Posts Tagged Utility

A Unifying Principle for Economics?

Commenter Dan thinks economics has not yet found its watershed moment:

Think about Biology before DNA was discovered or Geology before plate tectonics was understood, both disciplines had learned a lot but they still lacked a comprehensive model that made everything fit into place.

I am sympathetic with this viewpoint. Heterodox criticisms come at economists thick and fast – personally, I think most of these criticisms are valid and very little of neoclassical economics should be left. Yet neoclassical economics persists.

However, in my opinion this isn’t because economics lacks a unifying theory; it’s the exact opposite. Economists already think they have found a unifying concept: namely, the optimising agent. Consumers maximise utility; producers maximise profits; politicians maximise their own interests/their ability to get reelected. Sure, there are a few constraints on this behaviour, but overall it is the best starting point. It all blends together into a coherent theory that can tell a plausible story about the economy. I find economists are resistant to any theory that doesn’t follow this methodology.

I have gone over my problems with this approach many times, so I shan’t repeat myself. The important question is what an alternative theory would look like.

The typical definition of economics is the study of how resources are allocated. Hence, a unifying theory should empirically and logically do a satisfactory job of explaining prices, production and distribution. Such a theory would be able to underlie virtually any economic model in some form, whether being the wider context of a microeconomic phenomenon, or the basis of macroeconomic phenomenon. No easy task, then, but luckily many approaches of this nature already exist.

Alternative Theories of Behaviour

If we want to stick with agent-based explanations of the economy, there are any number of alternatives to the ‘optimising’ agent. Among these are:

I consider all of these approaches useful, but none of them sufficient for the task at hand.

In the case of the first two, replacing ‘optimising’ agents with ‘satisficing’ agents isn’t exactly revolutionary. Maslow’s hierarchy can, in fact, work as a utility function. In both cases, we still run into similar problems of aggregation and of reductionism. And we end up trying to shoehorn every decision into a particular approach. The simple truth is that agents have a lot of different motivations for their actions and sometimes these aren’t always clear, even to them.

My main issue with these, and any agent based approach, is that they aren’t necessarily relevant for the wider question of resource allocation in society. Individualist-based neoclassical economics has to reduce things down to a  few agents with only a few goods in order to have any conclusions whatsoever; I can’t help but feel similar problems would emerge here. Class struggle may determine distribution but it doesn’t tell us much about what is produced and at what price it is sold. In order to understand how production takes place and prices are determined, we will have to look elsewhere.

A Theory of Value

The value approach has a lot of pluses. A theory of value underpins the explanation of relative prices, and also has normative implications that recognize the inevitable value judgments in economics. The only problem I have here is that I’ve yet to find a convincing theory of value – the two most widely known are the neoclassical/Austrian subjective theory of value and the Labour Theory of Value (LTV).

I object to the idea that prices merely reflect subjective valuations for the basic reason of circularity: prices must be calculated before subjective valuation takes place, so they cannot purely reflect subjective values.

I have more sympathy with the LTV (mostly because its proponents seem to have coherent responses to every criticism thrown at it), but I remain unconvinced. The defences of the labour theory of value tend to rest on appeals to ‘the long run’ and ‘averages” of socially necessary labour time. These may be useful, but, like the neoclassical ‘long run’ approach they seem to leave open the immediate question of what’s going on in the economy and what we can do about it.

In my opinion, these approaches both contain some validity, and are not mutually exclusive. I tend to agree with Richard Wolff, who asserts that suggesting one has refuted the other is like saying knives & forks have refuted chopsticks. Both are useful; neither are all-encompassing theories. I also believe both are compatible, to some degree, with my favoured approach:

The ‘Reproduction and Surplus’ Theory

This approach is the one emphasised by Sraffians and Classical Economists. It starts from the basic observation that society must reproduce itself to survive, and that generally society manages this, plus a surplus. The reproductive approach emphasises what I believe to be an important aspect of capitalism, and perhaps all systems: the collective nature of production. Industries are interdependent; people work in teams; various institutions, often state-backed or provided, underlie all of this. Hence, no special moral status is accorded to prices or the allocation of surplus, except that prices must be appropriate for the continued existence of industries and society as a whole.

On first inspection the ‘insight’ that society must reproduce itself might be considered trivial, but following through its implications can yield interesting and useful conclusions. The framework can be used to determine prices technically, independently of either preferences or values. It emphasises the interdependent nature of the economy: if one industry or input fails, it has severe knock on effects. For this reason, it would do a great job of explaining both the oil shocks and resultant stagflation of the 1970s and the 2008 financial crisis, something modern macroeconomics cannot manage.

On top of this, the model is versatile: it can interact with its institutional environment, which determines key variables exogenously (e.g. the monetary system determines interest rates, political power determines distribution). The classical approach is, for example, compatible with class theories of income distribution, post-Keynesian theories of endogenous money and mark-up pricing, and even neoclassical utility maximising individuals! Probably the most promising and complete framework out of them all – I look forward to further developments of this approach.

It is feasible that the task of finding a watershed moment is not possible in the fuzzy world of social sciences. Psychology and sociology are both characterised by competing approaches; psychology in particular has improved since the neoclassicals Freudians were dethroned. If neoclassical economics has taught us nothing else, it’s the importance of not being trapped by particular theories for want of elegance, which is why there is a lot to commend in the institutional school of economics.

Nevertheless, I think there is scope for exploring unifying principles. Progress in neurology may provide such a foundation for psychology; similarly, ideas such as societal reproduction could equally be applied to sociological concepts such as the role of beliefs, class, sports or what have you. As far as economics goes, such a substantial step forward could be what’s required to displace neoclassical economics, whose staying power, in my opinion, cannot be accorded to either its empirical relevance or its internal consistency. Perhaps neoclassical economics persists simply because its building blocks are so well defined that other approaches seem too incomplete to offer their opponents sure footing.

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What on Earth is Utility, Anyway?

In mainstream economic models, consumer’s behaviour is generally assumed to follow a ‘utility function.‘ Consumers derive utility (creatively measured in ‘utils’) from whatever they consume, and they will attempt to maximise this subject to their budget constraint – and, perhaps, at a later level, some extra terms to incorporate behavioural quirks, social pressure or what have you. Unfortunately, even with modifications, the concept of utility is an explanation of behaviour that is questionable at best.

The first conundrum – as posed in the title of this post – is exactly what form utility takes. Is it supposed to be some sort of cumulative attribute that people collect as they go through life, like a stat on a video game? Or is it a temporary sensation experienced after consumption, so that economic agents are effectively utility junkies, chasing around temporary highs? There may be a case for regarding anyone who truly maximised utility as clinically insane and in need of help. In any case, thoughtlessly following predetermined utility functions leaves neoclassical agents with no real room for ‘choice’ – we know what their behaviour will be in advance, and it is unchangeable.

There is also the problem of fungibility: is it fair to suggest that joining a gym gives someone the same kind of satisfaction as eating a donut? Or that eating a donut gives the same feeling as owning a car? These nuances are lost in the aggregated world of ‘utils,’ a unit which has no relation to anything else and hence is hard to verify – at its worst, utility is simply circular: only measurable by the same behaviour it supposedly explains.

Economists have a standard response to contentions that utility is unrealistic. They will assert that, even though utility doesn’t really ‘exist’ – a position few would endorse, surely – it still follows that if preferences follow economist’s axioms, then an effective utility function can be derived. That is: utility is not meant to be taken literary, but economist’s assumptions are sufficient to ensure a relationship between preferences that is functionally the same thing. So it would appear the only way out for opponents of utility is to critique the axioms. I don’t believe this is true, but the axioms are worth critiquing before I explain why.

The two most important axioms required to derive a basic utility function are completeness and transitivity. There are other axioms that are also commonly used – independence, non-satiationconvexity – which are all vulnerable to criticisms, but since they pertain to the the exact form of a utility function, rather than the concept as a whole, I will focus only on completeness and transitivity. Without these, there is no utility function, whichever way you paint it.

The first axiom – completeness – is the idea that all relevant decisions can be definitively compared to one another: that is, there is no room for ‘I don’t know.’ There are clear problems with this. Often, it is hard to choose between two options, particularly if one is a bundle of many goods (e.g. two shopping baskets). In fact, as a decision rule this is generally computationally impossible. So people may act based on chance or impulse; they may seek advice or ask someone else to make the decision for them. What’s more, often people find it difficult to evaluate choices even after they’ve made them. Sometimes there is no ‘correct’ choice!

The other axiom, transitivity, implies that people will be consistent in their ordering of preferences. If I prefer A to B, and B to C, I will prefer A to C. It is an important axiom because, even if preferences are complete, a violation of transitivity means that utility functions can basically have any shape and therefore be pretty useless for clear calculations. While I expect numerous behavioural quirks suggest transitivity may be violated under certain circumstances, overall it is a fair axiom – for the individual. However, it has been known for some time that, once we have more than two agents, it becomes impossible to establish a clear, consistent ordering of preferences for the group. This isn’t moving the goalposts: it is highly relevant when we are using representative agents for the entire economy. (This problem also applies to the aforementioned independence axiom).

My most important point, though, is that even if preferences do follow all the axioms, utility is still highly flawed. This is because, like so many neoclassical models, all utility functions give us is a static snapshot of the economy (or individual) at a particular point in time, and there is no room for change. The simple fact that preferences are highly volatile and will be different in the morning and the evening, or in summer and winter, is enough to render utility useless for practical questions about the economy, which must surely incorporate time. Similarly, preference reversal has shown that the way options are presented has a large impact on the choice made by somebody, suggesting again that underlying ‘preferences’ are highly subject to change, and not really useful for the practical purpose of predicting behaviour. One can only wonder how utility might deal with a theory such as multiple selves, which would surely create the aforementioned aggregation problems for preferences, but for one person!

Now, I can almost hear the cries of “ah, but what is your alternative?” Actually, that doesn’t matter for the immediate critique. If I have a map of London Underground and I’m in New York, I’m not going to use it (even less so if I have a map of a fantasy land that exists only in the minds of economists). To push the analogy a little further, it is worth asking what I would do in this situation. I can think of two possibilities: either ask for help, or follow some simple rules of thumb based on what knowledge I have. This is the strategy economists should adopt.

In the case of ‘asking for help,’ what I mean is that economists should turn to other social sciences; namely, psychology, which has a far more empirically driven methodology than economics and has numerous explanations of behaviour. Economists truly interested in understanding human behaviour – rather than preserving their favoured assumptions – should collaborate with psychologists to create sound behavioural foundations.

Until then, economists should be content with simple empirically observed rules of thumb and intuitive aggregate relationships (they already do this with the marginal propensity to consume). Objections of ‘but Lucas Critique‘ are special pleading, since preferences are also liable to change with political decisions. In fact, I’d shout ‘Lucas Critique’ right back at economists, and suggest that they spend less time on the impossible task of making their models ‘immune’ to the Lucas Critique, while spending more evaluating the ever-changing relationship between policy and observation. It is better for economists to be vaguely right than precisely wrong.

Out of all the concepts in neoclassical economics, none is more imaginary, absurd and empirically falsified than utility. Economists supposedly follow a methodology of strict positivism, and based on the experimental evidence against utility, there is surely no reason to keep it. Yet for some reason, it doesn’t seem to attract the same level of criticism as other areas of neoclassical economics. Personally, I am puzzled as to why.

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