Friday, March 14, 2014

Steve Keen on Consumer Theory

Steve Keen (2011: 67–70) reviews the neoclassical theory of consumption under utility maximisation.

The crux of this theory is the neoclassical view of economic rationality.

Keen (2011: 67–70) points to the work of Reinhard Sippel (1997) on consumer behaviour, which appears to demonstrate that the “rational consumer” view of neoclassical economics is empirically unsound.

Sippel tested the “axioms of revealed preference” as formulated by Paul Samuelson (1938a; 1938b), which can be listed as follows:
(1) Completeness:
Given the choice of different bundles of goods which he can compare, a “rational” consumer can either (1) state which bundle of goods A or B he preferred or (2) state he was indifferent between them.

(2) Transitivity:
If a consumer preferred A (a bundle of goods) to B (a different bundle of goods), and preferred B to C, then logically he must necessarily prefer A to C.

(3) Non-Satiation:
This means that more is preferred to less, so that if A has one more unit of goods than B, then A will be preferred to B.

(4) Convexity:
The law of diminishing marginal utility applies to bundles of goods so that a bundle with units of the same good will be less desirable than a bundle with at least one different good. (Keen 2011: 68).
It should be noted that yet another assumption of these axioms, if they are invoked to define rational consumer behaviour, is that any given consumer’s tastes and preferences must be held constant over the relevant time period (Sippel 1997: 1431).

In experiments with 12 subjects and then 30 with a choice of 8 goods and a budget constraint, Sippel found that most subjects did not obey the axioms of revealed preference: 11 out of 12 in the first group were “irrational,” and 22 of 30 in the second group were also “irrational” (Sippel 1997: 1438).

As Keen points out, even in a simplified model of how to create different bundles of goods with discrete units of measurement only, there are over 16.7 million different bundles of goods which could be constructed, and even when the budget constraint is imposed over 1,600 different combinations of goods (Keen 2011: 70–71).

The problem, as Keen notes, is this:
“The neoclassical definition of rationality requires that, when confronted with this amount of choice, the consumer’s choices are consistent every time. So if you choose trolley number 1355 on one occasion when trolley 563 was also feasible, and on a second occasion you reversed your choice, then according to neoclassical theory, you are ‘irrational.’

Nonsense. The real irrationality lies in imagining that any sentient being could make the number of comparisons needed to choose the optimal combination in finite time. The weakness in the neoclassical vision of reality starts with the very first principle of ‘Completeness’: it is simply impossible to hold in your head – or any other data storage device – a complete set of preferences for the bewildering array of combinations one can form from the myriad range of commodities that confront the average Western shopper. With
this principle being impossible, any sane person’s shopping behavior will certainly also violate the neoclassical rules of Transitivity and Convexity (and probably Non-satiation as well). But it will be because the neoclassical principles themselves are irrational, not because
the shopper is.

Consider, for example, your regular visit to a supermarket. The typical supermarket has between 10,000 and 50,000 items, but let’s segment them into just 100 different groups. How many different shopping trolleys could you fill if you limited your decision to simply whether to buy or not buy one item from each group?

You would be able to fill two to the power of one hundred shopping trolleys with different combinations of these goods: that’s 1,267,650,600,228,229,401,496,703,205,376 trolleys in total, or in words over 1,000 million trillion trillion shopping trolleys. If you could work out the utility you gained from each trolley at a rate of 10 trillion trolleys per second, it would take you 100 billion years to locate the optimal one.” (Keen 2011: 71–72).
In neoclassical theory “economic man” (homo economicus) when making a rational choice – say, in spending a given income on a basket of goods – will weigh the various choices and choose that basket of goods which best maximises utility.

But it is clear that you have to be omniscient – a type of god-like agent – in order to be “rational” in the neoclassical sense.

Of course, what actually happens in the real world is that any consumer buying a basket of goods cannot do any such thing, for human beings lack the time, ability and computational power in engage in any such real utility maximisation on the basis of an evaluation of all possible combinations of goods.

For Keen, “[t]ruly rational [sc. consumer] behaviour is therefore not choosing the best option, but reducing the number of options you consider so that you can make a satisfactory decision in finite time” (Keen 2011: 72). To do this, habit, convention, custom, and simple rules of thumb are used or even decisions via influence from other people.

A consumer determines what to consume by dividing goods into different categories and arranging them in a hierarchy, the most basic types of goods at the top of the list, and where the highest basic classes of goods are generally considered in isolation.

Following Herbert Simon, human behaviour is perhaps better described as “satisficing” (conducted so as to satisfy the minimum requirements for achieving a particular result), and not “optimising” (Keen 2011: 72).

Further Reading
Lars P. Syll, “Paul Samuelson and revealed preferences – nothing lost, nothing gained,” 1 March, 2013
http://larspsyll.wordpress.com/2013/03/01/paul-samuelson-and-revealed-preferences-nothing-lost-nothing-gained/

BIBLIOGRAPHY
Keen, Steve. 2011. Debunking Economics: The Naked Emperor Dethroned? (rev. and expanded edn.). Zed Books, London and New York.

Samuelson, P. A. 1938a. “A Note on the Pure Theory of Consumer’s Behaviour,” Economica n.s. 5.17: 61–71.

Samuelson, P. A. 1938b. “A Note on the Pure Theory of Consumer’s Behaviour: An Addendum,” Economica 5.19: 353–354.

Sippel, Reinhard. 1997. “An Experiment on the Pure Theory of Consumer Behaviour,” Economic Journal 107. 444: 1431–1444.

2 comments:

  1. its speaking about bounded rationality right?

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  2. Great example by Keen. Although the axiom of completeness could still be defended by way of "abstraction" in order to define the most "rational agent" a.k.a the superman. But I don't know any supermen apart from comics and scripture.

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