Debunking Economics Part 1.5: The Myth of the Rational Consumer

At the end of Chapter 3 of Debunking Economics, Steve Keen has a fantastic section on a paper by Reihard Sippel called An Experiment on the Pure Theory on Consumer Behavior. This paper tests the theory of the “rational” consumer of in an experiment like setting.

Paul Samuelson defined consumer rationality using four basic principles:

1. Completeness: When given two combinations of goods A and B, a consumer can decide which one he prefers. So A > B, B > A, or A = B (he can get the same degree of satisfaction from both combinations, in which case he is indifferent).

2. Transitivity: If A is preferred to B, and B is preferred to C, then A is preferred to C.

3. Non-satiation: More is always preferred to less

4: Convexity: The marginal utility a consumer receives from each commodity falls with additional units consumed.

This definition is still widely used in Intro Economic classes (as well as some more advanced courses).

Sippel tested consumers to see if they acted according to these rules. He gave his test subjects a set of eight commodities to choose from, a budget, and a set of relative prices.

The experiment was repeated ten times, with ten different price and budget combinations designed to test various aspects of Revealed Preference. Since Sippel only wanted to analyze individual behavior, only one subject at a time came to the laboratory. There was also no time constraint placed on the subjects to make their choices. Basically, Sippel created ideal experimental conditions for consumers to meet the Axioms of Revealed Preference.

In Sippel’s first experiment, 11 out of 12 of the subject violated Samuelson’s criteria for a rational consumer (laid out above), and in the subsequent second experiment, 22 out 30 violated Samuelson’s criteria. Sippel tried to save the “rational consumer” by saying that consumers can’t distinguish the differences in utility between two bundles of goods.

It might be the case that the difference in ‘utility’ or satisfaction between a chosen bundle and another one revealed preferred to it is, in fact, hardly noticeable for the subject. We might then regard the inconsistency of not choosing the seemingly preferred bundle as being of minor importance.

Sippel controlled for this by essentially making the indifference curves thicker.

By doing this, the number of violation was greatly reduced, but it also had the impact of making random choice appear more rational than the consumption decisions of the subjects.

In other words : a non-parametric test of optimizing behavior with 95 % efficiency has practically no power against the alternative of purely random choice.

Sippel concluded his experiment with:

We conclude that the evidence for the utility maximization hypothesis is at best mixed. While there are subjects who appear to be optimizing, the majority of them do not. The high power of our test might explain why our conclusions differ from those of other studies where optimizing behavior was found to be an almost universal principle applying to humans and non-humans as well. In contrast to this, we would like to stress the diversity of individual behavior and call the universality of the maximizing principle into question.

Despite the fact that a few test subjects met the Axioms of Revealed Preference, most did not. Human decision making is a complex process that varies from individual to individual. When given a situation seemingly as simple as choosing various bundles of eight commodities in a controlled experiment, there is a number of underlying processes that occur in our brains. This makes simple outcomes such as “maximizing utility” extremely complex. Keen provides a useful analogy:

In Sippel’s experiment, however, this resulted in 8 raised to the power of 8 – or in longhand 8 by 8 by 8 by 8 by 8 by 8 by 8 by 8 by 8, which equals 16.7 million. Many of these 16.7 million combinations would be ruled out by the budget – the trolly containing a maximum amount of each items is clearly unattainable, as are many others. But even if the budget ruled out 99.9 percent of the options – for being too expensive or too cheap compared to the budget – there would still be over 1,600 different shopping trolleys that Sippel’s subjects had to choose between every time.

The neoclassical definition of requires that, when confronted with this amount of choice, the consumer’s choices are consistent every time. So if you choose trolley number 1355 on one occasion when trolley 563 was also feasible, and on a second occasion you reversed your choice, then according to neoclassical theory, you are ‘irrational’.

To put it bluntly, expecting consistent behavior out of highly variable humans that live in an very complex world is nonsense. Humans are fascinating animals and any theory that tries to put our behavior in a mathematical equation will have severe problems.

 

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Links:

1. Not Rational Utility Maximizers by John Aziz
2. Behavioral Finance Lecture 01: Debunking Revealed Preference by Steve Keen

References:

1. Keen, Steve. Debunking Economics: The Naked Emperor Dethroned? London: Zed Book, 2011. Print.

2. Sippel, R (1997) ‘An experiment on the pure theory of consumer’s behaviour’, Economic Journal, 107(444): 1431-44

Debunking Economics Part 1: Why Demand Curves Aren’t Downward Sloping

This post will mark the beginning of a series on Steve Keen’s book Debunking Economics. My first impression after reading his book was that it was chalk full of great ideas and solid criticisms of “neoclassical” economics as it is currently taught to undergraduate and graduate students. I’m not always fond of Keen’s tone, but isn’t some crank. I’m writing these posts in order to better retain the ideas and concepts expressed in the book, as well as to spark discussion. Other bloggers have also written about and summarized this book, and I will be linking to these posts as well. I’ll say that I don’t really have anything new to add to what has been perviously said, and I am doing this for my benefit.

Keen’s begins his criticism of neoclassical (micro) economics in chapter 3, which centers around the “Law of Demand” , i.e. the idea that market demand curves don’t necessarily slope downwards. This is in direct contrast to what is taught in an “Intro to Microeconomics” course, and subsequent economic courses use the assumption when explaining other concepts.

Market Demand Curves Don’t Slope Downwards

Economists look at demand curves to see how demand for a commodity changes as its price changes, while the consumer’s income remains constant. When you don’t make that assumption, things get complicated quickly. The decrease of price in one good raises the real income of the consumer (the income effect), allowing the consumer to increase the consumption of all goods, not just the good that has become cheaper. So in the case of Giffen Goods, because the rise in price of one good make another good unaffordable, you have a paradox where demand increases as prices rise. Consider necessary, luxury, and normal goods, and you have a very complicated picture and some interesting looking demand curves.

This is why economists make the distinction between the income effect and the substitution effect (if price falls, consumption rises and vice versa). The substitution effect is always negative and it’s what economists use to establish the “Law of Demand”. However, the income effect can be both negative and positive.  So economists neutralize the income effect by using a Hicksian compensated demand function. The consumer is given a level of utility and a set of prices. The consumer then minimizes the amount of money that he/she would need to spend to achieve that given level of utility, thus separating the income effect and the substitution effect.

But once you introduce more than one agent into the economy, things don’t work out so nicely. With two economic agents, one person’s spending is another person’s income. It’s impossible to separate the income effect and the substitution effect, creating loads of complications for the “Law of the Demand”.

Economists have known this for years. One paper to mention this was written by William Gorman in 1953 (I give Keen a lot of credit for translating this terribly written paper):

We will show that there is just one community indifference curve locus through each point if, and only if, the Engel curves for different individuals at the same prices are parallel straight lines.

Because all utility functions pass through (0,0), this is essentially saying that all consumers have exactly the same preferences. This implies that there is only one consumer in the entire economy, an outright absurd assumption. Because Gorman’s paper was so opague, these results weren’t rediscovered until the 1970s, known as the Sonnenschien-Mantel-Debreu conditions.

But does any of this matter? Keen even admits that “there are some sound reasons why demand might generally be a negative function of price.” Well, it does matter, and there are three reasons why:

1. That contrary to what most lower level economics textbooks will tell you, markets don’t necessarily maximize social welfare.

2. It undermines the idea that “everything happens in equilibrium.” If we have a demand curve like the one above, then the resulting marginal revenue curve (the MR curve is derived from the demand curve) will be even more volatile. The marginal revenue curve will cross the marginal cost curve in multiple places, resulting in multiple points where “everything happens.”

3. The assumption of identical consumers is only valid when when we split society into different classes, which is what the Classical economists were trying to do. However, this approach isn’t used in neoclassical economics. The “one size fit all” treatment clearly has its limitations and macroeconomic theories shouldn’t necessarily be built up from individual behavior.

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Links:

1. Debunking Economics’, Part I: Demand Curves Can Have Any Shape by Unlearning Economics

References:

1. Gorman, W.M. (1953) ‘Community preference fields,’ Econometrica, 21(1): 63-80

2. Keen, Steve. Debunking Economics: The Naked Emperor Dethroned? London: Zed Book, 2011. Print.