Replacing ‘Rational Economic Person’: Networks, Behaviour and Policy in the 21st Century

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This is the first of two guest pieces by Paul Ormerod, the author of “Positive Linking” (Amazon USA; Amazon UK) and several other important books on non-equilibrium economics.

Paul and I have been research colleagues and friends for over a decade now, and I regard him as the foremost exponent of multi-agent and network economics today. As regular readers will know, I prefer a “tops down” approach to economics over the multi-agent approach, mainly because the phenomenon of emergence is a significant conceptual barrier between the “macro” systems we wish to describe and the “micro” behaviour of the individual entities that comprise the system. Paul has a flair for being able to develop models that penetrate that barrier successfully. I particularly like the model in this paper on competition and market structure, and I use it in my own lectures as an example of how competition should be modelled by economists, in contrast to the Neoclassical myths of perfect & imperfect competition and oligopoly.

Over to Paul…

Modern economic theory was first set out on a formal basis in the late nineteenth century. There have certainly been developments since then, but at heart the basic view in economics of how the world operates remains the same. Economics is essentially a theory of how decisions are made by individuals, of what information is gathered and how it is used by the decision maker.

All scientific theories, even quantum physics, are approximations to reality. Theories involve making assumptions, simplifications, to enable us to understand problems better. A key feature of a good theory is that its assumptions are a reasonable description of the real world.

In the early twenty-first century, just as it did in the late nineteenth, economics in general makes the assumption that individuals operate autonomously, isolated from the direct influences of others. A person has a fixed set of tastes and preferences. When choosing amongst a set of alternatives, he or she compares the attributes of these alternatives and selects the one which most closely corresponds to his or her preferences.

This view of the world dominates both social and economic policy making.

At first sight, this may seem quite reasonable, indeed even ‘rational’, as economists choose to describe this theory of behaviour. But there is a serious problem with the assumption that individuals operate in isolation from each other, that their preferences are not affected directly by the decisions of others.

The social and economic worlds of the twenty-first century are simply not like this at all. We are far more aware than ever before of the choices, decisions, behaviours and opinions of other people. In 1900, not much more than 10 per cent of the world’s population lived in cities. Now, for the first time in human history, more than half of us live in cities, in close, everyday proximity to large numbers of other people. In the last decade or so, the internet has revolutionised communications in a manner not experienced since the invention of the printing press in the mid-fifteenth century.

The assumption that people make choices in isolation, that they do not adopt different tastes or opinions simply because other people have them, is no longer sustainable. Perhaps – perhaps, and it is a big ‘perhaps’ – over a hundred years ago this might not have been a bad assumption to make. But no longer.

The choices people make, their attitudes, their opinions, are influenced directly by other people. The medium via which this influence spreads is the social network. Often, social networks are thought of as purely a web-based phenomenon: sites such as Facebook. These can indeed influence behaviour. But it is real-life social networks – family, friends, colleagues – that are even more important in helping us shape our preferences and beliefs, what we like and what we do not like.

Network effects, the fact that a person can and often does decide to change his or her preferences simply on the basis of what others do, pervade the modern world. Throughout history, a crucial feature of human behaviour has been our propensity to copy or imitate the behaviours, choices, opinions of others. We can see it in the fashions in pottery in the Middle Eastern Hittite Empire of three and a half millennia ago. And we can see it today in the behaviour of traders on financial markets, where the propensity to follow the herd can lead all too easily to the booms and crashes we have lately experienced. Scientists such as Robin Dunbar have argued that our anomalously large brain (compared to other mammals) evolved precisely because, from an evolutionary perspective, copying is a very successful strategy to follow.

This concept is just as crucial for companies and markets as it is for people. In September 2008 Lehman Brothers went bankrupt, precipitating a crisis which almost led to a total collapse of the world economy and a repeat of the Great Depression of the 1930s. It was precisely because Lehman was connected via a network to other banks that made the situation so serious. Lehman’s failure could easily have led to a cascade of bankruptcies across the world financial network, first in those institutions to which Lehman owed money, then spreading wider and wider from these across the entire network. Incredibly, neither the systems of financial regulations which were in place, nor the thinking of mainstream economics which influenced policy so strongly, took any account of the possibility of such a network effect.

A world in which network effects are a driving force of behaviour is completely different from the world of conventional economics, in which isolated individuals carefully weigh up the costs and benefits of any particular course of action. A world in which network effects are important is a much more realistic description of the human social and economic realities which exist in the twenty-first century. It is the implications of this world which I explore in my book.

Incentives have not disappeared as a driver of human behaviour. This is the world which economic theory describes. It is not wrong. But it is often misleading, for it offers only a very partial account of how decisions are made in reality. Network effects can be far more powerful than incentives leading to outcomes completely different from those intended by policy makers.

We need a new basic building block of agent behaviour, based on the fact that agents, whether individuals, companies or government, have behaviour which is nit fixed, but which evolves. And it evolves by observing what others do.

Network effects require policy makers, whether in the public or corporate spheres, to change radically their view of how the world operates. In part, they make policy much harder to implement successfully, and they help explain many of the failures of policies based on the assumption that incentives and not network effects are the key drivers of behaviour.

But they open up the possibility of much more effective and successful policies, ones which harness our knowledge of network effects and how they work in practice. Hence the main title of this book: Positive Linking.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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13 Responses to Replacing ‘Rational Economic Person’: Networks, Behaviour and Policy in the 21st Century

  1. F. Beard says:

    And we can see it today in the behaviour of traders on financial markets, where the propensity to follow the herd can lead all too easily to the booms and crashes we have lately experienced. Paul Ormerod

    With credit creation, the options during the boom are follow the herd and borrow or risk being priced out of the market by those who do borrow. So it should be no surprise if most choose to borrow. And during the bust, the options are borrow with a significant risk of not being able to repay or to sit on cash or other risk-free assets such as US Treasuries. So it should be no surprise if most prefer to sit it out.

  2. Steve Hummel says:

    Emergent qualities undeniably exist. However some apparently emergent qualities or troublesome instability are really just missing data, errant assumptions in models or un-examined paradigms gone on too long. Not that one should not use science as a tool for discovery, but the study of wisdom, which is really the higher level order of integrative thinking or the “science” of balancing human emergent qualities, is still the best guide for policy both on the personal and systemic levels.

  3. koonyeow says:

    Title: Emergence, Visually (Gangnam Style by Birds?)

  4. Steve Hummel says:


    The concept of subsidiarity is what Europe needs to define and implement in regard to their current crisis. If they’d wed that to a change in the consumer financial paradigm from loan only to individual dividend and loan if desired and creditable, they’d then have the internal national demand they need to humanely proceed, with which to restructure as needed their individual national economies, and the way to head off the austerity induced idiocies they had to deal with last century. It’s simple wisdom which is blocked by the self interest of the Banking system’s monopoly on credit. Europeans need to ask themselves (as do we all) whether they are homo economicus or homo sapiens, whether their systems serve them or they their systems.

  5. Payam Sharifi says:

    Steve Hummel, absolutely agree re the study of wisdom. A shame, however, that in mainstream economics and even in business schools we’re taught instead to be mechanics.

    However, economics does use models, which can and do abstract from reality a little bit, even in heterodox economics. But the idea is that there is greater learning in simplifying it a bit (or leaving variables out of the equation). This is unlike mainstream economics, which leaves no room for reality and mathematizes everything, leaving no actual economics behind.

  6. Luke Davis says:

    We should set up a new branch of economics – called hairnomics. As most people know the price for a male hair cut is rarely varried in a local region except for some niche hairdressers that offer something special. I have been paying $20 for my haircut for the last 10 years.

    What does change is my hair cut. Not by much each time but certainly over the last two decades it is considerably different.

    No one tells me how to have my hair cut, I am not loosing hair and the price is the same no matter what cut I get, so why does my style change.

    Simple, how my male family and friends get their hair cut and to a lesser extent society, tv an movies. As they change I change. Now a study into how hair memes get transmitted would be interesting look into how economic decisions get made, like bubbles and such in property markets.

    Anyway my ramble for the day 🙂

  7. TruthIsThereIsNoTruth says:

    Let this be the first hypothesis in hairnomics.

    In a longitudinal study there is a net bias towards diminishing rates of haircut utility assuming a constant price to hair volume ratio.

  8. TruthIsThereIsNoTruth says:

    duh – I messed that up, constant ratio would mean constant rate of utility D’OH!

  9. TruthIsThereIsNoTruth says:

    On a serious note, I’m sure there is more subtle distinction, but network effect reads like another label for herd mentality which is more or less understood and probably covered to some extent in literature.

  10. mahaish says:

    “The assumption that people make choices in isolation, that they do not adopt different tastes or opinions simply because other people have them, is no longer sustainable”

    well, that depends on what particular type of ego maniac we are dealing with.

    some people especially economics proffessors(with the exception of our gracious host) think they have all the answers

    our modern economic text books are a testament to people not listening to others and following a particular blind delusion 😉

    so at best such propositions are dependent on how hard the granite our personalities are made of 😉

  11. mahaish says:

    “Simple, how my male family and friends get their hair cut and to a lesser extent society, tv an movies”

    and what ever paranoia or vanity we may aquire along the way.

    a change in ones hairstyle, is usually preceeded by the birth of a new obsession or phobia 😉

  12. mahaish says:

    that also applies to earings , nose rings and other bodily appendages as well 😉

  13. mahaish says:

    “The choices people make, their attitudes, their opinions, are influenced directly by other people”

    well yes and no,

    we have two personalities. a permanant one we are born with, and a present one, where the world either chisels out a few more jaggered edges or sandpapers over a few rough spots.

    steve keen, is who he is, and he was born that way. so he was always destined to annoy the hell out of the economic establishment.

    his parents family and friends may have given him much wise councel, but that would have only made him less annoying, as opposed to eliminating that wonderful qaulity out of him 😉

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