Tuesday, February 24, 2015

Stubborn theoretical ideas

Commenter LAL pointed me to a working paper by Chris Sims [pdf] on rational inattention that represents the closest approach by an economist to the way I am using information theory.

But it also usefully sums up the history of economic thought and is an excellent demonstration of path dependence in theoretical pursuits. Economics got its own ball rolling with the idea that people try to maximize utility, which explained market forces like supply and demand ...

Idea: supply and demand

Problem: how does it work?

Solution: people make utility maximizing decisions

Problem: persistent unemployment

Solution: Phillips curve, sticky prices

Problem: they change

Solution: add expectations [1]

Problem: intractability

Solution: rational expectations [2]

Problem: EMH not exactly true

Solution: rational inattention


Utility maximization was an important step in economics as it lead to an understanding of the basic forces of markets back in the 1800s. I think it may have outlived its usefulness, though ... but it's not the fault of economics as a field. Here's an analogous progression in physics, where humans behaving as utility maximizers is switched out with the ether that was used to explain how light could be a wave (a more successful theory than the corpuscular theory).

Idea: light waves

Problem: waves propagate in medium

Solution: ether

Problem: shouldn't we be moving with respect to ether?

Solution: partial ether dragging

Problem: can't measure movement with respect to ether

Solution: complete ether dragging

Problem: inconsistent with astronomy

Solution: length contraction

Problem: nature appears to be conspiring to prevent measuring ether motion

Solution: speed of light is constant and there is no ether

I had always wondered why the idea of ether took so long to dislodge. I think there is an entropic force that works to counteract changes in theoretical ideas ...

Seriously, when you create a model to explain how something works (light waves, markets), but then the main idea of that model (ether, utility maximization) starts to be the source of all the new problems, with new work-arounds that essentially seek to diminish the impact of the original model, then you are probably having a path dependence problem. The history of electromagnetism since the advent of waves consists primarily of an effort to minimize the impact of the ether introduced so that people could accept light as waves. Analogously, the history of economics since the advent of supply and demand consists primarily of an effort to show how deviations from utility maximization can be explained.

I'd like to think that I could add a bit at the bottom of the economics list ...

Problem: conspiracy of factors preventing human utility maximizing behavior from impacting markets [3]

Solution: hey, maybe markets aren't the result of utility maximizing behavior?


[1] The idea that Keynesian economists neglected the inflation-augmented Phillips curve is something of a straw man argument, but it is useful to include here because there is a difference between considering the theoretical idea and implementing it in a model.

[2] One thing I'd like to note is that the SMD theorem basically says that rationality assumptions do not carry over from micro to macro, so all of this should have been nipped in the bud around the time of the Lucas critique ... which actually contradicts the SMD theorem unless you assume that an economy can be represented by an individual agent, per Kirman 1992:
Now if the behavior of the economy could be represented as that of an individual, ... [human utility maximizing behavior] would be saved, since textbook individual excess demand functions do have unique and stable equilibria. This is where the representative individual comes into the picture. By making such an assumption directly, macroeconomists conveniently circumvent these difficulties, or put alternatively, since they wish to provide rigorous microfoundations and they wish to use the uniqueness and stability of equilibrium and are aware of the Sonnenschein-Debreu-Mantel result, they see this as the only way out.
[3] These 'conspiracies' are:
  1. SMD theorem, dodged using a representative agent assumption
  2. Rational expectations aren't empirically accurate and prices are sticky, fixed by new ideas like e.g. rational inattention
  3. Utility is unobservable, so assume weak axiom of revealed preference


  1. Personally I find your argument of the analogy with thermodyamics, that economics should be based upon observables to be extremely convincing, and therefore worthy of investigation.

  2. Sims' working paper discusses Lucas 1973 which sounds like a re-interpretation of the Lucas Island models (which itself is not exactly a representative agent model).

    The Lucas 1976 critique is more general than rational expectations because you could use either model to illustrate his same critique of econometrics.

    Information frictions are an old idea but none of them in my opinion had quite latched onto the right tools (though i remain a pretty big fan of the lucas islands)..if I recall the story correctly the argument against those information models was that if agents face these information frictions, where are the markets to solve them?

    I interpret David Glasner pointing out in his discussions of Lucas' models that maybe we should force these islands to be subject to more nominal aggregates (presumably more than just an aggregate price)...your model seems to fit the bill for this kind of microfounded enterprise

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  4. “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it” – Max Planck

    Most people think that Max Planck had a great understanding of physics. I think he had a great understanding of people too.


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