Claiming that the faults of big business are not the faults of capitalism is logically and morally equivalent to saying that the faults of big governments are not the faults of communism.
Last I heard, the modern corporation was defined by its system of distributing residual claims and the nature of those claims. Just as socialism is a definite system of governance and socialists should not be blurring it to simply mean anything that desires the greater benefit of the society, capitalism is also a very definite system of ownership and cannot be over-extended to mean just all the good things with the idealised free market. Corporatism is a stupid word.
So, stop with that argument already. It is tautological.
Monday, November 17, 2008
Wednesday, October 29, 2008
On Economic Thought - 6
From behavioural finance, we move on to behavioural economics. The original and most pervasive idea in behavioural economics is that of bounded rationality. This simply means that contrary to the assumptions of neoclassical economics, human beings are not perfectly rational and often make errors in judgment, though full rationality could be a plausible first cut approximation. We do not optimize economic well-being functions like utility, because we lack the information processing capabilities required to optimize. Instead, we satisfice, i.e. we have certain targets in our mind that we set through a combination of experience, incomplete information and intuition, and then we work towards achieving those targets. We are happy with results that are sub-optimal but still good enough to meet the thresholds that we set for ourselves.
Computer engineers or others with some exposure to the field of artificial intelligence will recognise the difference between optimizing and satisficing to be exactly analogous to the difference between a best-result algorithm and a quickest/computationally easiest good-result heuristic. Thus, the central idea used to move from standard programming to AI is exactly the basis of the move from neoclassical to behavioural economics. It is no surprise then that Herbert Simon, the economist who introduced the idea of bounded rationality, was also a computer scientist. In fact, he is the only person ever to win both the Nobel in economics as well the ACM Turing Medal (possibly the highest recognition in the field of Computer Science). Herb Simon is probably the economist most under-explored by the mainstream, though he finds some pride of place in management literature.
Apart from bounded rationality, behavioural economics also makes some very interesting changes to neoclassical utility theory. Research by Kahneman and Tversky showed that people are not risk-averse, rather they are loss averse, i.e. they place higher weight on the possibility of losing some money as opposed to gaining the same amount. People also measure outcomes relative to some benchmarks that they set for themselves, and a typical example of this is an investor refusing to sell a stock at a loss in a market that is going downwards. Thus, if I have bought a stock at Rs 1000, I will refuse to sell it at 900, even if I believe that tomorrow the price is going to be 800 and rationally, I am better off selling today and holding cash. People value the same thing more once they posses it (status quo bias and endowment effect) and discount future cash flows by inordinately large discount rates (hyperbolic discounting). Importantly, people give different answers to questions that are logically equivalent depending upon the way they have been framed and give logically incorrect answers to seemingly simple rational choice questions if they are posed differently (framing). All this work led to what is known as cumulative prospect theory, which Avataram has sometimes written about. It is essentially an alternative to neoclassical utility theory.
Many of these assertions explain a lot of phenomena that we observe in practice to be near-ubiquitous. The endowment effect results in people demanding higher prices for houses they own than they would be wiling to pay themselves if they were customers, resulting in many unsold houses and reduced liquidity in the real estate market. Hyperbolic discounting means that people systematically err by saving too little for their retirement, something that we see rationalized away in the name of 'living for the moment'. Framing effects imply that people will respond to the exact same information and decision problem differently if the information is unstructured.
Behavioural economics has not only introduced new ideas, its central technique of conducting experiments with people to reveal utility preferences and cognitive biases is also very different from the largely arm-chair approach of mainstream microeconomics. It seems only intuitive that a science that is founded upon assertions of human behaviour follow this approach, but for some strange reason economists of the past have had a disdain for experimentation. The Austrian school was the epitome of such disdain. But more on the Austrian school later.
Back to experiments in economics. Enthused by what I read about behavioural economics, I tried conducting an experiment myself on the relevance of how decision problems are framed.
If you answered 2, you'd be in the majority but you'd be wrong. While this may seem to be an effort to illustrate the stereotypes and biases prevalent in society, it is actually nothing of the sort. Bias or no bias, the set of lesbian newsreaders is a subset of the set of all newsreaders. The probability that somebody is a newsreader is thus always greater than or equal to the probability of her being a lesbian newsreader. If you are a rational economic agent who makes the correct choices in decision problems, you would have chosen 1, irrespective of the mass of information presented to you and irrespective of any biases that you may have. However, the vast majority of people across levels of education, political beliefs and geographies pick 2.
I got this simplest of decision problems off something I was reading on the internet, and have posed it to many friends of mine, all MBAs from top institutes in the country. Barring one, every single one of them has given me the wrong answer. One of them (Frust), when offered the solution, suggested that the context matters - had the question been asked in a test measuring his quantitative abilities and knowledge, he might have given the correct answer. Over a dinner table conversation, he faltered. He may very well be right, and that only goes to illustrate the overarching importance of framing - the way and context in which information is presented to you may radically alter your decision. And we all know that real world information and decision choices resemble a dinner-table conversation far more than a probability test.
(You could also use this fact to infer that MBAs are stupid. That conclusion, however, will be dependent on your biases and has nothing to do with such googly-type solutions to decision problems.)
While Herb Simon would count as the big daddy of all behavioural economists, Richard Thaler is the one most prominent now. However, whenever I have read about Keynes and his theories, I have had a sneaking feeling that he may be the original behaviourist. The man who called the stock markets a beauty contest seemed unlikely to be anything else. Indeed, recent research into interpreting his works has followed that path, and the foremost researcher on that front happens to be George Akerlof.
Akerlof won the nobel for his seminal work on information asymmetry, which resulted in the formulation of the adverse selection problem. We don't need to go into the details but suffice it to say that his work introduces the last of the most significant tenets of behavioural economics. Not only are people incapable of processing large amounts of information and prone to multiple cognitive biases, they often do not even have the information rquired to make the requisite optimization or satisficing, and this leads to multiple complications. When this aspect is introduced, even Kenneth Arrow could be counted as a seminal behaviourist. Indeed, his 'learning by doing' model was probably the first endogenous model of growth.
The most interesting thing is that Akerlof has been looking at a theory of 'behavioural macroeconomics' by re-interpreting he works of John Maynard Keynes. He has been among the foremost New Keynesians with his efficiency wages theory that explains how people who get jobs during good times lock in higher-than-equilibrium salaries, and people who look for work during busts have to continue with lower-than-equilibrium salaries even when the times are good. His formal exposition of this intuitive idea has led to considerable new developments on the Phillips curve, the emprically known trade-off between reducing unemployment and reducing inflation. He has also been collaborating with Robert Shiller towards this goal of a theory of behavioural macroeconomics, which can be loosely described as the current New Keynesian macromodel with microfoundations explicitly in behavioural economics. Currently, the microfoundations of the New Keynesian macromodel are largely neoclassical, with a few market imperfections.
From whatever little sense I have been able to make of economics, George Akerlof happens to be my favourite economist. Robert Shiller is another one to watch out for, and let me predict here that he may get the Nobel soon enough, in 2009 or 2010. Shiller correctly called the dot com and the real estate bubbles, but more on him later.
Computer engineers or others with some exposure to the field of artificial intelligence will recognise the difference between optimizing and satisficing to be exactly analogous to the difference between a best-result algorithm and a quickest/computationally easiest good-result heuristic. Thus, the central idea used to move from standard programming to AI is exactly the basis of the move from neoclassical to behavioural economics. It is no surprise then that Herbert Simon, the economist who introduced the idea of bounded rationality, was also a computer scientist. In fact, he is the only person ever to win both the Nobel in economics as well the ACM Turing Medal (possibly the highest recognition in the field of Computer Science). Herb Simon is probably the economist most under-explored by the mainstream, though he finds some pride of place in management literature.
Apart from bounded rationality, behavioural economics also makes some very interesting changes to neoclassical utility theory. Research by Kahneman and Tversky showed that people are not risk-averse, rather they are loss averse, i.e. they place higher weight on the possibility of losing some money as opposed to gaining the same amount. People also measure outcomes relative to some benchmarks that they set for themselves, and a typical example of this is an investor refusing to sell a stock at a loss in a market that is going downwards. Thus, if I have bought a stock at Rs 1000, I will refuse to sell it at 900, even if I believe that tomorrow the price is going to be 800 and rationally, I am better off selling today and holding cash. People value the same thing more once they posses it (status quo bias and endowment effect) and discount future cash flows by inordinately large discount rates (hyperbolic discounting). Importantly, people give different answers to questions that are logically equivalent depending upon the way they have been framed and give logically incorrect answers to seemingly simple rational choice questions if they are posed differently (framing). All this work led to what is known as cumulative prospect theory, which Avataram has sometimes written about. It is essentially an alternative to neoclassical utility theory.
Many of these assertions explain a lot of phenomena that we observe in practice to be near-ubiquitous. The endowment effect results in people demanding higher prices for houses they own than they would be wiling to pay themselves if they were customers, resulting in many unsold houses and reduced liquidity in the real estate market. Hyperbolic discounting means that people systematically err by saving too little for their retirement, something that we see rationalized away in the name of 'living for the moment'. Framing effects imply that people will respond to the exact same information and decision problem differently if the information is unstructured.
Behavioural economics has not only introduced new ideas, its central technique of conducting experiments with people to reveal utility preferences and cognitive biases is also very different from the largely arm-chair approach of mainstream microeconomics. It seems only intuitive that a science that is founded upon assertions of human behaviour follow this approach, but for some strange reason economists of the past have had a disdain for experimentation. The Austrian school was the epitome of such disdain. But more on the Austrian school later.
Back to experiments in economics. Enthused by what I read about behavioural economics, I tried conducting an experiment myself on the relevance of how decision problems are framed.
Consider the following question
There's a red-haired woman who is single. She plays tennis, is a feminist and a member of Greenpeace. What is she more likely to be ?
1) A newsreader
2) A lesbian newsreader
If you answered 2, you'd be in the majority but you'd be wrong. While this may seem to be an effort to illustrate the stereotypes and biases prevalent in society, it is actually nothing of the sort. Bias or no bias, the set of lesbian newsreaders is a subset of the set of all newsreaders. The probability that somebody is a newsreader is thus always greater than or equal to the probability of her being a lesbian newsreader. If you are a rational economic agent who makes the correct choices in decision problems, you would have chosen 1, irrespective of the mass of information presented to you and irrespective of any biases that you may have. However, the vast majority of people across levels of education, political beliefs and geographies pick 2.
I got this simplest of decision problems off something I was reading on the internet, and have posed it to many friends of mine, all MBAs from top institutes in the country. Barring one, every single one of them has given me the wrong answer. One of them (Frust), when offered the solution, suggested that the context matters - had the question been asked in a test measuring his quantitative abilities and knowledge, he might have given the correct answer. Over a dinner table conversation, he faltered. He may very well be right, and that only goes to illustrate the overarching importance of framing - the way and context in which information is presented to you may radically alter your decision. And we all know that real world information and decision choices resemble a dinner-table conversation far more than a probability test.
(You could also use this fact to infer that MBAs are stupid. That conclusion, however, will be dependent on your biases and has nothing to do with such googly-type solutions to decision problems.)
While Herb Simon would count as the big daddy of all behavioural economists, Richard Thaler is the one most prominent now. However, whenever I have read about Keynes and his theories, I have had a sneaking feeling that he may be the original behaviourist. The man who called the stock markets a beauty contest seemed unlikely to be anything else. Indeed, recent research into interpreting his works has followed that path, and the foremost researcher on that front happens to be George Akerlof.
Akerlof won the nobel for his seminal work on information asymmetry, which resulted in the formulation of the adverse selection problem. We don't need to go into the details but suffice it to say that his work introduces the last of the most significant tenets of behavioural economics. Not only are people incapable of processing large amounts of information and prone to multiple cognitive biases, they often do not even have the information rquired to make the requisite optimization or satisficing, and this leads to multiple complications. When this aspect is introduced, even Kenneth Arrow could be counted as a seminal behaviourist. Indeed, his 'learning by doing' model was probably the first endogenous model of growth.
The most interesting thing is that Akerlof has been looking at a theory of 'behavioural macroeconomics' by re-interpreting he works of John Maynard Keynes. He has been among the foremost New Keynesians with his efficiency wages theory that explains how people who get jobs during good times lock in higher-than-equilibrium salaries, and people who look for work during busts have to continue with lower-than-equilibrium salaries even when the times are good. His formal exposition of this intuitive idea has led to considerable new developments on the Phillips curve, the emprically known trade-off between reducing unemployment and reducing inflation. He has also been collaborating with Robert Shiller towards this goal of a theory of behavioural macroeconomics, which can be loosely described as the current New Keynesian macromodel with microfoundations explicitly in behavioural economics. Currently, the microfoundations of the New Keynesian macromodel are largely neoclassical, with a few market imperfections.
From whatever little sense I have been able to make of economics, George Akerlof happens to be my favourite economist. Robert Shiller is another one to watch out for, and let me predict here that he may get the Nobel soon enough, in 2009 or 2010. Shiller correctly called the dot com and the real estate bubbles, but more on him later.
Monday, October 27, 2008
On Economic Thought - 5
Last time, I asserted how financial markets and securities help cut out the tautological subjectivity of value. Well, they go further. The idea of 'rationality' is well defined. 'Efficiency of a market' can be tested sharply because the implication of an 'efficient' market is very objective and can be checked for against market prices. There is a tremendous amount of high quality data available. Finally, even information has some precise definitions in the field of finance.
Among the most celebrated and debated ideas in finance is the efficient market hypothesis (EMH). What does it say? Well simply, that financial markets are rational and hence stocks are fairly priced all the time. In case there is a move away from this ideal equilibrium, it adjusts back to the stable equilibrium state fast enough.
But isn't that absurd? To assume that investors are always rational? Well, that's the catch. The rationality of a market on the whole (or indeed, of the entire economy) has very little to do with the rationality of every individual participant. You see, for the market to be rational, it is not necessary for every, or indeed, even most investors to be rational. All that is needed is that
1) The 'irrationality' is randomly distributed across people and has a mean of zero.
2) There are a reasonable number of 'arbitrageurs' who have the capital and the freedom to make use of those opportunities in the market when stocks are incorrectly priced.
Thus, when Ravikiran asserts here and here that retail investors in India are stupid and hence the EMH may not hold for India, it makes me wonder if he understands the EMH at all. As long as the idiot retail investors in India (or elsewhere) are idiotic in their own randomly distributed ways, the EMH would still hold. The argument is simple - the overestimations of the positive idiots will cancel out the underestimations of the negative idiots. The only problem arises when idiocy is systemic - when idiots make mistakes that are very similar to each other.
Even if the mistakes are systemic, the EMH may not be affected. If there are some few rational people working for a few hedge funds or investment banks who spot these systemic mistakes, they will use their money to capitalize on it to make riskless profits, or arbitrage. These smart guys will make the EMH work by two means
1) The mispricing will correct immediately.
2) If the mispricing does not correct, the arbitrageurs will keep making money and over some time drive out the idiot investors who will be losing their shirts.
Thus, any reasonably mature financial market should be efficient. In this fully developed form, the EMH was among the technically soundest theories to have propped up. It ruled out the efficacy of either technical or fundamental analysis, and implied that your best bet in investing was to buy an index fund, or to passively replicate the benchmark index.
The theory was especially popular in the Chicago School tradition. It fit beautifully with the idea of rational expectations and other such tenets of neoclassical economics. Opposition to this theory has come from various quarters. One of them has been the value investors - the supremely successful stock pickers of the Warren Buffet mould. They rubbish the idea of the market always being fairly priced, buy when things are cheap, sell when they are expensive, and generally make millions doing this. However, it must be noted that they are only aghast at the claim that markets are always efficient. Because, this strategy of buying low and selling high makes money only if prices will someday be correctly priced in. In this manner, the value investor is only performing the role of the rational, efficiency-inducing arbitrageur of the EMH. The value investing school thus quarrels with the more extreme conclusions of the EMH, but has no strong theoretical model to oppose it.
The real challenge to the EMH has come from behavioural finance. Now Avataram probably believes that he has introduced the Indian blogosphere to the existence of Daniel Kahneman, but I stumbled upon these theories while preparing for my summer internship interviews last year. Behavioural finance hit the EMH on its two most important pillars - on the assumption of irrationality being random instead of systemic, and on the assumption of the possibility of profiteering from riskless arbitrage.
Multiple experiments have shown that people across levels of education make choices that are wholly inconsistent with the idea of risk-averse expected utility maximization. The Ellsberg paradox and the Allais paradox are two illustrations of that. More importantly, arbitrage is never truly riskless. There are limits to arbitrage, and the most important one is capital preservation. Arbitrageurs can be driven out of business if the mispricing that they are trying to take advantage of deepens and does not correct as quickly as they'd want to. Their trades will keep losing money, and they run the risk of getting fired for losing money or underperforming their benchmarks. About 50 years before behavioural finance became en vogue, this idea was captured beautifully by Keynes in the quote that I'm sure many have heard - "Markets can stay irrational longer than you can stay solvent". Indeed, if there is one adage that you should know and remember about the financial markets, it is this one. The most striking example of the risk of arbitrage preventing a rational outcome in the markets has been the celebrated case of Royal Dutch and Shell, where stocks of the exact same company split in a 60:40 ratio refused to trade in that ratio for elongated periods of time.
Research into behavioural finance and behavioural economics has over the years produced a rich body of evidence of the systemic cognitive biases that individuals have. The idea of the importance of market microstructre has also gained relevance. I have long believed that if mathematics is at the base of the natural sciences, and philosophy is at the base of the humanities, then psychology is definitely at the base of the social sciences. Since economics is a somwhat scientific social science, I should probably say that cognitive science is at the base of all economics. Some of the ideas presented by the behavioural economists are easily among the most compelling arguments on economic activity that I have come across. But more on that later.
Among the most celebrated and debated ideas in finance is the efficient market hypothesis (EMH). What does it say? Well simply, that financial markets are rational and hence stocks are fairly priced all the time. In case there is a move away from this ideal equilibrium, it adjusts back to the stable equilibrium state fast enough.
But isn't that absurd? To assume that investors are always rational? Well, that's the catch. The rationality of a market on the whole (or indeed, of the entire economy) has very little to do with the rationality of every individual participant. You see, for the market to be rational, it is not necessary for every, or indeed, even most investors to be rational. All that is needed is that
1) The 'irrationality' is randomly distributed across people and has a mean of zero.
2) There are a reasonable number of 'arbitrageurs' who have the capital and the freedom to make use of those opportunities in the market when stocks are incorrectly priced.
Thus, when Ravikiran asserts here and here that retail investors in India are stupid and hence the EMH may not hold for India, it makes me wonder if he understands the EMH at all. As long as the idiot retail investors in India (or elsewhere) are idiotic in their own randomly distributed ways, the EMH would still hold. The argument is simple - the overestimations of the positive idiots will cancel out the underestimations of the negative idiots. The only problem arises when idiocy is systemic - when idiots make mistakes that are very similar to each other.
Even if the mistakes are systemic, the EMH may not be affected. If there are some few rational people working for a few hedge funds or investment banks who spot these systemic mistakes, they will use their money to capitalize on it to make riskless profits, or arbitrage. These smart guys will make the EMH work by two means
1) The mispricing will correct immediately.
2) If the mispricing does not correct, the arbitrageurs will keep making money and over some time drive out the idiot investors who will be losing their shirts.
Thus, any reasonably mature financial market should be efficient. In this fully developed form, the EMH was among the technically soundest theories to have propped up. It ruled out the efficacy of either technical or fundamental analysis, and implied that your best bet in investing was to buy an index fund, or to passively replicate the benchmark index.
The theory was especially popular in the Chicago School tradition. It fit beautifully with the idea of rational expectations and other such tenets of neoclassical economics. Opposition to this theory has come from various quarters. One of them has been the value investors - the supremely successful stock pickers of the Warren Buffet mould. They rubbish the idea of the market always being fairly priced, buy when things are cheap, sell when they are expensive, and generally make millions doing this. However, it must be noted that they are only aghast at the claim that markets are always efficient. Because, this strategy of buying low and selling high makes money only if prices will someday be correctly priced in. In this manner, the value investor is only performing the role of the rational, efficiency-inducing arbitrageur of the EMH. The value investing school thus quarrels with the more extreme conclusions of the EMH, but has no strong theoretical model to oppose it.
The real challenge to the EMH has come from behavioural finance. Now Avataram probably believes that he has introduced the Indian blogosphere to the existence of Daniel Kahneman, but I stumbled upon these theories while preparing for my summer internship interviews last year. Behavioural finance hit the EMH on its two most important pillars - on the assumption of irrationality being random instead of systemic, and on the assumption of the possibility of profiteering from riskless arbitrage.
Multiple experiments have shown that people across levels of education make choices that are wholly inconsistent with the idea of risk-averse expected utility maximization. The Ellsberg paradox and the Allais paradox are two illustrations of that. More importantly, arbitrage is never truly riskless. There are limits to arbitrage, and the most important one is capital preservation. Arbitrageurs can be driven out of business if the mispricing that they are trying to take advantage of deepens and does not correct as quickly as they'd want to. Their trades will keep losing money, and they run the risk of getting fired for losing money or underperforming their benchmarks. About 50 years before behavioural finance became en vogue, this idea was captured beautifully by Keynes in the quote that I'm sure many have heard - "Markets can stay irrational longer than you can stay solvent". Indeed, if there is one adage that you should know and remember about the financial markets, it is this one. The most striking example of the risk of arbitrage preventing a rational outcome in the markets has been the celebrated case of Royal Dutch and Shell, where stocks of the exact same company split in a 60:40 ratio refused to trade in that ratio for elongated periods of time.
Research into behavioural finance and behavioural economics has over the years produced a rich body of evidence of the systemic cognitive biases that individuals have. The idea of the importance of market microstructre has also gained relevance. I have long believed that if mathematics is at the base of the natural sciences, and philosophy is at the base of the humanities, then psychology is definitely at the base of the social sciences. Since economics is a somwhat scientific social science, I should probably say that cognitive science is at the base of all economics. Some of the ideas presented by the behavioural economists are easily among the most compelling arguments on economic activity that I have come across. But more on that later.
Saturday, October 25, 2008
On Economic Thought - 4
We spoke of the Neoclassical theory of prices being hit by the New Keynesians. But what exactly is this theory of price? A theory of prices and values is nothing more than an attempt to answer the questions - 'what is this good actually worth?', and 'why should it be worth that much?'. The analysis could be both descriptive (or as economists would like to call it, positive), or judgmental (normative).
When younger, I often wondered why SRK gets Rs. 2 crs for hamming through a steaming pile of rubbish like KKHH, while the guy who builds your house has no place to sleep once he is done building your house. Needless to say, these were just ponderings over the theory of prices and values. A belief that there is some 'true' value of a product or service is a very intuitive thought and is known as the intrinsic theory of value. In this case, the price of the good may be very different from its perceived value. This belief has a normative bias, for it asserts what a good should be worth, and thus lends itself very easily to adjectives like 'overpriced', 'too cheap', 'unjustified' and 'exploitative'.
On the other hand, the belief that a product or service is worth whatever its user is willing to pay for it is called the subjective theory of value. It thus converges the theory of value and the theory of prices into one. This idea is also known as utility theory and came to the forefront during the marginalist revolution, which is more or less the genesis of neoclassical economics as we know it today. It is somewhat unintuitive, and the fact that it can escape common intuition is one of the main reasons why people are often unwilling to place faith in the market system. It is also ostensibly descriptive in nature - it doesn't say what goods should be worth, just explains why they are priced the way they are.
Before the neoclassicals came along, there were, unsurprisingly, classical economists. I believe that there are three main strains of classical economics, i.e economics of the 18th and 19th centuries. The fountainheads of these strains are Adam Smith, David Ricardo and Karl Marx respectively. One could argue about this point forever, but let's accept the current categorisation as an easy rule of thumb. All three strains have similar, yet subtly different theories of value. They are similar in the sense that all three believed in the intrinsic theory of value. However, while Adam Smith proposed that the 'natural price' of a good is its cost of production, Marx asserted that the true value of a good should be the amount of labour that goes into producing it. Ricardo's ideas were somewhere in between, and he believed that while the labour theory of value is inherently wrong, it can serve as a good approximation. All three agreed, of course, on the fact that market prices can be widely different from this intrinsic value. However, while Smith believed that prices would tend to converge to the intrinsic value, Marx saw the difference between market prices and intrinsic values as another fault of the capitalist system.
Marx, of course, was uneasy with the importance of capital in the first place. But Smith was vindicated to an extent later when neoclassical economists showed that in a competitive market, prices should converge to the cost, albeit the marginal cost. Ricardo's ideas were resurrected later by Pierro Sraffa, but more on Sraffa and his followers later.
The neoclassical idea of the utility theory of value is an extremely powerful concept. However, I think that its claim of being descriptive and not judgmental is somewhat misplaced. If you make the ideas of price and value converge by asserting that a good is worth whatever its user is willing to pay, you are indulging in a tautology. The normative bias in this idea is the inbuilt implication that nothing is ever mispriced. The argument then becomes circular.
This is where the financial markets come in. Unlike, say a shirt, a stock is difficult to fall in love with. The idea of subjective values hardly makes sense when one talks of financial instruments. Thus, while the market price of a financial instrument is dependent upon the actual demand and supply, it is possible to arrive at a 'true intrinsic value' on the basis of a theoretically consistent system of valuation. This true value may differ, sometimes widely, from the market price and thus the financial markets provide a brilliant opportunity to test many of the assumptions and conclusions of neoclassical economics, including rationality and efficiency of markets and market participants. But more on the the financial markets later.
When younger, I often wondered why SRK gets Rs. 2 crs for hamming through a steaming pile of rubbish like KKHH, while the guy who builds your house has no place to sleep once he is done building your house. Needless to say, these were just ponderings over the theory of prices and values. A belief that there is some 'true' value of a product or service is a very intuitive thought and is known as the intrinsic theory of value. In this case, the price of the good may be very different from its perceived value. This belief has a normative bias, for it asserts what a good should be worth, and thus lends itself very easily to adjectives like 'overpriced', 'too cheap', 'unjustified' and 'exploitative'.
On the other hand, the belief that a product or service is worth whatever its user is willing to pay for it is called the subjective theory of value. It thus converges the theory of value and the theory of prices into one. This idea is also known as utility theory and came to the forefront during the marginalist revolution, which is more or less the genesis of neoclassical economics as we know it today. It is somewhat unintuitive, and the fact that it can escape common intuition is one of the main reasons why people are often unwilling to place faith in the market system. It is also ostensibly descriptive in nature - it doesn't say what goods should be worth, just explains why they are priced the way they are.
Before the neoclassicals came along, there were, unsurprisingly, classical economists. I believe that there are three main strains of classical economics, i.e economics of the 18th and 19th centuries. The fountainheads of these strains are Adam Smith, David Ricardo and Karl Marx respectively. One could argue about this point forever, but let's accept the current categorisation as an easy rule of thumb. All three strains have similar, yet subtly different theories of value. They are similar in the sense that all three believed in the intrinsic theory of value. However, while Adam Smith proposed that the 'natural price' of a good is its cost of production, Marx asserted that the true value of a good should be the amount of labour that goes into producing it. Ricardo's ideas were somewhere in between, and he believed that while the labour theory of value is inherently wrong, it can serve as a good approximation. All three agreed, of course, on the fact that market prices can be widely different from this intrinsic value. However, while Smith believed that prices would tend to converge to the intrinsic value, Marx saw the difference between market prices and intrinsic values as another fault of the capitalist system.
Marx, of course, was uneasy with the importance of capital in the first place. But Smith was vindicated to an extent later when neoclassical economists showed that in a competitive market, prices should converge to the cost, albeit the marginal cost. Ricardo's ideas were resurrected later by Pierro Sraffa, but more on Sraffa and his followers later.
The neoclassical idea of the utility theory of value is an extremely powerful concept. However, I think that its claim of being descriptive and not judgmental is somewhat misplaced. If you make the ideas of price and value converge by asserting that a good is worth whatever its user is willing to pay, you are indulging in a tautology. The normative bias in this idea is the inbuilt implication that nothing is ever mispriced. The argument then becomes circular.
This is where the financial markets come in. Unlike, say a shirt, a stock is difficult to fall in love with. The idea of subjective values hardly makes sense when one talks of financial instruments. Thus, while the market price of a financial instrument is dependent upon the actual demand and supply, it is possible to arrive at a 'true intrinsic value' on the basis of a theoretically consistent system of valuation. This true value may differ, sometimes widely, from the market price and thus the financial markets provide a brilliant opportunity to test many of the assumptions and conclusions of neoclassical economics, including rationality and efficiency of markets and market participants. But more on the the financial markets later.
Friday, October 24, 2008
On Economic Thought - 3
So, I happen to be excited about the New Keynesians these days. But before we latch on to the New Keynesians, a little background on Keynesians themselves may be in order.
Everyone has heard of John Maynard Keynes. But what many people do not know or realise is, none of the Keynesian macroeconomic models that economists quibble and debate about ad-infinitum were actually drawn by him. The IS/LM was formalised by John Hicks and Alvin Hansen. The Phillips curve, of course, came later. Keynes himself, wrote his magnum opus and a few other books, debated with intellectual rivals, and became a policy adviser. But much of post World War 2 macroeconomics was dominated by his thought, or more precisely, by various interpretations of his thought. If there is a single important takeaway from Keynesian economics, it is that government policy has the ability to manage aggregate demand (of goods, money and labour) and that demand is the key factor, supply will adjust. This is in opposition to the Neoclassical (or Classical, as Keynes chose to call it) view of aggregate supply being the key factor. The government could manage this demand through deficit spending or interest rates. Thus, it affords ample scope for both monetary and fiscal policy, though the reconstruction efforts after the Great Depression and after World War 2 largely focussed on fiscal initiatives.
The standard textbook interpretation of Keynes is what is called Neo-Keynesian macroeconomics. Paul Samuelson, Robert Solow, Franco Modigliani, John Hicks and James Tobin are probably the most important figures of Neo-Keynesian economics. At its core, it is a marriage of the Neoclassical macromodel of old to the insights from Keynes's opposition to it. Crudely, economists agreed that Keynesian insights were more relevant in the short-run, while the Neoclassical model held in the long run. Whenever assertions about human behaviour had to be made, the Neo-Keynesians turned to standard Neo-Classical microeconomics. In fact, on some important counts (growth theory, for example) Neo-Keynesian macroeconomics had almost nothing to do with the original Keynesian theory. Thus, there was a synthesis of the Neoclassical and the Neo-Keynesian view of markets and the economy. This combination is what introductory courses in economics at most places teach. It is also the academic thought underpinning mainstream right-of-centre capitalism, which supports freedom and efficiency at the individual market level, while allowing an important role for government intervention when dealing with aggregate variables and special situations.
The problem with this synthesis is, it can sometimes be ad-hoc and inconsistent. It talks of microeconomics when it wants to, else it ignores microfoundations. More pertinently, some of the Keynesian conclusions that it draws are logically at contradiction with the assumption of rationality in neoclassical economics. Plus, the demand boosting goverment initiatives that neo-Keynesians speak of are typically inflationary. The stagflation of the early 70's called into question the implied positive correlation between inflation and economic growth.
New Classical Economics arose as a result of these inconsistencies. Robert Lucas and Thomas Sargent insisted that macromodels be formed on grounds that are consistent with microeconomic foundations. They emphasised rational choice, rational expectations and real business cycles. They arrived at some pretty unbelievable conclusions, including one that crudely put, asserts that unemployment is always voluntary. In their view, in a recession, people are basically taking a vacation. There was bound to be some academic backlash to these outlandish theories. Enter the New Keynesians.
The New Keynesians tried to integrate most of the tenets of Keynesian, or neo-Keynesian economics with the neoclassical microfoundations, making room for some more market imperfections than traditional neoclassical economics allowed, while still allowing people to be rational in the long run (Actually, the idea of 'rationality' needs to explored in greater detail, but more on that later).
The details can be left for the serious academic, but one feature of New Keynesian economics (other than DSGE) needs to be talked about. The single most consequential market imperfection that the New Keynesians introduce is the idea of 'sticky' wages and prices. In short, this is the theory that when there is a supply-demand mismatch, it is the quantity rather than the prices that change. Neoclassical theory argues that if for some reason the supply of some product exceeds its demand, its price will drop, and there will be a supply-demand equilibrium at the new price. New Keynesians argues that these hardly happens in practice, and that it is much more common for the suppliers to re-adjust their supply, keeping the prices at their original level. This downward 'stickiness' of prices can be due to a multitude of reasons, from psychological resistance against revision of prices to the costs that are incurred in making this revision. Nowhere is this concept more beautifully illustrated than in the real estate market, where sticker prices continue to be the nearly the same though the developers have lost more than half of their market value.
So what's the big deal, you ask? There is a supply-demand equilibrium anyway, right? So where's the imperfection? Well, the informative role of prices is lost. At an elementary level, this is the single biggest takeaway from the idea of sticky wages and prices. Prices may no longer be indicative of true supply and demand scenarios. There could be extended booms and busts. Thus, while accepting most of the tenets of neoclassical microeconomics, it delivers a blow where it matters the most - on the theory of prices. But, more on the theory of prices and values later.
Prominent New Keynesians include Greg Mankiw, Michael Woodford, Jordi Gali, George Akerlof, Stanley Fischer & Olivier Blanchard.
Everyone has heard of John Maynard Keynes. But what many people do not know or realise is, none of the Keynesian macroeconomic models that economists quibble and debate about ad-infinitum were actually drawn by him. The IS/LM was formalised by John Hicks and Alvin Hansen. The Phillips curve, of course, came later. Keynes himself, wrote his magnum opus and a few other books, debated with intellectual rivals, and became a policy adviser. But much of post World War 2 macroeconomics was dominated by his thought, or more precisely, by various interpretations of his thought. If there is a single important takeaway from Keynesian economics, it is that government policy has the ability to manage aggregate demand (of goods, money and labour) and that demand is the key factor, supply will adjust. This is in opposition to the Neoclassical (or Classical, as Keynes chose to call it) view of aggregate supply being the key factor. The government could manage this demand through deficit spending or interest rates. Thus, it affords ample scope for both monetary and fiscal policy, though the reconstruction efforts after the Great Depression and after World War 2 largely focussed on fiscal initiatives.
The standard textbook interpretation of Keynes is what is called Neo-Keynesian macroeconomics. Paul Samuelson, Robert Solow, Franco Modigliani, John Hicks and James Tobin are probably the most important figures of Neo-Keynesian economics. At its core, it is a marriage of the Neoclassical macromodel of old to the insights from Keynes's opposition to it. Crudely, economists agreed that Keynesian insights were more relevant in the short-run, while the Neoclassical model held in the long run. Whenever assertions about human behaviour had to be made, the Neo-Keynesians turned to standard Neo-Classical microeconomics. In fact, on some important counts (growth theory, for example) Neo-Keynesian macroeconomics had almost nothing to do with the original Keynesian theory. Thus, there was a synthesis of the Neoclassical and the Neo-Keynesian view of markets and the economy. This combination is what introductory courses in economics at most places teach. It is also the academic thought underpinning mainstream right-of-centre capitalism, which supports freedom and efficiency at the individual market level, while allowing an important role for government intervention when dealing with aggregate variables and special situations.
The problem with this synthesis is, it can sometimes be ad-hoc and inconsistent. It talks of microeconomics when it wants to, else it ignores microfoundations. More pertinently, some of the Keynesian conclusions that it draws are logically at contradiction with the assumption of rationality in neoclassical economics. Plus, the demand boosting goverment initiatives that neo-Keynesians speak of are typically inflationary. The stagflation of the early 70's called into question the implied positive correlation between inflation and economic growth.
New Classical Economics arose as a result of these inconsistencies. Robert Lucas and Thomas Sargent insisted that macromodels be formed on grounds that are consistent with microeconomic foundations. They emphasised rational choice, rational expectations and real business cycles. They arrived at some pretty unbelievable conclusions, including one that crudely put, asserts that unemployment is always voluntary. In their view, in a recession, people are basically taking a vacation. There was bound to be some academic backlash to these outlandish theories. Enter the New Keynesians.
The New Keynesians tried to integrate most of the tenets of Keynesian, or neo-Keynesian economics with the neoclassical microfoundations, making room for some more market imperfections than traditional neoclassical economics allowed, while still allowing people to be rational in the long run (Actually, the idea of 'rationality' needs to explored in greater detail, but more on that later).
The details can be left for the serious academic, but one feature of New Keynesian economics (other than DSGE) needs to be talked about. The single most consequential market imperfection that the New Keynesians introduce is the idea of 'sticky' wages and prices. In short, this is the theory that when there is a supply-demand mismatch, it is the quantity rather than the prices that change. Neoclassical theory argues that if for some reason the supply of some product exceeds its demand, its price will drop, and there will be a supply-demand equilibrium at the new price. New Keynesians argues that these hardly happens in practice, and that it is much more common for the suppliers to re-adjust their supply, keeping the prices at their original level. This downward 'stickiness' of prices can be due to a multitude of reasons, from psychological resistance against revision of prices to the costs that are incurred in making this revision. Nowhere is this concept more beautifully illustrated than in the real estate market, where sticker prices continue to be the nearly the same though the developers have lost more than half of their market value.
So what's the big deal, you ask? There is a supply-demand equilibrium anyway, right? So where's the imperfection? Well, the informative role of prices is lost. At an elementary level, this is the single biggest takeaway from the idea of sticky wages and prices. Prices may no longer be indicative of true supply and demand scenarios. There could be extended booms and busts. Thus, while accepting most of the tenets of neoclassical microeconomics, it delivers a blow where it matters the most - on the theory of prices. But, more on the theory of prices and values later.
Prominent New Keynesians include Greg Mankiw, Michael Woodford, Jordi Gali, George Akerlof, Stanley Fischer & Olivier Blanchard.
On economic thought - 2
So I mentioned last time that microeconomics involves much less math than macro does. Well, let me make a qualification to that. There is an important field of microeconomics that is very math heavy - general equilibrium theory. Mainstream economics of the past 200 years owes a lot of techniques and terms to physics for its mathematical analysis. The idea of 'equilibrium' is thus deeply embedded in economics. In microeconomics, the most commonly encountered equilibrium is that between the supply and demand of any product or service. This is referred to as a partial equilibrium - it says nothing about the supply demand relations of other products, and how they affect the equilibrium under consideration.
General equilibrium theory refers to the attempt to bring together the equilibria of all or most of the products and services in the marketplace. Its earliest proponent was Leon Walras, followed a little later by Vilfredo Pareto. Both these economists belonged to the 'Lausanne School', and were highly mathematical in their thought and approach. The Walrasian and the Paretian ways differed in some details, and were brought together int a more general, more refined and highly mathematical neoclassical general equilibrium theory by Kenneth Arrow and Gerard Debreu. Dynamic programming, comparative statics - the modern GET has it all. Unsurprisingly, GET is considered tough and beyond the scope of introductory courses. As a result, I have very little exposure to it. Why do I speak of it then?
Well, even though it's categorised under micro, and uses microeconomics techniques and variables, the level of analysis in GET is very macro. Crudely, while macroeconomics typically tries to analyse aggregate variables in the economy from a top-down perspective, GET tries to aggregate them from their microeconomic components. If you're talking about all product markets inside the economy, you are pretty much talking of the entire real economy (assuming a closed economy - no currency transactions). It is not surprising that the first true macroeconomic model was more or less a scaled up general equilibrium model with some additions. Irving Fisher's neoclassical macromodel draws heavily from the mathematics and analysis of Walras. GET thus forms an interesting bridge between micro and macroeconomics, and a refined GET could be considered one legitimate way of looking at economics in an integrated fashion.
The importance of such an integrated approach cannot be over-emphasized. Indeed, the most technically sound and scathing criticism of Keynesian macroeconomics came from Robert Lucas, who insisted that macroeconomic models be necessarily founded upon and consistent with microeconomic foundations. A branch of macroeconomics that arose as a response to this critique is called New Keynesian Economics. Essentially, it tries to provide Keynesian macroeconomics with consistent and complete microeconomic foundations. But more on that later.
The thing I want to highlight now about New Keynesian Economics is, it uses something called a Dynamic Stochastic General Equilibrium. This is a GE model that attempts to remove some of the more central flaws of the Neocalssical GE model. It is dynamic, instead of static. It allows room to make technology endogenous. It models transitions between equilibira as stochastic processes, and hence it must be cool.
Basically, DSGE models are the high point economics has yet reached in general equilibrium theory. I don't know much about DSGE models, but they excite me. And they are only one of the many things that get me excited about New Keynesian Economics.
General equilibrium theory refers to the attempt to bring together the equilibria of all or most of the products and services in the marketplace. Its earliest proponent was Leon Walras, followed a little later by Vilfredo Pareto. Both these economists belonged to the 'Lausanne School', and were highly mathematical in their thought and approach. The Walrasian and the Paretian ways differed in some details, and were brought together int a more general, more refined and highly mathematical neoclassical general equilibrium theory by Kenneth Arrow and Gerard Debreu. Dynamic programming, comparative statics - the modern GET has it all. Unsurprisingly, GET is considered tough and beyond the scope of introductory courses. As a result, I have very little exposure to it. Why do I speak of it then?
Well, even though it's categorised under micro, and uses microeconomics techniques and variables, the level of analysis in GET is very macro. Crudely, while macroeconomics typically tries to analyse aggregate variables in the economy from a top-down perspective, GET tries to aggregate them from their microeconomic components. If you're talking about all product markets inside the economy, you are pretty much talking of the entire real economy (assuming a closed economy - no currency transactions). It is not surprising that the first true macroeconomic model was more or less a scaled up general equilibrium model with some additions. Irving Fisher's neoclassical macromodel draws heavily from the mathematics and analysis of Walras. GET thus forms an interesting bridge between micro and macroeconomics, and a refined GET could be considered one legitimate way of looking at economics in an integrated fashion.
The importance of such an integrated approach cannot be over-emphasized. Indeed, the most technically sound and scathing criticism of Keynesian macroeconomics came from Robert Lucas, who insisted that macroeconomic models be necessarily founded upon and consistent with microeconomic foundations. A branch of macroeconomics that arose as a response to this critique is called New Keynesian Economics. Essentially, it tries to provide Keynesian macroeconomics with consistent and complete microeconomic foundations. But more on that later.
The thing I want to highlight now about New Keynesian Economics is, it uses something called a Dynamic Stochastic General Equilibrium. This is a GE model that attempts to remove some of the more central flaws of the Neocalssical GE model. It is dynamic, instead of static. It allows room to make technology endogenous. It models transitions between equilibira as stochastic processes, and hence it must be cool.
Basically, DSGE models are the high point economics has yet reached in general equilibrium theory. I don't know much about DSGE models, but they excite me. And they are only one of the many things that get me excited about New Keynesian Economics.
Monday, October 20, 2008
On economic thought - 1
(Finance will come soon enough, but for now, economics)
Most introductory courses in economics split the discipline into microeconomics and macroeconomics. Very crudely, microeconomics deals with markets, while macro deals with the entire economy. Government policy spans the entire spectrum, for eg. product market regulations on the micro front, fiscal and monetary policy on the macro.
Microeconomics is a set of assumptions, assertions, observations and models on which the foundation of economic thought is built. While a fair bit of it (especially in its mainstream form) is mathematical, it is essentially just a modeling of human behaviour, action and interaction. On the other hand macroeconomics is highly mathematical, deals with huge amounts of data, employs complicated econometric models and often deals at an uncomfortable level of abstraction. To be sure, there are assumptions, assertions and comments on human behaviour galore. However, at all points of time, the attempt is to analyse the cumulative sum of all agents in a given economy.
Therefore, microeconomics tends to be easier and much more intuitive than macro. For example, to assert that 'government inspection of schools is debilitiating' requires only a certain level of knowledge and competence. To claim that 'the correct way for India to fight inflation is to sell its dollar reserves' takes a wholly different level.
Most non-academic thinkers and commentators miss this fact. As ordinary citizens, what influences us most is government policy, and that straddles both micro and macro. Somehow, the average commentator on economic policy tends to assume that if he is able to, say, critically evaluate the regulatory aspects of tax, he is also able to make very informed comments about the ideal fiscal policy. In the past, it has often amused as well as irritated me to see inflation-is-a-monetary-phenomenon-explained-for-dummies type of posts floating around in the blogosphere. However, I have always reserved comment, for I was one of the dummies myself.
To be sure, the basic relationships between macroeconomic variables can be broadly understood by a single course in macro, or even casual reading. What I am refering to here are the prominent macroeconomic debates. Many of these tend to very fine-grained and extremely non-trivial in nature. While one side of the debate may seem intuitively more appealing if explained properly, criticism of the other side should typically be left to the experts. Most dilletante commentators are only projecting their policy biases when they take sides. Uninformed macroeconomic analysis mixed with policy bias makes for a terrible concotion.
Another key point that we often miss out is that many economic (micro and macro) debates are academic in nature, centred on a theoretical contention or on interpretation of avaliable data, and may not have any policy or ideological implications. For example, neo-classical economics (mainstream microeconomics as it is taught at most places) assumes that technology is exogenous to all firms in the economy. The macro-level implication is that technology can be treated as an exogenous variable to the economy and changes in technology lead to 'shocks' or transitions between different 'equilibrium' states of the economy (more on equlibriums later). I find this assertion to be patently absurd on the micro-level. Of course, no neoclassical economist lives or dies by this theory and it is only a model-simplification. However, I find this simplification extremely distortionary. Sure enough, it has been criticized on many fronts by many economists who also find it absurd. But does this criticism have any policy implications? Most probably not.
If I was to argue that this flaw in neoclassical economics means that the capitalist economic system that it serves as the foundation of is principally flawed, it would be a stupid argument. Yet, often enough, people believe that by finding out one flaw with a system of economic theory they have destroyed the credibility of the policy implications of that system. More commonly, one finds people trying to place their own understanding of a purely academic debate on a simplified policy spectrum of left and right, socialism and capitalism.
Of course, there are many other tenets of economic theory that have direct policy implications. A blow to one of these tenets would lead to genuine policy debates. One prominent example is that of the ridiculous idealization of perfect competition. But more on imperfect competition and other such things later.
(this is the part 1 of an n-part series, n is as yet undecided)
Most introductory courses in economics split the discipline into microeconomics and macroeconomics. Very crudely, microeconomics deals with markets, while macro deals with the entire economy. Government policy spans the entire spectrum, for eg. product market regulations on the micro front, fiscal and monetary policy on the macro.
Microeconomics is a set of assumptions, assertions, observations and models on which the foundation of economic thought is built. While a fair bit of it (especially in its mainstream form) is mathematical, it is essentially just a modeling of human behaviour, action and interaction. On the other hand macroeconomics is highly mathematical, deals with huge amounts of data, employs complicated econometric models and often deals at an uncomfortable level of abstraction. To be sure, there are assumptions, assertions and comments on human behaviour galore. However, at all points of time, the attempt is to analyse the cumulative sum of all agents in a given economy.
Therefore, microeconomics tends to be easier and much more intuitive than macro. For example, to assert that 'government inspection of schools is debilitiating' requires only a certain level of knowledge and competence. To claim that 'the correct way for India to fight inflation is to sell its dollar reserves' takes a wholly different level.
Most non-academic thinkers and commentators miss this fact. As ordinary citizens, what influences us most is government policy, and that straddles both micro and macro. Somehow, the average commentator on economic policy tends to assume that if he is able to, say, critically evaluate the regulatory aspects of tax, he is also able to make very informed comments about the ideal fiscal policy. In the past, it has often amused as well as irritated me to see inflation-is-a-monetary-phenomenon-explained-for-dummies type of posts floating around in the blogosphere. However, I have always reserved comment, for I was one of the dummies myself.
To be sure, the basic relationships between macroeconomic variables can be broadly understood by a single course in macro, or even casual reading. What I am refering to here are the prominent macroeconomic debates. Many of these tend to very fine-grained and extremely non-trivial in nature. While one side of the debate may seem intuitively more appealing if explained properly, criticism of the other side should typically be left to the experts. Most dilletante commentators are only projecting their policy biases when they take sides. Uninformed macroeconomic analysis mixed with policy bias makes for a terrible concotion.
Another key point that we often miss out is that many economic (micro and macro) debates are academic in nature, centred on a theoretical contention or on interpretation of avaliable data, and may not have any policy or ideological implications. For example, neo-classical economics (mainstream microeconomics as it is taught at most places) assumes that technology is exogenous to all firms in the economy. The macro-level implication is that technology can be treated as an exogenous variable to the economy and changes in technology lead to 'shocks' or transitions between different 'equilibrium' states of the economy (more on equlibriums later). I find this assertion to be patently absurd on the micro-level. Of course, no neoclassical economist lives or dies by this theory and it is only a model-simplification. However, I find this simplification extremely distortionary. Sure enough, it has been criticized on many fronts by many economists who also find it absurd. But does this criticism have any policy implications? Most probably not.
If I was to argue that this flaw in neoclassical economics means that the capitalist economic system that it serves as the foundation of is principally flawed, it would be a stupid argument. Yet, often enough, people believe that by finding out one flaw with a system of economic theory they have destroyed the credibility of the policy implications of that system. More commonly, one finds people trying to place their own understanding of a purely academic debate on a simplified policy spectrum of left and right, socialism and capitalism.
Of course, there are many other tenets of economic theory that have direct policy implications. A blow to one of these tenets would lead to genuine policy debates. One prominent example is that of the ridiculous idealization of perfect competition. But more on imperfect competition and other such things later.
(this is the part 1 of an n-part series, n is as yet undecided)
Thursday, October 16, 2008
Of blogging and finance
Tanuj (or as we call him here, Bhaiyya) brings to my notice that every post of mine on the first page of my blog is a criticism of someone. He is quite pleasantly amused by this fact, but I will have to disappoint him by saying that of late I have developed an aversion of this tendency of mine, and not only for what it implies abut my behaviour and nature.
You see, criticism bores me now. I refuse to criticise the commies, because their arguments are not worth criticising. Ditto for religious / political hawks and fundamentalists. Libertarians were a prime target earlier, but India Uncut has stagnated remarkably and Sabnis doesn't blog any more. Ravikiran came back on the scene and some new juice was offered, but I have noticed that my arguments with him often become too defensive and pedantic - of the 'no, I never said this' and 'yes, you did' type. (Was he also a debator in a previous avatar?) That stuff bores me much faster now than it did earlier.
Of course, criticising Avataram still remains fun, but the problem is that he blogs on The Maanga. Nilu has the attention span of a poodle if the discussion gets beyond his intellectual comprehension, as it frequently does. Which is why, often enough, a perfectly good rant-fest with Avataram is spoilt by his infantile posturing.
Basically, I am bored of criticising now. And hence, I will make a conscious attempt to shift the tone of this blog from critique to construction. In management jargon, I asked myself the question - what business am I in? And I discovered this.
So where does finance come in? Well Avataram seems to believe that blogging, and not finance, is my cobbling last. And I seem to think that I definitely understand finance better than I write on the blog. So how shall the twian meet? The answer, dear readers, is financial blogging, or more precisely, blogging on finance. Now don't run away - I am not going to write only on finance. In fact the non-financial posts will still greatly exceed the finance-related posts. Also, often enough, I will simply link to the efforts of my intellectual superiors rather than post myself. All I'm saying is, this blog will see more finance than it has seen in the past. Apart from all the stuff that I promised to write on some 2 years back.
You see, criticism bores me now. I refuse to criticise the commies, because their arguments are not worth criticising. Ditto for religious / political hawks and fundamentalists. Libertarians were a prime target earlier, but India Uncut has stagnated remarkably and Sabnis doesn't blog any more. Ravikiran came back on the scene and some new juice was offered, but I have noticed that my arguments with him often become too defensive and pedantic - of the 'no, I never said this' and 'yes, you did' type. (Was he also a debator in a previous avatar?) That stuff bores me much faster now than it did earlier.
Of course, criticising Avataram still remains fun, but the problem is that he blogs on The Maanga. Nilu has the attention span of a poodle if the discussion gets beyond his intellectual comprehension, as it frequently does. Which is why, often enough, a perfectly good rant-fest with Avataram is spoilt by his infantile posturing.
Basically, I am bored of criticising now. And hence, I will make a conscious attempt to shift the tone of this blog from critique to construction. In management jargon, I asked myself the question - what business am I in? And I discovered this.
So where does finance come in? Well Avataram seems to believe that blogging, and not finance, is my cobbling last. And I seem to think that I definitely understand finance better than I write on the blog. So how shall the twian meet? The answer, dear readers, is financial blogging, or more precisely, blogging on finance. Now don't run away - I am not going to write only on finance. In fact the non-financial posts will still greatly exceed the finance-related posts. Also, often enough, I will simply link to the efforts of my intellectual superiors rather than post myself. All I'm saying is, this blog will see more finance than it has seen in the past. Apart from all the stuff that I promised to write on some 2 years back.
Thursday, October 02, 2008
Ajay Shah confounds me
He links to this site, and claims that by one measure, the usage of IE and hence MS browsers has dropped below 50%. Then, on top of that he adds that the measure under-represents mobile phones and hence over-represents Microsoft.
Immediately below the statistics (which seemed to me to be fishy because they showed Chrome to have a 3% usage!), the developers of the website explicitly mention
Immediately below the statistics (which seemed to me to be fishy because they showed Chrome to have a 3% usage!), the developers of the website explicitly mention
W3Schools is a website for people with an interest for web technologies. These people are more interested in using alternative browsers than the average user. The average user tends to use Internet Explorer, since it comes preinstalled with Windows. Most do not seek out other browsers.
These facts indicate that the browser figures above are not 100% realistic. Other web sites have statistics showing that Internet Explorer is used by at least 80% of the users.
And yet, what Dr Shah infers from the site is that IE's usage may even be lesser than 49%. This absolutely confuses me. I am not even sure what the point of such selective representation could be. (I call it selective representation because I am ruling out incompetence and oversight) Is he cheer-leading for Mozilla? Is he anti-Microsoft? Or is he, in some perverse way, trying to argue that Microsoft's monopoly is not as much of a monopoly as it seems to be; that the web and hence the new information economy are wonderfully competitive and informative places and thus the relevance of free markets to the modern world is established.
There have been other such missteps in the past, which seem like subtle nuances at first but are quite shocking mistakes when evaluated to any depth. Using the SJTU ranking to rubbish IITs and thus establish the relevance of GARP- FRM is one such shocker in recent memory.
Dr Shah is a respected professor and wrote large chunks of what is one of the definitive studies and policy recommendations for the Indian financial landscape (Percy MIstry Report). Stuff like this just causes dissonance then.
Sunday, September 21, 2008
Dear Mr Varma,
Please stop. Your recent lack of activity had done you a lot of good. I was wondering if you really had found the good sense to not talk about stuff you don't know. But, you have risen to the occasion again.
The SEC has got it wrong time and again in this crisis. The failure of the regulator, however, is not adequate evidence for the failure of regulation, if you can make the distinction. Plus, this is finance. There is some math involved. There is some macro-economics involved. There are some accounting laws involved. Of all three things, I'm sure you have no effing clue. There are also many tenable conspiracy theories, but when one does not know the basic facts, indulging in conspiracy theories is the worst kind of arrogance that one can display.
Your interest and ideological grandstanding of policy prescriptions based on links and rhetoric (the Kashmir issue, and now this) with nearly zero knowledge of the underlying matter remind me more and more of the communists everyday. You share your predilection for ideology over issue and analysis with them. Which sort of confirms my longheld position that the world is round (yes, I translated from Hindi, I am a vernie) and the more extreme you get on either side of a divide, the closer you become to your ideological opposites in ways that you did not foresee. (You can call this Ritwik's theorem of the unintended consequences of ideology. )
The consistency with which you mange to sift out, read and link only the most half baked portions of non-representative analyses is amazing. So is your failure to perform even the most routine reserach on that which you wish to comment upon. There is Google, Bloomberg, the Yale law school online library (for Kashmir). You seem to be unaware of teh existence of these resources, and much worse, unwilling to fish them out.
I have to say - you were quite right when you said that when you try non-fiction, you end up repeating yourself. However,your diagnosis of things being cynically recurrent and non changig was not correct. Try this for an alternate hypethesis - you don't have much to say anymore. You have plateaued, stagnated. I wish you luck for the awards that you are competing in. I may even buy and read your novel, if I ever get the time. But for now, I have a sincere request. Please do stick to fiction. Invoking David Ricardo, Niranjan Rajadhyaksha and Ravikiran, that is your comparative advantage.
I must also thank you, though. For two thing. First, about three years ago, when I had just about discovered the world of blogs, you were thought provoking - infuriating at times, wonderfully insightful at others. I now realize that this was primarily because I was unexposed to the ideas that you hold, and some of them were very strong challenges to my world view. I don't know if it is result of my education in the last thre years or simply your stagnation, but you no longer have anything worthwhile to offer me as a reader. But let's give credit where it's due.
Second, I have been off the blogging scene for some 8 months now and I have a deadine to meet at 11 pm. Yet, your consistent piling up of rubbish has now broken my patience. I am back on my blog now, and I must thank you for that.
Thanks,
Ritwik
p.s I don't think I would be reading you much from now on. Ta-da. If you ever read this, you can use this as the perfect example of how the free-market system works. For a change, that will actually make sense.
The SEC has got it wrong time and again in this crisis. The failure of the regulator, however, is not adequate evidence for the failure of regulation, if you can make the distinction. Plus, this is finance. There is some math involved. There is some macro-economics involved. There are some accounting laws involved. Of all three things, I'm sure you have no effing clue. There are also many tenable conspiracy theories, but when one does not know the basic facts, indulging in conspiracy theories is the worst kind of arrogance that one can display.
Your interest and ideological grandstanding of policy prescriptions based on links and rhetoric (the Kashmir issue, and now this) with nearly zero knowledge of the underlying matter remind me more and more of the communists everyday. You share your predilection for ideology over issue and analysis with them. Which sort of confirms my longheld position that the world is round (yes, I translated from Hindi, I am a vernie) and the more extreme you get on either side of a divide, the closer you become to your ideological opposites in ways that you did not foresee. (You can call this Ritwik's theorem of the unintended consequences of ideology. )
The consistency with which you mange to sift out, read and link only the most half baked portions of non-representative analyses is amazing. So is your failure to perform even the most routine reserach on that which you wish to comment upon. There is Google, Bloomberg, the Yale law school online library (for Kashmir). You seem to be unaware of teh existence of these resources, and much worse, unwilling to fish them out.
I have to say - you were quite right when you said that when you try non-fiction, you end up repeating yourself. However,your diagnosis of things being cynically recurrent and non changig was not correct. Try this for an alternate hypethesis - you don't have much to say anymore. You have plateaued, stagnated. I wish you luck for the awards that you are competing in. I may even buy and read your novel, if I ever get the time. But for now, I have a sincere request. Please do stick to fiction. Invoking David Ricardo, Niranjan Rajadhyaksha and Ravikiran, that is your comparative advantage.
I must also thank you, though. For two thing. First, about three years ago, when I had just about discovered the world of blogs, you were thought provoking - infuriating at times, wonderfully insightful at others. I now realize that this was primarily because I was unexposed to the ideas that you hold, and some of them were very strong challenges to my world view. I don't know if it is result of my education in the last thre years or simply your stagnation, but you no longer have anything worthwhile to offer me as a reader. But let's give credit where it's due.
Second, I have been off the blogging scene for some 8 months now and I have a deadine to meet at 11 pm. Yet, your consistent piling up of rubbish has now broken my patience. I am back on my blog now, and I must thank you for that.
Thanks,
Ritwik
p.s I don't think I would be reading you much from now on. Ta-da. If you ever read this, you can use this as the perfect example of how the free-market system works. For a change, that will actually make sense.
Friday, January 25, 2008
I have to rush, but...
Ok, I was holding out of doing this for various reasons. But this needs to be done, and hence yours truly shall go ahead. Read this. Especially this bit,
I’m not dissing the armed forces—they keep our borders and engineers safe—but there are better reasons to feel proud of being an army man than the power you have over people’s lives.
I’m not dissing the armed forces—they keep our borders and engineers safe—but there are better reasons to feel proud of being an army man than the power you have over people’s lives.
The other profession marked out by such lust for power is politics. How staggeringly sad.
Oh dear god! Such farce is not even funny.
Sunday, January 13, 2008
Of momblogs, children and externalities
Dear Mombloggers,
I don't read any of you. I know none of you read me either, but that's immaterial. It does surprise me that you would choose to share details of your life and your children with the world wide web, but I also know that I can't even begin to understand. We all write about what we like, so it's ok I guess.
I am, however, extremely surprised at the way you react to all the people who try to slag you on the blogosphere. It shows the great danger of being emotionally attached to what you write about. We all are, at some level. But when it's one's own children, it's a little too close for comfort. I am genuinely amazed at your willingness to read random people rant about children and be infuriated enough to even try to think of cyber-rebuttals. Feminists fisk stupid things all the time, but I see their point - it's an uphill battle when a large majority of the people don't even share some of your basic views on equality and don't realise that they are being bigoted. Libertarians fisk non-fisk-worthy commie arguments too, but I get their point as well - far too many people have notions of achieving great utopian equality without the slightest idea of how we're going to get there.
You, on the other hand, face no such uphill task. The world at large likes children. Since when did Nilu, Aadisht and Falstaff become representative viewpoint-holders on children? Their rants can be attributed to too much porn, too many graphic novels and too much poetry respectively. I don't agree with them, but I see the point in their rants (except for Nilu, in whose case having a point would defeat the entire point) - they are the ones who face an uphill task. Essentially, people with that extra bit of intelligence and a life that largely revolves around solitude and a computer develop slightly warped views of reality. You need not worry about them. You need to however, think about people like me.
You see, I too have a life that revolves largely around solitude and a computer. However, I am a country boy. I don't pontificate about the US presidential election - I frankly am more interested in the Bharat Ratna controversy. My intellectual rebellion developed much after my initial upbringing had grounded in me the virtues of appreciating the status quo and the constraints of decision makers. I am the one who you should be bothered about, for the majority of people with experiences similar to those three worthies turn out like me, and not like them. Country boys who hopefully understand economics but stop short of seeing Ronald Coase everywhere.
And you will be pleased to know - I don't dislike children. I don't necessarily like them either - but I know that they are going to happen in a few years and am absolutely ok with that. I think I'll like them once they are there, and I see the merits of the status quo. You will never hear me talk in appreciative terms about a growing population (oops, sorry, human capital base) and yet talking ill of children, because it appears terribly inconsistent to me. Don't be bothered yet, because people at large believe that it's not ok to be openly intolerant of children. Not yet.
So am I with you or against you? A bit of both. I sympathise with your predicament and yes kids are cute, but I wish that you'd display some more gravitas and sangfroid. Children rants are not to be replied to - it's a little like trying to beat children at their own game of not listening to reason. You fall into the trap by imitating them, only to realise that its not your core competence. And yes, some emotional distance from what one writes helps.
Thanks.
2) Which brings me to the question of negative externalities. Venu reminds me that to some people, children are akin to pets or smokers that impose negative externalities on other people. There are two questions here - one more fundamental than the other. We shall not even go into the 'pets' argument, for if you bring non-human life into the picture when we are trying to deal with human social systems, I am sorry to say that you've missed the point completely. However, the other aspect is worth examining.
There is obviously a negative externality when a smoker exhales fumes into a setting that involves non-smokers. There is also an obvious externality, though slightly intangible this time, when a child cries through what could have been a perfect rendition of a Mozart concerto. There is also an externality, intangible and not so obvious, to many devout Hindus when they so much as get news of an M F Hussain painting that shows a naked Sita on Hanuman's tail. Or to Muslims when they see their prophet depicted as a terrorist in a cartoon strip. You may want to brush the last two under the 'freedom of speech' carpet (and I would agree) but there's no denying the fact that there exists an externality - it is not for you to judge whether my mother should get angry at MFH or not, the fact that she does get genuinely disturbed is proof enough of the externality's existence. The question is, is the disturbance caused by the child's crying more similar to the MFH example, or more similar to the smoker example? The answer is quite obvious to me, but I would like to know your views on the issue.
Essentially, if you believe that a first principles based, non Coasian solution is the answer to the free speech issue, I fail to see why that should not be the case with children. However, even if you think a child is more analogous to a smoker than to MFH, there is another issue here. Am I the only one who sees the problem with trying to create an analogy between what is a choice, and what is a stage/fact of life that one does not really choose? Being of a particular age is far more like being a boy, a girl, a white or short than being a smoker. Coasian solutions for the gender and race issues as well, sirs?
Of course, private property rights are part of the solution - a theater owner would be well within his rights to ask the family of an unruly child to leave. Restaurants that an the entry of children could easily come up if it was a viable business model. But the point is not that - the point is, does there exist sufficient moral ground to ask for a Coasian solution at the society level?
Which brings me to the last, most confusing point. Is it correct for the government to have legislation that requires companies to have explicit no-discrimination policies? It is coercive, an infringement of absolute private property, and yet necessary if equity forms a reasonable chunk of the social welfare function. What are your views on this?
I don't read any of you. I know none of you read me either, but that's immaterial. It does surprise me that you would choose to share details of your life and your children with the world wide web, but I also know that I can't even begin to understand. We all write about what we like, so it's ok I guess.
I am, however, extremely surprised at the way you react to all the people who try to slag you on the blogosphere. It shows the great danger of being emotionally attached to what you write about. We all are, at some level. But when it's one's own children, it's a little too close for comfort. I am genuinely amazed at your willingness to read random people rant about children and be infuriated enough to even try to think of cyber-rebuttals. Feminists fisk stupid things all the time, but I see their point - it's an uphill battle when a large majority of the people don't even share some of your basic views on equality and don't realise that they are being bigoted. Libertarians fisk non-fisk-worthy commie arguments too, but I get their point as well - far too many people have notions of achieving great utopian equality without the slightest idea of how we're going to get there.
You, on the other hand, face no such uphill task. The world at large likes children. Since when did Nilu, Aadisht and Falstaff become representative viewpoint-holders on children? Their rants can be attributed to too much porn, too many graphic novels and too much poetry respectively. I don't agree with them, but I see the point in their rants (except for Nilu, in whose case having a point would defeat the entire point) - they are the ones who face an uphill task. Essentially, people with that extra bit of intelligence and a life that largely revolves around solitude and a computer develop slightly warped views of reality. You need not worry about them. You need to however, think about people like me.
You see, I too have a life that revolves largely around solitude and a computer. However, I am a country boy. I don't pontificate about the US presidential election - I frankly am more interested in the Bharat Ratna controversy. My intellectual rebellion developed much after my initial upbringing had grounded in me the virtues of appreciating the status quo and the constraints of decision makers. I am the one who you should be bothered about, for the majority of people with experiences similar to those three worthies turn out like me, and not like them. Country boys who hopefully understand economics but stop short of seeing Ronald Coase everywhere.
And you will be pleased to know - I don't dislike children. I don't necessarily like them either - but I know that they are going to happen in a few years and am absolutely ok with that. I think I'll like them once they are there, and I see the merits of the status quo. You will never hear me talk in appreciative terms about a growing population (oops, sorry, human capital base) and yet talking ill of children, because it appears terribly inconsistent to me. Don't be bothered yet, because people at large believe that it's not ok to be openly intolerant of children. Not yet.
So am I with you or against you? A bit of both. I sympathise with your predicament and yes kids are cute, but I wish that you'd display some more gravitas and sangfroid. Children rants are not to be replied to - it's a little like trying to beat children at their own game of not listening to reason. You fall into the trap by imitating them, only to realise that its not your core competence. And yes, some emotional distance from what one writes helps.
Thanks.
2) Which brings me to the question of negative externalities. Venu reminds me that to some people, children are akin to pets or smokers that impose negative externalities on other people. There are two questions here - one more fundamental than the other. We shall not even go into the 'pets' argument, for if you bring non-human life into the picture when we are trying to deal with human social systems, I am sorry to say that you've missed the point completely. However, the other aspect is worth examining.
There is obviously a negative externality when a smoker exhales fumes into a setting that involves non-smokers. There is also an obvious externality, though slightly intangible this time, when a child cries through what could have been a perfect rendition of a Mozart concerto. There is also an externality, intangible and not so obvious, to many devout Hindus when they so much as get news of an M F Hussain painting that shows a naked Sita on Hanuman's tail. Or to Muslims when they see their prophet depicted as a terrorist in a cartoon strip. You may want to brush the last two under the 'freedom of speech' carpet (and I would agree) but there's no denying the fact that there exists an externality - it is not for you to judge whether my mother should get angry at MFH or not, the fact that she does get genuinely disturbed is proof enough of the externality's existence. The question is, is the disturbance caused by the child's crying more similar to the MFH example, or more similar to the smoker example? The answer is quite obvious to me, but I would like to know your views on the issue.
Essentially, if you believe that a first principles based, non Coasian solution is the answer to the free speech issue, I fail to see why that should not be the case with children. However, even if you think a child is more analogous to a smoker than to MFH, there is another issue here. Am I the only one who sees the problem with trying to create an analogy between what is a choice, and what is a stage/fact of life that one does not really choose? Being of a particular age is far more like being a boy, a girl, a white or short than being a smoker. Coasian solutions for the gender and race issues as well, sirs?
Of course, private property rights are part of the solution - a theater owner would be well within his rights to ask the family of an unruly child to leave. Restaurants that an the entry of children could easily come up if it was a viable business model. But the point is not that - the point is, does there exist sufficient moral ground to ask for a Coasian solution at the society level?
Which brings me to the last, most confusing point. Is it correct for the government to have legislation that requires companies to have explicit no-discrimination policies? It is coercive, an infringement of absolute private property, and yet necessary if equity forms a reasonable chunk of the social welfare function. What are your views on this?
Thursday, January 03, 2008
The value of human life
We're fresh from a small round of blog discussions about the value of human life and the policy implications of executing murderers and executing 'vermiscripters' (computer virus writers). Steven Landsburg here and Ravikiran here assert that people who claim that a value cannot be attached to human life are making "invalid" and "wrong" statements. The crux of their argument is that we make choices about our lives and our safety all the time. So if I drive a bike at a 100 kmph for half an hour today, and that increases the chances of my death by .01%, then the fact that I am making this tradeoff means that utility (.01 % increased safety of life) = utility (driving a bike at 100 kmph for half an hour). It is easy to see that the RHS of this equation can be replaced in money terms - for e.g if I am willing to pay 1000 Rs to drive a bike for half an hour at 100 kmph, then utility (1000 rs) = utility (driving....half an hour) and by substitution, utility (.01% increased safety of life) = utility (1000 Rs). So far so good - the argument is flawless until here. But truth is a little more nuanced after this.
The flawed leap in the argument comes when people extend utility (1000 rs) = utility (.01% increased safety) to , say, utility (100000 rs) = utility (1% increased saftey). There are two assumptions underlying this extrapolation, both wrong, one more wrong than the other. The first assumtion is that utility (100000 rs) = 100 * utility (1000 rs). The second, and more incorrect assumption, is that utility (1% increased safety) = 100 * utility (.01% increased safety). (Of course, mathematically it is possible to come at the same conclusion without either fo the two assumptions, using a third more integrated one. But the decomposition into its parts will help illustrate the folly in logic better, and hence I take this route).
Let's deal with the first assumption. In classical analysis, goods are supposed to have diminishing marginal utility. Money is the one good that is exempted from this consideration - an extra buck is always as good as any other extra buck. It makes some amount of intuitive sense, plus it is necessary to exempt money from the concept of diminishing marginal utility if one is to compare the utility (and hence prices) of other goods. However, in decision analysis under uncertainity, things change a bit.
Rational people are risk averse. If I was to offer you a game where you could win 150000 rupees with 50% chance and win 50000 Rs with 50% chance, you would typically not accept this gamble at a price of Rs 100,000. The expected value of this game is 100000 - it has an expected return of 0 and it is irrational to take it up. You are bearing some risk, and hence would want a non-zero return. (In fact you would want a return above the risk free rate of interest, but lets not get into that). Mathematically, if U(x) is the utility function of money, U(50000) + U(150000) < 2 * U(100000). What kind of a function would U be? Concave to the x axis. Consider the simple example of U(x) = sqrt (x). It is easy to check that the inequality holds (in fact, it reduces to the RMS-AM inequality, or equivalently, to the statement that variance is non zero). Now, it's easy to see that with U(x) = sqrt (X), U(100000) = 10 U(1000) < 1000 U(1000). This is, of course, a cooked-up example that makes the inequality very strong, but it is easy to see that for any concave function, U(kx) < k*U(x). Hence, U(100000) < 100 * U (1000).
(Through all that not-so-fancy math, all that we're saying is that a 100 times more money will not make you a 100 times more happy. Which is something we all intuitively know. But since we are trying to counter some 'rational' arguments, we will stick with the math. )
The second assumption, and this is where the extrapolation gets hit very badly, can be invalidated by a simple thought experiment at the extreme. You make me two promises - one in which you promise to save me from near certain death, and another in which you promise to provide me with an extra .01% of safety. What is the worth of your first promise vis-a-vis your second promise to me? Is it worth 10,000 times more? Far from it. It is worth a whole lot more. I want to consume, I want to ride bikes, I want to do various things, but most of all, I want to live. I'd give you my entire wealth (everything above subsistence) if you saved me from near certain death. In fact, if someone was willing to take a leveraged position on my life, I'd be willing to give you a huge chunk of my future wealth as well. Put mathematically, the marginal utility of extra safety of life is increasing. U(1% safety) > 100 * U(.01% safety).
(Actually, it will not increase monotonically, for reasons that should be obvious. But we shall sacrifice behavioural assertions and mathematical rigour for the purpose of relevant analysis)
Now, if we put the mathematical formulations of our two intuitive results together, what do we get? U(1% safety) > 100 * U(.01% safety) = 100 * U(1000) > U(100000). The extrapolation of the 'value of life' from a single decision has been hit on two counts. Essentially, extrapolations like this will end up severely understating the actual value that we place on our safety and our lives. And therefore, the time frame of the analysis and the absolute numbers becomes of critical importance. It is useless to compare one exceution of a murderer with one execution of a vermiscripter if over my lifetime, many more than one executions take place.
Hence, dear economists and other rational type people - if you are going to estimate the value of my life by extrapolating from the value I place on .01% of my safety, say it like that. Because the answer that you will get will be different from your answer if you were to extrapolate it from the value I place on 1% of my safety. If you directly ask me the value of my life, I will refuse to put a figure to it. Not because I'm being a moralist. But because I am then thinking about the value of my entire life. 1 or 0. Life or death. Not 10000 times .01% or 100 times 1%. And I can genuinely not answer that, except for saying that my life is rather priceless. Not because I am irrational. But because I am rational and hence risk-averse. Because the marginal utility of money is diminishing while the marginal utility of safety is increasing. Because the way you frame a question will lead to a different answer.
The time frame of policy and an approximation of the utility of safety/life are of critical importance beofre one starts asserting things about the value of life and the costs and benefits of deterrence. If you are only going to multiply two numbers, don't bother. I learnt multiplication and pretty much mastered it when I was 7 years old.
The flawed leap in the argument comes when people extend utility (1000 rs) = utility (.01% increased safety) to , say, utility (100000 rs) = utility (1% increased saftey). There are two assumptions underlying this extrapolation, both wrong, one more wrong than the other. The first assumtion is that utility (100000 rs) = 100 * utility (1000 rs). The second, and more incorrect assumption, is that utility (1% increased safety) = 100 * utility (.01% increased safety). (Of course, mathematically it is possible to come at the same conclusion without either fo the two assumptions, using a third more integrated one. But the decomposition into its parts will help illustrate the folly in logic better, and hence I take this route).
Let's deal with the first assumption. In classical analysis, goods are supposed to have diminishing marginal utility. Money is the one good that is exempted from this consideration - an extra buck is always as good as any other extra buck. It makes some amount of intuitive sense, plus it is necessary to exempt money from the concept of diminishing marginal utility if one is to compare the utility (and hence prices) of other goods. However, in decision analysis under uncertainity, things change a bit.
Rational people are risk averse. If I was to offer you a game where you could win 150000 rupees with 50% chance and win 50000 Rs with 50% chance, you would typically not accept this gamble at a price of Rs 100,000. The expected value of this game is 100000 - it has an expected return of 0 and it is irrational to take it up. You are bearing some risk, and hence would want a non-zero return. (In fact you would want a return above the risk free rate of interest, but lets not get into that). Mathematically, if U(x) is the utility function of money, U(50000) + U(150000) < 2 * U(100000). What kind of a function would U be? Concave to the x axis. Consider the simple example of U(x) = sqrt (x). It is easy to check that the inequality holds (in fact, it reduces to the RMS-AM inequality, or equivalently, to the statement that variance is non zero). Now, it's easy to see that with U(x) = sqrt (X), U(100000) = 10 U(1000) < 1000 U(1000). This is, of course, a cooked-up example that makes the inequality very strong, but it is easy to see that for any concave function, U(kx) < k*U(x). Hence, U(100000) < 100 * U (1000).
(Through all that not-so-fancy math, all that we're saying is that a 100 times more money will not make you a 100 times more happy. Which is something we all intuitively know. But since we are trying to counter some 'rational' arguments, we will stick with the math. )
The second assumption, and this is where the extrapolation gets hit very badly, can be invalidated by a simple thought experiment at the extreme. You make me two promises - one in which you promise to save me from near certain death, and another in which you promise to provide me with an extra .01% of safety. What is the worth of your first promise vis-a-vis your second promise to me? Is it worth 10,000 times more? Far from it. It is worth a whole lot more. I want to consume, I want to ride bikes, I want to do various things, but most of all, I want to live. I'd give you my entire wealth (everything above subsistence) if you saved me from near certain death. In fact, if someone was willing to take a leveraged position on my life, I'd be willing to give you a huge chunk of my future wealth as well. Put mathematically, the marginal utility of extra safety of life is increasing. U(1% safety) > 100 * U(.01% safety).
(Actually, it will not increase monotonically, for reasons that should be obvious. But we shall sacrifice behavioural assertions and mathematical rigour for the purpose of relevant analysis)
Now, if we put the mathematical formulations of our two intuitive results together, what do we get? U(1% safety) > 100 * U(.01% safety) = 100 * U(1000) > U(100000). The extrapolation of the 'value of life' from a single decision has been hit on two counts. Essentially, extrapolations like this will end up severely understating the actual value that we place on our safety and our lives. And therefore, the time frame of the analysis and the absolute numbers becomes of critical importance. It is useless to compare one exceution of a murderer with one execution of a vermiscripter if over my lifetime, many more than one executions take place.
Hence, dear economists and other rational type people - if you are going to estimate the value of my life by extrapolating from the value I place on .01% of my safety, say it like that. Because the answer that you will get will be different from your answer if you were to extrapolate it from the value I place on 1% of my safety. If you directly ask me the value of my life, I will refuse to put a figure to it. Not because I'm being a moralist. But because I am then thinking about the value of my entire life. 1 or 0. Life or death. Not 10000 times .01% or 100 times 1%. And I can genuinely not answer that, except for saying that my life is rather priceless. Not because I am irrational. But because I am rational and hence risk-averse. Because the marginal utility of money is diminishing while the marginal utility of safety is increasing. Because the way you frame a question will lead to a different answer.
The time frame of policy and an approximation of the utility of safety/life are of critical importance beofre one starts asserting things about the value of life and the costs and benefits of deterrence. If you are only going to multiply two numbers, don't bother. I learnt multiplication and pretty much mastered it when I was 7 years old.
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