If our models are correct, then people are smarter than we realised!

Whilst making pies yesterday I happened to recall a sentence I read 7 or so years ago, which suddenly struck me as very silly. So I just looked it up to make sure I hadn’t imagined it.

I didn’t.

Here’s the whole paragraph.

A final point worth noting on gang wars is that their strategic
aspects are not lost on the participants. Gangs use violence on
their competition’s turf as an explicit strategy for shifting demand
to their own territory. As one former member of the rival gang put
it during a gang war:
See the thing is they [the gang for which we have data] got all these
places to sell, they got the numbers [of sellers], you know. It’s not like we can
really do what they doing. So we gotta try get some kinda advantage, a
business advantage. If we start shooting around there [the other gang’s
territory], nobody, and I mean it you dig, nobody gonna step on their turf. But
we gotta be careful, ’cause they can shoot around here too and then we all
f——. But, it’s like we ain’t got a lotta moves we can make, so I see shooting in
their ‘hood as one way to help us.
In fact, in some cases, a gang engages in drive-by shootings on a
rival’s turf, firing into the air. The intention is not to hurt anyone,
but rather to scare potential buyers. It is interesting to note that 
the gang member understands the game-theoretic consequences
of such actions corresponding to retaliation by the rival, in which
case both parties are worse off than if no violence had occurred.  (my emphasis)

Some of you might recognise the paper, given it was popularised in Freakonomics. It’s “An Economic Analysis of a Drug-Selling Gang’s Finances” by Levitt and Venkatesh.

On reflection I might be unfair in calling it silly, but it reflect a strange pathology I think I often see in economics. Economists attempt to understand the consequences of human behaviour, so they build models. Models are necessarily simplified, so we include things like the assumption of rationality, which is then described in terms of optimal behaviour from an individual standpoint. We then use these to try and understand the world.

Except somewhere along the road economists take a detour, and rationality stops being a simplifying assumption, and starts being a way of thinking clever and properly educated people (i.e economists) do. Subsequently when economists observe real life behaviour like the drug gangs, the conclusion isn’t;

Looks like our game theory models are useful for understanding strategic behaviour in drug gangs. Cool.

Rather it is;

Drug dealers understand Game Theory?! Amazing!

Which is a very silly way to go about trying to understand human societies and economies.

I also recall a post on the Freakonomics blog [fn1] in which Levitt remembers fondly a conversation with Milton Friedman early in his career. Levitt had said he was careful to save money on his early salary, and Friedman chided him for being irrational and neglecting to take into account that Levitt’s higher salary in the future would allow him to smooth out his consumption. Here Friedman was clearly drawing on the Permanent Income Hypothesis, his “best scientific work” and one of the cited reasons for his Riksbank prize.

So we have Friedman chiding people for not acting the way his models said they would. A very smart man and a positivist no less!

It is a very strange discipline that is surprised when its models are useful, and cranky at reality when they are not.

 

[fn1] Which I can’t find. I guess they wanted to make sure all memory of the blog prior to the past few years of hissy fits is damned.

 

 

 

About Richard Tsukamasa Green

Richard Tsukamasa Green is an economist. Public employment means he can't post on policy much anymore. Also found at @RHTGreen on twitter.
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7 Responses to If our models are correct, then people are smarter than we realised!

  1. Paul Frijters says:

    Richard,

    you are right: the assumption that a previous generation makes to simplify things gets to be taken as the absolute truth by the next one. It is a tendency with advantages and disadvantages. The advantage is that the next logical step is taken of ‘well, if this is true, then something else also has to be true’. The Coase theorem is a good example. You can just hear a young Coase thinking: if markets are really so good, trading property rights would solve a lot of problems. Its the kind of theorem that would only occur to someone indoctrinated in the usefulness of markets and who doesnt immediately see them as a very coarse abstraction. The disadvantage is that people take the same assumptions where they are wholly inappropriate, such as when they take very long-term concepts like equilibrium and as-if rationality seriously for short-run or medium-run problems. Arguing that unemployment in recessions is voluntary is a good example of the inevitable silly conclusion you are going to draw as soon as you forget that the assumptions of a single capital stock, single labour stock, and perfect markets in the macro-economy has abstracted away from a whole lot of other stuff and only in the long run make sense.

    The tendency is, unfortunately, also somewhat inevitable. There is simply not the time in the curriculum to teach young students all the reasons for why our models are imperfect and where they dont fit well. Nor do they want to know: they see that all the professional advantages are to those who do not doubt so why should they buy into doubt?

  2. Richard Tsukamasa Green says:

    Although I agree with you, what I’m talking about here is a different kind of silly.

    Here the assumption of rational behavior (or optimal strategic behavior in the drug gang example) isn’t being interpreted as “absolute truth”, it ends up being interepreted as “the way smart educated people, like us, should behave”. They then end up surprised when the people they made the assumption about behave in a way that makes the assumption a good one and thus conclude that people understand rationality.

  3. Paul Frijters says:

    hmm, ok, that was not so clear to me from the post. On reflection then, I might be with Levitt on this one. I would also subscribe to the notion that rationality is something we teach people and that it is hence a desirable and more often observed trait in the better educated. And it would be equally surprising to me that gang members do not merely behave as-if they understand game theory, but are even able to articulate the strategic implications of their actions (at least as gleamed from the quote above). Sounds to me like Levitt managed to find a particularly smart and reflective gang member, but still.

    I dont see the ‘cranky about reality’ bit in the post above. Freedman was merely reminding Levitt about his lifetime income and the implications he should draw from that, i.e. pointing him to a clear possible improvement in his choice set. I tell my students and kids the same thing about their current consumption choices (i.e. saving on a salary of 10 dollars a week is silly) with the express intent of teaching them rationality.

  4. Dan says:

    This is not exactly rocket science. People are sensibly scared of gunfire; therefore, if you want to scare someone away from an area, fire a gun in that area.

    As for the second bit: gangs know about retaliation! Who’d have thunk.

  5. Glen says:

    Good post. I guess a clearer seperation of the positive (how people act)and normative (how people should act) is helpful here. Often social science rhetoric is doing both of these things, and it can become a bit muddled.

    I think you’re right that many people carry around the conflicting ideas that ordinary people are both incredibly stupid and supremly rational. This means that everything can be easily explained by the lazy thinker. If someone does the right thing, it’s because they are rational and if they do the wrong thing it’s because they are stupid. Its a temptation i find myself succumbing to far too often.

    However, this is somewhat true. I find how gangs and crime operate extremely interesting, so am a huge fan of the wire and have read a fair bit of the literature. And you often get both leaders and ordinary people playing highly sophisticed games of strategic interaction and stupid things.

    Indeed, getting involved in drug crime is usually stupid given most of the gains only go to the top people. But to an outsider, it is very difficult to tease out what is a good decision given the heavy constraints someone operates under and what is simply stupid. Short of living in that community, it will always be very difficult to understand the dynamics properly.

    In the Friedman example, it seems he is teaching Levitt that he is not acting rationally, even though he thinks he is. This fits Paul’s point above that people need to learn, through teaching and reflection, to act rationally. It seems you can fit together a positive theory of people acting in line with the permanent income hypothesis in the aggregate, with many many deviations for individual cases.

    It’s fashionable at the moment to assume people don’t act rationally most of the time or really know their best interests. But it’s very rare that people who believe this will count themselves amongst the stupid mass, rather than looking down from on high.

  6. Mike Pepperday says:

    When I was a child, receiving a few shillings a week, I was encouraged to save. I had one of those tins with a slot in the top for inserting coins. Now I learn that this was silly. How my parents, who were fairly well educated and very business-savvy, justified this irrationality I don’t recall. I expect it was some irrational guff about thrift and profligacy.

    A penny saved is a penny earned, said Ben Franklin. What an irrational dill he must have been.

  7. Patrick says:

    Mike, Paul is probably not directing his comments at fully-supported dependents trying to develop prudent fiscal management.

    And as you know perfectly well Ben Franklin wasn’t talking about saving over consumption (of non-investment goods) but was also talking about the prudent fiscal management your parents hoped to instill in you: minimising expenses so as to spend the money otherwise (including, perhaps, on investment goods). I’m sure Paul agrees with not wasting money!

    That said, there may be something for non-sciences/med/law/finance students saving something even taking into account lifetime income ;)

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