What should replace utility maximization in economics?

Mainstream economics has been based on the idea of people producing and trading in order to maximize their utility, which depends on their assigning values and conditional  probabilities to outcomes. Thus, in particular, mainstream economics implies that people do best by assigning probabilities to possible outcomes, even when there seems no sensible way to do this (such as when considering a possible crash). Ken Arrow has asked, if one rejects utility maximization, what should one replace it with?

The assumption here seems to be that it is better to have a wrong theory than to have no theory. The fear seems to be that economies would grind to a holt unless they were sanctioned by some theory – even a wrong one. But this fear seems at odds with another common view, that economies are driven by businesses, which are driven by ‘pragmatic’ men. It might be that without the endorsement of some (wrong) theory some practices, such as the development of novel technical instruments and the use of large leverages, would be curtailed. But would this be a bad thing?

Nonetheless, Arrow’s challenge deserves a response.

There are many variations in detail of utility maximization theories. Suppose we identity ‘utility maximization’ as a possible heuristic, then utility maximization theory claims that people use some specific heuristics, so an obvious alternative is to consider a wider  range. The implicit idea behind utility maximization theory seems to be under a competitive regime resembling evolution, the evolutionary stable strategies (‘the good ones’) do maximize some utility function, so that in time utility maximizers ought to get to dominate economies. (Maybe poor people do not maximize any utility, but they – supposedly – have relatively little influence on economies.) But this idea is hardly credible. If – as seems to be the case – economies have significant ‘Black Swans’ (low probability high impact events) then utility maximizers  who ignore the possibility of a Black Swan (such as a crash) will do better in the short-term, and so the economy will become dominated by people with the wrong utilities. People with the right utilities would do better in the long run, but have two problems: they need to survive the short-term and they need to estimate the probability of the Black Swan. No method has been suggested for doing this. An alternative is to take account of some notional utility but also take account of any other factors that seem relevant.

For example, when driving a hire-car along a windy road with a sheer drop I ‘should’ adjust my speed to trade time of arrival against risk of death or injury. But usually I simply reduce my speed to the point where the risk is slight, and accept the consequential delay. These are qualitative judgements, not arithmetic trade-offs. Similarly an individual might limit their at-risk investments (e.g. stocks) so that a reasonable fall (e.g. 25%) could be tolerated, rather than try to keep track of all the possible things that could go wrong (such as terrorists stealing a US Minuteman) and their likely impact.

More generally, we could suppose that people act according to their own heuristics, and that there are competitive pressures on heuristics, but not that utility maximization is necessarily ‘best’ or even that a healthy economy relies on most people having similar heuristics, or that there is some stable set of ‘good’ heuristics. All these questions (and possibly more) could be left open for study and debate. As a mathematician it seems to me that decision-making involves ideas, and that ideas are never unique or final, so that novel heuristics could arise and be successful from time to time. Or at least, the contrary would require an explanation. In terms of game theory, the conventional theory seems to presuppose a fixed single-level game, whereas – like much else – economies seem to have scope for changing the game and even for creating higher-level games, without limit. In this case, the strategies must surely change and are created rather than drawn from a fixed set?

See Also

Some evidence against utility maximization. (Arrow’s response prompted this post).

My blog on reasoning under uncertainty with application to economics.

Dave Marsay

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About Dave Marsay
Mathematician with an interest in 'good' reasoning.

11 Responses to What should replace utility maximization in economics?

  1. Blue Aurora says:

    Hello sir! It’s been a while. Have you ever looked into what Paul A. Samuelson called “revealed preference”? IIRC, his first article on revealed preference was published in Economica in the late 1930ies.

    • Dave Marsay says:

      I haven’t studied revealed preference theory, because – looking at it briefly – it seems to be much too simplistic. But maybe I have missed some more credible version?

      Wikipedia talks about apples and oranges. From a game theory perspective my optimal strategy would sometimes be to choose them probabilistically, with probabilities that depend on circumstances. Revealed preference theory seems to regard this as ‘inconsistent’. It even seems to suppose that with steady prices etc I should never eat apples, or never eat oranges, advice which I feel free to disregard.

      It seems to me that often preferences are not revealed between bundles of goods but between ‘higher level’ things (such as diets) that economists often seem oblivious to.

      Thanks for your interest.

  2. Pingback: Empirical Evidence Against Utility Maximization | WEA Pedagogy Blog

  3. Asad Zaman says:

    I have provided a comment on this topic, and also a link to this post, on the WEA Pedagogy Blog:
    http://weapedagogy.wordpress.com/2014/09/03/empirical-evidence-against-utility-maximization/
    @Blue Aurora: Please see my discussion of revealed preference in section 3.2.1 of my paper “Normative Foundations for Scarcity” published in Real World Economic Review, and also available from http://ssrn.com/abstract=1554202

  4. Dave Marsay says:

    In postulate I Samuelson says: “Thus, confronted with a given set of prices and with a given
    income, our idealised individual will always choose the same set of goods.” In postulate III says “In any two price and income situations and corresponding quantities of
    consumer’s goods …) the individual must always behave consistently …”. These seem to me to be the most obviously false aspects of the usual version of utility maximization.

    In choosing holidays and meals, for example, I routinely break both postulates. Perhaps Samuelson had a very dull life?

    I also systematically break postulate III. For example, I often decline to participate in events that I associate with a lifestyle that I couldn’t keep up. I might accept them if I could. At a mundane level, I might do my regular shopping at a discount store and save what is left over, whereas if I had a greater income I might do all my shopping at the posh store next door. Postulate III seems to suggest that I should select an optimal mix of goods to get the most satisfaction for my income.

    I think the fundamental problem is that I do not pick individual goods, but strategies, such as where to shop, what social life to enjoy, etc. (It is not just economics theory that suffers from this problem.)

    Regards.

    • Blue Aurora says:

      I think Paul Samuelson understood the limitations of axioms, but reading his original paper on revealed preference, I get the impression that all he was really trying to say was: “If a person proclaims that he (or she) favours “Good X” over “Good Y”, or vice-versa, why don’t we just observe the person’s choices and see if it holds up?”

      Granted, in some ways, it isn’t that much of a departure from conventional theory, but Paul Samuelson did generate a lot of controversy when he published these articles. Apparently, other economists disapproved of what he was trying to do.

      • Dave Marsay says:

        I am no expert on what Paul S was trying to say, but it seem to me that ‘utility maximization’ is meaningless and not falsifiable without some constraints, as referred to by your notion of “holding up”. One common constraint is Bayes’ rule, hence the link to this blog. Bayes’ rule (in odds form) states that as you receive more evidence, E, the relative odds for two propositions (H, K) are multiplied by their relative likelihoods: P(H|E)/P(K|E) = (P(E|H)/P(K|E)).(P(H)/P(K)).

        For the interesting bits of economics (as in the possible break-up of the UK) this is false, so it is unreasonable to hold utility maximization to this standard. The problem is that Bayes’ rule assumes that the context is fixed and known. But right now it isn’t for Scotland, the Ukraine, … . To adapt Keynes: when the context changes, my estimates of the likelihoods can change, which means that my estimates of the priors will change if they depended on my estimates of the likelihoods. Applying Bayes’ rule naively means never re-assessing your previous estimates. But perhaps sometimes you should. In terms of utility maximization, ‘holding up’ would mean continuing to value oil even once nuclear fusion came on-stream. Why?

      • Blue Aurora says:

        Well, I can’t claim to be an expert on Paul Samuelson’s scholarship either. But by “holding up”, I believe all Samuelson meant to say was whether an individual’s choices in purchases revealed a pattern. But that stated, I don’t approve of the concept of “utility maximisation” either, and I find it interesting that Samuelson didn’t seem to push the issue as time went on.

  5. I think looking Hyman Mynsky approach is the best way to go about it. Basically Economic actors have balance sheets and cashflows associated with them. The attempt to maximize cashflow, while minimizing risk of default. Action is determined by beliefs about future economic conditions that come from condition of balance sheets, past preformance and policy stance. This leads to cycles of instability, since during qiuet periods and following government intervention agents become more optimistic and less concerned about default.

  6. Dave Marsay says:

    Minsky’s model is still relevant today. I take him as saying that most economic actors take short-term views, as if current trends were sustainable and there were to be no more ‘booms and busts’. I agree. But his proposed remedy is for some form of government intervention, which may not be the best solution.

    From a technical mathematical view, any remedy would seem to depend on an understanding of the longer-run issues, which would not consistent with pure utility maximization. But if one is trying to manage both short-term cash flow and annual profits and also to build a business in the long-run, you wouldn’t be best advised to be a pure utility maximizer either, unless you were in a very dull business. In this sense, Minsky and I agree with Knight and Keynes.

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