Philosophy of economics

Economic philosophy provides an account of the logical processes by which the intellectual discipline of economics has been constructed.

The assumption of rationality

The process of discovery

The process of discovery in economics usually starts with an insight as to which of the many interactions in the economic system are likely to be relevant to the matter under investigation. That is followed by the formulation and analysis of an imaginary system or model in which only those interactions are represented. The subject of that analysis is thus an abstraction in the literal sense of ignoring all but the chosen selection among the perceived aspects of reality (an approach known to philosophers as instrumentalism ). The interacting relationships that are ascribed to that imaginary system need not have any connection with reality: the only question with which it is concerned is how such a system would behave if it existed in reality. Answers to that question are then sought using deductive logic, sometimes assisted by mathematical analysis. At that stage, the process of discovery involves two conceptually distinct “worlds”: the model world, and the real world. In the real world, propositions can be true or false, but that distinction has no meaning in the model world, which is concerned only with the validity and consistency of its analysis.

The final stage in the investigative process is an attempt to establish a connection between the model world and the real world by using the model’s analysis to predict the consequences of events in the real world. The process of making a scientific discovery is deemed complete if the use of the model results in better predictions than had previously been possible.

Thus the end-product of an investigation is the discovery of a way to make a useful estimate of the economic consequences of particular actions . But the content of economic theory is much broader than that: it also contains a variety of intermediate products that serve as tools in the process of discovery. Those intermediate products provide a framework or “filing system” that enables the economic system to be categorised and examined in an orderly way, and so enables models to be formulated . They include classifications, terminologies, and tautologies: matters that can be intellectually important without having any direct connection with reality.

Economic laws

The end-products of those investigative processes are normally expressed as "economic laws". The interpretation that is to be placed upon them was explained by Alfred Marshall in the following terms:

...a law of social science, or a Social Law, is a statement of social tendencies; that is a statement that a certain course of action may be expected under certain conditions from members of a social group. Economic Laws, or statements of economic tendencies are those social laws which relate to branches of conduct in which the strength of the motives concerned can be measured by a money price. There is no hard and sharp line of division between those social laws which are, and which are not, to be regarded also as economic laws. For there is a continuous gradation from social laws concerned almost exclusively with motives that can be measured by price, to social laws in which such motives have little place; and which are therefore generally as much less precise and exact than economic laws, as those are than the laws of the more exact physical sciences."

Microeconomics

Production

As an example, the statement that “the factors of production are land, labour and capital” is sometimes wrongly presented as an observation about the real world. In fact it is a definitional statement, amounting to no more than the proposition that everything that contributes to production, other than human activity and natural resources, are to be termed capital. The converse statement that capital (or land or labour) contributes to production is not a statement of fact but merely a tautology. In fact, economics has had little to offer by way of factual statements about production. Production processes have been grouped into categories according to the response of their outputs to the scale of their operations, and individual processes have been successfully modelled, but nothing useful has emerged that amounts to a useful factual statement about production in general. The so-called law of diminishing returns is a statement that certain types of production exist which yield a successively diminishing increment of output for each further increment of an input . Other statements acknowledge that types of production also exist for which no such diminution occurs, some of which exhibit increasing returns to scale. (All three possibilities are embodied in a single equation, known as the Cobb-Douglas production function, which has been adopted as an assumption in many hundreds of economic studies. The Cobb-Douglas production function is not , however, regarded as an empirically established scientific discovery: it is not claimed to be anything but a mathematically useful assumption that can be used to represent the production process in broader models of economic activity.) Other concepts that figure as diagrams and equations in the economics textbooks, such as the production-indifference function and the production possibility curve, are also intermediate products that are useful for organising thoughts and building models. They are not statements about reality such as rank as end-products of the discovery process.

Utility

The major contribution of economics to the understanding of economic activity came from its consideration of the role of people as consumers as well as producers, and in that context, its most influential concepts are “utility” and the related concept of “welfare” . However, those concepts make no direct contribution to the understanding of real activity because they are exclusively terminological. Utility has been described as “ a metaphysical concept of impregnable circularity” because it is used, on the one hand, as a definition of what it is about a product that makes someone want it, and on the other hand as an explanation for the fact that someone wants it. (The term “welfare” is used synonymously, except that it refers to its effect upon the recipient.) Although it performs the valuable function of ascribing a purpose to economic activity, the concept of welfare presents pervasive conceptual difficulties that have widespread effects upon the practice of economics. The fundamental difficulty arises from the impossibility of measuring an increment to one’s personal welfare in such a way that successive increments can be added. All that can be achieved by introspection is a ranking of the marginal utilities provided by different items in order of one’s personal preferences; and the only measure of the marginal utility provided by a particular item is the amount of something else that one would be willing to accept in exchange for it. A secondary difficulty that is often presented as fundamental, arises from the impossibility of knowing what goes on in someone else’s mind, which makes it theoretically impossible to compare, or to add together, the marginal utilities that different people attach to any particular item. That difficulty is tackled by practising economists for the purpose of cost/benefit analysis by the adoption of Daniel Dennett’s intentional stance, under which people’s preferences are estimated from their personal characteristics and their market behaviour. At the theoretical level, however, the difficulty has been evaded by the adoption of the concept of economic efficiency under which an action is deemed to increase the total “social welfare” of a community if it produces a welfare increase for some without reducing the welfare of any others. (The proposition that social welfare is also increased by an action if those who gain from it are able to compensate those who lose from it, remains a matter of theoretical controversy , but is generally accepted by practising economists.)

"The marginal utility of a thing to anyone diminishes with every increase in the amount of it that he already has" . Usually stated as the law of diminishing marginal utility, that is an intentional statement that is firmly based upon introspection, and which is taken to be so obviously useful a generalisation as to require no empirical verification. However, it also leads to a paradox and to a question for which economics has no answer. The paradox arises from the corollary that the greatest possible social welfare of a community would be achieved by transfers which removed all differences in personal welfare. It is a paradox because the consequence of such an attempt to maximise the objective of economic activity would be to eliminate the motive for such activity. Economics has provided no answers to questions concerning the connection between total welfare and its distribution (a matter which has been examined as an ethical question by John Rawls, Robert Nozick and others).

Markets

The economist’s market is an abstraction that seeks to adapt and generalise the essential characteristics of real markets. In its idealised form, everyone is fully informed about the product, buyers experience diminishing marginal utility, suppliers experience diminishing returns, and everyone is in instant communication with everyone else. Having added the further abstraction of the Walrassian auctioneer, the result is a coherent, but completely abstract, model of the procedure of bringing supply into line with demand through the price mechanism. It does not purport to typify reality in mechanistic detail, but its outcomes are claimed to be reasonably representative of what happens in some real markets (such as efficiently organised financial markets) and it provides a useful reference point for the purpose of explaining shortages and surpluses as the consequences particular forms of “market failure”. Rather than an end-product of economic theory, the so-called “law of supply and demand” is an intermediate product that provides a fruitful way of thinking about economic activity.

Macroeconomics

The concept of an economy

Unlike microeconomics, macroeconomics takes account of the possibility that the effects of collective actions may differ from the collective effects of individual actions. It came into being during the Great Depression with the realisation that, whereas individual spending cuts would be a rational response to the recession, government spending cuts would be counter-productive.

The concept of an economy provides a means of accounting for the aggregate effects of both individual and collective actions upon the community as a whole. Collective actions are normally assumed to be taken in the interests of the community, who are assumed to delegate responsibility for them to governments. Individual actions are considered only in terms of broad aggregates such as manufacturing, services and households.

The Keynesian revolution

The “Keynesian revolution” in economics introduced several new departures in economic philosophy, one of which was the adoption of an "open systems" approach. Although, like his predecessors, Keynes used mainly deductive processes of discovery, his premises were not axiomatic: they were assumptions that were chosen to meet the objective of explaining mass unemployment. He did not consider those assumptions to be universally true, or to be representative of all economies, and he certainly recognised that there were other possibilities. He postulated a closed system for the purposes of representing the current economic system by a plausible intellectual model, but his philosophical approach included a recognition that the behaviour of any economic system is open to internal and external influences that may not be represented in any particular intellectual model. Followers of Keynes were able to represent his model as one of a family of possible representations of an economy, each based upon different assumptions - implying that each might represent a different version of reality.

Another departure was the introduction of falsifiability . Although the Keynesian model was not derived from any systematic empirical evidence, it was about measurable factors, such as saving ratios and disposable income. That meant that, unlike much of previous economic theorising, it generated readily testable conclusions. The practice continued of generating untestable abstract models but most of the subsequent advances in economic knowledge were the consequence of the systematic testing of hypotheses. The availablity of collections of reliable economic statistics and the development of the techniques of econometrics both contributed to that departure.

There were several other, more detailed departures from previous orthodoxy, including a recognition that money could be used as a receptacle for uninvested savings, as well as performing its traditionally-recognised function as a medium of exchange.

Expectations

It is an inescapable fact that behaviour is influenced by expectations, and economic theory has had to take account of that fact without the possibility of any axiomatic premiss concerning the extent of that influence. It would be absurd either to suppose that people base their decisions upon successful predictions of the consequences of events, or to suppose that their decisions are unaffected by their expectations. Those considerations make unavoidable the adoption of an open systems philosophy. Since expectations cannot be directly measured, their influence cannot be discovered from evidence other than that of the decisions that are actually taken. Hypotheses, such as the rational expectations hypothesis or the various forms of adaptive expectations hypothesis, are adopted solely on the grounds of their predictive success. It is not claimed that the assumption adopted represents how people actually behave, only that the economy usually behaves as though they behave in that way.

Financial economics

Economists and professional investors gave little attention to financial economics until the adoption in the 1970s of models based upon the efficient markets hypothesis. That hypothesis was the basis of risk analysis using the assumption that price variations on the markets for financial assets could be treated as random variations, which could be represented by established probability distributions. It was not until the a crash of 2008 that it was widely recognised that the efficient market hypothesis was no more than a statement of a general tendency, and that additional risks could occasionally arise from statistically unpredictable patterns of investor conduct. That recognition led to renewed interest in hypotheses that take account of the findings of cognitive psychology, and of behavioural economics on general.

Behavioural economics

"Think how hard physics would be if particles could think" . That remark by a famous physicist is an apt reference to the uniquely difficult problem of dealing with human behaviour that economics has to tackle. Attacks on the philosophy of economics on the grounds that "people don't behave like that" have to be examined in that context. Properly understood, its philosophy is essentialy instrumentalist, making no claims for the truth of its assumptions about behaviour, except that some of them sometimes contribute to the prediction of outcomes. Also, in adopting an open-systems approach to economic activity, it implicitly recognises the existence of exogenous social and psychological influences. And that implies a recognition that a hypothesis that passes the predictability test in one social psychological environment, might fail to do so in others. The empirical information about human behaviour generated by behavioural economics and neuroeconomics is of scientific value in its own right, but can be considered to be part of mainstream economics only to the extent that it contributes to the objective of generating knowledge that is of predictive value. In the meantime it serves as a caution against applying the findings of economics to circumstance for which they were not designed.