pessimistic takes (Shogren and Taylor, 2008):
– “Numerous empirical studies over the last four decades reveal
that rational choice might, in some circumstances, be a poor
guide for economics in general, and for environmental
economics in particular (see Tversky and Kahneman 2000).”
– “…nature's goods and services frequently lack the active marketlike arbitrage needed to encourage consistent choice (Crocker, Shogren,
and Turner 1998).”
Shogren and Taylor (2008)
• Optimistic takes:
– Vernon Smith (2003): identification of behavioral failure follows
from a program to deliberately search the “tails of the
distributions” for deviations from the standard model.
– “There are some free lunches in design which takes into account
cognitive limitations.” Dan Ariely (2008)
Deviations from the rational model:
Effective consent rates for organ donation
“Do Defaults Save
Lives?”
Johnson, Eric J., and Daniel
Goldstein. 2003. Science,
302(5649): 1338–39.
Explicit consent/opt-in:
must check box to donate.
Presumed consent/opt-out:
must check box to not donate.
People don’t check/don’t
donate
People don’t check/do donate
Dan Ariely: Much of decision-making is determined by designer of decision context.
http://www.ted.com/talks/lang/eng/dan_ariely_asks_are_we_in_control_of_our_own_decisions.html
“…half of all households are at risk for coming up short on retirement money.
Why? Partly because people aren't saving enough. Well, new research suggests
a novel way to change that….” (NPR, 4/11/12)
Hershfield et al. 2012
Age 67
Age 107
Appendix of add’l material
The beauty of markets is that prices show how much different
people value things and by doing so facilitate the efficient
allocation of goods and services.
Problem: How do you match up the huge flow of donated food with a vast system of
food banks with different needs on a weekly basis?
• In the past: manual allocation meant that food banks in Idaho had too many
potatoes and Alaska had too little fresh produce.
• Now: Food banks get credits for the number of people they feed, then they use
those credits to bid on units of donated food in an online auction space. Food goes
to the location that “values” it the most .
NPR, 2015 •
•
Flickr/Jaypeg
“SMITH: There is this phrase in economics, the local
knowledge problem. And it's why, essentially, planned
economies don't work very well.
GOLDSTEIN: No matter how smart the people in control
are, whether they're in headquarters or the capital or the
castle or whatever, they just don't have the knowledge to
decide whether the people, you know, out in Alaska
should get pickles or oranges. …the clear answer to the
local knowledge problem is a market, a place where
buyers and sellers come together, because the beauty of
a market - and in particular, the beauty of prices - is they
show you how much different people, or in this case
different food banks, value different things.”
Definitions
• Marginal benefits and demand:
– [Recall] MB, Marginal benefits (or MWTP): the (maximum)
willingness to pay for a one unit increase in quantity of a good.
– Demand curve: summarizes how much buyers will buy at a
given market price (individual or aggregate)
• Marginal costs and supply:
– [Recall] MC, Marginal cost: the change in total cost when the
quantity is increased or decreased by a unit.
– Supply curve: summarizes how much sellers will sell at a given
market price (individual or aggregate)
Market equilibrium
• the combination of quantity and price at
which SUPPLY = DEMAND
• Equilibrium  a stable
outcome
Welfare measures:
• Consumer surplus: the
difference between
(maximum) WTP and
actual payment.
• Producer surplus: the
difference between
minimum WTA and actual
payment.
• CS+PS = social surplus
• Optional additional slides…
EPA (2010)
FTWE:
2nd TWE:
Arrow (1963)
Ariel Rubinstein
on behavioral economics
• “intuitive and “sexy” results are gladly accepted by behavioral
economists without sufficient criticism”
Gneezy and Rustichini (2000):
[In the words of C. Camerer]
• ‘To discourage parents from picking their children up late, a daycare center instituted a fine for each minute that parents arrived late
at the center. The fine had the perverse effect of increasing parental
lateness.
• The authors postulated that the fine eliminated the moral
disapprobation associated with arriving late and replaced it with a
simple monetary cost that some parents decided was worth
incurring.
• Their results show that the effect of price changes can be quite
different than in economic theory when behavior has moral
components that wages and prices alter.’
Rubinstein, 2006
Rubinstein’s skeptical response to Gneezy and Rustichini
(2000):
• “Israel…is a country where rules are rarely enforced. It is hard for
me to believe that teachers would really fine a parent who is ten
minutes late. In my experience, any excuse for lateness is accepted.
• Furthermore, it is impossible for me to imagine that Israeli teachers
would have kept even roughly accurate records of late arrivals with
noisy parents crowding around the entrance of the school to take
home their screaming kids.
• Therefore, I at least want to know what the procedure was for
collecting data. The paper does not provide such details. In
correspondence, one of the authors claimed that professional
standards had been maintained. Apparently, an RA went to the
schools once a week and asked the assistant teacher who was late
the previous week. There was no attempt to control the accuracy of
the RA’s records. Oddly, I was not allowed to talk with the teachers.
• “Behavioral Economics…. must become more open-minded and
much more critical of itself.”
Is greed good? Part 2
(2012)
• “We reason that increased resources and
independence from others cause people to prioritize
self-interest over others’ welfare and perceive greed
as positive and beneficial, which in turn gives rise to
increased unethical behavior.
• “We predict that…upper-class individuals should
demonstrate greater unethical behavior and that one
important reason for this tendency is that upper-class
individuals hold more favorable attitudes toward
greed.
Study 6 (of 7):
• Participants: play “game of chance”; computer presents
them with one side of a six-sided die, ostensibly random;
five separate rolls.
– Told: higher rolls increase chances of winning cash.
– Asked: report their own total score. In fact, die rolls were
predetermined to sum up to 12.
• Results:
– Average score: 12.85 (SD=2.78). Cheating: extent score exceeds 12
– Significant correlations:
•
•
•
•
Social class and attitudes toward greed
Cheating and social class
Cheating and attitudes toward greed
Cheating and {Social class + attitudes toward greed}
– More favorable attitudes toward greed among members of the
upper class explain, in part, their unethical tendencies.
The rational model
McFadden (1999) on Homo
economicus/ “Chicago-man”
• convenient, successful,
unnecessarily strong,
false.
• “Almost all human behavior has
a substantial rational
component…. However, there is
overwhelming behavioral
evidence against a literal
interpretation of Chicago-man as
a universal model of choice Image:
performancetrading.it
behavior.”
Behavioral failure?
• framing effects: how a question is asked (or how
a decision is posed) matters
• the willingness-to-accept (WTA) willingness-topay (WTP) gap
• time inconsistency: make a choice today about
tomorrow but then don’t stick to it
Shogren and Taylor (2008)