Continuing with Freakonomics

The comments to my first two posts about Freakonomics provide some interesting discussion. (The thread was continued as well at Stumbling and Mumbling, under Bold, True, or Trivial.) My assertion was that economics is about exactly two ideas--optimization and equilibrium.

I still maintain that this is the right way to think about what economics introduces to any given situation that may be underappreciated by other social science disciplines. This is the context in which Freakonomics is making its contribution. But I shouldn't put words in the authors' mouths on this. Here is their take, in excerpts from the book (p. 13 -14):

Economics is above all a science of measurement. It comprises an extraordinarily powerful and flexible set of tools that can reliably assess a thicket of information to determine the effect of any one factor, or even the whole effect. That's what "the economy" is, after all: a thicket of information about jobs and real estate and banking and investment. But the tools of economics can be just as easily applied to subjects that are more--well, more interesting.

This book, then, has been written from a very specific worldview, based on a few fundamental ideas:

• Incentives are the cornerstone of modern life. ...
• The conventional wisdom is often wrong. ...
• Dramatic effects often have distant, even subtle, causes. ...
• "Experts"--from criminologists to real-estate agents--use their informational advantage to serve their own agenda. ...
• Knowing what to measure and how to measure it makes a complicated world much less so. ...

These are not incompatible with "optimization and equilibrium," but they are much more focused on measurement than frameworks. (That's what makes Levitt such an interesting innovation in the Chicago School.) And the comment by Max, and several good comments by rjw, were about what economics professors would teach their students or others trying to learn the field. They bristled at the notion that I would list "tools" as the essence of the field. I confess, I do tell this to my students in the first meeting of each term, but then I proceed to show them many applications of these tools that are successful to varying degrees.

In fact, the first topic we address in my finance seminar is embodied in these two papers:

Shleifer, Andrei and Lawrence H. Summers, “The Noise Trader Approach to Finance,” Journal of Economic Perspectives, Vol. 4, No. 2 (Spring 1990): 19-33.

De Long, J. Bradford, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann, “Noise Trader Risk in Financial Markets,” Journal of Political Economy, Vol. 98, No. 4 (August 1990): 703-738. (optional)

I teach these papers because the noise trader model represents a thoughtful use of these tools--both optimization and equilibrium. In the mid- to late-1980s, the finance profession had two camps--noise is incidental, and noise is fundamental. In a nutshell, this paper finds a principled middle ground by adding just two reasonable assumptions--that arbitrage is limited (and therefore risky) and that some investors are influenced by sentiment (which is correlated across investors). The end result is a model in which noise traders can survive in a market, despite their tendency to buy high and sell low. There was now a way to model noise as having an impact on financial markets without having to characterize those markets as completely uninterpretable. That innovation has been fundamental to the science of finance over the subsequent 15 years.

We would be remiss as a profession if we did not teach the tools, and it doesn't seem to me to be unnatural that both Freakonomics and my post on it characterize economics by its main tools of analysis (though we differ in the way we have specified those tools). But, as the commenters have pointed out, we would be equally remiss if we suggested (which I did not) that a pre-occupation with technique was the key to success in the profession more broadly. That rests in the thoughtful use of those tools and the ability to see their relevance in a broad range of environments. Ultimately, its ability to do that will determine the success of Freakonomics.

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