Oct 27 2009

Homo Economicus – “Economic Man”: Guest Lesson for ZIS Theory of Knowledge classes

Homo Economicus, the “Economic Man” is the concept underlying most economic theories. It holds that all humans are purely self-interested, rational actors who have the ability to make judgments that fulfill their subjectively defined ends. In modern economic theory, the end man seeks is generally accepted to be increasing monetary well-being and material wealth.

Philosophical foundations of “homo economicus“:

Aristotle (350 BC):

Again, how immeasurably greater is the pleasure, when a man feels a thing to be his own; for surely the love of self is a feeling implanted by nature and not given in vain, although selfishness is rightly censured; this, however, is not the mere love of self, but the love of self in excess, like the miser’s love of money; for all, or almost all, men love money and other such objects in a measure. And further, there is the greatest pleasure in doing a kindness or service to friends or guests or companions, which can only be rendered when a man has private property. These advantages are lost by excessive unification of the state.

  • What does Aristotle think about the interference of government in the private property rights of man?

Adam Smith (1776):

In almost every other race of animals, each individual, when it is grown up to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer: and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher the brewer or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.

  • How does Smith believe the pursuit of individual self-interest can lead to benefits for society as a whole?

John Stuart Mill (1836)

What is now commonly understood by the term “economics” is not the science of speculative politics, but a branch of that science. It does not treat of the whole of man’s nature as modified by the social state, nor of the whole conduct of man in society. It is concerned with him solely as a being who desires to possess wealth, and who is capable of judging of the comparative efficacy of means for obtaining that end. It predicts only such of the phenomena of the social state as take place in consequence of the pursuit of wealth. It makes entire abstraction of every other human passion or motive; except those which may be regarded as perpetually antagonizing principles to the desire of wealth, namely, aversion to labor, and desire of the present enjoyment of costly indulgences. These it takes, to a certain extent, into its calculations, because these do not merely, like our other desires, occasionally conflict with the pursuit of wealth, but accompany it always as a drag, or impediment, and are therefore inseparably mixed up in the consideration of it.

  • According to Mill, labor is not something humans value for its own sake, but only because it allows us to do what?

Fredrick von Hayek (1930s):

We will benefit our fellow man most if we are guided solely by the striving for gain. For this purpose we have to return to an automatic system which brings this about, a self-directing automatic system which alone can restore liberty and prosperity.

  • How would Hayek respond to those who argue that the government’s role in society and the economy is to promote fairness and equality?

Are you a “homo economicus“? – The Golden Balls Game

The prize: $1 million

How to play:

  • Find an opponent from among your classmates.
  • You and your opponent have never met before today, never spoken to one another, and will never see nor speak to one another again after the game ends.
  • Since you do not know or care about your opponent, you must play this game with your own self-interest in mind, and assume that your opponent will play it with his or her self-interest in mind.
  • You have in front of you two folded pieces of paper. One says “SPLIT” and one says “STEAL”
  • You must decide which piece of paper to select, based on the following possible outcomes

The payoffs:

  • If both players decide to “split”, each player will take home $500,000.
  • If one player chooses to “split” and the other chooses to “steal” then the one who chooses to steel will take home $1 million, and the one who chose to split will get nothing
  • If both players choose to “steel”, both players go home empty handed.

Split

Steal

Split

Player 1: $500,000

Player 2: $500,000

Player 1: $1 million

Player 2: 0

Steal

Player 1: $0

Player 2: $1 million

Player 1: $0

Player 2: $0

Let’s play!

  • You only have one chance to play this game. Remember, you care only about yourself and should do what is best for you.
  • On the teacher’s command, reveal your decision to your opponent.
  • Take note of your payoff and report it to the teacher

Discussion:

  • What was the outcome of your game?
  • Was the outcome rational? Was it predictable?
  • Did the outcome reflect the concept of “homo economicus“? Were you and your opponents’ decisions purely self-interested and coldly rational, intended to maximize your OWN payoff?
  • Are you a homo economicus? What would homo economicus have done? Why?

Videos:

Golden Balls – the real gameshow: http://www.youtube.com/watch?v=p3Uos2fzIJ0&feature=player_embedded

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  • Which player was more like homo economicus? Sarah or Steve?
  • Which player acts rationally? What makes it rational?
  • Which player acts irrationally? What makes it irrational?

“The Trap”: Intro to game theory and rational self-interest in politics and economics: http://www.youtube.com/watch?v=qzNcY-gZdiA&feature=related

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  • John Nash’s Game Theory proved that “a system driven by selfishness did not have to lead to chaos”, that “there could always be a point of equilibrium in which everyone’s self-interest is perfectly balanced against each other”? How does such a theory support the concept of homo economicus?
  • What is the Prisoner’s Dilemma? “The rational choice is always to betray the other person.” What does this say about humans in society? Is government regulation needed to prevent constant betrayal by greedy, self-interested individuals? Or are constant betrayal and self-interest themselves capable of achieving a socially optimal outcome?

Noam Chomsky on the inefficiency of markets and the threat posed by de-regulation: http://www.youtube.com/watch?v=QPl27BO7fHE&feature=related

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  • What is the “externality” of financial market failure that Chomsky identifies?
  • Why is the failure of a financial market more worrisome than the failure of a market like that for used automobiles?
  • How does Chomsky feel about the de-regulation of financial markets? Does he think markets are always rational and efficient?

Modern applications of the concept of Homo Economicus:

  • Rational Expectations Theory (RET): This economic theory assumes that humans acting generally in their own self-interest will make rational decision based on the best available information. Therefore, it assumes that people (and therefore, markets, which are made up of rational people) do not make systematic errors when predicting the future.
  • Efficient Markets Hypothesis (EMH): Rooted in Rational Expectations Theory, which itself is rooted in the concept of homo economicus, EMH says that prices in markets, particularly financial markets (whose collapse has caused the today’s global economic crisis) represent the best possible estimates of the risks attached to the ownership of various financial assets (stocks, shares, bonds, etc…) Asset bubbles are therefore impossible, since “bubble” implies an irrational and unsustainable increase in the value of an asset which will ultimately “burst”. Markets are “self-correcting”, and the most effective tool for assuring economic stability is free markets, rather than government regulation or oversight.

Connecting the dots – from Homo Economicus to today’s Economic downturn:


The general acceptance of theories rooted in the concept of homo economicus led to the de-regulation of financial markets, which allowed money and resources to go whichever way the “market” (rational or not) determined.

  • During the last decade, the market decided that more and more money and resources should go towards particular assets, specifically the United States mortgage market (the market for new homes in the US).
  • As money flooded the US home mortgage market, it became cheaper and easier for Americans to get loans to build a home. GREAT, RIGHT?! Well, only until it came time to pay back those loans.
  • Trillions of dollars worldwide became tangled up in the US mortgage market, representing households’ savings from around the globe.
  • When Americans suddenly found their loans coming due, they found it hard to repay them due to adjustable interest rates and falling home price (supply had grown more rapidly than demand).
  • American and many Europeans began defaulting on their mortgages, meaning all that money that had been lent to home buyers literally disappeared.
  • Banks and financial markets faced a “liquidity crisis”, meaning they had no money.
  • Lending stopped to households, firms, and other banks , meaning spending on goods and services decreased, meaning jobs were lost and economies entered recession.
  • How could any of this have happened if the concept homo economicus and the economic theories based on the concept are correct? Are humans always rational, calculating, perfectly informed, self-interested beings acting purely in their own self-interest?

Conclusion: The concept of homo economicus has formed the basis for economic theories for centuries and for major macroeconomic policies over the last 30 years. Policies of “market liberalization” (freeing the market from the guiding, regulatory hands of government) have led to great prosperity, but even greater risk and volatility as irrational exuberance over asset prices has led to inefficient market outcomes, bubbles, and financial shocks plunging the “real” economies of the world into recession.

Perhaps a more complete understanding of humans is needed as the human science of economics enters a new era. The human as a cold, rational, calculating creature interested in only his own gain is an over-simplification, and forming theories and policies on such an assumption is dangerous. The future of economics must incorporate a more complete and complex understanding of human behavior if the economic crises of the last two years are to be avoided down the road.

2 responses so far

2 Responses to “Homo Economicus – “Economic Man”: Guest Lesson for ZIS Theory of Knowledge classes”

  1. Mark Michael Lewison 29 Oct 2009 at 4:08 am

    I will offer a couple points to quickly provide a potential Hayek-ian answer to your question:

    1) The Golden Balls / Prisoner Dilemma.

    As anyone who has studied this knows that if you play the game once, you get different results than if you play the game multiple times with the same people. The more you play the game with the same people, the more cooperation naturally occurs. Why? because there are feedback and results – i.e., people learn that cooperation leads to "better" results, so they learn to cooperate.Basically, no matter how you stack the odds, there will be an equilibrium in which cooperation basically wins.

    Why? because people are essential rational. Not like Spock, but like Kirk. We trade off and look for the best possible solution given our understanding of the situation and what is in our best interest. In that sense, homo economicus is not a theory, it is a basic description of our experience of human beings…being human. No big deal.

    2) The real question hinges on the idea that homo economicus makes their "rational" choices "in solely economic terms." The idea that a choice is "solely economic" is problematic for the following reason (there are others):

    Money is only valuable because it purchases non-monetary items, often called "products and services." But what are products and services, but fuel/tools and time:

    When we buy finished products, we save ourselves the time of creating them, and get to use them as fuel/tools. (food, clothing, shelter, medical care, transportation, computers, phones, etc.)

    When we buy someone's services, we save ourselves from buying/creating the fuel/tools they employ, and the time of performing the service.

    The more money we have, the more fuel, tools, and time we have to pursue our non-monetary values (love, compassion, art, dance, entertainment, etc.) In other words, money is simply a symbol of our capacity to achieve and express our values.

    Money is the universal translator of values. It is the medium that allows people with completely different values to exchange their services and goods with one another, even if they disagree about fundamental values. It is the universal language of humanity, that allows the butcher, baker, candlestickmaker, yoga teacher, physicist, musician, artist, priest, mullah, rabbi, lama, shaman, and guru to exchange values with one another.

    In this sense, saying that homo economicus makes choices in "solely economic terms" is like saying that people make choices based on their perception of what will best achieve their values as they understand them. It is not a theory, it is a truism.

    3) People judge their self-interest differently, using different criteria and methodology. My rational calculation is different than yours, because I value things differently than you do. Similarly, John values things differently than Jane, times 6 billion people. I might not like the choices that you and John and Jane make. True. I might think that your choices are self-destructive. True. I might think that society would be better off if you didn't make those choices. True.

    4) The question then becomes, who gets to decide what to decide is in John Q Public's best interest: John Q. Public? Or Jane Q. Politician? Should John be allowed to make choices according to his rational calculation, or should he be forced to make only those choices that Jane has authorized, on pain of fines and jail time if he disobeys Jane?

    This is where the "fairness" and "equality" comes in. The idea is that government will police people from making bad decisions that "take advantage" of other people or "destabilize" the morals or finances of others.

    The challenge with this are three-fold (at least).

    – First, Jane doesn't know what is best for John, despite her certainty that she does. Her arrogance does not make her right.

    – Second, 530 Janes in congress disagree about what is best for John, making any proposed solution the violation of other's values.

    – Third, by using force to change how John chooses, she destabilizes his rational choice making ability, leading him to make choices that reduce his intelligence and ability to plan and partner with others.

    – Fourth, those Johns who know how to leverage (cheat/abuse) the regulations in their favor will do so, exacerbating the original problem regulations were meant to solve, and creating new problems unique to the regulations themselves.

    – 250 million Johns in this condition destabilizes the market as a whole, leading to systemic corruption and problems that the market cannot solve BECAUSE the regulations get in the way.

    End result, in trying to create fairness and equality, the government creates systemic unfairness and inequality. This drives more regulation, creates more systemic problems, driving more regulation.

    5) All this leads back to the implicit question this article does not address: if not "homo economicus" – what is the alternative?

    If we are going to create economic models to predict the outcome of human behavior given multiple and varied incentives, how do we understand their process of decision making?

    Homo Economicus says that they will make rational choices according to their perception of their best interest. This is not a wild economic theory, but the most obvious of common sense, that matches our daily experience of ourselves and others.

  2. Jason Welkeron 29 Oct 2009 at 5:59 pm

    Mark,

    Great response! Thanks for your insights!

    In order to make the rational choices according to their perception of best interest, and for those choices to aggregate into efficient market outcomes, humans need perfect information. Perhaps the assumption of perfect information in un-regulated markets is more of a failure of modern economic policy than the assumption of rational "homo economicus". One reason the reasons for the failures of economic policies is the imperfect information that exists in financial markets, the "under-pricing of risk" resulting from complex financial instruments that most investors did not truly understand the make-up of.

    Incentives also matter. The incentive in modern financial markets is to maximize short-run returns even if it means neglecting the long-run risk resulting from asset bubbles. An asset bubble presents an opportunity to self-interested investors who can buy and sell quickly enough to earn short-run returns. The "externality" of such a bubble is that is eventually bursts and spills over to the real economy.

    Anyway, lots of things to think about. I appreciate the "Hayek-ian" views of your comment!

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