Categories
Philoeconomica

Economics as Cultural Tell

Why do economic explanations feel so much more insightful than humanistic explanations? The answer may be that economists take social types as their axioms, the unsplittable atoms of the economic universe, whereas humanists take mental states to be their atoms. And we have lost the capacity to believe–really, truly believe–in the inner life.

Consider economist A.O. Hirschman’s argument that monopoly may be better for consumers than the sluggish competition of highly concentrated markets if “exit is ineffective as a recuperation mechanism, but does succeed in draining from the firm or organization its more quality-conscious, alert, and potentially activist customer or members.”

One immediately has the experience of insight here. Yes! If the competitors are already so large that most customers can’t abandon an underperforming firm, but there remain enough options that activist consumers can still bail on underperforming behemoths and buy from some scrappy startup on the competitive fringe, then the behemoths won’t be subject to voice–to the pressure campaigns that only activists are likely to bring–and so the big firms may well perform worse than if there were a single monopoly and the activists were to have nowhere to go but into the streets, onto the message boards, and to Congress to compel change.

What’s driving this experience of insight? The answer is the division of the consumer group into types. Hirschman posits the existence of an activist type, and a sleeper type who does not complain about poor quality. This typology does all of the work in his argument, as the sleepers bail out of underperforming firms when competition persists, depriving all consumers of the massive positive externality that is their activism applied to big firms.

Now consider a humanistic explanation of the same phenomenon. The sociologist, for example, might argue that competition is sometimes worse for consumers than monopoly because the absence of alternatives to a monopoly focuses consumers’ minds on using complaints and activism to induce the monopoly to reform. Whereas the existence of competition leads to apathy, because consumers know that they have the option to buy elsewhere in response to bad behavior, even if they do not exercise that option.

This humanistic explanation does not produce the same experience of insight as Hirschman’s account, at least for me. And yet it is saying exactly the same thing.

Hirschman doesn’t actually know that there are activist types, human beings who have fixed personalities that make them prone to activism in ways not true of other people. But Hirschman does know that there is a human tendency toward activism that is expressed more under some conditions than under others. The mechanism of expression is simply unclear to him and to us all. It could be that there are fixed activist types, as Hirschman suggests, but it could also be that people do change, there are no types, and activism is really a contingent mental state, called forth by monopoly buying, as the humanist suggests. Both Hirschman and the humanist are describing the exact same phenomenon, but imposing upon it different preconceptions regarding the causes of social behavior.

The humanist ties the explanation to an intellectual worldview in which mental states are the axioms, the first principles that produce the experience of insight when applied to observed phenomena. Whereas Hirschman ties the explanation to an intellectual worldview in which personality types are first principles.

But why is Hirschman’s type-casting move so intellectually irresistible?

The reason may just be that we feel more comfortable on an intuitive level dealing in human types than in mental states. If Hirschman had said that monopoly makes us complain, or makes us angry, we would have dismissed him as fishing in the soup of introspection, conjuring up emotions to suit his explanatory tastes. We would not hear “the feeling of being trapped” and say: yes! That’s why consumers discipline monopolies!

But when we hear that activist types can’t bail on monopolies, we feel a veil pulling from our eyes because we already think in terms of types informally. We all already know that there are activist types out there in the world. We have seen them with our own eyes marching in the streets. Economics is satisfying because we intuitively accept its axioms.

In other words, our love of economics should teach us that we do not really, truly, fully believe in the inner life. We feel more comfortable, as a cultural matter, with the immutable personality type than with the notion that the human is a vessel the contents of which are constantly changing as circumstances change, as new thoughts and emotions pour in and old ones pour out. Feelings are, to us, arbitrary, untrustworthy, a kind of magic trick or supernatural spirit conjured up by lazy thinkers to gloss a reality that lies elsewhere. We don’t actually believe in feelings despite all the lip service we like to pay to them.

Somehow I’m reminded of an experience watching a couple of movies with foreign friends in graduate school. One of the films was an American romcom. The other was a film by Almodovar: Women on the Edge of A Nervous Breakdown. I’d seen the romcom before and it was one of my favorites; I’d felt that it was all about the human condition, feelings, and so on.

But watching it with this crowd, and back to back with the Almodovar, was, well, embarrassing. I realized that the entire romcom was a vehicle for the expression of a single emotion at one discrete moment in the film, a kind of exhausting, Herculean effort to get in touch with feelings by a culture for which feelings remain distinctly unnatural to this day. My friends were bored out of their minds.

By contrast, the Almodovar, which for me was dizzying and inscrutable in the way that its characters seemed constantly buffeted by unseen forces, was engrossing and deeply insightful for my friends. I realized that unlike my romcom, the Almodovar film didn’t struggle to present a feeling so much as it took feelings for granted, making of them a vast ensemble of principal players in a drama that unfolded almost entirely on the plane of the inner life. With respect to that plane, that film was like the Mona Lisa standing next to the stick figure of my romcom.

All of economics is a tell regarding this type-casting value system of ours. The economist’s basic model of human behavior is the immutable preference function. When economists model individual behavior, they write down a single function, the utility function, which defines the consumer’s preferences, and then they model the consumer as acting always in a manner consistent with those immutable preferences. Thus for economists, people are always just types. The rise of so-called behavioral economics has not changed this one bit; it has just changed the menu of types.

The economist has no defense for the type-casting approach, anymore than Hirschman could possibly have been prepared to defend his attribution of activism to types as opposed to the changing mental states of consumers. It is simply in the nature of economics to approach the world in this way. You are asked to take it or leave it. And we take it, and have taken it, to a far greater extent than we have embraced any other field of social science, because economics creates for us a more visceral experience of insight.

That tells us something ultimately about ourselves.

Categories
Antitrust Monopolization Philoeconomica

Economic Plotting

The assumption that people behave rationally does a lot of work in economics, but perhaps its most important function is to allow economists to assume that mutually beneficial deals always get done. If a seller places a value of a $5 on a good, and a buyer a value of $10, the assumption goes, the seller and buyer will agree on a price somewhere between $5 and $10, and trade will take place, simply because the exchange is mutually beneficial.

Economists and their detractors have spent at least half a century tearing apart the assumption that good deals always get done, first through the lens of transaction costs, and later through behavioral economics. Transaction costs dealt only a glancing blow to the assumption, however, because additional costs don’t really undermine it. One can certainly accept that some deals do not get done because the cost of negotiating them–the legal fees, the time required to induce the other party to accept a particular share of the benefits generated by the deal, and so on–are too high, without giving up on the notion that good deals, defined to be those that are mutually beneficial after transaction costs are taken into account, still always do get done.

Behavioral economics has turned out to be harder to dismiss because it suggests that neither party to a transaction may actually want to execute mutually beneficial trades. If the seller doesn’t place the right value on his good, thinking it is worth $20 to him when instead it is worth $5, and the buyer thinks the good is worth $5 to him when instead it is worth $10, then the two will not be able to agree on a price, and so a mutually beneficial trade will not take place. But objections based on behavioral economics are not what interest me about the assumption that good deals always get done.

What is really interesting about the struggle over whether good deals get done is that economics has always needed the fact that some good deals do not get done to create the tension that gives economic inquiry its meaning. An economics in which good deals always get done is an utterly uninteresting, unrealistic, and indeed solipsistic undertaking. And economics has always understood that. Long before transaction cost economics and behavioral economics, economists were careful to build into their models discrete loci of irrationality in order to give the models meaning. Without these areas of irrationality, the models would lack what a creative writing teacher would tell you is the essential element of any story: conflict.

But if a novelist were to try to introduce tension into a plot this way, by asking the main character to treat similarly situated supporting characters differently for arbitrary and unexplained reasons, the novel would be panned.

Consider, for example, as doctrinaire and orthodox a model as the general equilibrium model of Arrow and Debreu. If these men had really taken the assumption that all good deals get done seriously, they would have started with a bunch of households and firms, written down their utility and production functions, and then: bam! The model would have been done. For the assumption that all good deals get done would then have ensured that all trades that, according to the utility functions and production functions they had written down, are mutually beneficial, would then immediately be carried out.

To give the story the conflict it needs to be of interest, Arrow and Debreu added another assumption: that prices are uniform in all markets. (This assumption does not of course originate with them, but their model represents a sort of apotheosis of orthodox economics, making it useful to frame the discussion around it.) Uniform pricing creates tension because when prices are uniform a seller can make more money by intentionally refusing to sell to certain buyers, even when those sales would be mutually beneficial. This is the classic problem of the inefficiency of the uniformly-pricing monopolist.

Consider a seller who places $5 of value on a good and has two prospective buyers, one who places $100 of value on the good and the other who places $10 of value on the good. Without the uniform pricing restriction, the seller would always sell to both buyers, because whatever profits he happened to generate from his sale to the first buyer he could always increase by selling to the second buyer as well.

That changes with uniform pricing, because then the price the seller charges the first buyer must be the same as the price the seller charges the second buyer. If the seller is able to negotiate a price of $95 with the first buyer (a price the first buyer will, under the all-good-deals-get-done assumption, accept because he places a value of $100 on the good, and so would enjoy a net gain of $5 from the deal), then the seller will not sell at all to the second buyer, who is only willing to pay up to $10 for the good and therefore won’t buy at a price of $95. So a deal with the second buyer becomes impossible, even though, if a lower price could be charged to the second buyer, a deal would be mutually beneficial. If the seller and the second buyer could agree on a price of $7, for example, the seller would earn an additional $2 of profit.

But that price is impossible under uniform pricing, because to charge the second buyer $7 would require that the seller charge the first buyer $7 as well, eliminating $83 of profit from the deal with the first buyer relative to the $90 earned at a price of $95, in exchange for a paltry gain of only $2 in profit on the second deal. The seller could still ensure that all good deals get done, by charging that $7 price, or any price between $5 and $10, but it is not in the interest of the seller to do that.

Now the Arrow and Debreu model has the opportunity to become interesting, by giving the conditions under which all mutually beneficial deals will still get done, in spite of the uniform pricing restriction and therefore in spite of the failure of the assumption that all good deals get done as a general matter. In particular, the Arrow and Debreu model makes clear that perfect competition, or some other mechanism that leads to competitive prices, is required for all good deals to get done when prices are uniform. Competition ensures that if one seller tries to charge $95, the $90 in profits generated thereby will induce other sellers to enter the market and steal the buyer’s business by charging a slightly lower price, and as competition intensifies that price will be bid down to the $5 of value that sellers place on the product, ensuring that the second buyer is able to purchase the product as well. All good deals get done after all. By circumscribing the assumption that good deals always get done using a restriction that is realistic–many goods are sold at uniform prices–the model poses a problem that has a certain verisimilitude–how to ensure that all good deals get done when prices are uniform–and then gives the conditions sufficient to solve the problem (e.g., competitive markets).

All economic models follow the same playbook: all economic models create tension and practical interest by limiting the general economic assumption that all good deals get done in some way (usually, but not always by assuming that prices are uniform), and then trying to show what legal rules or policy interventions might be needed to ensure that all good deals do get done anyway. (Another example is the assumption of risk aversion in insurance economics.)

What is so peculiar about this rhetorical posture of economics is that the baseline assumption is always that good deals do always get done, and the model is then built around the introduction of some discrete deviation from that assumption. The model never starts from the assumption that good deals never get done.

Which gives all economic models an internally discordant character.

Why, for example, should I assume that when the monopolist charges $95 to the first buyer, that buyer will magically trade at that price, simply because trade is mutually beneficial, but at the same time I should also accept that the seller won’t try to charge a lower price in order to be able to engage in mutually-beneficial trade with the second buyer? Yes, the seller generates more profit by charging the higher price and selling only to one buyer. But by the same token, the first buyer could enjoy a greater net gain from the transaction by insisting on paying no more than $80 for the good, as opposed to the $95 price that I am asked to assume that the buyer will accept. The buyer does better insisting on a lower price, and if the seller insists on a higher price, then the two might never reach a deal, as Robert Cooter so insightfully pointed out years ago. I am therefore asked to accept that the profit motive is not the be-all-and-end-all for the seller and the first buyer, otherwise I could not assume that the good will sell at $95, and yet I am asked to accept that the profit motive is the be-all-and-end-all for the seller in relation to the second buyer, which is why the seller won’t think twice about pricing the second buyer out of the market and missing an opportunity for mutually beneficial trade with the second buyer. Why ever would that be the case?

Of course, it is in the nature of the introduction of a deviation from the assumption that good deals always get done to have such dissonance. But that just begs the question: does it make sense to rely upon inconsistent behavioral assumptions within the same model?

Keep in mind that in order for uniform pricing to give rise to tension in the Arrow and Debreu model, the same individual seller must be willing to compromise profits for the sake of completing mutually-beneficial transactions with buyers who are willing to pay high prices–inframarginal buyers, they’re called–but not be willing to compromise profits for the sake of completing mutually-beneficial transactions with buyers who are able to pay only lower prices–marginal buyers, these are called. There seems to be no basis for assuming that sellers are socially oriented with respect to inframarginal buyers but rapaciously-profit-driven with respect to marginal buyers, other than the rhetorical need of model builders to introduce tension into the stories they are telling about economic activity.

But if a novelist were to try to introduce tension into a plot this way, by asking the main character to treat similarly situated supporting characters differently for arbitrary and unexplained reasons, the novel would be panned. The trouble for economists is that if they start adding content to the personalities of economic actors, they end up falling down the behavioral economics rabbit hole. There are too many different personality types from which to select , and the mathematics required to build models in any case becomes intractable. But if economists stick with the basic assumption that all good deals get done, then they paint a Panglossian portrait of economic activity that leaves them unable to identify economic problems or solve them. The result is an economic theory built on arbitrary and self-contradictory assumptions about when deals get done.

A more tenable theoretical approach would be to accept that good deals don’t always get done, all the time, in all circumstances. That means that even in competitive markets, sellers will fail to sell to buyers at the market price. That also means that in monopoly markets, sellers may fail to sell to inframarginal buyers at the monopoly price. Laying off absolute assumptions regarding whether deals always get done should also release economics from going to the opposite extreme: assuming that when good deals do not always get done good deals must therefore never get done. Which means that we should not be surprised to come upon monopolists that charge competitive prices.

Jettisoning absolute assumptions about whether good deals get done would prevent economics from making grand claims, such as the claim of the Arrow and Debreu model that competitive markets are always efficient. But it would not make economic theory useless. Economic theory could still tell us plenty about potentials: such as the amount of gain that would be created were policymakers to encourage buyers and sellers to strive to make mutually beneficial deals whenever possible. (Guido Calabresi makes a similar point when he argues that economics should focus less on how to expand the production possibilities curve and more on how to get the economy to that curve.) It would also help explain economic institutions that economics has so far been unable to penetrate.

Like advertising. The classic economic explanation for advertising is that it provides consumers with useful product information, something that is almost impossible to believe in the information age, if it ever was credible. But in a world in which good deals don’t always get done, there is another potential economic justification for advertising: that it seeks to overcome whatever cognitive or bargaining failures otherwise prevent good deals from getting done. In a world in which mutually beneficial transactions don’t always happen, because consumers are irrational, one would expect to find sellers spending large amounts of money trying to cajole buyers into buying, even in situations in which the deals on offer are good for buyers and so in theory they should embrace them without needing to be persuaded to do so. (That would go some ways toward undermining my own argument here that persuasive advertising must be bad for consumers, because absent advertising rational consumers always purchase the products that are best for them.)

There’s nothing wrong with the use of simplifying assumptions in economics, or in thought of any kind. But the use of inconsistent assumptions about behavior in the same model–often in relation to the same economic actors in the model–is a different story.

And all of economic theory is based upon doing just that.

Categories
Philoeconomica Quantity World

The Discreteness of Death

Death is a discrete phenomenon. It is a creature of units. Vegetation relies on sunlight for life. A plant can die, however, only because it is a unit of vegetation. When the amount of light falls from 3.481 to 2.377 on some scale, there is death only because each plant requires a minimum of 0.05 of light, or 0.3, or 0.4.

So, why? Why this discreteness?

Categories
Philoeconomica

Ecoan

Suppose that you are indifferent between two fountain pens and one pencil and one fountain pen and a hundred pencils. But at current prices you need more wealth to buy a fountain pen plus a hundred pencils than to buy two fountain pens and one pencil. Are you therefore poorer if you are forced to give up 99 pencils in exchange for a fountain pen?

Categories
Civilization Meta Philoeconomica Quantity

The Illiteracy of the Literate

The complex feelings of lawyers and humanist scholars with respect to quantitative subjects, and particularly the quantifization of the social sciences, ought to give them greater empathy for the illiterate and uneducated. The humanist scholar is to the scientist as the illiterate are to the literate.

The illiterate view books with distrust, for books are used to undermine their most heartfelt positions in ways against which they are unable to mount a defense. But this is precisely how the lawyer feels when her nuanced doctrinal argument is demolished by a mathematical model of the economy that shows that regardless of the substance of the legal rule, the same economic outcome will obtain.

“It’s just mathematical mumbo jumbo,” says the lawyer. “These economists don’t know how things work in the real world.” But what the lawyer cannot do is to beat the economist at her own game. She can’t show that the economic model cannot withstand close scrutiny; all she can do is try to delegitimize the entire method. But the illiterate levy the same charge on the literate: “it’s just book learning,” they say. They cannot defend themselves in writing; but they can try to delegitimize writing itself.

It is particularly bitter for the humanists that they have been socialized to occupy the power position. For millennia, since the invention of writing, they have been the ones who use their learning to lord it over others. But now these merely-literates, these innumerates, must know what it means to be crushed by ideas. A very bitter position indeed.

I do not mean to say that the mathematicians have any better claim on the truth. But if the humanists think the mathematicians don’t, then it should perhaps worry the humanists to think that maybe they don’t either, in relation to the illiterate. Or maybe we are marching forward, after all, from one stage of intellectual progress to the next!

Categories
Philoeconomica

A Model for Macro

So far we have been discussing the properties of matter from the atomic point of view, trying to understand roughly what will happen if we suppose that things are made of atoms obeying certain laws. However, there are number of relationships among the properties of substances which can be worked out without consideration of the detailed structure of the materials. The determination of the relationships among the various properties of the materials, without knowing their internal structure, is the subject of thermodynamics. Historically, thermodynamics was developed before an understanding of the internal structure of matter was achieved….

We have seen how these two processes, contraction when heated and cooling during relaxation, can be related by the kinetic theory, but it would be a tremendous challenge to determine from the theory the precise relationship between the two. We would have to know how many collisions there were each second and what the chains look like, and we would have to take account of all kinds of other complications. The detailed mechanism is so complex that we cannot, by kinetic theory, really determine exactly what happens; still, a definite relation between the two effects we observe can be worked out without knowing anything about the internal machinery!

1 Richard P. Feynman et al., The Feynman Lectures on Physics 44-1-44-2 (1963).

Cf. http://rajivsethi.blogspot.com/2010/02/case-for-agent-based-models-in.html .