Limits of formalization in economics

30 Sep, 2015 at 10:16 | Posted in Economics | 4 Comments

A complete modeling system which yields definitive predictions (or at least multiple equilibria) requires the following conditions: given structures with fixed (or at least predictably random) interrelations between separable parts (e.g., economic agents) and predictable (or at least predictably random) outside influences. Such a system is … a‘closed’ system. Such a system, correctly applied, promotes internal consistency but risks inconsistency with the nature of the economic system unless that too is closed …

An open system is not the opposite of a closed system, since there is a range of possibilities for openness, depending on which conditions are not met and to what degree … Deviating from a closed system, and thus from certainty or certainty equivalence, does not mean abandoning theory or formal models. On the contrary, Keynes was concerned to identify the logical grounds on which we habitually form beliefs, make judgments and take decisions (both as economists and as economic agents) in spite of uncertainty. The question was what view on probability would be logically justified, in relation to the evidence, within an open system …

Any formal model is a closed system. Variables are specified and identified as endogenous or exogenous, and relations are specified between them. This is a mechanism for separating off some aspect of an open-system reality for analysis. But, for consistency with the subject matter, any analytical closure needs to be justified on the grounds that, for the purposes of the analysis, it is not unreasonable to treat the variables as having a stable identity, for them to have stable interrelations and not to be subject to unanticipated influences from outside … But in applying such an analysis it is important then to consider what has been assumed away …

Keynes’s argument is that any formal model is bound to be an incomplete representation of an open-system reality … Models are inevitably partial representations, invoking closures which are both porous and provisional. They can only be approximated in reality and even then cannot be presumed to persist …

This methodology explains why Keynes’s general theory did not take the form of a single large model, including formal microfoundations … It was not that Keynes lacked a microeconomic analysis, but rather that his study of individual behavior concluded that it was organic rather than atomistic.

Sheila Dow