The second theme of economics is that it deals with large groups. If you are in charge of a small group of people you might be able to deal with each of them as an individual. For a large group you will need to have some idea of how what you do will change the incentives each of them responds to. Mainstream economics takes this into account, but is already beginning to have problems. It tends to deal with a single representative agent, assuming that this will encompass the behaviour of everyone in the population. The trouble is that this may miss effects that depend on how these members of the population interact with each other.
Thirdly, economics systems will involve risk. Mainstream economics doesn’t deal with this very well, as was illustrated by the 2008 global financial crisis. Financial models claimed that deviations obeyed a normal distribution, which is obtained from the effect of lots of small deviations acting independently. In 1905 Einstein deduced the properties of Brownian motion from such independent small deviations due to the bombardment of a particle by molecules. Five years earlier, in 1900 Louis Bachelier studied the behaviour of financial markets, and his work was very similar Einstein’s ideas of Brownian motion. But is the behaviour of financial markets really like that of a particle being buffeted by atoms? Here is one important response to Bachelier’s work:
When men are in close touch with each other, they no longer decide randomly and independently of each other, they each react to the others. Multiple causes come into play which trouble them and pull them from side to side, but there is one thing that these influences cannot destroy and that is their tendency to behave like Panurge’s sheep. And it is that which is preserved.
(Panurge is a character in Rabalais’s Gargantua and Pantagruel. He buys a sheep from the merchant Dindenault and then, as a revenge for being overcharged, throws the sheep into the sea. The rest of the sheep in the herd follow the first over the side of the boat, in spite of the best efforts of the shepherd.)
This tendency for herd behaviour in economic affairs brings in what I consider to be the missing fourth component of economics: Bluffing. Game theory is offered as an advanced option in economics courses, but this is few person (and largely symmetric) games. What I’m looking for is something that gives useful advice in large systems. Sometimes it is best to follow the herd, sometimes it is more profitable to be the one who is different. Often things aren’t that simple though. In the lead up to the financial crisis, many people suspected that the huge gains for those in the financial sector weren’t sustainable, but if you went on doing the same as everyone else your job would be secure (for long enough to make a healthy profit). If you raised objections you might well be replaced by someone who didn’t
It’s my intention that future posts in this blog will look into how including bluffing in the study of economics will help us better understand the causes of problems such as the financial crisis, and indicate how such problems might be avoided in future.