PHILOSOPHY OF ECONOMICS

Why would philosophers be interested in economics? There are at least two answers. First, lessons from economics bear directly on moral and political philosophy, as well as on theorizing about rationality. Second, economics provides a case study of some of the most challenging problems in the philosophy of science.

Economics as Moral Philosophy

What is the ethical basis of economics? If economics is grounded in a theory of the right, what kind of theory is it? Is it a theory of the right grounded in a utilitarian conception of the greatest good for the greatest number, or a Kantian conception of the sovereignty of individual economic agents? Or, if economics is grounded in a theory of value, is the value to be understood in utilitarian or contractarian terms (as an aggregate, or as a matter of mutual advantage)?

plato

Alfred North Whitehead described philosophy as a series of footnotes to Plato. What about economics? Plato's Republic describes the emergence of a society not by social contract or by conquest but spontaneously, through the workings of the market. "The barest notion of a state must include four or five men" (Book II, 369D). People need food, shelter, and clothing, but "all things are produced more plentifully and easily and of a better quality when one man does one thing" (Book II, 370B). People thus start to specialize in farming, carpentry, and weaving. It quickly becomes obvious, though, that "more than four citizens will be required, for the husbandman will not make his own plough … Neither will the builder make his tools—and he too needs many; and in like manner the weaver and shoemaker" (Book II, 370C). Commercial society thus emerges as an unplanned consequence of the transparent advantages of the division of labor.

adam smith

In more substantial ways, economics is a footnote to yet another philosopher, born some twenty centuries later. It was Adam Smith, professor of logic and of moral sciences at the University of Glasgow, whose work led more or less directly to the rise of economics as a separate academic discipline. The first three chapters of Smith's Wealth of Nations (1981 [1776]) explain the role that division of labor plays in a prosperous society, culminating in a brilliant critique of protectionist trade policy. Using the manufacture of pins as an example, Smith notes that a solitary worker could scarcely make one pin per day, but in a pin-making factory employing ten workers, "one man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head … ; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations … Those ten persons, therefore, could make among them upwards of forty-eight thousand pins a day" (p. 15).

Smith then explains how the division of labor is facilitated by the propensity to truck and barter. We do not build factories for our own personal consumption. We specialize to that degree only when we have opportunities to serve large communities. Smith's next insight is that the extent of specialization is limited by the size of the market. A rural carpenter specializes in anything made of wood; a carpenter in a large city specializes in residential house construction; a carpenter serving national and international markets can specialize in making childproof doorknobs. The wealth of nations depends on economic agents being able to reach far beyond their small circle of friends. The farther they can reach, the larger the markets they can reach both as producers and as consumers, the greater will be the division of labor, and the richer they and everyone with whom they trade will be. Because economic agents work with suppliers, distributors, and customers on a global scale, they can produce thousands of pins a day, rather than a small handful at best.

The homage Smith pays, then, is not so much to the self-interest of butchers and bakers as to the division of labor that enables artisans to continuously be renewing, reinventing, and extending the limits of their craft. These opening chapters of Wealth of Nations are perhaps the most insightful part of the most insightful work of economics ever written.

Smith's most pointed argument on behalf of a lightly regulated economy, though, is probably to be found in his less famous work, The Theory of Moral Sentiments (1976 [1759]). There, Smith argues that a "man of public spirit" will not be a fanatical reformer but instead "will respect the established powers and privileges even of individuals, and still more those of the great orders and societies … When he cannot conquer the rooted prejudices of the people by reason and persuasion, he will not attempt to subdue them by force" (p. 223). By contrast, a "man of system," "is apt to be very wise in his own conceit, and is often so enamored with the supposed beauty of his own ideal plan of government that he cannot suffer the smallest deviation from any part of it. He goes on to establish it completely and in all its parts, without any regard either to the great interests, or to the strong prejudices which may oppose it. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess board. He does not consider that the pieces upon the chessboard have no other principle of motion besides that which the hand impresses upon them; but that in the great "chess board" of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might choose to impress upon it" (1976 [1759], p. 234).

smith's legacy

Smith anticipates Marx in expressing reservations about the alienating aspects of repetitive labor in a factory setting. Smith also comes close to anticipating James Buchanan and Gordon Tullock's insight (1962) that legislators respond to incentives as much as anyone else does—that legislators are not philosopher-kings, above the fray, but instead make their moves on a chess board of society, like everyone else. None of the pieces gets to decide where all the other pieces will be at a given moment. Political order, like economic order, biological order, or any other complex order, will take its shape not because any particular designer intended it to take that shape, but simply because that is what happened when the pieces came together, all with plans of their own. The insight of Smith, Buchanan and Tullock, and others, is that our world is strategic—all the way up. Even a country's most powerful politicians can do no more than hope to exert some influence. It is hard to incorporate this insight into moral and political philosophizing. What would it be like to develop a theory of how to live, and how to pursue social change, in a world where no one is in charge?

Alexander Rosenberg (1988) observes that the products of natural selection are exquisitely functional and almost unimaginably complex, despite no one being in charge. Unplanned economies likewise are functional, indeed typically more functional than centrally planned ones. How is this possible? Friedrich Hayek (1994) argues that a free economy economizes on rationality, morality, and knowledge in a way that a central plan cannot. Central planning models assume central planners will know what they need to know, and will use such knowledge wisely, and for purposes other than their own. Starting with such assumptions, advocates of central planning aim to invest planners with enough power (to implement the "right" decisions) that other agents with less benign plans will be unable to interfere. Unfortunately, giving central planners that much power to do the right thing also gives them that much power to do the wrong thing: to repay debts to their most powerful supporters, to cover up mistakes, to eliminate enemies (anyone who criticizes them), and so on. According to Hayek, there is a fatal conceit involved in thinking that economies would work better if, per impossible, central planners were in charge.

To Ludwig von Mises (the other main protagonist in the "Socialist Calculation Debate," along with Hayek), economics is a value-free, a priori science, more or less like mathematics. But Daniel Hausman and Michael McPherson (1996) plausibly conclude that, "economics remains partly a moral science. It can't be done without moral presuppositions, and it's hard to do it well without addressing moral issues intelligently. Similarly, moral philosophy can't be done without beliefs about human interactions, and it's hard to do it well without knowledge of the kind that economists seek" (p. 8). For example, Hausman and McPherson ask whether market competition results in firms with moral scruples being driven into bankruptcy. They give several reasons to think the answer is no, but their main point is simply that the question matters, and matters in economics, not only in moral philosophy. It bears whether there is any point in being in favor of the market competition that economists study.

Extending Hausman and McPherson's point, and relating it back to Adam Smith, if a firm would need to dominate a small town market in order to do a profitable volume of business, it may find itself needing to cater to the interests of a "lowest common denominator." Or at least, the firm that survives to serve that small market in the long run will be the one that best serves the majority of clients in that small market. By contrast, if a firm can operate on a global scale (advertising on the Internet, perhaps), then capturing even 1 percent of the market can be hugely profitable. In this way, globalization makes possible a proliferation of specialized firms catering to especially discerning clientele, raising free-range poultry, growing organic broccoli, auctioning nineteenth-century German marbles, manufacturing parachutes out of recycled newspaper, or whatever entrepreneurs think of next. (Israel Kirzner, a student of Mises, criticizes how standard equilibrium models treat entrepreneurial innovation. As Kirzner sees it, standard models treat innovations as exogenous shocks, when in fact entrepreneurial innovation is a central driving force in all but the most repressive states, which is why real economies are always in disequilibrium.)

Economics as Science

Lionel Robbins (1935) defined economics as "the science which studies human behavior as a relationship between ends and scarce means which have alternative uses" (p. 16). It is amazing how much can be derived from a premise that economic agents put scarce resources to their most efficient use. But is the premise true? Milton Friedman (1984) seems to say it makes little difference; the unrealism of a theory's assumptions are unimportant, so long as the theory's predictions are correct. Hausman describes Friedman's essay as the most influential work on economic methodology of the twentieth century. Analogously, Hausman says, Ptolemy's astronomy is still used for navigational purposes. Is Hausman right? The idea is theory-laden, and more technical than it appears. It is true that the Copernican revolution did not require us to make any radical changes in our ways of navigating, but is that like saying our navigational methods are premised on the earth being at the center of the universe? Probably not, but Hausman's main point still stands: We do not need to know the rock-bottom truths of astronomy, astrophysics, or anything else in order to have theories that track relevant facts well enough to enable us to navigate. Likewise, in economics, the statement that economic agents are pursuing their own self-interest is close enough to the mark for many purposes, and accordingly has, for many purposes, a lot of explanatory and predictive power. We better understand much of what we see around us when we grasp that self-interest is a more or less ubiquitous motive. Yet, we also see every day that people are motivated by things other than self-interest: by benevolence, vengefulness, and also (as Hobbes observed) by pigheaded, self-destructive vainglory.

the scientific attitude

One of the biggest methodological blunders we could make would be to retreat from this messy empirical reality to the empty platitude that people do whatever they do, and this is all we really mean when we say all action is self-interested. When we give up the willingness to let our generalization be tested (and sometimes disconfirmed) by reality, we also give up the generalization's relevance as a tool for understanding reality. As a sometimes disconfirmed generalization, the postulate of self-interest lets us know when to regard a behavior as surprising, worthy of scientific curiosity, and so on. We may find that seemingly altruistic behavior turns out to be, in some previously unnoticed way, self-interested after all. But so long as we avoid the trap of assuming this must be the case, no matter what, we leave ourselves open to learning something new. (The new direction of progress may not be economics per se. New directions tend to evolve into new sciences. Just as moral philosophy helped spawn economics, economics can help spawn new disciplines or subdisciplines.) Meanwhile, so long as we understand the postulate of self-interest as a simplification of reality, one that abstracts from messy empirical details, the postulate will be useful.

Karl Popper sought to distinguish between science and nonscience. The real issue is about scientific attitude—whether a theory's proponents treat the theory as something to scrutinize rather than to zealously defend. In any case, it is hard to confirm an economic theory, or any other kind of theory. We give theory a chance to fail, and are impressed by and more confident in it as it survives repeated testing. But as scientists we acknowledge that surviving a test does not put us in a position to be supremely confident. Real science does not work that way; its fruits are not indubitable certainties.

What are the limits of a general theory's ability to help us understand? Daniel Little suggests, "The abstract analysis of the firm based on rational agents arriving at efficient outcomes must be supplemented with more detailed analysis of the specific circumstances and arrangements within which the firm took shape" (1995, p. 6). This is not a throwaway line but is in fact rather disturbing. It suggests there are severe albeit vague limits on the prospects for general explanation.

In the same way, one might see the history of philosophy as pointing to a similar conclusion. Namely, the search for general explanations, general theories, even general definitions, has a history of butting up against recalcitrant limits. There is a point to analyzing knowledge as justified true belief; yet, we now know of cases where this analysis is not good enough. It seems that no matter how much we tweak a theory or a definition, perfection is not an option. When cartographers try to map a three-dimensional terrain by projecting it onto two dimensions, there is no such thing as a representation of the terrain without distortion. A Mercator projection makes Greenland look as large as Africa, and anything we do to correct this distortion of relative size will distort something else in the process. This is an example of a problem for which a perfect solution simply does not exist, and theorists in all sorts of philosophical disciplines, confident though they may be that there is an objective truth about the three dimensional terrain out there, and that their job as theorists is to provide an accurate map of that objective reality, are finding themselves facing the reality that, as a rule rather than as an exception, there are no perfectly accurate theories. Our theorizing needs to be supplemented by knowledge of the local terrain. There is no denying our need for practical wisdom, or as Little puts it, for "detailed analysis of specific circumstances and arrangements" (1995, p. 6).

economics as an experimental science

Experimental economics starts with the idea that economic hypotheses are testable in replicable ways in laboratory settings. What is an experiment? What is a theory? What would count as testing a theory? When we test a theory, are we trying to prove it, or disprove it? Are the meanings of economic concepts exhausted by their verification conditions, or are economic theories important and meaningful apart from any efforts we make or could make empirically to test them?

For example, Hausman says, "one might argue that preferences and beliefs are in some sense unobservable" (1984, p. 15). But inferential bases for the ascription of preferences can rather unambiguously be observed in laboratory settings. Experimental subjects can be given opportunities to buy and sell "widgets" that are stripped of all properties other than resale value—the widgets are nothing more than entries on a computer-kept ledger. Experimenters specify those resale values (that is, how much money subjects will be paid for any widgets they possess at the end of the experiment). Thus, much information that is hidden outside the laboratory can be known and controlled in a laboratory setting, enabling researchers to draw reasonably well-grounded inferences about subjects' motives and strategies.

For example, if we interpret subjects as being in a prisoner's dilemma situation, such that declining to cooperate is a dominant strategy, and then we see subjects cooperating instead, we are free to hypothesize that the situation is not really a prisoner's dilemma, retreating to a view that by definition subjects will act to maximize their payoff, and therefore by definition subjects will decline to cooperate in a genuine prisoner's dilemma. In a laboratory setting, we can do better than that. We can specify all the payoffs and communicate them unambiguously to experimental subjects. We can train them over a sequence of trial runs to make sure they understand their situation. Then we can observe and learn. If subjects do not behave as our theories predict, or if 60 percent behave as predicted and 40 percent do not, then so be it. There is no such thing as being in a situation where there is exactly one theory that fits the observed facts. It is a truism in philosophy of science that any given set of observations will be compatible with an infinite number of theoretical explanations.

Nevertheless, what we learn to accept in the laboratory is that subjects do not consistently act to maximize their monetary payoff. They show inclinations to cooperate, to trust, to be "fair," and so on, that go beyond anything it is reasonable for us to try to explain in terms of the hypothesis that subjects are acting to maximize their monetary payoff. We can even design the experiment so as to yield fine-grained information about why subjects decline to cooperate, when they do. For example, we can suppose that the two main reasons not to cooperate in a prisoner's dilemma are greed (the preference to get the good for free when one expects others to cooperate in producing the good) and fear (the preference not to cooperate when one expects others not to). In the field, it may be impossible to tell the difference between greed and fear, since all we observe is whether subjects are cooperating. Laboratory experiments, though, can be designed to tell the difference. That is, we can go beyond the hypothesis that everyone will defect when defection is a dominant strategy to test the hypothesis that when people defect, it is because they are afraid their partners will defect, not because they hope to exploit partners who cooperate. In the laboratory there is much defection, but also much cooperation, and much more cooperation when fear is eliminated as a motive for defection, even when the motive to free ride is left untouched, indeed, even when defecting remains a dominant strategy (see Mark, Schmidtz, and Walker 1989). Perhaps this takes us from economics proper into fields such a psychology, sociology, and so on. But economists probably should find move encouraging, inasmuch as it indicates that their simplest behavioral postulates, in virtue of being disconfirmable (and sometimes disconfirmed), are at the same time fruitful and interesting.

environmental economics and environmental philosophy

Environmental economists are presumed to be advocates of conservationist "wise use" policies, where environmental philosophers are presumed to be advocates of preservationist "no use at all" policies regarding scarce environmental assets. Perhaps the picture never was this simple, but in any case it is changing. Philosophers like Bryan Norton (1991) and Mark Sagoff (2004) are, in various ways, going beyond simple dichotomies in search of new policy paradigms that make sense from both long-term environmental and medium-term economic perspectives.

the psychological and institutional prerequisites of market economies

Since the fall of the Soviet Union, and the subsequently mixed results of formerly communist countries in establishing market economies, wiser and humbler economists have been exploring the idea that market economies cannot be invented, manufactured, or decreed but must instead be treated as organically evolving systems that grow over time. Citizens of the former Soviet Union, it seems, do not understand instinctively how to behave as market agents. If they grow up in a world where the only examples of entrepreneurship involve bribery and theft, then they will think of entrepreneurs as a species of predator and will not grasp the concept of mutual advantage in the way that owners of small businesses in free countries do.

economics of culture

Economists likewise have begun to turn their attention to the intertwined evolution of economy and culture. Explosions of cultural innovation seem to occur in cities that are at the same time undergoing explosive growth as worldwide commercial centers.

beyond homo economicus

As noted earlier, the postulate of self-interest is most illuminating when treated as a testable empirical hypothesis, so that when behavior fails to conform, it will not simply be ignored but will instead be seen as of scientific interest. One of many cases in point is the "ultimatum" game. Two subjects are assigned the task of dividing a fixed amount of money. The first subject, Proposer, makes a proposal about how to divide the money. The second subject, Responder, has two options: reject the proposal, in which case neither subject gets anything; or accept the proposal, in which case the subjects split the money as proposed. The game is not repeated, so a Responder who is rational as per the Homo economicus model ought to accept any proposal that offers Responder a positive payoff. A bit more tenuously, Proposer, expecting Responder to be rational as per the Homo economicus model, ought to offer responder the smallest possible positive payoff. In fact, neither of these predictions is born out in the laboratory. Proposers most commonly offer to split the money fifty-fifty. Cristina Bicchieri (2005) reports that in a variety of trials and conditions, including in different cultures, responders tend to reject offers below 20 percent of the total, even when the stakes are substantial relative to prevailing wage rates in the subjects' community.

neuroeconomics

Kevin McCabe tested a variation of the ultimatum game while recording subjects' brain activity with functional MRI (Kevin McCabe, et al, 2001). In some trials, subjects were informed that their partner was a computer program playing a fixed probabilistic strategy; these were paired with trials where subjects were informed that their partner was another human subject. Roughly half the subjects chose not to cooperate with human partners. Their brain activity was similar in the computer partner and human partner trials. Subjects who did cooperate, roughly half the total, showed markedly greater brain activity in the prefrontal cortex. The implication: subjects who cooperate are not treating trials with human partners as situations calling simply for payoff calculation. The prefrontal cortex is thought to be the part of the brain dealing with social situations, not with arithmetic calculation. Cooperators evidently are treating the transaction not only as an economic exchange but also as a social exchange, calling for empathetic understanding of the motivations of another agent. It is too early to say where this line of research is leading, but it suggests we may hope some day for a unified explanation of departures from the postulate of self-interest, including the above-reported departures from dominant strategy in the prisoner's dilemma. That is, subjects who do not conform to the predictions of Homo economicus models may be departing from the models in virtue of perceiving the situation as calling not for calculation of their possible payoffs, but instead for something else, such as an exchange of tokens of mutual respect. In any case, our sensitivity to economic motives is a variable. What gets us to focus on the economic bottom line—the numbers—rather than on friendships, grudges, self-esteem, status, and so on, is interestingly complex.

See also Decision Theory; Game Theory; Philosophy of Social Sciences.

Bibliography

economics as moral philosophy

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Coase, Ronald. Essays on Economics and Economists. Chicago: University of Chicago Press, 1994.

Gauthier, David. Morals By Agreement. New York: Oxford University Press, 1986.

Griswold, Charles. Adam Smith and the Virtues of Enlightenment. New York: Cambridge University Press, 1999.

Hausman, Daniel M., and Michael S. McPherson. Economic Analysis and Moral Philosophy. Cambridge, U.K.: Cambridge University Press, 1996.

Hayek, F. A. Road to Serfdom. Chicago: University of Chicago Press, 1994.

Kirzner, Israel. Competition and Entrepreneurship. Chicago: University of Chicago Press, 1973.

Mises, Ludwig. "Economic Calculation in the Socialist Commonwealth." In Collectivist Economic Planning: Critical Studies of the Possibilities of Socialism, edited by F. A. Hayek, 87–130. London: Routledge & Kegan Paul, 1935.

Plato. Republic and Other Works. Translated by B. Jowett. New York: Anchor Books, 1973.

Rosenberg, Alexander. Philosophy of Social Science. Boulder, CO: Westview Press, 1988.

Sen, Amartya Kumar. On Ethics and Economics. Oxford, U.K.: Blackwell, 1987.

Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations [1776], edited by R. H. Campbell and A. S. Skinner. 2 vols. Indianapolis: Liberty Fund, 1981.

Smith, Adam. The Theory of Moral Sentiments [1759], edited by D. D. Raphael and A. L. Macfie. Indianapolis: Liberty Fund, 1976.

economics as science

Friedman, Milton. "The Methodology of Positive Economics." In Philosophy of Economics, edited by Daniel M. Hausman, 210–244. New York: Cambridge University Press, 1984.

Hausman, Daniel M., ed. The Philosophy of Economics. New York: Cambridge University Press, 1984.

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Little, Daniel. Varieties of Social Explanation. Boulder, CO: Westview, 1991.

McCloskey, Deirdre. The Rhetoric of Economics. 2nd ed. Madison: University of Wisconsin Press, 1998.

Robbins, Lionel. An Essay on the Nature and Significance of Economic Science. 2nd ed. London: Macmillan, 1935.

experimental economics

Mark, Isaac R., D. Schmidtz, and James M. Walker. "The Assurance Problem in a Laboratory Market." Public Choice 62 (1989): 217–236.

Smith, Vernon. "Constructivist and Ecological Rationality in Economics." Nobel Prize lecture, December 8, 2002.

environmental economics and philosophy

Norton, Bryan. Toward Unity among Environmentalists. New York: Oxford University Press, 1991.

Sagoff, Mark. Price, Principle, and the Environment. New York: Cambridge University Press, 2004.

Schmidtz, David. "When Preservationism Doesn't Preserve." Environmental Values 6 (1997) 327–339.

psychological and institutional prerequisites of market economies

Brennan, Geoffrey, and Philip Pettit. The Economy of Esteem: An Essay on Civil and Political Society. Oxford: Oxford University Press, 2004.

Fukuyama, Francis. Trust: The Social Virtues and the Creation of Prosperity. New York: Free Press, 1996.

North, Douglass. Institutions, Institutional Change and Economic Performance. New York: Cambridge University Press, 1990.

economics of culture

Appiah, Kwame Anthony. In My Father's House: Africa in the Philosophy of Culture. New York: Oxford University Press, 1992.

Cowen, Tyler. Creative Destruction: How Globalization Is Changing the World's Cultures. Princeton, NJ: Princeton University Press, 2002.

Cowen, Tyler. In Praise of Commercial Culture. Cambridge, MA: Harvard University Press, 1998.

beyond homo economicus

Bicchieri, Cristina, The Grammar of Society: The Nature and Dynamics of Social Norms. New York: Cambridge University Press, 2005.

Guth, W., R. Schmittberger, and B. Schwarze. "An Experimental Analysis of Ultimatum Games." Journal of Economic Behavior and Organization 3 (1982): 367–388.

Henrich, Joseph, Robert Boyd, Samuel Bowles, Colin Camerer, Ernst Fehr, Herbert Gintis, and Richar McElreath. "In Search of Homo Economicus: Behavioral Experiments in 15 Small-Scale Societies," American Economic Review, 91 (2001): 73–79.

Kahneman, Daniel, and Amos Tversky. "Choices, Values, and Frames." American Psychologist 39 (1984): 341–350.

Schmidtz, David. Rational Choice and Moral Agency. Princeton, NJ: Princeton University Press, 1995.

Simon, Herbert. Models of Bounded Rationality and Other Topics in Economics. Cambridge, MA: MIT Press, 1982.

neuroeconomics

McCabe, Kevin, Daniel Houser, Lee Ryan, Vernon Smith, and Theodore Trouard. "A Functional Imaging Study of Cooperation in Two-Person Reciprocal Exchange." Proceedings Of the National Academy of Science 98 (2001): 11832–11835.

David Schmidtz (2005)