Month: May 2006

Let’s start with five:

1. Believe in comparative statics, the income effects will wash out in the aggregate.  (Larry Summers once taught me: "Economics is a theory of substitution effects but we live in a world of income effects.")

2. The model predicts well, don’t worry about the assumptions.  (As Paul Samuelson pointed out, don’t false assumptions, by their nature, involve a very large number of (sometimes implicit) false predictions?)

3. People may make mistakes when the stakes are small, but as they become more decisive over larger prizes, the irrationality goes away.  (Name any major politician or how about Tom Cruise on Oprah?)

4. IS-LM models make sense.

5. There are many firms in the sector, they must be price-takers.  (Does demand go to zero when your local Chinese restaurant raises prices by a penny?  Or for that matter by a dollar?)

Do you wish to suggest other lies in the comments?

Here is Guy Kawasaki with The Top Ten Lies of Engineers.  The Top Ten Lies of Entrepreneurs.  The Top Ten Lies of Venture Capitalists.  Thanks to Chris F. Masse for the idea and the pointer to Kawasaki.

Behavioral economic research has tended
to ignore the role of cultural differences in economic decision-making.
The authors suggest that a systematic bias affects existing behavioral
economic theory – cognitive biases are often assumed to be universal.
To examine how cultural background informs economic decision-making,
and to test framing effects, morality effects, and out-group effects in
a cross-cultural study, the authors conducted an experiment in the
United States and China. The experiment was designed to test cultural
and cognitive effects on a fundamental economic phenomenon – how people
estimate the financial values of objects over time.
 
Results
of the experiment demonstrated dramatic cultural differences in
financial value estimations, as well as on the influence of variables
such as framing effects. Chinese participants made higher object value
estimates than Americans did, even when adjusting for differing
national inflation rates. In addition, the results showed that
contextual information, such as framing, morality information, and
group membership affected judgments of financial values in complex
ways, particularly for Chinese participants. The results underscore the
importance of understanding the influence of cultural background on
economic decision-making. The authors discuss the results in the
context of behavioral law and economics, and propose that importing
cultural competence into behavioral models can lead to cognitive
debiasing, both temporary and permanent.

Here is the link to the paper.  Bravo I say.  Have you heard of the phenomenon of "running amok"?  It is not rational in anything but the tautological Misesian sense.  And it happens at much higher rates in nations where it is culturally central, such as Malaysia.  Thanks to www.politicaltheory.info for the pointer.

I said yesterday that the Bush tax cuts are actually tax shifts.  But that was
being kind, once we take into account tax roughening, Bush’s tax
cuts are tax increases.

Deficits caused by tax cuts can reduce the total tax burden if they are used to smooth taxes.  Too see why remember that holding tax revenues constant it’s better to spread taxes across as many goods as possible.  The first penny of apple taxation causes you to stop consuming the marginal apple – the one that was barely worth its price anyway.  Raise apple taxes a bit more and you stop consuming apples whose value far exceeds their price.  Better to lose one marginal apple and one marginal orange than two apples the second one of which was really valuable.

The same thing is true of labor.  The first dollar of wage tax causes you to cut back on the last hour of work, but your wage on that last hour was barely worth the lost leisure time anyway so the first dollar of tax doesn’t create too much waste.  Raise taxes more, however, and you cut into valuable infra-marginal hours.  It’s better, therefore, to spread taxes over time periods – as Arrow taught us, the future is just a different set of goods.

Unfortunately, today’s deficits are tax roughening rather than tax smoothing.  Even with big cuts in Medicare and Social Security, taxes will rise.  Smoothing taxes now requires higher taxes and lower spending.  Unfortunately we have had tax cuts and spending increases and thus the tax stream has become rougher and the total tax burden has increased.

Several years ago in an op-ed I wrote:

I favor a much smaller government but I do not favor the Bush tax cut.
Or, to be more precise, I would support a tax cut if one had been
proposed. But so far President Bush has neither proposed nor
implemented a tax cut–only a tax shift.

Brad DeLong nicely explains the difference:

I, full professor Brad DeLong, am having lunch with lecturer Dariush Zahedi
today. After lunch, I presume Dariush will say we should split the bill–$10
each. Suppose I say: "That isn’t fair. Berkeley pays you less (a lot less: what
we do to our lecturers is shameful) than it pays me. I should lay out more cash
for this lunch. How about this: I put down $5 cash, you put down $0, and we put
the balance on your credit card. That would be fairer, wouldn’t it?"

Dariush would then be an unhappy camper. He would think–correctly–that I
was mocking him.

Back in 2000 the U.S. government was running a surplus of some $200 billion a
year–a broadly appropriate fiscal policy, given the state of the business cycle
and the looming health care costs dilemma. Today we’re running a deficit of
$300-$400 billion a year. Relative to what would be a sane, reality-based, and
appropriate fiscal policy, the Bushies are putting $500-$600 billion this year
on our collective national credit card. That bill will come due: somebody has to
pay it. To pretend that it won’t…well, that would be the equivalent of me telling Dariush that only cash matters:
that when we talk about who paid for lunch, we should count only cash put down
now, and we shouldn’t count the fact that his credit card bill will show an
extra $15 due next month.

Here it is, run by Peter Klein and Nicolai Foss.