Download The Economic Approach to the Social Sciences – Scope and

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The Economic Approach to the Social
Sciences – Scope and Limitations
Prof. Dr. Michael Fritsch
Winter 2016 / 2017
(December 1, 7, 8, 14, 15, 2016)
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Contact
Chair of Business Dynamics, Innovation, and Economic Change
Carl-Zeiss-St. 3, 07743 Jena
Secretary: Frau Anja Ladig, Room 5.10
Tel.: (036 41) 9 - 4 32 30, [email protected]
Prof. Dr. Michael Fritsch
Room 5.12, Tel.: – 43 220
[email protected]
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Literature
A number of sources is available in the Approaches to Economic
Science Library
http://www.uiw.uni-jena.de/index.php/sonstiges/approaches-toeconomic-sciences-library
of the Chair for Business Dynamics, Innovation, and Economic
Change (user-id and password necessary). Use of the
Entrepreneurship Library is only permitted in connection with the
courses.
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Topics
1. The economic approach in the social sciences
2. Economic approaches to explain social behavior
3. Limits of the economic approach
3.1 How to identify irrational behavior ? The debate about
„merit“ goods
3.2 When is exchange ‘involuntary’ ?
3.3 Moral limits to the market
3.4 Methodological individualism and ‘systemic’ phenomena
3.5 Instrumentalism: Do assumption need to be empirically
“true” ?
4. The economic theory of constitutions
5. An overview of critique of the economic approach―How
relevant ?
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General literature on the topic
Becker, Gary S. (1976): The economic approach to human behavior.
Chicago: University of Chicago Press.
Frey, Bruno S. (1992): Economics as a science of human behaviour:
towards a new social science paradigm. Boston: Kluwer.
Kirchgässner, Gebhard (2008): Homo Oeconomicus: the economic
model of individual behavior and its applications in
economics and other social sciences. New York: Springer.
MacKenzie, Richard B. and Gordon Tullock (1978): The new world of
economics: Explorations into human experience. Homewood
(Ill.): Irvin.
Noteboom, Bart (2014): How Markets Work and Fail, and What to
Make of Them. Cheltenham: Elgar.
Sandel, Michael J. (2013): Market Reasoning as Moral Reasoning:
Why Economists Should Re-engage with Political
Philosophy. Journal of Economic Perspectives, 27(4), 121140.
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1. The economic approach in the social sciences
The economic approach tries to explain human behavior based on
four principles:
Methodological individualism,
Choices are based on the evaluation of alternatives oriented at
individual utility,
Rationality,
Action is regarded as voluntary exchange.
Further assumption: Preferences are relatively constant over time.
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Methodological individualism: Pro and cons
Basic assumption: The individual is the starting point of any explanation,
not the group, state, nation, etc !
Opposite position: Methodological collectivism, popular particular in
large parts of sociology and political science. States that the
collective body has a specific identity that can not completely be
explained by the characteristics of its members; it is a separate
ontological phenomenon.
“The whole is more than the sum of its parts!” (Aristotle,
Metaphysics)
However, methodological individualism says nothing about the rule
of aggregation; this may be adding up, multiplication, etc. and
should particularly account for the relationships between actors.
Against methodological collectivism: Who is entitled to express the
preferences of the group as a whole? May justify dictatorship!
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Methodological individualism vs. collectivism Conclusions
Synthesis: Given that both approaches cannot explain social
phenomena completely, they imply different research strategies:
Methodological individualism: From the inside, starting with
individual action (“skeleton”-approach). Example: Academic
medicine.
Methodological collectivism: From the outside, starting with the
behavior of groups or societies (“corset”-approach). Example:
Holistic medicine (e.g., Ayurveda, homeopathy).
Q: Is macroeconomics economic theory?
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Evaluation of action by the consequences for
individual utility I
Basic approach: Actions are evaluated on the basis of their
consequences, they have no value as such (intrinsic value). The
criterion for judging the consequences is their effect on individual
utility (pain and pleasure). → Utilitarianism → “Greatest happiness
principle” (Jeremy Bentham).
Problem I: Do actions have no value as such? (e.g., procedural value
such as democratic vs. dictatorial decisions)
Problem II: What determines utility?
Economic approach: Subjective utility, i.e. the individual knows best
what is good for him (sovereignty of the individual). Hence, the
utility of an individual can not be judged from the outside, i.e. by
other actors.
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Evaluation of action by the consequences for
individual utility II
What determines utility (continued)
pecuniary based vs. non-pecuniary based utility
ethical values (J. St. Mill, 1863: “It is better to be a human being
dissatisfied than a pig satisfied, better to be Socrates
dissatisfied than a fool satisfied”). → Rule utilitarianism?
other actor’s utility → altruism as utility maximization? →
pareto-optimal redistribution.
Important implication of the concept of subjective utility: Different levels
of utility can not be compared in terms of cardinal values. We may
only know that someone’s utility has remained unchanged or if
he/she is better off or worse off. We can not say anything about
the amount of utility change.
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Evaluation of action by the consequences for
individual utility III
Implications of the concept of subjective utility (continued)
 Utility levels of different individuals can not be compared →
Pareto-criterion!
 Redistribution can not be justified on the basis of economic
theory (exception: pareto-optimal redistribution).
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Rational behavior
Basic assumption: Actors chose the alternative that they appreciate
most, i.e. which has the highest utility for them (rational choice
behavior).
Forms of rationality:
Objective rationality: Actors have perfect information about all
relevant alternatives and maximize their individual utility.
Subjective rationality: Actors may have incomplete or even
incorrect information and maximize their individual utility.
Bounded rationality: Actors may have incomplete or even
incorrect information and chose the alternative that matches
their aspiration level. They act as utility “satisficers”, not
“maximizers”.
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Features of bounded rationality
Gathering and processing information causes effort (cost).
Actors contrast the expected benefit of additional information
with the respective cost and stop searching for additional
information if they do not expect a net-benefit.
Since actors stop to search for further alternatives or to apply
more sophisticated evaluation methods they may chose a suboptimal alternative. Hence, which alternative is chosen may
heavily depend on the order in which they are evaluated.
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Human action as voluntary exchange
Basic assumption: Human action is an exchange relationship
(“There is no such thing as a free lunch!”). Hence, individuals will
establish and maintain relationships if this appears rewarding to
them. It is of crucial importance that this exchange is voluntary.
Exchange does not need to occur simultaneously. Actors may
just expect to attain a reward at some time in the future.
(Example: Insurance contract).
Tipping ?
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Pareto Criterion and the Pareto Region
Utility A
E
I
D
IV (Pareto region)
F
C
II
III
Utility B
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An important implication: The ‚liberal prejudice‘
Voluntary exchange relationships between rational egoists lead to
an increase of social welfare.
 Restriction of individual exchange relationships need to be
justified ! Main economic argument: Market failure.
Examples:
Free trade
Mergers & Acquisitions
Regulation of shop opening hours
Policy restrictions to entry
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Methodological individualism, political individualism,
and anarchism
Methodological individualism: An approach to empirical
analysis and theorizing. Taking the individual as a starting
point. Explanation!
Normative individualism: Emphasizes individual freedom.
Wants to protect individual freedom and autonomy against
obligations imposed by social institutions (such as the state or
religious morality). Recommendation!
Anarchism: Denies the legitimacy of the state and its right to
interfere with individual behavior. Extreme form of political
liberalism.
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2. Economic approaches to explain social behavior
Microeconomic theory, particularly the model of perfect
competition.
Macroeconomic theory
Theory of bureaucracy
Economic theory of politics / public choice
Choice of constitutional rules
…
The economic approach is able to explain a considerable part of
human behavior in the economic sphere as well as in other fields. It
is particularly well suited if relationships are ‘impersonal’ and / or
anonymous. But even some parts of the ’personal’ relationship (e.g.
trust) may be explained on the basis of economic theory.
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Applications of the economic approach outside the
sphere of economics in the narrow sense
Literature
Kirchgässner, Gebhard (2008): Homo Oeconomicus: the economic
model of individual behavior and its applications in economics and
other social sciences. New York: Springer.
MacKenzie, Richard B. and Gordon Tullock (1978): The new world
of economics: Explorations into human experience. Homewood (Ill.):
Irvin.
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Examples
Rule breaking
Criminal activity
Spouse selection
Child production
Sexual behavior
Riots and panic
…
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3. Limits of the economic approach
3.1 How to identify irrational behavior? The debate about „merit“
goods
3.2 When is exchange ‘involuntary’?
3.3 Moral limits of the market
3.4 Methodological individualism and ‘systemic’ phenomena
− Macroeconomics
− Innovation systems
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3.1 How to identify irrational behavior? The debate
about „merit“ goods – Literature
Musgrave, Richard A. (2008): Merit Goods. The New Palgrave, Vol.
5, London: McMillan, 579-582.
Sunstein, Cass and Richard Thaler (2009): Nudge: Improving
Decisions about Health, Wealth, and Happiness. Revised and
expanded edition, New York: Penguin.
Thaler, Richard and Cass Sunstein (2003): Libertarian Paternalism.
American Economic Review, 93, Papers and Proceedings, 175-179.
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How to identify irrational behavior? The debate about
„merit“ goods
Basic idea: There may be cases in which it is desirable that
government ‘corrects’ individual decisions and preferences
(Richard Musgrave).
Definitions:
Merit good: Actors do not consume “enough” of a good. 
Subsidize the respective good or service in order to increase
consumption.
Examples: Education, school lunch, health services, cultural
events (opera houses), … .
Demerit good (“sin good”): Actors consume too much of a
certain good or service.  Put a special tax on that good or
regulate supply of the good in order to reduce consumption.
Examples: Cigarettes, alcoholic beverages, ‘hard’ drugs,
regulation of opening hours for shops and bars, regulation of
prostitution, … .
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Alternative justifications for correcting individual
preferences and behavior
External effects  public goods.
Insufficient information  provide more information.
Misleading advertizing  Inhibit misleading advertizing, provide
correct information.
Non-rational or irrational behavior  ???
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Types of non-rationality
Behavioral anomalies: Behavior violates basic assumptions of
decision theory.
Differences between existing and perceived opportunities.
Irrational behavior.
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Non-rationality: Behavioral anomalies
Examples:
Actors do not maximize their expected utility.
Information is processed selectively.
Decisions are considerably influenced by the way the problem is
presented.
Risk-attitude depends on the type of decision to be made.
Behavior deviates from certain assumptions of decision theory.
Behavior may appear rational if these assumptions are modified. 
Relevance for public intervention questionable!
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Non-rationality: Differences between existing and
perceived opportunities
Differences between existing and perceived opportunities lead to a
systematic underestimation or overestimation of possibilities and
events.  Decisions may not be optimal.
Examples:
Actors do not have an insurance because they underestimate the
probability of a damage.
Over-optimism when founding a business, marrying, … .
Resignation of unemployed persons.
Strategic avoidance of certain situations.
Strategic excessive ambitions.
Relevant for the justification of public intervention?
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Non-rationality: Irrational behavior
Definition: Individual behavior is irrational if it violates the own
interests.
Examples:
Consumption of addictive drugs.
Self-inflicted injury, suicide.
Contradictory behavior.
Problem: Identification of irrational behavior requires knowledge of
individual preferences!
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Justification of public intervention based on „nonrational behavior“ of actors?
Approach to the problem: A correction of individual decisions is
justified if the respective actor agrees to the intervention ex-post
(“Educational dictatorship”).
Problems:
One can never know for sure ex-ante that the respective
actors will indeed agree ex-post..
How does the change of preferences come about? (by
“brainwashing”?)
 Justification of public intervention based on non-rationality is not
in accordance with the economic approach !
However: There may exist a problem that requires public
intervention even if we are currently unable to explain it on the
basis of the economic approach !!!
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Libertarian paternalism: Nudges
Nudges: An attempt to direct human behavior by means of a
conscious design of a decision framework, i.e., ‘gentle’ persuasion
towards certain kinds of desired behavior (‚libertarian
paternalism‘).
Goal: Induce rational decisions and support self control.
Examples:
Sales-promotional placement of healthy food in cafeterias and
supermarkets; unfavorable placement for unhealthy food.
Shock pictures and health warnings on cigarette packets.
Obligatory consultation for certain financial transactions.
Supply of contracts that include self-commitment (e.g., saving
plans, retirement savings, in case of addiction).
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Nudges – The Problems
Who decides? In what way legitimized?
Even ‘gentle’ paternalism may reduce individual freedom (Who
pays for respective political campaigns? …).
Paternalistic guidance may reduce a person’s capability of
autonomous problem solving.
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3.2 When is exchange ‘involuntary’ ?
The concept of ‘coercion‘: In which cases does coercion cause
involuntary exchange?
Being held at gunpoint
Blackmail
Wants to keep the job / avoid unemployment
Poverty, hunger, sickness
The concept of ‘reasonable alternatives’ / freedom of choice
Market concentration / market power
‘Unreasonable’ behavior (e.g., price cartels, dumping)
‘Unfair’ behavior (e.g., false promises and cheating)
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3.3 Moral limits of the market
Literature
Sandel, Michael J. (2012): What Money Can't Buy: The Moral Limits
of Markets. London: Allen Lane.
Sandel, Michael J. (2013): Market Reasoning as Moral Reasoning:
Why Economists Should Re-engage with Political Philosophy.
Journal of Economic Perspectives, 27(4), 121-140.
Waldfogel, Joel (1993): The Deadweight Loss of Christmas.
American Economic Review, 83, 1328-1336.
See also http://scholar.harvard.edu/sandel/home
http://www.justiceharvard.org/
http://www.justiceharvard.org/
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When economic exchange may be immoral or
harmful
Economics is a value-neutral (amoral) science. It can hardly help
to decide which goods should be allocated by the market and
which goods should be allocated by nonmarket principles.
Examples for market transactions that might be regarded immoral:
sex for sale,
pregnancy for pay,
selling citizenship (by the state, by citizens),
selling a kidney or a child for adoption,
selling votes in political elections,
paying to kill animals (e.g., shoot a walrus),
a market for human blood, … .
Trading certain goods on markets may lead to the erosion of
morals in a society.  There are moral limits to market allocation!
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Waldfogel, Joel (1993): The Deadweight Loss of
Christmas. American Economic Review, 83, 13281336.
Argument:
Presents in kind instead of money
lead to a welfare loss because
preferences of people are not
perfectly met.
 Recipients would be better off
with money transfers.
 Stigma of cash giving is an
irrational obstacle to utility and
should be overcome.
Why should behavior based on norms that reach beyond a
simple market calculus be irrational? Gifts instead of cash
giving may reflect norms such as attentiveness and
thoughtfulness. Be careful with normative conclusions!
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3.4 Methodological individualism and ‘systemic’
phenomena
Three examples:
Macroeconomics
Innovation systems and networks
Systems of entrepreneurship
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Methodological individualism and ‘systemic’
phenomena: Macroeconomics
Why ‘macroeconomics‘?
Mass phenomena
Coordination problems (e.g. investment overshooting, pork
cycle)
Interdependencies between markets (e.g., the money market
and the commodity markets)
Macro phenomena (e.g. inflation, gross domestic product,
business cycles).
Macroeconomics for description and forecasts
Macroeconomics as a basis for policy?
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Innovation systems
Literature
Edquist, Charles (2006): Systems of Innovation – Perspectives and
Challenges. In Jan Fagerberg, David C. Mowery and Richard R.
Nelson (Eds): The Oxford Handbook of Innovation. Oxford: Oxford
University Press (Chapter 7).
Metcalfe, Stan (1995): The Economic Foundations of Technology
Policy: Equilibrium and Evolutionary Perspectives. In: Paul
Stoneman (ed.): Handbook of the Economics of Innovation and
Technological Change. Oxford: Blackwell, 409-512.
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Methodological individualism and ‚systemic‘
phenomena: Innovation systems
Basic recognition: Innovation activity is characterized by a
pronounced division of labor between different organizations and
actors.  It would be inappropriate to focus analysis solely on
innovation activities of certain individuals or organizations.
 Holistic perspective: the system, not only the individual actor!?
The efficiency of an innovation system depends to a substantial
degree on the interaction (= division of innovative labor) of its
components as well as on its integration into external knowledge
flows.
This interaction particularly comprises:
competition,
market exchanges,
cooperative relationship, networks (“embedded markets“).
 interactive learning.
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Innovation system: a definition
“A .. system of innovation is that set of distinct institutions which
jointly and individually contributes to the development and diffusion
of new technologies and which provides the framework within
which governments form and implement policies to influence the
innovation process. As such it is a system of interconnected
institutions to create, store and transfer the knowledge, skills and
artifacts which define new technologies." (Metcalfe, 1995, 462f).
Principle constituents of an innovation system are:
actors,
relationships of actors,
the institutional framework,
the knowledge base.
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Innovation networks
Jena
Halle
BSW Ingenieurbüro
Schott
Tridelta
inocermi
c
CZ
AM
FH Merseburg
IPHT
SL
HITK
FhG
FSU
Jenapharm
IMB
Siemens
LM
Jenoptik
MPG
HITK
AI
GESO
HKI
TITK
MUEG
KataLeuna
MLU
Jenaer Glas
SynTec
Agfa
LeunaWerke
FEW
Chemtec
Leuna
Paraffinwerk
HKI
RMH
TITK
Krupp
Buna
Sow
Leuna
OvGU
TUC
Sanierungsges. Wolfen
Inofex
MD
Haack
TITV
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Systems of entrepreneurship
Literature
Qian, Haifeng, Zoltan J. Acs and Roger R. Stough (2013): Regional
systems of entrepreneurship: the nexus of human capital,
knowledge and new firm formation. Journal of Economic
Geography, 13, 559–587.
Szerb, Laszlo A., Zoltan J. Acs and Erkko Autio (2013):
Entrepreneurship and Policy: The National System of
Entrepreneurship in the European Union and in Its Member
Countries. Entrepreneurship Research Journal, 3, 13, 9-34.
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A systems perspective on entrepreneurship
Systems of entrepreneurship are “those economic, social,
institutional and all other important factors that interactively
influence the creation, discovery and exploitation of
entrepreneurial opportunities.” (Qian, Acs and Stough, 2013,
561f.).
“The National System of Entrepreneurship is the dynamic,
institutionally embedded interaction between entrepreneurial
attitudes, abilities, and aspirations, by individuals, which drives the
allocation of resources through the creation and operation of new
ventures.” (Szerb, Acs and Autio, 2013, 13).
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The entrepreneurship system
Source: Lundström & Stevenson (2005, 270).
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Entrepreneurial profile of three European regions
Source: Szerb
et al. (2014)
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3.5 Instrumentalism: Do assumptions need to be
empirically “true”?
Basic literature
Friedman, Milton (1953): The Methodology of Positive Economics. In
Milton Friedman (ed.): Essays in Positive Economics, Chicago:
University of Chicago Press.
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The structure of alternative uses of hypotheses
Assumption
I.
Explanation:
II. Prediction:
Effect
If
then it follows
?
known
known
?
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Instrumentalism – Basic statements
I.
The quality of theories has to be judged by their practical value.
II.
The practical value of theories is their ability to yield valid
predictions about phenomena not yet observed.
III. The empirical truth of assumptions is irrelevant as far as a theory
has sufficient predictive power.
Assumptions of a good theory need to be unrealistic (abstract,
simplified).
Abstract and empirically wrong „as if“ assumptions can yield
correct predictions.
Examples: Profit maximizing behavior, theory of masterly billiard
playing.
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Criticism against instrumentalism
Instrumentalism neglects explanations. Not only predictions
but explanations can be the purpose of science.
Instrumentalism implies no procedure how to attain better
theories (e.g., by having assumptions that are empirically
true).
A theory based on wrong assumptions does not provide an
adequate basis for political intervention.
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4. The economic theory of constitutions
Literature
Original sources:
Buchanan, James M. and Gordon Tullock (1962): The Calculus of
Consent – Logical Foundation of Constitutional Democracy. Ann
Arbor: University of Michigan Press.
Rawls, John (1973): A Theory of Justice. Cambridge, Mass. :
Belknap Press.
Rawls, John (1974): Some Reasons for the Maximin Criterion.
American Economic Review, 64, 141-152.
Textbook:
Mueller, Dennis C. (2003): Public Choice III. Cambridge (UK):
Cambridge University Press.
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Constitutional consent about decision rules
(Buchanan & Tullock)
Costs
Expected external costs
+
Expected decisions
making costs
=
Interdependence costs
Interdependence
cost
Expected
external
costs
1%
Expected
decision
making
costs
GKmin
100%
Gkmin represents the
optimal decision rule.
Required share of
voters
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Basic principles of a fair society according to John
Rawls
I. “Each person has the same indefeasible claim to a fully adequate
scheme of equal basic liberties, which scheme is compatible with
the same scheme of liberties for all.”
II. "Social and economic inequalities are to be arranged so that they
are both:
(a) to the greatest benefit of the least advantaged, consistent with
the just savings principle (Difference principle),
and
(b) attached to offices and positions open to all under conditions of
fair equality of opportunity.“
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Economics and ethics: John Rawls’ difference
principle
Nutzen
Utility AA
D
ID
E
IE
G
45°
Utility BB
Nutzen
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The evolutionary approach to a theory of constitutions
Criticizes social contract theory. Main argument: Real
constitutions do not emerge out of thin air but they develop
step by step.
Explains a factual constitution as the result of a darwinistic
selection procedure according to a „survival of the fittest“, i.e.,
the better constitutions survive and are chosen (→ Systems
competition)
 The ‘better‘ constitutions replace the ‘inferior’ constitutions
or rules.
 Over time, the quality of constitutions increases.
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5. An overview of critique of the economic
approach―How relevant ?
Literature
Noteboom, Bart (2014): How Markets Work and Fail, and What to
Make of Them. Cheltenham: Elgar.
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An overview of critique of the economic
approach―How relevant ?
Economic models are irrelevant because they are based on
unrealistic assumptions.
Actors’ choices are not completely rational.
Actors do not make decisions completely autonomous and
independent. They are strongly influenced by other actors and
their social environment.
People are not entirely egoistic but have also ‘social’ preferences
and values. The economic approach ignores and cannot explain
such social preferences and values
The concept of ‘homo economicus’ ignores important issues such
as personal identity, self-esteem (dignity), respect, sympathy
(friendship, love and hate), trust etc. that matter in establishing
and maintaining exchange relationships.
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Critique of the economic approach―How relevant ?
(continued)
The economic approach ignores moral limits to exchanges.
The economic approach largely fails in analyzing the role of
formal and informal institutions for economic development.
The economic approach fails to appropriately deal with complex
social phenomena such as ‘systemic’ effects.
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Thank you for your attention !
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Simple Questions
1. What is the basic difference between methodological
individualism and methodological collectivism?
2. Explain why the economic approach implies a ‘liberal
prejudice’?
3. Individual A has 30 units of a good, individual B has only 20
units. After a redistribution of 5 units from A to B both would
have 25 units each. Is the society better off due to this
redistribution?
4. Explain how the economic approach can be applied for
explaining the behavior of politicians? What is the basic
assumption that is made in this respect concerning the utility
of politicians?
5. People have imperfect information that may lead to
suboptimal choices. Is this kind of behavior irrational?
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Simple Questions (continued)
6. Does the economic approach imply political individualism?
7.
Empirical research has found convincing evidence that
smoking may kill. Therefore, the majority of politicians want
to forbid smoking. Can this be justified under the economic
approach?
8. Explain moral limits of markets using two examples!
9. Explain the assumption of a ‘veil of ignorance’! Why are
individual preferences more homogeneous behind this veil?
10. Do assumptions of economic theory need to be empirically
true?
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