What’s wrong with the contemporary economics, Part II: Futility of utility

Most of the contemporary microeconomic theories rely one way or the other on the concept of utility. Wikipedia defines utility as a measure of the relative satisfaction from, or desirability of, consumption of various goods and services. Given this measure, one may speak meaningfully of increasing or decreasing utility, and thereby explain economic behavior in terms of attempts to increase one's utility [1].

My original plan was to write about how difficult the concept of utility is from a practical economics point of view. I have not seen “utility” booked in any balance sheet, written in any law that governs commerce in any country or written in any real life contract. Utility is obviously a purely theoretical concept, but is it useful for anything, or can it even be well defined? I (among many others) doubt that it can.

But it turned out that there was already so much material on the internet about the criticism of the use of utility that I think it’s ok just to refer to [1] for the most part, becuase criticism was based partly on what someone had wrote there: Another criticism [about utility] come from the assertion that neither cardinal nor ordinary utility are empirically observable in the real world. In case of cardinal utility it is impossible to measure the level of satisfaction "quantitatively" when someone consume/purchase an apple. In case of ordinal utility, it is impossible to determine what choice were made when someone purchase an orange. Any act would involve preference over infinite possibility of set choices such as (apple, orange juice, other vegetable, vitamin C tablets, exercise, not purchasing, etc),
where cardinal utility is the magnitude of utility differences as an ethically or behaviorally significant quantity and ordinal utility describes just ranking and not strength of preferences.

Now maybe utility would have some use in philosophy, sociology or behavioral science, (…I don’t know…). But in economics it just seems like a messy concept. People have tried to quantify utility so that it could be used in economics by postulating an expected utility hypothesis, which defines utility as a function of expected return on investment (ROI), risks, and personal preferences….sounds rather good at first hearing, doesn’t it? But it has been shown to lead to a several paradoxes like St Petersburg paradox [2], Allais paradox [3] or Ellsberg paradox [4] for starters.

And what’s worse, people just don’t think in terms of utility in practice. On the other hand concepts like (expected) ROI, risks and personal or strategic preferences are real things that people use in their decision-making. So why would it be so difficult to postulate a utility function that would work as a “preference relation” over a set of possible decisions? In fact making such a relation in theory is not so hard. The great mathematician John von Neumann together with economist Oskar Morgenstern already did it (see for example [5]…although there are surely easier to read references somewhere, too =), and their theory looks quite convincing at the first glance….but is it really of any use? I think not, because
a) the concept of “utility” is still messy. Although people do take into account ROIs, risks, and personal preference, I think it is hard to think of a universal relation that would apply to all people in the same way.
b) In order for the expected utility theory to truly describe real life, people are expected to make decisions always rationally….but in practice they do not. People act also “irrationally” or unpredictably, even in corporate decision-making.
c) Making decisions in business is never dependent on one party alone. In order for commerce to take place, you need at least two parties in each individual transaction (see my quantum theory of economics :-)). Thus there is always also the element of negotiation present in every transaction.
d) Even if we would not care about a)-c) the paradoxes of [2]-[4] would still be there. That alone should be a logical proof that an expected utility function is not a satisfactory concept to derive higher level economic theories. Logically one should scrap it!

So why do we use Utility at all? Wouldn’t it be ok just to operate with more easily definable entities like ROI, risks, personal preferences, reference valuations, negotiation strategies, etc….? I think yes it would be and that’s just what is happening in practice too. For example, if you go to Nasdaq internet pages, and take a financial analysis of any given company, you can see the quarterly balance sheet valuations, ROI, risk and other analyses and make your own judgments based on that. But utility has been hypothesized in order to get started with a theory, that would enable a way to connect theories in a vertical dimension, from the micro to macro level. But perhaps there is also something in the rigidity in the ways we like to think. To me it seems that in the history of thought we have had a tendency to create unnecessary concepts like “god” or “space-time ether” or “utility”, that would explain the behavior of the world around us, even if the concept used in the explanation would be fictitious or a fallacy ;-)

So I would propose to free our minds and get rid of the concept of utility in making economic theory. I propose to view this as an analogy to the development of physics theory since wouldn’t it be a little similar to getting rid of the ether hypothesis a hundred years ago? As it turned out there was no need for a universal space-time ether or universal co-ordinates, and in the same way I think there is no need for a universal expected utility function.

Well, maybe the space-time ether analogy is disputable, but I would still like to comment one statement when comparing physics and economics that I have heard many times both in rl and sl, namely the claim that economics would be somehow more difficult to model than physics… but is it really?

If you take the microscopic “quantum” approach to economy, I think the processes in economics are very well defined, because they are defined in the law! The laws governing individual transactions are usually reasonably unambiguous whereas I think the physical theories are constantly challenged. Namely how well are the elementary interactions between elementary particles known really? Aren’t they actually under continuous study in particle colliders and nuclear physics? Perhaps one could claim that the mechanisms of economic interactions are even better known, since they are defined in writing!

Of course the operators in economics are people, who are complicated creatures, but on the other hand, if you think about how the natural science experiments are interpreted...isn’t it also people who operate as cognitive processors making observations, interpreting results and making judgments? And if we talk about technology, isn’t it the often irrational people who design the various gizmos for different purposes, and these purposes are defined by human imagination…sounds rather complicated to me!!!I have not thought very thoroughly how good these analogies to physics really are (or if the analogies actually serve any purpose for that matter) but intuitively it would seem to me that there are grounds to challenge the statement “economics is harder to model than natural sciences”. I think there are good arguments to claim the opposite!

Ursäkta om jag verkade lite provokativt den här gången, men det var bara ivrigheten att få dessa idéer utskriven nånstans =).
Hälsningar till alla SL vänner!

Quin

References:

[1] internet page http://en.wikipedia.org/wiki/Utility, April 6th 2009
[2] internet page http://en.wikipedia.org/wiki/St._Petersburg_paradox, April 6th 2009
[3] internet page http://en.wikipedia.org/wiki/Allais_paradox, April 6th 2009
[4] internet page http://en.wikipedia.org/wiki/Ellsberg_paradox, April 6th 2009
[5] internet page http://cepa.newschool.edu/het/essays/uncert/vnmaxioms.htm, April 6th 2009

thanks again for help Strider