This is the first of two guest pieces by Paul Ormerod, the author of “Positive Linking” (Amazon USA; Amazon UK) and several other important books on non-equilibrium economics.
Paul and I have been research colleagues and friends for over a decade now, and I regard him as the foremost exponent of multi-agent and network economics today. As regular readers will know, I prefer a “tops down” approach to economics over the multi-agent approach, mainly because the phenomenon of emergence is a significant conceptual barrier between the “macro” systems we wish to describe and the “micro” behaviour of the individual entities that comprise the system. Paul has a flair for being able to develop models that penetrate that barrier successfully. I particularly like the model in this paper on competition and market structure, and I use it in my own lectures as an example of how competition should be modelled by economists, in contrast to the Neoclassical myths of perfect & imperfect competition and oligopoly.
Over to Paul…
Modern economic theory was first set out on a formal basis in the late nineteenth century. There have certainly been developments since then, but at heart the basic view in economics of how the world operates remains the same. Economics is essentially a theory of how decisions are made by individuals, of what information is gathered and how it is used by the decision maker.
All scientific theories, even quantum physics, are approximations to reality. Theories involve making assumptions, simplifications, to enable us to understand problems better. A key feature of a good theory is that its assumptions are a reasonable description of the real world.
In the early twenty-first century, just as it did in the late nineteenth, economics in general makes the assumption that individuals operate autonomously, isolated from the direct influences of others. A person has a fixed set of tastes and preferences. When choosing amongst a set of alternatives, he or she compares the attributes of these alternatives and selects the one which most closely corresponds to his or her preferences.
This view of the world dominates both social and economic policy making.
At first sight, this may seem quite reasonable, indeed even ‘rational’, as economists choose to describe this theory of behaviour. But there is a serious problem with the assumption that individuals operate in isolation from each other, that their preferences are not affected directly by the decisions of others.
The social and economic worlds of the twenty-first century are simply not like this at all. We are far more aware than ever before of the choices, decisions, behaviours and opinions of other people. In 1900, not much more than 10 per cent of the world’s population lived in cities. Now, for the first time in human history, more than half of us live in cities, in close, everyday proximity to large numbers of other people. In the last decade or so, the internet has revolutionised communications in a manner not experienced since the invention of the printing press in the mid-fifteenth century.
The assumption that people make choices in isolation, that they do not adopt different tastes or opinions simply because other people have them, is no longer sustainable. Perhaps – perhaps, and it is a big ‘perhaps’ – over a hundred years ago this might not have been a bad assumption to make. But no longer.
The choices people make, their attitudes, their opinions, are influenced directly by other people. The medium via which this influence spreads is the social network. Often, social networks are thought of as purely a web-based phenomenon: sites such as Facebook. These can indeed influence behaviour. But it is real-life social networks – family, friends, colleagues – that are even more important in helping us shape our preferences and beliefs, what we like and what we do not like.
Network effects, the fact that a person can and often does decide to change his or her preferences simply on the basis of what others do, pervade the modern world. Throughout history, a crucial feature of human behaviour has been our propensity to copy or imitate the behaviours, choices, opinions of others. We can see it in the fashions in pottery in the Middle Eastern Hittite Empire of three and a half millennia ago. And we can see it today in the behaviour of traders on financial markets, where the propensity to follow the herd can lead all too easily to the booms and crashes we have lately experienced. Scientists such as Robin Dunbar have argued that our anomalously large brain (compared to other mammals) evolved precisely because, from an evolutionary perspective, copying is a very successful strategy to follow.
This concept is just as crucial for companies and markets as it is for people. In September 2008 Lehman Brothers went bankrupt, precipitating a crisis which almost led to a total collapse of the world economy and a repeat of the Great Depression of the 1930s. It was precisely because Lehman was connected via a network to other banks that made the situation so serious. Lehman’s failure could easily have led to a cascade of bankruptcies across the world financial network, first in those institutions to which Lehman owed money, then spreading wider and wider from these across the entire network. Incredibly, neither the systems of financial regulations which were in place, nor the thinking of mainstream economics which influenced policy so strongly, took any account of the possibility of such a network effect.
A world in which network effects are a driving force of behaviour is completely different from the world of conventional economics, in which isolated individuals carefully weigh up the costs and benefits of any particular course of action. A world in which network effects are important is a much more realistic description of the human social and economic realities which exist in the twenty-first century. It is the implications of this world which I explore in my book.
Incentives have not disappeared as a driver of human behaviour. This is the world which economic theory describes. It is not wrong. But it is often misleading, for it offers only a very partial account of how decisions are made in reality. Network effects can be far more powerful than incentives leading to outcomes completely different from those intended by policy makers.
We need a new basic building block of agent behaviour, based on the fact that agents, whether individuals, companies or government, have behaviour which is nit fixed, but which evolves. And it evolves by observing what others do.
Network effects require policy makers, whether in the public or corporate spheres, to change radically their view of how the world operates. In part, they make policy much harder to implement successfully, and they help explain many of the failures of policies based on the assumption that incentives and not network effects are the key drivers of behaviour.
But they open up the possibility of much more effective and successful policies, ones which harness our knowledge of network effects and how they work in practice. Hence the main title of this book: Positive Linking.
