## Probability and economics (wonkish)

3 October, 2015 at 08:59 | Posted in Economics, Statistics & Econometrics | 2 CommentsModern neoclassical economics relies to a large degree on the notion of probability.

To at all be amenable to applied economic analysis, economic observations allegedly have to be conceived as random events that are analyzable within a probabilistic framework.

But is it really necessary to model the economic system as a system where randomness can only be analyzed and understood when based on an *a priori* notion of probability?

When attempting to convince us of the necessity of founding empirical economic analysis on probability models, neoclassical economics actually forces us to (implicitly) interpret events as random variables generated by an underlying probability density function.

This is at odds with reality. Randomness obviously is a fact of the real world. Probability, on the other hand, attaches (if at all) to the world via intellectually constructed models, and *a fortiori* is only a fact of a probability generating (nomological) machine or a well constructed experimental arrangement or “chance set-up”.

In probabilistic econometrics randomness is often defined with the help of independent trials – two events are said to be independent if the occurrence or nonoccurrence of either one has no effect on the probability of the occurrence of the other – as drawing cards from a deck, picking balls from an urn, spinning a roulette wheel or tossing coins – trials which are only definable if somehow set in a probabilistic context.

But if we pick a sequence of prices – say 2, 4, 3, 8, 5, 6, 6 – that we want to use in an econometric regression analysis, how do we know the sequence of prices is random and *a fortiori* being able to treat as generated by an underlying probability density function? How can we argue that the sequence is a sequence of probabilistically independent random prices? And are they really random in the sense that is most often applied in probabilistic econometrics – where X is called a random variable only if there is a sample space S with a probability measure and X is a real-valued function over the elements of S?

Bypassing the scientific challenge of going from describable randomness to calculable probability by just assuming it, is of course not an acceptable procedure. Since a probability density function is a “Gedanken” object that does not exist in a natural sense, it has to come with an export license to our real target system if it is to be considered usable. We still have to show that the real sequence somehow coincides with the ideal sequence that defines independence and randomness within our “nomological machine,” our “probabilistic model.”

**Just as there is no such thing as a “free lunch,” there is no such thing as a “free probability.”** To be able at all to talk about probabilities, you have to specify a model. If there is no chance set-up or model that generates the probabilistic outcomes or events – in statistics one refers to any process where you observe or measure as an experiment (rolling a die) and the results obtained as the *outcomes* or *events* (number of points rolled with the die, being e. g. 3 or 5) of the experiment – there strictly seen is no event at all.

Probability is a relational element. It always must come with a specification of the model from which it is calculated. And then to be of any empirical scientific value it has to be *shown* to coincide with (or at least converge to) real data generating processes or structures – something seldom or never done!

And this is the basic problem with economic data. If you have a fair roulette-wheel, you can arguably specify probabilities and probability density distributions. But how do you conceive of the analogous nomological machines for prices, gross domestic product, income distribution etc? Only by a leap of faith. And that does not suffice. You have to come up with some really good arguments if you want to persuade people into believing in the existence of socio-economic structures that generate data with characteristics conceivable as stochastic events portrayed by probabilistic density distributions!

From a realistic point of view we really have to admit that the socio-economic states of nature that we talk of in most social sciences – and certainly in economics – are not amenable to analyze as probabilities, simply because in the real world open systems that social sciences – including economics – analyze, there are no probabilities to be had!

The processes that generate socio-economic data in the real world cannot just be assumed to always be adequately captured by a probability measure. And, so, it cannot really be maintained that it even should be mandatory to treat observations and data – whether cross-section, time series or panel data – as events generated by some probability model. The important activities of most economic agents do not usually include throwing dice or spinning roulette-wheels. Data generating processes – at least outside of nomological machines like dice and roulette-wheels – are not self-evidently best modeled with probability measures.

**If we agree on this, we also have to admit that much of modern neoclassical economics lacks a sound justification.** I would even go further and argue that there really is no justifiable rationale at all for this belief that all economically relevant data can be adequately captured by a probability measure. In most real world contexts one has to *argue* and *justify* one’s case. And that is obviously something seldom or never done by practitioners of neoclassical economics.

As **David Salsburg** (2001:146) notes on probability theory:

[W]e assume there is an abstract space of elementary things called ‘events’ … If a measure on the abstract space of events fulfills certain axioms, then it is a probability. To use probability in real life, we have to identify this space of events and do so with sufficient specificity to allow us to actually calculate probability measurements on that space … Unless we can identify [this] abstract space, the probability statements that emerge from statistical analyses will have many different and sometimes contrary meanings.

Just as e. g. **John Maynard Keynes** (1921) and **Nicholas Georgescu-Roegen** (1971), Salsburg (2001:301f) is very critical of the way social scientists – including economists and econometricians – uncritically and without arguments have come to simply assume that one can apply probability distributions from statistical theory on their own area of research:

Probability is a measure of sets in an abstract space of events. All the mathematical properties of probability can be derived from this definition. When we wish to apply probability to real life, we need to identify that abstract space of events for the particular problem at hand … It is not well established when statistical methods are used for observational studies … If we cannot identify the space of events that generate the probabilities being calculated, then one model is no more valid than another … As statistical models are used more and more for observational studies to assist in social decisions by government and advocacy groups, this fundamental failure to be able to derive probabilities without ambiguity will cast doubt on the usefulness of these methods.

Or as the great British mathematician **John Edensor Littlewood** says in his *A Mathematician’s Miscellany:*

Mathematics (by which I shall mean pure mathematics) has no grip on the real world ; if probability is to deal with the real world it must contain elements outside mathematics ; the meaning of ‘ probability ‘ must relate to the real world, and there must be one or more ‘primitive’ propositions about the real world, from which we can then proceed deductively (i.e. mathematically). We will suppose (as we may by lumping several primitive propositions together) that there is just one primitive proposition, the ‘probability axiom’, and we will call it A for short. Although it has got to be true, A is by the nature of the case incapable of deductive proof, for the sufficient reason that it is about the real world …

We will begin with the … school which I will call philosophical. This attacks directly the ‘real’ probability problem; what are the axiom A and the meaning of ‘probability’ to be, and how can we justify A? It will be instructive to consider the attempt called the ‘frequency theory’. It is natural to believe that if (with the natural reservations) an act like throwing a die is repeated n times the proportion of 6’s will, with certainty, tend to a limit, p say, as n goes to infinity … If we take this proposition as ‘A’ we can at least settle off-hand the other problem, of the meaning of probability; we define its measure for the event in question to be the number p. But for the rest this A takes us nowhere. Suppose we throw 1000 times and wish to know what to expect. Is 1000 large enough for the convergence to have got under way, and how far? A does not say. We have, then, to add to it something about the rate of convergence. Now an A cannot assert a certainty about a particular number n of throws, such as ‘the proportion of 6’s will certainly be within p +- e for large enough n (the largeness depending on e)’. It can only say ‘the proportion will lie between p +- e with at least such and such probability (depending on e and n*) whenever n>n*’. The vicious circle is apparent. We have not merely failed to justify a workable A; we have failed even to state one which would work if its truth were granted. It is generally agreed that the frequency theory won’t work. But whatever the theory it is clear that the vicious circle is very deep-seated: certainty being impossible, whatever A is made to state can only be in terms of ‘probability ‘.

**This importantly also means that if you cannot show that data satisfies all the conditions of the probabilistic nomological machine, then the statistical inferences used – and a fortiori neoclassical economics – lack sound foundations!**

*References*

Georgescu-Roegen, Nicholas (1971), *The Entropy Law and the Economic Process*. Harvard University Press.

Keynes, John Maynard (1973 (1921)), *A Treatise on Probability*. Volume VIII of *The Collected Writings of John Maynard Keynes*, London: Macmillan.

Littlewood, John Edensor (1953) A Mathematician’s Miscellany, London: Methuen & Co.

Salsburg, David (2001), *The Lady Tasting Tea*. Henry Holt.

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“real data generating processes”. It’s worse than tying things to those. Because the ‘real data generating processes’ have been strapped to the Procrustean bed of neo-liberal economics for 40 years. So unsurprisingly after years on the rack, they fit the bed.

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How do you analyse the possible movements of a man if the man is in a straitjacket?

Comment by Neil Wilson— 3 October, 2015 #

“In most real world contexts one has to argue and justify one’s case. And that is obviously something seldom or never done by practitioners of neoclassical economics.”

While Critical Theory has revolutionised most of the social sciences and almost all quickly saw the limitations of game theory, positivist methodology and deductivism decades ago,for some reason economics went on its own tangent and these practices became even more entrenched, going well beyond the absurd, for reasons I must admit, I dot fully understand.

In political science there has been some return to rational choice approaches (even though they long ago abandoned techniques like game theoretical approaches to explain the stability of bipolar geopolitical structures, such as during the Cold War). But it is not as bad as it sounds. Models and theories are not the basis of analysis in that discipline, and a large number of theories are referred to, whether realist, liberal or Marxist, and when they are they are used as reference points; not the sole basis of discussion.

Models should not be used to frame your analysis. The evidence – quantitative and qualitative – should.

Keep these great posts coming, the heat needs to be kept on.

Comment by nanikore— 6 October, 2015 #