Economics frequently neglects the principles of science, but one failing stands out above all others. The most fundamental assumption—the assumption of rationality—is unfounded. But the problem is not what you usually hear. It’s not that people are somewhat illogical, or have “bounded rationality.”
The problem is that economic “rationality” contains a hidden and overlooked assumption that runs directly counter to human nature. And if economics does not pertain to humans, it is merely a special branch of mathematics, not a science. The hidden assumption is that people are not social creatures—that they take absolutely no account of their social standing or what others think of them. This assumption is strictly enforced throughout all of standard economics by the “utility” function, which only allows consumers to care about their own personal “bundle of goods.”
Envy, status seeking, “keeping up with the Joneses,” honor, feelings of guilt, altruism and a desire to be fair, and much more — all of this is ruled out. Essentially, economics assumes that all humans suffer from some extreme form of Asperger’s syndrome—that humans are not a social species. This is an adequate assumption for predicting quit a few market outcomes, but not for discussing economic efficiency, the lynch pin of neoclassical economics. Efficiency depends crucially on human utility, which is econ-speak for happiness or satisfaction. And that depends crucially on the many facets of one’s social standing.
In fact, there is a good deal of evidence that once basic needs are met, social standing is far more important to happiness than is the bundle of goods a person consumes. But the indictment of neoclassical economics does not flow so much from the fact that it is based on a grossly incorrect happiness function, as it is on the fact that it has refused for a century to look at its most fundamental assumption. Even this might be excused if the assumption seemed so plausible as to be self-evident. But, in fact, everyone outside of economics knows it is anything but self-evident. To miss this point requires the blinkers of a strong and confining ideology.
What are the implications? First, the fundamental welfare theorems of microeconomics, although mathematically correct, are not descriptive on planet Earth. Second, a pure market economy without the slightest market imperfection may produce a grossly inefficient outcome.
Behavioral Econ Blog
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Jul 7, 2014. Bolton and Ockenfels ERC paper replaces the standard utility function with a motivation function: m = m(y, sig), where y is player i's wealth and sig is y / (total wealth = c).
When a player has average wealth, sig = 1/n, where n = # of players.
Assumption 3 states that, for any y, dm/dsig = 0 for sig = 1/n. And the second partial of m w.r.t. sig < 0 for all sig. Hence m(y,sig) is maximized for any y, by sig=1/n.
This appears to be contradictory:
- Consider m() for a specific player i
- m(1, 1/2) has a zero derivative w.r.t. sig in [Read more...]