ECONOMIC MODELS AS ANALOGIES
by Martin Dumav (MWF-ECO)
Economics is concerned with the abstract concepts related to the inter- action between people. Economists formulate thoughts via what we call “models.” In an economic model as in Harry Potter or the Tales of King Solomon we amuse ourselves in imaginary worlds. Models can be denounced for being simplistic and unrealistic, but modeling is essential because it is the only method we have of clarifying concepts, evaluating assumptions, ver- ifying conclusions and acquiring insights that will serve us when we return from the model to the real life.
A description of an economic model is like the introduction in a tale, pre- senting the heroes, their interests and the setting in which they operate. An array of rules by which the model is “allowed” to develop from its beginning to its end is called a solution concept.
The key solution concept is rationality and it is cast in a canonical decision problem in which a decision maker has a set of alternatives (trade- off ), preferences over them, and clear goal to maximize happiness. This represents “as if ” behavior rather than an actual thought process that results in a choice. Assumption of decision maker’s rationality enables us to describe and make predictions about human behavior. The flood of experimental results contradict this view. Although quantitative results have very limited significance in any case because the sample of participants does not represent more than a group of economics or MBA students in a particular university. The qualitative results are usually insights that common sense had already suggested prior to the experiment and also useful in illustrating a certain thought process.
In recent years, economic theory has actually responded positively to criticism and we have witnessed the development of fields of research called “bounded rationality” and “behavioral economics” –fields that lay an in- frastructure for building economic models in which the rational person is replaced by decision makers with other characteristics.
Another important modeling tool is Game Theory which is a cute name for a collection of models of Rational Decision-Making in interactive situa- tions. In addition to the set-up of the canonical choice problem, now one must exercise strategic thought. Game theory speaks of a player who steps into the shoes of the other in order to assess what the other will do, and he does this for his own benefit, in accordance with his own preferences. The theory can also accommodate the preferences reflecting affection, sympathy and benevolence, or hatred, bitterness and revenge. The key solution con- cept is Nash Equilibrium. According to Nash, the answer to the question “what will happen?” is consistent with the assumption that each individual is able to step into the other’s shoes, correctly predicts his moves, return to his own shoes and choose the best action from there.
It is applied to variety of situations: contribution to the provision of public good, voting, contract theory, auction theory, bargaining, labor contract re- lationship, insurance, banking and finance, political economy. Experiments indicate some limitation of game theoretic analysis and recent theories have responded to include behavioral elements to bring models closer to the re- ality.
Last, not the least, economics has models of aggregate behavior with microfoundation. That is, in the analysis there is a decision maker as a prim- itive unit and a set of rules for interaction between the individual and the society. For tractability, the key simplifying solution concept is Rational Expectations. It postulates that rational agents: do not make persistent mistakes; make the best possible use of their resources and their available information; have their expectations fulfilled; use the correct distribution in predicting the variables relevant for their decisions; know the “model” of the economy. The models in this family use computational methods to map the model to match stylized facts about an economy. Given the strong assumptions on the behavior, the descriptive and predictive power of such models are somewhat limited.
The main solution concepts of economic models reflect the deductive reasoning. There are limitations with the approach in economics in par- ticular. This is probably a special case of a more general claim raised by Max Weber: “He argues that ‘law-like’ generalizations are not suitable to understand social world. The knowledge of ‘laws’ is of great value as heuris- tic means.”1 On the other hand, there are difficulties with the inductive reasoning. In particular, as Hume observed the induction problem: the induction cannot be justified and it is a contingent method.2
A possible resolution is to view economic models as analogies. Instead of offering general rules or theories that should be contrasted with data, economists often analyze models that are “theoretical cases” helping under- stand problems by drawing analogies between the model and the prob- lem. In this view, models, empirical data and experimental results (as well as cases and realization in history, case studies in law, and applied political science work) are all cases to which a given problem can be compared. The judgement of similarity calls for an interdisciplinary view on social interac- tions or a systematic interaction between inductive and deductive inference.