Adventures in Economics

Introduction

Human beings are by nature economic animals who, according to Adam Smith, have an inherent propensity to “truck, barter and trade”. In order to facilitate exchange and improve their well-being, people create money, markets and institutions. Interaction of entirely selfish individuals may produce a mutually beneficial and a Pareto optimal outcome. Coordination among the activities of individuals participating in a market is spontaneous and is guided by
the “invisible hand” of self-interest. This “invisible hand” was rigorously encapsulated in the First and Second Theorems of Welfare Economics.

But despite claims of universality of economic laws, economists have extreme difficulty identifying such laws and agreement on the validity of such laws may be impossible to achieve.

For this reason John Stuart Mill referred to economics as an inexact science and characterised its laws as tendency laws. Such expressions of tendency are, in simple terms, generalisations
regarding what will happen if no disturbing event should intervene.

Economics is, and rightly so, concerned with insight appreciably more than it is concerned with prediction of events. In Keynes’s words,

“the theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, a technique of thinking, which helps its
possessor to draw correct analytic conclusions.”

These scant references to the history of economic thought figure as aids to a non-anachronistic understanding of the past, not as gratuitous arrows pointing to the relevance of earlier ideas.

The limitations of Mill’s and Carlyle’s philosophically expressed understanding of economics are obvious not only when compared to modern theories, but also when set within the course of economic history. At the same time, all can enjoy and benefit from applications of the “dismal science” that are relevant, insightful and anything but dismal.

Modern industrial market societies show enormously complex functional integration. Although economists’ models of the market exhibit why we need only enforce certain abstract rules – such as prevention of fraud and property rights – in order to achieve an efficient social order, they do not explain how the set of rules itself can be created, adapted to new situations, or sustained. The provision of the moral and legal framework for a market economy is itself a public good, and subject to the free rider problem.

And yet, today economics is the most rigorous and systematic of the social sciences and a starting point for understanding not only the economy but other aspects of society. An economic model is an intellectual mechanism, used to explain a particular variable or event. Although a model can take a literary form, the economics profession has preferred that models be expressed in formal mathematical terms.

Mathematics is vitally important in terms of the expression and communication of ideas in economics. This in itself is a matter of interest, particularly with respect to the public understanding
of economics. However, the use of mathematics in economics has drawn criticism from a variety of source, mainly from outside the profession.

In essence, a formal model contains a set of endogenous variables whose values (prices, quantities etc.) are determined logically within the model. Economic theory is used to develop mathematical statements about a set of observable endogenous variables which are related to another set of observable explanatory variables. Economic theory may also relate the endogenous
variables to a set of unobservable variables. Thus, economics is essentially a collection of formal models applied to analysis of specific problems and to an explanation of specific
phenomena.

The economics of information

There have always been organisations and institutions capable of creating and disseminating knowledge: from the medieval guilds through to the modern market research agency. One
hardly needs reminding that information is a valuable resource: knowledge is power.

And yet, realistic economic study of information and information producing industries is a relatively recent development in the evolution of economic thought. Developments in economics
that have taken place since the 1990s have led to improved understanding of the extent to which markets, agents and institutions process and convey information.

The subject of the economics of knowledge poses fascinating and challenging questions – theoretical, empirical, conceptual and normative. Although knowledge has been at the heart of economic growth and the gradual rise in social well-being since antediluvian times, social scientists spent the last century realising that value itself was not some intrinsic property of the world, but more a construction of our interaction with the world. Arguably,  economic analysis alone is not sufficient, since knowledge is context-dependent. However, focusing on scarcity and cost helps us to understand that psychology.

For a long time, formal modelling in economics was based on assumptions about perfect information (including efficiency, full employment of resources and uniform prices). While
the fact that information imperfections are pervasive in the economy was recognised by all economists, it was hoped, in the spirit of Alfred Marshall’s dictum”Natura non facit saltum,”
that it was defensible as an assumption: a heuristic by which to approximate behaviour.

Of course, one can make the Wittgensteinian argument that no general analysis of knowledge can exist since no general analysis could capture the nuance and variety of contexts in which
human beings recognise instances of human knowledge. However, the exploration of this philosophical thread yields surprisingly little about economic behaviour.

The marginal productivity of information depends on how the quantity of information is measured. Some economists, such a Stigler (Nobel Prize 1982), argued that information is just
a transaction cost – that is to say, once the real costs of information were taken into account, the standard results of economics still hold. However, it was famously shown by Stiglitz (Nobel
Prize 2001) that this was not true, and the conclusions derived from it do not hold. One of the main implications from this research was that even a small amount of information imperfection could have a profound effect on the nature of the equilibrium.

The economics of altruism

With regards to the discipline of economics, a common misconception is that economists think that people are self-interested or rational, or should be self-interested. Although this is
not strictly true, the assumption of rational self-interested behaviour has been a highly fruitful one in modern economic theory.

In The Theory of Moral Sentiments, Adam Smith points out that people often care for the well-being of others and that this may have significant economic consequences. Similar observations are made by Gary Becker, Kenneth Arrow and Paul Samuelson. In fact, there is extant literature on economic behaviour and policy analysis when agents are altruistic or exhibit other-regarding preferences.

So, what insights can we gain into altruism? First, we must make distinctions between economic, biological, anthropological and psychological theories of altruistic motivation. In fact, altruism can be defined in numerous incompatible ways. In the interests of brevity, here we are only concerned with what economics says about altruism.

However, things are far from easy. Altruistic behaviour does not necessarily lead to a more socially efficient outcome. It is also known that competitive equilibria with transfers need not be efficient when agents are altruistic. In this context, if altruistic transfers are permitted then both First and Second Welfare Theorems of Classical Welfare Economics do not generally hold.

A theoretical framework for distinguishing between economically altruistic and non-altruistic acts must specify a number of different goods which enter into each individual’s utility function and distinguish those which are directly beneficial to the individual’s economic well-being. Some economists use a concept of “felicity” which corresponds with happiness or experienced utility.

It is also worth pointing out that there are different types of behaviour contained in the spectrum of altruism. Such behavioural types range from true selfishness to true altruism, where
there is no ambiguity about the social desirability or divergence between appearance and motivation of an altruistic phenomenon. Apparently non-altruistic behaviour which is not altruistically
motivated and is socially detrimental will have different implications to apparently altruistic behaviour which is altruistically motivated and is socially beneficial.

Into the former category would fit standard cases of market failure where rational self-interested individuals are, for whatever reason, not led to behave socially efficiently by the economic environment in which they make their decisions. On the other hand, the latter scenario fits closely with the classic case of an altruistic act, which benefits others at a cost to the altruistic individual, and where the total benefit conferred is greater than the cost. Here, an individual
with truly altruistic preferences would carry out such an action because it would increase their utility. This includes the felicity of other individuals.

An understanding of the (repeated) prisoners’ dilemma leads to the conclusion that cooperation can emerge and be sustained in small groups. On the other hand, co-operation is much more difficult with a large number of players. This is due to problems of monitoring and
the threat of Nash reversion or other strategies to punish the individual defector. This is the reason why some externalities cannot be negotiated away via Coasian bargaining. Yet, this is
also the reason why competition works.

Charles Shaw
Birkbeck EFS
Birkbeck EFS is a society. Their interests lie in bringing together fellow students and furthering their interest in Economics and Finance by inviting speakers, organising events, and engaging in discussion on contemporary issues.

Charles Shaw
Charles Shaw

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