Tuesday, November 30, 2010

Economics - What is it Good For

I think of economics as the study of money and how it travels. I had a written conversation with one of my brothers and he explained that economists do not think of economics this way. They think of economics as the study of human choice and allocation of resources. For example, my brother wrote:

What are these non-economic spheres of which you speak?  Give me a couple of examples and I'll understand better.  To me, the economy IS society.  It's people using their resources to exchange with other people.  Taking the time to respond to you is a choice in the use of my resources.  I could have been riding my bike.  Economics studies how we make these choices.  It's as abstract as Galois theory and, IMHO, way more fun.

This is a very grand ambition, a unified theory of human choice. If this could be accomplished it would stand among the greatest human achievements.

When I speak of non-economic spheres, like religious or scholarly pursuits, there is an obvious mismatch with the economists view. If economics is about choice and resource allocation, there are no non-economic spheres. Cloistered nuns make the choice to spend their resources in meditation and prayer and scholars choose to spend their resources on acquiring and disseminating knowledge.

I took a negotiation class. The first exercise was to act out a scenario about buying/selling a car. Everyone in the class had exactly the same information about buyer, seller, and car. We paired off into buyers and sellers and negotiated. Perhaps because it was an exercise, no one walked away from the deal. At the end of the exercise each pair was satisfied with their transaction. The range of prices was huge. Some people bought a classic car that was likely to appreciate in value. Some people bought a source of spare parts, most of which would turn out to be useless. Each person brought their own sense of value to the table and negotiated the transaction based on that value.

This is the strength of the free market. Both buyers and sellers get to say what an item is worth and either complete a transaction or walk away. Each person assigns value and chooses how to allocate resources.

This is a basic notion of economics. To make it a science we have to be able to generalize, theorize, and test those theories. That "sense of value" is called a utility function. The utility function represents the value that a buyer or seller assigns to a resource at any given point in time. We can also speak about utility functions for large numbers of people. What is, for example, a fair price for an iPad where there are hundreds of millions of potential buyers. Can we establish that the collective utility function is such that 10 million buyers will pay $500 dollars but only 8 million will pay $600.

Here are a some facts about utility functions, both individual and collective.

  • They vary over time. A rotary telephone is worth much less today than it was 75 years ago.

  • They are discontinuous. When lcd televisions reached a certain price/quality point, CRT televisions suddenly lost almost all of their monetary value.

  • They are chaotic in the mathematical sense. That is, utility functions that are initially very close may, over time, diverge to be arbitrarily far apart. Two men may agree on the worth of a new Mercedes. One of them has a baby and suddenly the Mercedes is worth no more to that man than a Honda Civic.

These qualities are common in nature but are, so far, mathematically intractable. Economists generally work with simplified models assuming that utility functions are, at least locally, continuous and non-chaotic. That is, to make the mathematics simpler they ignore the basic complexity.

All scientists make simplifying assumptions in their models. The difference between economists and scientists becomes clear when the models fail. Scientists blame their models and re-examine their assumptions. Economists blame the world and try to persuade people that they should behave more like the model.

The brightest and most analytically rigorous economists have an impressive track record of failure in their predictions. Given this legacy, what does contemporary economics have to say that helps us with our lives? Is this a reasonable tool to use when looking at the world, or is it simply a case of "when you have a hammer everything looks like a nail".

Transactions are all about value, and value is mostly ontological. That is, what are we negotiating about? Is this a classic car or a bucket of bolts? To a philanthropist value might lie in the name of a building "The Jones Center for Advanced Learning". The question is not one of discovering the utility function, but of creating a story about the world. The utility function follows from the story. In creating the story, the tools of psychology are much more important than economics. This is marketing. I have almost never seen a marketer do an economic analysis. They create the story, the shape of the world, to make the object as desirable as possible to potential customers. It is the story that determines the utility function.

Unrealistic utility functions are not the only simplification made in economics. There are also the patently absurd notions that humans are rational actors (even in the limited economic sense) and that all parties have the same information about transactions.

While this discussion has mainly focused on microeconomics, macroeconomics has been equally unsuccessful in prediction and in guiding policy. Countries that defy conventional economic wisdom often end up better off than those that follow it. To see this, look at the history of the IMF and the results of following or disobeying its advice.

Given that the basic premises used in economics are faulty and that realistic mathematics are intractable, what is the use of current economic theory? Ben Bernanke explains:

Economic models are useful only in the context for which they are designed ... standard models were designed for these non-crisis periods, and they have proven quite useful in that context.

That is, economic theories and models are great except for the fact that they fail catastrophically from time to time.

Perhaps formal economics has failed us because the economists have not developed the analytical tools necessary for realistic models. Despite this, economic notions could provide us a particularly useful way of looking at the world or determining how we should behave.

I am not an economist and have not deeply studied the field. As a result my views are probably distorted. I see the field as an educated lay person.

I find viewing human relations in terms of self interested agents, resource allocation, and transactions to be largely bankrupt. It is true that we often work for our own gain, have limited resources and engage in many transactions. For most of us, these issues are not central to how we live our lives. Moreover, the notion that we are individualistic self interested agents has infected US society leading to a "greed is good" mentality. This flies in the face of what we know about our success as a species, which is dependent on cooperation and sacrificing self interest for family, friends, neighbors and nations.

Here is the bottom line. Economics as it is currently formulated has failed us in prediction, guidance and in world view. Economic models are only useful in the simplest situations. In world view, contemporary economics leads to greater inequality, poorer health and welfare for society as a whole, divisiveness between individuals and groups, and the mistaken belief that government cannot solve problems. All in all, an impressive record of complete failure.


Anonymous said...

"Economists blame the world and try to persuade people that they should behave more like the model." -- LOL, funny one, Colin.

celeste.boyd said...

I {heart} your blog. You need to have an email subscription option. :)

sf said...

Economics, what is it good for? Absolutely nothing.