Blackboard Theory Versus the Reality of Markets

Mark Thoma's recent article in the Fiscal Times does a great job of laying out the typical case most undergraduate economics majors hear for government intervention in markets. Undergrads are taught the requirements for perfect competition in markets: an infinite number of buyers and sellers, perfect information, price-taking behavior by firms, etc. Thoma is quick to point out that these conditions are not often found in real-world markets, thus government intervention is necessary to correct the failures of real-world markets to live up to these ideals.

As Farmer Hayek readers might expect, I didn't find his arguments terribly convincing. First, this is a classic case of the Nirvana fallacy. The real world will never live up to any perfect ideal. The policy-relevant comparisons are thus not between this impossible ideal and real-world markets, but between alternative policy regimes that actually exist or could exist.

Economic Theory: Rigor and Relevance

Physicist Mark Buchanan recently wrote an article in BloombergView entitled "Explaining How Economists Explain." In the article Buchanan makes some good points about how economists conduct theoretical work. He writes:

Several years ago, in the immediate wake of the financial crisis, economist Ricardo Caballero wrote about what he called the “pretense-of-knowledge syndrome” in academia. Economists, he argued, had become “so mesmerized” with the internal logic of their theories that much of the discipline -- even that part concerned directly with policy making -- had spiraled off into fantasy. Even when they studied issues close to the crisis, such as bubbles, panics and fire sales, they relegated them to the periphery of macroeconomics, which at its core valued mathematical elegance over usefulness. [n.b. Caballero has written a handful of papers over the past several years analyzing the financial crisis through the lens of a version of Austrian Business Cycle Theory]

Not much has changed since then. That, at least, is the conclusion of Itzhak Gilboa and a group of economists who recently tried to understand why their profession operates so differently from most sciences. Academic economists, they say, use the term "explanation" in a way that other scientists never would. Instead of developing realistic and testable theories like those in biology or physics, they often aim only to develop "theoretical cases" -- imaginary mathematical worlds with their own rules of cause and effect.

The main point here is that internal validity has trumped external validity as the focus of economic theory (at both the macro and micro levels). This has produced, broadly speaking, a body of literature that is more concerned with mathematical elegance (or rigor) than policy relevance (whether that means government policy or smart business strategy) or an improved understanding of economic reality. This doesn't imply that mathematical modeling can't be useful or that some focus on internal validity isn't necessary, but there's a tradeoff between mathematical rigor and real-world practicality. For every unrealistic assumption made we get more tractability and measurability, and less practicality and generalizability.