Economics for the 21st Century

Bloomberg editor-at-large Tom Keene recently posted “Economics Education Has It All Wrong” on LinkedIn, essentially lamenting the fact that the economics education at most universities is so… boring. Many economics students don’t even get to “issues of interest” until the second or third year of study.

But while I agree with Tom’s basic assessment, I don’t think the solution is simply to revise the way economic theory is presented. The problem is that the kind of economic theory taught in many university courses just doesn’t explain “real life.”

Unfortunately, the dominant train of thought in academic economics is still the “neoclassical model” of supply-and-demand equilibrium. But of course in the real world (as opposed to the academic world) supply and demand are never actually in equilibrium. If the economy were truly in equilibrium there’d be no buying and selling, no transactions of any kind.

Decades ago, when communication was less ubiquitous and technological disruptions were rarer, the pace of economic activity was slower, so the neoclassical model was more useful. But in the face of today’s disruptive technologies and accelerated innovation, social media platforms, and behavioral studies, the discipline of economics has been increasingly left behind.

Evolution by Innovation

To replace or supplement the neoclassical model, one candidate might be what could be called the “evolutionary model” of constant change, driven by invention and innovation.

In the neoclassical model, invention and innovation are considered “exogenous variables,” and exist outside the real, day-to-day economy. But in the real world, it is obvious to everyone that invention and innovation drive virtually all value creation. Whether it’s an inventor with a new kind of mousetrap, or a business executive with an innovative idea for raising the standard for customer service, actual wealth is created through improvement and change, not through stasis and equilibrium.

So rather than relegating invention and innovation to the sidelines, a more useful economic model would put them stage center. And there are some new thinkers who are trying to do just that, studying how innovation and invention drive the creation of value.

One book that should be required reading for any new student approaching the subject of macroeconomics is Eric Beinhocker's Origin of Wealth, which demonstrates how a better explanatory tool for understanding the mechanics of economic activity is the process of evolution. Innovations don’t spring into existence out of thin air. Every new innovation results from combining and upgrading previous ones. This is analogous to biological evolution, which explains how different species combine, mutate, and adapt in a constant trial-and-error process.

It’s not a perfect analogy, but it has a lot of explanatory power, and it means that rather than supply-and-demand equilibrium equations, economics students might be better off learning about fitness landscapes and adaptation by trial and error.

Self-Interest and Economic Incentives

And then there is the question of pursuing one's self-interest. One of the primary reasons people try to innovate in the first place is to create wealth for themselves. Devise a new smartphone app and you could get rich.

But studying how personal self-interest works in real life is likely to be much more educational to the beginning economics student than putting together partial differential equations based on comparative utility metrics.

And for a study of incentives you could hardly do better than some of the “pop economics” books recently available, such as the Freakonomics series by Levitt and Dubner, or perhaps Wheelan and Malkiel’s Naked Economics.

Books like these tend to be long on the readable and entertaining examples of how incentives work, but short on the math that drives economic analysis. So for the non-mathematically inclined students, a useful introduction to the basic principles of statistical reasoning can be found in something like The Drunkard’s Walk, by Leonard Mlodinow.

Irrational Behavior

While the study of incentives assumes that people constantly act to further their own self-interest, there is actually an increasing body of thinking that this perfectly rational, self-interested person – “homo economicus” – exists only in economic theory, not in real life.

In real life, people aren’t purely “rational” in their decision-making, and may not be purely motivated by self-interest, either. We are all plagued with biases, prejudices, and misconceptions about how the world works, and most of us are blessed with empathy and genuine compassion for others, as well. In other words, self-interest isn't everything.

So in this day and age, no economics curriculum should omit the study of “behavioral” economics. Pioneered by Daniel Kahneman and the late Amos Tversky, this field explains a great deal about how human beings make decisions. Kahneman’s recent book, Thinking, Fast and Slow, is a great primer, but Dan Ariely’s Predictably Irrational series, and Robert Cialdini’s classic book Influence, originally published 30 years ago, would also contribute to this field of study.

Social Production

Finally, the study of economics must account for the fact that a great deal of value today is actually created without any real commercial activity at all -- no buying or selling, no profits or shareholder value. This is value creation through voluntary cooperation. Wikipedia, open-source software, and crowd service all illustrate the immense value being created by groups of collaborating innovators without increasing any single individual’s wealth.

Social production is increasingly influential in our always-on, always-connected world, from the millions of blogs conveying free content, entertainment and information, to the thousands of videos uploaded to YouTube every hour.

In the Twentieth Century the political debate between Left and Right about the most efficient way to stimulate economic growth assumed that the answer would naturally lie either with free-market, capitalistic solutions, or with government action on behalf of the “people.” With the fall of the Iron Curtain, it was obvious that free markets had won the debate, but social production was never even considered. The very idea would have seemed preposterous, like trying to boost GDP with a series of barn raisings.

Now that the technology is available, however, unpaid volunteers are in fact creating billions of dollars’ worth of time savings, entertainment, instruction, new information, and knowledge, through a wider and wider variety of social-production enterprises. Some social production endeavors, like Wikipedia, are entirely non-commercial, but most social production supplements other, commercial production. And it’s entirely conceivable that within fifty or a hundred years social production will account for the majority of new value and wealth creation.

The point is, whether you call it social production or the sharing economy, if you don’t study how voluntary participation in social initiatives can create value, you should get an “incomplete” in your economics education. Personally, I’d recommend Yochai Benkler’s Wealth of Networks, Lawrence Lessig’s Remix, or maybe Clay Shirky’s Here Comes Everybody.

Bottom line: If we want university students to begin to grasp how and why prosperity happens, we should broaden the way “economics” is taught. It’s not too late for the teaching of economics to catch up to the 21 Century.