Economists: Blind to Reality

Over the past century, the theory that rational behavior involves maximization of utility has become central to Economic theory. In economics, this theory is established on axiomatic grounds, and supported by speculative arguments. However, When psychologists examined this theory of behavior by carrying out actual experiments on human behavior, they found that the theory leads to wrong predictions in many examples. By now, an overwhelming amount of evidence has emerged to show the strong conflict between economic theories of human behavior and actual behavior; a survey is given in “Empirical Evidence Against Neoclassical Utility Theory: A Survey of the Literature,” This post provides the details of this conflict in one example taken from the paper, where four major predictions of economic theory are all in direct conflict with the experimental evidence. For a different approach, better aligned with the realities of human psychology, see?A New Approach to Islamic?Economics.

It is not just that utility theory is wrong, what is worse is that it acts as a blindfold, which prevents economists from understanding simple realities of human behavior. The paper provides many examples of this phenomenon, which I will illustrate briefly with one simple example from section 1 of the paper. Another example that shows that stark conflicts between behavior and theory is given in a later post based on Section 2: “Game Theory for Humans with Hearts“.

Details of the conflict between economic theory and behavior are as follows. Consider the two-player Ultimatum Game. The Proposer (P) has ten dollars in single dollar bills. He makes an offer of $m to the Responder (R), which allows him to keep $(10-m). The responder can either Accept or Reject. If Responder Accepts then P gets $10-m, and R gets $m as proposed; it is convenient to denote this outcome as (P:10-m, R:m). If Responder Rejects, then both get $0: (P:0, R:0)

Here are four predictions made by Game Theory, based on utility maximization behavior.

1. Responder will be indifferent between the two choices Accept and Reject if he is offered $0.
2. Responder will Accept an offer of $1, resulting in outcome (P:9, R:1). R prefers 1 to 0.
3. Proposer believes that Responder is a Utility Maximizer; that is, he will behave in accordance with propositions 1 & 2 above.
4. Proposer will therefore offer $1, as it maximizes his share at $9. If he offers $0, the outcome is uncertain because both responses A and R are possible maximizing responses, which is why an offer of $1 is the unique utility maximizing offer.

All four of these propositions are false. Furthermore, every layman will easily be able to see that all four of these propositions are false. However, economists have great difficulty in seeing that they are false and in understanding why this is so. This is because economic theory teaches economists to “think like economists” which means modeling humans as being?homo economicus: cold, selfish, and callous?(Vulcans, for short). This makes economists unable to understand real human behavior. As everyone (except economists) knows, the responder will reject the offer of $0; he will not be indifferent between accept and reject. Empirical studies conforming to our intuition about human behavior show that in situation 2, the vast majority of responders will reject the offer of a 10% share, preferring to get $0 rather than accepting injustice or an unfair offer.

While no one else is surprised by this [rejection of small offers], economists are startled to learn about this routine finding of the ultimatum game. Empirical findings of research on ultimatum games along these lines were routinely rejected by economics journals on the grounds that small stakes and unfamiliarity led people to irrational behavior in an artificial environment. As Colin Camerer, Behavioral Game Theory 60-62 (2003) puts it: “If I had a dollar for every time an economist claimed that raising the stakes would drive ultimatum behavior toward self-interest, I’d have a private jet on standby all day.” Despite this ideological conviction of economists, experiments at high stakes, equivalent to one month's salary, replicated this phenomenon of refusal of unfair offers. Widespread robust replication in different environments designed to answer the standard objections to experiments ultimately led to a reluctant acceptance by economists, and publications of these results in reputable journals. However, despite the flat rejection of utility theory by human behavior, this theory continues to be taught as a?“tautological” truth in mainstream economic textbooks.

The fact that proposition 3 is false is somewhat deeper than the fact that 1 and 2 are false. Whereas 1 and 2 represent false assumptions by economists about human behavior, 3 represents a stronger false assumption about human beliefs about human behavior.?Even if the proposer is Vulcan, he might have enough intelligence to realize that others on this planet are not like him. In this case, he would not rely on propositions 1 and 2. Even a Vulcan may be able to realize, without necessarily understanding why, that normal human beings might resent being offered such a pittance, and might refuse a low offer for emotional reasons. However, not only does game theory teach economists to think that everyone is a Vulcan, it also misleads them into believing that everyone is a stupid Vulcan – they cannot figure out that they are on planet Earth, and therefore other people will not behave like them. It is only a stupid Vulcan who will offer $1 under the mistaken belief that the responder will accept this offer because $1 is better than the $0 he will receive by rejecting. We cannot quantify the level of stupidity displayed by economists who calculate outcomes of games under the assumption that every on this planet is a stupid Vulcan, are surprised when their predictions fail to match reality, and stubbornly refuse to revise theories in face of obvious conflicts with Reality. Keynes' rejection of classical theories led him to the same perception of economists:?The classical economists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight, as the only remedy for the unfortunate collisions which are occurring.?

And that is why the findings of behavioral economics conflict with economic theory, and are not welcomed by economists. When economists talk about “sound” micro-foundations, these are the micro-foundations upon which they wish to build macroeconomics. In his written testimony for the Congress on “Building a Science of Economics for the Real World,” Robert Solow wonders about which planet the macro policies based on DSGE models are designed for. Olivier Blanchard said that the DSGE models make assumptions profoundly at odds with what we know about consumers and firms. There is no surprise that these models were unable to predict the Global Financial Crisis. What is surprising is that, despite overwhelming evidence against it, utility maximization continues to be used as the foundation of microeconomics in all textbooks. We provide an alternative, based on radically different principles, in?A New Approach to Islamic?Economics