What I learned: Economics

When I was younger, I didn’t like the idea of economics. I didn’t like money (money being too material and mundane), and I thought economics was about money, so it wasn’t very interesting.

That obviously changed (or I wouldn’t bother to write this post), and I actually remember the conversation that sent the first cracks in my walls of ignorance. It was Michael Katsevman trying to explain the wonders of Facebook in economic terms, and me not understanding what the heck he was talking about. He kindly elaborated (in the following IRC dialog, Michael is procto and I am TFK):

<procto>    now I would use some economics to discuss here
<procto>    but you don’t like it
<procto>    I don’t know how a computer scientist can dislike economics
<procto>    the only reason I can think of is that you don’t know enough of it
<procto>    it’s one of my favourite things in the world
<procto>    proper economics, not just “stocks and bonds and stuff”
<procto>    things like
<procto>    game theory
<procto>    utility theory
<procto>    incentive structures
<procto>    information asymmetry
<procto>    etc.
<procto>    there’s a cool new branch called neuroeconomics
<procto>    which studies decision theory
<procto>    i.e. how people decide stuff
<TFK>    Those things don’t sound like economics per se, although may utilize concepts and methods from it.
<procto>    TFK: ok, want a definition of economics?
<procto>    ”Economics is the science of scarce resources and the decisions people make about them.”
<TFK>    Anyway… when put that way, it can be interesting.
<TFK>    But when people hear “economics” they usually equate it with “economics of business”.
<TFK>    Not abstract mathematical models on decision-making in a prisoner’s dilemma (which I do find interesting).
<procto>    that’s because most people are ignorant
<procto>    I use the term Finance to describe the former
<procto>    vis a vis the term Economics
<procto>    which is a more abstract science
<TFK>    Hmmm. I will henceforth adopt your distinction of terms.
<procto>    :D
<procto>    I like to divide that “type” of stuff into three categories: Accounting, Finance, and Economics
<procto>    in order of increasing abstraction

Economics, broadly construed, is very far-reaching. Many of our choices lay in its domain, obvious examples being what to consume, where to invest, how to spend our free time, how to navigate our careers, etc. Among those obvious examples, there is a lot of interesting research to be found. For example, positional goods – expensive but without apparent increase in utility compared to cheaper alternatives (for example, an original Picasso and an identical print). A most striking example is diamond jewelery, which rose to market prominence with ingenious social engineering by the De Beers group.

Positional goods are consumed conspicuously to display one’s wealth and status and are not limited to the rich. Fancy dressers and sports-car drivers are often not especially wealthy, but they will invest in those particular goods even at the cost of more useful expenditures (or simply saving).

Conspicuous consumption is an example of signaling. A signal is any communication or action which carries information about one’s abilities, desires, alliances. A most obvious example is a plain advertisement or a resume, but more interesting examples include education (covered in the Wiki). The idealistic view sees formal education as a grand endeavor of the soul, while economics sees it as a mere signal of abilities. (“Mere” because the students forget most of the material – it is not important in the workplace, but only for the coveted diploma.) I will have more to say to say on signaling, since it is a mind-blowing concept to learn for a utilitarian.

A much more known field generally associated with economics is game theory. Most famous is the Prisoner’s Dilemma, a simple model of cooperation and defection. (I actually learned of it long before I knew its name – in evolutionary biology, it plays a huge role in the study of the evolution of altruism.) In PD, it pays to defect if you only play one game. But when an unknown number is to be played, a tit-for-tat strategy is best. These results are now classic; less known is Hofstadter’s superrationality, which leads to cooperation even in a one-off PD game.

Moving on to more prescriptive ideas, the efficient market hypothesis is one of the few things I’d like to see taught in schools. Broadly, it states that all available information is already reflected in the market prices. Practically, this means that any clever theory you may have about stocks that will rise or fall, and it happens to be true, then other folks are likely to have already thought and acted on it. Worse, markets are anti-inductive: any useful rule regarding their future will quickly be exploited and thus made obsolete. This insight has a wonderful practical application for investing. It also suggests a more serious observation regarding the economy in general and the current crisis in particular – neither crises nor periods of intense growth can be predicted. For if such knowledge existed, it would already be reflected in the prices! It thus makes no sense to rely on or criticize pundits and regulators for market failures (or praise them for market success, as a corollary).

The final important take-away is this – if you have true knowledge, buy now, or forever hold your peace. Very few folks bet against the recent bubble, even though the market allowed such bets. It is much easier to pontificate than to seriously stand behind one’s claims, and this is also material for a future post.

There is another usage for the efficient market hypothesis – prediction markets. In a prediction market, the traded “stocks” represent an outcome, and the price can be seen as a probability measure – how strongly the market believes the outcome will obtain. A most radical usage of prediction markets is futarchy – a style of government driven by prediction markets.

A final idea I’d like to report on today, which is pretty disturbing, is the economics interpretation of human values. We’d like to believe ourselves to be at least somewhat principled, carrying about various Big Issues, but in practice we contribute very little. Being a half-cynic, it always appeared to me somewhat hypocritical, but in economics the verdict is much more harsh – people’s values are measured by their expenditures in resources. After all, if one claims to care about poverty, but does nothing substantial about it – in what sense does one actually care? This type of care would actually be considered criminal negligence if a dependent was involved. And more disturbingly: once one decided to help substantially, which policies would work?

Economics occupies a strange place in academia. It is not considered a hard science – there are no economics blogs on ScienceBlogs.com (but there are psychology blogs). Neither is it a big hit in the social sciences. To what extent do historians, sociologists, anthropologists use economics, or are even familiar with it? In the popular mind, economics is conflated with finance. Yet it appears to be in the unique position of having a no-bullshit view of individuals and societies. Whether we’d like to hear such views, and what practical conclusions we might reach, is another question entirely.

But I, for one, am fascinated. And hope you are, too :-)