History of Economic Doctrines

Lecture 4

The “Economic Way of Thinking”

(See the link Behavioral Economics for substantial elaboration.)

Standard Economic Assumptions

1. Human beings are self-interested.
2. Humans seek pleasure and try to avoid pain.
3. Human beings are rational and forward-looking.
4. Limited resources and choices imply that self-interest is a process of optimization.

Self Interest and Rational Optimization?

Self Interest:

Naïve Egoism: U = U(x1, x2, …, xn) … [xi = some good]

Present Aim Rationality: U = U(X, Y) [vectors]

Production and Resources:

The creation of value (utility?)

Labor / Land / Capital / Entrepreneurship

The Nature of Reason

1. Choices are rational if we expect the consequences to be consistent with our goals. Goals that are inconsistent with each other may also be a symptom of irrationality.

2. Choices are irrational if we know them to be inconsistent with achieving our goals.

3. A behavior is arational if, for example, it entails our tastes – preferences between chocolate and licorice, for example, or our aesthetic sensibilities.

The conventional economists’ view of behavior: humans are rational and do the best they can with what they have. Mistakes are consequences of imperfect information and imperfect foresight.

ADAM SMITH – Theory of Moral Sentiments (1758)

Suppose you sliced off your pinkie while buttering your toast tomorrow morning. If you then heard on the Today show that an earthquake had swallowed most of China, causing 1.3 billion deaths, which event would bother you more? Adam Smith (1723-1790), widely viewed as the founder of modern economics, had one answer.

. . . loss of a little finger would keep the average European from sleeping through the night, but, provided he never saw them, he would snore most profoundly over the loss of millions of his brethren, and the destruction of that immense multitude seems plainly an object less interesting to him than this paltry misfortune of his own.

Adam Smith, The Theory of Moral Sentiments, 1759

Smith went on to say that, nevertheless, most individuals would sacrifice their little fingers to save someone else’s life, primarily because we all like to think of ourselves as “good people.” But how much would we be willing to sacrifice? An arm or leg? Our own lives?

Smith’s thinking was subtle, and seems based substantially on introspection. Although he was a lifelong bachelor, he pondered love in a number of dimensions.

How selfish man may be supposed, there are evidently some principles in his nature, which interest him in fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it. … What so great happiness as to be beloved, and to know that we deserve to be beloved? What so great misery as to be hated, and to know that we deserve to be hated?

Adam Smith

The Theory of Moral Sentiments

Chapter 1

JEREMY BENTHAM – Utilitarianism

The optimization of satisfaction and profit?

“The hedonistic conception of man is that of a lightning calculator of pleasures and pains, who oscillates like a homogeneous globule of desire ... under the impulse of stimuli that shift him about the area but leave him intact ... He is an isolated, definitive human datum, in stable equilibrium except for the buffets of the impinging forces that displace him in one direction or another ... When the force of the impact is spent, he comes to rest, a self-contained globule of desire as before.”

THORSTEIN VEBLEN

The Theory of the Leisure Class (1899)

Issue: Does human behavior merely reflect amoeba-like attempts to maximize pleasure and minimize pain in a deterministic fashion?

Aside: ¨Freedom”

Capitalism is supposed to maximize freedom, according to Milton Friedman and most other libertarians. But freedom is defined by the ranges of choices that are available to you (budget constraints, time, etc.). Are you as free as Bill Gates? Are you more free than a child born in the slums of Nairobi or the favellas of Rio de Janeiro?

The law in its majestic equality forbids the rich as well as the poor to sleep under bridges, to beg in the streets, and to steal bread.

Anatole France

Paradox for Freedom: Are we free to choose, or are choices deterministic? [See Session 1 notes.] If economists can explain decisions with deterministic math, are we truly “Free to Choose”, per the title of one of Friedman’s books?

Example: Indifference Curve: Pizza vs. Chocolate … there is a point where a person’s preferences between having extra chocolate or extra pizza [reflected in the slopes of indifference curves] are in precise ratio with relative market prices [the slope of the consumer’s budget line]. Our optimal choice occurs where an indifference curve is tangent to our budget line.

Is this choice consistent with freedom in a meaningful way? Or are we captives of our budgets and tastes that are deterministically based in our physiology and experience?

Another Example: Voting: In the median voter model, the likelihood that a single vote will swing an election approaches zero rapidly as the number of voters increases, but many people are under the illusion that our individual vote “matters.” Voting because it makes us feel good is rational. Voting because we think that our individual vote will affect the outcome of an election is not rational.

Relative Prices

-- buyers prices (what you’re willing to pay)

-- sellers prices (what you are willing to accept)

- “either carrots or sticks work as prices”

-prices can vary depending on who has rights -- buyer vs. seller.

Example: The price you would charge to allow someone to cut off your arm is likely to be huge, but the price you would be willing and able to pay to prevent someone from chopping off your arm is likely to be far less.

Behavioral Economics: Standard Economic Assumptions are Unrealistic.

We are not always good at optimizing. If people were as rational and forward-looking as economists assume, every chess match would yield the same result, which might be a stalemate, or perhaps white would win, or black might win. None of us is smart enough to know with certainty what that ending would be. Numerous paths might lead to the monotonously predictable ending of each game, but every counter to every possible move by an opponent would generate a countermove yielding the same result. Chess would be no more intellectually challenging than tic-tac-toe.

bounded rationality:	Nobel-prize winner Herbert Simon coined the term “bounded rationality” to describe limits to people’s ability to rationally solve complex problems. Conventional economic theory assumes that every agent possesses infinite amounts of infinitely rapid brainpower to optimally solve every problem. Simon observed that many people fail to understand probabilities, and that people universally lack the ability to process information with consistency, precision, and accuracy. Consequently, Simon asserted that consumers often fail to maximize their utility, and that business decisionmakers often fail to maximize profits, so that behavior should be assumed “satisficing” instead of maximizing per se. Simon pointed out that instead of the precise maximization assumed by economists, most people rely heavily on cognitive shortcuts, e.g., they make lists, or develop “rules of thumb.”
bounded self interest:	Behavioral theorists use the phrase bounded self interest to describe the phenomenon of altruism. Research indicates that individuals who believe themselves treated fairly in the marketplace tend to engage in charitable activities to benefit other people, contrary to the view that self interest as a motive is narrowly egoistic. (These findings hint that charitable giving is income elastic.)
bounded willpower:	Behavioral economists have observed that individuals frequently exhibit bounded will power, in that people sometimes knowingly act in ways in the short run that they recognize as inconsistent with their long run self interests. For example, a person who smokes may be very aware of the long run consequences of smoking, but procrastinate on quitting despite knowledge of the likely long term consequences. Procrastination and addiction (to, e.g., gambling, drugs, or alcohol.) are among several categories of behavior that reflect problems associated with bounded will power.

How “self-interested” are people?

Robert Frank (Cornell University – Behavioral Economist) confronted three groups of volunteers with a prisoners’ dilemma problem.

1. Grad students studying economics.
2. Undergrads studying economics.
3. Students with no background in economics courses.

Results? Members of group 3 trusted each other and cooperated most. Group 2 was more trusting and cooperative than Group 1. This raises the issue of whether people who choose to major in economics are inherently less trusting, or does increased exposure to “the economic way of thinking” program students to cynically view others as narrowly self-interested?

How “rational” are people?

Kahneman and Tversky

Cognitive psychologists Daniel Kahneman [Nobel Prize in Economics, 2002] and Amos Tversky [henceforth, K-H] built a 20 item questionnaire to try to ascertain how rational people are, and how consistent they are in dealing with risk.

K-H Results?

The results of the K-H surveys of college students at Stanford. Princeton, Toronto, and Tel Aviv suggested strongly that people are far less rationally consistent and far less systematic in their treatment of risk than economists suppose.

Doug Sue

For his senior honors thesis, Douglas Sue (UNC BA 2004) used the K-H questionnaire in an attempt to ascertain if economists are more rational than most people, and if they are more consistent in dealing with risk.

Doug Sue’s Results? Sue’s research queried 100 UNC juniors and seniors. One-third were majoring in liberal arts, one-third were majoring in mathematics or the sciences, and one-third were economics majors. Sue’s results indicate that people who choose to be educated in economics tend to be more rationally consistent and to treat risk more systematically than is true of students who major in other social sciences (broadly construed) or in mathematics or the sciences.

Alexandra Samet

For her senior honors thesis, Alexandra Samet (UNC BA 2005) extended the Sue results by having 50 undergraduates majoring in economics and 50 undergraduates majoring in business administration answer the K-H questionnaire. Samet’s study focused on whether taking courses in economics or business administration improved the logical consistency and made risk averseness a more consistent pattern.

Alexandra Samet’s Results? Samet’s research strongly suggests that taking courses in economics or business does not improve the rational consistency of people, nor does it change their treatment of risk. Moreover, Samet’s results confirmed the results of Sue to the effect that economists are “more rational” and “more consistent in their treatment of risk” than are other people, and found that business majors not also specializing in economics were no more likely to be rationally consistent than were liberal arts or science and math majors, nor were they any more consistent in their treatment of risk.

Inasmuch as all of the students studied by Samet had credit for principles of economics courses, further research is currently underway to ascertain if rational consistency and treatment of risk are affected by exposure to the principles of economics courses.

Jennifer Wade

For her senior honors thesis, Jennifer Wade (UNC BA 2004) secured data covering purchases in a grocery store to test whether the way prices are “framed” affect consumer behavior, contrary to standard economic theory [SET]. For example, if whether an item’s sale price is stated as 2/$4 versus $2 per unit affects consumer purchasing patterns, then consumers are not acting in accord with SET.

Jennifer Wade’s Results? Wade’s study of more than 100,000 consumer purchases of nine items compared the amounts people bought at regular prices [e.g., $3.19) versus purchases at sale prices [e.g., 2/$4]. When prices were stated as, e.g., 2/$4, customers bought in increments specified in the stated price. In other words, even though 2/$4 translates to $2 per unit, consumers bought 2 or 4 or 6 units far more often than they bought 1 or 3 or 5 units. These results were quite robust, with confidence intervals for seven items at the 99+% range, and for the other two items, the confidence intervals exceeded 95 percent.

Kahneman’s “Peak-End Rule”

1. It’s not where you are that determines happiness, but the path that you followed to get there. People on an upward trajectory (ex: recent promotions or increases in wealth) tend to be much happier than people at the same level who have recently experienced some type of reversal.

2. People are often poor forecasters of what will make them happy, but they do tend to know when they are happy.

---

These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.