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economic methodology

Ever since the Global Financial Crisis, there have been an increasing number of voices calling for change in the economics curriculum/syllabus. However, even people who are sharply critical of mainstream (Rodrik, Stiglitz, Krugman) merely suggest minor and peripheral changes, and do not question the fundamental methodological basis on which neoclassical economics rests. In fact, a radical paradigm shift is required. According to current nominalist methodology, any model which produces a match to observables is a good model. The economists have lowered the bar further by not even requiring a good match, and not even comparing model results to reality. See “Friedman’s Methodology: A Stake through the Heart of Reason.” When the methodology is seriously deficient, people are allowed officially to make crazy assumptions, as long as the model produces a match with reality. For example, Paul Romer says in the Trouble with Macro: (macro) models attribute fluctuations to imaginary forces (like phlogiston), instead of agent behavior.  This methodology is such that a good model can only emerge by a random accident — just as the theory of evolution holds that life emerged by accident. I have explained how this seriously mistaken methodology came to be adopted, as a result of the wrong side winning the battle of methodologies; see “Method or Madness?

Keynesian models remain substantially superior to modern RBC and DSGE models because they can explain voluntary unemployment, which is ruled out by assumption in the latter models. They can also explain how money, banking, and debt have significant impacts on the real economy, unlike modern macro models. Nonetheless, Keynesian models were rejected in favor of dramatically inferior models — — see postscript on linked post for “70 years of Economists’ Failure to Understand the Labor Market“. When the methodology is so bad that it cannot differentiate between good and bad models, and cannot revise models in face of conflicting observations, then it become useless to debate whether any particular model is good or bad. After all, even though Solow thought that DSGE models were developed for Mars (see Solow testimony), and Lucas and Sargent were akin to madmen who believed themselves to be Napolean Bonaparte — DSGE models continue to be used throughout the world, and Lucas and Sargent are extremely respected names in the profession. This is true despite  the fact noted by Olivier Blanchard that their models make “assumptions profoundly at odds with what we know about consumers and firms.”

Building good models within the current methodology will serve no purpose; one must change the methodology to one which is CAPABLE of distinguishing between good and bad models, and which is CAPABLE of correcting and revising models when they do not match observational evidence. Such a methodology, which is radically different from what is currently in use, is available in Polanyi’s Methodology  It rejects methodological individualism in favor of giving agency to collective action — groups, communities. It rejects the isolation of economics, arguing that all dimensions of human societies — social, political, economic — interact and cannot be understood in isolation. It also asserts, contrary to mainstream views, the economic theories cannot be understood outside of their historical context, and also, history cannot be understood without considering the economic theories formulated to understand this history — since policies were based on these theories and shaped the course of history. To take this “entanglement” into account, we must study the co-evolution of theories and history. I have several posts explaining entanglement; for instance — The Entanglement of the Objective and the SubjectiveHunter-Gatherer Societies, and The Three Methodologies.

The main point I am trying to make here is that our problems with current macro and micro models cannot be resolved at the level that we are seeking solutions — that is, criticizing models as being bad, contradicted by data, meaningless, nonesensical, or absurd. Providing better models is useless, when there is no methodology (other than Solow’s smell test, infinitely subjective) to determine whether a newly proposed model is better than the previous one.  Solutions can only be found at the META-Level, where we consider theories about how theories come to be accepted. This point is made in the article ” On the Central Importance of a Meta-Theory for Economics“. The main methodological question we need to focus on is: How do we distinguish between good and bad theories? Given theory A and theory B, how do we decide which one should be used? Economists methodology is based on rules which make impossible the emergence of good theories. As Mankiw states in the intro to one of his texts (and Krugman repeats) good economic models are based on optimization and equilibrium. Overwhelming empirical evidence shows that human behavior is driven by heuristics. Studies of dynamic systems show that essential aspects of these systems are determined by what happens out of equilibrium; it is impossible to say what will happen by just calculating the equilibria of the system. So once one is committed to Optimization and Equilibrium, one has put on a blindfold that makes it impossible to see reality.  The methodological principle that a theory is good if and only if it is based on maximization/equilibria is what leads to construction of theories which are profoundly at odds with observed facts. Furthermore theories which are aligned with facts — like Keynesian involuntary unemployment — are rejected, only because economists cannot create models which align Keynes with optimization and equilibrium (though this is just due to inability of economists to understand complexity, due to which they default to single-agent models). Even though Keynes CAN be aligned with optimization/equilibrium — this has been the AGENDA of the New Keynesians, to show that standard methodology need not reject Keynesian theory — this is the WRONG agenda. The right agenda requires thinking seriously about methodology — HOW can we find a methodology which allows us to discriminate between good and models, and allows us to make PROGRESS over time, as we gradually learn to build better models, overcoming defects of previous poorer models? If we had such a methodology, we would not face a situation which, according to Romer, there has been three decades of intellectual regress, where models have become worse, and hard won knowledge has been lost.

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Whereas conventional economics takes the nature of man as fixed and exogenous, Islamic teachings consider humans to simultaneously possess the potential for being better than angels and also for being worse than animals. Given this dual nature of man, the focus of Islamic teachings is to invite towards the good, and to discourage and prevent the evil. The focus is to try to transform human beings so that they become kind, compassionate, cooperative and generous, instead of acting on their base instincts of greed and competition. For more details in this connection, see Spirituality and Development.

The following ABSTRACT of proposed paper submitted for consideration for the 12th ICIEF at Ummul-Qura University, 10-11 Feb 2019, Mecca, Saudi Arabia outlines a methodology for working on transformation of human beings towards the good.

ABSTRACT:

All social sciences consist of three distinct dimensions. The first is a positive description of human realities. The second is a normative description of an ideal state of affairs. The third is a prescription of what needs to be done to transform the current state to the ideal state. Conventional economics describes humans as being homo economicus, motivated solely by the desire to maximize pleasures obtained by consumption (of goods and services). The ideal state of affairs is for all people to be able to satisfy all desires, but this is not possible due to scarcity. The transformative strategy is economic growth – we increase the amount of production in order to be able to remove scarcity and achieve plenitude. The pursuit of economic growth at all costs, prescribed by conventional economic theory, has caused massive economic injustice, and put the future of mankind in peril, by destroying planetary resources and human communities in the mad rush for growth.

Islam differs from conventional economics in all three dimensions. The description of human beings is substantially more complex, and closer to realities of human behavior. Humans have a wide variety of different goals, and they have conflicting desires and motivations. The human heart is a battleground between the forces of good and evil. The human being has been give the capabilities for excellence in both directions, for the greatest good as well as the greatest evil. The ideal state to strive for has been described theoretically in the Quran and Hadeeth, and the perfect model for behavior has been sent to us in the form of our Prophet Mohammad SAW. The strategy for transformation of human beings is Tazkiya, or purification of the heart from idle desires.
Conventional economic theory takes the nature and desires of man as exogenously given, and works on producing goods to satisfy all desires. Islam works on changing the hearts of men to purify them of the greed and competition for worldly goods, and replace these by the higher norms of cooperation and generosity. True richness is the contentment of the heart, which comes from abundance thinking, rather than worrying about scarcity. The Prophet Mohammad SAW created a revolution in history, transforming ignorant and backwards Arabs to become leaders of the world, and to launch a civilization which enlightened the world for a thousand years. Today, the central strategy of an Islamic approach to economics must similarly be to work on the hearts of men, instead of on the production of wealth.

OUTLINE of Proposed Paper:

Conventional Economics is wrong in all three dimensions.

As a DESCRIPTION of human behavior, homo economicus fails miserably.  As behavioral economists have discovered, actual human behavior is dramatically different from the predictions made by economists — see “Behavioral Versus Neoclassical Economics” or “Homo Economicus: Cold, Calculating, and Callous” for the contrast between reality and economic theory.

As a normative theory, the idea that everyone should seek to maximize the pleasure obtained from a lifetime of consumption is dramatically flawed. Seeking material comforts only brings short-term pleasure, but does not lead to long term happiness. See my earlier post on The Coca-Cola Theory of Happiness — even though a drink of coca cola may bring a lot of pleasure to a hot and thirsty man, keeping the referigator stocked with cold drinks will not bring him a lifetime of happiness. Deeper study shows that long term welfare and happiness is strongly dependent on cultivation of gratitude, compassion, and other characteristics and qualities encouraged by Islamic teachings.

As a transformative theory, the idea that growth will remove scarcity is exceedingly foolish. As we fulfill desires, they increase. Furthermore, people seek to have higher standards than their neighbors, in order to feel happy. This creates a rat race where everybody spends huge amounts of time and effort trying to achieve higher standards of living, but nobody feels happier as a result — the Easterlin Paradox: Can Money Buy Happiness?.  Islam teaches us if we give someone a valley full of gold, he will desire another one. Nothing will fill the belly of man except the dust of the grave. Islam offers the solution that we should NOT fulfill our idle desires, and control our Nafs. Instead, we should learn contentment of the heart, which is the true wealth.

Islamic Economics Offers a Superior Alternative in All Three Dimensions

As a descriptive theory, Islam provides us with a rich description of the complexities of human behavior. The human heart is a battleground between good and evil, and the human being has the capacity to be higher than the angles and also the capacity to be worse than the beasts. This matches with experimental evidence and also with our personal observations — human beings display cooperation and generosity, along with the selfishness and greed assumed by economics. Islam provides a far more accurate match to the observations of behavioral and experimental economics, giving us a better descriptive theory.

As a normative theory, Islam is far superior to conventional economics. Economics suggest that the sole purpose of life is maximization of pleasure obtained from the utiltiy of consumption. Islam teaches us that this pursuit of material goods and worldly pleasure is attractive to the hearts of men, but this is an illusion. Real satisfaction comes from higher pursuits, and cultivation of character traits like gratitude towards Allah for His countless gifts and blessings. The path to everlasting pleasure, both in this world and the next involves learning Tawakkul or Trust in God, cultivating Contentment, and learning Taqwa.

As a transformative theory, Islamics demonstrated their power by catapulting the backwards and ignorant Arabs to world leadership positions, and by launching a civilization that educated the world for a thousand years. These teachings still retain their power to change our hearts and to change the world — see Our Prophet SAW as a Guide for Revolutionary Change or Modern Miracles of Mohammad SAW. Unfortunately, as prophesied, Islam has become a stranger to the Muslims. Today the Muslims no longer believe in the power of Islam to create a revolution — instead, they think that we must rely on Western teachings in order to make progress. For a more detailed explanation, see The Modern Mu’tazila

To conclude — in all three dimensions, modern economics is seriously wrong, while in all three dimensions, Islamic economics provides a dramatically superior alternative. Sad to say, Muslims have been so impressed with the West that they have accepted Western economic theory as superior. Whenever they saw a conflict between Western economics and the Quran, they re-interpreted the Quran instead of rejecting the Western theories. As a result, they have been trying to create an Islamic economic based on Western foundational principles of scarcity, greed, and competition — see “The Crisis in Islamic Economics“. What we need to do instead is to build directly on Islamic foundations based on the abundance of the provision by Allah leading to generosity and cooperation. For further explanations, see The Spiritual Obstacle to Genuine Islamic Economics, and Questioning All of Economic Theory?

This is the second lecture on Understanding the Rise and Fall of the Gold Standard — shortlink: bit.do/azifa2 — we start with a  Summary of First Lecture 

The first lecture discusses the Keynesian theory that the exact level of money in an economy is critically important – too little leads to recessions, while too much leads to inflations. Furthermore, domestic business cycles, and international financial crises are caused by pro-cyclical behavior of current artificial systems of money creation and international trade. Standard macro theories make it impossible to understand the economy because they assert that money is neutral, and does not affect the real economy – exactly the opposite of the Keynesian idea that the quantity of money is all important. Standard macro model currently in use throughout the world have no explicit role of money, banks, and credit, even though these factors are of central importance in understanding the world. Once we understand the vital role and function of money within an economy, it becomes possible to understand historical events of the twentieth century – whereas this is impossible using conventional macro theories. The first lecture summarizes how the colonial system came into being, and the monetary arrangement for a hard currency at the core and soft currencies in the periphery. This system of fiat currencies works fine within one system of colonies, where the value of money is decreed by sovereign fiat. For trading between different countries, the gold backed currencies were used. As European countries prospered by exploiting resources throughout the globe within their colonies, inter-European trade increased. The optimal quantity of money required for the domestic economy is not the same as that required for stable international exchange rates. The pro-cyclical money creation which is characteristic of the system creates cycles, and large cycles lead to crises on a routine basis. World War I was partly caused by the breakdown of the colonial trading system due to the end of expansion possibilities after the completion of the conquest of the globe. Efforts to restore the gold standard after World War I failed. The second part of the lecture discusses the post World War I history, with reference to the international financial architecture that emerged in the post-Gold era after World War I.

3100 Word Summary of Second Lecture on Global Financial Architecture

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[bit.do/azifa] Lecture 1 on Rise and Fall of the Gold Standard, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture. Shortlink for Lecture 2: bit.do/azifa3

3100 word summary of lecture:

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The talk linked below explains why the positivist/nominalist methodology used in Econometrics leads to mostly nonesense regressions. It also explains how a realist alternative can be developed.

“The Philosophy and Techniques for Quantitative Research” – Keynote Address by Dr. Asad Zaman, VC PIDE at Workshop on 19-20 April, 2018 Dept of Economics, Fatima Jinnah Women’s University, Rawalpindi, Pakistan.

My message will come as a surprise to students gathered here to learn advanced econometric techniques. Let me begin by stating it baldly: “Econometrics is nothing more than Fraud by Numbers”.

As Joan Robinson famously said, “The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.” A similar statement holds for econometrics. We should learn it not in order to acquire techniques which will teach us how to use data sets to make inferences about reality. Rather, we should learn it to avoid being deceived by econometricians. The techniques described by Perkins in “Confessions of an Economic Hit-Man” are in common use around the world. Fancy econometrics is used to persuade people to adopt policies which harm the public, while fattening corporate coffers.

As a simple illustration of econometric fraud, consider the following regression:

CONS    =              -268.7    +  6.78 SUR – 1.82 CO2 +  error    (R2=0.84)

Std Err:                  (25.9)       (0.73)         (0.65)           (20.0)

Where CONS = Private Consumption Expenditure in Pakistan, SUR =Survival to age 65, female (% of cohort) = SP.DYN.TO65.FE.ZS, C02 =CO2 emissions from gaseous fuel consumption (% of total)= EN.ATM.CO2E.GF.ZS – these are variables taken from the WDI data set.

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My article about the Battle of Methodologies, published in March 2018 issue of NewsLine Magazine:

Because of the universal spread and impact of Western educational systems, necessary for survival in the modern world, we have all learned to view the world through glasses manufactured in Europe. Just as a fish is unaware of the waters in which it swims, so we are unaware of the currents of history which have shaped European thought. Yet to understand the world we live in, and how our perceptions have been shaped by the dominance of West, it is essential to acquire an understanding of how the Western worldview has been radically transformed over the past few centuries. In this brief essay, we will discuss the “Methodenstreit”, the battle of methodologies, which took place in the late nineteenth century. While this is only one piece of the complex and multi-dimensional historical experiences of Europeans, the methodenstreit had a decisive impact on modern social science, which shapes our current understanding of human beings and their social, political and economic lives. The title of the book “How Economics Forgot History” about the methodenstreit by Geoffrey Hodgson accurately describes the impact of this battle on the discipline of Economics. In this battle, the German Historical School, championed by Schmoller and his colleagues, lost to the Austrian School of Menger, who favored a scientific and quantitative approach to economics.

But what is wrong with taking a scientific approach to the formulation and solution of economic problems, the reader might ask. This essay provides an answer to this question. The idea that economics is a “science” is firmly embedded in the foundations of modern economics. This means that economics provides us with a set of laws which have universal applicability across time and space, independent of social, political, geographic, and historic context. In fact, there are no such economic laws. How we organize our economic affairs differs in different societies, and also varies across time. The attempt to create a “scientific” economics resulted in forcing mathematical laws upon human behavior. Over the past few decades, psychologists who study actual human behavior have established that humans do not behave according to these laws. This has resulted in the creation of field of “Behavioral Economics,” and many researchers working in this area have been awarded Nobel Prizes (most recently, Richard Thaler) for discoveries which contradict the laws of behavior still being taught across the globe to students of economic theory. Despite discoveries that human beings are temperamental, driven by diverse and conflicting emotions, and free to make sudden changes in behavior, the scientific methodology of modern economics currently being taught to students across the globe continues to describe human beings as predictable robots subject to mathematical laws. The insights from behavioral economics are so radically in conflict with economic theory, that economists have not been able to assimilate them into the mainstream curriculum.

Similarly, the scientific method leads economists to ignore specific historical events in their vain quest for universal laws which describe economic systems. Essential insights about economics are lost due to this disregard of history.  For example, the two world wars, The Great Depression, The Bretton-Woods agreement, and Nixon’s revocation of gold backing for the dollar are events of central importance for understanding the economics of the twentieth century. However, economists do not study these events since they are particular and specific historical events, which cannot be described using universal scientific laws. On a larger scale, the birth of modern market society can be traced to the industrial revolution, which created possibilities of massive overproduction of goods in 18th century England. This overproduction concentrated a massive amount of wealth and power in the hands of a small group of people, who were able to use favorable historical circumstances to increase their wealth and power by expanding the role and influence of markets to the point that they came to dominate and destroy traditional societies all over the world. The deep insights which emerge upon connecting the historical context with economic theory have been brought out by Karl Polanyi in his magnum opus: “The Great Transformation: The Political and Economic Origins of Our Times.” One of the central themes of Polanyi is the dramatic contrast and opposition between values of traditional societies and the emerging modern market society. Traditional societies organize their economies on principles of redistribution and reciprocity, cooperatively taking care of all members. Furthermore, traditional societies value many characteristics like heroism, generosity, knowledge, spirituality, literature, arts, sports, etc. over and above the possession of wealth. In contrast, wealth becomes the primary marker of status in market societies, and becomes the main object of personal and collective endeavor. Studying the evolution of economic system and the co-evolution of economic theories adapted to the study of these systems in historical context yield deep insights not available using the currently dominant ‘scientific’ methodology.

An important consequence of the opposition between market values and social values is that traditional societies do not and cannot evolve into becoming market societies – this change is always brought about by a revolution, which destroys traditional values and replaces them by anti-thetical values of a market society. This revolution occurs on both the physical and material dimension, and, more importantly for our present essay, it also occurs on the ideological dimension. As Marx realized, capitalism produces laborers conditioned by education, tradition, and habits into thinking of the economy as subject to natural laws, and accepting their own exploitation as a necessary, fair, and just part of the system. Similarly, even though the market society provides enormous amounts of wealth and power for a few select members, expansion of the market into all human affairs requires this minority to create and popularize market ideologies. At the core of market ideologies is the idea that markets are governed by natural laws which provide equitable outcomes to all participants and create maximum wealth for all. This ideology runs counter to traditional ideas about social responsibility for the poor and disadvantaged, and suggests that interfering with market mechanisms will cause harm to everyone.

To understand the “origins of our times,” it is necessary to understand the parallel growth of market institutions which expand the scope and power of the marketplace, and the accompanying market ideologies which counter and negate traditional ideas about social norms. For example, exploiting the possibilities of massive overproduction created by the industrial revolution required the creation of consumers for these products. The globe was occupied by traditional societies which prized self-sufficiency as a virtue, and did not have markets for British goods. The productive capacities of the industrial society created the power to physically take over and colonize weaker societies all over the world. The destruction of local institutions for provision of social welfare, and the harnessing of all factors – labor, land, natural resources – to the global production of capitalist wealth was also accompanied by ideologies promoting the idea that this was the best path for all concerned. In particular, the economic theory of “comparative advantage” was invented to justify the absurd idea that it was in best interest of the colonies to remain engaged in the production of raw materials, leaving England to specialize in the production of industrial manufactures. Since it is easily refuted by empirical evidence, comparative advantage cannot be understood as a “scientific theory”. It can only be understood as a product of historical circumstances, as a part of a collection of theories required to justify the brutal processes of colonization and the accompanying destruction of local economies.

Since ‘comparative advantage’ was a manifestation of political power, effective counters also required political power. In Germany,  Friedrich List created the ‘infant industry argument” to support protectionist policies in Germany and Europe, which allowed European industries to catch up to England. Similarly, the American Revolution allowed the USA to implement protectionist policies which developed strong industries in North America. Colonies which did not have the political power to resist the ideology of comparative advantage remain agricultural economies providing raw materials to advanced economies to this day.  Like all major modern economic theories, comparative advantage can only be understood within its historical context, by seeing how the interests of the powerful imperialists were protected and advanced by the spread of this theory. The theory of free trade, which remains popular and widely believed by economists, is very similar. Wars by European powers against China and Japan were concluding by signing treaties which opened these countries to European goods, creating a market for industrialized European economies. Not only was free trade forced upon them by war, but the ‘theory of free trade’, which says that this was in their best interest, was forced upon them by the corresponding ideological war. It was the ability of China and Japan to resist this ideological war that has led to their economic success today. Similarly, it has been our failure to resist the invasion of ideologies and theories of the economic hit-men that has led to our poor economic performance for several decades.

The most important insight which emerges from studying history, politics, geography, and society in conjunction with economics is the deep inter-connections between all these spheres of human lives, and the impossibility of studying them in isolation. Like all of social science, modern economic theory derives directly from the analysis of economic systems of Western capitalist societies. The victory of the scientific and quantitative school over the German historical school in the battle of the methodologies created the misconception that this analysis is a “science” which is universally valid across time and space, for all societies. This has led to the current situation, where we teach and study capitalist economics relevant to modern European and USA economies but largely irrelevant to our economy, which is structured along different lines. At the same time, we do not study the success stories in patterns of the miraculous growth achieved by China and East Asian economies, which followed radically different policies. Discarding the blinders created by “scientific” pretensions of Western economics would create much-needed skepticism about the applicability of Western economic  theories to our radically different historical and cultural context, and also open our eyes to non-European models for prosperity which offer us substantially greater chances of success.

PostScript: For a more detailed discussion, see Origins of Western Social Sciences

Romer writes that macro-economists casually dismiss facts, and the profession as a whole has gone backwards over the past few decades, losing precious and hard-won knowledge. He does not consider WHY this happened. What are the methodological flaws that create the possibility of moving backwards, losing knowledge, affirming theories known to be in conflict with facts. How is it that leading economists can confidently assert theories which border on lunacy, and receive Nobel Prizes instead of psychiatric treatment?

This is due to the famous AS-IF methodology of Friedman, which gave economists a license for lunacy.  Friedman came up with this defense of orthodoxy when numerous emprical investigation revealed clearly that firms did not maximize profits, did not know their marginal costs, typically used mark-up pricing, and did other things which did not square with neo-classical theories. Friedman’s argument has been universally condemned by logicians and philosophers as an instance of the logical fallacy of “Affirming the consequent” – the use of modus ponens in reverse. That is, Friedman says, in effect, that theory T implies observable consequence C. We observe C, and therefore we can affirm that T holds. This is obviously fallacious since many different theories, inconsistent with T, may also imply consequence C. Even more importantly, a false theory T will always imply consequences C* which are not observed — since the theory is false, it will have consequences which are false. Ignoring all of these problems,  Boland uses an instrumentalist interpretation to defend Friedman, just like all economics textbooks. He writes that even though critics universally condemn his logic, Friedman is right, and ALL the critics are wrong.

In my lecture on  AM2L07 (code for Advanced Micro II: Lecture 7) Methodological Mistakes: Prospect Theory and Psychology Protocols, I explain why Friedman is wrong and his critics are right by discussing this methodological debate within the concrete context of trying to understand search theory. Consider a hypothetical problem where a person is searching for the highest wage. He goes from one firm to next. At each point he is offered a job at a certain wage W. He can accept and quit searching, or reject the offer and go on searching. We want to find a theory which explains search behavior that we observe in lab experiments designed to emulate this situation.

In simple models, it is easy to show that optimal search sets a reservation wage W* and the laborer searches until he/she finds the first offer above this value. The Economist is committed to the assumption that humans are hyper-rational, and they maximize. ONLY theories satisfying these assumptions will be examined for validity. This means that there is NO QUESTION of looking at human behavior itself to see whether or not this hypothesis about behavior holds. Rather, the ONLY problem is to find the FUNCTION which is being maximized.  Economists start by using Expected Utility theory. A rather large number of empirical examples show that this theory does not match human behavior. Nonetheless, this continues to be the dominant theory of decision making under uncertainty and continues to be taught in textbooks, even though the theory is KNOWN to be wrong.

An improvement upon this is PROSPECT theory. By making ad-hoc modifications to probabilities, utilities, and FRAMING the problem in a suitable way, this theory can achieve a MUCH BETTER match to observed behavior than Utility theory. This theory preserves MAXIMIZATION – humans maximize something. However it abandons rationality — why should humans treat probabilities INCORRECTLY. Economists cannot stomach this observed failure of rationality and so AFFIRM theories solidly in conflict with observed facts about human behavior.

NEITHER of these approaches is scientific, since both dogmatically assert allegiance to the maximization principle regardless of observation. The articles by John Hey show how one can move beyond this to a genuinely scientific methodology. He explains how many researchers have investigated search behavior, but have only been concerned with whether or not it matched ASSUMED theories of behavior. INSTEAD he proposes to investigate how humans ACTUALLY behave, without imposing any assumptions about behavior in advance. He used psychological protocols, asking subject to think out loud about the process with which they arrive at the decision on whether to accept an offer or to go on to search for the next one. As can be expected, humans cannot make complex calculations that theory requires of them, and instead they use various heuristics and rules of thumb. These heuristic work fairly well, and get them reasonable close to what someone with full information and infinite computational capabilities could achieve. Nonetheless, the use of heuristics gives radically different results about what we could expect to see in markets where these behaviors, rather than the hypothesized AS-IF behavior is used. The full lecture is linked below

For lecture slides and reference materials, links to related articles, as well as the whole sequence of lectures, see the course website: Advanced Micro II (shortlink: bit.do/ee2018)

POSTSCRIPT: The process of lecturing, trying to explain to my students how their fellow students are being duped by economic textbook, always give me greater clarity. In this lecture, I examine three approaches to understanding human behavior in the process of searching for the best wage (or searching for the best price).

1: AXIOMATIC — represented by Expected Utility. Here we know in advance what human behavior is. We do not need to look at human behavior at all. If someone ELSE studies this behavior and finds that our theories do not match actual behavior, we say that the experiment must be wrong.

2: DESCRIPTIVE — represented by Prospect Theory. Unlike economists, experimentalists and behaviorists study actual behavior. When it fails to match Expected Utility, they came up with a new theory — prospect theory — which summarizes and encapsulates a description of how humans behave in decisions under uncertainty. Economists REJECT this picture because it shows how human behavior is IRRATIONAL – and this conflicts with their FUNDAMENTAL assumptions of rationality, which must be maintained regardless of any inconvenient facts or observations or introspection.

3: SCIENTIFIC: An accurate description permits us to proceed to the next stage, which is to try to understand the REASONS for this behavior. For example, we observe that most people are risk-averse. They prefer the certain outcome of $50 to a gamble with offers $0 and $100 with equal probabilty. Now we can ask why — this is with regards to unobservable, hidden motivations, about which we can never be certain. A good explanation for this is REGRET. Because of our psychological makeup, the flatness of the utility function in gains, a win of 100 does not feel vastly superior to a win of 50. But the real kicker is the feat that if I take a gamble and lose, I will feel so stupid. Avoiding the regret that might occur when I say I should have taken that certain $50 might be the explanation for risk aversion.

Actually, even “reverse Modus Ponens” is not a good description of Friedman’s methodology — there is an added F-Twist: If we can FIND some observations C such that theory T implies them, then we affirm theory T, and IGNORE any other implications of T which actually conflict with observations.

The METHODOLOGICAL point is the Friedman, like all nominalists and instrumentalists, GIVES up on the possibility of understanding human behavior. All he wants is a model which provides a SUPERFICIAL match to some observations. However, many many real life situations show that this is NOT ENOUGH — we need to have a deeper understanding, in order to be able to explain economic and social phenomena. See also previous related post on Economists Confuse Greek Methodology with Science