Palko writes, “When the arrogance of physicists and economists collide, it’s kind of like watching Godzilla battle Rodan . . . you aren’t really rooting for either side but you can still enjoy the show.”
Hey! Some of my best friends are physicists and economists!
But I know what he’s talking about. Here’s the story he’s linking to:
Everything We’ve Learned About Modern Economic Theory Is Wrong
Ole Peters, a theoretical physicist in the U.K., claims to have the solution. All it would do is upend three centuries of economic thought. . . .
Ole Peters is no ordinary crank. A physicist by training, his theory draws on research done in close collaboration with the late Nobel laureate Murray Gell-Mann, father of the quark. . . .
Peters takes aim at expected utility theory, the bedrock that modern economics is built on. It explains that when we make decisions, we conduct a cost-benefit analysis and try to choose the option that maximizes our wealth.
The problem, Peters says, is the model fails to predict how humans actually behave because the math is flawed. Expected utility is calculated as an average of all possible outcomes for a given event. What this misses is how a single outlier can, in effect, skew perceptions. Or put another way, what you might expect on average has little resemblance to what most people experience.
Consider a simple coin-flip game, which Peters uses to illustrate his point.
Starting with $100, your bankroll increases 50% every time you flip heads. But if the coin lands on tails, you lose 40% of your total. Since you’re just as likely to flip heads as tails, it would appear that you should, on average, come out ahead if you played enough times because your potential payoff each time is greater than your potential loss. In economics jargon, the expected utility is positive, so one might assume that taking the bet is a no-brainer.
Yet in real life, people routinely decline the bet. Paradoxes like these are often used to highlight irrationality or human bias in decision making. But to Peters, it’s simply because people understand it’s a bad deal. . . .
This is not quite a “no-brainer”; it’s kinda subtle, but it’s not so subtle as all that.
Here’s the story. First, yeah, people don’t like uncertainty. This has nothing to do with the economic or decision-theoretic concept of utility, except to remind us that utility theory is a mathematical model that doesn’t always apply to real decisions (see section 5 of this article or further discussion here). Second, from an economics point of view you should take the bet. The expected return is positive and the risk is low. I’m assuming this is 100 marginal dollars for you, not that this is the last $100 in your life. One of the problems with this sort of toy problem is that it’s often not made clear wat the money will be used for. There’s a big difference between a middle-class American choosing to wager the $100 in his wallet, or a farmer in some third-world country who has only $100 cash, period, which he’s planning to use to buy seed or whatever. Money has no inherent utility; the utility comes from what you’ll buy with it. Third, from an economics point of view maybe you should not take the bet if it requires that you play 50 times in succession, as this can get you into the range where the extra money has strongly declining marginal value. It depends on what the $100 means to you, and also on what $1,000,000 can do for you.
The above-linked argument refers to “plenty of high-level math,” which is fine—mathematicians need to be kept busy too—but the basic principles are clear enough.
And then there’s this:
Peters asserts his methods will free economics from thinking in terms of expected values over non-existent parallel universes and focus on how people make decisions in this one.
That’s just silly. Economists “focus on how people make decisions” all the time.
That said, economists deserve much of the blame for utility theory being misunderstood by outsiders, just as statisticians deserve much of the blame for misunderstandings about p-values. Both statisticians and economists trained generations of students in oversimplified theories. In the case of statistics, it’s all that crap about null hypothesis significance testing, the idea that scientific theories are statistical models that are true or false and that statistical tests can give effective certainty. In the case of economics, it’s all that crap about risk aversion corresponding to “a declining utility function for money,” which is just wrong (see section 5 of my article linked above). Sensible statisticians know better about the limitations of hypothesis testing, and sensible economists know better about the limitations of utility theory, but that doesn’t always make it into the textbooks.
Also, economists don’t do themselves any favors by hyping themselves, for example by making claims about how they are different “from almost anyone else in society” in their open-mindedness, or by taking commonplace observations about economics as evidence of brilliance.
So, sure, economists deserve some blame, both in their presentations of utility theory and in their smug attitude toward the rest of social science. But they’re not as clueless as implied by the above story. The decision to bet once is not the same as the decision to make 50 or 100 of a series of bets, and economists know this. And the above analysis is relying entirely on the value of $100, without ever specifying the scenario in which the bet is applied. Economists know, at least when they’re doing serious work, that context matters and the value of money is not defined in a vacuum.
So I guess I’ll have to go with the economists here. It’s the physicists who are being more annoying this time. It’s happened before.
The whole thing is sooooo annoying. Economists go around pushing this silly idea of defining risk aversion in terms of a utility curve for money. Then this physicist comes along and notes the problem, but instead of getting serious about it, he just oversimplifies in another direction, then we get name-dropping of Nobel prize winners . . . ugh! It’s the worst of both worlds. I’m with Peters in his disagreement with the textbook model, but, yeah, we know that already. It’s not a stunning new idea, any more than it would be stunning and new if a physicist came in and pointed out all the problems that thoughtful statisticians already know about p-values.
OK, I guess it would help if, when economists explain how these ideas are not new, they could also apologize for pushing the oversimplified utility model for several decades, which left them open to this sort of criticism from clueless outsiders.