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Wednesday 23 February 2011

Is Self-Interest Self-Fulfilling?

Vicious or Virtuous?

By report and repute our planet has become a less pleasant place over the last hundred years. We’re wealthier and healthier – well, at least in some parts of the world – but this doesn’t seem to have made us any happier. Certainly the world of work is a harsher place, where people are no longer socially attached to their places of employment but a rather viewed as resources to be disposed of as and when required.

One line of argument suggests that this change is not simply due to increased economic pressures on people and corporations to get results but is because managers have learned – been trained – to behave in accordance with the principles of economics, founded on the dubious idea of self-interest. When we act on the basis of ideas these become self-fulfilling. Vicious circle or virtuous ladder?

Belief is Self-Fulfilling

The idea that social science theories can become self-fulfilling – because we learn to act as though these ideas are true – is not a particularly new one. Back in 1970 Thomas Kuhn, in The Structure of Scientific Revolutions, proposed that theories don’t have to be true to be accepted, as long as enough people believe in them. Of course, in the hard sciences there tends to be the limiting factor of reality, where eventually nasty facts get in the way of nice ideas, but it’s not clear that this is true in the social sciences.

Ferraro, Pfeffer and Sutton tackled this idea in Economics Language and Assumptions: How Theories Can Become Self-Fulfilling. They start by arguing that the concept of self-interest is the core assumption of economics. As people ruthlessly pursue their own self-interest, regardless of the people around them or the corporations they work for, it becomes necessary to incentivise them to overcome this.

In this world the market is the most efficient way of organising exchanges and, remarkably, produces socially beneficial results out of this underlying ethos of rampant individualism. Ergo - the more we can structure the world around markets the better for us all.

CBOE and Black-Scholes

The researchers think that this line of thinking can become self-fulfilling – if we believe the ideas we act as though they’re true and, seemingly, they become true. They provide a whole range of examples of which we’ll look briefly at a few.

Firstly they look at the experience of the Chicago Board Options Exchange which opened in 1973 at around the same time that the Black-Scholes option pricing model was invented. Well, it turned out that the model was pretty rubbish at predicting prices to start with. Yet after a couple of years the real-world results and the model’s results had pretty much come in alignment. As MacKenzie and Millo (2003) have shown this happened because firstly traders started to use the model and secondly software and regulation was developed around it.

Economists and Charity

A second example is the behaviour of people trained in economics as compared to those who aren’t. Numerous studies have shown that the former behave more in accordance with the concepts stemming from the idea of self-interest than the rest of us:
“Students in a German university were asked to recommend a plumber for a film club from a set of offers that varied both by the price charged and the amount the person would receive if the plumber they recommended was accepted. Economics students were more likely to recommend a plumber that charged a higher price when they received more money for doing so”.
Economics professors are less likely to donate to charity, too. Tightwads. The idea here, of course, is that those who understand the ideas behind economics are more likely to behave as though they’re true. As economists insinuate themselves into every institutional nook and cranny they become more and more influential leading to a world that increasingly behaves as they predict.

Corporations and Layoffs

Ideas from economics have informed the labour market as well:
“Layoffs have also increased and, more important, have changed in character. In the past, layoffs were the last option that many managers used when confronted by recessions and plummeting firm performance, but since the early 1980s, firms have started proactively using this practice to decrease costs”.
However, downsizing does not improve shareholder returns. In fact in some cases it may damage them – one reason for the growth of the bonus culture in the financial industry is that successive waves of layoffs led to a reduced pool of talented people whose talents were bid-up by firms too myopic to look beyond the next quarter’s results. The net result of this is a situation where neither employees nor employers trust each other – exactly what economic theory would predict and neatly self-fulfilling.

Social Reality

Which constitutes a nice theory, but is it true? Well, not everyone thinks so. After all if someone comes up with a theory in physics which is utter nonsense it may be accepted for a while but will eventually fail under the weight of truth. There’s an argument that the social sciences are no different: if economics comes up with erroneous theories these will eventually fall by the wayside as, for example, has happened with the idea of perfect rationality.

In Social Reality, The Boundaries of Self-Fulfilling Prophesy, and Economics the authors, Teppo Felin and Nicolai Foss, mount a defence based on this idea. At root they point out that if you think that all theories are socially constructed rather than based on some underlying “truths” then you end up in a world in which nothing can be trusted and in which we have no basis for believing anything. The real test is whether or not a theory stands up to the evidence of the real-world.

Univeral Grammar, Universal Economics

This line of thinking isn’t new and in fact goes back to Noam Chomsky’s ideas that there is a universal grammar embedded in each of us – or, more generally, that we have evolved to operate on sound principles based on the fabric of the world around us and can’t imbibe new ideas entirely at random. There are eternal truths and they are encoded in our neural pathways.

Felin and Foss make a number of points but perhaps the most telling is that the evidence that economic self-interest is a self-fulfilling prophesy seems more a plausible folk-tale than a theory based on evidential truth: it feels like it ought to be true but that's far from constituting proof. It may indeed look like economics is ‘persuading’ people to behave in such ways but we’ve seen all too often that periods of a few years, or even decades, aren’t sufficient to establish the difference between temporary norms and universal constants.

Scarcity and Rationality

As they point out, self-interest isn't the only economic and psychological mechanism at play and economists focus on it because it’s the one thing that allows management of scarce resources, whether these be cognitive capacities or physical commodities. Without scarcity there’d be no need for self-interest because we could all have whatever we wanted.

Perhaps the biggest issue here is that even if Felin and Foss are right there’s no guarantee that Ferraro, Pfeffer and Sutton are wrong. The idea of perfect rationality managed to survive in mainstream economics for the best part of a century, and still informs many of the business practices used today, despite the fact that assuming there’s no scarcity of brain power in order to generate a model of how to manage scarce resources is probably the most stupid idea since mercury was used to cure constipation.

Resolving this is not a question of economics, but of human nature. If self-interest is the predominant focus of the human condition then these models will be, if not right, at least on the right lines. At issue is the nature of humanity itself: are we the altruistic ape, or simply a self-interested monkey?

Related articles: Financial Lessons in Mass Deception, The Special Theory of Behavioral Finance, Studying Economics Makes You Mean

1 comment:

  1. How would you resolve your question if the answer to the last question is something like this:

    Humans fall along a spectrum between alturistic and self-interested, tending, on average, to be more towards the self-interested side (i.e., there are some who are way over to one side or the other, but the average is towards self-interest but not at the very extreme). However, humans are not so rational either. Humans are also excellent at rationalizing their self-interested behavior, so on top of everything else, they are not honest with themselves - making it difficult to cleanly define "self-interest." It may be, as I think you suggested, that certain personality types, e.g. more self-interested, may tend to dominate certain professions, e.g. economics, while more alturistic personality types, may go into other fields.