How Markets Work

A conversation with a coauthor on the financial knowledge of Americans recently incited some deep thinking about market efficiency, one of the holy grails of economics. While discussing our results on investors in English stocks from 1690-1720 or so, she brought up a recent paper in which the authors gave a random sample of (contemporary) Americans a financial literacy test. The test consisted of only three simple questions on interest returns, inflation and volatility of stocks versus mutual funds. The vast majority of respondents failed the test, unable to answer any of the multiple choice questions correctly. It is disturbing in and of itself, but also begs the question of how models incorporate investors’ knowledge. The information may be out there, but if investors aren’t using it, or aware of it, how can we conclude that individuals are savvy enough to choose the right investments? To create optimal portfolios for their individual situations? To save adequately for retirement? To choose an affordable mortgage? All this without even adding in the risk of shocks like a financial crisis or a recession or a bubble.

It’s a good reminder, my coauthor noted, that markets may do what they are supposed to, but people in markets rarely do. Without the information we assume they have, without the forward-thinking savvy we assume they have, our models are profoundly lacking.


The Promise of a Baby

I’m currently reading an ethnography called Promises I Can Keep by Edin and Kefalas. It’s about marriage and childbearing in poor communities in and around Philadelphia, PA and relates the findings from interviews with women of all races.

I’m finding myself blown away again and again by the content and the revelations of the authors, but as an economist, I’m particularly interested in this extent to which fathers are said to encourage pregnancy early in the relationship. Many mothers report their boyfriends saying “I wanna have a baby by you”, with seemingly little regard for the costs and responsibilities that come along with childbearing. I think having a child in general flies in the face of a rational agent that can plan forever regardless of class, but the discount rate seems particularly uncoupled from reality in these respondents.

One of my thesis chapters is on promises of financial support and how that affects investments in children. My original thought was that a promise of support would be just as effective as additional income in motivating mothers to invest in their children, particularly in financially-constrained decisions. In my data work, I came across the problem that controlling for race (and essentially class in this data set as most of the well-off mothers are white), strips away most of the variation. That is to say, that black mothers who receive a promise of support are not much different than the very few black mothers who don’t receive a promise of support. Edin and Kefalas’ work indicates that the promise of support is almost a prerequisite for childbearing, even when all circumstances–availability of drugs, lack of good jobs, the father’s tendency to “run and rip” with his friends, etc–point to the statement having no credibility whatsoever.

It’s puzzling that women, ultimately knowing that they won’t get financial support, through a legal arrangement or otherwise, would choose to have children with men in the hopes that he might turn around for the baby. It certainly flies in the face of models we use where we can assign realistic probabilities to future events and make our decisions based on our expected utility. The number of reform stories is stiflingly small, but apparently enough to encourage the dreams of so many.

Irrational Tonics

My name is Erin, and I’m a professor at a small liberal arts college in Pennsylvania. Or, rather, that’s what I’ll be come August. Right now, I’m just a grad student trying desperately to get some projects out the door. And frankly, a grad student who’s looking for more projects. I like projects. I intend this to be my new one, but first, a little background.

A few months ago, a friend making a documentary in Africa sent me the link to a blog post on how relationships between prostitutes and their clients affect tips. She was aghast, not because of the topic, but rather because it got so much attention. Is it possible, she asked incredulously, that economists could be just now figuring out that human relationships have bearing on how we make decisions?

My response was well, yeah, and in fact, you should be ecstatic that they’re even starting to examine it. Economists like models. They like simplified versions of reality and to be honest, life is not all that simple. For as much as the dismal science has grown and evolved and gone back and forth on monetary policy, we’re still not very good at figuring out how individuals make decisions. We impose rules on them and hope that our models give good results, but in truth, our models are only as good as the assumptions we put into them. The assumptions we tend to put on people is that they are rational agents, and generally time-invariant rational agents. In simple terms, that means that if I asked you to choose among several scenarios–say, what you would buy, where you would get food, etc, in a given month–, you could tell me which one of those scenarios would make you the happiest, the second happiest and the third happiest. That’s the rational part, you know exactly what is good for you. The time-invariant part is that, likely, your ranking of these scenarios wouldn’t change from day to day unless something big happened to shift your worldview or change your preferences for, say, pizza (like you saw a rat at your favorite restaurant).

For the past five years, or at least the past three, I’ve been writing a dissertation in which I try to illuminate, to some small degree, how human relationships affect our decision making. We’re not very good at measuring these types of relationships, primarily because of what economist call “unobservables.” For instance, I can see that you, as a mother, decide to put your child in private school. From your private school application, I might know your level of education, your income, your occupation and all of these things about your husband, as well. These are “observables” and with this limited information, I can make a pretty good prediction about how many years your child will go to school and what kind of money he will make. Or at least, averaging among all the children who have parents like you, I can predict an average value for these characteristics. However, there are lots of things I don’t know about you. I don’t know how impatient your child is, or how motivated you are to make him study. I don’t know whether you’re a hands-on parent or if your marriage is in trouble. As emotionally intelligent people, we know that these characteristics probably have an effect on the child’s well-being, but as economists, we don’t have a good way to incorporate them into our models.

So, I aim to incorporate them into our models. I’m not the only one doing it, and my plan for this space is to highlight people who are doing work in the same vein as mine–how do our relationships affect our decisions?–but also people who are doing other work that seeks to shed light on decision making as influenced by other aspects of life that we don’t normally incorporate into our models. That won’t be all, of course. I’ll also use this space to talk about research on gender and children. Occasionally, I might throw in some water stuff; water is pretty cool, and pretty important.

In any introductory economics course, your professor is sure to tell you that economics is the study of allocation of scarce resources. It’s true, but it’s also just the beginning, that’s why we call it introductory. My hope is that this blog will make economics, as it is studied beyond the introductory level, more accessible and remind people that it’s not all about money. I can’t tell you which stocks to pick or tell you whether unemployment is going to fall (though, actually, at this point, I’m inclined to say no as it seems that money is cheap and companies are investing in capital instead of hiring workers, but that’s a post for another day and another blog). But I can talk to you about love and friendship and how it makes us totally irrational.