Don't Listen to What People Say. Watch What They Do.

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I was recently reading a book on war in which the authors note that the justifications for war are often meant to inspire a willingness or a desire to fight. As a result, the justifications for war might have some relationship with the reasons that the war is being fought, but justification and explanation are not exactly the same. This is not to say that the justifications are necessarily false, but rather that the justifications need not correspond with a careful analysis of cause and effect.

To some extent this is a description of a long-known problem in the study of human affairs. Herodotus, for example, is simultaneously known to us as the “father of history”, but also as someone who is considered an unreliable narrator in some respects.

What struck me about this argument is that it was very Alchian-esque. Don’t listen to what people say, watch what people do. The careful reader will recognize that Brian and I make statements like this often. However, today I would like to explore this statement a bit.

A few decades ago, economist Truman Bewley set out to write a book on why wages don’t decline during recessions. In the process, he went around and interviewed businessmen, union leaders, and others. In general, I think that this can be a useful exercise. However, I have always found the way that economists talk about this book to be a bit bizarre. For example, the way the book was first described to me (and has been many times since) was that “it is a book in which an economist actually went and talked to people. Imagine that!”

The inference is apparently that economists should go out and talk to more people. But should they? To the extent to which academics are completely detached from the real world, perhaps they should. Let’s set that issue aside. One consistent finding that Bewley stumbled upon by talking to people is that firms tended to avoid lowering wages because they didn’t want to lower the morale of the workers. As someone who grew up in a blue collar town, this finding didn’t seem all that surprising.

Nonetheless, one doesn’t need to have had that real world experience to understand the point. There is a basic price theoretical point here. Workers might prefer a constant wage for a given level of effort even if it means they might experience periods of unemployment to a scenario in which wages fluctuate with business cycle in the same way that consumers might prefer constant prices for a given level of quality even if it means they have to periodically wait in long lines. This doesn’t seem all that crazy to me. Imagine showing up at work each day and being expected to put forth the same level of effort, but one’s hourly wage is determined by the firm’s estimate of demand or something like a lagged measure of sales. In that context, it is not hard to imagine that workers might prefer occasional periods of unemployment to their wage always fluctuating in conjunction with the market-clearing wage.

At the same time, if the firm has two options to cut costs (reduce wages or lay off workers), they should choose the less costly option. Remember that costs are not just accounting costs. It is easy to create a wage cut that is equal to the reduction in payroll from laying off workers, but there are other costs. If wage cuts reduce morale and/or effort more than layoffs, then it is not surprising that firms would choose the less costly option.

Thus, contrary to some of the blurbs on the back of the book, Bewley’s findings don’t require us to dismiss any of the basic tenets of economics.

Although it might sometimes be useful to ask people why they make particular decisions, it is not clear to me how much value or understanding one gets from that. I’ve discussed this before when I argued that you shouldn’t ask people why prices are rising. When you ask these questions, people are going to answer based on the knowledge that they have. However, the knowledge that they acquire in their day-to-day life might lead an economist to draw the wrong conclusion. For example, firms experiencing an increase in the demand for their product might blame rising costs for their decision to increase their price without realizing that the rising costs are the result of greater competition for inputs caused by the increase in demand for the output good. But knowledge of the supply and demand model can actually help the economist to figure out what is going on by looking at prices and quantities in both the output market and the input market.

This insight that one should watch what people do rather than listen to what they say is grounded in the fact that economics is fundamentally about the study of human action. The job of an economist is to be able to explain and understand these actions. Tools like supply and demand help us to understand the actions that people take and why particular prices are changing. The supply and demand model doesn’t require that anyone other than the economist understands the model. On the other hand, asking someone why they raised their price or why they bought less gasoline this month might provide misleading answers — even if the person is truthful and answering the question in good faith. The meaning of some of the answers might only be decipherable to those who understand supply and demand.

That point is important because a common erroneous critique of economics is that we economists assume that everyone is just a rational, calculating actor. As I have discussed before, that is wrong. Economists use rational models, they do not assume rational actors. If I see a rock sitting in my yard, I can confidently predict it will remain sitting in my yard without any belief that the rock understands Newton’s First Law of Motion. In the same way, I can confidently predict that when the price of a good rises, the quantity demand for that good will decline regardless of whether any given consumer understands the Law of Demand. It is the framework that is rational, not the subject.

As a study of human action, this also means that economics is not the study of human cognition or human desire. That doesn’t mean that these things are not worthy of study or that better understanding of cognition and desire couldn’t improve the predictive power of certain economic frameworks. It is important to note though that even fields like behavioral economics, which is sold as dispensing with notion of rational economic actor, use rational frameworks to draw conclusions and make predictions.

The value of economics is in the predictive power of the models. The purpose of Economic Forces is to point out just how much explanatory and predictive power that one can generate from simple price theoretic models. Those models are not models of how people think. They are models of what people do.