Debunking Economics Part 1: Utility and Society

I’ve been reading Prof Steve Keen‘s book Debunking Economics this week. Now, I was already aware that some quite unrealistic assumptions go into economic models. But I assumed these models were at least internally consistent – they just didn’t describe reality. What’s interesting about Prof Keen’s book is the he zones in on many areas where economic models aren’t even internally consistent.

The latest edition of Debunking Economics

The “economics” of these posts (and Prof. Keen’s book) refers to the neo-classical school of economics by the way, which dominates modern economic policy making.

One of the most amusing examples of internal inconsistency comes in the book’s first in-depth chapter, about the theory of consumer demand. Economics has built its models upon the Utilitarian philosophy of Jeremy Bentham. Margaret Thatcher’s famous dictum that “there is no such thing as society” can be interpreted as a para-phrasing of this quote by him:

“The community is a fictitious body, composed of the individual persons who are considered as constituting as it were its members. The interests of the community then is, what? It is the  sum of the interests of the several members who compose it. It is in vain to talk about the interests of the community, without under-standing what is the interest of the individual.”

According to Bentham’s Utilitarianism, “the interest of the individual” is to maximise pleasure and minimise pain:

“Nature has placed mankind under two sovereign masters, pain and pleasure. It is for them alone to point out what we ought to do, as well as to determine what we shall do.”

Classical economists sought to prove that the optimal outcome for society emerges from  each individual seeking to selfishly maximise pleasure and minimize pain through voluntary free-market exchanges. This would make the free-market “the best of all possible worlds”. Economics then becomes a powerful ideological weapon against those opposed to “laissez-faire”, since economists can claim it is demonstrable, by pure logic, that all alternatives are inferior. The claim is nonsense though, as I now explain.

A key assumption required to prove Bentham’s notion that the interest of the community was just the sum of  individual interests, was the following “law”, which Prof Keen states thus:

“This concept, that a consumer always derives positive utility from consuming something, but that the rate of increase in utility drops as more units of the commodity is consumed, is the key concept in the economic analysis of human behaviour.”

Economists call this the law of diminishing marginal utility. The marginal utility is the satisfaction one gets from consuming an additional unit of some good. If we measure utility, the sum of all these marginal increases, then the “law” of diminishing marginal utility says we get a curve like this:

Diminishing marginal utility

Clearly the above curve is a lousy guide to consumption behaviour in general. Say I start downing shots of alcohol – is my marginal utility still positive  when I vomit them up? When I have my stomach pumped? When I die of alcohol poisoning? And of course numerous other examples occur. Obviously marginal utility can be negative. It was necessary to assume it couldn’t be, so that economists didn’t run into trouble with curves like this one:

Negative marginal utility for alcohol consumption

Marginal utility goes negative after the “tipsy” point above. Two points with the same utility are labelled with red crosses. It becomes impossible to associate a given amount of goods consumed with a definite utility and the entire theory breaks down. To prevent this, a “law” of economics must declare it impossible to have negative marginal utility, so that the theory resulting from this “law” can make definite predictions.

But let’s ignore for now that this assumed “law” has little to do with real consumption and press on. So far the assumptions economists have made, absurd as they are in general, have at least not been shown to be mutually inconsistent.

An individual then seeks to maximise their utility consistent with their income. When more than one good is available, each providing different levels of satisfaction at different costs, the consumer has to factor in a budget constraint. Say the goods are bread and cake. Each loaf of bread costs £X, each cake costs £Y. The consumer has a fixed income £I to spend on B loaves of bread and C cakes. Hence the equation I = XB + YC will determine the budget line bounding the various quantities of cake and bread our consumer can buy.

In the space of goods (here bread and cake), there exist a set of so-called indifference curves; curves of constant utility. These are the paths of constant height on the utility hill below:

A utility hill; indifference curves are the iso-countours

For example, perhaps three cakes and 2 loaves of bread gives the same utility as five cakes and one loaf of bread and a curve exists to connect these points. Here is a plot with several indifference curves and a budget line shown, for bread and cakes:

Indifference curves and a budget line

Maximum utility is the red cross shown above – the number of loaves of bread and cakes the consumer will purchase is the point where the consumers budget line is tangential to the indifference curve of maximum utility.

So much for the theory of individual behavior – Bentham’s “what we ought to do”. Does the second half of Bentham’s assertion then follow – that “the interests of the community then is … the sum of the interests of the several members that compose it” ? Prof. Keen has this to say:

“Two centuries after Bentham, mathematical economists established that the second leg of the Benthamite agenda was, in general, impossible.”

Why was it impossible, in general? Let me now introduce you to the Engels curve– this is what economists call the relationship between income and spending. Here’s are some examples:

Engels curves for different types of good

A “necessity” could be something like toilet paper – the quantity purchased falls as a percentage of income. A billionaire doesn’t spend the same percentage of his income on toilet paper as you or I. A “luxury” could be something like a private jet – the billionaire could spend say 10% of his income on this where you or I would spend 0%. A “representative” good is defined by economists as something everyone spends the same percentage of their income on. What is an example? Well, as Prof Keen points out:

“I can’t give you an example of a “representative good”, because strictly speaking, there are none. Spending on such a commodity would constitute the same percentage of income as a person rose from abject poverty to unimaginable wealth, and there is simply no commodity which occupies the same proportion of a homeless person’s expenditure as it does a billionaire’s.”

As we are about to find out though, economists will need to assume that all goods are “representative goods” !

When determining an individual’s utility map, the shape of their Engels curve doesn’t matter – my income is independent of the utility I can derive from it. This cannot be the case for the social utility map though, since as Prof Keen puts it:

“if income is redistributed between individuals, then there is no way in general to say whether this results in a greater or lesser degree of total [social] utility. The redistribution of income might effectively transfer one banana from someone who gets a great deal of utility – since what gives great utility to one individual may give very little to another. There are therefore many social utility hills, one for every distribution of income.”

So in reality then, there will be a complicated system of feedbacks between the set of all individual incomes and the social utility map, such that the latter is neither independent of the former, nor the sum of the individual utility maps. Such systems containing feedbacks are described by non-linear equations. While the solution to a sum of linear equations is the sum of the solutions to each equation, this property is not true of non-linear equations. So Bentham’s assertion will be false, in general.

In order for it to be possible to sum individual utility curves to obtain the social utility curve – to force the equations describing social utility to be linear – it was shown to be necessary to assume that either:

1 The distribution of income is fixed and Engels curves have a constant slope, or:

2 Engels curves must have a constant slope and they all have the same slope.

Economists didn’t like assuming the first of these: in “the best of all possible worlds” incomes are supposed to be determined optimally, by a free-market in which everyone gets what they deserve, not by fiat. So they preferred to assume the second – that everybody will behave the same way with regards to buying goods, no matter what their income. This assumption is equally unpalatable though, as prof Keen points out:

“Think about what these two additional constraints mean in practice. They mean, for example,  that Bill Gates must spend the same proportion of every new dollar he earns in exactly the same way that you do; that you must allocate each new dollar you earn in the same way Bill Gates does.”

Prof Keen writes that economists model people as behaving like the crowd in Monty Python’s Life of Brian!

In the attempt to make it self-consistent then, the theory that “there is no such thing as society” becomes so manifestly absurd as to be worthless – “the best of all possible worlds” supposedly emerging from the unconstrained free-market cannot be our world. There can be such a thing as society. Or, as Prof Keen puts it in his book:

“The obvious conclusion from this is that Bentham was wrong: ‘society’ must exist as an entity in its own right, and the selfish pursuit of individual welfare does not necessarily maximise social welfare. That economists, in general, failed to draw this inference speaks volumes for the unscientific nature of economic theory.”

Click here to read part 2!

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~ by freedomthistime on December 19, 2011.

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