The Undoing Project

The Freakonomics episode The Men Who Started a Thinking Revolution from January this year induced me to get a copy of Michael Lewis’s latest book The Undoing Project. However, having read Daniel Kahneman and Amos Tversky’s papers on Prospect Theory and the Framing of Decisions, as well as Kahneman’s Thinking, Fast and Slow, I was not sure whether I would enjoy a re-iteration of their ideas from an outsider’s perspective. My concerns actually turned out to be unfounded. The book does not intend to be a pure summary of Kahneman and Tversky’s research. It has a distinct novel touch; Michael Lewis tells the story of Kahneman and Tversky’s partnership beyond what is recorded in their papers and the book. It provides one with the context when reading about their insights into the heuristics and biases in decision-making, and Prospect Theory. For me, especially the second chapter The Outsider (aka Kahneman), and the third chapter The Insider (aka Tversky) put another complexion on their academic works and accomplishments. Admittedly, the book has strengths and weaknesses. The introduction, for example, is not very interesting if (1) you are not a baseball fan or (2) you have not read Michael Lewis’s 2003 book Moneyball. The many quotes and memos from Kahneman and Tversky, however, make up for this mediocre introduction. They are plainly ingenious and I collected my favourites to not forget them. Here they are:

Amos Tversky’s notes on conversations with Danny Kahneman in Spring 1972

People predict by making up stories

People predict very little and explain everything

People live under uncertainty whether they like it or not

People believe they can tell the future if they work hard enough

People accept any explanation as long as it fits the facts

The handwriting was on the wall, it was just the ink that was

invisible

People often work hard to obtain information they already have

And avoid new knowledge

Man is a deterministic device thrown into a probabilistic

Universe

In this match, surprises are expected

Everything that has already happened must have been inevitable (p.197)

 

Amos Tversky’s memorable sentences (collection by Don Redelmeier)

A part of good science is to see what everyone else can see but

think what no one else has ever said.

The difference between being very smart and very foolish is

often very small.

So many problems occur when people fail to be obedient when

they are supposed to be obedient, and fail to be creative when

they are supposed to be creative.

The secret to doing good research is always to be a little

underemployed. You waste years by not being able to waste

hours.

It is sometimes easier to make the world a better place than to

prove you have made the world a better place. (p.230)

 

Amos Tversky’s note to Danny Kahneman on Loss Aversion (appeared also in a 1977 draft of Prospect Theory)

The greater sensitivity to negative rather than positive changes is not specific to monetary outcomes. It reflects a general property of the human organism as a pleasure machine. For most people, the happiness involved in receiving a desirable object is smaller than the unhappiness involved in losing the same object. A high sensitivity to losses, pains, and noxious stimuli also has adaptive value. Happy species endowed with infinite appreciation of pleasures and low sensitivity to pain would probably not survive the evolutionary battle. (p.269-270)

If these paragraphs sound interesting, you might want to give the book a chance. Overall, I can recommend The Undoing Project to anyone who would like to know more about how the heuristics-and-biases programme came to be, and how Prospect Theory was born. For this, it is a worthwhile reading.

Jasmin


References

Dubner, S. (2017). The Men Who Started a Thinking Revolution. Available at: http://freakonomics.com/podcast/men-started-thinking-revolution/

Lewis, M. (2016). The Undoing Project: A Friendship that Changed the World. London: Allen Lane.

 

Econometrics Refresher

It has been a bit quieter on my blog over the exam period and the Christmas break, but now university is back on again and I cannot wait to start my second semester! As we have our consolidation and development week this week, it seems like the perfect time to prepare for my classes and as the semester is going to be my last one before graduation, I can pick from a list of electives.

So, besides Behavioural Economics and Industrial Economics, I get the chance to do Applied Econometrics. The course builds upon the Econometrics component from my third-year classes in Micro- and Macroeconomics and introduces:

  1. Models with limited dependent variables
  2. Panel data sets
  3. Topics involving time series data (volatility and cointegration).

One of the class prerequisites is a change in notation to the matrix form of econometrics. This is a very useful step as many econometric problems have a multivariate character and for this, the matrix form is much more convenient. While I have studied matrices in my advanced mathematics course as well as through MITOpenCourseware, I have yet to relate it to econometrics and this is what I am up to this week! Ben Lambert has a great graduate course in econometrics on his YouTube channel which covers topics from the undergraduate course in matrix formulation:

It is an indispensable source for developing your understanding and getting a feel for this representation. In particular, the course starts with an introduction to the matrix formulation of econometrics, followed by an example of it. It then continues with the differentiation with respect to a vector as well as the derivation of OLS estimators in matrix form. So, if you want or need to refresh your econometrics skills or develop them to the next level, this is for you.

Many thanks for reading!

 Jasmin

David Kreps on Dynamic Choice

While researching and preparing for my applications for graduate studies in Economics, I came across a highly inspiring lecture by David Kreps who is the Adams Distinguished Professor of Management as well as Professor of Economics at Stanford. Under the heading “Choice, Dynamic Choice, and Behavioral Economics” Kreps contrasts how the discipline of economics models choice and, in particular, how the discipline models dynamic choice with more realistic models which draw on behavioural economics. Thereby Kreps’ research program is at the forefront of this with Kreps’ mission being:

To provide economists with “better” (more realistic, more consistent with observed behaviour) models of dynamic choice.

As an introduction to the lecture, Kreps first discusses how the discipline of economics works. Kreps argues that the bedrock of standard economics is that: (1) people make consistent choices and (2) these choices are equilibrated in markets and other institutional settings. Note here that some economists say that people make ‘rational choices’ rather than ‘consistent choices’. However, Kreps reverts to the wording ‘consistent choices’ to circumvent calling choices ‘irrational’ which do not conform with the standard economic model. Having laid out the basics, Kreps exemplifies what consistent choice in economics means in reality. It prohibits any situation like the following:

David Kreps.png
(Kreps, 2015, 2:37-3:12)

The situation in the roadside diner is the typical example of inconsistent choice. Why? Because the customer prefers the apple pie initially when having the choice between apple and peach pie. We could say that the individual maximises his utility by purchasing the apple pie. However, when confronted with a seemingly irrelevant third alternative, that is banana crème, his preference changes. He now chooses peach pie over both apple pie and banana crème. In the world of standard economics this cannot happen because economists assume that the customer will stick to his preferences no matter what. If he chooses apple pie and not peach pie if both options are available to him, then he will never choose peach pie over apple pie when both options are available to him. In short: He will always choose apple because he prefers apple pie. Besides consistent choice theory being the bedrock for economics, this assumption is also necessary for maximising utility. We need this independence of irrelevant alternatives/ preference stability in the choice of an economic agent to conclude that individuals are utility maximisers. Otherwise we cannot model the decision-making process as one of maximising utility with a simple numerical function as commonly done in utility theory, expected utility theory and subjective expected utility theory.

After having set the scene what consistent choice is in economics, Kreps looks at empirical evidence. He argues that empirically the assumption that people make consistent choices does not hold. There is watertight evidence that the environment and other seemingly irrelevant alternatives available to you change the ‘frame’ of the choice. One of the examples is marketing which relies heavily on manipulating the frame of a decision, inducing individuals to buy their products. Hence, compared to economists, marketers have long recognised that people fall prey to inconsistent choices, for example depending on which products they advertise simultaneously. In contrast, economists still go with ‘consistent choice’ because otherwise their decision theory breaks down. Conventional economists tend to ignore the ‘frame’ of the decision.

Next Kreps looks at dynamic choice. The situation of the apple and peach pie is an example of static choice. Kreps, however, is more interested in dynamic choice; that is, choices that have implications for the future and influence future choices like education or savings decisions. Again, standard economics looks at dynamic choice problems through the lens of utility maximisation. It assumes that economic agents act ‘as if’ they could figure out the set of strategies and the outcomes of each strategy in a dynamic choice problem and hence could plainly act ‘as if’ they maximised their utility subject to their ‘budget constraint’. According to Kreps, utility maximisation and the ‘as if’ assumption are not a good model of dynamic choice due to the following three reasons:

  1. Tastes change.
  2. People know that the future is highly uncertain and often unpredictable and they take this into account in the decisions they make today.
  3. People rely on heuristics when it comes to complex dynamic choice problems.

In the remainder of the lecture Kreps looks at all three reasons in more detail. In terms of changing tastes, he argues that people have three basic options. On the one hand, individuals can acknowledge that tastes changes but do nothing. On the other hand, if they wanted to take some action, they could either constrain themselves via a commitment device or deliberately choose to remain flexible and choose not constrain themselves.

In relation to the second reason, Kreps takes a closer look at what motivates people. Conventional economics models individuals as homo economicus; that is consistent (or rational) and selfish. Under these assumptions incentives are guaranteed to work. Economics has a complete theory of incentives. An example is the simple principal agent model: In order to incentivise the agent, the principal can pay the agent a monetary bonus. This is sufficient for compensating the agent for the risk of putting in high effort but just being unlucky and ending up with an unsuccessful project. On the other hand, social psychologists take a rather different stand on motivation. Kreps points towards the concepts of self-determination and self-perception in social psychology. He sees both as superior to the standard economics stories and argues that social psychology needs to be incorporated into economics if we want to build theories approximating real-world behaviour.

In terms of the third reason for why the ‘as if’ model is unlikely to be a good one for dynamic choice problems, one needs to acknowledge that most of the dynamic decision problems like how much to save for retirement, which school to go to or which career to pursue are far too complex. What is more, in the real world individuals tend to choose by trial-and-error. The only way to find out which option is the best one is often merely to try or alternatively simplify the problem and then use some rule of thumbs, i.e. certain heuristics.

The bottom line of David Kreps’ lecture is that dynamic choice problems matter. They are among the most important ones in terms of their impact on individual’s economic well-being, the economic well-being of society and in aggregate the macroeconomic outlook. However, standard economics, by modeling individuals as utility maximisers, abstracts from how actual individuals behave in our economy. In contrast, what economics really should do is modeling actual human choice using proper assumptions which necessarily move away from “rational decision making” because our world is complex, risky and uncertain. Acknowledging that people do the best they can, given their cognitive limitations, paves the way to a superior theory of choice and, in particular, theory of dynamic choice.

If my short discussion of David Kreps caught your interest; then you should check out the full lecture available from here! Kreps is an amazing speaker and his way of presenting makes the topic – which is fascinating in its own right – even more captivating!

Thanks for reading,

Jasse

 


References

Kreps, D. (2015). Choice, Dynamic Choice, and Behavioral Economists [Video]. Available at: http://www.gsb.stanford.edu/insights/david-kreps-choice-dynamic-choice-behavioral-economics [Accessed 22 October 2016].

Germany’s Energiewende – The New Electric Mobility Strategy

I am pleased to see that Germany continues to drive its energy transition. The so-called ‘Energiewende’ (German for energy transition) is overhauling the country’s energy concept fundamentally. Thereby the three pillars of the new energy concept are reliability, environmental sustainability and economic viability. The government’s vision is to transform the country into a role model for energy efficiency and a green economy coupled with competitive energy prices and a high level of prosperity (BMWi, 2010). The four main political objectives of the energy transition are to combat climate change, to avoid the risks of nuclear power, to improve Germany’s energy security and to increase competition and growth in the sector (Pescia and Graichen, 2015). But there are more potential benefits to it, including the reduction of energy imports and therefore oil dependency and exposure to external energy supply shocks, as well as the strengthening local economies and the provision of social justice (Morris and Pehnt, 2015).

In order to achieve the ambitious vision, the government’s agenda includes:

  1. Cost-efficient expansion of renewables, e.g. expansion of offshore and onshore wind farming and increasing sustainability and efficiency in the use of bioenergy
  2. Enhancing energy efficiency of private households, the industry and the public sector, e.g. the modernisation campaign for buildings with the vision of energy-efficient buildings by 2050
  3. Shifting the energy mix away from nuclear power and fossil-fuel power plants toward renewable energy sources
  4. Improvements in the country’s grid infrastructure and storage technologies with demand-responsive electricity generation
  5. Electric mobility strategy with one million electric vehicles on Germany’s streets by 2020 and six million by 2030
  6. Energy research programme with focus on innovation and new technologies regarding renewable energies, energy efficiency and storage methods (BMWi, 2010).

Although some of the policy measures, which the government has adopted, are debatable, the overall plan is clearly well thought out. A month ago I already dedicated a blog post to the idea of ecological fiscal reforms (green tax shift) and eco-social market economies. In this post I used Germany as a textbook example for the evidence of the wide-ranging benefits of such green reforms.

In my opinion, the ‘Energiewende’ provides the necessary nudge to the industry, consumers as well as the public sector to enhance their energy efficiency and sustainability. It reshapes the incentives of economic actors in favour of green research, innovation and consumption. In addition, it is also a poster child for demonstrating that “coherent government policy can transform an industry” and that it is possible to “to blend low-risk feed-in tariffs with market price signals” (Fares, 2014).

The motivation for today’s post stems from the fact that Germany is now starting to implement its electric mobility strategy (item 5 on the agenda above). It is about to introduce a new nudge targeting electric cars. In particular, the German Federal Cabinet has just approved a new legislative package for the preferential treatment of electric cars. It will include a subsidy of 4,000 Euro when purchasing a new electric car and 3,000 Euro when purchasing a hybrid car. In addition, electric cars will be exempt from the motor vehicle tax for a period of 10 years (Tagesschau, 2016). This initiative for electric mobility will be funded jointly by the government and the automobile industry, each contributing 0.6 billion of funding. According to the government Daimler, VW and BMW have already agreed to the 50:50 split in costs (ZEIT, 2016). The initiative will be coupled with the roll out of charging points. This, in turn, will be funded by the Federal Government swallowing another 300 million of public funds.

The main goal of the latest initiatives for electric mobility is to achieve a more than ten-fold increase the amount of electric and hybrid cars from currently less than 50,000 to more than 500,000 in the short-run and to more than one million in the medium-run (Tagesschau, 2016). As noted earlier, electric mobility is at the heart of the country’s energy transition. Transport is currently one of the main drivers of Germany’s oil dependence. It continues to rely heavily on fossil fuels rather than renewable energy sources despite efforts like the development of the National Hydrogen and Fuel Cell Technology Innovation Programme (BMWi, 2010). This is why the government is now taking action. It is starting to pave the way for preferential treatment of electric cars in order to increase the incentives for both fleet operators and first-time private buyers to purchase an electric car and to drive its energy transition also in the area of transport.

Overall, the legislative package still has to be discussed and approved by the German Federal Parliament and Federal Council. However, the package is likely to go through shortly with the subsidy for the purchase of electric and electric cars being expected to already begin in May. Subsidies will be claimable through an online application facility (Tagesschau, 2016). So there are interesting times to come; especially whether the subsidy will be sufficient to increase the adoption of the electric mobility technology. Electric cars continue to carry an excessive price tag for their zero emissions image. Even under the assumption that both fleet operators and first-time private buyers care about the image associated with a zero-emission vehicle (BMWi, 2010), it is not clear whether this together with the government’s subsidy and tax exemption is an incentive large enough to justify the higher initial investment costs. One should not forget that it is ultimately the price which determines demand (and supply). The initiative has the potential to break ground, but it is unlikely to turn the larger share of society into electric car users; at least not yet. Still, I would argue that we are heading into the right direction due to the right policy mix. Firstly, Germany focuses on competition and market orientation. Secondly, Germany introduces incentives in favour of greener transportation without restricting society’s choices as well as important incentives for green innovation. Both are key to rethink transportation and mobility issues in a century where renewable energy sources are clearly on the rise.

 Thanks for reading,

Jasse


BMWi (2010). Energy Concept for an Environmentally Sound, Reliable and Affordable Energy Supply. Berlin: Federal Ministry of Economics and Technology. Retrieved from: http://www.bmwi.de/English/Redaktion/Pdf/energy-concept,property=pdf,bereich=bmwi,sprache=en,rwb=true.pdf

Fares (2014, 7 October). Energiewende. Two Energy Lessons for the United States from Germany. Retrieved from: http://blogs.scientificamerican.com/plugged-in/energiewende-two-energy-lessons-for-the-united-states-from-germany/

Morris, C., and Pent, M. (2015). Energy Transition: The German Energiewende. Berlin: Heinrich Böll Stiftung. Retrieved from: http://energytransition.de/wp-content/themes/boell/pdf/en/German-Energy-Transition_en.pdf

Pescia, D., and Graichen, P. (2015). Understanding the Energiewende: FAQ on the ongoing transition of the German power system. Berlin: Agora Energiewende. Retrieved from: https://www.agora-energiewende.de/fileadmin/Projekte/2015/Understanding_the_EW/Agora_Understanding_the_Energiewende.pdf

Tagesschau (2016, 18 Mai). Kaufprämien und Steuerboni für Elektroautos: Kabinett beschließt Förderung. Tagesschau Online. Retrieved from: http://www.tagesschau.de/wirtschaft/elektro-autos-103.html

ZEIT (2016, 27 April). 4.000 Euro Prämie für Kauf eines Elektroautos. ZEIT ONLINE. Retrieved from: http://www.zeit.de/politik/deutschland/2016-04/bundesregierung-elektroautos-subvention-kaufpraemie

The Price of Postcards around the World

My blog post today is rather short and more like a little fun exercise to gain familiarity with the concept of Purchasing Power Parity and the PPP exchange rate. I researched the price for a postcard as well as a 100 gram (3.53oz) letter charged by the post offices of ten countries around the world and then used the PPP exchange rate* to convert the values into international dollars. My initial goal was to see whether there are substantial differences that can be explained due to competition or non-competition in the market. However, as the table below shows, each country has very different thresholds which makes cross-country comparisons for at least the 100 gram letter somewhat difficult. It skews the picture in particular for New Zealand, Germany and South Africa, which do not have a category for the 100 gram letter itself.

Country max weight max length max width max thickness
Bangladesh 100g n/a n/a n/a
Canada 100g n/a n/a n/a
France 100g n/a n/a 3cm
Germany 500g 35.3cm 25cm 2cm
India 100g n/a n/a n/a
Japan 100g n/a n/a n/a
Norway 100g 35.3cm 25cm 2cm
New Zealand 500g 23.5cm 13cm 6mm
South Africa 1kg 25cm 17.6cm 1cm
UK 100g 24cm 16.5cm 0.5cm
USA 3.5oz 11-1/2inch 6-1/8inch 1/4inch

It is also important to note that Canada’s, France’s New Zealand’s, and the UK’s rates for postcards are identical to their rates for small letters, while countries like Germany or the USA price differentiate between these two. In general, postcards are mostly taken as any cards below 10 grams, but the exact maximum length and width can vary. From personal experience, I know that Germany can be quite strict in these regards, levying surcharges for non-standard sizes if you’re unlucky.

Country PPP Exchange rate* Postcard LCU Letter LCU Postcard int.$ Letter int.$
Bangladesh 27.05 2 20 0.07 0.74
Canada 1.23 1.00 1.80 0.81 1.46
France 0.82 0.70 1.40 0.85 1.71
Germany 0.78 0.45 1.45 0.58 1.87
India 16.98 10 25 0.59 1.47
Japan 104.72 52 140 0.50 1.34
New Zealand 1.42 0.80 0.80 0.56 0.56
Norway 9.34 11 21 1.18 2.25
South Africa 5.39 3.60 7.15 0.67 1.33
UK 0.70 0.55 0.55 0.79 0.79
USA 1.00 0.34 1.10 0.34 1.10

After obtaining the prices for the ten countries I went to the World Development Indicators published by the World Bank (2016) and downloaded the PPP conversion factor for each. The latest year available is 2014. One then has to divide the currency by the PPP exchange rate to obtain the value in international dollars which can then be compared while accounting for different purchasing power parity.

In both categories Norway has the highest prices. A domestic 100 gram letter, for example, costs twice as much in Norway compared to the USA. The UK and New Zealand benefit in this category in particular, because their post offices (Royal Mail and NZ Post) have a single band for letters up to 100 grams and 500 grams, respectively. They do not price differentiate while countries like France or Germany have the thirst threshold, i.e. price increase, after 20 grams already. This is why New Zealand ends up being actually cheapest in my ranking here. So, the fun fact: if you could really fit 500 gram into a standard New Zealand letter, you would get the greatest value for your money relative to all the other countries.

letter 2

In terms of the postcards, the picture is less skewed as there is less volatility in size and weight. It is a less heterogeneous product as the postcard mail service tends to be more standardized. It is therefore probably better for comparison if one really wanted to study postal services and their effectiveness across countries. Postcards are cheapest in Bangladesh at only 7 cents. France, Canada and the UK rank in the upper part, mainly because they charge the same prices for small letters and postcards putting their services at the more expensive end. This could arguable be a deterrent for writing postcards, inducing people to maximize their utility gained from the postal service and writing heavier letters instead than light-weight postcards. Germany’s postcards are actually quite cheap and comparable to India’s prices when using the PPP exchange rate method. This does not take into account the quality of service though. And while the USA’s postal service (USPS) is still a monopoly, it actually does perform pretty well in my postcard comparison, coming second after Bangladesh if one just looks at the prices.

letter 1

As highlighted before, these statistics are more a little exercise and are of limited value because the postal service is not a homogeneous good and countries do vary greatly in their service offerings. What is more, there will be cross-country variation in the quality of service. Thanks for reading!

Jasse

 


*PPP conversion factor, GDP (LCU per international $)

World Bank (2016). PPP conversion factor, GDP (LCU per international $) [Data file]. Retrieved from: http://databank.worldbank.org/data/home.aspx