## March 14, 2007

### Hal Varian: What Use is Economic Theory?

This article is suggested in a comment from Hal Varian to a post where I compared economics to physics. The article says it "is a mistake to compare economics to physics; a better comparison would be to engineering. Similarly, it is a mistake to compare economics to biology; a better comparison is to medicine." Having also made the comparison to medicine (when I wasn't comparing economics to physics and evolutionary biology), I'm in agreement with the perspective set forth in the paper.

The view adopted in the paper is that economics is inherently a "policy science" and thus the focus is on "how neoclassical economic theory is useful to the understanding of economic policy," and on describing "the role of economic theory in economics." It's a little bit longer than usual, but well worth it:

What Use is Economic Theory?. by Hal R. Varian, August, 1989: Why is economic theory a worthwhile thing to do? There can be many answers to this question. One obvious answer is that it is a challenging intellectual enterprise and interesting on its own merits. A well-constructed economic model has an aesthetic appeal well-captured by the following lines from Wordsworth:

Mighty is the charm
Of these abstractions to a mind beset
With images, and haunted by herself
And specially delightful unto me
Was that clear synthesis built up aloft
So gracefully.

No one complains about poetry, music, number theory, or astronomy as being ‘‘useless,’’ but one often hears complaints about economic theory as being overly esoteric. I think that one could argue a reasonable case for economic theory on purely aesthetic grounds. Indeed, when pressed, most economic theorists admit that they do economics because it is fun.

But I think purely aesthetic considerations would not provide a complete account of economic theory. For theory has a role in economics. It is not just an intellectual pursuit for its own sake, but it plays an essential part in economic research. The essential theme of this essay that economics is a policy science and, as such, the contribution of economic theory to economics should be measured on how well economic theory contributes to the understanding and conduct of economic policy.

1. Economics as a policy science

Part of the attraction and the promise of economics is that it claims to describe policies that will improve peoples’ lives. This is unlike most other physical and social sciences. Sociology and political science have a policy component, but for the most part they are concerned with understanding the functioning of their respective subject matters.

Physical science, of course, has the potential to improve peoples’ standards of living, but this is really a by-product of science as an intellectual activity.

In my view, many methodologists have missed this essential feature of economic science. It is a mistake to compare economics to physics; a better comparison would be to engineering. Similarly, it is a mistake to compare economics to biology; a better comparison is to medicine. I think that Keynes was only half joking when he said that economists should be more like dentists. Dentists claims that they can make make peoples’ lives better; so do economists. The methodological premise of dentistry and economics is similar: we value what is useful. None of the ‘‘policy subjects’’--- engineering, medicine, or dentistry---is much concerned about methodology, and economists, by and large, aren’t either.

When you think about it, it is quite surprising that there isn’t more work on the methodology of engineering or medicine. These subjects have exerted an enormous influence on twentieth century life, yet are almost totally ignored by philosophers of science. This neglect should be contrasted with with other social sciences where much time and energy is spent on methodological debate. Philosophy of science, as practiced in philosophy departments, seems to be basically concerned with physics, with a smattering of philosophers concerned with psychology, biology, and a few social sciences.

I think that many economists and philosopher who have written on economic methodology have not given sufficient emphasis to the policy orientation of most economic research. One reason for this is the lack of an adequate model to follow. There is no philosophy of engineering, philosophy of medicine or philosophy of dentistry---there is no model of methodology for a policy science on which we can build an analysis. The task of constructing such a theory falls to economists. This is, in my view, one of the most interesting problems for those concerned with methodological issues and the philosophy of the social sciences.

2. Role of theory in a policy science

Given my view that economics is a policy science, if I want to defend a practice in economics, then I must defend it from a policy perspective. So I need to argue about how economic theory is useful in policy. The remainder of the paper will consists of list of several such ways. The list is no doubt incomplete, and I would welcome additions. But perhaps it can help focus some discussion on why economists do what the do, and how theory helps them do it.

Theory as a substitute for data

In many cases we are forced to use theory because the data that we need are not available. Suppose, for example, we want to determine how a market price will respond to a tax. We could estimate this effect by running a regression of market price against tax rates, controlling for as many other variables as possible. This would give us an equation that we could use to predict how prices respond to changes in taxes.

We rarely have data like this; taxes just don’t change enough. But if people only care about the total price of a good, inclusive of tax---a theory---then we can use estimated price elasticities to forecast the response of price to the imposition of a tax.

This uses a theory about behavior---people will respond to the imposition of a tax in the same way that they respond to a price increase---in order to allow data on price responses to be useful. We can use the theory to forecast the outcome of an experiment that has never been done.

Here is another, slightly more esoteric example. Consider the assumption of transitivity of preferences mentioned briefly above. This theory asserts that if A chosen when {A,B} is available and B is chosen when {B,C} is available, then we can predict A will be chosen when {A,C} is available. This is certainly a theory about behavior; it may or may not be true.

If we had data on choices between all pairs of A, B, and C, then the theory wouldn’t be necessary. When we want to predict the choice out of the set {A,C} we would simply look at how the person chose previously---that is, we would just use brute induction. And we know why induction works---it has always worked in the past!

But we rarely observe all possible choices; typically we observe only a few of the possible choices. Theory allows us to interpolate from what we observe to what we don’t observe. In the case of the {A,B,C} example brute induction requires observing all choices the consumer could make from the various proper subsets available, which requires 3 choice experiments. But if the assumption of transitivity holds, then 2 choice experiments are all we need. The theory of consumer choice allows us to economize on the data.

Naive empiricism can only predict what has happened in the past. It is the theory---the underlying model---that allows us to extrapolate.

Theory tells what parameters are important and how we might measure them.

The Laffer curve depicts the relationship between tax rates and tax revenue. At some tax rates tax revenue decreases when the tax rate increases. It has been said that the popularity of the Laffer curve is due to the fact that you can explain it to a Congressman in six minutes and he can talk about it for six months.

The Laffer analysis demonstrates both good and bad economic theory. The bad theory is that inference that because the Laffer effect can occur it does occur. The good theory is that we can use simple supply and demand analysis to determine what magnitudes the elasticity parameters have to be for the Laffer effect to occur. We can then compare the magnitudes of estimated elasticities to estimated labor supply elasticities. In the simplest model a marginal tax rate of 50% requires a labor supply elasticity of 1 to get the Laffer effect. The theory tells us what the relevant parameters are; without the theory, one would have no idea of the relevant parameters are. Indeed, if one examines the rather sordid history of the use of the Laffer curve in public policy debates in the U.S. this becomes painfully clear.

For another example, consider the theory of investment in risky assets. I take it as given that risk is a ‘‘bad.’’ Therefore when wealth goes up, people may want to purchase less of it. On other hand, you can afford to bear more risk when you have more wealth. So an argument based on intuition alone shows that investment in a risky asset can go up or down when wealth increases. A systematic theoretical analysis shows what the comparative statics sign depends on: how risk aversion changes with wealth. So the risk aversion parameter is the one you want to estimate in order to predict how investment in risky assets changes with wealth. Conversely how investment changes with wealth tells you something about how risk aversion changes with wealth.

Theory helps keep track of benefits and costs

I indicated above that the sorts of optimizing models used by economists serve the purpose of providing guidance for policy choices. Indeed one of the important roles of economic theory is to keep track of benefits and costs. The idea of opportunity cost is a fundamental one in economics, and would be very difficult to use without a theoretical model of economic linkages.

This brings up the important point that the correct way to measure an economic benefit or cost can only be determined in light of a theoretical model of choice: a specification of what objectives and the constraints facing an economic agent.

Consider for example, the practice of computing present value or risk adjusted rates of return. These computations are only meaningful in light of a model of choice behavior. If the model of behavior does not apply, the policy prescription cannot apply either.

Benefit-cost analysis is only one small field of economics. But the idea behind benefit-cost analysis permeates all of economics. If economic agents are making choices to maximize something, then we can get an idea of what is being optimized by looking at agents’ choices. This objective function can then be used as an input to making policy decisions. In some cases, one may need a quantitative estimate of the objective function. In other cases, one may want to show that one kind of market structure, or tax structure, may do a better job of satisfying consumers’ objectives than another. But the basic framework of moving from individual objectives, to individual choice, to social objectives and social choice is common to many, many economic studies.

Theory helps relate seemingly disparate problems

If one describes a model in a purely mathematical way, it often happens that the underlying equations will describe a rich set of economic phenomena. The classic example of this phenomenon is the Arrow-Debreu general equilibrium model. The concept of ‘‘good’’ can be interpreted as a physical commodity available at different times, locations, or states of nature. One theoretical model can thereby provide a model of intertemporal trade, location, and uncertainty.

Another example from general equilibrium theory is the First Welfare Theorem. This result shows the intimate relationship between the apparently distinct problems of equilibrium and efficiency.

A third example is that a formal analysis of the problem of second-degree price discrimination shows that it is equivalent to the design of an auction or the determination of optimal provision of qualities. Quality discrimination, auction design, and nonlinear price discrimination are essentially the same sort of problem.

Each of these insights came from examining an abstract theory. Once the the ‘‘irrelevant’’ details are stripped away, its becomes apparent that the same essential choice problem is involved.

Theory can generate useful insights

Let me illustrate this role of economic theory with an example. In the U.S. most interest receipts are taxable income, but many kinds of interest payments are tax deductible. This policy has been criticized as ‘‘subsidizing borrowing.’’ Does it?

The answer depends on the tax brackets of the marginal borrowers and lenders. If the tax brackets are the same, for example, the policy has no effect at all on the equilibrium after-tax interest rate. The supply curve tilts up due to the tax on interest income, but the demand curve tilts up by the same amount due to the subsidy on interest payments. This is a simple insight, but it would be very difficult to understand without a model of the functioning of the market for loans.

A theory that is wrong can still yield insight

Pure competition is certainly a ‘‘wrong’’ theory many markets; pure monopoly is a wrong theory for other markets. But each of these theories can be very useful for yielding significant insights for how a particular market functions. No theory in economics is ever exactly true. The important question is not whether or not a theory is true but whether it offers a useful insight in explaining an economic phenomenon.

In my undergraduate textbook I examine a very simple model of conversion of apartments to condominiums. One result of the model is that converting an apartment to a condominium has no effect on the price of the remaining apartments---since demand and supply each contract by one apartment.

This result can hardly be thought of as literally ‘‘true.’’ There are a host of reasons why converting an apartment to a condominium might influence the rent of remaining apartments. Nevertheless, it focuses our attention on a crucial feature of such conversions: they affect both the supply and the demand for apartments. The simple supply-demand framework shows us how to start thinking about the impact of condominium conversion on apartment prices.

Theory provides a method for solving problems

I take the method of neoclassical microeconomics to be 1) examine an individual’s optimization problem; 2) look at the optimal equilibrium configuration of individual choices; 3) see how the equilibrium changes as policy variables change.

This methods doesn’t always work---the models of behavior or equilibrium may be wrong. Or it may be that the specific phenomenon under examination is not fruitfully viewed as an outcome of optimizing, and/or equilibrium behavior. But any method is better than none. In the words of Roger Bacon: ‘‘More truth arises through error than confusion.’’

Methodological individualism is a limited way of looking at the world, no question about it. It probably doesn’t do very well in describing phenomenon such as riots or class loyalty. Certainly this sort of individualistic methodology works better for describing some sorts of behavior than others. But it is likely to add insight to all problems.

Theory is an antidote to introspection

Most people get their economic beliefs from introspection and their personal experience- --the same place that they get their beliefs about most things. Economic theory---and indeed science in general, can serve as an antidote to this kind of introspection.

Consider, for example, the widely held belief that all demand curves are perfectly inelastic. If the price of gasoline increases by 25%, a layman will argue that no one will change their demand for gasoline. He bases this argument on the fact that he would not change his demand for gasoline.

Indeed, it is perfectly possible that most people wouldn’t change their demand for gasoline...but some would. There are always some people at the margin; these people would change their demand. At any one time, most people are infra-marginal in most of their economic decisions. The marginal decisions are the ones that you agonize over. If the price were a little higher or a little lower, the results of your agonizing might be different, and this is what causes the aggregate demand curve to slope downward.

Another nice example of this phenomenon is free trade. It’s hard to convince a layman of the advantages of free trade since it is easy to see where the dollars go, but difficult to see where they come from. People have personal experience with imports of foreign goods of foreign goods; but they rarely encounter their own country’s exports unless they travel abroad extensively. Only by abstracting from introspection can we see the total picture.

A third example is the bias in perceptions of inflation: price moves are perceived to be exogenous from the viewpoint of the individual, but wage movements are personalized. Even if prices and wages move up by the same amount, people may feel worse off since they think that they would have gotten the wage increases anyway.

Verifying that something is obvious may show that it isn’t

One of the criticisms that economists have to deal with is that they spend a lot of time belaboring the obvious. Isn’t it obvious that demand curves slope down and supply curves slope up? But many theories that seem to be obvious turn out not to be. It may be obvious that demand curves slope down---but as the theoretical analysis shows, it is possible to have demand curves that don’t.

Economic theory shows that a profit-maximizing firm will decrease its supply when the output price decreases. But farmers often claim that removing milk price supports will increase the supply of milk since farmers will have to increase output to maintain the same income. The second effect sounds like it might be possible---after all, farmers wouldn’t advance the claim unless it had some plausibility. However, theory shows us that this particular claim cannot be true if the farmers attempt to maximize profits.

Strategic interactions are a good source of counterintuitive results. A simple analysis of a two-person zero-sum game shows that improving your backhand in tennis may lead to your using it less often.

It would seem that a public offer to match any competitor’s price is a sign of a highly competitive market. But when you think about the problem facing a cartel it is not so obvious. The prime problem facing a cartel is how to detect cheating on the agreed-upon prices and quotas. Offering to match a competitor’s price is a cheap way to gain information about what your competitors are doing. What appears to be a highly competitive tactic can easily be viewed as a device to support collusion.

Theory allows for quantification and calculation

According to Lord Kelvin, ‘‘When you cannot measure it, when you cannot express it in numbers, your knowledge is of a meagre and unsatisfactory kind.’'[1]

Theoretical economics gives us a framework to calculate and quantify economic relations. Consider the Laffer curve mentioned above. Laffer gave the existence proof, but it took some theoretical calculations to see what magnitudes were important.

In fact, one of the major differences between economics and the other social sciences is that in economics you can compute. There is very little computation in sociology, political science, history or anthropology. But economics is filled with computation.

Economic theory is useful since you can use it to compute answers to problems. They aren’t always the right answers---that depends on whether the model you have is right. (Or, at least, whether it is good enough for the purposes at hand.) But a desideratum of a good model is that you can compute with it: the model can be solved to determine some variables as a function of other variables.

In my view, it is impossible to learn economic theory without solving lots of problems. Richard Hamming, a highly prolific electrical engineer, once gave me some excellent advice about how to write a textbook. He told me to assemble the exams and problem sets that you want the students to be able to solve by the time they had finished the course, and then write the book that would show them how to solve them. In general, I have tried to follow this advice, with, I think, some success.

Economics is amenable to experimental verification

Because neoclassical economic models enables one to compute answers to problems, it is possible to compare the answers you get with the outcomes of controlled experiments. In my view, experimental economics has been one of the great success stories of the last 20 years. We now have rigorous ways to test models of human behavior in the laboratory. Some standard models, such as supply and demand, have turned out to be much more robust than we would have thought 20 years ago. Other models, such as expected utility, have turned out to be less robust.

But this is to be expected---if there were no surprises from experiments, they wouldn’t be worth doing. The growth of experimental economics has led many theorists to construct theories that simple, concrete and testable, rather than theories that are complex, abstract, and general. And experience in observing human subjects in the laboratory has no doubt contributed to the current emphasis on investigating models of learning. Laboratory observations have also been instrumental in alerting us to theoretical dead ends, such as some of the more convoluted refinements of game-theoretic equilibrium concepts.

I expect that the interaction between theory and experimentation will continue to grow in the future. As economists become more comfortable with experimentation in the laboratory, they will also become better at identifying ‘‘natural experiments’’ in real-world data. Such developments can only lead to better models of economic behavior.

3. Summary

I have argued that in order to why economic theorists behave in the way they do one has to understand the role of economic theory’s contribution to policy analysis. The fact that economics is fundamentally a policy science allows one to explain many aspects of economic theory that are quite mysterious otherwise.
___________________
1 However, the same poet whose praise for abstraction and synthesis I quoted in the introduction also once said: ‘‘...High Heaven rejects the lore of nicely calculated less or more.’’

Posted by Mark Thoma on March 14, 2007 at 12:33 AM in Economics, Methodology | Permalink | Comments (43)

Listed below are links to weblogs that reference Hal Varian: What Use is Economic Theory?:

Lafayette says...

HV: "No one complains about poetry, music, number theory, or astronomy as being ‘‘useless,’’ but one often hears complaints about economic theory as being overly esoteric."

Because we take it too seriously.

Economics is supposed to not only relate but explain the functioning of the economy. Too much emphasis has been placed upon "forecasting" in order to exploiot economics as a policy tool.

Economics is a social-science, which employs mathematical models to predict the future. Given the fundamental variables, including the rather unpredictable manner in which humans behave sociologically, prediction is extremely difficult.

But, as regards understanding how economies work, then the whole body of "philosophical thought" down through the centuries has given it a solid base of logical presumption. The work of Keynes has been particularly instrumental in casting it into a "science".

The development of econometric models only confirms, in our minds, that it is a "science". Let's presume it is a science. If so, it is an inexact one and we should not lend as much credence to its analyses as, perhaps, we do.

Models are nifty manipulations because they seem to explain a patterned relationship between dependent and independent variables. But, there is not a model on earth that is any better than its fundamental data. And, this applies to all sciences, which are more or less exact than economics.

Is our data all that good? I suspect they aren't, due to fundamental variations in their nature. Are the models all that exact? If they are, why haven't they shown exactness over the past 20/30 years that they have been employed?

Posted by: Lafayette | Link to Comment | Mar 14, 2007 1:58:40 AM

reason says...

Economics as applied mathematics? No as Lafeyette, what it measures (apart from when it measures currency) is so inexact that that is exactly what it isn't. Economics should be about understanding how processes work, about self-organising (and disorganising) systems. Engineering does this, but it designs the systems, economics doesn't.

I still Ecology is the best metaphor.

Posted by: reason | Link to Comment | Mar 14, 2007 2:30:02 AM

Stephen Kinsella says...

Another paper that might be interesting in this debate is Joseph McCauley's working paper "What Economists can learn from physics and finance". It's available on Repec here:

http://mpra.ub.uni-muenchen.de/2240/.

Yet another interesting quote, this time from Paul Samuelson, in Inside the Economist's Mind, (http://tinyurl.com/2nzufx), pg. 157--158:

"I would be rash to ignore analytical sciences outside of the social sciences. But I would be stupid, if out of physics envy'' or snake oil salesmanship, I would inject into economic theory analytical mathematics that fit only gases and liquids.In my writings, I have criticized wrong analogies to physics by Irving Fisher (whom I admire as a superlative American theorist). Even the genius of von Neumann has not escaped my critical auditings. I have given only qualified approval to Marshall's hope for a more \emph{biological} and less \emph{physical} approach to future economics.\ldots Maybe someday, future Phillip Mirowskis and Roy Weintraubs will better fine-tune their nuances."

Posted by: Stephen Kinsella | Link to Comment | Mar 14, 2007 3:20:42 AM

evagrius says...

I take it then that economics, being a science, has nothing to do with ethics.

Posted by: evagrius | Link to Comment | Mar 14, 2007 5:40:11 AM

Lafayette says...

reason: "Economics should be about understanding how processes work, about self-organising (and disorganising) systems"

Interesting thought.

Economics is about a very human activity, almost as old as humanity itself and brought about by our ancestors who discovered that by means of the division of labor people could produce more and therefore proliferate faster.

That division of labor brought forth the need for transaction amongst sellers and buyers ... and economics is the study of offer and demand in the marketplace. The alpha and the omega of economics is ... consumers, people like you and me.

Your thought is nonetheless interesting because the division of labor evolves along with knowledge and technologies, which prompt change. Managing that change, in terms of understanding how processes work and innovating them, makes for alterations in the markets of goods/services.

This forum seems focused on macro-economics not micro-economics, where such analyses are undertaken. Besides, micro-economics is, by comparison, very much less related to the ordinary concerns of people who are on this forum. Which does not make it less interesting in principle, just less interesting in general.

Posted by: Lafayette | Link to Comment | Mar 14, 2007 5:48:26 AM

owen paine says...

ev
keynes
still called it by an older name
a moral science

i find this varian piece
not false but surely
a baconian confusion

Posted by: owen paine | Link to Comment | Mar 14, 2007 6:09:17 AM

Bupa says...

Mark, this hard science envy is unnecessary. Economics is an academic discipline that uses scientific methods to study some aspects of human behavior. It has more in common with other disciplines that focus on human behavior -- anthropology, sociology, psychology, and history than it does with physics, chemistry, biology etc. All of these fields of study are worthwhile. No need for envy. Let’s move on.

Posted by: Bupa | Link to Comment | Mar 14, 2007 6:20:26 AM

Robert D Feinman says...

Economics consists of (broadly) two aspects - micro and macro. Microeconomics is amenable to experiments on human behavior. In effect it is a branch of psychology. If you do well constructed experiments you can predict the general outcome when the experiment is repeated.

Macroeconomics claims to be able to discover larger patterns, but it suffers from two fatal flaws. First, the number of variables is so large that which are responsible for what is hard to determine.

Second, it fails the first law of hard science - that a theory must be testable. One creates a theory based upon existing observations and then uses it to make predictions. If the predictions come true than confidence in the theory is increased. If the predictions are wrong then the theory must be discarded or revised. One cannot do this with societies.

How do we know, for example, that changing the marginal tax rate or the prime rate was responsible for some economic shift? We don't. The effect seen could have been due to any number of other factors (see point one). So since the "theories" are not testable they are not theories.

So what we have instead is ideologically motivated conjectures masquerading as a theory and being used to justify whatever policies that faction wishes to promote.

Just look at the present moment. Not only are there debates about present Fed policy options, but we have seen recent discussions here on whether prior actions were a good thing or not. Did Fed policy in 1929-31 make things worse or not? No one can tell. That's not a theory that's a religion.

By conflating micro- and macro-economic techniques it is possible to make macro look better than it is. Sorry it's not a science and the ideologues who make their careers from promoting their pet ideas can't make it so.

In fact by assuming that money is the be all and end of all of life economists distort the entire range of human experience. Why not pursue the goal of happiness as Jefferson indicated instead of wealth? Oh, sorry, that would put all the economists out of work.

Posted by: Robert D Feinman | Link to Comment | Mar 14, 2007 6:38:35 AM

evagrius says...

"ev
keynes
still called it by an older name
a moral science

i find this varian piece
not false but surely
a baconian confusion"

If it's a moral science, where's the moral?
Do economists have to be trained in ethics, ( and the foundation of ethics- a vision of The Good), before they practice?
Do they ponder the matters of Life and Death?
Or do they dismiss these as private concerns?

Posted by: evagrius | Link to Comment | Mar 14, 2007 6:39:38 AM

owen paine says...

ev

the b schools (clearly anologues of the engineers
and doctors schools)
do study .......ethics

but
ethics in and for pure science
tends
to run in other directions

what needs to be discovered first
or what needs to be left undiscovered
are not questions like
what are
the countering objectives
(if any)
for top managers own decisions
when piloting
a profit max missioned organization

------------
my sense of the confusion
in the piece above
seems best suggested
by the distinction between

original investigation and application

application is not discovery.... obviously
and just as
obviously
policy consequences
are not mandated by what is discovered

economics is a science
and it has potential applications
both micro and macro

these application
to civil project planning
market process management
taxes pollution etc
are in themselves
a possible science or sciences
policy sciences
but
varian i think
conflates this with economics the research science

economics is not
the base of some
universal social engineering discipline
that eager benthamites and comteans dream about

precisely because
economics has no deductable policy consequences
even if some act as if it does

application of economics
in biz , non prof , and state spheres
is not economics

it uses economics
like biology
is used in human medicine
or enviromental management

policy science has a very different
foundation
as a clinical science
unable to defer decision
(till spock has enough data or a complete theory )
operations like the fed
or the local hospital
must act on the basis
of best known practices

which are always
not only debatable
but obviously
sub optimal

Posted by: owen paine | Link to Comment | Mar 14, 2007 7:21:21 AM

Lafayette says...

RDF: “In effect it is a branch of psychology. »

If one restricts it to human behaviour in an economic context, yes.

Otherwise micro-economics also deals with other areas of micro-economic interest, such as individual companies and even households. (I remember studying optimization theory in a micro-economic context regarding transportation systems. In such a case, it borders on management science.)

When we take the notion of the “rational person” who makes a decision based upon knowledge of all parameters involved, it is borrowed from micro-economics. But, there is no study (that I know of) that confirms this. And, observation indicates that it may well indeed be otherwise. The “rational being” is therefore the construct of pre-20th century philosophers who gave far too much importance to the concept, unproven as it is.

So, when aggregating all individuals to a macro-economic “aggregate demand”, there is reason to believe that what applies at the atomic level also applies to the conglomerate as a whole.

For the moment, what economics does NOT touch upon is moral or ethical behaviour of individuals or corporations - largely, I suspect, because if one cannot quantify a parameter, then economists tend to lose interest in it.

And, finally, if we gave micro-economics 1/1000th the attention we give macro-economics we might understand the latter far better.

Posted by: Lafayette | Link to Comment | Mar 14, 2007 8:39:52 AM

Lafayette says...

evg: "Do economists have to be trained in ethics, ( and the foundation of ethics- a vision of The Good), before they practice?"

What a brilliant idea!

But, not in America. Debunking what makes Wall Street run (greed) would ruin half the nation.

Posted by: Lafayette | Link to Comment | Mar 14, 2007 8:42:19 AM

piglet says...

"it is a mistake to compare economics to physics; a better comparison would be to engineering. Similarly, it is a mistake to compare economics to biology; a better comparison is to medicine."

Let me see. The success of medicine is measured in whether it heals or aleviates suffering. So where is the analogy to economics? "Shock therapy" in Russia, liberalization and monetarism in Argentina, financial deregulation creating crises, IMF "reforms" making developing countries poorer and degrading their infrastructure and economic base, that's what comes to mind. All of those economic therapies have made the patients suffer more. Economists typically responded by claiming that more of the same therapy is needed. Stories like that are not unheard of in the history of medicine, of course, but they are more typical for modern age medicine's early period (think of early 19th century birth clinics with abysmal mortality rates due to lack of hygiene). In fact, Varian is making an interesting point by insisting that economics should compare to medicine *rather than* biology. But successful scientific medicine is *based* on a proper understanding of biology, just as engineering is based on physics. So if economics is like engineering or medicine, what is the scientific base on which it can rely? If economics itself cannot provide that base, it appears that there is none.

Medicine without biology is quackery. If Hal Varian is right, then economics is just that.

Posted by: piglet | Link to Comment | Mar 14, 2007 10:44:20 AM

James Killus says...

evagrius says...
"I take it then that economics, being a science, has nothing to do with ethics."

Do you _really_ think that science has _nothing_ to do with ethics? You believe that there is no such thing as an unethical experiment, or that, for example, a scientist who invents or misrepresents data is not being unethical?

And I see that piglet is constructing more straw men. There are plenty of cases where medical treatments were based on biological theories that turned out to be incorrect, or, more often incomplete, and great harm has been done because of it. piglet's argument would imply that this invalidates medicine, just as he is claiming that ill-advised economic policy invalidates economics. Actually, it just invalidates his argument.

Posted by: James Killus | Link to Comment | Mar 14, 2007 11:32:11 AM

James Killus says...

I recently reposted an essay that might also shed some light on this general subject. The conclusion is as follows:

"Some of the more extreme advocates of relativism and deconstruction claim that science is an enterprise no different from any other, and that the results of science are conditioned/determined/biased/required by the social, cultural, or gender outlook of the scientific community. One can, of course, deconstruct such claims by noting that they are made by one class of university academics who are locked in the usual struggle with a different class of university academics, but that is a petty, or at least trivial insight.

"Scientists generally hold themselves to be “reality based,” to use another culturally biased phrase and I strongly agree that no amount of cultural relativism will make N-rays exist and X-rays imaginary. But that is not the be-all and end-all of bias and cultural determinism. No, the phrase “where one’s interests lie” says a lot about science. We study chlorine in the 1920s and 1930s, not because of some rational, objective criterion of how chemistry should progress, but because cultural factors made it important to do so. I can point to a number of objective truths that my colleagues and I uncovered over the course of my career in science, but it would be folly to think that we were not looking “where the light’s better,” under the streetlights of funding, social interests, and group status within our little part of the scientific community.

"If I had to make my own philosophical stand, holding up my own interpretation of both free will and the forces that work against it, I’d give that as a capsule summary: it has to do with paying attention, to what, and for what reasons."

The full essay may be found here:

http://unintentional-irony.blogspot.com/2007/03/paying-attention.html

Posted by: James Killus | Link to Comment | Mar 14, 2007 11:38:10 AM

evagrius says...

So....make a distinction then between "theoretical economics" and "applied economics", ( not the same as micro and macro since the distinction could also apply to them).
Then it becomes clearer.

The "science" or theory would be one set of assumptions, models, etc; based on logical and mathematical proofs etc;

The application would be then the theory, reified through a moral perspective, that moral perspective being as universal in scope as possible, ( that is, the Good would not just be concerned with one particular group but would include all the population present and future and the Good would not be limited to "profit", ( whatever that may be), but would include all aspects, positive and negative of an intended activity).

I see that the former has been easily established but the latter has yet to do so.

It's this lack which confuses most people who look at economics from a less than professional view.

Posted by: evagrius | Link to Comment | Mar 14, 2007 11:45:41 AM

piglet says...

And I see that piglet is constructing more straw men. There are plenty of cases where medical treatments were based on biological theories that turned out to be incorrect, or, more often incomplete, and great harm has been done because of it.

Sorry James, you are the one building straw men here. That successful medicine must be based on a correct biological understanding is *exactly what I said*. Varian, however, says that economics is like medicine but he doesn't explain what it should be based on. Do you agree with Varian?

Posted by: piglet | Link to Comment | Mar 14, 2007 11:48:35 AM

calmo says...

Bupa says we should move on or at least off "physics envy" and dang, if I don't think he's right and act disaccordingly...by extending this thread...but I have been known to terminate many a thread...so there is hope.
In physics there is this thingie called the Heisenberg
Uncertainty Principle (wiki it you proud non-physicists to learn more about it than me) that limits what we can know. The other thread (I am also trying to terminate) FRBSF: The Economic Outlook worries about (item #3) the workers expectations responding to perceptions manufactured atleast in part by those measuring the expectations. The Heisenberg thingie dealing with nice simple particles helps me appreciate this problem in economics.

Posted by: calmo | Link to Comment | Mar 14, 2007 11:53:17 AM

JRossi says...

Economic theory is an absolute mess. And this is a big problem for economics as a whole because it stifles progress, leading to a degenerate science. Unfortunately it is professionally risky for economists and economists-in-training to try to re-found the discipline, so they stay stuck in the hundred-year cul-de-sac of neoclassical economics. And the rest of us have to been in there with them. But don't just take my word for it. Go to Economists' Voice and look at the article by Barbara Bergmann. Supply and demand curves--yeah, right.

Posted by: JRossi | Link to Comment | Mar 14, 2007 12:58:40 PM

owen paine says...

ev
"The application would be then the theory, reified through a moral perspective, that moral perspective being as universal in scope as possible"

my guess
the policy maker
really could take any moral perspective
so wanted
as long as its explicit

"the science "
would then be applied to the mission
thru nominated policy routes
and cross evaluated
vis a vis furthering that mission
evaluated/debated that is

art and science in a tango

Posted by: owen paine | Link to Comment | Mar 14, 2007 1:09:43 PM

Patrick says...

This whole discussion sounds familiar to me. I used to argue a lot with medical doctors about whether medicine is more of a "hard science" than psychology. I usually retorted to this tactic:

Give me a room full of randomly selected people and a doctor can tell you how many of them are likely to develop cancer in the next 10 years.

The moment a doctor can tell you WHICH people will develop cancer, then we can start talking about medicine as a "hard" science.

The truth is that many people have very vague and quite frankly ridiculous notions of what makes a "hard" science. Hint: how accurate your predictive models are isn't a very good heuristic for determining whether or not you are in a "hard" science. Ask a meteorologist if you don't believe me. By the way, I'm pretty sure that field is closely related to, um, PHYSICS.

Whether or not you practice science, and not philosophy, is dependent on one thing, and one thing only: whether or not you employ the scientific method.

Those that claim that economics does not require the scientific method are living in a dream world, or maybe they are just pissed off that the housing bubble didn't burst when their economist friend predicted it would.

And, please, please, please stop the straw man arguments. Every whack job that postulates an "economic truth" does not represent the science, any more than a physician writing about creationism represents biology. Finding someone who didn't use the scientific method and jumping up and down shouting "SEE!?!?" does not make you look like someone who wants to have an earnest discussion.

If you can find an economist for whom the following conditions exist:

a) the majority of economists agree that this economist is correct, and his/her theoretical work is sound
b) this economist does not employ the scientific method

then I'd really like to hear about it.

Posted by: Patrick | Link to Comment | Mar 14, 2007 1:47:41 PM

Patrick says...

JRossi says...

Go to Economists' Voice and look at the article by Barbara Bergmann. Supply and demand curves--yeah, right.

So I did. This part in particular struck me:

In 1939, R. L. Hall and C. J. Hitch published a
paper reporting on a survey they had conducted
among business managers. They found that
managers were unfamiliar with the concepts of
marginal cost and marginal revenue, and that
they did not use them when setting prices and
output. Rather, they made an estimate of cost
per unit at what they took to be some plausible
level of sales, and then tacked on an amount
for profit.

Seriously, I really hope they don't. It's one of the reasons I am pretty damn confident that my MBA makes me a better businessman than 90% of the other guys out there.

I'm afraid I don't quite see her point. Microeconomic theory doesn't specifically rely on the fact that all firms/sellers will price as long as MR = MC. More specifically, it postulates that any firms who do not do will lose money (either from excess capacity or from negative profit margins) and will either a) learn from their mistakes or b) go broke [in a competitive market, anyway]. Over the LONG RUN, it is simply easier to say that "all sellers will sell as long as MR >= MC, and no longer."

One should also point out that many of the theories we like to bandy about only apply to competitive markets. Microsoft, for example, can be just about as inefficient and irrational (from a micro-economic perspective) as it wants, and no market forces will punish it any meaningful way; it will still make money hand-over-fist. Again, microeconomic theory predicts this as well (that monopoly markets are inefficient). Yet many (mostly in the Bush administration) LOVE to babble on about how privatization makes everything more efficient, and talk about how "Markets make things efficient", as if that were true regardless of the market form, which of course, it is not.

Posted by: Patrick | Link to Comment | Mar 14, 2007 2:11:30 PM

piglet says...

Patrick, you could contribute greatly to this discussion by pointing out how economic theories actually "employ the scientific method".

Do economists even agree on the meaning of "scientific method"? Hal Varian says that they are not "concerned about methodology", and he's a professor of economics. Duncan Foley says that "economics at its most abstract and interesting level is a speculative philosophical discourse, not a deductive or inductive science". He's a professor of economics, too.

Me, I can't tell for sure what scientific method was employed by those economists I mentioned in Mar 14, 2007 10:44:20 AM, but I'm pretty sure that few economists at the time publicly disagreed.

Posted by: piglet | Link to Comment | Mar 14, 2007 2:20:30 PM

James Killus says...

In point of fact, scientists generally do not agree on what constitutes scientific method.

However, when an economist collects data that indicates that the elasticity of demand for a particular commodity is, say, 0.5 and a supply shock occurs that reduces the supply of the commodity by 10% and the market clearing price increases by 20%, that would seem to correspond to the "observational experiment" that is the norm in observational sciences. One can reverse this, of course, since there are ways of stipulating prices for some commodities, and demand curves can be verified in that way, which looks mighty damn close to standard experimental science.

Frankly, it looks to me like reflexive bashing of economics does more to play into the hands of quack economists than anything else, in much the same way that quack physicians like to call standard medicine "allopathy" so as to make things like homeopathy sound like just another medical choice.

Posted by: James Killus | Link to Comment | Mar 14, 2007 4:39:24 PM

owen paine says...

i think
the science of the firm
in the last 40 years
its just no one popularizes
the new theory
of imperfect comp
etc
most lay objections are to
the media phantasms

and the obvious ideological mission
of the corporate sphere
its hegemony
of open markets free profits
from taxes and regulators

magic spells are very effective
placebos

if for example
the fed policy cycle
makes hog wash
appear to be
emergent necesssities

hell its a lot
like the RC hierarchy
attacking sodomy by day
while practicing it every night

Posted by: owen paine | Link to Comment | Mar 14, 2007 5:02:48 PM

Philos says...

Please, everyone: stop talking about the scientific method. There is no such thing. The methods of reasoning used in science are no different than those used in ordinary discourse; they are just carried out more thoroughly and at greater length. The idea that the success of physical science could be explained by a "method" occupied philosophy for much of the 20th century. It is no longer accepted by anyone who knows what they are talking about.

IMHO, the thing that makes economics slippery, and gives some people queazy feelings about it, is that it is a methodolically mixed field, and the boundries are sometimes fuzzy. Sometimes economics is an emperical science, studying the world the way any other science does. (It may is successful than physics, but not because it is less scientific). Sometimes it's a branch of mathematics, sometimes it's a branch of philosophy, and sometimes I swear it's practiced as if it were a religion (for instance, at Arnold Kling's site). All of these, except perhaps the last, are perfectly valid activities, but bad things result from a combination of 1) confusing the types, and 2) basing policy prescriptions on the confusion.

An additional complication comes from actual corruption; concepts and data being selectively picked to support pre-defined desired policy prescriptions for the profit of those doing the prescribing. Examples have been cited on this and the related thread on this blog. The people doing this claim to be economists; some, like Kudlow, are fake, and others, like Mankiew, are real. I think it's reprehensible that mainstream economists let such abuse of their field go by with so little protest. There have even been cases where economists pointing out the inapplicability of over-simplified models to certain situations were criticized by their collogues for, e.g., undermining public faith in free trade.

Piglet, above, pointed out the worst problem: extending policy prescriptions beyond actual competence. It's understandable that economists as policy advisors try to do the best they can with inadaquate tools, because policy makers, like doctors, don't have the luxury of waiting until complete information is available. It's less so when, out of arrogance or ideology, they don't listen to others who might know things they don't.

Piglet mentioned Russia, and rightly; it's been estimated that the Russian fiasco caused about a million excess deaths. And that came from the blunders of real economists. The strategy for the economic reconstruction of Iraq, which was based on the presumption that all would be well if the rules of a libertarian paradise were enacted, was absurd to the point that it would have been funny if it wasn't so tragic.

The examples in Varian's paper were of situations where the problem scope was limited enough that economic models could be applied with some confidence. These certainly exist. He didn't deal with the hubris problem. (His paper has other problems as well, but they are beyond the scope of this already bloated post.)

Posted by: Philos | Link to Comment | Mar 14, 2007 8:14:24 PM

JRossi says...

Sometimes you need to get out of the asylum to see how nuts you were when you were in it. How about this: The American Economic Association or some consortium of leading academic econ departments could put together a blue-chip panel consisting of scientists from other fields-physics, chemistry, biology, geology, mathematics, psychology, sociology, etc- to conduct a review of standard economic theory and experiment\observation. It would be interesting to see what those folks think about the state of this discipline and what, if anything, could be done to improve it.

Posted by: JRossi | Link to Comment | Mar 14, 2007 9:01:20 PM

Lafayette says...

Philos: "The strategy for the economic reconstruction of Iraq, which was based on the presumption that all would be well if the rules of a libertarian paradise were enacted, was absurd to the point that it would have been funny if it wasn't so tragic."

Regardless of what anyone might feel about the "Iraq adventure", the above is patently untrue.

It is not absurd to think that the Iraqis, their sectarian differences behind them, will not be able to rebuild the country in due course (and by means of sub-contracted renovations of its infrastructure).

What is/was absurd was to believe the generals who thought that Iraq2 would be a repeat of Desert Storm1. Dubya won the war and lost lamentably the peace. As a consequence, any reconstruction of Iraq was compromised. But, that has nothing to do with libertarian values.

The Iraqis are now up against a wall. And, so are we. Meaning this: They get their act together and put the sectarian animosity behind them, or there is a civil war and the country stops pumping petrol.

And, given the tightness of supply, the consequence is the price of gas in America sky-rockets. Are you ready for this? Is your SUV ready for the run-up? No? So, go buy a diesel engine car now rather than later ...

Posted by: Lafayette | Link to Comment | Mar 15, 2007 2:23:06 AM

Barry says...

Lafayette, you've got things reveresed - the administration thought that Iraq II would be Desert Storm II - with more rice and flowers. As for losing the 'peace', that would only apply if there had been peace.

Posted by: Barry | Link to Comment | Mar 15, 2007 7:07:15 AM

Barry says...

Patrick: "The truth is that many people have very vague and quite frankly ridiculous notions of what makes a "hard" science. Hint: how accurate your predictive models are isn't a very good heuristic for determining whether or not you are in a "hard" science. Ask a meteorologist if you don't believe me. By the way, I'm pretty sure that field is closely related to, um, PHYSICS."

In the previous post ('Dark Side'), somebody stated that economics had failed because it couldn't predict recessions. Of course, physics has a problem predicting the weather - and the weather isn't looking at the predictions, and changing its behavior accordingly.

Generally these 'economics is/is not a science' threads demonstrate that a number of phsyics and engineering students don't know what a science is.

Posted by: Barry | Link to Comment | Mar 15, 2007 7:08:58 AM

reason says...

Maybe we should rephase this, much of what passes for economics does not respect scientific principles. I know this, I used to work in the economics department of a central bank, and certain results were suppressed if they didn't correspond to certain pre-conceptions.

Posted by: reason | Link to Comment | Mar 15, 2007 7:22:11 AM

__earth says...

Theory of moral sentiment, anyone?

Posted by: __earth | Link to Comment | Mar 15, 2007 7:39:45 AM

Patrick says...

Please, everyone: stop talking about the scientific method. There is no such thing.

I'm sure that if Sir Francis Bacon were alive today, this comment would piss him off.

http://en.wikipedia.org/wiki/Francis_Bacon

You may think that these things are trivial and common sense, and that we don't need to actually establish rules about what constitutes inductive reasoning and acceptable methodology, but you are woefully wrong.

The problem with "common sense" is that like a sense of humor, everyone THINKS they have it in abundance. And like driving skill, a very large majority of people assess their own as "above average".

Hmmmmm.

Posted by: Patrick | Link to Comment | Mar 15, 2007 11:48:46 AM

says...

And like driving skill, a very large majority of people assess their own as "above average".

Which must imply that the driving skill distribution is skewed to the right.

Posted by: | Link to Comment | Mar 15, 2007 11:51:28 AM

piglet says...

Barry said: "Generally these 'economics is/is not a science' threads demonstrate that a number of phsyics and engineering students don't know what a science is."

In light of that remark, I would like to ask your opinion about Hal Varian comparing economics to engineering, and his approvingly observing that economists are not "much concerned about methodology".

It is unfortunate that few in this forum seem to be ready to take a clear position on Hal Varian's essay. Varian at least lays out a more or less coherent justification of economics. Whether his account is acceptable or not is quite relevant to this forum.

I will have another go at it. The analogy between economics and medicine, dentistry and engineering is intriguing since both engineers and physicians are operating under a very peculiar set of methodological constraints: they can be held responsible if they screw up. The dentist who pulls the wrong tooth, the phyisician leaving tools inside the patient's abdominal cavity, or the engineer who's bridge collapses, they are all liable and can be sued out of their pants or even go to prison. So the question is, can this model be applied to economists? Would economists put their money where their mouth is (which, as economists, ) and accept liability for what they are doing? Or would they prefer to view their science as an esoteric speculation, like physicists' dark matter? Or is the whole analogy not applicable, and if so, why not?

I just don't see our abstract reasoning about scientific method going anywhere. Every scientific establishment defines for itself what it regards as "scientific", and while I wouldn't agree with Philos that there is no such thing as scientific method, in the real world, "science" is a tautology: it is what "scientists" do. But we should at least be able to agree that there must be a reality check. This is what I would like to hear about.

Posted by: piglet | Link to Comment | Mar 15, 2007 4:10:53 PM

piglet says...

Sorry, incomplete sentence: "Would economists put their money where their mouth is (as economists, they appreciate the effectiveness of financial incentives) and accept liability for what they are doing?

Posted by: piglet | Link to Comment | Mar 15, 2007 4:14:40 PM

evagrius says...

"Sorry, incomplete sentence: "Would economists put their money where their mouth is (as economists, they appreciate the effectiveness of financial incentives) and accept liability for what they are doing?"

Didn't some economists, ( Nobel prize winners among them) join some investment firm and it went bust following their advice?

Posted by: evagrius | Link to Comment | Mar 16, 2007 8:18:19 AM

piglet says...

Indeed, and that ridiculed the whole profession. If I remember right, they said that their chance of being wrong was less than one out of the number of atoms in the universe. Maybe that was when economics-bashing became fashionable... at least it was one of several factors. At about the same time, we also had economists claiming that recessions were a thing of the past, energy deregulation advocated by many economists let the lights go out in California, Argentina's austerity policies crafted by neoclassical economists bankrupted the country, "Free Trade" and globalization didn't deliver the promised benefits, etc. etc.

This is the reality check I was talking about, and that's why I frankly have no sympathies for Mark's complaints about physicists' incomplete understanding of distant galaxies.

Posted by: piglet | Link to Comment | Mar 16, 2007 9:51:15 AM

Philos says...

The sensible piglet says:

"while I wouldn't agree with Philos that there is no such thing as scientific method"

Sigh. So few people do. Only those who have studied philosophy of science.

A number of these points were summed up in a two-part article titled "Prospects of a Modest Empericism", by Israel Scheffler. The piece was published in Philosophy of Science during the 1950s, which shows how far behind the curve a lot of this discussion is.

As for the snide reference to Bacon, it is to laugh. Try reading e.g. Nelson Goodman and W.V.O Quine. They're a lot more recent than Bacon, and have an enormously better appreciation of epistemological issues than he had (indeed, in the Philosopy of Science commnumity Bacon is considered a joke).

Piglet also raises the interesting question:

"Would economists put their money where their mouth is (which, as economists, ) and accept liability for what they are doing?"

I would draw an analogy with medical malpractice. Doctors cannot be sued for a bad result; the only cause of action (other than actual malice, which is quite rare) is failure of "due care." The duty to exercise due care is satisified by the use of the best known methods.

Actually, doctors used to be able to be allowed to raise a "community standard" defense; they'd just bring a couple of their friends to court to testify "Yep. That's how we do it around here." But eventually the courts recognized the existance of easy communication and stopped letting them off so cheaply.

Holding doctors "strictly liable" for their actions would render the practice of medicine impossible, which no one is willing to do.

So, I don't think imposing a liability standard on economists would impose the discipline piglet (apparently) desires. Nor do I think it a good idea, even though I have a lingering desire to make Andrei Shleifer live through him own shock therapy.

One other thing. Libertarian principle were indeed the "plan" for the post-war Iraqui economy. This has been documented, although I'm too lazy to google up the reference at the moment.

Posted by: Philos | Link to Comment | Mar 16, 2007 10:27:46 AM

piglet says...

"So, I don't think imposing a liability standard on economists would impose the discipline piglet"

You are missing my point a little bit. I was exploring the qonsequences of Hal Varian's claim, that economics is like medicine or engineering, and I was pointing out that those disciplines must submit themselves to some clearly defined reality check. That, for me, is at the heart of the matter.

Posted by: piglet | Link to Comment | Mar 16, 2007 3:56:31 PM

James Killus says...

Philos is almost entirely correct; there is no "scientific method." There are methods that are commonly used in science.

I'm told that Bridgman's _The Logic of Modern Physics_ has an index entry, "The Scientific Method -- see Scientific Methods"

As for whether I would consider economics to be analogous to medicine, I'm trying to think of which Economics Nobel is equivalent to lobotomy (Nobel Prize in Medicine in 1949).

Of course the Economics Nobels are of recent vintage. I'd certainly consider the Gold Standard as a candidate, otherwise.

Posted by: James Killus | Link to Comment | Mar 16, 2007 11:24:51 PM

piglet says...

James, you are' I'm sorry to say, bucking the question.

Posted by: piglet | Link to Comment | Mar 17, 2007 5:46:02 AM

piglet says...

what did I write? Dodging the question.

Posted by: piglet | Link to Comment | Mar 17, 2007 5:50:29 AM