21/11/95

 

Where is Economics going ?

John Quiggin

Department of Economics

James Cook University

 

 

 

 

EMAIL jquiggin@coombs.anu.edu.au

FAX + 61 77 814149

Phone + 61 77 81 5387

+ 61 77 251269

 

 

 


Where is Economics going ?

A history of economic thought written in, say, the early 1960s would almost certainly have been a story of uninterrupted progress. The development of Keynesian macro-economics and the synthesis of Keynesian and neoclassical ideas developed by Hicks and others appeared to give economists and the governments they advised the power to banish economic fluctuations, unemployment and inflation. The fallacies of the classical economists with their belief in a self-stabilising competitive economy were triumphantly refuted. At the microeconomic level, the general equilibrium analysis of Arrow and Debreu appeared to offer both a final resolution of the thorny issues of the theory of value and a potential basis for assessing the merits or otherwise of almost any potential government intervention in the economy. The prospect for the future seemed similarly rosy. The advent of powerful computers would give macroeconomics the capacity to make ever more complete models of the economy and permit ever more detailed fine-tuning of its performance. The use of more sophisticated mathematical tools would permit greater understanding of the properties of general equilibrium, and improved definition of the scope for government intervention.

Only a decade later, the picture looked radically different. The macro-economic stabilisation policies of the Keynesian era had broken down irretrievably. Meanwhile, the decades of Keynesian prosperity had led many to ask whether steady increases in consumption of material goods could be regarded as an adequate social goal. Environmental issues moved from the periphery of concern to generate a major social movement.

The response of the economics profession was both confused and confusing. Presidential addresses to the American Economic Association criticised the increasing dominance of mathematical theory and called for a return to social relevance. Institutionalists, Marxists, Austrians and post-Keynesians all offered fundamental methodological critiques of the mainstream approach. Environmentalists sought to replace growth theory with sustainability theory.

At the same time, from within the mainstream profession, there was a reaction against the ideas of the Keynesian period and a reassertion of the free-market economic ideas of the 19th Century. Homo economicus, the hyper-rational self-seeking economic man returned to centre stage in economic analysis. Intellectual innovations associated particularly with economists from the University of Chicago and various institutions in Virginia undermined the theoretical foundations of the earlier Keynesian-neoclassical synthesis. These ideas include public choice theory (the application of the homo economicus model to political processes), the use of property rights analysis to criticise a variety of environmental policies and the use of the theory of contestable markets to attack government intervention in markets dominated by one or a few firms (monopolies and oligopolies). After the usual process of vulgarisation, these ideas have become the basis of the trend in economic policy commonly referred to as economic rationalism or economic fundamentalism.

Not surprisingly, these innovations met with considerable resistance. In addition to the methodological critiques described above, the homo economicus model was attacked as a radically impoverished representation of human motivations. The battle was fought most sharply in relation to public choice theory, where the empirically unsatisfactory nature of the homo economicus model was most obvious (Quiggin 1987). Defenders of the Chicago-Virginia approach, such as Brennan and Pincus (1987) argued that the fundamental approach was consistent with a wide range of possible motivations and not simply maximisation of money income. The key issue was the assumption of methodological individualism, the idea of analysing social process as the result of interactions between the rational choices of separate individuals. It seemed natural to associate this methodological individualism with political individualism, the idea that the scope of government action should be confined to the provision of a level playing field for competition between individuals.

Where is economics going in the mid-90s ? At one level, the advocates of methodological individualism have triumphed. The methodological critiques discussed above have either withered on the vine or remained in the shadows. Analysis based on methodological individualism has been extended to cover an ever wider variety of phenomena. In the process, however, the link between methodological individualism and political individualism has been severed. In order to make progress, economists have developed more complex and realistic models of the objectives individuals pursue and of the interactions between them. In the process, the simple verities of laissez-faire have been swept away.

Mainstream economists now recognise the complexity of economic life. The hubris that characterised both the Keynesian revolution and the free-market counter-revolution, the belief that one or two simple principles could provide the basis for an ideal economic policy has been replaced by a greater degree of humility and a recognition of the need for detailed analysis of particular problems. One sign of this change in attitude has been a rise in the professional status of empirical work and a corresponding decline in the status of highly abstract theoretical work.

The object of the present paper is to illustrate the way in which economics has moved towards a more complex and realistic representation of human motivations and economic interactions. This is illustrated by work in a number of fields, including the analysis of choice under uncertainty, the economics of health, education and the environment, and the developing theory of institutional design. Some suggested implications for the role of economists in the policy process are offered.

 

Uncertainty

Before 1944, economic analysis was normally undertaken on the basis that individuals sought to maximise their money income. Uncertainty was dealt with by simply assuming that the expected value of wealth was maximised. Such a simplistic approach failed to take any account of the idea that people value stability and dislike risk, and meant that large areas of the economy such as the insurance industry were simply not amenable to economic analysis.

The publication of the Theory of Games and Economic Behaviour by von Neumann and Morgenstern (1944) appeared to provide a solution. The idea of expected utility replaced the notion of maximising the expected value of wealth. In particular, because the marginal utility of a dollar of additional income may be expected to decline as wealth increases, the expected utility model permitted an analysis of the demand for insurance and other tools for risk-management. With the exception of Allais (1953), whose arguments were dismissed at the time and for many years afterwards, the expected utility model swept the economics profession.

By the late 70s, however, it was apparent that expected utility theory was inadequate. It failed to account for well-established empirical evidence, such as the fact that many people engage in gambling while also taking out insurance. Experimental evidence also revealed systematic violations of the predictions of the model. More fundamentally, the expected utility model excluded a wide variety of human feelings about uncertainty - optimism and pessimism, regret over the path not taken, preference for certainty and hope for something better.

One of the first responses was the prospect theory presented by Kahneman and Tversky (1979) in one of the most widely-cited papers of the decade. Kahneman and Tversky introduced a number of ideas and also gave wide currency to an idea that had been proposed previously, that individuals tend to 'overweight' low probability events. Unfortunately, their model also implied that people would make choices which rendered them worse off with probability 1, a conclusion which was highly unappealing to economists and had little empirical support.

This problem was resolved in Quiggin (1981, 1982), where the idea of rank-dependence was introduced. The key idea was that individuals do not overweight low probability events in general, but only low-probability extreme events. This idea may be represented formally by transforming the cumulative distribution function rather than the probability of individual events. At around the same time, Machina (1982) presented a framework encompassing a wide range of 'generalised expected utility theories' and Chew (1983) presented another generalised model. The stage was set for an explosion of research in the field, much of it published in the newly established Journal of Risk and Uncertainty, which has rapidly become one of the most frequently cited journals in economics, outstripping many long-established competitors. The award of the Nobel Prize for Economics to Allais in 1991 symbolised general recognition of the fundamental importance of the ideas.

The importance of generalised expected utility theory is twofold. First, it is based on the principle that people should be represented as they actually are, and not as economists would like them to be. Second, it shows that mainstream economic analysis can be undertaken without relying on simplifying assumptions of hyper-rational behavior. In some cases, including the theory of the firm under price uncertainty (Quiggin 1991a) it turns out that the simplifying assumptions are 'harmless'; that is, the economic implications of the generalised model are similar to those of the simplified model. In other cases, for example, portfolio choice, the simple model turns out to be incorrect, and observed behaviour is better explained by the general model. Finally, there are important activities such as gambling for which the simplified model gives no account whatsoever, but which can easily be explained by more general models. Amore complete account is given in Quiggin (1992a) and some corrections to the original presentation are made in Quiggin and Wakker (1994).

Welfare theory and well-being

As the adage suggests, the usual conception of the good life involves being 'healthy, wealthy and wise'. Economics has traditionally focused on the middle member of this trinity, arguably the least important.

Health has often been regarded as lying outside the scope of economic analysis. This view is misguided on two grounds. First, good health is a fundamental prerequisite for participation in economic activity. At the most basic level, you can neither produce nor consume if you are dead. More generally, any degree of illness reduces both the capacity to contribute to production and the capacity to derive benefits from consumption. Second, our health status is primarily the result of individual and collective economic choices. It might be supposed that we cannot put a monetary value on health. But every time an individual smokes a cigarette or drives a car, and every time a government chooses a tax cut in preference to increased funding for hospitals, we are doing just that.

One of the key difficulties in analysing these choices is that they are inherently uncertain. No-one (or almost no-one) would drive to work rather than walking if they knew they were going to be involved in a fatal crash. When the risk is small enough, however, most people are prepared to take it. It seems clear that expected utility theory is too rigid to capture the kinds of choices people actually make. An accurate analysis of health choices has only become possible with the advent of generalised expected utility theories.

Economic analysis is just beginning to come to grips with these problems. Health economists have so far focused on trade-offs between different health risks, using the notion of QALYs (Quality-adjusted-life-years), as in Broome (1992). At the aggregate level, a variety of arbitrary adjustments to standard GNP measures have been suggested. The most popular is the United Nations Development Program's Human Development Index (HDI), based on life expectancy, literacy and per capita GDP. In recent work (Dowrick, Dunlop and Quiggin 1995) the tools of revealed preference have been applied to show how the standard logic of economic choice may be extended to reveal the implicit valuation placed on life expectancy, or, more precisely on reductions in age-specific death rates. A disturbing finding is a massive disparity between the implicit valuation of life in rich and poor countries, far greater than that which might be estimated on the basis of a simple comparison of per capita GDP. This difference of course reflects choices made in rich countries as well as in poor ones.

In comparison to health, economic analysis of 'the getting of wisdom', at least insofar as this involves formal education is quite well advanced. The key concept is the idea of 'human capital'. The human capital model is an elaboration, using the economic terminology normally applied to production of physical goods, of the commonsense notion that the function of schools is to teach students, that is, to provide them with information and skills that will be valuable in later life.

The metaphor of 'human capital' is one that many people find off-putting, even repugnant. It is, indeed, arguable that it is better to adopt the Marxian converse of this metaphor and refer to physical capital as 'congealed labour'. But whichever way the metaphor is put, it is necessary to recognise that the skills and knowledge each of us possess are the products of human labour (our own, and that of our parents and teachers) just as much as the tools we use and the houses we live in.

Once this point is accepted, it is necessary to guard against the opposite temptation; that of postulating 'capitals' so freely as to stretch the metaphor to its limits. It is easy to begin by eliminating 'land' from the classical set of factors of production, replacing it with 'natural capital', proceed to add 'social capital', 'intellectual capital' and 'cultural capital' and end with a situation in which every aspect of life has its associated capital stock. Unless we can analyse how labour is transformed into these different capitals, how one sort of capital is transformed into another and how all of these factors combine to determine the choices available to use as a society, this multiplication of capitals is of little value in enhancing our understanding of the world. Furthermore, it must be admitted that a good deal is lost in the translation from 'wisdom' to 'human capital'. The essential point was made by John Stuart Mill. Economic analysis including the notion of human capital tells us how we may best satisfy our wants. The core of wisdom is knowing what we should want and how to moderate our wants.

With all of these qualifications, the notion of human capital nevertheless marks an important advance in our understanding of the economy and society. Human capital plays a major role in neoclassical growth theory and growth accounting (Denison 1962, 1979, 1984) and an even greater role in the 'new growth theory' (Stokey 1991, Glomm and Ravikumar 1992, Tallman and Wang 1992, Hartwick 1992). In broad terms, these approaches may be distinguished by saying that old growth theory sees education as important, while new growth theory sees education as critical.

Economists have used two main methods to analyse the determinants of economic growth. First, they have undertaken cross-country comparisons in an attempt to isolate those factors that are conducive to economic growth. A great many such factors have been suggested but the literature displays very few consistent results, with one important exception. A systematic study of such factors found that the great majority or proposed correlations (for example, between growth and inflation, or between growth and public spending) are not robust to changes in the specification of estimating equations (Levine and Renelt 1992, Levine and Zervos 1993). Almost the only policy-relevant causal relationship that has been identified is that the higher the proportion of school-age young people actually attending school at the beginning of any given period, the higher the growth rate over the subsequent period (Barro 1991, Woo 1991, Mankiw, Romer and Weil 1992).

National accounting has not yet caught up with the idea of human capital. Education is still treated as an item of current consumption, and the labour of students is disregarded altogether. A key element of my current research program, supported by the Australian Research Council, is the incorporation of appropriate measures of education into national accounts and comparisons of living standards.

Property rights and the environment

The rise of the environmental movement represents a major challenge to mainstream economics. In some ways this is surprising. Environmental advocates such as David Suzuki denounce economics in strong terms, yet the core of their analysis is the classical growth theory of Malthus, Ricardo and Mill. Given a fixed factor (natural resources or 'land' in the terminology of the classical economists) and bounded opportunities for substitution, or even a constant elasticity of substitution, growth must come to an end.

The impossibility of exponential growth was one of the first discoveries of economics, and much ingenuity over the past two centuries has been expended in trying to reconcile the fact that economies have indeed grown exponentially with the very robust prediction that income levels must eventually level out or decline. Until recently, the only solution has been to invoke the deus ex machina of technological change.

It is, of course, true that economists have been among the strongest critics of neo-Malthusian modelling exercises such as those undertaken in The Limits to Growth (Meadows et al 1972). The centrepiece of The Limits to Growth was a 'world model' incorporating exponential growth and a number of feedback processes. It included estimates of exhaustion dates for the key resources used in industrialized societies (worst-case projections had metals such as lead, mercury and copper being exhausted in the 1990s). As a modelling exercise, The Limits to Growth had little to commend it. The large scale (for the day) computer model was simply window dressing for a radically simplified classical growth model, similar to that which led Jevons to predict the exhaustion of coal reserves in the 19th Century. The model ignored technical progress, factor substitution and price incentives to energy efficiency. All of these faults were pointed out by critics such as Nordhaus (1973).

However, the rejection of The Limits to Growth model and similar exercises does not mean that economic theory denies the existence of limits to growth. Some economists (and many more 'business economists' and advisers on government economic policy) have indeed denied that there are any such limits, but this claim is based on assumptions imported from outside economics, that technological progress can be extended indefinitely and that human- made resources can be freely substituted for natural resources. If these assumptions are not accepted, the classical Malthusian conclusion remains valid.

Some recent developments in economic analysis of growth will, I believe, go a long way towards improving our understanding of these issues. The first is the new growth theory mentioned above which seeks to endogenise technological progress as a particular form of economies of scale. The second is the large literature built around the notion of 'sustainability'. Although there are probably more definitions of sustainability than there are economists working on the topic, the core idea is the need to explore the inter-generational implications of the fact that natural resources are both finite and essential to human well-being in the sense that they cannot be substituted for by physical capital (Hartwick 1977, Quiggin 1993a). I conjecture that the synthesis of these two streams of thought will ultimately be an analysis demonstrating the existence of strict limits to growth in material consumption, but unlimited potential for the expansion of knowledge-based human services.

Thus, at an aggregate level I do not believe there is any inherent conflict between the concerns of environmentalists and economic theory, as opposed to the opinions of some economists on non-economic questions such as the likely future potential for technological growth. At the microeconomic level, however, the picture is rather less satisfactory. Neither the externality model of Pigou nor the property rights analysis of Coase provides an adequate set of tools for the analysis of environmental problems. The externality model, focusing on direct interactions between individuals, fails to take account of the crucial role of the natural environment. In this respect the property rights approach is a step forward, since property rights are normally rights over something. However, the analysis of the property rights school is vitiated by an exclusive focus on private property rights and a tendency to caricature alternative property rights systems, exemplified by the identification of 'common property' with 'no property'. This has led them to adopt as fact utterly unhistorical and inaccurate accounts of the operations of the European common field system, given wide currency in Hardin's well-known tragedy of the commons story (Hardin 1968, 1972). (Although not an economist himself, Hardin acknowledges the influence of property rights economists). It has also led to the advocacy of highly damaging policies in developing countries where well-functioning common property systems have been dismantled in order to conform with a private property ideology (Quiggin 1986, 1988, 1993b, 1995a).

Although the inadequacies of both the externality approach and the private property rights school are now widely recognised, no really satisfactory alternative has been developed. Instead, much the intellectual energy in environmental economics has gone into attempts to value those elements of the natural environment (such as the existence of pristine wildernesses) that do not have any obvious implications for human welfare. The key idea here has been the notion of existence value (Weisbrod 1964) and the key tool has been the contingent valuation method (Mitchell and Carson 1989), also referred to as the total valuation framework (Randall 1983). While the motivation behind this effort is admirable, and the demands of policy processes are frequently such that a dollar value must be derived somehow, I do not believe that the existence value concept is satisfactory (Quiggin 1993c, d). Rather I believe it represents an overextension of methodological individualism into areas where values are derived not from individual preferences but from beliefs about the welfare of society as a whole and indeed, of the natural ecosystem of which society is ultimately a part. Blamey, Common and Quiggin (1996) refer to this as a distinction between 'consumer' and 'citizen' models of choice.

As an economist I would prefer to accept that economic analysis is powerful but ultimately limited, and that there are some genuine values which are not amenable to economic analysis. On the other hand, the fact that economic analysis has been successfully extended into areas that would one have been regarded as manifestly non-economic suggests that the boundaries should not be drawn to tightly. As the model of human motivation used by economists becomes richer and more complex, the scope of economic analysis will expand. The price will be a loss of the dogmatic certainty that can be obtained from working with one-dimensional homo economicus models.

Institutional design

The world of textbook microeconomics is one of perfect information, or at most of uncertainty about the state of nature. One of the central theoretical developments of the 1980s has been the analysis of situations of asymmetric information. This approach leads to a great many insights into hierarchical relationships and the broader issue of the design of social and economic institutions. The issues may usefully be illustrated by considering the efficiency wage literature.

To illustrate the efficiency wage idea suppose that a risk-neutral employer hires a risk-averse worker, to undertake a task. There is uncertainty in the outcome of the worker's efforts. This may be represented by the occurrence of one of two states of nature 'Good' and 'Bad'. The worker can allocate his effort so as to determine the output in the two states of nature, but it is more costly to increase effort in the Bad state than in the Good state. If the employer could observe the state of nature and/or the worker's effort level, it would be possible to sign a fixed-wage contract in which the worker put forward the optimal level of effort, produced the optimal state-contingent output and received his reservation utility level. A situation where the worker received more than his reservation utility would be inconsistent with profit-maximisation by the employer.

In the efficiency wage literature, however, it is assumed that the employer cannot observe effort, but only the output level. Faced with a fixed wage contract, then, the worker would have an incentive to shirk, putting forward a low level of effort and reporting the occurrence of the bad state of nature to explain the low level of output. If the worker were risk-neutral, and there were no constraints on the set of payments the principal could make, the optimum response would be a piece-rate contract.

In practice however, these conditions are not satisfied. In particular, even where there does not exist a legislated minimum wage, there is a lower bound to the feasible set of wages that may be paid in the bad state of nature. The employer may be able to dismiss the worker without pay but she will not in general be able to make the worker compensate her for all losses incurred in the bad state.

In these circumstances, the optimal second-best contract may allow the worker to receive more than reservation utility. The intuition is that it is more important for the employer to give incentives for high output than it is to pay the minimum amount for which the worker would sign on. This intuition may be pushed further when we think about the contract being extended in time. If the penalty for excessively low output is dismissal, the worker will be motivated to put forward high levels of effort if the wage for the job in question is more than he could get in the outside labour market.

The likelihood of such an outcome is greater, the greater is the difficulty of monitoring and the greater is the cost to the employer of bad outcomes. These conditions seem more likely to be satisfied in large enterprises than in small ones, and for capital-intensive as opposed to labor-intensive enterprises.

The analysis of efficiency wages offered here differs from that usually presented in the literature because of the explicit use of a state-contingent production framework in the tradition of Arrow and Debreu. This apparently small, but in my opinion crucial point, is the basis of the research program presented in Chambers and Quiggin (1994, 1995a, b) and Quiggin and Chambers (1995). Research in this program has already yielded new insights into moral hazard and mechanism design problems. More importantly perhaps it offers a method of incorporating notions such as exploitation into a rigorous mainstream economic analysis. Such an achievement would represent an effective response to Marxist and other critics of mainstream analysis who have argued, with some justice, that it contains no account of power or conflict.

Policy implications

As Keynes observed, policymakers, even the most practical-minded, are largely driven by the ideas of intellectuals, but the process works with a considerable lag. The ideas of Keynes and his immediate followers, developed in the thirties, were most influential in the fifties and sixties. This was combined with the new welfare theory developed by Samuelson and others in the forties and the idea of 'market failure' arising initially from Pigou's analysis of externalities and made rigorous by the general equilibrium analysis of Arrow and Debreu. The result was a potent set of arguments in favour of government intervention in the economy which supported the growth of government in the postwar period, and remain as the basis of much of the actual operations of government today. As Keynes pointed out, the influence is often indirect and unconscious and ideas typically lose their intellectual purity on the road to application. The official proudly quoting favorable GNP growth statistics is generally unaware of his debt to Keynesian macroeconomics and will not welcome the observation that such statistics were never designed as indicators of national welfare.

The policy debate today is dominated by a set of ideas which were developed by economists in the sixties and seventies and have since been heavily qualified, and in some cases, abandoned altogether. These ideas amounted to a counter-attack against the Keynesian-neoclassical synthesis and a reassertion of the relevance of the textbook model of competitive markets populated by narrowly egoistic and hyper-rational individuals, each seeking to maximise their own income. The key developments included public choice theory, the theory of contestable monopoly and the early versions of the rational expectations hypothesis and property rights analysis. The inheritance is not only intellectual. The dogmatic tone of the policy debate today (exemplified by the frequent use of religious analogies in both favorable and hostile discussions of 'economic rationalism') owes much to the simple verities of textbook microeconomics. The result, in Australia, has been a simplistic faith in the policy programs variously referred to as 'micro-economic reform' or 'the Hilmer reforms' including compulsory competitive tendering and contracting out, privatisation and private provision of infrastructure. I have pointed out some of the problems with these programs in Quiggin (1992b, 1995 b, c, d, 1996a,b). A more general critique of the fundamentalist approach to policy is given in Langmore and Quiggin (1994, Ch 4).

The contrast between the policy debate in Australia and the debate going on among the leading researchers in economics could not be more striking. In place of simplistic certainties, leading economists now recognise the need to take account of the complex details of each particular case. Indeed, in areas such as game-theoretic analysis of oligopoly behavior there has been a tendency to go to the opposite extreme; a view that anything can happen and probably will (for a demonstration that standard game-theoretic models have this property and a suggested alternative approach, see Klemperer and Meyer 1989 and the related work of Grant and Quiggin 1994, 1995).

Concluding Comments

Economists have rarely been more influential, or less popular, in Australia than they are today. Yet the theoretical framework and style of analysis that guides much economic policy, and is the subject of such bitter criticism, is decades out of date. Economic policy is increasingly dominated by simplistic models of narrowly self-seeking individuals populating competitive or pseudo-competitive markets. At the same time, the economics profession has been moving steadily in the direction of richer and more complex models of human behavior and social institutions. It is to be hoped that, after the usual time-lag these ideas will begin to influence policy processes. Meanwhile, this is an exciting time to be an economist.

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