PhD Economists won’t admit Granny was (sometimes) wrong

PhD economists make freshman mistakes:

Examples of Brad Delong, John Whitehead, Ted Gayer, Jim Hamilton, etc. variously: perpetuating the sunk-cost fallacy, denying the energy gap, misapplying the efficient market hypothesis to markets in everything, decrying, bemoaning and mocking economic illiteracy while making freshman mistakes.

Yep, I’m an idiot…TOO.
BTW… I’m sure I’ll exhibit my posterior regularly here, while I have freshman college credit in Econ, I’ve successfully avoided ever taking a class (even in high school).  Given that Ed Prescott runs the Econ dept at my alma mater, that probably leaves me better educated than the alternative, yet still woefully ill-informed, no doubt.  I welcome correction.

Jim Hamilton-Brad Delong

From comments on a post by Jim Hamilton on his Econbrowser (http://www.econbrowser.com) regarding the “Cash for Appliances” program:

JDH said: “I remain deeply skeptical that junking working capital in this fashion is the best way to grow Americans’ wealth. …. Destroying durable goods in order to build new ones goes beyond even this [burying cash to employ folks in digging it up] colorful recommendation from Keynes.”

“JUNKING WORKING CAPITAL” I’m really getting sick of hearing this from economists. I understand having to explain to a grandma who grew up in the depression why “use-it-up and wear-it-out,” while often an admirable economic strategy, is not invariably one’s best option from a cost-benefit standpoint. I don’t understand the seeming inability of Econ PhD’s to grant the same point.

This is no more nor less than the sunk-cost fallacy being propagated by the excellent Hamilton…I’m guessing some political blinkers are operative here.

The 23W CFL uses $2.67 electricity in 1000hours, the lamp cost $2 and the throw-away incandescent cost 40 cents for a total of $5.07 cents for 1000 hours light compared to $11.60 for 1000 hours from the “free” brand new lightbulb. I have removed the lifetime advantages from the CFL to make the argument clearer. Thus you save $6.53 by “JUNKING WORKING CAPITAL.”

While the analysis for junking a working refrigerator is “not clearly positive NPV” as Kevin T. quite fairly puts it, the light bulb example CLEARLY shows that the knee-jerk horror many of us have of throwing away something which “ain’t broke” and the constant invocation of “broken windows” or “JUNKING WORKING CAPITAL” is unfair, as replacement of working but obsolescent equipment with more cost-efficient equipment is clearly NOT broken windows, just because both pieces of equipment happen to be termed “refrigerators.”

Delong also misapplied (less egregiously) Bastiat to Cash for Clunkers.

Ted Gayer-John Whitehead

Ted Gayer claims your self-employed newspaper boy is better able to calculate the cost-benefit of energy efficiency investment than engineers or economists, and what is more has already done the calculation and made all cost-effective investments.  John Whitehead defends this nonsense. 

After all, Gayer says, “This finding violates the basic principles of economics. If firms (or consumers) could reduce emissions at negative cost, then they would do so. To say otherwise is to say that they are willingly or ignorantly passing up profits.” 

Yes, that’s right boys and girls–market inefficiency violates the basic principles of economics!  I don’t know the man, but I’m somewhat disinclined to give him much benefit of the doubt given his final paragraph mocking the idea that subject-matter-experts know more than Joe Schmoe, CEO by invoking the strawman that experts must know more than Joe about information not available to the experts about his firm. 

Yes, wait for it, he invokes IMPERFECT INFORMATION to dismiss the market inefficiency largely CAUSED by IMPERFECT INFORMATION with respect to technical knowledge of energy efficiency opportunities.  His argument is of the form: If A knows something B does not, B must not know anything A does not.  The correct response to this in elementary school was “HUH?”  Even better, he ignores the agency problem which causes much of the remainder of the energy gap, to invoke the canard that either negative cost investments do not exist or energy efficiency experts must not know much about cost-effective energy efficiency investment, otherwise they’d be rich from investing in all the negative cost investments available.  This has even less validity than the classic judging of economists by their personal stock-market returns.  After all, the economists at least have access to the stock market.

Gayer: “The fourth possible reason for the negative cost finding is that firms do indeed irrationally forego profit-maximizing activities, or they are ignorant of such activities. Economics takes the profit-maximizing motive as a premise. This assumption, like all economic assumptions, is used to simplify the complex economic world in order to make manageable inferences. It is an approximation of reality, not a physical law met with certainty. But to assume that negative cost opportunities exist because firms are irrational, people must also assume that the analysts who identify negative costs are more knowledgeable about profit-making activities than the firms. They must also assume that firms continue in their irrationality even after the analysts show them that profit-making opportunities exist. Finally, they would wonder why the analysts don’t act on their superior information and rationality and reap all the negative costs they have identified.”

Excerpts from Response to Whitehead of Environtmental Economics (http://www.env-econ.net) defense of this baloney:

“I thus still hold with Gayer’s 4th possibility (the one HE mocks). This is that analysts and energy professionals DO know more about the private cost-benefit of energy efficiency investment than Joe Schmoe, CEO, that investments of positive NPV with rational discount rates ARE available to Schmoe, that Schmoe DOES decline to fully believe this when engineers, analysts, and electricians explain it to him, and that this makes Schmoe your average moron (I’ve met him personally, any number of times). ….

2/3rds of houses with thermostats don’t have a programmable one. That’s about 60M households who either think that it isn’t worth the money OR have some non-economic reason for not making this investment (Hmmmm???). Perhaps they overestimate their ability to manually control the thermostat? Or perhaps it’s a hassle that they don’t really have time to think about? According to Energy Star a programmable thermostat saves the typical household $180/yr. You can buy a basic programmable thermostat for under $30 (you’d have to try hard to spend $100) and put it in yourself in 15 minutes (or pay a handyman less than $50 if you are completely incapable of any manual/mechanical activity). So, less than a 1 year payback. Let’s review: 2/3rds of households have made an incorrect economic choice about whether to install an energy efficiency measure with a less than 1 year simple payback (600% annual tax-free return if you get your 6 y.o. kid to put it in for free). What makes you think they’re doing any better with the hard stuff?” …

“I’m not defending the specifics of a McKinsey report, or McKinsey, or the idea that a general model is more accurate at a detailed level than case-specific detailed analysis (though models ARE suggestive of the fact that such detailed analysis is rarely actually done). I AM defending the idea that market inefficiencies exist, specifically in the market for energy efficiency upgrades, creating an energy ‘gap’. Do you really want to attempt to defend the idea that ‘if it made rational economic sense it would already have been done?’ The inefficiencies in the energy efficiency market, in my detailed personal experience, generally relate to: A)incomplete information as to potential efficiencies by decision makers, B)An excessive risk premium placed on simple and sound energy investments by decision-makers who lack a high-school level understanding of the underlying physics on which to differentiate between snake-oil and science, C)market structure under which investment costs and benefits are decoupled (landlord-tenant relationships).

McKinsey report flaws

To be fair–the McKinsey report has issues, too.

BTW, having now read the whole McKinsey report, I want to reiterate that I am not setting myself up as a defender of the details of the report (which I consider indicative rather than prescriptive), only of the premise that significant unexploited strongly positive NPV energy efficiency investments exist in the private sector.

The assumptions made in the report are made largely to avoid charges of optimism bias.

For instance, it is assumed that not a single household adds a programmable thermostat not just in the reference case, but in the “high-range” abatement case. After all, not over-heating/cooling your McMansion while at work would be a “consumer utility reduction” (of the consumer’s bill, yeah).

For instance, the baseline projection for power generation construction by McKinsey in the 2 y.o. report was the highly politicized Bush-era DOE 2007 Annual Energy Outlook reference case(which projected only 17GW of net capacity of all renewable electricity generation to be constructed from 2005-2030, accompanied by massive levels of pulverized coal plant construction). This is what’s known in the reality-based community as DCWD. In the reality of the intervening 2 years, the U.S. has constructed more renewable generation than this ‘baseline’ predicted over the next 25. It was further assumed no incentives were provided for renewable construction (PTC had driven strong wind construction in 5 of the preceding 7 years). In fact, when the report was published near the end of 2007, new wind turbines constructed in 2006 and 2007 had already reached 45% of that 25 year baseline “projection” for all renewables and had been 35% of new generation capacity added in 2007.

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