neoclassical economics

Profit maximization

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I read today David Colander’s article How to Market the Market: The Trouble with Profit Maximization and Aswath Damodaran‘s response in the most recent issue of the Eastern Economic Journal. By coincidence we’re also talking producer theory in my economics 101 class right now, so the timing is good. I favor Colander.

As the 101 story goes, profit maximization plus the assumptions of the perfectly competitive model generate maximal efficiency in the hypothetical economy. The Colander article establishes the historical context, entwined with the formal mathematical turn in economic theory and the methodological-ideological mashup of “free market” economics circa Friedman.

My feelings on the use and abuse of “efficiency” as a concept are well established. On top of this we have the evidence that learning about profit maximization induces students of economics and business to answer moral dilemmas involving hypothetical businesses differently than other people.

Something that bugs me is that I feel like “business” gets a pass on things that would never fly in other walks of life. I mean, sure United Airlines gets a justified backlash when a passenger is violently concussed on one of their flights, but the subtext is “well, yeah, they’re trying to make money.” Albert Burnenko was on to this at Deadspin after the United incident. The motives of the corporation are taken for granted to be inhuman.

In politics, behavior that would sink a typical politician a hundred times over rolls off the back of an “outsider” candidate from “the world of business”.

I struggle to think of examples from books, movies, or television in which firms, business, corporations—whatever you want to call them—are the good guys. Instead if you’re consuming the culture you’re getting a creeping collective paranoia about the callousness of the profit motive. This is what Angela Allan is getting at in this Atlantic article that I continue to assign regularly. I realize that the people who create art may have a particular perspective distinct from the average businessperson or person-on-the-street, but if culture creates and reflects itself then corporations are not the heroes of this story.

Damodaran concludes his response like so:

Implicit in that statement is the presumption that talking about private businesses making profits makes people feel queasy, a presumption which may be justified in the rarefied air of some parts of Vermont but it is not true in the rest of the world!

I don’t agree with this at all. Every semester I try to have my students think about what connotations they and their peers are carrying about “business”, “corporations”, “profit”. The connotations of “big business” are not positive. Economics is infected by association, and I know what the average person thinks of economists.

Or, more nuanced, the idea that a corporation is a callous automaton that is supposed to do whatever it can get away with to make as much profit as possible is so baked in that it doesn’t even seem like a bad thing anymore.”Of course” businesses are supposed to try to make as much money as possible, right?

On the other hand, Damodaran is quite right that there is nothing new in human suspicion of the pursuit of wealth just because economists came to adopt profit maximization into the canonical texts. It’s just another one of those aspects of our methodology that gives us a pedagogical PR problem.

I find profit maximization a lot riskier and more nefarious in econ 101 than utility maximization. It’s too real. It’s tricky enough to tease out the technical meaning of rational choice and preferences to sell utility maximization properly, but this ultimately lets profit maximization off very lightly since it doesn’t require the same technical ramping up. It just feels too obvious, and so I find myself having to work twice as hard to give it the interrogation it deserves. There’s no getting around either of them if you want to teach general equilibrium and the welfare theorems, and of course we do. I worry about the proportionality.

I also find it interesting the advent of behavioral economics has mobilized so much energy beating up on utility maximization, and the 20th century debates on profit maximization that Colander describes have given way to consensus. I think this is way out of proportion with the funkiness of the concepts. Utility maximization is abstract and flexible in way that profit maximization just is not. Profit is a real thing in the real world, very close to the model version of profit in its definition and spirit. Utility is not. Maybe we could pick the straw man of homo economicus up from under the bus, since I for one am much more relaxed about selling rationality than I am about selling profit maximization.

Methodology, ideology

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From Tim Barker’s review of Johanna Bockman’s Markets in the Name of Socialism:
The Left-Wing Origins of Neoliberalism, which is currently waiting in my to-read line:

Her real focus is the relationship between socialist politics and neoclassical economics. As her intellectual and political history deftly illustrates, there is no inherent affinity between neoclassical theory, market institutions, and capitalism. (Here she offers a corrective to Marxists like Harvey, whose key text on neoliberalism conflates it with neoclassical economics.) The pioneers of neoclassical economics recognized the relevance of socialism to their project and assumed that one scientific vocabulary could therefore apply to socialism and capitalism.

The conflation of an ideology with the pervasive methodology of economic theory is a disheartening one. It bleeds into the quandaries of teaching introductory economics, into the otherwise valuable methodological critiques and innovations within economics, the characterization of economists as evil.

I submit that (i) we have two words that are slippery to define and both start with “neo-“, and (ii) “economics” is sometimes taken to connote “business” and soulless bean-counting, and so we are stuck with a misconception that I very much wish we could shake.

This conflation is not acceptable to me and I don’t see any easy way to battle it. I do think it argues in favor of an unapologetically wonky Econ 101 that explicitly includes more fundamental methodology, whatever the cost. We must teach our methodology properly if we want it to be interpreted properly.

Experimental philosophy, experimental economics

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Interesting article at Prospect Magazine called Philosophy’s Great Experiment, about the rise of ‘experimental philosophy’. Doubly interesting to me, because it could equally well be talking about experimental economics, albeit a few years too late. Or about “neuroeconomics“; the philosophers in the article are using fMRI machines “to look for patterns of neuronal activity when subjects are presented with philosophical problems”, just like the researcher who does the same for resource allocation – economics – problems. But here’s the rub:

Some philosophers quietly dismiss the movement as a cynical step by researchers to appear cutting edge and to tap into scientists’ funding.

Indeed, it’s easy to feel this way about the kind of experiments in which economists step on psychologists’ toes. The drive toward empiricism in philosophy that the article talks about seems to be symptomatic of social sciences’ and humanities’ desire to be taken “seriously” as science.
And as we know, that means we need something falsifiable or verifiable. “There is no article in Prospect Magazine called Philosophy’s Great Experiment” is falsifiable, because I can find such an article and falsify the statement. “There is at least one article in Prospect Magazine called Philosophy’s Great Experiment” is verifiable, because I can find such an article and verify the statement. 
In experimental economics, often it seems (at least to this observer) that we’re replicating, or at least mirroring, psychology experiments. Unfortunately, the economics experiment is much less likely to be “scientific”, not because of the method or the issue at hand, but because of the specific question. This is precisely what Lawrence Boland discusses in the paper “On the futility of criticizing the neoclassical maximization hypothesis” (pdf), which I read as a welcome withering put-down to all of those who claim to “disprove rationality“, etc etc. He says:
Properly stated, the neoclassical premise is: ‘For all decision makers there is something they maximize’… The person who assumed the premise is true can respond: ‘You claim you have found a consumer who is not a maximizer but how do you know there is not something which he is maximizing?’

For experimental economists and experimental philosophers alike, the challenge is to pose a scientific question; without that, no method will save us. “Are people ethical?”, for example, is equally a dead end as “are people rational?”. 

Happiness and behavioral stuff again

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Via Arts & Letters Daily (again) comes a wonderful (and long) article by Alan Wolfe for the New Republic: “Hedonic Man, The new economics and the pursuit of happiness.” There’s far, far too much for me to discuss in suitable depth here, but, beyond recommending the article, let me pick out a couple of choice bits.

I wholeheartedly agree with Wolfe when he says:

“The social sciences are not just empirical; they are normative, too. It was precisely the insistent normative preference for market-based social arrangements that turned me against Chicago School economics. Governmental regulation is always sub-optimal, they inevitably maintained. Individual freedom is worth more than social equality. If market logic works for firms, surely it can work for recruiting an army, fighting poverty, or providing kidneys. Non-Chicago economists were subtler about these matters, and at times questioned the reliance on markets; but for the many sons and daughters of Milton Friedman, we are hard-wired to be rational choosers, and any efforts we make to direct the course of our actions collectively are bound to fail. Myself, I do not believe that any of these propositions bring us closer to a good society. Other people feel differently. Democracy requires that we argue out our differences. But democratic debate is not well served by pretending that the empirical findings of a single controversial approach in a single academic discipline contain definitive answers to these questions.”

The presentation of economics as a discipline of study certainly does make it seem like we’ve magically cracked the nut of what is the ‘best’ way to organize a society, and, as I’ve argued before, that’s not just dangerous, it’s a misrepresentation of what good economic science is capable of. One reason why it’s a misrepresentation is the measurement issue at work again: to say ‘best’, we need a metric, and to do that we need to ask what people want, to speculate on their motivations and desires. Of course, as misrepresentations go, it’s a tempting one, because from day one of a Principles of Economics course it’s made again and again and again.

Wolfe’s article is built around the review of two books: Predictably Irrational by Dan Ariely (which I’ve talked about before, much to the author’s chagrin, so I won’t return to it now) and Happiness: A Revolution in Economics by Bruno Frey. ‘Happiness’, as discussed by Wolfe, is concerned with exactly that big question in normative social science, which is: what exactly constitutes a ‘good’ outcome? It’s exactly that question that’s the dangerous misunderstanding within economics, the dangerous belief that we know what’s ‘good’.

Wolfe talks at length about Daniel Kahneman and Amos Tversky, the pioneers of what has become ‘behavioral economics’, and I admit that I share Richard Thaler’s reaction, as reported by Wolfe:

“When I read this paper,” [Thaler] wrote of Kahneman and Tversky’s classic article “Judgment Under Uncertainty,” which appeared in 1974, “I could hardly contain myself.”

He talks further about the supposed ‘revolution’ in economics to account for the kind of behavior documented by Kahneman and Tversky and the whole slew of experiments run by economists since:

“One has to wonder why the revolution in economics failed so badly even before it really got off the ground. Neoclassical economics may in some ways be preferable to what the revolutionaries offer, but it remains a vulnerable approach, stuck in unrealistic assumptions about human behavior and all too complacent about the beneficial equilibria established by markets. Nor can one deny the ingeniousness of the early days of economic psychology, especially the inventive puzzles that Kahneman and Tversky devised. If ever a field were ripe for revolution, it is economics. Yet if these two books are any indication, supply and demand, marginal utility, rational choice, and cost-benefit analysis are not going away. At best, economists will tweak their models a bit to account for some of our odder calculations. More likely, they will simply reiterate their belief that we need not examine the internal mechanisms of utility satisfaction because the price someone is willing to pay for something is really all we need to know.”

Again, though, I offer this as the reason why the ‘revolution’ has ‘failed’: we simply can never say what motivates people, whether a person is “rational” or not. ‘Neoclassical economics’ does not restrict the range of assumptions one can make about human behavior. It is therefore completely resilient to any evidence on how people act in a given situation. That’s not a defense of the approach, it’s a fact. It’s distressing, because my prejudice is definitely to agree that economics is ‘complacent’ about the superiority of markets (again, because we ignore the variety of normative metrics of comparison), and that there’s too much arcana.

We need true normative debate. Look again at what Wolfe says about economics: “it remains a vulnerable approach, stuck in unrealistic assumptions about human behavior and all too complacent about the beneficial equilibria established by markets”. It’s a mistake to conflate this problem – the arrogant assumption that we know what’s ‘best’ – with the neoclassical assumptions on human behavior, because, as I’ve argued repeatedly, the method of scientific economics doesn’t actually assume anything about human behavior, as evidenced by the fact that the ‘behavioral revolution’ is comfortably within the confines of ‘neoclassical economics’.

The real revolution would be quieter, and would say something much more familiar: keep your science separate from your opinion.

Searching for a schism

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Word reaches my desk this afternoon of an interesting-looking new book on the horizon, called “The Foundations of Positive and Normative Economics“, an essay collection edited by Andrew Caplin (of the monkey brains) and Andrew Schotter. Details are a bit sketchy, but the idea is just fine with me. I have a high tolerance for this kind of thing, and hopefully it lives up to my expectations.

On that note, I hope for something a bit different to the endorsement quotes on the book’s rather empty webpage:

“Are you puzzled by the implications of behavioral economics? Are we in the throes of a paradigm shift? Is neoclassical economics refuted? Economic methodology has never been more disputed. If you want to be part of the debate, this book is the place to start.”–Ken Binmore, University College London

I still don’t see this distinction between ‘behavioral economics’ and ‘neoclassical economics’, to be honest (see here, for example). Why is a different model of people an abandonment of neoclassical economics? ‘People maximize stuff’ is my minimalist description of neoclassical economics, and the behavioral set is just trying to figure out what the stuff is. Again (again, again), since it’s not possible to test rationality, the ‘maximize’ bit just has to float out there unattached.

I don’t really get this one either:

“Should economics take account of neuro-physiological data? Can subjective states of mind play a useful role in economic analysis? These and other provocative questions are examined and debated in this fascinating volume of essays from some of the deepest thinkers in contemporary economics.”–Eric Maskin, Nobel Laureate in Economics, Institute for Advanced Study

Maybe I’m behind the curve on this one, but I’m not sure what that really means. It gives the impression that this book might be predominantly concerned with the implications of psychological and neurological research, but to me all that is really something different from the epistemological question of what positive and normative economics are doing for us, where they came from and where they’re going. The state-of-the-art in economic theory or modeling is one thing, but I hope the book tackles the big questions rather than obsessing about the value of behavioral evidence.

I disagree fundamentally that “economic methodology has never been more disputed”, hence the futility of chipping away at the tiny and ultimately boring debates at the root of modern research. The assumptions, the beliefs can surely differ, but I think the approach is set on some fundamental level. Superficial differences in approach do not go down very far: yes, a ‘behavioral economist’ might be searching for realism by figuring out how people act, and an ’empirical economist’ is running regressions on cleverly constructed data, a ‘theorist’ is off in the land of abstraction and algebra, but all are operating on the same field of positive economic science. The real question is how we got to be that way, not why some economists do one thing and some another. That’s the question of the foundations of positive and normative economics.

Heterodox economists

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A couple of months ago, seemingly every book review section in every newspaper or magazine carried a review of “How To Talk About Books You Haven’t Read” (here’s an example). How is a literary critic supposed to resist reviewing a title like that?

I have here a book called “A Guide To What’s Wrong With Economics“; how am I supposed to resist looking at a book like that? More to the point, I haven’t actually read it properly yet, but just by browsing I know what it’ll say, because it’s actually a (very thorough) critique of that thing called “neoclassical economics“, which is familiar but important stuff, even if my guide would be a bit different. Economists who write these kind of books are, by the way, called “heterodox economists”, though perhaps not by themselves.

There are lots of promising chapter titles, anyway: “The Pitfalls of Mainstream Economic Reasoning (and Teaching)”, “Five Pieces of Advice for Students Studying Microeconomics”… there’s a whole section called “Micro Nonsense”! I feel compelled to share this brilliant quotation:

“Because there is no direct access to the ‘real’ world, an economist is forced to see that world through the lenses of theory.”

Either I’m living in a complicated dream, or we do actually have access to the real world… I see what the author (Charles Wilber, in the chapter “Teaching Economics as if Ethics Mattered”) is getting at, though. It’s a theme that keeps cropping up throughout the book, one that seems to be raised again and again, something like “there is not enough diversity in economics teaching and practice”. I think Wilber might be saying that the economist is forced to see the world through the lenses of a particular theory that he, and the heterodox economists, dislike.

Superficially, I agree, if by that we mean that too often differences of opinion are suppressed in the profession, when in fact positive economics is logically incapable of doing so. However, the criticisms being raised again and again in the book are that “neoclassical economics” is taught as a loaded dogma, which is terrible, but not the same thing. The method of economics, whatever you think of it, can accommodate anything, any theory. Not just that, but exactly the same “anything” could happily be accommodated in any other method.

Would the authors be happy if we taught our methods on a blank slate, or would they demand that their own particular views were put on the academic pedestal? This must not degenerate into an arms race: the method is the language, not the meaning. I am suspicious that the “heterodox” economists want to change the language only to change the meaning. Please: there is no substance in a method, a language.

Actual theories are invoked incessantly, through all chapters: the usual suspects, like perfect competition, “rationality”, equilibrium… what’s “wrong” with economics, according to these essays, is that these theories are presented as “true”. Now, of course, a proved theory cannot be false under its own conditions; by “true” we really mean “does not conform to the real world, either in assumption or prediction”. That’s something I can buy into, and that is, perhaps, the valid, practical version of the criticism.

It’s twofold: first, using methods to promote a single normative angle is certainly possible, but doesn’t show what the method can do, and in any case is probably bad teaching. Second, it might indeed be nice to bring some more reality into introductory economics courses, not just “applications”. There are certainly valid reasons to construct abstractions, but it might keep people on board if we devote at least some time to economics that conforms to reality – it’s odd that when a student progresses through an economics sequence, the economics she sees often gets less unreal as it gets more esoteric, if that makes sense. We don’t need boring tables of numbers, just show the flexibility of the economic method to deal with the real.

What bothers me about this so-called “heterodox economics” is that it’s attacking the wrong thing. They are not questioning the teaching and practice of economics by digging as far as it’s possible to dig to find the true foundations of what we do, absent any superficial details. Whether it’s right or wrong to try that, it’s fundamentally different to the heterodox method. See the wood for the trees: you don’t have to convince anyone – student, economist, layperson – that economic theory is usually unrealistic. Deep down, though, we’re all playing for the same team, and if we could just figure out what our team was doing, we could have a real competition.

Unreal

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As someone who laments misperceptions of what economists are and do, the barriers to communication with anti-capitalist groups make me very sad indeed. How did I get there? I was looking for something entirely different when I stopped to read an article by Roy Weintraub talking about neoclassical economics. To someone with my beliefs in what economics is, it’s a bit schizophrenic. This is nice:

“Neoclassical economics is what is called a metatheory. That is, it is a set of implicit rules or understandings for constructing satisfactory economic theories. It is a scientific research program that generates economic theories.”

This is pretty good news: the beast called “neoclassical economics” is merely a box inside which we concoct scientific theories: inside our box, this would lead to that. Weintraub continues to say that the assumptions of neoclassical economics

“include the following:

1. People have rational preferences among outcomes. 2. Individuals maximize utility and firms maximize profits. 3. People act independently on the basis of full and relevant information.”

Of these, 1 is redundant to me because I think rationality is not testable and is therefore irrelevant, especially since it’s probably implied by 2, and 3 is at best outdated (economists these days are very interested in the implications of imperfect or asymmetric information). If I was pressed to define neoclassical economics, I think perhaps the definition I would use is similar to 2. I’d say that neoclassical economics is the branch of economics that models entities (individuals, firms, governments, etc) as if they try to get the outcome they like best from the ones that are available.

I disagree more with the stance of the article when Weibtraub repeatedly invokes “the neoclassical vision”. The connotations of this phrase probably reinforce the misconception that economists think the box in which neoclassical economics works obeys the same rules as the real world. I doubt a physicist thinks that a vacuum is the same as the real world, just as I doubt that any economist thinks that the abstractions of economic modeling are the same as the real world.

It’s true that a positive economist who seeks to explore “what is” should not neglect to examine the differences between abstraction and reality, but again we must ask at what point the value of realism is eroded by its inability to draw any conclusions. I think the real choice we’re faced with is the application of the economic method that says “if this unrealistic simplification, then that” versus a shrug of the shoulders; if it were possible to achieve the ideal “if this, then that”, who would reject it? Should we stop trying because we can’t be perfect?

Perhaps partly because of such confusions, “neoclassical economics”, aside from having a silly name, seems to have become something of a lightning rod for the anti-capitalist set as much as it is for economists with different ideas. Google neoclassical economics and you get – on page one – a page from adbusters (an anti-consumerist publication – Wikipedia entry), and a less histrionic “critique of neoclassical economics” by Herb Thompson.

“Neoclassical economists normally treat economic instability as the effect of exogenous, stochastic factors even though nonlinear economics suggests that what may previously have been considered exogenous, or random, may more likely be endogenous to capitalist social formations.”

I confess I’m not sure what “nonlinear economics” means (the almighty Google was inconclusive): clearly I, too, have been indoctrinated to the neoclassical cabal. However, I actually think that the quotation touches on an interesting idea. Can we figure out if the primacy of money as a measurement of outcomes “caused” the rise of the capitalist method of organizing resources, or if the capitalist method “caused” the rise of the primacy of money?

A difficult one. For example, to take a typical example of an anti-capitalist complaint, do people buy sweatshop goods because they don’t know they’re sweatshop goods or because they care more about cheap goods than where they came from? I think the latter is more consistent with “money primacy leads to capitalism” and the former is more consistent with “capitalism leads to money primacy”, although I’m sure that could be debated.

It is possible to imagine that incorrect normatization of positive economics – by which I mean the mistaken assumption that some measurable positive economic variable is a measure of the quality of an outcome – actually causes problems within the economic system. People will do what they will, but if a policymaker chooses a policy based on the primacy of money as a measure of the quality of an outcome, there’s a real possibility that the system itself is influenced by its measurement.

The Thompson article also includes the following excellent paragraph:

“The ‘rational’ consumer of the mainstream economist is a working assumption that was meant to free economists from dependence on psychology…. The dilemma is that the assumption of rationality as intertemporally optimising is often confused with, and regularly presented as, real, purposive behaviour. In fact, the living consumer in historical time routinely makes decisions in undefined contexts. They muddle through, they adapt, they copy, they try what worked in the past, they gamble, they take uncalculated risks, they engage in costly altruistic activities, and regularly make unpredictable, even unexplainable, decisions.”

First of all, this is crucially wrong: “rationality” is not something that can ever be more than an assumption, unless you think you can test it. Further, assuming rationality does not exclude any of the motivations Thompson talks about. It would be trivial to write down a model of a rational person who “engaged in costly altruistic activities” – I simply have the person care about others and optimize rationally. The assumption that Thompson is really discussing here is the straw man of “rationality equals maximizes money”, which I have previously argued is absolutely not an assumption of any economic theory, neoclassical or otherwise.

Beyond that, this is really back to the same problem that the Weibtraub article was getting at: we’re doing the “if this unrealistic simplification, then that”. There’s a strong push in so-called “behavioral economics” to figure out if there’s a workable way to first make realistic generalizations on how people behave and second to incorporate them into the unrealistic simplification of neoclassical economics. While that goes on, the economist who seeks to defend his method must be clear on what his unrealistic simplification actually is and what it is used for.

As usual, no-one is fit to judge if the anti-capitalist model is “better” than the capitalist status quo, but I greatly hope that we would be able to talk about what each would mean. If somehow I were able to convince adbusters to sit down with me and I asked them what they wanted to do and what they wanted to achieve, what might they reply? I don’t know what they would say, but whatever their answer, I would like to figure out what it would take to achieve their goals, what the consequences of their chosen actions would be, what it would mean for people, not just them or me. I hope they would like to figure that out too. That’s positive economics.