The Methodology of Positive Economics - Reversed

Leigh Caldwell, a behavioural economist, writes about microfoundations in economic models. Microfoundations means that you don't just talk about aggregate-level variables, but model the decision-making of economic agents (typically persons) in your theory, and develop the aggregate-level predictions on that basis. Caldwell correctly points out that homo oeconomicus isn't very realistic and that, consequently, microfounded theories based on the idea of homo oeconomicus are wrong.

He goes on to outline two typical responses to the critique that humans aren't the superrational decision-makers many economic models portray them as. One, actual people are pretty close to homo oeconomicus; two, let's forget about microfoundations. Caldwell suggests that instead economic models be built on more realistic microfoundations.

Between the two of us, Caldwell's the only economist, but I'll still try to make the case that the above is all besides the point. Naturally, it all leads back to Friedman (1953). The article - "The Methodology of Positive Economics" - is all about microfoundations. Friedman's point is simple: He doesn't care whether the microfoundations are correct, as long as they give the right macropredictions, and they often do. 

What Friedman doesn't tell you is this: Economic models are consistent with a lot of predictions, and hence a lot of microfoundations.

Let's take the economic theory of crime. If you ask economists, it starts with Becker (1968).* Among other things, the theory predicts that if the likelihood of being punished for a crime goes up, the volume of crime goes down, all other things equal. Ehrlich (1973) translated that into a microfounded model in which agents make decisions in part based on their rational calculations about the likelihood of being punished if they commit a crime. It's basically the same thing (frankly, I fail to see the point). Both models predict: Punishment up, crime down.

But it doesn't say by how much. And it's not just the economic theory of crime. All that mathematical modeling in economics is highly misleading: It looks exact, but all they'll really tell you is the direction of an effect. The rest is left to empirical estimation. 

You might think that's a big problem for economics, and compared to an ideal world of exact predictions, it is. But, in fairness, it's not as though the other social sciences deliver anything else. As far as I can see, all social science theory is about signs.**

Back to the example: If you can show that a rise in the likelihood of punishment leads to a reduction in crime, that's consistent with superrational decision-makers. It is also consistent with some decision-makers being superrational and all the other people not responding at all to the change in the likelihood of punishment. Etc. If you think it through you end up with something like the following: The finding is consistent with some of the people being sorta rational some of the time, and their effects outweighing the effects that are due to people behaving contrary to what the theory says. 

For Friedman and me, that's fine. Leave psychology to the psychologists.

But there is one very important consequence of all this: If your macro-level finding is consistent with a theory built on a microfoundation that assumes rational agents, this does not show many people act rationally in any substantial sense. This is important because economists like to argue otherwise, and soon you arrive at the stance that all drugs should be legal because drug addicts are rational. I'm open to the idea that all drugs should be legal, but a finding that increases in financial or nonfinancial drug prices decrease demand does not provide a strong argument in favour of legalization. If you want to argue individual decision making, bring individual-level data.

Note. All cites from memory. And not even a list of references!
*Of course, the ideas formalized in Becker's theory had been around for centuries, even in writing. E.g., Cesare Beccaria.
**There's also quite a bit of "theory" in the social sciences that's not really theory in the sense of a system of falsifiable hypotheses. Sociology is big in this department.

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