Where Economics Runs Off the Rails

Traditionally economics is taught as the allocation of scarce resources based on a tradeoff between cost and utility. You pay more for things you need. A market is a struggle between supply and demand where supply springs forth as price goes up and demand goes down as customers with a high utility are supplied and leave the market to those for which the resource has less utility.

But there is something funny about "utility" in economics. Water is essential to life but diamonds are generally worthless except as status symbols. We pay little for water but large amounts for diamonds.

But even the idea of utility is odd. Economists develop a funny stories about marginal utility, the fact that the value of something to you declines as you get more. The marginal value is what we would pay for the next little bit. The marginal utility of water collapses quickly as our thirst is sated, but our desire for diamonds actually goes up as others demand more since diamonds are a "luxury good" whose value is in it status, specifically in the demand by others, its "utility". It's utility seems to go up with demand and not down!

Here's a very nice conundrum for economists. The behavioural economist Dan Ariely points out a case where a locksmith is not paid purely for utility delivered. Instead he is paid by a complicated relationship between utility and "fairness" (as realized by effort put into a task)...



This comes from Dan Ariely's web site.

This bit from a Scientific American article by Michael Shermer shows that "fairness" plays a very deep role in our willingness to cooperate, and a market is the epitome of cooperation:

In studies with both chimpanzees and capuchin monkeys, the Emory University primatologists Frans deWaal and Sarah Brosnan found that when two individuals work together on a task for which only one is rewarded with a desired food, if the reward recipient does not share that food with his task partner, the partner will refuse to participate in future tasks and expresses emotions that are clearly meant to convey displeasure at the injustice. In another experiment in which two capuchin monkeys were trained to exchange a granite stone for a cucumber slice, they made the trade 95 percent of the time. But if one monkey received a grape instead — a delicacy capuchins greatly prefer over cucumbers — the other monkey cooperated only 60 percent of the time, sometimes even refusing the cucumber slice altogether. In a third condition in which one monkey received a grape without even having to swap a granite stone for it, the other monkey cooperated only 20 percent of the time, and in several instances became so outraged at the inequity of the outcome that they heaved the cucumber slice back at the human experimenters!

Such results suggest that all primates, including us, evolved a sense of justice, a moral emotion that signals to the individual that an exchange was fair or unfair. Fairness evolved as a stable strategy for maintaining social harmony in our ancestors’ small bands, where cooperation was reinforced and became the rule while freeloading was punished and became the exception. Apparently irrational economic choices today — such as turning down a free $10 with a sense of righteous injustice — were at one time rational when seen through the lens of evolution.

Go read the whole article to get details about the Ultimatum Game. This is the clearest device to demonstrate that humans are not 'homo economicus', i.e. a purely calculating beast focused only on utility.

Sadly, the current financial crisis and the behaviour of the Wall Street bankers (and hedge fund managers) demonstrates that these people are not truly human. They've imbibed too much economics and/or are born sociopaths without empathy. They believe the "earned" their billions through manipulating the market and crashing the economy and putting 9 million people out of work and causing millions of houses to be foreclosed.

Universities need to kill homo economicus and re-write the economics courses with a lot more input from behaviour economics. This is the economics of real humans bound up in social relations. Not the cold, calculating, sociopathic mind of the classical economics model of a "market participant".