Thursday, April 24, 2014

The Stocks & Flows of the Homo Economicus

Economists and sociologists debate whether the homo economicus exists and make rational decisions based on profit maximization and utility considerations or not. Critics of the neoclassical economic theory argue that a lot of people seem to behave differently, that markets are not always efficient, that power can play a big role, information is not available and that people have group-behavior. (e.g. debate in FD on 12 and 24 april 2014). Nico Lemmens argues that group-behavior and consensus seeking, love and emotion can still be rational from an ecological perspective. Sure.

What (neo-)classical economists and their opponents overlook is the fact that there are stocks and flows involved here. The debate described above is a debate with a linear world view. A happens thus B happens thus C happens and all in the same proportion. Even when emotions are to be included it is still linear: more love is more marriage.  This is not realistic and therefore it does not fit the empirical observations.

In Stock and Flow terms (hence “Flostock”) not only a quantity of matter is a stock, but also opinions and feelings are stocks. Any movement is a flow and linear behavior like selling or travelling is a flow.  But there is also other behavior and that is much less straightforward and non-linear. That is behavior in relation to the speed of response to a pulse. A person or a group of persons can adapt their opinion on a subject fast or slow. This behavior is rational, and rather stable over time, and for large groups it is therefore predictable, but it is non-linear.

Example: suppose a group of the population has a strong preference for supplier A (say Apple) and a second group has a strong preference for supplier B (say Huawei). Both preferences are stocks, with advertisements, coffee-machine conversations, user friendliness, price comparisons and other experiences as inflow. After a couple of years, the preference has become quite strong, a big stock. You could call this stock customer loyalty. This stock has a memory, of course, in fact it is a memory, and it generates a rather constant flow of buying products of supplier A respectively B. Now one of the two suppliers introduces a new toy, or one of the suppliers is found to be secretly spying on its consumers. This new experience and knowledge is an inflow into the preference stock and slowly changes its value. The speed at which it changes is a behavioral parameter and could be referred to as customer inertness. So customer inertness is the speed at which customer loyalty adapts to an inflow. Obviously if the stock is large and the inflow is small, the change in preference will be small. So a strong brand can survive a small PR mistake.  When the preference stock changes in value, the group will change its buying flow.  

By the way, there is a second non-linear determinant of the buying flow and that is the amount of products already owned by the group. This is also a stock and let’s call that the pool of toys. The pool of toys will make the buying behavior flow non-linear e.g. when saturation is almost reached. The speed at which the group wants to reach saturation is also a behavioral parameter that we could call customer eagerness. Customer eagerness is the speed at which customers want to follow a trend. High eagerness will create hypes, panic run-aways, bank runs and overshoots. Medium eagerness creates fashion waves. Low but positive eagerness creates stable growth.