In this essay, Alasdair White takes a cold hard look at the current state of consumerism as an economic model and with the help of Daniel Kahneman and Nassim Nicholas Taleb concludes that consumerism and classical microeconomic theory is no long sustainable – it’s time for a re-think!
Are consumerism and the consumer society dead? Well, we’re all consumers but we don’t all live in a consumer society. This begs the questions as to what are consumers and what is a consumer society.
Consumers are those people who acquire, usually by buying, goods and services and then use them before disposing of them, often before the end of their useful life. This has given rise to the idea of a consumer society, which is one in which people often buy new goods, especially goods they want but do not need, and place a high value on owning many things. This, in many ways, is another way of describing economic materialism which is the excessive desire to acquire and consume material goods. It is usually closely connected to a value system that regards social status as being determined by affluence as well as the perception that happiness can be increased through buying, spending and accumulating material wealth.
In purely economic terms, this is directly contrary to the rational self-interest of the individual as an economic actor, a self-interest that is rationally served by the optimisation of the person’s scare economic resources – or, in other words, is best served by getting the best value for the limited money they have available. Very few people have an unlimited source of funds – almost all of us have income which is taxed leaving us with a disposable income from which we have to purchase the goods and services we ‘need’ (the goods and services that without which our health will decline and we will eventually die). This then leaves us with a discretionary disposable income with which to purchase those goods and services we want – and to do that we make decisions as to what to purchase so that we optimise our spending to acquire goods and services that have the greatest value to us. This element of choice, this discretion, means that we can choose to spend now or to save so that we can spend later (deferred expenditure). It also means we can choose to spend on goods that have no essential value but which satisfy an emotional need.
If we are rational, then we will seek to optimise our expenditure and only purchase those goods that are needed and present the greatest value to our long-term self-interest. This, of course, is the direct opposite of what the sellers of goods require us to do. The sellers (or retailers) are operating a business model that requires them to do everything they can to maximise the consumers spending – in other words, to get the consumer to spend the maximum possible amount irrespective of value or need. There is no possible situation in a consumer society in which a retailer can ever act in the consumers’ best interests as the economic objectives of the retailers and the consumers are mutually exclusive.
But why don’t consumers realise this? Why do they persist in believing that the offers from retailers represent something that will benefit them?
The answer is remarkably simple: people are not rational and seldom act in their own best interests. They are easily manipulated, usually by appeals to their emotions, and they seldom think things through to determine what course of action is actually in their real best interests. Essentially people are intellectually lazy, easily swayed by the opinions of others, and in many cases totally unable to think things through. This is where the work of Daniel Kahneman is of such importance. In his book Thinking, Fast and Slow, Kahneman explores the two types of thinking that appear to take place in the human brain. The dominant type is the Fast thinking (system 1) which creates heuristic models – experienced-based problem solving methods that use readily available information (and memories) that may be only loosely applicable and appropriate and usually render a sub-optimal (though often ‘good enough’) answer that contains systematic errors or cognitive biases. We tend to rely on these heuristics even when we shouldn’t, believing that our experience in similar such situations is appropriate in the current situation. This is simply not rational.
In comparison, the Slow thinking (system 2) engages in detailed analysis of all the information available to reach conclusions that a free of cognitive biases, systematic errors and requires consistent and conscious thought. It generally operates in a ‘bounded rationality’ but is still far more accurate than system 1, however it is an energy-intensive and costly process that takes significant amounts of time although it at least ensures that the subject is properly studied and a rational decision is made.
Why do we, as humans, allow our brains to adopt system 1 thinking at the expense of rationality? This is not explored by Kahnemen, possibly because the answer is not to be found within the field of psychology, but within biology. Studies show that an average human being has a resting metabolic rate of 1300 kcals per day (obviously this is dependent on age, gender, size and health, but this is an average) and the brain, which is about 2% of the body weight, consumes around 20% of that just to maintain its normal resting activity – about 260 kcals per day, but when the brain engages in system 2 thinking, the energy consumption increases dramatically and the amount of energy the body needs increases accordingly. This is empirically obvious to anyone who has been a student or has worked with students (or senior school pupils), at the end of a long day of study, they are exhausted and often fall asleep or need to consume high calorific foods before they can do their private study or homework – it is also measurable by studying blood glucose levels and other blood chemistry factors. Now, my hypothesis is that the brain has evolved in such a way that it has learned that deep thinking is costly in terms of energy and, as sources of energy are limited, it has set up decision-making and problem-solving methodologies (heuristic models) that make far lower energy demands while at the same time creating sub-optimal but ‘good enough’ solutions. In other words, our brains have evolved to use non-rational techniques as a way to save energy.
Obviously, if the system 1 heuristics are based on appropriate experiences, then they will become progressively more accurate in their outcomes and so less system 2 thinking has to be undertaken thus releasing the brain to engage in other activity without creating a spike in demand for energy. This, of course, is the basis of repetition or rote learning, repetitive practise, and our ability to provide ‘good enough’ solutions to most of our day-to-day activities. Kahneman builds on this by suggesting that when we do engage in energy-intensive system 2 thinking, the outcome can then be used from the memory and can inform the appropriate heuristic bringing its outcome closer to the optimal.
But Kahneman identifies something else that the brain does which makes our system 1 thinking sub-optimal and that is that the correct frames of reference for the problem, the understanding of risk and probability, and correction of our emotional biases are all active in system 2 but are not active in system 1. Such is our addiction to mistakenly believing that we are rational, we end up believing that all actions have an identifiable cause and if we can identify the cause, then we can control our response. But the shocking truth is that a great deal of what happens to us and in our environment is random in that there is nothing we can do to neutralise the cause or avoid the consequences. This school of thought is brought into clear focus by Nassim Nicholas Taleb whose work on randomness and risk is worth the effort (system 2) of reading and by ‘chaos theory’ which shows mathematically that very small differences in initial conditions (which may have existed at some indeterminate time and location in the past) can yield widely diverging outcomes in otherwise identical systems thus rendering long-term prediction of the outcome impossible. Both these concepts can and do invalidate the predictability which is a fundamental belief in micro-economics (and much else).
The truth of the matter is that behavioural psychology has undermined the foundations of micro-economic theory to such an extent that much of what we have been told is true about our economic activities is in fact unreliable. Take the prevalent and popular consumer model that is promoted so strongly by many societies, particularly western ones. This is, ostensibly, a market-economy model in which supply and demand play a dominant role so that rising demand for goods is matched by rising supply of those goods. But when we delve deeper, it becomes evident that the ‘market’ is a creation of the ‘supply-side’ elements – the producers and retailers – and not of the ‘demand side’ – the consumers. Let me explain.
During the world war that took place between 1939 and 1945, production was revolutionised, no longer were things made by artisans and by hand, machines were created and employed to mass produce the materials of war – everything from ammunition to aircraft were produced on a production line basis that churned out usable end products at a phenomenal rate. This was a classic ‘demand side’ situation: the military required huge quantities of everything and industry geared up to provide it. Costs were not a problem as governments simply printed money or the banks lent it and so production (a supply side element) knew no bounds. The problem was that after 1945/46 demand fell precipitously leaving the economy with a huge ‘over capacity’ on the supply side.
The solution, as far as the policy makers were concerned, was firstly to convert from the production of weapons to the production of consumer products (but involving the same technologies) and then to artificially create a demand via the promotion of consumption through advertising, marketing, bank loans, and governmental policy. Much of this was focused on creating a desire to own goods and services, irrespective of need, and the award of status for owning lots of material possessions. In other words, the creation of a consumer society to provide ‘demand’ for the over abundance of ‘supply’. Little attention was paid to whether these goods were needed, they were presented as being the rightful entitlement of the victors of the recent war: in other words, this was the reward for the privations and destruction endured. All the supply side actors were involved: banks lent money to consumers so that they could buy goods, producers made goods irrespective of need or value, advertisers and the media promoted the idea that greed was good and that owning lots of things was our entitlement and a desirable thing, that it gave us status.
Somewhat inevitably, there were just so many washing machines and other items that any one family could use and so producers started to build in obsolescence, they started creating products that were deliberately designed to break down after a certain period of time so that the consumer felt compelled to purchase a replacement – something that is certainly not in the best interests of the consumer and his or her need to optimise their economic activity, but certainly something that maximised the producers’ side of the equation. It didn’t take long for the consumer to become addicted to this bonanza of products and to create a huge demand bubble that was promoted by advertising and marketing communications in the media and fuelled by cheap loans from the banks.
Inevitably, these bubbles burst, lenders found themselves exposed to defaulting borrowers, many of whom should never have been allowed to borrow in the first place, greed had turned the lenders and the consumers into gluttons, more and more producers were entering the market thus inexorably inflating the supply side while squeezing the demand side by cutting off the supply of money that fuelled the consumer boom. Eventually, the consumers got the message that greed was NOT good, that the markets were a zero-sum game in which people could only obtain if someone else lost. It was not a win-win situation but a strictly win-lose with the consumer on the losing end. Eventually, the consumers stopped consuming, demand dried up and the supply side producers started to cry foul and pressurised their governments ‘to do something to stimulate demand’ – the governments, blinded to the reality of the simple win-lose equation and made up of normal non-rational thinkers, obliged and the result is the monumental mess the western economies are in as we enter 2014.
Bizarrely, governments are even telling us that we should not save our money (deferred spending) but we should spend now. These are the same governments that have no way of funding the pensions that will have to be paid and have been telling people to save for their own retirement. Well, rather obviously, we cannot spend now and save for our retirement … but there again, politicians are not known for their rationality.
Alasdair White is a business school professor, author and publisher. He is the author of three best selling management books and under his pen-name of Alex Hunter, the author of two thrillers.
The winner of the 2000 Nobel Prize for Economics, Daniel McFadden, in a recent paper entitled “The New Science of Pleasure” (NBER Working Paper No 18687) published in February 2013, calls for his fellow economists to re-think the standard models of economic theory. Something I have been calling for in my recent blog essays.
As can be expected, given his work on choice, Daniel McFadden’s new paper focuses on consumer choice. His basic approach is, however, unusual in that he argues that the standard economic model is flawed by being incomplete. In summing up his hypothesis, he writes “Economists since the days of Adam Smith and Jeremy Bentham have traditionally viewed consumers as driven by relentless and consistent pursuit of self-interest, with their choices in the marketplace providing all the measurements needed to reveal their preferences and assess their well-being. This theory of consumer choice is empirically successful, and provides the foundation for most economic policy. However, the traditional view is now being challenged by evidence from cognitive psychology, anthropology, evolutionary biology, and neurology.” In other words, it is easy to observe the human economic actor and to conclude from his actions and decisions that he is acting rationally: that he has all the information he needs concerning the options facing him, he is aware of all the risks associated with each option, that he has the capacity to consider all the options, and that he then makes a decision that delivers the maximum self-interested benefit.
In real life, on the other hand, as Nobel prize-winning psychologist and behavioural economist Daniel Kahneman and his colleague Amos Tversky have shown, people actually make decisions in a very different manner relying far more on heuristic models of habitual behaviour resulting in decisions that can be shown to be based on limited information and are often not in the person’s economic self-interest. With this in mind, McFadden has, in the past, memorably challenged his colleagues by saying that their cherished Everyman, homo economicus, the standard human economic actor, bears no resemblance to a real person and is indeed a “rare species”.
As befits the work of an eminent economist, McFadden’s paper is full of cogent arguments, elegant analysis and complex mathematical formulae … and it is not an easy read for those of us who are not economists! Fortunately, The Economist, a British newspaper, in their 27 April 2013 edition, published a Free exchange blog essay entitled “The debt to pleasure” which provides a thoughtful analysis of McFadden’s paper written in way that is far easier to read and understand and requires little prior knowledge of economics.
McFadden’s basic argument is that the standard economic model of consumer choice is incomplete because it is based a number of unsustainable assumptions. To take one example, the model assumes that ‘people’ in economic models have fixed preferences, which are taken as given. Yet there is a large body of evidence from cognitive psychology that shows that preferences are in fact rather fluid. Other evidence, from cultural studies, show that these preferences are likely to be culturally determined. The standard model is also unable to handle the role of memory and experience in determining choices – both of which form part of the heuristic models of behaviour and which provide a clearer and more sustainable theory of decision making.
Indeed, McFadden argues that economic models are not sound in explaining human decision making as they consistently fail to take into account such ideas as trust (a function of both history and brain chemistry), the influence of others (considered by behavioural psychology), and altruism and kindness (which is best explained by biology). Instead, economists make a limited allowance for human behaviour, emphasising the dogged pursuit of self-interest. McFadden believes that economists need to do things differently if they are to remain relevant and they need to reassess their articles of faith. For example: most economists believe that more (consumer) choice is a good thing and yet people faced with many options often make no choice at all. If economists were more willing to accept ambiguity in decision making and choice, then they may come to understand that abundance of choice may not be a good thing. It may also make them look again at their fixation with ‘revealed preference': the idea that a person’s valuation of different options can be deduced from their actions.
Of course, Daniel McFadden is not the only person calling for a re-think of economic theory and back in July 2012, I wrote a blog essay entitled “The economist’s new clothes” in which I questioned whether economists in general, and many politicians as well, are merely ‘in thrall to some long dead economist’ (to quote Keynes) and that it was time to recognise that the microeconomic rules and theories that are used to govern our lives are only true in a limited number of circumstances and that economists are often simply wrong. I followed this essay with another entitled “Are economists out of touch with reality?” in which I questioned the logic of assuming that people are rational in their decision making. Rationality is the very foundation stone on which microeconomics is based and is also the basis of market theory and free-market economics. I also argued that much of what we accept as economic truth (i.e the standard economic theory or ‘received wisdom’) is affected by our national culture and I ended up by writing
“The reality is that ‘bounded rationality’ is a concept closer to the truth. Bounded rationality is the idea that, in decision-making, the rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision. Economists in particular and the public in general should learn that they almost never have access to all the information they need; that their cognitive abilities are limited by their culture, their upbringing, their education and their willingness to think outside the false limitations set by others; and that we simply don’t have the time to ponder all the variables. Those who can accept ‘bounded rationality’, and work within it successfully and sustainably, are the people we should be listening to.
That the hubristic are often young and generally dismissive of older and more experienced voices reminds me of the Zen expression: “I am no longer young enough to know all the answers”. On the other hand, those who are older and should be wiser have forgotten that knowledge is neither finite nor fixed, that there are infinite versions of the truth, and that a wise man can entertain two conflicting ideas in his mind at the same time while being willing to discard concepts when demonstrably unsustainable.”
In a third essay, in October 2012, entitled “Economics – an incomplete theory” I argued that in addition to culture we need to look at the emotional response of people in an economic environment. I then discussed how greed seems to be the over-riding emotion and driving force of most of our economic decisions.
Finally, in April 2013, I wrote a fourth essay on economics entitled “Time for an economic rethink” in which I questioned that holy grail of western economic theory: the consumer society. A consumer society is the direct outcome of a socio-economic model called ‘consumerism’ that encourages the provision of an abundance of choice of goods (and services), the purchase of those goods (and services) in excess of basic needs, and the eventual disposal of those goods (and services), often before the end of their economic life. This is an international phenomena that appears to be strongly linked to developed economies and is particularly encouraged in the USA and UK where its preservation is a matter of political policy. However, this concept needs re-examining in the light of the collapse of the consumer-driven economies of the western world.
At the time of writing my essays, I was unaware of Daniel McFadden’s paper, which was published in February 2013, just before I wrote the fourth essay in the series, and I was blissfully unaware of the level support my calls for change were about to receive. Had the McFadden paper had a wider distribution, or The Economist article been published earlier, the flak that came my way might have not occurred. Mind you, the main source of disagreement with me (and thus with McFadden) did come from those whose work is not based on original thinking but on writing ‘textbooks’ (which are out of date when they are written and three years out of date when they are published) and from those who slavishly follow those textbooks. I now think it is safe to say that it really is time for a re-think of microeconomic theory
Alasdair White is a business school professor, writer and publisher. He is the author of five management books and a thriller novel as well as writing the Management Blog. He lives in Belgium.
29 May 2013
There are times when I feel we need to question the ‘received wisdom’ to see if it is still properly based on a realistic and rational foundation. And when the US Treasury Secretary, Jack Law, recently called on countries, especially Germany, to boost economic growth via boosting consumer demand, I had a “that’s weird, let’s look at that again” moment.
There is a well known economic theory of efficient markets that is, broadly speaking, based on the idea that if the supply of goods matches the demand for those goods then everyone is happy and prices are stable, and if they are misaligned then either the price will go down as goods become abundant, markets might collapse and the suppliers become poor (too much supply), or prices will rise as goods become scarce and the suppliers will get rich (too much demand). But what is forgotten is that this is a ‘zero sum game’ in which there will be winners and losers, so let’s look at the theory the other way round. When the supply of goods is greater than the demand, then prices collapse as a result of greater abundance of goods and the consumer gets to save more of their money and so they become ‘richer’, and when there is too much demand, prices rise and the consumer has to spend more of their money for scarcer goods and so becomes ‘poorer’. Of course, the intrinsic value of the goods does not change in either scenario but the price does as suppliers manipulate it to maximise return – in other words, because they are greedy!
So, in simple terms, if the supplier is getting richer, the consumer is getting poorer; conversely, when the supplier is getting poorer, the consumer is getting richer. So if the supply and demand are not in balance, then is it better that the supplier gets richer or that the consumer gets richer? The answer to that is almost certainly that it depends on whether you are a ‘supplier’ or a ‘consumer’.
Because greed seems to be a fundamental of human economic behaviour, suppliers almost always try to manipulate the situation so that consumer ‘demand’ rises and the supplier gets richer at the expense of the consumer. What also happens is that government policy of whatever shade of political belief also tries to manipulate the situation to make the suppliers richer and the consumers poorer – the ‘poor’ are always far easier to control as they are often dependent on the government.
Now back to Jack Law. For most of the two decades covering the end of the last century and the beginning of this, we have been ‘demand’ led in that consumers have been demanding more and more of all types of goods – which they usually do not need and frequently dispose of before the end of their useful life – and paying for them with cheap credit that, six years ago, suddenly ran out. Consumers found themselves in severe debt and unable to pay it off while being equally unable to re-schedule their debts with new credit lines: having made themselves believe they were ‘rich’, consumers all over the developed economies were spending money they did not have and the dawning of reality has been painful.
During those same two decades, the suppliers of goods saw cheap credit as a cornucopia and grabbed it with both hands making huge sums of money in the process. And now that the credit taps have been turned off and ‘the consumer’ has realised they were living a false dream, the suppliers are hurting (read: going broke) and are demanding that ‘government do something’ to get the consumers to spend again: after all, they reason, the consumers are merely the tethered milk-cow to be milked and bilked out of their money for the benefit of the suppliers. Jack Law was merely doing his bit to help the suppliers make money and to keep the consumers poor, thus clearly positioning himself on the side of business and opposed to the good of the people.
The materialistic, consumer-driven society that exists in its purest form in the USA and almost as purely in the UK is a very individualistic, greed-driven and selfish model, and is neither in the rational self-interest of the consumer nor in the interest of the greater society. However, for the last half-century there has been an assumption amongst those who think they know what-is-what that the consumer society is the only viable economic model that will deliver growth and prosperity. But what has happened over the last six years is that the consumer has finally, perhaps irrevocably, discovered that consumerism using other people’s money is great fun, but when the owner of the money wants it back the result is extreme and sometimes insupportable pain: they have discovered that there is no such thing as a ‘free lunch’, and no such thing as a right to prosperity.
The trouble is, in societies that are not consumerist (the vast majority of the world) and are significantly less individualistic than the USA and the UK (see the work of Geert Hofstede), prosperity is based more firmly on supply and demand being balanced – thus in those economies, suppliers make and supply only what they can sell and consumers only buy what they genuinely need; everyone is happy with less but there is a more equal division of the wealth of the society. The balance is restored between the consumers and the suppliers, and neither is pursuing a ‘beggar thy neighbour’ policy.
But the USA, and to a lesser extent the UK, are finding the change very difficult, simply because it involves a fundamental change in attitudes, behaviours, and fundamental beliefs, leading to a profound change in the way the society operates. Instead of the unrestrained pursuit of personal gain at the expense of all others, Americans and Britons in particular will have to once again learn the value of cooperation with others – a cooperation based on trust rather than contract law; based on mutual interests rather than self-centred, self-interest; based on being a good neighbour rather than the bully boy on the block. There is plenty of evidence that, at the grass-roots level of ‘Everyman’, this is already happening: cooperatives are forming, and neighbour-help-neighbour groups, barter markets and the like are springing up. But this reality, this need to change, has yet to reach the company strategists, the corporate leaders and the governmental policy makers. Entrenched pork-barrels, fat-cat remuneration packages, and a gut-wrenching fear that they’ve been wrong all along are all contributing to an evident ‘denial of reality’ that change has to begin at home, that beggaring the consumer citizen for the benefit of the suppliers is not a viable or sustainable solution and that ‘the people’ have had a enough. Jack Law’s call for other countries to push up demand (essentially to push up demand for US goods) so that the USA need not change its ways is just the latest example of this sense of denial.
Alasdair White is a business school professor, writer and publisher. He is the author of five management books and a thriller novel as well as writing the Management Blog. He lives in Belgium.