Wednesday, September 9, 2009

Irrationality -- The Latest Red Herring Pulled from the Sea of Big Government Advocacy

The fundamental result of economics is that incentives matter. These laws of economics constrain public policy dreams, but show no signs of bending or breaking.

When non-economists get their first glimpses of economics, they often see an apparent reliance on an assumption that “market participants are fully rational,” and some of them react by dismissing economic analysis.

It is true that much of technical economics features a rationality assumption, and that the assumption serves some purpose. It offers technical tractability. It simplifies the stories of why incentives matter. Acknowledging the rationality of market participants may even inject a dose of humility into a social scientist who might otherwise think he is the ideal “social engineer.”

But the rationality assumption has little to do with the fundamental result that incentives matter. Incentives, rather than rationality, have been the basis for essentially all of my blog posts, including this one, this one, this one and this one.

One of the core components of Ph.D. training in economic theory is the article “Irrational Behavior and Economic Theory,” published by the Nobel laureate Gary S. Becker in 1962. The article shows how the market would likely respond to incentives – and respond significantly – even if the individual participants were impulsive and habitual.

To see how incentives matter even when consumers are irrational, consider a toy model of the market for alcoholic beverages.

In this model, half of people are teetotalers and consume no alcoholic beverages, regardless of what prices might prevail in the market. The other half of the population are alcoholics and “irrationally” spend all of their discretionary income on alcoholic beverages, also regardless of what prices might prevail in the market.
Now introduce a liquor tax that doubles the price a consumer must pay for each of his alcoholic beverages. Not surprisingly, the teetotalers do not respond by drinking less, because they would not drink regardless. The alcoholics, however, must cut their drinking in half because they have no more discretionary income to increase their expenditures on alcoholic beverages.

More generally, a liquor tax hits the heavy drinkers the most, and they are the ones for whom necessity (that is, the fact that one’s income is limited) alone may cause them to consume less.

As an empirical matter, our economic history is full of evidence that incentives matter. Taxes discourage activity in the market taxed by raising prices paid by consumers, and subsidies encourage it by lowering the prices paid by consumers.

As a result of the impressive combination of theory and evidence compiled over the years, it has been widely acknowledged that the “law of demand” works as it should even in markets like the cigarette market where it is commonly believed that many of the individual consumers are not particularly “rational.” For example, the president of the Lung Cancer Foundation of America wrote the “cigarette tax should be used to fight lung cancer.” Other public health groups support that position — that raising the price of cigarettes would reduce smoking — even if they do not understand smokers to be completely “rational.”

Yet, ever since last year’s financial crisis, an outspoken group of economists have essentially been telling us that incentives do not matter.

The fundamental result of economics tells us, among other things, that the employment and gross domestic product impacts of fiscal policy depend critically on whether policy creates, or destroys, incentives for work and the earning of income. Nevertheless, we are told that massive federal government spending is guaranteed to stimulate the economy, even if it were wastefully spent and destroyed incentives to work, as programs like unemployment benefits and mortgage modifications do.

Additionally, anyone who might bring an analysis of incentives to the policy debate is branded “foolish,” “blind,” “crazy” and “seduced by a vision of a perfect, frictionless market system.” To many advocating more government intervention in the economy, a proper analysis of the fiscal stimulus law, and other matters of the day, would completely ignore the incentives created by public policy.

Yet only one reason – that market participants are irrational – has been given for their sudden, wholesale rejection of the fundamental result of economics.

Even if they can muster evidence for their irrationality hypothesis — perhaps the events of 2008 will ultimately be interpreted that way — they ought to know that this theory cannot deny the reality that incentives matter, even when rationality is limited. Until then, they will continue to be surprised by how bright public policy promises are followed by dismal performances.


TGGP said...

I think you'd like Micha Ghertner's "What Does the Free Market Require?". According to Matthew Mueller, the original version of the Alchian theorem (not the stronger claim made by Milton Friedman) tells a similar story.

Sheng said...

Finally someone speaks out! As a matter of fact, we are now in a recession of economics education!

Tino said...

Anyway low demand as postulated by Keynesians is a collective action problem, a matter of collective rationality that has nothing to do with individual rationality.

Larry said...

I don't like the alcohol analogy, though. Dr. M has probably never been to an AA meeting. Spending on booze by an alcoholic is not discretionary spending, it is a necessity. And when he spends his money he spends his wifes, his kids, his friends, his company's. It is irrational and economic thinking doesn't need to explain it. Many alcoholics drink themselves to death. Not rational. The idea of an own price elasticity of booze for an alcoholic is something only a sober academic could imagine.