Off the Ten Pillars of Economic Wisdom - A Discussion On the Link Between Economics and Pyschology

I was asked by widgetfox for my views on The Ten Pillars of Economic Wisdom by David Henderson.

I broadly agree with them. Not as the absolute Truth of Economics, but as a handy guide for students. More anon.

A conversation developed on twitter between widgetfox, andrewducker and myself which we all agreed would not suit twitters 140 character format. I offered to set up a conversation on LJ. Here is it. I’m starting by recapping the position so far. In the interests of cohesion I’ve expanded my own original points a little. If I’ve misrepresented any of the contributions from WidgetFox or Andrew Ducker, then I’d welcome their correction.

To my broad agreement with the Ten Pillars I offered my opinion that one should remember that macro-economics sits on a foundation of human psychology and that you should be able to build up to macro-economic principles from the psychology of individuals and you should be able to work down from macro-economic principles to the psychology of individuals.  I’d go further, if you can’t root your macro or micro-economics in human psychology then you’d better start work on the economics again.  I think my favourite example of this is Modigliani and Millers Nobel Prize winning statement of the bleeding obvious in relation to the Weighted Average Cost of Capital.

WidgetFox disagreed (1).  She suggested that 1) (a) humans are distinct from each other and (b) are inconsistent in their behaviours so are hard (impossible) to model. 2) people interact in complex systemic ways with each other and this makes their behaviour even harder to model.

Andrew Ducker said he disagreed with these statements from WidgetFox.

We touched on time preference and risk preference.

At this point we all decided that having this conversation on twitter wasn’t going to work.

I’m not sure whether I agree with WidgetFox or not.  I certainly agree that humans are inconsistent in their behaviour and that they interact in complex systemic ways.  I’m not so sure that, in macro-economic terms, they are distinct. In any event, this might make their individual behaviour difficult to model. I’m not sure, that it makes it impossible to model. I think I’m a gnostic on this point.

What I think we’re dealing with in economics is not the way individuals behave in a particular situation, but the way they behave on average and in aggregate and the way they make individual decisions. I think that macro-economics is the aggregation of micro-economic behaviour and that micro-economic behaviour rests on heuristics and bounded rationality (amongst other things, but heuristics and bounded rationality is most germane to this discussion.)

Whilst there is a difference between All People are X and On Average People are X I think in macro-economics the difference is cancelled out by the sheer volume of transactions and actors. For most, if not all, macro-economic situations I think it is unlikely that there is a significant difference between All People Being X or the Aggregate Position Being X (for an individual who is facing whatever curve macro-economics is offering.)  A large part of the practical business of macro-economics is about trading positions. If there are evenly balanced outliers in a set of economic actors then the curve takes the same shape as if all people agreed that it should have a certain shape. (2)

On a micro-economic scale it’s not necessary to understand how particular individuals will behave. What you need to understand is whether heuristics tells you that whatever black box the human mind is, either single minds or complex systemic groups, sufficient people will be nudged into your shop to make opening that shop worthwhile.  There might be sufficient people who will buy very low quality at a very high price to keep you in business (3) but on average economics and experience says not.

The fact remains that individuals and firms manage to anticipate the individual and group behaviour of others sufficiently well in order to engage in economic transactions with them.

(As a side note I wonder at the effect on macro-economics that many of the large volume actors are professionals.)

WidgetFox will undoubtedly have made and be about to make a more subtle and nuanced argument than I understood. I look forward to it, knowing that the fault for not understanding what she says lies with me. 

I’m looking forward to Mr Ducker expanding on why he disagrees with WidgetFox on the modelability of humans.

(1) She didn’t call me Lord Copper this time. I’m not sure this strengthens my position.

(2) I’m quite interested in the ability of betting markets to predict outcomes. So far it looks like they no worse than any other method.

(3) and they are called tourists

On the Ten Pillars of Economic Wisdom - General Points

I was pointed in the direction of the Ten Pillars of Economic Wisdom by widgetfox and she asked for my thoughts on them.

Here are Ten Pillars

The Ten Pillars of Economic Wisdom
By David R. Henderson
1. TANSTAAFL: There ain't no such thing as a free lunch.
2. Incentives matter; incentives affect behavior.
3. Economic thinking is thinking on the margin.
4. The only way to create wealth is to move resources from a lower-valued to a higher-valued use. Corollary: Both sides gain from exchange.
5. Information is valuable and costly, and most information that's valuable is inherently decentralized.
6. Every action has unintended consequences; you can never do only one thing.
7. The value of a good or a service is subjective.
8. Creating jobs is not the same as creating wealth.
9. The only way to increase a nation's real income is to increase its real output.
10. Competition is a hardy weed, not a delicate flower.

Here are my thoughts on them as a group.

Broadly, I agree with them as a body in the spirit in which they are intended. I think that the spirit in which they are intended is not as the Gospel of Economic Truth. I think they are intended in two ways.

Firstly, they are Economic Wisdom for Students. I think they function well as a list of things economic neophytes should remember and which they should use as a filter to view any case studies they are looking at whilst they gain a foundational understanding of economics.

I think Henderson is saying, Hey, whilst you are learning about the science of economics here are Ten Things you should remember. Try reading them before each lecture or before each day’s reading. If you think you’ve found an exception or situation that falsifies one of them have a really good think about whether you’re right or not before you send off for your Noble Prize. Maybe sleep on it for a few nights.

Don’t stand up in class and say “X is the case. Doesn’t this disprove such and such a pillar”. A more valuable starting question for you, the student to ask, is “In this situation, how or why does such and such a pillar apply?” Perhaps follow up with “Are there any situations where it doesn’t apply?”  You’ll look like a dick who is trying to impress the cool kids less often. Bearing in mind that you’re in an economics lesson trying to impress the cool kids isn’t a strategy with good returns. Remember, 3 and 6.

I think the second use of Ten Pillars is a Field Guide for the Economic Anthropologist.  If you, the economically literate (or numerate) citizen is going about your daily business and you find a situation you don’t understand, this list functions as a quick and dirty prompt to work out what is really going on.

Take my recent gripe about Amazon for example.  

Amazon could sell me more books if they curated their offering better.  However, curating their offering better requires them to get over the cost hurdle implicit in Pillar 5. Remembering my Michael Porter and thinking about Amazons generic strategy I realise Amazon are in the Cost Leadership mode. Taking on the costs of building a system to gain more knowledge doesn’t help them with 99% of their sales but adds costs that have to be paid for. So, Pillar 2, they won’t bother with my list of ways to improve their curation. Someone else might. (And if it's you, let me know and we'll do business.)

So, it’s a useful starting point for students or for those trying to understand specific real-life situations from an economics point of view.  For more on this I’d recommend Tim Hartford and his book, The Undercover Economist. 

It’s not the Bible of Economics. (For a start there are no charts with curvy lines on them anywhere. You call that a religion science. When you don’t even have any curvy lines crossing anywhere. What are you? A biologist?) Is it the case that all Ten Pillars hold true in all cases. Probably not, but I’d not bet against any of the Pillars being wrong in any particular situation without giving it considerable thought.

Is this the only useful list. Not at all.  There are other toolkits out there.  I'm going to find some and I may one day produce my own.

What is useful about this list, well, Pillar 5, again. If you don't already have a degree in Economics this list might help you out.

Finally, I’d add two of my own, for my own use as an Economic Anthropologist.

11 If the solution is not either elegant or brutal it is probably not the optimal solution.

12 You should be able to reason from the psychology of the individual through micro-economics and up to macro-economics and back down again.

Someone else’s from comments on the various discussions that I’d add  would be

13 Any cost (or revenue) not accounted for in an entity’s books is passed on to society.

Some people agreed with me up to a point on this.