Economic Egoism

Economics, like any other empirical enterprise, makes simplifying assumptions to make the challenges in question tractable. However the solutions provided are dependent upon those assumptions having been in some sense empirically validated, otherwise such simplifications might mislead more than edify.

One assumption is over how individual agents exercise choice. They are assumed to operate with purely self regarding desires or only selfish motivations. From this a theory of economic rational behaviour is derived, based on the combination of selfish motivations (ends) and instrumental (means-end) rationality, where everyone is seeks to maximise their benefits from the exercise of their choices. Selfish agents are rational maximisers. This assumption is sometimes known as the rational expectations hypothesis.

Now actual individuals vary from behaving as identical rational maximisers due a wide range of disparities in biology and culture - age, skills, education, influence, information and so on. However it is also assumed that these disparities cancel out, so that in an aggregate fashion, individuals collectively tend to be selfishly motivated rational maximisers. This also allows for non-selfish motivation, other regarding desires as noted in my last post. However these values are expressed, it is assumed that they tend to cancel out.

When people wish to maximise their available resources they seek to maximise their return whether due to labour, investments or some combination and to minimise the risk associated with that return. In order to gain more - a higher return - they might undergo more risk to achieve this. Working for a junk food shop offers low risk and related low return. Starting your own business offers a potentially higher return but with an associated higher risk (the business might fail). Generally most would not undertake more risky endeavours or investments without the accompanying expected return. One does not create a start up to earn junk food wages. There is purportedly an optimum risk and return ratio for any agent's particular skills, resources and requirements.

The economic challenge is to measure such risk to discover this optimum. A key benefit of rational expectations approach is the relatively simple mathematical characterisations of risk that should be expected, if this is true. No man is an island and so statistical averages can be derived due to everyone interacting with everyone else. That is the rational expectations hypothesis enables everyone to be considered as both making decisions independently and to conform to an identically distribution - due to, in aggregate, all behaving as rational maximisers as other behaviours cancelling out. The aggregate is the arithmetic average, the distribution is the normal, Gaussian distribution or bell curve and the measure of risk is the standard deviation around this average.

The above is just a sketch but whilst a crude simplification of this economic issue sufficiently captures key assumptions that are embedded in and used in economic reasoning not just in business but governments. Does this approach lead to empirically sound models of choice behaviour?

In fact other sub-disciplines within economics such as behavioural finance and in other disciplines such as cognitive psychology have more than cast doubt on the assumptions underlying and the conclusions resulting from the rational expectations hypothesis.

A large variety of studies have shown that we are exhibit a variety of consistent and predictable asymmetries in decision making and that we are affected in various ways by many heuristics and biases and all which are regarded as irrational and not self regarding according to the rational expectations hypothesis. Further these asymmetries, heuristics and bias can be systemic on an aggregate level and so rather than cancel out - with or without negative feedback - and can persist or even be amplified in positive feedback in group choice making actions.

The implication of such systemic biases is that this destroys the independence and identically distributed * assumptions that underlay the statistical assumptions of our most common risk measures. This makes our measures of risk at best different and at worst undefined and this means that the amount of effort and investment undertaken to generate an expected reward for a given risk might be wildly different to reality.

Another challenge to the rational expectations hypothesis is over the maximising assumption. Herbert Simon won a Nobel Prize in Economics for his work on satisficing- choosing what is "good enough" over a few choices compared to seeking the optimum value over many choices. Later psychological work has shown that satisficers are happier than maximisers.

All in all this work shows that the rational expectations hypothesis or economic egoism - as I titled this post - has little empirical support. We are not purely selfishly motivated, and even when we think we are we are "irrationally" affected by heuristics and biases in a systemic fashion that can be taken advantage deliberately and unwittingly by various interests.

An important fact is while much of this work is recent, it is not that recent, and is sufficiently well known within economics, even it has been all too often repeatedly ignored. This makes the recent financial debacles quite different to last major ones in the 1980s. Yet still it has occurred and is indeed still occurring and it is quite unclear as to its resolution.

One factor in this has been the interaction between economic egoism and ethical egoism. Each position has been drawing support and justification from the other. However this and the last post together indicate that there is no empirical support for either type of egoism. Neither can the lack of empirical evidence in either area - even noting that they have similar but distinct notions of selfishness - cannot jointly support either egoism.

Clearly though selfish motives, of course, do exist, some people can act with extreme selfishness, with utter disregard for others, as the latest financial meltdown has nfortunately demonstrated. The points here do not contradict this but rather indicate that such arguments for economic and ethical egoism, ones that have been used to support and justify regulations and policies that have contributed to the mess we are in, did not and do not have the empirical support that was assumed.

* [In fact Stable Levy or Pareto distributions with undefined or infinite variance can be the result of iid variables. This paragraph is focused on the measurement of risk issue]