Friday, June 1, 2012

Studying Reality: A New Path For Economics

In a post titled, Assuming Away the Economy, UnlearningEcon discusses the “disconnect between economic models/assumptions and the economy they purport to represent” based on a recent reading of the following quote by Frank Knight:
“To begin with a general abstract answer, it will be evident to anyone with a rudimentary understanding of economic processes and analysis that profit (always in the sense of pure profit) would be absent under the conditions of equilibrium with “perfect competition,” (which may be defined in more than one way). The”tendency” of the competitive processes of buying and selling and the control of production is to impute the whole product to the productive agencies which create it, leaving nothing for entrepreneurship as a distinct function (except for monopoly gain, referred to below). This means that under the conditions of ideal equilibrium (stationary or moving) the function of entrepreneurship itself is entirely absent from the economy.”
This morning, on my drive to work, I listened to a recent EconTalk podcast by Russ Roberts with Ronald Coase. One of the topics discussed was a paper Coase wrote as an undergraduate, “The Nature of the Firm.” Traditional economic theory of that time implied that firms should not exist because of the price system. Firms obviously did exist and Coase set out to understand how and why. To the surprise of many, he found that price signals were often not used in decision-making within firms. As Coase mentions in the podcast:
It's cheaper because the price system is a very expensive system. If you think of all the things you have to know in order to make a bargain it's obvious it's not a cheap system. And a system that avoids negotiations is one that saves a lot of costs.
Coase’s paper was written in 1937 and the quote by Knight is from 1942. Seven decades later economics is still dealing with the fundamental problem that equilibrium underlies all mainstream theories but fails to provide a reasonable representation of the real world.

Thinking about this topic led me to consider Milton Friedman’s essay "The Methodology of Positive Economics", in which he argues that an economic theory should be judged based on the validity of its predictions rather than the accuracy with which its assumptions describe reality. The economics profession appears to have taken this argument one step too far, broadly applying and assuming the validity of assumptions from theories that only proved accurate in a very limited sense. To my mind, this extension may have been prevented had Friedman’s argument been accompanied by the following caveat: The predictive validity of an economic theory only validates the use of inaccurate assumptions in the limited environment for which the predictions hold.

Unfortunately history has not played out that way. Mainstream economics broad application of assumptions that abstract from the real world has resulted in a whole host of theories that could not foresee the Great Recession or offer practical policy resolutions for the ongoing crisis. On the current status of economics, Coase comments:
I think the time has come when we should study what actually happens
Hopefully this view will soon become a reality.


  1. This whole topic is unfamiliar to me, this meta-level evaluation of economic thought rather than economic data. I *do* like that last quote from Coase.

    I think of myself as a student of the economy. I think that's the kind of thing you're talking about.

    Good post.

    1. You're definitely on the right track. I appreciate your blog because you analyze economic data as is, not as you might hope it to be in an abstract universe.

  2. Sometimes models predict events in spite of their assumptions - a lucky guess in other words. But you can only really learn from models that use valid assumptions rather than lucky guesses.