Applying Economics in a Multidisciplinary Context
Paper for the NZAE Conference, Rotorua, 30 June - 2 July 1999
Stuart Birks and Gary Buurman
Abstract
Economic theory offers some powerful tools for the analysis of policy issues. The application of economics generally requires reference to other disciplines, however. Mechanical application of standard models will be inappropriate if there is inadequate consideration of the specific nature of the area of application. This paper identifies some of the issues and presents examples, showing how economic methods can be merged with other information to enhance the level of understanding of policy issues.
The writers advocate a broader interpretation of economics, and a recognition of the assumptions and limitations in commonly applied approaches.
"There are four chief obstacles to grasping truth, which hinder every man, however learned, and scarcely allow anyone to win a clear title to knowledge; namely submission to faulty and unworthy authority, influence of custom, popular prejudice, and concealment of our own ignorance accompanied by the ostentatious display of our knowledge." Roger Bacon (in Sykes, 1989, p.202)
"The more mathematics has been invoked in a particular problem, the greater the emphasis on technical aspects and the less accessible to scrutiny and understanding by persons outside the fraternal order." Ida Hoos (in Sykes, 1989, p.206)
1. Background – Delusions and Misperceptions
Let us take as a starting point that we are trying to understand certain aspects of our society. We may well be doing this for policy purposes, so as to better organise our affairs in the pursuit of our chosen wider objectives. We use formal or informal methods to shape our perceptions and determine our actions. Sometimes these methods are grouped according to academic disciplines, effectively ringfencing a set of perspectives, assumptions, and techniques. The resultant limitations have been frequently acknowledged.
Arnold Toynbee wrote:
"Any account of anything is bound to be selective. The human intellect does not have the capacity for comprehending the sum of things in a single panoramic view. Selection is unavoidable, but it is also inevitably arbitrary; and, the greater the mass of information from which a selection has to be made, the more disputable will be the investigator's choice." (Toynbee, 1976, p.x)
Erwin Shrodinger, Austrian physicist and Nobel prizewinner, said:
"It seems plain and self-evident, yet it needs to be said: the isolated knowledge obtained by a group of specialists in a narrow field has in itself no value whatsoever, but only in its synthesis with all the rest of knowledge …""
(from Goleman, 1997, p.6)
And Daniel Goleman, seeing the process as potentially very harmful and restrictive, wrote:
"Self-deception operates both at the level of the individual mind, and in the collective awareness of the group. To belong to a group of any sort, the tacit price of membership is to agree not to notice one's own feelings of unease and misgiving, and certainly not to question anything that challenges the group's way of doing things." (Goleman, 1997, p.12)
"Perception is selection ... As William James put it, "My experience is what I agree to attend to. Only those items I notice shape my mind."" (Goleman, 1997, p.21)
"... shared schemas guide group dynamics ... the social construction of reality. Shared schemas are at work in the social realm, creating a consensual reality. This social reality is pocked with zones of tacitly denied information. The ease with which such social blind spots arise is due to the structure of the individual mind. Their social cost is shared illusions." (Goleman, 1997, p.23)
"A frame is the shared definition of a situation that organises and governs social events and our involvement in them. A frame, for example, is the understanding that we are at play, or that "this is a sales call", or that "we are dating". Each of those definitions of social events determines what is appropriate to the moment and what is not; what is to be noticed and what ignored; what, in short, the going reality involves." (Goleman, 1997, p.197)
Avinash Dixit rejected the separation of economics from other disciplines for purposes of analysis when he said:
"... the political process should be viewed as indeed a process - taking place in real time, governed and constrained by history ...In this view, the traditional dichotomy of markets versus governments, and the question of which system performs better, largely lose their relevance. Markets and governments are both facts of economic life, and they interact in complex ways. We cannot find feasible improvements by wishing away one of the components." (p.xv)
"My starting points are simple to the point of being trite - one must accept that markets and governments are both imperfect systems; that both are unavoidable features of reality; that the operation of each is powerfully influenced by the existence of the other; and that both are processes unfolding in real time, whose evolution is dependent on history and buffeted by surprises. Most important, I will argue that the political process should be viewed as a game between many participants (principals) who try to affect the actions of the immediate policymaker (agent)." (p.2)
Superimposed on this specification of the complexities of issues and the way that analyses can be misleading is the wider issue of the delusions that societies can suffer. A century and a half ago Charles Mackay described many of these (Mackay, 1995). They included such notable economic examples as the South Sea Bubble and Tulipomania. In his introduction to the 1852 edition (reprinted in Mackay, 1995) he says:
"In reading the history of nations, we find that, like individuals, they have their whims and their peculiarities; their seasons of excitement and recklessness, when they care not what they do. We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first." (p.xv)
"Popular delusions began so early, spread so widely, and have lasted so long, that instead of two or three volumes, fifty would scarcely suffice to detail their history." (p.xvi)
This is no mere historical aberration. We are almost certainly, even without our knowledge, collectively suffering from such delusions now. The historian, Norman Stone, wrote an introduction to the 1995 edition of Mackay’s work. There is no doubt in his mind what might be included in contemporary delusions:
"Throughout the world people have tended to focus on individual issues rather than on the good of society as a whole. Thus, we have seen the emergence of minority groups who demand 'rights' on the grounds of past grievances rather than present responsibilities. In the wake of these demands has come the requirement not to be insulted - and the rise of 'political correctness' which reduces languages that have been centuries a'growing to a childish level of primness. Sudden enthusiasms to alter states of affairs that have endured - for good or ill - for centuries have swept through nations and continents. The opponents of child abuse and the advocates of animal rights are examples where evils that have endured through history have suddenly come to the forefront of human notice, though frequently the zeal with which campaigns are conducted damages the causes they are meant to promote." (p.v)
Contemporary writing on "moral panics" describes situations that bear a close resemblance to delusions (Bartholomew and Dickeson, 1998). This emphasises stereotyping and "media amplification", along with "spurious attribution". In economic terms, economic actors’ behaviour is influenced by their perceptions, which depend on the information available and the perspectives used. They may be accidentally or deliberately inappropriate, especially given the operation of the media and the actions of interest and lobby groups (including input from academics).
Labels have been given to phenomena which may assist in this process whereby groups or whole societies develop inappropriate beliefs and perceptions.
Communal reinforcement is the process by which a claim becomes a strong belief through repeated assertion by members of a community. (http://skepdic.com/comreinf.html) "Sound bites" are particularly useful in this process.
Selective thinking is the process whereby one selects out favorable evidence for remembrance and focus, while ignoring unfavorable evidence for a hypothesis. (http://skepdic.com/selectiv.html) This might not be entirely independent of the "intuition" that analysts may use, possibly in conjunction with statistical or other information, to select from among alternative representations of phenomena.
Confirmation bias refers to a type of selective thinking whereby one tends to notice and to look for what confirms one's beliefs, and to ignore, not look for, or undervalue the relevance of what contradicts one's beliefs. (http://skepdic.com/confirmbias.html) This may also influence the research undertaken and the hypotheses that are tested.
2. Economics and Education
There are general areas where an economics approach alone is inadequate; one example is education. Basically we have two choices. We can try to fit education into an economics framework or we can go another way. As the problem is one in education, why not define it as such. This would be to start from an educator’s perspective and then integrate economic principles into the analysis. Initially we discuss the first choice.
The economics of education is a "sub-discipline of neo-classical economics" and dates from around 1960 with the advent of modern human capital theory (Marginson, p. 5). It tries to fit education into an economic theory framework. This theory is based on an abstract and simplified view of the structures which might exist in an area of application. Human capital theory is one approach taken in the economics of education. Another is through using the idea of the production function. Human capital theory is based on the idea that investment in education increases the marginal productivity of an educated person and hence that person’s future earnings. The production function approach looks at how inputs into education are transformed into outputs in order to assess efficiency.
Economic theory possesses powerful techniques, but they must fit the structure that is under analysis. Economics assumes a simple standardized structure that may not always be appropriate. Consider a standard cost-minimisation problem. This would commonly assume a single product produced by a firm in a constrained minimisation setting with a single objective. The problem would be defined in the context of isoquants and iso-cost lines. In education, can inputs be readily measured? Teachers are of variable quality. What is the output? Do we use pupil-years, qualifications awarded, or improvements in skills? What is the production relationship? There is not even a clear relationship between achievement and class size, for example. Who are the decisionmakers, and what is the funding structure? Consideration of issues such as these in the case of pharmaceuticals markets can be found in Birks and Buurman (1993).
As a general principle, we would stress the importance of understanding the area of application if economics is to be appropriately used. Moreover, the questions that economists might pose may not be the policy issues being considered in the field, although economics might be able to contribute constructively to an assessment of those issues. To illustrate these points in more detail in the education context, we briefly consider four questions: i) what is being produced? ii) how is it produced? iii) who are the participants and decisionmakers? And iv) how can economics help?
2.1 What is being produced?
An education system is producing educated individuals, but the problem for economists is, what exactly are the attributes of an educated individual and how do we quantify them in monetary terms? The New Zealand Treasury (pp. 24-25) recognized four functions of education. These were fulfillment (to the individual), integration (into society), economic (preparing an individual for an economic role) and custodial (relieving parents from child rearing duties). Clearly they are far broader than considered in a human capital approach to education. All four functions are associated with output, but as Atkinson (p. 121) has stated, output in education is so varied that it is difficult or impossible to calculate. Pupils begin with varying levels of attainment and other activities contribute to these outputs also, so it can be difficult to identify the impact of a particular educational activity.
A typical analysis might use standard achievement tests to show the part played by education in increasing attainment levels. However these tests cannot measure many important qualities schools wish their pupils to attain. The human capital approach concentrates on increased earnings of educated people and links this to the productivity of education through increased cognitive development. Musgrave and Musgrave (p. 207) describe the calculation of returns to education by consideration of observed average earnings by education level. They note that this assumes that differentials are caused entirely by education. Reynolds (p. 48) notes that an association between education and higher earnings is not necessarily causal. Part may be due to greater mental ability or superior home background or other advantages. Thus from the gross increase in earnings associated with increased education, we should deduct the amount attributable to other factors to get the net increase in earnings from more schooling. As a production process, inclusion of the effect of home environment results in complex structures such as one with two producers jointly producing one product.
An alternative hypothesis (screening) is that employers use educational attainment as a measure of how productive a worker will be once hired (see Blaug, p. 20). Can we then say that increased productivity is derived from education? It may be that educated labour is not more productive, but is paid more because employers treat educational credentials as a screening device reducing uncertainty about productivity.
2.1 How is it produced?
What are the inputs? How are they combined? On the input side, it is probably the interrelationship of inputs more than any single input that is important, with little standardisation being observed. Many indicators become substitutes for what economists and educators actually wish to measure as inputs, being the only data available. For example, experience, qualifications or salary might be used as proxies for what makes a "good teacher". There is also a wide diversity of teaching resources and also learning styles by pupils.
Another example again concerns valuing the output of inputs in the service sector.
We also have an interesting body of research (see Hanushek) which fails to find a relationship between educational quality and variations in expenditure or class size. There is also no strong evidence that teacher-student ratios or teacher education or experience have a positive effect on student achievement. This implies that increased funding to upgrade what many believe are important indicators of the quality of education on the input side may have little overall effect. One question is do these studies control for other variables? Of course here there must also be some qualification as to the ‘relevant range’ (one teacher to 1,000 students for instance?) and more research is probably needed.
2.2 Who are the participants and decisionmakers?
This is far more complex than the supplier and consumer model commonly assumed in economic theory. The public sector is a major consumer and supplier, acting as both purchaser and provider, but pupils/students and their parents also play a part as decision-making consumers. Participants on the supply side include teachers and administrators. All of these participants are acting according to their own objectives and constraints. At the government level, input is provided by advisors and researchers concerned with areas of economics and accounting as well the broad field of education. Imperfect information, and special interest groups, both public and private, with their own ideologies are present and raise the possibility of ‘capture’ in education policy.
Each group will use positions on education and education research results to support their agendas. As education focuses on impacts on pupils, educators are likely to promote the view that smaller class sizes and improvement in the quality of inputs benefit students. A spinoff is that smaller classes are easier to handle. However a Treasury economist or other government official concerned with keeping government expenditure in check, is likely to emphasize research results similar to Hanushek’s. While there are economic issues at stake, the crucial information comes from education research rather than simply economics. The education results are simply assumed as inputs into an economic analysis.
Clearly, we are unlikely to be able to usefully apply the standard economic theory formulations of economic problems to education issues. An economics approach in education (and in other areas) is likely to require input from other specialized disciplines.
2.3 How can economics help?
Economics provides us with problem solving techniques, but these must be suited to the area/problem. In this example, education provides a definition of the problem and identification of the relevant relationships. That should form the basis for economic analysis.
Even with the difficulties, economics has a powerful part to play in the arena of education. It has many tools and techniques which, with recognition of their limitations, can be of immense benefit. They include cost-benefit analysis with discounting; shadow pricing and present values; the human capital approach with attempts to estimate the net return to education; the recognition of market failure and spillover benefits; analysis of the voucher system and loans versus grants; and location analysis.
This use of economics as a refinement to educational analysis is not the common practice. Rather, we find that economists and educators bring two distinct approaches to the field. They can completely misunderstand each others’ perspectives and terminology. To illustrate, there has been heated debate on the public sector approach to education with the definition of a public good being the crucial issue. Economists recognize that education is not a pure public good by their criteria of non-rivalry and non-excludability. Grace, an educator, argues this point, expressed in the New Zealand Treasury Brief (1987). He terms the Treasury’s view as an ideological challenge to discredit education (p. 27). In fact his counter-argument is based on a quite different concept of public goods. Yet nowhere in his article do we get a precise definition. Finally, near the end, we find that he believes education to be a public good because it has the potential to let persons realize their abilities; to develop social, cultural and political awareness; to assist the effective operation of the democratic political process; assists in the emergence of more equitable conditions as it operates against class, race and gender (p. 35). Economists recognise these factors, but under different terms. The debate would have been more constructive, had they used a common language. Had Grace referred to these effects as positive externalities from education, many economists would have been in agreement.
3. Potential Weak Points in an Economic Theory-based Approach
3.1 Perceptions
Economic agents act not according to what is happening, but according to their perceptions of what is happening. These may not be the same. This is important not simply in terms of imperfect information, but also in the context of the way people respond to policy announcements or anticipated events, described by Shaw as announcement effects (Shaw, pp.19-20).
3.2 Homogeneity
Homogeneity is a common assumption in markets and in relation to factors of production. Even with identical inputs or outputs, points c d and e below can make the assumption questionable. Aggregation problems can arise if the components of an aggregate are not homogeneous. It is not only in macroeconomics that aggregation occurs.
3.3 Time dimension
Static and comparative static analyses do not consider adjustment paths and behaviour in disequilibrium situations. Economies are continuously going through the process of adjusting to change. Unless we consider adjustment paths, it is not possible to determine the feasibility of attainment of a new equilibrium. Even with dynamic models, there are issues of consideration of continuous activities in terms of discrete time intervals. This affects lag structures and even the chance of identifying relationships between variables. While continuous time models can be considered in theory, for estimation purposes we commonly use discrete data.
3.4 Spatial dimension
Models which ignore the spatial dimension are overlooking location factors, consideration travel/transport times and costs, and issues of accessibility and the geographical boundaries of markets. Even within a market, distances may have an impact on levels of demand and prices that people are prepared to pay. It is common to use geopolitical boundaries to define areas, if only because they provide the areas for which data are available. Such boundaries do not necessarily coincide with the boundaries of economically meaningful areas (an aggregation issue). Where data are grouped by geographical area, once again discrete groupings are made. To illustrate the problem, consider a worker and a suitable job. If they are at opposite boundaries within a region, the worker could be considered frictionally unemployed. If they are within metres of each other across a boundary dividing two regions, then it could be a case of structural unemployment.
3.5 Level of aggregation
An analyst can sometimes exercise discretion as to the level of aggregation, but the choice can affect results. This applies in numerous areas. How broadly the product is defined can affect the determination of the market structure. Time intervals can affect observed relationships and lag structures. Aggregation over groups within society can conceal advantage or disadvantage for sub-groups.
3.6 Substitutability/differentiability
The linear programming approach to production allows for consideration of a limited set of fixed factor proportions production options. Given the limited number of options with production machinery and the relatively fixed number of workers that can work with each machine, this may be more realistic than the approach which assumes continuous substitution of capital and labour and differentiable isoquants.
3.7 Utility/welfare assumptions
Utility theory commonly assumes that satisfaction/utility is obtained from goods and services, with preferences being exogenous. This is very limiting and disregards the possibility of relative requirements in relation to others or in relation to (endogenous) expectations, or the operation of influences shaping preferences. As economists, why not consider the possibility that we can become more efficient at obtaining utility by developing cheaper tastes? Might a benefit of education be that we can more easily get enjoyment from low cost activities such as reading or discussing a freely obtainable library book?
3.8 Decisionmaking in organisations
It is inappropriate to assume single-minded pursuit of specified objectives when there are several decision-makers or beneficiaries involved. Note that alternative approaches have been considered in both the public and the private sector, if only in a simple way, in the economics of bureaucracy (Niskanen, 1971) and X-inefficiency (Leibenstein, 1966). We should possibly ask who is making what decisions to meet what objectives and under what incentives/constraints?
3.9 Institutional constraints
The organisational structure of society, the beliefs, customs, and laws, the professional bodies and their behaviour, as well as the political system and the media have a significant influence on the activities and preferences which shape a society. Economic analysis commonly pays little regard to these, while inevitably implicitly assuming an underlying structure. Even where structures are well established and commonly used, they may be subject to economic scrutiny only rarely. The legal system is central to the implementation of many government policies, but has received little attention to date. One paper on this topic is Birks and Buurman (1997).
3.10 Learning and repeat games
Behaviour changes over time as people learn from past experience. This results in more complex and dynamic structural relationships and strategies. As an added dimension, people's current behaviour may be shaped by past experiences and cultural traditions. An interesting literary illustration of this is the story "Merry Christmas, Mr Lawrence", by Laurens Van Der Post, from which was made the film of the same name.
3.11 Econometric limitations
These are more severe than econometricians would generally admit, even ignoring the accuracy of and perceptions of the data.
For example, the basis of a theoretical approach is to simplify. This includes the omission of relevant but less important variables. Ramanathan describes the effects of omitting a relevant variable as: likely bias of estimated coefficients; biased constant and forecasts; and invalid hypothesis tests (Ramanathan, 1995, p.187).
Econometric models include a variable in a specified functional relationship, commonly requiring additive separability either of the variable or of some transformation of the variable or relationship. The relationship between variables can be complex, especially with time series data which require consideration of possible lag structures. We can conceptualise the relationship between two time series variables as an input wave from one variable going into a "black box" and generating an output wave in the other variable. In econometrics we make specific and restrictive assumptions about the form of the output wave and its relationship to the input wave. This is particularly apparent when we consider qualitative exogenous variables, or lagged relationships estimated in discrete time.
Single equation estimation assumes the existence of exogenous variables, but the complexity of economic systems suggests endogeneity is more likely, if only indirectly through the relationships with other variables. Ignoring simultaneity can lead to biased and inconsistent estimates and forecasts, with invalid hypothesis tests on parameters (Ramanathan, 1995, p.661).
4. Conclusion
We believe that economics has much to offer to improve our understanding and enable us to develop good policy. We would stress the qualification, however, that this can only occur with due recognition of the limitations of economic thinking and a sound understanding of the areas and issues to which it is being applied.
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