Posts Tagged ‘microeconomics’
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.
Author Alasdair White
Alasdair White has long argued that some of the ‘economic truths’ of the last 50 years are built on shifting sands and unstable foundations. In this second blog on the subject, he looks at the underlying fallacy of most economic theory – the subject of full knowledge and rationality.
The basic theory of efficient markets and certainly that of microeconomics (the school of economics in which people are involved as individuals) is based on the idea that economic actors (or economic agents – the various people involved) have full knowledge of all the factors that influence the decisions being made AND that they then act in a rational manner based on that knowledge. The truth is somewhat different: the actors involved very often do not have access to the knowledge they require, or they do not have the experience and ability to interpret that knowledge, or they simply do not know that they do not have all the information and knowledge they need.
And then there is the question of rationality!
Rationality – the quality of being rational or having the faculty of reasoning – presupposes an evidence-based process of decision-making as against, I suppose, decision-making based on emotions and superstitions. Rationality first appeared as a concept under that name in the late 1500s, at a time when philosophers were seeking to establish that what differentiates ‘man’ from all other animals was the ability to take decisions based on consideration of abstract information. This is also the time when we see the emergence of the type of thinking that less than a hundred years later gave rise to Newtonian physics and scientific rationalism.
In philosophy, a rational decision is one that is not just reasoned, but is also optimal for achieving a goal or solving a problem. This makes it conceptually normative (how things ought to be – i.e. a value judgment – as against how things are) and assumes (a) that rational people should (or will) derive conclusions in a consistent way given the information at their disposal, (b) they really do understand the goal or problem, and (c) they are able to judge whether a method is actually optimal rather than something they want to believe is optimal. A ‘rational decision’, therefore, demonstrates conformity of the decision-maker’s beliefs with their reasons to believe, or of their actions with what they believe are their reasons for action.
In the strange world of the economist, rationality and rational decision-making have given rise to ‘rational choice theory’ – also known as choice theory or rational action theory – which is a framework for understanding and modelling social and economic behaviour and is the main theoretical paradigm in the currently dominant school of microeconomics. Rationality, here equated with “wanting more rather than less of a good”, (i.e. something that can be bought and sold) is widely used as an assumption of the behaviour of individuals in microeconomic models and appears in almost all economics textbook treatments of human decision-making.
Microeconomists seek to examine how the decisions of individuals are affected by the supply and demand for goods and how this determines the prices of those goods. In other words, they seek to examine ‘markets’ as a mechanism for establishing prices and assume that such markets are perfectly competitive. Indeed, much of their theory is based on trying to justify the fluctuation in prices, usually why prices always seem to rise even when there is no ‘actual’ shortage of the goods but merely a perceived risk that a shortage may occur, which most behavioural psychologists would explain is caused by an emotive response called ‘greed’!
Behaviourists and many others think that any kind of rationality along the lines of ‘rational choice theory’ is a useless concept for understanding human behaviour and they are dismissive (rightly so, in my opinion) of the economist’s term homo economicus: the imaginary man being assumed in economic models as a rational and narrowly self-interested actor who has the ability to make judgments toward their subjectively defined ends, who is logically consistent but amoral, and attempts to maximize utility as a consumer and economic profit as a producer. All of which is another way of saying that homo economicus is assumed to be profoundly selfish, would never act altruistically, and is greedy, which is in stark contrast with the concept of homo reciprocans who is assumed to be primarily motivated by the desire to be cooperative and to improve their environment.
If you have studied the work of Geert Hofstede on cultures, one reasonable conclusion would be that those who come from a highly individualistic culture (for example: the classic “Anglo-Saxon” cultures of the USA or the UK,) are likely to fit the concept of homo economicus while those who don’t (for example, the Asian cultures) are likely to fit the concept of homo reciprocans. It will also come as no surprise to find that the leading microeconomic theorists are from theUSA and theUK.
While the concept of homo economicus can be used to justify and even encourage greed, selfishness, and short-term horizons, it does nothing to address long-term enlightened self-interest. Perhaps inevitably, it leads directly to the sort of economic activity – especially trading activity – that led directly to the financial crisis of the last five years in which ‘free-market economics’, (a sub-set of microeconomics in which light regulation is thought to encourage perfectly competitive markets) has proven to be unsustainable and that homo economicus cannot function without enforceable rules to mitigate or control behavioural and often emotional responses. Indeed, we have much to learn from this failure – not the least that slavish adherence to such a flawed theory leads to economic collapse and demonstrates that homo economicus is either wilfully self-destructive or simply irrational.
Hard as it may be for many of the commercial and economic ‘masters of the universe’ to accept, they are not acting in the best interests of anyone and the result has been economic losses of staggering proportions as the world struggles to avoid recession, depression and deflation. An example at a micro level would be to consider the performance of investment ‘professionals’ and their failure in their fiduciary responsibility towards those who ‘trusted’ them with their money: one well-known and ‘respected’ British life-assurance company managed to achieve just 18% net growth in 25 years (or a staggering minus 50% growth in inflation-adjusted terms), and then there are the thousands who have had their pensions wiped out and who will now have to work long past their planned retirement age.
I suppose the truth is that economists, especially microeconomists, have been so persuasive that over time the politicians (who should have regulated) and the public (who should have known better) have become enthralled ‘to some long dead economist’ (to quote Keynes) and the dismal science has been allowed to rule our lives as we abandoned rational thought and assumed that these so-called ‘experts’ knew what they were talking about.
How much better it would have been if the so-called economic ‘gurus’ had not suffered from an excess of hubris in which they have lost contact with reality and have overestimated their own competence. And how much better it would be for all of us if the news media did not encourage that hubris by wheeling out ‘an economist’ every time they reported on commercial or financial matters.
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.
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 as well as preparing for the new academic year.
Posted in Academic Management, FutureParadox, Miscellaneous Ramblings | 
Tags: economics, microeconomics | 
No Comments »