Arnold Kling  

Boettke on the Lamp Post Problem

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I recently came across Where Did Economics Go Wrong? Modern Economics as a Flight From Reality, published by Pete Boettke in Critical Review. Looking at its themes, you can see issues that I have dwelt on considerably on this blog. However, given that it appeared in 1997, it won't be Boettke who gets accused of plagiarism. For example, he writes,

we can usefully distinguish the older use of the equilibrium model as an ideal type from its use by free-market Chicago-school economists as a description of reality, as well as its use by interventionist Neo-Keynesians as a critical standard with which reality could be indicted when it failed to measure up. In the latter two uses of equilibrium, it constitutes a static ideal, and the question is whether reality does or does not match it. In the ideal-type use, by contrast, the question is how departures from the ideal type--denied by the Chicago school; equated with market "failure" by Neo-Keynesians--may constitute forms of incomplete success...disequilibrium is not necessarily a market failure; something less than perfection may yet be better than any attainable alternative.

Much later,

What both schools overlooked was the fact that equilibrium...could not possibly represent a dynamic world of time, ignorance, and uncertainty; but that the divergence between ideal and reality can highlight the ways reality may have institutionalized error-correcting properties that can, in fact, be seen as propelling the world in a direction reminiscent of general equilibrium. But like any ideal type, equilibrium is a postulate that is not necessarily effected in the real world.

The way I put it is "Markets Fail. Use Markets."

Another overlap with my concerns is what I call the lamp post problem. Boettke sees economists' use of formal models as blinding them to the "world of time, ignorance, and uncertainty."

As an example, consider the conventional treatment of the Great Depression as a market failure. The conventional economist looks at the 1930s and sees an economy that is not on its production possibility curve. But which production possibility curve should it be on? The production possibility curve of 1950, the next peace-time period of full employment, was not feasible in the 1930s. The physical capital was not available for the boom in suburbia that fueled post-war growth, nor was the human capital available for the clerical work that emerged.

On the other hand, the economy could have stayed on the production possibility curve of 1929. But that would not have been efficient. As Alexander Field pointed out in A Great Leap Forward (both Tyler Cowen and I put this among the best economics books of 2011), the production possibility curve shifted out in the 1930s--more than in any other decade, according to Field.

The PSST approach sees the unemployment of the 1930s and the outward shift of the production possibility curve as both reflecting the groping of entrepreneurs toward new patterns of sustainable specialization and trade. The conventional macroeconomist treats the higher production possibility curves as if they appear by a process of immaculate conception and sees the unemployment as a market failure.

The PSST approach is not easy to embed in a formal model. One can compare formal models to the lamp post in the old joke about a drunk who loses his watch in a dark place but decides to search for it somewhere else where there is a lamp post, because the light is better there.

For the economist, is it better to grope in the dark, meaning to discard formal models? Or is the better approach to strain to bring the lamp post to the likely place to find the watch? That is, should we attempt to formalize the issues of "time, ignorance, and uncertainty."

Boettke points out that attempts to use formal models in the "economics of information" wound up treating information as something that a consumer or entrepreneur can simply "pull off the shelf," perhaps by paying some cost. This serves to re-cast the problem into familiar equilibrium terms, But it does a poor job of representing the process of discovery, which I think is at the heart of the PSST approach to economic fluctuations.

So is there a way to make formal modeling a help, rather than a hindrance? Can the lamp post be moved to where the watch can be found?

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CATEGORIES: Economic Methods

COMMENTS (15 to date)
david writes:

The conventional economist looks at the 1930s and sees an economy that is not on its production possibility curve. But which production possibility curve should it be on?

It should be on a curve without 15% unemployment. This isn't really that difficult. You would have to be positing a rather chunky technology for there to be no viable patterns between 15% and 5% unemployment, even in the short-run.

There's a lot of work already done on the process of price groping; in general if you want "use markets rather than an auctioneering state board a la Oskar Lange" to be the conclusion, you really want to avoid positing deeply discontinuous technologies. Previous thinkers who have worried about price adjustment in general equilibrium tended to be socialist for good reason; it is very difficult to argue that individual profit-maximizing incentives line up in the right direction. You may recall the point Noah Smith made about PSST not having an invisible hand.

All this said - this is all rather philosophical when the most concrete thing about PSST that has been said invoked a two-good two-country international trade model. So much for avoiding formal modeling.

Eric Falkenstein writes:

I agree with much of your PSST approach, but your slogan needs work.

Alex Godofsky writes:

Seconding david, there's no logical reason that entrepreneurs could only possibly do that 'groping around' if we having 15% unemployment. How about staying on the 1929 production possibility frontier until they figure it out?

Silas Barta writes:

I was interested in David's reference to Noah Smith's point about PSST having no invisible hand, so I googled it, and I think this is the relevant blog post, just in case anyone else wanted to read about it.

(David, if there's a better post explaining Smith's point, feel free to link to it.)

Silas Barta writes:

@david & Alex_Godofsky: Conventional explanations, combined with PSST, suffice to explain the 15% unemployment rate. In a period of disruptive innovation, a lot of workers' marginal product drops. Until such workers can find a new sustainable comparative advantage, their best option may be to stay on for less money. But the policies at the time tried to keep wages from falling.

So you had (otherwise) highly productive workers resorting to selling "Hoover apples" on the street. These people would have almost certainly been better off working in a field where they had comparative advantage, as they'd be making more, even at a wage below what might have recently prevailed.

Nicholas Weininger writes:

For modeling time and uncertainty in information discovery, wouldn't stochastic simulation be a natural tool to use? So instead of information discovery being something you pay for, it's something in pursuit of which you roll a die. On a 6 you learn something useful, on a 2-5 you learn nothing, on a 1 you "learn" something which looks useful but turns out to be worse than useless. Those are probably the wrong weights (how to set the weights in a way that accurately reflects reality seems like a very hard problem!) but you get the idea.

Yancey Ward writes:

Dr. Kling,

I have not read the Field book, but I want to ask whether or not he means the 1930s saw the greatest movement of the production possibilities frontier, or whether it is just the case that it saw the greatest gap between what was possible and what was done?

Yancey Ward writes:
It should be on a curve without 15% unemployment. This isn't really that difficult. You would have to be positing a rather chunky technology for there to be no viable patterns between 15% and 5% unemployment, even in the short-run (emphasis added by Y.W.).

What is the short run and what is the long run? Why do you think the 1930s persisted with 15% unemployment when no other decade before it did? What had changed?

Matt writes:

I don't know much about models, but maybe you could borrow something from quantum physics and start thinking about putting models into probability distributions.

RPLong writes:

Models are great, so long as we are aware of the fact that they are models. In "Human Action," Mises makes routine references to economic models despite the fact that he seemed to be perfectly content with the fact that "equilibrium" doesn't really exist.

Markets don't "clear." There is always wiggle room to haggle. Just because I prefer 2 apples to 1 orange doesn't mean I always prefer twice as many apples as oranges. I might prefer 2 oranges to 3 apples.

It baffles me that economists have such a hard time accepting the fact that human desires aren't continuous functions. It is acceptable to assume continuity for the benefit of some models, but to take these models to be accurate descriptions of reality is utter lunacy.

Economics as a discipline would be much better off if people understood that continuity and equilibrium are attributes of models, not reality.

Critics of PSST and similar economic concepts will always have a problem with this because they genuinely believe that marginal utility is an actual mathematical derivative, rather than an intangible state of human psychology.

People will run as far away from this concept as possible because they are completely unwilling to relinquish the "convenient" assumptions of their toy models.

Alex Godofsky writes:

@Silas Barta: yes, and that gives us plenty of justification to use monetary policy to raise the price level, allowing real wages to fall. So where in this is a critique of conventional macro?

Silas Barta writes:

@Alex_Godofsky: Why not just stop jawboning businesses into keeping flat wages? And what about the costs of continually maintaining false illusions of purchasing power?

david writes:

@Silas Barta

Do you really think that the primary barrier to private-sector wage adjustment is political? There are plenty of rational, profit-maximizing reasons for firms not to pursue wage (and price!) adjustment in the short run.

There is no need to invoke money illusion if one accepts that nominal and real rigidities exist (as they seem to), anyway.

Becky Hargrove writes:

We have to be careful about the assumption that in ten or fifteen years "all will be okay". To be sure, there is the issue of unemployment in the present that is expected to remain, irregardless of political action. But the real long term issue is that we need ideas how to structure a better future that give us the confidence to invest in better social and economic structures now. In retrospect there were incredible positives of economic and social change in the Great Depression years. People found ways to survive even without jobs, for the most part. But people do not have the same strong familial units now, that were a part of that gradual recovery. In the present, often it's every person for himself in survival terms. That reality becomes even more of a problem in that economic solutions of all kinds tend to be structured for both familial units and the parts of the market that maintain their leverage at the expense of any other definition of market possibility. What that means is recovery could finally come when many baby boomers have just died off or given up, along with the generation that followed them.

What could keep such a bitter scenario from happening? We can likely get the better future we hope for if knowledge integration happens at the level of the local and the individual. There will be no economic recovery if countless parts of the world - yes even in the developed world, remain outside what is now defined as productive economic realms. Until such knowledge integration happens, knowledge of all kinds will be increasingly devalued, and people will increasingly devalue one another. Knowledge only works for humanity when it is allowed to be a part of both our social and economic lives.

Nathan Smith writes:

I think the best way to come up with a formal model of PSST will be along the lines of the second chapter of my dissertation, "Complexity, Competition, and Growth":

I use a new method of formal modeling, namely, agent-based simulation. One feature of this is that the assumption of equilibrium is dropped. As I explain in the paper, a sort of quasi-equilibrium obtains most of the time, and for certain specifications it closely matches the Walrasian equilibrium. But it is more general than Walrasian equilibrium, which-- little known but very important fact-- DOES NOT EXIST (at least, usually does not exist) when there are any non-convexities in the underlying functional forms.

In my model, there are a large number of goods, each of which enters into a taste-for-variety utility function and has fixed costs of production. Agents have an incentive to specialize because of the fixed costs, but only if they can trade with other agents in order to satisfy their taste for variety. What results is an endogenous division of labor and economies of scale at the macro level. I overturn the Solow model result that capital accumulation cannot fuel long-run growth; capital is subject to diminishing returns, but these are offset by gains from specialization and trade.

I arrive at a different interpretation of technological change from that pioneered by Paul Romer. In my model, technological change can occurred without the discovery of any new technologies, merely by "exploring the technology space," that is, exploiting technologies that are already "known" (probably to specialists rather than to the general public) but are not economically viable until a certain amount of capital and/or market scale is available.

I think this is the formal model Kling is looking for. It might take some modification but the deep problems have been solved. One of these days I've got to find the time to get it into the journals.

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