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P. R. Brahmananda

Despite the blending of historical method with quantitative economics, the inability to conduct a controlled experiment has remained a basic weakness in economics. The Nobel memorial awardees in Economics for 2002, Daniel Kahneman and Vernon Smith, have been recognised for their efforts to build the foundations of economics on the basis of experiments. P. R. Brahmananda describes their work.

THE Nobel Foundation celebrated its centennial in December 2001 by arranging several symposia. One of the latter was on economics and the papers in that symposium were concerned with studies relating to induction of psychology with its bias towards experiments on animals and humans (refer this writer's article on "Nobel Economics: Asymmetry in Committee's information?" (Business Line, October 12, 2002).

One hunch expressed at that time was that the Nobel Committee in economics would be turning their attention in awards to scholars working in the areas of application of experimental approaches towards understanding the psychology of economic behaviour.

Historically, almost all leading economists have argued that the chief difference between natural and physical sciences, and economics is that, in the latter, controlled experiments are not possible either to test hypotheses or to derive generalisations and laws.

Consciously controlled experiments upon selected human beings or groups are not permitted, especially in individualistic and democratic societies. This is the reason why, though some portions of economic theory are based on stable and predictable assumptions of human behaviour, the latter are taken as axioms or postulates and not as derived results out of controlled experiments on masses of human beings.

Economists have argued that the validity of postulates or assumptions cannot be directly verified. But Friedman and others have held that if empirical studies lead to generalisations that are acceptable from a statistical angle, it would follow that, indirectly, the postulates are also valid.

But Friedman's argument was strongly contested, and the lack of inductive support to the postulates or axioms in a direct manner through results of experiments on human beings has been considered as a sort of a deficiency in the science of economics. However, the absence of scope for controlled experiments has been compensated partly by econometric studies on quantitative data.

Also, history as perceived through time series has served as a basis for many generalisations in economics. The marriage of historical method with quantitative economics has been a great revolution in recent years. But the basic weakness of the inability to have controlled experiment has remained in respect of economics.

The Nobel awards in economics for 2002 have now been declared and these have gone to two scholars, Daniel Kahneman and Vernon Smith, both working in the US, for their efforts to build the foundations of economics on the basis of experiments, often in the form of questions and answers on selected human beings.

The Nobel Committee states that some portions of received market generalisations are supported, but some very popular hypotheses, especially in the field of statistics, are not. Herbert Simon, who received one of the early Nobel awards in economics, challenged the rationality postulate underlying economics. He introduced the concept of bounded rationality.

Actually, in the area of choice, decisions are taken on the basis of limited alternatives, and full information about all the choices possible are not available to the decision-makers. There is also the time constraint, apart from the inability of most persons to incur the expenditure necessary to obtain full information at the time decisions are being taken.

George Stigler showed that information supply itself has large expenses, and anyone who seeks full information has to pay the costs of agencies that procure the information and make it accessible to the parties concerned. We now know that the information and communication industries have their own huge costs and these are sought to be reimbursed through charges on the parties who make use of the information.

One must remember here that not all information is made available when the markets are imperfect or oligopolistic. Kenneth Arrow, when asked in the Mysore University after his lecture about the possibility of increasing returns in the information and communication industry admitted that it may be necessary to bring the industry under some public control.

Increasing returns always tend to lead to monopolies and the pricing under monopoly has to be a public concern. But what about information obtainable through controlled experiments on human beings? One of the findings to which the Nobel Committee refers is that the hypothesis on the need for large samples — that are supposed to have the property of compensating for idiosyncratic or abnormal behaviours — is not supported by human beings who were examined with respect to their behaviours.

They referred to the attitudes of the chosen human beings who derived their basis for choice from their experiences and environment, and who thought that small samples have equal validity as large ones. The law of large numbers, which has made empirical economics amenable to statistical investigations, is thus falsified. At the same time, the Committee refers to the concept of representative human beings for purposes of investigations.

The concept of representativeness, to be determined a priori, involves a bias in specification that is one of the cardinal sins in econometrics based on quantitative or objective probability theories. It may be mentioned that Keynes was a strong supporter of subjective probability, particularly in respect of investment and liquidity behaviour. He argued that rationality is not the basis of crucial investment decisions involving the future. He introduced the notion of animal spirits as governing investment behaviour in booms and depressions.

While he recognised the distinction between bulls and bears, he also pointed out that there are circumstances where everyone in the market is a bull, and conditions when everyone is a bear. The main point here is that human behaviour is often unstable. It is conditioned by external circumstances, mixed with psychological states; hence arises the phenomena of basic instability in projections based on postulates of normal human behaviour in the light of external information.

Keynes had thus thrown the hammer on theories of economics based on stability of human behaviours even in the large.

Controlled experiments and treatment of psychological reactions are admissible clinically in respect of abnormal or schizophrenic behaviour. Medical counselling, especially psychological counselling, is now an important healer. But in the case of society, with its large numbers, laws cannot be derived on the basis of controlled experiments that no constitution can permit.

Implications of rationality, that is defined in terms of maximising behaviour under constraints, can be challenged, particularly when we assume that individuals are interested only in themselves; often, each individual has a component of society or of social well-being, independent of initial conditions, in mind.

It is this latter aspect which thinkers like Marx and most economists with goals of welfare account for when they refer to social reforms and state efforts to improve the social sector. To take away society from the minds of people is to make economics a non-social science. Society is not an aggregate of self-interested behaviour oriented individuals.

Some years ago, dissertations based on simulative quantitative exercises, were frowned upon in American universities.

Alternative simulation models concerning human beings involve interferences in the lifestyles of human beings, and the consequences could be dangerous, from society's angle. But the Nobel Committee's efforts are directed at widening the foundations, scope and boundaries of economics, considered as an `Imperial Science'.

Whether economics as a whole will be rewritten as a result of selective controlled experiments and the conclusions therefrom is rather doubtful at this stage. But one never knows. Cloning has already been permitted in laboratories and the scope of cloning experiments is vast.

Similarly, in a free society, controlled experiments on economic matters (if the subjects voluntarily agree) may also become permissible. Rats and rabbits have no choice, but human beings in free societies can opt in or out of experiments.

In poor societies, however, human beings themselves may become guinea-pigs because of vulnerability to monetary incentives from rich organisations which may like to conduct controlled experiments.

One of the dangers is that in such experiments the hypotheses may themselves emerge as results through the manipulation of the choice of those undergoing the experiments. The people themselves also may be doctored for some consideration!

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