Fundamental Economics

Steven Landsburg explains one of the basic building blocks of economics well:

What economists do believe (or act as if they believe) is that people maximize expected utility, which is a different thing altogether. To assess the value of a 50% chance of $100, we multiply 50% times a number called the utility of $100, and we predict that when confronted with multiple choices, they choose the one that maximizes their expected utility. This is a far better theory than Nagel’s bastardized version, for several reasons. First of all, it’s not an assumption; it’s a conclusion. We start with some very simple axioms about human preferences and deduce that people behave so as to maximize expected utility. Second, there’s a vast body of empirical work that’s largely compatible with this theory’s predictions.

One of the most widespread misconceptions among non-economists is that these “utility” numbers represent some subjective measure of well-being. (Because it fosters this misconception, the word “utility” was probably a poor choice from the get-go, but we’re stuck with it.) All the relevant theorem says is that people act as if they assigned a number to each possible outcome (e.g. $100 is assigned a 2, $1000 is assigned a 3, etc) and then act as if their choices were based on these numbers, multiplied by probabilities a la Nagel (so that a 50% chance of $1000 is assigned a 1.5, making it inferior to a sure $100). The numbers, according to the theory, are different for different people, which is why, confronted with identical circumstances, different people make different choices.

One of the reasons economics does not do well in predicting outcomes is that it is difficult to observe what utility numbers people “assign” to different outcomes. I put the word assign in quotes, because people do not actually assign them explicitly — they just act as if they do. And it gets more complex on the macro level where several billion people, all with different preferences, interact with each other.

I enjoy Landsburg’s writing, blog and books. He has a knack for expressing his thinking in a clear way, challenging you to figure out exactly why you disagree with him, when indeed you do.

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