Michael Battalio

Friday, January 30, 2015

Discussions on Wealth (part 6): Chapter 3

This discussion on wealth is an offshoot of Serious Conversations parts 53 and 54. We are considering the book The Origin of Wealth by Eric D. Beinhocker. (I do not profit from clicks). (Ed.: we will be taking the general format of outlining the major points of the chapter and then discussing what we believe to be important or intriguing points.)

Chapter 3 is a critique of the theories in the first two chapters.  In the debate between physical scientists and economists, a great complaint by the scientists was that humans are not rational (among others).  

The point is made that simply making a correct prediction is not enough in science.  The point of a science is to explain a process.  If the prediction is correct for the wrong reasons (or luck) but the explanation obviously wrong, then you still have nothing.  This seems obvious to me, but apparently not to Milton Friedman.  

The largest assumptions in traditional economic theory are:
Perfect rationality:  people pursue self-interest in economic matters with absolute understanding of economic theory using perfect knowledge of economic variables (inflation rates and beer is the example used.)
Time:  models are instantaneous in transition from one equilibrium to another instead of linearly using time
Ignored Exogenous inputs:  economic models treated outside variables as incapable of being understood instead of trying to incorporate some of the unpredictability into the theories themselves (unemployment from 1982 jumping from 7.5 to 11% for no external reason)
Lack of positive feedback mechanisms: traditional economics assumes that processes are dominated by negative feedback and so damp out. (stock market bubbles were used as an example of positive feedback)

Traditional economics is not supported by data.  Some example where the data do not support traditional economics:
Supply and Demand:  on a large scale this law holds, but on a small “fine-grained” scale, this law almost never holds (example was a car dealership)
Law of one price:  in the idealized world exactly similar goods are the same price due to an “absence of barriers”, but in our imperfect world that is not the case  (43% differences in the price of ketchup in London)
Equilibrium requirement:  in fact the economy is always in a state of flux - settling down after each exogenous shock.  The economy never has time to enter equilibrium between shocks.
Nonrandom walks:  future stock prices are not independent of previous prices

Equilibrium is an inappropriate metaphor in economics.  He compares it to the laws of thermodynamics.  Walras built economic equilibrium theory on the first law — that is energy is conserved, meaning that the different forms of energy must reach a balance at some point.  This is where the idea of equilibrium came from and why it was so appealing.  Walras left out the second law — that entropy increases because it had not yet been fully enumerated, so the concept of closed and open systems was not available to Walras and Jevons.  Walras assumed the economy is a closed system, one that will reach an equilibrium (as in the case of thermodynamics one of maximum entropy).  The economy is actually an open system (the complex adaptive system mentioned in chapter 1).

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