by Unlearning Economics

This appeared originally at The Institute for Dynamic Economic Analysis Blog.

Agents in neoclassical economics typically maximize some function, such as utility (‘satisfaction') in consumption, or profits in production. Taken at face value, this is a transparently unrealistic depiction of how the world works, since it's pretty difficult for people or firms to truly ‘maximize' anything – especially something as intangible as utility – in the real world. But economists have shown that if you start with some not-too-unreasonable assumptions about human behavior, then you can derive relationships that are functionally equivalent to maximizing behavior.

Thus the names of the theories and their pop interpretation should not be taken too literally, as these are not the criteria on which the theories stand or fall. Unfortunately ‘not-too-unreasonable' is not the same as ‘correct'. I believe that three relatively simple violations in the core assumptions of standard Walrasian theory prevent it from being a workable model of individual behavior.

These share a common characteristic: they strip away possible choices – or information about these choices – and reduce the number of feasible actions an agent can take. It thus becomes generally infeasible for agents to take an ‘optimal' action. Below I discuss the implications of this in each case, and then go on to suggest an alternative path for modelling the behavior of economic agents.

Computational constraints: Utility maximisation may seem a plausible approximation to consumer behaviour in the 2-good models of undergraduate classes, or even in the ‘n-good' models of more advanced classes (since n is generally left unspecified). Both cases are generally taught with straightforward examples using oranges, bananas and so forth. But once we start to look at how utility maximization might work when people face choices in the real world, such as shopping in a supermarket, the limitations of the theory become clear.