Rational behaviour is maximising ... what?

Utility maximisation

In economics, rational actors are assumed to maximise their utility. However, the fact that world is uncertain means that you can't always know what would maximise your utility, so this is instead amended to expected utility. This means: a rational actor makes the decision that on average produces the highest utility. Many people then take a step further and move from utility to money: rational individuals make decisions that maximise their expected worth.

This assumption also feeds through into a lot of financial modelling and optimisation. For example, valuations using methods such as dynamic programming typically assume that decision making maximises expected utility and nothing else.

But... does this make any sense? To see why it might not, consider what you would do if a billionaire offered you a choice. If you accept, he will flip fair coin. If it comes up heads, he will give you a million pounds, and if it comes up tails you will give him all your assets. Now let's consider the expected value here. If your assets have value A, and you take the bet, then your expected financial worth after the bet is:

0.5 x (A + 1,000,000) + 0.5 x 0 = 0.5 x A + 500,000

Obviously, if you don't take the bet then your assets will continue to be worth A. Therefore, the expected improvement in your financial position if you take the bet is:

(0.5 x A + 500,000) - A = 500,000 - 0.5 x A

So if your assets are worth less than 1,000,000 then you should take the bet if you are maximising your expected worth. What's more, the less your assets are worth, the stronger the expected benefit of the bet, and therefore the more "rational" it would be to take it as an maximiser of the expected.

But do people behave this way? And should they? This bet would mean, for a middle income home owner, that they have a 50% chance of becoming a millionaire, and a 50% chance of becoming a homeless pauper. I think a significant proportion of people would not risk becoming homeless even for the chance of becoming a millionaire. It has been demonstrated experimentally that people are strongly averse to losing what they have, even when there are significant rewards to taking the risk.

As to whether they should... well, despite the fact that many economists equate rational with maximising the mean, it does not seem irrational at all to decide not to risk homelessness. In fact, it seems pretty rational to protect your access to necessities before trying to get the nice-to-haves. But this kind of maximising the minimum, rather than the mean, behaviour is too often ignored.

Agricultural modernisation
 
The same phenomenon crops up in traditional agriculture. New high yield varieties of major crops have slowly spread through the world, but in traditional communities there was a lot of resistance to their use. Why? Don't those peasants want to improve their lives? Modern agricultural experts tended, I think, to see peasants in poor countries as backwards, since the new high yield varieties would make them more money.

But it is seeing yield from a commercial perspective that makes you miss why standardisation on high yield varieties was resisted. From the point of view of the subsistence peasant, the product of agriculture is not just food to sell, but survival into the next year. For this reason, an extremely high value was place on reliability, and the ability to reliably produce enough to survive. The natural consequence of this was:

1. to grow crops that could tolerate tough conditions and still produce something
2. to grow diverse crops so that if one failed there would be another source of food

In other words, the backwards peasant was making the perfectly rational decision to maximise the minimum yield instead of to maximise the average yield. Peasants and subsistence farmers are conservative because their system, while it might leave them hungry, at least minimises the risk of widespread starvation. Any change is risk, and risk is what they are trying to minimise.

The book below, which I would like to read from cover to cover one day, discusses some of these issues in more detail:

A book partially about how peasants maximise the minimum

Three economic words with too many senses

As people who read my previous blog might know, I'm not a huge fan of mainstream economics. But there are a few commonly used words that annoy me because they are used in a sloppy and confusing way, or because I think they are misleading. Here's my top three.

Investment

Investment is one of the favourite words of the economic analyst. Apparently every country either has not enough of it or, occasionally, too much. The problem I have is that there are really two perspectives on investment that are often not differentiated when people use the term:

1. 'Investment' = spending of money by an individual to secure more money in future
2. 'Investment' = spending of resources at a societal level to increase productivity in future

Perhaps I can illustrate with an example. As an individual, I might decide that the best way to have an income in retirement is to buy a house which was previously owner occupied and rent it out. Does this pay back for me personally in the long term? Possibly. But the productivity of the economic system is not increased - no new factories were built, no new processes were discovered. Even though for me the house was an investment, it was not an investment in future productivity for society as a whole.

Basically, when people talk about the need to increase investment in a country as a whole, they should be talking about creating or improving productive assets, not buying up existing assets and creating asset price bubbles in the process.
 
Capital

I am constantly confused by what people mean when they say 'capital'. As far as I can tell, the original meaning of the word was assets used in production, for example tools and factories. But then there are people who use it to just mean 'money for investment', and/or 'the total monetary value of physical assets and savings'. The problem is that monetary savings and physical assets are very different things - the mapping between them is not constant. And not only in the mapping between capital as assets and money not constant, it is to some extent arbitrary, as demonstrated during the cambridge capital controversy. 

Production

Another favourite word in economics is the verb 'produce' or the noun 'production'. But the word produce suggests an act of creation, which isn't really an appropriate word for some activities. For example, mining is not an act of creation, it is an act of extraction or depletion of natural capital. Produce seems to be becoming generalised to refer to almost any economic activity with an output, but in some cases it seems inappropriate given the original sense of the word.

Probability in TV and Economics

In TV, nothing proves how clever you are than spouting off probabilities. "I estimate a 75.2% chance of destruction!" cries Mr Spock when encountering some new alien, or perhaps "There's a 30% chance he's guilty" from a university boffin on a show like Numb3rs. There's just one problem with this: it's complete and utter bollocks.

The problem is that in real world complex situations, there is basically no way of accurately estimating probabilities. In situations where the rules are simple and known, probabilities can often be calculated, but when you move to a situation where a lot of information is hidden, estimated probabilities are more or less meaningless.

If we go back to Mr. Spock and his attempts to estimate how likely James T is to get everyone killed, the following might be major stumbling blocks:

1. Often, the knowledge of the enemy is very limited. If your overall probabilities involve decisions by living beings, then you need to be able to assign probabilities to the different decisions they might make.

2. The number of variables quickly becomes impossibly large - not only do you have to worry about the probability of the enemy captain making decisions, but also the competence of the guy actually firing the guns. For example, if the gunner falls asleep on the job 50% of the time, then this has a major impact on the probability of the Enterprise getting blown up.

And so on. Of course, Mr. Spock can try to make assumptions, but if you make big assumptions you cannot rely on the result. For example, Mr. Spock might assume that the enemy captain has a very low probability of making suicidal decisions, but if the enemy happens to believe that a flock of beautiful virgins are waiting for him in the next life he might actually not be bothered by an "everybody dies" result. You could say that Mr. Spock's original probability estimate was reasonable given his knowledge, but it was also useless precisely because of his lack of knowledge.

This same issue plays out in economics. Economists assume that:

1. everyone is rational
2. people make decisions that maximise something ("utility") over time

How does (2) work in an unpredictable world? Economists say that people maximise "expected utility", e.g. the average result of their actions. The problem with this is that, in order to know the average or expected result, people would need to know the probability of all the different possible outcomes of their choices. Is this really possible?

Most economists basically assume it is. Keynes said it wasn't, because the future is unknowable - not only can you not know what will happen, you can't even know with any accuracy the probability of any particular thing happening. The reason is that the world is so extremely complex that building any kind of model of it without a vast number of basically untestable and unjustifiable assumptions is impossible. People are too limited in perception, knowledge, and processing power to accurately calculate the probability of far future events.

Of course, people can try to estimate probabilities anyway, and big financial institutions do use statistical models, but if those probabilities are based on a larger number of assumptions, any of which could be invalidated at any time by events, it means that people's probability estimates are extremely volatile and their decisions might suddenly swing strong from one direction to another. In this situation, using a model is not really any better than just using your gut.

Thus, what people do is use heuristics and make a guess. This is reasonable because doing better is impossible, for the reasons just discussed. It does however make planning less of a pure scientific exercise, with one correct answer, and turn it into a subjective area where it is impossible to prove which plan is the best. And because people tend to make the same (incorrect) assumptions, it also means that crowds tend to show volatile and herd-like behaviour, which then causes "irrational" booms and crashes which the models don't predict.

And that's why Mr. Spock is spouting nonsense to look clever, and how economists oversimplify the world in their models.