Monday, May 12, 2014

Building Micro-foundations: Rules, Entrepreneurship, and Emergent Macro

In considering the appropriate framework for modeling a macroeconomics of market processes, consider two Austrian suppositions: humans act purposively and all social and economic phenomena are the result of individual action. As I have suggested before, a rule-based macroeconomics can include both of these. It allows us to include the entrepreneur in our analysis. As equilibrium is not part of this framework, we can integrate aspects of both Kirznerian and Schumpterian entrepreneurship. For Kirzner, the entrepreneur is guided “to nudge the market in the equilibrative direction” by the lure of pure profits and pain of pure losses (1997, 73).” Yet this inclusion of entrepreneur in the process of equilibration promotes an uncomfortable synthesis as “continual change in tastes, resource availabilities, and known technological possibilities always prevent the equilibrative process from proceeding anywhere near to completion (72).” Preference sets and profit opportunities exist in a kaleidic world where the fulfillment or change of one leads to changes in others. Thus, the entrepreneur operates in a world of uncertainty. It is as though she fires at a moving target whose velocity is inconsistent.

Kirzner’s entrepreneur suffers from “entrepreneurial error” whereas Schumpeter’s entrepreneur can move the economy away from equilibrium as she interrupts the plans of other entrepreneurs (Schumpeter 1982, 131-32, 225-36). According to his hypothesis, error is systematic. Respected entrepreneurs might lead others into a sector where they earn profits for an extended period of time. Presumably, this occurs in a sector where there exists, or is expected to exist, high demand. More entrepreneurs will follow and compete amongst one another to coordinate resources and nurturing innovation where it is most needed. Inevitably, failure must occur where entrepreneurs cluster as rates of return fall and borrowing costs increase. In every step, the decisions of an entrepreneur and the results of that decision exhibit an effect, whether small or large, on those with whom she competes and indirectly on the emergent macrophenomena that otherwise constrain her actions (Hodgson 1986). Equilibrium models fail to capture the kaleidic nature of the world in which we live.

At the heart of the work from Mises, Hayek, Schumpeter, and Kirzner is the interaction between individuals and institutions that emerge by the agglomeration of individuals’ actions. The trend of modern Austrian macroeconomics has not been in this direction. What is needed is not that Austrian economics “catch-up” to the modern paradigm, “but an effort to create the contemporary analytics that might have been created had Austrian macro theorizing continued to evolve since 1940 with the same robustness that it exhibited before 1940 (Wagner 2003, 98).” This revision must concentrate on rules that guide decision-making and human action and the emergent nature of institutions that constrain those rules. Only such a radical paradigm shift can procure substantive microfoundations. Building upon the examples of Schumpeter and Kirzner, we can begin to envision a world comprised not of homogeneous, perfectly informed agents subject to the calculus of optimization, but heterogeneous agents who are imperfectly informed, interpret information subjectively, and who persist in experimentation in order to pursue profit opportunities and avoid failure.

Those who endeavor to develop this research program might model in terms of agents with heterogeneous rule sets. Rules are the source of order that guide macroeconomic phenomena (Page 2008, 118). As Wagner (2011, 435-36) notes there is a difference between the order apparent in a parade, where many individuals act uniformly appearing to comprise a single or few units, and a piazza, where individuals are not coordinated externally, but manage to avoid one another. This occurs because individuals can coordinate amongst one another by creating complementary rule sets guiding their action. Scott Page describes the process in a story of a stampede:

In applying an equilibrium game theory model to explain dynamic phenomena, we’re doing the equivalent of using a snapshot to describe the behavior with the stampede. This snapshot cannot tell us what will happen next… the behavior of the bison during the stampede is rule based, not optimal, and it produces complex patterns not equilibria. (2008, 120)

The stampede is less complex than the piazza, as bison lack the degree of intentionality exhibited by humans, but the basic mechanism is the same. No one agent guides either process. Individual agents interact and produce emergent phenomena by their interactions. This logic applies to the actions of and interactions between entrepreneurs and the macro phenomena that result from these. These phenomena are not objects of choice that can be appropriately studied with macroeconomic equilibrium models, at least not with these models alone. Nor can they be studied by assuming that the modeler knows - even only in the probabilistic sense – the ends that individuals will move toward. We do not know what will result from these interactions. A rule-based macroeconomics allows for this open-endedness that complex systems engender.

Hodgson, Geoff. “Behind Methodological Individualism.” Cambridge Journal of Economic 10 (1986): 211-224.

Kirzner, Israel. “Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach.” Journal of Economic Literature 35, no. 1 (March 1997): 60-85.

Page, Scott. “Uncertainty, Difficulty, and Complexity.” Journal of Theoretical Politics 20 (2008) : 115-149.

Schumpeter, Joseph. The Theory of Economic Development. New Brunswick, NJ: Transaction Publishers, 1982.

Wagner, Richard. “Institutions, Emergence, and Macro Theorizing: A Review Essay on Roger Garrison’s Time and MoneyThe Review of Austrian Economics 16, no. 1 (2003): 97-112.

Wagner, Richard. “A Macro Economy as an Ecology of Plans.” Journal of Economic Behavior and Organization 82 (2011): 433-444.