September 15, 2007

Foundational Dismal Science Blogging

Attention conservation notice: 1200-odd words on two old papers on the foundations of economics, one of them by two of my fellow SFI external faculty members. Only of interest if you are the kind of person who'd care about the summer's Methodenstreit: The Extended Blogospheric Remix, but posted too late to contribute to that discussion, which in fact it does not address. Mostly written in November 2005 and then abandoned to the gnawing criticism of the mice finish a grant proposal.

Who knew that Reinhard Selten was the author of a dialogue on the foundations of economics?

Reinhard Selten, "Evolution, Learning, and Economic Behavior", Games and Economic Behavior 3 (1991): 3--24 [No free copy]
No abstract.

The participants are a Bayesian, an economist, an experimental psychologist, an "adaptationist" (i.e., an evolutionary game theorist), a population geneticist, an ethologist, and a "Chairman" standing in for Selten. The topic, rather than the nature of love or justice, or even the ideal city, is, in the Chairman's words, "What do we know about the structure of human economic behavior?" The ultimate answer is "squat all, but it's not Bayesian; we need lots of experiments" (Prof. Dr. Dr. h.c. mult. Selten phrases this somewhat more elegantly).

This is a lot more empirical than I, for one, expected from the inventor of the idea of sub-game perfect equilibria, but it turns out, from his autobiographical sketch, that Selten was doing experimental economics back in the early 1960s, before anyone recognized there was such a field...

For that matter, who knew that Reinhard Selten maintains a page about his cats?

On a not-unrelated note, Bowles and Gintis are also looking at the foundations, and bringing to mind a pair of contractors who are telling the homeowner that, sadly, sadly, everything will have to be replaced.

Samuel Bowles and Herbert Gintis, "Walrasian Economics in Retrospect", The Quarterly Journal of Economics 115 (2000): 1411--1439 [JSTOR; PDF reprint via Bowles]
Abstract: Two basic tenets of the Walrasian model, behavior based on self-interested exogenous preferences and complete and costless contracting have recently come under critical scrutiny. First, social norms and psychological dispositions extending beyond the selfish motives of Homo economicus may have an important bearing on outcomes, even in competitive markets. Second, market outcomes depend on strategic interactions in which power in the political sense is exercised. It follows that economics must become more behavioral and more institutional. We can return to these themes of the classical tradition, now equipped with the more powerful mathematical tools developed over the past century.

Walras helped inaugurate the modern form of mathematical economics in many ways, but one of his contributions which has really stuck is a picture of the market economy as a kind of centralized system of simultaneous auctions. In this picture, everyone starts with some initial allocation of goods and other resources, and a utility function which tells them how satisfied they would be with some other basket of goods. The auctioneer calls out a vector of prices, and everyone indicates to the auctioneer how much of each good they would be willing to buy or sell at that price. The auctioneer then adjusts the prices to try to make supply equal demand; when they do and the market will clear, trades take place at that price. Finis. Now, this is clearly not at all how a real market system works --- though I have been told that the Paris stock exchange used to use a system along these lines back in the day --- but that particular scheme is not the important part of Walrasian economics. The bits that really matter are the assumptions that (1) everyone has a well-behaved, fixed, completely self-regarding utility function, and (2) there are markets in everything, and participating in these markets (finding counter-parties, discovering prices, etc.) is automatic and costless.

What Bowles and Gintis say makes a lot of sense to me:

[E]conomic analysis must become more social and psychological in its treatment of the human actor, more institutional in its description of the exchange process, yet no less analytical in its model-building and no less dedicated to the construction of general equilibrium models.

Though I don't completely agree with the very last bit. The point of a general equilibrium model is that it depicts the economy as an interconnected system, and lets us model the global effects of locally-applied changes. They're quite right that we should want to keep doing that; but they don't seem to have a strong argument that the only way to do this is through an equilibrium model.

[W]e must judge policies and institutions not by how closely they approximate the assumptions of the fundamental theorems of welfare economics, but rather according to their ability to function effectively in the second-best world of ineradicable state and market failures
They do insist, correctly, that, "Contrary to the claims of many of its critics, Walrasian economics never had a policy agenda." I'd go further and say that many forms of heterodox economics — in particular, the Austrian school — are much better suited to ideological mystification in the service of capitalism. (But many of them also can't, as my mother would say, think their way out of a wet paper bag, which may limit their effectiveness.)

They have some fun with the absurdity of trying to use the Walrasian framework to explain the differing fates of, say, East Asia and sub-Saharan Africa. To give a concrete example, though not one they mention: South Korea and Ghana had nearly the same per-capita GDP in 1958, but by 1998 South Korea's was about seven times larger. Differences in investment, which is nearly all that the Walrasian framework can appeal to, can account for less than half of this difference; and this includes the somewhat dubious notion of investing in human capital. (See chapter 1 [PDF] of the World Bank's 1998--1999 World Development Report .) This is not unrelated to what they describe as an "equally telling failure":

[Walrasian economics'] surprising inability to understand the shortcomings of the main competitor to capitalism in this century, state ownership and central planning. The basic problem with the Walrasian model in this respect is that it is essentially about allocations and only tangentially about markets — as one of us (Bowles) learned when he noticed that the graduate microeconomics course that he taught at Harvard was easily repackaged as "The Theory of Economic Planning" at the University of Havana in 1969.

This is a point elaborated on at book length in Joseph Stiglitz's Whither Socialism? (a much better guide to recent work in the economics of imperfect information and imperfect competition, especially Stiglitz's work on those subjects, and the light they shed on how not to run a socialist or capitalist economy, than it is to feasible, market-based socialisms), and is quite correct.

Were I less lazy, I'd describe Bowles and Gintis's plans for the new structure, and how it would actually deal with things like markets, competition, and economic growth, but, well, I'm lazy, so go read them.

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Posted at September 15, 2007 17:08 | permanent link

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