Chapter 22: Frontiers of Microeconomics

Welcome to Last Minute Lecture.

This free chapter overview is designed to help students review and understand key concepts.

These summaries supplement not replaced the original textbook and may not be redistributed or resold.

For complete coverage, always consult the official text.

Okay, let's unpack this.

Today, we're taking a deep dive into the fascinating edges of microeconomics.

Yeah, the frontiers.

Exactly.

Where the classic models meet the messy realities of, you know, actual human behavior and complex interactions.

Right.

Our mission.

Yeah.

It's really to give you a shortcut to being truly well informed on three cutting edge topics that are expanding how we understand the economy really works.

Indeed.

We'll be pushing past some, let's say, traditional economic assumptions.

We're going to explore the economics of asymmetric information, political economy,

and behavioral economics.

Three big ones.

Yeah.

Think of it as like a concentrated dose of insight designed to give you some profound aha moments about the world around you, maybe even your own decisions.

Sounds good.

So let's start with a foundational challenge.

We often assume, kind of implicitly, that everyone has all the same info when making economic choices.

Right.

The perfect information assumption.

But that's rarely the case, is it?

Almost never, really.

So we're diving into asymmetric information.

It basically boils down to, I know something you don't know.

Precisely.

Information asymmetry, it simply means one party in an interaction has more or better information than the other.

Okay.

And this imbalance, it profoundly affects choices, outcomes, even trust between people.

I can see that.

We see it everywhere.

Buying a used car, a worker's effort on the job.

Right.

These situations generally fall into two main categories, hidden actions or hidden characteristics.

Hidden actions.

No.

Hidden characteristics.

Okay.

Let's begin with hidden actions.

These give rise to what economists call moral hazard.

Moral hazard.

Okay.

What's that?

This is when one person, let's call them the agent, performs a task for another person, the principal.

Okay.

Agent and principal.

But the principal can't perfectly monitor what the agent is doing.

Oh, okay.

So the agent then has an incentive, maybe, to exert less effort or maybe take on more risk than the principal would want.

The hazard is that, well, inappropriate or undesirable behavior.

The classic scenario here is the employer -employee relationship, right?

Yeah.

The employer's the principal, the worker's the agent.

Exactly.

That's the textbook case.

The temptation for workers who aren't perfectly monitored to, you know, shirk responsibilities.

That's a classic moral hazard.

So how do employers deal with that?

Well, they try to counter it in a few ways.

They might increase

monitoring, you know, cameras, supervision, or they might pay what we call efficiency wages.

These are wages deliberately set above the market equilibrium.

Why do that?

Because it makes workers less likely to shirk.

If you get fired, you lose a really high -paying job, not just any job.

Ah, makes sense.

The cost of getting caught is higher.

Precisely.

Another strategy is delaying payment.

Think year -end bonuses or maybe higher pay later in your career.

It increases the penalty for poor performance or getting caught slacking off earlier.

So it sounds like this problem of moral hazard isn't just about employees slacking off.

Where else do we see these hidden actions causing trouble?

Oh, it's pervasive.

Absolutely everywhere once you start looking.

Think about insurance.

Okay.

A homeowner, say, with fire insurance, might then buy fewer fire extinguishers.

Why?

Because the insurance company bears much of the financial cost if there is a fire.

Right.

The incentive to prevent the fire is slightly reduced.

Exactly.

Or think about a family living near a flood -prone river.

They might take on more risk, maybe build closer than they should, knowing that disaster relief will likely come from the government if the worst happens.

So the government acts like an insurer there.

In a way, yes.

Now, regulations try to mitigate this, right?

Insurance companies might require fire extinguishers.

Governments might prohibit building in flood zones.

But the core problem, that imperfect information, means the moral hazard persists.

It's hard to eliminate completely.

Okay.

And you mentioned corporations earlier.

Yes.

What's truly fascinating is how this plays out in corporate management.

Think about large corporations.

Shareholders are the principals they own the company, but the managers, they're the agents.

They run it day to day.

And the shareholders aren't watching everything they do.

Exactly.

So managers might have their own goals, self -serving goals, maybe, you know, plush offices, private jets, things that benefit them, but don't necessarily maximize profit for the shareholders.

That sounds like a conflict of interest.

It is.

And get this, even the board of directors who are supposed to oversee management for the shareholders,

well, they're agents, too.

Agents of the shareholders.

So it's like agents watching agents.

Kind of.

It creates another layer of principal agent problem.

How do you ensure the board provides proper oversight?

We saw extreme examples of this, sadly, with scandals like Enron, Worldcom.

Oh yeah, I remember those.

Where managers really enrich themselves at shareholder expense, it tragically highlights how critical this information asymmetry can be.

Okay.

So we've explored the problem of hidden actions, where you can't really see what someone's doing.

What happens when the secret isn't about their actions, but about who they are or what they're selling?

That's where we get into adverse selection, isn't it?

That's a perfect segue.

Yes.

Adverse selection happens in markets where the seller knows more about the attributes, the quality of a good than the buyer does.

So the buyer risks getting a low quality good.

The selection of goods actually available on the market might be adverse or bad from the uninformed buyer's point of view.

The classic example of this is the lemons problem in the market for used cars.

Exactly.

The famous paper by George Akerlof.

Sellers, they know if their car has hidden defects, if it's a lemon,

buyers don't.

So who is most likely to want to sell their car?

The owners of the lemons.

Because they know it's bad.

Right.

Buyers anticipate this risk.

They think, hmm, any used car for sale might be a lemon.

So what do they do?

They offer lower prices.

Okay.

That makes sense.

But then that lower price discourages owners of good used cars from selling.

They think my car is great.

I'm not selling it for that low price.

So the good cars leave the market.

Potentially.

Yes.

This phenomenon helps explain why even a slightly used car often sells for much less than a brand new one.

Buyers infer something negative just from the fact it's being resold quickly.

It's not just about a few bad apples.

Then it can actually damage the whole market.

It can fundamentally disrupt the market's invisible hand.

You can end up in situations where maybe the best used cars are rarely sold.

Or another example, think about insurance markets.

Has it worked there?

Well, people who suspect they have hidden health problems, they're more likely to want to buy health insurance, right?

Sure.

They need it more.

So the insurance company knows this pool of applicants is likely riskier than the general population.

They set the price higher to reflect that higher average risk.

Okay.

But then healthier people see that high price and think, wow, that's expensive.

I probably don't need it that much.

And they opt out.

Leaving an even riskier pool of buyers.

Exactly.

It exacerbates the problem.

When adverse selection is present, the market might fail to allocate resources efficiently.

This is often cited as a key reason for government involvement in areas like health insurance.

Okay.

So if markets often fail or struggle in these situations with hidden information.

Yeah.

How do people try to overcome these gaps themselves?

Do they just give up?

Well, no, markets aren't helpless.

They've developed some pretty ingenious ways to deal with these problems.

One way is signaling.

Signaling.

Like sending a signal.

Pretty much.

It's an action taken by an informed party, the one who knows the hidden information solely to credibly reveal their private information to the uninformed party.

Okay.

Like a firm spending a ton of money on Super Bowl ads.

Is that signaling quality?

That's a potential example.

Yes.

Or think about a student earning a college degree.

It increases their productivity, sure.

But it also signals their high ability and perseverance to potential employers.

Okay.

So what makes a signal effective?

Can anything be a signal?

Good question.

No.

For a signal to work, it generally needs two things.

First, it must be costly.

If it were free, everyone would do it and it wouldn't reveal anything.

Right.

Second, it must be less costly or somehow more beneficial for the person with the higher quality product or the desirable hidden attribute.

Okay.

Explain that.

Well, take advertising.

A company with a genuinely good product benefits more from advertising because they'll get repeat customers.

The ad spending pays off more for them than for a company selling junk.

Got it.

Or education.

Talented, hardworking people generally find completing a difficult degree program easier, less costly in terms of effort, than less able people do.

So the degree is a more effective signal of their underlying ability.

Interesting.

Are there other, maybe less obvious examples?

Oh, definitely.

A great case study here is gift giving.

Why do we give gifts instead of just cash?

Yeah, I've always wondered that.

Yeah.

Cash seems more efficient.

From a purely rational homo economicus standpoint, maybe.

But giving a thoughtful gift is costly.

It takes time, effort, knowing the person's preferences.

And that cost depends on private information specifically, maybe.

How much you care about someone.

If you care deeply, choosing a good gift is arguably easier because you're more attuned to what they'd like.

So giving cash, which costs very little effort, can sometimes signal a lack of effort and implicitly maybe a lack of strong affection.

It explains why giving your romantic partner cash for their birthday might be offensive.

Yeah, probably not a good idea.

But it's perfectly acceptable usually for parents to give cash to their college student kid.

The underlying strength of affection isn't really in question there.

The signal isn't needed in the same way.

That's a fascinating way to think about gifts.

Okay.

So that's signaling the informed party trying to reveal information.

What about the other side, when the uninformed party wants to figure things out?

Right, the uninformed party isn't passive either.

That's where screening comes in.

Screening, okay.

Screening is an ashen taken by an uninformed party specifically designed to induce the informed party to reveal their private information.

So flipping the script, how does that work?

Let's go back to the used car.

If you're the buyer, the uninformed party, you might insist on taking the car to an independent mechanic for an inspection before you buy.

Yeah, standard practice.

Right.

If the seller readily agrees, that's a good sign.

But if the seller refuses,

that refusal is a powerful signal that they're hiding something the car's probably a lemon.

Your action induced them to reveal information through their reaction.

Clever.

Any other examples?

Car insurance companies do this too.

They often offer different policies, maybe one with a high premium but full coverage and a low deductible, and another with a lower premium but a really high deductible.

Okay.

So why offer both?

Because risky drivers, the ones who expect to have more accidents, are much more burdened by that high deductible.

They're more likely to choose the higher premium full coverage policy.

Safer drivers might prefer to save money with the lower premium and take their chances with the high deductible.

So the drivers sort themselves out based on the choices offered.

Exactly.

They effectively screen themselves into different groups, revealing their private information about how risky they perceive themselves to be.

The insurance company's action offering the choice induced this revelation.

Wow.

Okay.

So signaling and screening are ways the market tries to cope with asymmetric information.

Yeah.

But taking a step back, what does this all mean for policy?

You said asymmetric information gives us a reason to be cautious about market outcomes.

That's right.

Markets might not always put resources to their best use when information is unevenly distributed, and this can sometimes justify government intervention.

But it's not always a straightforward solution, is it?

Yeah.

Just because the market isn't perfect doesn't mean the government can fix it easily.

Absolutely not.

You've hit on a crucial point.

Three facts really complicate this.

First, as we just discussed, markets often develop their own solutions through signaling and screening.

They aren't helpless.

Second, the government rarely possesses more or better information than the private parties involved.

So even if the market outcome is an ideal, government intervention might not actually improve things.

They might lack the knowledge to do better.

Right.

The government doesn't magically know which used cars are lemons either.

Exactly.

And third, and this is key, the government itself is an imperfect institution run by real people with their own incentives and limitations, which actually leads us perfectly into our next frontier.

Ah, okay.

So the government often steps in when markets fail, but sometimes the cure can be as complicated as the disease.

This sounds like political economy.

Precisely.

Political economy uses the tools of economics to understand how government really works, not just how we wish it would work in theory.

So moving beyond assuming benevolent leaders who always act in the public good.

Exactly.

That's often an unrealistic assumption.

We need to analyze government as an institution with its own complexities, incentives, and potential failings.

Let's start with a classic and frankly quite puzzling paradox of democratic decision -making.

The Condorcet voting paradox.

Okay, Condorcet.

This one highlights how majority rule, which seems so simple and fair, can actually run into weird problems when there are more than two options on the table.

It really does.

The 18th century French theorist, the Marquis de Condorcet, noticed this issue.

Imagine a simple scenario.

Three groups of voters, let's say types one, two, and three, and three possible policy outcomes, A, B, and C.

Okay.

And they have different preferences.

Maybe type one prefers A over B and B over C.

Type two prefers B over C and C over A.

And type three prefers C over A and A over B.

So everyone has clear preferences.

Right.

Different rankings.

Now let's see what happens if we use pairwise majority voting pitting two options against each other at a time.

Okay.

A versus B.

A versus B.

Well, type one prefers A.

Type three prefers A.

That's two out of three.

So A beats B.

Okay.

B versus C.

Type one prefers B.

Type two prefers B.

Two out of three again.

B beats C.

So A beats B.

B beats C.

Logically, A should beat C.

Right.

That's what logic or transitivity would suggest.

But let's check.

C versus A.

Type two prefers C.

Type three prefers C.

That's two out of three again.

C beats A.

Wait, what?

A beats B.

B beats C.

But C beats A.

That doesn't make sense.

It's circular.

Exactly.

That's the Condorcet Paradox.

Democratic outcomes derived from majority rule don't always obey that basic logical property of transitivity.

So what does that imply?

It has some pretty big implications.

One is that the order in which you vote on the pairs can determine the outcome.

Agenda setting.

Precisely.

The power to set the agenda to decide which pairs get voted on and when becomes incredibly important.

Depending on how you structure the votes, this society could end up choosing A or B or C even though the underlying preferences haven't changed at all.

Wow.

So majority voting alone doesn't necessarily tell us what society truly wants if there are more than two choices.

It's definitely not as straightforward as it seems.

It reveals a potential instability or ambiguity in collective decision making.

Okay, if majority rule can lead to these kinds of, well, illogical cycles, is there any perfect voting system out there?

One that avoids these kinds of pitfalls?

That is a fantastic question and it's exactly what the economist Kenneth Arrow asked.

He won a Nobel Prize for exploring this.

He started by defining several properties that seem, you know, really desirable for any voting system.

Like what would a perfect system look like?

Well, first, unanimity.

If absolutely everyone prefers option A to option B, then the group choice should also rank A above B.

Seems obvious, right?

Makes sense.

Second, transitivity, which we just talked about.

If the group prefers A to B and B to C, then it should also prefer A to C.

No cycles.

Okay.

Third, independence of irrelevant alternatives.

This means the group's ranking between any two options, say A and B, shouldn't depend on whether some third option C is also available or not.

Adding or removing an irrelevant option shouldn't flip the preference between A and B.

That seems reasonable, too.

And fourth, no dictators.

No single person's preferences should always determine the group outcome regardless of what everyone else wants.

Right.

Democracy means no dictators.

So four common sense properties.

Did Arrow find a system that meets them all?

Here's the kicker.

Arrow mathematically proved that no voting system for choosing among three or more options can possibly satisfy all four of these desirable properties simultaneously.

No system at all.

None.

This is known as Arrow's impossibility theorem.

It's a really profound and frankly kind of disturbing result.

Wow.

So every voting system has some kind of flaw.

According to Arrow's criteria, yes.

Majority rule, as we saw with Condorcet, can fail transitivity.

Other systems, like one called the board account, where you assign points based on ranking, can fail the independence of irrelevant alternatives property.

Removing one candidate can actually change who wins between the remaining two.

So there's no perfect way to translate individual preferences into a single consistent social choice using voting.

That's a startling conclusion.

No matter what voting system a society adopts, it's going to be flawed in some fundamental way as a mechanism for aggregating preferences.

Okay, that's sobering.

But despite these flaws, we still use voting all the time.

So when we do use majority rule, who tends to determine policy?

Who usually gets their way in a democracy?

What's fascinating here, despite the theoretical problems, is a practical observation captured by the median voter theorem.

The median voter.

Okay, who's that?

It's a pretty intuitive idea.

Imagine you could line up all voters based on their preference for something,

say government spending on parks, from lowest preferred amount to highest.

Median voter is the one exactly in the middle of that line.

50 % of voters want to spend less, 50 % want to spend more.

Okay, the person right in the center.

Exactly.

The median voter theorem states that if voters are choosing along a single dimension like spending,

and everyone prefers outcomes closer to their own ideal point,

then majority rule will tend to produce the outcome most preferred by that median voter.

Why?

Why does the middle person win?

Because their preferred outcome can beat any other two way majority rule vote.

Any proposal to spend more will be opposed by the median voter and everyone who wants to spend less, more than half the voters.

Any proposal to spend less will be opposed by the median voter and everyone who wants to spend more, again, more than half.

The median voter's position is strategically unbeatable in a pairwise contest.

Okay, so what are the implications of that?

Well, one big implication is for political parties to maximize their chances of getting elected in, say, a two party system, both parties have an incentive to move their platforms towards the position favored by the median voter.

Which might explain why the two major parties sometimes seem quite similar on many issues.

They're chasing that middle ground.

That's one common explanation, yes.

It also implies that minority views, even if they're very strongly held by some groups, might get little consideration under simple majority rule because the focus is always on capturing that median voter.

Okay, that makes sense.

Now, throughout economics, we usually assume consumers maximize utility, firms maximize profit.

Right, rational self -interest as the driving force.

But what about politicians?

Should we assume they are purely acting in the public interest?

That's the final point in this section.

It would be nice, perhaps, to think they always act solely in society's best interest.

But maybe not realistic.

Probably not Political economy reminds us that politicians are people too.

Self -interest is a powerful motive for political actors, just like it is for consumers and firms.

So what kind of self -interest?

Re -election power.

It could be re -election influence,

maybe sometimes simple greed, unfortunately.

Think about corruption in some countries.

That's often politicians prioritizing their own enrichment over the national interest.

The point is economic policy isn't made in a vacuum by perfectly benevolent philosopher kings.

It's made by real people operating within a political system with their own ambitions and constraints.

So we shouldn't be surprised when actual policy outcomes don't always perfectly match the theoretical ideals derived from assuming a purely public spirited government.

That's a really important dose of realism.

And it leads us perfectly into our third frontier, where economics really meets psychology head on.

How do our own human imperfections or biases shape the economic decisions we make?

Exactly.

This brings us to behavioral economics.

It's a really exciting and relatively newer subfield that explicitly integrates psychological insights into economic analysis.

So trying to build a more realistic model of human behavior.

Precisely.

It offers a more subtle, complex, and arguably more accurate view of how people actually behave compared to the standard assumptions of conventional economic theory.

Which assumes we're perfectly rational.

Yeah.

Conventional theory is often populated by this creature called homo economicus, a perfectly rational calculating maximizer who always weighs all the costs and benefits and chooses the absolute best course of action.

Like Mr.

Spock making purely logical choices.

Kind of, yeah.

But the reality is we're homo sapiens.

We're real people.

We can be forgetful, impulsive, emotional, sometimes confused, often short -sighted.

We don't always have the time, information, or cognitive ability to be perfectly rational.

So not quite Spock.

Not quite.

Early thinkers like Herbert Simon suggested humans are often satisficers.

We don't necessarily optimize.

We just make decisions that are good enough.

Others talk about bounded rationality.

We're rational, but within limits.

Okay.

So if we're not always perfectly rational,

what are some of the systematic mistakes or biases that behavioral economists have identified?

Oh, there's a whole list.

And they're fascinating because we can often recognize them in ourselves.

One common one is overconfidence.

Thinking we're better than we are.

Basically, yeah.

Or at least more certain.

For example, studies ask people to provide a 90 % confidence interval for some numerical question, like the length of the Nile River.

Most people get ranges that are way too narrow.

The true answer falls outside their 90 % range far more often than 10 % of the time.

We're too sure of our own precision.

Guilty as charged, probably.

What else?

We tend to give too much weight to vivid observations.

Imagine you're buying a car.

You read a consumer report survey of 1 ,000 owners that says the car is reliable.

But then your friend tells you this one dramatic, vivid story about their car being a total lemon.

That single vivid story, even though it's just one beta point, might weigh more heavily on your decision than the statistical evidence large survey.

That sounds very human.

It is.

Another big one is reluctance to change minds or confirmation bias.

We tend to look for and interpret information in a way that confirms the beliefs we already hold.

So we filter out stuff that contradicts us.

We often do, subconsciously.

There was a famous study where people read the same report about, say, capital punishment.

Afterwards, both the strong proponents and the strong opponents became more of their initial views, selectively focusing on the parts that supported their side.

Wow.

So these aren't just little quirks.

They can really affect important decisions and beliefs.

Absolutely.

And they can have significant economic consequences.

Consider 401k retirement savings plans again.

Standard theory might suggest people rationally calculate how much to save, but behaviorally, we see huge differences based on default settings.

Workers are far, far more likely to participate if they are automatically enrolled by their employer and have to actively opt out compared to a system where they have to actively opt in.

Just changing the default makes that big a difference.

A massive difference.

It shows this kind of substantial inertia or status quo bias that purely rational models struggle to explain easily.

It highlights why economists, while often assuming rationality because it simplifies models, need to be aware that sometimes that assumption isn't true enough.

Sometimes the deviations are too important to ignore.

That makes sense.

Now, another key insight from behavioral economics is that people seem to care about fairness,

not just maximizing their own payout.

Yes, absolutely.

This is beautifully illustrated by a famous experiment called the ultimatum game.

The ultimatum game.

How does that work?

It's simple, but very revealing.

You take two strainers who can't communicate except through the game.

Give them, say, a hundred dollars to split.

One person is the proposer.

They suggest maybe $70 for me, $30 for you.

Okay.

The other person is the responder.

They can either accept the proposed split and they both get the money accordingly, or they can reject the split.

And if they reject?

If they reject, both players get nothing.

Zero dollars.

Ah, okay.

So what does conventional economic theory predict should happen?

The homo economicus approach.

Conventional theory based on pure self -interest predicts a very specific outcome.

The proposer should offer the smallest possible amount above zero, say $1 to the responder, keeping $99 for themselves.

And the responder should accept.

Yes, because $1 is better than the zero dollars they'd get if they rejected.

So the prediction is a $900, $900, $1 split accepted every time.

That's the Nash equilibrium where neither player can improve their outcome by unilaterally changing their strategy.

But that's not how people actually behave in these experiments, is it?

Not at all.

It's quite dramatic, actually.

Responders routinely reject offers they perceive as unfair, like maybe $10 or $20 out of $100, even though rejecting means they get nothing too.

They're willing to punish unfairness, even at a cost to themselves.

Wow.

So they care about fairness more than just getting some money.

It seems so.

And proposers anticipating this usually don't offer $1.

They typically offer much more, often around $30 or $40,

to ensure the offer is accepted.

So it suggests people have this innate sense of fairness, or maybe they just dislike being treated unfairly.

Exactly.

And this has real world implications.

Think about wages in a firm.

Workers might have expectations about what constitutes a fair share of the company's profits or success.

If they feel treated unfairly, they might retaliate, maybe not by outright rejecting the job, but by reducing effort, being less cooperative, maybe even going on strike.

Firms might pay wages above the bare minimum equilibrium level, partly to maintain morale and avoid this kind of punishment from perceived unfairness.

Fascinating.

Okay.

Another area where we seem to deviate from perfect rationality is consistency over time, right?

Like procrastination.

Oh, yes.

Procrastination is a classic example of time inconsistency.

We make plans for our future selves.

Tomorrow, I'll start that project.

Next week, I'll start dieting.

But then our present selves often fail to follow through, especially when faced with the temptation of instant gratification.

Tell me about.

There are clever experiments showing this.

Many people, if offered a choice between doing a kind of dreary 50 -minute task right now versus a slightly longer 60 -minute version of the same task tomorrow, they might choose to get it over with.

Now take the 50 -minute hit today.

Okay.

Preferring the shorter tasks sooner.

Right.

But if you ask the same people about doing that 50 -minute task in, say, 90 days versus the 60 -minute task in 91 days, now they often switch.

They prefer the shorter 50 -minute task in 90 days.

But logically, it's the same trade -off, 10 extra minutes of work to delay it by one day.

Why does it change when it's far in the future?

That's the puzzle.

The mere passage of time shouldn't logically change the preference between the two options relative to each other.

It suggests our perspective on trade -off shifts as they get closer.

Immediate costs loom larger than distant ones.

So it's that internal battle between our planning self and our doing self.

Exactly.

Smokers promise themselves they'll quit tomorrow.

Dieters promise they'll skip dessert next time.

But when the moment arrives, the immediate craving often wins out over the long -term plan.

And this affects economic decisions too.

Hugely.

Especially the consumption -saving decision.

Saving requires a present sacrifice giving up consumption now for a future reward having more later.

This makes saving highly vulnerable to the pull of instant gratification.

Many, many people say they wish they had saved more, indicating a conflict between their long -run goals and their short -run actions.

So how do people deal with this if we know we're likely to give into temptation later?

Sometimes we seek out commitment devices.

These are ways to essentially lock up our future selves to prevent them from acting on those short -term impulses.

Like what?

A smoker might literally throw away their cigarettes to make it harder to smoke later.

A dieter might lock the fridge or just not buy junk food in the first place.

Removing the temptation.

Exactly.

And think back to 401k plans again.

They often act as powerful commitment devices for saving.

The money is automatically deducted from your paycheck before you even see it, making it less tempting to spend.

And there are often penalties for withdrawing the money early.

These features help protect people from their own predictable tendency towards instant gratification.

That makes so much sense, like designing systems acknowledging our human flaws.

Speaking of real -world impact, Richard Thaler, who, as you mentioned, won a Nobel Prize for his work in behavioral economics, gives a fantastic example of what he calls supposedly irrelevant factors being hugely important.

Yes, Thaler's work is brilliant on this.

His own story about grading his students' exams is just perfect.

He found experimentally that students were actually happier getting a score of, say, 96 out of a possible 137, which is about 70 percent, than they were getting 72 out of 100, even if the grading was done on a curve where the 72 was actually a better relative performance.

That's bizarre.

Why would they prefer the lower percentage score?

It's totally irrational from a homo economicus perspective.

But Thaler argues it shows students, like all humans, misbehaving compared to those purely rational icons.

They were perhaps anchored the higher absolute number, 96, even though the denominator was also much higher.

He argues that traditional economics often discounts factors that shouldn't influence a rational econ, things like framing, context, default options.

But for real homo sapiens, who he calls humans,

these supposedly irrelevant factors, or SUFs, matter significantly.

So things like how information is presented, or what the default choice is, can have a huge impact, even if a perfectly rational person wouldn't or shouldn't care about them.

Precisely.

Thaler gives great examples.

An econ wouldn't buy way too many groceries on Sunday just because they happen to be hungry while shopping, knowing they won't need that much for Tuesday's dinner.

But humans definitely do that.

Right.

An econ wouldn't force themselves to finish a huge restaurant meal they already paid for, even if they're uncomfortably full.

That's the sump cost fallacy.

Econs would probably be perplexed by gifts, preferring the efficiency of cash.

Thaler strongly challenges the idea.

He calls it the invisible hand wave.

That market forces somehow magically turn ordinary, flawed humans into perfectly rational econs.

He argues that often markets cater to consumer biases rather than correcting them.

Okay, so what's the real world impact of paying attention to these SUFs?

It's profound, especially in policy design.

Remember our 401k example?

Features like automatic enrollment, automatic contribution increases over time, default investment choices.

These are all to a pure econ.

The econ would make their own optimal choice regardless.

But for real humans, these design features dramatically improve retirement savings outcomes.

So the irrelevant factors are actually doing most of the work.

In many cases, yes.

Thaler points to a Danish study on saving incentives.

It found that traditional economic incentives like tax breaks for saving, which should be relevant to e -coms, accounted for only about 1 % of the observed increase in saving.

Meanwhile, automatic enrollment features supposedly irrelevant SIFs accounted for the other 99%.

Wow.

Irrelevant indeed, as Thaler might say.

He also discussed how the Obama administration designed a tax cut.

Spreading it out gradually over paychecks rather than giving a single lump sum was predicted by behavioral economics to be more effective at stimulating spending because people are more likely to spend small, regular increments than a large windfall they might decide to save.

That's using a SIF strategically.

So behavioral economics isn't just pointing out flaws.

It's using those insights to design better systems and policies by acknowledging how humans actually behave.

That's exactly the goal.

By incorporating these SIFs and understanding psychological biases, we can see how seemingly small factors can have huge impacts and potentially use that knowledge to, well, make the world work a little better for actual humans.

This whole deep dive into the frontiers of microeconomics, asymmetric information, political economy, behavioral economics,

it truly shows us that the economy is far more nuanced, far more complex than the simplest models might suggest.

From hidden information messing with markets to the quirks of voting and our own very human biases, it's clear that life and economics is indeed messy.

That's precisely it.

If we think back to the classic 10 principles of economics, we learned that markets are usually a good way to organize economic activity and that governments can sometimes improve market outcomes.

Right, foundational ideas.

But these frontiers add crucial caveats.

Asymmetric information should make us

appropriately wary of relying solely on market outcomes.

Political economy should make us equally wary of assuming government intervention is always the perfect solution.

And behavioral economics.

And behavioral economics, well, it makes us wary of any institution, whether it's markets or government, that ultimately relies on the decisions of imperfect, biased, time inconsistent human beings, which is pretty much everything.

So it adds layers of realism and maybe caution to our understanding.

Exactly.

Economists continue to explore these imperfections, these frontiers to better explain the world as it is, and hopefully to find ways to improve it.

Understanding these areas challenges all of us to look beyond simplistic models and really embrace the complex, sometimes frustrating, but always fascinating reality of economic life.

A great place to leave it.

This has been incredibly insightful.

We hope this deep dive has given you plenty to think about.

Thank you for joining us today on The Deep Dive.

And for you, our listeners, here's a final thought.

Consider a decision you recently made, maybe something you bought, a choice you made at work, even a vote you cast that you later regretted or found puzzling.

How might the concepts we discussed today, asymmetric information, the challenges of group decision making, or even your own potential behavioral biases, have played a role in that outcome?

Something to mull over.

Thanks for tuning in.