The Conflict between Microeconomics and Reality

In my paper entitled “Empirical Evidence Against Neoclassical Utility Theory: A Survey of the Literature,” I have argued that neoclassical utility theory acts as a blindfold, which prevents economists from understanding simple realities of human behavior. The paper provides many examples of this phenomenon, which I will illustrate briefly with one simple example in this post.

Consider the two player Ultimatum Game. The Proposer (P) has ten dollars in single dollar bills. He must offer a share of this money ($m) to the Responder (R). He keeps the portion which he does not offer: $(10-m). The responder can either Accept the offer of $m or Reject this offer. If Responder Accepts the he gets $m, while the Proposer get $10-m. But if Responder rejects the offer, then both parties get nothing.

Game theoretic analysis of this game is very simple. First we note that the responder must accept all positive offers for utility maximization. Accepting gives him a positive amount of money, while rejecting gives him ZERO – so rejecting can NEVER be superior option. Even if Proposer offers ZERO, the two options accept or reject are EQUIVALENT because both lead to ZERO payoffs. Once this principle is understood, we can easily derive four predictions from Game Theory, based on utility maximization behavior.

1. Responder will be indifferent between the two choices Accept and Reject if he is offered $0. Both lead to same outcome, and hence same utility.
2. Responder will Accept an offer of $1, resulting in outcome (P:9, R:1). R prefers 1 to 0.
3. Proposer believes that Responder is a Utility Maximizer; that is, he will behave in accordance with propositions 1 & 2 above.
4. Proposer will therefore offer $1, as it maximizes his share at $9. If he offers $0, the outcome is uncertain because both responses A and R are possible maximizing responses, which is why an offer of $1 is the unique utility maximizing offer.

All four of these propositions are false. Furthermore, every layman will easily be able to see that all four of these propositions are false. However, economists have great difficulty in seeing that they are false and in understanding why this is so. This is because economic theory teaches economists to “think like economists” which means modelling humans as being homo economicus: cold, selfish and callous (Vulcans, for short). This makes economists unable to understand real human behavior. As everyone (except economists) knows, the responder will reject the offer of $0; he will not be indifferent between accept and reject. Empirical studies conforming to our intuition about human behavior show that in situation 2, the vast majority of responders will reject the offer of a 10% share, preferring to get $0 rather than accepting injustice or an unfair offer.

While no one else is surprised by this [rejection of small offers], economists are startled to learn about this routine finding of the ultimatum game. Empirical findings of research on ultimatum game along these lines were routinely rejected by economics journals on the grounds that small stakes and unfamiliarity led people to irrational behavior in an artificial environment. As Colin Camerer , Behavioral Game Theory 60-62 (2003) puts it: “If I had a dollar for every time an economist claimed that raising the stakes would drive ultimatum behavior toward self-interest, I’d have a private jet on standby all day.” Despite this ideological conviction of economists, experiments at high stakes, equivalent to one months salary, replicated this phenomenon of refusal of unfair offers. Widespread robust replication in different environments designed to answer the standard objections to experiments ultimately led to a reluctant acceptance by economists, and publications of these results in reputable journals. However, despite the flat rejection of utility theory by human behavior, this theory continues to be taught as a “tautological” truth in mainstream economic textbooks.

The fact that proposition 3 is false is somewhat deeper than the fact that 1 and 2 are false. Whereas 1 and 2 represent false assumptions by economists about human behavior, 3 represents a stronger false assumption about human beliefs about human behavior.  Even if the proposer is Vulcan, he might have enough intelligence to realize that others on this planet are not like him. In which case, he would not rely on propositions 1 and 2. Even a Vulcan may be able to realize, without necessarily understanding why, that normal human beings might resent being offered such a pittance, and might refuse a low offer for emotional reasons. However, not only does game theory teach economists to think that everyone is a Vulcan, it also misleads them into believing that everyone is a stupid Vulcan – they cannot figure out that they are on planet Earth, and therefore other people will not behave like them. It is only a stupid Vulcan who will offer $1 under the mistaken belief that the responder accept this offer because $1 is better than the $0 he will receive by rejecting. We cannot quantify the level of stupidity displayed by economists who calculate outcomes of games under the assumption the every on this planet is a stupid Vulcan, are surprised when their predictions fail to match reality, and stubbornly refuse to revise theories in face of obvious conflicts with Reality. Keynes rejection of classical theories led him to the same perception of economists: The classical economists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight, as the only remedy for the unfortunate collisions which are occurring.  

And that is why the findings of behavioral economics conflicts with economic theory, and are not welcomed by economists. When economists talk about “sound” microfoundations, these are the micro-foundations upon which they wish to build a macroeconomics. In his written testimony for the Congress on “Building a Science of Economics for the Real World” Robert Solow wonders about which planet the macro policies based on DSGE models are designed for.  For sources for this, and many other quotes about how economists stubbornly cling to theories which are dramatically in conflict with empirical evidence, see “Quotes Critical of Economics“.

This is a slightly modified re-post of “Behavioral VS Neoclassical Economics” on the WEA Pedagogy Blog.

Date posted: October 14, 2019
Author: Asad Zaman
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Categories: Blogs