Saturday, April 03, 2010

Fluffy nonsense

I hate Business Economics, indeed. With a passion. I hate it so much because the cello part is the worst cello part ever written in the history of

Wait, wrong rant.

I'm currently studying for actuarial exam CT7* (Business Economics). Essentially, the purpose of Business Economics is to determine when a sale will occur and at what price. I've hated this subject from the get-go, but it's taken me some time to really articulate what I dislike about it...

What is Business Economics?

To understand Business Economics, the first thing you need to know is: price is determined by the demand for a product and the supply of that product. When the demand at a given price equals the supply at that price, the market is in equilibrium and all produce will be sold. Markets tend towards equilibrium.

The supply function is determined by the seller's return on investment at various prices. A seller will pick the price that maximises their RoI. You can draw a "supply curve" showing the amount that will be produced at various prices. This will be a fairly straight upwards-sloping line.

The demand function is determined by the buyer's utility function. This is a subjective measure of how much value a buyer gets from a product, denominated in currency (e.g. £). Buyers will seek to maximise their total consumer excess: their total utility minus the products' purchase price. You can draw a "demand curve" to show how the amount bought varies at different prices, which will be a fairly straight downwards-sloping line.

To really understand Business Economics, the second thing you need to know is: all of the above is counterfactual bollocks. Markets don't really work like that under any circumstances. You can't draw demand or supply curves, and they wouldn't look like their descriptions if you could.

Theology meets practicality

These two different views of BE are both presented in the same textbook. Chapters 4-7 and 9-12 describe everything about a business in terms of demand and supply. Chapter 8, however, discusses the marketing mix.

The marketing mix is a widely-referenced checklist of things to consider when selling a product. It lists the following components of a successful sale:

1) Product
2) Price
3) Placement (e.g. location, visibility)
4) Promotion (e.g. advertising)

The traditional demand/supply model handles the first two of these fine, but is completely blind to the last two. The only way to account for e.g. the effect of advertising is to say "well, that just means that the person's utility function is higher for this product than it would otherwise have been".

But this just highlights the problem with the demand/supply model. It's not answering the question of "what determines price". It's just restating it in a more sciencey fashion. It is theology rather than science: no more meaningful than answering the question "what created everything" with "God did it".

In short, it sucks.

What went wrong?

I'm not sure why it sucks so much. My best guess is that the people who came up with this theory of economics had "engineering envy". In engineering, you start with various general principles (the laws of science) and reason your way to specific applications of those principles (bridges, buildings, microcircuits, etc).

I would conjecture that the early economists rather liked this idea, so they came up with some vague principles (the "laws" of demand and supply) and tried to reason from them to specific conclusions. But because those broad principles were not reality-based, the effect is similar to a Christian trying to reason from the existence of the Trinity to the existence of an earthquake in Haiti. It's an exercise in applied fuzziness, goalpost-moving, equivocation and redefinition of terms that would shame a Jesuit***.

This entire approach sucks.

First Principles

I'm still working on my own Grand Unified Theory of Economics, and probably will be for some time. But I already know where to start looking.

Look at the big picture again, and start to zoom in. Zoom in on a single continent (Asia). Zoom in on a single country (India). Zoom in on a single region (Uttar Pradesh). Zoom in on a town (Agra, home of the Taj Mahal). Zoom in on a little shop selling tables made of marble, and inlaid with semiprecious stones. Zoom in on the room where a tourist and a salesman are sipping tea together.

That tourist is me. That salesman, I am fairly sure, overcharged me by an order of magnitude for what was, I must admit, a rather lovely souvenir for my parents.

When an economic model can explain what happened in that room, in concepts more meaningful than the data they abstract...

When an economic model can explain what happened in that room, in a way that helps me to identify and avoid such situations in future...

When an economic model can explain what happened in that room, in enough detail that I can see how to return the "favour"...

...then I will consider it worth learning for exams.

Rant over.

* "CT" stands for "Core Technical". To become a fully fledged Fellow of the Institute of Actuaries** I need to have completed:

9 x Core Technical exams
3 x Core Applied exams
2 x Specialist Technical exams (from a choice of 9)
1 x Specialist Applied exam (from a choice of 6)
1 x Partridge in a Pear Tree.

** In Britain, for historical reasons, we have both an Institute of Actuaries and a Fellowship of Actuaries (collectively known as the Profession). Most Cambridge grads join the IoA. This is so that, when we've claimed our congregational MA and achieved the rank of Fellow of the IoA, we can put the letters MA FIA after our name and pretend to be Sicilian dons.

*** Yes, I know that the Jesuits were actually quite science-minded for their time. Their reputation for inflicting "sophisticated" theological arguments on the uninitiated is probably still valid.

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