I realized I’m suffering from Money Illusion, which is when decisions are influenced by nominal amounts of money. [...]]]> My friends from childhood, and even my brother, would say that I’m “stingy“. However, an Indian girl from Delhi I met some weeks ago, told me that I have “splurging tendencies”. It is, indeed, very confusing. What’s happening?

I realized I’m suffering from Money Illusion, which is when decisions are influenced by nominal amounts of money. What does this mean? Economists tend to think that people who are “rational” will make choices based only on what they could buy or sell with the money they have, and not its nominal amount. This means that $5 dollars shouldn’t make any sense to you in terms of the number (five) but more in terms of what can you buy with them. So having money illusion is when you do pay attention to the nominal money. For example, would you care if your company decides to cut your wage given that the prices in the economy went down? This would mean that your purchasing power is the same after the wage cut than before. If you do care, so you also suffer from Money Illusion. And, interestingly, people do care about this, and this behavior is consistent with previous economic crisis like the Great Depression of the early 30s.

You might have heard that in developing countries, such as India, prices (of services and non-tradable goods) and wages are much lower than in developed countries. So for tourists India could be very cheap. You could have a nice lunch in that hotel for about $10. Probably, in front of the nice hotel, in an Indian local restaurant – where mostly local people eat – you can have lunch even for $1 or $2. However, this is the big problem of the Money Illusion. If I were “rational”, I wouldn’t be thinking of Rupees in terms of US Dollars and how I would never be able to have lunch or buy something for that price in the USA. If I were rational, I would bargain even for 5 rupees (10 cents of a dollar) for the price of an auto rickshaw (small three wheels motorized taxi). As my friend from Delhi told me: “Why shouldn’t you bargain? If you save 5, 10 rupees in every auto-rickshaw ride you would be able to eat more, to buy more and to enjoy more of the money you have in India”. Which means, translated to economic jargon: you should think of the rupees in terms of the purchasing power in India, otherwise, you are NOT RATIONAL! You should think of expensive and cheap in terms of the the price index in India, and not the one in the USA.

So, is this true? Are we people not rational? I’ve been reading the book “Animal Spirits” by (Nobel Prize in Economics laureate) George A. Akerlof and Robert J. Shiller, two Kensyan economists, that try to explain business cycles with human psychology. Among the possible explanations, one of them is Money Illusion, and they bring the wage cuts story that I mentioned at the beggining of this post.In fact, they argue, people do suffer from Money Illusion.

Now, what to do? Should I start thinking in Rupees for what is left of my time in India? I don’t really know. On the one hand I already take only the local bus for 3 rupees to go every day to the office. On the other hand, I still travel in A/C class in the train. So I try to keep this balance in the limbo between rationality and irrationality. What I know for sure is that if I’ll come some day to India and earn my salary in Rupees, most probably, also my Indian friends will start calling me “stingy”. In the long run equilibrium, as all the economist will say, Money Illusion will be over.

I’ve found repeated evidence of Free Riding in Thanjavur:

These pictures are taken by me in the back seat of two different auto rickshaw that took me to the office [...]]]> In Economics, the term “Free Rider” refers to a situation when an individual “consumes more than their fair share of a public resource” (from Wikipedia).

I’ve found repeated evidence of Free Riding in Thanjavur:

These pictures are taken by me in the back seat of two different auto rickshaw that took me to the office at two different days. However, the differences have some similarities. Afterthe usual negotiation over the rate with the driver, I jumped into the auto-rickshaw (which was empty – just the driver and me), and then he starts driving, but makes a phone call, and suddenly he turns back and I see someone running towards us, and jumps into the rickshaw – in the front seat.

I don’t really know what economic inefficiencies this causes, but these people, ladies and gentlemen, are free riders…

RBC created a revolution [...]]]> I think I may have just stumbled upon the holy grail of macro-economics. I think I have found qualitative evidence in support of the seemingly ridiculous intuition of the Real Business Cycle (RBC). RBC theories try to explain why there are booms or recessions which deviate the economy from their growing trend.

RBC created a revolution in economic understanding but in recent years has experienced significant backlash. Theoretically RBC models, given a few simplifying assumptions, seem extremely sound.  They are derived from the almost now canonical micro foundation of utility maximizing individuals and profit maximizing firms. The problem however is their seemly nonsensical conclusion. Basically they imply that unemployment during recessions, even those as horrible as the current one, is optimal. The idea is that as real wages go down because of the recession, the relative value of leisure goes up and some people, even many people, choice to go on an extended holiday until the good times return. So then we would expect the unemployed in a recession to be happy. Sounds crazy right?

Well not in Sunny South Africa. I just returned from a short visit home to find many of my friends are now unemployed and to my surprise absolutely loving life. Golf 3 mornings a week, hours at the gym and of course long leisurely lunches. Funnily enough their status as victims of the global recession is also helping their sex life. In addition to the benefits of the extra gym and sun, they have more time to actively pursue girls. And their sad sob story about being retrenched really seems to work.

Now despite what you may think these people are no bums.  Most are professionals with tough undergraduate degrees and at least 3 years work experience. Granted most of them have hated the working world and only studied what they did to appease their parents but their expected future earning potential is very high. They also very importantly have no significant credit constraints. You see most still live at home and have access to their generally well off parent’s credit cards. So why shouldn’t they be taking full advantage of their fortuitous situation.

I asked sarcastically if their lifestyles had been hurt in anyway. The only possible consequence they could think of was that maybe the regular oversees December holiday would be a bit extravagant this year. Sadly renting a house for 2 weeks overlooking the sea in Cape Town is all that they will be able to afford.

How can this be the case you ask? Every good economist knows that people should smooth their consumption over their lifetimes. If they were rational they would follow Milton Friedman’s life cycle hypothesis and go on that big holiday to Brazil or Thailand. The problem is that here they run into a credit constraint. This is where their parents draw the line. They can understand their children loafing around the house while the recruitment agent searches in vain for a suitable job. An important key to this whole story is the need to keep the bankroller (in this case the parents) sure that this is just a temporary phenomenon. They need to believe that the expected future earning of their darlings is still high and one day, very soon, they will be back on their feet.

Now you might be forgiven for thinking my friends are spoiled brats. Perhaps you may even be a bit jealous. But if you put aside your personal feelings for a moment and think like an economist you will understand that they are in every sense rational utility maximizing individuals and we shouldn’t expect or want them to behave in any other way. Viva la recesión!!!

Effectively, [...]]]> I rarely drink coffee, but the other day I went with a couple of friends to Starbucks, and decided to try an iced coffee. I asked for the smallest one available. However, the woman in the counter told me: “Are you sure? You know you could get the “Grande” (medium sized) for the same price”.

Effectively, when I looked at the menu, I actually found out that both the Tall and Grande sizes (small and medium respectively in Starbucks jargon), were being selled at USD $1.95. After seeing that, I actually asked the seller, why do they even offer the small one? Who would buy the small one if they can get a medium one for the same price? Actually, she told me that some people still stick to the small, even though the price is the same. Is this rational?

Economist Tim Harford relates to Starbucks and price discrimination issues in his blog. Thanks to my friend Ussal for the link!

However, shocks can move us out of equilibrium, and it is interesting to see if after a shock we [...]]]> In economics, equilibrium is the long term stable outcome of any dynamic process. We not always reach equilibrium, and to be honest, we don’t really care how do we reach them. We only care about their existence.

However, shocks can move us out of equilibrium, and it is interesting to see if after a shock we will indeed reach again an equilibrium (i.e. an stable situation). Thinking about this process is quite interesting. The swine flu is a shock and we don’t know where is going to be the new equilibrium regarding health outcomes in the world: whether it will be a huge epidemic and all of us are going to die (I hope this is not the case), or this is going to be under control a few weeks from now.

However, the interesting thing about these kind of epidemics is that you don’t know who is out there in the streets carrying the illness. So you must take measures not to catch the flu. Ok, so how do we do that?

Well, you don’t know who out there has the flu, but you have a pretty good idea of the distribution and the probabilities of someone having it (if you see the local news). Then you should think that people will “protect” themselves more in areas with more incidence of the flu than in areas with less. However, this is not the only factor. People don’t have the same levels of risk aversion. Some of them are more averse to risk, some of them don’t care so much (some people gamble, some don’t). So depending on the (expectation of the) distribution of the incidence of the flu in your area, and your risk aversion you will take the measures.

In an area with low incidence, a person who is not risk averse won’t do nothing since he presumes there are no people out there with the flu. As your level of risk goes higher, you will do other thing, such as washing your hands regularly, wearing a mask, or not going out at all.

If you think I’m crazy, let me show you some evidence of a very risk averse people that take measures even in places where the incidence of the swine flu is very low, you can see the following picture I took today in downtown Boston:

PS: The author is not responsible if you catch the swine flu because he was making fun of someone wearing a mask and you didn’t want to wear a mask, thinking that someone will take a picture of you and put you in a blog.

It is interesting to see that rationality and incentives have ruled the world way before money markets.

And for the male readers, here is the tip of today Check out the link:

http://sciencenow.sciencemag.org/cgi/content/full/2009/408/3

An application to real life, is this scene in [...]]]> Another interesting study regarding Chimpanzees. Thanks to my friend Cesar for the link.

It is interesting to see that rationality and incentives have ruled the world way before money markets.

And for the male readers, here is the tip of today Check out the link:

http://sciencenow.sciencemag.org/cgi/content/full/2009/408/3

An application to real life, is this scene in Seinfeld:

GEORGE: Listen to this. Marcy comes up and she tells me her ex-boyfriend was over late last night, and “yada yada yada, I’m really tired today.” You don’t think she yada yada’d sex.
ELAINE: (Raising hand) I’ve yada yada’d sex.
GEORGE: Really?
ELAINE: Yeah. I met this lawyer, we went out to dinner, I had the lobster bisk, we went back to my place, yada yada yada, I never heard from him again.
JERRY: But you yada yada’d over the best part.
ELAINE: No, I mentioned the bisk.

Of course, all these questions depend on one’s preferences. Each one of us have [...]]]> Most of consumer’s theory in Economics is based on – guess what – consumption. How do people make their consumption decisions? What if the price of one good increases or if suddenly you have more income or an increase in your salary?

Of course, all these questions depend on one’s preferences. Each one of us have preferences – I for instance HATE mayonnaise, but love Spinach Pie and, say, Peanut Butter. But depending on the “levels” of my preferences I will decide how to spend my money among Spinach Pies, Peanut Butter and all the other goods. Of course that this decision depends on how much money you have available. If you had infinite money, you could buy all of everything you like, what would you care? But since this is not the case – at least for me (and if it is for you, maybe you might consider contributing to my blog with some small donation) – you have to decide what share of your budget goes to every good – and one of those “goods” might be tomorrow’s consumption, meaning: savings.

In any case, many policies are based in this simple model. If you want to create an incentive to consume more of an specific good (such as education for example) you just reduce the price of that good. Consumer’s theory shows how – in most cases – reducing prices will make you consume more of that good and less of others – proportionally.

But one thing that economist almost never talk about is that another way to generate incentives to induce an specific outcome is not to change prices or increase the wealth of the individual, but inducing a change in one’s preferences. For instance, if we convince people that sending their children to primary education is very important, then we would not see policies such as hot meals or a daily glass of milk in school – which are meant to create incentives by reducing the costs of school for your children.

But why don’t economist talk about this often? Well, it is because in real life, we don’t know – and we cannot know – what are the preferences of individuals. Therefore we don’t know how to change them. However, when creating and effective policy is out of our hands or we don’t have the political power to do so, people engage in activities that are aimed to change the preferences of people. This is what information campaigns are all about.

For example, vegetarians in the USA don’t have the political power to impose taxes on meat or poultry so that people will consume less of those. But they can engage in demonstrations and information campaigns that are intended to change the preferences of people, such as the one I saw in Boston a couple of weeks ago.

Protest Outside McDonald's

Some vegetarian protesters gathered outside McDonald’s to try to convince people not to eat there. This is clearly their best bet to reduce consumer’s demand for meat, because they cannot close the establishment or increase prices. Both measures would probably increase the cost of McDonald’s hamburgers: the second one by increasing prices directly and the first one by increasing searching costs of looking for another establishment with meat (imagine that in a small city in India should be very hard to find an restaurant nearby that sells a steak, so it will involve more time to look for it, increasing the costs of meat indirectly). However, as I said, they cannot promote these policies, so they have to try to change people’s preferences by standing there and handing out pamphlets with information.

Another example of this is Al Gore. He cannot clearly impose environmental laws in all countries in the world. So aside from lobbying for laws that protect the environment worldwide, he also tries to engage with “final consumers” by convincing them that there are some activities we could be doing to help the environment. He is clearly trying to affect our preferences so that we will invest part of our time in environmental activities (since time is costly, deciding to what we dedicate our time it has costs involved, so we also do it according to our preferences). A previous related post about recycling and why people choose most of the time not to invest their time in recycling activities is here.

Changing preferences is possible, but we don’t know how effective it would be. Think about smoking. The real decrease in smoking in the USA didn’t come after all the information campaigns against smoking, but after the bans for smoking in public closed areas. This last “policy” just increased the cost of smoking, therefore, reducing demand for it.

The reason of the  “inefficiency” of changing preferences is that we don’t know how to measure preferences, therefore, we don’t know how to change them – and if indeed they changed. However, aside from being costly and unmeasurable, it is still a very used method. The world of marketing is intended to change preferences, by trying to convince people that one particular brand is better, even though the product is the same across all brands. Information campaigns are aimed to do the same thing.

In short, next time you see an add or any information campaign, be careful, they are trying to change your preferences!