Monday, July 8, 2013

The Value of Economic Assumptions

A common complaint made against the field of economics is that simplifying assumptions made in economic models are unrealistic. Economists are definitely prone to making bad assumptions and certain models (ex. DSGE) suffer because of unrealistic assumption, but that is not sufficient cause to dismiss simplifying assumptions as a whole. I have been inspired to write this post based on Krugman's Crib Sheet post.

Assumption in theoretical economics have the benefit of removing the noisiness of human behavior and decision-making. Human behavior is immensely complex and difficult to predict based on observation alone. Modeling assumption help to cancel out some of the noise associated with human behavior and allow economists to isolate a topic of interest. Essentially, theoretical models try to build a perfect world to serve as a benchmark to the real world. It might not be able to full encompass human behavior but it can provide a much clearer picture to help analyze a basic problem. If we understand how people would act in a perfect world, then we have a better framework to understand real world deviations.

The analytic framework made possible by simplifying assumption is one area where economics has the potential to follow the scientific method. A formal economic theory provides a hypothesis that has the potential to be tested based on available data or observation of the real world. Great economic theory inspires a vast stream of literature that continue to evolve and correct itself based on new data. The macroeconomic revolution started by Keynes is a wonderful example of the potential to apply the scientific method to economics.

However, it a danger to economics is theory induced blindness that widely accepted models and assumptions can create. Daniel Kahneman and Amos Tversky's development of prospect theory is a perfect example of how economics can develop a blindness to the weaknesses of widely accepted assumptions. It is important to treat models as a tool to be used to understand the real world and not an actual representation of it. The rise of behavioral economics has helped to keep the unrealistic nature of most assumptions at the forefront of the field. Behavioral economics is another development that will improve the development of economic theory in the future.

The development of prospect theory is an important event in economics, not only because of the improvement of utility theory but because it highlights the need for collaboration with fields outside of economics. The inclusion of psychology, sociology, and other social sciences will only serve to improve and enrich economic economic theory.    

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