The Reality of Economic Rationality

“What problems they argue mainstream economics has?” based on
“Neoclassical Economic Theory: a Special and Not a General Case” by Paul Ormerod

By Michael Rybin
University of Utah, ECON 2010 (Microeconomics)
Professor Do Youn Won
v03, August 1, 2012

We must ask, has the best Nobel Prize winning economic theory proved to benefit our nation’s economy or the world’s economy?  To answer these questions, all we have to do is look at a relatively short period in human history including about 100 years, from 1910 to 2012.  During this period we see the catastrophic crisis of the Great Depression in the United States with recessions including high unemployment, failing banks and businesses plus hunger and fear.  At the same time we recognize through all these difficulties that the standard of living has increased with prosperity and improvement to basic human health, and general wellbeing.  However, today’s picture of economic wealth is not objectively complete without the painful acknowledgement that many people continue to suffer from lack of the basic necessities like clean drinking water, food, housing, freedom, employment, and medical care.  Half of the answer to the benefits and results of putting into practice our best economic theory looks very good, while the other half of the results are terrible.  It is a shame that people, individually or collectively, cannot stand up and take responsibility for the honest reality, both the good and the bad.  Most economists would not claim the current economic crisis is the result and understanding or implementation of their award winning economic theory.  Simultaneously we wholeheartedly acknowledge that the nation’s economy is more complex than any single economic theory, government leader, political party, or government economic policy. 

Even though economics has several great strengths including the theory of incentives, the skill of analytical thinking, insights into how the economic and social world actually operates, and the ability to find answers to particular questions, the problems of mainstream economic theory consist of approximations to reality, restrictive assumptions of tastes and preferences, rational maximisers, and the prideful or dogmatic claim of economic achievements. 

Of the strengths, “by far the most important idea in economics is that agents respond to incentives to prices”.  The strengths of economics also include the academic skill of analytical thinking.  It also helps people learn to distinguish important insights into how the economic and social world actually operates.  Perhaps its most important strength is the ability to find answers to particular questions versus creating a new generic economic theory.  This is particularly evident by the work of George Akerlof and Joe Stiglitz as cited by Paul Ormerod’s work Neoclassical Economic Theory: a Special and Not a General Case.  Further evidence comes from the insightful work of American economist and professor of economics at Harvard University professor Roland G. Fryer, and the more recently published book Freakonomics by University of Chicago economist Steven Levitt and New York Times journalist Stephen J. Dubner. 

Even though economics as an academic and professional discipline has several strengths it also has a few problems.  The first problem, Paul Ormerod argues, is that economic theories are approximations to reality.  “Even the most rigorously tested theories in physics are not absolutely and complete true.  Sooner or later, someone will develop a theory which explains reality just that little bit better.”  Paul goes on to point out the value of neoclassical economic theory has strengths.  However the bottom line to any economic theory should be based on its useful practice.  As mentioned above, history is evidence enough to tell the whole truth regardless of individual opinions or interpretations. 

First “the single most restrictive assumption of conventional economics is that the tastes and preferences of individual agents – whether people or firms – are fixed”.  This includes an oversimplification in conventional economic theory dictating that people want to purchase products simply because other people do.  In some circumstances this is true.  The real world is more complex with greater intrinsic implications where individuals have the capacity to make different decisions despite the influences of their social predicates or neighbors and friends.  People maintain the ability to make judgments and choices with uncertainty, which makes some traditional rock-solid, number-crunching, and Nobel-prize-winning economic theories weak. 

Second, there is a “widespread assumption in economic theory that agents are rational maximisers”.  The theory of “general equilibrium breaks down completely in the face of limits on the ability of agents to compute optimal strategies” because it assumes agents have all information relative to potential alternative and future consequences.  Where “tastes and preferences can vary according to the actions of others, there is no point at all in looking for optimal rules of behavior”.  For example the high volatility of markets is complex and difficult to explain let alone understand the implications of interactions and behavior between people.  Kirman’s model shows that the behavior of individuals follow very simple rules which in the aggregate are evidence to complex world financial markets. 

The third and final problem of economic theory is embedded in a long history of academic pride, culture, and tradition.  “The teaching of economics has become too dogmatic, and too much a claimed for the achievements of the discipline.”  Compared to engineering and building a bridge, economic textbooks present many economic problems as if they have “been solved and students simply need to absorb a settled body of knowledge.”  Most college economics courses are “fixated on the old-fashioned theory based on rational maximization which as John Sutton notes, many students simply disbelieve”.  This is evident because of the sharp drop in college students choosing economics as their major and career. 

The problems with mainstream economics are deeply rooted in the academic and socioeconomic or cultural belief of strict economic theory together with the almost religious fanaticism that their theory is the answer to most if not all economic problems.  History shows that government intervention of economic policy did not prevent or stop the Great Depression.  Recent history shows the conflicts between leading economists who argue in their own defense about the cause and effect or correlation and causality of Enron or Lehman Brothers failures.  Some would say the economist and leaders of the Great Depression or these companies were not blindly ignoring the fiscal reality, but honestly knew the financial implications and consequences.  They create and teach the economic theory!  From the movie Freakonomics, “what keeps us from seeing corruptions are our illusions that our economy is rational system, a free market open to all.  The fact is that rigging markets and [Sumo] matches is good business if the rigging is hidden from all but a few”. 

So you can see that economics has several great strengths including the theory of incentives, the skill of analytical thinking, insights into how the economic and social world actually operates, and the ability to find answers to particular questions versus creating a new generic economic theory.  Also, mainstream economic theory consists of several problems including approximations to reality, restrictive assumptions of tastes and preferences, rational maximisers, and prideful or dogmatic claim of economic achievements.  In spite of the above cited problems and many critics, Paul Ormerod says “the discipline of economics is in the process of re-inventing itself”.  This new exciting and creates genuine hope! 

Copyright© 2012 Michael Rybin All Rights Reserved.