Not Rational Utility Maximisers

One cornerstone of neoclassical economic thought is the assumption in microeconomics (and microfounded macroeconomics) that humans behave as “rational utility maximisers”.

Yet this assumption is increasingly outdated. Empirical findings in behavioural economics show that the neoclassical assumption of utility maximisation has very little basis in reality.

First, it is crucial to define what we mean by utility maximisation. Paul Samuelson, one of the grandfathers of the neoclassical New Keynesian school defined consumer rationality as follows:

• Completeness — Given any 2 bundles of commodities A & B , the consumer can decide whether he prefers A to B (A≻B), B to A (B≻A), or is indifferent between them (B≈A).

• Transitivity — If (A≻B) and (B≻C) then (A≻C).

• Non-satiation — More is preferred to less.

• Convexity — Marginal utility falls as consumption of any good rises.

This definition remains dominant in neoclassical economics today.

Sippel (1997) tested whether consumers really adhered to these four rules. He gave his student test subjects a budget, and a set of eight priced commodities to spend their budget on:

UtilityMaximisation

This was repeated ten times, with ten different budget and price combinations. Sippel found that 11 out of 12 of his test subjects’ behaviour failed to meet Samuelson’s criteria for rational utility maximisation. Sippel repeated the experiment later with thirty test subjects, finding that 22 out of 30 did not meet Samuelson’s criteria. Sippel concluded:

We conclude that the evidence for the utility maximisation hypothesis is at best mixed. While there are subjects who appear to be optimising, the majority of them do not.

It is interesting that some individuals obey the rules set out by Samuelson, and that some don’t. Human behaviour is highly variable from individual to individual. If the hypothesis of utility maximisation is right about a subset of individuals, but wrong about much of the general population, then this underlines the variability of human behaviour. And different circumstances call for different decision-making frameworks — some individuals may act like rational utility maximisers under some sets of circumstances and not others. This is really an area that deserves much, much more empirical study.

The evidence so far suggests that humans are complex animals whose decisions are multi-dimensional. This could be because our brains have evolved to use different neuro-circuitry for different decisions. According to the behavioural economist Daniel McFadden:

Our brains seem to operate like committees, assigning some tasks to the limbic system, others to the frontal system. The “switchboard” does not seem to achieve complete, consistent communication between different parts of the brain. Pleasure and pain are experienced in the limbic system, but not on one fixed “utility” or “self-interest” scale. Pleasure and pain have distinct neural pathways, and these pathways adapt quickly to homeostasis, with sensation coming from changes rather than levels. Overall, presumably as a product of evolution, our brains are organized well enough to keep us alive, fed, reproducing, and responsive to but not overwhelmed by sensation, but they are not hedonometers.

All of this points to the idea that microeconomics needs a new framework based on neurological and behavioural evidence, not decades-old assumptions that are unsupported by empirical evidence.

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Comparative Advantage and Global Trade Fragility

One of the cornerstones of the global economic status quo is globalisation and integration of markets. Here’s the growth in world trade as a percentage of global GDP since the 1970s:

worldtrade

There have been two key forces behind this outgrowth in global trade. First of all, the American military acting as hegemonic global policeman with bases in more than 150 countries and backed has created a situation generally known as the Pax Americana where goods and intermediaries can be shipped around the globe with minimal fear of piracy, seizure, theft, etc. Second, the international community has incentivised trade liberalisation through the policies of organisations including the International Monetary Fund (IMF), and World Trade Organization (WTO) requiring nations requesting loans or aid to open their markets to foreign trade competitors.

Most global policymakers and trade economists remain committed to and ultra-bullish about the agenda of global integration of markets. The OECD claims:

If G20 economies reduced trade barriers by 50%, they could gain:

More jobs: 0.3% to 3.3% rise in jobs for lower-skilled workers and 0.9 to 3.9% for higher-skilled workers, depending on the country.

Higher real wages 1.8% to 8% increase in real wages for lower-skilled workers and 0.8% to 8.1% for higher-skilled workers, depending on the country.

Increased exports: All G20 countries would see a boost in exports if trade barriers were halved. In the long run, many G20 countries could see their exports rise by 20% and in the Eurozone by more than 10%.

The overarching intellectual motivation for these policies is found in the work of the English classical economist David Ricardo and his neoclassical successors. The concept of comparative advantage introduced by Ricardo and expanded and formalised via equilibrium models by neoclassical economists including Samuelson, Mankiw, Hecksher and Ohlin (etc) has underpinned most of these policies.

Comparative advantage is the idea that nations benefit from specialising in what they are best at. Ricardo introduced the notion during debates about Britain opening her markets to European trade. Ricardo pointed out that total output and welfare would be greater for all countries in total if they specialised in what they were best at, and traded with each other to get what they wanted.

This principle works in Ricardo’s simple verbal model (and in the more sophisticated equilibrium models developed since). However empirical studies and meta-studies of modern day trade liberalisation suggest that there are some problems with this theory in practice.

Dani Rodrik noted in 2001:

Do lower trade barriers spur greater economic progress? The available studies reveal no systematic relationship between a country’s average level of tariff and nontariff barriers and its subsequent economic growth rate. If anything, the evidence for the 1990s indicates a positive relationship between import tariffs and economic growth.

The evidence on the benefits of liberalizing capital flows is even weaker. In theory, the appeal of capital mobility seems obvious: If capital is free to enter (and leave) markets based on the potential return on investment, the result will be an efficient allocation of global resources. But in reality, financial markets are inherently unstable, subject to bubbles (rational or otherwise), panics, shortsightedness, and self-fulfilling prophecies. There is plenty of evidence that financial liberalization is often followed by financial crash — just ask Mexico, Thailand, or Turkey — while there is little convincing evidence to suggest that higher rates of economic growth follow capital-account liberalization.

So what’s the difference between theory and reality?

There are a number of potential reasons why the theoretical promise of comparative advantage has not played out in reality.

First is graft and corruption. If countries are taking on loans from international institutions, and those loans are being deposited in the Swiss bank accounts of corrupt officials or businessmen instead of being spent on improving industry, skills or infrastructure, then what chance do developing countries have of developing?

Second is the danger of bubbles during the liberalisation process. Global capital flows into newly-liberalised countries can stoke bubbles in almost every sector (but especially equities, real estate, etc). When the bubble bursts, capital flows out, leaving the domestic economy deeply depressed.

Third is the social upheaval costs to labour, skills and institutions. As we have seen in the United States, manufacturing jobs and skills migrated abroad. Workers often cannot be retrained cheaply and easily, and often do not want or cannot afford to migrate to wherever their skills would be best-compensated. This stickiness can result in endemic unemployment and resultant economic weakness.

Fourth is the cost to capital stock.

As Steve Keen noted:

Some capital is necessarily destroyed by the opening up of trade.

Since capital is destroyed when trade is liberalised, the watertight argument that trade necessarily improves material welfare springs a leak.

Converting capital stock again and again to keep up with changing economic winds can be an expensive, difficult and mistake-ridden process.

Fifth is the problem of trade fragility.  Events like natural disasters and foreign wars can disrupt production and trade flows. Specialisation could cripple a country that depends on imports from foreign disrupted countries. Dependency on imported goods and intermediates renders countries vulnerable to shocks outside their borders. Wars and disasters that affect exporters have at times seriously disrupted and damaged the economies of importers, and vice versa.

The fact that trade liberalisation can have large social costs, create economic fragility and produce asset bubbles is a cause for pause. Is IMF-imposed globalisation opposed by the wider public really producing freer markets, or is it a misguided central planning experiment? Has the dogmatic pursuit of globalisation left global industry fragile to supply chain shocks caused by natural disasters and wars? Can the status quo really even be considered free trade, given that it is supported and smoothed by huge military-industrial subsidies? Does freedom of trade not also include freedom of nations to choose to protect domestic industries, institutions and supply chains from foreign competition? Why should the industries of developing countries be expected to compete against corporate multinational juggernauts?

While global trade may have provide a major disincentive against trade-disrupting wars, it seems probable that it has created a deep underlying systemic fragility. Trade interdependence means that regional or domestic shocks to production like a war or natural disaster may have consequences throughout the entire world, transmitted through dependencies. Similarly to the interconnective global financial system and the 2008 financial crisis, geopolitical shocks in coming years may well be magnified by globalisation.