Category: Experimental Economics

The Character and Role of Economic Theory

Over the years, much has been written about the methods employed in economic theory. The recent financial crisis and the ongoing economic crisis in Europe have resulted in a marked increase in criticisms directed at mainstream economic theory ‘ neoclassical economics (more precisely, marginalist economics). Internal critics of neoclassical economics have been modifying certain assumptions of marginalist economics and have ‘developed’ new forms of economic knowledge such as law and economics, welfare economics, neuroeconomics, new institutional economics and so on. Critics external to marginalist economics, often known as heterodox economics (examples include Classical/Sraffian economics, Post-Keynesian economics and Marxian economics), have provided compelling logical critiques of the theory. Additionally, they also supplement their analysis with empirical and historical details (which is not uncommon in neoclassical economic either). This post is reflective in nature and tries to comprehend the character of economic theory along with a commentary on its contemporary function in the form of questions, thereby reinforcing the reflective nature of this blog post.

First, the definition adopted has a critical influence on the aims and scope of economic theory. For instance, the definition of economics as a study of reproduction and accumulation of wealth/income (characteristic of the heterodox economic theories mentioned above) is qualitatively different from a definition which views economics as a study of allocating scarce resources among competing ends (characteristic of neoclassical economics). The former definition is more modest in scope and seeks to provide answers to a limited number of questions vis-‘-vis the latter one which encompasses any and every issue where human decisions are involved. Examining the causes of accumulation and growth warrant the following theories: a theory of value and distribution; a theory of activity-levels (at times, this is absent); and a theory of economic growth. While examining the causal connections within these theories, some features of human behaviour are taken as given. The most important, perhaps, is the human propensity for self-betterment in material terms. Such a limited domain enables these economic theories to be more specific and definite thereby improving their explanatory power in the analysis of economic growth, unemployment, technical progress, wage dynamics and so on. An extremely wide scope is entailed by the definition of economics present in neoclassical economics; consequently, we see the emergence of sub-fields such as: cognitive economics, neuroeconomics, economics of philosophy, experimental economics, evolutionary economics, cliometrics, etc. The questions addressed in many of these sub-fields often have nothing to do with the generation of income or its distribution. The questions being asked are different, and quite relevant in understanding various aspects of human behaviour and institutions. However, if the aim of economic policy and economists is to improve material well-being, neoclassical economics and its sub-fields are not entirely satisfactory, primarily for logical reasons. The two most dangerous tenets of marginalist economics are the marginal productivity theory and the tendency to full employment.

Second, economic theory, I think, has two broad functions. One is to explain the logically necessary connections which exist between various economic variables, and the direction of causation. Usage of terms such as exogenous, endogenous, dependent and independent variables convey the direction of causation. For example, classical/Keynesian theory argues that activity levels and economic growth is demand-led whereas marginalist economics posits that activity levels and economic growth is supply-driven. This is a theoretical debate, which cannot be resolved by recourse to empirical data given the high degree of correlation present among (macro)economic variables such as income, investment, saving, etc. Another reason for the debate being unresolved is the incommensurability of the two kinds of economic theory involved ‘ classical/Keynesian vs. marginalism. The other broad function of an economic theory is to provide an explanation for the manner in which these (marco)economic variables grow over time; strictly speaking, the dominant economics influences the way in which data is collected and presented and the explanation for the data is also provided by the dominant economics. (A chief, although not very reliable, exception to this is the econometric technique known as VAR which attempts to undertake ‘measurement without theory’.) Much of these numbers will need to be supplemented with contextual and historical details. Also, in economics, one needs to be careful about assigning too much ‘reliability’ to data so much so that they are considered ‘adequate’ to overturn a particular economic theory. This is not to say that data does not matter, but that it should be treated with significant caution.

Third and finally, it is of great practical importance to know what economic policies can be advanced based on economic theory, supplemented by data or not. In other words, what conditions must a particular theory fulfil in order for it to be reliable’ Is an empirical assessment necessary or is it sufficient’ How sound must the logic be’ To what extent must the assumptions be scrutinised’ Can econometric analysis provide conclusive evidence’

Utility in Microeconomics: Outdated’

This post clarifies the concept of a utility function, which occupies a very significant position in neoclassical microeconomics. Advances in neuroeconomics and related fields of behavioural economics is constantly challenging the conventional assumptions of microeconomics. This post takes up one such insight by Stephen B Hanauer which was published in Nature in March 2008.

A utility function can be understood in the following way:

U=f(x,y,z) where U is the utility derived from the consumption of x, y and/or z. Alternatively, a utility function transforms combinations of various goods into a single value. Note that x,y and z refer to ‘quantities’ of goods/services consumed.

Suppose, consumer A has the following utility function: U=x+y+z; arbitrary values of x,y and z would result in the following values of U.

x y z U
0 0 0 0
1 0 0 1
10 10 0 20
6 6 8 20
0 10 10 20
10 10 10 30

That is, microeconomics teaches us that the utility of the consumer is determined by the quantity of goods consumed. An common assumption is that ‘more is better’, which implies that the consumption of more goods gives the consumer more utility. The point to be noted is that microeconomic theory teaches us that utility is strictly a function of quantities. The question posed in this post is whether utility is ‘only’ a function of quantities. What happens if utility is also a function of prices’ At this juncture, we need to recollect the objective of utility functions. From the utility function, we derive indifference curves and marginal utilities. Utility or use value of the good or service forms the basis of the demand function, which along with the supply function determines the value/price of a commodity or service. Thus, the use value was employed so as to arrive at the exchange value/relative price of the commodity.

What happens if utility (or experienced pleasantness) is influenced by ‘changing properties of commodities, such as prices” That is, can neoclassical microeconomics accomodate the following utility function:

U=f(x,y,Px,Py)

And research in behavioural economics and related areas suggest that prices exert a significant influence on utility and hence on choice and demand. However, if we accept such a utility function, it can no longer be used to explain exchange values/relative prices. Another implication is that prices are no longer determined by the interaction of demand and supply. And the statement that ‘consumer is the king’ no longer holds. Also, producers can adjust prices in such a way as to affect consumers’ utilities. We know that high prices are often associated with better quality and hence higher utility.

x y Px Py U
0 0 10 10 0
10 10 10 10 200
10 10 5 10 150
10 10 4 4 80

The above table can be explained by the following utility function: U=x.Px + y.Py

In this case, a higher price gives more utility to the individual. The maximum utility is when x=y=10 and Px=Py=10.

The other extreme case is when high prices are detested by the individual. For instance, consumers with low incomes will get more utility from consuming goods which are priced less. Their utility function could be represented as follows: U=x.-Px + y.-Py

In which case, the consumers utilities based on the previous values of x,y,Px and Py will be 0, -200, -150 and -80. And the consumer’s utility is maximum when he/she consumes x=y=10 when Px=Py=4.

Empirical evidence suggests that utility is equally influenced by prices of commodities as well. Does this threaten the core of neoclassical microeconomics’ This is problematic because neoclassical economics assumes the following to be given: 1) tastes and preferences of individuals, 2) endowments of goods and 3) constant technology. It if from these ‘givens’ that prices and quantities (demanded and supplied) are arrived at through the mechanism of demand and supply/competition/market forces. How can we include the recent findings pertaining to consumer utility and satisfaction in a consistent manner’

‘Update

The link to the reference was embedded in the authors name. However, because of the comment by Dr. Thomas Alexander, the reference is prrovided below. Also,I acknowledge him for bringing this article to my notice.

Hanauer, S (2008), ‘Experienced Pleasantness,’ Editorial, Nature Reviews Gastroenterology and Hepatology 5, 119 (1 March 2008).

Experimental Economics: What Does it Offer’

The research output of experimental economics has been showing a marked increase in the recent past. This post provides a few insights regarding the works of the experimental economists. As Shyam Sunder writes, there are three streams within experimental economics: (1) macro stream to examine the properties of social structures, (2) micro stream to examine the behavior of individuals, and (3) agent stream to explore the links between the micro and macro phenomena using computer simulations.[Sunder 2007] At the first look, experimental economics seems capable of handling the micro stream as well as the agent stream.

The following image shows how laboratory data is presented for a double auction. (Retrieved from http://veconlab.econ.virginia.edu/htm_small/da_06_small.png )
An Illustration

It is believed that Edward Chamberlin conducted the first experiment in economics. Chamberlin examined market conditions in his classroom in a controlled atmosphere, whose results deviated from the prevalent Walrasian conclusions. The rationale of experimental economics is that theory/models suggest general tendencies among the variables of interest. The strength of the general tendency is not provided by theory. In other words, theory cannot tell us about its explanatory power. This is where experimental economics makes its contribution. Also, this is the reason why one carries out field surveys and why econometricians look for a high R-square.

Initially, experimental economics seemed to be aping the sciences to a large extent. However, after reading Sunder’s account, I am begining to get convinced about its potential in understanding aggregate economic behaviour. Sunder wonders how we can study social beings by completely negating free will ‘ that is, by treating it as a science. The other option is to highlight the heterogeneity of human behaviour and refuse to come up with general tendencies. As he writes:

‘Hence we see the dilemma of social sciences. Do we abandon free will, personal responsibility, and special human identity; and treat humans like other objects of science’ That is, drop the ‘social’ qualifier, and become a plain
vanilla science’ Or, do we drop the ‘science,’ abandon the search for universal laws, embrace human free will and unending variation of behavior, and join the humanities’ Either way, there will be no social science left. Is there a place where we can keep the ‘social’ and the ‘science’ together”

Advances in computer technology assists economists working on aggregate economic variables. This is done by conducting computer simulations. The model can be taken from any theory ‘ Marxian, Walrasian, Ricardian, Keynesian, etc ‘ and specific behavioural rules can be assigned so as to arrive at some conclusions. But what is to be remembered is that, these computer simulations are tools which assist the policy maker and are not substitutes for theory. It must be noted that when assigning behavioural restrictions, we are negating the free will of the individual economic agents. As economists, we are used to making such an assumption ‘ utility maximization, bounded rationality, tit-for-tat strategy, satisficing, reciprocative behaviour are all aspects of an individual’s behaviour.

To conclude, experimental economics offers economics the following benefits. Firstly, it provides data for verifying/falsifying a particular hypothesis. Secondly, through computer simulations, aggregate economic behaviour can be replicated to a limited extent. And lastly, experimental economics provides a strong flavour of science to economics.

Reference

Sunder, Shyam (2007) ‘Determinants of economic interaction: behavior or structure’, Journal of Economic Interaction and Coordination.