by Edwin Ivanauskas | Tags: Personal Finance, Banking

What is interesting here? Interesting term, homo economicus. What does this mean and how does it apply to the real world

What am I trying to say? That assumptions are necessary in economics but when used without regard to their inability to explain everything, are dangerous

Economic Man, Homo economicus, do You Fit the Bill?

In economic theory, it is common for researchers to use as basic of variables as possible when coming up with models. To this end, economists have created an "economic man" or homo economicus that possesses the traits necessary to make economic modeling simple.

The Traits of Homo economicus:

1. Homo economicus makes rational choices based on stable and predictable preferences.

   Sally is shopping for canned tuna, she knows exactly what features she wants from the tuna and then compares prices and selects the canned tuna which offers here the best price for the features she wants.

2. Homo economicus always maximizes utility.

   John finds that he can buy a video game for $50 and play it for 25 hours of entertainment, leading to $2 per hour of entertainment. He also knows he can spend $10 on a movie that lasts 3 hours, costing him $3.3 per hour of entertainment. He then decides to buy the video game as it maximizes his utility.

3. Homo economicus acts independent of others and will full and complete information.

   Peter is comparing investments in the stock market to investments in government bonds. He finds that government bonds will yield 3% and the government has exactly a 0% chance to fail. He compares this to a stock that yields 20% but has a 50% chance to fail. Knowing his preferences, and attempting to maximize value, Peter decides that the government bonds are ideal because he is close to retirement and does not want to take the stock risk.

 

These traits of homo economicus are used in many theories, and to great effect. But from reading the examples I put in italics you can start imagining the limits of these assumptions.

1. Sally is shopping for canned tuna, she knows exactly what features she wants from the tuna and then compares prices and selects the canned tuna which offers here the best price for the features she wants.

   This assumption of rational choices actually sounds fairly reasonable. People generally know what they want and will make quick comparisons in their head before making a decision. But the practitioners of marketing beg to differ and make quite a sum of money because people are not rational in this way.

   Companies will pay money to get ideal shelf space in super markets because customers are more likely to buy items at eye level. Companies spend vast sums of money on branding and advertising to get consumers to buy their product rather than another company's. This is because all of these tactics work; people are more likely to buy a brand they "trust" even if they have never tried it.

   If you want to take a step into the world of our own irrationality, check out this TED talk

2. John finds that he can buy a video game for $50 and play it for 25 hours of entertainment, leading to $2 per hour of entertainment. He also knows he can spend $10 on a movie that lasts 3 hours, costing him $3.3 per hour of entertainment. He then decides to buy the video game as it maximizes his utility.

   The example has many additional factors. For example going to a movie works far better as part of a date or going out with friends than playing a video game does. Additionally, with either form of media, you don't know how much you will actually enjoy it. Maybe the movie will be a big stinker and waste of time. Maybe the movie will be spectacular and the best you've seen this year. We get into a very confusing realm when we have to deal with how the past or someone's personality affects their decisions. Given the amount of variables, the choice is never as clear cut as this example.

3. Peter is comparing investments in the stock market to investments in government bonds. He finds that government bonds will yield 3% and the government has exactly a 0% chance to fail. He compares this to a stock that yields 20% but has a 50% chance to fail. Knowing his preferences, and attempting to maximize value, Peter decides that the government bonds are ideal because he is close to retirement and does not want to take the stock risk.

   This example illustrates the problem with full and complete information. The only assumption there that is accurate is the 3% bond yield. Even the 0% of government failure is not guaranteed, particularly when you are investing in an unstable country. Knowing the return and failure of a company is even more absurd.

   Another feature of the assumption of full information is the ability for the person to not only acquire the information at any moment, but also have the ability to process it. Even if someone were to get very detailed investment information, they wouldn't always be able to process it quickly enough to make an informed decision.

Another feature of the assumption of full information is the ability for the person to not only acquire the information at any moment, but also have the ability to process it. Even if someone were to get very detailed investment information, they wouldn't always be able to process it quickly enough to make an informed decision.

Using the assumption of homo economicus in modeling does not disprove them or make them useless. Simplicity, which is what "economic man" provides, is an important part of economics. All economic theories are based around very simple and easy to grasp concepts even though they aren't always correct:

• Scarcity, resources are limited
• People act based on the ideal of Homo economicus
• People and firms value different things at different levels creating supply and demand
• There is an opportunity cost to every decision
• And the list goes on...

The issue is when economists, or anyone else, use these assumptions beyond reason. It becomes even more of a problem with ideologues can latch on to a very simple concept and use it in an improper way.

Many economists, particularly those in the field of behavioral economics, work with the expressed understanding that these assumptions, and other assumptions, are often incorrect. They find ways to account for variables that make the theory fit the reality better.

So doesn't this sound like proper scientific progress, finding things that are not true and fixing them? Well, not necessarily. The danger is when wrong assumptions work their way into the real world and have a negative effect on it. Rather than going beyond the topic of homo economicus, I'll let you read this article by Paul Krugman that helps illustrate the more large scale issues false assumptions can create.

If you want to read more in depth about the divide in the economics profession assumptions have caused, I recommend The Macroeconomist as Scientist and Engineer by Gregory Mankiw.

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