Reasoning with Economics: Models and Information

Reasoning with Economics:Models and Information Chapter 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Why Be Abstract When You Have Facts? Economic models are simplifications of reality that help us to explain observed facts and make predictions about behavior. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Modeling Choice - Is Economics a Science? Positive economics describes and analyzes things as they are (or as objectively as they can be seen). Normative economics is about how things ought to be—it explicitly acknowledges the researcher’s values. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Modeling Choice - Rationality Economics studies the choices people make in the face of constraints that limit their options. Underlying this definition is an assumption that people act rationally, with an eye toward attaining objectives they have chosen. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Modeling Choice - Opportunity Cost and Forward-Looking Decisions The economy’s productive resources are limited, and a decision to use them in one place is also a decision not to use them elsewhere. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Modeling Choice - Thinking at the Margin Economists tend to examine choices at the margin, like those between the chances of a little more money (or some other desirable thing) and the chances of a little less life. If your drive to work takes 10 minutes on the freeway and 40 minutes on streets, is the freeway a rational choice? Picking it roughly doubles your odds of dying in an accident. When you choose the freeway you are accepting a higher risk of death in exchange for 30 minutes more sleep or an extra cup of coffee. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Objectives and Constraints - Maximizing Utility A model of choice starts by assuming that people want to make themselves as well off as possible. Economists say that a person attempts to maximize his utility, a subjective measure of well-being unique to that person. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Objectives and Constraints - Selfishness, Altruism, and Fairness Your utility probably depends on more than just the goods and services you enjoy. Almost everyone cares about the well-being of others, such as family members. “Fairness” might best be described as a normative term to describe a distribution of goods and opportunities with which a person agrees. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Objectives and Constraints - Constraints • Many different types of constraints put limits on our choices, and differences in the constraints different people face may lead them to different choices. For example: • Time constraints: The day has only 24 hours, life has a finite length, and we cannot make time flow in reverse. • Financial constraints: People’s incomes are limited, their abilities to borrow differ, and liquidity can constrain them—for instance, assets like houses cannot be quickly sold for predictable prices. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Objectives and Constraints - Accepting and Altering Constraints Many economic models simplify a complex situation by treating constraints as unalterable. Sometimes routine actions can alter a constraint, as when a manager cuts electricity costs by installing motion sensors that turn out lights in unoccupied areas. More drastic innovations and inventions can greatly change constraints or even eliminate them. More sophisticated models will accommodate the possibility of altering constraints. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Competition Whenever a good or service is scarce, people compete to determine who gets how much of it. Competition takes many forms, for example, people everywhere compete by trading with others, the winners being those who make more attractive offers to prospective counterparties. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Relevant Information Much of the information that most matters for our lives is never seen in classrooms or textbooks, and this book will be no exception. Its purpose is to show you the remarkable usefulness of thinking like an economist. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Acquiring Information In some ways information is a good like many others—it has value but is costly to obtain. If so, there will be a time to stop hunting out information and make a choice based on what you have learned. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Making Information Known Understanding the value of information and the nature of opportunity costs can help us understand the economic value of advertising. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ERRORS AND BIASES IN INFORMATION PROCESSING (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Limited Capabilities and Bounded Rationality Simple models of rationality may yield general predictions about behavior, but the accuracy of the predictions might increase if we knew more about how people reason. We may wish to make perfectly rational choices (at least in our business lives), but mental limitations make that an impossible standard. Thus, economists often treat decision makers as boundedly rational, trying their best for rationality but constrained by limited information and limited processing abilities. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How Rational Are People? People’s calculating abilities are indeed limited, and their foresight is far from perfect. But what if a person repeatedly makes the same error and fails to learn from experience? Is this rational? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Reasoning with Probabilities Decisions must be made without complete information, and we often cannot process that information in ways that lead to correct conclusions. Instead of thinking rigorously, people often use rules of thumb derived from experience or illogical shortcuts that economize on their mental capabilities. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Reasoning with Probabilities - Heuristics Imagine you are given the following description of a person: Jones is tall and not very muscular. He wears wire-rim glasses, has very precise handwriting, likes to help others, and enjoys reading. Is Jones more likely a truck driver or a librarian? Before you said librarian (as almost everyone does), did it cross your mind that there are 30 times more truck drivers in the United States than there are librarians? That 82 percent of all librarians are women? You probably used a representativeness heuristic, and so trusted in your image of librarians that you failed to collect additional data. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Selection Bias • We often hear that dolphins are playful and smart. There are verified stories of drowning people who were pushed toward shore by helpful dolphins. • Unfortunately, these stories tell nothing about whether dolphins are smart, or even whether they are nice. The only people who lived to tell them are those who were pushed toward shore. • The ones who were pushed out to sea never turned up again.

SIMPLICITY AND ACCURACY IN INFORMATION PROCESSING (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Smart Shortcuts Recent research on fast and frugal heuristics shows that people have abilities to devise shortcuts in reasoning that can be surprisingly effective. These heuristics often produce results nearly as accurate as methods that require more information, involve complex calculations, or tax our memories. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Recognition Heuristics • Is San Diego or San Antonio the larger city? • It might surprise you that nearly 100 percent of students surveyed at an elite German university correctly chose San Diego, but only 62 percent of students at a similar American university got it right. • When facts are at issue the correct answer is often the one people recognize, and the incorrect answer is the one they do not. Put another way, because Americans were familiar with both cities they were not ignorant enough to know the answer. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Can Groups Be Smarter than Their Members? An instructor brings a jar of jelly beans to class and asks each student to guess how many it contains. They cannot talk it over or see each others’ estimates. Almost every time the class average is within 3 percent of the actual number, despite the fact that many individual guesses are less than half or more than twice the true amount. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Racetrack Bettors Many bettors have little horse sense as they go for entertainment rather than income, but their aggregate bets are often good estimates of the true probabilities of winning, placing, and showing. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Event Markets In most elections (inside and outside the United States), event markets, like the Iowa Electronic Market that allows small bets on the outcomes of political events, are superior to the polls at predicting winners, whether on the eve of an election or weeks before it. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Event Markets – Which Crowds are Smart? • Smart groups often have four underlying characteristics: • …diversity of opinion (each person should have some private information, even if it’s just an eccentric interpretation of the known facts), • …independence (people’s opinions are not determined by the opinions of those around them), • …decentralization (people are able to specialize and draw on local knowledge), and • …aggregation (some mechanism exists for turning private judgments into a collective decision) (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Economics, Business, and Life Models that use economic reasoning can help you think more clearly about the behavior of others, and perhaps your own behavior as well. Experience has already taught you a lot about economics, even if you call it something else. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Reasoning with Economics: Models and Information