Wednesday, February 18, 2015

The Utility of Utility (about the methodology of economics)

For those who think that economics is, above all, a method and not a subject matter, the centerpiece of the whole enterprise is utility.  In the canonical set of models, individuals act to maximize their utility, and the purpose of economics is to identify the two-way relationship between factors that impinge on this choice procedure and the choices themselves.  The external environment (institutions, policies, claims on resources, technology, preferences of other agents), combine with the decision-maker’s own preferences to generate a choice, and the choices of all the relevant agents cumulatively alter their shared environment.  This is the program for all standard microeconomics and for microfounded macro.  One convenient feature is that, if you use this approach, the same analysis that provides your positive explanations and predictions does double duty as a normative tool: maximizing utility is why people do things and also the goal to be sought after.

A variant has appeared in the form of behavioral economics.  In this approach, people are ascribed decision rules that vary from utility maximization—some form of “irrationality” due to limited cognitive resources, convenient heuristics, etc.  The predictions cranked out by such models differ from those you get from utility maximization, and the normative task becomes that of devising clever tweaks so that predictably irrational behavior will nevertheless approximate a Pareto superior outcome.

Behavioral economics takes one step away from the utility framework, but remains connected to it.  Utility and its maximization remain the benchmark, and behavioral departures are defined in terms of the U-max requirements that are dropped or altered.  If you step back, however, this continued fealty to utility is rather strange, since utility does not play either a positive or normative role in any school of thought within psychology, which is presumably the academic discipline that tells us most of what we know about human behavior.

In formal terms, this is a problem of external consistency.  Internal consistency is about whether the elements in a model are consistent with one another; you can test this with algebra.  External consistency is about whether these elements are consistent with what is already known by those who work in other domains with other models.  If you devise a heat pump based on a set of assumptions about how its components work, and one of these assumptions violates the Second Law of Thermodynamics, your design might be internally consistent but fail the external consistency test.  That’s the state of economics today: it uses models which, if you accept their maintained assumptions, are internally consistent, but the assumptions are inconsistent with what research outside the discipline has demonstrated.  Or to put it more crudely, if economics is right, psychology is wrong.  Who are you going to believe if the question is about human behavior?

I know what some of you are thinking: this is absurd because economists have accumulated mountains of evidence consistent with utility and utility maximization.  And it’s true.  The problem here is “is consistent with”: the evidence we have for economic behavior is generally consistent with a wide range of assumptions, one of which is utility maximization.  If the price of something goes up people buy less of it.  You could get that outcome from U-max but also from a number of other psychological mechanisms.  When the predictions of U-max come into conflict with what other, more plausible mechanisms tell us, U-max generally performs worse.  That’s why psychologists don’t push U-max as a preferred theory of how people think and act.

That said, there is a valid use for utility, as a heuristic element in thought experiments.  Take game theory, for instance.  The analysis of strategic choice can get very complicated, and it’s helpful to construct models in which players attempt to maximize something we call utility; this helps us figure out the logical processes at work.  That does not mean, however, that we should assume that real human beings in the real world are crunching out expected utility values of their choices, much less that the normative value of a game’s outcome can be assessed on the basis of how much utility participants are getting.  A heuristic device is not a theoretical proposition; it’s just an aid to thought.

The confusion between heuristics and theory runs deep in economics, I’m afraid.  It’s difficult to find an article with even a smidgen of theoretical content that doesn't treat utility as if it were an actual psychic quantity whose pursuit motivates actual human decision-making.  This is as much a problem on the micro side as the macro, and it’s hard to imagine how this can change any time soon.  My only piece of advice is to stop thinking of economics as a normative enterprise at all, since nothing in their training prepares economists to have a special insight into what makes people better or worse off.  Wealthier, yes; better off, no.  If you can do that, you will at least abandon one of the main purposes behind unreflected utility-speak.

7 comments:

Sandwichman said...

"My only piece of advice is to stop thinking of economics as a normative enterprise at all, since nothing in their training prepares economists to have a special insight into what makes people better or worse off."

I.M.D. Little tackled this canard 66 years ago. It's ALL normative, covertly done with words that have "persuasive definitions." In other words bad faith "scientific" economics. If one should "stop thinking of economics as a normative enterprise" this leaves nothing left to think of.

Jim Harrison said...

A very large segment of actual economies is devoted to shaping peoples preferences. That's what cops, advertisers, and shrinks do for a living. It isn't just the available choices that constrain our behavior: as cultural animals, our desires are also constructed and manipulated. If your model of the economy is sufficiently short term, you may get useful results by assuming that preferences are givens; but that fiction quickly breaks down and you end up appealing to animal spirits or some other form of hand waving to explain change.

hcg said...

The quickest way to silence the doubters about utility maximization is to ask them if when they make decisions they try to do the best they can under the circumstances. Anyone who answers "yes" then is a utility maximizer.

And a "yes" answer means that they are necessarily concerned with their welfare, so the aggregation of individual welfares is a logical and unavoidable next step.

Jim Harrison says "A very large segment of actual economies is devoted to shaping peoples preferences."

Really? Do the best of my knowledge no one knows how preferences are formed. What marketers do is try to shape choices, and they do so of course relying heavily on psychology.

Sandwichman said...

"the aggregation of individual welfares is a logical and unavoidable next step"

"Logical" only if you ignore the measurement problem. How do you measure utility? How do you aggregate something you cannot measure? Yes, "logical" can be used as an adjective with a persuasive definition. But it has a more precise meaning in the philosophical tradition.

Sandwichman said...

Oh, and don't go "measuring" utility in dollars. Paul Samuelson correctly pointed out long ago that this would be committing the "same yardstick" fallacy.

Sandwichman said...

"there is a valid use for utility, as a heuristic element in thought experiments"

If I may sprinkle some rain on this metaphorical parade, what's the control group in a thought experiment? Oh, right, it's just a metaphor. There's no control group because there is no literal thought "experiment".

Unlearningecon said...

There are a lot of non sequiturs in hcg's post.

"The quickest way to silence the doubters about utility maximization is to ask them if when they make decisions they try to do the best they can under the circumstances. Anyone who answers "yes" then is a utility maximizer."

There are a few words/phrases doing a lot of work in this sentence. The first is 'try': utility maximisation doesn't say people 'try' to do their best; it says they manage it, in that they purchase their most preferred commodity. People may try and fail in the real world due to error, regret, unclear preferences etc.

The second word doing a lot of work is 'decision'. Utility maximisation is only concerned with one consumer purchasing simple commodities with fixed prices and under a number of other assumptions yada yada, rather than all decisions. There are numerous other decisions which do not readily fit this criteria: the aforementioned game theory is one, something like which class to choose at university may be another, or which surgery to have.

The third part which does a lot of work is 'under the circumstances'. Formally, utility maximisation assumes people have complete knowledge of all commodities available to them, can get to them, have fully considered which one they prefer ecetera. In reality, 'under the circumstances' might mean in a rush, unaware of the existence of a better clothes store down the road, stressed, desperate or what have you.

Now, you might want to reformulate 'utility maximisation' loosely, as you did above, to basically mean 'whatever people do'. But this just collapses it into a tautology which bears no resemblance to actual economic theory.

"Really? Do the best of my knowledge no one knows how preferences are formed. What marketers do is try to shape choices"

Yes, preferences are unobservable. In fact, they are just something posited by economic theory, which may not be so well-defined in the real world. This is why economic theory uses revealed preference to assume preferences can be inferred from choices. In other words, economic theory says that marketers changing choices is equivalent to them changing preferences.

You may want to disagree with economic theory, but in actuality squabbling over 'preferences' or 'choices' is irrelevant: the point is that it's clear marketers have an impact on peoples' economic decisions.

And Peter, you do not need to invoke utility in game theory. You can simply label the outcomes 'payoffs'!

PS Peter/anyone from Econospeak: on my browser your list of blogs is vibrating very fast. Is this supposed to be happening? And is anyone else reading having this problem?