Sunday, April 04, 2010

Envy is good. Envy is Right. Envy Works.

Mr. Falkenstein writes a wonderful essay identifying Envy as the driving force of most human behavior (I would characterize it as something else, but the point here is that there is no such thing as utility maximizing "homo econimus" as it is not objective wealth maximization that is the goal but relative status and position. This of course begs the question of "status for what purpose?").

Many, many good observations. One particularly poignant passage for me is reproduced below.

Economists strongly prefer the idea that people are merely wealth maximizing agents because this generates tractable models, and economists are primarily modelers. Envy would invalidate many models, if not entire subdisciplines, because in that case one cannot aggregate preferences into one person, as it makes no sense to talk about the aggregate happiness of people, when their happiness depends mainly on their relative positions. Economists like to add these curiosities outside models, but clearly the objective function to maximize GDP is misleading if envy is very important. As the old can opener joke goes, economists like the assumption because it generates nice answers.

So, over the years, economists have become good at defining exactly what kind of utility allows them to generate tractable models. While some assumptions, such as assuming everyone has the same beliefs and preferences, have been attacked, they generally haven't made much of a difference. But these are rather small compared to the idea that the utility function people are maximizing has 'constant relative risk aversion'. The idea here is that while we think it fundament that people have utility increasing in wealth at a decreasing rate, the specific functional form is actually highly circumscribed.

The problem is, we know that the utility curve becomes come much flatter as one rises in wealth, implying rich people are almost indifferent to wealth, and almost indifferent to risk. It seems implausible that risk preferences for you average person have declined over the past millenium, or century, as this would be reflected in all sorts of prices like the 'risk free rate, which has not changed considerably over the past 150 years. So, economists discovere we must have 'constant relative risk aversion', so that 'risk' is relatively the same regardless of how much wealth you have: a 10% gamble always much feel the same. If risk preferences were not of this sort, one can be presented with a series of risks, each of which one finds acceptable, that lead one into any position; the other party—say, the casino management—can always make a profit, and essentially "pump" money out of players. While some people undoubtedly are like that, the population in the aggregate cannot be, or the economy would grind to a halt forever. The modern notion of risk aversion that does not lead to an absurdity is that we value wealth via a function x^(1-a)/(1-a) (where a is the risk aversion constant), because only that function would imply the consistent interest rates we have seen over the past thousand years. How plausible is it that humans have this kind of mathematically precise instinct?

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