Do You Make Your Consumption Decisions This Way?
We are studying consumer behavior in my quantitative economics course. The model we are working with assumes that
1) Consumers gain utility from consumption, and act to maximize that utility given a budget constraint
2) They receive labor income and have the opportunity to save and receive interest or, in some cases, to borrow from future expected income
3) They consider future utility worth less than present utility, and discount it at a constant rate over time.
These are not, by and large, loony assumptions (except for the constant future discounting rate, which is certainly loony, but let's ignore for now). Given all these parameters, it's easy to write down the equations that give the consumption and saving patterns that maximize your utility. These equations relate the amount you consume today to the expected amount you will consume tomorrow. I say expected, because you don't know certain things about the future: in particular, you may be uncertain about your future income (maybe you face a risk of getting fired, or maybe you will win the lottery, etc.).
If you think about this, you will see that it's a little problematic. I need to know how much I will consume today, and the optimizing equation says that I need to average out my utility tomorrow. My utility tomorrow depends on my random income, and also on my utility the day after that, which depends on -that- day's random income and the next day's utility, etc. on to infinity (or death). The mathematics get a bit hairy. And it's only tractable at all if you actually know the probability distribution of your future income stream and future income rates so that you can calculate the mathematical expectation.
Naturally, estimating these distributions and solving these models pays the bills for numerous economists. They are not easy problems. In fact, finding the optimal consumption behavior requires computer simulation, as it is not analytically tractable with common utility functions. (I spent today writing a program to do it, which is why all this is on my mind.)
What is crazy about all this is that I spent the day writing a computer program that is supposed to tell me how I, as an economic agent, am presumed to behave. If it requires the efforts of scores of economists and many years of simulation, mathematics, and statistical analysis to derive the behavioral consequences of this model, is it not absurd to think that people actually behave in anything remotely like this way?
Contrary to what some people seem to believe (these people are coming out of the woodwork to complain to me now that I am becoming an economist), economists are not stupid, and are fully aware of these shortcomings. However, it's hard to come up with a satisfying alternative description of people's behavior. If people don't rationally optimize the value of their consumption, what do they do? If they are not "rational", what governs their decisions? If they don't have complete information, what assumptions to they make about the probability distribution of future events? Even if you can tell stories about these things, it may not be trivial to make them into meaningful, helpful mathematical models. But the fact that these kinds of big problems are still out there is, to me, one of the very exciting things about economics right now.
posted by thegio @ 3:02 PM
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4 Comments:
Since I can't really address the main body of your post (since I know the words all mean something taken individually, and apparently should mean something grouped, as they are, in a non-random manner meant to convey meaning, but still find they blur into nonsense in my head) I will comment on this point: "economists are not stupid, and are fully aware of these shortcomings."
I don't intend to argue the first point. However, in my limited knowledge of economists, taken largely from artciles about them written by people who also have limited knowledge, there is a danger that comes perilously close to posing a situational refutation to the second point.
I think the danger is that as economists are forced to deal with these flawed models, and work with the models day in and day out possibly for years to try and glean some knowledge out of them, they may lose some perspective on exactly how the models don't do a great job of describing people's behavior. It's the same problem anyone who spends intensive time with one project faces: although if you asked such an economist to explain the problems inherent in a model, s/he may be able to , but when they are working with the model they may be so mentally involved with the model they forget to even ask such questions of their results.
All of this is a long way of saying I think it's easy to get trapped into seeing the world through a model, rather than trying to build a model to see the world.
My take on this is that people generally can't be "rational" about their economic decisions.
Let's take a simple example -- I walk into the store and see three kinds of milk, organic milk (from california), milk from grass fed cows (from oregon) and plain old milk. let' just say they're $3, $2.50 and $2 respectively.
How exactly do I go about understanding which of these is my best utility? How do i measure the cost of water and air pollution from an industrial food lot that squeezed $1 out of the price of milk? How do I value the cost of ingesting synthetic hormones injected into those cow, and presumably at some heightened level in the milk?
I think *most* consumers look at the price tags, and see oh, this one is the "cheepest" because that's what the price tag says, and merrily goes on their way. You can't be "rational" until you are sufficiently close to omniscient to make a rational decision.
The hard part is having a consumer with sufficient information -- like knowing that stocks make a better investment than a savings account.
The problem is that ignorance isn't a constant, as soon as you can start pointing out an area of ignorance, your population will change to take advantage of it.
Daimon, you're probably right. I imagine that at LSE I'm more likely to interact with top-notch economists who are aware of the limitations of what they study. On the other side of the coin, I think journalists (yes! I am pointing the finger back at you! ^_^ ) have a very hard time representing the uncertainty and subtlety in economics.
This is, of course, a problem in any complicated, poorly-understood field. (When non-scientists hear Dr. Lindzen speak about global warming, do they understand the content of his objections, or do they simply parse the message "Global warming is not certain"?) And few people would want to read articles that say "we don't know whether the falling dollar is good or bad", nor do they want to read in-depth economic analysis about what we really do and don't know.
So though there are some model-blinded economists out there, I think the difficulty of presenting uncertainty to the general public accounts for a lot of economics' bad reputation -- it's not that economists are all loons, but their ideas often sound loony in simplistic translation.
Wait five years, then you and I should write a book together.
And Mike, you're right, too, though the problem is how you actually use this observation. I've been asking a lot of people why we have to have mathematical models of consumption, and the best reason I've heard is that we need to put some relationship between income and consumption (and GDP growth and other stuff) in our macroeconomic models (useful for all sorts of things, like setting interest rates). This relationship should capture certain facts in the data (consumption is smoother than income, saving is low, consumption peaks in middle age, etc.), and it should also inform counterfactuals (like "how would an increase in interest rates affect aggregate consumption?"). In the natural sciences, such questions would be investigated with experiments, which is a luxury economists don't usually have.
The utility maximization models manage to do a lot of these things, though certainly not perfectly. You may ask, "Why don't we abandon trying to describe how people actually make decisions, since our assumptions are so absurd anyway, and simply pick a functional relationship that best fits the macro data?" I did ask my economics professor this, and he basically said, "You could do that".
But there is some satisfaction to being able to tweak parts of your model that represent real aspects of human behavior, and not simply "the coefficient of the low-frequency cosine component". And right now, I suppose utility maximization is the best model we have that is tractable and reasonably approximates the data.
The incorporation of bits and pieces of realistic psychology into these utility maximization models is actually a very active area of economic research. (Today and tomorrow, I'm attending talks on hyperbolic discounting, for example.)
We're still a very very long way from realistic human behavior, though, and I, like you, find myself asking, if the car doesn't turn on, what's the point in changing the tires? I suppose the answer is just that it's better to have something than nothing, and it's hard to make a model out of consumer ignorance.
Not that I won't be trying in the next couple years.
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