Information, behavior, and frictions (short course on economics)

“Economics is really about two stories. One is the story of the old economist and younger economist walking down the street, and the younger economist says, ‘Look, there’s a hundred-dollar bill,’ and the older one says, ‘Nonsense, if it was there somebody would have picked it up already.’ So sometimes you do find hundred-dollar bills lying on the street, but not often—generally people respond to opportunities. The other is the Yogi Berra line ‘Nobody goes to Coney Island anymore; it’s too crowded.’ That’s the idea that things tend to settle into some kind of equilibrium where what people expect is in line with what they actually encounter.”
― Paul Krugman

I love this quote. These two jokes do sort of describe economics, at least what you might call “pure” or celestial economics, where there are no real world frictions to worry about. If we add frictions to the mix we get terrestrial economics, the economics of the real world.

Krugman’s first joke gets at the way economists think about information. It’s essentially epistemology, about whether to believe something is true. The second joke is about behavior, about how we model the response of people to changes in their environment. At the end I’ll add frictions, and try to give you a sense of how economists like me think about the world.  So here’s my 4-minute course on economics.

1. Information:  Imagine a giant encyclopedia, written in Japanese.  It contains a vast amount of information about the world.  But to read it one must first learn Japanese.  By learning economics we are able to read an enormous amount of information from prices, if we assume that people are rational utility maximizers.  Thus if conventional Treasury bonds yield 7% and indexed bonds yield 3%, we can infer that optimal forecast of inflation is 4%.  If that were not true, there would be $100 bills lying on the sidewalk for investors to pick up.

Here’s another example.  Suppose there’s a neighborhood of cookie-cutter homes on the Irvine/Lake Forest boundary, here in Orange County, CA.  If we compare two similar houses on each side the border, we can infer the difference in value that people see in living in each city, capitalized into the home value (actually land value.)  Most likely, this reflects differences in the perceived value of the two school systems, with Irvine viewed as superior.  If the price gap didn’t reflect amenity differences then homebuyers would take advantage of any mis-pricing.

Here’s another example.  Assume that Mexican farm workers in California earn $11/hour on average while Central American farm workers earn $10/hour on average.  We can infer that the Mexican farm workers are probably about 10% more productive, on average, otherwise California farmers would choose to hire Central Americans, not Mexicans.  Again, no $100 bills on the sidewalk.

The economy contains billions of such pieces of information, all embedded in prices, for those who know how to “read economics”.  It’s like a giant encyclopedia.

2. Behavior:  Economists assume that rational people will keep doing X up until the point where the benefit of one more (marginal) unit of X no longer exceeds the marginal cost of X.  This is the “equilibrium”.  X could be any activity: units consumed, hours worked, dollars invested, etc.:

Urban planners often suggest that expanding highways does not reduce traffic congestion.  That’s wrong.  If you widen a highway, more people will travel on the highway.  That part is true.  But traffic congestion will be reduced; indeed it must be in order to induce more people to travel on the highway.  Why do urban planners get this wrong?  Because they noticed that traffic did not seem to improve when places like Orange County built more highways.  But that’s because both lines were shifting at the same time, as Orange County’s population was growing rapidly when it was building new roads.  It is still true that, other things equal, building more highways reduces traffic congestion.  Recently, Orange County’s population stopped growing.  Now if they were to build more highways in OC, it really would reduce traffic congestion.

Or consider how firms respond to a change in the cost of inputs.  Most students understand that firms will respond to cost increases by raising prices, but often fail to see that firms will respond to price decreases by cutting prices.  But the model is symmetrical; a shift up in the MC curve has the opposite effect of a shift downward, even for a 100% monopoly.  In both cases, cost curve shifts move the optimal output point, which requires a price change.  And we know that firms don’t want to leave $100 bills on the sidewalk.

So that’s celestial economics in a nutshell.  It describes a world where inefficiencies should be quickly eliminated, as utility maximizers do deals to improve efficiency and share the gains.  No $100 bills left on the sidewalk.

3.  Frictions:  Here in the real world, things don’t work so smoothly.  One friction is transactions costs.  In principle, inefficiencies related to externalities (pollution, etc.) and monopoly could be eliminated through negotiations.  Pollution victims could bribe factories not to pollute.  Monopolies could negotiate perfect price discrimination with consumers.  But such negotiations are often costly and hard to do, for all sorts of reasons.  Another friction is sticky wages and prices, which result in nominal shocks having real effects.  Bad real effects, such as high unemployment.  Another friction is illiquidity, which explains why the TIPS spread may not perfectly measure the public’s inflation expectations.  TIPS are less liquid, and hence less desirable.  Furthermore, information is costly.  So there may be a few $100 bills on the sidewalk because no one spent the resources to look for those $100 bills.  And there’ll be lots of coins on the sidewalk.

Left leaning economists focus more on frictions.  Right leaning economists focus more on celestial economics.  I’m somewhere in the middle, but definitely leaning to the right.