"It makes economic sense, if you think economically."

One day in the midst of an economics class amongst a sea of hungover and facebook-occupied freshmen I began to ponder the implications of the Economics professor’s statement.

“It makes economic sense, if you think economically.” 

There’s an air of dissonance to the statement, unsettling even for it projects a sense of nihilism. If a single problem can make various forms of sense, “common sense, social sense, moral sense” what have you, that would have meant a single objective problem would have equally valid explanations drawn from established theories from varying disciplines. Of course in most cases this is fine, the world is sufficiently complex that a lot of factors are at work simultaneously.

But what if all of these trustworthy tools of academia- fortified by statistically significant empirical evidence – offer significantly different predictions? That would mean a moment of crisis for all of social science, as hard sciences like physics (quantum mechanics vs theory of relativity) could empathise.

That led me to think about the notion of the economic man, the rational decision maker populating economic models that came to life from Morgenstern and von Neumanns’ pages. Economists are prone to be exasperated when they are accused of being out of touch with reality to populate their models with such agents. Yet one can easily see how economists come to such expectations of the ordinary Joes, it just follows logically if one’s goal is to optimise scarce resources, even when some of the payoffs are random and/or only probabilistic. Yet psychologists(Kahnemann and Tversky for instance) have aptly demonstrated that empirical evidence weights unfavourly against the economists’ expectation, and when one looks at the data set they presented one could only think that it then,to modify my professor’s quote ” to make psychological sense, if you think psychologically.”

So what do we make of all these? In spite of how much economists (especially those writing textbooks) pride themselves to ground their thoughts more on positive rather than normative analysis, the expected utility theorem is in effect a logically superior normative analysis.On the other hand, Cognitive Psychology and some sub-fields of Sociology may offer better positive descriptions of  the behaviour of agents. For a science that aims to study how to optimise scare resources, all scientific endavours within Economics is fueled by the motivation to make the most all of scare resource. Economists are widely documented to be the ones with “economically correct” answers (see Thaler for instance).

Ultimately my opinion is that research in Economics should continue in two distinct but ultimately convergent paths. The first concerns the question “how do we optimise?” which is built up on the surfeit of theorems that have blessed our understanding of how the economy works; the second concerns “how do agents actually behave?” which could be built up and drawn from psychology,sociology and behavioural economics. Perhaps the best anecdote is provided by Richard Thaler, who in modifying Friedman’s billiard player analogy offered that perhaps the expert billiard playing making strategic moves with his understanding of physics and mathematics is to economists as the average players who plans at most 2-3 strategic moves ahead as that of the average decision maker.

Only when we are certain of how the actual behaviour of agents diverge from rational behaviour that we can offer policy prescriptions that are guided by reason, supported by empirical evidenced and refined by moral intuitions.

Suggested Reading

  1. “Choices, Values and Frames.” Daniel Kahnemann and Amos Tversky. Published in American Psychologist, 39:4,341-50
  2. “Prospect Theory, An Analysis of Decision under Risk”. Daniel Kahnemann and Amos Tversky. Published in Econometrica, 47:2,263-91, 1979.
  3. “Mental Accounting Matters.” Richard Thaler.
  4. “Toward a Positive Theory of Consumer Choice.” Richard Thaler. 

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