Do economists have a sensible way of thinking about the world?
The dominant framework that economists use for analyzing how the economy works is known as the neoclassical paradigm. According to this world view, consumers, workers, and firms all make a rational calculation as to what is in their own best interests. The aggregation of these rationally motivated behaviors is then used to make predictions about the quantity of goods that get produced and the prices at which they would be sold.
One doesn’t need to add much detail to a given decision problem before the calculation of the optimal action becomes extremely complicated. In a dynamic setting with many variables to choose, uncertainty about some of the key magnitudes, and strategic interaction with other actors, figuring out the optimal strategy can be beyond the capabilities of even the fastest computers. There is always a bit of culture shock as graduate students in their first year of an economics Ph.D. program are taught that ordinary people on the street make their decisions using algorithms with which these very smart and capable students had themselves been unfamiliar up until hearing today’s lecture.
And there can also be a bit of culture shock when scholars from disciplines outside of economics try to familiarize themselves with how economists think and encounter this theoretical world populated by flawlessly calculating and emotion-free homo economicus.
The Fall 2005 issue of the Journal of Economic Perspectives includes a very interesting effort to communicate to economists from a thoughtful scholar on the other side of the divide. Jonathan Cohen, a professor of psychology at Princeton, relates a variety of evidence from brain imaging studies supporting the view that a broad range of human decisions involve brain mechanisms that are associated with emotional response as distinct from rational analysis.
An example Cohen gives is based on experimental analysis of how people behave in the ultimatum game. In this experiment, the researcher gives a fixed sum (say $100) to one subject (call him Tom). Tom is then told to select an integer amount (for example $10) which he proposes to give to a second subject (say, Bob), and keep the rest ($90) for himself. Bob then has the option either to refuse the deal, in which case Tom and Bob both go home with nothing, or to accept the deal, in which case Bob gets the $10 and Tom keeps the $90 as proposed.
In terms of purely rational calculation, it would in fact never be in Bob’s interests to refuse Tom’s offer. If Bob says no, he gets nothing. If Bob says yes, he at least gets the $10. If Tom assumes rationality on Bob’s part, Tom should therefore offer Bob a measly $1, knowing that a rational Bob would always say yes even to the meagerest offer. The equilibrium prediction for the outcome of the ultimatum game is therefore that Tom ends up with $99 and Bob with $1.
The observed outcome in an experimental setting is that almost no one offers Bob a take as low as $10, and, for those unfortunately clever Toms who do, their Bobs almost invariably refuse the offer, leaving both with nothing. Cohen reported that, for those Bobs who were offered a split of less than 20% of the total, the researcher was more likely to observe stronger neural activity in the anterior insula, an area of the brain associated with negative emotional responses such as physical pain and disgust. The stronger the observed activity in this region of the brain, the more likely the researcher was to observe this particular Bob refuse the offer. According to Cohen,
These findings suggest that when participants reject an unfair offer, it is not the result of a deliberative thought process. Rather, it appears to be the product of a strong (seemingly negative) emotional response.
I would presume that most economists are perfectly willing to concede that many decisions are reached emotionally rather than rationally, and this particular regularity in experimental investigation of the ultimatum game may be an example of exactly this. But let me suggest a few reasons why even an experimental psychologist might be persuaded to take the neoclassical paradigm seriously.
The first is the observation that anybody’s behavior can be altered with reward or punishment. In the real world, if behavior A is rewarded by the market and behavior B is punished, most people eventually get trained to select A and keep their emotions under wrap. John Kagel, an economics professor at Ohio State, has performed a number of studies with other researchers using laboratory rats and pigeons which involved changing the “price” the animal had to pay to obtain a certain food, such as the number of times it would have to tap a lever to get the reward. These researchers found the critters responding to price incentives in similar ways to those predicted by neoclassical economic theory.
The second reason I might offer for an experimental psychologist to take the neoclassical paradigm seriously is based on the evolutionary forces induced by market rewards. Those who are unsuccessful in their investments, even if they never themselves learn to be any wiser, will find themselves with less money and therefore less of a vote in determining the equilibrium price. One can devise interesting counterexamples to this proposition. For example, Brad DeLong and coauthors proposed a model of “noise traders”, who buy and sell stock equities on the basis of partly faulty information from others who are better informed. It is possible in certain circumstances for the poorly informed to earn a higher return on average than those who are wiser, because the dimwits lack the sense to avoid those stocks which the better informed shun due to their risk. But that very risk gives rise to a higher average return earned on those securities favored by the uninformed, so that, over time, they acquire more and more of the wealth. But such examples seem unlikely to constitute a general rule of investing, and the natural expectation would be that those who are better informed end up controlling more of the wealth.
A third reason that economists adhere to the neoclassical paradigm may be less persuasive to those outside our discipline. This is the fact that the neoclassical approach imposes such a clear structure and discipline in theoretical modeling. If your model implies a certain environment that an economic agent would operate in, then you can’t just make up some story about what the person would do in that setting. Either the behavior you’ve postulated for that person is in their own best interest or it’s not, and, if not, you’d generally need some very strong evidence to persuade most economists that it is an accurate description of the economic phenomenon that you are purporting to explain.
I believe that most economists think of the neoclassical paradigm not as a literal description of all human behavior, but rather as a disciplined device for coming up with a first assessment of how a certain market should behave, and surely as something to be calculated as a base for comparison with any alternative scheme. If one does advocate a departure from rationality on the part of some subset of economic actors, we ask (as the noise trading models mentioned above try to deliver) for details of how such behavior persists and is consistent with evolutionary pressures.
So, I feel that there may be a rational basis for believing in homo economicus after all. But perhaps I should subject myself to one of Professor Cohen’s brain scans to see what’s really going on with my neurons when I make that claim.
Sometimes, when a new car model appears, the red one will sell at some premium over the white one. Economics can help us understand what red is worth in such a market.
To me that demonstrates both the strength of economics and the limitations. It certainly gives us the language to discuss why red is worth more than white, but it’s never going to enlighten what is so attractive about red. Or why we want a new car. Or why french fries are generally preferred to onion rings.
(that’s my silly man on the street response)
I’m no expert in game theory, but that “equilibrium analysis” seems obviously wrong to me. It seems to me an alternative equilibrium could be achieved by Bob taking note that Tom is bound to lose his entire endowment unless he is willing to ransom it to Bob, and thus Bob should rationally reject any offer that is less than $99. And thus the equilibrium outcome for the game is that Tom ends up with $1 and Bob gets $99.
But maybe a true equilibrium is impossible. I think the game is far more subtle than the article makes out, and that non-economists (and some economists) are far too willing to claim “irrationality” simply because the analysis of utility maximization has gotten too difficult.
Clarification question. Does “evolution” here refer to biological evolution or something distinctly economic? If the latter, what is the difference between the latter and “market forces?”
I vote biological. My “red car” post didn’t flow as well as I wanted it to, but the reasons we want that status, or attraction, vehicle are pretty related to genes and the pasing-on thereof.
Problems with “Homo Economicus” Model:
Assumes markets are rational.
Assumes equilibrium despite markets often not clearing.
Assumes an infinite number of players despite markets in which few firms exist.
Assumes perfect information required for optimal strategies.
Assumes markets allocate resources efficiently (Pareto optimum).
Fails to predict events.
Uses unobservable variables such as utility to explain facts.
Influenced by politics and special interests.
Corrupted by government distortion of economic statistics such as C.P.I.
Subject to non-economic value judgments such as the minimum wage.
Modeled after mechanics, which is deterministic.
Subject to nondeterministic social behavior which is statistical.
Prescribes rational behavior instead of describing actual behavior.
Neglects inputs and waste in its standard model of circular exchange value.
Extols Gross Domestic Product but ignores Gross Domestic Cost.
Cannot explain variance in earnings.
Cannot explain why many products have zero elasticities.
Cannot explain conspicuous consumption which violates marginal return concept.
Suffers from boiled frog syndrome: by the time were in hot water, were cooked.
Other than that, it’s a fine way of looking at the world.
Jon L, by “evolution” I refer to an economic natural selection mechanism– wealth tends to gravitate into the hands of those who are most skilled at acquiring wealth.
John, I disagree with essentially every statement you make. Listing the reasons in each case might get a bit tedious. Suffice it to say that I am using the expression “neoclassical paradigm” to refer to a broader academic approach than you appear to want to associate with the phrase.
I agree with odograph $99 for Tom and $1 for Bob as the “rational” outcome of the game is bunkums. Bob could rationally refuse such a offer for several reasons:
1) Bob wants to teach Tom a lesson in case the game is played again and if not then out of altruism so Tom does not go around “cheating” other Bobs. So it might actually be more rational to refuse a lowball offer. I have heard that if Bob was told that Tom was a machine then Bob tended to accept a much lower amount. In this case I guess the Bobs were not open minded enough to conceive the possibility of the machine Tom learning from experience.
2) Bob values being able to hurt Tom for being unfair to him more than $1. It seems that the value of Bob’s righteous glee is around $20. I am sure the game would be very different if all the dollars were multiplied by say a … no need to be stingy since we are talking about imaginary money … million.
Has anyone ever assessed the personalities of the “Bobs and Toms” If I were negotiating, I’d say “If I win I’ll offer 50% If you win, I’ll reject any offer less than 50%. Test me if you think I am a liar. This seems a more realistic example in the real world where “Tom” (of Walmart} says “I get 90% and you get 10% or I go to A. India, B. China, C Africa, D. Dominican Republic, E bellareuse…The Golden Rule, those who have the gold make the rules.
I’d say behavioral economics has already established that individual human beings are not well described by homo economicus.
Even so, one could still argue that the economic behavior of *populations* has some of the characteristics of homo economicus. In many instances, I think that may be true.
But there are a lot of cases — think “madness of crowds” — in which even aggregate economic behavior wanders away from the track set for it by rational computation. Soros uses the term “reflexivity” for the way human beliefs can function as self-fulfilling prophecies in financial markets. To me, these aggregate phenomena are a lot more interesting than the pathologies of heuristic reasoning in individuals (though the latter probably play a causal role in the former).
Call me a behavioral *macro* economist then 😉
Behaving in a rational manner is an evolutionary advantageous adaption. So a homo economus that evolved emotions that caused the creature to behave “as if” it was a calculus using maximizer would survive and pass on genes to its prodgeny.
An analogy: When I stand close to the edge of a cliff to see a view, I don’t think about the possibility that I might fall. Rather I get a feeling in the pit of my stomache that I don’t like and take action to avoid that feeling. Evolution has caused me to behave as if I am rational even though I am responding to an emotion.
From the persective of the Tom-Bob game, if Bob can evolve an emotion that credibly commits him to punish those who treat him unfairly and if Tom evolves empathy, so that he knows how Bob will feel, then Bob benefits by getting more out of Tom and Tom benefits by avoiding being punished by Bob. In effect, Bob’s emotions have converted him into the first mover, allowing him to improve his position in the game. Emotion drives what is a rational behavior by Bob (always commit to punish unfair behavior).
Fairness also has its price. If the quantities in the Tom-Bob game where larger, say U$100MM, Im sure Bob would prefer to keep U$1 million instead of getting nothing.
Chris, my girlfriend fills my house with “cute things.” Pause and consider the ratio of reason and evolution in that behavior.
Economics provides great tools, but what fraction of the total economy are you going to call emotional and human? Certainly there is less emotion in boring financial instruments, but entire industries live and die on trends of consumer preference.
BTW, I read this and other economic blogs because I think they have a great deal to tell us about our world. It’s just that sometimes I think people informed by economics forget the evolutionary subtext to everything.
And the creationists are going to think, what, that the devil wants them to buy that red car?
I agree with the point made by others in stating that the declining party in the game who refuses the offer of a dollar has purchased for a dollar the pleasure of punishing the offerer. I do not see any failure in classical economics here as compared with any other good purchased, for instance champagne is sold at a premium to other similar alcoholic beverages. If we look narrowly at one benefit of alcoholic beverages (that of getting drunk say) then we would conclude the classical economics also fails there, since people do buy champagne in preference to other cheaper drinks. But this misses the value of all the other benefits (the taste, the experience, the status etc). Those other benefits are all goods as well that are purchased in addition to the benefit of getting drunk. Just because those benefits are intangible does not mean that you cannot study the economics of the champagne industry. Where the game cited is of help is not in negating classical economics but in bringing to light that the pleasure of revenge is a benefit that can be bought and sold and therefore should be included in economics just as other intangible benefits are. Some interesting studies that might be possible are; (they may have already been done) is the revenge price fixed as the amount forgone increases? How about the average price offered by the offerer? This must surely increase as well to deal with the increased loss in the case of rejection, but in what relationship to the overall prize? Offerer’s might implicitly lower the risk of rejection partly compensating. Also, it seems the pleasure of revenge varies by individual – does a strong tendency make the individual more or less successful in other areas of economic life? My last point is that intangible benefits do not necessary have to increase an an individual’s advantage as a competitor for resources as is claimed sometimes as the origin of the pleasure of revenge. No-one claims that the reason people drink champagne is because the intangible benefits confer advantages to the drinker versus other drinks, so why should that apply here?
I’m suspicious of all economic models for the simple reason that we are unable to compute feedback effects from the models’ predictions.
Suppose we found a model that was 100% accurate in its forecasts. How long would it remain so once investors, governments etc started changing policy based on its results?
It would be fascinating to send all economists into space with no terrestrial communication (some would argue this is a good idea for other reasons) and run their models from there. Would economic events take an exact same course without their input?
“[E]volutionary forces induced by market rewards.” I think that argument works well on the production side, but does not apply well to consumption. If the laundry detergent I buy is less effective per dollar than the one my neighbor buys, I may have less money to spend on leisure activities or less clean clothes, but I will not be disciplined by the market in any meaningful way. Incompetent producers will lose their businesses, but incompetent consumers simply get less satisfaction.
Actually, Chris, I’m preparing a paper in a totally unrelated field that pretty well argues that humans are irrational at the core, and that is what makes us human (from an evolutionary perspective). I’ll share it with you if it makes print.
On the subject of financial evolution, I just hope and pray that Economic Intelligent Design sees fit to send a winning lottery tick to my pocket in the next year. Until then…
“I agree with the point made by others in stating that the declining party in the game who refuses the offer of a dollar has purchased for a dollar the pleasure of punishing the offerer.”
I believe the evolutionary, game theory, argument is that by establishing “fairness norms” we benefit in the long run. If a norm emerges that 60:40, or 70:30, is fair we end up surviving – no matter which end of the stick we hold.
The assumption that accepting 1 part out of 100 buys us nothing from a survival standpoint is probably statistically accurate (with exceptions like Virgilio’s million dollar example)
Now the interesting thing about economics is that it allows us to posit these “utilities” like “pleasure in the punishing of others.” Sometimes we can puzzle out a good utility … but sometimes I tihnk it’s pretty clear it is handwaving.
BTW, remember that there were very few “strangers” in the ancient world. They guy only offering you 1 part out of 100 would likely be making you another offer the next week … or you’d be in reversed positions a week or two later.
“1- I am a reductionnist in that I attempt to locate explanations in the actions of individual agents;
2- In theorising about the agent I look for some axioms of rationality;
3- I hold that some notion of equilibrium is required and that the study of equilibrium states is useful.
If a historian of thought considers these to be sufficient elements in the making of neo-classical economist, then that is what I am”
Franck Hahn.
Considering this definition, it is easy to understand why economists use the neoclassical paradigm; it is a basic toolbox in which you can put many things. If one day behavioural concepts like the desire for fairness, endowment effect, intepersonnal comparisons, limited rationality, can be properly modelised, they will be integrated in the neoclassical paradigm just like increasing returns were.
I agree that some economists seem to take much too seriously models that require, for example, individuals to solve complicated dynamic programming problems to plan their lives. These models have real value as a benchmark, but that’s about all…I think policy recommendations from such models should be taken with a large grain of salt. There are mountains of evidence to show that people routinely violate the predictions of these models. (BTW, I have a Ph.D. in econ from a top school.)
The most unfortunate thing about this is that it adds legitimacy to efforts by the economically semi-literate to simply dismiss all of economics. That means that they can smuggly ignore even economic principles that have real power, like efficient markets theories, or even simple adding-up constraints. Plenty of examples can be found in JDHs online debates with peak-oilers (in which I am continually amazed by the degree of restraint shown by JDH.)
JDH: My list was meant to show that the answer to your opening question, “Do economists have a sensible way of thinking about the world?” is often “No, they don’t.” I gave some valid — and by no means original — examples of irrational economic bahavior. Since you “disagree with essentially every statement,” I’ll expand on just one to avoid tediousness — when I have more time.
BTW, I think alot of the responses given here so far are much too academic/ unrealistic.
I’m just glad oil is back to $20/bbl …
I have a question for JDH.
First, I want to express all of my gratitude for such a wonderful blog on economics.
And now, I don’t want to sound harsh, but what do you think?
Is economics a science?
If it is so, why?
Is it a social one?
What do you think of Austrian Economics?
Thank you very much.
I agree with the comment of JDH.
Under certain circumstances it is perfectly rationale to decline $1, $10 or even $50 of $100.
Many of us do this all the time. Real estate agent usually ask for 6% (or $6 for each $100) to sell a house. Many of these agent won’t do it for say 2% since they would set a precedent or just deem their efforts not compensated properly at 2%.
In reverse, they same applies for houses directly sold by owners (instead of a real-estate agent). Home owners who directly sell don’t want to give 6% (or $6 per each $100) to a real estate agent. These home owners often think that 6% is not fair. They are acting absolutely rational directly selling the house if they get to sell the house at the same price or no less than 6% lower than if they would use a real estate agent.
I’m puzzled by the criticism of the utility concept on the basis that we can’t perceive it. Utility theory is a model, which we use to interpret our perceptions to make predictions. You don’t necessarily perceive the model.
When see a falling rock, do we perceive gravity, or do we perceive a falling rock and use gravity to explain why it’s falling? Similarly, when we see prices rise and consumption drop, do we perceive the law of demand? Or do we use the law of demand to explain why consumption drops?
It seems that both physics and economics are based on building, testing and refining models and that they thus both should be considered sciences.
The problem with the neoclassical framework is that it is so universal. It is just a toolbox, as said above. So it doesn’t tell nothing very important. It doesn’t solve the problem of the double deficits, forecast oil prices or recessions or the development of globalization.
Macroeconomics is not simply the aggregate of individual choices of the neoclassical homo oeconomicus. In fact, those who have followed the discussion here or in other economic blogs will easily see that economists are mostly quite clueless in front of the real problems of the present world. Dismal science, neoclassical or not.
Whether you call it the “dismal science” or the “queen of the social sciences”, there’s no question that, as currently constituted and practiced, economics belongs in the social science rather than the physical science division of most universities. I think the primary reason that we’re unable to act more like the physical sciences in terms of the rigor of intellectual progress is the practical difficulty we have in determining what causes what. Rather than being able to conduct a controlled experiment, we observe a world in which all the variables are changing all the time, and indeed, as FTX notes, the world itself is potentially changing in response to the fact that we are observing it.
Even so, I personally would prefer to see economists try to base as much of our understanding as we can on objective facts and testable predictions. I think there may be an eagerness for evidence and objectivity on the part of most physical scientists that economists would do well to try to emulate.
Ouch, unfair to economists. Trying to establish rational models in a boisterous world is not a bad thing. You can always observe actual behavior and add a correction, or a lot of corrections.
Bloomberg carried an article on a study showing investors with psychopathic personalities made the best investors, since they didn’t feel fear in the usual way. They would gamble again on the same odds. Psychopathy may be the ultimate model of homo economicus.
Better hire some prison guards!
What can objective and testable economics tell us about something like the Starbucks story?
We’ve been drinking coffee in the west for a few centuries. The technology of good tasting coffee was well understood. But for a variety of reasons (I’d say cultural reasons) we Americans drifted into the mass consumption of a mediocre product.
Suddenly, we woke up (as a culture) and discovered three things … one was that coffee could taste better, the second was that a pleasant retail environment could be created around coffee, and the third was that we were affluent (or posing as affluent) enough to pay a few dollars per cup to experience all that.
What can economics do, other than argue about the relative costs of real estate in the now-dominant Starbucks model?
I’m saying the economics was not so predictive that it stood up and shouted “hey! there is untapped utility in a cup of coffee!”
The neoclassical paradign is fine as long as we can predict outcomes.
f course, because none of us can predict the future, we are left in a quandry. To say that we make choices rationally simply forgets that, in real life, most outcomes are simply unknown.
I think the word is heuristic. A, usually speculative, formulation serving as a guide in the investigation of a problem.
I think these neuro-economic experiments are interesting, but not dispositive. Experimental subjects are usually undergraduates looking for beer money. They have nothing at stake other than the game. I will wait until they wire up the guys on the floor of the Chicago Board of Trade.
Further, what is the resolution of their machines. I can easily imagine that the emotion comes after the rational decision, but that the machine used by the experimenters is too slow to capture the cause and effect. I had an MRI on my back and my knee last week and it took about 2 hrs.
Economists do much larger human experiments than those with some volunteering students. Former Soviet Union and Eastern European counties were large macroeconomic laboratories in the ’90s.
One of the finest experiments was Albania. There World Bank / IMF economists wanted to see what happens if there are no banking regulation, no rules for financial enterprises. The result was interesting but somewhat expected: gigantic pyramid schemes were born. All the people threw all their savings in them. When these schemes bursted, they lost everything, of course, and rioting started. The whole country plunged into literal anarchy, the government escaped, police disbanded and the society collapsed. The order was restored by foreign troops.
Hearing this I suddenly understood that exactly this was the reason why I started to study economics. How nice it would have been to tell my grandchildren: “Look those rioting people with guns. Granddaddy did this. Nothing is like economics.” But honestly, I couldn’t imagine back then that economists could do human experiments so big. If I had known, I would have pursued my career as an economist more vigorously.
Cynicism is the professional ethos of macroeconomists. We can say that economics is a non-exact science, but this doesn’t prevent us from giving all the time advice on how to run big nations. We are doing it right here, in his blog, all the time. Most 2005 forecasts were wrong but we boldly make up new. Macroeconomists are the best, the brightest and the most cynical.
The training in cynicism that I have received as part of economics studies have helped me understand the world better. I am grateful for it. We are economists and proud of it!
I’ve had this idea that after a generation or two of training that “property is theft” and “capitalists are theives” … too many in the eastern block responded to capitalism with “ok, let’s be thieves!”
(from “eat the rich” I know that Albanians knew they were stealing with pyrimid schemes, but they (all) just planned on getting out in time)
The Albanian government doubted the idea that no regulation in the banking and financing business is needed, but the consultant economists thought that the country was in need of some capital concentration and rapid development of the the private banking system. Of course it didnt’t work. But the Albanian government pointed out that the US financial markets are heavily regulated and so are the European.
Pyramid schemes are illegal practically in every country. They are impossible to resist, everywhere. Everybody likes a good bubble, stock or housing, as long it is still bubbling. Also Americans want to be rich without working. And the ordinary Albanians had no way of knowing that those officially registered “banks” were in fact fraud. They were told that this was capitalism and they were at last free to become rich.
So this was really a nice, large-scale human laboratory experiment. Who likes to use few bucks and some students for boring econo-psychological tests in some university classroom when you could build an economic equivalent of a nuclear bomb and see it exploding live and impact real people? The economic collapse of the Soviet Union killed at least 30 million people (premature deaths). This was something those nuclear physicists got never to see. So macroeconomics rules!
I hope that professor Hamilton tells this his students. It will motivate them to study also macro, not only some petty micro stuff.
Well I wasn’t there, so I obviously can’t arbitrate between your “the ordinary Albanians had no way of knowing that those officially registered ‘banks’ were in fact fraud” and O’Rourke’s account.
I may have gotten a skewed view, but FWIW, I read it here. And I probably read it five years ago.
Pyramid schemes are criminal fraud everywhere. And for a good reason. I see the Albanian experience as an laboratory experiment about what happens when the financial system has practically no regulation. Remember Enron? That was also an interesting economic experiment, too. Everybody in US shouts for more regulation when these kind of things happen. Even seasoned investors can fall in the trap. Let us be fair towards the Albanians.
This is a mult-variable equation. We have, at a minimum:
– expectations of other actors
– expectations of government ‘watchdogs’
– moral codes for our own behavior
– expectations of ‘getting away with it’
Certainly Albanian watchdogs were absent, but are you telling me that after X decades of communist “instruction” in the market, Albanian expectations matched those of Americans?
(Note on Enron, the government watchdogs are working hard here in America to set expectations on getting away with it.)
I guess I’m saying my “poperty is theft” angle conspired with your lack of regulation.
Another argument in favour of human behaviour being a close approximation of neoclassical behaviour is that it is very hard to become rich. If humans were acting irrationally in regard to maximising their utility there should be plenty of money making opportunities exploiting these irrationalities. Last time I tried it was not easy to become rich – if you have proof otherwise, please contact me directly!
So Britney Spears became rich mining a vein of rationality? 😉
I get your point, but my early morning (one cup of coffee) thought is that maybe the problem is too many (rational?) competetors for those irrational buyers.
I am not sure how the equilibrium would be reached (in theory) at $1 vs. $99. I’d go with $50 vs. $50, and consider this the most rational approach. Just an idea, someone may need to check out the assumptions in that model…
John – some criticisms of your list.
I have only heard the term “Homo Economicus” as being a model of individual people who are assumed to be, depending on the exact modeller
– rational, utility-maximisers
– who have perfect knowledge.
In more complex models of Homo Economicus, the perfect knowledge assumption is chucked, e.g. when discussing asymmetric information. The rest of your list seems to be some vague criticisms of nothing clear, and nothing I have heard referred to as essential parts of “homo economicus”.
Classical models of the whole economy (as opposed to homo economicus, who is a model of a single human) started by assuming an infinite number of competitors and homo economicus, from which they proved in a mathematical sense that such idealised markets were rational and allocated resources as efficiently as any omniscient central planner could do. Every economist knows this result was about mathematical models and not about real markets. But this model was developed when socialists were arguing that markets were inherently inefficient and a central planner could do much better. When in fact omniscient central planners are as non-existant as markets with an infinite number of competitors.
I presume this argument between socialists and free-marketers is what you are talking about when you say that “homo economicus” has been influenced by special interests and politics. Of course, by this definition, all science is influenced by special interests and politics. It is generally believed that the reason physics advanced so much in England and Germany is because the political structure of the time allowed scientific research to take place. I do not think that any understanding of science could develop free of politics, given a broad definition of politics.
Markets with a limited number of competitors are generally analysed in Econ 101 as monopolies and then as oligopolies (a few, large competitors). They certainly are not ignored in classical economics, let alone neoclassical economics.
One of the noteworthy things about classical economic models to me, who had already taken some courses in statistical processing by the time I first encountered them, is that they were highly deterministic, and thus were not “Subject to nondeterministic social behavior which is statistical”. Generally the failure of classical economics models to include nondeterministic social behaviour is regarded as a failing in them, so I am not sure what you are criticisng them for including nondeterministic social behaviour.
And I am completely baffled as to why you say things like:
– Cannot explain why many products have zero elasticities.
– Cannot explain conspicuous consumption which violates marginal return concept.
– Suffers from boiled frog syndrome: by the time were in hot water, were cooked.
What do you think “Homo Economics” is, and can you please point to some model used by a real economist, which you think has all these faults? (Incidentally, depending on your definition of hot, being in hot water does not necessarily mean being cooked. I’ve soaked in geothermal hot pools without any damage to my body, and I have carried out numerous experiments that prove to my satisfaction that normal rice has to be cooked in boiling water for ten minutes or so before it is cooked. I am extremely doubtful that simply placing a human being in hot water will immediately cause it to be cooked, although I am not willing to carry out the experiment for all possible definitions of “hot”. And since homo economics is not a human being, but a mathematical model, I have no idea how you believe homo economics can be plunked in hot water at all. Can you put the theory of relativity in there at the same time?)
The first rule of Buyer Behaviour is that there is no such thing as a Rational Economic Man.
Buyers en masse may, to a degree, be somewhat predictable. However when you reduce the equation to 2 parties, other stuff creeps in. I.E. Each party has more invested in the outcome. If I’m merely one of 20 Million homeowners, then so what?
It’s just that when we use what we consider to be rational thoughts to predict what 2 people will do in a hypothetical situation, we’re projecting ourselves into that situation. Economics is not a Science so it is not possible to predict with a 100% degree of accuracy exactly how Tom and Bob will behave. All the Economists can reasonably say is, how they would like Tom and Bob to behave and then it will prove their model.
How many experiments have been conducted in the past 30 years which have demonstrated that people are anything but predictable? I’m thinking of the experiment where they invited people off the street to take part in an experiment to administer electric shocks to people. These guys off the Street however, did not know it was an experiment. They thought it was real. The experimenters were surprised to find so many willing participants. Further, the people who took part were prepared to go all the way and administer electric shocks to their victims that were finally large enough to kill the subjects.
Rational thinking would suggest that nobody would agree to inflict pain on a fellow human being in these circumstances. Rational thinking would also suggest that nobody would actually inflict pain and further that, they would not go all the way and actually kill the subjects. But that’s what actually happened.
The experimenters were amazed to find that people were actually prepared to walk in off the street and take part in an experiment that actually would have resulted in the death of the subject by electrocution (had they not in fact been actors, pretending to be in excruciating pain and then pretending to die). But the people who took part did not know that.
If people are prepared to be so irrational and that callous to each other, just imagine how many possible emotions 2 people can have during a negotiation, no matter how simple it may seem from the outside?
In the Tom/Bob game, assuming it is a one-off game and the players only payoffs are the financial ones (although I do tend to agree with the point that pleasure from punishing the other player shouldnt necessarily be seen as irrational and different to other economic goods), then the outcome of Tom $99, Bob $1 is the only credible Nash equilibrium. Bob using the strategy reject any offer less than $99 and Tom using the strategy offer $99 is also a Nash equilibrium, but it is clearly not a credible one. I believe any outcome where the offer is accepted is a Nash equilibrium, but there is only one credible one. This is fairly basic stuff (so I better hope I havent made an error then).
It think it was implied it is a one-off game. Of course if its a repeated game situation the outcome might change, I think that goes without saying.
Emotion drives what is a rational behaviour by Bob (always commit to punish unfair behavior).
If Bob can credibly commit to behave irrationally this may make him better off, but that doesnt mean you can call this behaviour rational.