In 1874, Max Plank’s physics professor explained to him that “in this field, almost everything is already discovered, and all that remains is to fill a few holes.” I heard the same thing in 1980 from a Nobel Laureate in Economics — almost verbatim. Didn’t he know? But how could he? Optimistically, I concluded that Economics was at a similar stage to physics in 1874.

My transition from physics to economics was baffling. Fellow graduate students explained that economics was unscientific because economists could not do experiments. Did they think Astronomers were busy experimenting on stars? And besides, economists could do experiments. Of course, parts of economics were scientific even back then. But times have changed and economics is now making steady progress towards becoming scientific thanks to behavioral economics and people like Esther Duflo. I hope this site can make a small contribution to this progress.

Here I will discuss problems caused by the unscientific nature of economics in three otherwise unrelated areas: the design of markets for electricity-generation capacity, international negotiations on climate policy, and the foundations of neoclassical economics.

Climate Change Negotiations

The problem is not so much Big Carbon as it is dedicated environmentalists. They have not been able to agree on anything substantial in 20 years. There are three reasons for this impasse (see also carbon

  1. Environmentalist are trapped by their moralistic command-and-control thinking.
  2. Economists are trapped by their fixation on narrowly defined efficiency.
  3. The resulting negotiation game is a prisoner's dilemma with 100+ prisoners.

Consequently the Paris climate conference in 2015 will fail (China's pledge shows zero ambition, and the US pledge is flimsy). Environmentalists and economists have the best of intentions, but the consequences can still be tragic. Fortunately, the three top US climate economists  [Read more...]

The Behavioral Foundations of Economics

Economics frequently neglects the principles of science, but one failing stands out above all others. The most fundamental assumption—the assumption of rationality—is unfounded. But the problem is not what you usually hear. It's not that people are somewhat illogical, or have "bounded rationality."

Proof: the fundamental theorem of economics is false for humans.

The problem is that economic "rationality" contains a hidden and overlooked assumption that runs directly counter to human nature. And if economics does not pertain to humans, it is merely a special branch of mathematics, not a science. The hidden assumption is that people are not social creatures—that they take absolutely no account of their social standing or what others think of them. This assumption is strictly enforced throughout all of standard economics by the  [Read more...]

The Great Energy-Only Fallacy

The question of how electricity spot prices can pay for generators that are almost never used has bedeviled market design from the beginning. But it would not cause much damage if it were not that a fundamental economic fallacy has become ubiquitous. Economics provides us with (roughly) the following result:

Result: Competitive pricing of a product will induce optimal investment in its production.

This has been almost universally interpreted to mean:

Fallacy: Uncapped competitive electricity spot prices will lead to optimal reliability.

[Read more...]