2. Explainawaytions
In the process of making economics more mathematically rigorous (in mathematical logic, you can
define a system in which statements are strings of symbols, and there is a list
of axioms (assumed to be true) and deductive rules (which derive a statement
from other statements). In this system, a proof of a statement is a sequence of
steps, which starts with the axioms, uses the deductive rules, and ends with
that statement. A fully rigorous result is one with a proof in this form) after World War II, the
economics profession appears to have lost its good intuition about human
behavior. Defective telescopic facilities were replaced with time-consistent
exponential discounting. Overweening (excessively arrogant or immodest)
conceits (way of behaving) were replaced
by rational expectations. And ephemeral
(lasting for only a short time) shifts in animal spirits were replaced by the
efficient market hypothesis. Economics textbooks no longer had any Humans. How
did this happen? I believe that the most plausible
(likely to
be true) explanation is
that models of rational behavior became standard because they were the easiest
to solve. This conjecture (the development of a
theory or guess based on information that is not complete) is not meant as a put-down (a comment intended to criticize someone and make them feel stupid). One begins learning physics by studying the behavior
of objects in a vacuum; atmosphere can be added later. But physicists never
denied the existence or importance of air; instead they worked harder and built
more complicated models. For many years, economists reacted to questions about
the realism of the basic model by doing the equivalent of either denying the
existence of air, or by claiming that it just didn’t matter all that much.
Matthew Rabin has dubbed these defensive reactions as “explainawaytions.”[1]
Let’s be blunt (saying what is true or what you think, even if this offends or upsets people). The model of human behavior based on the premise (a principle or statement that you consider to be true) that people optimize is and has always been highly implausible (doubtful).
For one thing, the model does not take into consideration the degree of
difficulty of the problem that agents are assumed to be “solving.” Consider two
games: tic-tac-toe and chess.
A reasonably bright first
grader (a student in one of the 12 years in
an American school) can learn to play the optimal strategy in
tic-tac-toe, and so a model that assumes players choose optimally in this game
will be a pretty good approximation of actual behavior for bright children and sober (not drunk) adults. Chess, on the other hand, is quite a
different matter. Most of us play chess terribly and would have no chance of beating
a free program on our smartphones, much less a grandmaster. So, it makes no
sense to assume that the representative
agent (to refer to the typical
decision-maker of a certain type, https://www.youtube.com/watch?v=Dvr3ICLId2s) plays chess as well as
tic-tac-toe. But that is essentially what we assume in economics. When we
assume that agents maximize utility
(a utility is a measure of how much one enjoys a movie,
favorite food, or other goods, https://www.educba.com/economic-utility/) (or profits) we do not
condition that assumption on task difficulty. We assume that people are equally
good at deciding how many eggs to buy for breakfast and solving for the right
amount to save for retirement. That assumption is, on the face of it, preposterous (utterly absurd or ridiculous,
https://www.youtube.com/watch?v=O5DgTB6ii7U). So why has it stuck? There has been a litany (a long, usually boring, list of things that someone talks or writes about,
https://www.youtube.com/watch?v=OYQtCJbDKTA) of explainawaytions.
A. As If
Grumblings (to say something in a complaining way, https://www.youtube.com/watch?v=o8txs7-YCM8)
within the profession about the so-called “marginalist
revolution” (is the development
of economic theory in the late 19th century which
explained economic behavior in terms of marginal utility
and related concepts, https://www.youtube.com/watch?v=PzgTKD8pC7o ) were
present in the 1940s, and this journal published several articles debating the
realism of the theory that firms set output and hire workers by calculating the
point at which marginal cost (in economics, marginal cost is the
change in the total cost that arises when the
quantity produced is incremented by one unit; that is, it is the cost of producing one more unit of a good, https://www.economicsonline.co.uk/Definitions/Marginal_cost.html)
equals marginal revenue (the revenue gained by producing one additional unit of a product
or service, https://www.economicsonline.co.uk/Definitions/Marginal_revenue.html)
. One of the participants in this debate
was Richard Lester of Princeton (Richard Allen Lester, a prominent labor economist and dean of
the faculty, emeritus, used in the title of someone such as a professor, chairman, or president if they no longer do that job, at Princeton University)
who had the temerity (excessive confidence or boldness, https://www.youtube.com/watch?v=EiLcrBsnYxo ) to ask the
owners of business firms how they actually made such decisions. Whatever firms
were doing did not seem to be captured by the term “equating at the margin,” (so long as the marginal cost of
producing a commodity is less than its price, a firm will produce extra units.
A profit-maximizing firm reaches equilibrium by equating marginal
revenue with marginal cost) and Lester (1946, p. 81) ended his paper this way: “This paper
raises grave doubts as to the validity of conventional marginal theory (marginalism is a theory of economics that attempts to explain
the discrepancy in the value of goods and services by reference to their
secondary, or marginal, utility. The reason why the price of diamonds is higher
than that of water, for example, owes to the greater additional satisfaction of
the diamonds over the water) and the assumptions on which it rests.” Machlup (1946) took up
the defense of the traditional theory and argued that even if firm owners did
not know how to calculate marginal costs and revenues, they would make
decisions that would closely approximate such choices using their intuitions.
Machlup’s defense was refined and polished by Friedman (1953, p. 21) in his
famous essay “The Methodology of
Positive Economics.”
Friedman
brushed aside questions about the realism of assumptions and argued that
instead theories should be judged based on their ability to predict behavior.
He proposed what is now a well-known analogy about an expert billiard player:
“excellent predictions would be yielded
(to make a profit, to finally agree to do what someone
else wants you to do) by the hypothesis that the
billiard player made his shots as if he knew the complicated mathematical
formulas that would give the optimum directions of travel, could estimate by
eye the angles, etc., describing the location of the balls, could make
lightening calculations from the formulas, and could then make the balls travel
in the direction indicated by the formulas. Our confidence in this hypothesis
is not based on the belief that billiard players, even expert ones, can or do
go through the process described; it derives rather from the belief that,
unless in some way or other they were capable of reaching essentially the same
result, they would not in fact be expert billiard players.”
Friedman had
a well-deserved reputation as a brilliant communicator and debater, and those
skills are on full display in this passage. Using the mere two-word phrase “as
if,” Friedman essentially ended the debate about the realism of assumptions in
economics. But given proper scrutiny (careful examination of someone or something), we can see that this passage is simply a
verbal sleight of hand (a deceptive or misleading act).
First of
all, it is no accident that Friedman chooses to discuss an expert billiard
player. The behavior of an expert in many activities may indeed be well
captured by a model that assumes optimal behavior. But what about non-experts?
Isn’t economic theory supposed to be a theory about
VOL. 106 NO. 7 THALER: BEHAVIORAL ECONOMICS: PAST PRESENT
AND FUTURE 1581
the behavior of all economic
agents, not just experts? The life-cycle hypothesis is intended to be a theory
of how the typical citizen saves for retirement, not just those with MBAs (Master of
Business Administration: a master’s degree in business management, https://www.hw.ac.uk/uk/edinburgh/map/4-edinburgh-business-school.htm ).
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