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Keeping the Macro wars out of Micro

Paul Krugman has a post in which he joins Peter Dorman in blaming Micro for Macro’s failures.   Given my last post, you might expect me to be a little miffed.   Ironically, though I often write about things I don’t know much about–the blog is supposed to be “practice” writing for me–this is a topic about which I really do know a great.   It involves my thesis.   Yet I don’t really have time to deal with the subject as it deserves.

Also, its  ironic because I’m on Krugman’s and Dorman’s side on most political issues.

What’s really interesting is that Krugman cites this paper to make  his case.   At the risk of violating PKIAR (“Paul Krugman is always right”), I’m going to have to point out that there are at least three problems with this.

That’s Science

Even if we take this research as Krugman has; it is not a sign of the weakness of micro theory, but a sign of strength.   You’re supposed to constantly test and re-test a theory to establish its empirical credibility.   Explanatory power is the key: if the theory works in most circumstances, than it is useful and scientific.   Truth is unimportant–let the philosophers worry about that.   Possible violations on the other hand–whether they bear fruit or not–lead to newer, better theories or deeper understanding.

The best possible place for a field to be in is to have a successful (empirically) theory in terms of broad–not necessarily universal!–explanatory power AND known violations.   High energy physics has been in a bit of a bind for several decades because the Standard Model of Particle Physics was TOO successful.   It is in this ideal point–a successful theory with possible violations–that micro theory now occupies.

As for microfoundations: well yeah if you assume that standard micro theory as it is applied in macro models is some kind of Deep-Truth-of-the-Universe… yes, then you’ll find that “micro theory” has led you astray.   Except it hasn’t: you’ve led yourselves astray by taking a theory as Truth which has no claim to the title.

In other fields reductionism is used to build the microfoundations for the theory and not the other way around.

That’s Standard

The Hasting/Shapiro claim that this is a violation of standard utility theory is, needless to say, dubious at best.   I’m a  fan of both guys and I could be convinced, but here’s the problem: this consumer behavior (keeping expenditure on a single good constant) is one of the easiest forms of behavior to reconcile with standard–even Econ 101 level–theory.   This is actually a common property.

It turns out that the absence of direct or indirect preference reversals is both necessary and sufficient for maximizing behavior.   A property call SARP (“Strong Axiom of Revealed Preference”).   What Hasting/Shapiro are trying to show is that there may in fact be a violation here.  Or at least that maintaining SARP would imply an implausibly large income effect.  It wouldn’t be the first claim to a violation of SARP, if true,but every attempt so far runs up against a hidden variable problem–you could say the ceteris is not paribus.

What Hastings/Shapiro seem, to me, to be doing is they are embracing the hidden variable.

Mental Accounting

So above I have a (toy) model of what they are thinking.   Our usual notion of what is “affordable” is not correct because it ignores the “cost” of “reoptimizing”.   If there is a shock to prices, then consumers habits are thrown off–the old habits are not affordable any long.   The consumer would like to do better, but she doesn’t know how, exactly–her plans have been upset and it will require effortful thinking to formulate new ones.   What is she to do?

Well, she does as well as she can do given her new money budget and her mental budget.   Well, there is a simple point that satisfies both–on just the edge!–which I marked ‘Z’.   It is right at the “kink” where her budget constraints meet.     Getting away from the silly picture, what could we say about the likely properties of ‘Z’ as opposed to other possibilities like ‘X’ and ‘Y’?

For one thing, Z would be at the point where expenditure on gas is unchanged, or as unchanged as possible, keeping other habits constant.   Why?   Because anything else would require her to re-optimize her demand for all other goods, which is a computationally expensive task.   On the other hand, the point ‘Y’ is in effect her setting aside more money than she strictly needs to in order to be certain that she can afford the rest of her “all other goods” basket–certainly a possibility, which would likely manifest in her expenditure falling.   While, finally, if she chose a point like ‘X’, there would be no observable consequences of her mental effort–my argument is that Hasting/Shapiro are unlikely to have eliminated the ‘X’-like possibility.

Given well-behaved utility, she would then have a strong tendency to prefer to point ‘Z’.    Hastings/Shapiro are saying that ‘Z’ is a more likely explanation than a pure money budget for their data than a point like ‘X’–in effect, the mental budget “binds” her choice.


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  1. May 30, 2014 at 5:24 pm

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