Emotions and Economics

In today’s post, I want to review the role of emotion in economic behaviour as emotions used to play an important part in Economics. Jeremy Bentham, for example, who is regarded as the founder of modern utilitarianism, gave emotions a prominent role in the decision process and viewed the concept of utility as the sum of emotions. Yet neoclassical economics abstracts utility from its psychological foundations (Loewenstein, 2000). Undergraduate students of Economics, in particular, familiarise with the representative economic agent as a rational and self-interested individual who deploys pure logic to maximise her utility. Insights from behavioural research rarely make it into an Introductory Microeconomics course. Yet more descriptive realism – particularly at undergraduate level – might help to arouse the students’ interest in the field.

economics-and-emotions
Figure 1. Consequentialist model of decision-making (Source: Rick and Loewenstein, 2008, p.139)

So, let’s start with the neoclassical view on emotions in economic behaviour. Standard economic models are consequentialist in nature (figure 1), meaning that choice is modelled as a cognitive process of utility maximisation. This does not rule out the influence of emotions in the decision process as consequentialist models can account for expected emotions, i.e. emotions which the decision-maker anticipates to experience because of her decision. Emotions experienced at the point of decision-making, however, are difficult to capture in these models as the decision-process itself is some form of expectation-based calculus.

Type

When Scope

Expected emotions

After making the decision

Related to the decision

Integral emotions

At the point of decision-making

Related to the decision

Incidental emotions At the point of decision-making

Unrelated to the decision

Table 1 The different types of emotions in decision-making

In contrast, behavioural research has identified two types of immediate emotions which are important for understanding an individual’s choice but which are typically neglected in the neoclassical view (see table above). First, there are integral emotions. They are related to the decision at hand and arise from thinking about the decision’s consequences. As shown in figure 1, consequentialist models can, in fact, be extended to incorporate this type of emotions as there is a causal link between the decision and this type of immediate emotions. Second, there are incidental emotions which are also experienced at the point of decision-making but which are unrelated to the decision, arising from situational influences and visceral factors (Rick and Loewenstein, 2008). Yet because incidental emotions are irrelevant to the decision, they are difficult to capture in the consequentialist perspective. What is more, economists tend to refrain from incorporating visceral factors in their analyses as (1) “visceral factors often drive people to behave in ways that they view as contrary to their own self-interest” and as (2) “people tend to underestimate the impact of visceral factors on their own current and future behaviour” because these complications run counter to the view that decision-making is a cognitive process (Loewenstein, 2000, p.428). Fortunately, with the rise of behavioural economics, integral and incidental emotions re-enter economic analyses. Starting with counterfactual emotions such as regret, more realistic models of behaviour emerge which re-connect emotions and utility. In the last few years, in particular, one can see a rethinking in economic modeling, for example, with the risk-as-feelings hypothesis by Loewenstein, Weber, Hsee and Welch (2001).

In sum, expected, integral and incidental emotions play an important role in economic behaviour and with a shift towards more psychologically realistic assumptions, they re-enter economic models.

Many thanks for reading; I hope you enjoyed today’s topic!

Jasse


References

Loewenstein, G.F. (2000). Emotions in Economic Theory and Economic Behaviour. Preferences, Behaviour, and Welfare, 90(2), pp. 426-432.

Loewenstein, G.F., Weber, E.U., Hsee, C.K. and Welch, N. (2001). Risk as Feelings. Psychological Bulletin, 127(2), pp. 267-286.

Rick, S., and Loewenstein, G.F. (2008). The Role of Emotion in Economic Behavior. In: M. Lewis, J.M. Haviland-Jones, L.F. Barrett (Eds.). Handbook of Emotions (3rd ed.). New York: Guilford Press.

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The Economics of Deception and Manipulation

I recently finished George Akerlof and Robert Shiller’s latest book Phishing For Phools. While I also enjoyed their earlier book Animal Spirits I have to say that Phishing For Phools is a hidden gem. So I decided to devote today’s post to the book and why every student of Economics should have a copy of it.

What makes Phishing For Phools different?

Phishing for Phools is different because Akerlof and Shiller give the reader a new perspective on Economics. It is not a re-iteration of New Behavioural Economics because it addresses:

  1. The Role of Equilibrium in Competitive Markets,
  2. The Difficulties with ‘Revealed Preference’ and
  3. Story Grafting.

First, Akerlof and Shiller in their perspective on Economics endorse that economic systems converge towards a general equilibrium, albeit a phishing equilibrium. In contrast, work in Behavioural Economics tends to centre on shrouded markets and economic actors having certain weaknesses (e.g. present bias). While these assumptions make phishing undeniable, the results of these studies are not generalisable. Shiller and Akerlof level criticism at Behavioural Economics in its current form because it misses the generality of phishing for phools in our economy. They describe a range of examples in the book with their favourite probably being Cinnabon® bakeries in airports and shopping malls to show that when “people have informational or psychological weaknesses that can be profitably exploited” (p.170), then we can be certain that phishing for phools is going to happen. Hence phishing for phools is a general feature of our economy rather than an externality of shrouded markets or biases of non-rational economic actors.

phishing equilibrium.png
A Phishing Game

I am thinking of Akerlof and Shiller’s phishing equilibrium in the Cinnabon® example as a Pareto-inferior equilibrium in a simple two-player “Phishing Game” with a consumer (C) and a firm (F). Here the consumer, that is the row player, has some true preferences and some monkey-on-the shoulder tastes. Both preferences map into some choice. However, the choice based on the consumer’s true preferences yields a higher payoff for her than her choice based on her monkey-on-the-shoulder tastes (assuming that the firm simultaneously chooses to provide her with that specific good and not the alternative). The column player, that is the firm, has two profit opportunities. It can open a healthy shop or a sweet & tasty shop in the airport or shopping mall where the consumer can easily be phished for a phool. I have arranged the firm’s and consumer’s payoff similar to the Battle of the Sexes game with the modification that the consumer receives a payoff of 3 and not 2 in the optimal equilibrium. This allows us to distinguish the two equilibria into an equilibrium which maximises social welfare (Healthy Shop | True Preferences) and a Pareto-inferior one, i.e. a phishing equilibrium (Sweet & Tasty Shop | Monkey-on-the-Shoulder Tastes). Both the consumer and firm want to coordinate in the sense that the consumer wants to consume and the firm wants to sell. However, the firm wants to maximise profits by selling its sweet and tasty products rather than selling a healthy product (which might allow for a lower mark-up).

Crucially, Akerlof and Shiller argue that such a ‘general equilibrium’ perspective with phishing for phools as a general feature of the economy gives an answer to why economists did not see the financial crisis coming: they did not look for phishes stemming from the informational and psychological weaknesses of economic actors and the counterparts that profitably exploited them.

Moving on to the second argument; the book is also not a re-iteration of Behavioural Economics because it challenges Revealed Preference. The authors criticise this concept and the general acceptance of it in Behavioural Economics. As mentioned above, Akerlof and Shiller distinguish between what people really want and what they think they want, i.e. their monkey-on-the shoulder tastes (and hence the book’s caption The Economics of Deception and Manipulation). Akerlof and Shiller criticise that both standard economic theory and Behavioural Economics assume that people optimise and therefore make choices which maximise their utility. Both fields tend to assume that people reveal their preferences if free to choose and given all the necessary information. This allows for the simple assumption that, in theory and practice, people’s choices reflect their true preferences. However, this is not what we observe: Akerlof and Shiller give plenty of examples in their book which they call the NO-ONE-COULD-POSSIBLY-WANTs. They categorise them into the areas of (1) personal financial security, (2) the stability of the macroeconomy, (3) health, and (4) the quality of government in order to highlight how prevalent they are. The book therefore challenges both standard economic theory and Behavioural Economics for overlooking this subtle but important difference between true preferences and what people think they want.

Third, Story Grafting makes the book different from Behavioural Economics. Akerlof and Shiller make the case for a new variable in Economics, that is the story that people are telling themselves. While Behavioural Economics has come up with a choice menu of psychological biases to explain non-rational behaviours, it has often eschewed the underlying mental frames of decision-making. Daniel Kahneman (1999, in Kahneman and Tversky, 2000, p.xiv) once said that we

apply the label “frame” to descriptions of decisions at two levels: the formulation to which decision makers are exposed is called a frame and so is the interpretation that they construct for themselves.

New Behavioural Economics has very much focused on the latter. It is the frame which decision-makers have control about. In contrast, the frame which decision-makers are exposed to is much broader and in some sense out of their control. Akerlof and Shiller’s stories describe these broader frames which are shaped in great deal by the media and our environment and peers. Rather than having a choice menu of psychological biases, Akerlof and Shiller argue for recognising these broad mental frames that influence individuals’ decisions. Stories, like phishes, are a general feature of our economy. Economics as a study of society needs to go beyond the analysis of the exchange of scarce resources. It needs to become more inclusive. In particular, Akerlof and Shiller argue that “we should be inclusive of whatever thinking, conscious or subconscious, is the basis for people’s decisions” (p.172).

In my opinion, Akerlof and Shiller have crafted a hidden gem with their book Phishing For Phools because it really offers a new perspective on Economics which goes beyond recent work in New Behavioural Economics. It makes the case for phishes and stories as a general feature of our economy and makes the subtle but important differentiation between true preferences and monkey-on-the-shoulder tastes. This New Economic perspective is more inclusive and much needed to understand how people make decisions.

So I hope that my post today has inspired you to give the book a chance. Many thanks for reading,

Jasmin


References

Akerlof, G.A., and Shiller, R. (2015). Phishing For Phools: The Economics of Deception and Manipulation. Princeton: Princeton University Press.

Kahneman, D. (1999). Preface. In: Kahneman, D., and Tversky, A., eds. (2000). Choices, Values and Frames. Cambridge: Cambridge University Press, pp. ix-xvii.

The Economics of an Uncertain World – Expected Utility Theory

My Microeconomics class this year deals with information economics. To be more exact, it looks at decision-making under imperfect and incomplete information in order to be able to explain individual behaviour in our economy as well as aggregate market outcomes.

The first block of the class is devoted to the analysis of decision-making under uncertainty. This is important because the agents in an economy face substantial uncertainty about the future. For example, firms’ future profits depend on prospective GDP/ GDP growth, the prospective interest rate and the prospective rate of inflation. Economic theory does recognise that we live in an uncertain world: Firms, as well as investors and households are generally confronted with ‘nature’ or ‘chance’ when making decisions.

The ‘workhorse’ theory for decision making under uncertainty in Economics is ‘Expected Utility Theory’. Its name already suggests that under uncertainty the rational individual does not maximise her utility but their ‘expected utility’. Expected utility, or EU in short, sounds like an abstract concept but it is essentially the weighted sum of the utilities of the payoffs of the possible outcomes, where the weights correspond to the probabilities of the payoffs (Campbell, 2006).

lottery-a-2

An example should make the concept of EU clearer. Suppose that you have a lottery A with a 50% probability of winning 10,000 and a 50% probability of winning nothing, as shown in the figure above. The expected value (EV) of this lottery is be the average of the payoffs weighted by their corresponding probabilities. Hence the EV of A is 5,000. The EU is actually very similar to this, the only difference being that one weighs the utility of the payoffs and not the payoffs themselves. Therefore, one needs to ‘plug in’ the payoffs into the utility function of an individual first. I have done this for a fictitious individual, say Berta, with the utility function U(w) = w^1/2. So Berta derives 100 ‘utils’ from the payoff of 10,000, and 0 ‘utils’ from the payoff of 0. Having calculated the utility of each payoff, we can now weigh them (that is 100 and 0) by their probabilities (that is 0.5 and 0.5) to get the expected utility of the lottery. It follows that EU(A) = 50, meaning that Berta’s predicted utility value of the lottery is 50 ‘utils’.

Now suppose that Berta could receive a “sure thing” of 5,000 instead of participating in lottery A. This “sure thing” which we offer Berta is equivalent to the average payout, i.e. the ‘expected value’, of the lottery. But what would be Berta’s utility from a “sure thing” paying her 5,000 with certainty? For this we need to ‘plug in’ 5,000 into her utility function, which yields U(5,000) = 50√2. The result should be surprising: lottery A and the “sure thing” have the same expected value of 5,000. Yet Berta derives a higher utility from the “sure thing” than from the lottery.

This apparent puzzle leads us to the concept of risk aversion. Expected utility theory does not only allow us to compute the predicted utility value of lotteries and gambles (as examples for economic decisions with uncertain outcomes); it accounts for the risk preferences of individuals and categorises them as either risk-averse, risk-neutral or risk-seeking. This is important, because people tend to be risk-averse in decisions involving gambling and the like. This feature can also explain why Berta derived a higher utility from the “sure thing” than from the lottery. She preferred the “sure thing” because she has risk-averse preferences. What is more, one can immediately see that Berta is risk-averse when examining her utility function in more detail. In particular, the parameter ‘a’ in the utility function defines an individual’s risk preferences. Because I have chosen a to be 0.5 in Berta’s case, her utility function exhibits diminishing marginal utility of wealth, which is equivalent to saying that she is risk-averse. The decision rule for determining an individual’s risk preferences from her utility function is as follows:

lottery-a-4
Risk Preferences and the Utility Function

But what does diminishing marginal utility of wealth mean exactly? It means is that a one-unit increase in an individual’s wealth yields a higher marginal utility, i.e. a higher increase in utility, at low levels of wealth compared to an equal-sized wealth increase at high levels of wealth. One might think of it like this: a one-unit increase in wealth matters a lot if an individual has no wealth at all but the same one-unit increase is negligible for individuals with a wealth of 1,000,000.

Lastly, I want to look at how risk preferences regarding our hypothetical lottery A can be analysed graphically.

lottery-a-5
Graphical Representation of Risk Preferences in Expected Utility Theory

A risk-averse individual like Berta has a convex utility function. She prefers the sure thing over the gamble. A risk-neutral individual does not care about risk. The utility she derives from the gamble and the sure thing are the same and her utility function is a straight line. A risk-seeking individual has a concave utility function. She prefers the gamble over the sure thing.

In sum, my post today looked the economic theory underlying an uncertain world. The ‘workhorse’ theory for decision making under uncertainty is Expected Utility Theory in which the rational individual maximises her ‘expected utility’. An important feature of this theory is that is allows for both risk aversion and risk loving, depending on the individual’s utility function. However, I would like to stress that there are other approaches for decision making under uncertainty which highlight the drawbacks of expected utility theory; for example, that the ‘utility-function’ is defined over absolute levels wealth rather than gains and losses. The most prominent alternative is prospect theory, formulated by Kahneman and Tversky in 1979.

Thanks for reading!

Jasse

 


References

Campbell, D.E. (2006). Incentives: Motivation and the Economics of Information (2nd ed.). Cambridge: The Cambridge University Press.
Kahneman, D. and Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), pp. 263-291.

Schelling’s Masterpiece Micromotives and Macrobehavior

Being back in Glasgow for my fourth and final year at university I got myself a copy of Thomas C. Schelling’s Micromotives and Macrobehavior (1978) from the Andersonian library. I picked the book first and foremost as an introduction to behavioural approaches in Macroeconomics. However, one may regard it also as a critique of New Classical Economics.

Today I want to talk about the first chapter which is named after the book. Schelling opens the chapter with an example that should be familiar to most university students. He explains that he once gave a lecture to an audience of eight hundred people. The large amount of people is not surprising given his prominence. Yet what was striking was the distribution of the audience within the lecture hall:

schelling-micromotives-and-macrobehavior

All people were crowding in the back while the twelve rows in the front remained empty. Schelling first assumed that the seats had been allocated like this but he was soon to find out that the seating distribution in the hall was, in fact, voluntary.

But what does it have to do with Economics? Despite being a rather harmless example, it does illustrate the importance of micromotives in macrobehavior. Simultaneously, it stands in stark contrast with the interpretation of the situation from the viewpoint of Economics. When people make decisions economists tend to assume that they maximise their utility; that is, choose the best alternative available to them given their preferences. In Schelling’s example all seats were available to all the members in the audience. As a result, one would be inclined to conclude that the people preferred to occupy the seats in the back. Their preferences induced them to make this choice voluntarily because they maximised their utility by sitting in the back neither being able to understand much of the lecture nor having enough space to sit comfortably. Yet this would disregard the complexity of the situation at hand. What is more, the example anticipates a major lesson of the book:

“These situations, in which people’s behaviour or people’s choices depend on the behaviour or the choices of other people, are the ones that usually don’t permit any simple summation or extrapolation to the aggregates. To make that connection we usually have to look at the system of interaction between individuals and their environment.” (Schelling, 1978, p.14)

Schelling’s insights prove valuable for Economics because he offers a starting point to re-think our economy as a system in which everyone who reacts to the environment is also part of it. In doing so, his work is probably mostly in unison with Keynes’ idea of animal spirits. Both take a more behavioural perspective in macroeconomics. Both stress that people show contingent behaviour; that is, their behaviour is correlated with other people’s behaviour in the economy. For example, individuals’ goals, aspirations and views are going to be influenced by others’ goals, aspirations and views. One might also note that with the spread of social media and global interconnectedness the concept of contingent behaviour is more important than ever before. Yet the more general moral of Schelling’s story is that social interactions matter and they do matter for Economics. While we may carry on to assume that economic agents have certain preferences it is important to recognise that these are influenced by their environment and other people’s behaviour.

Besides, the moral for university lecturers might be to use Schelling’s insights to nudge their students to choose front seats over seats in the back. This might not only make lecturers happier but also students, helping them reach their true preferences of hearing well and having a comfortable seat. Yet one would need to know more about the emergence of the patterns of aggregate behaviour in the seating distribution to tweak it for the greater good.

Despite not being finished with Schelling’s book, I can clearly say that it is one of the most inspiring books in the sphere of Social Sciences and Economics I have come across so far. In my opinion it joins the ranks of Kahneman’s Thinking, Fast and Slow and Animal Spirits by Akerlof and Shiller and I hope that my post today inspired you to pick up a copy from your library as well!

Thanks for reading,

Jasse

 


References

Schelling, T.C. (1978). Micromotives and Macrobehavior. New York: W.W. Norton & Company.

The Hypothetical World of Econs

One of my readings for my class ‘Macroeconomics in the Global Environment’ is George A. Akerlof’s The Missing Motivation in Macroeconomics (2007). It is a reading for the lecture on Business Cycles, however, it is much more intended to give us an idea about the state of the Macroeconomics profession today. The reading is also somehow a justification for why the class is dominated by New Keynesian thinking rather than New Classical thinking.

What I want to look at today is the consequences of New Classical Thinking for the field of Macroeconomics. It is inspired by Akerlof’s paper which gives an overview on the five neutrality results that derive from New Classical Thinking. First I am going to define the New Classical school of thought. Thereafter I am going to look at the implications of this view for the macro-economy before discussing the evidence in favour and against the five neutrality results in today’s economy.

New Classical Macroeconomics evolved in the 1970s and 1980s. It is the revival of the belief that shifts in the aggregate demand curve only change the aggregate price level, but not total output. Krugman and Wells (2009) point out that the return to the Classical view was triggered by two new concepts, namely (1) rational expectations theory and (2) real business cycle theory. The concept of rational expectations came into play in the 1970s and was first formulated by John Muth in 1961. Rational expectations theory argues that individuals and firms are utility maximisers, meaning that economic actors always make optimal decisions and take into account all available information. Rational expectations theory is based on the notion of rationality and the assumption that people are forward-looking creatures, thriving for optimal decisions. Richard Thaler and Cass Sunstein like to call these hypothetical individuals ‘Econs’. Their name stems from the idea of homo economicus. They describe these individuals as creatures that can “think like Albert Einstein, store as much memory as IBM’s Big Blue, and exercise the willpower of Mahatma Gandhi” (2009, p.6). Akerlof explains the revival of the Classical View with the belief that macroeconomic relationships should be built on microeconomic fundamentals, meaning that in order to develop proper macroeconomic theory, one has to take utility-maximising individuals and profit-maximising firms and create a truly rational economic system.

Having defined what New Classical Macroeconomics is (in a rather crude manner) and how it views individuals as Econs and firms as profit-maximisers, let’s take a look at the implications for such an economy. Akerlof points out that there are five separate neutrality results following from the New Classical school of thought. It should be noted, though, that these neutralities are also embraced by many New Keynesians while adding a range of frictions (credit constraint, market imperfections, information failures, tax distortions, staggered, contracts, uncertainty, menu costs or bounded rationality). These five neutrality results of the New Classical school of thought are:

  1. Independence of consumption on current income
  2. Irrelevance of current profits to investment spending
  3. Long-run independence of inflation and unemployment
  4. Inability of monetary policy to stabilise output
  5. Irrelevance of taxes and budget deficits to consumption (Akerlof, 2007)

The first neutrality result is the Life-Cycle Permanent Income Hypothesis, i.e. the concept that consumption depends on wealth and not on current income. Wealth is an individual’s permanent income, i.e. current income and the present value of future income (Akerlof, 2007). In the world of Econs there is no correlation between the consumption and current income, because individuals allocate their expenditures based on the present value of all their life-time earnings. This also implies that these individuals engage in what is called consumption smoothing and proper saving for retirement. Econs save enough of their current income for later and they also do not increase consumption in case of a pay rise or decrease their consumption in case of a pay cut.

The second neutrality result is similar to the first one but in the context of profit-maximising firms. The Modigliani-Miller Theorem states that a firm’s investment strategy does not depend on its current financial position (Akerlof, 2007). This is because a profit-maximising firm will only make profitable investments and therefore Modigliani and Miller (1958) argue that a firm’s liquidity position will not have any effect on current investment.

The third neutrality result is the Natural Rate Theory in Macroeconomics, a theory which is embraced by the majority of Economists today. It is based on the notion that there is an unobserved non-accelerating inflation rate of unemployment (NAIRU) in the economy. The National Rate Theory evolved as a response to the break-down of the perceived trade-off between unemployment and the inflation rate, also known as the Philips curve. In particular, the New Classical school of thought showed that this trade-off is at most a short-run phenomenon. In the long-run, there is a natural unemployment level which occurs when the economy is at its long-run equilibrium, i.e. at its potential output level. In this long-run unemployment trends back to its natural rate no matter what the inflation rate is.

The fourth neutrality result is Rational Expectations Theory which renders monetary policy ineffective for taming the business cycle. This is because wage and price setters will respond systematically to any changes in the money supply (Akerlof, 2007). Robert Lucas contributed a great deal to this neutrality result which is commonly known as the Lucas critique. Lucas argued that:

“Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models.” (Lucas, 1976, p. 41)

In sum, wage and price setters will adjust their expectations in anticipation of monetary policy and will therefore adjust wages and prices accordingly offsetting the effects of an increase or reduction in the money supply.

The fifth neutrality result is the concept of Ricardian Equivalence and Akerlof (2007) points out that this is chronologically the last neutrality result embraced by modern Eonomists. According to this concept lump-sum inter-generational transfers do not impact current consumption. Akerlof (2007) explains this concept with the use of an example. Imagine that there are only two people, a parent and a child and that there are only two periods, period one and two. Furthermore the parent derives not only utility from her own consumption in period 1 but also utility from her child’s consumption in period 2. Then it can be shown that any inter-generational transfer does not change current consumption. In essence, this is because the present value of parents’ and children’s consumption is limited by the present value of the complete family’s earnings and the family’s initial wealth. Lump-sum inter-generational transfers, such as social security payments, do not change the family’s budget constraint. The lump-sum transfer merely redistributes earnings from one generation to another, leaving the aggregate pie unchanged and the parent will take into account that, in order to receive social security payments, her child will be taxed by government later.

Having looked at all five neutrality results in the world of Econs in detail, let’s take a short look at how plausible they are. Do individuals not alter their consumption if their current income changes? Do firms not change their investment strategy if their cash flows and therefore their liquidity position changes? First, there is evidence for a positive relationship between current income and current consumption in today’s economy. Second, there is clear evidence that managers maximise their own interests instead of the interests of their shareholders and that they often engage in so-called empire building because they only care about their own compensation or because of the prestige that comes with it (Akerlof, 2007). There is also an on-going debate about the third neutrality result and some Economists argue that the Philips curve, i.e. the trade-off between unemployment and inflation, might still exist. Especially when Central Banks target very low levels of inflation of 0 to 2 percent, this (almost perfect) price stability might come at a cost of higher long-run rates of unemployment. Assuming that economic actors form rational expectations (the fourth result) is crucial for the world of Econs; however, it does not resemble reality and in recent years fields like behavioural economics have evolved in response. There is compelling evidence that Humans are not Econs and good examples questioning the assumption of rational expectations are herd behaviour or risk aversion. Lastly, there are many reasons for why Ricardian Equivalence does not hold in today’s economy as opposed to the world of Econs. Akerlof (2007) points out that there are for example childless families, there is uncertainty induced by uncertainty about one’s age of death, tax distortions or a mere lack of foresight on the effect of inter generational transfer payments on future taxes. One can easily argue that pensioners are unlikely to take into account that their social security payments will increase the debt burden for future generations to come.

In sum, the New Classical school of thought has created a hypothetical economic system in which utility-maximising individuals and profit-maximising firms are well-behaved and always make optimal decisions leading to the five neutrality results described above. In practice, this is far from reality and one of the reasons for the revival of Keynesian thinking, the New Keynesian school of thought, which has evolved as a response. In addition, the failure of New Classical Macroeconomics has opened the door for new ideas, such as behavioural economics and other unconventional schools of thought. Also the failure of many Economists and Macroeconomic models in predicting the global financial crisis proved the need for such fresh ideas. What is more, it showed that we do not live in a world of Econs but in a world of Humans as Richard Thaler and Cass Sunstein put it aptly.

Thanks for reading!

Jasse


References

Akerlof, G.A. (2007). The Missing Motivation in Macroeconomics. American Economic Review, 97(1), 5-36. DOI: 10.1257/aer.97.1.5

Krugman, P., and Wells, R. (2009). Macroeconomics. New York, NY: Worth Publishers.

Lucas, R. (1976). Econometric policy evaluation: A critique. Carnegie-Rochester Conference Series on Public Policy, Elsevier, 1(1), 19-46.

Modigliani, F., and Miller, M.H., 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48(3), 261–97.

Thaler, R.H., and Sunstein, C.R. (2009). Nudge: Improving Decisions About Health, Wealth, and Happiness. New York, NY: Penguin Books.

Deliberate Practice and Grit as Drivers of Productivity

In my recent post Self-Improvement Month: Math Refresher I touched upon how to become more productive and making use of tools like a to-do list – with a stretch goal and a distinct plan of how to achieve it – to structure one’s daily routine. For this I was inspired by the Freakonomics series on self-improvement. Today’s post is again inspired by the radio’s self-improvement series. In particular, I want to talk about how (1) deliberate practice and (2) grit might help improve one’s productivity.

In all aspects of life – from sports and music to work – we can observe that some people are more productive than others. Some people excel at what they are doing while others simply do not. But why is this the case? There are two contrasting views on why some people reach higher levels of productivity or performance than other people. On the one hand, it can be argued that these people have an innate talent or ability which allows them to excel at everything they do. On the other hand, it can be argued that these people have engaged in so-called deliberate practice which is superior to normal practice to excel at what they are doing. While the former view differentiates between people, the latter view assumes that anyone can excel with the help of high levels of practice over a sustained period. (You might have heard about the 10,000 hour rule.)

Because talent is more or less inherited, I want to focus on deliberate practice as a driver of productivity in the first part of the post. This term was coined by Psychologist K. Anders Ericsson. In his research Ericsson has shown that high performers have become experts in their field, because they are engaging in deliberate practice. In comparison to less efficient practice methods, deliberate practice generally consists of:

  • High levels of practice over a sustained period,
  • Learning the skills necessary for high performance step by step through smaller tasks in structured day-to-day practice,
  • Practice at steadily rising levels of difficulty and
  • Individualised supervision and immediate feedback from a teacher (Mayer, 2008).

While individualised supervision can partly be substituted by pre-defined curricula and group instruction, it remains superior and the most effective way of learning (Anders Ericsson, Krampe, and Tesch-Römer, 1993).

However, while the aspects mentioned above are necessary, they are not sufficient for deliberate practice. There are four further constraints which govern whether an individual is able to engage in deliberate practice. Firstly, there is the time constraint which limits the time and energy individuals can spent on practice rather than other commitments like work, school or family life. Second, there is a resource constraint. An individual needs access to appropriate training material and facilities as well as a supportive teacher who can coach the student in a manner which encourages deliberate practice. Third, there is a motivational constraint. Motivation is key to perseverance, because there are most often no immediate but long-term rewards for practice which might not be obvious to the learner in the short-run in daily practice. Fourth, there is the effort constraint. Individuals that engage in deliberate practice recognise the need for breaks and therefore limit daily practice to a healthy and sustainable level (Anders Ericsson, Krampe, and Tesch-Römer, 1993).

Given that these four constraints are met, K. Anders Ericsson argues that anyone can excel in life through deliberate practice. The high performers that we observe in society have benefited from such optimal conditions for learning and have mastered how they learn best.

After having talked about deliberate practice as one of the two main determinants of performance (the other being innate talent), let’s take a closer look at why these high performers are able to commit to such a high intensity of practice. As noted before, deliberate practice is not always enjoyable. It might even be painful in the day-to-day exercises (in sports for example) in order to reap long-term results. Still, high performers are able to commit to deliberate practice over a sustained time period and that is where grit comes into play. Psychologist Angela Duckworth has studied grit extensively in her book Grit: The Power of Passion and Perseverance. She defines grit “as passion and perseverance for long-term goals” (Duckworth, Peterson, Matthews and Kelly, 2007, p.1087). Hence grit can probably be seen as a lever for deliberate practice as well as a driver of productivity. It enables individuals to engage in such intensive and not always enjoyable levels of practice in order to become a high performer. Furthermore, grit is associated with success outcomes beyond that explained by IQ, with higher attainments in the level of education and less career changes (Duckworth, Peterson, Matthews and Kelly, 2007).

So, in order to become more productive two helpful ingredients are deliberate practice and grit. But is there a way to have more grit in life in case you are not a gritty person?

According to Duckworth any individual can learn to have more grit. This is because genius is “something that you can accomplish yourself as opposed to something that is given to you” she says in her interview with Stephen J. Dubner (Freakonomics, 2016). Her argument links back to the earlier discussion about whether it is innate ability or practice which determines one’s performance in life. Similar to K. Anders Ericsson, Angela Duckworth argues that it is not natural ability which determines one’s level of performance, but individuals can actively accomplish greatness through deliberate effort.

In her research Duckworth found that gritty people do not primarily differ in their character but rather in their behaviour (which can be learned or taught). Her research revealed that gritty people are different in four ways, namely (1) interest, (2) practice, (3) purpose and (4) hope. These four traits enable perseverance and passion for long-term goals. While interest, purpose and hope are new ideas, one can see that the concept of (deliberate) practice also plays a key role in having more grit in life. Hence, there is probably a two-way relationship between grid and deliberate practice.

Let’s look at all four traits in more detail. Interest or even stronger – passion – comes first. Gritty people have acquired high levels of interest in one particular thing. It is like an intrinsic motivator which drives their passion for becoming knowledgeable or an expert in a particular field. However, Duckworth acknowledges that not every individual is striving for becoming an expert in one field. She differentiates between dilettantes and experts. While the former strives for novelty, the latter “substitutes nuance for novelty” (Duckworth in Freakonomics, 2016). In the second stage, once people have become interested in a certain thing, it is about the right kind of practice. Gritty people practice in a very methodical way where this practice is more similar to labour. This is why the first stage of developing passion is crucial. Gritty people can engage in this labouring kind of practice due to their extremely well-developed interest. In the third stage, gritty people develop a beyond-the-self purpose. This means that the real purpose of their work or hobby does not stem from selfish interests but from its positive impact on others or the connectedness to other people (for example team sports). The fourth trait of hope governs all three stages of interest, practice and purpose, because it allows gritty people to remain optimistic even when being confronted with challenges or experiencing setbacks (Freakonomics, 2016).

In sum, deliberate practice and grit are two ingredients for becoming more productive and improve one’s performance in life. Deliberate practice, as coined by K. Anders Ericsson, differs greatly from less efficient ways of practice and allows anyone to excel in life if the four constraints (time, resources, motivation, efforts) are met. Grit is “a passion or perseverance for long-term goals” and enables individuals to become a genius through their own efforts rather than innate ability. Thereby gritty people are characterised by extreme high levels of interest in one particular thing, intensive practice, beyond-the-self purpose and hope. Overall, according to these concepts productivity and performance are more driven by the deliberate efforts of individuals rather than a natural talent. Given that there is a supportive external environment (resources etc.) any individual can improve and excel. This should be good news for anyone attempting to improve their skills!

In case that the grit concept sounds plausible to you, you might want to actually go ahead and calculate your own grit score. For this Angela Duckworth has published her 12-item grit scale here. On her website there is also a shortened interactive version if are short of time.

Thanks for reading today’s post,

Jasse


Anders Ericsson, K., Krampe, R.Th., and Tesch-Römer, C. (1993). The Role of Deliberate Practice in the Acquisition of Expert Performance. Psychological Review, 100(3), 363-406.

Duckworth, A.L., Peterson, C. Matthews, M.D., and Kelly, D.R. (2007). Grit: Perseverance and Passion for Long-Term Goals. Journal of Personality and Social Psychology, 92(6), 1087-1101.

Freakonomics, (2016, 4 May). How to Get More Grit in Your Life. Retrieved from: http://freakonomics.com/podcast/grit/

Mayer, R.E. (2008). Learning and Instruction (2nd ed.). Upper Saddle River, N.J: Pearson Merrill Prentice Hall.

Germany’s Shrinking Middle Class

The DIW has released an alarming new study on the shrinking middle class in Germany. It also links neatly into the debate of rising income inequality. New calculations based on the Socio-Economic Panel (SOEP) revealed that Germany’s middle class shrunk by 6 percentage points from 1991 to 2013 (Grabka, Goebel, Schröder and Schupp, 2016). This is as alarming as the adverse developments in the USA.

Germany income inequality 1
Diagram 1 (Source: Grabka et al., 2016; World Bank, 2016)

Germany’s middle income class includes all people in households that earn a gross total income of 67 to 200 percent of the median. The country’s middle class is still the largest income group today. However, the DIW study reveals that Germany’s middle class is now on decline. This is due to the fall in the middle-income group’s share in the adult population, meaning that less people earn a wage (high or low enough) to be classified as ‘middle class’. On the other hand, there has been an equal increase in people earning more or less (Grabka et al., 2016).

The DIW states that over the period from 1983 to 2013 the middle income group’s share in the adult population declined from 62 percent to 54 percent. This 8 percent decrease has been redistributed evenly to the other income groups. While 4 percent entered the low income and lower-middle income group, the other 4 percent entered the upper-middle income and high income group (diagram 1). Furthermore the middle class also saw a significant decrease in its share in total income while the high income group saw a significant rise in its share in total income. The study finds that the middle class’ share fell by more than 10 percentage points over the period from 1991 to 2010 (Grabka et al., 2016).

 Table 1

Gini Coefficient – Net Household Income

Year Germany West East
1991 0.247 0.245 0.205
2011 0.288 0.291 0.257

(Source: Sachverständigenrat Wirtschaft, 2015)

The DIW findings are not completely new. The Sachverständigenrat Wirtschaft releases a periodic study on income and wealth distribution in Germany. Its analysis published in 2014/15 (also based on the SOEP) showed similar trends. The study revealed that Germany’s Gini coefficient in net household incomes increased from 0.247 to 0.288 in 2011. Thereby it actually peaked in 2005 with a coefficient of 0.293. Importantly, income inequality is still greater in West Germany (0.291) compared to East Germany with a Gini coefficient of only 0.257 (2011).

 Table 2

Gini Coefficient – Equalised Disposable Income

Year Germany West East
1991 0.411 0.406 0.375
2011 0.485 0.472 0.529

(Source: Sachverständigenrat Wirtschaft, 2015)

When one looks at equalised disposable incomes (Marktäquivalenzeinkommen), the problem of income inequality becomes even more apparent. The Gini based on equalised disposable incomes has seen an increase from 0.411 in 1991 to 0.485 in 2011. Importantly, East Germany has seen a significantly greater increase than West Germany and is now more unequal than its counterpart. While East Germany’s Gini was 0.375 in 1991 it had risen to 0.529 in 2011. Over the same period West Germany’s Gini only rose from 0.406 to 0.472.

Germany income inequality 2
Diagram 2 (Source: BPB, 2014; Sachverständigenrat Wirtschaft, 2015)

The rise in the Gini coefficient can be shown graphically if one constructs Germany’s Lorenz curve for 1991, 2005 and 2011 based on the SOEP data (diagram 2). It has shifted outward and, because the Lorenz curves do not cross, it is clear that income inequality has risen from 1991 to 2005 while it somewhat improved from 2005 to 2011. The diagram shows nicely that the main shrinking in the middle class happened in the 1990s and the early 2000s. When one looks at equalised disposable incomes, the story remains the same even if it is less pronounced (diagram 3). However, this Lorenz curve was already significantly farer away from the line of equality than the net household income distribution Lorenz curve in 1991.

Germany income inequality 3
Diagram 3 (Source: BPB, 2014; Sachverständigenrat Wirtschaft, 2015)

 

While Germany’s middle class is in decline and income inequality on the rise, it should be noted, that the country still performs considerably better than the OECD average and other highly developed countries. Germany’s society is still a rather equal society in international comparison. The inequality adjusted HDI sat at 0.853 in 2014 and recorded a loss of 6.9 percent in potential human development due to inequality. Thereby inequality in life expectancy at birth (3.7 percent) and inequality in education (2.4 percent) played only a minor role. The main driver is income inequality at 14.1 percent, dampening potential human development. In international comparison, however, inequality in income is at 22.5 percent for very high HDI countries and even at 23.6 percent for OECD countries (UNDP, 2015).

Hence income inequality is of concern now but it is not too late to revert these adverse developments. It should be a key priority to stop a further increase in income inequality so that the fruits of economic growth and development continue to benefit the larger share of the population. Germany needs to ensure that it does not miss out on people at the lower end of the income distribution and does not further diminishes its middle class which has been one of the drivers of the country’s economic success since the mid-2000s.

Thanks for reading my post today as this is an issue one should care about.

Jasse


BPB (2014). Die Soziale Situation in Deutschland: Zahlen und Fakten – Einkommen und Vermögen [pdf]. Retrieved from: http://www.bpb.de/system/files/dokument_pdf/08%20Einkommen%20und%20Verm%C3%B6gen_1.pdf

Grabka, M.M., Goebel, J., Schröder, C., and Schupp, J. (2016). Shrinking Share of Middle-Income Group in Germany and the US. DIW Economic Bulletin, 18, 199-210. Retrieved from: https://www.diw.de/documents/publikationen/73/diw_01.c.533123.de/diw_econ_bull_2016-18.pdf

Sachverständigenrat Wirtschaft (2015). Analyse: Einkommens- und Vermögensverteilung in Deutschland [pdf]. Retrieved from: http://www.sachverstaendigenrat-wirtschaft.de/fileadmin/dateiablage/gutachten/jg201415/JG14_09.pdf

UNDP (2015). Human Development Report 2015: Briefing note – Germany [pdf]. Retrieved from: http://hdr.undp.org/sites/all/themes/hdr_theme/country-notes/DEU.pdf

World Bank (2016). World Development Indicators: Germany. Retrieved from: http://data.worldbank.org/country/germany