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 a professional economist 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 debts accumulated in Australia, 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?)

    http://www.youtube.com/watch?v=XH-groCeKbE

  4. Steve Hummel says:

    Regard­ing http://t.co/QufAI8JV

    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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