Andrew Bubala

E-Business Book Review

Most poor souls who have ever taken an introduction to economics have almost without exception been subjected to twin terrors of microeconomics and macroeconomics. Yet rarely is it explained why the study of individual economic behavior fails to account for the behavior of the economy as a whole. After all, if the macro economy is the aggregate of all the individual actors, why are the two schools incongruent?

A large number of students give up on economics because of such bald contradictions. At last, Paul Ormerod is giving a plausible explanation in his book “Butterfly Economics: A New General Theory of Social and Economic Behavior.” The book is primarily a rebuttal of the “orthodox economics” of the kind mentioned above. In a nutshell, Ormerod takes the traditional microeconomic agent and allows the agent to freely interact with other like agents, influencing and affecting behavior as a product of the interaction. In this way he avoids trying to simply take the fixed preferences and tastes of a single agent and sum up for the total population (as one might intuitively try to link microeconomics with macroeconomics). As Ormerond states, “The behavior of the system as a whole can never be understood by mechanistically adding together its component parts.”

By simply allowing the process of interaction to produce the swings and fluctuations observed on the macro scale, Ormerod has taken concepts from the world of complex systems and chaos theory and applied them the world of economics and economic forecasting in particular. He makes a persuasive argument that such modeling offers a good approximation to reality, and a powerful explanation of the micro and macro systems. At last!

Without delving into the details of his methodology, the key insights to be gained from Butterfly Economics include thoughts on volatility of asset prices and the implications of first-mover advantage.

Ormerod’s theory says that unpredictability is an inherent feature of asset prices and that future changes in prices are essentially impossible to accurately forecast. This inherent unpredictability combined with interacting agents gives rise to concepts such as momentum investing. If we see our neighbor buying, we can be positively influenced to buy as well (this also can go a long way toward explaining the popularity of items such as Cabbage Patch Kids and hit movies). In other words, “word-of-mouth” effects can powerfully influence economic variables beyond what we could rationally justify.

The key element in the interacting agents model is each agent’s propensity to change his mind. When this propensity is high, the aggregate behavior of individuals tends to converge to the mean. Conversely, when propensity to change is low, the aggregate behavior tends to swing to extremes for sustained periods of time. The implication is that when individuals are reluctant to switch their opinion/product choice or face high costs of doing so, one winner will emerge from a pack of ideas/products based upon early interactions and influences exerted by agents on each other. As examples, the US dollar might experience sustained overvaluation if currency traders have a low propensity to change their outlook on the future of the dollar. Also, inferior products might become standards due to a combination of early consumer preference and high switching costs (think Betamax/VHS).

So while the crux of Ormerod’s book actually focuses more on the implications for economic forecasting and modeling, one of the key takeaways in the E-Business context is to be a first-mover and create switching costs to consumers in order to consolidate position. And while this may be filed in the drawer of “common sense” by most, we can thank Ormerod for at last telling us why such tactics are successful

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