Why Policy Changes Are Often Misjudged – the Lucas Critique
When policies fail to deliver, it is often that the Lucas Critique that wasn't considered.
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Proponents of specific policies often assume that the outcomes of the policy are going to be straightforward. For example, in the picture below, we see an example of enacting a ‘policy’ that aims to improve safety by having bike riders get off their bikes on this path:
It seems like this policy should work – after all, if we block a path with a metal railing, the biker would need to get off their bike or significantly slow down. Right?
It should come as no surprise (especially to fellow bikers) that this ‘policy’ failed. Moreover, it may have even made things worse by ruining the lawn next to it. This error could have been prevented, if the Lucas Critique had been considered.
Lucas Critique
In a 1976 paper, future Nobel Prize winner Robert Lucas highlighted certain dangers regarding the evaluation of policy changes. He argued that it was wrong to predict the impact of changing economic policy using only the relationships found in historical data, especially macroeconomic data (such as GDP, inflation, unemployment). By changing economic policies, one cannot assume that all economic participants (individuals, firms, governments) would act in the same way as before. Thus, it was crucial to actually model the decision making of individuals, as only then would we be able to evaluate the impact of changes in economic policy by taking into account how they would potentially respond to this new economic policy. This critique of evaluating policy changes is now referred to as the ‘Lucas Critique’.
In the bike example above, the proponents of the metal railing assumed that bikers typically slow down when faced with an obstacle. Thus, if the whole path is blocked, they will significantly slow down. The Lucas Critique, however, tells us that we need to consider how bikers actually decide what to do. And a biker will do lots of things to avoid an obstacle before getting off a bike.
Thinking Through Economic and Social Policies
The inspiration for this article was our two recent articles on the impacts of immigration on the economy from both college-educated and non-college educated immigrants. A common argument heard in all circles is that immigrants take jobs from domestic citizens. However, research shows otherwise. That’s because the common argument makes the Lucas Critique mistake. A firm, when making labor employment decisions, isn’t restricted to just its local market – firms can often end up going abroad, automating work or importing certain goods. Once we model the firm decision making process better, it is clear to see these other options a firm has, separate from hiring immigrant or domestic workers, which explains why research struggles to find any adverse impact of immigrants on local worker employment.
Whether we realize it or not, every ‘causal’ argument (even the argument that immigrants take away jobs from local workers) comes from an underlying model of the world. In the case of the often seen immigration argument, the model most likely assumes that the number of jobs in an economy is fixed, firms cannot move abroad or import, and immigrants and local workers are perfectly substitutable (i.e. they are identical in every way). This model of the world, although interesting as a thought experiment, does not reflect reality well at all. The assumptions underlying the model are demonstrably false.
Ultimately, many economic and social policy discussions (at least the ones I’ve had) end up focusing on the validity of assumptions in a model. Any economic policy outcomes are directly related to these assumptions. This is why to have a fruitful policy debate, focusing, and potentially agreeing on assumptions, is crucial.
The Cobra Effect
To give another example of failing to account for the Lucas Critique is the Cobra Effect. German economist, Horst Siebert, recounted a situation in India during British Rule, where the colonial authorities wanted to reduce the population of deadly cobras in Delhi. The authorities proposed a bounty for each cobra brought to them. However, soon a new business of cobra farming emerged that would raise cobras just to kill them and bring them to the authorities for the bounty. Once the British authorities caught on to this scheme, they abandoned the bounty system, which made it no longer worthwhile for the cobra farmers to operate. The cobra farmers released all the cobras they had, which resulted in a higher cobra population in Delhi than the population prior to the bounty scheme. This particular kind of policy failure has happened more than once and all over the world.
Keeping the Lucas Critique in Mind
The Lucas Critique is important to keep in mind when designing and considering policy outcomes. Controlling for the Lucas Critique, especially using data, can be hard. At the same time, even if we cannot perfectly control for the Lucas Critique, it does not necessarily mean a policy will fail or be worthless. But it is still worth thinking through – below are some examples where contemplating the Lucas Critique may be helpful (note these are just high level thoughts with stylized examples):
Tariffs
Tariffs are sometimes considered as a tool to develop a domestic industry, as well as a government income generating policy. Using “Frozen” references, if Arendelle imposes tariffs on Northuldra, the exporters in Northuldra may choose to export to the Southern Isles. The Southern Isles will now export the same product to Arendelle. This would result in the Southern Isles replacing all exports of Northuldra to Arendelle. Arendelle will neither see an increase in domestic production (all imports are now from the Southern Isles) nor any tariff revenue.
Exporters in a country whose products face tariffs (like Northuldra) might export via other countries (Southern Isles), resulting in the tariff being effectively bypassed. This can result in simply a higher cost of goods (since the goods have to ship for a longer time) with no benefit to the tariff imposing country.
Pollution Regulation
Policies designed to reduce pollution often focus on domestically produced pollution. Domestic firms that adhere to the environmental regulations may struggle to compete with foreign imports that do not have such regulations. Ultimately, any domestic reduction in pollution emissions may be offset by pollution abroad (fishing regulations are potentially an example).
Zoning Laws
Zoning laws in cities, which restrict building, have potentially significant costs and typically favor incumbents in the city. Abolishing zoning laws, however, might not bring about the expected change, because incumbents can use other methods to mimic zoning laws (for example – forming a Homeowner’s Association or even seceding from a city to form a new municipality).
Congestion Pricing
Congestion pricing – a policy I support – can have an unintended consequence. Although it may reduce traffic and volume of traffic accidents, congestion pricing could increase the severity of accidents. This is because by reducing the number of cars and traffic bottlenecks, drivers can drive faster and thus any collision with a pedestrian or another vehicle has a higher likelihood of severe injury or death. This is a consequence that city planners should consider when implementing congestion pricing.
Designing Better Policies
The purpose of emphasizing the Lucas Critique is to improve policy design by thinking through how people will respond to a policy change. This entails building models of how people make decisions. By doing so, we can reduce the demand for bad policy.
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By way of introduction, I’m a PhD Economist. With Nominal News, I want to share what the field of economics can tell us about the current economic and societal issues. Beyond just telling, I would also like to share the tools and frameworks that I have acquired as a trained economist, and share with you how economists, using these tools, have generated these insights. I’ve always thought that understanding the mechanisms of research can be more important than just knowing the results. That is why some of my articles, like the one today, are more ‘theoretical’ or ‘conceptual’ with the focus on how to think about economic policies, rather than emphasizing which policies are ‘good’ or ‘bad’.
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Interesting Reads from the Week
- discusses the economic impacts of one of the biggest US events – the Super Bowl. Interestingly, it is a good example of the Lucas Critique – economic benefits to the host city are often over-stated (true benefits are $150mln rather than an oft quoted number of $1bln, because they ignore the fact that without the Super Bowl, other economic activity would take place).
- talks about the bifurcation we see in the US labor market – low unemployment, but also a low hiring rate. Although recession annoucements are often based on unemployment, but the risks of low hiring can result in a ‘good’ economy becoming quickly a severely ‘bad’ economy.
Article: Continuing our recent articles on immigration,
– a top New York City food critic – pays tribute to the immigrant food workers, who’ve kept the city running through the toughest times.
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Marriage Preferences and Gender Outcomes (March 26, 2023) – how partner preferences impact the glass ceiling.
This is fascinating, illustrating how we really need to have the best and brightest in our government for thoughtful analysis of policy making.
I wonder if the Critique is a rational response to policies that espouse an ideal result but fail to give credence to realistic human behavior in their genesis. Sounds as though it is to me. The cobra farm situation is typical of knee jerk policy decision making not well thought through and typical of too many governance hierarchies giving rise to analysis paralysis. A difficult cycle to break in elected political bureaucracies where CYA is elevated to a fine art form. Particularly applicable to the concept of the "Invisible Hand."