Thinking like an Economist A Guide to Rational Decision Making - Randall Bartlett

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Here is a summary of the key points from the lecture:

• Thinking like an economist can help one better understand the world, make personal decisions, formulate business strategies, and choose national policies.

• There are 6 foundational principles of economic thinking that serve as a framework for viewing the world through an economist’s lens.

• The first principle is that people respond to incentives. Rewarding a behavior increases it, while penalizing a behavior decreases it.

• The second principle is that there is no such thing as a free lunch. Everything has a cost. Resources are limited and must be allocated effectively.

• These core ideas reflect the essence of economic thinking - that human behavior can be systematically understood and predicted through incentives, costs, and tradeoffs involving scarce resources.

• Mastering these principles allows one to apply economic logic and reasoning to a wide variety of decisions and situations in a powerful and useful way. The goal is to develop the ability to think like an economist.

• Economics involves balancing limited resources with unlimited wants. There is always scarcity, so using resources for one purpose means not using them for something else.

• No interaction has only one side - there are always at least two perspectives to consider. Spending by some provides income for others.

• The law of unintended consequences holds that actions often have unanticipated effects, due to the complexity of economic systems. Changes in one part of the system can ripple out and impact others in unexpected ways.

• No individual or policy can fully control outcomes in a system as complex as the economy, with its billions of interdependent actors. Incentives can affect behavior but results will always be unpredictable.

• Rationality, marginal analysis, and optimization are the three core economic concepts. Rational actors evaluate alternatives and choose the best option given their constraints and incentives. Marginal analysis looks at incremental changes. Optimization seeks the best combination of choices given constraints.

• Thinking economically involves considering incentives, optimizing on the margin through trade-offs, and anticipating unintended consequences in a system no one fully controls. The key is analyzing how people and policies are likely to respond to changes, not claiming anyone can dictate results.

• The prisoner’s dilemma illustrates how rational individuals can make decisions that collectively harm everyone. When decisions are interconnected but made separately without communication or agreements, outcomes may not be efficient.

• Overfishing presents a real-world example of this dilemma. Individual fisher’s incentives are to catch as much as possible, but this depletes fish populations unsustainably. Restricting the fishing season does not fix the underlying incentives.

• An economist proposed changing fisher incentives in Iceland to address this. Altering individual incentives can change behavior and social outcomes for the better. Specifically in Iceland, fisher incentives were redesigned so their individual decisions would collectively sustain fish populations long-term rather than deplete them.

• More broadly, the way rights and rules are structured defines incentives, which then influence behavior. Economists look at how to design incentives optimally so individual rational choices aggregate into efficient social outcomes, rather than detrimental ones like the prisoner’s dilemma can produce.

• Rational decision making depends on having high quality information. Suboptimal information can lead to poor decisions.

• There is an optimal level of ignorance for each decision - you need to consider the tradeoff between ignorance and information.

• The marginal benefit of information is that it reduces the chance of a suboptimal decision. The potential costs of a wrong decision determines the maximum value of information.

• The marginal value of information declines as you acquire more. The marginal cost of acquiring information rises as you get more.

• The optimal amount of information, and level of ignorance, is where the marginal value and cost of information are equal. Acquiring more beyond that point is irrational.

• Individuals can overcome costs of ignorance by aggregating and leveraging collective knowledge through things like expert consultation, decision aids, and transparency about limitations and uncertainties. This helps decrease vulnerability to bad decisions from lack of information.

• Markets provide an efficient way to aggregate dispersed information from many independent sources into a clear price signal. However, price alone does not capture all valuable information.

• Other methods of gathering information at low cost include principal-agent relationships, where experts are paid to make decisions on our behalf, and studying the “wisdom of the crowds” by aggregating many independent estimates and averaging them.

• The cost of acquiring information must be balanced against the cost of making wrong decisions from lack of information. The optimal amount of information is where the marginal benefit of additional information equals the marginal cost.

• When making decisions under uncertainty, economists use the concept of expected value. This considers the probability and payoff of all possible outcomes to determine the average outcome over many repetitions.

• Not all probabilities can be precisely calculated. Judging risks requires estimating probabilities based on historical data while accounting for one’s own incentives and susceptibility to cognitive biases. Rational decision making involves carefully evaluating both probabilities and potential payoffs.

• Adding a time dimension to economic decisions introduces two new elements - the real value of money and the time value of money.

• The real value of money refers to its purchasing power, which is constantly changing due to inflation. Not accounting for inflation can lead to mistakes in rational decision making.

• People generally prefer benefits now and costs later, a concept known as pure time preference. This makes timing an important factor.

• The time value of money incorporates two related concepts - present value and future value. Present value is the current worth of a future sum of money, while future value is the amount a given sum will be worth at a specified point in the future, adjusted for interest.

• The power of compound interest means that modest sums invested for long periods have the potential to grow enormously over time as interest earns interest. This emphasizes the importance of starting to save and invest as early as possible.

• Properly accounting for inflation, time preference and the time value of money is essential for rational long-term economic decision making involving costs and benefits that are deferred into the future.

Here is a summary of the key points about behavioral economics from the lecture:

• Behavioral economics is an interdisciplinary field that applies insights from psychology to understand human behavior in economic contexts. It crosses the boundaries between traditional economics and experimental psychology.

• Findings from behavioral economics show that actual human behavior often deviates from the rational, utility-maximizing model assumed in traditional economics. People do not always calculate options and make perfectly rational decisions as expected theory.

• Experiments reveal systematic and often irrational patterns in human decision-making. People exhibit biases, use mental shortcuts, and make predictable mistakes in their judgments.

• The experimental evidence suggests people are not as rational as the traditional economic model assumes. Human decision-making is influenced by cognitive limitations, emotional and social factors, and subjective perceptions rather than entirely logical or objective calculation.

• By better understanding how people actually think and make decisions, behavioral economics provides a more realistic perspective on human behavior than the strictly rational model of traditional economics. It gives insights that can help improve policies, products, and services to nudge behavior in beneficial ways.

So in summary, behavioral economics uses experimental research from psychology to develop a more empirically accurate understanding of human decision-making that accounts for cognitive biases and non-rational influences.

• Behavioral economics experiments have shown that in the ultimatum game, people are often willing to sacrifice personal financial gain in order to avoid unfair outcomes. This demonstrates that fairness has real value to people and unfairness has real costs, contradicting the rationality view that only personal gains/losses matter.

• Another key finding is that anchor points impact spending decisions in irrational ways. Restaurant menus with high-priced items act as anchors, raising the average bill even though few order the expensive options. This shows how context influences rational decisions.

• In summary, behavioral economics reveals how human irrationality systematically impacts decision-making. While irrational tendencies like status quo bias and loss aversion evolve adaptively, they can produce poor outcomes. Understanding these biases allows designing incentives and “nudges” to promote better decisions for individuals and society. Rationality involves acknowledging and counteracting intrinsic irrational tendencies.

• The result is exponential growth in total dollar value when interest is compounded over time. Even small interest rates lead to large growth as money earns interest on prior interest.

• Discounted present value calculates the current worth of a future amount by discounting it based on a discount rate, which reflects time preference and risk. Higher discount rates lower the present value.

• Expected value is the probability-weighted average outcome of a scenario if repeated many times. It represents the average result one can expect.

• Future value calculates the amount a principal will be worth at a future date if earning a given interest rate compounded over time. Further dates mean higher future values.

• Information asymmetries occur when one party in a transaction has more relevant information than the other. This can lead to market inefficiencies or unfair outcomes.

• Marginal analysis examines the incremental effect of small changes, such as the extra revenue from one more unit of output. It is important for optimizing decisions.

• Optimization, or constrained maximization, is selecting the option that provides the greatest benefit given constraints like a fixed budget.

• Nassim Taleb uses the metaphor of “verywhere were white” to represent a failure to account for potentially catastrophic outcomes that have not yet occurred, simply because of a lack of experience with them.

• The validity of expected value as a measure of risk depends on accurately including all possible outcomes, even those that may have a very low probability but could be catastrophic if they occur.

• Thaler and Sunstein’s book “Nudge” proposes the idea of “libertarian paternalism” - using choice architecture and framing to gently influence or “nudge” people towards making better decisions about their health, wealth and happiness, while still preserving freedom of choice.

• One example they give is making enrollment in a retirement savings plan the default option, rather than requiring people to opt-in. This simple reframing dramatically increases participation rates compared to equivalent programs that require active signup.

• The book provides many examples and a framework for purposefully structuring choices in subtle ways to encourage wiser decision making while respecting individual autonomy and freedom.