Economists: there is no such thing as the ‘economic approach’

FT.com

January 14, 2014 4:50 pm

By John Kay

Economics is not a method but a subject – one defined by the problems it tackles

Forty years ago, Chicago economist Gary Becker wrote an essay describing “the economic approach to human behaviour”. In his view, “the combined assumptions of maximising behaviour, market equilibrium and stable preferences, used relentlessly and unflinchingly, form the heart of the economic approach”. He went on to claim: “The economic approach is a comprehensive one that is applicable to all human behaviour.” His own work included an economic analysis of family life. In 1992, he was awarded the Nobel Prize in economics for “having extended the domain of microeconomic analysis to a wide range of human behaviour”.

Professor Becker’s expression may seem somewhat extreme. But the Chicago-published Journal of Political Economy has carried articles explaining, for example, that people commit suicide when the net present value of their future utility is negative. (This prompted a future Federal Reserve governor to pen an exasperated response on the economics of brushing teeth.)

Prof Becker’s description of “the economic approach” is a fair characterisation of the dominant paradigm in modern economics. This tends to decry as “unscientific” analysis that does not investigate the properties of equilibria established by agents engaged in rational choice. It is also a starting point for critics of modern economics, who point out that people do not always maximise, preferences are not stable and markets are often out of equilibrium. These objections are well founded. Our motivations are complex, our behaviour sometimes unpredictable and markets rarely achieve equilibrium. Yet such superficial criticism fails to identify the real problem in this approach.

There are many situations where the assumptions Prof Becker describes provide useful conclusions, though family life and suicide are probably not among them. If rents are controlled, tenants still have much the same preferences in housing and potential landlords will still be looking for investment returns. Maximising tenants will maintain or increase demand, while maximising landlords will reduce supply. A new equilibrium in the housing market would leave fewer houses available to let, and a queue of people wanting to occupy houses at prevailing rents but unable to do so. And there is a good deal of empirical evidence that this is indeed what has happened.

On the other hand, applying the assumptions of maximising behaviour, stable preferences and market equilibrium to the prices of stocks leads to the capital asset pricing model. This model yields counter-intuitive propositions; for example, that investors will require lower rates of return for projects involving idiosyncratic risk that is project-specific, such as developing a new technology; and higher returns to invest in a broad portfolio of diversified assets. This is just the sort of empirical test that a scientist in the Popperian falsificationist tradition seeks, and the result is clear; the prediction does not appear to be true. That, one might think, would consign the CAPM to the dustbin of scientific history. But it has not; the model remains central to modern financial economics.

To understand why, parse the strange words of the citation for Prof Becker’s Nobel Prize. It was awarded for: “extending the domain of microeconomic analysis”, rather than for any new insights that emerged from that extension; for the application of technique, not for the solution to an empirical problem.

The model remains in vogue, not because its answers are right but because they are unequivocal, and supporters attach more importance to universality than to relevance. If you criticise its applications, you will be asked what theory you would use instead. But there is no obligation to answer. The alternative is not some other all-encompassing theory of human behaviour but a pragmatic view recognising that explanations are appropriately context-specific.

The real weakness in Prof Becker’s statement, then, is its assertion that there is such a thing as “the economic approach”. Economics is not a method but a subject – one defined by the problems it sets out to tackle not the techniques it uses. To a man with a hammer, everything looks like a nail: but the person useful about the house has a toolbox, and selects the implement appropriate to the task. As John Maynard Keynes observed, economics properly conducted is closer to plumbing or dentistry than physics.

johnkay@johnkay.com