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The winner of the 2000 Nobel Prize for Economics, Daniel McFadden, in a recent paper entitled “The New Science of Pleasure” (NBER Working Paper No 18687) published in February 2013, calls for his fellow economists to re-think the standard models of economic theory. Something I have been calling for in my recent blog essays.
As can be expected, given his work on choice, Daniel McFadden’s new paper focuses on consumer choice. His basic approach is, however, unusual in that he argues that the standard economic model is flawed by being incomplete. In summing up his hypothesis, he writes “Economists since the days of Adam Smith and Jeremy Bentham have traditionally viewed consumers as driven by relentless and consistent pursuit of self-interest, with their choices in the marketplace providing all the measurements needed to reveal their preferences and assess their well-being. This theory of consumer choice is empirically successful, and provides the foundation for most economic policy. However, the traditional view is now being challenged by evidence from cognitive psychology, anthropology, evolutionary biology, and neurology.” In other words, it is easy to observe the human economic actor and to conclude from his actions and decisions that he is acting rationally: that he has all the information he needs concerning the options facing him, he is aware of all the risks associated with each option, that he has the capacity to consider all the options, and that he then makes a decision that delivers the maximum self-interested benefit.
In real life, on the other hand, as Nobel prize-winning psychologist and behavioural economist Daniel Kahneman and his colleague Amos Tversky have shown, people actually make decisions in a very different manner relying far more on heuristic models of habitual behaviour resulting in decisions that can be shown to be based on limited information and are often not in the person’s economic self-interest. With this in mind, McFadden has, in the past, memorably challenged his colleagues by saying that their cherished Everyman, homo economicus, the standard human economic actor, bears no resemblance to a real person and is indeed a “rare species”.
As befits the work of an eminent economist, McFadden’s paper is full of cogent arguments, elegant analysis and complex mathematical formulae … and it is not an easy read for those of us who are not economists! Fortunately, The Economist, a British newspaper, in their 27 April 2013 edition, published a Free exchange blog essay entitled “The debt to pleasure” which provides a thoughtful analysis of McFadden’s paper written in way that is far easier to read and understand and requires little prior knowledge of economics.
McFadden’s basic argument is that the standard economic model of consumer choice is incomplete because it is based a number of unsustainable assumptions. To take one example, the model assumes that ‘people’ in economic models have fixed preferences, which are taken as given. Yet there is a large body of evidence from cognitive psychology that shows that preferences are in fact rather fluid. Other evidence, from cultural studies, show that these preferences are likely to be culturally determined. The standard model is also unable to handle the role of memory and experience in determining choices – both of which form part of the heuristic models of behaviour and which provide a clearer and more sustainable theory of decision making.
Indeed, McFadden argues that economic models are not sound in explaining human decision making as they consistently fail to take into account such ideas as trust (a function of both history and brain chemistry), the influence of others (considered by behavioural psychology), and altruism and kindness (which is best explained by biology). Instead, economists make a limited allowance for human behaviour, emphasising the dogged pursuit of self-interest. McFadden believes that economists need to do things differently if they are to remain relevant and they need to reassess their articles of faith. For example: most economists believe that more (consumer) choice is a good thing and yet people faced with many options often make no choice at all. If economists were more willing to accept ambiguity in decision making and choice, then they may come to understand that abundance of choice may not be a good thing. It may also make them look again at their fixation with ‘revealed preference’: the idea that a person’s valuation of different options can be deduced from their actions.
Of course, Daniel McFadden is not the only person calling for a re-think of economic theory and back in July 2012, I wrote a blog essay entitled “The economist’s new clothes” in which I questioned whether economists in general, and many politicians as well, are merely ‘in thrall to some long dead economist’ (to quote Keynes) and that it was time to recognise that the microeconomic rules and theories that are used to govern our lives are only true in a limited number of circumstances and that economists are often simply wrong. I followed this essay with another entitled “Are economists out of touch with reality?” in which I questioned the logic of assuming that people are rational in their decision making. Rationality is the very foundation stone on which microeconomics is based and is also the basis of market theory and free-market economics. I also argued that much of what we accept as economic truth (i.e the standard economic theory or ‘received wisdom’) is affected by our national culture and I ended up by writing
“The reality is that ‘bounded rationality’ is a concept closer to the truth. Bounded rationality is the idea that, in decision-making, the rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision. Economists in particular and the public in general should learn that they almost never have access to all the information they need; that their cognitive abilities are limited by their culture, their upbringing, their education and their willingness to think outside the false limitations set by others; and that we simply don’t have the time to ponder all the variables. Those who can accept ‘bounded rationality’, and work within it successfully and sustainably, are the people we should be listening to.
That the hubristic are often young and generally dismissive of older and more experienced voices reminds me of the Zen expression: “I am no longer young enough to know all the answers”. On the other hand, those who are older and should be wiser have forgotten that knowledge is neither finite nor fixed, that there are infinite versions of the truth, and that a wise man can entertain two conflicting ideas in his mind at the same time while being willing to discard concepts when demonstrably unsustainable.”
In a third essay, in October 2012, entitled “Economics – an incomplete theory” I argued that in addition to culture we need to look at the emotional response of people in an economic environment. I then discussed how greed seems to be the over-riding emotion and driving force of most of our economic decisions.
Finally, in April 2013, I wrote a fourth essay on economics entitled “Time for an economic rethink” in which I questioned that holy grail of western economic theory: the consumer society. A consumer society is the direct outcome of a socio-economic model called ‘consumerism’ that encourages the provision of an abundance of choice of goods (and services), the purchase of those goods (and services) in excess of basic needs, and the eventual disposal of those goods (and services), often before the end of their economic life. This is an international phenomena that appears to be strongly linked to developed economies and is particularly encouraged in the USA and UK where its preservation is a matter of political policy. However, this concept needs re-examining in the light of the collapse of the consumer-driven economies of the western world.
At the time of writing my essays, I was unaware of Daniel McFadden’s paper, which was published in February 2013, just before I wrote the fourth essay in the series, and I was blissfully unaware of the level support my calls for change were about to receive. Had the McFadden paper had a wider distribution, or The Economist article been published earlier, the flak that came my way might have not occurred. Mind you, the main source of disagreement with me (and thus with McFadden) did come from those whose work is not based on original thinking but on writing ‘textbooks’ (which are out of date when they are written and three years out of date when they are published) and from those who slavishly follow those textbooks. I now think it is safe to say that it really is time for a re-think of microeconomic theory
Alasdair White is a business school professor, writer and publisher. He is the author of five management books and a thriller novel as well as writing the Management Blog. He lives in Belgium.
29 May 2013
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Author Alasdair White
There are times when I feel we need to question the ‘received wisdom’ to see if it is still properly based on a realistic and rational foundation. And when the US Treasury Secretary, Jack Law, recently called on countries, especially Germany, to boost economic growth via boosting consumer demand, I had a “that’s weird, let’s look at that again” moment.
There is a well known economic theory of efficient markets that is, broadly speaking, based on the idea that if the supply of goods matches the demand for those goods then everyone is happy and prices are stable, and if they are misaligned then either the price will go down as goods become abundant, markets might collapse and the suppliers become poor (too much supply), or prices will rise as goods become scarce and the suppliers will get rich (too much demand). But what is forgotten is that this is a ‘zero sum game’ in which there will be winners and losers, so let’s look at the theory the other way round. When the supply of goods is greater than the demand, then prices collapse as a result of greater abundance of goods and the consumer gets to save more of their money and so they become ‘richer’, and when there is too much demand, prices rise and the consumer has to spend more of their money for scarcer goods and so becomes ‘poorer’. Of course, the intrinsic value of the goods does not change in either scenario but the price does as suppliers manipulate it to maximise return – in other words, because they are greedy!
So, in simple terms, if the supplier is getting richer, the consumer is getting poorer; conversely, when the supplier is getting poorer, the consumer is getting richer. So if the supply and demand are not in balance, then is it better that the supplier gets richer or that the consumer gets richer? The answer to that is almost certainly that it depends on whether you are a ‘supplier’ or a ‘consumer’.
Because greed seems to be a fundamental of human economic behaviour, suppliers almost always try to manipulate the situation so that consumer ‘demand’ rises and the supplier gets richer at the expense of the consumer. What also happens is that government policy of whatever shade of political belief also tries to manipulate the situation to make the suppliers richer and the consumers poorer – the ‘poor’ are always far easier to control as they are often dependent on the government.
Now back to Jack Law. For most of the two decades covering the end of the last century and the beginning of this, we have been ‘demand’ led in that consumers have been demanding more and more of all types of goods – which they usually do not need and frequently dispose of before the end of their useful life – and paying for them with cheap credit that, six years ago, suddenly ran out. Consumers found themselves in severe debt and unable to pay it off while being equally unable to re-schedule their debts with new credit lines: having made themselves believe they were ‘rich’, consumers all over the developed economies were spending money they did not have and the dawning of reality has been painful.
During those same two decades, the suppliers of goods saw cheap credit as a cornucopia and grabbed it with both hands making huge sums of money in the process. And now that the credit taps have been turned off and ‘the consumer’ has realised they were living a false dream, the suppliers are hurting (read: going broke) and are demanding that ‘government do something’ to get the consumers to spend again: after all, they reason, the consumers are merely the tethered milk-cow to be milked and bilked out of their money for the benefit of the suppliers. Jack Law was merely doing his bit to help the suppliers make money and to keep the consumers poor, thus clearly positioning himself on the side of business and opposed to the good of the people.
The materialistic, consumer-driven society that exists in its purest form in the USA and almost as purely in the UK is a very individualistic, greed-driven and selfish model, and is neither in the rational self-interest of the consumer nor in the interest of the greater society. However, for the last half-century there has been an assumption amongst those who think they know what-is-what that the consumer society is the only viable economic model that will deliver growth and prosperity. But what has happened over the last six years is that the consumer has finally, perhaps irrevocably, discovered that consumerism using other people’s money is great fun, but when the owner of the money wants it back the result is extreme and sometimes insupportable pain: they have discovered that there is no such thing as a ‘free lunch’, and no such thing as a right to prosperity.
The trouble is, in societies that are not consumerist (the vast majority of the world) and are significantly less individualistic than the USA and the UK (see the work of Geert Hofstede), prosperity is based more firmly on supply and demand being balanced – thus in those economies, suppliers make and supply only what they can sell and consumers only buy what they genuinely need; everyone is happy with less but there is a more equal division of the wealth of the society. The balance is restored between the consumers and the suppliers, and neither is pursuing a ‘beggar thy neighbour’ policy.
But the USA, and to a lesser extent the UK, are finding the change very difficult, simply because it involves a fundamental change in attitudes, behaviours, and fundamental beliefs, leading to a profound change in the way the society operates. Instead of the unrestrained pursuit of personal gain at the expense of all others, Americans and Britons in particular will have to once again learn the value of cooperation with others – a cooperation based on trust rather than contract law; based on mutual interests rather than self-centred, self-interest; based on being a good neighbour rather than the bully boy on the block. There is plenty of evidence that, at the grass-roots level of ‘Everyman’, this is already happening: cooperatives are forming, and neighbour-help-neighbour groups, barter markets and the like are springing up. But this reality, this need to change, has yet to reach the company strategists, the corporate leaders and the governmental policy makers. Entrenched pork-barrels, fat-cat remuneration packages, and a gut-wrenching fear that they’ve been wrong all along are all contributing to an evident ‘denial of reality’ that change has to begin at home, that beggaring the consumer citizen for the benefit of the suppliers is not a viable or sustainable solution and that ‘the people’ have had a enough. Jack Law’s call for other countries to push up demand (essentially to push up demand for US goods) so that the USA need not change its ways is just the latest example of this sense of denial.
Alasdair White is a business school professor, writer and publisher. He is the author of five management books and a thriller novel as well as writing the Management Blog. He lives in Belgium.
Author Alasdair White
It’s not that the main economic theories are wrong, but that they are incomplete. Trying to explain how markets work at a micro level without taking into account human behaviour is to ignore the fact that humans are the main economic actors. And trying to explain how the world economy works at a macro level without taking into account the political objectives of individual countries is to assume, some how, that all nations pursue the same ends. However, mathematically modelling human behaviour and national objectives is profoundly difficult, and so most economic theory simply ignores them and thus their explanations are simply wrong.
Let’s focus on human behaviour. The dominant schools of economic thought hold that humans will behaviour rationally and in their own self-interest and that when this happens en masse, the outcome works to the advantage of all. This appears true in many cases and it is the basis of the way many economies actually work – the most successful economic model, capitalism, is based on this principle. The trouble is that as soon as we factor in actual human behaviour, then the model is under strain – in capitalism, too much self-interested behaviour leads inevitably to cycles of boom and bust, to asset bubbles forming and then exploding, and to the type of greed-driven behaviour exemplified by the ‘rogue traders’ who have caused banks to lose billions of dollars, euros and pounds.
But is it true to say that people behave in a way that is rational? There are certainly times when this might be true, especially at a subconscious level, but almost all human behaviours actually seem to be driven by two things: emotions and habits.
As I argued in a previous blog, the dominant emotion in economic terms appears to be ‘greed’, the desire to obtain more of a good than is either ‘needed’ or ‘desirable from a group perspective’. Greed distorts the ‘zero sum game’ model in which for every winner there is a loser (or, in economic terms, for everyone that has a good, there is someone who does not have it). A few individuals seek to dominate the market for a good so that there are a few who have the good and a lot that do not. Such behaviour is often driven by a desire to control the supply of a product (a good) so as to drive up its value due to scarcity – a behaviour that displays greed in its rawest sense and is entirely self-interested, and which benefits only the person involved and disadvantages society as a whole. It is greed that is behind the trading behaviours of many in the banking and finance sector although other emotions such as desire for recognition, craving for attention, and even fear of failure also play a part – and this greed is encouraged by the corporate cultures of the institutions involved because greedy traders make bigger profits (in the short term) and that benefits the institution and fulfils a basic reason for its existence. However, when allowed to occur in an unregulated way, it also creates a sense of being beyond risk with the inevitable collapse as a result.
Greed is also behind the asset bubbles that regularly and frequently occur in free-market economies. Take housing as an example: the true value of a house is, in capital terms, the cost of replacing it (purchase of land, materials and building work). There is also an intrinsic value, which is determined by supply (how many such houses are available) and demand (how many people are prepared to pay to own one). But why should anyone want to ‘own’ a house? Sure, as Maslow theorised, there is a need to have a place to live, to provide protection from the elements and other threats to survival, but that can be satisfied by renting, so why own? The normal answer is that the house is an asset and an investment but this suggests that the house owner is prepared to sell when the market price rises to a level that provides the return they want – but then they would have no where to live and, anyway, only a very small percentage of house owners would sell their house because pride (an emotion) of ownership and the fact that house ownership conveys recognition of status in some societies more or less forces them not to sell. By refusing to sell, the market becomes inelastic and reduces the supply side of the equation and if demand holds up, then the perceived intrinsic value of the house rises as people will be prepared to pay more to obtain one. Thus in an inflexible housing market in which demand is sustained, house owners think they are making money.
But, I would suggest, we need to look deeper at why anyone would want to ‘own’ a house. House ownership causes the population to become more static and less flexible in terms of movement to where jobs are – if a good job is available in a distant part of the country, then the family will have to move, the house has to be sold, a new house has to be obtained and although this is, in theory, very simple, in practise it can prove to be incredibly difficult to achieve. Partners don’t want to move: they like it here, the children are in good schools, fear of the unknown pushes them outside their comfort zone and a rational economic decision is impossible due to emotional reasons. The result is often disharmony in the relationship, a decision is made that is not in the self-interest of the individuals concerned, and everyone loses.
And then there is the culture of the society and the habits this engenders. In many societies, people are encouraged to own a house because house ownership is a cultural norm and it becomes habitual for people to abide by the norms of the culture even when such norms and habits are clearly (from an economic perspective) not in the self-interest of the individuals.
The above example is just one of many that can be used to understand that emotions can get in the way of rational (economic) decision making and even the ‘bounded rationality’ I discussed in my previous post. The trouble is, emotions and their impact on human behaviour are not conducive to being mathematically modelled and so economists simply ignore them with the result that their vaunted economic models are bound to produce only approximations and are thus extremely unreliable foundations for political policy making. It is not the greed of bankers that produced the current global financial crisis but the habitual greed and self-centred self-interest of all those involved: potential owners, the society that pushes house ownership as desirable, politicians who fail to regulate correctly, bankers that see easy profits, and a culture that encourages the consumption of goods to excess.
And just in case you are wondering whether I am proposing abandoning a market economy for a socialist ideal, the answer is no, I am not! Market economies do appear to be the best solution to the development of the world but unregulated market economies are bound to a cycle of boom-and-bust and politicians should be wise and light in their regulation, but regulate they should to ensure the good of society. Unfortunately, such wise politicians are not to be found amongst those who seek political power – they, too, are driven by greed and self-interest and so the cycle continues.
In the next post, I will look at the impact of habits on economic decision-making and how observing the change in habitual behaviour can smooth out the ups and downs of economic life.
Alasdair White has been a business school professor and management development consultant for over 20 years. He has written five best-selling management books and a thriller. He is currently writing a second thriller.