Do Economists Understand Opportunity Cost?

When I took Macroeconomics with Richard Harris at SFU in 2003, he remarked one day that "there are only two things you really need to learn as an undergraduate in economics: the government budget constraint and the concept of opportunity cost." I reflected back on that comment when I read this New York Times article:

Virtually all economists consider opportunity cost a central concept. Yet a recent study by Paul J. Ferraro and Laura O. Taylor of Georgia State University (which is short and well worth reading in full, by the way) suggests that most professional economists may not really understand it. At the 2005 annual meetings of the American Economic Association, the researchers asked almost 200 professional economists the following question:

"You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $50." (answer at the end of the post)

The proportion of professional economists able to answer this question correctly?

21.3%. All of the available answers were selected with roughly equal frequency.

Let's pause a moment to contemplate the shocking awfulness of this result. Here we have 200 professional economists, most of them tenured professors at top universities, more than half of them responsible for teaching undergraduates, all of them capable of covering chalkboards with mind-binding mathematics... yet most of them are baffled by a problem from page 4 of Ben Bernanke's introductory economics textbook.

Is there any other academic field so disconnected and untethered from its own basic principles? Would a convention of physicists be unable to answer freshman questions about a ball rolling down an inclined plane?

The paper contained various defences of the economics profession in the face of this result, all of which were unsuccessful in my opinion, but one of which reflected a prejudice in the discipline that as a newcomer to economics I'd already noticed: the idea that the clarity and precision of definition is irrelevant to the skill of correct economic reasoning. It doesn't matter if you know what any of the terms mean, as long as you come up with the "correct result".

In fact, the authors of the paper surveyed nine major introductory textbooks and noted that only two of them provided a clear enough definition of the supposedly crucial concept of opportunity cost (emphasizing that both the costs and benefits of the alternative action must be weighed) in order to enable the question to be answered. The disdain for precision in this supposedly rigourous science is tolerated throughout the discipline.

However, I would assert that the economists' casual approach to clarity of meaning has two grave drawbacks. It is pedagogically ineffective (as evidenced by another fact noted in the paper - that students taking the above survey performed WORSE after taking an economics class than they did before), and it is intellectually dangerous; it flies in the face of 2,000 years of philosophical tradition on what it means to reason well and think clearly.

"If you wish to converse with me," said Voltaire, "define your terms." How many a debate would have been deflated into a paragraph if the disputants had dared to define their terms! This is the alpha and omega of logic, the heart and soul of it, that every important term in serious discourse shall be subjected to the strictest scrutiny and definition. It is difficult, and ruthlessly tests the mind; but once done it is half of any task. Will Durant, The Story of Philosophy (Chapter 2, Aristotle and Greek Science, Part 3, The Foundation of Logic).

The sophisticated manipulation of symbols counts for little if you don't know what the symbols really mean. Clarity matters. Without fully understanding opportunity cost you can't conduct cost/benefit analysis properly. You can't understand economic rent (not that modern economics has much interest in doing so, but that's another topic). You can't fully understand welfare economics. An important concept, indeed!

To any of my former colleagues from Queen's who happen to be reading this, I urge you: do better. Make the discipline better. Encourage it to think harder about what it does and says, and how it does and says it.

By the way, the answer is $10. (I myself got it wrong). Opportunity cost is defined as "the value of the next best alternative", but it is seldom emphasized that both the costs and benefits of that alternative must be considered. The Bob Dylan concert has a WTP of $50, but a ticket price of $40. The net benefit of attending the Dylan concert is 50-40 = $10, and that is the opportunity cost of attending the Eric Clapton concert.

Modelling in Economics, redux

A recent blog comment by "Cranky Observer" on Brad Delong's blog caught my eye. (The context: Brad's discussion of a model for stock valuation based on economic concepts like 'marginal cost of goods sold')

I am approaching 25 years in manufacturing companies of various types ...I have not ONCE encountered an organization that operates in the hyper-rational, mathematical manner that most posters here seem to believe is the norm in actual business. In fact the most successful of the places I have worked deliberately drove out anyone who attempted to make decisions in that manner in favor of people willing to spend long hours with the customer then make decisions intuitively.

I have also worked extensively in business information systems and associated data warehousing and I can tell you with absolute certainty that 97% of the organizations in the world have no bloody idea what their marginal cost is for purchased paperclips much less the product that they make.

Wow, that's quite an indictment. My response was as follows:

Cranky, when I started my economics education (after years in IT), I too was hostile to the use of mathematical modelling that did not take institutional and information realities into account. However, I am beginning to think some* of my hostility was misplaced for two reasons.

Firstly, simple equations governing the behaviour of stylized corporations are only meant to be approximations. It's a model. All models are false. Some, hopefully, are useful.... with a handful of equations you can describe a dynamic system that kinda, sorta, looks like the vastly more complex real world, and that's useful.

Secondly (and this is more speculative) a corporation need not consciously recognize what it is doing in order to behave in a certain way. To extend DLJ's natural argument, corporate structures could have evolved such that the end result is to behave in a way governed by a few simple equations. To borrow an analogy from the excellent Richard Dawkins: a bat's echo-location system involves the bat squeaking, listening to the echos, and inferring where the obstacles are (all in the presense of thousands of other squeaking bats). That little bat-brain must have some US military grade signal processing built in. Does the bat need to know how it does what it does? No. It just evolved: bats that are able to do this find food, bats that can't do this bump into things and die. Perhaps corporations evolve the same way :)

*(There are two places where economics goes astray, IMHO. Drawing naive and careless welfare implications from that same handful of equations is one, and simple overconfidence... forgetting that these models are only MODELS, is another.)

Phrase of the Day: "Foolish sophistication"

I enjoyed this article, discussing why the sophisiticated quantitative risk models used in finance have been failing so spectacularly over the last year in describing the expected returns of complex 'Structured Investment Vehicles' used in High Finance (tm).

http://economistsview.typepad.com/economistsview/2008/05/foolish-sophist.html

I like the phrase "foolish sophistication". My own phrase for this phenomenon, coined during my MA in Economics, was "pseudo-rigour".... analysis that covers a whole blackboard with squiggles and LOOKS rigourous, impressive, and irrefutable, but really isn't because the domain of applicability of the analysis has been forgotten. There is a certain kind of person prone to this kind of error, who is very comfortable with mathematics and quantitative analysis but isn't much of a critical thinker (critical thinkers tend to be driven mad by academic economics), and it is exactly THIS kind of person who is selected for in advanced quant finance/econ programs, and goes on to develop risk management models. They really DO believe what the models are telling them.

How Economics gets "is/ought" right, but "is" and "ought" wrong.

In Economics education, the prevailing methodology draws a distinction between "positive" economics (how things are, and why) and "normative" economics (how they ought to be). In this view, the economist's key contribution is objectivity: the ability to see how things are, without allowing one's own desires to colour their interpretation. Many observers (frequently on the "left") do not believe that such objectivity is possible; a researcher's views on how things ought to be will inevitably and unavoidably affect their view on how things are, and the researcher may as well abandon any pretense of objectivity and shamelessly promote their preferred viewpoint. These people tend to see modern economics as bearing a "right wing" agenda, and to them, the ostensible "objectivity" of economics makes its right wing influence all the more pernicious.

I have a foot in both camps. I believe objectivity is possible, and that the vigorously enforced positive/normative distinction is one of the very few things that economics gets right.* But the devil is in the details: while economics includes many of the correct ingredients when it teaches about "is" and "ought", it includes these ingredients in proportions that are so skewed as to appear intellectually negligent, if not downright sinister, to the thoughtful observer. The net effect is to leave economists with a much more "right wing" viewpoint than is warranted or healthy.

Starting out in economics, students are taught a model of perfect competition in markets ("is") and then taught that this is economically efficient in the Pareto sense ("ought").

From this foundation (and it's not a bad one), various avenues can be explored:
A) The model of perfect competition can be applied to various problems in macroeconomics, trade, etc (this is still "is"). It should be noted that solutions suggested in the framework of perfect competition and Pareto efficiency will pretty much always be market-based... any form of government intervention in a perfectly competitive market can easily be shown to be inefficient in the Paretian sense.
B) Departures from perfect competition (externalities, imperfect information, public goods) can be explored (more "is"). These are technically more difficult than the simple perfect competition model, but more "realistic", and government intervention often has a role to play.
C) The implications of these departures in B can be applied to macro, trade theory, etc. (still more "is")
D) A richer array of moral choices than those offered by Pareto optimality can be explored and quantified (like equality, justice, etc), and policy settings can be evaluated in the light of these various choices (here at last, we revisit "ought" and move it beyond utilitarianism). Exploring this richer array of market choices might also tend to lead one away from utilitarianism.

In my view, markets are rife with significant departures from perfect competition described in 2 above - perfect competition is not the rule, it is the exception. That's just the way things are: information is costly and some things can't be bought or sold in markets**. Also, I think it is self-evident that Pareto optimality is morally inadequate to guide economic policy.

If I'm right, then we can derive some good advice for economics from these observations. The first piece of advice is that economics should spend a great deal of time in economics on avenues B and C, and pay relatively less attention to A. The second conclusion is that economics should spend a great deal of time thinking about D, since this is what 80% of policy debates are really about, and economists presume to offer policy advice.

One might imagine that a first course in economics would concern itself largely with a perfect competition/Pareto efficiency framework while acknowledging the many possible limitations of that model, while more advanced courses would largely abandon the seductive ease of perfect competition and Pareto efficiency in favour of the realism and usefulness of imperfect markets and richer behavioural assumptions and moral viewpoints.

Sadly, this is not even remotely what happens.

What ACTUALLY happens is that the underlying paradigm (perfect competition and Pareto optimality) remains largely unchanged as the student progresses, but the mathematical rigour with which it is applied increases almost exponentially (especially in graduate school). The dead horse of perfect competition is beaten to a bloody pulp, and so are any critically minded, curious, and imaginative students. By the time a critically minded and curious student of economics gets to graduate school, the education process has become a nightmare.

Now, nobody *says* that Pareto efficiency is the be all and end all, nobody explicitly *denies* that departures from perfect competition exist, and your professors don't really *believe* in the completely selfish and unlovable people who inhabit our models. However, the relentless emphasis on technique*** occupies all available time and renders consideration of any broader criteria or approaches completely impossible.

When I started graduate school, I felt torn, as there were so many courses that I wanted to take. Trade looked interesting. Public Economics looked interesting. Environmental looked interesting. So much choice! So much variety! I felt like a puppy let loose in a public park. I soon learned that my "choices" were largely illusory: all the courses were the same shit with different labels on the buckets.

WHY this happens, I do not know. It might be institutional (perfect competition is simply easier to teach cf. Blaug). Partly it is because economics professors really believe that teaching you the high end stuff is really the best way to learn the low end stuff, even if they admit the low end stuff is better for you (cf. Solow). There might be something sinister at work, a shadowy cabal of capitalists wants it this way. I believe that this is just an example of accidental evolution: the profession didn't have to become this way, it just did. Those who don't want to get with the program leave, and the new leaders of the discipline end up creating little clones of themselves.

That this all does incalculable ruin to the world, as "ruin" is generally understood by most people, goes without saying.

* I might be wrong. In doing positive economics, one must inevitably describe what happens in terms of models. The economy is simply too complicated to describe or explain otherwise. But models include assumptions: behavioural assumptions about people and institutional assumptions about how the world works.

** Here, I am not alluding to the notion that some things "shouldn't be" bought or sold in markets. That's not an unworthy idea but it lies firmly on the normative side of the ledger. I'm saying that for technical reasons, they CAN'T be.

*** Economics professors claim that the emphasis on technique is necessary to do "cutting edge" research in the field, but what is "cutting edge" (ie what impresses the closed profession of academic economists and allows advancement in their insular little world) and what is actually useful are two different things.

Modern Economics is Sick

This Mark Blaug article is brilliant. I used to wonder if I was crazy for thinking about grad school as I did.

http://www.irpp.org/po/archive/sep97/blaug.pdf

If I'd read this before I'd gone back to school, I might have changed my mind.