Economic grow - implications for business

Friedman and the defense of “unrealistic assumptions”

Although some contemporary philosophers have argued that Mill's method a priori is largely defensible (Bhaskar 1978, Cartwright 1989, and Hausman 1992), by the middle of the Twentieth Century Mill's views appeared too many economists out of step with contempo rary philosophy of science. Without studying Mill's text carefully, it was easy for economists to misunderstand his terminology and to regard his method a priori as opposed to empiricism. Others took seriously Mill's view that the basic principles of economics should be empirically established and found evidence to cast doubt on some of the basic principles, particularly the view that firms attempt to maximize profits (Hall and Hitch 1938, Lester 1946, 1947). Methodologists who were well- informed about contemporary developments in philosophy of science, such as Terence Hutchison (1938), denounced

―pure theory‖ in economics as unscientific.

Philosophically reflective economists proposed several ways to replace the old- fashioned Millian view with a more up-to-date methodology that would continue to justify much of current practice (see particularly Machlup 1955, 1960 and Koopmans 1957). By far the most influential of these was Milton Friedman's contribution in his 1953 essay, ―The Methodology of Positive Economics.‖ This essay has had an enormous influence, far more than any other work on methodology.

Friedman begins his essay by distinguishing in a conventional way between positive and normative economics and conjecturing that policy disputes are typically really disputes about the consequences of alternatives and can thus be resolved by progress in positive economics. Turning to positive economics, Friedman asserts (without argument) that correct prediction concerning phenomena not yet observed is the ultimate goal of all positive sciences. He holds a practical view of science and looks to science for predictions that will guide policy.

Since it is difficult and often impossible to carry out experiments and since the uncontrolled phenomena economists observe are difficult to interpret (owing to the same causal complexity that bothered Mill), it is hard to judge whether a particular theory is a good basis for predictions or not. Consequently, Friedman argues, economists have supposed that they could test theories by the realism of their ―assumptions‖ rather than by the accuracy of their predictions. Friedman argues at length that this is a grave mistake. Theories may be of great predictive value even though their assumptions are extremely ―unrealistic.‖ The realism of a theory's assumptions is, he maintains, irrelevant to its predictive value. It does not matter whether the assumption that firms maximize profits is realistic. Theories should be appraised exclusively in terms of the accuracy of their predictions. What matters is whether the theory of the firm makes correct and significant predictions.

As critics have pointed out (and almost all commentators have been critical), Friedman refers to several different things as ―assumptions‖ of a theory and means several different things by speaking of assumptions as ―unrealistic‖ (Brunner 1969). Since Friedman aims his criticism to those who investigate empirically whether firms in fact attempt to maximize profits, he must take

―assumptions‖ to include central economic generalizations, such as ―Firms attempt to maximize profits,‖ and by ―unrealistic,‖ he must mean, among other things, ―false.‖ In arguing that it is a mistake to appraise theories in terms of the realism of assumptions, Friedman is arguing at least that it is a mistake to appraise theories by investigating whether their central generalizations are true or false.

It would seem that this interpretation would render Friedman's views inconsistent, because in testing whether firms attempt to maximize profits, one is checking whether predictions of theory concerning the behavior of firms are true or false. An ―assumption‖ such as ―firms maximize profits‖ is itself a prediction. But there is a further wrinkle. Friedman is not concerned with every prediction of economic theories. In Friedman's view, ―theory is to be judged by its predictive power for the class of phenomena which it is intended to explain” (1953, p. 8). Economists are interested in only some of the implications of economic theories. Other predictio ns, such as those concerning the results of surveys of managers, are irrelevant to policy. What matters is whether economic theories are successful at predicting the phenomena that economists are interested in. In other words, Friedman believes that economic theories should be appraised in terms of their predictions concerning prices and quantities exchanged on markets. In his view, what matters is

―narrow predictive success‖ (Hausman 2008a), not overall predictive adequacy.

So economists can simply ignore the disquieting findings of surveys. They can ignore the fact that people do not always prefer larger bundles of commodities to smaller bundles of commodities. They need not be troubled that some of their models suppose that all agents know the prices of all present and future commodities in all markets. All that matters is whether the predictions concerning market phenomena turn out to be correct. And since anomalous market outcomes could be due to any number of uncontrolled causal factors, while experime nts are difficult to carry out, it turns out that economists need not worry about ever encountering evidence that would disconfirm fundamental theory. Detailed models may be confirmed or disconfirmed, but fundamental theory is safe. In this way one can understand how Friedman's methodology, which appears to justify the eclectic and pragmatic view that economists should use any model that appears to ―work‖ regardless of how absurd or unreasonable its assumptions might appear, has been deployed in service of a rigid theoretical orthodoxy.

Rational choice theory

Insofar as economics explains and predicts phenomena as consequences of individual choices, which are they explained in terms of reasons, it must depict agents as to some extent rational. Rationality, like reasons, involves evaluation, and just as one can assess the rationality of individual choices, so one can assess the rationality of social choices and examine how they are and ought to be related to the preferences and judgments of individuals. In addition, there are intricate questions concerning rationality in strategic situations in which outcomes depend on the choices of multiple individuals. Since rationality is a central concept in branches of philosophy such as action theory, epistemology, ethics, and philosophy of mind, studies of rationality frequently cross the boundaries between economics and philosophy.

Individual rationality

The barebones theory of rationality discussed above in Section 1.1 takes an agent's preferences (rankings of objects of choice) to be rational if they are complete and transitive, and it takes the agent's choice to be rational if the agent does not prefer any feasible alternative to what he or she chooses. Such a theory of rationality is clearly too weak, because it says nothing about belief or what rationality implies when agents do not know (with certainty) everything relevant to their choices. But it may also be too strong, since, as Isaac Levi in particular has argued (1986), there is nothing irrational about having incomplete preferences in situations involving uncertainty. Sometimes it is rational to suspend judgment and to defer ranking alternatives that are not well understood. On the other hand, transitivity is a plausible condition, and the so-called ―money pump‖ argument demonstrates that if one's preferences are intransitive and one is willing to make exchanges, then one can be exploited. (Suppose an agent A prefers X to Y, Y to Z and Z to X, and that A will pay some small amount of money $P to exchange Y for X, Z for Y, and X for Z. That means that, starting with Z, A will pay $P for Y, then $P again for X, then $P again for Z and so on. Agents are not this stupid. They will instead refuse to trade or adjust their preferences to eliminate the intransitivity (but see Schick 1986).

On the other hand, there is considerable experimental evidence that people's preferences are not in fact transitive. Such evidence does not establish that transitivity is not a requirement of rationality. It may show instead that people are sometimes irrational. In the case of so-called

―preference reversals,‖ for example, it seems plausible that people in fact make irrational choices

(Lichtenstein and Slovic 1971, Tversky and Thaler 1990). Evidence of persistent violations of transitivity is disquieting, since standards of rationality should not be impossibly high.

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Collective rationality and social choice

Although societies are very different from individuals, they evaluate alternatives and make choices, which may be rational or irrational. It is not, however, obvious, what principles of rationality should govern the choices and evaluations of society. Transitivity is one plausible condition. It seems that a society that chooses X when faced with the alternatives X or Y, Y when faced with the alternatives Y or Z and Z when faced with the alternatives X or Z either has had a change of heart or is choosing irrationally. Yet, purported irrationalities such as these can easily arise from standard mechanisms that aim to link social choices and individual preferences. Suppose there are three individuals in the society. Individual One ranks the alternatives X, Y, Z. Individual Two ranks them Y, Z, X. Individual Three ranks them Z, X, Y. If decisions are made by pairwise majority voting, X will be chosen from the pair (X, Y), Y will be chosen from (Y, Z), and Z will be chosen from (X, Z). Clearly this is unsettling, but is possible cycles in social choices irrational?

Similar problems affect what one might call the logical coherence of social judgments (List and Pettit 2002). Suppose society consists of three individuals who make the following judgments concerning the truth or falsity of the propositions P and Q and that social judgment follows the majority.

The judgments of each of the individuals are consistent with the principles of logic, while social judgments violate them. How important is it that social judgments be consistent with the principles of logic?

Although social choice theory in this way bears on questions of social rationality, most work in social choice theory explores the consequences of principles of rationality coupled with explicitly ethical constraints. The seminal contribution is Kenneth Arrow's impossibility theorem (1963, 1967). Arrow assumes that both individual preferences and social choices are complete and transitive and (as completeness implies) that the method of making social choices issues in some choice for any possible profile of individual preferences. In addition, he imposes a weak unanimity condition: if everybody prefers X to Y, then Y must not be chosen. Third, he requires that there be no dictator whose preferences determine social choices irrespective of the preferences of anybody else. Lastly, he imposes the condition that the social choice between X and Y should depend on how individuals rank X and Y and on nothing else. Arrow then proved the surprising result that no method of relating social choices and individual preferences can satisfy all these conditions!

In the sixty years since Arrow wrote, there has been a plethora of work in social choice theory, a good deal of which is arguably of great importance to ethics. For example, John Harsanyi proved that if individual preferences and social evaluations both satisfy the axioms of expected utility theory (with shared or objective probabilities) and a stronger unanimity condition is imposed, then social evaluations are determined by a weighted sum of individual utilities (1955, 1977a). Matthew Adler (2012) has recently extended an approach like Harsanyi's to demonstrate that a form of weighted utilitarianism, which prioritizes the interests of those who are worse off, uniquely satisfies a longer list of rational and ethical constraints. When there are instead disagreements in probability assignments, there is an impossibility result: the unanimity condition implies that social evaluations will not satisfy the axioms of expected utility theory (Hammond 1983, Seidenfeld, et al. 1989, Mongin 1995). For further discussion of social choice theory and the relevance of utility theory to social evaluation, see Sen (1970) and for recent reappraisals Fleurbaey (2007) and Adler (2012).

Game theory

When outcomes depend on what several agents do, one agent's best choice may depend o n what other agents choose. Although the principles of rationality governing individual choice still apply, arguably there are further principles of rationality governing e xpectations of the actions of others (and of their expectations concerning your actions and expectations, and so forth). Game theory occupies an increasingly important role within economics itself, and it is also relevant both to inquiries concerning rationality and inquiries concerning ethics. For further discussion see the entries on Game Theory, Game Theory and Ethics, and Evolutionary Game Theory.

Economics and ethics

As discussed above in Section 2.1 most economists distinguish between positive and normative economics, and most would argue that economics is mainly relevant to policy because of the (positive) information it provides concerning the consequences of policy. Yet the same economists also offer their advice concerning how to fix the economy. In addition, there is a whole field of normative economics.

Economic outcomes, institutions, and processes may be better or worse in several different ways. Some outcomes may make people better off. Other outcomes may be less unequal. Others may restrict individual freedom more severely. Economists typically evaluate outcomes exclusively in terms of welfare. This does not imply that they believe that only welfare is of moral importance. They focus on welfare, because they believe that economics provides a particularly apt set of tools to address questions of welfare and because they believe or hope that questions about welfare can be separated from questions about equality, freedom, or justice. As sketched below, economists have had some things to say about other dimensions of moral appraisal, but welfare takes center stage. Indeed normative economics is often called ―welfare economics.‖

Welfare

One central question of moral philosophy has been to determine what things are intrinsically good for human beings. This is a central question, because all plausible moral views assign an important place to individual welfare or well-being. This is obviously true of utilitarianism (which hold that what is right maximizes total or average welfare), but even non-utilitarian views must be concerned with welfare, if they recognize the virtue of benevolence, or if they are concerned with the interests of individuals or with avoiding harm to individuals.

There are many ways to think about well-being, and the prevailing view among economists themselves has shifted from hedonism (which takes the good to be a mental state such as pleasure or happiness) to the view that welfare can be measured by the satisfaction of preferences.

Efficiency

Because the identification of welfare with preference satisfaction makes it questionable whether one can make interpersonal welfare comparisons, few economists defend a utilitarian view of policy as maximizing total or average welfare. (Harsanyi is one exception, for another see Ng 1983). Economists have instead explored the possibility of making welfare evaluations of economic processes, institutions, outcomes, and policies without making interpersonal comparisons. Consider two economic outcomes S and R, and suppose that some people prefer S to R and that nobody prefers R to S. In that case S is ―Pareto superior‖ to R, or S is a ―Pareto improvement‖ over R. Without making any interpersonal comparisons, one can conclude that people's preferences are better satisfied in S than in R. If there is no state of affairs that is Pareto superior to S, then economists say that S is ―Pareto optimal‖ or ―Pareto efficient.‖ Efficiency here is efficiency with respect to satisfying preferences rather than minimizing the number of inputs needed to produce a unit of output or some other technical notion (Legrand 1991). If a state of affairs is not Pareto efficient, then society is missing an opportunity costlessly to satisfy some people's preferences better. A Pareto efficient state of affairs avoids this failure, but it has no other obvious virtues. For example, suppose nobody is satiated and people care only about how much food they get. Consider two distributions of food. In the first, millions are starving but no food is wasted. In the second, nobody is starving, but some food is wasted. The first is Pareto e fficient, while the second is not.

Other directions in normative economics

Although welfare economics and concerns about efficiency dominate normative economics, they do not exhaust the subject, and in collaboration with philosophers, economists have made various important contributions to contemporary work in ethics and normative social and political philosophy. Section 5.2 and Section 5.3 gave some hint of the contributions of social choice theory and game theory. In addition economists and philosophers have been working on the problem of providing a formal characterization of freedom so as to bring tools of economic analysis to bear (Pattanaik and Xu 1990, Sen 1988, 1990, 1991, Carter 1999). Others have developed formal characterizations of equality of resources, opportunity, and outcomes and have analyzed the conditions under which it is possible to separate individual and social responsibility for inequalities (Pazner and Schmeidler 1974, Varian 1974, 1975, Roemer 1986b, 1987, Fleurbaey 1995, 2008). John Roemer has put contemporary economic modeling to work to offer precise characterizations of exploitation (1982). Amartya Sen and Martha Nussbaum have not only developed novel interpretations of the proper concerns of normative economics in terms of capabilities (Sen 1992, Nussbaum and Sen 1993, Nussbaum 2000), which Sen has linked to characterizations of egalitarianism and to operational measures of deprivation (1999). There are many lively interactions between normative economics and moral philosophy. See also the entries on Libertarianism, Paternalism, Egalitarianism, and Economic Justice.

Conclusions

The frontiers between economics and philosophy concerned with methodology, rationality, ethics and normative social and political philosophy are buzzing with activity. This activity is diverse and concerned with very different questions. Although many of these are related, philosophy of economics is not a single unified enterprise. It is a collection of separate inquiries linked to one another by connections among the questions and by the dominating influence of mainstream economic models and techniques.

Main Features of a Planned Economy If we have a look at the planned economies, say, Russian, Chinese or even Indian economy, we shall discover some characteristics. The formulation of the plan and its implementation call for a certain type of economic and administrative organization and a certain type of endeavor and set- up. It is only natural, therefore, that the planned economies reveal some common features.

Existence of a Central Planning Authority