No accounting for creatures of habit

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Successful industrialists claim not to act in accordance with economic theory – why is the theory still taught?

Every student of elementary economics learns that firms maximise their profits by equating marginal cost with marginal revenues. Fifty years ago, two Oxford economists called Hall and Hitch organised a series of evening seminars in which they grilled successful industrialists about how they ran their businesses (we plan to revive the custom). They discovered that few of these industrialists had ever heard of marginal cost or marginal revenue: they certainly did not know how to measure them.

Hall and Hitch thought they had made an important discovery. If business people did not understand about marginal cost and marginal revenue, how could they be maximising their profits? And how then could economists continue using theories of business behaviour which assumed profit maximisation? The two dons invented a theory called full cost pricing. Prices were determined by adding a mark-up to costs, which was what these industrialists said they did.

All this is the most familiar criticism of economics and economists. Economists, it is said, assume selfish and rational behaviour. But economic decisions are made by people, who are often unselfish and irrational. If only economists made more contact with the real world, they could construct theories which were properly descriptive of what people and firms actually do.

And yet every student of elementary economics is still taught about marginal costs and marginal revenue, while full cost pricing theory barely rates a mention. And not just because of the inveterate stubbornness of economists: for good reasons. Asking people what they do and why is not necessarily a good way of understanding their behaviour.

Milton Friedman may have indulged in characteristic overstatement when he wrote that asking businessmen to explain their behaviour was as useful as asking nonagenarians to account for their long life. But he was presenting a crucial argument. Rationality, and profit maximisation, are ‘as if’ hypotheses. Firms may behave as if they were profit maximisers, individuals as if they were rational, and they may do this even if they don’t make the calculations that profit maximisation or rationality requires.

Natural scientists have long been familiar with these kinds of ‘as if’ arguments. The way in which Venus revolves round the sun is described, fairly accurately, by a set of differential equations. No-one thinks that this happens because Venus sat down and worked out the sums. No-one would think that the theory of planetary motion had been refuted because a mathematician went to Venus and failed to find anyone who was familiar with differential equations. Why then should we think it impossible that another system of differential equations might describe how an economy grows, or how savings evolve over the lifetime of a household? And that, like Venus, people might behave in this way without having done the calculations.

Of course, we would have to have reasons for thinking that the equations worked, and evidence that they did. But biological sciences have shown us the extraordinary power of these ‘as if’ hypotheses. Dawkins’ metaphor of the selfish gene presents an argument that genes behave as if their purpose was to propagate themselves as widely as possible. Humans, and many other species, give more attention to our close relatives than to our distant ones, and more by an amount that can be quite accurately calibrated. This is not because we, or our genes, have calculated what proportion of our genes we share. Ant heaps are extraordinary feats of social organisation, but not because some Boss Ant worked the structure out and told everyone what to do. The ant heap is as it is because heaps built in that way fared better than heaps built in different ways. Rational structures emerge because they are favoured by the environment in which they operate.

And we have the same sort of reason for believing in rationality in the economic behaviour of individuals and firms. Everyone lives their life by rules of thumb. And rules of thumb and conventions of behaviour that produce good results will persist. Rules of thumbs that were not consistent with them would not. Just as Venus follows these differential equations because, if it did not, it would drift off into outer space and we would not have to describe its transit around the sun at all.

Now human behaviour seems different from the motion of the planets or the evolution of the species because we know that, in principle, we could make the calculations that rationality demands. There are some people who can solve systems of differential equations – although in practice most of us are as well equipped to do so as the inhabitants of the planet Venus. But is this difference of much importance? Is Microsoft as it is because Bill Gates calculated everything in advance? Or is it closer to the ant heap – an organisation that has evolved by pursuing things that work and abandoning what doesn’t?

And that is why I continue to believe that consumers act, more or less, rationally: that firms tend to do things that increase their profits: that prices in financial markets tend, in the long run, to reflect the intrinsic value of the underlying assets. Consumers do silly things, and so do firms, and so do people who trade in securities. But there is some tendency, over time, for sensible habits to drive out foolish ones. And that is all that the ‘as if’ hypothesis requires.

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