Outside the Beltway

Pessimism or Optimism?

Steve Verdon · Friday, September 23, 2005 · 2 comments

Over at the Oil Drum there is an interesting post. I found two things interesting. The first is how the post indirectly notes that people all too often take the latest data and give it way too much weight.

There is a rather odd side to human nature. Take a problem, present it to the audience in its maximum horror and suggest it is about to happen, then ameliorate it a little, and tell everyone how the world is not nearly as bad as it is painted. And everyone agrees that things are looking up. But you are still facing a very bad situation – only the way the news has been presented makes it seem that there is no longer a problem.

Consider that, just yesterday, Texas was facing the third worst storm in known history and things looked very dire. The storm has now got just a bit less intense and folk are already talking about Houston having “missed the bullet.” All of a sudden a Category 4 hurricane becomes news enough to ease oil prices.

We have seen this over the past year with oil prices themselves. Prices rise from $30 to $40 to $50 and then they fall back $3 and we discuss the “collapse of the price of oil.” It rises to $60 and then $70 and then slips $4 and suddenly “the crisis is over.”

I think to some degree this is right. People look at the most recent data and think, “Okay, it’s over now,” when in reality, it is minor fluctuation around a trend.

The rational thing to do is to consider all the data. The problem is that this is hard to do. One way to do it is the Bayesian method. The Bayesian method requires working with conditional probabilities and that is a pain in the butt for many people. For example, suppose we want to make an inference about prices. Ideally we’d like to know the following,

That is, what is the probability that price at time t+1 (this could be tomorrow, next week, next month, etc.) will be P given information D_t. If you are already suffering from MEGO (My Eyes Glazed Over) then I’ve proven my point. People don’t understand this, they don’t want to understand this, and hence generally wont use it in formulating inferences. So they rely on rules of thumb, and one problem is that a rule of thumb that is good in situation X, could be bad in situation Y.

I have no problem with this part of the post from the Oil Drum, mainly because I agree with it. What I do have a problem with is the implication that Prof. Hamilton has made the following argument,

Unfortunately the problems of the oil and gas loss in the Gulf will not let themselves be so easily moved from the front pages. The likely losses are identified in the posts that Prof G is so assiduously been keeping current over the past few days. Sadly they will become reality over the weekend. And the impact will then develop over the next couple of weeks as crude oil production fails to return to its early Summer levels, while needs start to go unmet. (And with due deference to Econbrowser those who have to heat a home in Boston this winter will not willingly forgo that need because the price is higher than last year).–emphasis added

The implication that either you heat your home or you don’t is a specious one. Sure if the price rises people aren’t suddenly going to say, “Oh, well I’ll just turn off the heat in the middle of December.” But there are things that can be done such as lowering the thermostat and putting on a sweater, or lowering the thermostat quite a bit at night and getting out a couple of extra blankets. People said the same thing about electricity here in California, but guess what? People do respond to price signals in regards to electricity. I know, I’ve seen the data as rates change and watched people move from direct access (buying electricity from an independent power producer) back to their default provider (their local investor owned utility) back to direct access, and so on (the utilities have their rates set by the CPUC with balancing accounts whereas the indpenedent power producers can vary their price depending on their costs, so there are often periods where there is a price differential). Just because a price is highly inelastic (not that responsive to price) doesn’t mean there is no response (perfectly inelastic). As one commenter put it, the argument is basically a strawman argument.