ISSUE #1

Journal of Economics and Philosophy

econo mics & science

03 / 10

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Copyright for articles belongs to the respective author. All views expressed herein are those of the authors and do not necessarily reflect the views of the editors or sponsors. All other work, published in the journal, is provided under the terms of Attribution-NonCommercial-ShareAlike 3.0 Unported Creative Commons License (http://creativecommons.org/licenses/ by-nc-sa/3.0/deed.en). The Transatlantic Journal waives the condition of attribution. All correspondence or complaints should be adressed to the editors: The Transatlantic Journal LSE Philosophy Society c/o LSE Students Union East Building Houghton Street London WC2A 2AE United Kingdom

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This journal is a publication by students from several universities, the Philosophy Society of the LSE Students Union, and the Columbia Economics Society.
LSE Students Union Columbia Economics Society LSE SU Philosophy Society

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the team transatlantic

Editorial Board: Leoni Linek (University of York, Columbia University), Editor Jakob Schaefer (London School of Economics), Co-Editor Felix Holler (Academy of Visual Arts Leipzig), Editorial Design, Cover Alina Lipcan (Oxford University), Corporate Relations Liaison Ronan Bligh Sato (Oxford University), Special Events Coordinator Eva Leung (London School of Economics), Institutional Support Officer UK Alexander Frantzen (Columbia University), Marketing Director US Josephine Fogden (Cambridge University), Marketing Director UK Rayna Coulson (London School of Economics), Copy-Editor Simon Fuchs (University of York, York University), Web Marketing and Development Peer-reviewers and proofreaders: David Abramsky (Kings College London) Jaiseung Bang (Columbia University) Philip Crone (Columbia University) Claire Field (Kings College London) Felipe Goncalves (Columbia University) Hans Martin Hermann (Shanghai International Studies University) Yuh Yiing Loh (Oxford University) Eleonora Paganini (University of Edinburgh) Luca Uberti (Kings College London) Justin Vlasits (Columbia University) Nicholas Evans (Kings College London) Zhi Hui Ho (Oxford University) Hannah Wilkinson (Oxford University)

When the recent financial crisis shook the world economy, students beliefs in economics in economic theory and economics as a science were out of balance, too. Many of us felt that they could not just carry on business as usual. There was a need to come together and discuss. But how do you discuss with people all over the world? Students in London and New York connected, and the idea of a transatlantic journal dealing with Philosophy & Economics was born. Soon students at Cambridge, Oxford and even Shanghai got involved, and The Transatlantic began taking shape. The aim was not to give consistent solutions to current economic problems but rather to foster debate about economics in a not merely technical, but, instead, in a philosophical way. We did and do not wish to approach economics from the viewpoint that is so well known to undergraduate students: a perspective that mistakes economics for a mechanical

method. Although methods, particularly mathematical methods, are undeniably part of the field, economics is so much more than that. Whether mathematics is in fact crucial to economics and its scientific status is a question that Tony Lawson, mathematician by training and professor of economics at Cambridge University, investigates into (p.9). Sir Robert Skidelsky, best known for authoring a multi-volume biography of the economist John Maynard Keynes, is a prominent critic of the way economics is taught at universities and proposes a different approach to teaching (p.31). The Transatlantic is pleased to present their guest articles in this issue. The topics of the student submissions range from game theoretical approaches towards economics (p.39), discussions of rational agency (p.35), and questioning of current models of efficiency (p.21), to an inquiry into the practices of peer-review in science (p.15) and the elabo-

editorial
ration of an identity model, determining an individuals economic path (p.25). Emanuel Derman, formerly a Managing Director at Goldman Sachs, and now a professor of financial engineering at Columbia University, met with us in New York to talk about models, theories and the relation between physics and finance (p.42). The next edition of The Transatlantic will be on the topic Growth. If you would like to write an article on economic growth, accumulation of knowledge, demographic economics, the growth of the financial sector, or any other related issue, contact us at submit@thetransatlantic.org. Undergraduates, postgraduates and academics are welcome to write.

Jakob Schfer & Leoni Linek

con
2 4 8 14 20 24 the transatlantic team editorial economics & science is science too authoritarian? that morality overrides the profit motive to improve efficiency the role of identity and social networks for economic outcomes in poor countries

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30 34 38 42 50 whats wrong with economics? redefining rationality a conceptual structure for offensive and defensive strategy interview with emanuel derman call for articles

economics

& science
BY TONY L AWSON

Tony Lawson is Professor of Economics at Cambridge University. He has contributed in various areas including Economic Methodology, Heterodox Economics, Evolutionary Economics and Feminist Economics, yet his focus lies on Ontology, in particular on Social Ontology. Lawson is a mathematician by training and a severe critic of the way mathematics is used in economics. He has published in numerous journals and is author of the books Economics and Reality (1997) and Reorienting Economics (2003). A recent overview of his contributions can be found In Edward Fullbrooks recent edited collection Economics and Ontology: Tony Lawson and His Critics (2009). Lawson is a founder of the Cambridge Realist Workshop and the Cambridge Social Ontology Group and sits on various editorial boards including the Cambridge Journal of Economics.

t Many economists accept that the modern discipline of economics is not in a healthy state (see Lawson, 2003, chapter 1). Indeed with the onset of the recent crisis perhaps most now do (see Lawson 2009b). Many even connect the problems of modern economics to the question of science, the topic of this short note. Amongst those who do so, however, there are significant differences. Indeed there are essentially two opposed groups to be distinguished. The first comprises those who think that the problems with the discipline arise just because an economic science is infeasible, that attempts to render economics scientific are misguided; it is the concern to be scientific that leads economists astray. The second group comprises those who, in contrast, think that problems arise just because economics has yet to realize its full scientific potential.

damentally, both groups associate science with the use of mathematical methods. And their contrasting expectations concerning the possibility of an economic science primarily reflect different expectations

Most typically, in Modern econoMics, it is held that the successful prediction of events is central to science.
concerning the possibility of gaining insight using mathematical models. My contrary view is that the use of mathematics is irrelevant to the question of whether a discipline qualifies as science. Further, with a revised conception of science to hand, I do argue that a science of economics is entirely feasible, but I also contend that the current emphasis on formalism in modern economics mostly obstructs the potential of economics for realizing its potential as a successful science. I thus side with the first group in being optimistic about the possibilities of a successful economic science, but hold a contrasting conception of science. I side with the second group in thinking that the emphasis on formalism is unhelpful in modern economics, but do not suppose that giving up on formalism impedes the possibility of economics being scientific in the sense of natural science. Let me briefly elaborate. 9

the use of MatheMatics is irrelevant to the question of whether a discipline qualifies as science.
I also believe the parlous state of economics is connected to stances taken with regard to the question of whether economics can be a science. But my assessment diverges sharply from those of proponents of both sides of this debate, given the terms in which the latter tends to be cast. For, fun-

What is science? Of course, the practices of successful science (where the obvious exemplars of successful science are certain natural sciences) are multifaceted, and it is problematic to single out any one (set) as the, or even as a, defining feature. Nevertheless such singling out is frequently attempted. And most typically, in modern economics, it is held that the successful prediction of events is central to science. Prediction of events is an activity whose success presupposes the existence of event correlations, that is, regularities of the form whenever event x then event y. Notably, such regularities, where they occur, do lend themselves to mathematical formulation. And indeed the widespread reliance upon methods of mathematical deductivist modeling in economics presupposes their ubiquitous occurrence in the social realm.

The most obvious observation to make here is that outside astronomy most of the event regularities regarded as of interest to natural science (and so facilitating of significant successes at event prediction) are restricted to conditions of well-controlled experiment. The point here is that it is more or less only in the latter experimental scenario that the predictionist world view even appears to hold up. Yet successful natural science is hardly restricted to situations of experimental control. Even so, the predictionist might contend that the controlled experiment is the most fundamental feature of successful (natural) science and so the fact that the preferred conception of science (based on successful prediction) fits here is sufficient to regard it as defining of science. There are various problems with such reasoning, but for now let me point out that even the situation of the well-controlled experiment, properly understood, provides relative support to the causalist account of science. That is, even the scenario that prima facie most lends support to the predictionist account, ultimately actually supports the causalist interpretation. We can see that this is so as soon as we question why it is that event regularities are mostly restricted to situations of experimental control. The only tenable explanation of this phenomenon of which I am aware is that in well controlled experiments, stable underlying causal mechanisms are insulated from countervailing causes, so that their unimpeded effects can be straightforwardly identified. Thus objects fall with a constant rate of acceleration in an experimental vacuum, because aerodynamic and other causal forces are prevented from affecting the outcome. So experiments, too, are primarily concerned with underlying causal factors. The point of the experiment is precisely to insulate and thereby empirically identify stable causal mechanisms. The event regularity that is successfully produced (when it is) correlates the triggering of a causal mechanism with its unimpeded effects. But these causal forces typically continually operate even when countervailing tendencies are in play, as is the case outside the experiment. Gravity is operating on the objects now on my desk as much as it would be if the objects were dropped in an experimental vacuum. In other words, the understanding of causal mechanisms (that can be backed up by experimental investigation), allows us to manipulate or anyway trigger those mechanisms outside the experiment, where event regularities typically do not hold. A medicine may work to aid my recovery even

instead of existing in isolation alMost all social phenoMena are in fact constituted in relation to each other.
Whatever science may be, I want to suggest that this association of it with successful prediction is misplaced. If there is a defining moment or feature of science, I want to suggest that a more sustainable contender is causal explanation. By this I mean the move from a conception of some event or phenomenon of interest to the identification and understanding of an underlying causal factor that (in part at least) produced it. It is the move from, say, symptoms of an illness (such as a high temperature) to the underlying cause making the difference (say a virus). It is the move from, say, observing cows manifesting the symptoms of mad cow disease in the UK in the 1980s, to identifying the prion as the cause. Notice, that causal explanation is a step that typically cannot be reduced to mathematical manipulation. For it typically involves a conceptual move from phenomena of one type to a cause of a quite different (and perhaps previously unknown) type. Causal versus predictionist accounts of science Though I cannot elaborate very much in a short note such as this, let me at least indicate why I take the causal conception of science to be a more reasonable account of what goes on in science than the more familiar predictionist conception. 10

Gravity, for example, does not reduce to and cannot be directly read off from the path of the autumn leaf, even thouGh it influences the latter.
if I simultaneously drink too much alcohol, say, or receive bad news, where the latter may work to make things worse. A knowledge of gravity can be used to build bridges and send rockets to the moon. My contention, then, is that if there is an essential moment in natural science it involves identifying and understanding causes of phenomena of interest. The practice of successful event prediction, and any attendant mathematical reasoning, may aid this process where it is feasible, such as in conditions of experimental control, but is not an essential feature. Of course, although science is my topic here, it is important not to be too concerned with the question of the possibility of economics as science per se. Far more important, ultimately, is the value to us of knowledge obtained by whatever route. As it happens, an understanding of causal mechanisms, for example of diseases, is what is typically required for helping us make the world a better place. Understanding the working of mechanisms that cause symptoms of illness allow us very often to intervene and provide an antidote to the problems that befall us. It is of course in large part just because causal understanding is so useful in helping us transform the world that causal explanatory practice is so central to science. 11

The Social Realm What bearing does any of this have for disciplines such as economics concerned with the study of social phenomena (where by social phenomena I mean those whose existence necessarily depends at least in part on us)? I want first briefly to indicate that on the causalist conception of science, the study of social phenomena can after all be scientific in the sense of natural science. I have already indicated that the application of mathematical formalism has no essential bearing on the issue. It seems, rather, that a condition of any discipline that is to qualify as a science, according to the causalist conception, is that the objects of study be structured. By this I mean that the relevant domain of reality is not wholly given in appearances. It is structured in the sense that there are underlying causal mechanisms working to bring about the phenomena of experience. Gravity, for example, does not reduce to, and cannot be directly read off from, the path of the autumn leaf, even though it influences the latter. Similarly, it seems clear enough that social phenomena are not reducible to the actualities of experience. In particular, social structures do not reduce to the practices they facilitate. Consider social rules. Certainly they bear on human practices. But in many countries, motorists on motorways, for example, mostly drive faster than the local legal speed limits, at least until a police car arrives on the scene or speed cameras are spotted. Workers in the UK carry rule books and threaten to work to rule when they are unhappy with prevailing conditions.

sitions, institutions and so on (see Lawson, 1997, 2003). The point then is that in principle a successful science of social phenomena, i.e., one concerned to identify and understand the causes of actual practices and outcomes of interest, is entirely feasible. Modeling social phenomena The successful prediction and/or mathematical modelling of social phenomena, however, seems less feasible. In the well-controlled experiment, event regularities are produced by way of isolating a stable causal mechanism from countervailing causes. These two conditions isolation and stability seem to be required if event regularities are to be systematically guaranteed. Yet such conditions are likely to be rare indeed in the social realm. Of course whereas experimental natural scientists work laboriously to achieve the isolation of a relevant intrinsically constant mechanism, economic modelers effectively, if somewhat optimistically, assume that such isolations of intrinsically constant causal factors occur quite spontaneously in the social realm, and indeed are even ubiquitous. But there is little grounding to this optimism. Consider first the condition of isolation. Instead of existing in isolation almost all social phenomena are in fact constituted in relation to each other. It is easy enough in modern capitalism to see the internal relationality of markets, and money, and firms and governments and households, etc; all depend on and presuppose each other. But human individuals as social beings are likewise formed in relation to others. All slot into positions, where all positions are constituted in relation to other positions. Thus employer and employee presuppose each other, as do teacher and student, landlord/lady and tenant, parent and child, gendered man and woman, and so on. We all slot into, and are molded through the occupancy of, a multitude of such positions, deriving real interests from them, and drawing upon whatever powers or rights and obligations are associated with those positions. So social reality is an interdependent, network, it is an internally related totality, not a set of phenomena each existing in relative isolation. Consider too the requirement of stability. Once more social phenomena seem not to conform. For everything social is constantly being transformed through practice. Think of a language such as English. At any point in time it exists as a (largely unacknowledged) resource to be drawn upon in our speech acts and so forth. But through the sum total of all people simultaneously drawing on it in their

social reality is an interdependent network, it is an internally related totality, not a set of phenoMena each existing in relative isolation.
Such considerations reveal an ontological gap between social structures (in this case social rules) and the practices that they facilitate. It is possible for the social scientist to identify rules, customs or norms, etc., by observing practices, especially on critical occasions. However, the practices cannot be reduced to these norms and so forth; social reality is structured. Of course, underlying social structure includes not only rules, but also social relations, po12

speech acts, the language is (largely unintentionally) reproduced and in part transformed. It thus exists as a process, as something that is constantly being reproduced and transformed through practice. This is its mode of being; it is intrinsically dynamic and subject to transformation. But a moments reflection reveals that all social phenomena share this mode of being: universities, towns, pollution, society at large, each and every organization, our positions and their associated powers, our embodied personalities and everything else. So stability of social phenomena (which along with their isolation seems required to guarantee an event regularity) seems unlikely and certainly is something not to be taken for granted. We are now in a position, in fact, to understand just how economics has come to be in such a parlous state. Economists hope to be scientific in the sense of natural science. However they are influenced in this by a misconception of science. If science is the move from phenomena of interest to underlying causes then this move is a feasible in economics as in natural science. However, in some special cases natural scientists can successfully carry out controlled experimentation. In such conditions, event regularities may be produced in the course of their evaluating a theory about an underlying causal mechanism. Economists, though, have typically not only restricted their focus to this special case, but also universalized the wrong aspect of it. Instead of seeing the central moment as furthering our understanding of some underlying causal mechanism, economists have focused on the experimental production of event regularities. And they have generalized this inessential feature of science to a context, namely the social realm, where typically the conditions are such that event regularities do not occur. Thus although a science of social phenomena remains entirely feasible the reliance on methods of mathematical modelling in economics, presupposing as it does a ubiquity of even regularities, mainly serves as an obstacle to the disciplines realizing its scientific potential (for a more positive elaboration of how an explanatorily successful economics can be realized see Lawson, 2009a, 2009b).

natural scientists. The latter, after all, do regularly achieve success in advancing human understanding. A less laudable justification is to pose as scientists merely in the hope of acquiring a certain status in society. Whichever of these or related motives is most pervasive in modern economics, the conception of science as necessitating the use of mathematical methods is mistaken. I have suggested instead that a causal conception of science is far more tenable. If the latter is accepted then economics can indeed take its place as a science in the sense of natural science, though, given the nature of social material, the current emphasis on formalism obstructs this outcome, and will have to be abandoned if a science of, or indeed any explanatorily useful, economics is to emerge. t

econoMists have generaliZed this inessential feature of science to a context, naMely the social realM, where typically the conditions are such that event regularities do not occur.

Bibliography Lawson, Tony (2003), Reorienting Economics, London and New York: Routledge Lawson, Tony (2009), Applied Economics, Contrast Explanation and Asymmetric Information, Cambridge Journal of Economics, (Special Issue in honour of Brian Reddaway), 33:3, May pp. 405-20 Lawson, Tony (2009), The Current Economic Crisis: its Nature and the Course of Academic economics, Cambridge Journal of Economics, 33:4, July, pp. 759-788.

Final Comments If there is a laudable justification for emphasis of mainstream economists on using mathematical formalism, it is the desire to be scientific in the sense of

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too authoritarian ? an economics of science perspective

BY CHRISTOPH SIEMROTH 14

is

science

While acclaimed scientists receive most of the attention, evidence suggests that it is their younger and still unknown colleagues who make the most significant contributions to science, thus challenging the quest for truth. Anarchy in science a suitable response?

Introduction t In what follows I shall investigate a potential shortcoming in the current system of science, namely that a strong reliance on scientists with reputation crowds out young scientists work. I present empirical evidence which establishes that (1) young scientists are more productive and that (2) well known scientists get a disproportionate amount of credit and attention. Hence, the status quo is an inefficient allocation of attention and resources that may inhibit progress. In order to correct the bias in favor of reputation rather than merit, I then consider a system of science that does not rely on authorities at all. This logical alternative, however, is refuted on grounds of high information costs. Therefore, in order to mitigate the problem, we have to improve the current institutions rather than overturn them.

Another feature of todays science structure is the peer-review process. The idea is that experts (authorities) assess the work of their peers and if deemed sufficiently innovative, correct and presentable accept it for publication in their journal. In effect, peer-reviewed journals monopolize1 access to scientific discourse, for everyone expects significant contributions to be published there. Potential Problem #1: The Input of Young Scientists is Undervalued Young scientists are more productive than older ones, or, phrased differently, scientific productivity fades with age2. Levin and Stephan, for example, investigated publishing activity of scientists over their life-cycle and concluded that productivity diminished with age in 5 out of 6 disciplines, even after controlling for factors like ability or motivation (Levin and Stephan 1991). Further evidence is given among others by Diamond and Kanazawa. The latter examined a random sample of scientists from the 16th century to the present (consisting mostly of male scientists), which also included the year of their most significant contribution to science, i.e. the peak of their career (Kanazawa 2003). He found that, in general, productivity undergoes a sharp rise at the very beginning of scientists careers, peaks around the age of 30 and then declines continuously. Most scientists (65%) have made their most important contributions before their mid-thirties and 80% have done so before their early forties (Ibid., pp. 25860)3. See also figure 1. If recognition is only given to scientists with reputations (i.e. older ones) or if attracting research funds is dependent on reputation (while funds are often a prerequisite for research in order to build a reputation), then we have a problem. For in this case, the high productivity and creativity of young scientists would be inhibited and their ideas suppressed or delayed. In economic terms, the allocation of funds and credit (which is one of the major incentives for scientists) would be inefficient. Consequently, the input of young scientists may be undervalued when publications are not exclusively rated on grounds of merit, but perhaps by the authors 15

it is usually acclaiMed scientists who influence public opinion or deterMine the future course of a scientific discipline.
Science Today: Authorities by Reputation and the Peer-Review Process There are a few acclaimed scientists who have a huge influence in their peer group and even on the public. If they publish an article, people read it not because of the content, but because of the authors name. The public follows them not because of the merits of their arguments (often few can comprehend them), but because they are perceived as authorities. It is usually these scientists who influence public opinion or determine the future course of a scientific discipline. Hence, it seems authorities are still a part of science today, for example as spokesmen of a school of thought or as a bridge between science and the public.

Figure 1: age (x) productivity (y) profile among 280 scientists, source: Kanazawa (2003)

Mean = 35.4 Median = 34.0 IRQ = 12.0

Unfortunately, the inherent mechanism of the attention-award system may be flawed. Scientists with past success get attention, because their peers seem to infer that this warrants future success. Yet, the previous section presents evidence to the contrary, namely, that (on average) significant contributions to science are less likely with older age. If we factor in the Matthew Effect in the age-productivity profile from above, then young scientists should be even more productive (relatively), given that they have less funding and opportunities at their disposal. In light of this, an excessive focus on acclaimed scientists may not necessarily be a good thing, for it crowds out other scientists work even if it has equal merits. The consequence is a distortion of incentives and scientific discourse, which in turn might delay progress.

Figure 1: age (x) productivity (y) profile among 280 scientists, source: Kanazawa (2003)

name. In the following section it is argued that reputation is indeed given a lot of weight in allocating attention or attracting research funds, thus making the aforementioned concerns plausible. Potential Problem #2: The Matthew Effect Merton learned from interviews with Nobel laureates that there appears to be a misallocation of credit in science; those who are already well-known are given more credit than would be adequate purely judged on merits (Merton 1968). He coined the Matthew Effect, which describes the phenomenon that the rich get richer, or in this context, the recognized get more recognition. When, for example, a Nobel laureate co-authors a paper with unknown scientists, then it seems that readers do not just associate the paper with his name, but seem to think the others were mere bystanders and the laureate contributed most to the content, even if this was not the case. This leads to cumulative advantage4 and the already famous get even more recognition due to their popularity. The effect is further strengthened by the fact that research funds are mostly allocated according to reputation in the peer group. Hence, the already acclaimed get more funding, which provides them with more research opportunities, which in turn add to their reputation. Moreover, given time constraints and the increasing number of publications, the readers selection of articles is, to a significant part, based on author identity. This is one of several reasons why there is a good chance that even good work from unknown scientists goes unrecognized (Ibid., p.59). 16

in order to extinguish biases caused by reputation or coercion, everything would be published anonyMously, only with a nuMber for referencing. one Might call it anarchy in science.
Whats the Alternative? But what are we to make of this? Let us think drastically for a moment and consider the alternative in a binary choice between a system of science with authorities (status quo) and without authorities. Choosing the latter without the apparent cause of the inefficiency (authorities) , we could hypothetically establish a web-based platform, where anyone would (need to) publish his theories, ideas or data and anyone could criticize available publications. In order to extinguish biases caused by reputation or coercion, everything would be published anonymously, only with a number for referencing. One might call it anarchy in science, for reputations would be erased and previous authorities made equals among equals. In theory, the non-coercive force of the better argument would prevail in this unbiased environment of critical scrutiny. The problems from section 4 and 5 are evaded, but would it make science on the whole more productive?

Economic Justification of Status Quo Institutions It wouldnt. This is because it creates new problems such as lack of incentives and prohibitively high information costs. What follows is an argument in an intuitive form. The anonymity of the web-based system would prevent the association of an authors identity with his work. Hence, what may be somewhat inefficient in reality would be entirely impossible in the hypothetical system: the allocation of credit. With the prospect of earning glory and recognition taken away, science would lose one of its major incentives. Needless to say, it would be even harder to establish a meritocratic allocation of research funds and academic positions if scientists could not be linked to their work. In this respect, the current practice even with reputation bias is the lesser of two evils. The more severe consequence, however, is that every scientist would have to read everything that is published in his field himself. After all, there would neither be peer-reviewed journals nor authorities that pre-select articles on behalf of the reader. Scientists would not be able to actually do research, because keeping up with publications and telling fruitful from plain wrong would consume all available time. Giving up the input of others is not a satisfying alternative either, since science is far too specialized for that. Hence, a reputation system would reestablish itself because it is less costly. If I know someone to be competent which requires an evaluation of his work or competences then I can be reasonably sure that his recommendations (explicitly or implicitly via citations) of articles are somewhat reliable. If several of my trusted colleagues advance the same recommendation, then this might even be better than my own judgment, because I might miss something they dont. Now it does not require much fantasy to see the similarity of this rationale to the concept of the peer-review process. It is in fact its institutionalization; scientists that we consider to be experts review submissions and give us recommendations by filtering out the waste of time articles. Certainly, some of these still get in and worthy others may be denied access, but this is far superior to an anarchy where everyone is on his own and excellent work is drowned in a mass of mediocrity. Returning to the binary choice from above, we are led back to a system of science with authorities.

Conclusion Firstly, it seems that scientists at the beginning of their careers in general the most productive years do not receive as much attention as is warranted, because attention is allocated according to reputation, not merit, and reputation is an expression of past success, not future achievement. Key factors supporting this conclusion are (1) the robust empirical finding that productivity fades with age and (2) the Matthew Effect. Secondly, this diagnosis does not mean that we should overthrow the principles of the current practice of science altogether. As the thought experiment illustrated, we need authorities and it is cheaper in terms of information costs to rely on them. Instead, the focus should be on the specifics of a system of reputation and peer-review, answering questions like: How do we further reduce bias? Or, how many reviewers are optimal, given the tradeoff between accuracy of evaluation and delay of publication? t

Endnotes In the context of science, a monopoly does not just result in higher prices. Instead, referees might misjudge the merits of submissions or even intentionally serve their own agenda and turn down papers which break with their own theories. In other words, papers with merits might be suppressed by denying them access to scientific discourse. In the cases where the review process is not double blind, it provides room for favoritism. And even when peer-reviewing is done double blind, manuscripts are often published as discussion papers or presented at conferences earlier, in which case it is easy to find out the authors identities. Moreover, experts in a field are often able to recognize someones work from included citations, style etc. Substantiating this, Yankauer (1991) found that 39% of the authors in a double blind review-process were identified correctly by the referees in his sample. Therefore, even if double blindness is implemented, peer-review is not completely effective in preventing biases or distortions of scientific discourse. 2 Due to formal confinements I cannot investigate why this is so. Possible reasons include, among other things, that older scientists are more dogmatic, less creative or have more administrative responsibilities than their younger colleagues. Also see next footnote.
1

17

It should be noted that Kanazawa (2003, pp.265ff.) provides an evolutionary psychology theory, which can explain the data. More importantly, it explains why female scientists seem to have a more even age-productivity profile than men (economic human capital models, on the other hand, do not distinguish between the sexes). Since his data almost exclusively consists of male scientists, the overall profile looks like the male scientists age-productivity profile. However, this might change because the proportion of female scientists is on the rise. Thus, considering all scientists, the effect of productivity fading with age might weaken in future. 4 Allison and Stewart (1974) provide empirical evidence for accumulative advantage based on quantitative analysis of cross-sectional data, in addition to the qualitative data from interviews used by Merton (1968). t
3

Bibliography Allison, P. D. & Stewart, J. A. 1974. Productivity Differences Among Scientists: Evidence for Accumulative Advantage. American Sociological Review 39. 596606 Diamond Jr., A. M. 1986. The Life-Cycle Research Productivity of Mathematicians and Scientists. Journal of Gerontology 41. 520-525 Kanazawa, S. 2003. Why Productivity Fades With Age: The Crime-Genius Connection. Journal of Research in Personality 37. 257-272 Levin, S. G. & Stephan, P. E. 1991. Research Productivity Over the Life Cycle: Evidence for Academic Scientists. American Economic Review 81. 114-132 Merton, R. K. 1968. The Matthew Effect in Science. Science 159. 56-63 Yankauer, A. 1991. How Blind Is Blind Review? American Journal of Public Health 81. 843-845

Christoph Siemroth is reading Philosophy & Economics at the University of Bayreuth, Germany. He has previously studied at the University of Helsinki, Finland.

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This is you.

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that morality overrides the profit motive to improve efficiency

So-called neoliberal economic assumptions of private property, competition and the profit motive are established to increase utility and efficiency. However they are morally bankrupt and only benefit a small elite, leaving most people in poverty. An impeachment.
BY ROY MOORE

t In this essay, I will question the efficiency of modern economics, particularly that of the prevalent neoliberal economics, focusing specifically on the efficiency of competition, the profit motive, and private property. Subsequently I will critique that view by adding a moral constraint to show that efficiency solely in terms of markets and financial profit alone does not benefit society generally, but rather promotes an increased wealth for a minority, often at the expense of the majority. The Right to Life Much of the following argument is based on an important assumption, that the right to property is secondary to the right to life. Life precedes property, for no-one can own property without first owning their life. Though property rights are often considered to have developed out of the need to hold personal possessions, to consume that necessary to sustain life, the permanent right to an exact possession in modern law has evolved, often superseding the right to life, as later shown. What follows from this is a new definition of profit. Throughout I will contrast the monetary definition of profit with a long-term social profit based around economics working for people rather than people working for economics. This new form of profit is based on the above assumption and sug20

gests that efficiency isnt just of monetary value, but must account for the inalienable right to life of each person. This difference is pivotal in understanding the inefficiency of the profit motive, competition and private property, as although it may be possible to bring about greater nominal wealth, it is inefficient, according to measures of inalienable rights, to concentrate wealth in the hands of a minority: this social definition of profit, then, is the practical application of the right to life superseding property. Profit and the Profit Motive Perhaps the most popularized argument for the free-market is that while the capitalist intends only his own gain... he is... led by an invisible hand to promote an end which was no part of his intention (Smith 1976, p.477). It is, however, also important to note Smiths concern for the capitalists greed, as All for ourselves, and nothing for other people, seems, in every age of the world, to have been the vile maxim of the masters of mankind. (Ibid., p.437) Though considered the founder of modern economics, Smith noted the threat of an unchecked and individualistic profit motive, arguing that markets do not always correct themselves; some control is necessary to protect the market from monopolies and other vested interests. Many liberals consider self-interest as rational or part of human nature. Since, in the formulaic

statistical approach of micro and macro economics, utility is often considered no more than self-interested financial gain, promoting monetary interests over others. With such assumptions of human nature, the inevitability of competition in producing both winners and losers leads those winners to logically strengthen their own position, creating a kind of superstructure perpetuating little but their own success. We must, therefore, question the purpose of such assumptions, and it is here that John Ruskin notes the effects of such economic principles, writing that profit in economics is a zero sum game: for every buyer, there is a seller; one receives only what another gives.

instead of an invisible hand gently pushing towards the benefit of everyone, coMpetition leads to an inequality which is Much More of a vivid slap in the face for that Majority born into poverty.
If the art of making money is to take all you can from the buyer perhaps You sold your bread well today: [but] was it to a dying man who gave his last coin for it and will never need bread more...? (Ruskin 2007, p.44) Thus, a brief history of how such developed countries financed their industrialization usually reveals some form of slavery, colonialism or coercion. Thus, while this means profit becomes the general maxim to Buy in the cheapest market and sell in the dearest, it seems that such financial profit usually comes at a social cost not factored into traditional economic accounting: Charcoal may be cheap among your roof timbers after a fire, and bricks may be cheap in your streets after an earthquake; but fire and earthquake may not therefore be national benefits. (Ibid., p.44) It is not difficult to see, then, how the art of profit is often the art of exploiting others, and economics without such moral constraint leads to such violations of humanity, to the point at which: ...the pluses, make a very positive and venerable appearance in the world, so that everyone is eager to learn the science which produces results so magnificent; whereas the minuses have, on the other hand, a tendency to retire into back streets, and other places of shade, or even to get themselves wholly and finally put out of sight in

graves: which renders the algebra of this science peculiar, and difficulty legible; a large number of its negative signs being written by the account-keeper in a kind of red ink, which starvation thins, and makes strangely pale, or even quite invisible ink, for the present. (Ibid., p.79) With such self-interest the capitalist may still, as Smith notes, benefit society. He argues that the farmer, butcher and baker all act in their own selfinterest but still provide a service to society, a better organization through the division of labor. Though such externalities do benefit society, Ruskin notes those negative externalities which are often forgotten, products and occupations which damage society, and the majority who suffer due to the distribution of such goods. Ruskins hypothesis, then, seems ever more correct the wealthier society becomes; despite increasing wealth, poverty and inequality continue to grow: in 1830, the ratio in average per capita income was three to one, in 1960 sixty to one, and in 1997 seventy-four to one. (Risse 2005, p.349). Competition The incentive and practicalities of making money can only exist in some sort of competitive framework. It is important to note, then, that those who finish first in any competition do so only in relation to those who finish second and third respectively. As results are found and winners receive their prize, their position is strengthened and thus their ability to reinvest with greater capital, gain greater mar-

John Ruskin

21

ket share, or extract more marginal product from employees. In this framework, Ricardo defines the natural rate of wages as that which maintains the laborer, but Ruskins appeal to morality shows that profit for the capitalist does not mean gain for all. Instead of an invisible hand gently pushing towards the benefit of everyone, such competition leads to an inequality which is much more of a vivid slap in the face for that majority born into poverty. Ruskin thus changes the priorities of economics, noting that Twenty people can gain money for one who can use it; and the vital question, for individual and for nation, is, never how much do they make? but to what purpose do they spend? (Ruskin 2007, p.85) Where Ricardo defines the natural rate of wages, Ruskin questions the very purpose of natural; what is natural for Ricardo, according to such economic theory, is that which serves his interests. If seeing laborers as mere tools in their factory and keeping a multitude in poverty for cheap labor is beneficial, then it is natural according to such a view. It makes economic sense, therefore, for even those working in healthcare to test banned drugs on children1 with falsified documents to support ethical consent, and to make their own product appear more effective by lowering the recommended dose of the control drug to patients, even if this leads to the disablement and death of children (Ahmad 2001). The entire relationship between capital and labor, then, between those who won the competition and those who have nothing, is based on a power struggle of exploitation. Without balance, one dominates the other, their interests effectively determining the life of the other. Until each person has an inviolable right to life, such exploitation can only continue. Where such exploitation exists, no inviolable right to life does so.

Private Property What follows competitive markets is inequality, but what permits the legality of the extreme inequality today is the institution of private property. Permanent property rights allow one person the legal right to choose to withhold even the means to life. Once we take our first assumption, however, the right to life is above property rights requiring a more just distribution. Even Nozicks Entitlement Theory, ultimately driven by property rights, acknowledges this priority; a point which when properly expounded erodes propertys permanence to agree with our assumption: an owners property right in the only island in an area does not allow him to order a castaway from a shipwreck off his island as a trespasser... the theory does not say that owners do not have these rights, but that the rights are overridden to avoid some catastrophe. (Nozick 1974, p.180) Consequently, in moderate scarcity should one person not have justly acquired enough property for their own consumption while another has justly acquired more than they can consume, some distribution seems to be required to avoid such catastrophe: the owners right to deny a person those means of life is overridden because of a greater need. It is this acknowledgement, that need is greater than property, which demands redistribution for the sake of social justice, particularly for those who have been born into poverty cycles and who had no choice in their acquisitions. In this sense, the efficiency of economics is judged by its ability to fulfill those obligations of social justice, rather than being a summary of collective wealth by GDP, PPP or some other average statistical measure.

here

is the conflict: where once, as ruskin argued, profit had a purpose, Money was a Means to an end, now it is the end.

22

When life precedes property, it becomes logical to conclude that distribution follows need. It is not a far stretch from here to the familiar slogan From each according to his ability, to each according to his need (Marx 1970): only those who have can provide the resources, only those with need will receive; anything else is unjust, an inefficient catastrophe. In this vein Proudhon declares Property is robbery! (Proudhon 1904, p.3) as it denies what is the right of those who need it. The problem is not scarcity, as there is enough food despite a 70% global population increase, as calories per person has increased 17% (FAO 2002). That the required redistribution cannot legally occur without the consent of the owner is due to the institution of private property. Economics as Morality Effectively, the debate is reducible to one thing: purpose; for what purpose are modern economic assumptions established as law? The answer is fairly clear given the historical basis of the evolution of power, that even voting rights, for example, were subject to conditions of property ownership. Competition, private property and the profit motive all serve the interests of a minority who won the competition and thus consolidate their wealth and power. Almost all of these are from those developed countries, creating a system of control, whereby entire nations of people are classed as first, second, or third world, according to their respective wealth, where two people from different economic situations are considered alien to each other based solely on statistics. Such definitions show the bankrupt morality of such principles. Perhaps this stems from the evolution of economics as a separate subject. The etymology of economics derives from house, meaning there was no clear distinction made between household management and the economy, or between politics and economics, or between economic theory and moral philosophy. (Holloway 1992, p.160) When separated from the political realm, as Holloway argues occurred in the transition from the Feudal to the Capitalist system, the end goal of economics becomes monetary gain. Instead of that transition leading to greater freedom, only greater poverty and inequality have been achieved; as capital and labor became free, masters could search the globe for cheap labor, rather than being tied to any particular serf. Within such extreme inequality, justice, fairness and even the right to life have been lost. But if we remove the partiality of those who establish profit motives for their own ends we are left with the conclusion that all people are equal, that life is worth more

than property, and we gain a purpose for wealth beyond the frivolous and useless consumption of scarce resources (Smith 1976, p.437). With growing poverty and inequality it is surely becoming more and more necessary to challenge these assumptions of neoliberal economics to stop, perhaps, the greatest injustice in the history of mankind. If the purpose of economics is in the accumulation of money we have our methods. If, however, we finally see the moral imperatives in repatriating economics with other disciplines we find a new rationality and efficiency. Where we finally accept the inalienable rights of each person we allow ourselves the chance to recreate our world and fashion society in a manner fair for all. The next step in economic evolution is with us: either we continue to reap the benefits of the suffering of so many, or we find those moral imperatives and create our own purpose, to change the course of economics and the lives of millions of people worldwide. t

Endnotes
1 Children are defined as those aged below five years old, thus the statistics are greater if children aged between five and sixteen are included. (You et al 2009)

Bibliography
Ahmad, K. 2001. Drug company sued over research trial in Nigeria. The Lancet, Volume 358, Issue 9284. 815 Food and Agriculture Organization (FAO), International Fund for Agricultural Development & World Food Program 2002. Reducing Poverty and Hunger: the Critical Role of Financing for Food, Agriculture, and Rural Development. http://www.fao.org/ docrep/003/Y6265e/y6265e00.htm, accessed on 03/02/2010 at 20:04. Holloway, J. 1992. Crisis, Fetishism and Class Composition. Open Marxism: Volume II, Theory and Practice. London: Pluto. Marx, K. 1970. Critique of the Gotha Programme. New Ed. Moscow: Progress. Nozick, R. 1974. Anarchy, State, and Utopia. New York: Basic. Proudhon, P.J. 1904. What Is Property? New York: Cosimo. Risse, M. 2005. How Does the Global Order Harm the Poor? Philosophy and Public Affairs 33. 349-76 Ruskin, J. 2007. Unto This Last. Minneapolis: Filiquarian. Smith, A. 1976. An Inquiry into the Nature and Causes of The Wealth of Nations. Chicago: University of Chicago. World Hunger Education Service 2009. World Hunger Facts 2009. http://www.worldhunger.org/articles/Learn/world%20 hunger%20facts%202002.htm, accessed 07/02/2010 at 20:31. You, D., Wardlow, T., Salama, P. & Jones, G. 2009. Levels and trends in under 5-mortality, 1990-2008. The Lancet, Volume 375, Issue 9709. 100-103

Roy Moore is a third year Politics, Philosophy and Economics (PPE) student at the University of York. 23

the role of identity and social networks for economic outcomes in poor countries - an application to aspirations
BY ZSOKA KOCZAN

24

Recently there has been an increasing tendency to incorporate in economic theory, as Keynes once did, the great variety of norms that determine human behavior, expanding the homo economicus assumptions. Identity and the role of social networks have hence increasingly featured in economic discussions.

Introduction1 In a world of social difference, one of the most important economic decisions that an individual makes may be the type of person to be. Limits on this choice would also be critical determinants of economic behavior, opportunity, and well-being.
(Akerlof and Kranton 2000, p.748)

t Sociologists, psychologists and anthropologists have repeatedly emphasized the importance of relative comparisons, role models or peer pressure (perhaps most vividly in Franks Choosing the Right Pond 1985). Economists have tended to be skeptical towards such cultural explanations. However, empirical studies have brought up puzzles that cannot be accounted for entirely by the usual maximizing framework. Numerous papers have found unexplained neighborhood effects hinting at some regionally and/or socially confined missing factor (e.g. Borjas 1995; Jalan and Ravallion 2002; Becker and Murphy 2000). Evidence also increasingly seems to suggest that human capital investment cannot be fully accounted for through rate-of-return credit constraint analysis (e.g. Carneiro and Heckman 2002; Cameron and Taber 2000; Marjoribanks 1999). Rooted in such empirical puzzles, this paper attempts to fit these factors into a mainstream economics framework by linking human capital investment to aspirations and optimization under secondbest constraints.

becomes central to driving group dynamics, possibly in a way quite different from what the simple aggregation of individual preferences would suggest. The microfoundations of the model discussed in the following section can thus be set out by linking aspirations backwards to an aspiration window, in turn determined by the choice of a reference group influenced by social networks2. The notion of an aspiration window is closely linked to the discussion by Ray (2004) who argued that individuals have some cognitive sphere to which they compare themselves, thus determining their aspirations. This can be formulated in more statistical terms, as looking at the experiences of individuals close to an agent (spatially, economically, socially) is like running an experiment with better controls. The selection of a reference group can thus be seen as a rational response to an information problem - the lack of perfect foresight.

robinson crusoe aside, econoMic agents do not live in isolation.

Reference may here be made to the recent work of Akerlof and Kranton on identity (2000, 2002, 2005, 2007). They developed a framework based on the assumptions that people have a view of who they are (a social category), and corresponding to who they are (this identity) they have an ideal for behavior, and lose utility insofar as they do not live up to that ideal. While Akerlof and Krantons arguments are based on the idea of merely extending utility functions, I rely on the notion of identity (in the sense of behavior being determined by an ideal) as applied to aspirations, closing the model by tracing the determinants of aspirations back to social networks. The essence of this argument is that the individuals cognitive neighborhood, the group of people he compares himself to, is determined by the networks he is a member of3. 25

The microfoundations of aspirations Mainstream economics has been based on methodological individualism, the conception of the individual as a very private person, unconcerned about the rest of the world. However, as Dasgupta noted, Robinson Crusoe aside, economic agents do not live in isolation (Dasgupta 2009). They do not exist in a social vacuum as consumer preferences are often assumed to do. However, if a persons behavior is conditioned by the experiences of other individuals, this

Figure 1: The social determinants of aspirations

The model The model is based on the graphical analysis of two curves in income aspirations (human capital investment) space. Its main predictions are (i) that including aspirations may affect the location of the poverty trap threshold and (ii) that aspirations can constitute the binding constraint and may account for rational inertia. Focus here is on human capital investment since aspirations could be more critical for this form of investment as (i) there may be less uncertainty about returns to physical capital and (ii) these may lie in the nearer future than returns to e.g. education. This distinction is however not essential to the arguments in the following.

Turning to a qualitative description of the curve (which will be the driving force behind the results discussed in section Equilibrium properties & transitional dynamics) it can be assumed to take the shape of a logistic function: flat at a low level for low levels of income (as the individual is likely to select a peer group with similarly low levels of income, little information and low mobility), then rising and flattening off at a higher level. The second curve of the model depicts ability to invest as a function of income. Following ample empirical evidence from LDCs, the presence of an initial credit constraint is incorporated in this curve. Investment (as a proportion of income) is then assumed to rise (more than) proportionately with income4: ability = 0 or Y < YT and g(Y)otherwise5

Equilibrium properties & transitional dynamics Examining the graphs of the above outlined curves, analysis may be broken down into three cases depending on whether the two curves cross with one, two or three equilibria, for different relative slopes of the two schedules.

The aspirations curve & the ability to invest curve The aspirations side of the model is rooted in the arguments brought forward by Ray discussed earlier (Ray 2004), and is extended by introducing costly investment in human capital. The individuals problem is thus to choose an investment effort that maximizes the difference between benefits (higher future living standards) and costs (current sacrifices in terms of consumption or leisure) - an inter-temporal choice in which social networks determining the selection of a reference group become important as the individual attempts to overcome the information constraint of a lack of perfect foresight. The aspirations curve can thus be seen as a function of the peer group selected by the individual ( S ) as well as personal characteristics ( P ). The former in turn depends on factors such as income (affecting socio-economic status), but also on perceptions of more macroeconomic variables such as mobility: aspirations = (S(Y, mobility ...),P) 26

the notion of an aspiration window is closely linked to the discussion by ray who argued that individuals have soMe cognitive sphere to which they coMpare theMselves, thus deterMining their aspirations.
The first case is that of a single, unstable equilibrium accounting for the poverty trap. Below this point aspirations exceed ability to invest in human capital, the credit/subsistence constraint is binding (as could be expected). Ability to invest is low, thus so is investment, resulting in low future income and a poverty threshold that is difficult to cross in the absence of some large exogenous shock. It is, however, worth pointing out that the poverty threshold lies above the point where the credit constraint is relaxed, leaving a role for inertia in the adjustment of expectations. Past the threshold the individuals

ability to invest exceeds his willingness. Though investment will increase, it is held back by this relatively lower willingness to invest as human capital investment out of equilibrium is always determined by the lower curve. Once the individual has escaped the poverty trap, emphasis shifts from credit constraints to aspirations. Beliefs and perceptions become important, highlighting the role of information availability and social networks in affecting aspirations, human capital investment and hence further growth.

Figure 2: First case with one equilibrium The second case is similar to the first scenario: although there are now two equilibria, the dynamics and predictions of the model are essentially as for the first case. There is a second equilibrium as the two curves are just tangent to each other, however this is still unstable; ability to invest exceeds aspirations both below and above this point; the aspirations curve is binding on both sides.

that along the transition path to this next equilibrium, human capital investment may actually be below the individuals ability to invest. Aspirations may lag behind, holding back investment and growth. This may be due to inertia or context-specific factors affecting expectations. Such causes could be either at the macro level (such as hyperinflation or wars) or could be limited to changes in beliefs at the micro level of social networks e.g. in a village. Above the stable equilibrium, aspirations have caught up (expectations may have improved), and credit may again be the binding constraint. This could be due to overshooting in aspirations, exceeding the increase in ability to invest. This is reflected in the initially steeper slope of the aspirations curve and may incorporate the inherent uncertainty surrounding beliefs (perhaps a trial-and-error adjustment of expectations to equilibrium). While inertia has frequently been imputed to traditional culture and habits or, in terms of the idea of identity, to the psychological cost the poor/marginalized would pay if they were to adopt the pattern of behavior of the rich/dominant group (Akerlof and Kranton 2000), here rational inertia may be explained by the fact that it takes time for the experience stock of the reference group to grow, for their expectations to adjust and for this to be considered by the individual.

Figure 4: Third case with three equilibria

Conclusions If the individual cannot form beliefs on a set of fully specified contingencies, including her own future tastes given the big choice, how is she to decide?
(Heifetz and Minelli. 2006, p. 3)

Figure 3: Second case with two equilibria The third case is a scenario with three equilibria (one stable and two unstable). As in the above two cases, the low unstable equilibrium may account for a poverty trap. Once past this point, the individual could slowly move up to the next stable equilibrium. Aspirations are, however, important as they mean This paper has outlined a model built from microfoundations of how aspirations may affect the poverty trap and account for rational inertia. Thus, it may go some way towards elucidating empirical puzzles concerning unexplained neighborhood effects or the dominant role of social background characteristics for human capital investment. 27

Although indirect evidence seems to provide support for this hypothesis, it should be remembered that several alternative explanations may be present, ranging from credit constraints to communitywide effects (such as public goods). This aspirationsbased view is proposed as complementary to these. Despite the need for further research (focusing in particular on testing at the micro-level) the model could be argued to have wide applicability. Socially determined aspirations may be used to explore a variety of issues e.g. why hyperinflation may have longer lasting real effects for a society, why relatively affluent countries destroyed by war may grow back quickly, why immigrants might save at extraordinarily high rates or why polarized societies may exhibit low social mobility. t

ertia in beliefs, with expectations requiring time to adjust and affect aspirations. Also, although some credit may be available, individuals may still need these funds to smooth consumption in the face of fluctuating income. They would thus be unable to commit funds to longer term investment projects this assumption has been confirmed empirically for instance by Dercon and Christiansen (2007).

Bibliography Akerlof, G.A. 2007. The missing motivation in macroeconomics. American Economic Review. Volume 97, Issue 1. 5-36. Akerlof, G.A. & Kranton, R.E. 2000. Economics and identity. Quarterly Journal of Economics. Volume 115, Issue 3. 715-753 Akerlof, G.A. & Kranton, R.E. 2002. Identity and schooling: some lessons for the economics of education. Journal of Economic Literature, Volume 40, Issue 4. 1167-1201 Akerlof, G.A. and Kranton R.E. 2005. Identity and the economics of organizations. Journal of Economic Perspectives, Volume 19, Issue 1. 9-32 Becker, G.S. and Murphy, K.M. 2000. Social economics: market behaviour in a social environment. Cambridge: Harvard University Press Borjas, G. 1995. Ethnicity neighbourhoods, and human capital externalities. American Economic Review, Volume 85, Issue 3. 365-380 Bronfenbrenner, U. 1994. Ecological models in human development. In Husn, T. and Postlethwaite, T.N. (Eds.) The international encyclopaedia of education. Oxford: Pergamon. Bronfenbrenner, U. and Ceci, S.J. 1994. Naturenurture reconceptualization in development perspective: a bioecological model. Psychological Review, Volume 101, Issue 4. 568586 Cameron, S. and Taber, C. 2000. Borrowing constraints and the returns to schooling. NBER Working Paper, no. 7761. Carneiro, P. and Heckman, J.J. 2002. The evidence on credit constraints in post-secondary schooling. Institute for the Study of Labour, Discussion Paper Series, no. 518. Dasgupta, P. 2009. Trust and cooperation among economic agents. Forthcoming in the Philosophical Transactions of the Royal Society (2010). Dercon, S. and Christiansen, L. 2007. Consumption risk, technology adoption

Endnotes This paper is based on the authors undergraduate dissertation - for the full version please contact zk219@cam.ac.uk. The author wishes to thank Dr. Pramila Krishnan and Prof. Sanjeev Goyal for helpful discussions and comments. 2 Although aspirations are of course dependent on internal, psychological causes as well, focus here is on their social determinants - a vast psychological literature deals with the complex psychological motivations, see for instance Bronfenbrenner (1994) or Bronfenbrenner and Ceci (1994). 3 As there is vast literature on the formation and determinants of social networks, reference here is only made to the distinction between inherited and chosen networks. 4 Focus here is on ability to invest in general, not only on ability to invest in human capital. Such a limitation could cause an endogeneity problem, which raises the question of how to determine what proportion of total funds the agent would be able to invest in human capital in the first place. The relationship is not necessarily linear, it is only drawn as such for simplification. This assumption does not affect the predictions of the model as the different cases allow for different slopes of both curves.v Ability to invest is assumed to lie initially below the aspirations curve. While the former may be essentially zero due to survival constraints/ binding credit constraints, we could expect the latter to be positive, though small. Furthermore, it will be assumed that the credit constraint is relaxed before aspirations start to rise as we could expect there to be some in1

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Zsoka Koczan received a BA First Class Honors Degree in Economics from Kings College at Cambridge University in 2009 and continues at Cambridge as an MPhil student in Economics. She has received the Gerald Shove Prizes for distinguished performance in Economics and was Scholar of Kings College in all three years of her undergraduate studies.

How might his aspirations form his future?

29

whats wrong with economics

BY SIR ROBERT SKIDELSKY

Lord Skidelsky is Professor Emeritus of Political Economy at the University of Warwick. He is best known as the author of a multi-volume biography of John Maynard Keynes. Skidelsky is a member of the cross benches and frequently writes columns for newspapers and magazines such as the Financial Times, the Economist or the New York Times. In response to the financial crisis he published the book Keynes: The Return of the Master in September 2009.

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t The recent economic collapse has produced widespread dissatisfaction with the state of economics and calls for changes in the way economics is taught at universities and business schools. Two professional straws in the wind are worth noticing: In November 2008, the Queen Elizabeth II of Britain asked at the London School of Economics why so few economists had foreseen the credit crunch. In August 2009, Professor Geoffrey Hodgson, editor of the Journal of Institutional Economics, drafted a letter, signed by ten leading British economists, which tried to answer the Queens question. The main points the signatories made were that economics had become a branch of applied mathematics, with little contact with the real world; that mainstream economics entertained a highly questionable belief in universal rationality and efficient markets; and that it was the narrow training of economists which concentrates on inappropriate mathematical techniques and the building of empirically uncontrolled formal models which helped explain the failure of economists to give adequate warnings of the economic crises in 2007 and 2008. The letter concluded that economists needed a broader training, involving allied disciplines such as psychology and economic history. But prediction, wrote Paul Krugman in the NYT on 2 September 2009, was the least of the fields problems. More important was the professions blindness to the very possibility of catastrophic failures in a market economy ... the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth ... economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations ... Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets especially financial markets that can cause the economys operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators dont believe in regulation. ... When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly.

An important critic from outside the profession was the financier George Soros who had long argued that financial markets were prone to huge errors because of the existence of reflexivity. On December 19, 2008 he wrote in the New York Review of Books: The salient feature of the current financial crisis is that it was not caused by some external shock The crisis was generated by the financial system itself. This fact that the defect was inherent in the system contradicts the prevailing theory, which holds that financial markets tend toward equilibrium.

econoMics students coMe and go (Mainly into banking, accountancy, and financial services) and econoMics, it seeMs, goes on oblivious of their presence.
There have been sporadic protests by students against the economics they are taught. For example, a student movement for the reform of economics teaching started in France in May 2000 and spread to Spain, the United Kingdom and the United States. The issues raised by the students focused mainly on the irrelevance of undergraduate and graduate economics teaching for understanding real economic problems. They were against imaginary economics worlds being imposed on students. This they called autism, and called themselves the post-autistic movement. But economics students come and go (mainly into banking, accountancy, and financial services) and economics, it seems. goes on oblivious of their presence. It is difficult at this stage to say what a post-autistic economics would look like. Economists themselves are at war. Consider the following clashing schools. 1. Chicago economics (for short). Agents have rational expectations. That is, they efficiently utilize all available relevant knowledge. There is perfect information, perfect competition, and complete markets. If these conditions hold, shares are always correctly priced, markets continuously clear, money has no utility. 2. The New Keynesians. Agents have rational expectations but imperfect information. Markets can therefore fail, and there is scope for government 31

intervention to correct these failures, and rescue economies from savage downturns. 3. Keyness economics. Keynes himself believed that humans behave rationally (or reasonably) but that the future is not just risky, but uncertain. This makes investment very volatile. Because of uncertainty money has utility as a store of value. When confidence falls there is a flight from investment into cash. This means that economies can run down as people curtail their spending. Once economies have contracted, they can stay depressed a long time unless government increases its own spending to offset the fall in private spending. This justifies stimulus policies. 4. Behavioral economics. This sets out to theorize on the basis of how human beings actually behave. It uses cognitive psychology to reach a momentous conclusion: humans are programmed to behave irrationally. They behave in ways which may have survival or social value but do not conform to rationality as traditionally understood by economists. Some New Keynesians have taken up behavioral economics in theoretical despair with conventional models. Obviously, policy and regulation will be different depending on which story one buys. In the last thirty years governments and regulators have bought the first story, with the results we now see. So we need to change the story. That means changing the way students are taught economics.

PhDs. So a disproportionate amount of teaching is allocated to mathematical techniques. This means that a student can achieve a first-class honors degree on the basis of mathematics alone. Indeed, provided a student can do the maths, he or she can achieve virtually 100% on the maths papers. A student in an Anglo-American top economics department may graduate with the highest grades without having to read a single word of Adam Smith or Marx or Mill or Keynes or Schumpeter or Hayek. Mathematics is not a problem in itself the contribution of mathematics and statistics as an aid to rigorous thinking and use of correct quantitative methods in appropriate contexts is a skill that students should be taught. However, the existing economics curriculum encourages overuse of inappropriate mathematical techniques without understanding of their conceptual underpinnings and limitations. Students study micro and macro completely separately. There is no course in the final year that would bring the two together into one coherent picture. They also have no way of relating micro and macro techniques to the wider context of economic history, political economy and so on. Given the war among economists, there is little chance, as yet, of a unified field of economic theory. What can be done is to ensure that students cannot obtain a degree in economics on the basis of economics and maths alone. Some or all of economic history, political economy, the history of economic thought, psychology, politics, sociology and (I would argue) philosophy should not be optional extras but an integral part of the training of an economist, especially at first degree level, and weighted accordingly. This would give the budding economist an insight into the way other disciplines have sought to understand human behavior. Specialization can wait until later, and only on the back of a broad first degree. This reform would ensure a modest de-professionalization of the discipline. Given its lack of real scientific standing, this would be a good thing. Not only is economics cut off from ordinary discourse, but it rarely engages in fruitful dialogue with adjacent disciplines. An economics department in which broader first-degree courses were taught would necessarily have a more heterodox body of professors, and students would be exposed to clashing views and methodologies.

not only is econoMics cut off froM ordinary discourse, but it rarely engages in fruitful dialogue with adjacent disciplines.
At present economics courses are highly mathematical. In the first two years, typical economics students in a British university would do three economics courses, three mathematical courses and two optional courses. In the third year they can select four courses from a list which includes modules in further mathematical methods, managerial accounting, commercial law, and so on. Students who are planning to go on to do postgraduate degrees or research are encouraged to select mathematical courses as their options as this would make it easier for them to get into top universities to do their 32

Even modest reforms of this sort will be immensely difficult to achieve. The whole system of textbooks, learned journals, tenure, job opportunities is built on an increasingly narrow technical concept of what it is to be an economist. This will need to be blown up. Perhaps the present crisis will contribute to that. But I suspect we will need to have more crashes in the real world before the present structure of economics comes crashing down. The models economists use influence the actions of regulators and governments. So the state of economics is a matter of vital concern to us. One might almost say economics is too important to be left to economists. t

Students studio 1915

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redefining rationality
The neoclassical definition of rationality, though continuously and consistently debated, has remained the cornerstone of economics for decades. How do current developments in areas ranging from finance to the natural sciences, necessitate and facilitate a departure from this paradigm?
B Y R A N I TA R AG U N AT H A N option-pricing model. Systemic actors in the global financial market grew to accept and implement such models, which were based on austere and unrealistic assumptions of how returns and variation could replicate Gaussian, lognormal and other theoretical distributions. Simon analogically articulates the core of the matter. He uses the example of a motionless, irregularly shaped bowl filled with molasses (Simon 1959). When in a steady state, or equilibrium, the molasses will display characteristics akin to that of any other liquid in a similar bowl. Under the earths gravitational pull, for example, a pliable substance of almost any kind will act to minimize the height of its center of gravity. The behavior of the molas-

t The widely accepted neoclassical definition of rationality has remained the cornerstone of economics for decades. The assumption that economic actors are utility maximizing beings with consistently clear preferences and access to perfect information, has to a large extent enabled the methodologies of economic studies to resemble those of the natural sciences. While even Robert Lucas himself has readily submitted and acknowledged the severe shortcomings of the rational actor assumptions, its application to the non-academic world did not noticeably hit a wall until the recent global economic crisis. An offshoot of the rational expectations theory is the efficient market hypothesis (EMH), which states that prices reflect all available information. The EMH spawned a whole slew of financial models, including the Capital Asset Pricing Model and the Black-Merton-Scholes 34

antnio r. daMsio [] observed patients who had lost their ability to experience eMotion due to brain surgery. he observed that one such patient, known as elliot, also lost his ability to Make rational decisions.
ses in equilibrium is dependent only on its goal and its environment (Ibid., p.255). In this case, the goal is the pursuit of the center of gravity and will be otherwise completely independent of the internal properties of the organism (Ibid.). If on the other hand, the said bowl were set in motion, the molasses would still eventually find its center of gravity as the bowl reached equilibrium. In order to ascertain its

behavior before the bowl reaches this point however, the physical properties of the molasses, such as its volume and viscosity, would have to be known. The assumption of rationality employed in neoclassical economics, has effectively assumed away the physical properties of economic actors. Ludwig von Mises, an influential Austrian School economist, once defined science as the endeavor to attain a mental grasp of the phenomena of the universe by a systematic arrangement of the whole body of available knowledge (von Mises 1963, p.21). Proponents of the Austrian School were, in general, averse to the mathematical methods employed by what we have come to know as mainstream economics. Von Mises ultimately dismisses the neoclassical definition of rationality as nothing more than a value judgment, stating that this was akin to declaring what one person would prefer based on what another would consider desirable. He asserted that eventually, the observation of all phenomena will reach a point where it can no longer be analyzed and

measured by present knowledge; the human psyche beyond the austere definition of rationality being one of them. Von Mises argued that irrational behavior wasnt irrational per se, but rather a reactive response to stimuli on the part of the bodily organs and instincts which cannot be controlled by volition of the person concerned (Ibid., p.20). Whether he was aware of it or not at the time, this statement described the basic framework of a branch in the field which we would eventually come to know, as behavioral economics. Behavioral economics seeks to explain economic activity in terms of market players behavior and has taken note of various human tendencies such as herding, overreaction and loss aversion. Shiller outlines the tendency for investors to be spurred on by feedback, making investments based on the observed successes of their peers (Shiller 2003). He goes on to articulate how interrupted feedback dynamics stimulates herding behavior and has the tendency to generate speculative bubbles. DeBondt 35

and Thaler found that investors tended to overreact to new information and therefore caused market movements more extreme than would be expected of rational agents (DeBondt & Thaler 1985). Their study of U.S. stock returns concluded that overre-

loss aversion and herding can be seen as basic priMal instincts; losses are More likely to deplete a species than the lack of gains, and power in nuMbers is essential to greater collective preservation.
action caused stocks that had previously suffered a loss to become underpriced, and previously winning stocks to become overpriced. Prospect theory, developed by Kahneman and Tversky, is based on the idea that economic agents tended to evaluate investment risks relative to their current levels of wealth (Kahneman & Tversky 1979). This is inconsistent with the rational expected utility theory, which assesses possibilities in terms of absolute final wealth. Within this framework, it was also found that investors placed greater weight on the value of potential losses than on that of potential gains.

The human tendency to submit to supposedly irrational behavior is a question that the developing field of neuroeconomics seeks to answer. By studying the link between reactions in the human brain and economic behavior, neuroeconomics looks into the origins of the decision-making biases identified by behaviorists. Based on the brief overview of the findings of behavioral economics earlier in this article, the propensity for human beings to produce irrational reactions seems to be related to emotions. Fear and greed, the most common emotional reactions in investors, appear to form the basis for most of the irrational behavior observed by behavioral economists. A study by Antnio R. Damsio, a behavioral neurologist, observed patients who had lost their ability to experience emotion due to brain surgery (Damsio 1995). He observed that one such patient, known as Elliot, also lost his ability to make rational decisions. The main implication of the study was that emotions and rationality are inextricably linked. Zajonc articulates how affective reactions precede cognitive reactions in the decision-making process (Zajonc 1980). He concludes that affect and cognition are under the control of separate and partially independent systems that can influence each other in a variety of ways, and that both constitute independent sources of effects in information processing (Ibid., p.151). However, is it possible that this seemingly intricately and incredibly interwoven web of reactions have its roots in the human evolutionary construct?

Perfect information or animal spirits? The NY Stock Exchange.

36

Consider, for example, the human reaction of jumping at the sound of a loud noise. It is only following this affective reaction that the human brain seeks to establish the source of the disturbance, which is arguably, the rational thing to do. This propensity to jump, in preparation to take flight, can be seen as part of our evolutionary construct, meant to aid the propagation and preservation of the human race. Variations in reactions can arise based on intensity of the sound, surrounding environment, and past experiences of the individual in question. This suggests that human beings learn and adapt to whatever circumstances they find themselves presently in. By extrapolating this notion to investor behavior in financial markets, it can be inferred that many of the observations made by behavioral economists are, at least partially, attributable to evolutionary human qualities. Overreaction in particular, can be seen as analogous to human responses to loud noises. Loss aversion and herding

not work when all players were betting on the same strategies. It has become evident beyond a shadow of a doubt that the field of economics has to incorporate components of the natural sciences that account for human behavior, as opposed to the former convention of solely employing generic mathematics, rife with unrealistic assumptions. However the biggest challenge lying ahead for observations of behavioral, evolutionary and neuroeconomics is aggregation. The manner in which these findings are applied to the macroeconomic realm, have to be clear enough to enable legislative and policy-making action. In light of the current global economic turmoil, it is now especially pressing that homo economicus, accepts its irrationality and evolves from the static entity it once was into the dynamic being it truly is. t

Bibliography Chen, M. K., Lakshminarayanan, V. & Santos, L. R. 2006. How Basic Are Behavioral Biases? Evidence from Capuchin Monkey Trading Behavior. Journal of Political Economic, Volume 114, Issue 3. 517-537 Damsio, A. R. 1995. Descartes Error: Emotion, Reason and the Human Brain. New York: HarperCollins. De Bondt, W.F.M. & Thaler, R. 1985. Does the Stock Market Overreact? The Journal of Finance, Volume 40, Issue 3. 793-805 Kahneman, D. & Tversky, A. 1979. Prospect Theory: An Analysis of Decision under Risk. Econometrica, Volume 47, Issue 2. 263-292 Simon, H.A. 1959. Theories of Decision-Making in Economics and Behavioral Science. The American Economic Review, Volume 49, Issue 3. 253-283 Shiller, R.J. 2003. From Efficient Markets Theory to Behavioral Finance. Journal of Economic Perspectives. Volume 17, Issue 1. 83-104 Von Mises, L. 1963. Human Action: A Treatise on Economics, 4th revised ed. Yale University. http://mises.org/Books/humanaction.pdf Zajonc, R. 1980. Feeling and Thinking: Preferences Need No Inferences. American Psychologist, Volume 35. 151-175

for the longest tiMe, huMan idiosyncrasies were rendered negligible in econoMic analysis.
can be seen as basic primal instincts; losses are more likely to deplete a species than the lack of gains, and power in numbers is essential to greater collective preservation. Chen, Lakshminarayanan, and Santos conducted an experiment using primates, in order to uncover the evolutionary properties behind economic decisions (Chen, Lakshminarayanan & Santos 2006). Primates were selected for this purpose due to their neurological construct being similar to that of human beings. The experiment found that the test subjects displayed behavior consistent with Kahneman and Tverskys definition of loss aversion (Kahneman & Tversky 1979). These findings have tremendous implications for the microfoundations of economics. For the longest time, human idiosyncrasies were rendered negligible in economic analysis; the argument being that on a macro level, variations would cancel each other out to bring about one very rational super-being that is the economy. However, this is proving to be less and less the case in practice. By not taking into account the effects of herding for instance, we failed to realize how deviations from so-called rational behavior wouldnt necessarily cancel each other out. Financial models meant to hedge and measure risk did

Ranita Ragunathan received her Bachelor of Science in Economics and Econometrics from the University of Southampton in 2006 and a Master of Arts in Economics from New York University (NYU) in 2009. She is currently working as a Research Associate for the Financial Standards Foundation. 37

a conceptual structure for offensive and defensive strategy

When an entrant gambles on ousting an incumbent, a follower mobilizes to depose a leader, or a predator targets the dissolution of a competitor - who will win and who will lose? An introduction to the game between the challenger and the defender.
BY BRADLEY BARTH

Introduction t The strategic behavior of firms can be captured in two ongoing activities: challenging other firms for their interests and defending their interests from other firms. Firms constantly find themselves as either the challenger or the defender in episodes of the game in which the challenger aims to increase his market share by capturing that of the defender, who aims to protect her share by retaining it from the challenger. In this game, the challenger formulates an offensive strategy, the defender formulates a defensive strategy, and the competition for the defenders share ensues. The outcomes of episodes 38 of this game, including those in which neither strategy ends up being executed, determine not only the fate of individual firms, but also the evolution of their industries. A model that could account for the outcome of episodes of this game would represent a quantum leap in the understanding of firms strategic behavior. Unfortunately, such a model does not exist, for modeling the economic world in which these strategic behaviors interact is indubitably tricky; hence philosophers of science question the feasibility of constructing such a model (Cartwright 2007). Argu-

ments that support this skeptical position toward meaningful economic modeling share a common theme: failure to explicitly account for innovative conceptualization as a plausible solution. Perhaps heretofore, attempts at economic modeling have been overly constrained by inadequate operational arrays of concepts; perhaps economic models constructed from innovative concepts can overcome the allegedly inherent limitations of economic modeling. This paper introduces an innovative conceptual structure for a model that accounts for the outcome of episodes of the game between the challenger and the defender. The object of this innovative conceptual structure is twofold: first, to further the understanding of firms strategic behavior by progressing toward the construction of a rigorous and tractable model; second, to persuade skeptical philosophers of science that innovative conceptualization can increase the feasibility of meaningful economic modeling. Quadripartite Coalition Structure The game features the challenger and the defender. The challengers function is to maximize the conversion of the defenders market share, while the defenders function is to minimize the conversion of her market share. The defenders market share is a function of her quadripartite coalition, which specifies her financial relationships with members of her economy. These members are categorized into four sets: the market set, the industry set, the government set, and the bank set. The members of these four sets become members of the defenders quadripartite coalition if and only if doing so earns them higher payoffs than not doing so. Market Coalition The market set includes all individuals with the potential to adopt the defenders offering. Members of the market set must choose to adopt or reject the defenders offering. The subset of the market set which chooses to adopt the defenders offering represents the defenders market coalition. The defenders market coalition is equivalent to the defenders market share such that, if the payoff advantage to her market coalition ceases and the members mobilize, her market share decreases. Industry Coalition The industry set includes all individuals with the potential to accommodate the defenders market share.1 Members of the industry set must choose to accommodate or retaliate against the defenders share. The subset of the industry set which chooses to accommodate the defenders share represents the defenders industry coalition.

Government Coalition The government set includes all individuals with the potential to authorize the defenders legality. Members of the government set must choose to authorize or regulate the defenders legality. The subset of the government set which chooses to authorize the defenders legality represents the defenders government coalition. Bank Coalition The bank set includes all individuals with the potential to appropriate capital to the defender. Members of the bank set must choose to appropriate to the defender or to repudiate their relationship. The subset of the bank set which chooses to appropriate to the defender represents the defenders bank coalition. The defenders industry, government, and bank coalitions are classified as ancillary coalitions. These three ancillary coalitions influence the defenders market coalition (and hence, market share) such that, if the payoff to one of her ancillary coalitions decreases and its members mobilize, the payoff to her market coalition will also decrease and its members will mobilize, thus decreasing her market share. In summation, the defenders market share is a function of her quadripartite coalition, which is comprised of her market, industry, government and bank coalitions. Three rules govern the choices of members of the defenders quadripartite coalition. The first rule is that members of her quadripartite coalition will continue their memberships if and only if doing so yields a higher payoff than mobilizing. It follows that members of her market coalition will continue their memberships if and only if choosing to adopt yields a higher payoff than choosing to reject. The second rule is that, if members of her market coalition choose to reject, they will automatically convert to the challenger. The third rule is that, unless the challenger causes the payoff for rejecting to be higher than that for adopting, the present payoffs will persist, and the members of the defenders market coalition will continue their memberships. Implications for Offensive and Defensive Strategies The quadripartite coalition structure demonstrates that the defenders market share is dependent upon the strategic choices of the members of her market coalition. If the defender is to protect her share, she must retain the members of her market coalition. Conversely, if the challenger is to capture 39

the defenders share, he must convert the members of her market coalition. The structure also demonstrates that the strategic choices of members of the defenders market coalition are dependent upon the stability of her industry, government, and bank coalitions, which denotes choices of the defenders ancillary coalitions to continue their memberships. The mobilization of members of the defenders ancillary coalitions, which denotes the members choices to discontinue their memberships, will decrease the payoffs to members of her market coalition, making each of the defenders coalitions targets for the challenger.

the unique profiles of power between the given firM acting as challenger and the given firM acting as defender Make each episode a variant of the gaMe
Furthermore, the quadripartite coalition structure exposes the degree to which the defenders market coalition is vulnerable to conversion. The vulnerability of the defenders market coalition is equivalent to the weakness of the members preference to adopt, indicated by the difference between the payoff for adopting and the payoff for rejecting. The measure of the defenders control over her market coalitions vulnerability to conversion is her power to preserve the members preference to adopt, which requires her to maintain the inequality between adopting and rejecting, such that adoption is preferred to rejection. The measure of the challengers control over the vulnerability of the defenders market coalition is his power to restructure the members preference to adopt, which requires him to reverse the inequality between adopting and rejecting, such that rejection is preferred to adoption. The defenders requisite power of preservation is therefore negatively correlated with the difference between the members payoff for adopting and the payoff for rejecting, while the challengers requisite power of restructuration is positively correlated with the difference. Pursuant to restructuring the market coalition members preference to adopt, the challenger formulates a set of possible strategies to reverse the present payoff inequality, thus yielding a higher payoff for rejection than that for adoption. The challengers strategies are investments aimed at dis40

rupting the stability of the defenders quadripartite coalition. Along with an investment aimed directly at inducing the defenders market coalition to convert, the challengers set of possible strategies includes investments aimed at mobilizing the defenders ancillary coalitions, thereby indirectly inducing her market coalition to convert. Pursuant to preserving her market coalition members preference to adopt, the defender formulates a set of possible strategies to defend against the challengers possible offensive strategies, thus maintaining the inequality that yields a higher payoff for adoption than for rejection. The defenders strategies are investments aimed at preempting or retaliating against the challengers investments. Along with investments aimed directly at deterring her market coalition from converting, the defenders set of possible strategies includes investments aimed at stabilizing her ancillary coalitions, thereby indirectly deterring her market coalition from converting. The payoffs in the game represent the percentage of the defenders market coalition that converts to the challenger for each strategy profile. In the game, the challenger potentially has recourse to four domains of investment: the defenders market, industry, government, and bank coalitions. Undefended investments in the defenders four coalitions will result in unique percentages of conversion, p. The defender potentially has recourse to preemptive investments and retaliatory investments against each of the four potential challenges to her quadripartite coalition. For each of her four coalitions, a preemptive strategy would decrease the conversion outcome of a challenge to some percentage p n, a retaliatory investment would further decrease the outcome to some percentage x, where x < (p n), and a retaliatory investment that is not preceded by a preemptive investment would decrease the conversion outcome of a challenge to some percentage y, where x < y < (p n). A preemptive investment decreases the conversion outcome of a challenge by deterring the execution or limiting the effectiveness of a potential challenge, while a retaliatory investment decreases the conversion outcome of a challenge by negating the effect of or reclaiming the losses from an executed challenge. It follows that the execution of a preemptive investment precedes that of a challenge, which itself precedes that of a retaliatory investment. This necessary sequence requires that the game be modeled as an alternating-move game, which in game-theoretic parlance is defined as extensive form, rather than a simultaneous-move game, which is defined as stra-

tegic form. The sketch in Figure 1 portrays the generic game between the challenger and the defender accordingly.

defensive strategy is limited to the capital available for defensive investment and the challengers power to restructure her market coalition members preference to adopt, which combine to represent her power to preserve those members preference to adopt. The unique profiles of power between the given firm acting as challenger and the given firm acting as defender make each episode a variant of the game, amenable to the extensive form of zero-sum games. Conclusion The quadripartite coalition structure has been introduced as the focal point of the game between the challenger and the defender. The quadripartite coalition is an innovative conceptual structure that organizes the economic world in which the defender and the challenger compete, according to the financial relationships that govern financial performance. Insights extrapolated from this innovative conceptual structure reveal limitations on offensive and defensive strategies, which make the game more amenable to a game-theoretic model. The defenders market share is shown to be a function of her quadripartite coalition, which reveals the basis of competition between her and the challenger. The defender counteracts the challengers investments to mobilize her quadripartite coalition with preemptive and retaliatory investments that stabilize her quadripartite coalition. Such progress toward constructing a game-theoretic model that can account for episodes of the game between the challenger and the defender increases the understanding of firms strategic behavior, which ought to inspire confidence in the potential for innovative conceptualization to increase the feasibility of meaningful economic modeling. t Endnotes
1 Accommodation of the defenders market share denotes a strategy that excludes a campaign to convert members of the defenders market coalition. 2 This strategy profile results if both the threat of retaliation and the outcome of the challenge after retaliation are unacceptable to the challenger.

Figure 1 The game between the challenger and the defender in extensive form. The challengers set of possible strategies includes investments to convert members from each of the defenders four coalitions (c14), as well as not challenging (~c). The defenders set of possible strategies includes preemptive (p14) and retaliatory (r14) investments against each of the challengers four possible investments, as well as not preempting (~p) and not retaliating (~r). The sketch in Figure 1 illustrates that, for each coalition, the defender chooses whether or not to execute a preemptive investment, the challenger chooses whether or not to execute a challenge, and if a challenge is executed, the defender chooses whether or not to execute a retaliatory investment. To be precise, there are six strategy profiles: (1) the defender preempts and the challenger withdraws his challenge; (2) the defender preempts, the challenger executes his challenge, and the defender withholds retaliation; (3) the defender preempts, the challenger executes his challenge, and the defender retaliates; (4) the defender withholds preemption and the challenger withdraws his challenge2; (5) the defender withholds preemption, the challenger executes his challenge, and the defender withholds retaliation; (6) the defender withholds preemption, the challenger executes his challenge, and the defender retaliates. The challengers offensive strategy is limited to the capital available for offensive investment and the present difference between the market coalition members payoff for adopting and that for rejecting, which combine to represent his power to restructure those members preference to adopt. The defenders

References
Cartwright, N., Causal Powers: What Are They? Why Do We Need Them? What Can Be Done With Them and What Cannot? Contingency And Dissent in Science Project, 2007.

Bradley Barth is a masters candidate at the London School of Economics, where his research centers on the application of games of incomplete information to problems in industrial organization. Barth holds honors degrees from the University of Utah, where he studied philosophy and organizational behavior.

41

interview with emanuel derman

t

Sunday January, 17 at 4pm Emanuel Derman is a professor at Columbia University and the director of their program in financial engineering, and is also the Head of Risk at Prisma Capital Partners, a fund of funds. Derman obtained his PhD in theoretical physics from Columbia University in 1973 and engaged in research on particle physics at Oxford University, the University of Pennsylvania and The Rockefeller University. He joined AT&T Bell Laboratories in 1980, and moved to Goldman Sachs in 1985, where he subsequently led the Quantitative Strategies group, co-developing the Black-Derman-Toy interest rate model and the local volatility model. He was appointed a Managing Director in 1997. After retiring from Goldman Sachs in 2002, Derman returned to Columbia University. He is the author of the book My Life as a Quant: Reflections of Physics and Finance.

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43

t The Transatlantic: Professor Derman, the recent crisis has shown many financial models to be utterly unreliable. What conclusions do you draw for the future of economics? Emanuel Derman: The financial crisis has indeed shown them to be unreliable but I think that most people who havent lived by using models have a massive misconception about them. So I am not surprised. Financial models only look so accurate, like a physics calculation, because they use similar mathematics and similar language. But although the syntax looks the same, the semantics is very different. In what way are models in finance different from models in physics? In physics you are dealing with the inanimate world and somehow by some unknown miracle you can write down an equation that describes the way it works. Just before I came here I was reading a biography of Dirac, the famous English physicist. He wrote down an equation that describes the way electrons behave to ten decimal places. The math looks similar to financial math ... but its hopeless to hope for the same kind of success with finance! Heisenberg, Newton, Einstein, other deep physicists, didnt just model the world, they described it in actuality: there is an identity between their equations and the

history is iMportant for huMan affairs but it isnt iMportant for physics or cheMistry. you can repeat the saMe experiMent but you cant repeat econoMic crises over and over again.
components of the universe. So for example, light satisfies Maxwells equations; very few people think that the Maxwells equations are a model for light; there is an identity between the model and the thing itself Maxwells equations are light So they are not just approximations? They may be approximations in some sense. I dont understand this completely. Newtons laws are replaced by Einstein, and so Newtons laws are approximations to something that is apparently better but nevertheless there is something incredibly accurate and, equally important, comprehensible 44

about Newtons laws. In physics people have discovered theories, quantum mechanics, for example, or Maxwells electromagnetic theory theories that seem to be almost indistinguishable from the phenomena they are describing. On the other hand physicists also make models of metals or of nuclei where you know you are making a model and that its a toy, a toy that is pretty accurate but not the thing itself: its a simplified version of it. You are always aware of the fact that you are trying to make something more Platonic that hopefully coincides with the way the thing behaves but its not actually the thing. In finance, however, there are no true theories that are identical with the phenomena; almost everything you conceive of is a model, so you are off on a bad start. Thats the way it is that is not a criticism, its a fact. Another difference: Physics models and physics theories try to predict the future, whereas finance models try to look at the present and try to tell you whats too expensive or whats too cheap right now, and they make assumptions about the future in order to tell you that. So all these models that were wrong in the crisis were making assumptions about, for example, mortgage repayments and defaults in the future to tell you what to pay for a CDO today. There are (at least) two places where this can go wrong: (1) The models can be too simplistic (will be, actually) and, on top of that, (2) they may be primed by incorrect assumptions about the values of parameters in the future, behavioral quantities like default rates or interest rates all of which are uncertain. Not only may the model be flawed but the stuff you are feeding into it may be wrong too. Would you say that only disciplines that can make predictions about the future qualify as science? Well, take biology for example. I dont know very much about biology, but evolution is not predictive. It doesnt predict the future, it explains parts of the past, not in detail but in terms of methodology. It cant tell you what will happen but it has a very plausible picture of the way things got here. Maybe we ask too much of the rest of the fields of knowledge based on the successes of a few sciences. A fundamental difference between the natural sciences and the social sciences seems to be that natural scientists can carry out controlled laboratory experiments in which they isolate cause and effect of a particular phenomenon. Unfortunately there are no such laboratories for economics. In the real world we cannot control all conditions.

As with evolutionary biology, I think that history is very important for human affairs but history isnt important for physics or chemistry. You can repeat the same experiment over and over again. However, you cant repeat economic crises over and over again because people change their behavior. So humans, unlike particles or cells, dont follow strict laws, their behavior changes. Is it then possible for economics to develop any models with a claim to truth? Its hard and probably unrealistic to make claims about the truth. I believe that economics should be a sort of moral science. Maybe it can be a quantitative science, too, but it should not be taught as though its value-free. Engineering can be value-free, to some extent, but not economics. In any event, economics has gotten much too quantitative So, is the use of mathematics not crucial for a discipline to qualify as a science? Its okay to use math in economics but the precision of the math in economics is much greater than the certainty of the assumptions or the reliability of

the models, a limitation which shouldnt be forgotten. I think it has gone overboard if you look at publications in finance or in economics, for example, they look like math articles, they have theorems and axioms and lemmas. It is a perversion of common sense. If human actions do not follow strict laws, then it seems to be very hard to do social science at all, social science that is meaningful. Yes, I suppose that is right. Ive never really been a social scientist though financial economics verges on the edge of it, but I think thats right. A young man I work with once told me that his father said that any field that has the word science in it is by definition not a science i.e. domestic science, computer science, political science, nutrition science, etc. You dont say physical science people say physics, or chemistry or biology. However, I think you can still do social science I never mean to denigrate the social sciences, theyre much harder than the natural sciences and one shouldnt get deluded into thinking that you can really be predictive or quantitative about them, or that your treatment can be value-free. 45

Do you think that a scientific paradigm shift in economics and finance is necessary to prevent future crises or do you think that crises are inevitable? I am not sure what will prevent future crises. To some extent they are inevitable, certainly in a capitalist system. For a while I thought I knew what the solution was but I dont anymore. There are too many unintended consequences. But I do think that people have to be much more cautious, allow less leverage and require more regulation. I oscillate between thinking there should be more regulation and, on the other hand, they should have let banks and other firms that were failing fail. Our financial leaders violated all the principles they espoused for others for years. I mean in 1997 or 1998 we kept telling all the emerging markets suffering capital outflows that thats the way capitalism works when they had a tough time, and as soon as it happened to us, we did the complete opposite. And it was the losses that were socialized, not the benefits. The financial sector accounts for less than 10% of the GDP. However, a disproportionately large share of the talent pool for example young scientists and engineers wants to go into finance. Will the financial sector grow larger and more important than research and development or does the talent pool need to be redirected? It is likely that too many physicists are going into finance and that the world would be better off if they did research or engineering but its not fair to tell other people what they should do with their lives. The economic incentive to go into finance has been unfortunately great, and the incentive to go into science lesser. Perhaps that will change for the better now. But still, I dislike the spectacle of talking heads or journalists who rebuke scientists for going into finance. Let those talking heads do something more useful themselves first and then advise scientists how they should spend their moral resources. It seems that economic incentives are necessary for science to flourish. Much of scientific progress occurred during the last few centuries, mainly since the industrial revolution and the introduction of intellectual property rights. However, markets often misguide research and development we spend billions of dollars on plastic surgery, viagra or hair loss but still have not been able to fight AIDS or Malaria. How can we induce science to deal with issues that are unprofitable but of major importance for a great part of the world? Thats very important, and very tough to answer. The obvious answer is money, I suppose, and pub46

lic praise and respect. It cant just be command and control. If you try running a country top-down like the Russians did, it becomes very difficult to figure out on which corner to put a restaurant or shoemaker. Free enterprise is good, letting demand drive what people do, but you need to tilt the playing field a little, as the government does every single day anyway with tax laws, etc. We dont live in a value-free unhindered economy at all. Unfortunately, there will not be research and development for something where there is no monetary incentive. Politicians can give the incentives to go into the right direction but no one can order it in peacetime. But America has become very hard to govern. There are so many people who have to agree first on what the right thing is and then to do it to build infrastructure, to improve medical services, to avoid waste, etc and there are so many people who benefit from inefficiency or misguidedness, and there are so many pressures in a free society that its hard to understand how even a politician with the right idea can get the right thing done. We need politicians with vision and the ability to lead people. You are teaching financial engineering at Columbia University. What advice do you give your students when they graduate? I warn them to avoid over-reliance on the mechanical use of models. I warn them to cultivate common sense and intuition based on solid knowledge of their field I warned them about this in my classes before the crisis. I warn them to look over their shoulder when they use a model. And I advise them to learn as much as they can about the business world. People mis-attribute the role of financial engineering in this crisis it did play a role, but business is much more than just financial models or financial mathematics. Those are tools, and they may get out of control at some point, but to be effective you should try to understand as much as possible about the business world, not just its tools, and not think that models are everything: there is no one model, which, if you just feed in the numbers, will tell you what to do. There is no crank to turn on the organ that will make the right music come out. You always have to make a judgment call. I also tell the students to learn how to explain to non-technical people what they are doing, and why, qualitatively. The business world, the whole world, runs on people talking to each other. Communication is important. t

Interview by Leoni Linek and Alexander Frantzen

there is no crank to turn on the organ that will Make the right Music coMe out. you always have to Make a judgMent call.

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