The irrational foundations of economics
Why neoclassical economists choose the wrong theory from physics
Sylvie Geisendorf (Universität Kassel) [BIO]
Rational choice or as-if methodology in economics is a largely disputed endeavour, although mostly at the margins of the profession. Mainstream neoclassical economists seem to be surer than ever of its relevance and justification, to the extent that they do not even see a need to give good reasons for it any more. Much can be said about the causes and even possible advantages for this venture and some of these arguments will be discussed in this paper.
Although being a fictitious assumption, rationality seems to fit nicely into several psychologically proven structures of human thinking, thus helping the economists to reason about an otherwise confusing amount of data (Røgeberg and Nordberg 2005). Though this may be true and important, the discussion about the foundation of rational choice theory in economics seems to forget where the assumption originally came from or rather why it was indispensable. Rationality was a necessary precondition for the employment of optimization mathematics. Economists wanted to fit their theory to the one of celestial mechanics long before Milton Friedman´s as-if reasoning. But optimization was not the only possibility to describe how physical systems react to gravity. It isn’t even the exact one. The real explanation for the impact of universal gravity is given by the equations of Newton´s law of gravity. The main argument of this paper therefore is that neoclassical economists adopted the wrong theory from physics. The paper tries to examine some of the reasons for this choice and discusses its consequences for the economist’s way of thinking. It finally illuminates the possibilities that an employment of the correct physical theory would bring about.
Neoclassical economics is based on optimization mathematics of classical physics, going back to Newton´s discovery of universal gravity (1687). All physical objects are amenable to the law of gravity and tend to equilibrium positions (falling objects) or stable orbits (planets), if no external force is exerted upon them. In physics, this insight was the beginning of the era of “rational mechanics”. Starting at the end of the 17th century with Galileo, Descartes and particularly Newton, physics began to turn away from the aristotelian metaphysical and teleological view in favour of a predictable world, guided by the laws of nature. In contrast to former times, natural phenomena were now explainable by causes, measurable and reproducible. In other words: nature became rationally tractable.
Economists, so far governed by Adam Smith´s invisible hand, that was more the hand of god than one of independent natural laws (Weise 1998), were inspired by the clarity and logic of these scientific explanations and wanted to transmit them to economics. They believed to see similarities between the physical and the economic system, justifying such a transfer. In 1871 Jevons wrote about the „mechanics of utility and selfinterest“. In 1874 Walras was convinced that: „It is already perfectly clear that economics, like astronomy and mechanics, is both an empirical and a rational science.” Edgeworth wrote 1881: „As electro-magnetic force tends to a maximum energy, so also pleasure force tends toward a maximum energy.” Thus natural sciences became “rational” and economics became “rational” and “mechanist”, the terms in both cases meaning measurable and guided by the laws of nature instead of metaphysical. At first therefore it was not economic agents (let alone physical objects) that were rational, but the science describing them. Long after this inaugural period of neoclassical economics – and as long ago from contemporary economics – an active debate about the justification of the assumption of rational agents was taking place. It was situated around Milton Friedman´s as-if argumentation (1953). Rational choice wasn’t a clear-cut postulate of economics but a helpful construction to approach reality: People do not act entirely rational, but market results present themselves as-if they would do (Friedman 1953). By later economists this was basically interpreted as: “assumptions are irrelevant if you predict accurately” (Røgeberg and Nordberg 2005: 547), although economists of the time seemed to take the assumption itself more serious. There are several variations of Friedman´s argument, indicating that the assumption was supposed to have something to do with reality. Alchian (1950) e.g. Stated that although not all economic agents behave rationally, the selective forces of the market rule out those who don’t. A similar argument was that rational behaviour could be learned with time.
A major problem of contemporary neoclassical economics might be that such a necessity to justify the as-if methodology seems not to be seen any more. Rational choice is an integral part of neoclassical models. Textbooks introduce optimization mathematics without even mentioning that it necessitates the assumption (thus making it seem as-if it was a deliberate choice). Røgeberg and Nordberg (2005) explain that the unquestioned acceptance of such an obviously “absurd” concept might be founded in the bounded rationality of economists themselves. Human beings have a strong believe in regularities, intentionality and predictability – even against hard evidence. And the subsuming of huge amounts of otherwise confusing data under a simple mental model enables them to think and theorize about some problem at all.
Trying to understand how economics evolved from a science trying to become rational to one based on an irrational assumption it doesn´t even defend anymore is interesting in itself and we will come back to this point. But it is even more interesting to see that economists, in their endeavour to make economics as logical as natural sciences, didn’t realize that physics offered two ways to formalize the phenomenon of equilibrium or gravity, and that they took the wrong one. Economists employ a formalism that isn’t even valid in physics when it comes to explain the causes of a phenomenon.
Physical phenomena concerned with gravity can be explained from two directions. One is the description of the forces exerted upon an object and its reaction thereupon. The other is a description of the effects this has. In other words, the former is a causal explanation, while the latter is a functional one. Both kinds of equations describe the same phenomenon and are mathematically correct, but only the former depicts how it is brought about. Imagine a ball you place at the edge of a bowl. It rolls inside and after a while rests at the bottom. It thereby generates the state of lowest energy requirement. The ball is doing so, because it is subject to gravity, not because it knows how to minimize energy needs. All the same it is possible to formalize its behaviour by minimization mathematics, using the form of the bowl as a function to be minimized. This is (one possible) explanation of the effect the behaviour of the ball has. The correct description of the causes of the phenomenon however would necessitate an employment of Newton´s law of gravity.
And this is the problem of neoclassical economics in a nutshell: Instead of describing the forces operating in economic systems, it describes the effects these forces produce and turns logic around in proclaiming these effects as reasons. A sentence like “When it is raining the street gets wet” becomes the assertion that it is raining in order to soak the street.
There are two reasons for such a method being tricky. First the original intention to make economics as rational as natural science can not be fulfilled this way. Economics, contrary to natural science, is not a rational science because it has made itself waterproof. Forced to admit that not everybody is literally maximizing monetary utility, the utility concept has been stretched more and more to encompass everything from love over a need for altruism to drug consumption (Becker 1996). Now virtually everything can be explained as the maximization of some sort of utility function. But this seeming and often criticised economic imperialism comes at a high cost for economics itself. The economic concept of maximizing utility is no theory any more. In explaining everything it becomes irrefutable and therefore tautological.
According to Rosenberg (1979) this is a problem of all “extremal” theories: „To stop such theories from being able to explain any possible observation we must be able to specify the domain or explanatory variables of these theories independently of what they try to explain.“ Physics and biology did so, economics failed to.
The second reason for the awkwardness of the chosen method is the analytical power of the causal explanation it has to renounce to by using the simpler functional explanation. Although mathematically equivalent, the two theories are quite different in their abilities. Let’s have one more look at the ball in the bowl to illustrate this point. Assume the bowl not being smoothly shaped anymore, but having a bulge somewhere on the way down. Now the ball is not able to just role down to global minimum but might be caught in the local minimum in-between.
Differential calculus is able to work out both minima. But it can not determine under which conditions the ball will reach which one of them. To do so, you would need something like Newton´s equations, enclosing mass, acceleration and friction of the ball. To analyse how a complex system like the economy behaves under more realistic conditions than a smoothly shaped bowl of states we need a more adequate description of initial conditions. In sticking with the wrong side of physics theories, economics deprives itself of this possibility.
The paper (and the speech proposed hereby) wants to discuss this problem, its reasons and possible solutions in some more detail. A different form of economic modelling, considering more sophisticated initial conditions and therefore the causes of economic phenomena, is possible today by simulation models.
Literature (used so far):
- Alchian, A. (1950): Uncertainty, Evolution, and Economic Theory. Journal of Political Economy 58: 3, 211–221.
- Becker, G.S. (1996): Accounting for tastes. Cambridge, M.A. and London: Harvard University Press.
- Edgeworth, F.Y. (1881): Mathematical Psychics. London: Kegan Paul.
- Friedman, M. (1953): Essays in Positive Economics. The University of Chicago Press, Chicago.
- Jevons, W.S. (1871): The Theory of Political Economy. London: Macmillan and Co.
- Røgeberg, O. & and Nordberg, M. (2005): A defence of absurd theories in economics. Journal of Economic Methodology 12: 4, 543–562.
- Rosenberg, A. (1979): Can economic theory explain everything? Philosophy of social science 9: 509–529.
- Walras, M.L.E. (1977, org. 1874): Elements of Pure Economics or the Theory of Social Wealth. [Reprint of the translation of the French 4th Ed. (Edition Définitive) 1926] Fairfield: Augustus M. Kelley, Weise, P. (1998): Der Preismechanismus als ökonomischer Selbstorganisationsprozess.
- Selbstorganisation, Jahrbuch für Komplexität in den Natur-, Sozial- und Geisteswissenschaften, Berlin: Duncker & Humblot: 315–331.