Extremes are better than the average! Concavity in practice
(picture from Wix's library)
Hello everyone! Yes I am still alive thank you for asking…
I have not made much improvement to the website and have not posted any article in a long time. Let me start by saying that I have not stopped working on my classes, which are close to being completed for my first course, Microeconomics.
I like to stay focused when I work, which means I put aside the website for long in order to progress substantially in my classes.
All right, enough boring explanations, here’s this month’s article: The average is worst than the extremes: Concavity in practice… here it goes!
We normally think of extremes as fairly bad compared to more mild (and average) behaviours. In Economics, we would say that a function is (strictly) concave when the average is worst than the extremes.
SO! I’ve been considering a new idea (new for me, I’m sure someone else thought of that before) regarding the amount of knowledge people generally have about Economics. I have thus far dedicated my time and knowledge towards spreading the understanding of Economics as far as I can.
I have, however, seen something I was not expecting at all: more knowledge about Economics can have perverse (negative) effects… it may be better for all of us if most economic agents had almost no knowledge of basic economic concepts (extreme) rather than some knowledge (average). I can’t push this argument for the other extreme but I would say that very few people can claim to have an absolute knowledge of economics (I know I cannot have such a claim).
Here’s how I got to that “revelation” of sorts: Economic theory tries to explain how people make decisions and Economists try to understand how to best serve a society’s desires and aspirations. This is generally known as “maximising social welfare” in our own vocabulary. We assume that people go around their daily activities and we can just observe them and try to model their behaviour.
Nothing too extraordinary so far… except that we are wrong! Very similar to the observer effect (Hawthorne effect) in which observed parties change their behaviour when they know they are being observed (making the exercise pointless), we have created a modeller effect (it’s not very catchy, I’m still working on it)!
This ‘modeller effect’ would work like that: we have created models to explain how people behave but these models influence people’s behaviour. Economics has gotten a lot of attention since the financial crash of 2007 (in the USA) and the Economic crisis that followed (in most of the OECD countries). Most investors, big and small, have a certain amount of knowledge of basic Economic principles. A high number of news agencies have now put Economics as a priority in their programmes and have their own specialists and guests trying to explain what is going on.
This new interest in Economics (which seemed to have been somewhat unpopular before the crisis) lead people to hear about basic academic arguments… which I was very excited about. I am trying to bring Economics to most people in the world and seeing my colleagues spread this knowledge seemed a very good thing. Well… I am starting to think that this is not such a good thing after all.
The ‘stories’ of Economics presented in most media outlets show our basic models as facts rather than possible outcomes. There is not enough effort given to explain underlying assumptions and possible shortcomings of Economic theory, which means that people still don’t understand the great majority of economic events. Even worst, this “modeller effect” leads people to think they understand well Economics and thus influences their choices, particularly for small-scale speculators. They hear academic arguments from news agencies about the theoretical effect of interest rates, growth figures, and others, and think these are proven, well understood, causations… which they are definitely not!
In a world where the great majority of transactions are made by seasoned investors with experience and a sense of the markets, this would not be such a big deal. They would just disregard some of our models and do whatever they think works. However, in a world where small speculative investors are becoming more and more important, this can lead to a big problem. These investors tend to be very nervous, and very inexperienced. As such, they tend to listen to the ‘experts’ and are not able to critically assess the relevance of this academic knowledge.
This leads back to my ‘modeller effect’ in which small investors will react exactly how Economic textbooks tell them to when faced with an Economic event. A lowering of interests rates, for example, can have no effect at all on the economy. However, textbook Economics tell these small investors that this will have a strong positive effect, making them buy government bonds or shares of the relevant companies that are supposed to benefit from it. I see disproportional reactions of the speculative markets to small insignificant changes in policies and in economic variables.
The funny thing is the following: Economics is filled with what we call “self-fulfilling prophecies” in which beliefs by a significant amount of agents will become true if they act on it. The fact that Economic textbooks tell them that something will happen makes people act in accordance with that idea, which in turn makes it happen… artificially and for a little while. If these investors had not heard about that theory, they would have probably done something else or nothing at all.
‘Not too bad’ you might say! They are right in the end since the markets did behave in the way you predicted right? Well… no.
These badly explained Economic models work well under certain specific conditions. However, they don’t work under other conditions, which is more than often what we are faced with in the real world. As such, these artificial choices made by these speculators create frictions in the markets, pressures if you wish. These distortions can lead to speculative bubbles or to the decline of industries that would have normally done well. In short, they force markets out of their ‘natural’ equilibriums, which can be fairly risky.
I am still developing this concept as I go along, please forgive me if that was a ramble of uncoordinated thoughts. The main point is the following: I would prefer that small speculators had no knowledge of Economic theory (and thus just act as they see fit) rather than a misguided impression of knowledge (and follow textbook Economics).
We have created models to explain Economic events and to understand how these events influence each other. However, our models are conditional on specific assumptions that are not made clear to the public. Our basic models of the economy are simplistic and they require more explanation than what is given to them through the media. I will hopefully be part of a better understanding of Economics that can help people make informed decisions rather than following dogmatic models that don’t always apply to real-life.
Thanks a lot guys! For those that wonder, I’m getting a new Logo and will put my whole first unit of Microeconomics online for free in the next few weeks.