The Ultimate Microfoundation: Human Action

by Ash Navabi

Originally posted on on January 25, 2014

Much fuss is made in macroeconomic circles over so-called “microfoundations”: microeconomic justifications for macroeconomic models, as opposed to macro models that make ad hoc assumptions about utility, preferences, and price setting. People like to bring up the “Calvo pricing model”, where (supposedly) a magical fairy selects a firm at random to change its price, as both an example of a solid microfoundation and a brazenly nonsensical one.

Of course, when the even foundations of mainstream microeconomics are shaky at best—assuming such silly things such as perfect competition, farmers who solve calculus equations, perfect information, infinitely lived households, and infinitely divisible tractors—many macroeconomists are rightly skeptical of blanket calls by microeconomists to cite their papers and books when macro guys are constructing a new model for inflation targeting or growth modeling. Some have even gone to deny any strong linkages between microeconomics and macroeconomics.

Ludwig von Mises acknowledged this debate and made a veiled attempt to solve it over a century ago in his first treatise, The Theory of Money and Credit (TMAC); and then made a more explicitly argument in his magnum opus, Human Action (HA).

In TMAC, Mises applied the microeconomic concept of marginal utility to the macroeconomic concept of money. Before Mises, economists had denied there was much usefulness to applying marginal utility theory to the problems of money; they were confused how could the marginal theory explain why a particular good today costs $1000, instead of, say, $10.  Money, it was thought, has value simply because it is money. Money is a strictly “macro” phenomena, and so it cannot have a micro cause.

However, by introducing the time element to the determination of the value of money, Mises could not only explain the origin of money as a barter good, but he could also explain the precise money price of a particular good today: namely, the relation between the money and the good did not come about out of thin air, it is a historical relationship that goes back to when the money was still a barter good. (For an excellent discussion on this matter, see pages 67-72 of Robert Murphy’s Study Guide to The Theory of Money and Credit.) Mises went to say that

If we start with a formula that attempts to explain the demand for money from the point of view of the community instead of from that of the individual, we shall fail to discover the connexion between the stock of money and the subjective valuations of individuals – the foundation of all economic activity. But on the other hand, this problem is solved without difficulty if we approach the phenomena from the individual agent’s point of view. [TMAC, p. 134]

In Human Action, Mises goes even further. As is reflected in his book’s title, economics is human action. He goes on to define human action as “purposeful behavior. Or we may say: Action is will put into operation and transformed into an agency, is aiming at ends and goals, is the ego’s meaningful response to stimuli and to the conditions of its environment, is a person’s conscious adjustment to the state of the universe that determines his life.” Mises is clear that only individuals act:

The We cannot act otherwise than each of them acting on his own behalf. They can either all act together in accord, or one of them may act for them all. In the latter case the cooperation of the others consists in their bringing about the situation which makes one man’s action effective for them too. Only in this sense does the officer of a social entity act for the whole; the individual members of the collective body either cause or allow a single man’s action to concern them too. [HA, p. 44]

In other words, only individuals act. What we see as society, or the “macroeconomy”, is merely the consequence and summation of individual actions. The state, the church, and the firm, are all euphemisms for certain actions carried on by certain individuals. Mises, again: “The hangman, not the state, executes a criminal.” [HA, p. 42]

Only by understanding individual behaviour can explain group behaviour. Yes, it’s true that individuals are born into groups, families, nations, and religious communities. It’s also true that the faculties of speech and reason, among others, only make sense within a larger society. However, these societies are driven and directed by the actions of individuals, not the other way around. Whether a group does something is inevitably the result of a decision by an individual (or consensus by a group of individuals) that others in the group choose to abide by.

To say “Germany invaded France” is really to say that certain individuals in the area called “Germany” made active decisions that, in aggregate and with conjunction with other social theories, we refer to as “invading” the area referred to as “France”. Economics is not concerned with the theories of defining or justifying the concepts “Germany”, “invading”, or “France”. Collectives can only be understood, as opposed to observed. One can only know the difference between the “German army” and a random gaggle of individuals who happen to be walking in lockstep carrying weapons by understanding the motivations of the individuals involved. In this effect, understanding individual action is prior to understanding collective action.

Economics is interested in understanding the ramifications of the actions of the individuals involved as they pertain to the allocation of scarce resources. All economic phenomena are the result of individual action. To stop the analysis at the national or state or other “macro” level, without attempting to identify or understand the reasons and reasoning of the individuals that make up those aggregates, is to be presumptuous about the motivations of individuals involved.