Faith in Homo Economicus Restored

By Kelvin Tai - Economics and Management Student @ Harris Manchester College, Oxford

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To those who are unfamiliar with economics, it may seem an antiquated theoretical subject that is largely based on an unrealistic model of humanity – the homo economicus – a selfish man grasping for his own self-interest and self-interest alone, with an unlimited capacity for rational decisions. This is commonly attributed to Adam Smith’s description of the Invisible Hand, so claimed because the functioning of the free market occurs without central coordination, but through the pursuit of self-interest.

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.” – Adam Smith

The Theory of Moral Sentiment is a lesser known work of Adam Smith, where he explores moral actions as a result of social psychology. He is not a proponent of humanity being a cold-hearted species but instead acknowledges that people are often altruistic.

“How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.” – also Adam Smith

Economics often assumes that agents seek to maximise their utility. However, utility does not actually relate strictly to the consumption of goods or the increase of self-interest. The utility function can be expanded to encompass the interests of others; utility is but a tool to gauge the behaviours of economic agents and predict their actions based on consistent past behaviour. Economic agents have been shown to display a preference for fairness, reciprocity and altruism.

1. Altruism can be observed through Dictator Games. A player is offered a sum of money and can choose to give any amount to another. While the rational actor might choose to give nothing, most people do give a considerable amount (though often less than 50%)
   

2. Reciprocity has been demonstrated in Ultimatum Games. In these games, a person is offered a sum of money and can choose to allocate a portion to another person. Only if the latter accepts the portion will both receive the money. While the rational agent would only give a token sum and that person would accept (a token sum is better than nothing), real-life experiments have shown that people tended to react negatively to unfair treatment
   

3. Fairness or inequality aversion has been tested through a variation of the Ultimatum Game, where a third party holds the veto power instead of the player receiving the allocation. This third party has to pay a certain amount to stop the first player from receiving anything. Instead of holding back out of self-interests, many third-party players will pay to punish what they view as unfair behaviour.

These quirks can be modelled in a utility function. Instead of being a function of an individual’s payoffs, the utility function can include the payoffs of others or a penalty if any payoff differs from the average, which reflects an aversion towards inequality. For those considering the study of Economics, be assured that the pedagogy is definitely not as heartless as commonly portrayed.

Further reading:

1. Smith, Adam, and Knud Haakonssen. The Theory of Moral Sentiments. Cambridge, 2002. Cambridge Texts in the History of Philosophy. Web.

2. Hoffman, Elizabeth, Kevin McCabe, and Vernon Smith. "Ultimatum and Dictator Games." The Journal of Economic Perspectives (1986-1998) 9.4 (1995): 236-239. Web.

3. Gürtler, Marc, and Gürtler, Oliver. "Inequality Aversion and Externalities." Journal of Economic Behavior & Organization 84.1 (2012): 111-17. Web.