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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