An Observation about Economic theory

[Tetro Kornbluth]

One of the things for which economics is most criticized for is the assumption of Homo Economicus, you know, the supposedly rational actor who is always looking out for his utility, acting to the whims of supply and demand. As a psychological theory, that's clearly absurd or at least rather incomplete, one that could only be believed by the sort of people who post at places like Less Wrong. But look at what I've done - I've added intentionalistic language to a description of what is supposed to be a behavioural science - a place where traditionally intentional language has been either verboten or at least held under great suspicion (that is, when the academics in question have been paying attention to their own theories, which doesn't seem to be that often).

Now what isn't understood is that this isn't a psychological theory, it's a theory of how people interact with an environment where scarcity exists and is all dominant. People have to act this way because the stress and discipline of scarcity - that human needs and desires always outstrip the available resources - and of a market system where individuals and groups act in competition with each other. It's a key insight - we can't separate our behaviour from our environment and so we can't separate our psychology from it either (or can we?).

However this requires that as the demands of scarcity are relaxed - i.e. the further away we get away from the struggle for existence - then so are the strictures that force us to behave in a homo economicus type fashion (this is, of course, why social conservatives and free market liberals are frequently allies). This is not arguing that there is now no scarcity, only that the limits of our preferences are increasingly those of our psychology, our whims and desires, not what is necessary (nor what is required social structurally speaking, like for example, dowries or family obligations). We are freer to act less like Homo Economicus.

Unfortunately for romantics, it seems though that with this greater freedom, we'd prefer to spend our time on pet food and watching video of cats over... well, most other things (except reading crap novels and watching crap TV it seems). It is frequently argued that the reason the industrial revolution didn't happen before the 18th Century was due to the intellectual limitations and horizons of previous cultures to that of the mercantile British. But it might not have been because nobody was arsed? What good was in that?

This was inspired by an intriguing if somewhat silly article by (who else?) David Graeber in The Baffler

[Franknburger]

The concept of homo economicus shares the features of many late 18th/ early 19th century concepts: Helpful as a theoretical framework when it was developed, it has in the meantime been amended / replaced by more complex assumptions.

Without going into details on current economic behavioural theory (I am also not really an expert in that field), there are  several important amendments that already several decades ago have been made to the homo economicus concept:

1. Minimising input vs. maximising output: Simple application of Algebra II tells that you cannot optimise both sides of an equation simultaneously - you need to decide on one side of the equation first, and can then vary parameters until the other side gets the optimal value. In practical terms: If you are provided with a certain set of resources (e.g. time) and skills, you can either try to obtain a pre-defined output from it by as little as possible effort (e.g. passing your exam without working yourself to death), or try to maximise output (e.g. getting the best exam score possible to you). Both approaches are in line with the concept of homo economicus, but of course imply a quite different behaviour. Each individual will in certain situations act as input minimiser, in others as output maximiser, which then leads into the theory of individually-differentiated utility functions. More generally, I have made the experience that sportsmen tend to act as input minimisers (you never know what you will need resources for, better not spend them already), while musicians or artists generally tend to orient on maximising output.

2. Risk vs. Return: When taking a decision, you assume a certain effect, but can of course never be sure that the effect will really materialise. As such, aside from the input-output ratio itself, the risk of not fully achieving the anticipated output, or even obtaining negative effects, needs to be considered as well. Poker is a perfect example of such a setting, and the various considerations and strategies it implies. People apply different risk-return functions to their decision-making, and it is empirically possible to reconstruct such functions, e.g., for investment decisions. Current economic behavioural theory tends to assume risk-return functions as pre-defined - by culture, but also individual ability to bear certain risks. Especially personal wealth, which makes it easier to continue even if a negative risk has materialised, is a key determinant of individual and aggregated risk-return functions. The whole approach doesn't question the fundamental concept of the homo economicus, but postulates that economical behaviour will only occur on the base of given risk-return functions, which may differ between individuals, cultures, and historical periods.

3.  Discounting: Linked to the issue of uncertainty / risk is the question how people deal with time horizons. Obviously, having money now is better than having it next year. But how much better? Would you prefer 100 Euros today, or 110 Euros next year? Eat a bit more bread today, or sow some of the grain in hope of a good harvest next year? Technically, we are speaking about discount factors (interest rates), which in fact have a time as well as a risk component (Will I still be alive next year? Will the landlord allow my to harvest next year?). The discount factor applied to future returns is individually and culturally defined, and there is ample empirical evidence that even Westerners apply quite specific discount factors that are not necessarily related to prevailing interest rates.
 A friend of mine, an agro-economist, in the 1980s studied decision-making of a specific ethnic in West Africa. He found out that what at first glance appeared to be irrational decision making was making perfect economic sense when applying a discount rate in the range of 40%. In other words - this ethnic did not plan for more than two years, actions should yield immediate benefit. Irrational to a European, of course. But in the Sahel, in the 1980s after having experienced several draughts and periods of famine, such an attitude makes quite some sense.

I am not sure if that excursion has helped. Economic behavioural theory is a fascinating, but unfortunately often neglected discipline. Economists tend to narrow their view on financial markets (for which ample empirical research has been done), while psychologists tend to be appalled by economists primarily looking at financial markets instead of at the humans driving them (and those many other humans which for various reasons don't participate in financial markets).

[Gustaf]

I think it's important to remember that economics is not psychology, as Gully says. A way of putting it is that economics is not attempting to explain why YOU bought that banana last night (the way a psychologist tries to explain why YOU killed your parents or whatever) - economics tries to explain why people buy bananas in general.

There is a lot of noise in social science data, but the standard theory in economics tends to be the standard theory because it actually works better than alternative theories so far. That is, people do, on average, act out roughly as the theory predicts in most cases.

Scarcity of resources is central to economics. If our resources were unlimited we need not worry about any of the stuff economists study. Of course, that is not the case nor is it likely to be anytime soon. As people get richer certain tastes and behaviours do change.

For example, a basic idea in macro is that we work a bit less now than we did 200 years ago because we don't have to work as much to get the basic things we need. However, even as we become richer, working also pays better and better compared to leisure time so in more recent years working hours have tended to stay the same.

[compson III]

Gully,

I will post a more thorough response later but your critique is very astute.  The problem is that economics is very unprepared to deal with intersubjectivity.  Analysis of atomistic actors works whenever the actors have stable preferences, which I think don't come from psychology but rather from a situation where preferences are shaped by survival and other immediate needs relating to the objective world.  Beyond survival, the most relevant determinants of behavior are perhaps inertia followed by imitation.  Imitation, particularly, leads to non-convex outcomes, which by itself invalidates 99% of economic theory which relies upon finding a single analytical equilibrium solution.

This leads us to a social theory that is very much along the lines of Baudrillard's fourth stage in Simulacra and Simulation.  And actually Keynes was very prophetic in conceiving of his "beauty contest" model of dynamic markets, in which you have infinite orders of intersubjectivity.