Neoclassical economics?

Neoclassical economics is the idea

that humans are rational, utility-maximizing agents with fixed preferences, that they make decisions ‘at the margins’ and that the mechanisms of supply and demand (operating free of government interference) will lead to a general equilibrium whereby resources are allocated efficiently

according to this article in The Nation.

I’m not sure this is right. Neoclassical economics articulates *assumptions* precisely to make certain predictions about human behavior. Historically, those assumptions have been rationality, complete markets and prices taking. The predictions generated from those assumptions can be tested. They are often verified (quantity demanded generally goes down when prices increase, for example) and when they’re not they provide a way of talking about negative results.

David Card famously found that minimum wages in New Jersey didn’t decrease employment in the fast food industry. The neoclassical framework gives us a means of discussing that result; its a sounding board. Why didn’t demand for low skill labor slope downwards? Was it because the assumption of rationality, price taking or one of the other assumptions of the theory was violated? Were prices (in this case wages) being measured correctly*?

That Card discovered data that contradicted the theory isn’t enough. We need to know *why* the theory failed. Its not enough to scream from the sidelines “the theory is wrong!” To make progress, we have to correct the theory by updating assumptions.

The neoclassical theory has traction because it has plausible assumptions, it implies tractable predictions and it has been useful. First, it seems likely that people use reason when making decisions. Obviously, that’s not strictly true and its not true that people are good at reasoning, but this is a feature of human behavior. It makes sense to try understand the implications of that feature. Also, unless you talk of certain industries, or even particular firms, the price taking assumption is the only general assumption one can make that is approximately true**.

Second, you can write out explicit models of neoclassical theory. There’s equations. They show precisely the relationships the modeler is interested in, no more and no less.

Third, neoclassical theory has delivered the goods in terms of scientific results (of which, I include Card’s).

Like any science, economics advances by identifying, precisely, the flaws in the theory and then updating the theory. More from the article:

some mainstream economists dismiss heterodox work as quackery, others claim that the mainstream has actually assimilated many of the heterodox critiques. (You’ll note that these two responses, both fairly common, are also logically incompatible.)

…but this isn’t incompatible. Real negative results from “heterodox” economics get incorporated***. Much of the inspiration for behavioral economics is from the “finding” that people aren’t rational, for example. I often feel that “heterodox” economists want to do theory-free economics. Theory-free economics is quackery.

UPDATE: Rodrik says is better: “To me [neoclassical economics] represents nothing other than a methodological predilection for deriving aggregate social phenomena from individual behavior–and as such it is a very useful discipline for any social science. You say people have some preferences, they face certain constraints, take others’ actions into account, and go from there. Neoclassical economics teaches you how to think, not what to think.”

UPDATE 2: HedgeFundGuy talks heterodox: “Like any science, there are those who think the current mainstream is really wrong about big issues. But these overbroad criticisms are lame because they offer nothing specific as an alternative, just a critique of the imperfect status quo. There’s mention of recognizing customs, norms, etc., but that’s just sociology, and that ‘science’ has hardly been more successful than economics… They have never made a statue in honor of a critic.”

UPDATE 3: I think Borjas picks up the grain of truth in the Nation article. Economists are herd animals.

*I’m thinking of non-wage compensation.
** I’m not an IO expert, but there’s certain competitive structures where industries with only two firms act like price takers (i.e. not like monopolies).
*** In the article, Card’s results are given as an example of a heterodox result.

Too much data, not enough theory

A professor forwarded this New Yorker article about the Large Hadron Collider in Europe.

One section of the article talks about tension between theorists and empiricists. The empiricists feel like they’ve been slaving away the last decade to build the collider and then the theorists are swooping in to claim credit for any of their discoveries. The theorist of course theorized the existence of any particles the empiricists might find.

Whatever the empirical physicists feel about the theorists, its clear that the LHC wouldn’t have been built, nor conceived of, if it wasn’t for theory. In physics, they have stories and then they run experiments to check those stories.

Economics has a different problem, I think. There’s too much data, not enough experimental data, and not enough theory. Econometrics allows a hundred ways to parse signal from noise. Given even with random data 5 of those ‘signals’ will be statistically significant, we end up making up stories to explain the data even if the data is just noise.

In economics, we have it backwards. We find data sources, we dig around until we get statistical significance, and then we have a paragraph in the last section of the paper outlining the several stories that can be told to explain the data.

Texting the Fed

I think this is cool.

Prof. Cogley warned us against textual analysis a la Romer and Romer today in lecture. Figuring this is a plot to steer us away from interesting research topics (he wants to keep them for himself, of course), I dove right into the Fed meeting notes and did some textual analysis. Below are some results (using this tool):
fed_freq.JPG

More talk about velocity under Volker, but less talk about inflation and unemployment.

I heart economists

We have a short economist arguing against a tax on height and a tall economist arguing for it. “Economic agents” maximize their own utility but economists don’t.

In any case, Mankiw’s paper is pretty interesting. The abstract:

Should the income tax system include a tax credit for short taxpayers and a tax surcharge for tall ones? This paper shows that the standard utilitarian framework for tax policy analysis answers this question in the affirmative. This result has two possible interpretations. One interpretation is that individual attributes correlated with wages, such as height, should be considered more widely for determining tax liabilities.
Alternatively, if policies such as a tax on height are rejected, then the standard utilitarian framework must in some way fail to capture our intuitive notions of distributive justice.

In a way, the controversy over the Stern report can be seen in the same light. If you believe, due to some ideas of cross-generation distributional justice, that we should do something about global warming but you believe our standard values of the discount rate are correct (i.e. 2%), then there must be something wrong with the standard utility models.

I don’t think its good enough to say “yep, the models are wrong… ignore the economists.” You have to come up with an alternative framework. Without a good alternative model, there isn’t a common ground for discussion. In this way, a model is just a mode of thought that we can use to think through an issue.