Economic Rules - Dani Rodrik

Overview ⅘

This book is wonderful. I came to it with no economic scholarship, I couldn’t tell you what a supply-demand curve looked like. However, from my first reading, which the present review is based on, I learned a tremendous amount. I need to reread and follow many references to fully appreciate the ideas, but what I can say is that I appreciate the field of economics and its importance far more than I ever had. Economics is less a unified theory than a collection of models. Most of these models are highly idealised and historically devoid of any attention to irrational actors. The art of economics is in bridging the subjective gap between the model and reality. In essence, merging with sociology.

What models do

Starts with motivating examples about economics policies Bretton Woods Conference was a conference to modify financial rules after WW2 Major players were John Keynes and Henry White This begets the IMF & World Bank.

Principles of Efficient Congestion Pricing demonstrates how economic modelling can have positive impacts on traffic. Santiago Levy argued for direct cash grants instead of foods stamps. Giving mothers an incentive to invest in their children. The leverage of the grants having positive ripple effects on general health and education.

There are two views of Economics

  1. Social science that studies the economy
  2. Apparatus for modelling & statistical analysis for many applications

The focus of the book uses view 2, as a collection of models.

supply-demand.png

The most simple is the supply-demand curves. Its insight is that there's an equilibrium, somewhere between \((Q1, Q2)\) and \((P1, P2)\) respectively where demand balances supply and the prices don’t move much.

It points out obvious things, like a rise in production cost increases \(P\) (price) and reduces \(Q\) (quantity).

A competitive market economy is defined as such when it’s impossible to improve one person’s wellbeing without reducing somebody elses (pareto efficiency).

The book points out such models miss,

  • The reality may not be a perfectly competitive market, with large numbers of producers and consumers
  • The people involved may have other motives besides material ones, that rationality is often overshadowed by emotion or erroneous cognitive shortcuts.

Models should be seen as frameworks for thought, fables; not as laws to themselves.

The word model sounds more scientific than fable or fairy-tale

model-validity.png

Economic models are often highly internally valid, being so frequently couched in maths, but the important question for wider policy decisions is their external validity, can they be fruitfully applied to the real world?

Economics doesn’t have to be highly mathematical, as Thomas Schelling proved, winning a Nobel prize using no maths!

Making models complex reduces their utility.

Models are never true, but there is truth in models.

Science of Modelling

Adam Smith coined the ‘invisible hand’ and an invisible force that a posteriori makes rational self-interest a benefit for wider society. Less regulation from the government means great societal benefit. The argument was never stated in such simplistic terms, and in fact is highly nuanced. Mostly misunderstood. There is a fine balance to be struck between regulation and free markets. Externalities, for example, where one actor's actions cause another’s loss, without compensation, happens frequently in so-called free markets. Free markets do not invest in science research, which is often funded by the government. There are many positives to unregulated markets, the hard problem is the balance.

Principle of comparative advantage states that free trades raises living standards and wealth. An example of Ricardo shows it best,

Good England Portugal
Wine 100 90
Cloth 120 80

Basically, if you work through the numbers, England has a comparative advantage relative to Portugal at producing wine, despite it being cheaper for Portugal to produce wine. Portugal has an absolute advantage producing wine. After an analysis, it becomes clear that England supplying wine to Portugal leaves them able to produce more cloth and the relatively more efficient cost of labour. In the end, both countries end up producing more goods if they trade with one another than if they trade alone.

Tariffs can have unintended global effects, in particular trade diversion, where the most efficient exporter can be handicapped by a tariff, and hence a less efficient producer continues to operate and everyone pays more for it.

Second best logic basically states you can’t have nice things. Models tend to assume first best, but in reality, often for political reasons, some part of the system can not feasibly be first best, and so the rest of the system must be regenerated with this variable constrained. The regeneration, it is stated, necessarily must cause the other unconstrained variables to in turn assume second best values. There is a wider philosophy to this idea, for example Richard Gabriel’s ‘Worse is Better’.

Economics assumed consumers were perfectly rational, behavioural economics accommodates irrationality.

Asymmetric information is when one party knows more about a good service being traded than the other. Doctors selling medical procedures know more than their clients, typically. Programmers selling consulting services likewise. Generally seen as a good thing, workers specialize more, and produce greater value to other workers. Honesty becomes an issue, and reputation systems must have integrity for this to work favourably. Free, accurate access to information hedges this risk.

“You’re not even wrong”, Pauli wrote of a student’s theory. He was a scolding person. It means that what is proposed can not even be challenged, since the assumptions, causal links and implications were so vague. So many ideas are like this I wanted to note it down!

A summary here is that Economics is science purely because of its models.

Navigating Models

This chapter discussed Game Theory

Barry Nalebuff is an interesting person.

Ultimatum game when two anonymous people simultaneously take a turn. There is a sum of money, and you propose to another what proportion to you would like. Say you start with £100 and on your turn bid that you will take 100% of the money. The other person may accept if they are especially generous, or they’ll feel you are greedy and reject, knowing that neither of you get money. If you bid 0%, it would be highly rational to accept.

Ultimately, the gap between a model and its reality can only be bridged by subjectivity, which means there’s an unavoidable “art” to practical economics that is not always logical.

Models and Theories

Whereas the natural sciences have theories, economics has models. Theories are unifying, whereas models answer a specific question.

Labour theory of value says value units are workers

French physiocrat value theory says value units are land

There was a lot of discussion about “marginal theories”, which I found exciting but didn’t follow well.

Keynes was a proponent of sharing simple fundamentals than trying to arrive at an impressive, crystallized theory of everything.

Robert Lucas says we should “put people back in economics”, harking to the idea that sociology should play a more important role in economics.

The biggest take-away from my first reading is that theories in social sciences are only models. They must be applied judiciously.

When Economics goes wrong

Raghuram Rajan was an early cassandra of the ‘08 financial crisis. The powers that be (Larry Summers) called him a luddite!

Eugene Fama coined the Efficient Market Hypothesis, which in brief claims market prices reflect all available information. You can not beat the market, there is no edge to gained through asymmetric information. The only source of truth is the prices, which everyone can see. In other words, no one could have predicted the financial crisis of ‘08.

Washington consensus, excessive zeal for unfettered markets and financial globalisation. The prevailing wisdom now is to move away from global blueprints and towards judicious and high-resolution model selection, localised to smaller areas.

The rest

The rest of the chapters I found too boring. They seemed mostly a defense of the profession that I had not that interested in.

References

Created: 2021-11-28 Sun 17:58

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