It's the holidays, so let's have some fun with economic puzzles

So it’s holiday season, when (almost) everyone takes a break, chills out and tries not to think about workaday worries. So let’s have some fun. Let’s do a few economic puzzles.

There’s an old joke in economics that says, “it may work in practice, but does it work in theory?” If you take that to mean economists care more about getting their theory right than about its usefulness then, yes, too many of them do.

But an empirical revolution is happening in economics, where economists test their standard theory to see how well it explains the real world. A big part of this is the rise of “behavioural economics” which, rather than simply making the conventional assumption that everyone acts “rationally” – with carefully considered self-interest – in the economic decisions they make, studies the many reasons people often make decisions that aren’t rational.

So, first puzzle. When, in 2012, prime minister Julia Gillard introduced what she called a “price on carbon” and opposition leader Tony Abbott correctly labelled a “carbon tax”, which increased the price of electricity, she took care to cut income tax and increase pensions in a way designed to leave households on average incomes no worse off.

Among Abbott’s many criticisms, he claimed the move would fail to reduce electricity consumption because people would simply use their tax cut to allow them to keep buying the same amount of power. Puzzle: conventional economics says Abbott was wrong, but behavioural economics suggests he may have had a point.

In compensating most people for the cost of her carbon tax, Gillard was doing just as economists advised. They were confident people would still reduce their electricity use because theory says a change in the price of some item has two, conflicting effects: the income effect and the substitution effect.

The income effect reduces the consumer’s real (after-inflation) income, whereas the higher price relative to the prices of similar items encourages the consumer to substitute other items for the now-dearer item, at least to some extent.

So even though Gillard’s compensating tax cut eliminated the income effect, economists were confident the remaining substitution effect would still encourage people to use less electricity and use what was left of their tax cut on something else they wanted more of.

But behavioural economics says maybe it’s not that simple. One of its early and major findings is that many people are “loss averse” – they hate losing money from the increase in the price of electricity more than they like getting the money back as a tax cut.

So, contrary to theory, many people wouldn’t have felt the tax cut left them no worse off. If so, they may well have chosen to use all their tax cut to keep buying the same amount of electricity.

For the record – and for whatever reason or reasons (remember, this wasn’t an experiment where all else was held equal) – electricity sales and emissions of carbon dioxide fell sharply during the two years before the Abbott government abolished the “carbon pricing mechanism”.

Then they rose again. History will not be kind to that man.

Second puzzle. An ABC series called How to Live Younger presented scientific evidence showing that regular exercise throughout life can rewind the clock on cognitive (mental) decline, fight cancer, prevent disease, beat depression and even enhance our lives by making us smarter and more creative.

So people who’ve exercised throughout their lives generally do much better in old age. It’s also true that people who aren’t used to exercising find it harder to start working out and so don’t get as much “utility” - enjoyment and benefit – from exercising.

The economists’ convention model of “rational decision-making” predicts that knowledge of all this will lead parents to encourage their children to exercise and lead kids to keep it up as young adults and in middle age, thus setting themselves up for a healthy, happy old age.

Doesn’t always happen that way, you say? True. By why not?

Because, as behavioural economists recognise, many people, even those who fully understand how keeping fit will benefit them in old age, still have trouble making themselves exercise regularly. If they get out of the habit, it’s hard to get back into it.

A finding of behavioural economics is that this is partly explained by the “projection bias” that affects the thinking of many people. They mistakenly believe that the benefit they enjoy from exercise at this stage of their life will be the same in later stages. Actually, they’ll benefit more in later stages if they keep exercising now; if they give up exercise now they’ll find it harder to take it up again later.

So, whereas conventional economics can’t see there’s a problem – also with adverse consequences for the health system and the taxpayer – behavioural economics can see it. It can see the case for a government education campaign to help people overcome their projection bias, for instance.

And there are techniques individuals use to overcome their projection bias, short-sightedness and lack of willpower. Psychologists call such techniques "commitment devices". I did little exercise until, in my late 40s, a diabetes doctor ordered me to start.

I’ve been able to keep going to the gym two or three times a week since then, and I enjoy it. The tricks I’ve used to keep it up are to have a highly qualified trainer and go at set times with a bunch of gym buddies who’ve become good friends.

A couple of times last year I criticised academic economists for not doing enough to make their theories more realistic – and more useful to the students they teach.

The two “puzzles” we’ve just looked at are derived from a university exam paper in behavioural economics, sent to me in response to my criticisms by Professor Simon Grant, of the Australian National University.

It seems that, at least at our better universities, economists don’t just bang on with conventional theory oblivious to its limitations.

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Exertion, not avoiding it, makes us happy

Forgive me for saying so, but don't you think you'd be better off going for a run - or even a brisk walk - than reaching for another mince pie? (The ones my wife made this year were irresistible.)

Chances are you don't think it. Or maybe you think it, but you don't intend to act on it. If you can't take a day off on Boxing Day, when can you?

I hate to say it, but humans have a slothful streak. We want to live comfortable, enjoyable lives and we assume the less physical effort this involves the better. But one of the most unremarked and remarkable discoveries of our times is that it doesn't work like that.

As a writer about economics, I suppose I'm required to be an advocate of progress. But I'm learning progress can be a tricky beast. Sometimes it involves moving away from the practices of the past as far and as quickly as possible. But occasionally we discover we need to retrace our steps.

A major element of humankind's progress - of our civilisation - has been our unrelenting efforts to take the effort out of all we're required to do to live our lives. That story begins with our discovery of first stone, then metal tools. It progresses to our discovery that settling in one spot and farming crops and animals was a lot safer, more comfortable and prosperity-inducing than hunting and gathering.

Fast forward to the industrial revolution, which began in the second half of the 18th century. It, too, was fundamentally about taking the physical effort out of work, first with the discovery of steam power, then later, electricity and the internal combustion engine - all of them powered by the burning of fossil fuels.

Along the way we invented a multitude of ways to mechanise work - from the spinning jenny to the typewriter - thereby greatly reducing the number of workers needed to produce a given quantity of goods and services or, looking at it another way, allowing a given number of workers to produce a much greater quantity of goods and services.

Whichever way you look at it, our unceasing search for new and better ''labour-saving'' devices has greatly increased the productivity of our labour - the quantity of goods and services the average worker is able to produce in an hour - and this explains why our material standard of living is many times higher than it was at the time of white settlement in Australia.

Usually, this is what economists portray as the object of this grand exercise, making ourselves richer. But it's equally true that a central element of the exercise has involved taking the physical exertion out of work. We haven't ended up doing a lot less work than we used to, but our work has become much less physical and much more mental, requiring us to be a lot better educated and trained.

More recently - and particularly with the advent of the information revolution - we've moved from taking the physical effort out of work to also taking it out of leisure. We drive when we could walk or ride around our suburbs at the weekend. For home entertainment we no longer sing or recite to each other, but turn on some electronic device. And the commercialisation of sport means not only that we watch professionals rather than playing ourselves, but needn't even leave the house to watch a game.

This is where we've overreached, however. This is where nature is striking back. Combine the way machine-produced food has never been more enticing, more plentiful or as cheap with the success of our efforts to strip physical exertion from work and leisure, and you get an obesity epidemic.

And it's not just that. As each year passes the medicos uncover ever more evidence of the many ways our lack of exercise is contributing to our ill-health, including heart disease, type II diabetes, high blood pressure, cancer, depression and anxiety, arthritis and osteoporosis.

To put it more positively, and to borrow a slogan from the American College of Sports Medicine, exercise is medicine. This is what I find so remarkable, so surprising.

Recent research by medicos in Texas has found that previously sedentary women who began moderate aerobic exercise a third of the way into their pregnancy had significantly fewer caesarean deliveries and recovered faster after the birth.

Research by Dick Telford and colleagues at the Australian National University has found that primary school children who are more physically active and leaner get better academic results and, even more so, that primary schools with fitter children achieve better literacy and numeracy.

Research quoted on the Exercise is Medicine website says active people in their 80s have a lower risk of death than inactive people in their 60s.

Regular physical activity can reduce the risk of recurrent breast cancer by about half, lower the risk of colon cancer by more than 60 per cent, reduce the risk of Alzheimer's, heart disease and high blood pressure by about 40 per cent and lower the risk of stroke by 27 per cent. It can decrease depression as effectively as Prozac or behavioural therapy.

According to the site, a low level of fitness is a bigger risk factor for mortality than mild-to-moderate obesity. And regular physical activity has been shown to lead to higher university entrance scores.

But here's the bit I like best (and know from experience is true): research shows that exercise makes you feel better, reducing stress, helping you sleep better and feel more energetic. The unexpected truth is that it's exertion, not the avoidance of it, which makes you happy.

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