Introduction to Economics Part 4 - The Wisdom of Crowds

It is often proposed that through centrally planned economies efficiency and benefit for all can be better achieved than through the "chaos" of the market. At the end of this note you will begin to understand why this is, firstly, completely impossible, and more importantly, undesirable.

GALTON'S OX

Francis Galton, cousin of Charles Darwin, was an English-Victorian polymath, inventor, geographer, proto-geneticist, meteorologist, and statistician. In 1906 he attended a livestock fair where he was intrigued by a contest - "guess the weight of this ox." When the contest had concluded, he looked at the winning guess, looked at the actual weight of the ox, looked at all of the guesses, and noticed something very peculiar! The winning guess was the median of all the other guesses. There were just as many guesses above the winning guess as there were below the winning guess!

Ox's Weight - 1198 lbs
Median Guess - 1208 lbs

Even more interesting, he took the mean (average) of all the guesses, and it turned out to be just one pound off from the correct value.

Mean - 1197 lbs

Keep in mind that this was a livestock fair. There were butchers, large-animal vets, and farmers present, dozens of experts in the field. Yet not one of them was able to guess the actual weight of the ox as accurately as the combined whole of fair attenders. This phenomenon is what we call the wisdom of crowds.

Since this event, numerous studies have been done showing how the wisdom of crowds is more accurate than the estimates of any single individual. You've probably participated in one.

JELLY BEANS

The most common way the wisdom of crowds experiment shows up is at fundraisers involving a jar of jelly beans. Everyone guesses how many jelly beans are in the jar, and the closest guess gets to keep it, or something along those lines. This is an easy way to test this phenomenon on your own if you ever want to. It's been done many times, and over and over again the wisdom of crowds proves more accurate than any single person. The only way the crowds can be fooled is to outright cheat, such as by putting a Styrofoam ball in the middle of the jar to alter the crowd's perception.

WHEN DOES IT WORK?

In order for the wisdom of crowds to work reliably, there are four requirements.

1. Diversity of opinion and knowledge
-You need people from different walks of life, different amounts of knowledge, different biases, and different lifestyles. The more diverse, the better.

2. Independence
-Everyone must make their own independent guess without influences from anyone else

3. Decentralization
-All the guessers must be part of different organizations.

4. Aggregation
-There must be some way of combining all the parts into a whole.

HOW CAN IT GO WRONG?

-The group can be too homogeneous. If the group is all part of the same culture or the same background, they may all be biased in the same direction.
-It can be too centralized. If everyone is from the same authority, it will not work.
-Incorrect information. There cannot be one set of information for one group and another set of information for another. When this happens, it usually indicates fraud or lies.
-Imitation - People copy the same methods other people use. If the methods are flawed, the results will be flawed.
-Emotion - If the decision is too emotional, the wisdom of crowds will not work.

THE WISDOM OF CROWDS IN THE ECONOMY

The wisdom of crowds is a big determining factor in economics. One of the most common ways it is disrupted is with government intervention.

The market, as we discussed before, is always moving towards total employment and maximum output. A lot of people don't trust the market, so they try to use the government to control it. The Federal Reserve is perhaps the most obvious manifestation of this fear. The idea behind the Federal Reserve is that an organization full of people who are knowledgeable and skilled in economics are more able to manage an economy than the population as a whole. They can anticipate total output, control the inflation rates, control the money supply, and so on, thus avoiding the boom and bust cycles.

Unfortunately for proponents of the Federal Reserve, there is a flaw. It is completely impossible for any individual human being to know the information they are ascribing to these financial experts. People can only be aware of their own personal desires and production, and have a vague idea of the desires and output of those with whom they directly interact. The idea that individual central planners can possibly comprehend the economic actions of over 300,000,000 people is as ludicrous as attempting to give a human being the responsibility of allocating oxygen to the millions of red blood cells in a person's body. This information is beyond human capacity to calculate, even with computers, and even if it was not, the data necessary to begin the calculations cannot be collected. No one knows what the total output of the economy is at any given time. The only way observers can make any sort of estimate is by relying on the wisdom of crowds to approximate reality. This interaction of millions of people supplying and demanding millions of goods and services is what determines prices. When you do not allow the wisdom of crowds to function, and instead leave this responsibility to a small group of limited human beings, they will get it wrong, and the result will be disastrous.

Thanks for reading! Have a nice day :-)