Are Humans Rational Utility Maximisers?

Paul Krugman's recent post on Wynne Godley involves a discussion that Yichuan Wang touched on this week — the widely-used assumption that people are rational utility maximisers. Krugman notes that the alternative approach — the sectoral rules of thumb approach embraced by Wynne Godley and many other post-Keynesians — was abandoned by mainstream macroeconomists in favour of other approaches:

So why did hydraulic macro get driven out? Partly because economists like to think of agents as maximizers — it’s at the core of what we’re supposed to know — so that other things equal, an analysis in terms of rational behavior always trumps rules of thumb. But there were also some notable predictive failures of hydraulic macro, failures that it seemed could have been avoided by thinking more in maximizing terms. 

First involved consumption spending. Conventional Keynesian consumption functions suggested that the savings rate would rise as incomes rose — and this wasn’t just the Keynesian interpreters, Keynes himself made the same claim. This, in turn, led to predictions of rising savings rates after World War II, and hence a persistent shortage of demand — hence the secular stagnation theory briefly prominent. (There was even an early Heinlein novel built in part around the secular stagnation theory. As I recall, it was pretty bad.)

In fact, however, savings rates don’t seem to follow the naive consumption function at all; they rise in booms, and are higher for the wealthy, but exhibit no secular trend. And Milton Friedman appeared to explain this paradox by arguing that people are more less rational: they base consumption on “permanent income”, a reasonable estimate of long-run income, and save temporary fluctuations in income.

The second big problem involved inflation. We can argue how many economists really believed in a stable tradeoff between inflation and unemployment, but that’s certainly what got taught to many students. In came Friedman and Phelps to argue that rational price-setters would build expected inflation into their choices, so that sustained low unemployment would produce accelerating inflation. And the stagflation of the 70s seemed to vindicate their argument.

You could argue, and I would, that the rebellion against hydraulic macro went much too far. It’s not at all clear how much good the whole apparatus of maximizing behavior in New Keynesian models really does, and to the extent that such models do seem more or less to work, it’s only by making some ad hoc behavioral assumptions that are grafted on to the rest of the structure. 

Krugman's points regarding the specific approaches of post-Keynesians of the day are reasonable. There emerged empirical observations that their models did not explain, that could be explained by alternative theories. On the other hand, that doesn't necessarily say anything about a rule of thumb or a sectoral approach to macroeconomics. Many approaches can be used to create a model consistent with data, and similar methodological approaches can lead to wildly divergent models with wildly divergent predictions through varying assumptions.

Post-Keynesian ideas — and those of other heterodox schools that made noise about the possibility of the crisis in the early and mid 2000s — have regained a certain amount of public spotlight in recent years, (and in some cases, almost immediately lost the spotlight by making subsequent bad predictions). On the other hand, they do not appear to have gained much academic credibility, perhaps because claims to have "predicted the crisis" are not as convincing to an academic audience as they are to a general one.

The key difference between post-Keynesian sectoral theories, and neoclassical micro-founded ones is in their assumptions. Post-Keynesians using Godley-style models make behavioural assumptions about group behaviours in different sectors; workers, the financial sector, etc. Neoclassical theories make assumptions about individual behaviour — individual utility maximisation, rational preferences and action based on full and relevant information. In both cases, these are all simple heuristics and should probably not really be taken seriously as an attempt to model reality in a literal sense; we should as Milton Friedman famously noted be concerned most by a theory's predictive power. On the other hand, it does not seem desirable to start off with a framework that is obviously wrong. That is, a good theory should have predictive power at both ends — it should start with an accurate (-ish) depiction of reality, and end with successful predictions of reality.

It is arguable that the notion of utility maximisation falls into the category of obvious wrongness. Krugman's conclusion that "It’s not at all clear how much good the whole apparatus of maximizing behavior in New Keynesian models really does" suggests that he may be cautiously leaning in that direction too.  There are two reasons for this — evidence from behavioural economic experiments, and results from neurophysiology. 

One of the most famous tests of Paul Samuelson's definition of utility maximisation (completeness, transitivity, non-satiation, convexity) was undertaken by Reinhard Sippel in 1997. He gave his student test subjects a budget, and a set of eight priced commodities to spend their budget on:

This was repeated ten times, with ten different budget and price combinations. Sippel found that 11 out of 12 of his test subjects’ behaviour failed to meet Samuelson’s criteria for rational utility maximisation. Sippel repeated the experiment later with thirty test subjects, finding that 22 out of 30 did not meet Samuelson’s criteria. Sippel concluded:

We conclude that the evidence for the utility maximisation hypothesis is at best mixed. While there are subjects who appear to be optimising, the majority of them do not.

The evidence emerging in neurophysiology against utility maximisation is more damning. As Daniel McFadden summaried this year in The Atlantic:

Our brains seem to operate like committees, assigning some tasks to the limbic system, others to the frontal system. The “switchboard” does not seem to achieve complete, consistent communication between different parts of the brain. Pleasure and pain are experienced in the limbic system, but not on one fixed “utility” or “self-interest” scale. Pleasure and pain have distinct neural pathways, and these pathways adapt quickly to homeostasis, with sensation coming from changes rather than levels. Overall, presumably as a product of evolution, our brains are organized well enough to keep us alive, fed, reproducing, and responsive to but not overwhelmed by sensation, but they are not hedonometers.

None of this, of course, should be treated as a conclusive blow for any other extant modelling approach or set of assumptions. One reason why neoclassical economics has remained dominant in academia is that other heterodox schools have not yet convincingly envisaged anything conclusively superior Yet, I think, it should be treated as a conclusive blow for the idea that a lot more work is required in coming to a better understanding of the patterns and systems underpinning human economic behaviour. And I think the answers will emerge not from theory but from experimental economics and psychology on the interpersonal level, and from neurology and neurophysiology on the individual level.

This is something that Krugman (and all wannabe Hari Seldons) may eventually be able to get very, very excited about. The only road, I think, to anything approaching psychohistory is mechanically understanding the underlying drives and dynamics of human behaviour, rather than making crude black box assumptions and hoping for the best.