Category Archives: Behavioural Economics

A2 Revision – Oligopoly and the kinked demand curve – download

With the A2 Essay paper tomorrow I thought something on the kinked demand curve might be useful. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

Global GDP per person vs Happiness

Some great graphics here from The Economist – The Data Behind Happiness. Each circle represents a country and the size represents its population.

Red circle = countries where happiness has moved in the opposite direction to GDP.

Blue circle = countries where happiness and GDP have moved in the same direction.

On a scale from zero to ten where would you place your life satisfaction right now? That question was asked of thousands of people around the world, and surprisingly the rich in the country the happier it is. That makes Europeans the most gleeful, Africans the most miserable – but there’s a snag.

Overall in about a third of countries happiness has moved in the opposite direction to income. Countries don’t always get happier as they get richer. USA people are less happy despite a growing economy and in the UAE happiness has risen despite falling wealth.

Veblen Goods and the impact of advertising.

When a firm advertises it does so to make consumers aware of their product / service so informed decisions can be made which ultimately, making the firm and consumer better off – positive advertising. But the way adverts are targeted, they can contribute to long-run health risks especially on those that are very impressionable – London has banned junk-food advertising on its public transport. Advertising a top of the range 4 wheel drive car on its way up to a chalet in the picturesque Swiss Alps doesn’t do much for the majority of people who can’t afford them – they see what others can afford but know that they are not in the same league – negative advertising.

Positive: advertising informs. It may promote human welfare by allowing people to make better choices about products. 

Negative: advertising stimulates desires that are not feasible. This creates dissatisfaction. Hence, advertising might reduce welfare by unduly raising consumption aspirations. 

So if advertising encourages people to have things they cannot have does this leave society worse off? Recent research by Chloe Michel, Andrew Oswald, Eugenio Proto and Michelle Sovinsky – Advertising as a Major Source of Human Dissatisfaction: Cross-National Evidence on One Million Europeans – did analysis of approximately 1 million randomly sampled European citizens across 27 nations over 3 decades. They showed that increases in national advertising expenditure are followed by significant declines in levels of life satisfaction. They estimated that a doubling of ad spending is associated with a subsequent drop in reported satisfaction of 3% – an effect about a quarter as strong as a spell of unemployment. Although the authors cannot be certain that advertising has this effect this area is not new to economists.

Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status.

Economists and sociologists often cite the 1980’s as a time of extreme conspicuous consumption. The yuppie materialised as the key agent of conspicuous consumption in the US. Yuppies didn’t need to purchase BMWs or Mercedes’ cars for example; they did so in order to show off their wealth. This period had its origins in the 1930’s with Austrian economists Ludwig von Mises and Fredrick von Hayek – the latter being the author of “The Road to Serfdom”, in which he said that social spending rather than private consumption would lead inevitably to tyranny. Margaret Thatcher (UK Prime Minister 1979-1990) and Ronald Reagan (US President 1981-1989) believed in this ideology and cut taxes and privatised the commanding heights in a move to a free market environment.

So-called Veblen goods (also as know as snob value goods) reverse the normal logic of economics in that the higher the price the more demand for the product – see graph below

Over the last three decades conspicuous consumption has accelerated at a phenomenal level in the industrial world. Self-gratification could no longer be delayed and an ever-increasing variety of branded products became firmly ingrained within our individuality. The myth that the more we have the happier we become is self-perpetuating: the more we consume, the less able we are to tackle the myth.

Conspicuous consumption plays a significant role in society. Most people in the developed world have their basic needs met but to keep workers (on higher incomes) striving for more stuff there must always be more desirable consumer goods out of their reach. Never ending dissatisfaction can increase the demand for goods and services and the desire to earn more income. However it is a sort of prosperity that depends on consumers never being satisfied with what they have.

Economics can make better use of culture

Once shunned by leading economists like Robert Solow, society’s beliefs and values are just as significant for economic progress as is capital accumulation. Joel Mokyr in his book ‘A Culture of Growth The Origins of the Modern Economy’ describes culture as:

‘A set of beliefs, values, and preferences, capable of affecting behaviour, that are socially (not genetically) transmitted and that are shared by some subset of society’.

Economics has traditionally been focused on rational self-interest as the guiding light of human behaviour. The true catalyst for kick-starting the industrial revolution was not cheap labour and capital accumulation but the continent-wide evolution in beliefs. Mokyr believes that the drivers of technological progress and eventually economic performance are attitude and aptitude.

Attitude – the willingness and energy with which people try to understand the natural world around them.
Aptitude – this determines their success in turning such knowledge into higher productivity and living standards.

Mokyr’s ideas gave rise to how economists can make better use of culture with an evidence-based humanistic approach to scientific inquiry which led to a shift in behaviour that enabled industrialisation. Cultural barriers create a gap between classes and can hinder the flow of ideas and work environments – the modern economic experience cannot be explained without it. The cultural changes in the political economy over the past century cannot be explained solely on the basis of rational self-interest e.g. the fortunes of racial minorities and the increased presence of women in aspects of society. Cultural change can act as a catalyst to the economic potential of people and ideas, and matter for reasons other than their effect on GDP.

Evolving norms that allow women, ethnic minorities, immigrants, and gay and transgender people to play full roles in society not only boost growth but reduce human suffering. But because these shifts matter economically, the dismal science needs a better understanding of when and how cultures change—especially now. These norms shaped behaviour, which enabled progress. But cultures change.

Source: The Economist July27th 2019 – The uncultured science

Behavioural Economics – do people return found wallets?

In Science magazine last month Alain Cohn of the University of Michigan and his colleagues published some interesting research into how honest people are. He surveyed 17,000 people people in 355 cities within 40 countries. Cohn’s research assistants entered public buildings – banks, theatres, hotels, police stations, post offices and courts – and handed into an employee at the reception area a dummy wallet. They stated that they found the wallet on the street outside. Each wallet was the same:

  • see through plastic card case
  • 3 identical business cards – with a unique email address and fictitious native man’s name
  • a shopping list – in the local language
  • some had a key
  • some had cash – $94.15 in local currency – only done in 3 countries
  • some had cash – $13.45 in local currency
  • some had no cash

Once handed in the researchers waited for the email about returning the wallet. Results were as follows:

  • In 38 of the 40 countries were more likely to return wallets which had money in them. The two outlier countries were Peru and Mexico – wallets with no money were more likely to be returned than those with.
  • When they increased the amount of money in the wallets by seven times in three countries, they found the average return rate climbed by 18%
  • For wallets with money, the highest rate of reporting was in Denmark (82%) and the lowest in Peru (13%).
  • Switzerland (73%) and China (7%) had the highest and lowest rates of reporting of wallets without money.
  • New Zealand – wallets returned – 60% with no money but 80% with money

People displayed more honesty when there was more money in the wallet – with greater temptation comes greater honesty. However economists are aware of previous research that shows whilst people do care about others they care more about themselves. Researchers concluded that participants main motivation was an aversion to viewing oneself as a thief so the psychological forces cane stronger than the financial ones. People stated that:

  • Not reporting a wallet without money – not stealing
  • Not reporting a wallet with money – stealing

What about the key?
Altrusim played a secondary role in the study. The key in the wallet is of no value to the finder but wallets with keys were more likely to be returned. Switzerland was the best place to lose a wallet containing a key but with no money.

The satisfaction from doing the right thing (returning the wallet) is a powerful motivator and goes against rational economic thinking. This study shows that altruism is evident and widespread.

Source: The Economist – June 22nd 2019, The Guardian

100k Challenge on a Concept2 indoor rower

Although not technically Economics you could say it does relate to Behavioural Economics and Happiness – the utility of completing a 100k row after 3 months and over 800k’s of training. The marginal utility of the last 5k’s was very high

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Starting at 5.30am on Friday 10th May, myself and Jim Potts (Director of Sport at King’s College) rowed 100km each on a Concept2 rower – Jim 8 hours 10 minutes, myself 8 hours 15 minutes. The idea behind the challenge was to raise awareness for youth mental health issues and to raise much needed funds for the Key To Life Charitable Trust.

Assisting us in achieving 100km, we managed to persuade a crew of 15 other staff members and parents who sat along side us and row 100 minutes each in relay. Many thanks to:

Kris Brewin, Ged Leicester, Udi and Marcel Delport, Onasai Auvaa, Daryl Williams, Daniel Mitchell, John Payne, Matt Cowie, Yvette and Richard Hall, Jonathan Ogg, Matt Tooman, Brendan Boreham and Sarah Couillault. Thanks also to all the students and teachers who dropped by during the day – it definitely helped us through.

Below is a photo from the day – Jim is on the extreme left and I am on the lighter coloured Concept2 rowing machine.

You can still donate – see link below:

https://givealittle.co.nz/fundraiser/the-100-challenge

China and the Easterlin Paradox

I have blogged before on the Easterlin Paradox and was interested to read about the relationship between economic growth and happiness. In the mid 1970s Richard Easterlin drew attention to studies that showed that, although successive generations are usually more affluent that their parents or grandparents, people seemed to be no happier with their lives. It is an interesting paradox to study when you are writing about measuring economic welfare and the standard of living.

What is the Easterlin Paradox?

  1. Within a society, rich people tend to be much happier than poor people.
  2. But, rich societies tend not to be happier than poor societies (or not by much).
  3. As countries get richer, they do not get happier. Easterlin argued that life satisfaction does rise with average incomes but only up to a point. One of Easterlin’s conclusions was that relative income can weigh heavily on people’s minds.

GDP growth is generally held as the most reliable predictor of a country’s level of happiness but in China GDP has increased 5 fold over the last 20 years but the level of well-being is less that in 1990. The levels of well-being bottomed out in the period of 2000-2005 and although have recovered they are not a level to that of 1990 – levels of happiness were high for then a poor country. This was similar to Russia before its transition where high levels of subjective well-being were reported.

Growth not a reliable indicator of happiness in China

Chinese level of happiness was highest in the 1990’s In the days of the “iron rice bowl system” – Chinese term used to refer to an occupation with guaranteed job security, as well as steady income and benefits. So it transpires that GDP growth in China was highest when happiness levels were falling. In fact, none of the six predictors used in the World Happiness Reports prove to be reliable predictors in China as there was little or no correlation between happiness and the six predictors- see below:

  1. GDP per capita,
  2. healthy years of life expectancy,
  3. social support (defined as having somebody to rely on in times of trouble),
  4. trust (defined as perceived absence of corruption in government and business),
  5. perceived freedom to make life deci-sions,
  6. generosity (defined as giving to charity)

The two main factors explaining China’s trajectory in happiness levels are unemployment and the social safety net. Unemployment rose sharply after 1990, reaching its peak in 2000–2005—the trough of China’s happiness—and has since declined moderately, as happiness levels have risen moderately. The level of unemployment is mirrored by the relative coverage of the social safety net over the same time period.

It seems that the restructuring of state-owned enterprises (SOE) has had the most profound effect on the happiness of Chinese people. This mirrors developments in Eastern European countries. In addition to unemployment rates and the social safety net, education and age are also important factors in determining Chinese people’s happiness over the period. Levels of education and of happiness are indeed linked; not only does a college education provide access to better job opportunities, but it also makes one more adaptable to changing circumstances.

Source:
Chinese Discourses on Happiness (2018) Edited by Gerda Wielander and Derek Hird

Hyperinflation – can be controlled with a different government.

Venezuela has been in the news for sometime with its economy spiralling out of control with the inflation rate last year at 100,000% – doubling roughly once a month. The occurrence of hyperinflation in economies has become more common with governments now printing money rather than that money being backed by the amount of gold that they held – gold standard. Because the gold supply is quite inelastic, being on the gold standard would theoretically stop government overspending and keep inflation under control. The country effectively abandoned the gold standard in 1933, and completely severed the link between the dollar and gold in 1971 – this was around the time of the Vietnam War.

The more recent hyperinflation in Zimbabwe, Bolivia, Argentina etc have come about through government’s not been able to control the printing presses and succumbing to the desire to stay in power at the expense of crippling the economy. Huge fiscal deficits and excessive borrowing are the common denominator here – see flow chart below:

Hyperinflation usually happens amongst chaotic domestic conditions, whether social unrest or that country being involved in conflict – e.g. post war Germany. However as reported by The Economist hyperinflation can occur under more mundane circumstances. For instance in Bolivia’s inflation reached 60,000% which was started by a commodity boom which allowed them to borrow heavily from overseas but once resource prices tumbled there was a significant reduction in government revenue. The  government under Hugo Banzer increased spending to satisfy the voters who supported them in the election and this created further inflationary pressure. In a way this is similar to the Venezuela experience with high oil prices generating significant revenue for the government but once the oil prices fell the printing presses started to work overtime. And once inflation starts to accelerate Inflationary expectations kick in and then it becomes very difficult to control. However these inflationary expectations could reflect the lack of seriousness of government policy to rectify the problem as a change of government which is focused on prices can end hyperinflation in weeks. This reflects the trust in the incoming regime and was true of Bolivia (see video below).  Here the incoming government under Gonzalo (Goni) Sánchez de Lozada were serious about the ravages of inflation and to deal with it  didn’t use highly sophisticated economic theory.  See below:

  • Government spending was slashed
  • Price controls were scrapped
  • Import tariffs were cut
  • Government budgets were balanced.
  • No borrowing from the Central Bank

As Jeff Sachs – advisor to the Bolivian government –  said:

“All this gradualist stuff just doesn’t work. When it really gets out of control you’ve got to stop it, like in medicine. You’ve got to take some radical steps; otherwise your patient is going to die.”

Sources:

The Economist – February 2nd 2019

Commanding Heights – PBS Video