Consider the following proposition: I’ll give you 1 million dollars for sure or a 50:50 chance at 2.1 million dollars. What’s your choice? If you’re like me, you’ll choose the certain 1 million. Yet, that is a violation of core economic theory that became known as the “Allais Paradox” based on the pioneering work of Maurice Allais in the 1950′s, who received the Nobel Prize in Economics in 1988.
The Allais Paradox provides a nice way to begin understanding the gap between economics and evolution. Using the notation that I introduced in E&E I, if A=the assumption that people maximize their mean expected utility and A’=the assumption that people are also sensitive to the variance in addition to the mean, then A’ is clearly superior to A as a description of our species. Call it evolution, psychology, common sense, or whatever you like. If core economic theory is a collection of assumptions (ABC), and if science is an incremental process, then the transition from ABC to A’BC should be straightforward. What Allais established would be progress, not a paradox. Instead, something about A’ made A’BC more problematic than ABC, interfering with incremental scientific progress. What was it?
Milton Friedman‘s classic paper “The Methodology of Positive Economics“, which was also published in the 1950′s, suggests at least three contributing factors:
1) An ideal of economic theory as like geometry or classical physics, complete with theorems that can be formally derived from each other. This sounds good but it can’t even be achieved for modern physics. Trying to achieve it results in such a restrictive set of assumptions that incorporating more realism is mathematically intractable.
2) The correct observation that models are simplifications that need not be realistic in every respect. A more realistic assumption is only worth incorporating into a model if it makes a difference for meaningful predictions that the model is trying to make.
3) An extremely lax set of criteria for comparing alternative models on the basis of evidence. Friedman wrote as if alternative models could be straightforwardly compared on the basis of evidence, resulting in incremental scientific change, but here is how he described the evidence for core economic theory:
An even more important body of evidence for the maximization-of-returns hypothesis is experience from countless applications of the hypothesis to specific problems and the repeated failure of its implications to be contradicted. This evidence is extremely hard to document; it is scattered in numerous memorandums, articles, and monographs concerned primarily with specific concrete problems rather than with submitting the hypothesis to test. Yet the continued use and acceptance of the hypothesis over a long period, and the failure of any coherent self-consistent alternative to be developed and be widely accepted, is strong indirect testimony to its worth.
If this isn’t a recipe for confirmation bias, what would be?
Against this background, we can begin to see why the Allais paradox posed such a threat to core economic theory. It violated the principle of maximization of returns, it could not easily be incorporated into the body of formal analytical theory, and it was a move toward realism that would definitely have consequences for economic predictions.
The lax criteria for comparing alternative models made it easy for proponents of core economic theory to ignore the Allais paradox. If risk sensitivity can’t easily be incorporated into the formal analytical framework, then it can’t become a coherent self-consistent alternative within the framework. Continued use and acceptance of a hypothesis over a long period testifies to its worth only when scientific change is incremental. An inferior paradigm can persist forever because it resists incremental change, like a local equilibrium in complexity theory or an adaptive peak in evolutionary theory. Longevity is no proof whatsoever of explanatory or predictive power.
Maurice Allais knows what it’s like for a paradigm to resist change. Here’s a passage from the entry that he wrote for the Allais paradox in the New Palgrave Dictionary of Economics (1987):
For nearly forty years the supporters of the neo-Bernoullian [expected utility] formulation have exerted a dogmatic and intolerant, powerful and tyrannical domination over the academic world; only in very recent years has a growing reaction begun to appear.” …”[The Allais paradox] is fundamentally an illustration of the need to take into account not only the mathematical expectation of cardinal utility, but also its distribution as a whole around its average, basic elements characterizing the psychology of risk.
The fact that Allais became a Nobel laureate in 1988 does not mean that he prevailed. In the next post, I will present a more recent example of how core economic theory still can’t seem to move in the direction of greater realism, even when it makes a huge difference for meaningful predictions that the models are trying to make.
I thank John Gowdy for bringing the Allais paradox to my attention, along with the other economists involved in the EI’s Nature of Regulation conference, for discussions and readings that provided the material for this post. It should be clear any field as large as economics or evolution is heterogeneous and that a sizable minority of economists are trying to move their field in the direction of greater realism, including integration with evolutionary theory. This discussion of the paradigmatic nature of economics and evolution will hopefully facilitate their efforts.
To be continued.