A Book Review on Armchair Economist (1)

7/27/2019 A Book Review on Armchair Economist (1)

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A report on issues related topoverty & inequality in India

SUBMITTED TO MR. MIHIR K. MAHAPATRA

SUBMITTED BY-

GROUP - 2

DEVENDRA BHANSALI 11015

DIPANKAR CHAKRAVRTY 11016

NARASIMHAN KESHAVAN 11032

RAJKUMAR SINGH 11043

VIPIN BAJAJ 11060


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PREFACE

The Armchair Economist: Economics and Everyday Life is aeconomics book written by noted professor of economics Sir StevenLandsburg. The book is a collection of routine examples illustratingimportant economic and financial theories.The underlying theme of thebook, as Landsburg states on the first page, is that most of economics canbe summarized in four words: People respond to incentives. In the first fewchapters, Author tried to explain the Responsiveness towards Incentiveswith quite a many examples such as Accidents, safety legislations, etc. Healso tried to explain the rationality issues with the economists slogan-Degustibus nonest disputandumthere's no accounting for tastes. With thisapparently innocuous observation, Landsburg discusses some unexpectedeffects of various policies such as automobile safety legislation andenvironmental policies.

Part Two entitled "Good and Evil" provides some insight as to how the pureeconomist thinks. Dr. Landsburg correctly points out that public policy-making is inherently fiawed because it is not based on any fundamentalprinciples relating to what constitutes good or fair.

Dr. Landsburg also explains the Coase Theorem of property rights using the

example of a doctor whose patients are upset by the noisy candy-makingmachines that are operated in the building next door.

The rest of the book includes expositions on a wide range of topics,including budget deficit, unemployment, economic growth, and cost-benefitanalysis.

What we, the group liked about the book is that the comprehension part. As,

it is very easy to comprehend and the authors way of explaining the things

is quite commendable. As the author remarked at the start of one of the

most enjoyable chapters-"Economic theory predicts that you are notenjoying this book as much as you thought you would." The point turns out

to be this: the fact that you have chosen to read it is a sign that you have

probably overvalued it in relation to all the other books you could have read

instead.

Landsburg has written a very clear introduction to the thinking of aparticular kind of economist: those of the so-called Chicago school of whichhe is himself a member. Where their thinking is confused, the book isconfused; where it is clear, so is the book. But we did enjoy it, and would

recommend it.


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THE AUTHOR

Steven E. Landsburg is a Professor of Economics at the University ofRochester, where students recently elected him Professor of the Year. He isthe author ofThe Armchair Economist, Fair Play, More Sex is Safer Sex, TheBig Questions, two textbooks in economics, a forthcoming textbook ongeneral relativity and cosmology, and over 30 journal articles inmathematics, economics and philosophy. His current research is in the areaof quantum game theory. He writes the monthly Everyday Economicscolumn in Slate magazine, and has written regularly for Forbes andoccasionally for the New York Times, the Wall Street Journal and the

Washington Post. He appeared as a commentator on the PBS/TurnerBroadcasting series Damn Right, and has made over 200 appearances onradio and television broadcasts over the past few years.


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The Armchair Economist: Economics and Everyday Life

The Author tried to amalgamate the general concepts of Economics with the

daily activities. Heres a brief summary of, what the author wants to express

and what we learnt.

The first chapter is about the critical role played by incentives in economicbehavior. Dr. Landsburg explains that the introduction of a regulationcauses a consumer to change his behavior. He says that economics can besummarized as people respond to incentives. The author says that if the

prices are allowed to rise freely, customers will reduce their consumption. Itclearly depicts the relationship between quantity demanded and price of theproduct as explained by Law of Demand. As per this principle, the incentivesprovided to the drivers in the form of seat-belts, padded dashboards,collapsible steering columns, dual-breaking systems and penetration-resistant windshield did not result in a decline in vehicular accident-relateddeaths as lawmakers had anticipated. While the use of safety belts helped toprevent some deaths, this phenomenon was offset by the propensity ofdrivers to drive less carefully because the incentive to drive with prudence inthe absence of seatbelt protection had disappeared.

The seat-belt regulation did reduce the number of driver deaths by making iteasier to survive an accident. But it also increased the number of driverdeaths due to reckless behavior and the number of pedestrian deaths. Therewere more accidents and fewer driver deaths per accident, but the totalnumber of driver deaths remained essentially unchanged. At the end of theday, incentives do matter. One cannot underestimate the power of incentives

Chapter Two explores talks about rational chaos. For example, why don'trock concert promoters raise ticket prices in the face of a sellout? Theanswer here is simple.Rock concert tickets sell out in advance even if the promoters increase the

price of the tickets. But the promoters dont increase the price. Therationality of this decision is argued and the probable reasons for notincreasing the ticket prices are as follows:The long queues for the concert are a good advertisement to the show.Therefore, the promoters do not increase the ticket price. But the authorargues that the high selling price of the tickets is also a good advertisementto the rock shows.The other reason for not increasing the ticket prices is that the promoterswant a teenage audience who buy rock memorabilia whereas adults dontbuy those. Therefore it is necessary to keep the ticket prices affordable.


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Describing the decisions made by individuals as rational and finding thereasons why the particular behavior is rational is one of the basic principlesin microeconomics.

Chapter Three, "Truth or Consequences," provides some timely insight intothe relationship between asymmetric information and insurance pricing. Theauthor contends that a deficit of information on consumer prudence leadsan insurance company to charge premiums that are commensurate with anaverage risk level. The risk averters, who know how they behave, feel theyare paying too high a price and forego insurance. This leaves a pool ofinsured parties that is dominated by risk takers. This increases average riskand results in a higher premium charged by the insurance company. As thenext level of risk averters conclude that the new premium charged is too

high, they too forego insurance, the average risk level rises once again, andthe cycle of rising rates continues. Ultimately, the pool of insured partieswould be so risky that the insurance company would incur large losses thatwould jeopardize its financial solvency.Insurers seek to ameliorate the asymmetric information problem and theassociated dilemma of moral hazard by providing rate incentives to partieswho reveal information about any behavior that affirms the inclinationtowards prudence. For example, getting a car alarm is one type of signal arisk averter can give to the insurance company in order to facilitate theprovision of cost effective insurance.

Then, the author talks about the Indifference principle. As per authorsargument, the gain is certainly not busboys. Because the wages of thebusboy is inversely proportional to the tip. The restaurant owner does notbenefitted even after decreasing the busboys wages. As the total cost offoodfalls by the amount of tip given by the diner, the owner cant afford to keepthe same menu prices. Therefore, the menu prices shrink. Thus, the benefitof the tip is returned to the diner. The Indifference Principle guarantees thatall economic gains accrue to the owners of fixed resources. Only the ownerof a resource in fixed supply can avoid the consequences of the IndifferencePrinciple.

Part Two entitled "Good and Evil" provides some insight as to how the pureeconomist thinks. Policy makers believe in list of pros and cons. They needmoral philosophy to guide the decisions. Dr. Landsburg correctly points outthat public policy-making is inherently flawed because it is not based on anyfundamental principles relating to what constitutes good or fair. He arguesthat taxes are almost always an evil, in as much as they contribute toeconomic inefficiency and create dead weight losses. Yet, there isoverwhelming political support for taxes, especially progressive taxes, as agood because some redistribution of income can be achieved. That begs thequestion as to whether redistribution of income is inherently moral. Since

rational self-interest underpins the idea of capitalism, the market-driven


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economist's response to this query would differ from the popular notion ofequalizing wealth.

ECONOMICS IN THE COURTROOM

In law and economics, the Coase theorem, attributed to Ronald Coase,describes the economic efficiency of an economic allocation or outcome inthe presence of externalities. The theorem states that if trade in anexternality is possible and there are no transactions costs, bargaining willlead to an efficient outcome regardless of the initial allocation of property

rights. In practice, obstacles to bargaining or poorly defined property rightscan prevent Coasian bargaining.Dr. Landsburg explains the Coase Theorem of property rights using theexample of a doctor whose patients are upset by the noisy candy-makingmachines that are operated in the building next door. Bridgman made candyin the kitchen of his London home. In 1879, Dr. Sturges built a newconsulting room at the end of his garden, adjacent to Bridgman's kitchen.Only after the construction was complete did the doctor discover thatBridgman's machinery made noiseso much noise that the consulting roomwas unusable. Sturges brought suit in an attempt to shut down Bridgman'sbusiness. But, the judge ruled for Sturges. When negotiations between thedoctor and the candy-maker are possible, it is shown that resources aremost efficiently allocated when they are directed to their most profitable use.A judge is unable to identify and thus direct resources to their mostprofitable use. This can only be decided by the owners of the resources. Inthe event that the doctor's business is more profitable than making candy,the doctor should pay the candy-maker a fee that is sufficiently largeenough to motivate him to cease making candy and allow the doctor to enjoya prosperous practice.Economists are usually far more concerned aboutthe allocation of resources than they are about transfers of income betweenindividuals. That is, it does not affect what gets produced, or the means of

production.

There is a flip side to the Coase theorem, which can be dealt as : When circumstances prevent negotiations, entitlementsliability

rules, property rights, and so forthdo matter. For certain cases the court's decision matters, and the efficient

decision depends on the particulars of the case.

Dr. Landsburg continues to argue in this chapter on the benefits of the pricesystem. He presents a cogent argument as to how signals by consumers andproducers are best reflected in the price-setting mechanism of a free market.

Adam Smith would be very happy with the explanation of the invisible handconcept presented herein. His conclusion is that inefficiency exists when


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markets are missing. This is a truism for economists. Unfortunately, themerits of a free-market system in which prices convey information aboutwants and needs is an idea that is woefully misunderstood by the public atlarge.

Consider air pollution. If a market existed for clean air, local residents andpolluting factories could set the appropriate price for clean air and theoptimal amount to be maintained. Because this market does not exist, theexact benefits and costs associated with clean air cannot be assessed andregulation is promulgated to provide for less pollution. Unfortunately, as Dr.Landsburg explains, regulation further distorts the supply and demandequation, and the result is a wholly unsatisfactory one for all parties.

THE MYTHS

In third Part, the Author explained of certain myths that are quiteprevalent in public. As, he pointed out quite rightly, at the rate of one dollarper second, it would take over one hundred thousand years to pay off thenational debt. Such facts titillate, but they do not enlighten.

MYTHS ABOUT WHAT THE NUMBERS MEANMyth 1: Interest on past debt is a burden. Interest payments on past debt

are included in the calculation of the deficit, which implies that thesepayments add to the taxpayers' burden.

Myth 2: A dollar spent is a dollar spent. That is, a dollar spent in erecting agovernment office building (which uses up steel, glass, labor, etc.) is theequivalent of a dollar paid out by Social Security (which makes one personricher and another poorer without actually consuming anything) which isnot correct.

Myth 3: Inflation doesn't count. In fact, inflation is an enormous boon to anydebtor, including the government.

Myth 4: Promises don't count.

MYTHS ABOUT INTEREST RATESMyth 5: The "Goliath" Myth. According to this theory, the country ispopulated by little "Davids," competing against the "Goliath" of tine federalgovernment, which annually consumes $200 billion that would otherwise beavailable to Davids seeking to finance their cars and their houses. Thiscompetition for a limited supply of money drives up interest rates to thepoint where David can't even afford to finance a slingshot.


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Myth 6: The Myth of Dick and Jane.

MYTHS ABOUT THE BURDEN OF THE DEBTMyth 7: Our grandchildren will inherit our debts. Our grandchildren willinherit not only our debts but also our savings accounts, which include theadditional wealth that we save by paying lower taxes in the present.

Myth 8: The Myth of Crowding Out. This is similar in form to the Goliathmyth, except that this one concerns physical resources rather than money.

Myth 9: Deficits hurt our trade position.

The author also explained about how we misinterpret Statistics and heexplained it with the help of some examples.Economy wide unemployment can be a sign that times are getting worse ora sign that times are getting better. The same is true at the level of theindividual.Theauthor explained it by a example thatwhen Peter chooses towork 80 hours a week and get rich while Paul chooses to work 3 hours aweek and get comfortable in other ways, who is to say which choice is thewiser?. In economics, morality, or for that matter personal instincts say we

should approve more of one than of the other. Unemployment or a low levelof employment, can be a voluntary choice and a good one.It is easy for observers to falsely convince themselves that Peter must havebeen wiser or more fortunate than Paul, because Peter's income is moreconspicuous than Paul's leisure. Statistics is a plain truth but we interpret itwrongly most of times. A doctor probably have different opinions about theaverage size of his waiting room crowd. Perhaps it's because you are justmore aware of people when they are coughing on you and there are noempty chairs. More likely it's because you and your doctor are measuringdifferent things. More justified when he says There are always more no ofpeople who know the clinic is crowded. Another examples can be aStatistical illusion of poverty and Finding a table in Non smokers section.

In fourth part, The author highlights the importance to investors ofassessing risk versus return. While this important tradeoff is a fundamentalprinciple of financial valuation to professional investors and academics,many are unaware that a higher expected return comes at the expense of ahigher risk potential for any given security. His advice to the reader is tofocus on constructing a well-diversified portfolio and forget about thecelebrations of a given stock provided by one's friendly broker. We thoughtthat his comments regarding the efficient market hypothesis were grossly

simplified. Still, the author can be forgiven this deficiency if you keep in


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mind that the intended audience probably wouldn't want more of anexplanation of market efficiency anyway.

Economic theory predicts that you are not enjoying this book as much asyou thought you would. This is a special case of a more general proposition:Most things in life don't turn out as well as you thought they would. Whilepsychologists, poets, and philosophers have often remarked it as anecessary consequence of informed, rational decision making. The authorelaborated it by the example of selection of a book. Choosing a book is aprocess fraught with risk and uncertainty. Fortunately, your lifetime ofexperience as a reader is a valuable guide. It enables you to form someexpectation of each book's quality. Your expectations are sometimes verywrong, but on average they are far better than random guesses.Some books are better than you expect them to be and others are worse, butit is unlikely that you err in one direction much more often than the other. If

you consistently either overestimated or underestimated quality, you wouldeventually discover your own bias and correct for it. So it is reasonable toassume that your expectations are too low about as often as they are toohigh.This means that if you chose this book randomly off the shelf, it would be aslikely to exceed your expectations as to fall short of them. But you didn'tchoose it randomly off the shelf. Rational consumer that you are, you choseit because it was one of the few available books that you expected to beamong the very best. Unfortunately, that makes it one of the few availablebooks whose quality you are most likely to have overestimated. Under thecircumstances, to read it is to court disappointment.

THE IOWA CAR CROP

The author quoted very beautifully that A thing of beauty is a joy forever and

nothing is more beautiful than a succinct and flawless argument. A few lines

of reasoning can change the way we see the world. The author talk about his

friends David Friedman one of the most beautiful arguments. While the

argument might not be original, David's version is so clear, so concise, so

incontrovertible, and so delightfully surprising and moreover the argument

concerns international trade.

David Friedman said that there are twotechnologies for producing automobiles in America. One is to manufacture

them in Detroit, and the other is to grow them in Iowa. When you have two

ways to make a car, the road to efficiency is to use both in optimal

proportions. The last thing you should want to do is to artificially hobble one

of your production technologies. Iowa trades Wheat for Cars with Japan.

Policies rooted in superstition do not frequently bear efficient fruit- Imported

cars traded in from IOWA are less American than cars manufactured in

Detroit. If we have two paths then we should pave a way that includes the

benefits of both.


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Finally, The Author talks about the Economics of Scientific Method andquestions whether Albert Einsteins theory of relativity is credible or not. In1915, Albert Einstein announced his general theory of relativity and some ofits remarkable implications. The theory "predicted" an aberration in the orbitof Mercury that had been long observed but never explained. It alsopredicted something new and unexpected, concerning the way light is bentby the sun's gravitational field. In 1919, an expedition led by Sir ArthurEddington confirmed the light-bending prediction and made Einstein aninternational celebrity.

Both the explanation of Mercury's orbit and the successful prediction oflight bending were spectacular confirmations of Einstein's theory. But onlythe light bendingbecause it was unexpectedmade headlines.The Author questions the reader- Does novelty matter?The "novelty doesn't matter" camp argues that a theory should be judged onits own merits, independent of how it was discovered. The author goes onthe extent to explain it by a example as Consider a simple analogy. Of thesocks in your left-hand drawer, one-half are black. Of the socks in yourright-hand drawer, none is black. If you choose a sock from the left-handdrawer, what is the probability it is black? Surely one-half. Now suppose

that while blindfolded, you reach into a randomly chosen drawer andremove a sock. Your spouse, who has been watching, then informs you thatyou chose from the left-hand drawer. What is the probability that the sock isblack? Still one half. All that matters is where the sock came from, not whatyou knew when you were choosing it. The scientist choosing among possibletheories bears some resemblance to a man choosing a sock. In his left-handdrawer are theories that conform to a particular set of facts, and one-half ofthese theories are true. In his right hand drawer are theories that arerefuted by the facts, and none of these theories is true.The scientists who describe their theories based on novelty produce truetheories.

There are two ways to produce a theory:- Theorize first and then produce Look first and then produce.

If scientists theorize first, their work is expensive, too few theories survive,

and not enough good bridges get built. If scientists look first, there is no way

to tell the good theories from the bad ones and too many bad bridges get

built and then fall down.

The author divided scientists into two groups-


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Lookers and Theorizers.Theorizers generally are the ones who producenovel predictions.

Theorizers who produce a novel prediction get a pay for $100,000.The ones who fail get $20,000 Lookers get a guaranteed pay of $50,000.

This is done to keep the BAD away from the GOOD. The government mustfund the researches that have no social value whatsoever. Thus the researchinstitutes will be efficient in producing successful theories by making wayfor the good scientists.

Science of Economics v/s the Religion of Ecology

Economics is a way of thinking, with an influence on its practitioners that

transcends the demands of formal logic. Economists are extraordinary in

their openness to alternative preferences, life-styles, and opinions. The

author explained it by examples like-

Recycling of paper- eliminates the incentive for paper companies to plant

more trees and can cause forests to shrink. If you want large forests, your

best strategy might be to use paper as wastefully as possible. Also, by

Removing pesticides which will lead to rise in prices of the vegetables and

fruits. Less people will consume them. More people will tend to spoil their

health.

Finally, to sum it up, In authors words, Economics in the narrowest senseis a science free of values. But economics is also a way of thinking, with aninfluence on its practitioners that transcends the demands of formal logic.With the diversity of human interests as its subject matter, the discipline ofeconomics is fertile ground for the growth of values like tolerance andpluralism.


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Conclusion

The Armchair Economist: Economics and Everyday Life is rich withstraightforward but powerful illustrations of key tenets of economics andfinance. An understanding of economics is indispensable to understandinghow financial markets work and how consumers and firms behave and this

book makes critical ideas easy to digest and fun to read about.The book is entertaining and often witty, and written in a conversational,easy-to-read style. The book is very good at presenting often unintuitive andnovel ways of looking at things. This is an invaluable book for pointing outcommon fallacies in arguments about deficits, inflation, unemployment, andother major political issues. At the same time, however, we think that thrauthor occasional misses significant relevant issues, most glaringly in thefinal chapter on environmentalism. For example, author describes a casewhere Jack wants a woodland at the expense of Jill's parking space and viceversa, and argues that the desires are exactly symmetrical. Whileenvironmentalists claim that the wilderness should take precedence"because a decision to pave is 'irrevocable'", Author says "a decision _not_ topave is _equally_ irrevocable" because "Unless we pave today, myopportunity to park tomorrow is lost as irretrievably as tomorrow itself willbe lost". While this is correct, this misses the environmentalist's point that itis much easier to convert woodland to parking lot than to do the reverse.The environmentalist fears taking actions that are irrevocable in the sensethat they cannot be undone in the future. Author's perspective throughoutthe book seems to me to ignore the possibility of actions taken which mayhave consequences which may adversely affect the very existence ofmankind.

Another example in the same chapter is when he suggests that the best wayfor environmentalists to support the existence of cattle is to eat beef: "If youwant ranchers to keep a lot of cattle, you should eat a lot of beef". Thispresumes that environmentalists care about the number of cattle inexistence, irrespective of their living conditions.Nonetheless, we recommend this book for the content clarity and for theexamples of economic and financial principles in an entertaining way.


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Documents

A Book Review on Armchair Economist (1)