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Policymaking Insights from Behavioral Economics

Behavioral economics is motivated by a range of empirical facts that are at apparent odds with assumptions of standard economic theory. But while behavioral approaches are becoming common in academia, it is unclear how behavioral models should inform economic policymaking in general, and central banking in particular.  This conference, entitled “Implications of Behavioral Economics for Economic Policy,” discussed the implications of behavioral economics for macroeconomic policy, with special attention to the regulatory and monetary policy responsibilities of central banks.

1. Introduction

Behavioral Economics: Its Prospects and Promises for Policymakers
Christopher L. Foote, Lorenz Goette, and Stephan Meier

2. Behavioral Aspects of Price Setting

Behavioral Aspects of Price Setting and Their Policy Implications
Julio J. Rotemberg, with comments by Jonas D. M. Fisher and John Leahy

3. Household Savings Behavior

Household Savings Behavior in the United States: The Role of Literacy, Information, and Financial Education Programs
Annamaria Lusardi, with comments by Alan S. Blinder and David I. Laibson

4. Fairness and the Labor Market

The Behavioral Economics of the Labor Market: Central Findings and Their Policy Implications
Ernst Fehr, Lorenz Goette, and Christian Zehnder, with comments by George P. Baker and John A. List

5. Behavioral Economics and the Housing Market

U.S. House Price Dynamics and Behavioral Economics
Christopher J. Mayer and Todd Sinai, with comments by Andrew Caplin and Robert J. Shiller

6. Should Central Banks Maximize Happiness?

Happiness, Contentment, and Other Emotions for Central Banks
Rafael Di Tella and Robert MacCulloch, with comments by Alan B. Krueger and N. Gregory Mankiw

7. Behavioral Economics and Economic Policy in the Past and in the Future

Behavioral Economics and Public Policy: Reflections on the Past and Lessons for the Future
James M. Poterba
Implications of Behavioral Economics for Monetary Policy
Janet L. Yellen
Behavioral Economics as “Psychologically Informed” Economic Inquiry
Lawrence H. Summers

Atul Gawande: Error in Medicine: What Have We Learned?

Over the past decade, it has become increasingly apparent that error in medicine is neither rare nor intractable. Traditionally, medicine has down- played error as a negligible factor in complications from medical intervention. But, as data on the magnitude of error aceumulate—and as the public learns more about them—medical leaders are taking the issue seriously. In particular, the recent publication of the Institute of Medicine report has resulted in an enormous increase in attention from the public, the government, and medical leadership.

Several books have been defining markers in this journey and highlight the issues that have emerged. Of particular note is Human Error in Medicine, edited by Marilyn Sue Bogner (2), published in 1994 (unfortunately, currently out of print) and written for those interested in error in medicine. Many of the thought leaders in the medical error field contributed chapters, and the contributions regarding human factors are especially strong. The book is a concise and clear introduction to the new paradigm of systems thinking in medical error.

Source

Dr. Atul Gawande, is the New York Times bestselling author of Better: A Surgeon’s Notes on Performance , Complications: A Surgeon’s Notes on an Imperfect Science, and The Checklist Manifesto: How to Get Things Right .

Information Without Context

Information without context is falsely empowering and incredibly dangerous.

As an adult, have you ever picked up a child’s shape-sorter and tried to put the square item through the round hole? Of course not. Adults know better — or at least we’re supposed to. Yet we often take square solutions and cram them into round problems.

Consider, for example, a project that falls behind schedule. A project manager is apt to adopt whatever solution worked the last time a project was falling behind schedule. If more people were added last time and that produced a successful outcome why not do it again? Our tendency to stick with what has worked in the past, regardless of why it worked, creates a powerful illusion that we are solving the problem or doing the right thing.

When posed a difficult question by an informed reporter, politicians often answer something related but simpler. The politician treats what should be a complex topic as something black and white and portrays the topic as simpler than it really is (reductive bias). In the corporate world we do the same thing when we take something that worked previously (or somewhere else) and blindly apply it to the next problem without giving due consideration to why it worked.

Maybe we’re just becoming an intellectually lazy society constantly looking for then next soundbite from “experts” on how to do something better.  We like the easy solution.

In Think Twice, Michael Mauboussin writes: “Consultants, researchers, and practitioners often observe some success, seek common attributes among them and proclaim that those attributes can lead others to succeed. This simply does not work.”

Our brains may be adult, yet we demonstrate a very childlike level of consideration. Decision makers often fail to ask key questions, such as: What’s different about this project? Under which circumstances is adding more people likely to work? and, Am I doing this because someone else is doing it?

Adopting best practices has become the reason to do something in and of itself.  It is, after all, hard to challenge logic of best practices. But what do best practices mean? Whom are they best for? What makes them successful? Can we replicate them in our company? Culture? Circumstance? Do we have the necessary skills? What are the side effects? What are the incentives? … More often than not, we embrace a solution without understanding under which conditions it succeeds or fails.

I think there are some parallels between business decision making and medicine. In Medicine our understanding of the particulars can never be complete: misdiagnosing a patient is common so doctors look at each patient as a new mystery.

A doctor, applying the same thoughtlessness spewed by management consultants might, reasonably, determine that all people with a fever have a cold. However, we know people are more complex than this simple correlation. Medical practitioners know the difference between correlation and cause. A fever by itself tells the doctor something but not everything. It could indicate a cold and it could be something more serious. Doctors, like good decision makers, check the context and seek out information that might disprove their diagnosis.

How credit cards bribe the purchasing agent

“They competed on the basis of raising prices. What other industry do you know that gets away with that?”

Charlie Munger talks about how you can bribe the purchaing agent.

I have one more anecdote: I have fun with this when I speak in front of students and professors. I say, “You all understand supply and demand curves. If you raise price, you sell less, but make more margin. So, give me four instances where the correct answer is to raise the price [meaning volume will go up].” I’ve done this about four times, and maybe one person in 50 can give me one answer that’s correct.

A recent New York Times article illuminates how Visa raises prices and bribes the purchasing agent (in this case, bank) with some of the proceeds.

Competition, of course, usually forces prices lower. But for payment networks like Visa and MasterCard, competition in the card business is more about winning over banks that actually issue the cards than consumers who use them. Visa and MasterCard set the fees that merchants must pay the cardholder’s bank. And higher fees mean higher profits for banks, even if it means that merchants shift the cost to consumers.

Seizing on this odd twist, Visa enticed banks to embrace signature debit — the higher-priced method of handling debit cards — and turned over the fees to banks as an incentive to issue more Visa cards. At least initially, MasterCard and other rivals promoted PIN debit instead.

As debit cards became the preferred plastic in American wallets, Visa has turned its attention to PIN debit too and increased its market share even more. And it has succeeded — not by lowering the fees that merchants pay, but often by pushing them up, making its bank customers happier.

In an effort to catch up, MasterCard and other rivals eventually raised fees on debit cards too, sometimes higher than Visa, to try to woo bank customers back.

“What we witnessed was truly a perverse form of competition,” said Ronald Congemi, the former chief executive of Star Systems, one of the regional PIN-based networks that has struggled to compete with Visa. “They competed on the basis of raising prices. What other industry do you know that gets away with that?”

Gresham’s Law: Why Bad Drives Out Good As Time Passes

Gresham’s Law

Whenever coins containing precious metals have been used along with base metal coins of the same denomination, both legally accepted as tender, the bad coins have driven the good coins out of circulation.

Gresham’s Law is named after Sir Thomas Gresham (1519-1579), an English financier in the time of the Tudors. However, the original principle had been stated at least forty years before by Nicolaus

However, the original principle had been stated at least forty years before by Nicolaus Copernicus and has been credited to Christian and Islamic scholars even before that. In some parts of the world (mostly Central and Eastern Europe) the law is still known as the Copernicus Law.

The idea may practically date back as far as the Athenian playwright Aristophanes. In his play The Frogs, Aristophanes compares the degradation of great politicians to the introduction of bad coinage.

I’ll tell you what I think about the way

This city treats her soundest men today:

By coincidence more sad than funny,

It’s very like the way we treat our money.

The noble silver drachma, which of old

We were so proud of, and the one of gold

Coins that rang so true

Throughout the world have ceased to circulate.

Instead the purses of Athenian shoppers

Are full of phoney silver-plated coppers.

Just so, when men are needed by the nation,

The best have withdrawn from circulation.

The coinage problem is mostly obsolete in the modern age, but the practical problems are as large as ever.

The outcome described by Aristophanes is common in competing human groups or organizations: When bad behavior has taken root, and that bad behavior has a “survival advantage” against good behavior, it becomes difficult, and occasionally impossible, to drive out the bad behavior; a process akin to natural selection.

In fact, one might call Gresham’s Law something of a special case of natural selection itself.

Forms of human behavior survive because they have a competitive edge against other behaviors. Self-interested groups naturally tend towards what works, so bad drives out good (in a moral sense) if it causes superior practical effects. This is one large reason why forms of regulation and policing are needed in human systems, to prevent the Law from working its magic.

Thomas Gresham, famous for Gresham's Law

In a wonderful illustration of this tendency, Charlie Munger applied Gresham’s Law to 1980s savings and loan banking practices in his 1984 Letter to Wesco Shareholders:

Although interest rates have subsided from the 1981-82 peak, the low and slowly changing interest rates of former years are plainly gone with the wind, as are the former government-decreed limits on interest rate competition for savings accounts and the favouritism for savings and loan associations over banks. But an agency of the U.S. Government (…) continues to insure savings accounts in the savings and loan industry, just as it did before. The result may well be bolder and bolder conduct by many savings and loan associations. A sort of Gresham’s Law (“bad loan practice drives out good”) may take effect for fully competitive but deposit-insured institutions, through increased copying by cautious institutions of whatever apparent-high-yield loan and investment strategies seem to allow competitors to bid away their savings accounts and yet report substantial earnings. If so, if “bold conduct drives out conservative conduct,” there eventually could be widespread insolvencies caused by bold credit extensions come to grief.

This can be common in some business fields. Take two drug salespeople – one willing to bribe doctors in order to make sales, and one not willing to do so. If the industry functions such that fraudulent business practices are not punished, and the bribery goes uncovered by the buyer’s organization, then bribery obviously gains a sustainable competitive advantage over non-bribery. Clearly, the deceptive practice will take hold, as salespeople unburdened by morals are promoted and compensated better than the high-roaders. It’s a clear form of Gresham’s Law.

Take also sub-prime mortgage lending practices in the lead up to the 2008 financial crisis. If two banks are competing for borrowers and one lets their standards slide to zero (or less), which is likely to prevail? Even if the practice is a “long-term loser,” it can still take hold in systems where short-term incentives provide encouragement to the actual decision makers.

Canadian Prime Minister Mackenzie King once described the origins of Gresham’s Law and its effects in a similar fashion, dubbing it the Law of Competing Standards.

In the reign of Queen Elizabeth, an official named Gresham observed that where different metals were in circulation as coinage and some were better than others of the same nominal value, the coins made of the inferior metal tended to drive the better out of circulation. The better coins were either hoarded or melted down and sold as bullion, were used in the fine arts, or were absorbed in the foreign exchanges. In other words, what Gresham discovered was that cheaper money tends to drive out dearer; that when people begin to discriminate between two coinages, they will invariably pay out the inferior and hoard the better, thus removing the better from circulation. This phenomenon once generally observed came to be described as a “Law,” and was identified with Gresham’ s name, since it was Gresham who was first successful in drawing public attention to it. Amongst money-changers, Gresham’ s Law of the precious metals is better known than the Ten Commandments.

Something analogous to Gresham’s Law will be found to obtain in the case of competing standards in Industry. Assuming there is indifference in the matter of choice between competing commodities or services, but that in the case of such commodities or services the labor standards involved vary, the inferior standard, if brought in this manner into competition with a higher standard, will drive it out, or drag the higher down to its level. This is effected by the opportunity of under-selling which comes, where in such cases human well-being is sacrificed to material ends. The superior standard, not being recognized or demanded, is unable to hold its own, and in time disappears. This Law is just as real and relentless in its operation in Industry as Gresham’s Law of the precious metals is with respect to money and the mechanism of exchange. Indeed, a more accurate exposition would describe both as manifestations of one and the same law, which I propose to call the Law of Competing Standards. I see no reason why economists should not recognize the existence of such a law, and incorporate it immediately in economic science as being quite as significant as the Law of Supply and Demand, the Law of Diminishing Returns, or any other Law accorded a place in its nomenclature.

The Law of Competing Standards is doubtless a part of the general Law of Competition, under which the cheaper of two commodities gains in competition a preference over the dearer. What Gresham discovered was an important sequence of the Law of Competition as applied to coinage; namely, the disappearance, in the course of time, of the superior metals. Observance of a like sequence in the case of standards in Industry is highly desirable. As respects labor standards, I believe that recognition of the operation of the Law of Competing Standards over ever-widening areas would do more than aught else to clear up the most baffling problems with which Industry is confronted, and to point the way to a solution of many situations which hitherto have seemed incapable of solution.

***

One practical application of Gresham’s Law and perhaps the most important is to avoid becoming part of systems where good behavior cannot win due to the nature of the Law. There are certain industries and human activities that lack the “policing” necessary to keep systems of behavior on the straight and narrow, and thus bad behavior has gained a hard-to-replace foothold. While it’s admirable to be the “cleanest shirt” in a pile of dirty laundry, certain areas of human life do not allow the clean shirts to win.

On the flip side, you’ll occasionally find situations where the good money drives out bad, and the cleanest shirts end up being worn the most. Those are the areas to aim your focus.

Gresham’s Law is one of Farnam Street’s Latticework of Mental Models.

Richard Feynman Teaches you the Scientific Method

The scientific method refers to a process of thought based on integrating previous knowledge, observing, measuring, and logical reasoning.

“If it disagrees with experiment, it’s wrong. In that simple statement is the key to science.”

— Richard Feynman

In this short video taken from his lectures, Physicist Richard Feynman offers perhaps one of the greatest definitions of science and the scientific method that I’ve ever heard. And he does it in about a minute.

Now I’m going to discuss how we would look for a new law. In general, we look for a new law by the following process. First, we guess it (audience laughter), no, don’t laugh, that’s the truth. Then we compute the consequences of the guess, to see what, if this is right, if this law we guess is right, to see what it would imply and then we compare the computation results to nature or we say compare to experiment or experience, compare it directly with observations to see if it works.

If it disagrees with experiment, it’s wrong. In that simple statement is the key to science. It doesn’t make any difference how beautiful your guess is, it doesn’t matter how smart you are who made the guess, or what his name is … If it disagrees with experiment, it’s wrong. That’s all there is to it.

For more color watch the longer version below, which offers the next 9 minutes of the lecture. In this clip Feynman explains that guessing is not unscientific: “It is not unscientific to take a guess, although many people who are not in science believe that it is.”

The Scientific Method is part of the Farnam Street Latticework of Mental Models.