On 4 July Paul Ormerod launched his new book, “Positive Linking – Why Networks Can Revolutionise the World”.
Modern economic theory was first set out on a formal basis in the late 19th century. There have certainly been developments since then, but at heart the basic view in economics of how the world operates remains the same. Economics is essentially a theory of how decisions are made by individuals, of what information is gathered and how it is used by the decision maker.
All scientific theories, even quantum physics, are approximations to reality. Theories involve making assumptions, simplifications, to enable us to understand problems better. A key feature of a good theory is that its assumptions are a reasonable description of the real world.
In the early 21st century, just as it did in the late 19th, economics in general makes the assumption that individuals operate autonomously, isolated from the direct influences of others. A person has a fixed set of tastes and preferences. When choosing amongst a set of alternatives, he or she compares the attributes of these alternatives and selects the one which most closely corresponds to his or her preferences.
At first sight, this may seem quite reasonable, indeed even ‘rational,’ as economists choose to describe this theory of behaviour. But there is a serious problem with the assumption that individuals operate in isolation from each other, that their preferences are not affected directly by the decisions of others. If I am interested in buying a product which many people want, the price may go up. So their choices affect me indirectly through the workings of the market. But my preferences remain unaltered.
The social and economic worlds of the 21st century are simply not like this at all. We are far more aware than ever before of the choices, decisions, behaviours and opinions of other people. In 1900, not much more than 10 per cent of the world’s population lived in cities. Now, for the first time in human history, more than half of us live in cities, in close, everyday proximity to large numbers of other people. In the last decade or so, the internet is revolutionising communications in a revolutionary way not experienced since the invention of the printing press in the late 15th century.
The assumption that people make choices in isolation, that they do not adopt different tastes or opinions simply because other people have them, is no longer sustainable. Perhaps – perhaps, and it is a big ‘perhaps’ – over 100 years ago this might not have been a bad assumption to make. But no longer.
The choices which people make, their attitudes, their opinions are influenced directly by other people. The medium across which this influence spreads is social networks. Often, social networks are thought of as purely a web-based phenomenon, sites such as Facebook. These indeed can influence behaviour. But it is real-life social networks, family, friends, colleagues, which are even more important in helping us shape our preferences and beliefs, what we like and what we do not like.
Network effects, the fact that a person can and often does decide to change his or her preferences simply on the basis of what others do, pervade the modern world.
Network effects have in fact been pervasive throughout human history. A crucial feature of human behaviour is our propensity to copy or imitate the behaviours, choices, opinions of others. We can see it in the fashions in pottery in the Middle Eastern Hittite Empire of three and a half millennia ago. And we can see it today in the behaviour of traders on financial markets, where the propensity to follow the herd can lead all too easily to the booms and crashes we have experienced. Scientists such as Robin Dunbar have argued that our anomalously large brain, compared to other mammals, evolved precisely because copying is a very successful strategy to follow from an evolutionary perspective.
This concept is just as crucial for companies and markets as it is for people. In September 2008, Lehman Brothers went bankrupt, precipitating a crisis which almost led to a total collapse of the world economy and a repeat of the Great Depression of the 1930s. It was precisely because Lehman was connected on a network to other banks that made the situation so serious. Lehman’s bankruptcy could easily have led to a cascade of bankruptcies across the world financial network, first in those institutions to which Lehman owed money, and spreading wider and wider from these across the entire network. Incredibly, neither the systems of financial regulations which were in place, nor the thinking of mainstream economics which influenced policy so strongly, took any account of the possibility of such a network effect.
A world in which network effects are a driving force of behaviour is completely different from the world of conventional economics, in which isolated individuals carefully weigh up the costs and benefits of any particular course of action. A world in which network effects are important is a much more realistic description of the human social and economic worlds which actually exist in the 21st century. It is the implications of this world which I explore in this book.
Incentives have not disappeared as a driver of human behaviour. It is still the case that if, say, Pepsi raises its price compared to Coke, more Coke and less Pepsi will be sold. This is the world which economic theory describes. It is not wrong. But it is often misleading. For it offers only a very partial account of how decisions are made in reality. Network effects can be far more powerful than incentives, and we will see many examples in which network effects have completely swamped the impact of incentives, leading to outcomes completely different from those intended by the policy makers when they altered the incentives.
Network effects require policy makers, whether in the public or corporate spheres, to have a markedly different view of how the world operates. In part, they make successful policy much harder to implement, and they help explain many of the failures of policies based on that incentives and not network effects are the key drivers of behaviour. But they open up the possibility of much more effective and successful policies, ones which harness our knowledge of network effects and how they work in practice.