Economics and Business

Towards A New Paradigm for Economics

J.KAU: Islamic Econ., Vol. 18, No. 2, pp. 49-59 (2005 A.D/1426 A.H)

Director General, International Institute of Islamic Economics
International Islamic University, Islamabad, Pakistan

ABSTRACT.

Current economic theory is mainly concerned with the factors which affect the wealth of nations. Issues of income distribution and elimination of poverty and deprivation is secondary. The present paper invites discussion on a new paradigm: hunger and homelessness to make the subject of economics really serve the humankind.

  1. Focus of Conventional Economics is Wealth and not Poverty

Current Economic theory is firmly set in the mold structured by Adam Smith 1904). His concern was to look into factors which affect the wealth (and hence power, prosperity) of nations considered as a whole. Issues of income distribution are secondary, since wealth belongs to the nation regardless of how it is distributed among individuals. Since then, economists have been primarily interested in wealth and power, and not so much in removing poverty, hunger and economic misery. Malthus (1798) provided a convenient sop for consciences, showing that poverty arose as a consequence of natural laws (all proven wrong empirically later) and the only cure was to reduce the birth rate of the poor. Tawney (1926) has looked at the process by which morality got divorced from economics in much greater detail; because of this, questions of fairness, equity, justice no longer form part of current economic discourse.

For those of us who are human beings first and economists second, the consequences of this preoccupation with wealth and power have been disastrous. One can receive a Ph.D. in economics without receiving one word of information about the extent of poverty in the world, or the meaning of hunger and deprivation. In informal conversation, an eminent labor economist, said that there was no point in policies to eradicate poverty since the bottom 10% of the income distribution would always be poor. There is no natural way to define poverty in our microeconomic theory, and our tools shape the way we look at the world. To a much bigger extent than realized, the failure of our theories to recognize the poor affects their fates. Trade theorists insist that free trade generates more global wealth (under ideal conditions) and hence can lead to a Pareto improvement if the wealth is redistributed. At the policy level, economists press hard for free trade but make no attempt to ensure that the redistribution will also take place. The failure of our theories at the macro and micro levels to recognize the existence of the poor leads numerous types of policy failures both at the theoretical and at the practical levels.

Numerous attacks have been mounted on the neoclassical paradigm. On the empirical side, it appears that people rarely behave “rationally,” when rationality is defined in the neoclassical sense. A prominent challenger on this side has been Herbert Simons (1982), who developed the concept of “bounded rationality.” Studies of decision making by psychologists show systematic deviations from neoclassical rationality, as documented by Kahneman, and Tversky (1985), etc. Applied studies of consumer behavior show systematic flaws in the utility model, the main ones being the relative instability of consumer preferences, and the effects of information/misinformation. In econometric studies, systems of demand equations based on utilities can be constructed only under rather restrictive assumptions. Such assumptions typically show systematic violations of predictions such as Slutsky (1937) symmetry conditions. On the other hand, with no restrictions, it shows that all patterns of aggregate demand are compatible with some underlying utility functions. Thus the theory is vacuous, in the sense that it yields no implications about observable aggregate demand functions. Experimental game theorists have also confirmed systematic violations of even the simple dominance principle (according to which people prefer more money to less) in the ultimatum game. Kuhn (1996) has shown that counter examples never suffice to replace a paradigm. It is only the emergence of a new paradigm which displaces the old one.

Convincing demonstrations of the failures of conventional micro and macro theories have been given by many economists, working from numerous different points of view and different schools of thought. However, no clear and well-defined alternative has emerged, partly because there is no agreement to a common framework among those who seek to displace conventional theory. In this paper we propose a simple alternative which could be used to replace conventional micro theory, and could command consensus among very diverse schools of thought which are critical of conventional theory. Adoption of this as shared paradigm, regardless of further refinements which may be added by adherents of different schools, would create a unity among the dissenters and perhaps create a coherent alternative to conventional economics.

  1. The Heart of the Neoclassical Model

At the heart of the neoclassical model lie some simplistic assumptions about
human behavior, plus some resolutions. The simplistic assumption is that human beings
prefer more to less – from here, it is a few short steps to utility functions. Additionally
we resolve not to study these preferences, how they are formed and how they change.
This task is allocated to psychologists. Consumer sovereignty represents the resolve not
to judge or to attempt to change these preferences. In addition we resolve not to measure
intensity of preference, and especially resolve not to make interpersonal comparisons of
utility, as this is not scientific. We also embrace the empiricist philosophy of science.
This leads us to study choices, which are observable, and avoid preferences which have
more to do with the “unobservable” internal states of satisfaction or dissatisfaction
resulting from choices. One consequence of demarcating our field of study in this way
is that it makes it impossible to provide “scientific” support for pro-poor policies. We
cannot even recommend taking away a glass of vintage wine from a multi-millionaire to
give bread to hungry children as professional economists. The loss to the millionaire
cannot be compared to, added to or subtracted from, the gain to the children. When a
conscience-stricken economist does wish to recommend some such measure, he has to
resort to subterfuge such as measuring productivity loss due to poor health of laborers,
or increases in crime rate. The hunger of the children cannot be a factor in his
“scientific” calculations.

  1. An Alternative Microeconomic Framework

We propose to make a modification to this basic set of assumptions. In some ways
it is a trivial change, and some may criticize it for conceding too much to conventional
economics. The net effect of the change is to make poverty a visible part of the utility
model in a mathematically elegant way. Despite the surface appearance that the change
is superficial, it has far-reaching consequences, as we shall see.
The proposal is to take the basic utility function of human beings as a
lexicographic ordering. Every bundle of goods x, is evaluated using two functions
(U(x),V(x)). Given bundles of goods x and y comparison between them is done first on
the basis of U(x) and U(y). If U(x)>U(y), then x is preferred to y. If U(x)=U(y) then
comparison is done by looking at the second component of the utility function, with x
being preferred to y if V(x)>V(y). U is interpreted as the basic needs function. If a man
is hungry, he will compare two bundles only with respect to their food content. Only
after his hunger is fulfilled will he turn to comparing other aspects. U will have certain
properties to conform to this interpretation. It should have satiation points beyond which
additional goods will not add utility. In addition, it should be sensitive only to certain
types of goods (basic needs) and insensitive to other types (luxuries). We would expect
V(x) to be relatively unstable (easily influenced by advertising, etc.) and have
externalities (my utility could depend on the commodities being consumed by my
neighbors). However, U might be considered as being biologically and socially
determined to some extent. There is room for a number of different interpretations in
conformity with basic idea. In order to allow for wide participation in development of
this alternative paradigm, we do not insist on any particular fixed interpretation for U
and V. It is enough to assume that choices of those who have unfulfilled basic needs
will differ (being based on U alone) from those who have fulfilled their basic needs.
This allows a natural partition of the population into poor and not-poor, and makes the
poor a visible part of our theory. By assumption, U reaches satiation for every person;
let U* be the maximum value that U can attain (which may vary from person to person
– the actual numerical value does not mean anything as in the conventional model).
Definition: A person is poor when he has a commodity bundle x such that
U(x)<U*.

Language is powerful. When a concept cannot be defined within the mainstream
economic framework, it becomes invisible. It is this invisibility which allows expert
economists to be completely ignorant about the extent and nature of poverty in the
world. Our redefinition of the basic utility function has the virtue of allowing us to talk
about poverty in a natural way. Currently, those concerned with poverty can either use
the complex and technical framework of income distribution theory, or else go outside
mainstream concepts and introduce ad-hoc subjective extensions.
One of the virtues of the lexicographic utility function as defined above is that it
fits squarely into the neoclassical framework. The conventional utility function is
obtained from primitive preferences by imposing the mathematical axiom of
“continuity.” It is clear that this assumption is made for mathematical convenience
alone. Dropping continuity leads to the possibility of the lexicographic utility functions
of the type we have introduced above. Can this minor technical change, which does not
challenge any of the central tenets of neoclassical methodology and mindset, have an
important impact? We hope to show that it can.

  1. A New Paradigm: Hunger and Homelessness

According to standard textbooks (for example Samuelson and Nordhaus) the key
ideas in economics are that goods are scarce and that society must use its resources
efficiently. Samuelson and Nordhaus (2001) go through two pages of discussion of why
one would want to study economics without mentioning hunger, homelessness, and
disease. It is heartbreaking that poverty gets a tangential mention as one item among a
list of seven definitions: economics examines the distribution of income and suggests
ways that the poor can be helped without harming the performance of the economy. The
sacred goal of efficient production of goods takes precedence over the helping of the
poor, according to this Bible of economics. Our purpose in proposing a new paradigm is
to change this mindset. We would like to put hunger, homelessness, and misery due to
lack of economic resources at the heart of the economics – to consider these issues to be
the main economic problems. This is entirely different from “scarcity and efficiency” as
well as more classical views of economics as a source for power and prosperity of
nations. Adding one ethical principle to our lexicographic utililty functions shows how
our framework changes the central problems of economics:
Pareto Principle (Lexicographic form): An allocation (x1,x2,…,xn) of commodity
bundles to individuals with utility functions (Ui,Vi) for i=1,2,…,n is socially preferable
to an alternative allocation (y1,y2,…,yn) if either (a) Ui(xi) ≥ Ui(yi) for all i, with strict
inequality for at least one i, or (b) Ui(xi) = Ui(yi) for all i, and Vi(xi) ≥ Vi(yi) for all i
with strict inequality for at least one i.

With lexicographic orderings, the above is clearly the mathematically appropriate
superstructure. Ethically, the judgement that feeding the hungry takes precedence over
the provision of luxury goods is almost universally agreed to. Disagreements take place
over tactics – that is, provision of food, subsidies etc. might damage the interest of the
poor in the long run by reducing their motivation to work. We do not know of
disagreements over the final welfare assessment that reduction of hunger takes
precedence over less urgent needs. Without getting into the impossibly complex issue of
interpersonal utility comparison, our lexicographic structure permits modest
comparisons between people living below subsistence levels and at or above subsistence
levels. While the exact poverty line may be fuzzy, its existence is not to be in doubt.
Malnourishment, reduction in life expectancies, and numerous other biologically and
medically well defined phenomena provide objective bases for assessing subsistence
levels. At the theoretical level, it is enough to agree that the phenomena of poverty
exists; the exact quantification (or even the quantifiability) is not relevant for the
considerations which follow.

If we accept this definition, the problems of scarcity and efficiency no longer remain
the basic economic problems. The current state of the world is that vast numbers of poor
people exist. The economic resources of the world are far more than adequate to eliminate
hunger worldwide. Thus scarcity is not the cause of hunger and economic misery. As Sen
(1986) has shown in his striking studies, thousands of people die of hunger when there is
enough grain available locally to feed all of them. The main economic problem becomes
one of discovering why there exists economic misery when there are enough resources to
eliminate it, and furthermore, there is widespread agreement on the ethical principle that
people should not be allowed to starve to death. Efficiency is no longer a central concern.
A proposal which eliminated hunger and poverty while wasting half the resources in the
process would still produce a Pareto (L) improvement – the (L) is for lexicographic, to
distinguish it from the original Pareto Principle.

A red herring that is frequently raised at this point is that we have input a strong
ethical judgement to arrive at this strong result, which re-orients us regarding the
fundamental economic problems. Thus we have jumped ship from positive economics
to a normative framework. In actual fact, there is no escaping the ethical dimension of
the problem. Consider a two person society, where one of them has far more than
enough for his needs while the other is about to die of hunger. To say that one should
not intervene and redistribute resources is as strong an ethical judgement as to say that
one should intervene. There is no neutral ground and no way to avoid introducing a
moral judgement. The moral judgement implicit in the original Pareto principle holds
property as sacred – moves to save lives cannot be justified if they require violating
property rights of others. The moral judgement explicit in our reformulation holds lives
to be sacred, and sacrifices property rights to this higher principle.

  1. Physics-envy, Positivism and Free Will

Pre-Galileo, the Bible was the only certain source of knowledge. As religious
belief waned in Europe, and the accomplishments of Newton dazzled the world,
scientific knowledge was placed on this pedestal. Symbolically, in November 10, 1793,
the Christian God was deposed in Notre Dame, in Paris, by the party of the Hebertists
and atheistic Reason proclaimed as anti-goddess. The adjective “scientific” became
synonymous for rational, logical, modern and enlightened while “unscientific” became a
pejorative. Even though studies of human beings, languages, cultures had little in
common with physics, the tag “sciences” was added to social in a scramble for
respectability. It was only after Kuhn’s (1996) influential book, The Structure of
Scientific Revolutions, that the uncertain status of scientific knowledge became
apparent. That scientific theories cannot claim certainty is apparent from the fact that
every new set of scientific journals demonstrates the falsehood of some earlier scientific
theories. However, the enormous respect commanded by science prevented people from
seeing/saying this until recently, much as in the case of the Emperor’s new clothes.
Now the pendulum has swung in the opposite direction, with some people claiming that
scientific theories emerge from social consensus and have no special claims to
truth/validity. The powerful effects of technology in transforming the world and society
cannot be denied. These must be due to some special properties of scientific knowledge
and how it accumulates, but exactly what these properties are is very unclear in a post-
Kuhnian world. It does seem clear that self-conscious attempts to mimic the “scientific”
method in the social sciences have caused considerable harm – human beings differ in
important ways from physical particles. In developing our new paradigm, we therefore
recommend moving away from writing “Collected Scientific Works” to devising useful
methodologies for studying the subjects of our interest.

Along with a paradigm shift, we also need to free ourselves from certain
methodological strictures which were fashionable in the early twentieth century. Since
the 1960’s, philosophers have been quarrelling about who killed logical positivism.
Meanwhile, economists continue to embrace the corpse. We now discuss why it is
essential to dispose of this burden, to make progress in economics.
Positivist attitudes prevent us from deeper study of internal states of human
beings, like happiness, sadness, etc. However, a deeper understanding of human beings
is essential for progress in economics. Consider, for example, two possibilities: (A)
human beings derive utility/pleasure/satisfaction from their own consumption, without
regards to others, and (B) the pleasure/satisfaction derived from consumption depends
solely on relative position of the consumption bundle within the society. Suitable
economic policies would differ drastically in societies where (A) holds from those
where (B) holds. Therefore, an economists cannot be agnostic about this issue. Yet the
conventional demarcation of the field leaves this question to psychologists and suggests
that economists can get by without knowing the answer to this question. Additionally,
consider a society such as that of the Amish in Pennsylvania, which strives for
simplicity, and shuns modernism and materialism. Surely economics, both descriptive
and prescriptive, would be different in such societies. From the Philosopher-Kings of
Plato, to Christian Ascetics and Zen Buddhists, there have always been communities
which have preached and practiced the virtue of simplicity, and denied that greater
consumption will lead to greater happiness. While communities of ascetics have
typically been very small minorities, with little impact on aggregate economic activity,
they do demonstrate the extremely variable range of human behavior, and the difficulty
of setting down universal laws characterizing it.

An even more damaging possibility must be faced squarely by economists. Human
beings are free, and free to choose and change their utility functions as an act of free will.
In times of war, appeals to patriotism elicit large changes in consumer behavior.
Conventional micro theory is simply not equipped to analyze policy designed to change
utility functions. In times of gasoline shortage, how can we compare a price increase to a
request to sacrifice inessential car trips for the sake of your country? If consumers feel
pleasure in being able to contribute to the welfare of the country by sacrificing personal
pleasures, and such changes can be induced by policy, should we analyze consequences
using pre-policy utility functions or post-policy utility functions? How can we do a cost
benefit analysis of policies designed to induce changes in utility? Consumer Sovereignty
assumes that utilities are given a priori and consumers choose on the basis of these
preferences. Empirical evidence shows that utility functions and preferences are
constructed on the basis of sequences of choices to some extent. If preferences can be
manipulated by manipulating the sequence of choices faced by consumers, consumer
sovereignty cannot be maintained and welfare implications of policies must take this into
account. Another problem with consumer sovereignty is issues like smoking and obesity,
both of which suggest that consumers can make choices against their own best interests. It
is impossible to state such problems within the extremely restrictive current economic
paradigm. Here again, our lexicographic model is useful in that we would expect the basic
needs function U(.) to be free of these problems, while the second component V(.) would
be more likely to be subject to the types of problems discussed here.

Dropping consumer sovereignty, as proposed above, has drastic consequences. If
utility functions are malleable, if they can be changed by acts of free will or by social
conditioning, or if there are significant externalities in the utility functions, the central
idea of modern economic theory no longer remains valid. It is no longer the case that
the market mechanism has any special claim to efficiency or any distinction as a
reasonable way of allocating resources within a society.

Multiple equilibria are ubiquitous in complicated games. This is another place
where current methodology impedes research by ignoring free will and treating humans
as physical particles with determinate laws. In line with current methodology one line of
research looks into prevailing social norms as a means of determining which of the
equilibria will emerge. Taking free will into account will introduce some indeterminacy.
Even more interesting is the possibility of social engineering. Very likely a talk on the
virtues of sacrifice for others would induce cooperative outcomes in a Prisoners
Dilemma, while a discussion of the rationality of selfishness would induce the noncooperative
outcome. If this is true, it would lead to important theoretical and practical
consideration currently outside the self-demarcated field of study for microeconomics.
The traditional escape from the complex problems sketched above is the
positive/normative distinction, grounded in the empiricist tradition. We merely attempt
to describe observable behavior in the economics domain, leaving the deeper
understanding of the human motivations to psychologists. However, if deeper
motivations affect choices in the economic realm in predictable ways, and the value of
our study of economics depends critically on its impact on human welfare, we cannot
afford to be ignorant of these aspects of human behavior. The analytic-synthetic
distinction of logical positivists was shown to be invalid by Quine (1982). The
positive/normative distinction is similarly invalid. A policy to give small plots of land to
peasants was under consideration in Italy at the time of Pareto. A positive implication of
the policy is that the rich landlords will have less property (and hence reduced
consumption streams?), while the peasant have more. Another positive implication is
likely to be that peasants health and longevity will improve. The act of choosing to
present the first implication and not the second at sessions deliberating this policy
change is a normative one. Any economic policy will impact on thousands of lives and
have very complex positive consequences. Selection of a salient set of consequence, or
a summary, will always be a normative act, guided by ones feelings as to what is
important and what is not.

  1. A Pot-Pourri of Research Problems

Armed with the tool of the lexicographic utility function, we can re-examine nearly
all existing topics in current micro and macro economics. Thus the frontier for research is
vast. Below we pick a small set of interesting issues which arise most directly.
Catering to the proclivities of my own training as a neoclassical economist, let us
begin with the theoretical foundations. Would there be an equilibrium in an exchange
economy which could be supported by prices? The answer is no. Consider a two person
economy where one is poor and the other is rich. For arbitrarily small amounts of bread
(or necessities) the rich man can get arbitrarily large amounts of nonessential
commodities which the poor man may be endowed with. This leads to possibility of
“exploitation,” a word which has no meaning in conventional economics. The
desperately unfair deals that hungry men will accept are graphically portrayed in Grapes
of Wrath, a depression era novel by Steinbeck (1997). In standard economics, all
exchanges voluntarily agreed to by both parties are equally “fair” – both parties must
gain by such exchanges, and it is impossible to compare the two gains to see which has
gained more. In our model, the rich can exploit the poor due to their more exigent
needs. The Marxist model of capitalist exploitation of laborers can be studied within a
neoclassical framework using the lexicographic utility functions.

Applying lexicographic utilities to trade theory yields a new argument against free
trade. Consider an agricultural economy consisting of peasants and a few rich landlords.
In autarky, there is enough food for everybody. With free trade, the landlords will
export food and other agricultural products, and import luxury goods. The price of foods
will rise, and the quantity consumed domestically will fall, leading to the possibility that
starvation/hunger will increase among the peasants. This will lead to a Pareto (L)
inferior outcome from free trade. Of course, the increased price of food should translate
in higher wages for peasants, offsetting the price rise to some extent. But there is also
the possibility that using the additional leverage of the hunger of the peasants, all
surplus could be extracted by the landlords, so that there is no wage increase. A lot will
depend on the details of how we model the situation, but there are many more
possibilities than exist under conventional models.

It seems clear that the market mechanism is unfriendly to the poor, and will lead to
inferior outcomes. Our model provides a clear theoretical basis for social welfare
programs of the type implemented in Europe, and to a lesser extent USA. Sen (1986) has
suggested that it is these programs which have eliminated famines in Europe over the past
century or so. The lexicographic functions will impact on taxation policy, and provide
support for negative income taxes and numerous other pro-poor policy initiatives. Cost-
Benefit analysis of projects would require separate examination of the impact of project
on the poor and on poverty to be valid in the proposed utility framework. Thus our
proposal creates a theoretical basis for something which is widely agreed to, and is being
carried out in many cases using informal and atheoretical apparatus.

  1. Conclusions

A very minor change in a technical axiom (continuity of preferences) leads to model with strikingly different features from that of the conventional micro model. If nothing else, this demonstrates how non-robust the main features of conventional economics are. A similar conclusion of non-robustness emerges from game theory, where outcomes of games are very sensitive to minor changes in structure, strategies and payoffs. This non-robustness all the more damning since economic methodology pays very little attention to human behavior and sources of human welfare. It strikes me as astonishing that an economist can sit in a closed room and demonstrate the optimality of free trade by drawing lines on a board, without any reference to history or understanding of motivations and goals of human beings. Without a more solid empirical grounding, how can we select among a large class of alternatives with  radically different implications?

Our proposed alternative utility model is based on a set of implicit assumptions which are worth bringing out here. We believe that the welfare of the rich correlates much less with their absolute wealth and much more with their relative standing in society. This makes economic striving into a rat race, where everybody strives to get ahead but net gain to society is zero among the wealthy. This belief is strongly supported by a variety of empirical evidence (Frey & Stutzer 2002, and references cited
there). If this is true there is not much point in trying to increase the size of the pie, at least for the wealthy people in the economicy. Instead, welfare would be increased by
teaching people to be less competitive and materialistic. The situation is very different for the poor. We should not be teaching spirituality to the estimated 800 million hungry
when 1/3 of the US population suffers from obesity. The means and resources are
available to eliminate hunger in the world, but economists have never espoused this
cause. They have been enthusiastic supporters of pro-market reforms and free trade, but
rarely of income re-distribution. We believe that this is partly due to the theoretical
blinders that we grow up with. Our central model does not allow us to perceive poverty
and hunger, and therefore professional economists do not pay these issues the attention
that they deserve. We believe that the lexicographic model has the potential of bringing
poverty to the attention of the economists in a framework with which they are
comfortable. The axiomatization of poverty has the potential of bringing poverty to the
center of economic discourse, much as probability became a respectable area of
mathematics after it was axiomatized by Kolmogorov (1950). Substantial disagreements
can exist regarding why poverty exists and how it can be removed; we do not intend to
advocate any particular framework over others here. We do believe that poverty and its
removal is the central problem that economists should be concerned with, rather than
the tangential issue it currently is. We hope that the framework proposed may prove to
be a means of moving in that direction.

Refrencess

Frey and Stutzer, (2002) “What Can Economists Learn from Happiness Research?”, Journal of
Economic Literature, Vol. 40, No. 2, June 2002.
Kahneman, D., and Tversky, A. (1985) “Prospect Theory: An Analysis of Decision under Risk”,
Econometrica 47, March, pp. 263-291.
Kolmogorov, A. N. (1950) Foundations of the Theory of Probability, Chelsea Publications, New York.
Kuhn, T. S. (1996) The Structures of Scientific Revolutions, University of Chicago Press, Chicago.
Malthus, T. (1798) An Essay on the Principle of Population, as it Affects the Future
Improvement of Society with Remarks on the Speculations of Mr. Godwin, M. Condorcet,
and other Writers, St. Paul's Church-Yard, London.
Quine, W. V. (1982) Methods of Logic, Harvard University Press, Cambridge.
Samuelson P. A. and W. D. Nordhaus (2001) Economics, McGraw-Hill Education, London.
Sen, Amartya (1986) Poverty and Famines: An Essay on Entitlements and Deprivations,
Clarendon Press, Oxford.
Simon, H. A. (1982) Models of Bounded Rationality, MIT Press, Cambridge.
Slutsky, E. (1937) “The Summation of Random Causes as the Source of Cyclical Processes”,
Econometrica, Vol. 4, 1937, p.105-46.
Smith, Adam (1904) An Inquiry into the Nature and Causes of the Wealth of the Nations,
Methuen and Co., Ltd, London.
Steinbeck, J. (1997) Grapes of Wrath, Penguin Book, New York.
Tawney, R. H. (1926) Religion and the Rise of Capitalism: a Historical Study, Harcourt and
Brace, New York.

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