The model of all economic models (wonkish)

3 December, 2015 at 19:38 | Posted in Economics | 9 Comments

Economics is perhaps more than any other social science model-oriented. There are many reasons for this — the history of the discipline, having ideals coming from the natural sciences (especially physics), the search for universality (explaining as much as possible with as little as possible), rigour, precision, etc.

Economic_eng

Mainstream economists want to explain social phenomena, structures and patterns, based on the assumption that the agents are acting in an optimizing (rational) way to satisfy given, stable and well-defined goals.

The procedure is analytical. The whole is broken down into its constituent parts so as to be able to explain (reduce) the aggregate (macro) as the result of interaction of its parts (micro).

Building their economic models, modern mainstream (neoclassical) economists ground their models on a set of core assumptions (CA) — describing the agents as ‘rational’ actors — and a set of auxiliary assumptions (AA). Together CA and AA make up what I will call the ur-model (M) of all mainstream neoclassical economic models. Based on these two sets of assumptions, they try to explain and predict both individual (micro) and — most importantly — social phenomena (macro).

The core assumptions typically consist of:

CA1 Completeness — rational actors are able to compare different alternatives and decide which one(s) he prefers

CA2 Transitivity — if the actor prefers A to B, and B to C, he must also prefer A to C.

CA3 Non-satiation — more is preferred to less.

CA4 Maximizing expected utility — in choice situations under risk (calculable uncertainty) the actor maximizes expected utility.

CA4 Consistent efficiency equilibria — the actions of different individuals are consistent, and the interaction between them result in an equilibrium.

When describing the actors as rational in these models, the concept of rationality used is instrumental rationality – choosing consistently the preferred alternative, which is judged to have the best consequences for the actor given his in the model exogenously given wishes/interests/ goals. How these preferences/wishes/interests/goals are formed is not considered to be within the realm of rationality, and a fortiori not constituting part of economics proper.

The picture given by this set of core assumptions (rational choice) is a rational agent with strong cognitive capacity that knows what alternatives he is facing, evaluates them carefully, calculates the consequences and chooses the one — given his preferences — that he believes has the best consequences according to him.

Weighing the different alternatives against each other, the actor makes a consistent optimizing (typically described as maximizing some kind of utility function) choice, and acts accordingly.

Beside the core assumptions (CA) the model also typically has a set of auxiliary assumptions (AA) spatio-temporally specifying the kind of social interaction between ‘rational actors’ that take place in the model. These assumptions can be seen as giving answers to questions such as

AA1 who are the actors and where and when do they act

AA2 which specific goals do they have

AA3 what are their interests

AA4 what kind of expectations do they have

AA5 what are their feasible actions

AA6 what kind of agreements (contracts) can they enter into

AA7 how much and what kind of information do they possess

AA8 how do the actions of the different individuals/agents interact with each other.

So, the ur-model of all economic models basically consist of a general specification of what (axiomatically) constitutes optimizing rational agents and a more specific description of the kind of situations in which these rational actors act (making AA serve as a kind of specification/restriction of the intended domain of application for CA and its deductively derived theorems). The list of assumptions can never be complete, since there will always unspecified background assumptions and some (often) silent omissions (like closure, transaction costs, etc., regularly based on some negligibility and applicability considerations). The hope, however, is that the ‘thin’ list of assumptions shall be sufficient to explain and predict ‘thick’ phenomena in the real, complex, world.

These economic models are not primarily constructed for being able to analyze individuals and their aspirations, motivations, interests, etc., but typically for analyzing social phenomena as a kind of equilibrium that emerges through the interaction between individuals. Employing a reductionist-individualist methodological approach, macroeconomic phenomena are, analytically, given microfoundations.

Now, of course, no one takes the ur-model (and those models that build on it) as a good (or, even less, true) representation of economic reality (which would demand a high degree of appropriate conformity with the essential characteristics of the real phenomena, that, even when weighing inn pragmatic aspects such as ‘purpose’ and ‘adequacy’, it is hard to see that this ‘thin’ model could deliver). The model is typically seen as a kind of ‘thought-experimental’ bench-mark device for enabling a rigorous mathematically tractable illustration of how an ideal market economy functions, and to be able to compare that ‘ideal’ with reality. The model is supposed to supply us with analytical and explanatory power, enabling us to detect, describe and understand mechanisms and tendencies in what happens around us in real economies.

Based on the model — and on interpreting it as something more than a deductive-axiomatic system — predictions and explanations can be made and confronted with empirical data and what we think we know. If the discrepancy between model and reality is too large — ‘falsifying’ the hypotheses generated by the model — the thought is that the modeler through ‘successive approximations’ improves on the explanatory and predictive capacity of the model. 

When applying their preferred deductivist thinking in economics, mainstream neoclassical economists usually use this ur-model and its more or less tightly knit axiomatic core assumptions to set up further “as if” models from which consistent and precise inferences are made. The beauty of this procedure is of course that if the axiomatic premises are true, the conclusions necessarily follow. The snag is that if the models are to be relevant, we also have to argue that their precision and rigour still holds when they are applied to real-world situations. They often don’t. When addressing real economies, the idealizations and abstractions necessary for the deductivist machinery to work simply don’t hold.

If the real world is fuzzy, vague and indeterminate, then why should our models build upon a desire to describe it as precise and predictable? The logic of idealization, that permeats the ur-model, is a marvellous tool in mathematics and axiomatic-deductivist systems, but, a poor guide for action in real-world systems, in which concepts and entities are without clear boundaries and continually interact and overlap.

Being told that the model is rigorus and amenable to ‘successive approximations’ to reality is of little avail, especially when the law-like (nomological) core assumptions are highly questionable and extremely difficult to test. Being able to construct “thought-experiments,“ depicting logical possibilities, doesn’t — really — take us very far. An obvious problem with the mainstream neoclassical ur-model — formulated in such a way that it realiter is extremely difficult to empirically test and decisively evaluate if it’s ‘corrobated’ or ‘falsified.’ Such models are from an scientific-explanatory point of view unsatisfying. The ‘thinness’ is bought at to high a price, unless you decide to leave the intended area of application unspecified or immunize your model by interpreting it as nothing more than two sets of core and auxiliary assumptions making up a content-less theoretical system with no connection whatsoever to reality.

Seen from a deductive-nomological perspective, the ur-model (M) consist of, as we have seen, a set of more or less general (typically universal) law-like hypotheses (CA) and a set of (typically spatio-temporal) auxiliary conditions (AA). The auxiliary assumptions give “boundary” descriptions such that it is possible to deduce logically (meeting the standard of validity) a conclusion (explanandum) from the premises CA and AA. Using this kind of model economists can be portrayed as trying to explain/predict facts by subsuming them under CA given AA.

This account of theories, models, explanations and predictions does not — of course — give a realistic account of actual scientific practices, but rather aspires to give an idealized account of them.

An obvious problem with the formal-logical requirements of what counts as CA is the often severely restricted reach of the ‘law.’ In the worst case it may not be applicable to any real, empirical, relevant situation at all. And if AA is not ‘true,’ then M doesn’t really explain (although it may predict) at all. Deductive arguments should be sound — valid and with true premises — so that we are assured of having true conclusions. Constructing models assuming ‘rational’ expectations, says nothing of situations where expectations are ‘non-rational.’

Most mainstream economic models — elaborations on the ur-model — are abstract, unrealistic and presenting mostly non-testable hypotheses. How then are they supposed to tell us anything about the world we live in?

And where does the drive to build those kinds of models come from?

I think one important rational behind this kind of model building is the quest for rigour, and more precisely, logical rigour. Formalization of economics has been going on for more than a century and with time the it has become obvious that the preferred kind of formalization is the one that rigorously follows the rules of formal logic. As in mathematics, this has gone hand in hand with a growing emphasis on axiomatics. Instead of basically trying to establish a connection between empirical data and assumptions, ‘truth’ has come to be reduced to, a question of fulfilling internal consistency demands between conclusion and premises, instead of showing a ‘congruence’ between model assumptions and reality. This has, of course, severely restricted the applicability of economic theory and models.

Not all mainstream economists subscribe to this rather outré deductive-axiomatic view of modeling, and so when confronted with the massive empirical refutations of almost every theory and model they have set up, many mainstream economists react by saying that these refutations only hit AA (the Lakatosian ‘protective belt’), and that by ‘successive approximations’ it is possible to make the theories and models less abstract and more realistic, and — eventually — more readily testable and predictably accurate. Even if CA & AA1 doesn’t have much of empirical content, if by successive approximation we reach, say, CA & AA25, we are to believe that we can finally reach robust and true predictions and explanations.

But there are grave problems with this modeling view, too. The tendency for modelers to use the method of successive approximations as a kind of ‘immunization,’ implies that it is taken for granted that there can never be any faults with CA. Explanatory and predictive failures hinge solely on AA. That the CA used by mainstream economics should all be held non-defeasibly corrobated, seems, however — to say the least — rather unwarranted.

Confronted with the empirical failures of their models and theories, even these mainstream economists often retreat into looking upon their models and theories as some kind of ‘conceptual exploration,’ and give up any hopes/pretenses whatsoever of relating their theories and models to the real world. Instead of trying to bridge the gap between models and the world, one decides to look the other way. But restricting the analytical activity to examining and making inferences in the models is tantamount to treating the models as a self-contained substitute systems, rather than as surrogate systems that the modeler uses to indirectly being able to understand or explain the real target system.

Trying to develop a science where we want to be better equipped to explain and understand real societies and economies, it sure can’t be enough to prove or deduce things in model worlds. If theories and models do not — directly or indirectly — tell us anything of the world we live in, then why should we waste time on them?

9 Comments »

RSS feed for comments on this post. TrackBack URI

  1. Rodrik’s new book on economics and models shows that things are less reductive than what you present here.

    • It’s on my reading-list, just waiting for delivery🙂

  2. The ur-blunder of economics and its rectification
    Comment on ‘The model of all economic models’
    .
    It is well known that all mainstream economic models — elaborations on the ur-model — are false, but the representative economist is not quite sure what the ur-blunder is. So let us settle this crucial point here once and for all.
    .
    (i) Economics is the science which studies how the monetary economy works.
    .
    (ii) It is a fact that the economic system is populated by acting human beings which are embedded in institutions.
    .
    (iii) Despite this commonsensical fact, economics is NOT the study of individual/social human behavior. This is the subject matter of psychology, sociology, anthropology, political science and other so-called social sciences. It is all closely interwoven, of course, but economics is about the economy and NOT about society.
    .
    (iv) Economics (a) uses the findings of other sciences, and (b) must not in one single case contradict the findings of other sciences. Therefore, theoretical economics is by no means free to apply self-invented behavioral or systemic assumptions. This mutual dependency is the meaning of interdisciplinarity.
    .
    (v) Methodological impossibility theorem: No way leads from the understanding of human behavior to the understanding of how the monetary economy works. Analogon: No way leads from the understanding of the behavior of passengers and crew of an airplane to the understanding of how airplanes can fly (which depends on the laws of aerodynamics and other scientific laws). The objectives, motives, actions of passengers/crew can explain why a flight from A to B takes place but they cannot explain how flying is possible. Likewise in economics. As a matter of principle, behavioral assumptions like constrained optimization cannot explain how the economic system works, evolves and eventually ends.
    .
    (vi) Because of (i) to (v) the research program of standard economics was bound to fail from the very start.
    .
    (vii) The program is verbally given as follows. “It is a touchstone of accepted economics that all explanations must run in terms of the actions and reactions of individuals. Our behavior in judging economic research … includes the criterion that in principle the behavior we explain and the policies we propose are explicable in terms of individuals …” (Arrow, 1994, p. 1)
    .
    The program is specified by the propositions CA1 to CA4 and AA1 to AA8 above (see intro). This set is referred to as neoclassical axioms (see also Weintraub, 1985, p. 147).
    .
    Proposition CA4 relates to a systemic property and states that interaction between individuals result in an equilibrium. Methodologically, this is a petitio principii.* It is inadmissible to put a systemic property like equilibrium, which cannot be known at the start of the analysis, into the premises.
    .
    (viii) The failure of standard economics is due to the fact that an essential condition of scientific analysis has not been met. Aristotle famously put it thus: “When the premises are certain, true, and primary, and the conclusion formally follows from them, this is demonstration, and produces scientific knowledge of a thing.”**
    .
    Now it holds
    (a) the premise CA4 (equilibrium) is NOT certain/true/primary,
    (b) the premise of a rational actor, CA1-CA4, is NOT certain/true/primary.
    And from this follows: the axiomatic basis of the ur-model is defective and forever inadmissible.
    .
    (ix) As Morishima put it “If the axiom is deemed to be incorrect it must be modified or instead a correct axiom must be found.” (1984, p. 53) What is required in the actual situation is a paradigm shift, that is, the TOTAL replacement of the standard axiom set.
    .
    J. S. Mill clearly formulated the starting problem, but neither the classicals nor the schools to follow solved it. “What are the propositions which may reasonably be received without proof? That there must be some such propositions all are agreed, since there cannot be an infinite series of proof, a chain suspended from nothing. But to determine what these propositions are, is the opus magnum of the more recondite mental philosophy.” (Mill, 2006, p. 746)
    .
    Economists failed at the opus magnum. The fundamental economic concepts income and profit are ill-defined since Adam Smith. And this means that employment theory, distribution theory, growth theory, and all the rest is provably false (2015). Neither the Walrasian, nor the Keynesian, nor the Marxian, nor the Austrian school satisfies scientific standards.
    .
    Conclusion: Since the methodological turn of Jevons/Walras/Menger economics is definitively on the wrong track. Numerous refinements since their time and the use of advanced mathematical tools cannot alter this fact. The defect resides in the axiomatic foundations.
    .
    The representative economist has not got the point until this very day. As Krugman put it on his blog “most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point …”. After more than 100 years of failure this is sorta-kinda stupid.
    .
    Economic analysis has to start with the definition of the objective structure/behavior of the economic system as a whole. So, economics has to be seen NOT as a so-called social science but as a systems science. The set of axioms as enumerated in the intro has to be fully replaced by a set of objective structural axioms.***
    .
    It is high time that economics becomes — what it falsely claimed to be — a science. That much is certain, though, mainstream economists are not up to the challenge of a paradigm shift. For them, now is the moment to say goodbye with a rest of scientific propriety.
    .
    Egmont Kakarot-Handtke
    .
    References
    Arrow, K. J. (1994). Methodological Individualism and Social Knowledge.
    American Economic Review, Papers and Proceedings, 84(2): 1–9. URL http:
    //www.jstor.org/stable/2117792.
    Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working
    Paper Series, 2624350: 1–40. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2624350
    Mill, J. S. (2006). Principles of Political Economy With Some of Their Applications
    to Social Philosophy, volume 3, Books III-V of Collected Works of John Stuart
    Mill. Indianapolis, IN: Liberty Fund. URL http://www.econlib.org/library/Mill/
    mlP.html. (1866).
    Morishima, M. (1984). The Good and Bad Use of Mathematics. In P. Wiles, and
    G. Routh (Eds.), Economics in Disarry, pages 51–73. Oxford: Blackwell.
    Weintraub, E. R. (1985). Joan Robinson’s Critique of Equilibrium: An Appraisal.
    American Economic Review, Papers and Proceedings, 75(2): 146–149. URL
    http://www.jstor.org/stable/1805586

    * Wikipedia
    https://en.wikipedia.org/wiki/Begging_the_question
    ** Wikipedia
    http://en.wikipedia.org/wiki/Posterior_Analytics
    *** For a start see cross-references New Curriculum
    http://axecorg.blogspot.de/2015/04/new-curriculum-cross-references.html

    • Quote: “(i) Economics is the science which studies how the monetary economy works.”

      No. Economics is a scientia that should be about how we provide for our needs {and wants} individually and together.

      How the monetary economy works is part of that study.It is not the whole of it by any means.

      Money prices are exchange prices/values which are not necessarily related to the benefits that arise from different uses of different goods.Monetary systems superimpose exchange values to the exclusion of other values.

  3. Thinking of 2005-2010, it seems to me that if CA4 is an axiom then one can’t rely on such economics to inform opinions about the possibility of crashes. CA3 is also distinctly odd. I often drink before I drive, but more is definitely not preferred. Maybe the problem is not the reliance on axioms, but the particular axioms?

    • Well, I think you’re actually pointing at one of the problems with social science axiomatics. Building on axioms these model builders derive theorems that are nothing but tautologies in no need of empirical tests beyond testing their implications. But, really, how many think this is a tenable approach for economics? I mean, in physics (perhaps, probably Nancy Cartwright would disagree) we have some pretty well-established “laws” — think of gravity — that we (maybe) could treat as axioms, but in economics there are no such “laws,” and a fortiori, we really have to look upon CA (and the theorems derived from them) as hypotheses. Not only can we then argue that when we put the model to test, several of the assumptions (hypotheses) making up AA are false and severely violate what we know about the way the world is, but we can actually also question CA on the same ground. So when building on the ur-model and applying the standard deductive-nomological explanatory reasoning to the universal claims inherent in the “laws” presented, we can question the model since (after instantiation of the premises) the claim that CA & AA (explanans) explains the phenomena (explanandum), would imply that both explananda and explanandum were true — and if severe testing shows that (parts of) both AA and CA are possibly false, well, then what do these models really show us? Nothing at all, if we talk about the world that these models were supposed to (indirectly) learn us something about!

  4. Quite an impressive discourse.
    .
    It seems curious to me that you did not do more to highlight market equilibrium and informational sufficiency as the key assumptions, as it would seem to me to be The Ur Assumption of Neoclassical Economics, from which all else follows. That the economy is a system of markets in which price allocates resources is the central premise, alongside the presumption that people know enough to make such a system work smoothly.
    .
    All the talk of instrumental rationality almost amounts to misdirection, as it is not the assumption of rationality, per se, that is the problem — it is the presumption that there is sufficient information that rationality is enough, enough to reliably arrive at a single, determinate, market-clearing solution in this, the best of all possible worlds.
    .
    One of the things that keeps so many theorists indoors is that economic theory is about the analysis of allocative efficiency in a system of markets where everyone is passably well-informed, while the actual economy is preoccupied by the pursuit of technical efficiency in a system of dominating hierarchies struggling to learn something in a world of pervasive uncertainty.

    They’ve used axiomatics and simplifying assumptions to make the problem of the economy simpler than it is, and they defensively call that, “rigor” and dress it up with “hard math” when it is just stupidity and cowardice. When they assume “profit maximizing” behavior, for example, they assume that the profit-maximizer knows enough to “maximize”, that he’s solved the technical and managerial problems of production and distribution to a degree that the economic problem reduces to the delightfully simple problem of optimal allocation, against which market price is a sufficient statistic for optimal choice.
    .
    Unfortunately, the problem isn’t that simple. We live in a world of uncertainty, in which investment in learning and experience is likely to mean increasing returns to scale and networks, and vast waste as well as externalized costs. People can be instrumentally rational in such a world, but price won’t clear many markets — there won’t even be many markets. There won’t be nice, permanently stable solutions, either. There will be cycles and crisis and surprise and entropy galore.
    .
    Sorry for the rant. I really just wanted to congratulate you on your performance. (The rant came out on its own.😉

    • Thanks Bruce for your congrats — and rant🙂
      The reason I didn’t discuss the particular assumptions making up CA and AA more, was basically that I have been over them before (in several of my books, but also in quite a few posts on this blog).
      I wanted to focus on a more “deep” modeling approach problematic that I think has come to be more and more obvious since Samuelson started (in the modern era) the formalization trend with his “Foundations”. In the search for rigour and deductively it was somewhere forgotten that there was a trade-off in terms of relevance and scope. Economic formalism soon derailed into an insistence on “As If” modeling (everything else was deemed “unscientific”) and “Model Platonism” (which is where you inevitably end up if you try to “save” CA by not treating its constituent parts as hypotheses rather than as axioms — bridging the gap between model and reality is not the same as collapsing it!)
      I also wanted to argue against a — nowadays rather popular — “defense” of the mainstream modeling strategy, according to which the theory can be “saved” by assuming that the problem is located in the “unrealism” of AA, and that via “successive approximations” we can improve the descriptive accuracy of both the the theory and model. Improving AA however doesn’t solve the problem that CA is not accepted as true beyond doubt (cf gravity in physics) — many would even argue it’s totally inaccurate. When both CA or AA are arguably shown to be inaccurate, the kind of improvement we are to anticipate is like going from “Lars Syll is a green Martian living in New York” to “Lars Syll is a green Martian living in Malmö.” Not very impressive or hopeful if you ask me🙂

      • An actual non-ranting question.
        .
        Possibly I am not familiar enough with the “defense” of the mainstream modeling strategy you refer to — the “unrealism” of the AA and successive approximations. What I see frequently in the popular discourse is reference to ad hoc frictions. On the “left” of mainstream economics, it is quite common to uncritically accept the ideal model with its CA as a base — and then to introduce ad hoc auxiliary frictions to “better” explain (often conveniently stylized) facts. This is how I see the tension in mainstream macro between RBC/New Classical use of DSGE models and New Keynesian use of DSGE models. So, the New Keynesian will pose as the Reasonable Man, and ridicule the RBC guy for supposedly believing that workers are spontaneously taking vacations (the RBC explanation of mass unemployment within the bounds of CA), but won’t attack the CA or modeling strategy of relying on an imaginary general equilibrium of markets; instead, the New Keynesian Reasonable Man, will lodge his better acknowledgement of reality in an ad hoc friction (AA?): sticky prices, for example. The RBC guy will argue from CA that “sticky prices” make no sense, and they don’t, as long as one accepts a general equilibrium of markets as the CA; the New Keynesian isn’t actually doing anything to deepen understanding.
        .
        Am I completely off-base in my understanding of what you are saying by relating it to this phenomenon in mainstream economics?


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Blog at WordPress.com.
Entries and comments feeds.