Rationality and Game Theory

People are very bad at “games”. What explains this? Well, they aren’t computers. But if people aren’t computers, what are they? How can they best be modeled? What is lost by modeling them as purely rational? Is this loss systematic? What could be gained by a more nuanced, realistic model of human behavior?

First, people work with imperfect information. A lot of work has been done on this, and methods have been created to deal with this. I do not feel like I need to say anything more in regards to this topic.

Second, people are not perfect at processing this information. They are bad at probability, and in general calculating expectations.

Third, people often have other goals that are not correctly being modeled (i.e. punishing low offers in the accept/reject both lose game).

Fourth, processing time is limited and exerting effort inflicts a cost on the economic agent.

I see people making choices in a kind of fog of imperfect information using their imperfect means of evaluation and taking into consideration what could be gained by spending more time on the problem and getting closer to the rational choice. That is why people spend more time deciding what house to purchase rather than which brand of cookies is the best. I feel like there is some analogue to probability theory and sample size, as in a larger purchase is similar to a larger sample size. I also think things we know such as risk aversion and prospect theory can fit right into this theory. I am not sure how exactly yet.

Though I have been discussing these difficulties in terms of individuals, it seems as if a similar thing could be applied to businesses and institutional actors. In fact, the processing time and cost might be more easily quantifiable and modelable.

To what extent are these imperfections in individual agents either smoothed out or amplified in the aggregate? Are the deviations from rationality systematic or random? Do these variations cancel each other out in some way, or magnified?

Health Care circa 1993

Before Obamacare was coined, and labeled as the source of all evils a very similar proposal was introduced in the Senate. This was a response to Clinton’s health care proposal. It was quite similar to what was passed by Congress in 2010.
In November, 1993, Sen. John Chafee, R-R.I., introduced what was considered to be one of the main Republican health overhaul proposals: “A bill to provide comprehensive reform of the health care system of the United States.
Two thoughts from this:
1. I am amazed how quickly the past is so forgetten. I am not so idealistic that I expect all everyday citizens to be able to make this connection, however, I feel like it is reasonable to expect that our news media would be able to do the background research and I expect that they should be calling out hypocrisy for what it is.
2. Strong partisanship leads to very strong cognitive dissonance. If an idea comes from your party is it right. If that same idea comes from the other guy, it’s the worse thing ever. I wish there was some way to make these proposals partisanly blind. No one would know who wrote them or who supports them until they decide them on their merits.

Conservatism and the GOP

David Frum has an excellent article in NY Mag about the current state of the Republican Party “When Did the GOP Lose Touch With Reality?“. The saliancy of this article hinges on the fact that David Frum for years was a GOP insider and a staunch conservative (http://en.wikipedia.org/wiki/David_Frum). He served in the Bush administration as a speech writer and is credited with developing the “axis of evil” phrase.

Frum illustrates beautifully how the Republican party has abandoned pragmatism in favor of pitched battles, winning at all cost and principle over practice. With that radicalization has come a willful ignorance of any inconvenient fact, and the demonization of those who disagree.

There is no true, reasonable conservative voice in politics right now. I do not know who to get back on course, but David Frum does a good job of illustrating where we’ve gone wrong.

Are Banks Evil? – Thoughts on “Occupy Wall Street”

With the media attention that the continuing “Occupy Wall Street” protest have been getting, I thought it was fitting to talk about banks. Some of the more radical protesters have been calling for the elimination of banks altogether. One could easily see where these people are coming from. Banks do not create anything tangible. They make money by moving money around. They take your bank deposits, and loan it to someone to build a house (see the classic scene from “It’s a wonderful life” for a good explanation of that role). Why do they make such big profits, and could we do without them? Even among those of us who are more moderate, the size of the “bail outs” that the banks were given makes us uncomfortable. Aren’t we giving away our money to help save rich people from a mess they created?

First, why should we have banks. The job of a bank is to help allocate resources to their most productive use. In order to use our resources properly, it is necessary to sometimes put a lot of money down early to create something that will continually give benefits in the future. That is the definition of an investment. A house is a good example. While it cost a lot of money to build the house, once it is built it provides a lot of benefit and does so for a long time. Roads are another good example. What banks do, is they provide the people or businesses who want to make an investment the ability to do so – that is to say a loan. If you have a good job and you want a house, you do not need to live on the street for 30 years, and then buy one when you are 50. Instead, you can get a loan, buy your house, and pay the bank back the money gradually. That way you are able to live in the house for those 30 years, while paying for it.

However, the flip side to that is that everyone wants to have access to their money whenever they need it. When you take out a loan from the bank, your not actually taking the bank’s money. The bank is giving you money from your friends and neighbors that otherwise would be sitting in their account. If a particular friend needs money, the bank can provide it for them because it keeps some money on reserve. However, if everyone decided they wanted their money the bank would have a problem because you used their money to buy a house and have not yet paid the bank back. The bank would collapse.

Banks are important because they are able to serve the needs of the people who want the ability to access their money on demand (liquidity) and the people who want to make investments (houses, new products, etc). They are actually normally very good about figuring out what the best use of their loans are, because they do a lot of research about what investments will probably pay off, and which will not. That is why banks are important.

However, what happened leading up to 2008 is that the banks research was very wrong. The banks systematically underestimated the risk for some housing loans. This meant we built too many houses, and the market priced them much higher than they were worth. When people started to not be able to their loans, the experts started to doubt whether banks would have the money that you needed whenever you need it, or ever. This doubt started people running to get their money out of banks. The system was literally close to collapse – as in the last people to get to the bank would not have any money, banks would cease to exist, there would be no way to get a loan and therefore the economy would not invest and would basically collapse. That is why the government felt it necessary to insure that the banks had the funds to pay people.

An important thing to realize about the $700B “bail out” is that the banks were not given free money. The $700B was set aside to ensure that the banks could still function and was used in a couple of ways such as direct loans to banks (paid back with interest) or purchases of company stock. Money given to the banks will be paid back unless the bank collapses.

Teacher Compensation

I did not go to public school, and have long found fault with many aspects of our public education system in this country. Which is why I find it strange to be semi-defending parts of the systeem. However, this article from the Wall Street Journal http://online.wsj.com/article/SB10001424052970203687504576655352353046120.html made so many erroneous claims that I felt compelled to dissect it.

Here is the insightful observation from their research: “[M]ost public school teachers would not earn more in private employment”. This supposedly means that public school teachers are overpaid. Their insight is that people who pursue education and spend years getting credentials and building up the particular skill set associated with teaching make more money teaching than doing something else. This is going to be true if we look at any narrowly defined field that requires some human capital (educational) investment. This would be true for truck drivers, surgeons, lawyers, basically almost any profession you can name. In an efficient economy, no worker would make more in any other job! This is neither an insight, nor a problem. To argue otherwise is both wrong. These guys should know better.

1. Selection Bias. They argues that because teachers are not as smart as others, they should be paid less. They fail to mention that the causality most likely runs the other way. High salaries attract would attract high quality teachers, low salaries attract low quality teachers. If teachers are so overpaid, than why do so few graduates desire to become teachers?

Because salaries are low, higher achieving students are not attracted to teaching. The converse of “if you can’t do, teach” is “if you can do, don’t teach”.

I suggest a different model. If teachers are truly overpaid, than the

2. The private sector retirement numbers are terribly unrealistic. No one the private sector invest all their money in treasury bills! According to my calculations the writer used an interest rate of around 2.5%, which is even less than a long term T-Bill! For years the standard, long run retirement interest assumption was around 7%. That difference is huge. With a 7% assumption the retirement annuity goes from his quoted $4,000 to $26,000, which is more than his public sector assumption. Even the more conservative assumption of 6% yields around a $19,000 annuity. These are smart people, and they know the assumption is bad. There is no excuse for this fudging of the numbers to prove a point. If you have a valid point, you can make it with valid numbers.

3. I don’t know any teachers that make $51,000.

4. How can you call an unemployed teacher a private school or public school teacher? The only way you could possibly make this distinction would be by looking at credentials, and if that is the case, it should not be surprising that credentialed teachers have a lower unemployment rate than non-credentialed teachers. This is not an indictment

Disclaimer: I am married to a former teacher, though she was a neuroscience major.