The Economic Rewards of Virtue

Foreword: This is a response to Nick Kraftt at Open Economics, where he follows up on his blog in which he "attacks" U Max or "old fashioned economics" by Parsing the Comments that resulted. For non-economists reading this, what follows is my attempt to draw a distinction between utility maximization, which is what economists have tended to assume best describes consumer behavior, and preference maximization, which is more likely to be what consumers are actually doing when markets fail, information is faulty, prices are distorted away from marginal social cost, or uncertainty (i.e., risk) cannot be or is not managed efficiently. We have tended to use the two terms as synonymous. I think the distinction is important. If preferences do not map accurately to something that can objectively be called utility, there is no guarantee that market allocations are efficient in any meaningful sense of that term. (Obey, if you're out there, this one's for you. :-))

Uncertainty, norms, institutions all matter and will shape consumer  preferences (more about this later). The real issue IMHO is whether or not individual preferences map accurately to something that could plausibly and objectively be regarded as individual utility. It’s JS Mill’s “better to be a human dissatisfied than a pig satisfied” problem. Mill implies that there is some objective state of the world that corresponds or “should” correspond to human happiness. Were we rational, it is the state of the world we would prefer to that characterized by satisfaction of irrational, short-term pleasures.

We economists have tended to ignore the normative aspect and assume that if someone is a “pig satisfied,” his/her preferences correspond to the highest utility that person can or would want to attain subject to the constraints of their income and prevailing prices (even if there is another feasible to attain (with a little rearranging of resources) state of the world in which the person could have health insurance, retirement security, and better nutrition). We also assume that in forming those preferences, the individual is 1) rational (defined rather narrowly as having preferences that don’t change or switch around at least in the short run and that are characterized by more always and everywhere being preferred to less); 2) self-interested (maximizing his/her own idea of what is best for him/her); and 3) fully-informed (s/he knows everything (and I mean everything) about the good and bad effects of consuming some good, the side effects to others of consuming or producing the good, and the future states of the world that will result from consuming or producing the good. And, finally, the prices s/he faces are assumed to reflect the marginal social cost of the goods and services s/he purchases. If any of these assumptions do not hold, then the consumer’s preferences most likely do not map directly and accurately to a state that could be characterized by JS Mill as a “human satisfied”, i.e., a state in which individual utility by some objective standard is being maximized.

When the assumptions do not hold, the consumer is a preference maximizer, not a utility maximizer. The effect will be to distort demand for things that maximize (uninformed, possibly irrational, maybe even bad in the long run) preferences (e.g., granite counter tops and large homes with en suite baths purchased with no money down and pick-your-payment mortgages) at the expense (opportunity cost) of things that would actually improve the long-term prospects and lives of both individual consumers, the economy, and society generally. In the extreme, we have a world of “pigs satisfied” and an economy with significant (inefficient) distortions in investments in and stocks of financial, human, and health capital.

Norms and institutions are important aspects of market exchange and individual behavior that should (there's that normative word again) act to align individual preferences with plausibly objective individual and societal utility. In so-called "free markets," they will embody and reinforce the "social" virtues of generosity, beneficence, fairness or justice as well as individual virtues such as prudence and temperance that lead individuals to take  broader and longer-term views of their own behavior and its impact on their own long-term objectives as well as on their community and the larger society.The result is that norms and institutions provide a moral counterweight to greed and other strong incentives to pursue short-term hedonistic "self-interested" objectives.

All policy solutions aimed at remedying or minimizing the divergence of preferences from utility will necessarily involve "paternalism" to a greater or lesser extent. The solution that is least paternalistic and that allows the most consumer autonomy is preferred. To minimize paternalism, it must include improved (and state-funded) education, improved consumer information, increased market transparency, some regulation, and some "nudging" in circumstances where uncertainty makes rationally, informed choice difficult. The more effective are societal norms and institutions at reinforcing virtues that promote long-term individual and societal well-being, i.e., at aligning individual preferences with individual and societal utility, the less paternalism will be required. For this reason alone, prevailing norms and beliefs in support of unfettered self-interest that are derived from misunderstanding the metaphor of Adam Smith's "invisible hand" and "self-interest" must be corrected.

Assuming virtue in economic models of individual decision making is much the same as assuming full-information. If the assumption is true, revealed preference probably approximates utility maximization. If it is false, then I believe we're in a second best world.

If individual virtue tempers our "piggy" desires and conditions our choices to something that is both individually and socially better, then the economic rewards of virtue as embodied in and promoted by societal norms and institutions are far greater than we have ever suspected. As economists, we would do well to recognize this when we teach U max.

Comments

[Mark Thoma]

I usually ask before reposting things, and I should have asked you, but I I hadn't posted anything for awhile, got in a hurry, and forgot.

I was going to offer to cut it down if you'd rather not have the post echoed, or even remove it altogether, but now I can't seem to find an email.

Anyway, apologies for not checking first.

[Coises]

Somehow it seems to me this has gotten turned around.

The defining characteristic of the “pig satisfied” is that his intellect is circumscribed; he is content because his imagination cannot reach beyond his circumstances. The human being dissatisfied is not better off because she cannot achieve the same pleasures as the pig, which indeed she can (and in which, at times, she may choose to indulge); but because she can envision far greater pleasures, many of which will forever elude her grasp.

When you write, “All policy solutions aimed at remedying or minimizing the divergence of preferences from utility will necessarily involve ‘paternalism’ to a greater or lesser extent,” I’m left with a picture that reminds me of the pigs much more than the human beings. Wise people will educate, regulate and “nudge” us until our “preferences” (what the ordinary person foolishly thinks is valuable) are aligned with “utility” (what the wise have determined is truly valuable).

I’m not at all convinced this utility/preferences dichotomy represents anything of significance, except perhaps a (possibly unwitting) Trojan horse within which to hide a nasty form of elitism.

[Coises]

In contrast to my previous comment, let me offer an example of something I think is relevant.

Suppose Burger King creates and airs a television commercial which I, like many other people, see; and suppose, as a result, I have a craving for a Whopper, which leads me to walk down the street to the nearest Burger King and buy one.

Did I satisfy a preference or maximize utility? Who cares? Certainly, once the commercial led me to prefer walking down the street, purchasing and having a Whopper to sitting in front of the TV without a Whopper, the Whopper gained some new utility (or my current state had more dis-utility, if you prefer).

But what about the overall picture? Burger King used scarce resources (the labor of the people who wrote and made the commercial and the air time to present it) to raise aggregate demand for still more scarce resources (Whoppers). In what sense is this possibly “efficient” or a system-wide good (or even neutral) thing?

Note that this doesn’t depend on any judgement as to whether a Whopper is “good for you”; it simply notes that it is in some actors’ best interests to consume scarce goods (and hence incur an opportunity cost) solely to create a demand for more scarce goods (rather than to satisfy any of people’s many existing needs and wants, which might or might not be represented as demand).

Isn’t that practically the definition of “moral hazard”? Yet no one seems to think much about the absurdity of a system the structure of which encourages, and the day-to-day operation of which depends upon, manufacturing demand while needs and wants that require no synthesis go unfulfilled.

I suggest this as just one example of the network of perverse incentives that support our modern economic systems. Like the bankers and analysts who thought nothing of the mess they were making because it was a commonplace — the rest of us recognize CDOs and CDSs and what have you as absurdities only because they are novel to us, so we see them in light of what we now know happened — advertising doesn’t appear absurd to us because we are used to it. Step back a moment and it’s a bizarre thing to which to devote a major sector of the economy. I’m pretty sure that by itself it could overthrow just about any attempt to describe the economy as “maximizing utility.”

[ryan a]

"If individual virtue tempers our "piggy" desires and conditions our choices to something that is both individually and socially better, then the economic rewards of virtue as embodied in and promoted by societal norms and institutions are far greater than we have ever suspected. As economists, we would do well to recognize this when we teach U max."

Who is the "we" here? Western consumers? Is this about a particular population, or are you talking about humanity as a whole?

[Sabina's Hat]

This is a bit confused. Mill claims that there is a way to rank actions according to normative criteria--that the best action is the action that maximizes pleasure. Preference satisfaction utilitarians also claim that we can rank actions on normative grounds--the best action is the action that maximizes preference satisfaction. The difference is that for utilitarians like Mill, utility refers to an objective state of the world independent of our preferences rather than what we happen to prefer(the pig and Socrates bit is actually about the how to compare pleasure across different beings--not utility v. preferences). For example, we often prefer to know the truth about whether our spouse is faithful, even when knowing it will bring us unhappiness.

The assumption that is made by economists is that (at least in large groups), people tend to perform actions that maximize their utility--however it is defined. Thus, it is not correct that the problematic assumption is whether preferences map onto utility. Rather, it is whether actions map onto preference satisfaction or pleasure.

There is another issue as well. The claim that humans are rational actors doesn't mean that they will do the actions that will maximize pleasure/preference satisfaction for everyone. Rather, it only means that they will do the action that will maximize their own pleasure/preference satisfaction. While free market economists are historically most associated with this claim, there is no reason in principle why they should be the only ones to do so. It is obviously possible that you might think that people acting as rational actors can lead to states of affairs that do not maximize total utility.