Thursday, April 7, 2011

The problem of micro-imperialism in economics

A couple days ago, in this blog post, I asked which of three labor markets were in a recession. My answer is - "I don't know, I don't have enough information". Hopefully, this revised figure helps explain why (assume, as the last piece of information, that every one of these economies has 15 people in it):

We have been trained to think that "unemployment" means "labor surplus". It doesn't. "Unemployment" means "the amount of people who want to work that aren't working". That is not the surplus gap between labor supply and labor demand. That is, in micro-speak, every point on the labor supply curve to the upper right of the labor market equilibrium. They don't know that their reservation wage is above equilibrium, and even if they did know that, since when has having your wage above the market equilibrium disqualified you from being considered "unemployed"? This is one of many examples of the intellectual imperialism of microeconomics in economics. Labor surpluses have nothing to do with unemployment or recessions - employment levels do. Labor surpluses tell you something about the likely behavior of wages and employment in the future, and perhaps about social welfare. There's nothing about labor surpluses that is of necessity relevant to the business cycle.

One of the problems with the way macroeconomics is thought about and done is that people have taken "understanding the business cycle" to mean "understanding what causes labor surpluses". This leads them down the path of sticky wages or minimum wages. These things may indeed influence the business cycle, but that is not automatically implied by the fact that they create a microeconomic labor surpluses. Which economy would you rather live in? I'd rather live in an economy with higher welfare, higher dead-weight loss, and higher employment, than in an economy with lower welfare, lower dead-weight loss, and lower employment.

This mentality has even creeped its way into where it shouldn't: Keynesian macroeconomics. Ryan Murphy has a further discussion of my 1920-21 paper and one of the things he says is: "Keynes believed that full employment is the special case, but Keynes didn’t develop IS-LM. One of the most surprising developments in the development of IS-LM was that its “general” case WAS full employment, and it took special things to get you to unemployment. This is really where I fundamentally disagree with Kuehn." He then links to the New School for Social Research's history of thought website which also claims that the Neoclassical Synthesis version of the IS-LM "tended to yield the Neoclassical result of "full employment"". I realize I am going somewhat out on a limb by criticizing the team at the New School on this, but I think it's the wrong interpretation of the model. The IS-LM model tends to microeconomic labor market clearing. That is quite different from saying that it tends to full employment.

I don't think much of "microfoundations", at least as any kind of theoretical obligation. Clearly if we can produce a correspondence between microeconomics and macroeconomics, that's fantastic. But "macrofoundations" are just as important. Even someone interested in "microfoundations" shouldn't pursue that by trying to superimpose microeconomic concepts onto macroeconomic concepts inappropriately. "Labor surplus" has to do with (1.) welfare/efficiency questions, (2.) questions about equilibrating tendencies, and (3.) match efficiency questions (because there is a pool of workers ready to work at a given wage). It has nothing directly to do with the problem of unemployment (although certainly point (3.) in that list will indirectly impact unemployment).

UPDATE: Another good way to think about the microfoundation obsession in economics is to look at other sciences. In physics, for example, we don't say "relativity is inadequate because it isn't derived from particle physics". The search for a unified theory of physics isn't a search to reproduce relativity from particle physics - it's an effort to find a consistency between relativity and particle physics, so physicists don't have to say "we know relativity is true and we know particle physics is true, and we can talk about both of them but we don't know a good unified way of talking about how they're both true". That should be how economics should approach the question. We oughta explore a lot of macrofoundations of microeconomics, a lot of microfoundations of macroeconomics, and also simply some new ideas. In the meantime, it's silly to consider some ideas tentative because we haven't hit on a correspondence. So why do we obsess over microfoundations? I think it's because microeconomics happens at the individual level, so our brains privilege that and assume any knowledge of what happens at the individual level necessarily has a sort of priority over other knowledge. You don't have this in physics because neither particle physics nor relativity happen at "our level". You did have this in biology for a while - it took a lot of pushing to get biologists to stop thinking about the selection of specific organisms and instead think of selection of what was actually being reproduced: genes. We have a bias towards that which we know best: ourselves. That cognitive bias can lead to bad economics if it generates an obsession with microfoundations.

15 comments:

  1. Steve Weinberg once said that there is no unified theory in physics, because nearly every new discovery breaks old assumptions and it is impossible to lay down a fundamental base to all of them.

    Physicists want to have some first order principles in physics, from which everything shall be derived, but that is impossible so far.

    To quote Christopher Nolan's "The Prestige", "Exact science is not an exact science."

    If this is the case in physics, just imagine how much harder it will be with human beings, who are even further away from exact science!

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  2. And I'm not claiming that there will be or even should be a unified theory of anything - but clearly establishing some correspondence between any set of theories is a reasonable endeavor.

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  3. Do you think my point about labor markets and unemployment is sound?

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  4. Why are you asking me?! I am a college student, and you are a research associate!

    Just joking.

    Let me just think about it though.

    It's like...a guy hears that there is a job that pays $50/hr. He lines up among hundreds of people but the front 10 people get the job and dozens of the rest leave. Another guy would have only come if there was a job that paid $60/hr, so he never came to the line. But they both would be unemployed anyway. Right?

    PS: Funny thing. When I first saw the minimum wage chart in first year economics, I was confused by "unemployment" written across the labour surplus. I thought how exactly is that unemployment. I wish you had been my econ prof!

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  5. "I was confused by "unemployment" written across the labour surplus. I thought how exactly is that unemployment"

    YES!

    Well, if that was more than a couple months ago I would have gone through without thinking about it too.

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  6. We have been trained to think that "unemployment" means "labor surplus". It doesn't. "Unemployment" means "the amount of people who want to work that aren't working". That is not the surplus gap between labor supply and labor demand. That is, in micro-speak, every point on the labor supply curve to the upper right of the labor market equilibrium. They don't know that their reservation wage is above equilibrium, and even if they did know that, since when has having your wage above the market equilibrium disqualified you from being considered "unemployed"?

    Perhaps I am missing something here, but aren't you just describing the natural rate of unemployment? If so, I don't agree with your first sentence that I have highlighted...

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  7. stickman - Take equilibrium in the center - not because we have to, but because it's easy to talk about. If that level of labor demand is a long run equilibrium, then I suppose points to the upper right of equilibrium on the labor supply curve is the "natural rate of unemployment". Then again, if that demand for labor is below full employment, it's not clear it is the "natural rate of unemployment" (although some portion of it is).

    So what don't you agree with, that people think of "labor surplus" as "unemployment"? Certainly if you're doing the macro that Phelps or Friedman or Keynes did there's nothing about their work that puts you in this trap. I suppose I'm just commenting that a lot of people do fall into this trap. See this: http://en.wikipedia.org/wiki/Unemployment#Classical_unemployment

    They identify "unemployment" as the labor surplus. I'm sure this sort of thing has been reproduced a lot.

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  8. Speaking of nonsensical college economics, here is another example.

    My professor was explaining Abba Ptatchya Lerner's Index in class. Eager to try it out, I went back home, dug up internet statistics, and did some number crunching.

    Since eD of wheat is -0.04 and eD of a Ford car is -2.8, we see that a wheat farmer in Pakistan has a monopoly power of 2500%, while Ford has a monopoly power of 35.71%.

    I told this to my professor, and asked him how a poor wheat farmer could be a bigger monopoly than Ford Motoring Company.

    He had no response.

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  9. You have a very inelastic price elasticity of demand for wheat.

    What does that imply? Depends on what elasticity we're talking about. What is more likely:

    1. Wheat is an essential food for much of the world and even at very high prices they need and will pay for a certain amount to live, or

    2. An individual wheat provider is so indispensible that he can continue to charge very high prices and maintain his market share.

    Both imply price inelasticity of demand... the question is, which of those two situations is more plausible. Once you figure out which situation is more plausible, you will figure out to whom the price elasticity of demand is inelastic. Once you figure that out you can re-think the implications for the Lerner Index.

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  10. So what don't you agree with, that people think of "labor surplus" as "unemployment"? Certainly if you're doing the macro that Phelps or Friedman or Keynes did there's nothing about their work that puts you in this trap. I suppose I'm just commenting that a lot of people do fall into this trap.

    i) Yes and ii) Okay.
    :)
    FWIW, unemployment has always been a big issue in South Africa, so maybe that's why I'm particular on the definitions.

    Out of interest, did you agree with any of the comments from your previous post? I still think search theory plays a key explanatory role in reconciling, say, the different clearing wages in diagrams 1 and 3... i.e. high versus low.

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  11. @Prateek

    Completely unrelated, but I don't where else I'd say this... Congrats on the World Cup! (Assuming you are a cricket fan, of course.) Can we have Gary Kirsten back, now?

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  12. It was all fine except insofar as the surplus was called "unemployment" in my mind... in other words, there could be just as much, or more, or less unemployment in #2 as in #1 and #3.

    I don't know enough about how search theory is applied to the standard market framework. I would think the easiest way to think about it is an additional match cost - probably for both the firm and the worker - much like a tax wedge, which means that #3 could be a stable outcome because of search frictions.

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  13. Ah cricket... the sport we Americans forget exists unless you guys happen to bring it up :)

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  14. I, uh, did not know there was a World Cup.

    And you just made me check.

    And it turns out India just won its first World Cup in cricket in 28 years.

    Which is, I must admit, a big deal. So...uh...yeah.

    This is what happens when I don't read tabloids or mainstream newspapers and when I don't have a TV. I need to quit all these financial newspapers like Economic Times of India and international newspapers like The Economist for a while.

    I am now like an American who does not know who won the SuperBowl.

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  15. I, uh, did not know there was a World Cup.

    Serious? I thought that it would have been impossible to escape for anyone living in India... but that may just reflect my preconceived notions of Indians being cricket mad :)

    Daniel, you may already have seen this amusingly convoluted "explanation" of the game before.

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