Wednesday, November 26, 2008

Behaviours, Not Rationality, Drive Markets

Peter Foster writes on “The dangers of behavioural economics” in Financial Post, Toronto (25 November) HERE about the alleged dangers of big bonuses on decision-making – apparently they are do not improve performace. (For the details, follow the link).

Peter Foster writes:

What is perhaps most fascinating about the rise of behavioural economics is that it reminds us that “conventional” academic economics somehow became sundered from human nature. We might remember that 17 years before he published The Wealth of Nations, Adam Smith published The Theory of Moral Sentiments. Smith never for a second imagined that humans were rational calculating machines. Similarly, the greatest economists of the twentieth century — von Mises, Hayek, Schumpeter and Keynes — all regarded homo economicus as a nonsense. Keynes was the odd man out, however, because he believed in an even more fanciful construct — homo politicus — a brilliant individual motivated solely by the public good.

The power of the market meanwhile does not derive from human rationality but from the fact that it rewards or punishes commercial behaviour on the basis of its contribution to society. It is doling out a whole mess of punishment right now, despite the attempts of government to shove cushions down everybody’s shorts.

Man is fatally flawed and periodically subject to Extraordinary Popular Delusions and Madness of Crowds, but a far great delusion is that there is a political solution to his shortcomings.

Unfortunately, behavioural economics is regarded as a new tool with which our political masters might improve us. That is far more potentially damaging than the most elaborate of bonuses.”

On the whole I agree with Peter Foster in his disdain for the fanciful theories of Homo economicus and Homo politicus, because I am not too fond of the idea of human rationality driving all behaviour in the economic models common among modern economists, other than in the sense we can rationalize any decision into it being rational for that person in those circumstances.

The fad for ‘explaining’ why some (it’s always some, never all, though the obvious caveat is often ignored in the admiration of the ‘rationalist’ for the beauty of the alleged explanation) behaviour can be seen to be ‘rational’.

For instance, teenage girls becoming pregnant is supposedly a rational search to qualify from welfare payments (but why don’t all girls who might believe they would benefit from welfare become pregnant?), or teenage boys develop criminal tendencies to enhance their prestige among their peers (but why do so many more boys in the same circumstances of broken families, slums, unemployment and poor education, not become criminal recidivists?).

Of course a ‘rational’ explanation for these girls and boys not covered by the initial explanation can be advanced too on other grounds, but if every variation is ‘rational’ too then ‘rational’ is no longer the explanation. People do what they do because that’s what people do when they do whatever they do!

Markets are the net effect of all behaviours, not just rational ones. And many of these behaviours are not captured in the rational calculus. Adam Smith understood that truth.



Blogger Simon Halliday said...

Your final paragraph is fantastic. Thanks.

9:12 am  
Blogger fnhh said...

Just a comment from me. I do believe that human behaves rationally (whether consciously or unconsciously), the reason that different people have different reactions towards the same incentive, in my view, is because different people attach different probability to their cost-benefit functions. As a result, they behave in a way consistent with the outcome of their own cost-benefit analysis.

2:17 pm  
Blogger Gavin Kennedy said...

Thanks Simon and Fnhh for your comments.

fnhh presents human behaviour with the conundrum I allude to: if behaveiour is always 'rational', whatever they do, what does 'rationality' contribute?

Anything that explains all human behaviour (as in the natural sciences, where electrons, etc., are well behaved and predictable) I raise an eyebrow.

In social science, there is a tendency to use personality as the commmon predictor of behaviour, which I find of no practical use.

How do we know that the 'outcome' is the product of their own CBA when we cannot observe the formation of their CBA.

Revealed preference is outcome based and produces results without going into asseumed, alleged and unobserved motives of those revealing their preferences.

Be clear, I am casting doubts on rational post-event explanations.

3:41 pm  

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